UNIT 1 NATURE OF LONG TERM FINANCIAL DECISIONS

Objectives
The objectives of this unit are to : explain the basics of financial decisions and spell out the distinguishing features and interlinkages between financing and investment decisions of the firm. describe and illustrate the primary objectives of financial decision making. discuss the cardinal principles of financial decisions. explain and illustrate the concepts of time value of money. explain and illustrate the computation of the implied rate of interest, implied principal amount and annuities in borrowing and lending transactions. narrates the basic factors influencing long term financial decisions.

Structure
1.1 1.2 Introduction Nature of Financial Decisions
1.2.1 Investment Decisions 1.2.2 Financing Decisions 1.2.3 Dividend Policy Decisions 1.2.4 Inter-relationship amongst these Decisions

1.3

Wealth Maximisation Objective
1.3.1 Value Maximisation vs Wealth Maximization 1.3.2 Objective of Maximization of Profit Pool 1.3.3 Other objectives and Value Maximization Objective 1.3.4 Net present value rule 1.3.5 VMO and NPV rule

1.4 1.5

Cardinal principles of Financial Decision Time value of Money
1.5.1 Compounded Value 1.5.2 Discounted Value

1.6

Determination of Implied interest Rates, Implied Principal Amount and Annuities
1.6.1 Determination of Implied Interest Rate 1.6.2 Determination of the Implied Principal Amount 1.6.3 Determination of Annuities

1.7 1.8 1.9 1.11

Basic Factors Influencing Long term financial Decisions Summary Key Words Further Readings

1.10 Self Assessment Questions 1.12 Answers 1

Overview of Financial Decisions

1.1 INTRODUCTION
Role and responsibilities of a finance manager have under gone a remarkable transformation during the last four decades. Unlike the past, finance manager plays pivotal role in planning the quantum and pattern of fund requirements, procuring the desired amount of funds on reasonable terms, allocating funds so pooled among profitable outlets and controlling the uses of funds. Since all business activities involve planning for and utilization of funds, finance manager must have clear conception of the financial objectives of his firm and cardinal principles of financial decisions. Against this back drop, we shall discuss the basics of financial decisions; nature of long term financing and investment decisions; NPV Rule; time value of money; determination of implied interest rates, implied principal amount and annuities and basic factors influencing long term financial decisions.

1.2 NATURE OF FINANCIAL DECISIONS
Financial decisions refer to decisions concerning financial matters of a business concern. Decisions regarding magnitude of funds to be invested to enable a firm to accomplish its ultimate goal, kind of assets to be acquired, pattern of capitalization, pattern of distribution of firm’s, income and similar other matters are included in financial decisions. A few specific points in this regard are (a) Financial decisions are taken by a finance manager alone or in conjunction with his other management colleagues of the enterprise. (b) A finance manager is responsible to handle all such problems as involve financial matters. (c) The entire gamut of financial decisions can be classified in three broad categories: Investment Decisions, Financial Decisions and Dividend Policy Decisions.

1.2.1 Investment Decisions
Investment decisions, the most important financial decision, is concerned with determining the total amount of assets to be held in the firm, the make-up of these assets and the business risk complexion of the firm as perceived by the investors. The salient features of investment decisions are as follows: (i) The investment decision are of two types, viz, long term investment decisions and short term investment decisions. (ii) Long term investment decision decides about the allocation of capital to investment projects whose benefits accrue in the long run. It is concerned with deciding : What capital expenditure should the firm make? What volume of funds should be committed? How should funds be allocated as among different investment opportunities? (iii) Short terms investment decision decides about allocation of funds as among cash and equivalents, receivables and inventories. (iv) A firm may have a number of profitable investment proposals in hand. But owing to paucity of funds, finance manager should be meticulous in choosing the most profitable one. (v) Thrust of financial decisions is on building suitable asset mix.

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

financing mix. It is concerned with how to raise money for business so as to maximize value of the firm. Highlights of financing decisions are as follows: (i) Question of making financing decision arise as soon as decision regarding investment outlets is made. At times investment decision follows financing decision. (ii) A finance manager has to decide the appropriate mix of debt and equity in such a way that wealth of the shareholders is maximized. (iii) A finance manager is supposed to delve into the following issues requiring financing decisions: (a) From which sources are funds available? (b) To what extent are funds available from these sources? (c) What is the cost of funds presently used? (d) What is the expected cost of future financing? (e) What instruments should be employed to raise funds and at what time? (f) Should firm approach financial institutions for securing funds? (g) What will be the terms and conditions on which the funds will be raised from different sources? (h) What will be the nature of underwriting arrangements? (i) What innovations can be made in raising funds from wide variety of sources? (iv) A finance manager has to be in constant touch with financial markets. (v) Financing decisions are primarily concerned with capital structure or debt equity compositions.

Nature of Long Term Financial Decision

1.2.3 Dividend Policy Decision
Dividend policy decision decides about allocation of business earnings between payment to shareholders and retained earnings. A part of the profits is distributed amongst shareholders and other part is retained for growth of the company. A few specific points in this regard are as follows: (i) Closely related to the issue of raising finance is the issue of distribution of profits, which is effectively a source of total fund requirements. This constitutes the area of dividend decisions. (ii) Although both growth and dividends are desirable, these two goals are conflicting: a higher dividend rate means less retained earnings and consequently, a slower rate of growth in earnings and stock prices. (iii) For maximizing the shareholder’s wealth, the finance manager has to strike a satisfactory compromise between the two. (iv) Prudent finance manager takes dividend decision in the light of investor’s preferences, liquidity position of the firm, stability of earnings of the firm, need to repay debt, restrictions in debt contracts, access to capital markets etc. (v) Dividend policy decision is integral part of financing decisions.

1.2.4 Inter-relationship Amongst these Decisions
The interrelationship between three types of financial decisions centres around the following issues: (a) Which decision comes first investment or financing? One often wonders whether the financing decision comes first or the investment decision. The difficulty with such a question is that any answer in favour of the one or the other is bound to be wrong. For example, why would

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Overview of Financial Decisions

any management want to raise any capital unless it had some kind of project already in mind? Alternatively, how can a management consider undertaking a new project unless it already had some ideas as to how it is going to raise the necessary finances? So how does one decide which comes first? Chicken or the egg? The answer in our context is somewhat simpler than the moot question concerning the egg and its parent. The two decisions are in reality simultaneous. In fact neither decision by itself makes sense without the other. There would be no financing decisions to make in the absence of investment decisions and vice versa. (b) Investment Decision Vs Financing Decision- Fundamental Difference This, however, is not to imply that the line dividing the two is fuzzy. In fact, conceptually the two kinds of decisions are quite different and it is important to recognize them as such. What is the fundamental difference between the two ? Evidently, both, financing as well as investment decisions involve a certain selection of cash flows. Typically, a financing decision involves accepting cash today (inflows) from the capital market and repaying the same together with interest or dividend subsequently over a period of time (outflows). On the other hand, an investment decision involves investing the cash today in the product market (outflow) and receiving a stream of earnings (inflows) subsequently. Now, the cash invested in the product market is, in fact, the cash which is raised from the capital market. (c) Relationship through NPV If after paying all lenders their interest and shareholders their normally expected dividends, some surplus is left, obviously, it will belong to the shareholders thereby increasing their wealth. Usually, however, it is extremely cumbersome, though not impossible, to match the cash flows arising from the financing decisions and the cash flows accruing from the investment decisions on a period basis on account of the possible mismatch between their timings. It is therefore far simpler to capture the financing cash flows through their cost (of capital and to use this rate for discounting the operating cash flows. Under this framework, obtaining a positive net present value (NPV) implies the same thing as minimizing the cost of capital. The point becomes further clear if we take another look at the NPV formula i.e. NPV=Co+C1/(1+r) where C0 and C1 are cash flows occuring at time 0 and 1 A close look into the formula would readily show that ‘r’ and NPV are inversely related. A higher ‘r’ would mean lower NPV and vice versa. The ‘r’ being the rate of discount which normally represents cost of capital. It clearly highlights the interlinkage between the financing and the investment decisions and provides an explicit justification of the NPV rule as the basic rule of financial decision making.

Activity 1
(a) Identify forces than brought about fundamental change in role and responsibilities of a finance manager in India. ................................................................................................................... ................................................................................................................... ................................................................................................................... ................................................................................................................... (b) Write down two sets of cash flows; one representing a financing scheme and the other an investment scheme. 4 ...................................................................................................................

................................................................................................................... ................................................................................................................... ................................................................................................................... (c) Show the IRR of the Financing Scheme. ................................................................................................................... ................................................................................................................... ................................................................................................................... ................................................................................................................... (d) Discount the cash flows of the investment scheme using the above IRR as the discount rate. ................................................................................................................... ................................................................................................................... ................................................................................................................... ................................................................................................................... (e) ‘NPV formula captures the interlinkages between investment andfinancing decision’. Explain, with examples. ................................................................................................................... ................................................................................................................... ................................................................................................................... ...................................................................................................................

Nature of Long Term Financial Decision

1.3 WEALTH MAXIMISATION AND MAXIMISATION OF PROFIT POOL OBJECTIVES
In a highly competitive environment, financial objective of a firm should be set within the framework of corporate objective of sustainable competitive edge. As such Wealth maximization objective has come to be widely recognized criterion with which the performance of a business enterprise is evaluated. The word wealth refers to the net present worth of the firm. Net present worth is the difference between gross present worth and the amount of capital investment required to achieve the benefits. Gross present worth represents the present value of expected cash flows discounted at a rate which reflects their certainty or uncertainty. Thus, wealth maximization objective (WMO) as decisional criterion suggests that any financial action giving positive NPV should be accepted. Algebraically, net present value can be expressed as follows:

NPV (W)

=

A1 A2 An + + − C 2 (1 + k) (1 + K) (1 + k)n

where W = net present worth A1,A2…An = the stream of benefits expected to occur over a period of time K = appropriate discount rate to measure risk C = initial outlay required to acquire the asset n = time The objective of wealth maximization removes the following limitations of profit maximization objective (all such actions increasing income and cutting down costs should be undertaken):

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maximizing sales. Assuming the shareholders to be economically rational beings. mapping of the value chain beyond the confines of legal entities. In fact there are a whole lot of researchers who interview practicing managers and ‘show’ that the managers often have a whole lot of other ‘legitimate’ objectives other than the VMO. adoption of flexible organizational structures and creation of net-worked organisations. (ii) Shape of a profit pool reflects the competitive dynamics of a business. In case of a publicly held company. lending your money may give you a consumption pattern which is less risky.Overview of Financial Decisions (i) The term profit as used in the profit maximization goal is vague. In other words.e. shareholders seek to maximize their return for a given level of risk or minimize their risk for a given level of return. it appears reasonable to assume that in general they want to get as rich as possible through their stake in the business. (iii) Profit concentrations emanate from actions and interactions of companies and customers. Main highlights of this objective are: (i) Profit pool concept is based on the concept of looking beyond the core business. finance manager has to focus on value maximization-not only maximization of shareholders’ value but also stakeholders’ value. maximizing profit after taxes. Additional value accrues only with efforts that maximize profit pool. In the final analysis. (iv) A profit pool is not stagnant. A profit pool can be defined as the total profits earned in an industry at all points along the industry’s value chain. These are often enumerated as maximizing return on investment. they are assumed to choose the risks associated with the consumption pattern chosen by them (for example. maximizing the market share of their products and so on. a manager is expected to act in the best interest of the shareholders. who are the owners of the business. 1.3 Other Objectives and Value Maximisation Objective There are many other objectives which are assumed to compete with Value Maximisation Objective (VMO). Further. 1. your money in a security or share may give you a consumption pattern with higher risk). They are assumed to trade their wealth so as to obtain their desired consumption patterns. (iii) It ignores risk factor.3. whereas investing.2 Objective of Maximization of Profit Pool: In his endeavour to foster overall objective of sustainable competitive edge over the rivals. what is in the best interest of the shareholders? This depends on what the shareholders want. It is often held that very few managers in fact agree to pursue value maximisation of their firms as an explicit objective. they want to maximize their wealth i. market value of shareholding.1 Value Maximisation is Wealth Maximisation The owner of the business employs a manager to look after his business interests. (v) A profit pool map answers the most pertinent question where and how is money being made. (vi) Profit pool may prompts the management to examine how same profit sources exert influence over others and shape competition.3. 6 . 1. The wealth maximization objective has the advantage of exactness and unambiguity and also takes care of time value and risk factors.3. It includes disaggregation of processes. (ii) it ignores time value factor. Now.

that such a course of action would eventually lead to enhanced profits in the long run. There are three proposals before him for its sale: A Rs. may be stated as follows: NPV = C1/(1+r) . 1 ) NPV2 NPV3 = 80. one researcher asked a manager who held maximization of market share as the corporate objective. he should have no objection to such a proposition.3.50 (1 + 0. Similarly.000 B Rs. 000 = 0 (1 + 0 . Other objectives such as maximization of return on investment or profit before taxes etc. as to whether he would like his company to capture 100% market share by pricing below costs. For example. his desire to maximize market share even at cost of profits in the short terms. an investment is worth making if it has a positive NPV. must have been triggered off by the possibility of attaining a monopolistic position so that profits in the long term can be maximized. If an investment’s NPV is negative.000 − 70. Clearly if market share maximization is the prime objective.000 = − 1817. The NPV rule really provides you with a simple way of making that comparison.C O Where CO stands for initial cash outlay. When he should sell his price of land ? By applying NPV Rule.75.77.70. the results will be as follows: NPV = C1/(1+r) –co NPV1 = 75. Nature of Long Term Financial Decision 1.000 − 70. you compare the returns on the investment with what the financial markets are offering. On comparing the present value of an investment with its initial outlay.27 (1 + 0.000 C Rs.A little reflection reveals the intrinsic weakness of such studies. in the form of a simple algebraic formula. r for is the discount rate. We can see that what are constructed as objective as other than VMO are in fact merely short term operational strategies for maximizing wealth of the shareholders in the long run. if not immediately.000 in a piece of land.4 Net Present Value Rule Wealth maximization objective gives Net Present Value (NPV) rule as the most basic rule of financial decision making.1) 7 . By computing the present value of an investment you are finding out what the investment is worth today. Example: X invests Rs. it should be rejected. And yet it would be a poor manager indeed who goes for such an opinion.000 = 2727 . you arrive at the net present value which may be positive or negative.1) = 77 . are at any rate linked to the wealth maximization criteria directly or indirectly. As a rule. The discount rate r should include an appropriate premium for risk. Clearly. a manager who maximizes sales may be operating under the assumption.000 His expectation of income is 10%. C1 for the cash that with be received from the investment in one year’s time. The concept of NPV. 000 − 70 . To make as investment decision.80.

. .................... Hence............... ........................... the market mechanism would ensure that the price of the firm’s share drops..... If the management of the firm fails to earn Rs.......................................... X will invest in land only where the land will sell for Rs.............80...................... ...................................................... positive NPV is the logic..............3............. How much will the drop be? It depends on the level of the firm’s earnings...............................................75..........100...............75.......................... so that this excess of the present value of inflows over the initial investment enhances the total market value of the shares belonging to the shareholders.................... the price of the share would drop to Rs............ why? This is because.................................. Activity 2 (a) Map out profit pool for a transport industry................. the principal objective in business becomes the maximization of the shareholders wealth.........................77................. given the earnings per share of Rs...................... thus. as long as the objective of the firm is value maximization......................20 per share............... .......................................... .....................Overview of Financial Decisions Applying the NPV rule........ the investors would be better off by investing their funds elsewhere... (c) Investors in a capital market revise their expectation of return from a particular company from 20% to 24% on account of that company having undertaken some risky ventures recently... If the earnings level falls to say Rs.............................5 VMO and NPV Rule It clearly emerges form the foregoing discussion that a manager can help the shareholders by making all business decisions in such a manner that the shareholders’ stake in the business is maximized..............................75................................ What could be the possible reasons? . Let us suppose that the market value of a firm’s share is Rs............... (b) The market price of a company’s share falls.....15 per share over a period of time......................................... Would the market price of that company’s share go up or go down ? why? 8 ..........................................000 next year and not where the land will sell for either Rs...........................................000 or Rs...... this drop in the price of the share would however lower the wealth of the shareholders....... 1.................. This would essentially mean that the managers would invest in all such investment opportunities where the present value of the expected future cash inflows exceeds the current level of investment........................................... Let us further assume that the shareholders of the firms expect to earn a return of 20% per annum from their investment in the firm... Thus the manager must invest the shareholders’ funds only in ventures which yield positive NPV such that the value of their shares is maximized..................................... ............................................ ..... One might ask here: Is this NPV rule valid for firms also? The answer is ‘yes’............................................000................. It should be clear that if the New Present Value (NPV) of an investment were to be negative.....15 of the firm... ........... the manager must ensure that the funds are invested in ventures which would be able to generate enough surplus to meet the expectations of the shareholders.. the shareholders can continue to earn their expected level of 20% return only if the price of the share fell to Rs..........

............................................................................. kinds of assets to be acquired............................................................................... extent of funds to be kept in liquid form............. etc.......... a firm should continue to operate upto the point where its marginal revenue is just equal to its marginal cost. ............ types of funds to be employed............. its financial performance is expected to improve in the future...............4 CARDINAL PRINCIPLES OF FINANCIAL DECISIONS: A finance manager in his attempt to maximize corporate value of the firm must keep in view the following basic considerations while making financial decisions: (i) Strategic Principle: According to this principle...................... ............................................................................................................................................. ...................... ............................................................ ..................... (vi) Flexibility Principle: According to this principle... financial plan of a firm should be capable to being changed in sync with changing environment......................................... ................................................. financial decisions of a firm should be tethered to the overall corporate objectives and strategies...................................... (d) On account of certain government concessions to a particular company................................................................... (iv) Marginal Principle: According to this principle......................................... 9 ..... return and risk are the function of decision relating to size of the firm............................. proper balance between fixed and working capital should be sought......................................................................................................... Given the product-market strategy......................... (e) A firm has decided to set up a steel plant........................................ (v) Suitability Principle: Focus of this principle is on creating an asset by a financial instrument of the same approximate maturity............................................. (iii) Risk – Return Principle Maintaining suitable balance between risk and return is the crux of financial decision making................................................................ .. (ii) Optimization Principle: Thrust of financial decisions should be on intensive use of available funds and for that purpose..................................................................................................................................................... ........................................ What sources of funds would you suggest to the firm for funding the plant? ....... Would the market price of the company’s share go up or go down? Why? ........... Nature of Long Term Financial Decision 1.......................................

(ii) An investor can profitably employ a rupee received today to give him a higher value to be received tomorrow. (ii) A person may prefer to accept less today for a rupee to be received in future. Money has a time value because of the following reasons: (i) Individuals generally prefer current consumption. What would your choice be ? Still Rs. Needless to say. instead of cash and the same amount of goods a year from now.100 a year from now might be worth much less than Rs. so that you are effectively protected against inflation. if it did not expect to earn more than Rs. that you are living in an economy which is free from inflation. Thus in this case. 1.100 today why ? A good reason can be that you could collect your Rs. (iv) Inflationary pressures make the money received in future of lesser purchasing power.5 TIME VALUE OF MONEY Suppose you are given an option to receive Rs. i. 10 .100 a year from now? Possibly.100 worth of goods today.10 by investing Rs.10) in return for your allowing them the use of your capital (Rs. (iii) Future is uncertain.100 today.10 than you would have been if you had received Rs. which option would you choose? Of course. They are called as compounded value and discounted value.110 a year from now. Investment and financing decisions should be taken at a time that enable the organisation to seize market opportunities and minimize cost of raising funds. put it in the fixed deposit in the bank for a year. for the sake of argument. the bank would not have agreed to give you Rs.100 elsewhere during the year. But this element or risk associated with Rs. and collect Rs. Why? Could it be that Rs. Thus. the real time value of money would depend on the total amount of money available in the economy and the investment opportunities available in the economy and so on. 10% per annum. Rs. therefore. So you are required to make your choice once again. so that you may disregard the possibility of such default.100 a year later.100 today.Overview of Financial Decisions (vii) Timing Principle: Timing should be crucial consideration in financial decisions.100 today represents greater certainty than Rs.100 a year from now could be eliminated or largely reduced through suitable promises. Let us suppose.10 represents the time value of Rs.e. there is preference of having money at present than at a future point of time. prepared to give you a rental (Rs. You may be promised Rs. why should the bank give you 10% interest on your deposit? The obvious reason is that cash is a scarce resource and the bank is. The next question could be. insurance against default and so on. assuming that the bank gives you 10% interest on your deposit. Would you still choose to receive Rs.100 today rather than a year form now? Why ? May be you are afraid that Rs.100 today on account of inflation. Time value of money or time preference for money is one of the central ideas is finance.100 today or Rs. This automatically means: (i) That a person will have to pay in future more for a rupee received today.100 for a period of one year. Rs.100) for a year.100 a year from today. Of course.10 for using your capital for a year. Thus you would be better off by Rs.

In case of discounted value. In mathematical terms: Terminal value of Rs.110.100 one year from now.100. and for ‘n’ periods from today will be p (1+r) (1+r) (1+r) …. you multiplied Rs. How did you arrive at the terminal value of Rs.5.110.110 a further one year hence.100 is the present value of Rs.100 @ 10% at the end of one year is equal to 100 + 0. Given that the time value of money (say interest rate) is 10% per annum. at a rate of ‘r’ per period.1 = Rs.110 after one year” stated in a numerical way means that Rs.1 Compounded Value The process of finding the future value of a payment or receipt or series of payments or receipts when applying the concept of compound interest is known as compounding.100 at the rate of 10% two years from today? (Hint : First find out the terminal value of Rs. 11 .12 = Rs. In case of multiple period compounding r  A = P 1 +   m m×n Nature of Long Term Financial Decision Where A m P r n = = = = = Amount after n period number of times per year compounding is made Amount in the beginning of period Interest rate Number of years for which compounding is to be done 1.100 by 0.100 and take back Rs. what will be the value of Rs. we estimate the present worth of a future payment/instalment or series of payments adjusted for the time value of money. It is also called terminal value. which will be Rs.2 Discounted Value “Deposit Rs.110 to be received a year hence.10 x 100 = 100 x 1. the terminal value of an amount ‘p’.5. Present Cash to Future Cash Let us now understand the concept of terminal value.110? whether you were aware of it or not.121 In general then.110. now find out the terminal value of Rs.1 = 100 x 1. n times = p (1+r)n Note: (1+r)n is known as the Terminal Value factor n periods hence.1. Thus the terminal (or compounded) value of Rs.110. Similarly.100 one year from today? Obviously Rs.) In mathematical terms.110. can you now find out the terminal value of Rs. this would be equal to 100 x 1. to obtain Rs.10 (being 10%) and added the result to Rs.100 at the rate of 10% a year from now is equal to Rs. at the compound rate of r per period.1 x 1.

.100 and Rs....................... Rs................800.. ............1................ ......64463.........500............................................100 one year hence @ 10%).................... what will be the present (or discounted) value of Rs....100 to be received one year hence..110 by 1.... @ 10% per annum = (100/1....1=90...........110 to be received one year from now? Clearly......................................................400 respectively at the end of one through five year... Find the present value of this stream of uneven cash flows................ Hence..........1.......................................................... Find the sum at the end of two years................................. (b) An investor has an Opportunity of receiving Rs.. if the investor’s interest rate is 8 present? .......... ........100 by by 1......... ..... What is the effective rate of interest if the compound is done (a) half yearly (b) quarterly and (c) weekly............. @ 10% per annum = 100/1......................Overview of Financial Decisions Future Cash to Present Cash At the rate of 10% per annum............................... .... this will be Rs................................. ......................1.................... @ 10% per annum? This will be Rs............................. how was this arrived at? By dividing Rs......................... Activity 3 (a) A sum of Rs.................. ............. was the terminal value of Similarly................... the present value of rs............................... In general then the present value of an amount ‘P’ to be received in ‘n’ periods hence.1=100(1.................... what will be the present value of Rs...... ......100 to be received one year hence........... 12 ......................................................................................100...... (c) You can get an annual rate of interest of 13 percent on a public deposit with a company...................1.. 100 to be received two years......................................000 is placed in the savings account of a bank at 5 percent interest rate....1..............000....110 Rs........................90909......................... arrived at by dividing Rs............... Rs......................................1)2 =82.....9.............................. .......................................................................................................................90909............ Rs............. at the discount rate of ‘r’ per period.........................................1)/1............................................... ................. at the rate or ‘r’ per period will be =P/(1+r)n..................................... In mathematical terms: Present value of Rs. Note: 1/(1+r)n is shown as the present value factor for an amount received ‘n’ periods hence................................................................. ........1 (Remember: Rs................................................... Similarly..........

2 and 7 intuitively. This is because at the end of one year.50 is outstanding as long for the second year so that the interest accrued on this amount at the rate of 20% in the second year is only Rs. in all these cases the implied interest rate remains 20% per annum.6.20. schedule 4. thus. Thus. Consider.20 is being paid at the end of every year. at the end of first year half of the principal is repaid. (Can you provide similar interpretations for schedules 3. through this would be somewhat more difficult. however. in this case. the process of determination of implied interest rates. at which time the principal of Rs.100 now: Repayment Schedule Repay at the end of Repay at the end of Repay at the end of Repay at the end of Repay at the end of Repay at the end of 1 20 20 120 — — — 2 20 20 20 120 — — 3 45 90 — — — — 4 70 60 — — — — 5 95 30 — — — — 6 95 5 5 5 30 — 7 20 20 20 20 20 20 20 1st year = Rs. In case of schedule 7.20 is paid again at the end of second and third years. IMPLIED PRINCIPAL AMOUNT AND ANNUITIES In this subsection. (Repay in perpetuity) What is the interest rate implied in each of the above repayment schedules? Is it 20% for all the schedules? At this stage you may find it more difficult to provide an answer. implied principal amount and annuities is explained. Similarly Rs. for example.6 DETERMINATION OF IMPLIED INTEREST RATES. Rs.1. Thus. Similarly. you are required to repay the principal of Rs.100 as well as the interest of Rs.5 and 6? You should be able to see that in all these cases the implied interest rate is 20% per annum). 2nd year = Rs. be relatively simpler to answer the question for schedules 1. For repayment schedules from 3through 6. However.1 Determination of Implied Interest Rates Suppose you borrow Rs. What is the interest rate implied by your borrowing? Clearly 20%. the principal is never repaid and hence the interest of Rs.100 is also repaid. how can one determine 13 .20. 3rd year = Rs.60. In the absence of prior information on the interest rate. It should be readily apparent that one may arrive at an infinite number of such repayment schedules all of which imply an interest rate of 20% per annum. the interest accrued is Rs. In case of schedule 1. a similar interpretation is possible. 5th year = Rs.100 for one year and the lender asks you to repay Rs. the principal amount is fully repaid only at the end of fourth year. till which time the interest of Rs.20 is being paid at the end of every year for ever. in case of schedule 2.10.70. the interest rate implied in this case is also 20%.50 is fully paid the end of second year so that the total repayment at the end of second year is Rs. The outstanding loan of Rs. It may. Nature of Long Term Financial Decision 1. this together with half the principal being repaid at the end of the first year amounts to Rs. suppose the lender offers you any one of the following repayment schedules for having borrowed Rs.120 one year later. 6th year = Rs. 4th year = Rs. However since the entire principal is outstanding for the whole of first year. only Rs.20 is paid towards interest at the end of first year since the loan is fully outstanding.

you should be prepared to lend Rs.45 to be paid one year later and 90/(1 + r) represents the present value of Rs.500 in the above case.2 Determination of the Implied Principal Amount Let us assume that a prospective borrower approaches you for a loan.120 how much would you be prepared to pay for the share of such a company today? “Clearly. how much amount would you be prepared to lend him today? In the light of our discussion above.45 and Rs.90 at the end of second year. -45 at the end of the first year. we must have: P = 193/(1. 30 and 40 at the end of one.20. In this case. In other words.193 for four years starting a year from today.Overview of Financial Decisions what interest rate is implied in a given loan scheme? One must have a more structured and systematic approach to determine the implied interest rate.2) + 193/(1. in time zero. it can be found that when r = 0. and -90 at the end of second year respectively (plus sign is for the inflow and minus sign is for the outflow). interest rate implied in a typical loan scheme which involves an initial inflow (borrowing) followed by subsequent outflows (repayments) is just like the IRR of the cash flows associated with the loan scheme. the equation is exactly satisfied. Let us suppose you expect a company to pay you dividends worth Rs. The Schedule represents a repayment of Rs. Mathematically. the present value of outflows exactly equals the initial inflow.90.100 now.100 Let this rate be equal to ‘r’. respectively. two and three years from today.2)3 +193/(1. for the set of cash flows represented by Rs. 100. the initial borrowing (inflow) is 100 and the repayments (outflows) at the end of the first and second years are Rs. Thus we must have: 100 = 45/(1 + r) + 90/(1 + r)2 (Note : 45/(1 + r) represents the present value of Rs. so that the interest rate implied in this case is confirmed to be 20%. the implied rate of interest is equal to 20%. At the rate of 20%. Let us assume that the amount you would be prepared to lend is P.2)4 = 500 Thus. You have studied that Internal Rate of Return (IRR) is the rate at which the present value of the inflows exactly equals the initial outflow. Assuming that your desired rate of interest is 20% per annum. at the rate of ‘r’ per annum). respectively. Further suppose you wish to hold the share for only three years and you expect to be able to sell the share at the end of the third year for Rs.6. Let us consider schedule 3. In the above example. it should be clear that the amount you should lend. Thus.45 at the end of first year and Rs.193 for four years discounted at the rate of 20%. 1.90 to be paid two years later. given a loan amount and its repayment schedule. against a loan of Rs.20. The interest rate may be defined as that rate at which the present value of the repaid amounts exactly equal Rs. The value of ‘r’ can be determined from the above equation using the hit and trial method without much difficulty. should exactly equal the present value of the annual stream of Rs. we must employ the same technique as above and 14 .2)2 + 193/(1. He is confident of being able to pay you Rs. The same logic may be employed to determine what is called’ fair price of a share’ in the market.

. -100.........30 at the end of second year and 160 at the end of third year (Rs.......................................... The present value of the above inflows when discounted at 25% yields about Rs.........3 Determination of Annuities Let us assume that you borrow Rs........... which is the amount you should be willing to pay for a single share of the company mentioned above..... What would you do if annual repayments were to commence as soon as loan was received..............117.........................................................e.....20 at the end of first year.... ................................... .......................................... ......50............................................................................................................................................... Guess why?).... you wish to repay the loan in two equal annual installments (also knows an annuities).. Let us assume that you wish to earn 25% on this investment as you consider the proposition somewhat risky (assuming that higher the risk.................................. (c) Given the cash flows + 500........... or 100 = 0...2) + X/(1.................................. What should be this installment? (If your answer is Rs................................................ higher the return expected).....................527 = 65...... Rs................100 at an interest of 20% per annum for a period of two years................. Nature of Long Term Financial Decision 1................. . Activity 4 (a) In the above example................ can you find out the annuity payments if the repayment period were three years or four years or five years? What will be the annuities.......... 15 ....................................... .......... .........................6............ i............................ ....... namely Rs................. Let us assume that each installment amount equals X............. the repayments commenced one year later...........................2........... instead of from the end of first year onwards? .................40 worth of dividends plus Rs........ However.......... -200. (b) In the annuity example given above...120 from the sale of the share) at a rate which you expect to earn on your investment”......................................................... -300...... it is obviously wrong................ X at the end of first year and x at the end of second year respectively...............694 X or X = 100/1.............1....................................find out the present value of the inflows..2)2.. .............................................................. According to the IRR rule................. respectively....... .............................................. We have a cash flow pattern of the kind + 100 in time zero........................................... -400 in period 0....................................... Calculate the Implied rate of interest........................................................................ if the payments were to commence immediately? .................49........833 X + 0............................................ ......................................................3 and 4............... from time zero onwards... we must have: 100 = X/(1........

(vi) Lending policies of financial institutions. phase of trade cycle. Internal Factors Internal factors comprise those factors which are related with internal conditions of the firm.8 SUMMARY Investment decisions pertains to choice of outlets in which funds are to be deployed so as to maximize value of the firm where as financing decisions concern with funding of the outlets and dividend policy decision shed light on allocation of net earnings between retention and distribution. (v) Expectations of Investors in terms of safety. therefore. The objective of a firm is to maximize the wealth of its shareholders. as listed below: (i) Nature of business (ii) Size of Business (iii) Age of the firm (iv) Ownership structure (v) Asset structure of the firm (vi) Liquidity position of the firm (vii) Expected return.Overview of Financial Decisions 1. 16 . The wealth of the shareholders is measured through the market value of their shares. only those projects which yield a positive NPV are accepted. Dividend Payment Restrictions etc. 1. discounted at the rate of return expected by its shareholders. liquidity and profitability. The following external factors enter into long term financial decision making process: (i) State of economy-i. be in fitness of things to take the decisions in the light of external and internal factors as discussed below. These factors are beyond the control and influence of management. In order to maximize the shareholders’ wealth. (ii) Institutional structures of capital markets (Developed or undeveloped). (iv) Taxation policy. (iii) State regulations in financing (Debt Equity Norms. cost and risk (viii)Probabilities of regular and steady earnings (ix) Attitude of management It is practically inexpedient to consider all the factors at a time since they are antagonistic to each other. It would. External factors External factors refer to environmental factors that bear upon operations of a business enterprise. risk.e. A prudent and skillful manager strives to strike a proper balance among these factors in the light of income. The Market value of a firm’s share is nothing but the present value of its future earnings. control and flexibility factors.7 BASIC FACTORS INFLUENCING LONG TERM FINANCIAL DECISIONS A finance manager has to exercise great skill and prudence while taking longterm financial decisions since they effect the financial health of the enterprise over a long period of time.

so that the Net Present Value (NPV) of the set of given cash flows equals zero. Financial Decisions refer to decisions concerning financial matters of a business concern. which is termed as the time value of money. Time Value of Money refers to the instrinsic value of money on account of its alternate use potential. This is so because the rupee can be put to some productive use during the intervening period and thus made to earn. The former involves discounting the future rupee to the present at the appropriate cost of money. Terminal Value is the value obtained when current cash flows are compounded to the future at a certain rate. either today or tomorrow. Dividend Policy Decisions decide about allocation of business earnings. when cash inflows are discounted at a suitable rate. Capital Market is where financial instruments are bought or sold. Net Present Value is the difference between the present values of cash inflows and cash outflows. reducing them to tomorrow’s value is known as terminal value. Present Value is value obtained when future cash flows are discounted to the present at a certain rate. It has a cost.A rupee today is not equal to a rupee tomorrow. Cost of Capital is a term used to refer to the weighted average of the cost of debt and equity. while the letter involves compounding the rupee today to a future date. 17 . Equity represents the share of an investor in a business. 1. capital does not come free.10 SELF-ASSESSMENT QUESTIONS 1) Why is Time Value of Money independent of inflation and risk? Differentiate Present Value and Terminal Value. Nature of Long Term Financial Decision 1. Financing Decisions refer to capital structure or optimal financing mix. Capital Structure is the composition of a firm’s capital in terms of debt and equity. Like any limited resources. Reducing them to today’s value is called their present value. Investment Decisions refer to assets mix or utilization of funds. The mechanism by which we equate a rupee today with a rupee tomorrow is by bringing both the rupees on a common date.9 KEY WORDS Annuity is an equalized stream of cash flows over a period of time. Finance manager has to exercise great skill and prudence to strike a proper balance amongst external and internal factors influencing financial decisions. Internal Rate of Return (IRR) is the rate at which the present value of a stream of cash inflows equals the initial outflow. Similarly.

000. project B.10.6.000 to produce. He plans to consume only Rs.000 1 year from now Alternate 2 : Rs.50.25.000 and will earn Rs. Project a will yield Rs.40.000 this year.000 this year. X will have to borrow the amount required for investment at the rate of 12% per annum.000.70. Lottery officials offer you the choice of the following alternate payouts: Alternate 1 : Rs. What will be Amir’s consumption potential next year? 13) It is estimated that a firm has a pension liability of Rs. Next year he will earn Rs. Payment is to be received at the end of 2 years.000 at the end of every year for three years.000. Mr. second and third years. The current interest rate is 10%. financial analyst wants to discount this liability back to the present.000 and 3.000. X is considering to invest Rs. What interest rate was the client charged? What would be the interest rate if the Manager had instead asked the client to repay in five annual installments of Rs.20. We will have : (1 + R) = (1 + r) 4. To assess the value of the firm’s stock.Overview of Financial Decisions 2) 3) 4) 5) 6) 7) What is Net Present Value? How is the NPV rule related to the wealth maximization objectives of a firm? What is IRR ? How does it relate to financing decisions? Can you use it for investment decisions of the accept/reject type? What is Investment Decisions? How is it different from financing decisions? Bring out the factors influencing long-term financial decisions of the firm ? ‘Obtaining Positive NPV implies the same thing as minimizing the cost of capital’ Explain with examples. Govinda is profligate and wants to consume Rs.60. what is the present value of this liability? 14) Consider a firm with a contract to sell a capital asset for Rs. If the discount rate is 16%.5.20. however. did the firm make a profit on this item? That is the interest rate at which the firm breaks even? 15) You have won the Nagaland State Lottery. The asset costs Rs. 4. Given that the interest rate is 10%.000 at the end of each year for 8 years.000. 4.20. will yield Rs. Project a and B require equal amount of investment.1 lakh in a project which is expected to result in a net cash flow of Rs.000 next year.60.5.000 down and for the seller to carry a contract .000 and 5. the Bank Manager requires the client to repay Rs.1 million to be paid in 24 years. respectively.12. Should he undertake the project ? 11) Suppose Govinda is currently earning Rs. What will be Govinda’s consumption potential by next year if he consumes according to his desires this year? 12) Amir is a miser.000. respectively in the first. second and third years.000 5 years from now Which should you choose if the discount rate is a) 0% ? b) 10% ? c) 20% ? 18 16) You are considering to make an offer to buy some land for Rs.3.000 in the first. Which project is superior? Why What will be the monthly time adjusted interest rate which is equivalent to an annual interest rate of 15%? Hint : if annual rate = R. He currently earns Rs.75.4. and equivalent quarterly rate = r. The current interest rate is 10%.000.000 at the beginning of every year starting from the date of borrowing? 10) Mr.50. 8) 9) A client goes to the bank and borrows Rs.000 Your offer will be to pay Rs.

you are willing to pay off the contract in equal monthly installments. Lawrence D.. James. you would like to pay off the contract over six years at an interest of 18 per cent per year. For the first year. A. New Delhi-1994 (Chapter 4). Corporate finance. He has discussed paying off the loan ahead of schedule with an officer of the bank holding the mortgage. The loan has a current balance of Rs. Introduction to Financial Management.000 and will be paid off in twenty years by paying Rs. “Financial Management – Principles and Practice”. Haley. 1986.000. “Financial Management”. New Delhi – 1993 (Chapter 1 & 8). Mumbai – 2003 (Chapter 1) Maheshwari. Srivastava..1102. 1988. Vikas Publishing House.50 19 . For the remaining five years.000 right now to pay it off completely. Westerfield. R. and Charles W.30.M. Financial Management and policy Himalaya Publishing House.270 per month.. 1986.N.4 & 6). Tata McGraw. C.2. He has a mortgage loan on the family home that was made several years ago when interest rates were lower. Weston. 1. briefly.30. you wish to pay interest only each month. What will be your monthly payment for years 2 through 6 if the seller agrees to your terms? 17) Sukhdev wants to save money to meet two objectives. First. The bank is willing to accept Rs.000.11 FURTHER READINGS Ross. the Dryden Press (Chapters 1. R. Nature of Long Term Financial Decision 1. the nature and types of financial decisions. Financial Management and Policy. J. 1985. New Delhi (Chapter 1).20. Brigham. McGraw Hill. Second he would like to purchase a plot of land five years from now at an estimated cost of Rs. He can afford to save only Rs. “Financial Management”’ Pragati Prakashan.for the remaining Rs. S.M. Schall.15. Chandra. What must his minimum annual savings be from years 6 through 20 to meet his objectives? 18) Deepak has asked your advice on the following problem. he would like to be able to retire twenty years from now and have a retirement income of Rs. Srivastava. Pandey. Managerial Finance.5. I. What advice would you offer to Deepak? 19) Which decisions comes first-investment or financing? 20) Explain. Stephen and Randolph W. New York (Chapters 1.M.000 per year for at least ten years. Times Mirror Missouri (Chapter 3).12 ANSWERS Activity 3 (a) Rs. Prentice-Hall of India. 2. 4 & 5).000 per year for the first five years. Shkhdev expects to earn 10 per cent per year on average from investments over the next thirty years. Sultan Chand & sons-1996 (chapter 1&2). Van Horne. Fred and Eugene F.27. “Financial Management – Theory and practice”. Prasanna.

Negative NpV – Rs.19 and Rs. 13.Overview of Financial Decisions (b) Rs.3921.39.44 Second part-Rs.33. 9 first Part – 23.47. 10 No.56. Rs.86% Activity 4 (b) First part –Rs. Prosecute B 8.51.42%.1. 1.648 20 .63 and Rs.27.60 (c) 13. Rs. 7.87 (c) Approximate -2) Self assessment Questions/Exercises.38.32. Second Part-20/.47. 13.65%.17.

equity shares.1 2. we shall dilate upon the concept of the cost of capital and its classification.1: Share Valuation with Constant Growth in Dividends 2.1 2. discuss and illustrate the various weighting approaches and the Weighted Average Cost of Capital (WACC). It links the company’s long-term financial decisions with the shareholders’ value as determined in the market place.3 2.3. the process of computing cost of capital of individual components. long term debt and debentures. significance of cost of capital and a few misconceptions about the cost of capital.3.2 Introduction Concept of Cost of Capital 2.6 2.7 2.10 2.3 2.4 2.UNIT 2 COST OF CAPITAL Objectives The objectives of this unit are to : provide conceptual understanding of the cost of capital and its variants. 1 . Two basic conditions must be fulfilled so that the company’s cost of capital can be used to evaluate new investment: 1) 2) The new investments being considered have the same risks as the typical or average investment undertaken by the firm. weighted cost of capital.3. examine the utility of cost of capital Structure 2.1 2.8 2. and retained earnings. In this unit.2 2.2 2.3.4 2. preference shares.2.5 2.2.11 Components of Cost of Capital Classification of Cost of Capital Cost of Long-term Debt Cost of Preference Capital Cost of Equity Capital Cost of Retained Earnings Computing Cost of Capital of Individual Components Weighted Cost of Capital Significance of Cost of Capital Some misconceptions about the Cost of Capital Summary Keywords Self Assessment Questions Further Readings Answers Appendix 2.1 INTRODUCTION The Cost of Capital is an important financial concept. The financing policy of the firm remains unaffected by the investments that are being made. illustrate the computation of cost of specific courses of long-term finance viz.9 2.

Money Rate Risk means the risk of an increase in future interest rates. a) Return at Zero Risk Level.2.2 Classification of Cost of Capital Cost of Capital can be classified as follows: 1) 2 Explicit Cost and Implicit Cost : Explicit cost is the discount rate that equate the present value of the expected incremental cash inflows with the present value of its incremental cash out flows. it is ‘the rate of .2. iv) It is usually related to long-term capital funds. vi) Cost of Capital has three components: Cost of Capital Return at zero risk level (Risk free returns) Premium for business risk Premium for financial risk 2. It represents the rate of return which the firm must pay to the suppliers of capital for use of their funds. b) Premium for Business Risk. iii) Cost of Capital as a rate of return is calculated on the basis of actual cost of different components of capital. used to discount the future cash inflows so as to determine their present value and compare it with investment outlay.Overview of Financial Decisions 2. and Cost of Capital with financial risk > Cost of Capital with Business Risk > Cost of Capital with no risk. Cost of Capital in terms of rate. it is not a cost as such.2 CONCEPT OF COST OF CAPITAL The term cost of capital refers to the minimum rate of return that a firm must earn on its investments so as to keep the value of the enterprise infact. Liquidity risk means the ability of a supplier of funds to sell his shares/ debentures bonds quickly. of return is used as discount rate. c) Premium for Financial Risk. a) b) Cost of Capital with Business Risk > Cost of Capital with no risk. Purchasing power risk arises due to changes in purchasing power of money. Thus. 2. The following are the basic characteristics of cost of capital : i) ii) Cost of Capital is really a rate of return. v) In operational terms.1 Components of Cost of Capital A firm’s cost of capital comprises three components: Return at Zero Risk Level : This refers to the expected rate of return when a project involves no risk whether business or financial. A firm’s cost of capital represents minimum rate of return that will result in at least maintaining (If not increasing) the value of its equity shares. The cost of capital may be put in the form of the following equation: K = ro + b + f Where K = ro = b = f = Thus.

....................................... 2...3 COMPUTING COST OF CAPITAL OF INDIVIDUAL COMPONENTS Computation of cost of capital from individual sources of funds helps in determining the overall cost of capital for the firm.............................................. After ascertaining costs of each source of capital................... In capital budgeting decisions.............................................. ..................... Cost of Capital 3) 4) Activity I 1) Define the following : i) Explicit Cost iii) Average Cost iv) Marginal Cost ii) Cost of Capital .............................................. Marginal cost of capital is the weighted average cost of new funds raised by the firm........................................................................... 3 .................................... In contrast................................................................. combined cost of capital is used for accepting /rejecting the investment proposals......................................................return of the cash flows of financing opportunity’.................................................... .... 2) Average Cost and Marginal Cost : The average cost is the weighted average of the costs of each components of funds........................................ .............. The combined cost of capital is the average cost of capital as it is inclusive of cost of capital from all sources.................................................................................................... In a nutshell.................................................... Future Cost of Capital : Future cost of capital refers to the expected cost to be incurred in raising new funds while historical cost represents cost of capital incurred in the past in procuring funds for the firms...................................................................... ................................ .................................................................. 3) State how can Cost of Capital help a firm in converting its future cash inflows in its present value.................................................................. 2) Discuss various types of risks associated with the concept of Cost of Capital........... ....................................................................................... ....................................................... Specific Cost and Combined Cost : The costs of individual components of capital are specific cost of capital................................................. ........................................................ .................................................. appropriate weights are assigned to each component of capital................................ .................... There are four basic sources of long-term funds for a business firm: i) Long-term Debt and Debentures............................... ...................................... In financial decision making future cost of capital is relatively more relevant....... explicit costs relate to raising of funds while implicit costs relate to usage of funds. implicit cost is the rate of return associated with the best investment opportunity for the firm and its shareholders that will be foregone if the project presently under consideration by the firm were accepted..................

