Other Modes of

Financing

BLOCK 5
STRATEGIC FINANCING DECISIONS

259
Long Term
Financing Decisions BLOCK 5 INTRODUCTION
In today’s competitive environment, just having a good product line and high
sales is just not enough, in order to translate these advantages into healthy
and robust bottom-line the companies has to constantly scan the economic
environment and respond as per the requirements of the environment.

This block deals with Strategic Financing Decisions, which implies that how
the financing decisions of companies can impart a competitive edge to the
companies over their competitors, i.e. Reliance & Infosys. The former by
way of distributing liberal dividends and bonus share has been able to build a
very strong investor base for itself. In case of Infosys the transparency in its
Operations has attracted a lot of domestic and foreign investors, The net
result of this is that both of the companies are able to raise funds from both
domestic and foreign sources at quite a low rate as compared to the
companies operating in the same industry.

Unit 13 deals with Capital Restructuring. The rapid change in the economic
variables i.e. interest rate, cost of capital, increasing integration of world
markets, has put pressure on the companies to change their capital structure.
This enables the companies to have a low cost of capital. In order to have a
low operating and financial cost the companies have to restructure
themselves in terms of capital structure, hiving of non-core business and by
takeovers and mergers

Unit 14 deals with Financial Engineering. The first half of the unit deals with
the factors that lead to the growth of financial engineering and what is the
financial engineering process. The second half of the unit deals with the
application of financial engineering to the equity, debt derivative products.

Unit 15 Investors Relations deals with the Corporate Form of Business

Organisation and what are the information demanded by the system from
these organizations. In order to make an informed decision the investors,
creditors, bankers, government etc. requires information, which is not usually
disclosed by financial statements therefore the companies are changing the
reporting formats and also shifting to universally accepted accounting
standards. By providing the full information companies also adhere to code
of corporate governance. Apart from information providing quality, services
to the investors also form a part of investor’s relations.

260
UNIT 13 CAPITAL RESTRUCTURING Capital
Restructuring

Objectives
The objectives of this unit are to:
• provide an understanding of concept, motives and dimensions of
corporate restructuring;
• explain concept, forms and motives of mergers;
• assess merger as a source of value addition;
• provide an understanding of criteria for determining exchanges rate;
• explain process entailed in formulating merger and acquisition strategy;
• throw light on divestiture and its financial assessment;
• explain leveraged buyout, leveraged recapitalization, spin-offs, carve-
outs, reorganization of capital and financial reconstruction.

Structure

13.1 Introduction
13.2 Corporate Restructuring
13.3 Financial Restructuring
13.4 Assessing Merger as a Source of a Value Addition
13.5 Formulating Merger and Acquisition Strategy
13.6 Regulation of Mergers and Takeovers in India
13.7 Takeover Strategies – Indian Experience
13.8 Divestitures
13.9 Characteristics of and Pre-requisites to Leveraged Buyout Success
13.10 Leveraged Recapitalization
13.11 Reorganization of Capital
13.12 Financial Reconstruction
13.13 Summary
13.14 Key Words
13.15 Self-Assessment Questions
13.16 Further Readings

13.1 INTRODUCTION
The world has witnessed tectonic and tumultuous changes during the last two
decades in terms of unification of Germany, rising economic power of Japan 261
Strategic Financing
Decisions
and NICs in the world market, dismantling of the erstwhile USSR,
emergence of new trade blocks, realignment of economic forces such as the
unification of the European Community, the North American Market,
ASEAN, etc; formation of WTO and far reaching changes in global trading
regulations prescribed by it, growing economic inter dependencies and
globalization of markets, free flow of capital and knowledge, following
economic liberalization, greater interactions among different financial
systems of different countries, faster growth in world trade, integration of
world financial markets at unprecedented reforms across the East European
and South Asian Countries, and path breaking proliferation and convergence
of technologies. These changes along with fast changing demographics of
work force, cataclysmic change in personal, social, familial and cultural
values of people and rapidly moving customer’s tastes have not only
increased business complexities but also rendered global business scenario
much more volatile and fairly competitive. To cope with the incredible
opportunities and enhance shareowners’ wealth, business enterprises across
the globe embarked on programmes of restructuring and alliance Corporate
restructuring is an important tool for increasing firm value and allocating
capital in efficient ways. Corporate restructuring stems from a system of
checks and balances on management and shareholders viz . if managers fail
to use assets and capital in a way that maximizes financial and operational
output, capital and assets can be transferred to different owners and/or
managers who are better capable of maximizing the value of these assets
Corporate restructuring aims to gain efficiency and increase overall value
either by pooling or separating assets within a given market, thus exploiting
potential synergies. Corporate value can also be enhanced by changing the
financing (capital structure) of companies.

To meet competitive challenges from the foray of multinationals following

liberalization, privatization and globalization and to ensure their survival
Indian corporate giants such as Tatas, A V Birlas, Reliance, HLL, SBI ,Adani
group, LIC have, of late, pursued, the strategy of restructuring their assets,
products, technologies, market and manpower resulting in spate of mergers
and acquisitions in recent years (Table 13.1).

Table 13.1: Mergers & Acquisitions

Year No. Of Transaction No. Of Transaction

M&A Value In(Billion $) Private Value
Deals Equity
Deals
2017 432 29.5 935 30.7
2018 442 47.7 1069 41.1
2019 453 33.5 1104 40.4
2020 332 38.3 954 44.00
2021 806 48.9 1258 66..1

262
13.2 CORPORATE RESTRUCTURING Capital
Restructuring

a) Concept of Restructuring

Paul Romer, the Stanford economist, remarked: “A crisis is a terrible

thing to waste.”

Most of the times need for corporate restructuring arises due to crisis on
the financial front or operational front or changes in macroeconomic
environment or changes on the technological front.

These changes provide both opportunity and challenges to corporate.

Those who choose to turn crisis into opportunity make suitable changes
while others who lack the agility either become insolvent or acquired by
others.

Corporate restructuring is a process of redefining the basic line of

business and discovering a common thread for the firm’s existence and
consolidation. Thus, restructuring is a process by which a corporate
enterprise seeks to alter what it owes, refocus itself to specific tasks
performance. This it does after making a detailed analysis of itself at a
point of time. At times restructuring would radically alter a firm’s
product market mix, capital structure, asset mix and organization so as to
enhance the value of the firm and attain competitive edge on sustainable
basis. While planning for restructuring, the management should specify
what type of business the firm can do most effectively. Those business/
market areas, which offer little or no potential, should be removed from
the basic business structure. Others having unsatisfactory earnings, poor
competitive position or management incapability should also be
discontinued.

b) Motives for Restructuring

Corporate enterprises are motivated to restructure themselves in view of
the following forces:
i) The Government policy of liberalization, privatization and globalization
spurred many Indian organizations to restructure their product mix,
market, technologies etc. so as to meet the competitive challenges in
terms of cost, quality and delivery. Many organizations pursued the
strategy of accessing new market and customer segment. Convertibility
of rupee has encouraged many medium – sized companies to operate in
the global market.
• Revolution in information technology facilitated companies to adopt new
changes in the field of communication for improving corporate
performance.
• Wrong diversification and divisionalization strategy has led many
organizations to revamp themselves. New business embraced by
companies in the past had to be dropped because of their irrelevance in
the changed environment. Product divisions, which do not fit into
company’s care business, are being divested. 263
Strategic Financing
Decisions
• Improved productivity and cost reduction have necessitated downsizing
of the workforce.

• Another plausible reason for restructuring is improved management.

Some companies are suffering because of inefficient management. Such
companies opted for change in top management.

• At times, organizations are motivated to reorganize their financial

structure for improving the financial strength and improving operating
performance.

c) Dimension of Restructuring

Corporate restructuring is a broad umbrella that covers the following:

a) Financial Restructuring: This involves decisions pertaining to

acquisition, mergers, divestitures, leveraged buyout, leveraged
recapitalization, reorganization of capital, etc.

b) Technological Restructuring: This involves decisions pertaining to

redesigning the business process through revamping existing technologies.

c) Market Restructuring: This involves decisions regarding product –

market positioning to suit the changed situations.

d) Organizational Restructuring: During the post liberalization period

many Indian firms embarked on organizational restructuring programme
through regrouping the existing businesses into a few compact business
units, decentralization and delayering, downsizing, outsourcing non-
value adding activities and subcontracting.

You may please note that a good restructuring exercise consists of a mixture
of all these. These alterations have a significant impact on the firm’s balance
sheet or by exploiting unused financial capacity.

Activity 1

1) List out the five primary forces that forced Indian corporate to engage in
restructuring exercises.

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

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

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

2) Name three top business groups in India, which embarked on

restructuring programmes.

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

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

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

264
13.3 FINANCIAL RESTRUCTURING Capital
Restructuring

Concept of Financial Restructuring

Financial restructuring is the process of reorganizing the company by

affecting major changes in ownership pattern, asset mix, operations that are
outside the ordinary course of business. Thus, financial restructuring covers
many things such as the mergers and takeovers, divestitures, leveraged,
recapitalization, spin- offs, curve-outs, reorganization of capital and financial
re-construction. Let us dilate upon each of these aspects.

Mergers and Takeovers Concept

A company intending to acquire another company may buy the assets or

stock or may combine with the latter. Thus, acquisition of an organization is
accomplished either through the process of merger or through the takeover
route.

Merger is combination of two or more companies into a single company

where one survives and the others lose their identity or a new company is
formed.

The survivor acquires the assets as well as liabilities of the merged company.
As a result of a merger, if one company survives and others lose their
independent entity, it is a case of ‘Absorption’. But if a new company comes
into existence because of merger, it is a process of ‘Amalgamation’.

Takeover is the purchase by one company of a controlling interest in the

share capital of another existing company. In takeover, both the companies
retain their separate legal entity. A takeover is resorted to gain control over a
company while companies are amalgamated to derive advantage of scale of
operations, achieve rapid growth and expansion and build strong managerial
and technological competence so as to ensure higher value to shareowners.
Indian takeover kings are R P Goenka, Chabria, Khaitan, Kumar Mangalam
Birla and London based Swaraj Paul.

Forms

Horizontal Merger

A horizontal merger is one that takes place between two firms in the same
line of business. This type of merger can have significant impact on the
market if the merged entity is going to have a significant market share and
can also pave way for further consolidation in the industry by merger of other
competing firms

Merger of Hindustan Lever with TOMCO and Global Telecom Services Ltd.
with Atlas Telecom, GEC with EEC are examples of Horizontal Merger.
Merger of Vodafone India and Idea Cellular Limited, is another example of
Horizontal merger between two telecommunication companies. These
companies came together to face challenge from a more powerful company
having deep financial pockets and latest technological advantage.
265
Strategic Financing
Decisions
Vertical Merger

Vertical Merger takes place when firms in successive stages of the same
industry are integrated. Vertical Merger may be backward, forward or both
ways. Backward merger refers moving closer to the source of raw materials
in their beginning form. Merger of Renusagar Power Supply and Hindalco is
a case in point. Forward merger refers to moving closer to the ultimate
customer. DU Pont acquired a chain of stores that sold chemical products at
the retail level for increased control and influence of its distribution.

Conglomerate Merger

Conglomerate Merger is a fusion in unrelated lines of business. The main

reason for this type of merger is to seek diversification for the surviving
company. Conglomerate mergers occur where two merging firms are in the
same general industry like travel and leisure, fast moving consumer goods,
scientific and calibration equipments but they have no mutual buyer/customer
or supplier relationship between themselves. It is the merger of two
companies that have no related products or markets. In short, they have no
common business ties. The rationale behind such merger is usually
diversification of risk.

There are two types of a conglomerate merger:

i. A pure conglomerate merger is between two companies that are totally
unrelated and that operate in distinct markets.
ii. A mixed conglomerate merger is between companies that are aiming to
expand product lines or target markets.

Example: Merger between Thomas Cook India Limited and Sterling Holiday
Resorts (India) Limited is an example of a conglomerate merger as both the
companies were involved in the tourism industry but their customer-bases
and process chains were unrelated. Another example is the merger of Brooke
Bond Lipton operating mostly in food products with Hindustan Lever, which
at that point of time was into personal hygiene products and detergents.

Market-extension merger

A market-extension merger is a merger between companies that sell the same

products or services but that operate in different markets. The goal of a
market-extension merger is to gain access to a larger market and thus ensure
a bigger customer base.

Example: Merger between Mittal Steel and Arcelor Steel, a Luxembourg-

based steel company, is an example of market-extension merger.

Product-extension merger

A product-extension merger is a merger between companies that sell related

products or services and that operate in the same market. It is important to
note that the products and services of both companies are not the same, but
266
they are related. A classic example of such merger is PepsiCo's merger with Capital
Restructuring
Pizza Hut. Both companies worked in the same sector i.e., food and
beverages industry, and sold related but not the same products.

Reverse Merger
It occurs when firms want to take advantage of tax savings under the Income
Tax Act (Section 72A) so that a healthy and profitable company is allowed
the benefit of carry forward losses when merged with a sick company. Godrej
soaps, which merged with the loss-making Godrej Innovative Chemicals is
an example of reverse merger.

Reverse merger can also occur when regulatory requirements need one to
become one kind of company or another. For example, the reverse merger of
ICICI into ICICI Bank.

Motives for Mergers

(i)To Avail Operating Economics

Firms are merged to derive operating economies in terms of elimination of

duplicate facilities, reduction of cost, increased efficiency, and better
utilization of capacities and adoption of latest technology. Operating
economies at the staff level can be achieved through centralization or
combination of such departmental as personnel accounting, advertising and
finance, which are common to both organizations. Merger of Reliance
Petrochemicals with Reliance Industries was aimed at enhancing
shareholders’ value by realizing

significant synergies of both the companies. Similarly, amalgamation of Asea

Ltd with Asea Browns Bover (ABB) was intended to avail of the benefits of
rationalization and synergy effects.
(ii) To Achieve Accelerated Growth
Both horizontal and vertical combination take place to achieve growth at
higher rate than the one accomplished through its normal process of internal
expansion. In fact, mergers and takeovers have played pivotal role in the
growth of most of the leading corporations of the world. Nearly two-thirds
of the giant public corporations in the USA are the outcome of mergers and
acquisitions.
(iii) To Take Advantage of Complementary Resources
It is in the vital interest of two firms to merge if they have complementary
resources each has each other needs. The two firms are worth more together
than apart because each acquires something it does not have and gets it
cheaper than it would by acting on its own. Also the merger may open up
opportunities that neither firm would pursue otherwise.
(iv) To Speed Up Diversification
Many companies join together to reduce business risk through diversification
of their operations. By merging with relatively more stable enterprise, a
267
Strategic Financing
Decisions
company prone to wide cyclical swings may be able to minimize the degree
of instability in its earnings and improve its performance. Similarly, a small
company may be hesitant to launch a new product with a high potential
market because of high-risk exposure to the projects, the potential loss will
not be as significant to the surviving company as to the small one. Recent
alliances of Jenson and Nicholson India Ltd. with Carl Scheneek A G, and

J K Corporation with Mitel of Canada are examples of acquisition based on

diversification motive.

(v) To Combat Competitive Threats

Majority of the recent mergers struck in India were motivated to thwart

competitive challenges both from domestic as well as multinational
companies and achieve competitive edge over the rivals. The fear of
increasing competitive resulting from the tie up between Procter and Gamble
and Godrej Soaps forced Hindustan Lever to merge with TOMCO.

Recent alliance between Max India and GIST–Brocades has made to convert
potential competitor into a partner.
To Access Latest Technology
Many organizations have, of late, forged alliances with foreign firms so as to
gain access to latest product technology cheaply. Tata Telecom tie up with
AT&T, Maruti-Suzuki alliance, Caltex alliance with IBP were made
essentially to secure latest technology.
To Widen Market Base
In recent few years’ large number of firms forged alliances with specific
purpose of globalising the firm’s products. Tie-ups between HCL and HP
Ltd, Tata-IBM, Ranbaxy Laboratories and Eli Lilly, Parle and Coco-Cola,
Hindustan Motors and General Motors, DCM Data and Control Data of USA,
Tata Tea and Tetelay of USA and Onida and JVC have been made to exploit
tremendous market opportunities of foreign countries.
To Strengthen Financial Position
Another cogent motive for the merger may be to mitigate the financial
problem. A company embarking on the expansion programme may find it
difficult to satisfy its requirements owing to temporary imbalance in its cash
flows, capital structure or working capital position. By joining with a stable,
unlevered cash rich company a firm may present a consolidated picture of the
financial position that will be more appealing to potential investors.
Merger of Renu Sagar Power Supply and Hindal Co and ICICI with ICICI
Bank are cases in point.

To Avail Tax Shields

A firm with accumulated losses and/or unabsorbed depreciation would like to

merge with a profit making company to utilize tax advantages better for a
long time.
268
To Utilize Surplus Funds Capital
Restructuring
At times, a firm in a mature industry having generated a substantial amount
of cash may not find adequate profitable investment opportunities.

Management of such firms may be tempted to acquire another company

shares. Such firms often turn to mergers financed by cash as a way of
redeploying their capital.

To Acquire Competent Management

When a firm finds that it is not a position to hire top quality management and
that it has none to come up through the ranks, it may seek merger with a firm
endowed with sapient and savvy management.

To Strengthen Controlling Power

Acquisition of profit making companies by Indian businesspersons like

Kumar Mangalam Birla, Ratan Tata, Mukesh Ambani, R P Goenka, G P
Goenka, Piramals, Modis, Ruias, Khaitan, etc. took place to get hold of the
controlling interest through open offer of market prices.

13.4 ASSESSING MERGER AS A SOURCE OF

VALUE ADDITION

While taking decision whether to acquire a firm, finance manager of a firm

must ensure that this step would add value to the firm. For this purpose he
has to follow the procedure laid down below:

• Determine if there is an economic gain from the merger. There is an

economic gain only if the two firms are worth more together than apart.
Thus, economic gain of the merger is the difference between the present
value (PV) of the combined entity (Pvxy) and the present value of the
two entities if they remain separate (Pvx + pvy). Hence,

Gain = Pvxy – (Pvx+Pvy)

• Determine the cost of acquiring firm Y. If payment is made in cash, the
cost of acquiring Y is equal to the cash payment minus Y’s value as a
separate entity. Thus,
Cost = Cash paid – Pvy
• Determine the net present value to X of a merger with Y. It is measured
by the difference between the gain and cost. Thus,
NPV = gain – cost
= ∆ Pvxy – (Cash–Pvy)
If the difference is positive, it would be advisable to go ahead with the
merger.