Long-term debt may be issued at par. 2. the cost of the debt should be calculated on the basis of net proceeds realized.60 ) Cost of debt issued at = 10% discount 4 = 4.Overview of Financial Decisions ii) Preference Share Capital.000.3. at premium or discount. 90. It may be perpetual or redeemable.1 Cost of Long-Term Debt Cost of long-term debt represents the minimum rate of return that must be earned on debt financed investments if the firm’s value is to remain intact.1. iii) Equity Share Capital. preference and equity capital as well as retained earnings is discussed in the following sub-sections. a company issues 10% irredeemable debentures of Rs. each firm will have some of these sources in its capital structure.00. The specific cost of each source of funds is the after-tax cost of financing.000 × (1 − .000 Cost of debt at par = = Rs. 10. The procedure for determining the costs of debt. Kd = Where Kd = I T = = Np = Cost of debt after tax Annual Interest Payment Net Proceeds of Loans Tax Rate I (1 − T) Np Example. (a) The formula for computing the Cost of Long-term debt at par is K d = (1 – T) R where Kd = Cost of Long-Term Debt T = Marginal Tax Rate R = Debenture Interest Rate Example.6) 10 = 4% (b) In case the debentures are issued at premium or discount.000 Rs. The formula will be as follows. 1.00.44% .000 × (1 − . The company is in 60% tax bracket. iv) Retained Earnings Though all of these sources may not be tapped by the firm for funding its activities.60) 4% Rs. The technique of computation of cost in each case has been explained in the following paragraphs. Rs.. if a company has issued 10% debentures and the tax rate is 60%. 10. the cost of debt will be (1 .

The debentures are to be redeemed in the beginning of 11th year.000 10 3 100 (1 – . Example.000 2 10.Discount + Premium) Example. The question of yield to maturity arises only when the loan is taken either at discount or at premium.60) 3. Underwriting and other issuance costs amounted to 3% of the proceeds. The cost of long-term debt is the investor’s yield to maturity adjusted by the firm’s tax rate plus distribution cost. 5.1.25 2 ) . each of Rs.500 10 + 7.000 − 12. A company raised loan by selling 2.000 + = 10. 5 per debenture (Par value = Rs.000 Cost of Capital Cost of debt issued at = 10% Premium = Rs.875 10 ) 3 (1 – .50.000 + 95. 10.e.500 3 50 = 5.5) 1. The tax rate is 50% = ( ( 25.63% (c) For computing cost of redeemble debt. (Par value . redeemable in the 11th year.00. they are adjusted in the same way as discount is being adjusted in net proceeds and other calculations.54. The formula for cost of debt will be I + Discount mp ( In case of premium Premium mp ) 3 (I – T) 3 100 p + nP 2 where mp = p = maturity period nominal or par value np = net proceeds i.000 + 2.Rs. 100 at 5% discount.5) 3 100 5 2.000 × (1 − .385% 97.000. a firm issued 1.10. the period of redemption is considered. 100).500 debentures with 10% rate of interest at premium at Rs.500 (d) In case of underwriting and other issuing costs. The tax rate is 50%. 10% debentures.

600 53.00. The tax rate is 60%.000 40.000 57.800 4.769 .000 Interest Rs. The terms of debenture issue provide for repayment of principal in 5 equal installments starting at the end of the first year.592 . It may symbolically be written as: n (cash outflows)t np = S ——————— t = 1 (1 + K)t where np (Cash outflows) t K = net amount available for use = amount of interest after tax + amount of repayment of principal = time period = discount rate Example.576 195067 Present Value 55366 37875 30744 25175 1 2 3 4 5 12% + (195067 − 190000) (195067 − 186512) (14 − 12) 12 % + 5067 8555 2 = 13 .313 × .000 40.000. repayment of principal or dividends”.00. A better method is that which converts yield to maturity into a discount rate. Van Horne says “ the discount rate that equates the present value of the funds received by the firm.000 17. 184 % (f) Effective cost of debt is lower than the interest paid to the creditors because the firm can deduct interest amount from its taxable income. 10.797 . 62. brokerage and other issuance costs amount to Rs.000.90. 6 .000 Cash Outflows Year Installment Rs. Cash inflow = Rs. 2.000 . Let us take an example.877 .630 .400 Total Rs.400 Discount Factor 14% .000 − 1250 + 788 2. These outflows may be interest payments.200 8. A company has issued 11% debentures for Rs. 40.5 × 100 = 4.865% (e) Yield to maturity method of computing cost of debt capital is an approximation method. James C.600 12. net of underwriting and other costs with the present value of expected outflows.000 40.712 . 1.52.675 . The higher the tax rate.Overview of Financial Decisions = 25.200 48. the lower the effective interest rate on debt and lower the cost of debt. The underwriting.000 40.519 Present Value 54374 44294 35910 28890 23044 186512 Discount Factor 12% .800 44. 10.000 = Rs. 2.Rs.893 . 22.

Mathematically this relationship can be expressed as follows: 7 . 200 lakhs outstanding debt and pays an interest rate of 10 per cent. If no taxes were paid.0. The firm B has Rs. 200). the only difference between the net incomes of the two firms would be the interest expense incurred by the firm B.0.5% Firm B 100 20 80 20 60 50% tax rate Firm A 100 0 100 50 50 10 5% Firm B 100 20 80 40 40 Cost of Capital Notes : a) NIAT of firm A .00) = 10% 2) Effective cost of debt at 25% tax rate = 10% x (1. 20 / Rs.NIAT of firm B. (Par value x no. The firm A has no debt and is totally financed by equity capital.There are two firms.100 interest and taxes Interest Taxable income Taxes Net income after taxes (NIAT) Difference Effective rate 0 100 0 100 20 10% Firm B 100 20 80 0 80 25% tax rate Firm A 100 0 100 25 75 15 7. we can say that the effective rate of debt is 10% (Rs. this difference diminishes. 200 lakhs of outstanding debt of firm B. In the case of 25% and 50% it is 7. 25 and 50 per cent and the resulting values of net incomes are compared. In the case of 0% tax rate. A simple formula for computing the cost of debt may be stated as follows: Effective cost of debt = Interest rate x (1. Tax Rates and Effective Cost of Debt Rs. 1) Effective cost of debt at 0% tax rate = 10% x (1. 0.0 . As the tax rate increases.50) = 5% 4) A more generalised way of calculating the cost of debt capital is to find out the discount rate which equates the present value of post tax interest and principal repayments with the net proceeds of the debt issue i.5% and 5%.0 .0 . A and B.e. Assume that the earnings before interest and taxes of both firms is Rs. b) (a) ' Rs. 100 lakhs each.tax rates) Substituting the data from the above example.5% Effective cost of debt at 50% tax rate = 10% x (1. of bonds – Issue floatation cost).0 .0. respectively.25) = 7. in lakhs 0% tax rate Firm A 1 2 3 4 5 (a) (b) Earnings before. The firm’s net income after-taxes is calculated using three tax rates.

What is the cost of debt if the firm desires to sell at 5% premium.. In the above eq......................................... I (1 ........ A firm intends to issue 1.......................(R ........... A firm issues 1........ 2.......................... ......... ..................... .........................T) ................... 3. 10% debentures each of Rs.......... n I (I ............................... 8 .. ........................... 100....................................... ..................000..... For solving the above equation an approximation can be used which yield fairly close value.....................................000.......T) + (R + P)/2 (R-P) n t (1 .....................................................................................Overview of Financial Decisions n I (I ......... 2...... the cost of debt capital would be K in the following equation...... 100 each at a premium of 5% with a maturity period of 10 years..................................................................................NP) R n + Np = ∑ t (1 + K) (1 + k)n t =1 An approximation for K is as follows K≅ I (1 .................... solving for K would yield the cost of debt capital.............. 10% debentures of Rs................ A company raises loan of Rs...........................................................000 by 10% debentures at 5% discount for a period of ten years.................................................. The tax rate is 50%. Find the cost of capital........................................................................ .......................................................................................... ................................. The tax rate is 50%...........................50..................................................................... ...................................................................................................... .......................................................................T) Activity 2 1....T) R Np = ∑ + + n t t = 1 (1 + K) t (1 + k) Where : np = net amount realised on debt issue I = Annual interest payment T = Tax rate applicable R = Redemption Value n = Maturity period of debt..................................................... ..... ..........................................NP) n η (R + NP) / 2 Amortisation of the Cost of issue: Since the issue floation cost is tax deductible cost and can be amortised evenly over the duration of debt finance....... ........................................................T) + K≅ (R .............................................. underwriting costs are 3% and tax rate is 50%....................

7. as perceived by investors at the margin as in the current market price per share. 3 per share. Cost of preference shares can be estimated by dividing the dividend stipulated per share by the current market price of the share. The costs of issuing and selling the shares are expected to be Rs.33% Rs. 7.3 Cost of Equity Capital “Cost of equity capital is the cost of the estimated stream of net capital outlays desired from equity sources” E. 82 per share.2. A Company is planning to issue 9% preference shares expected to sell at Rs. The cost of preference capital which is redeemable is the value of KP in the following equation NP = ∑ (1 + KP) t =1 n η D t + R n (1 + KP) η KP ≅ D + (R – NP) / N ( R + NP) / 2 2. Thus.Issue Cost Example. 85 par value. According to James C.65. 85 is Rs. the companies can issue only redeemable preference shares. the net proceeds are Rs. which are stated as 9% of the share of Rs. After deducting the floatation costs.3.2 Cost of Preference Capital Cost of preference share capital represents the rate of return that must be earned on preferred stocks financed investments to keep the earnings available to residual stockholders unchanged. 82 Now. cost of equity capital can be thought of as the rate of discount that equates the present value of all expected future dividends per share.65 = 9.W. 85 par value. This present value method for cost of preference share capital is similar to that used for cost of debt capital. 9 .3. Thus 9% of Rs. Dividend Cost of Preference Capital = —————————— Face Value . The first step in finding out the cost of the preference capital is to determine the rupee amount of preference capital is to determine the rupee amount of preference dividends. stated dividend on preferences share is used. Cost of capital for such shares is that discount rate which equates the funds available from the issue of preference shares with the present values of all dividends and repayment of preference share capital. the only difference is that in place of ‘interest’. Van Horne. Walker. the cost of preference capital : Dividend per share ——————————— Net proceeds after selling Cost of Capital = = Rs.

Rs.10)3 Rs.Overview of Financial Decisions In a nutshell. 50.31% × 100 = 10 (c) D/P Ratio Method : Cost of equity capital is measured by dividends price ratio. Earnings per share is not constant. where b is the growth rate as a percentage and estimated for a period of three years. Cost of equity capital is by for the most difficult to measure because of the following reasons: i) ii) The cost of equity is not the out of pocket cost of using equity capital. All the earnings are paid to the shareholders. Do (Dividend per share) ——— x 100 Po (Market price per share) . Eo (1+b)3 ————— Po 3 Where (1+b) = Growth factor. Example. Symbolically. A firm has Rs. (b) E/P Ratio + Growth Rate Method : This method considers growth in earnings. Symbolically.5 (1 + . Which earnings-current earnings or average earnings (Not clear). The current market price of equity share is Rs. The following are the approaches to computation of cost of equity capital: (a) E/P Ratio Method : Cost of equity capital is measured by earning price ratio. The method is useful in the following circumstance: The firm does not have debt capital. iii) The relationship between market price with earnings is known.5(1. it is the discount rate which equates present value of all expected dividends in future with net proceeds per share/current market price. Eo Po (current earnings per share) (current market price per share) ——— x 100 The limitation of this method are: Earnings do not represent real expectations of shareholders. There is no growth in earnings.665 × 100 50 50 = 13. Dividends also affect the market value (which one is to be considered). A period of 3 years is usually being taken into account for growth.331) × 100 6. The formula will be as follows. The cost of equity is based upon the stream of future dividends as expected by shareholders (very difficult to estimate). It represents the minimum rate of return that must be earned on new equity stock financed investment in order to keep the earnings available to the existing residual owners of the firms unchanged. 5 EPS with 10% growth rate of earnings over a period of 3 years.50 Rs.

D1 D2 D3 Dn P = ———— + ——— + ——— + ——— (1+Ke) 1 (1+Ke) 2 (1+Ke) 3 (1+Ke) n where. P = price of the share D1…Dn = dividends in periods 1. are estimated. the present value of future dividends. Given the current price P and values for future dividends ‘Dt’. the market price of equity share is Rs.2. as expected by the investors. Thus. 15 The following are the assumptions i) ii) The risk remains the unchanged.5 ———— x 100 = 10% Rs. Under this method. The investors give importance to dividend. 10 per share) Rs. one can calculate Ke by using IRR procedure. and its market price is Rs. discounted by Ke would be equal to the price of the share. 20. ii) it considers the capital appreciation. Po D1 Ke g = = = = current price of the equity share per share dividend expected at the end of year 1 risk adjusted rate of return expected on equity shares. Po = Where. Ke = the risk adjusted rate of return expected by equity investors. The firm is here viewed as a going concern with an infinite life.…n.Example. which it will give over an infinite time horizon. 10 as a level perpetual dividend. then P= 20 = Ke = D Ke 2 Ke 2 = 10% 20 (d) D/P + Growth Rate Method : The method is comparatively more realistic as i) it considers future growth in dividends. Thus. D1 D1 or Ke = + g Ke − g PO 11 . if K is the risk-adjusted rate of return expected by investors. the future dividend streams of a firm. This method is based on the assumption that the value of a share is the present value of all anticipated dividends. If the firm has maintained some regular pattern of dividends in the past. Cost of Capital iii) The investors purchase the shares at par value. 1.3. 15 and dividend rate is 15% (Par value Rs. The current price of the share is used to determine shareholder’s expected rate of return. constant annual rate of growth in dividends and earnings. it is not unreasonable to expect that the same pattern will prevail in future. Thus. If a firm is paying a dividend of 20% on a share with a par value of Rs.

on the average by the 10 per cent. held it to the present and sold it at the current prices. The firm expects to pay a dividend of Rs.) 3. The equation indicates that the cost of equity share can be found by dividing the dividend expected at the end of the year 1 by the current price of the share and adding the expected growth rate. The limiting factors to the usefulness of this method are the additional conditions that the investors expectation do not undergo change during the study period. (e) Realised Yield Method : One of the difficulties in using D/P Ratio and E/P Ratio for finding out Ke is to estimate the rate of expected return.97 The firm maintained a fixed dividend payout from 1986 onwards. Wishes to determine its cost of equity capital. If security has a beta 12 . The dividends paid on the equity shares over the past six years are as follows: Year 1997 1996 1995 1994 1993 1992 Dividend (Rs. if the total value of securities in the market moves up by 10 per cent.Overview of Financial Decisions The derivation of the formula has been given in Appendix 2. Hence.62 3. As these conditions are rarely fulfilled. and the attitudes of the investors towards the risk remain the same. 4 at the end of the coming year 1998.80 3.05 Rs. 4 + 0. the yield method has limited utility. This is also the realized yield by the investor.4 Ke − 0. 50 = 0.05 = 13% The 13% cost of equity share represents the return expected by existing shareholders on their investment so that they should not disinvest in the share of Raj Textiles Ltd. the yield often differs depending on the time period chosen. is approximately 5 per cent. A Beta of 1. Raj Textiles Ltd. and that the relevant risk of a particular security is the effect that the security has on the entire portfolio. In addition.47 3. The annual growth rate of dividends. A security’s Beta indicates how closely the security’s returns move with from a diversified portfolio.1. The prevailing market price of the share is Rs. And invest elsewhere. Example.80 + 0.0 for a given security means that.12 2.0. the stock’s price will also move up.33 3. no significant change in the level of dividend rates occurs. g. The most recent five to ten years are taken and the rate of return is calculated for the investor who purchased the shares at the beginning of the study period. Ke. 50 Ke = = Rs. this method depends on the rate of return actually earned by the shareholders.05 Rs. (f) Security’s Beta Method : An investor is concerned with the risk of his entire portfolio. By “diversified portfolio” we mean that each investor’s portfolio is representative of the market as a whole and that the portfolio Beta is 1. Rs. This yield is supposed to indicate the cost of equity share on the assumption that the investor earns what he expects to earn. Substituting the data in the formula. 50 per share.

.........................5 beta will rise by 10 per cent........ How is beta determined? the beta co-efficient for a security (or asset) can be found by examining security’s historical returns relative to the returns of the market........0......... Since.. its application remains limited perhaps because it is tedious to calculate Beta value.... The beta for Pan Am’s stock was estimated by Value Line to be 0.............. finance mangers will need this or similar approaches.......................... which other methods do not.......... A beta of any portfolio of securities is the weighted average of the betas of the securities..... 3 EPS and 10% growth rate of earnings over a period of 3 years................ Compute the cost of equity capital.................................. ...... ... The relationship is: Ke = riskless rate + risk premium x beta Where.... The major reason is that the method incorporates risk analysis.................... The Capital Asset Pricing Model (CAPM) uses these beta co-efficients to estimate the required rate of returns on the securities......... on the whole..... ................... 100..... ....... Thus the required rate of return on Pan Am’s stock in November 1984 was: Required Rate = 12% + 6% x 0.......... such compilation of beta co-efficient is provided by companies..0) security to a diversified portfolio increases the portfolio’s risk.....7% Cost of Capital The use of beta to measure the cost of equity capital is definitely a better approach.... and adding a low beta (beta less than zero) security to a diversified security reduces the portfolio’s risk....................................of 2... Adding a high beta (beta greater than 1..... ....... Beta co-efficients are provided by published data or can be independently estimated................................................................................................................95 in 1984................................................. A firm has Rs.. its price will................ as the competition intensifies and the availability of funds and their cost become a challenge... ...... The difference between the long-run average rate of returns between shares and government securities may represent the risk premium..............95 = 17.............. when the market drops by 20 per cent........................................... ........................................... a sample of securities is used................................. this was estimated in USA to be 6 per cent.... In United States................. A share with –0............................................ such as Value Line or Merill Lynch. Activity 3 1....................................... Ke = expected rate of return...... rise or fall by 20 per cent when the market rises or falls by 10 per cent............................... The current rate on government securities can be used as a riskless rate............... However. 13 ..................... Long-term government bond rates were about 12 per cent in November 1984........................................ The CAPM specifies that the required rate on the share depends upon its beta.......... The current market price of equity share is Rs................................. Nevertheless.......... ................... it is not feasible to take all securities......... where the weights represent the proportions of investments in each security............ During 1926-1981...........

........................... underwriting costs are 6% of the sale price........................3..... It definitely cost the shareholders something and this is an opportunity cost representing sacrifice of the dividend income which the shareholders would have otherwise received it and invested the same elsewhere to earn a return thereon...4 WEIGHTED COST OF CAPITAL Weighted cost of capital........................ properly weighted by the proportion they hold in the capital structure of the firm.... A firm issues 8% non-redeemable preference shares of Rs............................................................ Algebraically........ .................................................... ........ Find out the cost of capital...................................... 14 .. .... Brokerage is 3%.. this is not true.......4 Cost of Retained Earnings: Corporate managers and some analysts normally consider the funds retained in the firm as cost free funds because it does not cost anything to the firm to make use of a part of its earnings not distributed to the shareholders.................... Ezra Solomon suggested the concept of external yield to measure cost of retained earnings................... 3........................................................................ 5 per share............................................................................................ overall cost of capital or weighted marginal cost of capital............ .....................................03) = 8............30) (1-0................ 10 each for Rs........... 2................ .. However............00.................... the approach can be explained as:   d1  + G (1 − TR) (1 − B)   P0 = Ke (1-TR) (1-B) where Ke = Cost of equity capital based on dividend growth method TR = Shareholders’ Tax Rate B = Percentage Brokerage cost Example A firm’s cost of equity capital is 12% and Tax rate of majority of shareholders is 30%.............................. also known as composite cost of capital........................ .....................000.......................................................................................................................... = 12% (1-0. ............5 percent and the premium of 5%............. 1......... 100 and the growth rate of dividend is expected to remain constant at 10%.. the market price of the equity share is Rs....... Thus.................. is the average of the costs of each sources of funds employed by the firm..... The current dividend paid by the company is Rs...... Compute the cost of capital if shares are issued at discount of 2........... the minimum cost of retained earnings is the cost of equity capital (Ke)................................... ...15% 2.Overview of Financial Decisions 2............................

..... however.................... the target market value weighting scheme should be preferred............ historic or target................ ......................................... which can also be based on book or market values.................. Marginal weights are determined on the basis of financing mix in additional new capital to raised for investments......................... 20...................................... Book value weights are based on the accounting values to assess the proportion of each type of fund in the firm’s capital structure...................................................................000 10.............................................50 9.......................... ........................ Cost of Capital Activity 4 1) How is the cost of retained earnings computed? ...... Target weights...................2 Computation of The Weighted Cost of Capital Example A firm has the following capital structure and after tax costs for the different sources of funds used: Source of Funds Debt Preference Shares Equity Shares Retained Earnings Amount Rs..................00.......... However. the cost of capital is both the cases is mostly similar.....00 10................00 15 ...........................000 30............................000 40.................................. Market value weights are preferred because they approximate the current value of various instruments of raising funds employed by the company...... 2) List out three types of weights which may be used for computing weighted average cost of capital of the firm..1 Choice of Weights The weights to be employed can be book values................................................. would represent actual rather than desired proportions of various types of capital in the capital structure.......... 2.....................................00......... ..................................................00................4....... ...00.......................00............................... Market value weights measure the proportion of each type of financing at its market value.........000 1....................... Historic weights can be book or market weights based on actual data....................................... .....2.......00..... Such weights............ The new capital raised will be the marginal capital...................................... .. reflect the desired capital structure proportions.. market values............000 Proportion % 20 10 30 40 100 After tax cost % 4.. In the firm’s historic capital structure is not much different from ‘optimal’ or desired capital structure.............................. from a strictly theoretical point of view........00 11...........4. The propositions of new capital raised will be the marginal weights... ..........

00 11.60 3.90 3. Market value is based on interest rates provided in the firm’s annual report. The cost of capital of quality products is estimated at the end of 1996 for use in evaluating investment proposals in 1997.2 13. are as follows: Financial data for Quality Products Ltd. Thus: 16 . Since the firm’s dividend and earnings have been growing steadily since.30 4. 100 par: current market price is Rs.00 Weighted cost % 0.2 13.8%). Current Interest rate % 45 50 75 210 380 20 720 29 42 78 192 341 10 824 13. Though dividends have grown at a slightly higher rate than earnings.Overview of Financial Decisions On the basis of book value.00 9.77 4.60 in 1997.10% Example 2: Quality products is a consumer products company with wellestablished brand names. 2.90 0. 50 per share.000 Explanatory Notes Interest rates on the three debentures issues were set at the rate (13. ‘0000 Source Debentures (71/2%) Debentures (91/2%) Debentures (14%) Other debt Total debt Preference shares (7%) Equity shares Book Value Rs. 1991.73 1993 1.05 4.2 13. Rs.28 4.2 14. the cost of equity capital will be calculated as follows: Method of Funds Debt Preference Shares Equity Shares Retained Earnings Proportion% 20 10 30 40 Cost % 4.2 13. Market Value Rs. on the basis of the past record that the shareholders expect a dividend of Rs.95 50.86 1996 2.2%) on the recently issued debentures of the firm which is selling close to par. the constant growth model can be used to estimate cost of equity.50 9. one may assume that shareholders would expect them to grow at the same earnings (10.97 24. The data for Quality Products Ltd. This was considered to be the best estimate.83 1995 2. Preference share is Rs.45 2.21 1994 2.00 1992 1. Other debt includes different types of loans from financial institutions and other privately placed debentures.00 10. Also assume.0 Equity Share Data Years 1991 Dividend per share Earnings per share Price per share 1.48 4.

............. ....................... Activity 5 1) Compare Beta value of equity shares of any one company listed on Indian stock exchanges and list out the problems you faced in this regard. the cost of capital for Quality Products Ltd: Amount Rs..............................70 1...........................................1% Current preference dividend rate of 14% is used.... The market risk premium is 6%..................... ..... preference and equity shares are used.......... 50 = 16% If the investors expect the dividends to grow at the higher rate (11....................0 17...1% Explanation Market values of debt.............9 Weighted Average Cost of Capital : 14..............................46) = 7................................................................. Compute overall cost of capital of an Indian company of your choice......2% (1-0.................. 2.. 2) ........................... List out the steps you took for this purpose and the problems faced by you................1 11.....9 14....................3%).......5%................. 12 per cent.... Thus Ke = Riskless rate + Risk premium x beta = 12% + 6% x 0....... we obtain a somewhat higher number...............01 0...... Applying the beta method............ ..................85 = 17.. Debt Preference Shares Equity Shares Total 341 10 824 1175 Weight 0..................................................1 0........60 = ————— + 0...1% Thus....................... ................................108 Rs. .... the cost of equity capital works out to 16........................1 14.......................................................... Beta for Quality Products is assumed to be 0. 17 .. Interest rate on government bonds (riskless rate) in 1996 would be. ....00 Cost 7.................................................85......... which is the firm’s effective rate 13..................... Current interest rate on debt is adjusted for tax rate of 46 per cent...... ............................. say..............................................29 0........................0 17...............Ke D = —— + g P Cost of Capital Rs...0 Weight x Cost 2........................................................................................

................................................................. ............................................................ .......................................................... .......................................................................... ............................................................................................................................................................................................................5 SIGNIFICANCE OF COST OF CAPITAL The determination of the firm’s cost of capital is important because i) Cost of capital provides the very basis for financial appraisal of new capital expenditure proposals and thus serves as acceptance criterion for capital expenditure projects................................................................................................................................................................. iv) Cost of capital also helps in formulating dividend policy and working capital policy v) Cost of capital can serve as capitalization rate which can be used to determine capitalization of a new firm............... 2............................................................................................................................................................................... 2) What is Weighted Average Cost of Capital? ..................................................................................................................................................................................................................................... ...................................................................................................................................... .......................................................................................................................... ................................................................ ii) For what purpose? ...................................................................................................... Cost of capital helps the managers in determing the optimal capital structure of the firm.................... why not? ............... .................... .. ...................... ............................................................. .......................................................................................... iii) If not.......................................... ......................................................................................................... ........................ ......................................................................................................... 18 ........................................................................................................................ ii) iii) Cost of capital serves as the basis for evaluating the financial performance of top management.........................................................................................Overview of Financial Decisions 3) Try to know from the Finance Manager of an Indian Company: i) Do they compute the overall cost of capital of their company? ........................................ . Activity 6 1) List three uses of Cost of Capital.................

................................................. While the cost of debt and preference capital is the contractual interest/dividend rate (adjusted for taxes)...... .............. there are six approaches to estimate the cost of equity...........6 SOME MISCONCEPTIONS ABOUT COST OF CAPITAL The cost of capital is a central concept in financial management linking the investment and financing decisions...00.............. 10............ Realised yield method and using the Beta co-efficient of the share........ the taxes it must pay...... 19 .. and average those rates according to the market values of the various securities currently outstanding....... iv) Depreciation has no cost........... its weighted average cost of capital is low.. In estimating the cost of capital....... and the supply of and demand of various types of financing................... . the cost of equity capital is difficult to estimate.......... 2.... it is assumed that..................3) The following details are available: Equity (Expected Dividend 12%) Tax Rate 10% Preference 8% Loan Cost of Capital Rs................................... Broadly.. namely....... A few misconceptions in this regard are as follows: i) ii) The concept of cost of capital is academic and impractical It is equal to the dividend rate.......00........ In order to estimate the cost of capital... D/P method...... Weighted cost of capital is computed by assigning book weights or market weight.000 Rs................ The basic factors underlying the cost of capital for a firm are the degree of risk associated with the firm...000 You are required to calculate Weighted Average Cost of Capital..... E/P + Growth method.................................. including borrowings.... It represents minimum acceptable rate of return on new investments....................... 5................................. (1) the firms are acquiring assets which do not change their business risk. .........7 SUMMARY The cost of capital of a firm is mainly used to evaluate investment projects... ......000 50% Rs............. D/P + Growth method............... and (2) these acquisions are financed in such a way as to leave the financial risk unchanged. v) The cost of capital can be defined in terms of an accounting based manner............ 2....... iii) Retained earnings are either cost free or cost significantly less than external equity......... 15........................ we must estimate rates of return required by investors in the firm’s securities.. vi) If a project is heavily financed by debt... the E/ P method.....00...................................

Discuss various uses of the concept of Cost of Capital. How will you calculate the Cost of Preference Share Capital? Which method of calculating the cost of equity shares would be most appropriate for the following firms: a) A profitable firm that has never paid a dividend. At the same time management decided to invest heavily in facilities to manufacture a new product.9 SELF-ASSESSMENT QUESTIONS/EXERCISES 1) 2) Why is the cost of capital considered as the minimum acceptable rate of return on an investment? In using the cost of capital to evaluate investment projects. Business Risk is a possibility and the firm will not be able to operate successfully in the market. “since we are going to finance this project with debt. Do you agree or disagree? Explain. but has had steady growth in earnings. and the price of its equity share has dropped by 20 per cent. 3) 4) 5) 6) 20 10) Determine the cost of capital for the following securities. 5 crores last year. “Retained earnings are cost free” comment. why is it necessary to assume that the acceptance of projects and the financing structure would not attract the business and financial risks? How is the Cost of Debt Capital ascertained? Give examples. 2. Financial Risk is the possibility that the firm will not earn sufficient profits to make payment of interest on loans and/or to pay dividends. b) An electricity company that has paid a dividend every year for the last eighty years.8 KEY WORDS Cost of Capital is the minimum rate of return that must be earned on investment to maintain the value of firm.Overview of Financial Decisions 2. 7) 8) 9) How would you find the cost of capital for proprietorship or partnership firm? Can you thing of any ways to do this? List them. the manufacturing process has not worked properly. These are issued by different firms and the tax rate is 40 per cent. c) A firm that has grown very rapidly until two years ago. The firm lost Rs. You have just been communicated. Marginal Weights are determined on the basis of financing mix of additional capital. its required rate of return should only be the cost of debt”. . when capacity problems in the industry produced severe price cutting in the firm’s major product line. So far. Cost of Equity Capital is the discount rate which equates present value of all expected dividends in future with net proceeds per share / current market price.

R. The dividends of the firm have grown at an average rate of 13% per year over the same period. The financial Express and another financial fortnightly have issued a report indicating the problems of the firm with government’s regulatory agencies and forecasted that dividends and earnings of the firm will grow at no more than the overall growth rate of the economy which is 5 per cent.. Financial Management – Principles and Practices. Financial Management and Policy. Himalaya Publishing House (Chapter 13) 2.N. 100 to Rs. (Chapter 17).73% ii) 4. S. The debentures matures in five years and has a current market price of Rs. c) The historical average rate of return earned by equity shareholders of the firm C has been about 17% per year until very recently.99 ii) 15% iii) 8. Par value is Rs.M. New Jersy. 80. Englewood Cliffs. The dividends are likely to be Rs.76% Activity 3 i) 3. 1995. Srivastava. 1996. 100 per share and its current market price is Rs. Financial Management and Policy. Lawrence J. 2003. Prentice Hall Inc. New Delhi. Financial Management.10 FURTHER READINGS Gitman. Principles of Managerial Finance.62% Activity 6 iii) 7. per share. Meerut.67% 21 . New York.11% and 8. Maheshwari. Van Horne James W. Fundamentals of Financial Management. R. 100. Srivastava. b) A preference share pays 7 per cent dividend. Sultan Chan & Sons. Fourth Edition. Schall. London. Introduction to Financial Management. The price of the firm’s share adversely reacted to the report dropping from Rs.11 ANSWERS Activity 2 i) 4. Lawrence D and Haley Charles W. Cost of Capital 2. 2002. P. 1985. McGraw Hill Book Company. Chandra. New Delhi.64% iii) 5.a) A seven-year debenture with a coupon interest of 10 per cent. Harper and Row Publishers. New Delhi.M. Tata McGraw Hill. 50. Pragati Prakashan. Singapore. 90 as against its par value of Rs. 1986. Fourth (International Student’s) Edition.

it may be said that a firm having a higher debt content in its capital structure is more risky as compared to a firm which has a comparatively low debt content. It is generally determined by the capital budgeting decisions. (1) (1+Ke) a Multiplying each side of the equation by (1+Ke)/(1+g) and subtracting the resulting equation from (1). 22 . Besides financial risk and business risk. Greater the business risk. In general.(2) (1+Ke) a = Do - As Ke is assumed to be greater than g..Po 1+g Do(1+g) a —————— …………….. the higher will be the cost of capital.. the second term on the right hand side of (2) is zero. Thus 1+Ke Po (———— ..1) = Do 1+g Po (Ke – g) = Do (1 + g) D1 Po = ———— Ke-g ……………(3) …………….. and that g is the growth rate in dividend Do (1+g)1 Do (1+g)2 Po = —————— + —————— (1+Ke)1 (1+Ke)2 Do(1+g)a + ————— …. the following risks also affect the cost of capital..... Po (1+Ke) ——————— .1: Share Valuation with Constant Growth in Dividends Assuming so the most recent dividend.Overview of Financial Decisions Appendix 2.(4) Premium for Financial Risk : It refers to the risk arising out of pattern of capitalization.….. Premium for Business Risk : Business risk is the possibility that the firm will not be able to operate successfully in the market.

8 3.2 3.6.1 3.6. characteristics of important long-term sources of funds. Structure 3.1 INTRODUCTION Planning the capital structure is one of the most complex areas of financial decision making because of the inter-relationships among components of the capital structure and also its relationship to risk.2 3.2 3. return and value of the firm. the term capital usually denotes the long-term funds of the firm.5 Introduction Conceptual Framework Characteristics of Important long term sources of Funds Criteria for determining pattern of Capital Structure Risk and Capital Structure 3.UNIT 3 CAPITAL STRUCTURE DECISIONS Objectives The objectives of this unit are to: define and distinguish capital structure explain briefly the important Characteristics of various long term sources of funds. examine critically theories of capital structure-decision identify the factors influencing capital structure decision evaluate the relevance of debt equity ratio in public enterprises.6.6.11 3. comprises equity share capital and retained earnings. In this unit. 1 . Debt capital and ownership capital are the two basic components of capital.10 3.5.3 3.6 EBIT – EPS Analysis ROI – ROE Analysis Theories of Capital Structure Decision 3. factors influencing capital structure. Equity capital.4 3. etc are narrated briefly.12 Factors Influencing Pattern of Capital Structure Relevance of Debt-equity ratio in Public enterprises Summary Key words Self Assessment Questions/Exercises Further Readings 3.4 Net Operating Income Approach M-M Approach Traditional Approach 3. theories of capital structure decision. as one of the components of capitalization. Preference share capital is another distinguishing component of total capital. EBIT-EPS analysis. dilate upon the criteria for determining pattern of capital structure.7 3. In the end.5. For a student of finance. relevance of debt-equity ratio in public enterprises is also discussed.3 3.1 3.1 Net Income Approach 3.9 3. analyse EBIT-EPS and ROI-ROE relationship. ROI-ROE analysis.

A prudent finance manager strikes golden mean among them by giving proper weightage to them. equity share capital and Retained Earnings are summarized in Table 3.F. finance manager should keep into consideration certain fundamental principles. These principles are militant to each other. The distinguishing characteristics of debt. Thus. Because of the secondary position relative to debt. concept of capital structure includes the following: The proportion of long-term loans.Overview of Financial Decisions 3. Financial structure refers to all the financial resources marshelled by the firm. The main focus in the discussion that follows is on deciding the mix of debt and equity which a firm should employ in order to maximize shareholder wealth. The difference is that the preference dividend. preference share capital.deductible expense. 2 . suppliers of equity capital take greater risk and therefore. is not a tax. Convertible debentures have the features of both debt and equity capital. Preference shareholders have a prior claim to receive income from the firm’s earning through dividends. “ capital structure refers to the make up of a firm’s capitalization”.W. It does not have a fixed maturity date.Walker. there is no difference between the capital structure (as defined by walker) and financial structure.2 CONCEPTUAL FRAMEWORK According to Gerstenberg. E. 3. In other words.4 CRITERIA FOR DETERMINING PATTERN OF CAPITAL STRUCTURE While choosing a suitable pattern of capital structure for the firm. Financial structure means the composition of the entire left hand side (liabilities side) of the balance sheet. unlike debt interest. According to E. it represents the mix of different sources of long-term funds. retained earnings and long term debt.1. The proportion of equity capital and The proportion of short-term obligations In general.3 CHARACTERISTICS OF IMPORTANT LONG-TERM SOURCES OF FUNDS The four major sources of Long-Term funds in a firm are equity(or ordinary) shares preference shares. the experts in finance define the term capital structure to include only long-term debt and total Stockholders’ investment. It will include all forms of long as well as short-term debts and equity. Brigham defines the term as the percentage share of each type of capital used by the firm-Debt. as the amount of dividend to be paid is fixed. practically speaking. Many financial analysts and managers tend to think of preference shares as a substitute of debt. preference share capital and equity capital (equity share capital paid up plus retained earnings). In brief. Capital structure = proportions of all types of Long-Term capital Financial structure = Proportions of all types of Long-Term and Short-Term capital Capitalisation = Total Long-Term capital 3. must be compensated with higher expected returns.

preference Dividends are not taxdeductable. Shareholders forgo dividend income but they do not lose ownership rights.Table 3. the use of debt capital in the financing process is immensely helpful in raising income of the company. 5.4.1: Characteritics of Long-Term Sources of Funds Debt Preference Share Capitals Equity share capital 1. Money is raised by selling ownership rights.1 Cost Principle: According to this principle. Lenders can take action to get their money back 5. 6. Equity shareholders get the residual assets prorata after lenders & preference shareholders claims are met in liquidation. 3. Debt capital is cheaper than equity capital from both the points of view. 1. It is related to dividend policy decisions. 4. 2.4. 4. No maturity. 5. 3. 5. Lower amount of money for current dividends but can increase future dividends. Interest rate is based on risk of Principal and interest payments as perceived by lenders 2. Dividends are not contractually payable. Capital Structure Decisions 1. Lenders get preferred treatment in liquidation 3. 2. Now payment of dividend to preference shareholders for a number of years gives them the voting rights. ideal pattern of capital structure is one that tends to minimize cost of financing and maximize the value per share. Dividends are not legally required to be paid. Amount of money to be repaid is specified by debt contract. Value of the share is determined by investors. Equity dividends are not taxdeductable. when lenders are paid in liquidation. 2. Retained Earnings 1. 6.2 Risk Principle: 3 This principle suggests that such a pattern of capital structure should be . 3. Firm must pay back money with interest. Usually no voting rights except as per (2) above. Preference dividends are limited in amount to rate specified in the agreement. Cost of issuing securities is avoided. But dividend on equity shares can not be paid unless preference shareholders are paid dividend. if new equity shares are issued. Interest payments are tax-deductable 6. Funds are internal No need for external involvement. Voting rights can create change in ownership. No maturity but usually callable 3. According to this. 4. Cost of capital is subject to interest rate at which payments have to be made to suppliers of funds and tax status of such payments. Preference share-holders come next. 3. 4.

.... ................ 3............................................................................................3 Control Principle: While designing sound capital structure for the firm and for that matter choosing different types of securities................................................ ..................................... finance manager should also keep in mind that controlling position of residual owners remains undisturbed. the management should strive for such combinations of securities that enable it to maneuver sources of funds in response to major changes in need for funds.................................................................... ....... Equity share during boom is always welcome................................... .................................................................................. Not only several alternatives are open for assembling required funds but also bargaining position of the corporation is strengthened while dealing with the suppliers of funds (through bonds)........................................................................................................ ............... ............................................Overview of Financial Decisions designed so that the firm does not run the risk of bringing on a receivership with all its difficulties and losses................................. The use of preferred stock as also bonds offers a means of raising capital without jeopardizing control............................... demand of different types of securities oscillates................. 3) List out sources of long – term finance used by a company of India origin....................4..................................... Risk principle places relatively greater reliance on common stock for financing capital requirements of the corporation and forbids as far as possible the use of fixed income bearing securities............ Important point that is to be kept in mind is to make the public offering of such securities as are greatly in demand.................................... Depending on business cycles........................................................................... 3...................................... 2) Bring out in brief..................................................................................................................................... ....................................................................5 Timing Principle: Timing is always important in financing more particularly in a growing concern..4....... characteristics of equity share capital .. Maneuverability principle is sought to be adhered in choosing the types of funds so as to enable the company to seize market opportunities and minimize cost of raising capital and obtain substantial savings................. Activity 1 1) What is capital structure? How is it different from financial structure? ..............................................4.......................................................................... .....4 Flexibility Principle: According to flexibility principle................................................................................................................. ................................... Management desiring to retain control must raise funds through bonds and preference capital..... ...................................... ..... ............... 3........................ ............................................................................................................. 4) 4 Discuss the criteria for determining pattern of capital structure.....................................................................................

capital structure decisions are influenced by the business risk...2.............. Business risk is the relationship between the firm’s sales and its earnings before interest and taxes (EBIT).. tend to have less fixed operating costs. the greater is the financial risk.... The revenue stability means the variability of the firm’s sales revenues which depends on the demand and the price of the firm’s products....000 and 25 percent the sales will total Rs.e.... Table 3...... Capital Structure Decisions 3..........00.. Business risk varies among firms.. Example Raj Cosmetics Ltd... and The capital structure results in a certain level of financial risk to the firm.. the use of fixed operating costs-the higher is the business risk. Stated in terms of debt ratio) i..... revenue stability and cost stability also affect the business risk of the firm..... In addition to operating leverage..........2: Estimated sales and Associated levels of EBIT (000) Probability of Sales Sales -Variable operating costs (50% of Sales) -Fixed Operating Costs Earnings before interest and taxes (EBIT) 0... 50% and 25% respectively reflect the business risk of the firm and has to be taken into consideration when designing a capital structure. Percentage of debt in the total capital) these are 0.................25 400 200 200 —— 0 —— 0..000... These data are summarised Table 3.40........ has obtained estimates of sales and associated levels of EBIT. Risk can be considered in two ways: a) b) The capital structure should be consistent with the business risk of the firm.. Assume that (1) the firm has no current 5 .... The more fixed cost financing. Raj Cosmetics Let.... Let us take an example to illustrate this point. The EBIT data. The sales forecasting group feels that there is a 25 percent chance that sales will be Rs.....10............. Firms with high business risks. the business risk is not affected by capital structure decisions....100 or 200 thousands at probability levels of 25%......50. Whatever their lines of business.... engaged in the process of planning its capital structure.. The firm’s capital structure affects the firm’s financial risk arising out of the firm’s use of financial leverage which is reflected in the relationship between EBIT and EPS...... 4. Rs....000 a 50 percent chance that sales will be Rs........0....00........ In fact..... Is now considering seven – alternative capital structure...00... Cost stability refers to the relative predictability of input prices such as labour and material..50 600 300 200 —— 100 —— 0....... Let us take an example to illustrate the implications of business risk for capital structure decisions...... per cent. 6.e..25 800 400 200 —— 200 —— ...........5 RISK AND CAPITAL STRUCTURE: A firm’s capital structure should be developed keeping in view risk focus because the risk affects the value of the firm...e..30.... The more predictable these prices are the less is the business risk... Suppliers of funds will raise the cost of funds if the financial risk increases .. ............. 8. the greater the firm’s operating leverage i.. debt and preference capital in the firm’s capital structure.......e... In general. and 60.20........... i.......... i..

00 —— 185.00 22. and interest values calculated in table 3. Table 3.2.5 15.00 —— 100.3: Capital Structure Associated with Alternative Debt Ratios Debt Ratio% Total Assests (Rs.50 3.000 equity shares are outstanding at Rs.00 74.91 0.25 200.0 13.50 9.34 6 .0 11.50 100.00 0.50 15.e.30.5.5.4) Earnings after taxes Less Taxes (0. the calculation of EPS for debt ratios of 0.00 4. and (3) the total amount of capital remains constant at Rs.25 0.00 17.00 0.00 34.Overview of Financial Decisions liabilities.00 —— 0.50 1 0 10 20 30 3 0 50 100 150 As debt increases. (2) that its capital structure currently contains all equity (25.00.4.00 0.40 100.000) (3 = 1*2) 0.51) 0.00 —— 85.000) 2 500 500 500 500 Debt (Rs.000) (1) 0 50 100 150 200 250 300 Interest Rate on all debt % (2) 0.00) (6.00 —— 0.00 4.50 20.00 2.40) Earnings after taxes EPS (17.5.00 —— 51. the interest rate also increase with the increase in financial leverage (i.00) (0. Hence the total interest on all debt also increase (as successive debenture issues carry higher interest rates) as shown in Table 3.75 49.00 2.3) When Debt ration = 30% EBIT Less Interest Earnings before taxes Less Taxes (0.00 40.00 —— 60.00 0. 000) 4=2-3 4 = 2–3 500 450 400 350 Equity Shares outstanding (Numbers 000) 5 = (4 4 Rs.00 0.40) Earnings after taxes EPS (25. the effective tax rate is assumed to be 40 percent.5: Calculation of EPS for alternative Debt ratio Probability When Debt ration = Less Interest (Table 3.00 22.00 6.3. and 60 percent respectively is shown in Table 3.000) shares (table 3. 000) Equity (Rs.80 200.5 Interest amount (Rs. Table 3.00 —— 120.00 —— 111.00 0.5 10.0 9. Table 3. number of equity shares in the columns 5 of table 3.00 15. 20) 25.4: Interest amount at Various levels of Debt Capital Structure % of Debt 1 0 10 20 30 40 50 60 Debt (Rs.00 15.00 —— (15.00 80.00 33.000. debt ratios). 20 par value).00 —— 200.500 shares) 0.0 9.1 EBIT-EPS Analysis for Capital Structure Using the levels of EBIT in table 3.00 15.00) —— (9.4.

00 49.40 Notes: The standard deviation () represents the square root of the sum of the product of each deviation from the mean of expected value squared and the associated probability of occurrence of each outcome.00 49.12 3.74 0.50 —— (49.70 1. its co-efficient of variation of EPS also increases.83 0.03 200.55 2.80) (a) —— (29.20 —— 30. As the expected level of EPS increase with increasing financial leverage.30 9. Table 3.6 shows that as the firm’s financial leverage increases. Standard. Following the same procedure as in Table 3.88 2.13 2.40) Earnings after taxes EPS (10. the risk also increases which is reflected in the relative dispersion of each of the distributions.07 1.6: Expected EPS. as a result of carrying forward and setting off the loss against in the following periods. Deviation and Co-efficient of variation of EPS at 50% probability level for alternative debt ratios Capital structure debt ratio (%) 0 10 20 30 40 50 60 Expected EPS (Rs.5 we may obtain EPS for other debt ratios. signifying that the higher level of risk is associated with higher levels of financial leverage.30 3. The relative risk of the two of the capital structures at debt ratio=0% and 60% respectively is illustrated in Figure 3. The co-efficient of variation is calculated by dividing the standard deviation for an asset by its mean or expected value.20 —— 90.70) 2.78 0.72 2.50) (19.50 20.97 100.0 —— 150.03 Standard deviation of EPS (Rs.) (1) 2.50 —— 50.50 60. This is the most common statistical measure of assets risk.000 Shares) 0.00 49.18 3. the risker is the asset.40 2. Table 3. As the higher levels of financial EPS increase. 7 .83 3.When Debt ratio = 60% EBIT Less Interest Earnings before taxes Less Taxes (0.03 Capital Structure Decisions Notes: a ) It is assumed that the firm received the tax benefits from its loss in the current period. There are chances that there will be negative EPS depending on the probabilities of occurrence of the expected results.91 3.) (2) 1.24 Co-efficient of variation (2) + (1) = (3) 0.71 0. The higher the co-efficient of variation.1 by showing the subjective probability distribution of EPS associated with each of them.91 1. Table 3.6 gives expected EPS at 50% probability level (to be viewed as typical level ) for seven alternative debt ratios along with the Standard deviation and co-efficient of variation of expected EPS.42 2.39 4.

. 9.7 are used. . .34 9.1: A Graphic Presentation of Probability Distribution of EPS at Alternative Debt Ratios. 0. Table 3. 7. 6. The relationship between EBIT and EPS of the firm to analyse the effect of capital structure on results to the shareholders has been graphically shown in Figure 3.00 000 0 30 60 2.80 6. . .03 Earnings per share 10 . .2: A Graphic comparison of selected structures for Raj Cosmetics Ltd. . EPS can as well be used to measure the effect of various capital structure on shareholders’ wealth.1. Since EBIT is one of the major factors which affects the market value of the firm’s shares.2 where data from Table 3. .7 : EBIT-EPS Coordinates (Selected Capital Structures) Capital structure debt ratio (%) Rs. .00. . . . 4. . –5 –4 –3 –2 –1 0 . . . .Overview of Financial Decisions Probability Debt ratio = 0% Debt ratio . . 1 2 3 4 5 6 7 8 Figure 3. . . . . . . . The EBIT –EPS analysis helps in choosing the capital structure which maximizes EPS over the expected range of EBIT.. .91 303 EBIT Rs. 50 100 EBIT (Rs. 3. 2. 1.40 2. 5. . 8.2.000 4. . . . ‘000) 150 8 Figures 3. .

we find that (1) The ROI under capital structure X is higher than the ROE under capital structure Y (ROI is less than the cost of Debt). the risk of each capital structure can be seen in the context of the financial break even point.2 ROI-ROE Analysis In the preceding section. (2) The indifference value of ROI is equal to the cost of Debt. The higher the financial break even point and the steeper the slope of the capital structure line. (i. Looking at the relationship between ROI and ROE.5. With increased financial leverage. (3) The ROE under capital structure X (ROI is more than the cost of Debt).0% 10.5% Capital Structure Y Return on Equity is equity earnings divided by Net worth.8. the greater the financial risk. The assessment of the capital structure can also be made by using ratios. in lakhs) Equity 200 Debt 0 Capital Structure Y (Rs.5% 0.5% 5. Thus.0% 7. Example: Raj Ltd. Graphically. 0 0 0 0 0 10 10 10 10 10 Profit before tax 10 20 30 40 50 0 10 20 30 40 Profit after tax 5 10 15 20 25 0 5 10 15 20 Tax 5 10 15 20 25 0 5 10 15 20 Return on Equity 2. Below the x-axis. Thus.8: Relationship between ROI and ROE under capital structures X and Y Particulars Capital Structure X ROI 5% 10% 15% 20% 25% 5% 10% 15% 20% 25% EBIT 10 20 30 40 50 10 20 30 40 50 Int. 200 lakhs.Expected earnings before interest and taxes are assumed to be constant because only the effect of financing costs such as interest and preference dividends on equity shareholders’ earnings is to be analysed. Capital Structure Decisions 3.0% 20. EBIT divided by interest) ratio also measures firm’s financial leverage and associated risk.e. we may look at the relationship between the ROI and ROE for different levels of financial leverage. Table 3. the ability of the firm to service its debt decreases..0% 12. 9 . the relationship between ROI and ROE would be as shown in Table 3.0% 15. which requires an investment outlay of Rs.e. EBIT-axis intercept). is considering two capital structures propositions: Capital Structure X (Rs. the times Earned Interest Ratio (i.0% 5. in lakhs) Equity 100 Debt 100 Tax rate = 50 percent Cost of Debt = 12 percent Based on the above information. Pursuing a similar type of analysis. negative EPS would result.5% 10. we looked at the relationship between EBIT and EPS. the business risk is assumed constant.

............... 15 percent and 20 percent......... it is necessary for the finance manager to be familiar with the basic theories underlying the capital structure of corporate enterprises............. Collect the figures of any company and do the EBIT-EPS analysis by making necessary assumptions.......................................................... .....8.................................. ..................... ...... With a real company example make ROI-ROE analysis.................................................................... Do you agree? Give one reason........................................................................ we may calculate the value of ROE for two values of ROI namely............................................................................................................................................. ......................................................... In order to achieve the goal of identifying an optimum debt-equity mix............................... 4.................................................................................................................................................. Activity 2 1............ ...........................................Overview of Financial Decisions Mathematically this relationship can be expressed as: ROE = [ROI + (ROI-r) D/E] (1-t) Where r = Cost of Debt D/E = Debt............................................ Leverage decision is the same as capital structure decision........................................................................................................................5 = 10 % ROI = 20% ROE = [20+(220-10) 1]0..............................5 = 15% The results are the same as we see in Table 3........... ........................................... 2.............................................................................................................................................................................. ROI = 15% ROE = [15+(15-10) 1]0.................... ...... 3................................................................... .... N I Approach NOI Approach ........................................................................................................................................... ............................. ................................ The optimum capital structure is obtained when the market value per equity share is the maximum.......................................................Equity Ratio t = tax rate Applying the above equation when D/E Ratio is 1..................... Distinguish between EBIT and EPS............................................................................ ........................................................ ....................... ................ ............................................... 10 2.................... ................ 1........ 3.............................................................6 THEORIES OF CAPITAL STRUCTURE A firm should try to maintain an optimum capital structure with a view to maintaining financial stability............ ....

(ii) There are no corporate taxes. The approach is based on the following assumptions: (i) The overall cost of capital (kO) remains constant for all degrees of debt equity mix or leverage. “As the proposition of cheaper debt funds in the capital structure increases. The following are the strengths of NoI approach: (i) it tries to explain the effects of borrowings on overall cost of capital. The critical assumptions of this theory are (i) There are no corporate taxes.2 Net Operating Income (NoI) approach This approach.3. MM Approach Traditional Approach Capital Structure Decisions Common assumptions of the theories of capital structure decision are as follows: (i) Preference share capital is merged with debt. the theory ignores the risk consideration. The firm employs only debt and equity capital. also known as fixed ke theory. (iii) However. According to this approach overall cost of capital and value of the firm are independent of capital structure decision and change in degree of financial leverage does not bring about and change in value of the firm and cost of capital. This theory. The theory works like this. (iv) The firm’s total financing remains constant. (iii) The market capitalizes the value of the firm as a whole. 3. (iv) The advantage of debt is set off exactly by increase in the equity capitalization rate. This theory recommends 100% debt financing is optimal capital structure. capital structure decision is relevant to the valuation of the firm in as much as change in the pattern of capitalization brings about corresponding change in the overall lost of capital and total value of the firm.6.6. (ii) There are no corporate taxes. 3. (ii) It explains and emphasizes on favourable financial leverage. also propounded by Durand. (ii) The debt content does not change risk perception of the investors. the weighted average cost of capital decreases and approaches the cost of debt. is just opposite of Net Income (NI) approach. (iii) EBIT is not expected to grow. (iii) The cost of debt is less than the cost of equity. (vi) All investors have the same subjective probability distribution of the future expected earnings for a given firm. 11 . 4.1 Net Income (NI) Theory According to this approach. was propounded by David Durand. (v) The business risk does not change with the growth of business firm.

5. V= Where: EBIT KO = Value of firm. The following are the strengths of NOI approach: (i) it emphasizes on the role of NOI in the determination of total value of the firm. The dividend pay-out ratio is 100%. However. (iii) The cut-off rate for investment purposes is completely independent of the way in which an investment is financed. (ii) According to this theory.Miller (MM) Theory The Modigiliani-Miller (MM) approach is similar to the Net Operating Income (NOI) approach. All firms within the same class will have the same degree of business risk. The “arbitrage process” is the operational justification of MM hypothesis. 3. 2.3 Modigilian.6. The following are the three basic propositions of the MM approach: (i) The overall cost of capital (KO) and the value of the firm (V) are independent of the capital structure. In other worlds. The consequence of such action is that the market price of the securities of the two firms exactly similar in all respects except in their capital structures can not for long remain different in different markets. any capital structure will be optimum. new investment proposals should be based on NOI approach This theory seems to ignore the behavioral aspect of financing function of management. (ii) The cost of equity (KE) is equal to capitalization rate of a pure equity stream plus a premium for the financial risk. There are no corporate taxes. 3. MM approach maintains that the weighted average cost of capital does not change with change in the capital structure of the firm. = Overall cost of capital = Earnings before interest and tax. arbitrage process 12 .Overview of Financial Decisions According to the NOI Approach. the value of a firm can be determined by the following equation. V KO EBIT Thus. The MM approach is subject to the following assumptions: 1. It supports the NOI approach providing behavioural justification for the independence of the total valuation and the cost of capital of the firm from its capital structure. Thus. this assumption was removed later. Capital markets are perfect. All investors have the same expectation of a firm’s net operating income (EBIT). according to Net Operating Income (NOI) Approach. The term ‘Arbitrage’ refers to an act of buying an asset or security in one market having lower price and selling it is another market at a higher price. 4.

9 also gives the seven capital structures from the debt ratios ranging from 0% to 60% and expected EPS in Rs. Beyond a particular point of debt-equity mix. (iv) The effectiveness of arbitrage process is limited. MM agreed in 1963 that the value of the firm will increase and overall cost of capital will deciline because of tax deductability of interest payments. Stage III – Further Application of debt – cost of equity capital is very high – value goes down. a greater market value as compared to an unlevered firm. (ii) Transactional costs are involved. A levered firm should have.6). (iii) Home made leverage is not perfect substitute for corporate leverage.restores equilibrium in value of securities. The formula isVi = Vu + Bt Where Vi Vu B t : = = = = Value of levered firm Value of an unlevered firm Amount of Debt and Tax rate Capital Structure Decisions 3. Calculations are set out in column 4 of the Table 3. The following are limitations of MM’s theory(i) Rates of interest are not the same for the individuals and the firms. borrow additional funds on personal account and invest in the undervalued firm in order to obtain the same return on smaller investment outlay.9.9.4 Traditional Approach The traditional theory assumes changes in Ke at different levels of debt equity rate. Stage II – Further Application of debt: cost of equity capital rises-net income – debt cost increases – value same. it is possible to work out the expected share values in each of the alternative capital structures. From these data. It is the middle of the two extremes of NI and NOI. Since corporate taxes do exist. There are three stages:Stage I – Introduction of debt-Net Income rises. 13 . therefore. ke rises at an increasing rate. This is because in case the market value of the two firms which are equal in all overvalued firm would sell their shares. The value of the levered firm would exceed that of the unlevered frim by an amount equal to the levered firm’s debt multiplied by the tax rate. has estimated the following rates of return (Column (3) of the Table 3. cost of equity capital rises because of risk but less than earnings rate leading to decline in overall cost of capital and increase in Market value.6. The use of debt by the investor for arbitrage is termed as ‘home made’ or ‘personal leverage’. (from Table 3. Table 3. Example Raj Cosmetics Ltd.

... 3) Name of single most important factor which determines the capital structure of a company......40 2.......) (3) 0.......................... .............. In addition to the analysis of the EBIT-EPS..........................................125 0...140 0.... .....165 0.................................87 21................................................................................95 Table 3............27 15.................................................... ........................................................... required rates of returns and share value.....................................9 shows that the maximum share value occurs at the capital structure associated with the debt ratio of 30%.......) (From Table 3...91 3........................................ These are listed below: Adequacy of cash flow to service debt and preference shares Having stable and predictable revenues Limitations imposed by previous contractual obligations Management Preference and attitudes towards risk Assessment of the firm’s risk by financial institutions and other agencies Capital market conditions and investor preferences Considerations of corporate control. while the share value is maximized at 30% debt ratio.....9: Calculation of Share Value Estimate Associated with Alternative Capital Structures for Raj Cosmestics Ltd....................................... by the Co..............................121 0....................................................190 Estimated Share Value (Rs......... Capital structure debt ratio (%) (1) 0 10 20 30 40 50 60 Expected EPS (Rs............28 22................... .................. ................................. 2) Contrast traditional and M-M position regarding optimal capital structure..................... ..........115 0..117 0............................18 3...... ............................... certain other factors are also taken into account in determining the capital structure for the firm..................................................................................72 2.......... .. 14 ..........48 23................79 22................. It is noticeable that EPS is maximized at 50% debt ratio.....................................) (4) 20........... This is the optimal capital structure............................................. ..... Activity 3 1) In what manner are the corporate taxes relevant to capital structure decision? ..........................................Overview of Financial Decisions Table 3..................................6) (2) 2.............................................................................................................................................................. This discrepancy arises because EPS maximization approach does not consider the risk as reflected in required rates of return...................................29 19.............................03 Estimated required rate of return Esti..............................55 2. ..........................................................................12 3........................ ..........

.............................................................................................................................................. Larger concerns have to employe different types of securities to procure desired amount of funds of reasonable cost because they find it very difficult to raise capital at reasonable cost of demand for funds is restricted to a single source.........................................................................................................7 FACTORS INFLUENCING PATTERN OF CAPITAL STRUCTURE Following are the major factors which should be kept in view while determining the capital structure of a company: (1) Size of Business Smaller firms confront tremendous problems in assembling funds because of their poor creditworthiness....................................................................................................... special attention should be paid to maneuverability principle....................................... iii) Do they intend to change their capital structure in the near future ? why? ................................4) Try to know from Finance Manager of any two companies: i) What is their present capital structure? ............................ ..... control is undoubtedly an important consideration because control is concentrated in a proprietor or a few partners................................. .......... Lenders prescribe highly restrictive terms in lending.............................................................. Investors feel loath in investing their money in securities of these firms.................................................................................................................... In view of this....................................................................... 15 .................................................................... ................ This may not be so imminent in the case of public limited commanies whose shareholders are large in number........................................................ ................... ............................................................................................................................... 3........................................ ........................................................................................................ ..................................................................... ................................................................................................................... ............... ii) What are the factors which determine their capital structure? ........ .. ............ ...................................................................................................................................................................................... In proprietorship or partnership form of organisation............................................................ ............. Capital Structure Decisions 5) Show arbitrage process with an example. (2) Form of Business Organisation Control principle should be given higher weightage in private limited companies where ownership is closely held in a few hands.......................................................................................... This is why common stock represents major portion of this capital in smaller concerns.......................................

In a sharper contrast to this. (9) Period of Finance The period for which finance is required also affects the determination of capital structure of companies. be worthwhile for such companies accord to higher weightage to maneuverability factor. people may be interested in earnings high speculative incomes. if the funds are required more or less permanently. providing more welfare facilities to the employees the company should raise the funds by issue of equity shares. true in case of manufacturing enterprises. Leverage principle should be insisted upon in such concerns. say. funds are required. The relative weightage assigned to each of these factors will very widely from company to company depending upon the characteristics of the company. (7) Market Sentiments Times of boom investors generally want to have absolute safety. (5) Age of Company Younger companies generally find it difficult to raise capital in the initial years because of greater uncertainty involved in them and also because they are not known to suppliers of funds. Such company should depend upon the sale of stock to raise capital. However. influence the capital structure considerations. companies which do not have this advantage should rely on equity share capital to a greater extent for raising their funds. At other periods. the general economic conditions and the circumstances under 16 . established companies with good earnings record are always in comfortable position to raise capital from whatever sources they like. In the former case the management should pay greater attention to maneuverability factor. Banking Co. particularly. it will be appropriate to raise them by issue of equity shares. it will be appropriate to raise funds by issue of equity shares. (8) Credit Standing A company with high credit standing has greater ability to adjust sources of funds upwards or downwards in response to major changes in need for funds than one with poor credit standing. (4) Stability of earnings With greater stability in sales and earnings a company can insist on the fixed obligation debt with less risk. Act etc. if the funds are required for non-productive purposes.Overview of Financial Decisions (3) Nature of Enterprise Business enterprises which have stability in their earnings or which enjoy monopoly regarding their products may go for debentures or preference shares since they will have adequate profits to meet the recurring cost of interest/fixed dividend. it will be appropriate to raise them by issue of debentures. it will be appropriate to raise funds by issue of debentures. On the other hand. On the other hand. (10) Legal Requirements Companies Act. In such cases. This is. at such times. (6) Purpose of Financing In case funds are required for some directly productive purposes the company can afford to raise the funds by issue of debentures. This is true in case of public utility concerns. It would therefore. for 5 to 10 years. In case. But a company with irregular income will not choose to burden itself with fixed charge.

hence.g. the less debt the firm can use. Of course.8 RELEVANCE OF DEBT – EQUITY RATIO IN PUBLIC ENTERPRISES It is generally argued that the practical significance of the debt-equity ratio is limited in the case of public enterprises in many countries because most of the loans are derived from the government itself or from public sector financial institutions. so that institutional arrangements for diluting risks are not always available to these enterprises. A few observations in this regard are made as under : (a) Since not all of the public enterprise are wholly owned and financed (through loans) by government and there are many joint ventures. the government owned financial institutions can be should be expected to raise points also at the risk of further lending to an enterprise. greater the operating risk. a case could be made for justifying higher debt-equity ratios for public enterprises. it has to be appreciated that in real life. In any case. has access to all the information it needs about the financial health of the enterprise and does not need to refer to any favourable ratio to derive confidence before making loans to it. the debt-equity ratio of whose capital structure is not in line with the normal or which does not appear to be quite sound in context of its financial prospects. (c) It is also desirable from the enterprise’s own point of view to see that a sufficiently high proportion of equity is maintained in its capital structure because it should enable it some freedom of action in the matter of retaining its earnings for its “self-financed” projects or for financing a part 17 . planning and finance. Many of the worthwhile plans of investment in public enterprises. Capital Structure Decisions (11) Tax Considerations The existing taxation provision makes debt more advantageous in relation to stock capital in as much as interest on bonds is a tax deductible expense whereas dividend is subject to tax. while equity shares are issued to serve as a cushion to absorb the shocks of business cycles and to afford flexibility. public enterprises have to face the bias of the lending agencies (local or foreign) towards this measure of the strength of their capital structure. 3. for a critical scrutiny and appraisal of their proposals. in spite of the fact that the debt is cheaper the company should use it with caution. Since all this has the effect of making institutional arrangements for sharing risk and thus reducing the disadvantages of debt. require significant amounts of foreign exchange. the management would wish to raise degree of financial leverage by placing greater reliance on borrowing. the creditors make it a point to specify adherence to a range of ‘healthy’ debt-equity ratios (and also to a conservative dividend disbursement policy) till their loans are repaid. whether for replacement and rehabilitation of existing assets or for expansion and diversification.which the company is operating. The government as the owner as well as the lender. Companies issue debentures and preference shares to enlarge the earnings on equity shares. there is a government guarantee in one from or another that the loans will be removed and lightened by adoption of an appropriate policy measures. Even when the public enterprises are allowed to borrow from private banks or from foreign financial institutions. If these resources are arranged from foreign lending agencies like the world Bank/IDA. (b) In most of the countries public enterprises ministries e. In view of prevailing corporate tax rates in India.

.............. ............... short-term (and strategically unsuitable) solutions and further losses............................................... it will remain a useful indicator......................Overview of Financial Decisions of its working capital..... both with the administrative ministers and with the enterprise managements........... Having once been trapped in this situation................................................ When such proposals are being formulated and examined........................................... ................................ Debtequity ratio is one device by which the enterprise can be considered to have been compensated for its expenses/losses on meeting these additional obligations................ there is usually a demand for concerting at least a part of their loan capital into equity capital....... In the case of other enterprises which operate at a loss (whether because of government imposed pricing policies or because of their inefficiencies). the equity portion of a public enterprise must not be regarded as a device of cash convenience and as a no-cost input............... because it certainly has an opportunity cost for the economy as a whole.... ............................................................ in long run.............................. 2) “Debt Equity Ratio is not relevant for public enterprises” Comment......................................................... It may................. particularly when the Government departments ministries are not very prompt in analyzing the causes of these problems and providing the requisite relief’s........................................................ Activity 4 1) Bring out five factors that influence capital structure........ it can result in fixing a concessional rate of interest/return on the capital mix (loan at market rate plus equity at zero percent)............................. to operate under pricing and operating policies dictated by their owner governments socio-economic (and political) objectives...... .................... .......... that it is in the happy position of making profits........................... (f) If a certain range of debt-equity ratios is adopted for enterprise in a particular sector of the economy............... thus.................... provided............................. be concluded that the view that the practical significance of the debt-equity ratio is limited in the case of public enterprise is not based on a complete appreciation of all the factors in which these enterprises have to operate in many developing countries............... under utilization of capacity...................................... the question of a reasonable or proper debt-equity ratio for the type of enterprises under consideration is raised sooner or later............................. Public enterprises have...... low morale of workers and management inefficiencies....... to assess the strength of their capital structures............................. as a general rule................................... .. of course. This is likely to place the enterprise in a disadvantageous position vis-à-vis its competitions and can lead to a vicious cycle of accumulation of losses............................. 18 .............. ... it is difficult indeed for the enterprise to extricate itself and rehabilitate its capital structure.... (d) With an inappropriately high debt-equity ratio........................... the initial cost of a project/ manufacturing facility put up by a public enterprise has the effect of increasing the fixed costs of operation through the capitalization of interest during construction.. While the private sector analogy in this respect may have to be qualified suitably when applied to the public enterprise situation in a particular country....................... ....................... (e) There cannot be must argument with the proposition that......

The MM hypothesis is criticized because of its unreal assumptions. corporate control. risk and control principles are the criteria for determining patter of capital structure. Arbitrage refers to an act of buying a security in one market having lower price and selling it in another market at a higher price. The cost of debt increases beyong a certain level of leverage. contractual obligations. and the tax treatment. Capital Structure Decisions 3.3. Tax adjustment makes it more realistic. Timing. 19 . EBIT = Earnings before Interest and taxes. are taken into consideration while determining the capital structure. cost. EPS = Earnings per share NI Approach says more usage of debt will enhance the value of the firm. The practical significance of Debt-Equity ratio for public enterprises is limited and has different perspectives. Financial Structure is the proportions of all types of long-term and short-term capital.9 SUMMARY A firm’s capital structure is determined by the mix of long-term debt and equity it uses in financing its operations. The MM analysis suggests that the optimal capital structure does not matter and that as much debt as possible should be used because the interest is tax-deductible. etc. The traditional approach to capital structure indicates that the optimal capital structure for the firm is one in which the overall cost of capital is minimized and the share value is maximized. flexibility. Financial structure means the composition of the entire left hand side of the balance sheet. The mathematical relationship between ROI is [(ROE + ROI – r) D/E] (1-t) NI and NOI theories of capital structures are extreme. the claims on income and assets.10 KEYWORDS Capital Structure is the proportions of all types of long-term capital. The EBIT-EPS analysis shows how the desirable capital structure gives the maximum EPS. The basic differences in debt (including preference shares) and equity capital are in respect of the voting rights. The EBIT-EPS analysis can be used to evaluate various capital structure in the light of the degree of financial risk and the returns to the equity shareholders. Certain qualitative considerations such as cash flow. NOI Approach says that the total value of the firm remains constant irrespective of the debt-equity mix. management’s risk tolerance. A firm’s capital structure should be consistent with its business risk and result in an acceptable financial risk. The consequence of such action is that the market price of the securities will become the same.

00. The market place has assigned the following discount rates to risky earnings per share. 9.43 .47 .1. 7.000 per year and variable operating costs represent 40% of sales. Different debt ratios are considered. Explain the criteria for determining pattern of capital structure. what happens to the cost of debt and cost of equity as the firm’s financial leverage increases? Explain ROI-ROE analysis.00. 2.00. Explain the EBIT-EPS approach to the capital structure. The existing capital structure consists of 25.56 . Narrate the factors influencing capital structure. assuming (i) maximization of ePS and (ii) maximization of share value. Are maximizing value and maximizing EPS the same? Khosla Ltd. 6.20 0. 20 . b) Determine the optimal capital structure. 2.20 The company has fixed operating costs of Rs.000 equity shares of Rs.11 SELF ASSESSMENT QUESTIONS/EXERCISES 1. 4.Overview of Financial Decisions 3.60 . Critically examine various theories of capital structure. Debt Ratio 20% 40% 60% The tax rate is 40% percent. Discuss the relevance of debt-equity ratio for Indian Public Enterprises. 8.51 . a) Calculate the expected earnings per share.64 Estimated Required Returns % 15 16 17 18 22 24 The company is considering changing its capital structure by increasing debt in the capital structure vis-à-vis capital. 10 each. 3. with the associated probability of occurrence.00. the standard deviation of EPS and the co-efficient of variation of EPS for the three proposed capital structures. c) Construct a graph showing relationship in (b).000 3. Assume the figures of an Indian company and examine the relevance of MM’s theory of capital structure. 5. given here with the estimate of the required interest rate on all debt. Sales Rs. Co-efficient of variation of EPS . had made the following forecast of sales.000 4. Interest on all debt 10% 12% 14% 10.000 Probability 0.60 0. What is a firm’s capital structure? How is it different from financial structure? Under the traditional approach to capital structure.

Srivastava R. Maheshwari. Chandra. New York. Hemant R. S. Bombay. Principles of Managerial Finance Fourth Edition.M. 1993 Financial Management.... Singapore.. Meerut. Gitman Lawerence J. K. Dani. Ludhiana. Pragati Prakash. Srivastava.M. 1993 Financial Management Sultan chand & Sons. Pendey. Balance Sheets and How to Read Them. Haper & Row Publishers. Capital Structure Decisions 21 . New York. Introduction to Financial Management Fourth (International student) edition. 1986. R. New delhi. 2003 Financial Management and Pragati Himalaya Publishing Housing Mumbai. 2002 Financial Management.3.M. Hemant R.. I. P.12 FURTHER READINGS Dani. 1995 Fundamentals of Financial Management Tata McGraw. Upadhyaya. 1985 Financial Management Kalyani Publishers.N. Mc-Graw Hill Book Co.M.. Schall Lawerence D & Haley Charles W. 1973. 1985.

The project is complex 1 . For example. Structure 4. a project needs to be meticulously planned. so as to avoid project schedule slippages and cost overruns.1 4. effectively implemented and professionally managed in order to accomplish the objectives of time. construction of a house is a project.6 Introduction Nature of a Project Classification of Projects The Project Life Cycle Project Management Defined Planning Project Work 4.7 4.6. financial and technical performance goals. The distinguishing features of a project are : Purpose: A project is usually a one-time activity with a well-defined set of desired end results.5 4. Further. construction of foundations. construction of roof.6. to throw light on project life cycle.4 The Work Breakdown Structure and Linear Responsibility Charts 4. one-off undertaking. It can be divided into subtasks that must be accomplished in order to achieve the project goals. wiring etc.9 Summary Self-Assessment Questions Further Readings 4.2 NATURE OF A PROJECT The term ‘project’ has a wider meaning to include a set of activities. non-repetitive. project life cycle and concept of project management. This is why project management is receiving greater attention in developing countries like ours.6. In fact.2 System Integration 4. This demands fairly good understanding of nature and types of projects.2 4.UNIT 4 PROJECT PLANNING Objectives The objectives of this unit are: to provide an understanding of nature and types of projects. fixing of sanitary fitting. cost and performance. 4. fixing of doors and windows. project is the non-routine nature of activities. normally with discrete time.3 Sorting Out the Project 4.1 Initial Project Coordination 4.1 INTRODUCTION Effective management of projects is key to the progress of an economy because development itself is the outcome of a series successfully managed projects. construction of walls. It includes many activities like digging of foundation pits.4 4. to explain how project work is planned. It is a non-routine. a project is an organized programme of pre-determined group of activities that are non-routine in nature and that must be completed within the given time limit.8 4.3 4.6.

and performance. manufacturing. patterned ways. Technology survey. Finance is often involved at the beginning and accounting (the controller) at the end. then peak. Customer Specific : A project has always to be customer specific so as to cater to the needs of customers. Though it is clear that construction projects are usually more routine than research and development projects. Single Entity : A project is one entity and is normally entrusted in one responsibility centre while the participants in the project are many. a project may be unique in nature. ongoing operations. execution of the projects in time by proper scheduling of various activities contribute to the complexity of the project. time. Team Work : Successful completion of a project calls for teamwork.3 CLASSIFICATION OF PROJECTS Much of what project will comprise and consequently its management depends essentially on the category it belongs to. Interdependencies : Projects often interact with other projects carried out simultaneously by their parent organization. Life Cycle : Like organic entites. While the functional departments of an organization (marketing. as well as at periodic reporting times. begin a decline. projects can be classified as industrial and non-industrial projects Industrial projects are set up for the production of some goods. as noted above. No two construction or R&D projects are precisely alike. choice of the appropriate technology. projects have a life cycle. The project manager’s importance is emphasized because. cost. hiring the right kind of people. Uniqueness : Every project has some elements that are unique. Manufacturing may have major involvement throughout. but not in the middle. as a devotee of management by exception. However. the manager will find there are a great many exceptions to manage by. they often resist termination. location. and finally must be terminated. Complexity : A rich project represents complex set of activities pertaining to diverse areas. finance.Investment Decisions Under Certainty enough that the subtasks require careful coordination and control in terms of timing. size and need. but projects always interact with the parent’s standard. which can not be completely reduced to routine. 4. the organization should go for projects that are suited to customers. As such. ownership.) Some projects end by being phased into the normal. According to Type of Activity : Under this category. ongoing operations of the parent organization. (Also like other organic entities. Marketing may be involved at the beginning and end of a project. From a slow beginning they progress to a buildup of size. procuring the appropriate machinery and equipment. In addition to the presence of risk. Risk and Uncertainty : Risk and uncertainty are inherent in every project. The team is constituted of members who are specialists in relevant fields. the patterns of interaction between projects and these departments tend to be changing. and the like) interact with one another in regular. Non-Industrial projects comprise 2 . The project itself must often be coordinated with other projects being carried out by the same parent organization. The project manager must keep all these interactions clear and maintain the appropriate interrelationships with all external groups. precedence. arranging the financial resources. degree of risk and uncertainty will depend on how a project passes through its various life cycle phases. some degree of customization is a distinct feature of a project. Projects can be categorized according to type of activity.

backward integration and forward integration projects. the project team and initial resources are assembled. soil conservation projects. National projects are those set up in the national boundaries of a country. expansion. medium and large. and the work program is organized. projects can be classified as new balancing. The projec is born (its start-up phase) and a manager is selected. projects with investment on plant and machinery upto Rs. modernization. But completing the final tasks seems to take an inordinate amount of time.health care projects.4 THE PROJECT LIFE CYCLE Most projects go through similar stages on the path from origin to completion. According to Completion Time : Projects under this category can be divided into two types. there may be three categories of projects. 100 % Project competition Slow finish Quick momentum Slow start Time Figure 4. In case of normal projects there is no time constraint. The work gets under way and momentum quickly builds. Public sector projects are owned by the Government. According to Size : Based on size. Progress is made. Those with investment limit between these groups are medium scale projects. while international projects are set up by the government of private sector across the globe. As per the present guideline of the Government. projects can be categorized as national and international projects. irrigation projects. even at the cost of ending up with a higher project cost. viz. educational projects. In private sector projects ownership is in the hands of the project promoters and investors. as shown in Figure 4. Crash projects are those which are to be completed within a stipulated time. This continues until the end is in sight. normal and crash projects. According to Location : Location wise. partly because there are often a number of parts that must come together and partly because team members “drag their feet” for various reasons and avoid the final steps. We define these stages. Joint sector projects are those in which ownership is shared by the Government and private entrepreneurs. According to Need : Based on the need for the project. private and joint sector projects.1. as the project’s life cycle. diversification. According to Ownership : Projects under this category can be grouped into public. replacement.1: The Project Cycle 0 3 . Project Planning 4. small. 100 crores are categorized as large scale projects. 1 crore are classified as small and those with investment in plant and machinery above Rs. highway projects etc. viz.

usually in terms of man-hours or resouces expended per unit of time (or number of people working on the project) plotted against time. focus of attention is on time. The ever-present goals of performance. Anyone who has watched the construction of a home or building has observed this phenomenon. Figure 4. and cost goals would be met. may be maintained for the next appropriate project that comes along.2: Time distribution of project effort When the major “how” problems are solved. at the start of a project. control Conception Selection Evaluation & termination Time Figure 4. even if it means cost penalties.2 depicts project effort. how the performance time. This search for additional performance delays the schedule and pushes up the costs. and the real work of the project gets under way. often beyond the levels required by the original specifications. In some cases. The middle stages of the life cycle are typified by a growing concern with cost control. it is a result of the changing levels of resources used during the successive stages of the life cycle. If this hurdle is passed. We refer to the specific methods adopted to reach these goals as the project’s technology because these methods require the application of a science or art. scheduling. Early in the life cycle. where time is broken up into the several phases of project life. finally ceasing when evaluation is complete and the project is terminated. The new project will then emerge. Monitoring. Team members focus on how to achieve the project’s performance goals. the effort may never fall to zero because the project team. or at least a cadre group. In 4 . time. Peak effort level Level of effort Planning. activity rate increases as planning is done. With projects nearing completion. During the latter stages of the life cycle. Minimal effort is required at the beginning-when the project concept is being developed and is being subjected to project selection processes.Investment Decisions Under Certainty The pattern of slow-rapid-slow progress toward the project goal is common. It would be a great source of comfort if one could predict with certainty. there tends to be more flexibility in cost and efforts are directed towards bringing things into conformity with the approved schedule-as much as possible. performance takes precedence. project workers sometimes get preoccupied with improving performance. This rises to a peak and then begins to taper off as the poject nears completion. For the most part. and cost are the major considerations throughout the project’s life cycle.

............ .................................................................... 5 .............. Activity 1 a) Identify activities that constitute a project .... ........................ ................................................5 PROJECT MANAGEMENT DEFINED Project management is the process of identifying project opportunities..........................2 illustrates this uncertainty............................... .......... ................................................................................................................................................................................................................................................................................................... b) List out five national projects .................................................................................. c) List out five international projects .. procuring funds for project implementation.................................................... Project Planning 4.......................................................... ......................................................................................................................... ....................................................... for example routine construction projects............................................ .................................................................................................... but often we cannot.......... Defining what is to be done and ensuring that it is done and performed as desired within time and cost budgets fixed for it through a modular work approach...................... ................. ............................ ................ ........................................................... scheduling of project activities in such a way as to complete the project within the minimum possible time/cost..................................................................................................................................................................................................................................................................................... formulating profitable project profiles............................................................................................................... The crosshatched portion of Figure 4................................................................................................................................................................................................. ...................................................................................................................................................................................................................... .......................... ............. d) List out four stages of a national project.............................................................................. ..............................................a few cases.... using organizational and extra-organizational resources is what project management has to achieve.......................................... and monitoring of the project after its implementation........... There may be considerable uncertainty about our ability to meet project goals......................................... we can generate reasonably accurate predictions............................ .............. e) Identify four major elements that constitute an international project plan..........................

and when senior management has endorsed it. the detail description of projects tasks. what they must contain. (2) basic areas of performance responsibility are accepted by the participants. still not completely firm. Without a clear beginning. is approved by each participating group. and (3) some tentative schedules and budgets are spelt out.6.1 Initial Project Coordination It is a crucial that the project’s objectives be clearly tied to the overall vision and mission of the firm. But before we begin. The fifth planning sequence is a precise-description of all project status reports. any further changes must be made 6 . and to whom they will be sent. and schedules. we assume that the purpose of planning is to facilitate accomplishment of its objectives. the very act of engaging in the preliminary planning process increases the members’ commitment to the project. Senior management should define the firm’s intent in undertaking the project. Each subsequent approval “hardens” the plan somewhat.Investment Decisions Under Certainty 4. Whatever be the process. project planning can easily go astray. First comes preliminary coordination where the various parties involved in the project get together and make preliminary decisions about what will be achieved (project objectives) and by whom. explaining in advance how the project pieces will be redistributed once its purpose has been completed. the project is discussed in sufficient detail the potential contributors develop a general understanding of what is needed. If the project is unqiue in most of its aspects. Both the budget and the schedule directly reflect the detail (or lack of it) in the project work plan. by the project manager. 4. If the project is one of many similar projects.6 PLANNING PROJECT WORK Project planning as represents a set of six planning sequences. The planning techniques covered here are intended to smooth the path from idea to accomplishment. plans must be developed that deal with project termination. The world is full of plans that never become deeds. the outcome must be that : (1) technical objectives are established (though perhaps not “cast in concrete”). the meeting will be quite short and routine. and describe the project’s desired end results. These work plans are used for the third and fourth sequences. The composite plan. In addition. These preliminary plans serve as the basis for a detailed description of the various tasks that must be undertaken and accomplished in order to acieve the objectives of the project. when they are to be produced. plan about how that responsibility will be accomplished. by the next project meeting a preliminary but detailed. These plans are then reviewed by the group and combined into a composite project plan. Finally. At the meeting. It is a complicated process to manage a project. Such plans should contain descriptions of the required tasks. The map must have sufficient detail to determine what must be done next but be simple enough that workers are not lost in a welter of minutiae. outline the scope of the project. extensive discussion may be required. a sort of “touching base” with other interested units. Each individual/unit accepting responsibility for a portion of the project should agree to deliver. It is also vital that a senior manager should call an initial coordinating meeting and be present as a visible symbol of top management’s commitment to the project. and plans act as a map of this process. budgets. deriving the project budget and schedule. and then by senior organizational management.

The subsection on the managerial approach takes note of any deviation from routine procedure. informal written memoranda can substitute for the change order. and start the project on its way to completion. Resources: There are two primary aspects to this section. agreedon schedule. Contractual Aspects: This critical section of the plan includes a complete list and description of all reporting requirements. a brief explanation of their relationship to the firm’s objectives. In addition to the usual routine cost elements. any specific management agreements (eg. Schedules : This section outlines the various schedules and lists all milestone events. test equipment. proprietary requirements. The project master schedule is constructed from these inputs. a description of the managerial structure that will be used for the project. Project Planning 7 . The definition of “significant” depends on the specific situation and the people involved. it might note that this project is an extension of work done by the company for an earlier project. cost monitoring and control procedures should be described. The project manager is authorized to direct activities. request resources and personnel. The first is the budget. spend monies (usually within preset limits). without written notice. logistics. The responsible person or department head should sign off on the final. For example. which makes this a project budget. it also notifies sub-units in the organization that they may commit resources to the project. The estimated time for each task should be obtained from those who will do the work. The process of developing the project plan varies from organization to organization. The statement should include profit and competitive aims as well as technical goals. Second.by processing a formal change order. the wise planner will include it. following top management’s approval. The main point is that no significant changes in the project are made. General Approach: This section describes both the managerial and the technical approaches to the work. One-time costs are separated from recurring project costs. as well as the technical deliverables and their specifications and delivery schedule. Senior management’s approval not only signals its willingness to fund and support the project. Objectives: This contains a more detailed statement of the general goals noted in the overview section. but any project plan must contain the following elements: Overview: This is a short summary of the objectives and scope of the project. field facilities and special materials. advisory committees project review and cancellation procedures. However. for instance. liaison arrangements. It is directed to top management and contains a statement of the goals of the project. The technical discussion describes the relationship of the project to available technologies. Completeness is a necessity in this section. use of subcontractors). customer-supplied resources. and a list of the major milestones in the project schedule. Both capital and expense requirements are detailed by task.. laboratory usage or construction. approvals really amount to a series of authorizations. the monitoring and control procedures must be designed to cover special resource requirements for the project. the use of subcontactors for some parts of the work. such as special machines. if the project is not large or complex. If in doubt about whether an item should be included or not. Project Plan Elements Given the project plan.

Some Project managers disdain this section of the plan on the grounds that crises can not be predicted. and new. Potential Problems: Sometimes it is difficult to convince planners to make a serious attempt to anticipate potential difficulties. This makes clear when the various types of contributors are needed and in what numbers. typically through a requirement that the appearance of the system must be acceptable to the client. should be noted here. these are not separate. and plans to deal with unfavourable contingencies should be developed early in the project’s life cycle. strikes. such as security clearances. schedule. and evaluating the history of the project. One or more such possible disasters as subcontractor’s default. the timing of these disasters is not random. one has discovered an “arsonist. At times. resource limitations. but pre planning may avert some. In fact. maintainability. so the personnel. If the client approves. and any other special requirements. or the weather. It includes system design. systems integration is concerned with three major objectives. and events in the life of every project when progress depends on subcontractors. it is disseminated to all interested parties. These manpower projections are important element of the budget. possible recruiting problems. sudden required breakthroughs. or resource availability. technical failure. bad weather. It is helpful to index personnel needed for the project schedule. complex. or unfamiliar tasks are certain to occur. or coordination. and giving the client an overdesigned system is faster and less expensive than delivering precisely to specification. Special skills. schedules. insufficient authority in some areas. Once this basic plan is fully developed and approved. complex coordination requirements.” No amount of current planning can solve the current crisis. There are times. the aesthetic qualities of a system may be specified. and reparability. Further. The only uncertainties are which ones will occur and when. This section contains a brief description of the procedure to be followed in monitoring. 4.Investment Decisions Under Certainty Personnel : This section lists the expected personnel requirements of the project. storing. We are using this phrase to include any technical specialist in the science or art of the project who is capable of performing the role of integrating the technical disciplines to achieve the customer’s objectives. Evaluation Methods : Every project should be evaluated against standards and by methods established at the project’s inception.” It is quite possible that when one finds such a Project manager. critical sequences of tasks. types of training needed. Performance: Performance is what a system does. Any of these system performance characteristics is subject to over-design as well as undersign but must fall within the design parameters established by the client.2 Systems Integration System integration (sometimes called systems engineering) plays a crucial role in the performance aspect of the project. they claim to be very effective “fire fighters. Obviously. conditions. These are the elements that constitute the project plan and are the basis for a more detailed planning of the budgets. 8 . tight deadlines. and resources sections can be cross-checked with one another to ensure consistency. independent elements of the system. reliability. work plan.6. but are highly interrelated qualities. collecting. As such. and general management of the project. legal or policy restrictions on work-force composition. we may give the client more than the specifications require simply because we have already designed to some capability.

Design components to optimize system performance. In this section. The necessary resources must be available when and where they are needed. the project Action Plan. and when. First. is much more difficult if the number of activities is significantly greater than twenty. All activities required to complete the project must be precisely delineated and coordinated. preparing a network from this information. If the approach is too conservative. Added design cost may yield decreased production cost. list them in the general order in which they would normally occur. there are several major activities that must be completed. Each activity has an 9 . It can be used in any project where the relevant cost trade-offs can be estimated. This will aid the planner in identifying the set of required activities for the goals to be met. If a large project is to come in on time and within cost. and costs can be accumulated in several areas. The problem is to develop a list of both activities and outcomes that represents an exhaustive. To accomplish any specified project. Many mix the two. Value engineering examines all these cost trade-offs and is an important aspect of systems integration. There is nothing sacred about the “two to twenty” limits. but some may be done simultaneously. A good design will take all these trade-offs into account in the initial stages of the technical approach. It is simply the consistent and thorough use of cost/effectiveness analysis. Some activities must be done sequentially. Two is the minimum possible breakdown and twenty is about the largest number of interelated items that can be comfortably sorted and scheduled at a given level of task aggregation. leaving performance and effectiveness otherwise unchanged. And it will avoid locking the project into a rigid solution with little flexibility or adaptability in case problems occur later on or changes in the environment demand changes in project performance or effectiveness. This is accomplished throught the following guideline: Require no component performance specification unless necessary to meet one or more systems requirements. Systems integrations plays a major role in the success or failure of any project. the goals must be specified. and production cost may be trade-off against unit cost for materials. and in the correct amounts.6. Cost: Systems integration considers cost to be a design parameter. Project Planning 4. Sometimes a problem arises because some managers tend to think of outcomes (events) when planning and other think of specific tasks (activities). If a risky approach is taken by system integration. Added design cost may lead to decreased component cost. we forego opportunities for enhanced project capabilities or advantageous project economics. non redundant set of results to be accomplished (outcomes) and the work to be done (activities) in order to complete the project. a great many things must happen when and how they are supposed to happen.3 Sorting Out the Project In order to ensure a successful completion of a Project we need to know exactly what is to be done. we propose a simple method to assist in sorting out and planning all this detail. A reasonable number of major activities might be anywhere between two and twenty.Effectiveness: The objective is to design the individual components of a system to achieve the desired performance in a optimal manner. it may delay the project. not the performance of a subsystem. Second. Every component requirement should be traceable to one or more systems requirements. by whom. For an application of value engineering techniques applied to disease control projects. The procedure proposed here is a heirarchical planning system. Break each of these major activities into two to twenty subtasks. First.

The end results is a collection of work units each of which is relatively short in time span. The following general steps explain the procedure for designing and using the WBS 10 . The Project Plan is the set of these Action Plans. Each can be scheduled as one of the many jobs that the organization must undertake and complete. Each is a single.3. man hours. and scheduling. The advantage of the Project Plan is that it contains all planning information in one document.3: Responsibility/WBS relationship Source: Lavold. and W. G. in turn.Investment Decisions Under Certainty outcome (event) associated with it.4 The Work Breakdown Structure and Linear Responsibility Charts The Work Breakdown Structure (WBS) used in project management is a type of Gozinto chart and is constructed directly from the project’s Action Plans. it is wise to contact the managers and workers who will be directly responsible for each of the work packages. responsibility. and these activities and events can be decomposed into sub-activities and sub-events. be subdivided again. It pictures a project subdivided into heirarchical units of tasks. Each part of the project down to the smallest subtask elements is budgetable in terms of money.I.. 4.D. Each has definite beginning and ending points along with specific criteria for evaluating performance.. The WBS can be used to illustrate how each piece of the project is tied to the whole in terms of performance. King.R. and other requisite resources. work packages. The WBS may also be perceived as an organization chart with tasks substituted for people as shown in Figure 4. “Developing and Using the Work Breakdown Structure”. Project Management Handbook. meaningful job for which individual responsibility can be assigned. 1983. in Cleland D. and work units. Organisation Responsibility Defined by responsibility structre Organisation Divisional responsibility centre Departmental responsibility centre Engineering Departmental responsibility centre Construction Departmental responsibility centre Inspection Location Section 1 Location Section 2 Work Breakdown Structure (WBS) Facility Responsibility Material Responsibility Installation Responsibility Inspection Figure 4.6. Van Nostrand Reinhold. which may. These people can develop a hierarchical plan for the package delegated to them. budgeting. In constructing the WBS.

contingency reserves. schedule information and milestone events can be aggregated into a project master schedule. and responsibilities as the levels below it. Cost estimators can assist the Project Manager in constructing a task budget composed of costs for materials. For small or moderate-size projects. which may. be intentionally negative. which includes the profit derived from the project. freight. scheduled. and personnel. At the uppermost level of the WBS. and subtask relationships are now integrated to form the next higher level of the WBS. an indirect cost budget for the project. time schedules. Establish cost account numbers. and subcontractors who are or may be involved. The purpose of this review is to verify the WBS’s accuracy. It is helpful to construct a linear responsibility chart (sometimes called a responsibility matrix) to show who is responsible for what. break project tasks down into successively finer levels of detail. marketing costs. a project “contigency” reserve for unexpected emergencies. Continue the decomposition of work until all meaningful tasks have been identified and each task can be individually planned. budgets. Resource requirements. engineering. 3) The WBS. budget. whether hardware. Identify the resource needs. support. test results. which includes general and administrative overhead costs (G&A). manufacturing operations. monitored. budget. the specification reference. software. and so it continues at each succeeding level of the WBS hierarchy. potential penalty charges and other expenses not attributable to particular tasks. individuals should sign off on their individual elements of the project plan. funds. and specific end results to be achieved. on occasion. The master schedule integrates the many different schedules relevant to the various parts of the project. contract. and any residual. some of the steps might be skipped. schedule. and materials. the total project budget should consist of four elements: direct budgets from each task as described above. and other appropriate charges. List the personnel and organizations responsible for each task. the Project Manager can keep track of who must approve what and who must report to whom.as it would be used on a large project. or determining profit and loss. For the purpose of pricing a proposal. equipment facilities. For each such work element: Make up a work statement that includes the necessary inputs. etc. The WBS may be revised as necessary. we have a summary of the project budget. and time estimates are reviewed with the people or organizations who have responsibility for doing or supporting the work. It is Project Planning 2) 4) 5) 6) 11 . particular contractual stipulations. reports. and to check interdependency of tasks. 1) Using information obtained from the people who will perform the work. resources. combined. When agreement is reached. and controlled. such as manpower. This chart also shows critical interfaces between units that may require special managerial coordination. particularly if the project is of a type familiar to the organization. List any vendors. The only difference is that the information is aggregated to one higher level. or handled less formally than our explanation indicates. but the planner must be sure to check significant revisions with all individuals who have previously made inputs. Identify detailed end item specifications for each work element regardless of the nature of the end item. schedules. each succeeding level of the WBS will contain the same kinds of information regarding resources. budgeted. Similarly. With it. Thus.

and make sure that relevant corrective actions have been designed and are ready to implement if needed. Finally. Apart from allocating resources the various resources has to be coordinated. In this unit we have discussed about the unique features of the project. key interfaces and sequencing. is an integral part of the strategy to move towards higher rate of growth. while the project may be over budget. 7) One can now compare required task performance and outputs specified in the WBS with those specified in the basic project plan in order to identify potential misunderstandings. This series of steps complete the use of the WBS as a project planning document. Similarly. 8) 9) 4. the Project Manager can identify problems. Additional resources may be brought to those tasks behind schedule so as to expedite them. by work element. the project life cycle which represents the relationship between time and project completion and also depicts the rate of progress with respect to time. and so on up to the full project level. the expenses may be exactly as planned. It is necessary to examine resource usage in relation to results achieved because. the project schedule must be subjected to the same comparisons as the project budget. All this requires resources and strategy to allocate resources as resources are always in short supply. All this requires a specialized technique known as project management & planning. work package. package. These added funds may come out of the budget reserve or from other tasks that are ahead of schedule. task. and complete project. problem. The WBS is also a key document for implementing. harden the estimates of final cost. the Project Manager can continually examine actual resource use. step by step. task. to identify problems and take corrective action. and progress reports.8 SELF ASSESSMENT QUESTIONS 1) 2) 3) 4) 12 What are the six component planning sequences of project planning? Any successful project plan must contain nine key elements. responsibility. or even lower. monitoring.Investment Decisions Under Certainty comprehensive and must include contractual commitments. Actual progress is compared to scheduled progress. and controlling the project. and schedule slippages. As the project is carried out. a time contingency reserve for unforeseeable delays should be included.7 SUMMARY For any developing economy new investments in greenfield projects. diversification etc. the results may be further along than expected. By comparing actual against planned resource usage to a given point in time. In addition. budgeting and scheduling. In the next section we have discussed about the various elements which has to be kept in consideration while planning the project work we had talked about work Breakdown Structure which shows how each piece of the project is tied to the whole in terms of performance. What are the basic guidelines for systems design that assure that individual components of the system are designed in an optimal manner? What are the general steps for managing each “work package” within a specific project? . and then design corrective actions. milestone events. by work element. expansion of existing projects. but actual progress may be much less than planned. List these items and briefly describe the composition of each. 4. The remaining steps concern its use for these purposes.