269
Strategic Financing
Decisions
Example 1
Firm X has a value of Rs. 400 crore, and Y has a value of Rs. 100 crore.
Merging the two would allow cost savings with a present value of Rs. 50
crore. This is the gain from the merger. Thus,
Pvx = Rs. 400 crore Pvy = Rs. 100 crore
Gain = ∆ Pvxy = Rs. 50 crore Pvxy = Rs. 550 crore
Suppose that Firm Y is bought for cash, say for Rs. 130 crore. The cost of
merger is:
Cost = Cash paid – Pvy
= Rs. 130 crore – Rs. 100 crore = Rs. 30 crore
Note that the owners of firm Y are ahead by Rs. 30 crore. Y’s gain will be
X’s cost. Y has captured Rs. 30 crore of Rs. 50 crore-merger gain. Firm X’s
gain will, therefore, be:
NPV = Rs. 50 crore – Rs. 30 crore = Rs. 20 crore
In other words, firm’s X’s worth in the beginning is Pv = Rs. 400 crore. Its
worth after the merger comes to Pv = Rs. 400 crore and then it has to pay out
Rs. 130 crore to Y’s stockholders. Net gain of X’s owners is
NPV = Wealth with merger – Wealth without merger
= (Pvxy–cash) – Pvx
= (Rs. 550 crore – Rs.30 crore) – Rs. 400 crore = Rs. 20 crore

In the above procedure, the target firm’s market value (Pvy) is taken into
consideration along with the changes in cash flow that would result from the
merger. It should be noted that it would be incorrect to undertake merger
analysis on the basis of forecast of the target firm’s future cash flows in terms
of incremental revenue or cost reductions attributable to the merger and then
discount them back to the present and compare with the purchase price. This
is for the fact that there are chances of large errors in valuing a business. The
estimated net gain may come up positive not because the merger makes sense
but simply because the analyst’s cash flow forecasts are too optimistic.

Estimating Cost When the Merger is financed by Stock

In the preceding discussion our assumption was that the acquiring firm pays
cash compensation to the acquired firm. In real life, compensation is usually
paid in stock. In such a situation, cost depends on the value of the shares in
new company received by the shareholders of the selling company. If the
sellers receive N shares, each worth Pxy, the cost is:
Cost = NX Pxy – Pvy 7
Let us consider an example:

270
Example 2 Capital
Restructuring

Firm X is planning to acquire firm Y, the relevant financial details of the two
firms prior to the merger announcement are:

X Y
Market Price per share Rs. 100 Rs. 40
Number of shares Rs. 50,000 Rs. 2,50,000
Market value of the firm Rs. 50 lakh Rs. 10 lakh

The merger deal is expected to bring gains, which have a present value of Rs.
10 lakh. Firm X offers 125,000 shares in exchange for 250,000 shares to the
shareholders of firm Y.

The apparent cost of acquiring firm Y is:

125,000 X 100 – 10,000,000 = Rs. 25,00,000

However, the apparent cost may not be the true cost. X’ stock price in Rs.
100 before the merger announcement. At the announcement it ought to go up.

The true cost, when Y’s shareholders get a fraction of the share capital of the
combined firm, is equal to:

Cost = aPvxy – Pvy

In the above example, the share of Y in the combined entity will be:

a = 12,50,000/5,00,000 + 1,25,000 = 0.2

Terms of Merger
While designing the terms of merger management of both the firms would
insist on the exchange ratio that preserves the wealth of their shareholders.
The acquired firm (Firm X) would, therefore, like that the price per share of
the combined firm is atleast equal to the price per share of the firm X.
Pxy = Px (1)
The market price per share of the combined firm (XY) is denoted as the
product of price earnings ratio and earnings per share:
Pxy = (PExy) (EPSxy) = Px (2)
The earnings per share of the combined firm is denoted as:
EPSxy = Ex+Ey/Sx+Sy(Erx) (3)
Here Erx represents the number of shares of firm X given in lieu of one share
of firm Y. Accordingly, Eq. 2 may be restated as:
Px = (Pexy)(Ex+Ey)/Sx+Sy(Erx) (4)
Solving Eq. 4 for Erx yields:
Erx = –Sx/Sy + (Ex+Ey) (Pexy)/PxSy 271
Strategic Financing
Decisions
Let us explain the process of determination of exchange rate with the help of
an example:
Example 3
X corporation is contemplating to acquire Y corporation. Financial
information about the firms are set out below:
X Y
Total current earnings E Rs. 10 lakhs Rs. 4 lakhs
Number of shares 5 lakhs 2 lakhs
outstanding, S
Market Price Per Share,P Rs. 6 Rs. 4
Determine the maximum exchange ratio acceptable to the shareholders of X
corporation if the P/E ratio of the combined entity is 3 and there is no
synergy. What is the minimum exchange ratio acceptable to the shareholders
of Y corporation if the P/E ratio of the combined entity is 2 and there is
synergy benefit of 5%?
Solution:
1) Maximum exchange ratio from the Point of the shareholders of X
corporation
ERx = –Sx/Sy + PExy (Exy)/PxSy
= –5 lakh/2 lakh + 3X 14lakh/6X2lakh
= 1.0
2) Minimum exchange ratio from the point of view of the Y shareholders:
ERy = PySx / (Pxy) Exy – PySy
= 4X5lakh/2X (14lakhX1.05) – 4X2lakh
= 20 lakh/14.70 lakh – 8 lakh
= 0.3
Criteria for Determining Exchange Ratio
Commonly used criteria for establishing exchange ratio are earnings per
share (EPS), market price per share and book value per share.
Earnings per share reflect, the earning power of a firm. However, it does not
take into consideration the difference in the growth rate of earnings of the
two firms, gains stemming out of merger and the differential risks associated
with the earnings of the two firms. Further, EPS cannot be the basis if it is
negative.
Market price per share can also be the basis for determining exchange ratio.
This measure is very useful where the shares of the firms are actively traded.
Otherwise, market prices may not be very reliable. There is also possibility of
manipulation of market process by those having a vested interest.

272
As regards utility of book value per share as the basis for determining Capital
Restructuring
exchange ratio, it may be noted that book values do not reflect changes in
purchasing power of money as also true economic values.
Takeovers
Financial restructuring via takeover generally implies the acquisition of a
certain block of equity share capital of a firm, which enables the acquirer to
exercise control over the affairs of the company. It is not always necessary to
buy more than 50% of the equity share capital to enjoy control since effective
control can be exercised with a remaining portion is widely diffused among
the shareholders who are scattered and ill-organized.
Some of the major takeovers in the Indian corporate world are:
HLL : Modern Foods
HINDALCO : INDAL
Sterlite Industries : Hindustan Zinc
Chhabrias : Shaw Wallace
Tatas : CMC
Hindujas : Ashok Leyland
Goenkas : Calcutta Electric Supply Company
Wipro : Ner Ve Wire
Satyam : India World
Gujarat Ambuja : DLF Cement
Major Mergers in India in Recent Times
Name of the Merged Company Deal Value
Company
Vodafone Vodafone India $23 billion
Idea VI &Idea Cellular Ltd
Hindustan Glaxo Smith Kline Rs.317 billion
Unilever Ltd. Consumer Health
Care
Indus Tower Bharti Infratel Vodafone Idea received
Ltd. Rs.376 Cr for its 11.5%
stake
Arcelor Arcelor Steel &Mittal $38.3 billion
Mittal Steel
Talace(Tata Air India Rs. 18000 Crore
group
subsidiary)
Wipro Capco $ 1.5 billion
273
Strategic Financing
Decisions HDFC Life Exide Life Insurance Rs. 6,687 crore
Tata Steel Corus $12.02 billion
Wal-Mart Flipkart $16 billion for 77% stake
Zomato Ubereats $350 million
Zomato Blinkit Rs.4448 Crore
Tata Motors Jaguar & Land Rover $2.3 billion
division of Ford
Motors

FORMULATING MERGER AND ACQUISITION

STRATEGY

Mergers and acquisition should be planned carefully since they may not
always be helpful to the organizations seeking expansion and consolidation
and strengthening of financial position. Studies made by Mc Kinsey & Co.
show that during a given 10-year period, only 23 percent of the mergers
ended up recovering the costs incurred in the deal, much less shimmering
synergistic heights of glory. The American Management Association
examined 54 big mergers in the late 1980s and found that about half of them
lead straight down hill in productivity and profits or both.

Broadly speaking, acquisition strategy should be developed along the

following lines:

1. Laying down Objectives and Criteria

A firm embarking upon a strategy of expansion through acquisition must

lay down acquisition objectives and criteria. These criteria sum up the
acquisition requirements including the type of organization to be
acquired and the type of efforts required in the process. Laying down the
corporate objectives and the acquisition criteria ensures that resources
are not dissipated on an acquisition when these might more profitably be
used to expand existing business activities.

2. Assessing Corporate Competence

A detailed and dispassionate study of the firm’s own capabilities should

form an integral part of acquisition planning. Such a study is done to
make sure that the firm possesses the necessary competence to carry out
the acquisition programme successfully. Once the corporate strengths
have been formulated the management should appoint an adhoc task
force with a member of the top management team to head this body and
functional executives on its members to carry out the pre-acquisition
analysis, negotiate with the prospective firm and integrate the firm,
perform post-acquisition tasks and monitor acquisition results.

274
3. Locating Companies to Acquire Capital
Restructuring
Before undertaking search process the central management should
consider a number of factors, which have their significant bearing on the
aquisition. Some of these factors are listed below:

1. Choice of Company: A firm keen to takeover another company should

look for companies with high growth potential and shortlist firms with
large assets, low capital bases with fully depreciated assets or with large
tracts of real estate or securities.

2. Type of Diversification: Success of acquisition also depends on form of

diversification. Success has been reported mostly in horizontal
acquisitions, where the company purchased belonged to the same
product-market as the acquirer. Success rate in the case of vertical
integrations has been relatively lower. Further, marketing-inspired
diversifications appeared to offer the lowest risk, but acquisitions
motivated by the desire to take advantage of a common technology had
the highest failure rate of all. Pure conglomerate acquisitions, which tend
to be in low technology industries, had a lower overall failure rate than
all forms of acquisition except horizontal purchases.

3. Market Share: Another variable influencing acquisition success is the

market share. Higher the market share, greater the success of acquisition
move. Kitching’s study reveals that acquisition with market shares of
less than 5 percent for diversification moves had failure rates of over 50
percent.

4. Size of Purchase: The size of an acquired firm in relation to the acquirer

is an important determinant of acquisition success. The possibility of
success increases with increase in size of the acquisition because
acquisition of a large firm is likely to bring about material change in
corporate performance. For large purchases, management makes a
determined effort to ensure that the new acquisition achieves the results
expected of it quickly.

5. Profitability of Acquisitions: Success of acquisition also depends upon

profitability of the firm being acquired. Acquiring a loss-making firm
may not ensure success unless the acquiring firm is equipped with a
skilled management, capable of handling such situations. It may,
therefore, be in firms are not available for sale or require the payment of
such a premium as to make their acquisitions unattractive. Acquisition of
highly promising organizations may be resisted by the host country
governments. The firm may go for low profit organizations if they are at
the bottom of their business cycle or when the unprofitable assets are
broken up and disposed off to return more than the purchase price or
where there are tax shields of losses to be carry forward or other similar
financial advantages.

Keeping in view the above factors, the acquiring firm should ascertain
what the potential firm can be for the organization which it cannot do on
275
Strategic Financing
Decisions
its own, what the organization can do for the potential firm, what it
cannot do itself, what direct and tangible benefits or improvements
results from acquiring the potential firm and what is the intangible value
of these saving to the organization. In the same way, legal procedures
involved in acquisition must begin through in detail.

An enormous amount of information pertaining to the above aspects

gathered over a period of time is indispensable to a firm with an active
continuous acquisition programme. Commercial data are not readily
available everywhere. Financial data in particular is not reliable in some
countries due to varying accounting conventions and standards, local tax
patterns and financial market requirements. However, this should not
deter management from going ahead with its plan of acquiring overseas
firms. The desired information can be gathered particularly through
information service organizations such as Business International and
Economic Intelligence Unit, non-competing firms and from various
international publications like International Yellow Pages, the Exporter’s
and Directories of manufacturers, importers and other kinds of business
in world markets.

4. Evaluating the Prospective Candidates for Acquisition

After identifying firms according to the specification, the task force

should evaluate each of the prospective candidates to pick out the one
that suits most of the needs of the acquiring company. The following
aspects should receive attention of the evaluator:

5. General Background of the Potential Candidates

The background information of each of the identified companies about

the nature of business, past year business performance, product range,
fixed assets, sales policy, capital base, ownership, management structure,
directors and principal officers and the recent changes in regard to the
above should be collected and sifted in terms of the interests of the
acquiring company.

It will also be useful to scan the current organizational structure and

climate of the perspective firms. The focus of the study should be on
strength of labour, their skills, labour unions and their relations with
management. Departmentation of the firms, extent of delegation of
authority, communication channels, wage and incentive structure, job
evaluation etc.

6. Appraisal of Operation of the Potential Candidates

The task force should scan the location of the plants of the company, its
machines and equipments and their productivity, replacement needs,
operating capacity and actual capacity being used, critical bottlenecks,
volume of production by product line, production costs in relation to sale
price, quality, stage in life cycle, production control, inventory
management policies, stores procedures, and plant management
276
 competence. It may be helpful to appraise research and development Capital
Restructuring
capability of managing production lines and competence in distributing
products.

It will also be useful to undertake detailed appraisal of the product

purchasing organization and its competence, major suppliers and
materials supplied by them, prices being charged and alternative sources.
It should also be found out if there have been instances of bad buying,
overstocking, large stock write offs, slow ‘moving stock.’

Evaluator should assess the operations of the firm from marketing point of
view. Thus, current policies of the firm pertaining to product, pricing,
packaging, promotion and distribution and recent changes therein, channels
of distribution, sales force and its composition, markets served in terms of the
share held, nature of consumers, consumer loyalty, geographical distribution
of consumers should be kept in view. Identification of major competitors and
their market share are source of the critical aspects the must receive attention
of the evaluator.

13.6 REGULATION OF MERGERS AND TAKE

OVERS IN INDIA
Mergers and acquisition may lead to exploitation of minority shareholders,
may also stifle competition and encourage monopoly and monopolist
corporate behavior. Therefore, most of the countries have their own legal
framework to regulate the merger and acquisition activities. Previously in
India, merger and acquisition were regulated through the provision of
companies Act 1956, the monopolies and restrictive trade practices
(MRTP) Act 1969, the Foreign exchange regulation Act (FERA) 1973, the
income tax Act 1961, and the securities and exchange board of India (SEBI)
also regulates mergers and acquisition (take over).In the present times
mergers and takeovers are regulated through the Companies Act (2013), The
Competition Act (2002), Foreign Exchange Management Act (FEMA 2002),
Income Tax Act, 1961 and most importantly the SEBI regulations regarding
Substantial Acquisition of Shares and Takeover (2014)

Legal Measures Against Takeover:

The company’s act restricts an individual or a group of people or a company

in acquiring shares in public limited company to 25 percent (including the
share held earlier) of the total paid up capital. However, the control group
needs to be informed whenever such holding exceeds 10 percent. Whenever
the company, or group of individuals or individuals acquires the share of
another company in excess of the limits should take the approval of the
shareholders and the Government.

In case of a hostile takeover bid companies have been given power to refuse
to register the transfer of shares and the company should inform the transfere
and transfer within 60 days. Hostile takeover is said to have taken place in
case if
277
Strategic Financing
Decisions
• legal requirements relating to the transfer of share have not be complied
with or
• the transfer is in contravention of law or
• the transfer is prohibited by Court order
• the transfer is not in the interests of the company and the public
Protection of minority shareholders interests
The interest of all the shareholders should be protected by offering the same
high price that is offered to the large shareholders. Financial Institutions,
banks and few individuals may get most of the benefits because of their
accessibility to the process of the take-over deal market. It may be too late
for small investor before he knows about the proposal. The company act
provides that a purchaser can force the minority shareholders to sell their
shares if.

1. The offer has been made to the shareholders of the company.

2. The offer has been approved by at least 90 percent of the shareholders

when transfer is involved within four months of making the offer.

STRATEGIES AGAINST HOSTILE TAKEOVER

One of the main features of modern capitalist system is transfer of assets to

the most efficient users upon payment of adequate consideration. This
process of transfer can be easily hampered if there is misalignment among the
various stack holders. Generally those companies having high value of assets,
unique process and products and low stock valuation are targets of
acquisition and mergers. The embedded value of the company is not reflected
in the stock price, but at the same time other informed companies perceive
valve and tries to take over the company. In such cases the existing managers
may adopt preventive and defensive strategies against hostile takeover bids.
Few of such strategies are as follows.

The Poison Pill in Its Many Variations

The poison pill also known as “shareholder rights plans,” allow a company to
issue new shares to existing shareholders at a discount of the actual share
price.

The basic tactic in this strategy is to increase the number of existing shares
(floating stock) thereby the acquirer will have to shell a greater amount of
money to take the control of the company One of the strategy is to issue
convertible preferred stock. The shares are issued to shareholders at a
discount, granting the existing shareholders the right to convert the preferred
stock into common stock upon successful completion of a hostile takeover.

Another strategy is to give right to the existing shareholders, which allows

existing shareholders to buy at a discount the newly issued stock of the
combined entity after a successful takeover. This is also known as “flip-over”
pill, or “shareholder rights plan.”

278
Another strategy also known as the “flip-in” pill, involves issuing rights to Capital
Restructuring
the target’s existing shareholders to buy stock of the target company at a
substantial discount before a takeover attempt.

Golden, Silver, and Tin Parachutes

In this kind of strategy the target company tries to make the takeover
prohibitively expensive for the acquirer to take over the company. This is
done by incorporating severance agreements in their corporate bylaws setting
forth termination arrangements of senior management personnel’s
accompanied with large lump-sum payments for such personnel’s. This
agreements are triggered in the case of a forced change of control (Hostile
Takeover).

This can be an effective defense strategy if the value of a corporation is

strongly dependent on the skills of specific employees or management. The
very same agreement with variation in lump sum pay out for middle level
managers and employees is called as Silver Parachute. Tin parachutes contain
provisions that grant monetary benefits to every employee following a
change of control.

Staggered Boards of Directors

A widely used and very effective preventive strategy is staggering a

company’s board of directors, also known as “classifying” a board. This
basically means that the board members are elected not in one go but in
phases. If this provision is in place it will prohibit electing all board members
(or at least the majority) in one setting (i.e., at one shareholder assembly).
Even if the acquiring company is able to obtain enough voting rights to
successfully replace the board members of the target company, it will not be
able to have a majority board in place.

REMEDIAL DEFENSE TACTICS

The above-mentioned strategies were preventive in nature, but when

management of target company becomes aware that a hostile takeover
attempt is under way, target management can use various strategies designed
to fend off the attempt. Hostile takeovers are usually by the companies to
supplement and complement their existing know how, production facilities,
brands, products, or market share and through merger bidder hopes to create
synergies that will increase the economic value of the combined entity post
merger. Therefore, the remedial defensive strategies focus on tactics aimed at
destroying these potential synergies by eliminating the item of interest and
decreasing the economic value of the target. Few of these strategies are as
follows:

“Scorched-Earth” or “Jonestown” Strategies

“Scorched-earth” or “Jonestown” defenses is designed for the economic

destruction of the target company through its management and is
accomplished by striping the target company of its important assets,
employees, and cash to make it as unattractive as possible to the bidder. One
way of doing this is to sale the crown jewel of the company, which may be a 279
Strategic Financing
Decisions
production facility, research division, product division, or right to important
raw materials etc. This strategy is also known as suicide pill.