USA. Harrisons. Vikas Publishing House Pvt. “Advanced Project Management”. 1986. and Vervalin C. Project Management Journal. Pergamon Press.H. Gower Publicing. New Delhi 1996. 1976. How to make it work. American Management Association.R. CC.5) 6) 7) 8) 9) What percentage of the total project effort do you think should be devoted to planning? Why? Why do you suppose that the coordination of the various elements of the project is considered the most difficult aspect of project implementation? What kinds of problem areas might be included in the project plan? What is the role of systems integration in project management? What are the three major objectives of systems integration? In what ways may the WBS be used as a key document to monitor and control a project? Project Planning 10) Describe the process of subdivision of activities and events which compose the “tree” diagram known as the Work Breakdown Structure or Gozinto chart. Ltd.L. Hants. “Project Planning and Management”. Machiraju. Houston. Martin. International Project Management Year Book. 1981.9 FURTHER READINGS Goodman. Gulf Publishing Company. “Project Finance”. Butterworth. London. 13 .J. Project Management Institute. F. Kerridge A. 1990. Why is the input of responsible managers and workers so important an aspect of this process? 4.. England. L.E... 1984. August. “Project Management”. H... 1985.

2 5.3 5.6. it helps a firm in strenghthening its financial health and so also its competitive position.3 5.7 5. Capital budgeting also acts as a planning and control device. Permanent addition to working capital.9 Capital Budgeting Methods in Practice Summary Self-Assessment Questions 5.2 UTILITY OF CAPITAL BUDGETING Capital budgeting is the most potent technique employed in assessing financial viability of projects and for that matter. Capital budgeting technique involves matching of expected net cash inflows from the project with anticipated cost of the project these two components of capital budgeting technique are determinant of investment outlay.4 5. allocating prudently the funds among the projects by providing useful guidelines in identifying useful projects and ranking them in terms of economic desirability to choose the most promising one.6. acquisition of new facilities.2 5. such as expenditure on acquisition of new buildings.4 Payback Method Return on Asset Method (ROA) Present Value Method Internal Rate of Return Method 5.5 5. improvement of existing buildings. replacement of plant and machinery.UNIT 5 CAPITAL BUDGETING DECISIONS Objectives The objectives of this unit are: to explain nature and utility of Capital Budgeting.1 5. 5.8 5.1 NATURE OF CAPITAL BUDGETING Capital budgeting is a managerial technique of planning capital expenditures whose benefits are expected to extend beyond one year. R&D expenditure are also regarded as capital expenditures.6. 1 .10 Further Readings 5.6 Nature of Capital Budgeting Utility of Capital Budgeting Investment Proposals and Administrative Aspects Choosing among Alternative Proposals Estimating cash flows from Capital Budgeting Evaluating Investment Proposals 5. it helps the managements to determine long-term capital requirements and timings of such requirements.6. etc.6. new machines. Thus. to discuss various tools of ranking of Investment proposals.5 Profitability Index (PI) 5. As a planning tool. Structure 5. to provide an understanding of the process of evaluation of Investment proposals.1 5. It also serves as a control device when it is employed to control expenditures.

3 INVESTMENT PROPOSALS AND ADMINISTRATIVE ASPECTS Capital budgeting process involves several steps. 5. others are poor. Characteristically. the end product is a ranking of the proposals and a cutoff point for determining how far down the ranked list to go. Further. capital Under Certainty budgeting as a technique of decision-making suffers from the problems involved in predicting future cash benefits. The first step in the capital budgeting process is to assemble a list of proposed new investments. Capital Budgeting Decisions 5. After a capital budget has been adopted. When sales can be forecast with a high degree of reliability for 10 to 20 years. it fails to take cognizance of total consequences of the decision. One of the most important functions of the board of directors is to approve the major outlays in a capital budgeting program as well as the total capital budget for each planning period. The finance department is also primarily responsible for cooperating with the operating divisions to compile systematic records on the uses of funds and the installation of equipment purchased. 3. the analytical problems involved are considered in the following paragraphs. together with the data necessary to appraise them. Some proposals are good. Other (for example. The planning horizon for capital budgeting programs varies with the nature of the industry. often called the post-audit review.Investment Decisions However. the planning period is likely to be correspondingly long. funding must be scheduled. 2. as in certain segments of the aerospace industry. Essentially. proposals dealing with asset acquisitions are frequently grouped according to the following four categories: 1.the feedback and control phase of capital budgeting. Growth: new product lines. Effective capital budgeting programs require such information as the basis for periodic review and evaluation of capital expenditure decisions . the finance department is responsible for scheduling and acquiring funds to meet scheduled requirements. Although practices vary from firm to firm. The foregoing represents a brief overview of the administrative aspects of capital budgeting. electric utilities are an example of such an industry. there are more proposals for projects than the firm is able or willing to finance. Also. cost of capital. when the product-technology developments in the industry require an 8-to-10-year cycle to develop a new major product. Approvals are typically required at higher levels within the organization as we move away from replacement decisions and as the sums involved increase. Replacements of existing/old projects. a correspondingly long planning period is necessary. and methods must be developed for distinguishing between the good and the poor. Such decisions are crucial for the future well-being of the firm. Expansion: additional capacity in existing product lines. pollution control equipment) Other important aspects of capital budgeting involve administrative matters. 2 . 4.4 CHOOSING AMONG ALTERNATIVE PROPOSALS In most firms.

Thus. we start with increased revenues. for example the amount of debt which it uses. 3 . We focus on how the firm’s cash flows will be changed. Because the stadium and its housing are contingent. EBIT. Independent projects are those that are being considered for different kinds of tasks that need to be accomplished. Next.T (W EBIT) + W depreciation Note that this definition of cash flows is unaffected by the firm’s financing decision. we subtract the change in taxes and add back the change in depreciation because depreciation is not a cash outflow. For example. proposals are eliminated because some are mutually exclusive. W dep. other will not be required.In part. if there is a need to improve the materials handling system in a chemical plant. The work would require a packaging machine. The appropriate algebraic expression is: W Cash flow = (W R .1 provides an example of a pro-forma income statement which can be used to illustrate a cash flow calculation. plus noncash depreciation charges.W VC . the analysis requires that we consider them together.W FCC W dep) + W dep. assuming the firm has no debt. Table 5. Finally. the investment decision and the financing decision are kept separate when we use this definition of cash flows for capital budgeting purposes. the job may be done either by conveyer belts or by forklift trucks.W dep) .T(W R . The result is taxable income. If one piece of equipment is chosen. 5. W Cash flow = W EBIT . T(EBIT). To distinguish among the many proposals that compete for the allocation of the firm’s capital funds. less the taxes the firm would pay if it had no debt. Hence. this definition is equivalent to earnings before interest and taxes. This procedure requires calculating the estimated cash flows from the use of equipment and then translating them into a measure of their effect on shareholders’ wealth. The selection of one method makes it unnecessary to use the others: They are mutually exclusive items. then subtract out all items which are expensable for tax purposes (WVC + WFCC + Wdep). WR. Consequently.W VC . First. For example. the chemical firm may need equipment to package the end product. and the purchase of equipment for this purpose would be independent of the equipment purchased for materials handling.5 ESTIMATING CASH FLOWS FOR CAPITAL BUDGETING Cash flows for capital budgeting purposes are defined as the after-tax cash flows for an all-equity financed firm. The firm may undertake any or all independent projects.W FCC . Mutually exclusive proposals are alternative methods of doing the same job. in addition to the materials handling system. To arrive at the change in after-tax cash flows created by the project. we would want to compare the stadium within a metal structure with the alternative of the stadium within a geodesic dome. a ranking procedure must be developed. projects may be contingent. there may be only one way to build a football stadium but two ways of housing it (in a metal structure or a geodesic dome). Algebraically. we turn our attention to the problem of estimating cash flows for capital budgeting purposes.

.000) + Rs...................15.........................................................................................Rs.......................................... .................000 ...................... Sometimes this approach is easier to use................................................................000) + Rs.... ..........................................................................................145...T)W rD Activity 1 a) Identify expenditures that are considered in Capital Budgeting technique............... hence....................................................................000 ............ one can start at the bottom of the income statement............... with changes in net income (WNI) and build upward to arrive at the same definition..000 30.......................................000 = ......000 = Rs..............................................................................Rs.................................................90.................................................................................. ..............000 -10.......33.............................. WEBIT................................... Substituting in the numbers from Table 5. ............ c) Explain why net cash flows after tax is considered for decision making...............000 -90...10............................15..........000 -15.......................... 4 . ................................................ The algebraic expression for the change in cash flows is WCash flow-W NI+Wdep+(1 ........................ Alternately.............000 -10...............................6 (Rs................................................................................ b) List out steps involved in evaluating investment proposals...........000 25................ ..........................30.............. .......................Investment Decisions Under Certainty Table 5..................145... ..... ..Rs.................................000 -5................... ... .... we have: WCash flow = (1 .........000 The procedure described above starts with revenues at the top of the income statement and then works down to obtain the definition of cash flows for capital budgeting purposes......... ........................1........15.1 Pro-forma Income Statement Symbol WR W VC W FCC W dep W EBIT W rD W EBT W tax W NI Amount Rs................000 Capital Budgeting Decisions Description Change in sales revenue Change in variable operating cost Change in fixed cash costs Change in depreciation Change in earings before interest and taxes Change in interest expense Change in earings before tax Change in taxes (@T=40%) Change in net income This equation can be simplified as follows: W Cash flow = (1–T) (W R – W VC – W FCC – W Dep) + W Dep Note that the term in brackets is the same as the change in earings before interest and taxes..............4)(Rs............................................................000 .000 15... the equation becomes: WCash flow = (1-T) WEBIT + Wdep............

.. in total......... ......N j=1 This is a particularly important point because it means that projects can be considered on their own merit without the necessity of looking at them in an infinite variety of combinations with other projects.....d) Explain how depreciation is treated while considering investment proposals....... Net present value (NPV) method: Present value of expected future cash flows discounted at the appropriate cost of capital... or the present value of benefits per rupee of costs......... 3.................................... should be accepted? Among the many methods used for evaluating investment proposals............................ 4............................................ five are discussed here............. then simply adding their values........... Profitability Index (PI): It shows the relative profitability of any project.. ....... 5. 2.. It will appropriately consider all cash flows................................. The value additivity principle implies that if we know the value of separate projects accepted by management............... It will allow managers to consider each project independently from all others........................................... It will discount the cash flows at the appropriate market-determined opportunity cost of capital. 3... then the value of the firm will be: n N V = ∑ v j ....... 2................. Internal rate of return (IRR) method: Interest rate which equates the present value of future cash flows to the investment outlay. 5 ..... minus the cost of the investment........ What are the properties of an ideal criterion? The optimal decision rule should have four characteristics: 1.......... Payback method (or payback period): Number of years required to return the original investment................. the point of all financial analysis ... General Principles When comparing various capital budgeting criteria... If there are N projects.................. It will select from a group of mutually exclusive projects the one which maximizes shareholders’ wealth....... The capital budgeting process is designed to answer two questions: (1) Which of several mutually exclusive investments should be selected? (2) How many projects.......... This has come to be known as the value additivity principle.... ............is to make decisions that will maximize the value of the firm.. j = 1.................6 EVALUATING INVESTMENT PROPOSALS The point of capital budgeting ..indeed........... 5... V’ will give us the value of the firm....................... ... 1... 4................... it is useful to establish some guidelines......... Return on assets (ROA) or return on investment (ROI): An average rate of return on assets employed..........

(4) the internal rate of return. (5) Profitability Index.350 150 -150 -600 B -1.1 Payback Method The payback period is the number of years required to recover the initial capital outlay on a project. Once accepted. Decommissioning costs at the end of the economic life of the facility can be as large as the initial construction costs and they must be taken into account.Investment Decisions Table 5.6. they can be discounted at the same interest rate. If management were adhering strictly to the payback method.950 C -1. Now we turn our attention to the actual implementation of the five abovementioned capital budgeting techniques (1) the payback method. We shall see that only one technique .2 gives Under Certainty the cash flows for four mutually exclusive projects. 2-year payback Project B.500 150 300 450 600 1.050 1. 4-year payback Project D. Failure to discount them means that management would be indifferent between the following two cash flow patterns: 6 .satisfies all four of the desirable properties for capital budgeting criteria. and they all require the same investment outlay. Table 5. (3) the net present value.751 . The payback periods for the four projects in Table 5. 5.000 .2 are given below. For example.500 300 450 750 750 900 PVIF@10% 1. Rs.909 . (2) the return on assets.2 shows the appropriate discount factor for the present value of cash flows. five years.500 0 0 450 1. Since all four projects are assumed to have the same risk.500 150 1.the net present value method .826 . assuming that the appropriate opportunity cost of capital is 10 percent. Project A. They all have the same life.500. Once the project is accepted these expected cash outflows must be incurred.1. 4-year payback Project C. The difficulty with the payback method is that it does not consider all cash flows and it fails to discount them.2: Cash Flows of Four Mutually Exclusive Projects Cash Flows (Rs. An example of a project of this type is a nuclear power plant. Project A has negative cash flows during its fourth and fifth years.) Year 0 1 2 3 4 5 A -1. no project can be abandoned without incurring the outflows indicated. Even a casual look at the numbers indicates that this would be a bad decision.683 .875 D -1. 3-year payback. Failure to consider all cash flows results in ignoring the large negative cash flows which occur in the last two years of Project A.621 Capital Budgeting Decisions The last column of Table 5. then Project A would be chosen as the best among the four mutually exclusive alternatives.

but with the advent of pocket calculators and computers.2 Return on Assets (ROA) The return on assets (ROA) which is also sometimes called the return on investment (ROI)is an average rate of return technique. The payback method also violates the value additivity principle.950 ÷ Rs. Projects 1 and 2 are mutually exlusive but Project 3 is independent. . For example.500 + Rs. Rs.500 n = Life of the project = 5 years.000 900 100 because they have the same payback period.500 The ROA’s for the four projects are Project A.2 is computed from the following definition:  n    ROA =  ∑ cash flow/n ÷ Io   t = 0  where Io = Initial cash outlay = Rs. The only arguments in favour of using the payback method is that it is easy to use. 450 + Rs. we feel that other more correct capital budgeting techniques are just as easy to use.– 1. 5. even if the order of cash flows had been reversed with Rs. 1.950  ROA =  ÷ 5   = Rs. 0 + Rs.Cash Flows Year 0 1 2 G -1.050 at the end of Year 1.1.6.1. Rs.1.950 received now. 390 = 26% Rs. or any of the projects in isolation. Yet no one with a positive opportunity cost of funds would choose Project G because Project G* returns cash much faster. 2 and 3 in combination. It is computed by averaging the expected cash flows over the life of a project and then dividing the average annual cash flow by the initial investment outlay.2. we have  Rs.8% Project B.000 100 900 G* -1.1. Hence. The major problem with ROA is that it does not take the time value of money into account. the ROA for Project B in Table 5.1. Substituting in the correct numbers from Table 5. 0 + Rs.1. 22% The ROA criterion chooses Project B as best. But no one 7 . Consider the following example. 26% Project C. 1. 1. it is possible to undertake Projects 1 and 3 in combination.450 at the end of Year 2 and -Rs. We would have obtained exactly the same ROA for Project B.500 at the end Year 5. 25% Project D.050 + Rs.500 5 = Rs.

3 Present value method Capital Budgeting Decisions Another method based on discounted cash flow approach employed to evaluate financial viability of investment projects is the present value method. and D.2 is calculated below by multiplying each cash flow by the appropriate discount factor (PVIF). Project C NPV = Rs. The net present value of a project is exactly the same as the increase in shareholders’ wealth. Project with highest positive net present value is accorded the highest priority. k.2 are: Project A NPV = Rs.95. is 10 per cent.909 .28 The net present value of all four projects in Table 5. the project returns enough cash flow to do three things: 8 . net present value is computed.80 337. and so forth represent the net cash flows. Project C.28.500. The NPV rule also meets the other three general principles required for an optimal capital budgeting criterion.80 If these projects were independent instead of mutually exclusive. we select the project with the greatest NPV.683 .CF2.826 .I0 is the initial cost of the project. This fact makes it the correct decision rule for capital budgeting purposes.6. and n is the project’s expected life. which involves discounting of streams of future cash earnings to present value at required rate of return to the firm (cost of capital).80 1. 5. For ranking projects under this method. 796. All cash flows are discounted at the appropriate market-determined opportunity cost of capital in order to determine their present values. 766. In this case. we would reject A and accept B. k is the firm’s cost of capital. assuming that the cost of capital.95 409. Also.000 .Investment Decisions with a positive Under Certainty opportunity cost of capital would be indifferent between the alternatives. The opposite ordering of cash flows would always be preferred. Why? Since they are mutually exclusive.C.35 247. To see why. The equation for calculating the net present value of a project is : = n CFt ∑ − Io (1 + K) t t =1 Here CF1.00 136. 778. Project B NPV = Rs.05.500 150 300 450 600 1.875 X PVIF 1.38 NPV = 796. Project D NPV = Rs. start by assuming a project has zero net present value.621 = PV -1. The NPV of the project is exactly the same as the increase in shareholders’ wealth. the NPV rule obeys the value additivity principle. The net present value of Project C in Table 5. It takes all cash flows into account. –610.751 .164. Year 0 1 2 3 4 5 Cash Flow -1.

.CF2.30 434.000 .621 Pv@10% -1. try a higher interest rate and go through the procedure again.694 .3: IRR for Project D Year 0 1 2 3 4 5 Cash Flow -1. + Cf n (1 + IRR) n − Io = 0 n CFt ∑ − Io = 0 (1 + IRR) t t =1 Here we know the value of Io and also the values of CF1. Some value of IRR will cause the sum of the discounted receipts to equal the initial cost of the project. If the present value is higher than the cost figure.for example. to the initial cost outlay.CFn.410 . 3. It is this direct link between shareholders’ wealth and the NPV definition which makes the net present value criterion so important in decision making..1 graphs the relationship between the discount rate and the NPV of the project. a zero net present value project is one which earns a fair return to compensate both debt holders and equity holders.4% -1..70 . 5..1.00 384.833 ..10 286.00 249.3 shows computation for the IRR for Project D in Table 5.90 312. which was invested in the project.80 PV@20% 1.683 ..65 -1.507 . The equation for calculating the internal rate of return is : Cf1 (1 + IRR) 1 + Cf 2 (1 + IRR) 2 + .70 371.6. The internal rate of return may be found by trial and error. Continue until the present value of the flows from the investment is approximately equal to its cost.751 . and equity holders receive all excess cash flows because debt holders have a fixed claim on the firm.80 219.25 558.70 563.500.500. First. To pay off all interest payments to creditors who have lent money to finance the project.328 PV@25.500. To pay all expected returns (dividends and capital gains) to shareholders who have put up equity for the project..000 . we have an equation with one unknown.00 239.636 . equity holders’ wealth increases by exactly the NPV of the project. and we can solve for the value of IRR.482 .20 14.909 . A positive NPV project earns more than the required rate of return. if the present value is lower than the cost.00 272. Table 5. or receipts. Thus.00 288. each according to the returns which they expect for the risk they take.50 295.00 307.20 380. compute the present value of the cash flows from an investment.512 .4 Internal Rate of Return Method The internal rate of return (IRR) is defined as the interest rate that equates the present value of the expected future cash flows. making the equation equal to zero. Thus.80 -1. Conversely. 10 percent.500.00 289.000 240.00 1. Then compare the present value so obtained with the investment’s cost.90 778.402 -1. lower the interest rate and repeat the process. using an arbitrarily selected interest rate . 2. and To pay off the original principal.500 300 450 750 750 900 1650 1.322 9 .25 303.000 .25 361. The interest rate that brings about this equality is defined as the internal rate of return. and that value of IRR is defined as the internal rate of return. Table 5.579 .640 . I0.2 and Figure 5. Consequently.25 512.800 .797 . but we do not know the value of IRR.404 .826 .50 361.75 PV@25% 1.

there is no time value of money and the NPV of a project is simply the sum of its cash flows. while evaluating and ranking projects it focuses on one of the primary objectives of a firm. main drawback of this approach is that it does not take into consideration size of investment outlay and net cash benefits together while ranking projects. we would accept Projects B. Therefore. 10 . then NPV ® Rs.1.000 Capital Budgeting Decisions Rs.500 Rs. the NPV equals Rs. 2.4% 0 10% 20% 30% 40% 50% Rs. 1. increasing value of the firm.1 the NPV of Project D’s cash flows decreases as the discount rate is increased. C.e. At the opposite extreme. In Figure 5. or the benefit/cost ratio.1: NPV of Project D at Different Discount Rates In Figure 5. then the future cash flows are valueless and the NPV of Project D is its current cash flow.1. For Project D. the IRR rule leads us to accept Project D as best. as it is sometimes called: Present value methods had the merit of simplicity in as much as it helps the management in choosing the most profitable proposal..8% 25. and D.000 If K®¥. Profitability Index (PI) method has come to be employed to overcome the above drawback and to ensure rational investment decision by establishing relationship between the present values of the net cash inflows and net investment outlay. The IRR’s for each of the four projects in Table 1 are given below.Investment Decisions NPV Under Certainty Rs. i. -1. This may at times lead to faulty decisions. Somewhere between these two extremes is a discount rate which makes the NPV equal to zero. Further.00 IRR = 25. since these projects are mutually exclusive.200% Project B IRR = Project C IRR = Project D IRR = 20. -1. If the discount rate is zero. –Rs. if the discount rate is infinite. we accept any project which has an IRR greater than the opportunity cost of capital. However.4% If we use the IRR criterion and the projects are independent.650 when the discount rate is zero. However. which is 10 percent. -2.500.4 per cent.000 Figure 5.1. Project A IRR = . we see that the IRR for Project D is 25.9% 22. Profitability Index (PI) Another method that is used to evaluate projects is the profitability index (PI).

0............................. .......................................... its IRR must exceed k and its PI must be greater than 1.......................................... or benefits.......... the NPV........ based on a 10 percent cost of capital is: Similarly: Project A PI = 0..........................................................................................................................................The equation to compute ‘PI’ of a project is : CIFt ∑ (I + K) t PV benefits t=0 PI = = n PV Costs COFt ∑ (I + K) t t=0 n Here CIFt represents the expected cash inflows....................................................... c) Explain why.............................. ... and the PI methods must always reach the same accept/reject decisions for independent projects: If a project’s NPV is positive.................................................................................... and PI can give different rankings for pairs of projects.......... b) Approach Finance Managers of three MNCs to ascertain what methods are used to evaluate the projects..................................................................0..............................................................................................52 A project is acceptable if its PI is greater than 1............................................ ........ ................................................... .......................... ................................................51 Project D PI = 1.................. ii) Expected Investment outlay is not discounted ................................ or costs........ the higher the project ranking............................................ . NPV......................................................................... ......................... the IRR.............................................................................................................. ............59 Project B PI = 1................................................................................. Activity 2 a) Contact Finance Managers of five PSUs and five Indian Companies to find out the existing capital budgeting evaluation methods used by them......... However............................... 11 ......... or the present value of benefits per rupee costs........................................................................................ .............................. Mathematically..... This can lead to conflicts between the three methods when mutually exclusive projects are being compared........................................ ...................................... i) Future Net Cash flows are discounted ..................................................................... The PI for Project C...................................... ............................ and COFt represents the expected cash outflows........................... The PI shows the relative profitability of any project................................................. and the higher the PI................................................................. IRR................................................................................ ........ ...............

reveals that Indian Companies have started using discounting techniques more than nondiscounting approaches. Gitman and Forester received 103 usable responses from a survey sent to 268 major companies known to make large capital expenditures. NPV. some firms use more than one primary method. yet use it anyway because it is easy to explain to non-financial executives but use NPV as a check on IRR when evaluating mutually exclusive or non-normal projects.0% Capital Budgeting Decisions Method IRR ROA NPV Payback period PI Total Number 60 28 11 10 3 112 It may also be noted that almost all the respondents used at least two methods in their analysis.8 44. NPV and PI methods will result in the same decision. It is also doubtful the payback method can be used as a liquidity and/ or risk indicator. and as evidenced by the 112 primary methods from 103 respondents. IRR.0% Secondary Number Percent 13 13 24 41 2 93 14.0 25.7 100. Table 5. we suspect that many of the analysts of firms which use the IRR as the primary method recognize its drawbacks.Investment Decisions Under Certainty 5.6% 25. firms were technologically up to part in an economic sense. However. Lawrence Gitman and John Forester conducted a survey to help answer this question. that is. it is the net present value technique which is used quite widely. Table – 5. One interesting. 12 .0 9.7 CAPITAL BUDGETING METHODS IN PRACTICE The above discussion leads us to conclude that IRR. Gitman and Forester found that the discounted cash flow methods are gaining in usage.0% 14. The respondents also stated that defining projects and estimating their cash flows were the most difficult and the most critical steps in the capital budgeting process.9 2.4: Capital Budgeting Methods Used Primary Percent 53. particularly by companies which have high sales volume and large-paid-up capital. study of 100 medium and large scale companies conducted in 1994. Small and new companies are still relying on traditional approach like pay-back period.4 summarizes the capital budgeting methods used by the respondent firms. hence to help choose among competing projects whose NPVs and/or IRRs are close together. with the dominant method being IRR.8 8. the heavy use of ROA and payback as primary ranking techniques indicates that not all U. The results indicate a strong preference for discounted cash flow (DCF) capital budgeting techniques. and PI. As regards the use of assessment methods employed by Indian corporates.S. Although some companies are still using payback period approach.0 2. They found that the responsibility for capital budgeting analysis generally rests with the finance department. except in certain cases involving mutually exclusive projects or non-normal cash flows. The question that arises which capital budgeting techniques do firm actually use in practice. and encouraging note is that when compared with earlier surveys. Although the questionnaire did not bring this point out.2 100.

9 SELF ASSESSMENT QUESTIONS 1) Are there conditions under which a firm might be better off if it chose a machine with a rapid payback rather than one with the largest rate of return? Company X uses the payback method in evaluating investment proposals and is considering new equipment whose additional net after-tax earnings will be Rs.10. NMIMS. 1995. Sultan Chand and Sons New Delhi. b) What is the internal rate of return for the investment? c) Should the investment be made? 2) 3) 4) 5) 5.8 SUMMARY For any economy/company there are many avenues of investments. but one can’t go and invest in all of these avenues. and its expected life is ten years (straight-line depreciation). “Financial Management and Policy. R. Discounted and non discounted the major difference between these two is that in former the future cash flows are discounted at appropriate discount rate (usually cost of capital) to get net present value of future cash flows.150 a year. The equipment costs Rs.P. Here capital budgeting techniques play an important role in deciding which project to select & which to reject. “Public Enterprises Investment Decisions in India: A Managerial Analysis.M. Macmillan Company of India Ltd. L.. 1976. Dhankar Raj S.6. Srivastava. 5.. Porwal. Capital budgeting techniques are broadly classified in two categories. Mumbai.5.” 2003 13 .500. “An Appraisal of Capital Budgeting Decision Mechanism in Indian Corporates” Management Review. The net cash flows after taxes from the machine would be Rs. “Capital Investment decisions in Indian Industry”. Bombay 1985.56.2. Himalaya Publishing House. July – December. The applicable cost of capital for this project is 12 percent. New Delhi. 1977.”.10 FURTHER READINGS Besant C. Mumbai.670. This gives rise to problem of selection of a particular project out of the many available. “Capital Budgeting in India”. Murty.. Should the equipment be purchased under the above assumptions? What are the most critical problems that arise in calculating a rate of return for a prospective investment? What other factors in addition to rate of return analysis should be considered in determining capital expenditures? A firm has an opportunity to invest in a machine at a cost of Rs. Capital budgeting technique involves matching of expected net cash inflows from the project with anticipated cost of the project.S.. a) Calculate the net present value for the investment. The company uses a three-year payback as its criterion.000 per year and would continue for five years. G. Raj A. Himalaya Publishing House.

to focus on types of control Processes.15 Design of Control System Control of creative Activities Progress Review Personnel Reassignment Control of Input Resources Summary Self Assessment Questions Further Readings 7. as an activity.3 7.10 7. In our discussion it is important to remember that monitoring.2 DESIGNING OF THE MONITORING SYSTEM The first step in setting up any monitoring system is to identify the key factors to be controlled.1 7.14 7.5 7.9 7.7. cost. cost.2 Go/No-go Control 7. and time but must define precisely which specific characteristics of performance. for example. to explain concept of control and its various types. 7. the project manager wants to monitor performance. Structure 7.2 7. recording. and times should be controlled and then establish exact boundaries within which control should be maintained.6 7.1 Cybernetic Control 7. and reporting information concerning any and all aspects of project performance that the project manager or others in the organization wish to know.4 7. as well as from evaluation (through which judgements are made about the quality and effectiveness of project performance).12 7. And there may also be other factors of importance worth noting.13 7.3 Post Control 7.8 7.7.7.UNIT 7 PROJECT MONITORING AND CONTROL Objectives The objectives of this unit are: to provide an understanding of how the monitoring system is designed.11 7.1 INTRODUCTION Monitoring is collecting. to throw light on designing of control system.7 Introduction Designing of the Monitoring System How to Collect Data Information needs and the Reporting Process Report Types Project Control Types of Control Processes 7. at least at certain points in the life of the project. should be kept quite distinct from controlling (which uses the data supplied by monitoring to bring actual performance into approximate congruence with planned performance). the number of labour hours used. Clearly. the number or 1 .

work package. the project manager has options. the level of customer satisfaction.or to concentrate on “objective” measures that are easily defended at the expense of softer. and the like. and by the fact that it is desirable to improve the process of managing projects. In most cases. standards and criteria change because of factors that are not under the control of the project manager. These goals should relate to some fashion to each of the different levels of detail. performance criteria. and similar items may be worthy of note on individual projects. the nature of the required data is dictated by the project plan. operating data. The fundamental problem in this regard is to determine precisely which of all the available data should be collected. The criteria and data collection procedures are usually set up for the life of the project. For example. the project manager might want to know about changes in the client’s attitudes toward the project. Above all. Next. and mechanisms designed for gathering and storing such data. but. At this point in the construction of a monitoring system. may not be constant over the project’s life. standards. that is. as well as by the goals of the parent organization. They are interested in results. and work unit in the project. more subjective data that may be more valuable for control. If it does not collect and report information on some significant element of the plan. monitoring should concentrate primarily on measuring various facets of output rather than activity. Of course. It is worth repeating that the typical determinant for collecting data too often seems to be simply the ease with which it can be gathered. customer reactions. The monitoring system is a direct connection between planning and control. But the best source of items to be monitored is the project Action Plan actually. Given all this. the process of developing and managing projects should be considered and steps taken to ensure that information relevant to the diagnosis and treatment of the project’s organizational infirmities and procedural problems are gathered. time. Similarly. some should relate to the project. the first task is to examine the project plans in order to extract performance. when. control can be faulty or missing. specification changes. and the planned level of resource usage for each task. but are not reflected in the project’s action plan. some to its tasks. it is necessary to define precisely what pieces of information should be gathered and when. Therefore. it is common to focus monitoring activities on data that are easily gathered . the set of Action Plans that describe what is being done. The standards themselves. and data collection procedures must be established for each of the factors to be measured.3 HOW TO COLLECT DATA Given that we know what type of data we want to collect. the information to be collected must be identified. They may change as a result of altered capabilities within the parent organization or a technological breakthrough made by the project team. This may consist of accounting data. It is crucial to remember that effective project managers are not primarily interested in how hard their project teams work. engineering test data. These two latter items may be quite important. Data must be identified that measure achievement against the goals.Investment Decisions Under Certainty extent of engineering changes. perhaps more often than not. but it is not sufficient. and so on. Unfortunately.rather than important . the next question is how to collect this information. some to the work packages. however. questions 2 . and cost goals. 7. The measured and reported to the control system. Information on the morale of the project team might be useful in preparing for organizational or personnel changes on the project.

This type of measure is often used for “complaints. and tables should be updated on a timely basis. time/cost reports. These numbers are reported in a wide variety of ways. the project manager make sure that the linkage between the indicator and the desired performance measure is as direct as possible. but often as direct comparisons with an expected or standard number. as should statistical distributions of previous data if available. Also. and the meanings of the individual terms are consistently understood by all. it may be possible to find an indirect measure on indicator. As long as the set of characterizations is limited. Verbal Measures : Measures for such performance characteristics as “quality of team member cooperation. charts. Comparisons on ratios can also be plotted as a time series to show changes in system performance. These include project status reports. “comparables” should be reported. Project Monitoring and Control 2. The speed with which change orders are processed and changes are incorporated into the project is often a good measure of team efficiency. 5. Frequency Counts : A simple tally of the occurrence of an event. and specifications are usually reported in this way. Response to change may also be an indicator of the quality of communications on the project team. Plans. Indicators: When the project manager cannot measure some aspect of system performance directly. and we are quite aware that our project has been charged for work done on another project that is over budget? Are special forms needed for data collection? Should we set up quality control procedures to ensure the integrity of data transference from its source to the project information system? Such questions merely indicate the broad range of knotty issues that must be handled. 1.” or “quality of interaction with the client” frequently take the form of verbal characterization.” “morale of team members. The purpose of the control system is to act on the data.” “number of times a project report is late. 3. hours. but care should be taken to make sure that the numbers are not manipulated in ways only suitable for quantitative measures. Causes and effects should be identified and trends noted. “variances” are commonly reported as the ratios of actual to standard. made by knowledgeable individuals or groups. it is 3 .then arise. When using indicators to measure performance. these data serve their purposes reasonably well. The data are usually easy to collect and are often reported as events per unit time or events as a percent of a standard number. among others. Ordinal rankings of performance are included in this category. reports on project progress should be generated. Where known. The purpose of the monitoring system is to gather and report data. To aid the project controller. each of which is suitable for some types of measures. usually of a quality. They can be reported in most of the same ways that objective raw numbers are. Should cost data be gathered before or after some specific event? Is it always mandatory to collect time and cost information at exactly the same point in the process? What do we do if a specific piece of desirable data is difficult to collect because the data source (human) fears reporting any information that might contribute to a negative performance evaluation? What do we do about the fact that some use of time is reported as “hours charged” to our project. A large proportion of the data collected may take one of the following forms. Both help the project manager (and others) to interpret the data being monitored. and variance reports. Subjective Numeric Ratings : These number are subjective estimates. Raw Numbers : Dates.” “bugs in a computer program” and similar items. physical amounts of resources used. After data collection has been completed. 4.

The audit serves the purpose of ensuring that the information gathered is honest. The report schedule. The methods of statistical quality control are very useful for determining what size variances are “significant” and sometimes even help in determining the probable cause(s) of variances. overview reports describe progress in more aggregate terms with less individual task detail. nothing need be done. This must not be taken as advice to issue reports “every once in a while. Biased findings and correcting activities are worthwhile only if data with less or no bias are required. can prevent bias. 4 . however.” Reports should be scheduled in the project plan. etc. some care should be devoted to the issues of honesty and bias. reports. The first issue is to determine whether or not the possibility of bias in the data matters significantly. Significant variances from plan should be highlighted or “flagged” so that they cannot be overlooked by the controller. however. The frequency of reporting should be great enough to allow control to be exerted during or before the period in which the task is scheduled for completion. In creating the monitoring system. it should be noted.1. by whom. although the actual investigation may be conducted by the group responsible for monitoring. This means that project reports may not be issued periodically-excepting progress reports for senior management. it is actually not good advice. Few projects require attention so neatly consistent with the calendar. If not. There is some tendency for project monitoring systems to include an analysis directed at the assignment of blame. While the managerial dictum “rewards and punishments should be closely associated with performance” has the ring of good common sense. No audit. Lower-level personnel have a need for detailed information about individual tasks and the factors affecting such tasks. quarterly. In addition to the criterion that reports should be available in time to be used for project control. the practice is more apt to result in lower expectations. If achievement of goals is directly measured and directly rewarded. except for tradition. Where it is not known. Instead of motivating people to better performance. The decisions about when an investigation should be conducted. At times it may be necessary to move information among organizations. a tremendous pressure will be put on people to understate goals and to generate plans that can be met or exceeded with minimal risk and effort. an investigation may be in order. All data are biased by those who report them. as illustrated in Figure 7. Reports are issued less often. as well as among managerial levels. 7. Where causation is known. advertently or inadvertently. This practice has doubtful value. monthly. but reports need not be of the same depth or at the same frequency for each level. the timing of reports should generally correspond to the timing of project milestones.4 INFORMATION NEEDS AND THE REPORTING PROCESS Everyone concerned with the project should be tied into the project reporting system. The monitoring system ought to be so constructed that it addresses every level of management. need not call for periodic reports. to issue weekly. Reports must contain data relevant to the control of specific tasks that are being carried out according to a specific schedule.Investment Decisions Under Certainty helpful for the monitor to carry out some data analysis. and by what methods are the prerogative of the project controller. They should be issued on time. The controller must understand this fact of life.. For the senior management levels. There seems to be no logical reason. The former is dealt with by setting in place an internal audit. Report frequency is usually high.

Keeping the client and other interested outside parties up to date on project status. to ensue achievement of the project plan through control. Understanding the relationships of individual tasks to one another and to the overall project. Awareness of the progress of parallel activities and of the problems associated with coordination among activities.P. Early warning signals of potential problems and delays in the project. including attention directed to the immediate needs of the project. of course. particularly regarding project milestones and deliverables. 5 V V Project Manager V V V V V V . and scheduling systems. large changes in the resource base must be initiated. There is. or key technical results achieved. Minimizing the confusion associated with change by reducing delays in communicating the change. There are many benefits of detailed reports delivered to the proper people on a timely basis. therefore. Faster management action in response to unacceptable or inappropriate work. there are only a few milestones even in large projects. Ventures Consultant Project Monitoring and Control Steering Committee Marketing Project Manager V Technical Assistant Denotes information flow Figure 7.Company V. The scheduling and resource usage columns of the project Action Plan will serve as the key to the design of project reports.at least not by them. The primary purpose is. little reason to burden operating members of the project team with extensive reports on matters that are not subject to control . Higher visibility to top management. Among them are : Mutual understanding of the goals of the project. there may be many critical points in the project schedule at which major decisions must be made. The nature of the monitoring reports should be consistent with the logic of the planning. For senior management. budgeting.1: Reporting and information flows between organisations working on a common project Identification of project milestones depends on who is interested. More realistic planning for the needs of all groups and individuals working on the project. For the project manager. The milestones relevant to lower levels relate to finer detail and occur with higher frequency.

The monitoring of performance for the entire project is also crucial because performance is the raison d’etre of the project. the program manager decides that it would be less expensive for the company to carry small inventories in a few of the commonly used high alloys. capabilities of new software. At times. it may be useful to issue routine reports on resource usage periodically. and special analysis.” Second. Special analysis reports are used to disseminate the results of special studies conducted as part of the project or as a response to special problems that arise during the project. Variances are reported by the monitoring system.in other words. availability of external consultants. For senior management.5 REPORT TYPES For the purposes of project management. Distribution of these reports is usually made to anyone who might be interested. Exception reports are useful in two cases. First. they are directly oriented to project management decision making and should be distributed to the team members who will have prime responsibility for decisions or who have a clear “need to know. The Earned Value Chart Thus far. time. we have covered monitoring for parts of projects. and to estimate (and price) material use closer to actual expectations. The routine reports are those issued on a regular basis. Project variance reports usually follow the same format used by the accounting department. but. as we noted above. Individual task performanxce must be monitored carefully because the timing and coordination between individual tasks is important. evaluation of alternative manufacturing processes. A serious difficulty in comparing actual expenditures against budgeted or baseline expenditures for any given time period is that the comparison fails to take into account the amount of work accomplished relative to the cost incurred. and cost. or make use of analytic methods that might be helpful on other projects. and descriptions of new governmental regulations are all typical of the kind of subjects covered in special analysis reports. One way of measuring overall performance is by using an aggregate performance measure called earned value. Usually they cover matters that may be of interest to other project manager. variances are reported for those same variables. but at times they may be presented differently. and responsibility for action rests with the controller. but for the project manager and lower-level project personnel. The earned value of work performed for those tasks in progress is found by multiplying the estimated percent completion for each task by the 6 . as part of a sensible procedure for protecting oneself. the reports will usually be periodic. exception. occasionally on a weekly or even daily basis. But overall project performance is the crux of the matter and must not be overlooked. they may be issued when a decision is made on an exception basis and it is desirable to inform other managers as well as to document the decision . milestones may be used to trigger routine reports. Because the project plan is described in terms of performance. we can consider three distinct types of reports: routine. The real message carried by project reports is in the comparison of activity to plan and of actual output to desired output. regular does not necessarily refer to the calendar. As a result of this information.Investment Decisions Under Certainty 7. Studies on the use of substitute materials. This variance report shows the ratio of the material estimated to the material used in projects.

....2 can be constructed and provides a basis for evaluating cost and performance to date.. A graph such as that shown in Figure 7.............. If the planned (baseline) total value of the work accomplished is in balance with the planned cost (i......... and the total variance is the sum of the two: actual less planned cost.. If the earned value chart shows a cost overrun or performance under-run. the schedule variance is the value completed less the baseline plan............. or holding a meeting of project team members to see if anyone can suggest solutions to the problems. ... Project Monitoring and Control Rupees Cost Schedule Plan (Baseline) Actual Cost Total Variance Schedule Variance Spending Variance of Cost Overrun (quantity and price) Value Completed 1 2 3 Time Varience (10 day delay) Figure 7............ The project manager is concerned with all the three....... minimal scheduling variance)................ 7 .......... notifying the client that the project may be late or over budget....... The spending variance is the actual cost less the value completed....... Options include such things as borrowing resources for activities performing better than expected................... The result is the amount that “should” have been spent on the task thus far............. then top management has no particular need for a detailed analysis of individual tasks. a) List out the steps that you would take to design the monitoring system for the organization....... as mentioned above............... This can then be compared with the actual amount spent.... or perhaps.........e.........................planned cost for that task....... whereas the project controller is probably concerned with the spending variance (cost overrun) and the controller of the parent will track the total variance....... is usually most concerned with the schedule (or time) variance... ..... Top management...... the project manager must figure out what to do to get the system back on target.......2: Earned value Chart Three variances can be identified on the earned value chart.............. Activity 1 Managing Director of a Pharmaceutical of Company has approached you to design the monitoring system for his organization..... Thus the concept of earned value combines cost reporting and aggregate performance reporting into one comprehensive chart..... of course.......

.......... and accounting for why such differences exist are all parts of the control process...................................... must also be controlled................. and its financial resources... Note that reporting performance.. The project manager must guard the physical assets of the organization....... It is also the last element in the implementation cycle of planning-monitoring-controlling................ 2......... Physical inventory....... ......................................... At issue also is the timing of maintenance or replacement as well as the quality of maintenance. It is critical to accomplish preventive maintenance prior to the start of that final section of the project life cycle known as the Last Minute Panic (LMP). It is concerned with the asset maintenance....... and action taken if actual and desired performance differ sufficiently that the controller (manager) wishes to decrease the difference..... and all the other minor bits and pieces should be accounted... the project manager also has the problem of setting up maintenance schedules in such a way as to minimize interference with the ongoing work of the project.. whether preventive or corrective.............6 PROJECT CONTROL Nature of Control Control is the act of comparing the planned performance with the actual and reducing the difference between the two.......... and conserved.......................... Even such details as the project library............... its human resources... Most discussions of the control function are firmly focused on regulation....... project coffee maker. It must be received..Investment Decisions Under Certainty b) How would you collect the required data for monitoring purposes? .......... and possibly stored prior to use.. The same precautions applicable to goods from external suppliers must also be applied to suppliers from inside the organization..... compared with the desired (or planned) level....................... ...................... whether equipment or material....... The Project Manager is shepherd of the organization’s resources.. Records of all incoming shipments must be carefully validated so that payment to suppliers can be authorized......... Information is collected about system performance...... The project manager needs to be equally attentive to both regulation and conservation.. c) What information would you provide in your Report to the Managing Director? .. 8 ................... The stewardship of organizational assets.................................................... inspected (or certified)........... Types of Control Physical Asset Control Physical asset control requires of the use of these assets.. The regulation of results through the alteration of activities..................................... comparing the differences between desired and actual performance levels...... Objectives of control are : 1......... 7............ If the project uses considerable amount of physical equipment........... The processes for conserving these three different kinds of assets are different....... maintained...... project room furniture..