White Knights and Squires

In this strategy instead of bidder being given the majority shares by the
company a third party is given the majority shares and this third party is
known as “white knight” or “white squire” The bid of the white knight is
supported by the target company with lockup provisions or call option–like
agreements on the target’s stock. These agreements serve to protect . A white
squire is similar to a white knight except that it only buys a large minority
stake in the target company in exchange for special voting rights.

Guidelines for Takeovers:

A listing agreement of the stock exchange contains the guidelines of

takeovers. The salient features of the guidelines are:

1. Notification to the Stock Exchange: If an individual or a company

acquires 5 percent or more of the voting capital of a company the stock
exchange shall be notified within 2 days of such acquisition.
2. Limit to Share Acquisition: An individual or a company, which
continues acquiring the shares of another company without making any
offer to share holders until the individual, or the company acquires 10
percent of the voting capital.
3. Public Offer: If this limit is exceeded a public offer to purchase a
minimum of 20 percent of the shares shall be made to the remaining
shareholders.
4. Offer Price: The offer price should not be less than the highest price
paid in the paid in the past 6 months or the negotiated price.
Disclosure: The offer should disclose the detailed terms of offer in details of
existing holding.

Offer Document: The offer document should contains the offer and financial
information. The companies act guidelines for takeover are to ensure full
disclosure about the merger and take over and to protect the interests of the
shareholders.

The following in the legal procedure for merger or acquisitions laid out in the
Companies Act 2013.

Permission for Merger: Two or more companies can amalgamate only

when amalgamation is permitted under their memorandum of association. If
the memorandum of association does not contain this clause it is necessary to
seek the permission of the shareholder’s board of directors and the company
law board before affecting the merger.

Information to the Stock Exchange: The acquiring and acquired companies

should inform the stock exchange where they are listed about the merger.

280
Approval of Board of Directors: The Board of Directors of the individual Capital
Restructuring
companies should approve the draft proposal for merger and authorize the
management to further to pursue the proposal.

Application in the High Court: An application for approving the draft

amalgamation proposal duly approved by the board of directors of the
individual companies should be made to the high court. The high court would
convene the meeting of the shareholders and creditors to approve the
amalgamation proposal. The notice of meeting should be sent to them at least
21 days in advance.

Shareholders and Creditors Meetings: The individual companies should

hold corporate meetings of their shareholders and creditors for approving the
merger scheme. A minimum of 75 percent of shareholders and creditors in
separate meetings by voting in person or by proxy must accord approval to
the scheme.

Sanction by the High Court: After the approval of shareholders and

creditors on the petitions of the companies the high court will pass order
sanctioning the amalgamation scheme after it is satisfied that the scheme is
fair and reasonable. It can modify the scheme if it deems fit so.

Filling of the Court Order: After the court order its certified true copies
will have to be filled with the Registrar of companies.

Transfer of Assets and Liabilities: The assets and liabilities of the acquired
company will exchange shares and debentures of the acquired company of
accordance with the approved scheme.

Payment by Cash or Securities: As per the proposal the acquiring company

will exchange shares and debentures and or pay cash for the shares and
debentures of the acquired company. These securities will be listed on the
stock exchange.

13.7 TAKE OVER STRATEGIES: INDIAN

EXPERIENCE
The takeover strategies involve successful identification and takeover of
another corporation. However, it entails complex legal and financial action
on the part of the acquiring firm when a firm’s strategy is to seek external
growth through acquisition. This is generally done by the firm’s top
management, legal staff, and bankers and even outside consultants who
specialise in recommending workable corporate unions.

As financial analyst, we must have a way to evaluate mergers and

acquisitions. The evaluator of acquisition should analyse the price paid for
acquisition and its impact on the shareholder’s wealth. The shareholders’
wealth is interpreted by different people in different ways. There are several
methods of wealth maximisation of shareholders. The tools and techniques
for the evaluation of mergers are also used in support of the executive
judgement and political process in corporations.
281
Strategic Financing
Decisions
When a company wants to acquire another company, its share holders have to
pay considerations to the shareholders of the company under acquisition.
This consideration is the value of the shares or assets of the company under
acquisition. The right kind of consideration to be paid its current market
value of the firm under acquisition. However, it is found in many of the
acquisitions that the current market value is minimum consideration to be
offered, if the consideration price to be paid is more than the current market
price is at premium. The premium may be paid because of the under
valuation of the shares or as an incentive to the shareholders of the company
under acquisition. This would enable the acquiring company to have the
controlling right of the acquired company.

In 1932 the Lever Brothers (INDIA) began its manufacturing activity in India
(now Hindustan Lever Ltd) taking over North West South Co with a capacity
of 2,250 tones. Over the years and till the mid fifties Lever similarly acquired
sick factories at various other sites. The govt. got tough in 1969 with the
MRTP Legislation making takeover virtually impossible.

In the early eighties the Government accorded high priority to the revival of
sick units and enacted laws like the Industrial Reconstruction Bank of India
Act and other Sick Industrial Legislation.

Lever quickly saw an opportunity in taking over and reviving a sick company
viz. Stephen Chemicals a Punjab based soaps and detergents firm. The
company was not in attractive shape, its outstanding debts stood at Rs. 6
crore and its Rs. 3 crore capital had been wiped out by losses. But that did
not deter Lever from 10,000 tons of detergents and 7,200 tones of soaps that
Stephen had capacities for when lever started the lease. The Rs. 200 crore-
company today rolls out more than 50,000 tones of soaps and detergents. The
high point of Stephen’s success game four years ago is in the forefront of
Lever war against Nirma, “Wheel” washing power. Lever’s successful
answer to Nirma challenge was produced by Stephen.

The Stephen acquisition was followed by a chain of other sick units, which
Lever snapped up and quickly revived.

Detergent Bar Manufacturer Jon. Home products and Sunrise Chemicals, a

soap company in Rajkot. There is also a unique case of Shivalik cellulose a
Gujarat based paper plant, which was set up in seventies, but turned sick
though it was a paper plant. Lever was interested. Taking Shivalik on a 24
years lease with an option to buy after five years; Lever turned the paper
plant into a 30,000 tones soap plant has kicked of production recently.

TOMCO is Rs. 4,460 million turn over (1992) company and Lever’s Rs.
20,000 million.

Lever would control one-third of three million tones soaps and detergents
markets by this merger. Some competitors of Lever think that it will
eliminate competition but management of Lever, however, felt that the
merger would result into a strategic fit in many areas such as brand
positioning, manufacturing locations, geographical reach and distribution
network. Tomco has four manufacturing plants and large distributive network
282
covering 2,400 stockists and nine million outlets. It is strong in South. Capital
Restructuring
Merger would have many benefits for Tomco, which is reported to have
incurred a loss of Rs. 66 million for the first six months of 1992-1993. It was
Lever’s nearest rival but lagged much behind in the eighties. A number of
attempts by management to revive Tomco through diversification did not
succeed. The acquisition of Tomco by the Lever to gain market leadership
and dominance is seen strategically important in view of the intensifying
competition following strategic alliance between Godrej soaps and the
American multinational, Procter and Gamble.

Already most of Tomco’s brands Hamam, Moti, the 501 range of laundry
soaps range have been re-launched. Tomco takeover has helped on
capitalizing on new brand like Tomco hair Oil, Nihar and Tomco’s eau de
cologne.

With the new takeover code, the Indian corporate are experiencing the wave
of merger and acquisitions. The new legal framework governing the merger
and take over opened the doors to hostile takeover. The market for corporate
control has exploded, with merger and acquisitions being accepted as means
of corporate restructuring and redirecting capital towards efficient
management.

The ideal opportunity for takeover is when the share prices are depressed due
to variety of reasons. Nowadays the financial institutions are also ready to
sell their stock at good prices. They are no more interested in protecting the
existing promoters, in the recent half a dozen mergers and acquisitions. The
Rs. 8,342/- crore Hindustan Lever resurfaced with the negotiated acquisition
of the Rs. 59,11 crore LAKME from the Rs. 35,000 crore TATA GROUP the
Rs. 1,162 crore Indian Aluminum was targeted by Rs. 1,146 Sterlite
Industries by targeting 20 percent stock in the former one. Immediately
alarmed by this, Indian Aluminum targeted the Rs. 162 crore Pennar
Aluminum. In Pharmaceuticals, the Rs. 400 crore Wockhard targeted Rs. 200
crore Merind. The cement Industry saw a major restructuring bid as the Rs.
832 crore India Cements managed to take over the Rs. 349 crore Raasi
Cements.

Indian Cements Ltd.

The Chennai based cements major India Cements Ltd. (ICL) has pulled off a
quite coup in its bid to acquire Raasi Cement Ltd by winning over the
fighting main promoter and chair Dr. B.V. Raju ICL originally held 9.75
percent stake in RCL. Later it acquired 8.28 percent from Mr. M.K.P. Raju,
2.23 percent from APIDC and 1.14 percent from a Chennai based share
broking firm. The promoters of RCL sold their 32 percent equity to ICL. ICL
and its associates on the verge of picking up 8 percent from a transport
contractor who is also an the board of Raasi. ICL now plan to go ahead with
an open offer to mop up 20 percent at the earlier offered price of Rs. 300.
This will increase the total Stake in Raasi to nearly 78 percent. Dr. B. v Raju,
managing Director of Raasi said the “The present take over regulation do not
give protection to technocrat promoter who cannot have large stake in
companies. 283
Strategic Financing
Decisions
Financials 1996-97 (Rs. Crores)

India Cements Raasi Cements

Sales 632.50 410.19
Gross Profit 126.65 42.20
Net Profit 82.58 22.83
Equity 64.34 16.31
EPS (Rs) 12.83 13.99

The regulations should be modified to protect the technocrat entrepreneurs

and the government should seriously consider of introducing the buyback of
shares.”

While the merger and acquisition may become direction less and corporate
conglomerates may end up with unanticipated added costs instead of
anticipated economies of scale, the benefits of a successful acquisition are
powerful, offering dominant market share, the strength of sheer size and
unique competitive advantage. But how does the bidder for takeover know
beforehand whether the acquisition he is targeting will be worth the price he
has to pay?

Activity 1

Bharat Chemicals Ltd. is planning to merge Modern Fertilizers Ltd. Bharat

Chemicals has approached you to advise in this regard. Putting yourself in
the position of a financial consultant:

a) What information would you like to collect from the firms?

b) How would you evaluate feasibility of the proposal?

c) What important criteria would you take into account to determine

exchange rate between the two firms?

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

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

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

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

13.8 DIVESTITURES

While mergers and acquisitions lead to expansion of business in some way or

the other, divestiture move involves some sort of contraction of business.

Divestiture as form of corporate restructuring signifies the transfer of

ownership of a unit, division or a plant to someone else. Sale of its cement
division by Coromandel Fertilizers Ltd. to India Cements Ltd. is an example
of divestiture.
284
Divestiture strategy is pursued generally by highly diversified firms who Capital
Restructuring
have had difficulty in managing broad diversification and have elected to
divest certain of their businesses to focus their total attention and resources
on a lesser number of core businesses. Divesting such businesses frees
resources that can be used to reduce debt, to support expansion of the
remaining business, or to make acquisitions that materially strengthen the
company’s competitive position in one or more of the remaining core
business. For instance, A V Birla group divested a publicly announced paper
and chemicals project and a seawater magnesia unit in Visakapatnam and
MRPL a petrochemicals Joint Venture with HPCL, so as to strengthen its
core business.

Before taking a final decision, finance manager should assess if it is in the

interest of the firm to do so.

Financial Assessment of a Divestiture

Financial assessment of divestiture proposition involved the following steps:
• Estimate the post-tax cash flow of the selling firm with and without
divestiture of the unit in question.
• Establish the discount rate for the unit on the basis of cost of capital of
some firms engaged in the same line of business.
• Compute the unit’s present value, using the discount rate, as determined
above.
• Find the market value of the unit’s specific liabilities in terms of present
value of the obligations arising from the liabilities of the unit.
• Determine the value of the selling firm’s ownership position in the unit
by deducting market value of the unit’s liabilities from the present value
of its cash flow.
• Compare the value of ownership position (VOP) with the proceeds from
the divestiture (PD). PD represents compensation received by the selling
firm for giving up its ownership in the unit. Hence, the decision rule will
be:
PD > VOP = Sell the unit
PD = VOP = Be indifferent
PD < VOP = Retain the unit

13.9 LEVERAGED BUYOUT

Leveraged buyout (LBO) is an important form of financial restructuring
which represents transfer of an ownership consummated heavily with debt.
LBO involves an acquisition of a division of a company or sometime other
sub unit. At times, it entails the acquisition of an entire company.

285
Strategic Financing
Decisions
Characteristics of LBO

1. A large proposition of the purchase price in debt financed.

2. The debt is secured by the assets of the enterprise involved.

3. The debt is not intended to be permanent. It is designed to be paid down.

4. The sale is to the management of the division being sold.

5. Leveraged buyouts are cash purchases, as opposed to stock purchases.

6. The business unit involved invariably becomes a privately held

company.

Pre-requisites to Success of LBO

1. The company must have a several year window of opportunity where

major expenditures can be deferred. Often it is a company having gone
through a heavy capital expenditure programme and whose plant is
modern.

2. For the first several years, cash flows must be dedicated to debt service.
If the company has subsidiary assets that can be sold without adversely
impacting the core business, this may be attractive because sale of such
assets provides cash for debt service in the initial years.

3. The company must have stable, predictable operating cash flows.

4. The company should have adequate physical assets and/or brand names,
which in times of need may lead to cash flows.

5. Highly competent and experienced management is critical to the success

of LBO.

Example 5

Modern Manufacturing Ltd. (MML) has four divisions, viz; Chemical,

Cement, Fertilizers and Food. The Company desires to divest the Food
Division. The assets of this division have a book value of Rs. 240 lakh. The
replacement value of the assets is Rs. 340 lakh. If the division is liquidated,
the assets would fetch only Rs. 190 lakh. MML has decided to sell the
division if it gets Rs. 220 lakh in cash. The four top divisional executives are
willing to acquire the division through a leveraged buyout. They are able to
come up with only Rs. 6 lakh in personal capital among them. They approach
a finance consultant for financial assistance for the project.

The Finance Consultant prepares projections for the Food division on the
assumption that it will be run independently by the Four executives. The
consultant works out that cash flows of the division can support debt of Rs.
200 lakh it finds a finance company that is willing to lend Rs. 170 lakh for
the project. It has also located a private investor who is ready to invest Rs. 24
lakh in the equity if this project. Thus, the Food division of MML is acquired
by an independent company run by the four key executives, which is funded
286
through debt to the tune of Rs. 170 lakh and equity participation of Rs. 30 Capital
Restructuring
lakh.

In the above case, two forms of funds are employed:

Debt (Rs. 170 lakh) and equity (Rs. 30 lakh). Thus, LBO permits going
private with only moderate equity. The assets of the acquired division are
used to secure a large amount of debt. The equity holders are, of course,
residual owners. If things move as per plans and the debt is serviced
according to schedule, after 5 years they will own a healthy company with a
moderate debt. In any LBO, the first several years are key. If the company
can repay debt regularly, the interest burden declines resulting in improved
operating earnings.

Two types of risks involved in LBO are: business risk – arising out of
unsatisfactory performance of the company and the consequent failure to
service the debt – and interest rate risk arising out of changing interest rates,
which may, in case of sharp rise, involve increased financial burden.

Thus, the equity owners are playing a high-risk game and the principle of
leverage being a double-edged weapon becomes evident. Another potential to
service debt is the focus on short-run profitability. This may have telling
effect on the long-term survival and success of the organization.

13.10 LEVERAGED RECAPITALIZATION

Another kind of financial restructuring is leveraged recapitalization (LR). LR
is a process of raising funds through increased leverage and using the cash so
raised to distribute to equity owners, often by means of dividend. In this
transaction, management and other insiders do not participate in the payout
but take additional shares instead. As a result, their proportional ownership of
the company increases sharply.

LR is similar to LBO in as much as high degree of leverage is incorporated in

the company and the managers are given a greater stake in the business via
stock options or direct ownership of shares. However, LR allows company to
remain public unlike LBO, which converts public traded company into
private one.

As for the potentiality of LR as a means of value addition to the company,

LR has been found to have a salutary effect on management efficiency due to
high leverage and a greater equity stake. Under the discipline of debt, internal
organization changes may take place, which may lead to improvements in
operating performance.

Spin-Offs

A spin-off, as a form of restructuring, involves creation of a new,

independent company by detaching part of a parent company’s assets and
operations. Shares in the new company are distributed to the parent
company’s stockholders.
287
Strategic Financing
Decisions
Spin-offs widen investors’ choices by allowing them to invest in just one part
of the business. More important, spin-offs can motivate managers to perform
better. By spinning-off those businesses, which do not fit the company’s core
competence, the management of the parent company can concentrate on its
main business. If the businesses are independent, it is easier to see the value
and performance of each and reward managers accordingly. Investors feel
relieved from the worry that funds will be siphoned from one business to
support unprofitable capital investment another.

Announcement of a spin-off is generally greeted as good news by investors

who reward the focus and penalize scope, scale and diversification. Spin-off
is considered as a way of protecting the Crown Jewel from a predator. In
increases the competence of core business and keeps away the unwanted
activities resulting in improved profitability of the parent company.

Carve-Outs

Carve-outs are similar to spin-off with one exception that shares in the new
company are sold in public instead of distributing them among existing
equity owners. Carve outs result in new cash flows.

Although carve-outs share many of the virtues of spin-offs, the same depends
on whether a majority stake is sold so that the new company operates
independently. Sale of a minority stake leaves the parent company is control
and may not reassure without the investors who worry about lack of focus or
poor fit.

But at times a minority carve-out can create a market for the subsidiary
shares and allows compensation schemes based on management ownership of
shares or stock options.

13.11 REORGANIZATION OF CAPITAL

Reorganization of Capital refers to the restructuring of company by affecting

change in the capital structure of the company with a view to improving its
financial strength. It is an adjustment of gearing i.e. debt-equity ratio of the
company so as to maximize the wealth of the shareowners.

Despite careful financial planning, a firm may be constrained to bring about

certain adjustments in its capital structure because of changes in business
climate, fluctuation of interest rates need to avoid unwanted leverage or to
eliminate a bond issue carrying prohibitively restrictive features and similar
other situations.

In reorganization of capital a firm attempts to reduce total debt by reducing

fixed charges through raising fresh equity share capital. But when the equity
is higher, the cost of serving also tends to be higher which can be reduced by
relying more on debt for financing further expansion programmes. Firm may,
therefore, think of reducing fixed burden of debt financing through voluntary
extinction of bonds, extinction through refunding, extinction through
288
redemption and extinction through conversion. Capital
Restructuring

Extinction Through Refunding

Refunding means substituting old bonds by new bond issue. The
management uses this method to take advantage of cheaper sources of
financing. When interest rate in the market drops and the management
believes that the firm can sell new bonds at a lower rate of interest than that
being paid on outstanding debts. Sometimes, to avoid bonds carrying
unfavourable terms, the management may be tempted to substitute old bonds
by new ones. Also, a firm which borrowed funds in its initial years at higher
cost because of its weak financial position may find subsequently when it
gains strength that it can procure loans at cheaper cost and at convenient
terms.

Accordingly, the firm may take recourse to refunding as a means of reducing

its cost of capital. The management may also use refunding to consolidate
several existing bond issues to simplify their management. Among these
reasons, however, refunding is generally resorted to reduce cost of servicing
debt and to improve earnings per share of the firm.

Before refunding an outstanding bond the finance manager must determine

whether or not refunding is profitable. Accordingly he must, as in capital
budgeting decision, match the costs of refunding against receipts as a result
of the refunding operation. It is only when receipts exceed costs, the
management should proceed ahead with refunding operation otherwise the
idea of refunding must be dropped.

Extinction Through Redemption

Redemption is the actual paying off the debt. Through redemption, the firm
extinguishes the bonded debt absolutely. this is possible only when bond
issues contain call privilege giving the firm the option to buy back the bonds
at a stated price before their maturity. The bond indenture provides the prices,
which the firm pay the bondholder for a bond called for redemption before
their maturity. Generally, this redemption price is greater than the par value
of the bond. The actual price is fixed taking into account par value of the
bond plus a reasonable premium. This bonus is provided to enable the
bondholder whose bond has been called for redemption to take time to find
another profitable investment for his money without suffering any loss of
interest.

When bonds are redeemed, the firm needs cash to take them up. There are
two methods of providing the cash, viz; (i) voluntary setting aside of moneys
in such amounts as make it possible to meet the bonds when they are to be
paid and (ii) putting aside of a sinking fund to pay off the bonds. While the
former is done by the management as a matter of business and financial
policy and not because of any agreement with bondholders, the latter is made
obligatory by the terms of the bond indenture.

289
Strategic Financing
Decisions
Extinction Through Conversion

Management may sometimes convert bonds into stocks in order to simplify

capital structure and also to get rid of bonded indebtedness and the fixed
interest charges associated with it. When a firm converts its bonds, it does not
require cash to pay to the bondholders. When bonds are converted into stock,
bondholders become owner of the firm and bonded indebtedness is wiped
out.

This is possible only when bond issue is convertible. The conversion

privilege is exercised almost without exception wholly at the option of the
bondholders.

However, the company may force conversion at a time when it is more

profitable for the bondholders to convert rather than surrender the bonds and
receive cash. Before deciding about conversion finance manager must
examine the impact of the transaction on the market value of the stock as the
decision criterion. Rate of conversion is provided in debt indenture. For
example, one Rs. 1000 par value bond may be exchanged for 10 shares of the
stock.

Sometimes the conversion basis is expressed by stating that the bonds are
convertible into stock at some specified figure, say Rs. 100, which means that
the stock is being valued for conversion purposes at Rs. 100 a share.

13.12 FINANCIAL RECONSTRUCTION

Financial reconstruction is the recasting of firm’s capital structure to reduce
the amount of fixed burden of leverage. Where firm has been suffering
operating losses for several years but has potential to recover in future and its
economic worth as an operating entity is greater than its liquidation value,
management may think of keeping the firm alive by changing its capital
structure.

The major difference between reorganization of capital and financial

reconstruction is that the former is resorted to for further improving financial
health of the firm but the latter is taken up when the firm is continuously
suffering losses and is heading towards liquidation.

Formulation of reconstruction plan involves three steps:

(i) Determine total valuation of the company by capitalization of

prospective earnings. For example, if future earnings of a company are
expected to be Rs. 4 lakh, and the overall capitalization rate of similar
companies average 10 percent, total value of Rs. 40 lakh would be set for
the company.

(ii) Determine new capital structure for the company to reduce fixed charges
so that there will be an adequate coverage margin. To reduce these fixed
charges, the total debt of the firm is reduced by shifting to income,
bonds, preferred stock and common stock. In addition, terms of the debt
may be changed. If it appears that the reconstructed company will need
290
 new financing in the future, a more conservative ratio of debt to equity Capital
Restructuring
may be thought of so as to provide for future financial flexibility.
(iii) Valuation of the old securities and their exchange for new securities. In
general, all senior claims on assets must be settled in full before a junior
claim can be settled. In the exchange process, bondholders must receive
the par value of their bonds in another security before there can be any
distribution to preferred stockholders. The total valuation figure arrived
at in step 1 sets an upper limit on the amount of securities that can be
issued.
The existing capital structure of a company undergoing reconstruction is
given as under:
Rs. in lakhs
Debentures 18
Subordinated debentures 6
Preferred stock 12
Common stock equity (book value) 20
Total Rs. 56
If the total valuation of the company is to be Rs. 40 lakh, the following could
be the new capital structure:

Rs. in lakhs
Debentures 6
Income bonds 12
Preferred stock 6
Common stock 16
Total Rs. 40
After deciding about the ‘appropriate’ capital structure for the company, the
new securities have got to be allocated. Thus, the debenture holders exchange
their Rs. 18 lakh in debentures for Rs. 6 lakh in new debentures and Rs. 12
lakh in income bonds, that the subordinated debenture holders exchange their
Rs.6 lakh in securities for preferred stock, and that preferred stock holders
exchange their securities for Rs. 12 lakh of common stockholders would then
be entitled to Rs. 4 lakh in stock in the reconstructed company, or 25 percent
of the total common stock of the reconstructed company.

Thus, exchange claim is settled in full before a junior claim is settled. In a

harsh reconstruction, debt instruments may be exchanged for common stock
in the newly reconstructed company and the old common stock may be
eliminated completely. Much depends on negotiation between the
management and claimholders.

291
Strategic Financing
Decisions 13.13 SUMMARY
In recent years majority of the Corporate Organizations across the globe
including India engaged in restructuring exercises so as to cope with
increased business complexities and uncertainties and improve their
competitive strength. Corporate restructuring exercises were financial,
technological and organizational in nature.

Mergers, acquisitions, takeovers, divestitures, spin-offs, leveraged buyouts,

leveraged recapitalization and financial reconstruction, as significant forms
of financial restructuring, have become a major force in the economic and
financial milieu all over the world.

Mergers, which subsume both absorption and consolidation, may take the
form of horizontal, vertical, conglomerate and reverse. The principle
economic rule for a merger is that value of the combined entity should be
greater than the sum of the independent values of the merging entities. The
most cogent reasons for merger are economies of scale, higher growth,
advantage of complementary resources, speedy diversification, and access to
latest technology, larger market base, and strong financial position and so on.
The net economic benefit of a merger is the difference between the present
value of the combined unit and the present value of the combining entities if
they remain independent.
A divestiture represents sale of division or plant or unit of one firm to
another. Divestiture decisions are driven by a variety of motives such as
raising capital, strategic realignment and efficiency gain. Since divestitures
have become common, management should scan their financial desirability
systematically and rationally.
LBO as a form of restructuring represents transfer of an ownership
consummated heavily with debt. It is a cash purchase as opposed to stock
purchase. The firm going for LBO must have stable, predictable operating
cash flows and should have adequate physical assets and/or brand names.
LR is a process of raising funds through increased leverage and using the
cash so raised to distribute to equity owners. It is similar to LBO in as much
as high degree of leverage is incorporated in the company. However, LR
allows the company to remain public unlike LBO, which converts public
traded Company into private one.
At times, a company suffering from operating losses and financial problem
may go for financial reconstruction to recast its capital structure to reduce the
amount of fixed burden of leverage. Financial reconstruction process
involves three main steps, viz; determination of total valuation of the
company, determination of new capital structure for the company to reduce
fixed charges and finally valuation of the old securities and their exchange
for new structures.

292
13.14 KEY WORDS Capital
Restructuring

Absorption: refers to a situation where a company survives and others lose

their identity.
Amalgamation: refers to a situation where a new company comes into
existence because of merger.
Take over: is the purchase by one company of a controlling interest in the
share capital of another existing company.
Divestiture: signifies the transfer of ownership of a unit, division or a plant
to someone else.
Leveraged buyout: represents transfer of an ownership consummated
heavily with debt.
Leveraged Recapitalization: is a process of raising funds through increased
leverage and using the cash so raised to distribute to equity owners.
Spin-offs: involve creation of a new, independent company by detaching part
of a parent company’s assets and operations.

13.15 SELF- ASSESSMENT QUESTIONS

1. What is corporate restructuring? What motivates an enterprise to engage
in restructuring exercise?
2. Discuss various forms of mergers. What are the driving forces for
mergers & acquisitions?
3. Discuss various steps involved in a merger.
4. What are the regulatory provisions in India regarding mergers and
acquisitions?
5. How would you assess merger as a source of value addition?
6. What is the cost of a merger from the point of the acquiring company?
7. How would you determine the present value of a merger from the point
of view of the acquiring company?
8. What are the important bases for determining the exchange ratio?
9. What are the salient features of divestitures? How would you assess
divestiture programme of a company?
10. What is leveraged buyout? How is it different from leveraged recapitalization?
11. Distinguish between spin-offs and carve-outs.
12. Under what circumstances does a firm reorganize its capital? What are
the various techniques of reorganization of capital?
13. Divya Sugar Mills plans to acquire Shubhra Sugar Mills. The relevant
financial information are:
293
Strategic Financing
Decisions Divya Sugar Mills Shubhra Sugar Mills
Market Price per share Rs. 140 Rs. 64
Number of outstanding 40 lakh 30 lakh
shares
The merger is expected to generate gains, which have a present value of
Rs. 400 lakh. The exchange rate agreed to is 0.5.
Compute the true cost of the merger from the view point of Divya Sugar
Mills.
14. Dolly Electronics is contemplating to merge Smriti Electronics. The
following data are available:
Dolly Electronics Smriti
Electronics
Total Current Earnings, E Rs. 100 lakh Rs. 40 lakh
Number of outstanding shares, 40 lakh 20 lakh
S
Market Price per share, P Rs. 30 Rs. 20
(i) What is the maximum exchange ratio acceptable to the owners of Dolly
Electronics if the P/E ratio of the combined entity is 12 and there is no
synergy gain?

(ii) What is the minimum exchange ratio acceptable to the shareholders of

Smriti Electronics if the P/E of the combined entity is 11 and there is a
synergy benefit of 5 percent?

13.16 FURTHER READINGS

J.F. Weston, K.S. Chung and J.A. Siu, Takeovers, Restructuring and
Corporate Finance, Prentice-Hall, upper saddle River, N.J. 1998
Westerfield, R., Ross, S. A., Jordan, B. D., Hillier, D. (2021). Fundamentals
of Corporate Finance 4e. United Kingdom: McGraw-Hill Education.

Chandra, P. (2014). Fundamentals of Financial Management. India: Tata

McGraw-Hill Education.
Gaughan, P. A. (2017). Mergers, Acquisitions, and Corporate Restructurings.
Germany: Wiley.
Corporate Restructuring: Lessons from Experience. (2005). Norway: World
Bank.
Mergers, Acquisitions and Corporate Restructuring: Text and Cases.
(2019). India: SAGE Publications.
The Art of Capital Restructuring: Creating Shareholder Value Through
Mergers and Acquisitions. (2011). United Kingdom: Wiley.

294
UNIT 14 FINANCIAL ENGINEERING
Financial
Engineering

Objectives

The objectives of this unit are to:

• provide an overview of financial engineering and the process involved
therein
• focus on newly emerging fixed income products
• focus on newly emerging equity products
• explain derivative products developed by financial engineering

Structure

14.1 Introduction
14.2 Factors Contributing to Financial Engineering
14.3 Financial Engineering Process
14.4 Financial Engineering in Fixed Income Securities
14.5 Financial Engineering in Equity Products
14.6 Financial Engineering in Derivatives
14.7 Summary
14.8 Self-Assessment Questions
14.9 Further Readings

14.1 INTRODUCTION

In general, engineering is the process through which some value is added to

the raw material or semi-finished product so as to make it useful to the users
or consumers. Applying this general meaning of engineering, we can say
financial engineering is the process through which finance managers or
intermediary institutions in financial markets add value to existing plain
vanilla products that satisfy the users need. John Finnerty (1988) offers a
comprehensive and lucid definition of financial engineering as follows:
"Financial engineering involves the design, the development, and the
implementation of innovative financial instruments and processes, and the
formulation of creative solutions to problems in finance". The users of
financially engineered products include investors including institutional
investors like pension funds, banks and financial institutions, corporate,
suppliers, consumers, employees and government.

We provide you a quick and intuitive understanding of financial engineering

concept. The meaning and characteristics of debt and equity instruments are
well known. If you place these two instruments along risk-reward line, they
can be placed at two extreme points. Debt carries low risk and hence low 295
Strategic Financing return. Equity carries high risk and hence high expected return. These two are
Decisions
plain vanilla products. Many financially engineered products are in between
these two products or decomposing the risk and return or changing them to
the level users want. We can say preference shares is one of the earliest
financially engineered product since it has higher risk compared to debt but
also carries higher return. Compared to equity, it carries lower risk but also
lower return. So, an investor, who need moderate risk and return can choose
'preference shares'. Is there any alternative to this financially engineered
product? Yes, it is possible that one can buy both equity and debt (or
debenture) of the same firm and synthetically create a product somewhat
equal to preference shares. But it is something like mixing individual
chemicals in your home to prepare cough syrup instead of buying formulated
product. In other words, preference share is equal to formulated product and
ready for use whereas buying both equity and debt in certain proportion to
get the same effect is something similar to mixing chemicals by yourself to
get the same formulation.

Convertible debenture is another financially engineered product that is in

existence for a long time. Convertible debentures, which are optionally
convertible, provide an opportunity to share the reward if the equity price
goes up without risking your capital when the company is not doing well. In
other words, here is a product, which decomposes the risk and return of the
equity and passes on the return only to the investor. Of course, the
convertible debenture holder can't expect such product without incurring any
cost and interest rate for convertible debt will be lower than non-convertible
debt. While convertible debentures or bonds are financially engineered
product by the company, the market has created similar product called option
(call and put option). It again decomposes risk and return and hand over
return to one set of investors and risk to another set of investors. The
investors, who get return, agree to compensate the investors who take risk by
paying premium. Options are again financially engineered product.

We can extend the concept to an extreme situation such that corporate form
of business with limited liability itself is a financial engineered product in
which equity holders hold a call option on the value of the assets of the
company.

The plain vanilla product is sole proprietorship or partnership with unlimited

liability. Since the plain vanilla structure put a limitation on the growth of the
company, we need a structure in which many investors can participate but
management is vested only with few. Since there is no guarantee that
managers will manage the business well, there is a need to restrict the
liability of investors. Equity with a limited liability is financially engineered
product.

Though Finnerty definition requires 'innovation' as an essential characteristic

of financial engineering, not all engineered products are innovative. They are
to be different and add value to users. A financially engineered product may
be innovative today but it may eventually become a common product in the
future.
296
Before we discuss in detail financial engineering let us discuss the broad Financial
Engineering
classification of asset classes, which are broadly classified in six groups.
• Fixed income
• Credit
• Emerging markets
• Equities
• Commodities
• Foreign exchange

Each of these asset classes have their own risk and return profile and
combination of risk return profile of different asset classes into a new product
is termed as financial engineering and is primarily used for risk reallocation,
yield reduction (lower effective interest rate), enhanced liquidity, reduction in
information asymmetry thereby reducing agency cost, reduction in
transaction cost and playing on tax arbitrage.

Each of these asset class can be traded through three types of products or
process, which are:
• Cash instruments (Spot market)
• Futures and Swaps
• Derivatives and Structured products

Since the early 1970s each of these asset classes is becoming volatile.
Starting from the demise of Breton Woods’s agreement, oil shock, high
inflation in developing countries and sovereign debt default. From the early
1990s the asset classes are becoming more correlated and giving rise to
contagion among financial markets. For e.g. Russian crisis of 1998 where it
defaulted on local currency bonds (GKO) lead to downward reaction in
global capital markets and rally in bond markets of advanced countries. The
East Asian crisis and the dot com bubble also had severe consequences for
global financial markets. The financial crisis of 2008 (Residential Mortgage
Crash in US) lead to crash in financial markets and consequent recession
impacting commodity prices. To address this issue Central Banks in a
coordinated move embarked on easy money policy (low interest rates)
leading to boom in all asset classes, specially commodity markets. Recently
during COVID 19 crisis same policy was used leading to high inflation and
consequently raising of interest rate. Uncertainty in macro economic factors
and geo political situation gives rise to risk, financial engineering attempts to
mitigate/reduce to an certain extent.

14.2 FACTORS CONTRIBUTING TO FINANCIAL

ENGINEERING

As stated above financial, engineering produces products or in some cases

solutions that add value to the users. Why users of financial products or
297
Strategic Financing solutions want some value-added products? An understanding of such needs
Decisions
will be useful to appreciate the role of financial engineering and the products
and solutions that come out of financial engineering. John Finnerty (1988)
identified eleven factors that are primarily responsible for financial
innovation. These factors are briefly discussed below:

1) Tax Advantage: If there is a way to save tax or defer tax, everyone will
exploit the opportunity. Often financial engineering helps to develop
such products. For instance, if you buy a zero coupon bond in the
secondary market, the difference between the redemption value and the
purchase price is treated as capital gains whereas interest received from
interest paying bonds are treated as regular income. Since the tax rate for
capital gains is substantially lower (it is 10% now for long-term capital
gains) than marginal tax rate of high net worth investors (it is 30% for
individuals and 35% for corporate entities), it make sense for companies
to issue zero-coupon bonds. Small investors wanting to show the income
as regular income will buy the same in primary market whereas high net
worth investors will buy from secondary market. Mutual funds is also
tax-efficient medium through which you can change the character of the
income from one to another. For instance, if you invest in bond market
fund, which in turn invest the money in bonds and receive interest
income, you can still show the income as capital gain by choosing
certain schemes. You can convert capital gains into dividend and vice
versa.

Thus, mutual fund is a financially engineered structure to get tax

advantage and of course, it is also a vehicle through which investors can
achieve diversification at low investment. There are several other
examples. While operating leasing is a plain vanilla product, financial
leasing is an engineered product, which often used to gain certain tax
advantage. Some years back, many companies have done 'sale and lease
back' transactions to exploit loopholes in tax laws, which was plugged
subsequently. Similarly, a non-tax paying company and taxpaying
investors can save tax by investing in preference shares. It is possible for
a company to issue 'convertible preference shares' such that the
preference shares can be converted into non-convertible debenture on
default of dividend. Of course, many of the financially engineered
product to exploit tax law loopholes are effectively killed by the
government by amending the tax laws and sometime with retrospective
effect. The life of such products or solutions is generally short but
opportunities come regularly.