Project Monitoring and Control 7. The accounting profession has worked for some years on the development of human resource account. differing one from another in many ways. and retention are not particularly satisfactory devices for ensuring that the conservation function is being properly handled. we must monitor the system output.Human Resource Control Human resouces also need both regulation and conservation. The measurement of human resource conservation is far more difficult. and screening methods for appointment.7. go/no-go control. or steering control is by far the most common type of control system. and post control.7 TYPES OF CONTROL PROCESSES No matter what our purpose in controlling a project. their work on techniques for the conservation (and regulation) of financial resources have most certainly resulted in excellent tools for financial control. In this section we will describe these three types of control and briefly discuss the information requirements of each. The techniques of financial control. In order to do so. The structure of the techniques applied to projects does not differ appreciably from those applied to the general operation of the firm. This function is 9 . Stewardship of human resources requires controlling and maintaining the growth and development of people. conducted by the accounting/controller function for the most part. Figure 7. Because projects are unique. and while their efforts have produced some interesting ideas. Most financial controls do both. but the context within which they are applied is quite different. human resource accounting is not well accepted by the accounting profession. Capital investment. are well known. it is possible for people working on projects to gain a wide range of experience in a reasonably short time. or another division of the parent firm. It is this system that we wish to control. personnel performance indices. controls work to conserve the organization’s assets by insisting that certain conditions be met before capital can be expended.1 Cybernetic Control Cybernetic. These controls are exercised through a series of analyses and audits.”) The key feature of cybernetic control is its automatic operation. This is the best developed of the basic area needing control. Financial Resource Control Though accountants have not succeeded in developing acceptable methods for human resource accounting. One reason for the differences is that the project is accountable to an outsider . or both at the same time. Such devices as employee appraisals.an external client. promotion. Representation of this function on the project team is mandatory. Projects provide particularly fertile ground for cultivating people. It is difficult to separate those control mechanisms aimed at conservation of financial resources from those focused on regulating their use. 7. both conservation and regulation. Measurement of physical resource conservation is accomplished through the familiar audit procedures. They include current asset controls. (Cyber is the Greek work from “helmsman. and those same conditions usually regulate the use of capital to achieve the organization’s goals of a high return on its investments. there are three basic types of control mechanisms that we can use: cybernetic control.3 shows that a system is operating with inputs being subjected to a process that transforms them into outputs.

In regard to time and cost. in general. The part passes or it does not. The difference between actual and standard is sent to the decision maker. The same is often true of the cost and time elements of the project plan. For many facets of performance. It is. Other characteristics may be less precisely defined. early delivery can also carry a penalty. These are go/no-go controls. 10 V Effector and Decision maker Sensor Comparator V V V V V Investment Decisions Under Certainty Inputs x Process k Outputs y V . proportional to the size of the deviation from standard. The speed or force with which the control operates is. The project plan. are individually checked for quality conformance. If the difference is large enough to warrant action. Certain characteristics of output may be required to fall within precisely determined limits if the output is to be accepted by the client. which determines whether or not the difference is of sufficient size to deserve correction. which compares them with a set of predetermined standards. The parts of a new jet engine. presumably those aspects one wishes to control.7. of course. The precise way in which the deviation is corrected depends on the nature of the operating system and the design of the controller. and every part must pass its own go/no-go test before being used in an engine. 7. which acts on the process or on the inputs to produce output that conform more closely to the standard. a signal is sent to the effector. so the project manager has a predesigned control system complete with pre-specified milestones as control checkpoints. Penalty clauses that make late delivery costly for the producer are often included in the project contract. and schedules. Measurements taken by the sensor are transmitted to the comparator. and schedule are all control documents. At times. The difference between actual and standards. budget.3: A cybernetic control system performed by a sensor that measures one or more aspects of the output. If the system output moves away from standard in one direction. Cost overruns may be shared with the client or totally borne by the project. budgets. This type of control can be used on almost every aspect of a project. for instance. the control mechanism acts to move it in the opposite direction. it is difficult to know that the predetermined specifications for project output have been met.V V Standards Figure 7. A cybernetic control system that acts to reduce deviations from standard is called a negative feedback loop.2 Go/No-go Controls Go/No-go controls take the form of testing to see if some specific precondition has been met. necessary to exercise judgement in the use of go/no-go controls. Control can be exercised at any level of detail that is supported by detail in the plans. there may be penalties associated with nonconformance with the approved plans.

for instance. and by the time the next quarterly check is made. if not the duty. Where the same explanation is associated with both a schedule and budget deviation. weather. Post-control is directed toward improving the chances for future projects to meet their goals. Because actual project performance depends in part of uncontrollable events) strikes.” Cybernetic and go/no-go controls are directed toward accomplishing the goals of an ongoing project. periodic intervals. he or she should do so in moderation to be effective b) Milestones.While cybernetic controls are automatic and will check the operating systems continuously or as often as designed to do so. As reported here. calendar. Such periodicity makes it easy to administer a control system. and Budgets : This section starts with a full report of project performance against the planned schedule and budget. the key initial assumptions made during the preparation of the project budget and schedule should be noted in this section. Project milestones do not occur at neat. Usually. Instead. A certain amount of care must be taken in reporting these assumptions. or the operating cycles of some machine system. While it is clearly the prerogative. In many cases. For an early warning system to work. preset intervals. a) The Project Objectives : The post-control will contain a description of the objectives of the project. and that anyone caught sweeping problems and mistakes under the rug will be.” but post-control is not a vain attempt to alter what has already occurred. when significant variations of actual from planned project performance were indicated. Each deviation can be identified with a letter or number to index it to the explanations. at regular. the same identifier can be used. Things begin to go awry just after a quarterly progress check. Checkpoints. sudden loss of key employees. Explanations of why these. One might draw parallels between post-control and “locking the barn after the horse has been stolen. Significant deviations of actual schedule and budget from planned schedule and budget should be highlighted. this description is taken from the project proposal. not simply to the calendar. project objectives include the effects of all change orders issued and approved during the project. of every project manager to politically protect himself. it is a full recognition of George Santayana’s observation that “Those who cannot remember the past are condemned to repeat it. go/no-go controls function periodically. The intervals are usually determined by clock. it must be clearly understood that a messenger who brings bad news will not be shot. as well often be the case. and the entire proposal often appears as an appendix to the post-control report. but it often allows errors to be compounded before they are detected. deviations occurred will be offered in the next section of the post-control report. The Final Report on Project Results : Note that in the previous section.3 Post-control Project Monitoring and Control Post-controls (also “post-performance controls” or “post-project controls”) are applied after the fact. controls should be linked to the actual plans and to the occurrence of real events. some items may be seriously out of control. and other acts of God). no distinction was made between favourable c) 11 . thus. go/no-go controls operate only when the controller uses them. They should not be written with a tone that makes them appear to be execuses for poor performance. An important rule for any subordinate is the Prime Law of Life on a project : “Never let the boss be surprised!” 7. Post-control is applied through a relatively formal document that is usually constructed with four distinct sections. This can be prepared by combining and editing the various project status reports made during the project’s life.7. failure of trusted suppliers.

..... ......... weather.. Not only do most projects result in outputs that are more or less satisfactory..................... monitoring systems........................................ just as the likelihood of achieving good results...... the conduct of projects will become smoother............................ project managers focus their attention on trouble...............................................Investment Decisions Under Certainty and unfavourable variations........................................................... While this is quite natural...... Basically descriptive..................................... ..................................... the appearance of a new technology................... on time and on cost....... an explanation of the methods used to plan and direct the project........................................................................................................... the process of organizing and conducting projects can be improved by recommending the continuation of managerial methods and organizational systems that appear to effect.......................................................................................... b) List out the various assets of the organization that would require control..................... ............................................ ......... ........................... Activity 2 President of an MNC has asked you to develop control system for his organization: a) List out the activities that you would cover while developing control system for the organization.................... Provision for such things can be factored into future project plans.. c) List out the three basic types of control mechanisms that you would employ in the organization.................. strikes....................... 12 .............. Both sides........................... Like the tongue that invariably goes to the sore tooth.................... But some of the deviations from plan were caused by happenings that are very likely to recur. The concern here is not on what the project did but rather on how it did it............................................. together with the alteration of practices and procedures that do not.. it leads to complete documentation on why some things went wrong and title or no documentation on why some things went particularly well.... thereby adding to predictability and control........... ... as well as a discussion of intraproject interactions between the various working groups....................................... .................... ........ In this way.............................................................................................................................................. that themselves are not apt to affect future project-although other different one-time events may effect them........... is increased......... the good and the bad.................... Recommendations for Performance and Process Improvement: The culmination of the post-control report is a set of recommendations covering the ways future projects for improving........................................... ....................................................................................... etc..... and control methods............................. this part of the final report should cover project organization....................................... sickness...... should be chronicled here................................... ........................... and a review of the communication networks......................... ..... most projects operate with a process that is more or less satisfactory.................... Many of the explanations appearing in the previous section are related to one-time happenings.................................. Just as important.. .....

it should be able to react to and report unforseen changes in system performance. This review typically follows some particular milestone and. not the whims of the project manager. The system should be as simple to operate as possible. Problems must be reported while there is still time to do something about them. the system must be designed so that it appears to be sensible. or if things are going badly.” In addition to being sensible.7. Let us now consider some more specific aspects of control. The control system must be truly useful. the Project Manager is trying to anticipate problems or catch them just as they begin to occur. behaviours should be monitored? Should we monitor people? What kinds of sensors should be used? Where should they be placed? How timely must be monitoring be? How rapidly must it be reported? How accurate must sensors be? If the control system is to be acceptable to those who will use it and those who will be controlled by it. control is not always less expensive than scrap. The control system should be easy to maintain. Where possible. that is. Control limits must be appropriate to the needs of the client. Further. activities. cost. leads to a followon authorization to proceed to the next review point. The control of performance. rewards and penalties should “fit the crime.8 DESIGN OF CONTROL SYSTEMS Irrespective of the type of control used. there are some important questions to be answered while designing any control system: who sets the standards? How realistic are the standards? How clear are they? Will they achieve the project’s goals? What output. the project may be terminated. quality checks. The Project Manager wants to keep the project out of trouble because upper management often bases an incremental funding decision on a review of the project. Project Monitoring and Control 13 . all of the control systems described above use feedback as a control process. not merely set to show “how good we are. if acceptable. test results. The system should be cost-effective. As we noted above. a good control system should also possess some other characteristics as set out below : The system should be flexible. the control system should signal the overall controller if it goes out of order. The system must operate in a timely manner. Control systems should be fully documented when installed and the documentation should include a complete training program in system operation. The cost of control should never exceed the value of control.” Like punishment. Thus. The system should be capable of being extended or otherwise altered. It must satisfy the real needs of the project. and before they become large enough to destroy the project. Sensors and monitors should be sufficiently accurate and precise to control the project within limits that are truly functional for the client and the parent organization. and time usually requires different input data. the project manager may need such specific documentation as engineering change notices. To control performance. Standards must be achievable by the mechanical systems used. To a large extent. No matter how designed. the project manager must monitor and control the project quite closely. If all is not going well. other technological alternatives may be recommended.

First. the budget will probably be overrun. Consider Table 7. The closer the ratio is to one.1 for example. For cost control.5 % % % % % (6 (6 (4 (6 (6 7. income reports. the master project schedule. accounting projections. periodic activity and status reports. the fifth task is on schedule and is running under budget. design projects. Gantt charts. the project manager examines bench mark reports. then the activity may need to be investigated. The second task is on budget but its physical progress is lagging. labour hour charges. the greater the degree of uncertainty surrounding outcomes. amount of overtime worked.1: (Actual Progress/Scheduled Progress) x (Budget Cost/Actual Cost) Task Number 1 2 3 4 5 Actual Progress (2 (2 (3 (3 (3 / / / / / Scheduled Progress 3) 3) 3) 2) 3) Budgeted Cost Actual Cost / / / / / 4) 4) 6) 6) 4) = = = = = Critical Ratio 1. earned value graphs. and the like. On occasion it may be worthwhile. 14 . The critical ratio is. A cost saving may result. Even if there is slackness in the activity.67 1. the more creativity involved. and probably reviews the Action Plans. cost exception reports. If delay is no problem for this activity. the manager compares budgets to actual cash flows. the project manager need take no action. We can see that the first task is being scheduled but below budget. (Actual Progress/Scheduled Progress) x (Budgeted Cost/Actual Cost) If this ratio is exactly one. purchase orders. and similar processes that depend intimately on the creativity of individuals and teams. and the first task may need attention also. Second. The second and third activities need attention. the less important is the investigation. The project manager may set some critical-ratio control limits intuitively. exception reports. another probable cost saving. Earned value analysis was also described earlier. PERT/CPM networks. and maintenance activities. If the ratio differs from one. Some of the most important analytical tools available to the project manager to use in controlling the project are variance analysis and trend projection.0 .9 CONTROL OF CREATIVE ACTIVITIES Some brief attention should be paid to the special case of controlling research and development projects. Task 4 and 5 have critical ratios greater than one and might not concern some project manager but the thoughtful manager would like to know why they are doing so well (and the project manager may also want to check the information system to validate the unexpectedly favourable findings). then the activity is probably on target. The fourth task is on budget but ahead of schedule.5 1. Finally. The third task is on schedule but cost is running higher than budget.Investment Decisions Under Certainty rework tickets. creating another probable cost overrun. absenteeism. accounting variance reports.67 . Table 7. scrap rates. To control the schedule. particularly on large projects for the project manager to calculate a set of critical ratios for all project activities.

too much control tends to inhibit creativity. Control is not necessarily the enemy of creativity; nor, popular myth to the contrary, does creative activity imply complete uncertainty. While the exact outcomes of creative activity may be more or less uncertain, the process of getting the outcome is usually not uncertain. In order to control creative projects, the project manager must adopt one or some combination of three general approaches to the problem: (1) progress review, (2) personnel reassignment, and (3) control of input resources.

Project Monitoring and Control

7.10 PROGRESS REVIEW
The progress review focuses on the process of reaching outcomes rather than on the outcomes per se. Because the outcomes are partially dependent on the process used to achieve them - uncertain though they may be - the process is subjected to control. For example, in the case of research projects the researcher cannot be held responsible for the outcome of the research, but can most certainly be held responsible for adherence to the research proposal, the budget, and the schedule. The process is controllable even if the precise results are not.

7.11 PERSONNEL REASSIGNMENT
This type of control operates in a very straightforward way. Individuals who are productive are retained. Those who are not to be retained are moved to other jobs or to other organizations. Problems with this technique can arise because it is easy to create an elite group. While the favoured few are highly motivated to further achievement, everyone else tends to be demotivated. It is also important not to apply control with too fine an edge. While it is not particularly difficult to identify those who falls in the top and bottom quartiles of productivity, it is usually quite hard to make clear distinctions between people in the middle quartiles.

7.12 CONTROL OF INPUT RESOURCES
In this case, the focus is of efficiency. The ability to manipulate input resources carries with it considerable control over output. Obviously, efficiency is not synonymous with creativity, but the converse is equally untrue. Creativity is not synonymous with extravagant use of resources. The results flowing from creative activity tend to arrive in batches. Considerable resource expenditure may occur with no visible results, but then, seemingly all of a sudden, many outcomes may be delivered. The milestones for application of resource control must, therefore, be chosen with great care. The controller who decides to withhold resources just before the fruition of a research project is apt to become an ex-controller. Sound judgement argues for some blend of these three approaches when controlling creative projects. The first and third approaches concentrate on process because process is observable and can be affected. But process is not the matter of moment; results are. The second approach requires us to measure (or at least to recognize) output when it occurs. This is often quite difficult. Thus, the wise project manager will use all three approaches: checking process and method, manipulating resources, and culling those who cannot or do not produce.

15

Investment Decisions Under Certainty

7.13 SUMMARY
Project is a set of complex interelated activities. A bottleneck at any one of the stages has an impact on the completion schedule of other stages, therefore for any project a monitoring system is a must. The frequency and the type of monitoring as well as data collection for monitoring will vary from project to project. Project monitoring reports are basically of three types 1) Routine, 2) Exception, 3) Special Analysis. Project control is the act of comparing the planned performance with the actual and reducing the difference between the two. Project control has three domains 1) Physical Asset Control, 2) Human Resource Control, 3) Financial Resource Control.

7.14 SELF ASSESSMENT QUESTIONS
1) 2) 3) 4) 5) 6) 7) 8) What is the purpose of control? To what is it directed? What are the three main types of control systems? What questions should a control system answer? What tools are available to the project manager to use in controlling a project? Identify some characteristics of a good control system. What is the mathematical expression for the critical ratio? What does it tell a manager? How might the project manager integrate the various control tools into a project control system? How could a feedback control system be implemented in project management to anticipate client problems? Define monitoring. Are there any additional activities that should be part of the monitoring function? Calculate the critical ratios for the following activities and indicate which activities are probably on target and which need to be investigated.
Activity A B C D E Actual Progress 4 days 3 days 2 days 1 day 2 days Scheduled Progress 4 days 2 days 3 days 1 day 4 days Budgeted Cost Rs. 60 Rs. 50 Rs. 30 Rs. 20 Rs. 25 Actual Cost Rs. 40 Rs. 50 Rs. 20 Rs. 30 Rs. 25

9)

Give the following information, which activities are on time, which are early, and which are behind schedule?
Activity A B C D E Budgeted Cost Rs. 60 Rs. 25 Rs. 45 Rs. 20 Rs. 50 Actual Cost Rs. 40 Rs. 50 Rs. 30 Rs. 20 Rs. 50 Critical Ration 1.0 0.5 1.5 1.5 0.67

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7.15 FURTHER READINGS
Cleland, D.I., and W.R. King, “Systems Analysis and Project management,” MC Graw Mill, 1983. Kerridge, A.E. and vervalin C.H., “Project Management,” Gulf Publishing, London, 1986. Wadsworth, M.D., “Project Management Controls,” Prentic Hall, 1982.

Project Monitoring and Control

17

UNIT 8 CAPITAL BUDGETING DECISIONS AND THE CAPITAL ASSET PRICING MODEL
Objectives Objectives of the Units are : to examine the relevance of risk in capital budgeting decisions, to understand the application and usefulness of capital asset pricing model in capital budgeting decisions, to study the certainty equivalent and risk adjusted discounting rate approaches. Structure 8.1 Introduction 8.2 Capital Asset Pricing Model 8.3 Measuring Betas and Capital Asset 8.4 Stability of Betas over Time 8.5 Business and Financial Risk 8.6 What determines Asset Betas 8.7 Discounted Cash Flow Approach 8.8 Summary 8.9 Self Assessment Questions 8.10 Further Readings

8.1 INTRODUCTION
Long before the development of capital asset pricing theory1, which says that the equilibrium rates of return on all risky assets are a function of their covariance with the market portfolio; smart financial managers adjusted for risk in capital budgeting. They realized intuitively that, if other things being equal, risky projects are less desirable than safe ones. Therefore, they demanded a higher rate of return from risky projects or they based their decisions on conservative estimates of the cash flows. Various rule of thumb are often used to make these risk adjustments. For example, many companies estimate the rate of return required by investors in its securities and use this required rate of return to discount the cash flows on all new projects. Since investors require a higher rate of return from a very risk company, such a firm will have a higher company cost of capital and will set a higher discount rate for its new investment opportunities. You can use the capital asset pricing model as a rule of thumb for estimating the company’s cost of capital. For instance ABC Ltd. has a beta of 1.38, the risk free rate is 7.8 per cent and expected market risk premium 8.3 per cent then, the corresponding expected rate of return would be 203 or about 20 per cent. Therefore, according to the company cost of capital rule, ABC should have been using a 20 per cent discount rate to compute project net present values2.
1 2 CAPM was first developed by William Sharpe in 1963, 64, and later on developed by J.Mossin, 1963, J. Lintner, 1965, F. Black, 1972. ABC did not use any significant amount of debt financing. Thus its cost of capital is the rate of return investors except on its common stock.

5

Investment Decisions Under Uncertainty

This is a step in the right direction. Even though we can’t measure betas or the market risk premium with absolute precision, it is still reasonable to assert that ABC faced more risk than the average firm and, therefore, should have demanded a higher rate of return from its capital investments. But the company cost of capital rule can also get a firm into trouble if the new projects are more or less risky than its existing business. Each project should be evaluated at its own opportunity cost of capital. This is a clear implication of the value-additivity principle. For a firm composed of assets A and B, firm value will be: Firm’s value=PV(AB)=PV(A)+PV(B)= sum of separate asset values. Here PV(A) and PV(B) are valued just as if they were mini-firms in which stock-holders could invest directly. Note: Investors would value A by discounting its forecasted cash flows at a rate reflecting the risk of A. They would value B by discounting at a rate relfecting the risk of B. The two discount rates will, in general, be different.
(required return) Security market line showing Required return on project

20.3 Company cost of capital 7.8

Project beta Average beta of the firm’s assets = 1.38 Figure 8.1: Relationship between required return and Project Beta

Figure 8.1 exhibits a comparison between the company cost of capital rule and the required return under the capital asset pricing model. ABC’s company cost of capital is about 20 per cent. This is the correct discount rate only if the project beta is 1.38. In general, the correct discount rate increases as project beta increases. ABC should accept projects with rates of return above the security market line relating required return to beta. If the firm considers investing in a third project C, it should also value C as if it were a mini-firm. That is, it should discount the cash flows of C at the expected rate of return investors would demand to make a separate investment in C. The true cost of capital depends on the use to which the capital is put.

8.2 CAPITAL ASSET PRICING MODEL (CAPM)
CAPM approach is used to estimate risk adjusted discount rate for making investment decisioins. It is a theory about how the prices of risky financial assets (securities) are determined in the capial market. Capital asset pricing theory tells us to invest in any project offering a return that more than compensates for the project’s beta. This means that ABC

6

any investment decision that is made contains an implicit assumption about project risk. Discount rates might be set for different investment purposes as given below : Category Speculative ventures New product Expansion of existing business Cost improvement. has a low company cost of capital. The required rate of return on a security depends on riskless rate of interest the market risk premium and the security’s beta value. A security’s systematic risk is measured by beta value.1. Many firms require different returns from different categories of investment. If the project had a high beta ABC needed a higher prospective return than if the project had a low beta. 7 . 8.should have accepted any project above the upward-sloping market line in Figure 8. you would think it possible to enlarge the company’s opportunities by investing a large sum in risk free securities. it is justified in accepting projects that ABC would reject. any project offering a return of more than 20 per cent. If ABC used the company cost of capital rule. It is also fully to suggest that. Discount Rate Percent 30 20 15 (Company cost of capital) 10 Capital Budgeting Decisions and the Capital Asset Pricing Model In brief.3 MEASURING BETAS AND CAPITAL ASSET Now the question arises how to use beta pricing model to help cope with risk in capital budgeting situation the main problem in how to estimate the discount rate. it tells ABC to accept any project above the horizontal cost-ofcapital line-that is. It would be silly to suggest that ABC should demand the same rate of return from a very safe project as from a very risky one. That would make the common stock safe and create a low company cost of capital.1. known technology. the main insights of CAPM are : Investors need be rewarded for systematic risk only because insystematic risk can be reduced to zero through diversification of investment profolio. it would reject many good low-risk projects and accept many poor high-risk projects. The notion that each company has some individual discount rate or cost of capital is widespread. In terms of Figure 8. but far from universal. Now contrast this with the company cost of capital rule. which is to accept any project regardless of its beta as long as it offers a higher return than the company’s cost of capital. It is a difficult problem so much so that many people hope it will go away if they ignore it.rf) r = Discounting rate rf = Risk free rate rm = Market rate of return ßP = Project beta And in order to do that you have to figure out the project beta. just because XYZ Ltd. They may go away but unfortunately the problem won’t . r = rf + ßP (rm . If you followed such a rule to its seemingly logical conclusion.

’ Among other things we will find that a firm’s borrowing policy affects its stock’s beta. Table 8. To put it another way. Suppose that you were considering an across-the-board expansion by your firm. Financial Analysis Journal. Cooper.1 Sharpe and Cooper divided stocks into risk classes according to their betas in one 5-year period (class 10 contains high betas. which looks out one period into the future. but you should be able to recognize and deal with exceptions. can we jump from the capital asset pricing model. But then we have to define the ‘similar. you could begin by estimating the beta of the company’s stock. Therefore. for example. what do we mean by the project beta? There may be a separate beta for each year of the project’s life. It would be incorrect.M. In this case. although.Investment Decisions Under Uncertainty We will start by reconsidering the problems you would encounter in using beta to estimate a company’s cost of capital. we will need to dig a little deeper and look at what features make some investments riskier than others.F. 1931-1967”. Risk Percent in Same Risk Class 5 Years Later 35 18 16 13 14 14 13 16 21 40 Percent Within Class 5 Years Later 69 54 45 41 39 42 40 45 61 62 10 9 8 7 6 5 4 3 2 1 3 8 W. to average the beta of a company which has borrowed heavily and the one which has not. These tasks of financial management will be among the last to be automated. 28:46-54. to the discounted-cash-flow formula for valuing long-lived assets? Most of the time it is safe to do so. In order to handle that problem. The problem is to judge the relative risk of the projects available to the firm. To estimate that. Capital asset pricing theory supplies no mechanical formula for measuring and adjusting for risk in capital budgeting. They then looked at how many of these stocks were in the same risk class 5 years later. The company’s cost of capital is the correct discount rate for projects that have the same risk as the company’s existing business but not for those that are safer or riskier than the company’s average. It turns out that beta is difficult to measure accurately for an individual firm. they may have similarity otherwise. class 1 contains low betas). 81 (March-April 1972) . you should discount the projected flows at the company cost of capital. Some projects are safer in youth than in old age. The best a financial manager can do is to combine an understanding of the theory with good judgement and a good nose for hidden clues. There is still another complication: project betas can shift over time. “Risk-Return Classes of New York Exchange Common Stocks. Such an investment would have about the same degree of risk as the existing business. others are riskier. sharpe and G. much greater accuracy can be achieved by looking at an average of similar companies.

1 that there is a marked tendency for stocks with very high or very low betas to stay that way. The stocks with the lowest betas went into class1. and so on. You can see from Table . An extensive study of stability was provided by Sharpe and Cooper3. we would. it may be because it genuinely does have a high beta. It could vary from one period to the other.2: Estimating Beta An obvious way to measure the beta of a stock is to look at how its price has responded in the past to market movements. They divided stocks into 10 classes according to the estimated beta in that period. evidence from two (carefully selected) stocks is not worth much. We may plot monthly rates of return of Company against market returns for the same months. not have been too far off. Class 2 contained stocks with slightly higher betas.2). but betas appear to be reasonably stable. If we use the past beta of a stock to predict its future beta. They then looked at the frequency with which stocks jumped from one class to another. We may fit a line through the points. However. Beta is the slope of the line (See Figure 8. We can twist this the other way around. Each class contained one-tenth of the stocks in the sample. in most cases. The more jumps. If good company news coincides by chance with high market returns.Company return Capital Budgeting Decisions and the Capital Asset Pricing Model b Market return Figure 8.4 STABILITY OF BETAS OVER TIME Of course. If you are willing to stretch the definition of stable to include a jump to an adjacent risk class. then from 40 to 70 percent of the betas were stable over the subsequent 5 years. 9 . or it may be because we have over estimated it.8. If a stock appears to have a high beta. the less stability. a more important reason is that the betas in any one period are just estimates based on a limited number of observations. the stock’s beta will appear higher than if the news coincides with low market returns. One reason that these estimates of beta are only imperfect guides to the future is that the stocks may genuinely change their market risk. 8.

You wouldn’t share the risks with anyone else.) But debt holders of big firms such as TISCO bear much less risk than stockholders. You wouldn’t have to share the firm’s asset value with anyone. Its apparent (estimated) beta will fluctuate from period to period due to random measurement errors. Asset Betas and Equity Betas Think again of what the company cost of capital is and what it is used for. either. they have to share it with debt holders. We define it as the opportunity cost of capital for the firm’s existing assets. But we want the asset beta. and barrel. Asset Beta and Company’s Cost of Capital Now that we know how to derive the beta of a firm’s assets from the beta of its stock. common stock ß is 0. and they may bear part of the asset’s risks. and that firm value equals asset value. there will be no cash to pay stockholders or debt holders. stock. you bear them all. Let us take a simple balance sheet with assets on the left and debt and equity on the right. ß asset = ß portfolio = ß debt debt equity + ß equity debt + equity debt + equity Calculating LMN Ltd. The beta of this hypothetical portfolio is just a weighted average of the debt and equity betas4. If debt interest generates valuable tax savings. The remaining 65 percent consisted of debt and preferred stock. Say LMN Ltd. ßasset. Debt betas are typically close to zero-close enough that for large blue-chip companies many financial analyst just assume ßdebt=0. we can return to the problem of figuring out company’s cost of capital.36 and its common stock accounted for 35 percent of its market value.Investment Decisions Under Uncertainty This explains some of the fluctuation in betas observed by Sharpe and Cooper. Thus the beta of your debt plus equity portfolio would equal the firm’s asset beta. then the formula for ß asset changes somewhat. we use it to value new assets which have the same risk as the old ones. every rupee of cash the firm pays out would be paid out to you. The debt holders receive part of the cash flows generated by the firm’s assets. Suppose a company’s true beta really is stable.100 per cent of the debt and 100 percent of the equity. You would own the assets lock. its asset beta. To keep matters simple we will just 4 Here we ignore certain tax complications. if the assets turn out to be worthless. How do we get it? Suppose you buy all the firm’s securities . Stockholders own the firm’s equity but they can’t claim all of the asset value. 10 . (For example. Asset value Debt Value (D) Equity value (E) Firm value (V) Asset value Note that the values of debt and equity add up to firm value (D + E = V). So the stability of true betas is probably better than Sharpe and Cooper’s results seem to imply. The right beta for calculating the company cost of capital is the beta of the firm’s existing assets.

36 11 .36) despite its heavy use of debt and correspondingly high financial risk.078 + .078 + .22(.15.15(. and no change in the beta of a portfolio of all the firm’s debt and equity security. The difference between its equity and asset beta reflects financial risk.083) = .13 + (.5 BUSINESS AND FINANCIAL RISK A firm’s asset beta reflects its business risk. With a risk-free rate of 7. Let’s go back to the formula for ßasset.22 r = rf+ßasset(rm–rf) =. this is a very low number.089.13 – 0) = .7% 8. ß asset = ß debt+ß equity = . LMN’s cost of capital is r = rf+ßasset (rm-rf) = . debt equity + ß equity debt + equity debt + equity ß asset = ß debt and solve the formula for ßequity debt equity ß equity = ß asset + (ß asset – ß debt) If we assume LMN’s debt is risk-free. This gives us the following estimates for the beta of LMN’s assets: ß asset = ß debt = ß debt debt equity + ß equity debt + equity debt + equity Capital Budgeting Decisions and the Capital Asset Pricing Model = 0(.36(.35) = .8 per cent and an expected market risk premium of 8. however. What would happen if LMN decided to use more debt and correspondingly less equity? It would not affect the firm’s business risk.097. More debt means more financial risk. The reason for this is that LMM’s stock beta is low (only 0. because we arbitrarily assumed LMN’s debt was totally risk-free. we find the remaining business risk to be small. This estimate is probably low.36(.13(. There would be no change in the firm’s asset beta.083) .lump the preferred stock in with the debt and assume both are risk-free.13 Of course.65) + .65) + . If we had used ßdebt = 0. or 8.35) = . The equity beta would change.3 percent. When the financial risk is removed.9 per cent. or 9. we have ßequity = .

there are really just two points to remember. suppose a firm wants to analyze the risks of holding a large inventory of copper. the firm’s asset and equity betas would be exactly the same. Figure 8. we can simply estimate its beta from past price data. ßasset . Beta Effect of financial leverage on ßequity.13 . The higher the debt-equity ratio. and the ratio of debt to equity. D/E = 0 debt equity ß equty D/E. but as yet there is no completely satisfactory theory describing how those risks are generated. ß. First. asset betas can always be calculated as a weighted average of the betas of the various debt and equity securities issued by the firm. it is possible to calculate rates of return from holding copper and to calculate a copper beta.6 WHAT DETERMINES ASSET BETAS? Stock or industry betas provide a rough guide to the risk typically encountered in various lines of business. not the beta of the firm’s stock. In general. The beta of the firm’s stock increases in proportion to the amount borrowed. Nevertheless.0) = . we would expect to find: ß equity = ß asset (ß asset – ß debt ) = . On the other hand. Second. financial leverage creates financial risk. We see business risks surfacing in capital markets. When the firm uses no debt (E=0). some things are known.3 plots the relationship assuming risk free debt (ßdebt =0).Investment Decisions Under Uncertainty But if the company switched to 75 percent debt. the spread between the asset and debt betas. Note that this figure is drawn assuming risk-free debt (ßdebt=0). If so. the higher ßequity. But an asset beta for. ßasset. 8. 12 .13 + (.3: Effect of Financial Leverage on ß of equity In many ways we have given an oversimplified version of how financial leverage affects equity risks and returns.ßdebt. For example. for example. ßequity would go up to . if LMN paid off all its debt. widely traded commodity. What should we do if our asset has no such convenient price record? The advice is to search for characteristics of the asset that are associated with high or low betas.52. Of course. the observed equity beta depends on the firm’s asset beta. Not all investments made in the steel industry are “typical. For now. it is the asset beta that is relevant in capital-budgeting decisions. We wish we had a more fundamental scientific understanding of what these characteristics are. Debtequity ratio Figure 8. ßequity = ßasset ßasset. asset measures the business risk of the firm’s 0 assets. We have said nothing about taxes. say. the steel industry can take us only so far.” What other kinds of evidence about business risk might a financial manager examine? In some cases the asset is publicly traded. The finer points can wait. Because copper is a standardized.13 With no debt. the beta of the firm’s common stock.

The cash flows generated by any productive asset can be broken down into revenue. These are just like a real beta except that changes in book earnings or cash flow are used in place of rates of return on securities.firms whose revenues and earnings are strongly dependent on the state of business cycle . We can break down the asset’s present value in the same way: PV(asset)=PV(revenue)-PV(fixed cost) . Let’s see how this works.PV (variable cost) Or equivalently: PV(revenue)=PV(Fixed Cost)+PV(variable cost)+PV(asset) Those who receive the fixed costs are like debtholders in the project.tend to be high-beta firms. In just the same way. Even if they do find gold. or the wages of workers under contract. but whether or not they strike it rich is unlikely to depend on the performance of the market portfolio. What really counts is the strength of the relationship between the firm’s earnings and the aggregate earnings on all real assets. the commitment to fixed production charges . This means that cyclical firms .property taxes. Fixed costs are cash outflows that occur regardless of whether the asset is active or idle . operating leverage . Therefore an investment in gold has a high standard deviation but a relatively low beta. sales commission. they do not bear much market risk. But much of this variability reflects diversifiable or unique risk. and variable cost. the commitment to fixed debt charges .in other words.must add to the beta of a capital project.Cyclicality Many people intuitively associate risk with the variability of book or accounting earnings. We can now figure out how the asset’s beta is related to the betas of the values of revenue and costs. Lone prospectors in search of gold look forward to extremely uncertain future earnings. and some labor and maintenance costs. Costs are variable if they depend on the rate of output. We would predict that firms with high accounting or cash-flow betas should also have high stock betas . Thus you should demand a higher rate of return from investments whose performance is strongly tied to the performance of the economy. Cash flow = revenue – fixed cost – variable cost. Those who receive the net cash flows from the asset are like holders of levered equity in PV(revenue). Operating Leverage We have already seen that financial leverage .increases the beta of an investor’s portfolio. fixed costs. We just use our previous formula with the betas relabeled: ßrevenue= ßfixed cost PV (fixed cos t) + ßvariable cost PV(variablecost) + ßasset PV(revenue) PV (revenue) PV (asset ) PV (revenue) Capital Budgeting Decisions and the Capital Asset Pricing Model 13 . for example. Examples are raw materials.and the prediction is correct.in other words. We can measure this either by the accounting beta or by the cash-flow beta.

Remember that ßfixed cost = 0. the analogy between financial and operating leverage is almost exact. Empirical tests confirm that companies with high operating leverage actually do have high betas. 8. but good managers examine any project from a variety of angles and look for clues as to its riskiness. We have implied that an expected rate of return calculated from the capital asset pricing model r = rf + ß(rm . and the beta of the asset increases in proportion to the ratio of the value of the fixed costs to the value of the asset. given the cyclicality of revenue (reflected in ßrevenue).Investment Decisions Under Uncertainty In other words. because they respond to the same underlying variable. You cannot expect to estimate the relative risk of assets with any precision. As we have seen. We now have to worry a little about what happens as risk changes over the life of a project. Other things being equal. They think about the major uncertainties affecting the economy and consider how projects are affected by these uncertainties. The betas of the revenues and variable costs should be approximately the same. The beta of the stock increases in proportion to the ratio of debt to equity. They know that high market risk is a characteristic of cyclical ventures and of projects with high fixed costs. But going through a long list of these possible determinants would take us too far afield. Searching for Clues Recent research suggests a variety of other factors that affect an asset’s beta. the alternative with the higher ratio of fixed costs to project value will have the higher project beta. Now we have a rule of thumb for judging the relative risks of alternative designs or technologies for producing the same product. Firms or assets whose costs are mostly fixed are said to have high operating leverage.7 DISCOUNTED CASH FLOW APPROACH We have spent the bulk of this unit discussing how you might estimate the risk and required return on a project.rf) 14 . ß asset = ß revenue PV(revenue) − PV(variable cost) PV(asset) PV(fixed cost) PV(asset) = ß revenue 1 + Thus. we can substitute ßrevenue for ßvariable cost and solve for the asset beta. asset beta is proportional to the ratio of the present value of fixed costs to the present value of the project. the beta of the value of the revenues is simply a weighted average of the beta of its component parts. Therefore. the rate of output. Now the fixed-cost beta is zero by definition: whoever receives the fixed costs holds a safe asset.

But the betas of the assets which corporations hold are almost always positive. future value 1 period hence PV = C1 + PV1 1+ r = C1 + PV1 1 + rf + β (rm . Then Rs.800. but that you would be willing to trade it for a safe cash flow of as little as Rs. this requires the asset’s beta to be constant over the asset’s entire future life. PV = C1 1+ r = C1 1 + rf + β (rm .800 is the certainty equivalent of the risky cash flow. The end-of-period value depends on the cash flow in later periods. denoted by CEQ1 Suppose that the forecasted value of the risky cash flow is Rs. If C1 is certain.800 safe return and an expected but risky cash flow of Rs. The discounted cash flow formula does this is one step. its present value is found by discounting at the risk-free rate rf PV = C1 1 + rf If the cash flow is risky. What does that assumption mean in practical terms? In order to answer that question we must develop alternative formulae for calculating present value when beta and r do vary. Only under that crucial assumption it is strictly proper to write down the discounted cash flow formula with a single discount rate for all future cash flows. “What is the smallest certain return for which I would exchange the risky cash flow C1? This is called the certainty equivalent of C1. One-period projects pose no problems. 15 . Certainty Equivalents Let us start with a single future cash flow C1. Would you tell it not to bother about anything other than the cash flow in the first period and the end-of-period value? Of course not.rf )]t You should not take step without thinking about it first.This could be plugged into the standard discounted cash flow formula as T PV = t =1 Ct (1 + r) t T = t =1 Capital Budgeting Decisions and the Capital Asset Pricing Model Ct [1 + rf + β (rm . but the capital asset pricing model looks at rates of return and prices over one period at a time.5 Another approach is to ask. You would want a formula that explicitly took this into account. You are indifferent between an Rs.1000. the normal procedure is to discount its forecasted (expected) value at a risk-adjusted discount rate r which is greater than rf. Among other things.1000. 5 The quantity r can be less than rf for assets with negative betas.rf ) Longer-lived assets likewise pose no problem if you have an estimate of PVt.rf ) But suppose that your company is evaluating the construction of a nuclear power station and asks your advice on how to calculate its present value. This is formally correct only if we know that the discount rates that will prevail in future periods will be the same as this year’s. In capital budgeting we must usually value cash flows extending over several future periods.

the two formulas are exactly the same. Table 8.1000 at a riskadjusted rate. If PV = 1000 = Rs. PV = As long as you look only one period into the future.Investment Decisions Under Uncertainty What is the present value of Rs.894 0.945 0.74 1.740.06. Relationship of Certainty Equivalent and Risk-Adjusted Discount Rate Formulas for Long-Lived Assets We can easily extend the concept of certainty equivalents to long-lived assets: T PV = t =1 CEQ t (1 + rf ) t T = t =1 a tCt (1 + rf ) t where at is the ratio of the certainty equivalent of a cash flow to its expected value (at = CEQt/Ct).10)t Certainty Equilvalent CEQt Implied By use of 10% Discount CEQt = Ct 0 1 2 3 4 5 -350 100 100 100 100 100 -350 91 83 75 68 62 29 at Ratio of CEQt TO Ct Present Value of CEQS at 4% Risk-Free Rate 1 + rf 1+ r t -350 95 89 85 80 76 1. 740. but less than 1.1000 forecasted cash flow? It must be the same as the present value of a certain Rs. Normally at will be positive. But there are important differences when the concept of certainty equivalents is applied to cash flows generated by long-lived assets. PV = Ct/(1.755 -350 91 83 75 68 62 29 Net present value = Note: By using a constant risk-adjusted discount rate of 10 per cent the finance manager is implicitly making larger deductions for risk from the later cash flows.4 Example showing certainty equivalents implied by use of constant riskadjusted discount rate Period Expected Cash Flow = Ct Present Value Using 10% RiskDiscount Rate. Then PV of forecasted Rs.35.74 1+ r then r = 0.08. or 35 per cent Now we have two equivalent expression for PV. Suppose the risk-free rate of interest is rf = 0.1000 cash flow = 1 + r f CEQ1 = 800 = Rs.800. .845 0.00 0.799 0.08 We could have gotten the same answer by discounting Rs. Notice that discounting the cash flows at 10 per cent or the certainty equivalents at 4 per cent would give NPV = 29. We can figure out what the proper discount rate is. because by definition you are indifferent between the two flows.0 for negative-beta assets. 16 6 The quantity at would be greater than 1.

If the certainty equivalent and risk-adjusted discount rate formulas are really equivalent. decreases at a constant compound rate of about 5. The preliminary phase will take a year and cost Rs. they should give the same present value for each cash flow: C1 aC = 1 1 1+ r 1 + rf and C2 (1 = r) 2 = a 2C2 (1 + rf ) 2 Capital Budgeting Decisions and the Capital Asset Pricing Model But this implies that a1 1 + rf 1 + rf = and a 2 1= r 1= r 2 = (a1 ) 2 In general. then XYZ will build a Rs.67. The formula is at = 1 + rf 1+ r t = (a1 ) t Using Risk-Adjusted Discount Rates — An Example Consider a project requiring Rs.000 a year after taxes. therefore.10) t − 350 = Rs. the market risk premium is 9 percent.350 = t=2 100 (1. have come up with an electric mop. the project will have to be dropped. It is usually reasonable to assume that risk increases at a constant rate. By using a constant discount rate the finance manager is effectively making a much larger deduction for risk from the later cash flows. and the estimated beta is 0. if you are willing to assume that beta is constant in each future period.10.When we discount at a constant risk-adjusted rate rt we are implicitly making a special assumption about the coefficients at. 17 . Management feels that there is only a 50 percent chance that pilot production and market tests will be successful. If they are.67(0.5. you are justified in using a constant risk-adjusted discount rate r to value the cash flow for each period only if the value of at decreases over time at a constant rate. The risk-free rate is 4 percent.350 today (t = 0) and offering expected cash flows of Rs. Notice also that at.250. per cent per year. Consider an asset offering cash flows in 2 periods. or 10% The project’s net present value is calculated as 5 NPV = PV . and the firm is ready to go ahead with pilot production and test marketing. When You Cannot Use a Single Risk-Adjusted Discount Rate for Long-Lived Assets The scientists at XYZ Ltd.100 per year for 5 years. For example.09)= 0.125.000.04 + .29 What is the finance manager implicitly assuming about the values of at? The answer is given by Table 8. The larger deduction is reflected in lower values for at. If they are not successful.1 million plant which would generate an expected annual cash flow in perpetuity of Rs. then the risk borne per period will be constant but cumulative risk will grow steadily as you look further into the future. the financial manager settles on a discount rate of r = rt + ß(rm-rt) = 0.4.

for which the normal discount rate of 10 per cent would be appropriate. we could view the project as offering an expected payoff of .the project is certainly worthless. For example. then there’s no risk at all .5 (–1000 + .000 at t = 1 on a Rs. rather than XYZ’s normal 10 percent standard: 500 NPV = –125 – + 1.000 but at would have to be very small to justify rejecting the project.5(1500)+. = +.25) t This seems to show that the project is not worthwhile. they have a 50 percent chance to invest Rs.125.5 million: Success->NPV = –1000 + 250 = +1500 (50% chance) 0.750.3.500 1.1000 and 50% chance of 0 = . That means there is a 50 percent chance that in 1 year XYZ will have the opportunity to invest in a project of normal risk.1. the project is worth Rs.10 Pilot production and market tests Failure->NPV = 0(50% chance) Thus. = 50% chance of 250 and 50% chance of 0.07 = –125 + Not bad for a Rs. If it is a success. NPV = C o + a 1C1 1 + rf 0.5(0)= -500 Ct.500. there could well be only normal risk from there on.1 million in a project with a net present value of Rs. and the risk-free rate is 7 per cent.5(250) + . If the test phase is a failure. As such. 18 .000 investment . they discount the cash flows at 25 percent.750.225. Therefore.125.25 ∞ t=2 125 − 125 or – Rs.. Management’s analysis is open to criticism if the first year’s experiment resolves a high proportion of the risk.5)..and quite a change from the negative NPV that management got by discounting all future cash flows at 25 percent.125.5(750) = 225. if the CEQ is half the expected value (at=0..000 investment at t = 0.Investment Decisions Under Uncertainty The expected cash flows (in thousands of Rupees) are Co = – 125 C1 = 50% chance of . for t = 2. 225. the certainty equivalent of the payoff is less than Rs.5(0) = 125 Management has little experience with consumer products and considers this a project of extremely high risk.5(0)=750 or Rs.5. Of course. or Rs.00 t (1.