2) Reduced Transaction Cost: Financial products and solutions come with

high transaction cost. For instance, if a firm issues debenture for 7-year
period, it has to repay at the end of seventh year but invariably it has to
approach the market again with another bond issue in the near future
since growth demands fresh funds. An alternative is issue of fairly a
long-term bond, say 99-years with call and put options and in that
process tremendous transaction cost is reduced. Add more features to
298 take care of various concern like changes in credit rating, etc. and you
 will get truly financially engineered product to handle transaction cost. Financial
Engineering
Mutual funds and several products of derivative markets are aimed to
reduce either transaction cost or at least recurring transaction cost to a
large extent.

3) Reduced Agency Cost: Agency relationship between promoter/

managers and other shareholders/stakeholders creates certain cost, which
latter bear. Employee Stock Option (ESOP) is a financial innovative
product, which swaps part of salary for equity such that the value of
equity increases only if mangers perform well. Leveraged Buyout (LBO)
through issue of junk bonds is a financial process through which
inefficient management is replaced with efficient one and productivity of
the assets is improved. Compare this with a situation where banks and
financial institutions were not able to take action against defaulting
companies except initiating time consuming court action and in
meanwhile productivity of assets are deteriorate further.

4) Risk Reallocation: Financial engineering plays a major role in this

respect too. We briefly discussed this point in introduction. Through
financial engineering, it is possible to reallocate the risk to different
parties and of course such reallocation comes with a price. For instance,
fixed interest rate bond is plain instrument in which both investors and
issuer are exposed to interest rate risk. A floating rate bond takes away
the risk. However floating rate brings new problem and issuers are
exposed to higher cost of borrowing. A swap transaction can shift such
risk from company to counter party. Like this, you can create an
environment in which you can trade 'risk'!! We will see more examples
in subsequent sections.

5) Increases Liquidity: Liquidity reduces the cost and improves efficiency

of pricing. Liquidity is affected due to rigidity and inability to assess the
risk level. For instance, real assets in general are less liquid compared to
financial assets. Land is not as liquid as bonds issued by a company
dealing in buying and selling of land. Equity and bonds of leasing
companies are more liquid than assets funded by leasing companies.
Loan portfolio is less liquid if some banks want to sell the loan portfolio
compared to stocks and bonds of the bank. Through securitization,
financial engineering can improve the liquidity. Another example, is
open- end mutual funds, which give option to enter and exit at anytime
and of course with certain cost (entry and exit load).

6) Regulatory or Legislative Factors: Regulation or deregulation, both

make life complex. A regular public issue in the US market is highly
costly for an Indian company since the regulations are very high and the
cost of compliance of such regulations is high. ADR and GDR are
financially engineered products, which allow companies to issue shares
in US and other markets without attracting such high level of regulations.
Depository and electronic-trading are positive side of regulations, which
reduces level of risk and also transaction cost. Mutual funds are
introducing several new products within regulation to attract investors
299
Strategic Financing and tap new sources of funds. Insurance is another highly regulated
Decisions
industry but you can witness so many products offered by them. If
regulation puts certain restrictions, you have to be more innovative to
keep the interests of investors. If regulation removes certain restrictions
and allows competition, you have to be equally innovative to compete
and retain your investors. For instance, RBI puts lot of restrictions on
companies raising deposits from public.

7) Level and Volatility of Interest Rates: Interest rate influences the price
of almost all products of the economy and of course interest rate in turn
is influenced by several factors. Volatility in interest rate creates problem
for several players in the market but there are people who like volatility
of interest rates and hence want to assume additional risk. Financial
engineering can help these two parties to swap their risk appetite on
interest rate volatility. All interest rate derivatives are outcome of such
volatile behaviour of interest rates.

8) Level and Volatility of Prices: Producers and users of products (real as

well as financial) and services are exposed to high level of price risk.
Bonds linked to commodity prices shift such price risk from those risk-
averse players to those who are willing to take up such risk.

9) Academic Work: Sometime new and value added products are

developed as a matter of academic exercise and subsequently someone
finds it useful.

10) Accounting Benefits: Accounting regulation requires certain items to be

treated in a particular way. Earlier when there were no regulation on
treatment of stock option, many companies have reduced salary by
converting a part of salary into stock option (ESOP) but not recognized
as expense. In that process, profit and profitability increase. Zero-
coupon convertible bonds are beneficial if there is no regulation on how
to treat the discount in stock price that is going to be offered in the
future;

11) Technological Developments and other Factors: A complex exotic

derivative structure was neither in demand nor life was as complicated as
today requiring such products. Technological development in
computational finance today makes it possible to develop such products
and allow users to trade risk and return.
Activity 1
Visit the web site of few large Indian and US companies and see their annual
report. Examine whether they have issued any security other than plain equity
and bonds.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
300
 Financial
14.3 FINANCIAL ENGINEERING PROCESS Engineering

Financial engineering process is no different from the process that any firm
follows in developing new value added products or services. The process
starts with identification or realization of some needs. Sometime such needs
are known but many times, you have to identify the needs of the market and
bring out products or services or solution to the users without expecting them
to formally communicate such needs. Like car manufacturers, mutual funds
managers have to constantly look for ways to innovate new products that are
appealing to investors and at the same time achieves certain additional
objectives. It is quite possible that you may add one more feature to the
existing products, which increase its value to users. For example, an open-
end fund gives liquidity compared to close-end funds but still investors have
to fulfill so many formalities to get the money. Chequebook facility to mutual
funds holder takes away so many formalities relating to redemption and
provide instance liquidity. Corporate finance managers have to look for ways
to reduce cost of capital or reduce the risk arising out of operating activities.
Treasury managers of banks while talking to clients can get ideas for new
product or solutions. Once the need is identified, an initial sketch of the
product is developed. At this stage, depending on the product requirement,
complex model building exercise is used. For instance, a structured derivative
product requires high level of mathematical modeling. The next stage is
testing of the product so check whether the desired result is achieved.
Sometime it involves simple verification with the users or some senior
managers' assessment. Sometime, you may have to run some simulation
exercise to verify how the product will produce results under various
simulated future scenario. Once the product is perfected, the next stage is
pricing of the product. At the stage of pricing, it is quite possible that the
price paid by the customer may be more than the benefit derived out of the
product. So, the product may be restructured again so as to make it attractive
to the users. Finally, the product is launched or solutions are provided either
directly or after some test marketing.

Activity 2
Suppose you are in a large bank specialising consumer loans. You are asked
to develop a new product to achieve 20% growth in consumer loans.
Examine the existing products available and then develop a new product. List
down the process you have applied in developing new product.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

14.4 FINANCIAL ENGINEERING IN FIXED

INCOME SECURITIES
Fixed income securities have seen large-scale innovation and new products.
As was mentioned in the introduction of the Unit, zero-coupon bond and
301
Strategic Financing convertible bonds are some of the early part of new products. A zero-coupon
Decisions
bond enables the borrowers to defer interest payment whereas it gives an
option for the investors to show the appreciation either income or capital gain
depending on tax preference. An optionally convertible bond reduces interest
cost to borrowers whereas investors get an option for converting the same
into equity depending on the performance of the company, which may not be
assessable at the time of investment. Another major innovation in bonds was
floating rate bond, which takes away the interest rate risk. A number of
subsequent innovations on floating rate bond aim to deal with different types
of risk. A typical floating rate bond contains a float part and fixed part. For
example, it can be bank rate or LIBOR + fixed premium say 4% or 2%.
When the interest rate moves upward in the market, the bank rate or LIBOR
also moves up and hence investors get higher interest rate. When the rate
declines, borrowers are not stuck with higher interest liability. Thus, float
part effectively handles the interest rate risk. Here interest rate risk means
additional interest liability on account of fixed interest commitment that the
borrower has to bear when the interest rates are moving down in the market.
Similarly, when the interest rate moving upward, the investors of fixed
interest rate bonds lose money as the prices of bonds decline. In other words,
the market prices of bonds move up and down based on changes in the
market interest rates.

Instead of fixing the float to Bank Rate or LIBOR, if the issuer and investor
fix the float to some other value, they can tackle different types of risk. For
instance, a commodity producer or oil company is exposed to considerable
amount of commodity or oil price risk. Prices of commodities, oil, metal,
etc., are highly volatile and producers of these products are exposed to high
level of risk. In other words, in a balance sheet context, the asset side risk
(also called business or operating risk) is very high. Naturally, for these
companies, a pure fixed interest paying debt will add more problems. For
some reasons, if the prices of the products crash, it may hurt the business
considerably. While debt creates such adverse effect in a falling prices, it
creates value when price moves upward. The issue before the finance
managers of these companies is how to resolve the negative effect of the
debt in a falling market price while retaining profit opportunity when the
prices move up. It is resolved by linking floating rate with the commodity
price index. That is, the investors will get higher interest rate when the
market price of the commodity moves up and gets lower return when the
prices fall. For instance, if the interest rate of such floating bond is
4%+changes in oil price or price index, the bondholders will get a return of
4% only if the price remains same. If the price increases by 3%, then
bondholders will get 7%. Normally, there will be a floor rate and cap rate for
such issues. In the above case if the floor is 4% and cap is 10%, the interest
rate will be minimum of 4% (even in cases when the oil price declines by
10%) and maximum of 10% (even when the oil price increases by 20%). So,
the instrument, by and large, retains, the characteristics of debt but it brings
some equity flavour into the instrument.

What about the users of such commodities, metals and oils? They are also
exposed to price risk. When the prices of input moves up, it may not be
302
always possible for the company to adjust the end product price. This will Financial
Engineering
hurt the profitability of the company particularly cause distress if the
company also has fixed interest rate debt. Inverse floating rate bonds, where
interest is linked to commodity price changes but in a inverse direction. That
is, interest liability will be lower when the price of input moves upward.
Similarly, when the price of input moves downward, then interest liability
will be more. The borrower would be happy to share part of the profit caused
by lower input price with the lender provided the lender agrees to share the
loss when the input price increases. You may be wondering why no one
bothers to develop such instruments for consumers, who are ultimately
affected by the prices. They can invest in the bonds and shares of those
companies until financial engineers come out with a product.

As was discussed earlier, financial engineering developed several innovative

products in debt instrument. We mentioned earlier that zero-coupon bond is
one of the earliest innovations. But the problem is, investors who are looking
for regular investments that will avoid such instrument. To overcome this and
also to create some additional liquidity, issuers of such zero-coupon bonds
have started issuing baby bonds, which are also zero-coupon bonds. Those
who are looking for regular income can sell the baby bonds while retaining
the mother bond. Of course, tax treatment for such baby bonds was also one
of the reasons for such innovations.

Can you create Zero-coupon bond (ZCB) from an interest-paying bond?

There is nothing impossible before financial engineer. It works like this. If
you carefully look into interest-paying bond, it is a structure in which you
invest today some amount and borrower will pay you regularly interest at the
end of every period (say six months) and principal on maturity (say 10 years).
Thus you will be getting 20 cash inflows. Investment bankers issued 20
different series securities backed by investments in such interest paying
securities and the 20 such securities are zero coupon bonds with different
maturity. That is, series 1 will mature at the end of 6 months and the face
value of the same is equal to first interest payment. Series 2 will mature at the
end of 12 months and the face value is equal to second interest payment.
Such that series 20 will mature at the end of 10 years and the face value is
equal to principal and last installment interest. All these zero-coupon bonds
are discounted and issued today such that investment banker collects the face
value of the interest paying bond plus a small commission. Those investors,
who have surplus for 6 months, will invest in series 1, those who have
surplus for 12 months will invest in series 2, etc. Interestingly, all investors
of ZCB get benefit more than what they would get otherwise for investing
money for such term.

Innovation in debt instruments in general (a) aims to remove interest rate risk
(b) bring a bit of equity flavour into the instrument and (c) improve tax
efficiency of the product. Suppose a firm borrows money in dollar but does
not want to take the risk of foreign exchange rate fluctuations. It is possible
to issue a bond in one currency, pay interest in another currency and repay in
a different currency. Alternatively, you can peg the interest rate to the
303
Strategic Financing changes in foreign exchange rate fluctuations. In essence, foreign exchange
Decisions
risk is transferred from the company to others. In other words, any risk can be
handled, restructured and transferred from a person who is not willing to take
such risk to a person who is willing to assume such risk. Table 14.1 depicts
some of the financial innovations. These financial instruments are different
from plain vanilla type of debt products. The financial innovations in these
products have resulted in change in the process of interest rate fixation and
risk reallocation and yield reduction. Financial innovations in debt securities
also enhance liquidity, reduce agency and transaction cost along with
opportunities for tax arbitrage and other benefits, which depend on the nature
of financial innovations.

Activity 3
Reliance Industries has successfully leveraged convertible debentures for
expansion. Examine convertible debentures issues of Reliance and figure out
how it helped them to achieve high growth without diluting their stake. Also,
figure out why other companies like Essar Oil failed to replicate such
innovation.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

Table 14.1: Few Debt Instruments Developed Through Financial Innovation

Distinguishing Risk Enhanced Reduction in Reduction in Tax Other Benefits

Security Characteristics Reallocation/ Liquidity Agency Costs Transaction Costs Arbitrage
Yield
Reduction
Auction Rate Interest rate Coupon based Designed to Interest rate Intended to have
Notes and reset by on length of trade closer to each period is lower transaction
Debentures Dutch auction interest period, par value than determined in costs than
at the end of not on final a floating rate the repeatedly rolling
each interest maturity. note with a marketplace, over shorter
period. fixed interest rather than by maturity securities.
rate formula. the issuer or
the issuer's
investment
banker.
Bonds Linked Interest and/or Issuer assumes Attractive to
to Commodity principal commodity investors who
Price or Index linked to a price or index would like to
specified risk in return speculate in
commodity for lower commodity
(minimum) options but cannot,
price or index. coupon. Can for regulatory or
serve as a other reasons,
hedge if the purchase
issuer commodity
produces the options directly.
particular
commodity.

304
 Financial
Engineering

Credit- Issuer's Stronger credit Enables a privately

Enhanced obligation to rating of the held company to
Debt pay is backed letter of credit borrow publicly
Securities by an or surely bond while preserving
irrevocable issuer leads to confidentiality of
letter of credit lower yield, financial
or a surety which can information.
bond. more than
offset letter of
credit/surely
bond fees.
Dual Currency Interest Issuer has Euro yen-dollar
Bonds payable in US foreign dual currency
dollars but currency risk bonds popular
principal with respect to with Japanese
payable in a principal investors who are
currency other repayment subject to
than US obligation. regulatory
dollars. Currency swap restrictions and
can hedge that desire income in
risk and lead, dollars without
in some cases , principal risk.
to yield
reduction.
Extendible Interest rate Coupon based Investor has Lowe transaction
Notes adjusts every on 2-3 year put option. costs than issuing 2
2-3 years to a put date, not Which or 3 years notes and
new interest on final provides rolling them over.
rate the issuer maturity. protection
establishes, at against
which item deterioration
note holder in credit
has the option quality or
to put the below- market
notes back to coupon rate?
the issuer if
the new rate is
unacceptable.
Floating Rate Coupon rate Issuer exposed Investor
Tax-Exempt floats with to floating does not
Revenue some index, interest rate have to
Bonds. such as the risk but initial pay
60-day high- rate is lower income
grade than for fixed- tax on
commercial rate issue. the
paper rate. Effectively, interest
tax –exempt payments
commercial but issuer
papers. gets to
deduct
them.
Increasing Coupon rate Defers portion When such
Rate Notes increases by of interest notes are
specified expense to issued in
amounts at later years, connection
specified which with a bridge
intervals. increases financing, the
duration. step-up in
coupon rate
compensates
investors for
the issuer’s
failure to
redeem the
notes on
schedule.
305
Strategic Financing
Decisions
Indexed Issuer pays Investor Attractive to
Currency reduced assumes investors who
Option principal at foreign would like to
Notes/Principa maturity if currency risk speculate in
l Exchange specified by effectively foreign currencies
Rate Linked foreign selling the but cannot, for
Securities currency issuer a call regulatory or other
appreciated option reasons, purchase
sufficiently denominated or sell currency
relative to the in the foreign options directly.
US dollar. currency.
Interest Rate Interest rate is Reduced Investor is
Reset Notes reset 3 years (initial) yield compensated
after issuance due to the for a
to the great of reduction in deterioration
(i) the initial agency costs. in the issuer’s
rate and (ii) a credit
rate sufficient standing
to give the within 3 years
notes a of issuance.
market value
equal to 101%
of their face
amount.
Interest Rate Two entities Effective Interest rate swaps
Swaps agree to swap vehicle for are often designed
interest rate transferring to take advantages
payment interest rate of special
obligations, risk from one opportunities in
typically fixed part to particular markets
rate for another. Also, outside the issuer’s
floating rate. parties to a traditional market
swap can or to circumvent
realize a net regulatory
benefit if they restrictions.
enjoy
comparative
advantages in
different
international
credit markets.
Negotiable Certificates of Issuer bears More liquid Agents’
Certificates of deposit are market price than non- commissions are
Deposit. registered and risk during the negotiable lower than
sold to the marketing CDs. underwriting
public on an process. spreads.
agency basis.
Zero coupon Non-interest- Issuer assumes Straight-
Bonds bearing. reinvestment line
(Sometimes Payment in risk. Issues amortizat
issues in one lump sum sold in Japan ion of
series) at maturity. carried below- original
taxable market issue
yields discount
reflecting their pre-
tax advantage TEFRA.
over Japanese
conventional investors
debt issues. realize
significa
nt tax
savings.