................... The beta of the assets is weighted average of debt and equity betas.................................................................................................... Capital Budgeting Decisions and the Capital Asset Pricing Model 8....................................... to analyze risk.............................................................................. ....... they should be discounted at a higher rate than earlier cash flows................................................................................ ................................. ...... c) Identify two critical factors that affect asset betas.................................................................. A firm’s asset beta reflects it’s business risk............................................... ..................................... which one would you prefer? Why? .................................................................................. to analyze risk...................................................................... In order to find an appropriate discount rate it is necessary to find project beta which may be different from the firm’s beta executing that project................................................................................................................................................................ the greater the number of periods and the larger the total risk adjustment............................................................................................................................................................................. ............................................................. ........................................................................................................................................................ ........ Activity I a) Mention the most fundamental difference between Certainty Equivalent and the Risk Adjusted Discount Rate approaches of incorporating risk in Project evaluation............................................... which one would you prefer? Why? .................................................................................... ...................8 SUMMARY Capital Asset Pricing Model is used to estimate risk adjusted discount rate for making investment decisions.... That’s quite wrong: any risk-adjusted discount rate automatically recognizes the fact that more distant cash flows have more risk............. d) Given a choice between Certainty Equivalent and Probability Distribution approach............................................................................ Emperically it has been found that the betas are stable over time...................................... .................................................................. b) Given a choice between Certainty Equivalent and Probability Distribution approach. whereas the difference between its equity and asset beta reflects financial risk.................... ...................... The reason is that the discount rate compensates for the risk borne per perid.............................. ........................ ................... The more distant the cash flows.................................A Word of Caution We sometimes hear people say that because distant cash flows are “riskier”....................................... Certainly equivalent is the smallest certain return which one would exchange for a risky cash flow................................... 19 ............ .... .........................................................

the estimated risk premium on the market is 10 per cent.000 40. Dryden Press.” Prentice Hall.V. New York.000 in year 1 and Rs. 20 . Sharpe W. 3.equivalent cash flows to the expected cash flows in years 1 and 2? 4. one real and one nominal.Investment Decisions Under Uncertainty 8. Plug in numbers that are reasonable today.F.000 in year 2. Academic Press. and the project has a beta of 0. “Investments. (a) PQR Ltd has the following capital structure: Security Debt Preferred stock Common stock Beta value 0 0.10 FURTHER READINGS Brigham E... Alexander G. “Financial Decision Making under Uncertainty”. what would be: (a) The present value of the project? (b) The certainty-equivalent cash flows in year 1 and 2? (c) The ratio (at) of the certainty .000 200. What is the firm’s asset beta (that is.9 SELF ASSESSMENT QUESTIONS 1. 8.” Is this statement correct? Should the sign of the cash flow affect the appropriate discount rate? “The errors in estimating beta are so great that you might just as well assume that all betas are one. you should use a high discount rate to value positive cash flows and a low discount rate to value negative cash flows. The risk free rate is 8 percent. “For a high beta Project.” Do you agree? A Project has a forecasted cash flow of Rs. Sarnat M.20 1. New Delhi.120..5 If you use a constant risk adjusted discount rate.. beta of its stock if it were all equity financed)? (b) Assume the Capital Asset Pricing Model is correct.20 Total market 100. Levy H. What discount rate should PQR Ltd.J.100..F. set for investments that expand the scale of its operations without changing its asset beta? Assume any new investment is all-equity financed. Specify two discount rates.. “Financial Management Theory and Practice”.000 2. Bailey J. New York.

It is the inability to predict with perfect knowledge the course of future events that introduces risk. uncertainty is said to prevail.1 Concept of Certainty. Practically no generally accepted methods could so far be evolved to deal with situation of 1 . Risk and Uncertainty 9.2.1 9. a finance manager must take cognizance of risk factor while taking investment decision and additional adjustments must be made to cover risks.2. the outcome is known to have probability of 1. Structure 9.3 9.2.3 Summary 9. For example. However.4 Self Assessment Questions 9. Thus. The main attribute of risk situation is that the event is repetitive in nature and possesses a frequency distribution. risk and uncertainty. Since the valuation of the firm is very likely to be affected by the amount of risks assumed by it in accepting a project. then the return on the investment @ 7% can be estimated quite precisely.2. RISK AND UNCERTAINTY In the preceding chapters we considered investment decision without referring to the risk elements in projects. Rule for acceptance or rejection of projects was that any project with positive net present value will be accepted and the one with the negative net present value would be rejected.1 CONCEPT OF CERTAINTY.5 Probability Distribution Sensitivity Analysis Scenario Analysis Monte Carlo Simulation Decision Tree Analysis 9. Uncertainty is subjective phenomenon. the mere fact that the finance manager does not know before he makes the investment as to what would be the gains from the project indicates that uncertainty is attached to every investment project and different projects have varying degrees of risk.4 9. Certainty is a state of nature which arises when outcomes in terms of cash flows are known and determinate.2 Measurement of Project Risk : 9. Risk involves situations in which the probabilities of cash flows occurring are known and these probabilities are objectively or subjectively determinable. if one invests Rs. to explain various methods of measuring project risk.5 Further Readings 9.2.000 in five-yearly government bonds which is expected to yield 7% tax free returns.UNIT 9 PROJECT EVALUATION UNDER RISK AND UNCERTAINTY Objectives The objectives of this unit are: to provide conceptual understanding of state of certainty. In such a situation no observation can be drawn from frequency distributions. 20. In contrast. when an event is not repetitive and is unique in character and the finance manager is not sure about probabilities of cash flows themselves.2 9.

Rather than estimate only the most likely cash-flow outcome for each year in the future.namely Rs.000 4.500 4. For each project under consideration. As we see. mild recession.000. we are now able to formulate a probability distribution of possible cash flows for proposals A and B. To quantify our analysis of risk.Investment Decisions Under Uncertainty uncertainty while there are a number of techniques to deal with risk.1 Probability Distribution The Problem of Project Risk As noted above. we might say that it is relatively riskier.1.) 2. we need to know the likelihood of the occurrence of various states of the economy. 9.000 3. despite the fact that the most likely outcome is the same for both investment proposals . 4. however. Given this information.000 Proposal B (Rs. Measuring the Risk of a Project Since prime objective of a finance manager is to maximize value of the firm and the degree of risk in a project affects the value. The critical question is whether 2 . and of a major economic boom 10 per cent. The following paragraphs throw light on this aspect. As such. Suppose further that we were interested in making forecasts for the following alternative states of the economy : deep recession. we estimate the followin net cash flows for the next year : State of the Economy Annual Cash Flows Year1 Proposal A (Rs. of a minor boom 20 per cent. as shown in Figure 9. suppose that we had two investment proposals under consideration. normal.2 MEASUREMENT OF PROJECT RISK 9. and major boom. More specifically. An Illustration To illustrate the formunation of multiple cash-flow forecasts for a future period.000 5. “riskiness” of an investment project is the variability of its cash flows from those that are expected. After assessing the future under each of these possible states.) Deep recession Mild recession Normal Minor boom Major boom 3.000 We see that the dispersion of possible cash flows for proposal B is greater than that for proposal A.500 5. The greater the variability. of a normal economy 40 per cent. we need additional information. as follows : We can graphically depict the probability distributions. Assume that our estimate of the probability of a deep recession occurring next year is 10 per cent. the riskier project is said to be. we estimate a number of possible outcomes. Therefore. the dispersion of cash flows is greater for proposal B than it is for proposal A. In this way we are able to consider the range of possible cash flows for a particular future period rather than just the most likely cash flow.2. of a mild recession 20 per cent. he must measure degree of risk in different projects under consideration. the term risk and uncertainty will be used interchangeably in the following paragraphs. we can make estimates of the future cash flows.000 6. minor boom.000 4.000 3.

40 .1: Comparison of two proposals using probability distributions of possible cash flows. Expectation and measurement of Dispersion: A Cash-Flow Example Major boom State of the Economy dispersion of cash flows should be considered. If risk is associated with the probability distribution of possible cash flows.10 .000 5.10 . stockholders.000 Project Evaluation Under Risk and Uncertainty 3 .3 . proposal A would then be preferred to proposal B. such that the greater the dispersion.000 3.000 2.000 5.000 4.1 .3 .) 6. the greater the risk. 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 7654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 8765432 87654321 87654321 87654321 87654321 87654321 87654321 1 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 87654321 0 .40 .1 can be summarized in terms of two parameters of the distribution: (1) the expected value and (2) the standard deviation.20 .20 .2 .000 5000 6000 Probability .4 2000 Probability .Minor boom Normal Mild recession Deep recession The probability distributions shown in Figure 9.) 4.10 Proposal B Cash Flow (Rs.000 3. If management. and creditors are averse to risk.500 4.10 3000 Proposal A Proposal A Proposal B 4000 Cash Flow (Rs. proposal B would be the riskier investment.4 0 .500 3.1 . Figure 9.10 .2 .20 .

40) (4.Investment Decisions Under Uncertainty The expected value of a cash-flow probability distribution for time period t. σ 2 t .500 5.00 (CFx1) (P xt) (Rs. This means that there is only a 32 per cent chance that the actual outcome will be more than one standard deviation from the mean.000 – 4.20 . CFx1 (Rs) 3.000 – 4. n σt = ∑ (CFxt . P x1 .40 .000 4.000) 2 (. It is the square root of the variance.000) 2 (. Proposal A Possible Cash Flow. is known as the variance of the distribution.000) 2 (. the lower this measure will be. with the weights being the probabilities of occurrence. It is a statistical measure of the variability of a distribution around its mean. The square of the standard deviation. Pxt is the probability of that cash flow occurring. and the probability that it will fall within three standard deviations is over 99 per cent.000) 2 (.10 ª = 1. The tighter the distribution. To illustrate the derivation of the expected value and standard deviation of a probability distribution of possible cash flows.000 Probability of Occurrence. the wider the distribution.500 – 4.20) (5. is defined as n CFt = Σ = (CFxt ) (Pxt ) x =1 where CFxt is the cash flow for the xth possibility at time period t.000) 2 (.) 300 700 1600 900 500 ª = 4. Thus. CFt. The conventional measure of dispersion is the standard deviation which completes our two-parameter description of a cash-flow distribution.000 = s21 = (300. approximately 68 per cent of the total area of the distribution falls within one standard deviation on either side of the expected value. consider again our previous two-proposal example. The probability that the actual outcome will fall within two standard deviations of the expected value of the distribution is approximately 95 per cent. For a normal.10 .20 .500 4.10) (3.500 – 4.10) ª = 300.000)-5 = 548 = s1 4 . and n is the total number of cash-flow possibilities occurring at time period t. An Illustration.000 = CF1 (CF x1 ) – CF 1 ) 2 (P x ) (Rs) (3. σ t .000 – 4.000 3. The cash-flow standard deviation at time period t.CF t ) 2 (Pxt ) x =1 The standard deviation is simply a measure of the tightness of a probability distribution. can be expressed mathematically as where p represents the square-root sign. the expected value of cash flow is simply a weighted average of the possible cash flows.20) (4. the greater it will be. bell-shaped distribution.

.......... Total Project Risk If investors and creditors are risk averse – and all available evidence suggests that they are ....000 Probability of Occurrence..200. ...... A... Mathematically....... the coefficient of variation is CVA = Rs..000) 2 (. Coefficient of Variation : A measure of the relative dispersion of a distribution is the coefficient of variation (CV).000 (3....000 6..000) 2 (........................................ In other words.. we proceed to measure it for individual investment proposal. But remember that the riskiness of a stream of cash flows for a project can......... Otherwise..............14 While that for proposal B is CVB = Rs.000 = s21 = (1....... However.............it is necessary for management to incorporate the risk of an investment proposal into its analysis of the proposal’s worth.. 548.. Certain Projects Risky Projects Uncertain Projects ....10) 4................00 Project Evaluation Under Risk and Uncertainty (CFx1) (P xt) (Rs.......000 = .. Activity 1 a) Define the following.........10 .......... 4................... Thus............. and often does......095 = s1 The expected value of the cash-flow distribution for proposal A is Rs...000) 2 (....... capital budgeting decisions are unlikely to be in accord with the objective of maximizing share price...000 – – – – – 4..........000 4........Proposal B Possible Cash Flow.. the probability distributions are not necessarily the same from one period to the next...000)-5 = 1... change with the length of time in the future that the flows occur......... .... ........ For proposal.....000) 2 (.................. the same as for proposal B......... 5 . it is simply a measure of risk per unit of expected value..........40) 4....27 Because the coefficient of variation for proposal B exceeds that for proposal A............ indicating a greater dispersion of possible outcomes – so we would say that it has greater risk...................20) 4.... Thus....200.... it has a greater degree of relative risk.....................500 (4......................20) 4.............. 4000...095/Rs................. 4......000 3......000) 2 (.......... .............. it is defined as the ratio of the standard deviation of a distribution to the expected value of the distribution.............000 5... P x1 .............40 .............000 = CF 1 (CF x1 ) – CF 1 ) 2 (P x) (Rs) (2..20 ............000 (5..........000 = ....................... CFx1 (Rs) 2........ 548/Rs. proposal B has a higher standard deviation. 1............20 .) 200 600 1600 1000 600 ª = 4....................... the standard deviation for proposal A is Rs.....10 ª = 1... Having established the need for taking risk into account............10) ª = 1...........500 (6.

.......... We also know that if a key input variable............... sensitivity analysis answers questions such as these: “What if sales are only 20.. ...................................................... ............................................ ................................. ........... To illustrate the procedure............................................. calculate new NPVs........................................................................................................... In a sensitivity analysis. .... Figure 9................................................................................... or base case.... fixed costs........... sales price.................................... holding other things constant............................................................................................................. we know that most of the variables which determine a project’s cash flows are based on some type of probability distribution............... ............ ............................. b) Try to know from some finance managers the methods that they have used to incorporate risk while evaluating investment Projects............... let us consider the data given in Table 9..............................................3 gives the NPVs that were used to construct 6 ............ The values for unit sales........................................................ 9... project were shown.................... and the resulting Rs.......................2 is called the base case NPV.................... where projected income statements for ABC Ltd..........2 shows the ABC’s project sensitivity graphs for three of the key input variables................... ............................................................................................................... .............................000 units rather than 25.............................. ....... 11.................... and variable costs are the expected. ...................................1......................Investment Decisions Under Uncertainty .......................... ........................................ Now we ask a series of “what if” questions: “What if sales quantity is 20 per cent below the expected level?” “What if sales prices fall?” “What if variable costs are 70 per cent of total sales rather than the expected 65 percent?” Sensitivity analysis is designed to provide the decision maker with answers to questions such as these............................................................ we change each variable by specific percentages above and below the base case value..................................................................................................................000? What then will happen to NPV?” Sensitivity analysis begins with a base case situation based on expected input values..... and then plot the derived NPVs against the variable in question.......................................... ..................................................................... Sometimes called “what if” analysis.......................................... .......................465............................................................................................ .............................................. Sensitivity analysis indicates exactly how much NPV will change in response to a given change in an input variable......................................................2........... The Table 9....................................................................... so will the project’s NPV......... other things remaining constant...................................923 NPV shown in Table-9................ changes........................................................................................................................ ............................................... ............................................................ values................................2 Sensitivity Analysis Intuitively................................................................................................ ......................... such as units sold................................................................................................................................................. .......................... ..............................................

000 per year. 65 per cent of net sales. ABC will amortize the Rs. the more sensitive the NPV is to the change in the variable.500.300. sensitivity analysis provides useful insights into the relative riskiness of different projects. 7 . held constant.3 million over 1988 sales.5 million of capitalized R&D cost over 6 years. 7.000/6 = Rs. the one with the steeper sensitivity lines would be regarded as riskier-a relatively small error in estimating variables such as the variable cost per unit or demand for the product would produce a large error in the project’s projected NPV. If the project is accepted.12 (3. For example. then. deductible expenses for Rs. 12 per cent of next year’s increase in sales. Table 9. 1988-1993 1988 Unit Sales Sales Price Net Sales a a Project Evaluation Under Risk and Uncertainty 1989 25000 2332 1990 25000 2472 1991 25000 2620 1992 25000 2777 1993 25000 2944 25000 2000 55000000 58300000 61800000 65500000 69425000 73600000 35750000 37895000 40170000 42575000 45126250 47840000 8000000 12500000 400000 1425000 8175000 3760500 4414500 3075000 7489500 (396000) 8480000 1250000 800000 2090000 7785000 3581100 8988800 1250000 720000 1995000 8676200 3991052 9528128 10099816 10705805 1250000 640000 1995000 1250000 560000 1995000 1250000 560000 0 Variable Costsb Fixed Cost (Overhead)a R&D expensesc Depreciation (building)d Depreciation (equipments)d Earnings before taxes Taxes (46%) Project net income Noncash expensese Cash flow from operationsf Addition to NWCg 9511872 10393934 13244195 4375461 5136411 3885000 9021411 (471000) 8550411 4781210 5612724 3805000 9417724 6092330 7151865 1810000 8961865 4203900 46855148 4140000 8343900 (420000) 7923900 3965000 8650148 (444000) 8206148 (501000) (8832000) 8916724 17793865 NWC cash flows 7093500 a b c 1988 estimate increased by an assumed 6 per cent inflation rate.25. The cumulative working capital investment will be recovered in 1993. The slopes of the lines in the graphs show how sensitive NPV is to changes in each of the inputs’ the steeper the slope. If we were comparing two projects.1: ABC : Operating and Networking Capital Cash Flows. 3. fairly sensitive to changes in sales volume. so the addition to NWC in 1988 to prepare for the 1989 sales increase in 0. and relatively insensitive to changes in the cost of capital. 1. other things. Here we see that the project’s NPV is very sensitive to changes in variable costs.000. Net income plus noncash expenses. so it will have a noncash.000) = 396.the graphs. 1989 sales are estimated at Rs. 7. ACRS depreciation rates are follows Year Building Equipment 1 5% 15% 2 10% 22% 3 9% 21% 4 8% 21% 5 7% 21% 6 7% - d e f g Sum of R&D expenses and depreciation on building and equipment. Thus.

However.923 PI : 1. it is incomplete. it does have limitations. Here.10 + 10% (Base) Figure 9.2: ABC : Time Line of Consolidated Cash Flows End-of-year net Cash Flows 1985 1986 1988 1987 1989 1990 1991 1992 1993 4650000 4000000 19600000 7093500 7923900 8206148 8550411 Payback period : 5. the operating executives pick a “bad” set of circumstances (low unit sales. or base case.5 8916724 22961065 a) Unit Sold NPV (Rs. high variable cost per unit. IRR : 20. a project’s risk depends on both (1) its sensitivity to changes in key variables and (2) the range of likely values of these variables as reflected in their probability distributions.2. The NPV under the “bad” and “good” conditions would be calculated and compared to the exepcted. In general. a proposed coal mine whose NPV is highy sensitive to changes in both output and sales prices. for example. high construction cost.465.2: Sensitivity Analysis for ABC (Thousands of Rupees) Table 9.) c) Cost of Capital NPV (Rs. Consider.6 years from first outflow.) 19416 15442 11468 7493 3519 Cost of Capital (Rs. low sales price.3 Net Present Value Change from Base Value -10% -5 0 +5 +10 Units Sold (Rs.) 13109 12273 11468 10692 9946 9. NPV. Because sensitivity analysis considers only the first factor.43 + 10% (Base) -10% 0. 8 . NPV : 11. A risk analysis technique which considers both the sensitivity of NPV to changes in key variables and also the range of likely variable values is scenario analysis.4% versus a 10% cost of capital.) 11468 11468 11468 -10% 25000 + 10% (Base) -10% 1. plus inflation adjustments. then the mining venture may not be very risky in spite of the steep sensitivity lines. if a utility company has contracted to buy most of the mine’s output at a fixed price per ton.Investment Decisions Under Uncertainty Table 9. and so on) and a “good” set.3 Scenario Analysis Although sensitivity analysis is widely used in industry.) 7549 9463 11468 13472 15476 Variable Cost per Unit (Rs.) b) Variable Cost Per Unit NPV (Rs.

9.700 to Rs. suppose we have estimated the probability distribution of the ABC’s Project sales price as represented by Columns 1 and 2 of Table 9. 2. Thus.) 22. 1. or a rise above 40.4: Scenario Analysis Results Summary Scenario Worst case Base case Best case Sales Volume (Units) 5. let us return to the ABC project.20 0.400 2. and the best case. but we cannot easily attach a specific probability to this loss.000 units at a price of Rs. as being extremely unlikely.200 2. 5.200.700 2. we can say that there is a chance of losing on the project. while 40. while scenario analysis can be done using a hand-held calculator.200 2. We see that the base case forecasts a positive NPV.700 2. Further.000 Sales Price (Rs.200. 2.05 0. so named because this type of analysis grew out of work on the mathematics of casino gambling. However. we use the worst case variable values to obtain the worst case NPV and the best case variable values to obtain the best case NPV. the worst case. simulation requires a relatively sophisticated computer. Remember that the expected. a negative NPV.468 50.000 2. Assume that ABC executives are fairly confident in their estimates of all the project’s cash flow variables except price and unit sales.421 11.000 units. 2.Table 9. with future years’ prices expected to rise because of inflation.4 Monte Carlo Simulation Monte Carlo simulation. To carry out the scenario analysis. Table 9.700 Probability (2) 0. they expect the sales price as set in the marketplace to fall within the range of Rs.700 defines the upper bound or the best case scenario.700. Similarly.700 defines the lower bound or the worst case scenario. The expected sales price is Rs. values are 25. Clearly. 1. suppose they regard a drop in unit sales below 5. or to make a decision based on it. or base case.000 40. Also. This leads us directly to Monte Carlo simulatioin.) 1.700. 1. the best case. ties together sensitivities and input variable probability distributions. However.000 25. 2. Table 9.000.000 units at a price of Rs. but the price can range from Rs. 1. The third column gives a set of random numbers associated with each price estimate.5. the most likely case. note that the indicated sales prices are for 1988. In our example. a very large positivie NPV. what we need is some idea about the probability of occurrence of the worst case.05 Associated Random Numbers (3) 00-04 05-24 25-74 75-94 95-99 The first step in a computer simulation is to specify a probability distribution for each of the key variables in the analysis.2.4 summarizes the results of the analysis. 2. coupled with an efficient financial planning software package.700 NPV (Thousands) (Rs. Notice that 9 . and all the other cases that might arise.20 0.700 to Rs.50 0.000 units at a price of Rs. To illustrate.5: Probability Distribution for ABC’s Project Sales Price Sales Price (1) Rs.093 Project Evaluation Under Risk and Uncertainty As an example. it is not easy to interpret this scenario analysis. which is described in the next section.

000 units. for sales price. The NPV generated in Run 2 is again stored. and an upper limit of 40. 500. 2. and 16 for labour costs. 500 from the expected value. unit variable costs. 5 digits (0. three standard deviations should equal Rs. 3. Once the distributions and associated random numbers have been specified for all the key variables . we merely specify their expected values. or they can generate random numbers. Computers have stored in them. we assume that ssales price = Rs. Next. and 4) are assigned to this price. suppose that the expected value is Rs. These cash flows are then discounted at the cost of capital (which may also be treated as a random variable).e. First. 167.000 units. Twenty digits are assigned to a price of Rs.200 and that the actual sales price is very unlikely to vary by more than Rs. Values for all the other variables are set in like manner.5 has been set up for sales quantity. 2. once a table such as 9.in other words.000.2. it might select 44 for units sold. 500/3 = Rs. The 17 associated with the sales price indicates in Table 9.. we can perform a simulation analysis on ABC’s project. and hence cash flows. Further. 167.700. As in our scenario analysis. construction costs. there is a 5 percent probability that sales price will be as low as Rs. we assume that the estimated distribution of unit sales is also symmetric. is used. sales could be as low as 10.000 is most appropriate. and the result is the net present value of the project on the computer’s first run.1.000 and so on for the other possible prices. sales quantity and sales price.700 or rise above Rs. the expected value is 25.the computer simulation can begin. We could have again specified a normal distribution.000 units. Using this procedure. with an expected value of 25.Investment Decisions Under Uncertainty in column 2. The NPV generated on Run 1 is stored in memory. Therefore. In our simulation analysis. We know that in a normal distribution. but if public acceptance is poor. For all the other variables.200 and a standard deviation of Rs. given our production capacity. Here a different set of random numbers. 2. i. a value is determined for each variable. so as a reasonable approximation. and the model proceeds on for perhaps 500 runs.000 a lower limit of 10. 1. Modern computers can complete this operation almost instantaneously for a vary low cost. 166. 17 for the sales price. on Trial Run 1. we tell the computer that the sales price distribution is a normal distribution with an expected value of Rs. we assume that sales prices can be represented by a continuous normal distribution. but in this case. 1. 2. therefore.67 = Rs. 2. but sales could be as high as 40. management feels that a triangular distribution. 5. Further. 4. Depending on the random number selected. and the computer then goes on to Run 2. The stored NPVs (all 500 of them) are then printed out in the form of a frequency distribution.700.5 that the appropriate sales price for use in the firs turn Rs. 10 . together with the expected NPV and the standard deviation of this NPV. 2. Thus.000. For example.3. the computer generates a set of income statements and cash flows. fall below Rs. Once a value has been established for each of the variables. and so on. we have simplified the illustration by specifying the distributions for only two key variables. These are the steps involved: 1. the computer will select a different random number for each uncertain variable. the expected value plus or minus three standard deviations will encompass virtually the entire distribution.

...........000?” The answer is..................6: Summary of Simulation Result Probability of NPV or IRR being Greater than the Indicated Value (Thousands of Rupees) 0. 11 . ............ is Rs......11.......50 0.. .... When evaluated at a cost of capital of 12 per cent.............. using expected values of all variables.....000........ even at the high-risk cost of capital......124.....60 0.......... 5.....20 0....124......975.. “What is the probability that the project will have an NPV greater than Rs. “About 70 per cent..000....... Suppose someone asks.000 lies between 70 and 80 percent but much closer to 70 per cent........ The top line of the table shows the cumulative probability distribution................. 11..533. Activity 2 A) Write two points of difference between Sensitivity Analysis and Scenario Analysis of determination degree of risk in investment projects. Our analysis thus far was based on ABC average cost of capital as 10 per cent.1 We used the Interactive Financial Planning System (IFPS) to conduct a simulation analysis of the project. 975..90 Rs.......000 CVAverage Project = Rs..40 8397 11393 13683 0....10 19639 25286 0.70 5144 0...... .. as calculated by the computer in the simulation.........Table 9.370..... with attached probabilities.80 1825 0....... the NPV of the project.... 10... To illustrate.........151 0......... If we assume that ABC’s average project has an expected NPV of Rs...... To account for risk..................6..000.. then we can calculate the coefficient of variation (CV) for this project and compare it with the CV of the average project as follows: Coefficient of variation = CV σ NPV Standard deviation = Expected NPV Expected value CVProject = Rs..080 0............299 Project Evaluation Under Risk and Uncertainty Skewness 0.......... we must now reevaluate the project with a project cost of capital of 12 per cent.119 Mean 11228 0... Thus.. it can be used to compare the relative riskiness of projects which differ in size....204 0............................. the office robot project has a large positive NPV......242 0. Thus..000.......000 Since the coefficient of variation is a standardized risk measure. .... not just a point estimate of the NPV..000 = 0.........000 = 0......... ABC adds two percentage points to the cost of capital of such high-risk projects as this particular project........10...722.000 and sNPV = Rs.......179 0...........” because NPV = 5......263 0.....................228. while the variability of this NPV as measured by sNPV can be used to measure risk....288.............. 8... Then the key results of our simulation are presented in Table 9.30 16516 0.38 Rs..... it appears to be acceptable.. We see that the CV of this project is much larger than the CV of ABC average project........ The expected NPV can be used as a measure of the projects profitability.......000 and the standard deviation of this NPV....... 370.. the ABC’s project’s expected NPV is Rs...... Therefore............90 NPV -1860 IRR 0.......... The primary advantage of simulation is that it shows us the range of possible outcomes....221 NPV Sample Statistics Standard Deviation 10124 0................. is sNPV = Rs.............

................................ .........6 (1000) 0............................5 t=3 (4) (16000) Conditional Probability (5) 0................... B) List out the five steps involved in Monte Carlo Simulation of Analyzing risk in investment projects.............................3.............000 or Rs............................ the net payoff is expected to be either Rs.............. 36 (1000) 0.................................................................... The capital budgeting decision for this project will be broken down into three stages....4 Stop 0..... 9.....000...............000.................................... . as set forth in Figure 9............2 1..........................2....................) ....................................3: ABC Decision Tree (Thousands of Rs................................................................................................. Stage 1 : At t = 0.............32 0.....................................................000 study of the market potential for this product X.....................000................00 Expected NPV = 12 Figure 9................. suppose ABC is considering the production of a product X for some other company.................................................. .......Investment Decisions Under Uncertainty ....5 Stop 3 13000 0......... ..000 to design and fabricate several prototype of Product X......................... 16...................................... 500..............8 (500) 1 2 0.......................... .......... If this stage were reached.............. 13.....................000 depending on the state of the economy. then at t = 2........................................................................... spend Rs............ which are made as the project progresses through stages.............................................. they consist of two or more sequential decisions.............000............................................. conduct a Rs................................................ 10. For example............ and so forth...................................................................5 Decision Tree Analysis Many capital budgeting decisions are not made at a single point in time........... .......................................................... then at t = 1........................................... Stage 2 : If it appears that a sizable market for this product X does exist....................... Stage 3 : If reaction to the Prototype Product X is good.. ............... .................................. ............................................................................................. ........................... Time t=1 (2) t=0 (1) t=2 (3) 0........................ ........ competition............................... build a production plant with a net cost of Rs.. 1...............20 0......... .........................24 0...................................000... ............... Rather....24 NPV (6) 2347 94 (1409) (500) NPV Product (5) x (6) = (7) 563 23 (450) (100) Rs.............................

If the management accept the product. Finally. Management estimates that there is a probability of 0.000. If the project is stopped here.32 of losing almost Rs. then company would spend the final Rs. similar to the one we obtained using simulation analysis for the single-stage project. or sequential. and a 0. For example. and hence used the unadjusted cost of capital to evaluate it. and that a strong economy will produce a Rs. less. the project would be dropped.) Column 5 of Figure 9. 500. The decision tree provided a distribution of NPVs. Managemetn estimates (before even making the initial Rs. 36. With those high loss 13 . 2. and a cost of capital off 10 per cent. the probability the ABC will. we could have used any number of outcomes or even a continuous distribution of outcomes. 500. then ABC will go on to Decision Point 2 and spend Rs.The diagram in Figure 9. Based on the expectations set forth in Figure 9. Each circle represents a decision points. (Although we used only two production outcomes for simplicity.000 net cash inflow. leading to the decision to move on to Stage 2.000 on the product.2 probability that the marketing study will produce negative results. since management only assumed that the project is of average risk. the payoff is assmed to be either Rs.000.000. and management assumes initially that all projects have average risk. should ABC initiate Stage-1? Not necessarily. A decision tree lays out the analysis like the branches of a tree. is (0.5 million.000 while if the management do not like it.000 (1. 1. 10.52 of losing money and a probability of 0.000.000 or Rs. With this project. decisions. move through Stage 2 and 3.8 that the study will produce favourable results. Each diagonal line represents a branch of the decision tree.10) 2 − Rs.000 investment) that there is a 60 per cent probability that product will be useful and a 40 per cent probability that it will not be useful. we assume that as on year goes by between decisions and that a single net cash inflow from the project would occur one year after the final decision to go into production.10) 3 − Rs. the cost of ABC will be Rs.8) (0. The NPV of the top (most favourable) outcome is about Rs. and if it does yield positive results.000.3 is called a decision tree. In Figure 9.000. 16.6) (0.000. However. The sum of the NPV products is the expected NPV of the project. if Stage 1 is undertaken.000. 500. 16.000 (1.3.000 for the initial market study. or stage. if ABC decides to “go” with the project at Decision Point 1.5) = 0. there is a probability of 0. Since the expected NPV is positive. the expected NPV is approx.000 on a marketing study. 1. Each conditional probability is obtained by multiplying together all probabilities on a particular branch. 16. 10.000: NPV = Rs.000. and each branch has an estimated probability.000. a procedure often used to analyze multi-stage. it will have to spend Rs. ABC must now reconsider and decide whether this project is more. If the marketing study is undertaken.3. Rs.3 gives the conditional probability of occurrence of each final outcome. indicating that the project should be cancelled after State 1. For example.24 Column 6 of Figure-9.00 Project Evaluation Under Risk and Uncertainty Other NPVs were calculated similarly Column 7 of Figure 9. 1.3 gives the product of the NPVs in Column 6 times the probabilities in Column 5. with each outcome having a 50 per cent probability.10)1 = Rs. if ABC does go into production.3 gives the NPV of each final outcome. or as risky as an average project.000 (1. 500. The rupee value to the left of each decision point represents the investment required if the decision is “go” at that point. 13.347. ABC has a cost of capital of 10 per cent.

3 SUMMARY Risk involves situations in which the probabilities of cash flow occuring are known and are objectively or subjectively determinable.) 1000 1500 2000 Branch 1 2 3 .00 Year 2 Net Cash Flow (Rs. is it more risky than project B. 9.4 SELF ASSESSMENT QUESTIONS 1.40 . 14000 and standard deviation is Rs. 3000. Why should we be concerned with risk in capital budgeting? Is the standard deviation an adequate measure of risk? Can you think of a better measure? 2. In contrast when an event is not repetitive in nature and the probability of occurance is not determinable uncertainity is said to prevail.Investment Decisions Under Uncertainty probabilities. 4000.00 .40 2000 2500 3000 4 5 6 14 . A risk analysis technique which considers both the sensitivity of NPV to changes in key variables and also the range of likely variables value is Scenario Analysis. If project A has an expected value of net present value of Rs. 9. and joint probabilities? b) What are the benefits of using simulation to evaluate capital investment projects? 4.40 .30 1.) 1500 Conditional Probability P (2/1) . conditional. and future after-tax cash flows depend on demand for the company’s products.00 2500 . The tabular illustration of a probability tree of possible future cash flows associated with the new saw is as follows: Year 1 Initial Probability P (1) Net Cash Flow (Rs. 3. There are sevral techniques to measure project risk. 20.000 and a standard deviation of Rs. and the small NPV relative to the amount required to undertake the project. The saw costs Rs. Monte Carlo Simulation ties together sensitivities and input variable probability distribution. Another technique is Sensitivity Analysis which measures the effect of change of variables on NPV of the project. Another technique is that of Decision Tree Analysis which is used when Capital Budgeting Decisions are dependent on the outcome of a precedent event.20 1. The most basic and widely used technique is Standard Deviation. whose expected value is Rs. chances are good that it would be rejected. what are initial. The event is repetitive in nature and the inability to accurately predict the future course of events introduces risk. 3000? Explain. a) In a probability tree approach to project risk analysis.30 .60 1.40 . Naughty Pine Lumber Company is evaluating a new saw with a life of two years.

. Chapter 12.. “The Revolution in Corporate Finance” Basil Blackwell.30 .. R. a) Without calculating a mean and a coefficient of variation.M. Prentice . assuming a risk-average management? b) Verify your intuitive determination.).30 . 2003. “Principles of Corporate Finance”.C. Myers.M. can invest in one of two mutually exclusive. 15 .40 . Srivastava.00 Cash Flow 2000 4000 6000 8000 .10 .10 1. McGraw Hill Company. The two proposals have the following discrete probability distributions of net cash inflows for the first year : Project A Probability .00 Project B Probability Cash Flow 2000 4000 6000 8000 Project Evaluation Under Risk and Uncertainty c) 5.a) b) What are the joint probabilities of occurrence of the various branches? If the risk-free rate is 10 per cent. can you select the better proposal. one-year projects requiring equal initial outlays.M.Hall. Chew (Jr. “Fundamentals of Financial Management”. Stern J. J. Wachowicz. 9. Himalaya Publishing House. what is (i) the net present value of each of the six complete branches and (ii) the expected value and standard deviation of the probability distribution of possible net present values? Assuming a normal distribution. D.20 ..5 FURTHER READINGS Brealy R..H. Financial Management and Policy.40 .20 1. what is the probability that the actual net persent value will be less than zero? What is the significance of this probability? XYZ Inc. VanHorne J.

3 Game Theory 10. and it has rank >q. ‘a’ is a matrix of estimates of some unknown parameters.5 The Expected Utility Model 10.1 INTRODUCTION Most of the literature on capital budgeting decisions has been woven around the assumption of certainty and single goal. (1) In order to convert into a real linear functional.4 Expected Utility Approach 10. The multi-objective criteria and the problem of risk and uncertainty could be taken care of with the help of a stochastic goal programming model by incorporating priority coefficients for different objectives.2 Stochastic Goal Programming Model 10. As we know. x2. Structure 10.6 Summary 10. xn)we analyse the goals such that ¦(x1. . in real world not only we are faced with lot of uncertainty but companies tend to have multiple goals like rate of return. However.… ..UNIT 10 RISK ANALYSIS IN INVESTMENT DECISIONS Objectives The major objective of this unit is to discuss and show the application of some advanced techniques of risk analysis in investment decisions.. The non-singular variance-covariance matrix S is known since only nonsingular matrices have ordinary inverses.8 Further Readings Appendix : A Goal Programming Model for Capital Budgeting 10. we have continued to assume that a company has a single objective.2 STOCHASTIC GOAL PROGRAMMING MODEL Assumptions 1.… . . 1 .7 Self Assessment Questions 10.e. + anxn = bi (2) where a1. 10. xn)= a1x1 + a2x2 + . x2. a2.. In unit two of this block. Given the goals (x1. an are any real numbers such that ¦ is a real linear functional. sales. employment.1 Introduction 10. 2. xn) = bi where b represents given goals. higher rate of return. x2. etc.… . i. 3. Random variables ui are normally distributed with mean 0 and variancecovariance matrix S.. we have discussed various techniques of risk analysis presuming that true certainty in expected cash flow and the required rate of return do not exist in the real world. this may be written as: ¦(x1..

2) Risk Analysis in Investment Decisions The problem may be formulated in a linear programming format as follows: Minimise z =(Pid+t + Pid-i) axi + d t . a2. if the matrix in our problem of goal analysis has its ordinary inverse. i. 2 .1) xi ³ 0. when a matrix is non-singular). we formulate the problem into a generalized inverse matrix form as follows: bi = axi + ui (6) in the presence of linear constraints on the variables.e. xn and let ‘a’ be a row vector with components a1. d-2 – d+i ³ 0 + (5) (5. (i. Let x be a column vector with components x1.Investment order to simplify In Decisions Under Uncertainty the notation. Such that b e B*.1) (5. i. i. . The stochastic equation bi = axi + ui has the form of a linear model in reduced form if we consider the goals bi as endogenous and jointly determined and variable ai as exogenous variables.. then the solution sub-goal which attains the given goal can be obtained by using the ordinary inverse of the matrix. Therefore.e.x2.. When a matrix has the ordinary inverse.2) where bi refers to a given set of goals and xi are linearly related to bi variables and ui are random variables. it is identical with generalized inverse of matrix. an then the (2) may be represented equivalently by Axi = bi (3) If a matrix A has an ordinary inverse A-1 then we have a unique solution x to Axi = bi which is given by xi = a-1bi. . bq) = 2II)q-/2 | S |-½ e-q/2 (7) where the quadratic form Q is defined as Q = (b-ax)’ S -1 (b-ax) (8) A simple criterion function analogous to that used in the goal programming model may be interpreted by analysing the statement b*t = axi as follows: Let B* be an appropriately defined region which covers the point b.. b2. we use the ideas of matrix algebra. Bxi < h xi > 0 (6...2) when the assumption of certainty is dropped.e... Then one chooses the goals xi for which the probability that the random vector bi = axi + ui will lie inside the region B* is maximized. whereas the transformation defined by A-1 transforms bi precisely back into xi. (4. (4.e.d i = bi xi . Bxi £ h. it follows from the assumptions that bi is normally distributed with means (ax) and variance-covariance matrix S. Geometrically.. By the generalized inverse matrix the possible solution to axi=bi is given by Bi = axi (4) In the presence of linear constraints on the variables.1) (6. ¦(b1. the transformation defined by A transforms xi into bi. Therefore..

d-i.4 1 See Appendix for detail of Lorie and savage problem. the stochastic goal programming model may be formulated as follows: Minimize Z=(K+xAx’ + 2p’x) (11) subject to Bxi < h Xi > 0 (11. and semi positive definite if q < n.1) (12.1) (11.1) and (11. A = a’ S-1 a.Assumption I suggests that B* should be taken to be falling in defined region and centred at b* of the form : Q* £ c2 (9) Where Q* is the quadratic form Q* = (b – b*)’ S -1 (b-b*) (10) We know that if y is normally distributed and S is non-singular then quadratic form (10) has the chi-square distribution with q degrees of freedom.2) where Pi refer to priority coefficients and d±i refer to positive and negative devotional variables. Therefore.d+t = bi xi .2) where K = b*’ S-1 b*. The above stochastic goal programming (11) may be formulated into a linear programming format as follows: Minimize z =(Pidi+t +.1) 3 . d+i > 0 (12) (12. (13. The above stochastic goal programming models equivalent to a quadratic programming problem in standard form since the constraints (11. Lorie and Savage modified problem may be formulated under the conditions of uncertainty as follows:1 Minimize z= p1d-1 + p2d-2 + p3d-3 + p2d-4 +4 p2d-5 +p4d-6 (13) p4d-7 + p5d+4 + p6d+6 + p6d+7 Subject to (A) Present value of investment goal 14x1 + 17x2 + 17x3 + 15x4 + 40x5 + 12x6 + 12x7 + 10x8 + 12x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-1 = 32. Using (12).Pid-i) subject to axi + uixi + d-i . Region B* may be restricted to be of the form Q* = c2.2) are linear. p = a’ S-1 b* and A is (mxn) positive definite if q=n. and the problem can be solved by any of the existing algorithms. Thus B* can be interpreted as confidence region for b at level a because if we choose a set of goals x° such that E(b) = ax° = b* then the probability of b falling in the region B* is given by a.

0 3x1 + 7x2 + 6x3 + 12x4 + 35x5 + 6x6 + 4x7 + 3x8 + 3x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-3 = 20.2. .5) (13. Ax = b Where Xi ³ 0(j = 1. (where i = 1. j=1 The conditions that the n vector x solve the problem for l > 0 may be written as: Ax=b Cx – V + A’u+ p’u + p’l = 0 (15) x ³ 0. x9. with n x 1 matrix.2) (13. d1.0 15x1 + 42x2 + 16x3 + 12x4 + 52x5 + 14x6 + 34x7 + 28x8 + 21x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-5 = 84. .3) (13. dn ³ 0...7) (13. x2..4) (13. d2... xn)’ where x is to be taken to be a column vector..x) = lpx 1/2x’ cx May be specified as x ³ ). v ³ 0 (14) 4 . m)..0 (C) Sales goals 14x1 + 30x2 + 13x3 + 11x4 + 53x5 + 10x6 + 32x7 + 21x8 + 12x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-4 – d+4 = 70. . ... If A be an m x n matrix and b an m x 1 the linear constraints of the problem for l ³ 0. Minimize f (l. N=9) Computational Procedure The Wolfe’s algorithm of a simplex type of a quadratic problem which apply to the stochastic goal programming problem formulated for capital budgeting decision under uncertainty is of the following form: Let the variables of the problem constitute the n vector x = (x1.6) (13..0 x1..Investment Decisions Under Uncertainty (B) Budget ceiling goals 12x1 + 54x2 + 6x3 + 6x4 + 30x5 + 6x6 + 48x7 + 36x8 + 18x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-2 = 50..8) When ui = 0).0 12x1 + 16x2 + 13x3 + 13x4 + 16x5 + 14x6 + 9x7 + 22x8 + 13x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-7 – d+7 = 40. Risk Analysis in Investment Decisions (13.. .. n) n S aij xj = bi(i = 1....0 (D) Employment goals 10x1 + 16x2 + 13x3 + 9x4 + 19x5 + 14x6 + 7x7 + 15x8 + 8x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 + u6x6 + u7x7 + u8x8 + u9x9 + d-6 – d+6= 40..

n If S Zk > 0.. The computational procedure. The solution of the system would be: Ax = b Cx .v + A’u + Ez = -p’ X. i Keeping v and u zero. The x part of the terminal basic solution in a solution of the quadratic programming for l. we would discard w and unused components z1.z ³ 0.and m component vectors.or in the detached coefficient form as x³0 v³0 A C 0 -I l l 0 A’ 0 p’ = b =o (16) Constituting m x n equations in 2 n non-negative variables and m unrestricted variables and where l is not considered as a variable. y2 .and z2 and w be respectively n-. when the number of constraints is larger may be presented in the following manner alongwith line discussed above: Let the constraints be A 11x 1 + A12 x2 A21x1 + A22x 2 + y2 A31x1 + A32x 2 + y3 X 1 . let the remaining n components be denoted by z and their coefficients by E. . An initial basis for this system can be formed from the coefficients z1. we do not admit vk. then we repeat the step (18) and the form will K=1 vanish in subsequent iterations yielding z=0. n. y 3 > 0 = b1 = b2 = b3 (20) 5 . x. if xk is in the basis. v’x = 0 and n S Zk > 0. Let z1. we do not admit xk. Given a basis and basic solution satisfying (17). v. z2. make one change of basis in the simplex procedure K=1 minimizing the linear form n S Xk K=1 (17) (18) under the side condition for k=1.z2 and w since b ³ 0 by using the simplex method to minimize Swt = 0... and if vk is in the basis.

we do not admit (v-1)k. if (y-2)k is in the basis we do not admit (u3)k. if number of variables involved or the number of iterations required is large. the reader might be inclined to pitch his hopes for useful guidance a little higher. If (x1) k is in the basis. a2 release two-thirds of the water in the reservoir. (b1) full flood and (b2) no flood.80. and the options open to the decision maker.Investment Decisions the new system Under Uncertainty of linear constraints (corresponding to 16) will be: y2³0 I -I -I Risk Analysis in Investment Decisions x1 ³0 A 11 A 21 A 31 C x2 A 12 A 22 A 32 y3³0 v1³0 u1 u2³0 u3³0 A’ 11 A’12 A’21 A’22 A’31 A’32 l =b 1 =b 2 =b 3 p’1=0 p’2=0 The algorithm would proceed the same way as in (18) above. a decision is required on the amount of water to be released. however. If. and (a3) release all the water in the reservoir. However. Now the amount of water that can be released from the reservoir can range. the gains to one party being exactly equal to the losses suffered by the other party. computer package programme may be used to arrive at the solution. he is likely to be disappointed. one of which may be ‘nature’. In order to illustrate the principle. or strategies.000. a decision is taken to release two-thirds of the reservoir. the net benefit – that is the value of the harvest less the value of the damage done by the flood — is assumed to be known. But before pronouncing judgement we shall illustrate with one or two simple examples the relevant techniques known as the ‘two-person zero-sum game’. which is option (a2). but it will damage the harvest to some extent. a lot of water is released now it will make flood damage virtually impossible. the net benefit that arises if the full flood (b1) occurs is assumed equal to Rs. and (2) that there are no mutual gains to be made. Again. Again.3 GAME THEORY Since game theory can be used as a technique for dealing with cases of complete ignorance of the initial probabilities of possible outcomes. Consider first a reservoir which is full at the beginning of the season and can be used both for irrigation and for flood-control. 10.140. and two 6 . but it will be ineffectual as a contribution to preventing future flood damage. In addition to the possible states of nature. that of releasing all the water. and a full flood. If a little water is released now it will be good for the harvest. if instead we choose the (a3) option. we are also assumed to have a clear idea of the quantitative result corresponding to the particular outcome and the option adopted. (a1). and vice versa. (b1). happens to occur. Since there are three options. for example. The options open to the decision-maker are also to be restricted for simplicity of exposition : they will be (a1)release one-third of the water in the reservoir. and (a3).000. if it occurs it can be either negligible or highly destructive. (a2). If. Our emphasis here has primarily been to suggest a model of stochastic goal programming for capital budgeting decision problem under risk and uncertainty and the computational procedure for its solution. (b1) and (b2). instead. we can restrict ourselves to two possible outcomes. in general. Without any prior knowledge of whether or not a flood will occur. In this example we shall assume it is equal to Rs. so called for the rather obvious reason (1) that the game is played between two persons or groups. As for the flood. and vice versa . from nothing at all to the whole lot.

400.000 and Rs. Rs.000 90.1 below.2: The Maximum Procedure b1 b2 Row minima Maximin (maximum of row minima) Rs.140. option a3 – requiring the release of all the water in the reservoir – will never be adopted.) 400. a fact that is revealed by the figures in the a1 row (Rs. and Rs.000 80.400.000) and those in the a2 row (Rs.000).000 for a2. 130. or states of nature.140.) a1 a2 a3 130. Table 10. it will be realized that the worst that can happen is the occurrence of b1.80.000 260. Now the choice of a2 or b2 occurs respectively. Rs.000 140. In the Jargon. or minimal net revenue.000 and Rs.130.80. Similarly if he chooses option a3 he can be sure of obtaining at least Rs.90.80. option a3 is dominated by the other options. We shall only illustrate the former for understanding the application of the game theory. Assuming that the decision-maker is a conservative person. We could then save some unnecessary calculation by eliminating the dominated option a3. If he chooses a1.000 90. he will want to compare this worst result.possible occurrences.130.000 for a3 are all shown in the third column of Table 10. provided the six figures above are all accepted as correct estimates of net benefits. since there are no circumstances in which it would pay to adopt it.1 except for the addition of two columns. b1 and b2. both sets of figures being larger than the a3 row figures (Rs. as the additional exercise will be useful while the additional calculation will be slight complex. that he can obtain from choosing a1 with those minimal he might obtain if instead he adopts the a2 or a3 option.130.2 which is the same as Table 10.000 140.000).000 140.000 Rs.000 b2 No Flood (Rs. Rs. corresponding to each of the two possible alternative states of nature.000 and Rs. The scheme is depicted in Table 10.000 80. Nevertheless we shall retain it in this simplified example.000. Whether b1 or b2 occurs the net benefits of adopting the a3 option will be lower than those of either a1 or a2. Given no information other than in Table 10.000 80. when the decisionmaker chooses option a1. 140.140.000 Rs.1 showing the net revenues.000 Down this third column he reads off the worst possible outcome corresponding to each option. Table 10. The maximum procedure : If he looks along the first row of Table 10. he can be sure of not getting less than 7 .000 for a1.1: Net benefit figures for various options and various outcome b1 Flood (Rs. yielding a revenue of only Rs.000.260.000.000 and Rs.400.000 a1 a2 a3 Rs. He can then be sure of at least Rs.000. there will be altogether six possible outcomes each identified by a net benefit figure. These three row minima. 130.1 we could employ either of two standard methods to produce a decision: a maximin procedure and a minimax procedure.000 260.000 A glance at the Table will convince the reader that.130.

2 is spoken of as the Maximin. Three possible occurrences are to be considered: b1. Table 10.8 Row Maximum -13. a2. -13 is less than -12. the maximum procedure b1 a1 a2 a3 -13.000 in column four of Table 10. installing an oil-fired boiler.0 -11.5 and -12. Of these row minima.140.140. and b3.0 -12.5 Risk Analysis in Investment Decisions By convention costs are to be regarded as negative revenues.130. he can be sure of not getting less than Rs. 8 . which figures are entered in the fourth column. Looking along the a1 row the worst outcome is 13. the relative prices of the two fuels remain on the average unchanged. An example would be the installation of a boiler in a works.3: Net benefit figures for various options and outcomes.Investment Decisions Rs. this cost would be incurred if event b2 took place. The maximin principle. he will receive only Rs.3 are all negative.140.000. the cost would be 13. which column contains the minimum possible net revenues corresponding to each option. whereas if he chooses a3 he will receive only Rs. Under Uncertainty If he chooses a2. If we assume instead that revenues are fixed and that costs alone vary according to the decision made and the event which takes place. the maximum (or least cost) is -12.000. he can be sure of not getting less than Rs.000. so the figures in Table 10. coal prices rise relative to oil prices over the next twenty years by an average of 25 per cent. This enables us to compare directly the net revenues—annual revenues less annual loss in each of the first two columns. would be the one to be chosen.140.) The largest costs. or the smallest gains. respectively. therefore. we can be sure that the cost to which the firm can be subjected cannot exceed 12. Having chosen a2.3 -12.8 b3 -12. Hence the figure chosen Rs.80. -12. requires that he chooses option a2 (releasing twothirds of the water in the reservoir).5 -12. If a1 is chosen and b1 should occur. on the maximum principle.8-.140. and assure himself of no less than Rs. b2.0 -12. b1 occurs. If. The largest net revenue he can be sure of obtaining is.5 -12. the reverse of this. at negligible cost.0.130. Again we can suppose three options: a1. installing a coal-fired boiler.000 according as event b1 or event b2 occurs.5 corresponding to option a2 which. One feature of the above example is that capital costs are taken to be constant for each of the alternative options.3 -12. the figures being the present discounted values (in thousands of rupees) of the streams of future costs associated with each option for each of the three possible outcomes. If he chooses a3.000.000 or Rs. event b1 or b3 occurred the cost would be only 11. and vice versa.8 b2 -12. The guiding idea has been to pick out the maximum figure from column three.3. It will then occur to him that if he chooses any option other than a2 he might get less than Rs. The outcomes of the relevant calculations are summarized in Table 10.8 Maximin -12.5.000.000.000. we can go through the same sort of exercise. installing a dual boiler. one that could be switched from using coal to using oil.80. if having chosen a1. then Rs. corresponding to options a2 and a3 are.0 -11. for example. however.3. seen as a negative revenue and considered algebraically. or a3.90. (13 is the highest absolute figure in the row but. Thus -13 is the lowest figure in the row.

the expected utility hypothesis states that when faced with a set of mutually exclusive actions. Thus in order to solve the individual’s sequential consumption .4 THE EXPECTED UTILITY APPROACH Here we will develop a model for consumption investment decisions by individual under conditions of uncertainty. W2 is also a random variable.C2. therefore. The individual is assumed to derive satisfaction only from consumption and his problems is to map out a consumption – investment strategy that maximizes the level of satisfaction provided by anticipated consumption over his lifetime. At the first decision point he has a quantity of wealth W1 that represents the maximum possible level of consumption during time period 1. and an action is a r period consumption . The general problem can be described as follows: Consider an individual who must make a consumption .investment problem. In general terms.C1) (1+R2) R2 is the % expected rate of return in period 2. At the beginning of period 1.. In the r period consumption . we need a theory of choice under uncertainty that defines the criteria that the individual uses in choosing among different probability distributions of lifetime consumptions. purely for convenience. 10.investment decision at each of r discrete points in his lifetime..investment problem.10.Cr). first see the model in its most general form. Under uncertainty the decision problem is of course complicated by the fact that the actual lifetime consumption sequence is to some extent unpredictable.5 THE EXPECTED UTILITY MODEL The theory of choice under uncertainty that we apply to the consumption investment problem is the ‘Expected Utility hypothesis’. and the consumption . 9 .. because as indicated above the wealth levels produced through time by any given investment strategy are usually random variables. the last period of the individual’s life at which time the entire available wealth is consumed. W2 must in turn be allocated to consumption and investment. utilities to each outcome and then chooses that action whose associated probability distribution of outcomes provides maximum expected utility.investment strategy that produces a probability distribution for different possible lifetime consumption sequences. R2 is a random variable. At the beginning of period 2. At the beginning of period 2. the individual’s wealth level is _ _ W2 = h1 (1 + R2) = (W1 . But because the consumption investment problem is just one possible application of the expected utility model. W1 must be split between current consumption C1 and investment h1=W1-C1. an outcome is a complete sequence of lifetime consumption Cr = (C1.investment decision problem is faced at the beginning of each subsequent period until period r. each involving its own probability distributions of ‘outcomes’ the individual behaves as if he attaches numbers called.

The expected utility approach deals with consumption investment decisions under conditions of uncertainty. just as behaviour in conformity with the ordinary utility model.Z:µ) ~ G(Y.Z:µ). So we. For example X>Y and Y>Z imply X>Z or X~Y and Y~Z and so on. Here G(X. according to expected utility requires a utility function in which the differences between the utility levels assigned to different elementary prospects have some meaning. and Y~G(X.Z: µ) > G(Y. that is. for only two prospects X and Y in S. Game theory is a technique for dealing with cases of complete ignorance of the initial probabilities of possible outcomes. a random prospects. and G(Y.Z:µ). To cope with a problem of this kind it is helpful to resort to mathematical programming models which aids in determining the optimal solution without explicitly evaluating each feasible combination. 10. then G(X. Stochastic Goal Programming is one on them. If X~Y. Axiom 3 : (Strong Independence) The rankings of two prospects are not changed when each is combined in the same way into a a gamble or probability distribution involving a common third prospect. Intuitively it is clear that ranking random prospects which are just probability distributions of elementary prospectus. with probabilities µ and 1-µ.G(X. with probability 1-µ. Risk Analysis in Investment Decisions The Axiom System The set of axioms we use is as follows: Axiom 1 : (Comparability) The individual can define a complete preference ordering over the set of prospects in S. Axiom 5 : If X³Y³Z and X³U³Z. that is. We also assume that if X>Y.Z:µ). he can say that X>Y and Y>X or X ~ Y. or Z. Axiom 2 : (Transitivity) The ordering of prospective assumed in Axiom 1 is also completely transitive. there is a unique µ such that Y~G(X.Investment Decisions Since we are Under Uncertainty confronted here with how the individual ranks outcomes and probability distribution of outcomes. with probability X.Z:µ2) then µ 1 > µ 2 implies Y>U and µ 1 = µ 2 implies Y~U.Z:µ) represents a gamble.Z:µ). or if X ³ Y then G(X. if the utility of a random prospect is just the expected or average value of the separate utilities of each of its component then elementary prospects differences in utility levels must have meaning. Z:µ) likewise represents a gamble that produces either Y or Z. then for any third prospect Z in S.6 SUMMARY As the number of variables and number of years in planning horizons increases it becomes very tedious and cumbersome to evaluate risk in investment decisions. have five axioms that can help produce a better understanding of the model. that is.Z:µ) ³ G(Y.Z:µ1) and U~G(X. in which the individual gets either X. 10 . Y and Z are such that either X>Y³Z or X³Y>Z. Axiom 4 : If the prospects X.

1994.10.H.7 SELF ASSESSMENT QUESTIONS 1. 2. Hiller F. “The Evaluation of Risk Interrelated Investments”. 11 . “Risk. Uncertainty and Profit”.. North-Holland Pub. “Reading in Financial Management”. Chicago.. What is meant by utility? Do you feel financial managers should be risk averse? Why or why not? 10. Discuss the capital budgeting techniques without probabilities. IIF. Co. Describe the general formulation of a goal programming model. Delhi Publication.D.. University of Chicago Press.S. London.8 FURTHER READINGS Agarwal J.. 3. Knight F.

the GP model (12) for the above problem is reformulated here below changing the priority coefficients for the different objectives of the same objective set. The problem may be specified as follows: Exhibit .Investment Decisions Under Uncertainty APPENDIX A Goal Programing Model for Capital Budgeting Weingartner (1963) suggested a linear programming formulation taking up Lorie and Savage (1955) problem and suggested an optimal solution.1) . The budget constraints for two periods were Rs.) 3 7 6 2 35 6 4 3 3 PV of Investment (Rs.) 12 54 6 6 30 6 48 36 18 PV of outlays Period II (Rs. Lorie and Savage problem specifies for consideration nine mutually exclusive projects with given present values of outlays for period I and II and given prsent values of investments.4 (10.I Lorie-Savage Problem of Investment Proposals Investment Project 1 2 3 4 5 6 7 8 9 Period I (Rs. The different priority coefficients assumed for the following reformulated GP model (13) are as follows: Goals Net present goal (over achievement) Budget constraint goal I Budget constraint goal II (under achievement not desired) Sales goal I (under achievement not desired) Sales goal II (under achievement not desired) Employment goal I (under achievement not desired) Employment goal II (under achievement not desired) Sales goal I (over achievement undesirable) Employment goal I (over achievement not desired) Employment goal II (over achievement not desired) Priority Coefficient 1 7 8 2 3 4 4 5 6 6 The GP model for capital budgeting decisions with modified priority coefficients may be specified as follows: Minimize z= p1d-1 + p7d-2 + p8d-3 + p2d-4 +4p3d-5 +p4d-6+ p4d-7 + p5d+4 _ p6d+6 + p6d+7.50 and Rs.20 respectively.) 14 17 17 15 40 12 14 10 12 Risk Analysis in Investment Decisions In order to examine the effect of priority coefficients on the CBD. (10) 12 Subject to (A) Present value of investment goal 14x1 + 17x2 + 17x3 + 15x4 + 40x5 + 12x6 + 14x7 + 10x8 + 12x9 + d-1 = 32.

4) (10.0 x1. x2.3) (10.. 13 .53334.2) (10. x3. x9. However.d+4. d 7. (10. x4.0 (D) Employment goals 10x1 + 16x2 + 13x3 + 9x4 + 19x5 + 14x6 + 7x7 + 15x8 + 8x9 + d-6 – d+6= 40.00933. x7 and x9 should be selected.0 3x1 + 7x2 + 6x3 + 2x4 + 35x5 + 6x6 + 4x7 + 3x8 + 3x9 + d-3 = 20.0 15x1 + 42x2 + 16x3 + 12x4 + 52x5 + 14x6 + 34x7 + 28x8 + 21x9 + d-5 = 84.5) (10.7) Exhibit II reveals that to attain the optimal solutions for each of the seven objectives four projects.65466. it may be concluded that a goal programing solution is certainly better than the linear programming solution since a GP model allows (i) a simultaneous solution of a system of complementary and conflicting objectives rather than a single objective only. x7 = 0.6) (10. The optimal solutions under the two situations remained to be almost the same because the overall formulation with regard to different objectives and their over achievement was the same. The optimal solution of (13) is presented in exhibit II. d-1. Thus.. (ii) that more than any one period can be included in the final programme of choosing projects.e.0 (C) Sales goals 14x1 + 30x2 + 13x3 + 11x4 + 53x5 + 10x6 + 32x7 + 21x8 + 12x9 + d-4 – d+4 = 70..0 12x1 + 16x2 + 13x3 + 13x4 + 16x5 + 14x6 + 9x7 + 20x8 + 13x9 + d-7 – d+7 = 40..d+7 ³ 0. . x4 = 2. if the formulation with regard to the under achievement and/or over achievement is also simultaneously changed the optimal solution would also be different..d+6. i. The respective units of these projects to be chosen are x3 = 2. On comparison of the solutions presented in exhibit I and exhibit II it may be observed that the basic difference which the modified priority coefficients made is the choice of the projects and their respective units..(B) Budget ceiling goals 12x1 + 54x2 + 6x3 + 6x4 + 30x5 + 6x6 + 48x7 + 36x8 + 18x9 + d-2 = 50..

12129 26.00933 X 4 =2.40008 11.0000 X 7 =0.32803 X 8 =0.30932 29.40008 9.12129 32.00007 84.26672 6.51058 12.09064 69.0 84.92796 34.89194 34.65466 X 5 =0.0000 Net Present Value Goal Budget Constraint Goal I Budget Constraint Goal II Sales Goal I Sales Goal II Employment Goal I Employment Goal II . Risk Analysis in Investment Decisions Investment Decisions Under Uncertainty Projects X 6 =0.79478 1.00012 56.60002 6.4 Total Goal Programming Solution X4 X7 3.14 Exhibit II Goal Programming Solution with Modified Priority Coefficients X 1 =0.20126 31.27744 8.81069 2.0469 8.85592 23.12129 12.25867 Goal Constraints X2 83.15861 39.0 32.14928 26.0 40.00000 70.62138 12.41616 1.200014 4.00022 20.0 20.60012 1.05598 5.05598 15.93342 X 2 =0.89332 26.0000 X 3 =2.99997 50.0 70.0000 The GP Solution is computed on IBM 360 and involved 24 iterations.0000 X 9 =0.53334 X9 6.0 50.81990 ³ £ £ = = = = 40.

These insittutions are generally grouped into Money Market and Capital Market. on the other hand. Structure 11.2.5 Summary Self-Assessment Questions Further Readings 11. The mechanism includes a wide variety of institutions which cater.8 11. capital formation has been recognized as the most crucial factor in the economic growth of the developing countries.2 11.11 Public Deposits 11. thus.1 INTRODUCTION Economic growth implies a long-term rise in per capita national output.12 Bank Credit 11.2.6 11.10 Secured Premium Notes 11. explain different methods of raising funds by corporates through capital market.1 11.3 11.2.2.13 Venture Capital 11.1 Introduction 11.2. 1 . liquidity and profitability notions of the savers.2. highlight redeeming features of capital market.2.1. The process of capital formation. to the safety.4 11.5 11.2.2 Money Market Capital Market Equity shares Rights Issues Private Placement Non Voting Shares Preference Shares Cumulative Convertible Preference Shares (CCP) Warrants Debentures Bonds 11.1 11.2 Methods of Procuring Finance 11. Capital formation implies the diversion of the productive capacity of the economy to the making of capital goods which increase future productivity capacity.9 11. The basic conditions determining the rate of growth are effort.2.UNIT 11 FINANCING THROUGH CAPITAL MARKETS (DOMESTIC SOURCES) Objectives The objectives of this unit are to: provide an understanding of money market and capital market. involves transfer of savings from those who have them in the hands of those who invest the same for productive purpose.3 11.2.4 11.2.7 11.1. and on the other to the different types of requirements for working and fixed capital of the investors. Among these.2.2. Finance provides mechanism through which savings of myriads of savers are pooled together and are put into the hands of those able and willing to invest. Saving & investment activities are linked by finance. capital and knowledge.

equity share capital is what ever remains in the way of assets after all the debts and other charges have been paid or provided for.1. control. both the primary market and secondary market play an important role in raising maximum resources for capital formation and balanced and diversified industrial growth in the country. Money market provides a mechanism by which short-term funds are lent out and borrowed. Thus.2 METHODS OF PROCURING FINANCE A company can raise funds through capital market by issuing the financial securities. 11. a share is a part of unit by which the share capital of a company is divided. Further. privatization and globalization with the walls cocooning the economy being torn and unprecedented technological advancements have led to geographical and functional integration of international financial markets and intensification of competition among various players both in banking and nonbanking sectors. It is a place where a bid is made for short-term investible funds at the disposal of financial and other institutions. which is not preference share capital.. However. Viz. 2 .1. Equity share capital is also defined as the “amount of the value of property over and above the total liens and charges. The capital market is composed of primary market and secondary market (also known as stock market). 11. the issuers adopt different methods. Thus equity share capital is also appropriately referred to as residual capital. Equity share capital refers to the share capital. A financial security is a legal document that represents a claim on the issuer. There are also securities known as hybrid securities having the mix of the features of ownership securites as well as creditorship securities.1 Money Market Money market comprises those financial institutions which cater to the notions of savers of high liquidity and safety along with profitability and which provide working capital to trade and industries mainly in the form of loans and advances. 11. Each method of financing has got its distinctive features in terms of risk.2 Capital Market Capital market is the place where the medium-term and long-term financial needs of business and other sectors of the economy are met by financial institutions which supply medium and long-term funds to borrowers. repayment requirements. it is through this market that a large part of the financial transactions of a country are cleared. In other words. equity share capital and preference share capital. and security.Financing Decisions 11. individuals and the Government itself. company can also raise the funds through public deposits and borrowings from banking sector. The Act makes a provision for only two classes of shares capital.1 Equity Shares According to the companies Act 1956. transferability and continuous price formation of securities. The corporates securities are broadly classified into ownership securities and creditorships securities. metamorphic environmental developments in and outside the country following the policy of liberalization. blurring of boundaries between money and capital markets and culminating in the emergence of more diversified multipurpose financial institutions and financial innovations of unprecendented dimensions.2. return. money market is reservoir of short-term funds. While the primary market provides a mechanism through which the resources of the investing public are mobilized. Thus. Depending upon the market conditions and financing strategies. the secondary market provides mechanism to facilitate an investor to buy and sell securities through dispensation of benefits of easy liquidity.

the company should follow various regulations and guidelines of the Companies Act. and pay when it’s earnings are adequate to do so. earnings and control of the company. but at the same time they have greater opportunities for getting higher returns. unless they contribute proportionately. while the first three are discussed here. private placement. Raising capital through equity enhances the company’s debt capacity. etc. Its holders are residual owners who have unrestricted claim on income and assets and who enjoy all the voting power in the company and thus can control the affairs of the company. The following are the advantages and disadvantages of raising capital by issuing equity shares. flotation costs. The debt capacity of a company depends on it’s equity including reserves. As a result. the firm can conserve the cash when it faces the shortages. Advantages: 1) The equity shares are not repayable to the shareholders. Therefore. unless the company opts to return it through buying its own shares. through public issue. Raising of capital by offering equity shares will reduce the controlling power of promoters.. Arrangements for listing the equity share in the stock exchanges. The important activities to public issue are: 1) 2) 3) Prepare a detailed project report. unlike the debt for which interest is payable. 3 .Equity shares represent the owner’s equity. So it is a permanent capital for the company. The company has no legal obligation to service the equity by paying a certain rate of dividend. non-deductibility of dividend for tax purposes. Preparation of prospectus. convertible debentures. Viz. Another redeeming feature of equity shares is that its holders have pre-emptive right. and filing the same with SEBI. equity shareholders have the power their proportionate interest in the assets. The other two are explained in the later part. So. the companies should offer higher return to attract equity capital. rights issue. Equity share capital is also known as risk capital as the equity shareholders are exposed to greater amounts of risk. or opt for nonvoting shares which are costlier than ordinary equity shares. and warrants. right to purchase additional issues of equity shares before the same is placed in the market for public subscription. because of various reasons like higher risk. for which funds are intended. but will dilute the earnings per shares. Financing Through Capital Markets (Domestic Sources) 2) 3) Disadvantages: 1) Among the alternative sources of capital the equity capital’s cost is high. uncertainty of dividend and capital gains. 2) 3) 4) Companies can raise funds by issuing equity shares in five ways. Public Issue: To approach the public with a public issue to raise capital. Investor’s perceive the equity shares as highly risky due to last claim on assets. The equity shareholders also enjoy getting higher returns. and Securities and exchanges Board of India (SEBI). Addition to equity capital may not raise profits immediately. adversely affecting the value of the company.

The sale can take place in short-term or long-term. raising of capital through rights issue instead of public issue leads to lower flotation. Third. etc. As per SEBI norms a company cannot issue shares to more than 99 persons under private placement. exiting shareholders of a company have a right to subscribe for news equity shares. In India the financial institutions acquired large number of shares by using the loan conversion clause policy. The wealth and controlling power of the shareholder will be reduced if he fails to subscrible to the rights issue. NRI’s employees. This method has the advantages of negligible floatation’s costs (if any) and better price for the shares. Therefore. proportionately. Second. 11.3 Private Placement In this method of raising capital. or other companies. especially when the rights share price is set much below the prevailing price of the share. the controlling power of the shareholders including promoter will not be disturbed the promoters may enhance their controlling power. the money so colleted should be returned to the public within 120 days of the last subscription date. by allotting themselves additional shares to the extent of rights un-utilised by other share holders. First the existing shareholding pattern will remain constant. the rights pricing will not influence the value of the company. In case of over subscription. the response to the rights issue is easy to guage. Even the over subscription will be limited. Often these institutions buy the shares through private placement. proportional allotment has to be made as per SEBI guidelines. and firm allotments. In such cases the promoters prefer public issue to rights issue. and public.2. The loan extended can be converted into equity shares at a pre-determined conversion price at the option of the financial institution. 4 . shares will be issued in bulk to issuing houses through financial intermediaries. commission. brokers. If the public issue is not subscribed to the extent of atleast 90 percent of the equity issue.2 Rights Issues Under section 81 of the Companies Act. those shares can be issued to the public. with an intention to make profit by selling them to the investors in the secondary market through clients. leading to lower costs of returning the excess capital received. when adjusted for the capital collected towards rights shares.2. When rights are offered in proportion to the existing shares of the shareholders. investment companies. If shares are left out even after giving additional allotment to the existing shareholders. 11. Instead of acquiring the rights shares the shareholders can transfer the rights to others or can simply forego them. If the company intends to raise additional equity capital in proportion to their share holding. The right issue offers three main advantages.Financing Decisions 4) 5) 6) 7) Underwriting agreement with merchant bankers. Those shares not subscribed will be allotted to the other shareholders applying for more. While issuing bankers and brokers normally resell the shares acquired through private placement in the short-term. and can reduce the publicity costs. Finalization of quotas to promoters. Bridge loan arrangements to complete the project before equity share capital is raised. these shares are called rights shares. In some profitable companies their share holdings become more than that of the promoters making their controlling power valuable.

the preference shareholders have got the protection that no dividend can be declared on the ordinary shares. 5 . At time. if the preference shares are cumulative type. the investors who seek security and assured returns than in found in equity shares generally subscribe preference shares. 11. the non-voting shares will automatically stand converted into ordinary equity shares with voting rights.5 Preference Share Preference shares are those which carry certain preferential rights as compared to other securities. The features of CCP are: 1) 2) 3) The CCP’s can be issued by any public limited company to raise funds for new projects. Preference shares are also of different kinds like redeemable preference shares. dividends not paid in any year will accumulate and must be paid at a later date. dividend declaration by the company is not obligatory and may not be paid in a year when profits are not enough. Financing Through Capital Markets (Domestic Sources) 11. but rank below creditors.4 Non-Voting Shares The government came out with the proposal of non-voting shares to safeguard the promoters from hostile takeovers. Further. The amount of funds raised can be to the extent of the equity shares to the public for subscription. The preference shareholders have the right to get dividend at a fixed rate prior to any other class of shareholders. Similarly. If a company fails to pay dividend for more than a stipulated period. unless dividend on preference shares is declared and paid. the preference shareholders get repayment of capital before any other class of shareholders get it when the company is liquidated. and as a compensation for loosing the voting rights. The owners of non voting shares do not possess voting right. before paying dividend on ordinarily shares.11. Companies generally issue preference shares in order to maintain the status quo in the control of the equity stock and also to reduce the cost of capital as the preferred stock carries lower rates of dividends as compared to other debt securities like debentures which usually carry higher rates of interest. Cumulative preference shares carry accumulated unpaid dividends year to year till the company is in a position to pay all the dividends including the arrears at a stated rate. expansion and diversification etc. the preference shareholders may have a right to share the surplus profits by way of additional dividend and the right to share in the surplus assets in the event of winding up after all kinds of capital have been repaid. cumulative preference shares and convertible preference shares. preference shares have prior claims over equity shares on earnings and assets in the event of liquidation.2. Redeemable preference shares are those which will be redeemed in course of time as per the terms and conditions as stated in the offer document. But unlike interest on bonds. they will be paid a few percentage points of higher dividend than that was paid to ordinary equity holders. The dividend payable is 10 per cent.2. In other words. the preference shareholders cannot take legal action against the company for not declaring dividends. However.2.6 Cumulative Convertible Preference Shares (CCP) Cumulative Convertible Preference (CCP) shares were introduced by the government in 1985. While the convertible preference shares get converted into equity shares as per the terms and conditions as stated into offer document. In other words. As per the Government proposal the nonvoting share is similar to ordinary equity shares in all respects except in case of voting rights and dividend payment.

the investor can opt for warrants with a right to buy the same number of shares at a specified price in future paying a small amount for the warrants. It is a right to buy a share of a company which issues them at a certain price during a specified period of time. Warrants may be issued in the following circumstances. The difference betwen the total consideration for the cash received represents the cost of corporate financing. and (c) the consideration for the earlier financing supplied to the company. Benefits to the Investor The investors seeking warrants advance funds to a company bearing the risk of expecting return based on future share price of that company. Benefits to the Company By issuing warrants the company will receive funds for its investment needs. This is not a common practice. The funds. Through exchange as a result of reorganisation. Price of Shares Issued Through Warrants The company will receive the consideration for shares issued through warrants in three parts of (a) Cash received on sale of the warrants. Through separate sale. in terms of paying interest. or dividends on their investment unless the warrants are converted into shares. ii) 6 . saved can be used for other investment avenues. 11.7 Warrants Warrants is similar to call options. The following are the benefits to the company and investor. (b) Cash received on exercise of warrants. However dividends become tax free in the hands of shareholders from the fiscal 1998-99 and therefore CCP’s may become popular. thus. when warrants are issued. However. At the same time dividend of 10 percent is also not attractive to the invester. The warrants are usually traded on the stock exchanges offering liquidity. Normally. The Investor can book profits. The possible gains to the investor are : i) Instead of investing in the equity shares of a company at current price.2. When a warrant is exercised. and sale of the warrants. This instrument is yet to become popular. Companies did not prefer it because the dividend on CCP’s is not tax deductible as in case of interest on debt. The price of this privilege is the obligation to deliver the share wherever the warrant holder desires so during the prespecified time period. i) ii) iii) Warrants may be attached to the sale of new equity shares as sweetener. the number of shares of the company increases.Financing Decisions 4) The entire amount of CCP would be convertible into equity shares between three and five years. and principal amount. at the same time resulting in cash flow for the company. The investors do not get any interest. The fair value of shares issued on the exercise of warrants is the most reasonably determinable measure of the total consideration for the shares issued through warrants. if necessary. as issued to promoters of some Indian companies to strengthen their controlling power. the exercise price will be more than the current price of the share.or can en-cash the warrants. it has no obligation to service those funds raised.

the debenture holders cannot interfere with the operation of the company as they do not have voting rights. Debenture are usually redeemable and therefore have maturity period whereas the equity shares are not redeemable. The charge may be fixed charge or floating charge. Of all the various kinds of debentures. there is scope for reducing the cost of capital. convertible debentures. (ii) Fully convertible.11. (iii) Redeemable and irredeemable debentures.8 Debentures Debentures are one of the principal sources of funds to meet long-term financial needs of companies. Though there is no specific definition of debenture. Till conversion. The partly convertible debentures with buy back facility are also issued. i) ii) iii) iv) v) The equity shareholders have proprietary interest in the company whereas the debenture holders are only creditors of the company. The investors may also have the option of retaining the debentures without exercising the conversion option. according to the Companies Act 1956. have become more appealing to the investors. on the assets of the company. wherein one part of the debenture is converted into equity and non convertible part may have the facility of buy back either by the company or its associates. Debenture holders have priority over shareholders in the distribution of assets on liquidation of the company. of late.2.2. The equity shareholders have voting rights whereas debenture holders do not enjoy such a right. There are many advantages of debenture issues for the company. if there is a high likelihood of capital appreciation of the company’s shares in later years. More particularly. usually arising out of loan and mostly secured by charge. For the company. these debentures are treated as debt instruments and enjoy the same priority in claims as those of ordinary debenture holders. The cost of debentures is usually low. bonds and any other securities of a company. since investors would be content with a lower return than that on ordinary debentures. 7 . Bond holders have a prior claim on the receipt of the interest and repayment of the principal over other creditors of the company. which is also mentioned in the agreement. The major differences between shares and debentures are as follows.9 Bonds A bond is a creditorship security whereby a company obtains money from the lenders for a promise to pay the stipulated rate of interest at specified intervals and to repay the principal on maturity. as the interest payments on debentures are tax deductible expenses. Thus. Debenture holders are entitled to interest at a fixed rate whereas the equity Shareholders are entitled to dividends at varying rates. a debenture is widely understood as a document issued by a company as evidence of debt to the holder. The company using debentures usually offers some sort of a security which is called charge. 11. and they get the principal sum on maturity. The convertible debentures can be exchanged for equity shares of the same company on the terms and conditions stipulated at the time of issue of the debentures. the word debenture includes debenture stock. if it defaults on its interest payment or principal repayment when these become due. Financing Through Capital Markets (Domestic Sources) Debenture holders can initiate legal proceedings against a company. partly convertible and non-convetible debentures. Debenture are of various forms like: (i) secured and unsecured debentures.

they need not bother about reinvestment of interest as there is no periodical interest payment. the floating rate bonds provide varying rates of return with a minimum assured return to the investors. Floating Rate Bonds (FRB) have also become popular in recent years. 11. bearer bonds. since there is no periodical payment of interest. For the companies. For example. But most of them used 364-days Treasury bill rate as the bench mark plus certain basis Points. the difference between the acquisition cost and maturity value of the bond is considered as capital gain and therefore. convertible bonds. each SPN will be repaid in four equal annual instalments of Rs. ICICI issued floating rate Bonds adopting 364-days T-bill rate : 180 BP but Anvind Mills launched floating rate Bonds adopting 364 days T Bill rate : 325 BP. public deposits provide a simple avenue for investment in good and 8 . all types of money received by a company except the contribution to capital would fall in the category of deposits. 75 from the end of the fourth year together with an equal amount of Rs. The issuers may also have the benefits of making interest payments according to the current market. which again varied from issue to issue. 80 per share. As far as investors are concerned. as issued by TISCO are as follows: The face value of a SPN was Rs 300 and no interest will become due or accrue during the first three years after allotment.2. etc. 75 with each installment. Thus.2. it attracts lower rate of tax as compared to the tax rates applicable to interest incomes. Further.11 Public Deposits According to the companies Act. 11. perpetual bonds. SPN can serve as long-term securities and given more flexibility to the companies as well as investors. which will consist of a mix of interest and premium on redemption. For the issuer. Later many corporate and development finance institutions came out with floating rate bonds of different maturity periods. sinking funds bonds. There are certain advantages to both the investors and issuers. the company may not have the cash flow problem in the initial years of the projects whereafter the payment to the bondholders can be synchronized with cash flow pattern of the project. Such rights are exercisable between first year and one and a half year after allotment. Therefore. The zero coupon bondholders are not entitled to any interest and they get the principal sum on maturity. Fixed deposits which are also known as public deposits have become attractive for companies as well as investors. zero coupon bonds. The zero coupon bonds are usually sold at a hefty discount and the difference between the face value of the certificate and the acquisition cost is the gain to the investors. For the investors. The first floating rate bond in the Indian capital market was issued by the State Bank of India adopting a reference rate of one-year bank deposit rate plus 300 basic points (BP).10 Secured Premium Notes (SPN) The Tata Iron and Steel company was the first corporate to issue SPN on rights basis. floating rate bonds. The bank also had the call option after 5 years to redeem the bonds earlier than the maturity period of 10 years at certain premium. public deposits are easy form of fund mobilization without mortgaging assets. 1956. The main features of SPN. Zero coupon bonds have become very popular in recent years with the investing public. Further. Thus.Financing Decisions Bonds are of different types like secured and unsecured bonds. each SPN will have a warrant attached to it which will give the holder the right to apply for or seek allotment of one equity share for cash payment of Rs.

The funding should be for new project or for rapid growth of the business. In other words. The objective of the venture capital is to encourage those desiring entrepreneurs by providing long-term capital without the risk of losing control. Financing Through Capital Markets (Domestic Sources) 11.A. The relatively high risk will normally be compensated by the possibility of high return in the form of capital gains in the medium term. It can also be in the form of loan or convertible debt. Even if other investors are willing to chip in despite negligible promoter contributions. In India venture capital market is emerging as a new source of funds. 1975. the U. the promoter cannot retain the control of the business after establishing and stabilizing in a profitable path. 9 ii) iii) . with cash transferring from the fund to the company. the industrial credit is a major revenue earner to the banking sector as other types of credit like agricultural credit are subject to many restrictive conditions and regulations of RBI and therefore. the repayment of deposits and regular payment of interest are subject to a lot of uncertainty. However. The usual sources of capital generally do not suit those promoters who are not in a position to put in enough contribution to satisfy the other investors and lending institutions. Banks extend credit to industries and commercial establishments at varying rates of interest depending upon the credit worthiness of the borrower as well as period of loan. especially feasible projects. 11. by presenting false information some companies manage to collect large deposits from the gullible public and fail to honour commitments on payments. had a well developed venture capital market. the basic objective of a venture capital fund is to earn capital gain. venture capital organization provides value addition in the form of management advice and contribution of overall strategy. as contained in the Companies Act and Companies (Acceptance of Deposits) Rules. However. The following are main features that distinguish the venture capital from other sources of capital market.2. Further. the margins on such credits are very thin.12 Bank Credit Banks including the development finance institutions have become chief source of funds to the corporate sector. in return for minority shareholding in the business or the irrevocable right to acquire it. i) Venture capital is a form of equity capital for relatively new companies. It is long-term investment. The major advantage for the companies in that the bank credit is a flexible source of financing and it is relatively easy to mobilize funds through this source. The transfer of existing shares from other shareholders cannot be considered as venture capital investment. Features: It is defined as (similar to) equity investment in growth oriented small or medium business to enable the investors to accomplish corporate objectives. if the other investors chose to vote them out.S.popular companies at a better rate of interest without many formalities as involved in the case of shares and debentures.13 Venture Capital Governments around the world have been actively encouraging small and medium business. which usually will be higher than interest at the time of exit.2. inspite of many regulatory provisions. The venture capital organization will actively participate with the top management of the firm. the public deposits being unsecured. Venture capital is also called as private equity. By 1980’s. which find it too premature to approach the capital market to raise funds. The proportion of bank credit in the total funds of the companies is very high in many a case. That is.

Thus. skill is a focus area for many venture capital funds. Start-up : This refers to the stage when commercial production is ready to begin. the venture capital firms fund both early and later stage of requirements of investor firms. they come forward to provide money. or even unclear risk perceptions. Expansion and Buy-outs : In this stage the firms try to expand their productive assets and marketing facilities considerably either by procuring assets or by acquiring controlling power of other similar firms through controlling stakes or other options. They require not only money but also management skills. In this stage some indication of the potential market for the new product will be available. some of the ventures yield very high return to more than compensate for heavy losses on others. In addition. 10 . with limited financial resources. Once the venture capitalists identify the firms with good management skill. As the risk perception is high. or too small amounts involved. expansion. but can not raise funds in the capital market. refinancing of existing debt etc. threats from technological obsolescence and preliminary views on preferred exits. If the prototype is satisfactory. The involvement of the venture capital organization at this stage also is relatively less. because very few venture capital funds finance this stage. This stage includes development capital. the stages of financing are (a) early stage and (b) later stage. Later stage Financing : At this stage the investor firms require funds but cannot approach markets. Due to the unwillingness of the promoters to dilute their controlling stake. The risk perception is still high. improving marketing facilities. Normally promoters complete this phase with their own resources. The reasons for venture capital funds at this stage are for purchase of new equipment/plant. At this stage product will be commercialized in association with the venture capital organization. Development Capital : It is for financing of established firms which have overcome the high risk stage with a profit record for a few years. However. buy-outs and turn around.Financing Decisions iv) All the projects financed by the venture capitalists will not be successful. this stage moves towards the development phase leading to product testing and commercialization. The stages of financing and the mode of financing will also be finalized at this stage. Turn Around : This is an important segment of venture capitalists business. This is an ideal source of capital for promotes having very good technical and management skills. the venture capital organization may persue track record of enterpreneurs. balancing between risk and prifitability. In this stage the risk perception is medium and venture capital funds involve actively. Selection for Investment The appraisal procedure for investment is similar to feasibility studies of the development finance institutions for grant of term loans and other financial assistance. Early stage Financing: This stage is essentially an applied research phase where the concepts and ideas of the promoters are discussed and tested leading to a prototype. expansion. Stage of Financing: Generally.

Technocrats and entrepreneurs with feasible project but having limited financial resources can approach venture capital organization. SELF ASSESSMENT QUESTIONS What are the characteristics of capital market? How is it different from money market. Himalaya Publishing House. Vanhorne. 11. Himalaya Publishing House.M. 2003. 4. Investment Management. Capital market can be classified as primary market and secondary market which are complimentary to each other. Each method has got its own distinctive features and depending upon the market conditions and financing strategies the issuers adopt different methods. Mumbai. S. Comment. Financial Management and Policy. 11. Hemalatha and S. Indian Financial system. Divya Nigam.L. 6. R. Vikas Publishing House. Sinha. Explain the relationship between primary market and secondary market? Assess utility of equity shares as source of corporate financing. 2. IFMR. “Preference shares are known as ‘hybrid’ securities”.4 1. They also raise their funds through public deposits and borrowings from banks. The corporates in India mostly raise their funds through capital market by issuing equity shares. M. What is creditorship security? How is it different from ownership security? Examine potentiality bonds as source of corporate financing. Srivastava. Financial Management and Policy. The competition in the market has become so intense necessitating the introduction of several kinds of securities. Vikas Publishing House.N.3 SUMMARY Financing Through Capital Markets (Domestic Sources) Capital market plays a very important role in the mobilization of funds for Investment.5 FURTHER READINGS Jaimes C. Chennai.M. New Delhi. preference shares. The capital market has experienced metamorphic changes over the last few years. Pandey. 2001.Y. RM Srivastava. Mumbai. Financial Mangement. Management of Indian Financing Institutions. Bombay.11. 5. Prentice Hall of India. 3. D. 11 . bonds and secured premium notes. Bombay. debentures. R. I. Khan. Balakrishan.

1 INTRODUCTION In financial circles in recent years. globalisation goes beyond national frontier to create a ‘borderless’ market in which national borders gradually disappear.9 12. uniform ‘global’ market. we hear of tendencies towards common transaction methods and common settlement periods across the globe. Not only has there been a complete integration of these markets in any given country or economy.10 Introduction Deregulation in Financial Markets Developments in the Banking Sector Developments in the Foreign Exchange Markets Special Financial Institutions Indian Scenario Global Sources of Financing Summary Self Assessment Questions Further Readings 12. Not surprisingly. Foreign exchange markets.5 12. While the Phrase ‘internationalisation’ refers to cross border transactions among national markets.UNIT 12 GLOBALISATION OF FINANCIAL SYSTEMS AND SOURCES OF FINANCING Objectives The objectives of this unit are to : explain the concept of globalisation. study the various global sources of financing. This catch word sums up the Phenomenon in which financial transactions increasingly transcend the geographical and time limitations of local financial markets. there has been a virtual transformation of these markets.8 12. such as the World Bank. scan the Indian Scenario of globalisation.4 12.1 12.3 12.7 12. A complete integration of the markets world-wide. and Special financial institutions. the word ‘globalisation’ is often heard. throw light on globalisation of world Financial systems. The banking sector.2 12. The developments in technology whereby information can be had within a matter of seconds from 1 . etc. giving rise to a single. no doubt.6 12. Structure 12. but the ties have been strengthened as to result in a unified financial system on a world-wide scale. The international financial system is characterised by the following types of institutions: a) b) c) d) Financial markets. most commonly with reference to the heightened internationalisation of financial transactions. requires swift communication between countries. Since the early eighties. IMF.

The October 1987 crash is much too recent to be forgotten and a telling evidence of the extent to which markets have been integrated. The financial integration of markets whereby funds can be easily transferred from one place to another has certainly influenced the financing and investment decisions financial managers make on a day-to-day basis. it is said that when America catches a cold.2 DEREGULATION IN FINANCIAL MARKETS Many factors have helped the globalisation process in which no market. Innovative financing techniques are constantly being designed to turn the financing game. The traditional distinction between brokers (who buy and sell on behalf of investors) and jobbers (who make the markets on the floor of the Stock Exchange) has been given a body blow in other financial centres also. relaxation of interest rate ceiling. The OPEC phenomenon of the 1970s and the debt crisis triggered by the developing countries in the 1980s also significantly influenced the volume of international capital flows and the restructuring of the financial system as a whole. removal or reduction of withholding tax on interest earnings of non-residents and changes in regulations governing access of foreigners to domestic markets. howsoever remote.1986. and reduction in barriers to entry into the domestic financial system by both foreign and non-banking institutions. Popularly too. remains isolated and insulated from developments taking place world-wide. which besides permitting institutional membership has also taken up computerization on a mass scale. the share prices move in tandem with each other. The liberalisation. instead of the zero-sum game that was witnessed in the 1980s. for providing finance and financial services compelled banks to look into hitherto uncharted territories.Financing Decisions any part of the globe have made the process of globalisation much easier and profitable. extension of the geographical domain of existing institutions. The innovativeness in finacing techniques and tools have also been accompanied by the growing deregulation of the national financial markets. has been the most memorable one in the far-reaching changes that were introduced in the financing of the London financial market. The deregulation of the London Stock Exchange that took effect from October 27. The increasing competition among banks themselves on the one hand and between banks and non-banks on the other. interest rate deregulation and securitisation since the 1970s have been among the major factors behind the steady progress of financial globalisation. 2 . ecstatically referred to as the ‘Big Bang’. characterised by relaxation of barriers separating the activities of different types of institutions. The abolition or relaxation of exchange controls. Not to be left behind is the Bombay Stock Exchange in India. Financial managers across the world are concerned with identifying profitable opportunities with associated minimum risk. Japan sneezes. In general. There have also been a number of studies on the integration of European markets with the American market. The introduction of the floating exchange rate regime in 1973. and access of residents to international markets has tremendously helped the national markets to forge a global financial market. though initially intended to be limited to the abolition of the fixed commission on broking business and the separation of the functions of brokers and jobbers. Globalisation of Financial Systems and Sources of Financing 12. The permitting of institutional membership into the stock market has meant the injection of new capital into the UK. elimination of quantitative credit ceilings. of American and Japanese markets. now encompasses a wide range of related aspects for facilitating competition and internationalisation of the London Stock Exchange.

The prominence of the Swiss market to its present status has been largely due to its deregulated functioning. A significant portion of the Euro-deposits came to be parked in the Swiss market because of the virtual absence of Governmental control as well as tax-free income from securities. The emerging role of Tokyo as an important financial center has also been because of the easy access it provides to both domestic and overseas investors and financial intermediaries to a growing variety of instruments issued by or for Japanese entities. Foreign banks can now engage in trust business (although on a selected basis) and can join in the government bond underwriting syndicate. Foreign securities houses can lead-manage Euro-yen bonds and can be members of the Tokyo Stock Exchange. Amongst the great variety of debt instruments and financial packages available in Japan are also the multicurrency bonds and the leasing bonds, where-in by providing funds to leasing companies to purchase high-valued items such as aircraft, cross-border financial leasing is facilitated. The need for financial innovation to make large amounts of funds easily accessible has also been felt because of the growing trend towards privatisation of nationalised industries and increase in flexibility of operations leading to mass restructuring and consolidation of business entities. Competitive pressures have led to a growing awakening towards maximising both economies of scale and scope. The mass restructuring and consolidation of business entities have resulted in more frequent breakups and dispositions, leveraged buyouts (LBOs) and management buyouts of units of companies that do not fit into coherent strategic alliances, often with significant equity stakes, have also been entered into as alternatives to full mergers or acquisitions. Resources for financing merger transactions have also been provided with bridge loans, ‘mezzanine financing’ synthetic securities, junk bonds, and other related techniques. While ‘mezzanine financing’ refers to the issue of equity-related bonds, e.g., bonds with warrants, the term synthetic securities refers to a package of securities such as a Eurobond and a currency swap arrangement that converts an original security into a security with different currency or other characteristics. Junk bonds are simply bonds rated below investment grade (BBB) by rating agencies but are popular because of the extremely high yields they promise. The junk bond market flourished initially by financing large volumes of LBO transactions.