306
 Table 14.2: Few Convertible Debt/Preferred Stock Instruments Developed Through Financial
Engineering
Financial Innovation

Distinguishing Risk Enhanced Reduction Reduction in Tax Arbitrage Other

Security Characteristics Reallocation/ Liquidity in Agency Transaction Benefits
Yield Costs Costs
Reduction
Adjustable Debt the Effectively, tax Portion
Rate interest rate on deductible common of the
Convertible which varies equity. Security has issue
Debt directly with the since been ruled carried as
dividend rate on equity by the IRS. equity on
the underlying the
common stock. issuer’s
No conversion balance
premium. sheet.
Convertible Convertible No need to Issuer can exchange Appears
Exchangeab preferred stock reissue debt for the preferred as equity
le Preferred that is convertible when it becomes on the
Stock exchangeable, security as debt- taxable with interest issuer’s
at the issuer’s just exchange rate the same as the balance
option for it-when the dividend rate and sheet
convertible debt issuer becomes without any change until it is
with identical a taxpayer. in conversion exchange
rate and features. d for
identical convertib
conversion le debt.
terms.
Convertible Convertible Investor is
Reset bond the protected
Debentures interest rate on against a
which must be deterioratio
adjusted n in the
upward, if issuer’s
necessary, by financial
tan amount prospects
sufficient to within 2
give the years of
debentures a issuance.
market value
equal to their
face amount 2
years after
issuance.
Debt with Notes with Notes provide a Commerci
Mandatory contracts that stream of interest tax al bank
Common obligate note shields, which (true) holding
Stock purchasers to equity does not. companie
Purchase buy sufficient s have
Contracts common stock issued it
form the issuer because it
to retire the counted
issue in full by as
its scheduled “primary
maturity date. capital”
for
regulatory
purposes.
Zero Non-interest- If issue converts, the If holders
Coupon bearing issuer will have sold, convert,
Convertible convertible debt in effect, tax- entire
Debt issue. deductible equity. debt
service
stream is
converted
to
common
equity.
307
Strategic Financing
Decisions 14.5 FINANCIAL ENGINEERING IN EQUITY
PRODUCTS

Equity product witnessed limited innovations since by definition, these

products are designed to carry high risk. Nevertheless, a few attempts have
been made to reduce the risk or share the risk and change some of the basic
characteristics of the instruments. One of the basic characteristics of common
stock is voting rights that it gets for the holders. Unlike co-operative form of
organization in which each shareholder gets only one vote irrespective of
share that the shareholder contributes, common stocks holders' votes equal to
number of shares that the shareholder possess. For instance if you have 1000
shares and your friend has 100 shares, you get 1000 votes and your friend
gets 100 shares. Voting rights give the shareholders to participate in key
decisions to the extent of their stake in the company. Such voting right has a
value. This basic characteristic of the equity has been changed and voting
rights value is swapped for additional dividend by issuing different classes of
shares. For instance, under Indian law, it is now possible for the public
limited company in India to issue non-voting shares. Subscribers of such
shares have no voting rights and in this process it is almost like preference
shares but without any right on even dividend. However, when companies
issue such non-voting shares, a suitable compensation either in the form of
discount in offer price or additional dividend is offered to the subscribers.
Though so far no company has issued such shares, some companies may
issue such shares in the future. The benefits that non-voting shares offer are
(a) it enables key promoters to retain their voting rights while issuing
additional shares and (b) many small investors and mutual funds are not
interested in voting rights of good companies and they are happy with
additional dividend to exchange the voting rights. Empirical studies have
shown that there is no significant difference in market price between the
shares of different classes except in period of takeover contest where voting
rights assume importance.

A more common form of this kind of shares is 'differential voting rights'

shares in which all classes of shares have voting rights but in a
disproportionate form. For instance, Class A shares will have voting right of
one vote for one share whereas Class B shares will have a voting right of 100
votes for one share.

Sometime, the arrangement will be such that Class B shareholder will not get
any dividend from the company or get only one-tenth of dividend of Class A
shareholders. Typically, promoters would subscribe Class B shares whereas
most small investors would prefer Class A shares. Initially, companies will
issue Class A shares to all investors and subsequently will announce for
exchanging Class A shares with Class B shares on certain terms (e.g. For
every 10 shares of Class A surrendered, the shareholder will get one Class B
shares, which has 100 voting rights per share and no dividend). Naturally,
those who are interested in control stake would go for exchange. Sometime,
companies may issue non-voting or low-voting shares for ESOP. While the
uses of such instruments could be many, it is generally considered that non-
308
voting or low-voting shares increase the agency cost since promoters are Financial
Engineering
trying to retain their control without investing an equal amount.

Some companies in the US and West have issued puttable common shares in
which the holders of the equity shares have right to surrender the equity
shares at a pre-determined price on a pre-determined date. If you closely
observe the basic characteristics of the instruments, it is somewhat equal to
buyback of shares or selling puts. In other words, the risk associated with
equity shares is considerably reduced by issuing such shares. You might
wonder that why Indian regulators have not insisted such instruments from
companies since many Indian companies during the period of 1994-96 and
recently in 2000-01 have been promoted by fly-by-night operators. Good
companies gain by charging more premium for such shares because of less
risk associated with such shares. There is no loss to the company since the
shareholders will not exercise their right if the company performs well.
Companies like Intel have issued 'put option' instead of puttable common
shares.

Table 14.3: Few Equity Instruments Developed Through Financial Innovation

Distinguishing Risk Enhanced Reduction Reduction in Tax Arbitrage Other Benefits

Security Characteristics Reallocation/ Liquidity in Agency Transaction
Yield Costs Costs
Reduction
Additional A company issue Establishes
Class(es) of a second class of separate market
Common common stock value for the
Stock the dividends on subsidiary while
which are tied to assuring the
the earnings of a parent 100%
specified voting control.
subsidiary.
Americus Outstanding Stream of PRIME
Trust shares of a annual total component would
particular returns on a appeal to
company’s share of stock corporate
common stock is separated investors who can
are contributed to into (i) a take advantage of
a five-year unit dividend the 70% dividends
investment trust. stream (with received
Units may be limited capital deduction.
separated into a appreciation SCORE
PRIME potential) and component would
component. (ii) a (residual) appeal to capital-
Which embodies capital gain-oriented
full dividend and appreciation individual
voting rights in stream. investors.
the underlying
share and permits
limited capital
appreciation, and
a SCORE
component,
which provides
full capital
appreciation
above a stated
price?

309
Strategic Financing
Decisions
Master A business is Eliminates a layer
Limited given the legal of taxation
Partnership form of a because
partnership but is partnerships are
otherwise not taxable
structured, and is entities. (in few
traded publicly, tax jurisdictions)
like a In India it is
corporation. taxable
Puttable Issuer sells a new Issuer sells The put Equivalent under
Common issue of common investors a put option certain conditions
Stock stock along with option, which reduces to convertible
rights to put the investors will agency bonds but can be
stock back to the exercise if the costs recorded as
issuer on a company’s associated equity on the
specified date at a share price with a new balance sheet so
specified price. decreases. share issue long as the
that are company’s
brought on payment
by obligation under
information the put option
al can be settled in
asymmetrie common stock.
s.

Source for Table 14.1,14.2&14.3:Financial Engineering in Corporate

Finance: An Overview by John D. Finnerty

Yet another innovation from mutual funds and investment bankers is splitting
the total return of equity into two components and trade them separately. For
example, SBI Mutual fund could invest 100000 shares in Infosys and create
100000 Class A and 100000 Class B stripes against the investment in
Infosys. SBI defines that those who purchase Class A shares will get only
dividend (or dividend plus 20% capital appreciation) and Class B shares will
get no dividend but entire capital appreciation (or 80% capital appreciation).
The Class A is called PRIME and Class B is called SCORE. While small
investors prefer Class A or PRIME, speculators will prefer Class B or
SCORE component.

14.6 FINANCIAL ENGINEERING IN

DERIVATIVES

The contribution of financial engineering on derivatives is substantial. In fact,

every derivative instrument is the outcome of financial engineering. To
appreciate the contribution of financial engineering on managing risk through
derivatives, let us go back to the origin of such developments. Market is a
place where goods, products or services are exchanged. Normally, such
exchanges take place when the parties transact and such trades are called cash
market trades. However, cash market transaction creates certain problems.
For example, a food processing company may not be in a position to buy its
entire one-year requirement of wheat and wheat producer may not be in a
position to supply entire quantity of wheat. Both parties are exposed to price
risk if they decide to transact periodically, say once in a month - that is,
producer will supply one-month wheat every month based on the price
310 prevailing in the market. To manage the price risk, producers and consumers
have started transacting in forward market. Forward is an agreement between Financial
Engineering
the two parties entered today with all terms of contracts agreed today but
settled at a future period. Forward is a plain vanilla instrument that gives
birth to derivatives through financial engineering. Forward performs almost
all requirements of both parties of transactions but there are certain
limitations. For instance, if one of the parties wants to get out of the contract
before the settlement date, both parties have to negotiate for the reversal of
the contract, which often will be expensive. In other words, there is no easy
way for getting in and getting out of the forward contract. However, futures
(both commodity and financial futures), which are a derivative instrument,
offer this facility.

Future is a standardized forward contract entered between two parties and

traded in the exchange. Because of standardization, it is possible to trade in
organized exchanges and because it is traded in exchanges, it is easy to get in
and get out of the contract. Today, futures are highly liquid and available on
large number of financial products like stocks, bonds, currencies and
commodities like coffee, cotton, plantation, etc. They are also available on
metals and energy products.

While futures resolve basic problem of liquidity while allowing parties to

'lock- in' the price today so that there is no price risk, the parties forgo the
opportunity to exploit the price advantage. For instance, the buyer will
continue to pay higher price even the current market price is much lower. Of
course, the producers gain in such situation. On the hand, if the prices move
up, the producers continue to sell at lower price while buyers' gain in such a
situation.

Hence when the prices move up or down, one of the parties gain and other
incur loss. Financial engineers designed options contract, which allows buyer
of the option to retain in the benefit of price movement while avoiding loss.

Consumers buy call option, which gives them a right to buy at a

predetermined price. They exercise the right only when the price is more than
the predetermined price. Producers buy put option, which gives them a right
to sell at a predetermined price and producers exercise their right when the
price moves downward. Option contracts split the risk into positive and
negative and allow parties to take whatever they like. Buyers of option, who
take positive side of the risk, are expected to pay a price or premium to
sellers of option, who take negative side of the risk.

Swaps are similar to futures but the difference is it is a series of futures.

Swaps are normally entered into exchange fixed rate borrowing/lending with
floating rate borrowing/lending or to exchange one currency borrowing/
lending with another currency borrowing/lending. Suppose your company
has borrowed money in the US but your exports are primarily to Europe. It is
possible that you can swap dollar loan with Euro currency loan so that your
foreign exchange risk is reduced. Swaption is another variation of swaps
contract and it brings option element into swaps. Financial engineers have 311
Strategic Financing developed several such variations and you will have an opportunity to learn
Decisions
them in derivative courses.

Activity 4
Visit internet and find out the details of some exotic derivatives like weather
derivative and write a brief report on the same.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................

14.6 SUMMARY

Financial engineering like any other engineering has brought several new
products and solutions to the market. It has completely changed the financial
market today. Its main contribution is to split the risk and return into several
components and allow investors of financial markets to decide the
combination that is most suitable to them. Such innovations are seen in
bonds, equity, derivatives, and also in other fields like merger, acquisition
and corporate restructuring. It also provides mechanism to price such
combinations by developing various pricing models for futures and options.
Some of the models are cost-of-carry model, binominal model, Black-
Scholes Option Pricing Model, etc. Today, it is possible to quantify risk and
return of any new products and also price them with the help of these models.
Financial engineering is an exciting field, which attracts some of the best
human resources. The profession is also highly rewarding.

14.7 SELF-ASSESSMENT QUESTIONS

1) What is financial engineering? Do you feel financial engineers play an
economic role in the society?
2) Briefly discuss the financial engineering process that you will follow
while developing new products or solutions.
3) List down with examples any five variables that contribute new products
development.
312
4) Explain how fixed income securities are used to manage product price Financial
Engineering
risk.
5) Discuss innovation that took place in equity products and explain what
they achieved.
6) What is non-voting share? How is it useful to the company and
investors?
7) What is the use of derivatives? Is it an instrument designed for
speculators or useful to others too?
8) Explain any two derivative products and show the value addition in
them.

14.8 FURTHER READINGS

Beaumont, P. H. (2004). Financial Engineering Principles: A Unified Theory

for Financial Product Analysis and Valuation. Germany: Wiley.

Bufalo, M., Orlando, G., Penikas, H., Zurlo, C. (2021). Modern Financial
Engineering: Counterparty, Credit, Portfolio And Systemic
Risks. Singapore: World Scientific Publishing Company.

Chatterjee, R. (2014). Practical Methods of Financial Engineering and Risk

Management: Tools for Modern Financial Professionals. United
States: Apress.

Finnerty, J. D., Financial Engineering in Corporate Finance: An Overview,

Financial Management, Winter 1988, Pp. 14-33.

Kosowski, R., Neftci, S. N. (2014). Principles of Financial

Engineering. Netherlands: Elsevier Science.

Marshall, John.F and Bansal, Vipul K, Financial Engineering: A Complete

Guide to Financial Innovoation, Printice-Hall of India,New Delhi, 1996.
Mason, S P., Merton, R.C., Perold A. F., and Tufano P., Cases in Financial
Engineering: Applied Studies of Financial Innovation, Prentice Hall,
Englewood Cliffs, New Jersey, 1995.
Miller, M H. Financial Innovation: The Last Twenty Years and the Next,

313
Strategic Financing
Decisions UNIT 15 INVESTORS RELATIONS

Objectives
The objectives of this unit are to:
• explain the corporate form of business organization and the need for
maintaining investor relations
• highlight the importance of investor relationship for the corporate form
of business organization.
• pinpoint the different forces that demand for information from the
companies and varying purposes for which it is demanded by the
stakeholders
• bring out the rationale for corporate governance in building by good
investor relations
• explain the advantages achieved from being a good governance
company
Structure
15.1 Introduction
15.2 Corporate form of Business Organization
15.3 Demand for Information
15.4 Transparency and Disclosure
15.5 Corporate Governance
15.6 Investor Service
15.7 Summary
15.8 Self-Assessment Questions
15.9 Further Readings

15.1 INTRODUCTION

Savings and investment determine the growth, be it the economy or the

company. Business units require funds for acquiring assets for manufacturing
and investing in good projects and thereby achieving economies of scale. The
company form of business organization facilitates the creation of such large
firms with large capital base. This is made possible by collecting money from
millions of investors. Investors provide capital at the time of starting the
venture as well as for the growth of the firm. While the funds provided by the
equity holders make them the owners of the company, the funds provided by
the debt holders make them the lenders.

Hence, the company form of business mostly has a financial structure with a
314 mix of debt and equity. In case of publicly listed company the equity holders
are the promoters, the directors and their relatives, Government, sometimes Investors Relations
the institutional investors, the banks and the general public (or small
investors) and they all jointly own the company. The debt holders are
basically financial institutions, banks and general public who lend money
against a mortgage or by getting bonds or debentures issued from the company.
In some cases, the debt holders are issued convertible bonds, as per which
they can submit their bonds and get them converted to equity at later stage.
So in this case they become owners from lenders.

The existing companies diversifying & growing at rapid pace and new
business ventures with unconventional ideas and products require funds to
execute their ideas into products and services. These funds are provided by
investors in the form of equity and debt by investors. These investors require
information regarding the use of their funds and likely returns associated with
the investment. The Investor Relation Team has the primary responsibility
of providing information and interacting with investors. Table 15.1 presents
the different kind of investors who invest in the equity of the company. This
classification is as per the SEBI regulations

Table 15.1 : Category of Investors/ Shareholders

Institutional
Investor
A Promoters and
promoter group
(1) Indian promoters
(a) Indian individuals / Hindu undivided Family
(b) Central and state governments as promoters
(c) Indian corporate bodies as promoters
(d) Financial institutions and banks as promoters X (D) *
(e) Other promoters
(2) Foreign promoters
(a) Foreign individuals as promoters
(b) Foreign corporate bodies as promoters
(c) Foreign institutions as promoters X (F) *
(d) Qualified Foreign Investors X (F) *
(e) Other foreign promoters
(3) Promoter groups
B Non-promoters
(public
shareholdings)
(1) Institutions as non-promoters
(a) Mutual funds as non-promoter X (D) *
(b) Financial institutions and banks as non-promoters X (D) *
(c) Venture capital funds as non-promoters X (D) *
(d) Insurance companies as non-promoters X (D) *
(e) Foreign institutional investors as non-promoters X (F) *
(f) Foreign venture capital investors as non-promoters X (F) *
(g) Qualified Foreign Institutional Investors X (F) *
(h) Other institutions as non-promoters X (D) *
(2) Central and state governments as non-promoters
(3) Non-institutional investors
315
Strategic Financing (a) Corporate bodies as investors
Decisions
(b) Individual investors
(c) Qualified foreign non-institutional investors
(d) Other investors
C Custodians

Table 15.2 furnishes the details of the equity share capital and the number of
equity shares held by the investors of large Indian companies forming part of
NSE 50 index. The table shows that the paid up share capital of these
firms. The paid up capital of these companies range from Rs. 24 crores to
9696 crores. The number of equity shares issued run into millions and in
some cases in billions. Table 15.2 also depicts the equity share capital and the
number of equity shares outstanding. The last two columns of the table shows
free float market capitalization and ratio of free float market capitalization to
total market capitalization. Free float market capitalization is a proxy
measure to determine the diversification of investor base. Free float market
capitalization is calculated by considering only those outstanding shares that
are or can be actively traded in the open market. To compute free float
market capitalization the shares held by the following are excluded but are
not limited to:

• Shareholding of promoter/founders/directors
• Shares held by hedge funds/private equity funds etc.
• Locked in shares
• Cross holding by related companies in a group company
• Shares held by various trusts which are not actively traded

A company having a diversified investor base will have higher proportion of

free float market capitalization in its total market capitalization. The last
column in table 15.2 calculates this proportion and it can be observed that for
most of the companies free float market capitalization ranges from 40% to
60%, implying a large and diversified investor base. When the company has
large and diversified investor base the investor relation has to be designed so
as to meet the information requirements of each category of investors

Table15.2 Equity Share Capital of NSE (NIFTY 50) Companies

Company Name Face Number Equity Total Market Free Float FFMC/
Value of shares Capital Capitalisation Market TMC
(in lakhs) (in (in crores) Capitalisation
crores) (in crores)
Adani enterprises ltd. 1 11400.01 114.00 379463.17 90556.21 23.86429
Adani Port and Special 2 21123.73 422.47 171007.17 57851.56 33.8299
Economic Zone
Apollo Hospital 5 1437.85 71.89 63560 45021.94 70.83376
Asian Paints 1 9591.98 95.92 298396.84 140731.14 47.16241
Axis Bank 2 30724.01 614.48 275824.75 240263.64 87.10735
Bajaj Auto 10 2836.55 283.65 105031.68 47432.53 45.16021
Bajaj Finserv Ltd. 1 9556.89 95.57 161129.21 103004.82 63.92684

316 Bajaj Finance 2 6054.29 121.09 432285.55 191973.13 44.40887

Bharti Airtel 5 55632.32 2781.62 446810.95 196339.79 43.94247 Investors Relations
BPCL 10 21692.53 2169.25 65196.89 28705.72 44.02928
Britannia 1 2408.68 24.09 89964.3 44871.51 49.87702
Cipla 2 8070.02 161.40 93265.17 62011.85 66.48983
Coal India 10 61627.28 6162.73 147689.78 50392.62 34.12059
Divis Lab 2 2654.69 53.09 94808.12 46031.61 48.55239
Dr. Reddy's Lab 5 1664.97 83.25 74090.5 53189.84 71.79036
Eicher Motors 1 2734.56 27.35 100356.88 50781.05 50.60047
Grasim Industries 2 6583.80 131.68 112977.99 63755.11 56.43144
HCL Technologies 2 27136.65 542.73 279643.18 109177.25 39.04163
HDFC Ltd. 2 18145.95 362.92 433452.3 433452.3 100
HDFC Bank Ltd. 1 556999.59 5570.00 814328 642901.1 78.94867
HDFC Life Insurance 10 21491.05 2149.10 115750.77 51208.1 44.23996
Hero Motrocorp 2 1998.22 39.96 51461.21 33534.86 65.16532
Hindalco Industries 1 22471.75 224.72 89999.36 57776.55 64.19662
Hindustan Unilever 1 23495.91 234.96 590076.34 229737.86 38.93358
ICICI Bank 2 69702.31 1394.05 646279.85 645392.51 99.8627
Indusind Bank 10 7752.43 775.24 88575.44 74616.49 84.24061
Infosys Ltd. 5 42078.28 2103.91 641988.24 555646.25 86.55085
ITC 1 123991.79 1239.92 427895.65 306094.8 71.53492
JSW Steel 1 24172.20 241.72 155439.36 59353.39 38.18427
Kotak Mahindra Bank 5 19857.38 992.87 368443.81 278564.07 75.60558
Larsen Toubro 2 14051.91 281.04 271222.97 230786.49 85.09106
Mahindra & Mahindra 5 12431.93 621.60 157823.29 121662.73 77.08794
Maruti Suzuki 5 3020.80 151.04 269677.44 116506.17 43.20205
Nestle India 10 964.16 96.42 195069.24 74469.26 38.17581
NTPC 10 96966.66 9696.67 162855.5 79324.06 48.70825
ONGC 5 125802.79 6290.14 164550.05 51790.49 31.474
Power Grid Corporation 10 69754.53 6975.45 152832.17 74802.31 48.94409
Reliance 10 67653.70 6765.37 1665228.13 855630.46 51.38218
SBI Life Insurance 10 10007.14 1000.71 124924.08 56632.38 45.33344
State Bank of India 1 89246.12 892.46 515307.08 218934.11 42.48614
Sun Pharma 1 23993.35 239.93 236886.34 106566.46 44.98633
Tata Consumer Products 1 9215.52 92.16 71097.71 46180.56 64.95365
Tata Motors 2 33212.67 664.25 135441.25 72024.33 53.17754
Tata Steel 1 122212.10 1222.12 123984.17 81627.9 65.83736
Tata Consultancy 1 36590.51 365.91 1160285.19 323927.03 27.91788
Services
Tech Mahindra 5 9731.59 486.58 105076.88 66301.1 63.09771
Titan 1 8877.86 88.78 236337.55 111988.27 47.38488
Ultratech Cement 10 2886.72 288.67 185988.43 73837.66 39.70014
UPL Ltd. 2 7506.08 150.12 52167.23 37736.87 72.33827
Wipro Ltd. 2 54856.40 1097.13 211142.27 56976.99 26.98512

Table 15.3 shows the outstanding corporate bonds as of end of June,2022

quarter ,which is the most important source of funding for companies. As of
June 2022 quarter outstanding corporate bonds were to the tune of
Rs.39,57,796 crore. Investor relation team has to work effectively to raise
funds through debt at minimum cost. Here we shall understand that the
information requirements of debt holders is different from that of equity
holders. The debt holders are concerned with liquidity and debt coverage 317
 Strategic Financing during the tenure of the debt whereas equity holders are concerned with long
Decisions
term growth prospects of the company.

Table 15.3 Outstanding Corporate bonds – From Sep 2020 Quarter

Quarter Type of Number Opening No. Opening Number No. of (Amount in Number Number (Amount Number No. of Net
Instruments of of Outstandin of Issues Rs. Crores) of of in Rs. of Instrum Outstandin
Issuers instruments g Amount Issuers Issuers Redempt Crores) Issuers ents g Amount
Outstanding (Rs. In ions outstan (Rs. In
crores) ding Crores)

Septr-20 Fixed Rate 2400 17948 3036883 499 1337 181464.1 359 843 114062.1 2470 18514 3103564
Floating 519 2889 128711.5 67 286 17428.11 74 209 7003.288 523 3000 138861
Rate
Structured 102 859 36818.57 19 116 2105.99 24 186 3455.335 105 841 35371.99
Notes
Others 554 2845 126888.7 191 722 5365.949 214 848 6372.166 563 2770 127978.4
Total 3575 24541 3329302 776 2461 206364.1 671 2086 130892.9 3661 25125 3405776
Jun-22 Fixed Rate 3502.00 21398.00 3546658.56 556.00 1496.00 116164.00 423.00 969.00 177001.48 3558.00 21606.00 3479398.39

Floating 786.00 3682.00 243284.59 121.00 348.00 16085.92 50.00 104.00 12636.97 810.00 3729.00 249868.84
Rate
Structured 158.00 1089.00 45678.98 37.00 128.00 5624.85 36.00 198.00 4953.49 166.00 1120.00 46449.86
Notes
Others 843.00 3189.00 181403.10 234.00 847.00 16986.28 69.00 117.00 16549.85 860.00 3290.00 182079.25
Total 5289.00 29358.00 4017025.23 948.00 2819.00 154861.05 578.00 1388.00 211141.79 5394.00 29745.00 3957796.34
Source : NSDL& CDSL

To get better understanding of who actually controls the company, we need to

look into the shareholding pattern data of these companies. Table 15.4
presents the percentage of equity holding by different categories of equity
shareholders of nifty 500 companies which account for nearly 95% of the
total market capitalisation of Indian companies.. The promoters holding
represent the equity holding of those who had promoted the company and
they basically control the management. The foreign promoters' holding arises
if there is joint venture between an Indian company and a foreign company.
Such investment can also arise if the foreign firm sets up its own company in
India, which are often called as multinationals and also when foreign
investors invest in Indian Companies through Foreign Portfolio Investment
(FPI) route. Hence promoters could comprise of either Indian or foreign
based on how they originated. The institutional investors' holding represents
the equity holding of the financial institutions, the banks and mutual funds.
The other private corporate body equity holding implies the holdings of other
companies. For instance if Britannia industries invests in the shares of the
ABB Ltd, it would be classified into other company holdings. Companies at
times do this form of investing, when excess cash is available and it lies idle
in the company. The others equity shareholding represent the holdings of
small investors, who are also owners of the company. But these small
investors mostly invest for the sake of investment or speculation. They sell
their shares if they feel that the company's share is performing badly in the
capital market.

318
These two tables thus highlight the fact that number of investors are large Investors Relations
typically in large companies and also the categories of the investors are of
different kinds. While the average promoters' holding of these companies is
around 43%, non-promoters contribution is 57%. In such a scenario a formal
investor relationship arrangement assumes importance. Many companies
today have a full fledged investor relations department headed by an investor
relationship officer. The present unit is dedicated to discuss why the
companies need to have a good relationship with investors and what exactly
should the companies do to maintain such good relationships.

2013 2014 2015 2016 2017 2018

A. Promoters 49.0 49.1 49.0 49.2 49.5 50.8
and
promoter
group
1) Indian promoters 45.1 45.2 45.3 45.6 46.1 47.3
a) Indian individuals 22.0 22.1 22.6 23.8 24.5 25.7
b) Central and stategovernments 1.3 1.2 1.3 1.2 1.2 1.4
promoters
c) Indian corporate bodies as 19.4 19.4 19.0 19.2 18.8 18.5
promoters
d) Financial institutionsand banks as
promoters 0.2 0.2 0.2 0.2 0.1 0.1
e) Other promoters 2.2 2.2 2.2 1.3 1.4 1.6
2) Foreign promoters 3.9 3.9 3.7 3.6 3.5 3.5
a) Foreign individuals as promoters 0.6 0.5 0.6 0.6 0.6 0.6
b) Foreign corporate bodies as 3.3 3.3 3.0 2.9 2.7 2.8
promoters
c) Foreign institutions as promoters 0.0 0.0 0.0 0.0 0.0 0.0
d) Qualified Foreign Investors 0.0 0.0 0.0 0.0 0.0 0.0
e) Other foreign promoters 0.1 0.1 0.1 0.0 0.1 0.0
3) Promoter groups 0.0 0.0 0.0 0.0 0.0 0.0
B. Non-promoters 50.6 50.6 50.8 50.7 50.4 49.2
(public
shareholding)
(1) Institutions 5.1 5.0 4.9 4.9 5.1 5.1
as non-promoters
a) Mutual funds as non-promoter 0.8 0.9 1.0 1.1 1.2 1.3
Financial institutions and banksas
b)
non-promoters 0.8 0.8 0.7 0.7 0.8 0.7
c) Venture capital funds as non- 0.0 0.0 0.0 0.0 0.0 0.0
promoters
d) Insurance companies as non- 0.6 0.6 0.5 0.5 0.5 0.5
promoters
e) Foreign institutional investorsas
non-promoters 2.4 2.5 2.2 2.3 2.3 2.4
f) Foreign venture capital investorsas
non-promoters 0.1 0.1 0.1 0.0 0.0 0.0
g) Qualified Foreign Institutional 0.0 0.0 0.0 0.0 0.0 0.0
Investors
h) Other institutions as non- 0.1 0.1 0.2 0.2 0.2 0.2
promoters

319
Strategic Financing Table 15.4 : Percentage Equity Holdings of Various Investor Classes
Decisions
2) Central and state governments as 0.1 0.1 0.1 0.1 0.1 0.1
non-promoters
(3) Non- 45.5 45.6 45.9 45.6 45.2 44.0
institutional
investors
a) Corporate bodies as investors 10.9 11.0 10.9 9.8 9.8 9.2
b) Individual investors 31.7 31.6 31.8 31.6 31.5 30.7
c) Qualified foreign non-institutional 0.0 0.0 0.0 0.0 0.0 0.0
investors
d) Other investors 2.9 2.9 3.1 4.2 4.0 4.0
C. Custodians 0.4 0.3 0.2 0.1 0.1 0.1

In order to understand the growing importance of investor re In order to

understand the growing importance of investor relations and its evolving role
as strategic enabler let us discuss the findings of a KPMG survey published
in 2019, in which 91 companies Were surveyed to understand the role of
investor relation function as strategic enabler. The main finding of the survey
are as follows.

The top three goals for IR functions were

• Enhance shareholders engagement
• Improve financial disclosure and overall creditability
• Enable better compliance and corporate governance
Other findings of the survey were
• 68% of CFO’s and 51% of CEO’s actively participated in IR activities
• 40% companies outsourced their IR activities mainly for backend
processing activities
• Perception studies were mainly outsourced and annual report preparation
involved both in-house and outsourced effort
• In terms of challenges with reference to IR function, top three challenges
faced by the companies were
• Successful articulation of intrinsic equity value and potential equity
value
• Since IR function is not perceived as a hardcore management function
the positioning of IR function as a strategic function in the company
• Communicate the guidance/expectations of top level management to
managers down the line

15.2 CORPORATE FORM OF BUSINESS

ORGANIZATION

The company form of organization is governed by the Companies Act. In

India, the Companies Act was passed during 1956 and subsequently amended
320
and revised and eventually replaced by Companies Act,2013. The Companies Investors Relations
Act of most countries allow a group of people to start a company and
approach public to raise large capital in the form of debt or equity. Generally,
the small investors buy the shares and become the owners of the company.
Institutional investors, as explained earlier, not only buy the shares, they also
lend money to these companies against bonds or mortgage. Hence it can be
found that the owners of a company could be any number of small investors.
The investor range increases with the size of the company. So the ownership
is spread across the world or countries. Figure 15.1 provides an overview of
the links between the company, the shareholders, the institutions and the
market.

While ownership is widely spread, the control is retained by a few. In the

sense that the management of the company is handed over to few Board of
Directors elected by the shareholders. This is because not all owners can
manage the company with a very small stake. This separation of ownership
and control leads to agency problem. Since agents behave with self-interest,
it might harm other investors who are not directly involved in management of
the company. For instance, managers may invest the capital in not so good
projects, and the result being the shareholders bear the loss of such bad
investment. The managers may also use the shareholders money in
different possible ways to serve their own interest.

Corporate Capital Investors

Market

Primary / Secondary Institutions

Finance
Functional
Function Shareholders
Managers
Managers

Figure 15.1: The Functioning of Corporate Form of Business

These managers may also get involved with creative accounting, with the
help of the auditors. We have seen many instances of scams of this nature. In
all these cases, every stakeholder is affected. The equity holders, on learning
such frauds, start selling the shares and this pulls down the prices of the stock
in the market. Not only will the small investors do such act, this could
happen with the institutional investors as well. The matter is even worse
with the institutional investors. This is because the institutional investors are
both lenders as well owners in many companies. They not only cause
damage by selling the shares, they will avoid lending to these companies in
future. So the growth of the firm gets affected and finally the company
might get liquidated.
321
Strategic Financing There are several ways in which the management or promoters can assure the
Decisions
managers manage the firm efficiently. Investor relationship in a broader
sense includes all such efforts taken by the agents to ensure that investors are
not affected by the agency problem. Investors expect management to run the
firm efficiently in a most transparent manner and take all decisions that
maximize the investors return. The next section would explain in detail the
expectations of the investors from the management of the company. If these
expectations are not met, then the company would be heading towards
serious trouble.

In the corporate form of business the stakeholders who put their resources
based on trust, reputation and risk reward profile of the investment. In order
to create and consequently enhance trust and reputation and provide
information to investors to decide on risk return profile IR function plays an
important role.

Key Considerations for investor relation function

Investor relation function is an evolving corporate function. In order to

maximise the output of this vital activity the IR team shall keep the following
considerations in mind.

Secure Board Commitment:

The contents and the direction of IR is generally guided by the higher

management. It is always a better idea to seek the commitment of the Board
of Directors regarding long term and open two way communication with
various existing and potential stakeholders. The stakeholders may be
domestic or foreign entities and may be long term or short term stake holders
one thing of importance here is that different categories of stakeholders will
have need for different kind of information therefore IR function shall design
the communication meeting the expectation of different stake holders. In
addition there should also be a broad policy regarding communication with
analysts, brokerage houses and media.

Form the investor relation team and assign responsibilities:

In normal circumstances CEO and CFO of the company are assigned with the
responsibility of investor relation, . but when the company is venturing into
new business line or developing new product it is better to associate key
personnel handling these activities to be part of IR team. Another aspect of
IR team is the role of external advisers. If the team consist of them then
specify clearly the role and responsibilities of external members/advisors.
Also decide beforehand the activities to be handled in house and the activities
to be out sourced.

Identify current and future investors:

The investment climate is a dynamic one and there is always a probability of

investors shifting from one company to another in search of better yields and
future potential benefits. In order to avoid this; regularly analyse the share
322 holders register and bond holders register and benchmark that against peer
companies. Another aspect is the composition of investors viz. retail or Investors Relations
institutional. In case of opaqueness in company’s operations retail investors
can be targeted as they are less demanding as compared to institutional
investors. Similarly in case of foreign investors the level of disclosures
requirement is high as compared to domestic investors. The segmentation of
investors profile is important in order to target specific investors suited to
company’s profile.

Determine the investment proposition:

The IR team should clearly articulate why an investor should invest in their
company. This requires a thorough analysis of the finances and operations of
the company. This would translate into specifying the current and future
ability of company to provide investors with capital growth/capital returns
including their size and timing

Select appropriate mix of communication tools:

Communication is one of the most vital aspect of investor relation. Apart

from the mandatory communication of price sensitive information to the
stock exchanges where the company’s share are listed, the IR team should
choose communication tools which are capable of transmitting information to
large number of present and future investors. Apart from investors also
design your communication strategy so as to result in wider media coverage
and analyst attention.

Set the financial reporting calendar:

Timely reporting of financial results (quarterly/half yearly/yearly) is an

important aspect of IR. In between the results if any price sensitive
information evolves then communicate the same to the investors.

15.3 DEMAND FOR INFORMATION

Basically, the demand for corporate information comes from the shareholders
and investors, managers, employees, customers, lenders and other suppliers,
security analysts, policy makers, regulators and government. Purpose of
soliciting information by different stakeholders of the organization varies to a
great extent. For instance, the Government seeks financial information of the
company mainly to check if it pays the right amount of taxes as also to check
if it does not violate licenses granted, export-import policies etc.

The suppliers would be demanding the financial information basically to

ensure that the company would be in business for sufficiently long period of
time and it would be worthwhile to have business with them. They would
like to know if the company would be able to pay their dues. Likewise, the
lenders would use information to verify the creditability of the company.

The managers call upon information of various types for planning and control
purposes. Of course, the information supplied to the managers within the firm
323
Strategic Financing may be much more in detail and confidential compared to the information
Decisions
provided to the outsiders. The customers, particularly the consumers of
durable goods or vehicles or IT products, would be interested in knowing
whether the company would exist in near future to provide them the service
for the product they purchased. So they would be constantly watching the
company’s performance for the same. The employees would be interested in
the company information because they would want to know if they would get
better wages or salaries for the coming years. Because if the firm is not doing
well, the chances are that they might lose their jobs and also lose wages. So
they keep a watch on the performance of the company.

The analyst demand information to publish reports on the performance of the

company and to rate its debt payment capacity. He continuously tracks the
company for information and analyzes the company accordingly and informs
the public on buy and hold strategies. On the other hand, the demand for
information by small and retail investors differs from that of the experienced
analysts. The small investors simply do not have the time to keep track of the
company’s latest information. This is because small investors invest in a
number of companies and it is difficult for them to keep track of the
information of all these companies. Moreover they would not be able to
analyze the information as usefully as the experienced analysts do. Hence,
they require much more detailed information and mainly in a processed
format so that they can evaluate the risk and return characteristic of the
company. This is for the fact that the risk and return of a firm are dependent
on the following:

i) the social, political and macroeconomic factors which are common to all
companies belonging to different industries, such as social harmony,
relations with other countries, political stability, growth rate of gross
domestic product (GDP), inflation rate, money supply, and policies of the
government;
ii) the industry factors which are common to all companies in a particular
industry, such as labour conditions in the industry, policies of
government which have influence on the industry, and demand and
supply factors and;
iii) company-specific factors which are important to any company, such as
financial performance, changes in the top management, decisions
relating to financing, investment and dividend. With the knowledge of
these factors, investors would be able to calculate the expected returns of
securities of different firms, the risk associated with their returns and
accordingly take their investment or portfolio decision.

Once the investment decision is made, shareholders and investors demand

information for the purpose of safeguarding their interest in the corporate
firm. This involves control of managerial behaviour so as to guide managerial
activities towards the maximisation of shareholders' wealth. Thus,
shareholders and potential investors require information so as to help them to
make the investment decision, as also to design contracts and mechanisms for
324 controlling the behaviour of managers, and orient the managerial behaviour
towards realizing the objectives of a firm. Accordingly, they demand all Investors Relations
information that is non-proprietary, i.e. information whose disclosure does
not affect the firm's future cash flows.

We know that the objective of existing shareholders is to maximise their

expected utility or wealth, even if it is at the expense of other parties involved
in the activities of a concern. First, they wish to safeguard their interest and
want to limit the possibilities for expropriation by all other parties. Second,
they will try to achieve the goal of maximisation of the wealth of the firm or
alternatively the expected utility or wealth of shareholders by expropriating
the other parties involved. Towards this end, they would like the management
to take decisions which would increase their wealth either through achieving
higher sales, higher incomes and higher profits or through transfer of wealth
from other parties involved in the corporate activity such as creditors,
managers, employees, customers and government. They also demand the
management of the company to disclose information that maximizes the
value of the firm.

However, we should also note that the demand for disclosure of corporate
information of prospective shareholders differs from that of existing
investors. Whereas the former wants the firm to reveal both value enhancing
as well as value diminishing information, the latter, expects the firm to reveal
only the value enhancing information and not to reveal the value diminishing
information. Such conflicts can be seen as amount existing groups of
promoters, institutional shareholders and public shareholders.

There are several agencies engaged in protecting the interest of small

investors and other stakeholders. The requirement that the company form of
organization has to be registered under the companies Act, 1956 is the first
protection to investors and others. The Registrar of companies makes sure
that the company that is formed is genuine and has been formed for the
purpose of being in the business. The investors' interests are protected by the
Securities Exchange and Board of India (SEBI). SEBI had laid down some
listing requirements for the companies seeking to raise money from the small
investors or public. Once the company accepts the listing agreements, the
company's shares get listed in the stock exchange. SEBI has also brought
several regulations and guidelines for market participants and intermediaries
to protect the interest of investors. The Institute of Chartered Accountants of
India lays down the necessary accounting standards based on which the
companies need to prepare the financial statements and get it audited by the
chartered accountants. This is done to ensure that the financial statements
represent true and fair view of the financial position of the company.

Basically the investor demands can be classified into three basic categories.
1) Transparency and Disclosure
2) Good corporate governance
3) Investors Service
Each of these are discussed in detail in the following sections. 325
Strategic Financing Activity 1
Decisions
Check with some of your friends who invest in stocks on the information that
they require/use while selecting the stocks for investments. Identify whether
companies disclose such information in the annual report.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
Activity 2
Check with your friend whether he/she is happy with the information
supplied by the company in disclosing such information. Also, find out
whether they are satisfied with the role of SEBI and Stock Exchanges in
improving disclosure standards.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................

15.5 TRANSPARENCY AND DISCLOSURE

Companies typically do not make available information on a day to day basis

because of strategic reasons, and huge costs involved in collection and
dissemination of such information to all the users. At the same time, the
companies disclose summary of information periodically for various
purposes. Corporate disclosure of information is determined by the market
forces, costs associated with corporate disclosures and the regulatory forces
(Refer Figure 15.2)

Market forces which influence the decision of corporate firms may relate to
the capital, labour and corporate control market. Corporate firms compete
with each other in the capital market for resources. They may issue different
instruments which meet the requirements of investors. The various forms of
raising finance have been discussed in the earlier sections. Under these
circumstances, capital market forces exert pressure on firms to provide
information relating to the instruments offered, terms of instruments, the
distribution of expected returns and importantly, on the projects for which the
capital is being raised. This is necessary because the investors have no
foresight about returns and the quality of the product. And firms may be
apprehensive, that in the absence of the authentic information, they may be
perceived by investors as 'lemon'. In the instance of non-disclosure by
corporate firms, the investors may not be able to assess the risk and returns
on the projects undertaken by the firms, as they would have no idea as to
which firm's projects are good or bad. Investors, under such circumstances,
326
require on average a high return. This higher required return may force the Investors Relations
issuers of capital to withdraw from the market as the net present value of the
project would be negative, if the projects are implemented with resources
mobilised at a higher cost. When 'good' issues are withdrawn from the
market, investors revise their required return upwards, which force some
firms to withdraw from the market. In this process, the capital market ends up
in a situation where there are only high risk offers, and there would be no
investors ready to supply the resources. Given the uncertainty about the
product quality, success of the projects and the cost of being perceived as a
'lemon', corporate firms have an incentive to supply the information that they
believe will enable them to raise capital on the best available terms.

Some firms may make overly optimistic forecasts about the future cash flows
associated with a project. However, checks such as (i) reputation of the firm,
(ii) reputation of the management, (iii) third-party assessment and
clarification, and (iv) legal penalties, act as deterrents for firms to make these
overly optimistic forecasts.

The labour market forces also exert pressure on the management to disclose
information to the public. This can be due to either external or internal forces.
For example, reputation of a management plays a vital role in determining
the managers' prospects of promotion and other incentives structure within
the firm as well as outside the firm. Hence, managers would not be willing to
take steps that damage their reputation of competence. Further, professional
managers are governed by a set of standards of behaviour or a code of
conduct which are determined by professional bodies, and non-adherence to
standards may lead to disciplinary action against them by the professional
bodies. Thus, forces in the labour market prompt the managers to disclose
information which improves their prospects, as well as their reputation.

The corporate control market forces also influence the firms' decision of
disclosure, and the timing of information release to the public. The efficient
working of a concern depends on the soundness of the policies determined by
the board of directors, and their effective implementation by the managing
director and his team of managers. If investors perceive that a company is
not run efficiently and identify ways in which its functioning can be
improved, they may attempt to take over the controlling stake of the
company. This perception of non-controlling stakeholders is influenced by
their private information. Such private information gives them an
advantage, as they can acquire the stocks of the company at the existing
prices. Under such circumstances, managers are forced to improve not only
their working but also the level of information disclosure. At times, even
when the investors do not have information about its good future prospects,
the prices of a company's securities may be under priced. However, the
corporate predators and raiders, under such circumstances, make attempts to
take over the company by actively buying the securities of the company in
the secondary market. This forces the managers to reveal the information
about the prospects of the company to the outsiders. Thus, the market forces
influence the supply of information in two ways: first by prompting the
existing management of firms to disclose information to the public and 327
Strategic Financing secondly, through the threat of actions of corporate predators and raiders,
Decisions
who continuously explore the opportunities for takeovers.

Fig. 15.2: Factors Influencing the Information Set Available to External Parties
Source: Foster, George, Financial Statement Information, p.24, Prentice-Hall International,
Englewoodcliffs, New Jersey, 1986.

The costs associated with corporate disclosures also influence the time and
extent of disclosure of information. These costs include: (i) collection and
processing costs, (ii) litigation costs, (iii) political costs, (iv) competitive
disadvantage costs, and (v) additional constraints on management decisions.

Collection and processing costs include the costs borne by both the suppliers
and users of financial information. Corporate firms as well as users of
information incur the costs of collection of information. The corporate
management has to make decisions on what information is to be collected
and at what frequency. It is not possible for firms to collect all the
information on a continuous basis, as it involves unlimited resources, both
human and financial.

The decision on information collection is often based on the assessment of

costs and benefits associated with such information. Firms, while computing
the costs of collecting and processing information, have to bear in mind
the costs incurred by the firm as well as the costs borne by investors in
performing such task. Similarly, while computing the benefits of information
production and processing, firms have to take into view the benefits that
accrue to all the users of corporate information who have a stake in the
corporate firm.

Litigation costs arise when the corporate has to face a dispute in a legal
forum. The prompt public release of information as well as corrective
information, if any, can reduce the potential losses to shareholders and the
potential exposure of the firm and its management in subsequent litigations.

Political costs arise in situations where the perception of government and

policies of government are influenced by the disclosure of corporate
information which influences the government to take actions which transfer
328 resources from the corporate to the other constituents of society through
fiscal and other measures. In these circumstances, firms may choose Investors Relations
accounting methods that they perceive will reduce the likelihood of large
profit increase being reported in any one year.

Competitive disadvantage costs arise when firms choose to reveal a portion

of proprietary information. Typically, firms choose to keep strategic
information such as information on research and development, new products,
advertising expenditure, break down of major customers and forecasts of
gross margin, income or sales by individual lines of business, when they
perceive that they have an advantage over competitors in these areas.
However, they face a difficult situation when they want to raise new capital.
In such a situation, irrespective of whether the firms disclose the
information or not, the firm stands to experience a reduction in its value. For
instance, unless firms provide some information pertaining to their research
and development activities or new products, the capital market is not likely to
support a new share offering, and yet, if they do provide detailed information,
they may reduce the lead time with which competitors learn about
developments within the company.

Disclosure of certain types of information by managers imposes constraints

on their behaviour and may lead to a conflict between their efficiency and
reputation. For example, earnings forecasts and their disclosure to the public
put pressure on managers to implement policies that result in the actual
earnings converging towards the forecast values.

Regulatory forces also influence the disclosure and timing of release of

information by firms. A number of regulatory agencies govern the
functioning of corporate and regulate their information disclosure. Such
agencies can be broadly discussed under four levels: (i) level one consists of
the executive, legislative, and judicial branches of the government. The
legislative makes laws which are enforced by the executive. The legislative
and executive define the manner in which the corporate has to disclose
information. The judiciary exerts influence on the disclosure practices by its
rulings; (ii) level two includes government regulatory bodies. As discussed
briefly in the earlier sections, in India, this level includes the Securities and
Exchange Board of India (SEBI), the Company Law Board, and the
Department of Company Affairs under the Ministry of Finance. These
agencies are often delegated with the authority of overseeing the adherence
of rules and procedures by corporate firms; (iii) level three includes private
sector regulatory bodies such as Accounting Standard Board, the Institute of
Chartered Accountants of India, and Stock Exchanges. Professional bodies,
through conducting seminars and publication of discussion papers and in-
depth analysis, from time to time, recommend standard practices to be
followed in the preparation of balance sheets, cash flow statements and profit
and loss accounts; (iv) level four includes lobbying groups that attempt to
influence the decisions made by the parties in the above three levels. These
professional bodies include industrial and trade associations, investor
associations and other interest groups.

The market forces and regulatory forces, described above, influence the 329
Strategic Financing decisions of both the corporate firms and non-firm information sources such
Decisions
as brokerage houses, and industry and trade associations as to what to
disclose and when to disclose. The decisions of corporate firms and decisions
of sources other than corporate firms influence each other.

However, not all information disclosed by the companies are mandated by

regulation. Companies also choose to disclose voluntarily information like
the social services performed by them, the company philosophy, objective,
business they are operating, the market share of the business, etc. However,
as sated earlier, companies would be hesitating to provide information, which
would reveal their competitive advantage to the competitors. For instance, the
ICAI introduced a new accounting standard on Segment Reporting (AS-17)
with effect from 2001. However, most companies still do not provide this
information despite being made mandatory by claiming that they are single
segment company. This is because as per this standard, companies are
supposed to disclose their financial information based on the different
segments. Prior to 2001, investors did not know whether companies were
performing good in all the segments in which they were operating. For
instance, prior to 2001 investors did not know whether L&T was performing
well in their cement or construction segment. Only the performance of L&T
was made known to the companies.

There has been tremendous improvement in the last few years in the
disclosure level of the Indian companies. This is mainly due to the new
accounting standards introduced by the ICAI like consolidation of accounts,
segment reporting, revealing the related party transactions, revealing the
intangible asset valuation etc. Apart from this the listing requirement had
also been tightened.

And listing requirements demanded more information from the companies.

One such latest requirement is the introduction of the Clause 49 on corporate
governance code. Accordingly, every company wanting to get listed in the
stock exchange will have to disclose the corporate governance systems and
procedures existing within the company. Detailed aspect discussion on this
made had been made in the next section.

Activity 3

Compare for any one company, the annual reports of the year ending March
2000 and March 2003. Identify major changes that you have seen on the
items disclosed by the company.

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

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

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

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

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

330
15.6 CORPORATE GOVERNANCE Investors Relations

Corporate governance plays an important role in building a good relationship

with the investors. This is because when companies are able to keep their
investor well informed about the way the business is done in a transparent
manner, this would definitely present a positive image. No investor would
want to do away his investment from such a company. McKinney in one of
their surveys (2000) reported that investors are willing to pay more for
companies with good governance. And the premium the investors would be
willing to pay for well-governed companies, they reported, differed by
country. As reported, the investors were willing to pay 18 percent more for
the shares of a well- governed UK or US company, for example, than for the
shares of a company with similar financial performance but poorer
governance practices. But they would be willing to pay a 22 percent premium
for a well-governed Italian company and a 27 percent premium for a well-
governed company in Indonesia. A well governed company is defined as
having a majority of outside directors on board with no management ties;
holding formal evaluation of directors; and being responsive to investor's
requests for information on governance issues. In addition, directors hold
significant stockholdings in the company, and a large proportion of director's
pay in the form of stock options. (Monks, 2001).

However, the existence of corporate governance by itself does not become a

sufficient condition for the better performance of a firm. It can, however,
become a necessary condition in the highly competitive world, particularly
when the market has become global. But why does it become a necessary
condition? Corporate governance can do a lot of things for the better
performance of the company:

1) Good corporate governance helps the company to evaluate the better

investment decisions.
2) It would help resolve the agency cost of debt and equity.
3) It can help retain the existing investors.
4) It can attract more and more investors, implying raising capital would be
easier.
5) Suppliers would be willing to deal with such companies.
6) Lenders would not be hesitating to lend to such companies, as the
systems are transparent and the performance of the company is well
revealed.

Companies like Infosys could be shown as a good example for maintaining

good corporate governance. The corporate governance report of the Infosys
Technologies Ltd., for the year 2003 as required under clause 49 is given in
Appendix to this Unit.

331
Strategic Financing Activity 4
Decisions
Find and write a brief report on events that lead to appointment of Cadbury
Committee on Corporate Governance in the UK.

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

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

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

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

Activity 5

Find from your stock market investor friend whether he or she is happy with
the corporate governance set up of Indian companies.

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

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

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

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

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

15.7 INVESTOR SERVICE

In the earlier sections we had discussed about the importance of companies
maintaining a good relation with the investors. We had seen that companies
gain a substantial advantage by transparent policies and disclosure practices.
However, in order to sustain the good relationship earned, the companies
need to provide the right information at the right time at the right place.
Further they must also attend to the queries of the investors promptly and
provide them a better service.

Though most of the information discussed above is filed with the stock
exchanges, information in the annual report are sent to the shareholders by
post. Some information are sent to the interested parties on demand. The
better practice has been that companies these days provide almost all
information in their websites. In fact, this is also mandatory by regulation.
The quarterly returns filed with the stock exchange have to be made
available in their website as well.

Some good governance companies provide a lot of these information in a

systematic manner in their websites; for instance the website of Infosys
technologies covers almost all information filed with the regulatory agencies.

As part of the annual reports, companies furnish the following details which
are useful to investors.
1) Financial calendar specifying the dates of holding the annual general
332 meeting
2) Dates on which the quarterly returns are to be released Investors Relations

3) Dates of book closure for different purposes like share transfer and
dividend payment
4) The addresses of the companies and the head office
5) Listing in stock exchanges
6) Information on dividend payment
7) Details about the investor grievances committee
8) Method of voting by proxy
9) Shareholding pattern of the company
10) The number of shareholders present in the company supplying the
different range of shares held.
11) Market price data of the shares traded in the listed stock exchanges and a
comparison of the share performance with the indices are also given.
12) Share transfer procedures. Though all the share trading is performed
these days in the demat mode, the details of the same are also given.
13) Plant locations
Investors are comfortable dealing with companies that furnish the maximum
information for the shareholders and also provide them good service.

Activity 6

List down the procedure to be followed when a shareholder has grievance

against the company. What are the alternative avenues available to investors
and what is the role of SEBI in handling investor’s grievances?

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

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

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

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

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

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

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

Activity 7

Visit SEBI's web site (www.sebi.gov.in) and visit EDIFAR link and write a
brief note on EDIFAR and its usefulness to investors.

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

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

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

....................................................................................................................
333
Strategic Financing
Decisions 15.8 SUMMARY

Mr. Narayanamurthy of Infosys stated that "The primary purpose of corporate

leadership is to create wealth legally and ethically. This translates to bringing
a high level of satisfaction to five constituencies -- customers, employees,
investors, vendors and the society-at-large. The raison d'être of every
corporate body is to ensure predictability, sustainability and profitability of
revenues year after year." Some companies not only state their
philosophies in just letter but they act on it as well. Having a mission
statement, underlying principles for achieving the mission and delivering
value to the owners and the other stakeholders enables the companies to have
a long-term good relationship with its investors. If the companies do not
sustain such long-term good relationship, we have seen that most companies
get liquidated in the process of cheating the investors. Hence, maintaining a
good relationship with the investors and performing the operations in the
most transparent manner helps the companies in the long term.

15.8 SELF-ASSESSMENT QUESTIONS

1) Who are the stakeholders of a company?
2) Why is that the investor relationship gains more importance in corporate
form of business organization rather than the other forms of business
structures. Does it really matter or apply for other forms of business
organizations? If so, how?
3) What are the forces that drive for information from the company?
4) What type of information is demanded by the different type of
stakeholders including the shareholders?
5) Do you think corporate governance matter in investor relationship?
6) Find out about 5 companies who have been rated as 'Good Corporate
Governance' company and examine their investor relationship. Are the
information provided by these companies to the investors differ to a great
extent? If so, list down in what aspects they differ.
7) What are the regulatory agencies that govern the disclosure of
information by companies. List them and their roles.
8) How does the information demanded by the inside shareholders differ
from the retail or external investors?

15.9 FURTHER READINGS

Bhabatosh Banerjee and Arun Kumar Basu (2001), Corporate Financial
Reporting (Eds.), University of Calcutta, Calcutta.
Bhabatosh Banerjee (2002), Regulation of Corporate Accounting and
Reporting in India, World Press, Calcutta.
334
Birgul Caramanolis-coteli, Lucien Gardiol, Rajna Gibson Asner Nils S. Investors Relations
Tuchschmid (1999), "Are Investors Sensitive to the Quality and the
Disclosure of Financial Statements?" European Financial Review 3, 131-
159.Monks, Robert A. G. (2001), "Redesigning Corporate Governance
Structures and Systems for the Twenty First Century" Corporate Governance
Journal 9(3), July: pp. 142-147.
John E. Core (2001), "A review of the empirical disclosure literature:
discussion" Journal of Accounting and Economics 31, 441-456.
Paul Coombes and Mark Watson (2000), "Three Surveys on Corporate
Governance" Mckinsey Quarterly, No. 4.
Paul M. Healy, Krishna G. Palepu (2001), "Information asymmetry,
corporate disclosure, and the capital markets: A review of the empirical
disclosure literature" Journal of Accounting and Economics 31, 405-440.
Stenberg, Elaine, (1999), "The Stakeholder Concept: A Mistaken Doctrine"
Working Paper, Centre for Business and Professional Ethics, University of
Leeds.
Ubha D.S. (2002), Corporate Disclosure Practices, Deep & Deep Publications.

335