12.3

DEVELOPMENTS IN THE BANKING SECTOR

The banking sector too, has gone through revolutionary changes. At least three trends characterise the future of banking the world over: i) The banks’ role as funding intermediaries is diminishing and instead banks are taking on the role of broker and/or underwriter for credit transactions; Banks’ formerly protected turf is being invaded by investment banks, thrifts, insurance companies, and even retail firms. In response, banks are expanding their activities into the domain of investment banks and insurance companies; and finally Banks are expanding geographically as they compete in inter-state and even international markets.

ii)

iii)

However, although the role banks play as funding intermediaries is diminishing, it will not disappear entirely. Banks’ ability to fund loans will continue to be important in, at least, two ways. First, banks will continue to make and hold loans that are not readily securitised. To make loan-backed securities marketable, securitisation requires the standardisation of loan terms and conditions. Similarly, it requires that

3

Financing Decisions investors be

able to evaluate the credit risk of the underlying pool of loans at relatively little cost. Loans that require special knowledge of the expertise in local markets, therefore, are not easily standardised. To compensate lenders for the higher costs associated with making these non-standardised loans, their yields will rise relative to the yields on debt obligations that can be securitised. Consequently, banks will have incentives to continue to make and hold nonsecuritised loans. A second way in which banks will remain important intermediaries is as backup sources of liquidity when borrowers find it difficult and/or costly to raise funds in capital markets. For this reason, even the borrowers that have ready access to commercial paper and other direct securities markets still pay banks substantial fees to maintain lines of credit and loan commitments. Likewise in international capital markets, borrowers have been attracted to the note issuance facilities offered by banks. These facilities ensure access to funds, should the borrowers be unable to sell their notes directly to investors. The volume of newly arranged underwritten facilities reached their peak in 1985 - about 18 per cent of total international financing. In 1986, they accounted for only 8 per cent of total international financing, due to the imposition of capital rations on banks’ off balance-sheet activities (OBSAs) since 1984. Nevertheless, bankers will continue to engage in these activities, as historical experience indicates that losses on such activities have been small. Other fee-generating activities include issuing stand-by letters of credit, commercial letters of credit, loan commitments and indulging in foreignexchange obligations and interest rate swaps. Such business for major palyers run into billions of dollars. Some idea of the globalization of banking can be had from the following table:
Table 12.1: The Growth of Bank Off Balance-Sheet Activities 1981-1987 Activity $ Billions 1980 1986 Compound Annual growth $ Billions 1980-1986 Annual growth from 1986 -1.6% 9.6% 5.4% 110.0% 93.9% -2.2%

Globalisation of Financial Systems and Sources of Financing

Letters of Credit Stand-by Commercial Loan Commitments Foreign-exchange transactions Interest-rate swaps Band Capital

47 20 432 177 186 108

170 28 572 893 367 183

23.9% 5.8 9.8% 31.0% 97.3% 9.2%

168 30 595 1558 602 180

Source: Joseph F. Sinkey, Jr., Commercial Bank Financial Management in the Financial Service Industry, Macmillan Publishing Co., 1989, p.578.

The table clearly shows that foreign exchange transactions and interest rate swaps are now the most important sources of revenues from OBSAs. Profits in foreign-exchange trading come from two main sources: i) ii) trading profits generated by the bank trading for its own accounts; and fees generated by trading in currencies for its customers.

4

Multinational banks are very active in Euro-currency markets wherein they gather deposits and make loans, usually in Eurodollars. Interest-arbitrage transactions are frequently entered into, i.e., borrowing funds in one foreign currency and country and making loans in another currency and country, due to

substantially different interest rates across countries. The objective of these arbitrage transactions is to maximise the interest-rate spreads, given the banks’ risk preferences.

12.4

DEVELOPMENTS IN THE FOREIGNEXCHANGE MARKETS

Foreign-exchange markets exist because of trade between countries with different currencies. That is, exporters prefer not to hold foreign currencies; they want to be paid in their national currency. Foreign exchange transactions have, thus, become an integral, even essential, part of international trade and finance. In the immediate aftermath of World War II, foreign exchange trading was relatively limited, as most major currencies were subject to extensive exchange controls, and the opportunities for the movement of funds across national boundaries were severely limited. The subsequent recovery and growth of the world economy brought a gradual relaxation of these controls and as a result foreign exchange trading became more and more active. The really explosive growth of the exchange markets began, however, with the advent of floating exchange rates following the collapse of the Bretton Woods system in the early 1970s. Since then, not only has world trade continued to expand very rapidly, but international financial transactions have grown exponentially and with them, the foreign exchange markets. Moreover, not only has the volume grown, but the markets have become increasingly volatile, and that, in itself, has drawn in additional players to the market, both, for defensive and aggressive trading. The foreign exchange market is dominated by giant commercial banks. To provide foreign exchange services to customers, these banks take a position (i.e., hold inventories) in the major currencies of the world. Some banks do this by keeping deposits with foreign banks. In addition to providing for customers’ foreign currency needs in either the spot or the forward markets, banks also trade on their own account in the foreign exchange market. The importance of foreign-exchange income to the major US banks is reflected by the fact that it accounts for anywhere from 10 per cent to 60 per cent of the overseas operating income of these banks. This increased internationalisation has, nevertheless, meant increased vulnerability of the players in these markets. Amongst the various risk-reduction methods that have come to be employed, swaps, futures and options are the most conspicuous. These facilities enable banks and corporations to hedge their exposure to financial risks arising from interest rate and exchange rate changes. In the international markets, currency options are more predominant than interest rate options. In currency options, standard period options (3 months, 6 months, etc.) for major currencies against US dollars are being increasingly traded. In the options market, banks may act as agents for other parties or as principals. Financial futures have registered significant expansion in recent years with the expansion of the business of existing futures markets and also with the setting up of futures markets in other centres particularly London, Singapore and Amsterdam. Interest and currency futures not only offer actual hedging facilities but also speculative innovative techniques, which, though useful to transfer risks to counterparties has also called for appropriate management control and monitoring systems. Capital adequacy norms for the banking sector was one such step in the regulatory system. The need for regulation is heightened with fiascoes of massive proportions, such as the failure of BCCI. 5

Financing Decisions

12.5

SPECIAL FINANCIAL INSTITUTIONS

The World Bank’s role as a catalyst in attracting development finance for highpriority programmes in the developing countries through co-financing has increased significantly in recent years. Co-financing has been a feature in about 37 per cent of Bank/IDA operations and the volume of funds mobilised from other sources external to borrowing countries has been equivalent to more than 36 per cent of the total volume of banks group lending. Although historically, the major source of co-financing has been official bilateral and multilateral aid agencies, projects with private co-financing especially in the industrial and power sectors are becoming more and more popular. The Special Drawing Rights (SDRs) mechanism operated by the International Monetary Fund whereby member countries bail each other out in times of foreign exchange crisis has provided a fair measure of stability to the international development agencies such as the export-import banks in various countries providing loans to domestic borrowers for export, import and overseas projects, as well as technical service credits in such projects as the construction of factories, dams, etc., and direct loans to foreign governments, banks and corporations.

Globalisation of Financial Systems and Sources of Financing

12.6

INDIAN SCENARIO

The Indian capital market had been insulated from changes in the international economy till 1991. It was due to high insulation of the Indian capital market that during the Gulf War when global capital markets were declining, the Indian capital market was actually having a bullish run. However, since 1991 Indian capital market has globalised so much so that now changes in any major capital market or economy are reflected in the sensex. The Indian capital market has now become a major investment avenue for foreign investors. Foreign Institutional Investors (FIIS) have invested over US $ 6 billion directly, while Indian companies have raised over US $ 4 billion from the international market through the global depository receipts route. The last one and a half decades witnessed dramatic change in the pattern of financing of corporate sector, with its increasing reliance on capital market. Till 1980, funds raised from the capital market were less than Rs.200 crores and, in fact, less than Rs.100 crores in several preceding years. Industry had to depend largely on financial institutions and its own surplus generation for meeting long-term investment needs and on banks for working capital requirements. Capital market emerged as a major source of funds to industry in 1980s. The equity culture which was lacking in its thrust earlier developed fast during this period. Within a period of 10 years, the amount of capital raised from the market rose 33 times from Rs.195.9 crores in 1980 to Rs.6473.1 crores in 1989-90. The buoyancy in the capital market gained further momentum right from the beginning of 1990s with significant boost in the activities in the new issues market. The amount raised from the capital market was of the order of Rs.22,480 crores in 1993-94 (11.4 per cent of the gross domestic savings) and Rs.25,000 crores in 1994-95, however, in 1996-97 it slowed down. The number of stock exchanges increased from 9 in the beginning of 1980s to 23 now. Around 8000 companies are currently listed on the stock exchanges against only 2265 in 1980. The market capitalisation rose sharply from Rs.50 billion to about Rs.4330 billion during this period. The number of shareholders and investors in mutual funds increased from about 2 million in 1980 to over 40 6

million now. As a result, India ranks second in terms of investor population in the world, next only to the U.S. At the end of 1993, the International Finance Corporation ranked India 22nd in terms of market capitalisation and 24th in terms of total value traded among 40 countries with developed as well as developing markets. India is second only to the United States, at the end of 1993, in terms of the number of listed Domestic Companies with 8000 companies listed on Domestic Stock Exchanges. India has become today an important market in the emerging markets of the world, next only to Malaysia, South Africa, Mexico, Taiwan, Brazil, Korea and Thailand in terms of Market Capitalisation. With the expected new offerings pouring in at the rate of about 10 per cent of the market capitalisation, disinvestment of public sector undertakings taking place at the rate of about 5 per cent of the market capitalisation and prices registering all appreciation of about 20 per cent, market capitalisation of Indian Stock Markets can be estimated to rise by one-third every year which would mean doubling up the market capitalisation every two and a half years. In terms of average company size (market capitalisation/listed domestic companies), India, however, did not figure in top 40 markets. The market has been brought to a focal point by policy reforms initiated by government since 1991. Pricing of equity is free and the Office of the Controller of Capital Issues (CCI) is abolished. Capital market has been opened to foreign institutional investors and Indian companies have been allowed to raise funds from abroad through Euro Issues. Private sector has been permitted to set up mutual funds. Today it is possible to raise capital at lower cost, although there definitely continues to be a time lag between the going to the Securities and Exchange Board of India (SEBI), taking permission with regard to fixation of premia and clearance of prospectus and coming to the market with their issues.

12.7
1. 2. 3. 4. 5.

GLOBAL SOURCES OF FINANCING

Some of the major global sources of financing are; Global Depository Receipts (GDR). Euro Convertible Bonds (ECB). Foreign Direct Investment (FDI). Portfolio Funds (FII). International Financial Institutions like World Bank, IMF, etc.

The Euro Currency Market:
The Euro Currency Market is outside the legal purview of the country in whose currency the finances are raised. The term ‘Euro’ is affixed to an offshore currency transaction. Capital raised in the Euro Currency Market can be classified temporarily as under: Eurocurrency Finance: Short term (upto 365 days) (a) Euroloans from banks (b) Eurocommercial paper (ECP) Medium term (2 to 10 years) (c) Syndicated Loans (d) Revolving Underwriting Facilities (RUFs) Long term (10 Yrs and above) (e) Eurobonds (f) Euroequities

7

Table 12. Eurobonds are long term unsecured debt securities usually fixed rate instruments.7 million through Euro Issues. repay and redraw the funds after giving due notice. $5. since convertible bonds add to the external debt of the country till the time of conversion.152 627 1.94 million. with bullet repayments.43 billion (or 81 per cent) have come in the form of GDRs and the remaining $1.2: Resources Raised Year 1992-93 1993-94 1994-95 1995-96 1996-97 (Apr-Dec) Total 8. . Syndicated (Euro-currency) loans are given by syndicates of banks to borrowers at a variable rate of interest (e.g. The issuance of ECBs was discouraged by the government during 1994-95 and 1995-96.25%). ECB approval as on December 2002 were US $ 2788. Core Strategies for a successful Euro-Issue: Careful selection of a lead manager Company Fundamentals Timings of Issue Careful Pricing Good Marketing Innovative options in terms of financial instruments offered Euro Issues ($ Million): The Finance Ministry permitted Indian Companies to make Euro Issues of GDRs and Euro convertible bonds in the Union Budget speech of 1991-92. The interest charged is a mark up on the London Interbank Offered Rate (LIBOR).493 2. which varies according to the credit worthiness of the borrowing company. Libor + 0. Revolving Underwriting Facility (RUF) involves sale of bearer notes to investors on a revolving basis.189 8 Of the total inflows through Euro issues.27 billion have been in the form of ECBS. The investors under RUF undertake to make certain amount of funds available to the borrower upto a certain date during which the borrower is free to draw down. These are targeted at high net worth individual and institutions and are listed on stock exchanges such as Luxembourg or London to provide liquidity.701 (Amount Rs) 240 2.Financing Decisions Euro-loans are essentially short term accommodations provided by bankers to their clients. Euroequities are company shares which could either be directly offered listing on the foreign stock exchanges or take the form of global depository receipts with shares underlying such receipts. These are typically issued at a discount of their face value which represent the yield to the investors. Indian companies have raised $ 6. Since May’92 when the first Euro Issue was made till December’96. Globalisation of Financial Systems and Sources of Financing Euro-commercial Papers are short term promissory (bearer) eurocurrency notes.

Till the end of 1995-96.63 billion as compared to $2. three companies issued Euro convertible bonds for an aggregate amount of $273 million.4: Size of Indian GDR Issues Range ($ Million) Below 50 50-100 100-150 150-200 Above 250 Total No. fearing the possibility of having to price their issue at a steep discount over the domestic price. the sizes of 22 issues were in this range. been small. $ 102 million were raised in the form of ECBs as compared with $ 896 million raised in 1993-94. 34 were priced at a discount over the domestic price at the time of pricing. 9 . by and large. in the region of $50 million to $ 100 million. Out of the total 62 GDR issues made till October 1996. The Finance Ministry permitted Indian companies to issue Euro convertible bonds during 1996-97. Table 12.5 per cent for funds raised in dollar terms. During 1994-95. No ECB issue was floated during 1995-96.5 per cent to 5. Indian companies raised $0. Till December 1996.GDR Issues: Inflow through the issuance of global depositor receipts (GDR) declined sharply during 1995-96. Of the 62 GDR issues made. This has been in view of the government guidelines issued in October 1994 which banned the issuance of convertible bonds.3: GDRs/ADRs Issues ($ Million) Year Amount 94-95 2082 95-96 683 96-97 1366 97-98 645 98-99 270 99-00 768 00-01 831 01-02 477 Size of Indian GDR Issues: GDR issues of Indian companies have. of Issue 17 22 16 5 2 62 Pricing of Indian GDRs: Indian GDRs have generally been priced at a discount over the prevailing domestic market price. Table 12. Euro Convertible Bonds: Resources raised through Euro convertible bonds have been much lower than those raised through GDRS. During 1994-95. there were 29 GDR issues. This crowding of issues resulted in a clear oversupply of Indian paper in international markets.05 raised during 1994-95. placed convertible bonds with a coupon rate of just 1 per cent. with the result prospective companies either deferred or shelved their plans of making GDR issues. The coupon rates offered on these bonds ranged from 2. During this year. Bharat Forge. two companies issued ECBs designated in Swiss Bangs and one of these.

5: ECB Issues ($ Million) Year 1992-93 1993-94 1994-95 1995-96 1996-97 (Apr-Dec) Total Amount 0 896 102 0 273 1.271 Globalisation of Financial Systems and Sources of Financing Although Indian corporates have raised resources through convertibles bonds at low interest rates.28 568.12 242.41 2607.7) Although.63 1315. mutual funds. If we expect the Indian economy to grow at a rate of 7 per cent per annum. they are now facing redemption pressure.00 1783. Foreign Direct Investment: Foreign direct investment is very necesssary for any developing country as it brings not only badly needed financial resources but new technology as well. we have not been able to cross the actual FDI level of $4 billion mark per annum.37 709. Table 12. since 1991. which is really peanuts in comparison to countries like china which is attracting anywhere between $30 to $50 billion per annum.6: Foreign Investment Inflows (US $ Million) in India Year Direct Investment Portfolio Investment Direct Investment as percentage of total investment 1993-94 94-95 586 3567 14. 1 per cent of the total world foreign direct investment. Although most of the FDI has come in the area of infrastructure but the actual flow is only 25 per cent of the proposed FDI (Table 12.41 2822. institutional Portfolio managers or their power of attorney holders in 10 . Portfolio Funds: Portfolio funds are basically brought in by foreign institutional investors.11 1314 3824 25. It is largely through pension funds.Financing Decisions Table 12.05 98-99 2462 -61 99-00 2155 3026 00-01 01-02 2339 3904 2760 2021 45. investment trust.59 Table 12.79 946. scope is unlimited but somehow.87 65.57 95-96 2144 2748 43.99 97-98 3557 1828 66.49 per cent.7: Foreign Investment (US $ Millions) Approvals 1991 1992 1993 1994 1995 (Jan-April) Total 207.54 41. Almost all the bond issues have a put option which enables the bondholder to convert or redeem the bond before the bond matures.58 1067. then we would need $ 10 billion of FDI annually. However.23 4519.97 Actual Investment as a percentage of approved investment is 24. asset management companies.89 102.82 96-97 2821 3312 45.85 Actuals 141. Since 1991 India has made hectic efforts to attract FDI but the actual flow has been much lower than the desired level.

International Financial Institutions: India has been financing its Public Sector as well as private sector industrial. This may require appropriate changes in certain legislations and the will on the part of the Indian corporate enterprises to take risks and tune their decision making to the investor’s psychology and market preference. Their imaginative use can provide finance in abundance at a lower cost.. India has figured amongst the top ten borrowing nations of the world. etc.securities traded in the primary and secondary capital markets. the foreign exchange markets and the capital markets are becoming more and more integrated with world financial systems. right from the inception of these institutions. debentures/bonds. In the new economic environment which stresses on opening and globalising the Indian economy. add-on products and derivatives. Currently about 400 FIIs are registered with SEBI and about 100 are active players. FIIs investment in Indian capital markets has been hovering around $2 to $3 billion annually over the years (Table-12. To ensure the timely availability of sufficient funds at reasonable cost. In this process the basic building blocks of financial system viz.8 SUMMARY Globalisation has lead to increased degree of trade between various countries and as a consequence of that the domestic financial systems are alligning themselves to international financial systems. The new financing instruments possess great potential to fund the requirements of the Indian industry. One of the major impact of globalisation on Indian companies is that now they can raise low cost funds from abroad by ADRs. 11 . banks moving into insurance and activities of non banking financial companies. now forex rate are market determined with little or no intervention from the government. 12. This would necessitate efforts on the part of the industry as well as necessary relaxations in policy guidelines. Asian Development Bank. Recent years have witnessed a change of roles of the financial institutions i. about over $ 100 billion worth of funds are being made available by various international financial institutions. making Indian industry competitive and enabling it to globalise its operations. ECBs etc. During the last decade the forex market has also witnessed quite a change. Finance is a vital input for accelerating the pace of industrial progress. social and economic projects from the funds available from international financial institutions like World Bank.6).e. Apart from this due to the increased FII’s activities the shares of Indian companies are being quoted at fair value and there is less of information asymetry in the capital markets. Currently. GDRs. IMF. the banking system. The current intensity of the Indian financial market reveals that there is a tremendous scope to deploy new financial instruments connected to equity. it would be important to strengthen the existing sources of finance and simultaneously initiate measures to tap alternate sources and new financial instruments. Indian industry will have to play a major role to keep the economy on a high growth curve. The alternate sources of finance have to be increasingly tapped.

K. 1994.H. 4. Neelamegham S. “Global Corporate Finance . 2. and S. “Competing Globally . Discuss some of the major types of institutions that constitute the international financial system. New Delhi. 3. Oxford. U. What do you mean by globalisation? Comment on the level of globalisation of Indian capital market.Text and Cases” Blackwell.1996. 1995. 2001. New Delhi. Allied Publishers.C. Mumbai. Kim.Challenges and opportunities”. What are euro issues? Discuss some important instruments of euro currency. New Delhi.Financing Decisions 12. Economic Survey.9 SELF ASSESSMENT QUESTIONS 1. “Multinational Financial Management”. Prentice-Hall.. Shapiro A.. 12 .10 FURTHER READINGS Kim S. Himalaya Publishing House.H. Government of India.. What are the major global sources of financing? How far have Indian Corporates tapped these global sources? Globalisation of Financial Systems and Sources of Financing 12. Management of Indian Financial Institutions.

By the turn of the century. Encouraged by the success of ‘Credit Mobilier’.however remained common to all FIs. etc.4 13. This even led to the founding of the International Bank for Reconstruction and Development [IBRD]. This was followed by the establishment of the French Credit Mobilier in 1852. Developing economies.1 HISTORICAL SETTING Financial Institutions (FIs) popularly known as Development Banks have started engaging the attention of the people in the industry as early as in 1822. England started its effort with the setting up of “Carterhouse Industrial Development Company” in 1934 and Industrial and Commercial Finance Corporation and Finance Corporation for Industry in 1945. always looked to their rulers for innovation in forstering development.7 13. the core activity — financing industrial units . Structure 13. Though there is lot of diversity in the structure. objectives and methods of financing across the globe. Germany set up its first development bank in 1949 for the purpose of supplying long term loans to the industry. Italy. discuss the norms on the basis of which finance is extended. being no 1 . As a matter of fact. analyse the trends in financing extended by FIs to different sectors.9 Historical Setting Financing by All FIs Role of Banks in Term Finance Financing Norms Share of FIs in the Company Financing Reforms in the DFIs Sector Summary Self Assessment Questions Further Readings 13. Japan founded the Industrial Bank of Japan. survey the reforms initiated by the government together with the action taken and the future agenda. when the Societe Generale de Belgique was founded in Belguim. Switzerland and Spain have also floated financial institutions of the French kind.UNIT 13 FINANCING THROUGH FIs Objectives The objectives of this unit are to: trace out the historical setting with respect to the role of FIs in financing industrial units.2 13. though there were attempts at founding a congenial agency for financing industrial development. A review of the experiences of the various countries reveals the fact that almost all the countries realised the need for creating a separate machinery for financing industrial development. industries. the real impetus for the development of FIs took place only after the Second World War.3 13. there was great interest generated in this exercise and almost every country followed suit.8 13. The economies in the west shattered by the war followed by the Depression found it a necessity to innovate on the industrial front including the financing of it. which happen to be the colonies of the West.6 13.1 13. Netherlands. countries like Austria.5 13. In 1902. India.

The RCI was intended primarily to provide refinance facilities to commercial banks in respect of their medium term lending to medium sized borrowers in the private sector. acquisitions and debenture trusteeship. 2. The main objective of IDBI was to provide term finance and financial service for the establishment of new projects as well as for expansion. LIC and some leading commercial banks. Responding to the emerging needs of the industry. the SFCs and SIDCs came into existence during 1950s. 18 SFCs. 2. The constitution of IFCI was changed in 1993 from a statutory corporation to a company under the Companies Act. During the same time. diversification. underwriting. Further.The IFCI followed by the setting up of the Industrial Credit and Investment Corporation of India [ICICI] Limited in 1955 as a public limited company. debentures.2 FINANCING BY ALL FIs Overall Position of Sanctions and Disbursements: As indicated earlier. modernisation and technology upgradation of existing industrial projects. It provides a variety of merchant banking services which include project counselling. however.08 crore respectively. The activity of establishing some more specialised agencies for taking care of financial and non-financial needs of the industries is continuing till now.90 and Rs. issue management. As at present. The RCI was merged with the Industrial Development Bank of India (IDBI) in September 1964. the sanctions and disbursements of IFCI during 1949-50 stood at only Rs. 1956 to ensure greater flexibility in the operations and to cope up with the changing financial system of the country. Starting with the operations of IFCI. guarantees. The primary objective of establishing ICICI was to promote industries in the private sector and to meet their foreign currency requirements. the Financial Institutions today have been advancing finance in sizeable amounts. IFCI provides financial assistance by way of both rupee and foreign currency loans. Financing Through FIs 13. took a sharp turn with the establishment of the IDBI in July. Thus. these institutions have developed and introduced a variety of products and diversified into newer areas. the structure of Financial Institutions catering to the needs of Indian Industry comprises of 6 All-India level FIs. 1964 under an Act of Parliament as a principal financial institution to provide credit and other facilities for the development of industry in the country. mergers.Financing Decisions exception to this kind of a tendency. 4 specialised financial institutions. Financial institutions have been instrumental in providing term finance to industry. However. As a premier organisation. 3 investment. in 1955 the Government of India set up an exclusive agency for the development of small industry in the name of National Small Industries Corporation Limited (NSIC). financial restructuring. suppliers credit and equipment leasing. also emulated the experiments of the West and founded its first financial institution . Financing through FIs. The network has spread now to 2 . In retrospect.Industrial Finance Corporation of India [IFCI] in 1948 to cater to the medium and long-term credit needs of industrial units. The IFCI has now been merged with Punjab National Bank. Export Import Bank and many other technical consultancy organisations. This institution was promoted jointly by the RBI. besides NABARD. loan syndication. direct subscription to shares. several state governments have floated a variety of Financial Corporations and Industrial Development Corporations. IDBI was also vested with the responsibility of coordinating the activities of the other financial institutions engaged in the promotion and development of the industry. The next agency that was set up in this network for the provision of industrial finance was the Refinance Corporation for Industry Limited (RCI) in 1958. 28 SIDCs.

6 per cent to the highest of 18. compared to the fund base of IDBI.2 per cent went to private sector. IFCI had only Rs. But the objective of setting up FIs in India was stated to be the financing of private sector enterprisese.1). It sanctioned an amount of Rs. Their participation into the equity was once very limited. development banks established in the underdeveloped countries in the initial years were required to execute government investment projects. these restrictions are not followed now and by following the rules and regulations any industrial enterprise can get sanction from the FIs.2) mainly account for this reason.13 institutions at the national level and 46 at the state level. Altogether a new dimension is added after the establishment of UTI in 1964. This was followed by the IFCI and UTI (See Table 13. The individual record of the FIs during the same period presents diversity of a still higher magnitude. Above all. However. While piloting the bill for the setting up of IFCI. These rates varied from the lowest of 2. 4354065 crore respectively registering an annual growth rate of over 40 per cent by the end of March 2000 (See Table 13. Sector-wise Assistance: To whom assistance should be sanctioned is always a matter of concern. While IDBI had Rs. 1. Forms of Assistance: These FIs are mainly set up to finance long-term operations of the industrial units.9 and 43.2). It is only after the constitution of IDBI in 1964. it could not excel in sanctions for want of limited funds available at its disposal. In case of some of the FIs there is even negative growth in the finance extended by them to the industrial units. The differences that could be noticed in the figures (Table 13. but only to provide finance for the needs of private industry. As a matter of fact. loans and guarantees. Similarly. FIs started providing direct finance in the form of subscription to shares and debentures of industrial concerns. since the very objective of this Trust was to channel household sector savings for investment in risk bearing industrial securities. 84. 69849 crores at its disposal by the end of March 2000. The intention of these institutions in extending underwriting support was not merely to ensure that the financing of the project was fully tied up. 9. All these institutions could sanction and disburse an amount of Rs. highest amounts were sanctioned by IDBI. they sanction assistance in the form of loans at specified rates of interest.687 crores by the end of March 2000. Some FIs concentrated in financing the public sector projects. Though IFCI was the first to be set up.4 per cent to public sector and 6.4 per cent to joint sector. This would be evident from the growth rates of sanctions and disbursements. 22.17.978 crore and disbursed Rs.0 per cent in case of sanctions during 1980-96. This may be in the form of equity. although private sector is the major receipient of their assistance. Of the cumulative sanctions made so far by all the FIs in India. the then Finance Minister was reported to have observed that the IFCI was not intended to meet the financial requirements of nationalised industries. while others were engaged in the task of promoting the private sector. One particular problem with the financial assistance sanctioned by these FIs is that it lacks consistency. 3 . underwriting of new issues of companies has been the continuous activity of FIs since their inception.73.974 crore at its command. 1. To a great extent. Some were even authorised to formulate plans for economic development. 6181747 crore and Rs.3 per cent in case of sanctions and between 4. Institution-wise Assistance: Among the FIs. the size and nature of activities also varied depending upon the peculiar conditions under which FIs were constituted and operated.

the form in which assistance in sanctioned by the FIs is also dependent on the specific provisions incorporated in their legislations. for the IBRD in respect of loans sanctioned by them to industrial concerns. In much the the same way. underwriting and direct subscription to the securities of 4 . and (iii) with the prior approval of the central government. Table 13. the SFCs were authorised to provide financial assistance of the following types to small scale and medium sized industries: i) ii) iii) granting loans or advances or subscribing to debentures of industrial concerns. (ii) deferred payments in connection with the purchase of capital goods manufactured in India. Their significance seems to be more pronounced in case of SIDCs. There are no restrictions as regards nature and type of security that may be accepted from the industrial concerns. shares. and underwriting the stock. For instance. The financial sector liberalisation initiated in early nineties has also led to a structural transformation in the business of FIs. Further. granting loans or advances to or subscribing to debentures of industrial concerns. The Bank has been empowered to finance all types of industrial concerns in whatever form it prefers to.3 provides the details regarding the different forms of assistance sanctioned by diverse FIs by the end of March 2000. loans raised from or credit arrangement made by industrial concerns with any bank or financial institution outside India in foreign currency. As indicated earlier. bonds or debentures by industrial concerns. underwriting the issue of stock. The Corporation was also empowered to subscribe directly to the stock or shares of any industrial concern. and extending guarantee in respect of diferred payments by importes who are able to make such arrangements with foreign manufactures. guaranteeing loans raised by industrial concerns on such terms and conditions as may be mutually agreed upon. It is evident from the table that loans forming part of the direct assistance are occupying the prime place. shares. bonds and debentures. financing pattern. They are now expected to respond to the challenges imposed by the new competitive and deregulated financial environment.Financing Decisions but also to indicate that the project was support-worthy and that investors could take the risk of investing in such securities. Financing Through FIs v) The powers given under section 23 of the Act were widened in 1960 through an amendment to the Act to enable the Corporation to guarantee: (i) loans raised by industrial concerns from scheduled banks or state co-operative banks. acting as agent for the central government and/or with its approval. and the agreements already entered into by the promoter. These restrictions on the form of assistance have started losing their significance after the setting up of IDBI in 1976 with a considerable measure of operational flexibility. The FIs are now diversifying into both project and non-project lending and fee-based services. besides the financial standing of the promoter. under section 23 of the IFC Act. the Corporation was authorised to carry on and transact the following kinds of business: i) ii) iii) iv) guaranteeing loans raised by industrial concerns.

IFCI and ICICI. The loans from the foundation were granted on liberal term such as no interest. long repayment periods. is to be satisfied that the proposed project is necessary in the interests of industrial development of the country. energy conservation and other venture capital schemes. As a matter of fact. products. high debt equity ratios. The fund is intended to provide assistance to those industries which. one-fifth of their money is earmarked for this purpose. Risk Capital Foundation Scheme of IFCI: This scheme was started by IFCI in June 1976 with an initial money of Rs. cement. This was meant to enable the new entrepreneurs to contribute their share of promoter’s equity. control of environmental pollution.. These loans were to be repaid by the promoters out of their own income. may not be able to obtain funds in the normal course. however specific mention may be made of the following: Development Assistance Fund of IDBI: This fund was set up by the IDBI in 1965 with its own resources and from the resources of the central government.industrial units is also a preferred activity of the FIs. juste. Certain Special Schemes of FIs: Yet another glaring feature of the assistance of FIs is that they have launched diverse schemes to cater to the special needs of the industrial units. the same is now operated jointly by IDBI. 1 crore. limited service charge and repayment in 15 years. These state level FIs are expected to make a thorough evaluation of the entrepreneur as to his capability to set up and run the project successfully. for various reasons like heavy investment involved or low anticipated rate of return. processes. 5 . Soft Loan Scheme of IDBI: This scheme is meant to finance traditional industries such as cotton. renovation of their old and obsolete plant and machinery. sugar and some engineering industries towards modernisation. textiles. The scheme is operated through the SFCs and SIDCs. etc. Further. IDBI has introduced this scheme in 1976. Though this scheme was originally introduced by IDBI in November 1976. Assistance from the fund requires prior approval of the central government. Seed Capital Assistance Scheme of IDBI: In order ot encourage new enterpreneurs having technical and other skills. extended the operation of this scheme to include innovative technologies. The IDBI is supposed to maintain separate accounts for this fund and also to submit a report on the operations of the fund to the Central Government. This scheme is intendedto induce and encourage the setting up of small and medium industrial units. Under this scheme. Nearly. This scheme was merged with the Risk Capital and Technology Finance Corporation (RCTFC) from January 1988. the list of such schemes is quite exhaustive. The scheme is named as such because of a number of concessions offered by the FIs to industrial units such as low interest rates. 3 crore as seed money. The government. The RCTFC Ltd. a liberal view is taken in respect of imposing margins and security. This money is granted free of charge. This scheme was similar to the Seed Capital Scheme of IDBI. entrepreneurs are provided with necessary finance upto Rs. less promoters contribution. replacement. The assistance is also extended for the projects which have been appraised by the IDBI or any other all India FI. The objective of this scheme was to meet the seed capital requirements of entrepreneurs who have other abilities but no finance to launch a project. in turn.

The supplier will get around 80-90 per cent of the invoice value much early.D. those having foreign exchange earning potential. sugar and other food products and those engaged in the creation of necessary infrastructure for the development of Indian industry. regarding the grant of assistance to different sectors. This scheme has been liberalised to make it more worthwhile and effective. Though they have opened their doors for industrial units. financial. the above industries certainly had a better preference. chemicals. Thus term lending by commercial banks is of a recent phenomenon. banks realised the potentiality of the corporate sector in their exercises for deposit mobilisation. banks have mainly concentrated on the financing of trade and commerce. 6 . Table 13. but also any one who has a worthy project can approach IDBI for this assistance. Each of them have got around 10 per cent of the total assistance. Under this scheme. 13. the FIs are relatively free to choose the industry of their choice. Perhaps.3 ROLE OF BANKS IN TERM FINANCE Though the nexus between banks and industry is evident from the beginning of the growth of commercial banking during 19th century in India. Industry-wise Assistance: Though there are some restrictions at least in the initial years. The purchaser is provided with a deferment period varying between 5 and 7 years. This was also because of the fact that the Central Banking Enquiry Committee in 1931 and the A. Shroff Committee in 1954 advised against the banks’ entry into the term finance. Similarly.Financing Decisions establish on the basis of appraisal. Further. They felt that they could improve their deposits only with closer contact with the industrial units. they are obliged to look into the priorities indicated in the Five-Year Plans regarding the encouragement to be given to a particular type of industry. banks had the facility now to get ‘refinancing facility’ from IDBI and NABARD for the term loans extended by them. As one can observe from the operations of the FIs. Now that not only technically qualified persons. More so. those based on indigenous technoloy and those that are designed to fulfill the increased demand for mass consumption goods like medicines. textiles. with the growth of various merchant banking activities. It is clear from the table that the industries such as textiles. Compared to over fifty categories of industries considered by them for assistance. the technical. the scheme is no longer restricted to projects in backward regions or priority sectors. economic and feasibilities of the project and continously monitor the progress of the unit at various stages. payment is made by ICICI directly to the supplier of equipment without involving banks. The facility under this scheme is available only to actual users of equipment. Financing Through FIs Suppliers’ Line of Credit Scheme of ICICI: This scheme was introduced by ICICI to help indigenous machinery manufacturers to offer deferred payment facilities to the buyers so as to increase the sales. their financing is based on the British tradition with rule that banks provide only the working capital requirements of the industries. electricity generation and services have got major share of the assistance from FIs. those located in backward areas. there is a general preference towards the funding of projects promoted by new entrepreneurs and technologists. and in different forms. It is for this reason that banks have in recent years started exploring various possibilities and are participating in the ‘Consortia’ for meeting the term needs of the industrial units.4 provides the relevant statistics pertaining to the allocation of FIs assistance to different industrial sectors.

........... when Refinance Corporation was established by Reserve Bank of India (RBI)....... comprising of 8..... it could boost the profits of the lending banks and on the other hand................................. the RBI urged the commercial banks to step up their term-lending particularly in the following areas: a) b) c) d) e) f) g) Deferred export payments.............. However................................ ..................................................... commercial banks also take part in a limited way and subscribe directly to theshares and debentures of the joint stock companies.................... As a result of this the...................7 crores of shares and 4.. enable the borrowing units to enjoy certainty of having funds for a specified period irrespective of any change in the monetary policy......Initially....................... the holdings of banks of these securities (both shares and debentures) constitutes only around 2 per cent of the aggregate investments of banks..0 crore of debentures by the end of 1951. Capital good industries..........3 crores and debentures of 65... Small scale industries involving investment and exceeding Rs......... Industries in the industrially backward areas.....000....................................................... Agricultural sector......................... ................................................................................... In may 1975.......................................................................................................................... Industries having short gestation period particularly in the core sector and especially those producing mass consumption goods..... commercial banks started evincing interest in term-lending but on a very nominal scale..................... Industries where a significant portion of the output is meant for exports.. . 7 ............ comprising of shares of 27................................... 12............. Activity 1 a) Establish the need for founding specialised financial institutions for financing industrial units.. Further........................................... ........................ This has gone upto Rs....................... Quantitatively speaking........... since 1958............ ....... b) Refer to the Memorandum of Association of any FI and list out the objectives for which it is set up............................. c) Explain different Forms of Assistance.......................................4 crore..... the latter was eager to recommend a change in the attitude of commercial banks towards term lending because......................................7 crore by the end of March 1976................................. .........7 crores... 25... 92... Their holdings of these securities may be sometimes out of their underwriting commitments......................... comprehensive data on investments in shares and debentures by Commercial Banks is not available........ Unfortunately.. ............................ .. it was felt that the commercial banks could not afford to lock up large funds in long-term assets because it would affect their liquidity and would make it difficult for them to meet the working capital needs of trade and industry... on the one hand................................. ... Moreover......... the share of term loans in total advances of scheduled commercial banks grew from one-tenth in seventies to about one-fifth now.... A remarkable feature of the banks investment in these securities is that their investment in debentures vis-a-vis shares is increasing over time.............. Available data reveal that the holdings of banks of shares and debentures aggregated to Rs......................................

................ cash flow projections....Financing Decisions d) Collect the Annual Report of any FI and write a note on its operations........ till nationalisation in 1969.... personal guarantees of the Directors and promoters... FIs appraise the projects of the latter from various feasibility points of view including economic.. etc. 4............ 8 ....... rates of return and finally the viability of the project................. 13.. Suitability of plant and equipment Collaboration Agreements Project implementation schedule.....then the FI may conduct other feasibility studies and satisfy itself about the worthiness of the project..... If satisfied...... export promotion............... Under the technical feasibility...... they are more inclined to appraise the projects from the ‘Commercial’ point of view rather than ‘development’ point of view. Project appraisal Security of loans granted Interest rate Repayment schedule Disbursal procedures Conversion option Post sanction monitoring Project Appraisal: While granting financial assistance to industrial units......... Same is true in case of FIs also... commission.... technical... restrictions on the payment of dividends. Perhaps this is for this reason the word ‘Development’ has outlived its existence now........... The economic feasibility may include the verification of the project’s suitability in terms of plan priorities..... mode of financing.. Security of Loans Granted: Security happens to be the basic tenet of lending. which may be of the nature of : priority for repayment. 5.............................. Scale of operation......... commercial banks followed only ‘security-based lending’ instead of ‘need-based lending’... FIs accept many things as security including the assets of the business. Though FIs are often termed as Development Banks......... Security is considered a necessary adjunct to financial appraisal............. 3.......... ........4 FINANCING NORMS There are certain aspects which need to be known to fully appreciate the issues involved in financing through FIs.. Financial feasibility relates to the aspects like cost of the project..................... financial and marketing...... FIs also try to ensure security for their loans by incorporating certain conditions in the loan agreements. maintenance of minimum working capital.. They include the following: 1.......... This is considered all the more important due to non-availability of accurate information to probe into the credit worthiness of the applicant in terms of his character................... Appropriateness of the technology......... 6.......... Financing Through FIs . .. 7.. 2..... use of resources and import substitution.. As many of us are aware................................. capital structure........... the FI may go into the aspects such as: i) ii) iii) iv) v) vi) Location of the project....... This is really a paradox..............

we have an administered interest rate system controlled by the Reserve Bank. However. there existed two prime lending rates.5 per cent. whether FIs should necessarily extend the same benefit to business units in the form of lower interest rates. in majority of the cases.1. the refinance facility extended by IDBI is subject to a specific maturity period. they must add some spread to continue in the business. This has little to do with the rates determined by the market forces. the repayment period is decided taking into account the gestation period. FIs are using their discretion subject to these limitations and the loans advanced by FIs are usually repayable in annual or semi-annual installments spread over a period of 10 to 15 years. nor they should put it high to drive away the business units. The reason being that FIs also undertake various kinds of financial and non-financial services involving financial commitment. However. As such. For example. the FIs used to charge a composite rate taking all its expenses into account. Central Bank whose cost of funds is lower. there are only two rates of interest prescribed on the lending side and on the deposit side. FIs also receive grants from the Government having no interest element. This argument is not accepted by many. When such is the case. Apart from making available the needed finance. After the recent changes. there is only the prescription of a maximum rate. we can say that ‘Disbursal delayed is assistance denied’. whereas SBI could fix it at 12:75 per cent for long term loans. there is lot of gap between sanctions and disbursements. A minimum lending rate prescription for large borrowers was introduced in 1988. No institution can lend at the rates lower than its own cost of capital. This process began in 1990 when the plethora of lending rates for different slabs of borrowing were rationalised into six. The issue that engages the attention of many as for as interest rate policy of FIs is concerned is that whether they should charge market rate or a lower rate. The repayment period is also sometimes governed by the provisions in the respective legislations of the FIs. repayment is an important matter to be decided. There is lot of focus on the interest rate policy of FIs. disbursements are just little over half of the sanctions. In India. under the provisions. viz. life of the project and cash flow generation. Repayment Schedule: In case of the financing through FIs. IFCI is permitted to extend loans having a maximum of repayment period of 25 years. As applicable from October 1997. Then. The RBI used to announce the changes in the interest rates (both for deposits and loans) from time to time keeping in view of the money supply and demand for credit. IFCI and ICICI is pegged at 13. There 9 . As it is said in law that ‘Justice delayed is law justice denied’. As far as FIs are concerned prime lending rate is decided and FIs can lend at varying rates subject to this. Similarly. Sometimes. Consequent upon the recent policy changes (October 1997). since the FIs may secure funds from Government. the prime lending rate of IDBI. This is done as a matter of policy to maintain monetary stability in the economy.Interest Rates: What should be the rate of interest charged to industrial units on the finance extended by FIs is a matter of great concern. some relaxation is provided in this regime now. For. Sometimes. they should look into equity and their own cost of funds. Usually. one for the long-term loans and the other for the short-term and medium-term lending. Disbursal Procedures: As can be seen from the data contained in Table 13. FIs should not charge too low a rate to make loans to be a gift.

the FIs are forbidden to acquire more than 40 per cent of the total share capital of a company through loan conversions. the institutions are expected to exercise the option only after two or three years of the implementation of the project. the coverage has been increased to 675 companies with almost the same percentage in 10 . Post-sanction Monitoring: In view of the large stakes involved in the assistance sanctioned to different industrial units. This clause came into the picture in the industrial financing on the recommendations of the A. It is also important for the company to ensure that the assisted units recruit qualified and experienced technical and managerial personnel. Realising this. To start with convertibility clause was not introduced into the agreements if the amount of loan is below Rs. submitting the relevant information and other necessary documents. Thereafter. if the assistance is more than Rs. etc. but also to ensure effective utilisation of the funds and timely completion of the projects. The reasoning was that through convention. The FIs may take appropriate measures to cut short these delays. FIs may hold discussions. convertibility clause is introduced in the case of loans exceeding Rs. As a matter of fact. This is a sample study of its assisted units (417) covering about 55 per cent of the paid-up capital of the non-government public limited companies at work in India by March 1981. 25 lakh. In this regard. the FIs have related this to the magnitude of assistance. In addition. In which case.Financing enormous is Decisions delay in the disbursal of assistance. ICICI and IDBI have adopted a rigorous followup procedure and have made a practice of carrying out regular inspection of the projects financed by them. It may be introduced at the discretion of the institution. profitability. there is a need to monitor the working of the assisted units closely. sales. cost structure. not only to ensure safety of the funds invested. the FIs can acquire upto 51 per cent of the total share capital. stock brokers and fellow FIs. Shroff Committee. if the assistance is between Rs. FIs would be able to participate in the management and control of industrial concerns and also in the profits made by them. conversion option is not now applicable in case of loans sanctioned for the purpose of modernisation and rehabilitation.1 crore. but the actual exercise of the option by FIs is also significant. Depending on the necessity. and the clause is compulsorily introduced. The government has relaxed these norms in June 1980. borrowers also should help the FIs in completing their responsibilities in terms of providing their contribution to the project. Later. ICICI is publishing a report entitled ‘Financial Performance of Companies: ICICI Portfolio” almost from the year 1971-72. FIs have to call for periodical reports about the operations of the projects in terms of production. cash flows. FIs have started invoking this clause almost from 1970 in their loan agreements. The objective of this provision was to check the use of public money for private gain and to curb concentration of economic power. there was lot of opposition from the industrial units regarding the convertibility clause. Not only the stipulation. On the other hand. whereby the lender will have an option to convert his loan into equity at his discretion. FIs like IFCI. Further. 50 lakh. excepting in the cases of persistent default by the company. consultations and conferences with the others interested in the project like bankers. this is caused due to cumbersome loan procedures adopted by the FIs. Because of the above. Perhaps. 25 to 50 lakh. In this regard. Usually. Financing Through FIs Conversion Option: Convertability option refers to a provision in the loan agreement.D.

..................................... Instead of using their own discretion........................ in the subsequent years............ there is also the practice of nominating directors to the Boards of the assisted units............... It is felt that the role of the nominee directors should be an unmixed blessing rather than suspicious hindrance............. there is the practice of appointing nominee directors by the FIs...... The data of RBI covers a sample of 1720 nongovernment....... It should be constructive rather than destructive...................... ..... The relevant data is presented in Table 13................ Activity 2 a) Note down the salient features of Seed Capital Assistance Scheme of IDBI................................... ICICI has also initiated exclusive studies on the topics like export performance and capacity utilisation. .............................. Nominee directors are largely criticised for their inaction and overaction.......................................................... It is no matter of exxaggeration that these institutions have now assumed a position that without their support..................................................... non-financial public limited companies... For this purpose............................................. ................................... ... In addition.................5 SHARE OF FIS IN THE COMPANY FINANCING The foregoing analysis on the financing by FIs in terms of sanctions and disbursements clearly reveals the fact that FIs played a useful role in supporting the rapid industrialisation of the country................ It is evident from the table that FIs could provide about one-fifth of the total external sources and around one-sixth in terms of the total sources in 1991-92............... they are guided by the dictates of the employer............................ 13................................... Similar to this exercise......... there is lot of criticism on the role and function of these nominee directors.................................................. we have compiled data from the finances of Public Limited Companies published by RBI.......................... .... However..... IDBI has also started compiling and publishing data on the performance of its assisted units............................. c) Elucidate the project appraisal procedure of any FI... Further.......... .................. This is naturally denounced.paid-up capital.............6 per cent of such companies in terms of paid-up capital....................................................................... . Nevertheless........................................... The discussion on the Financing through FIs cannot be considered complete......................... accounting for 32........................ unless we also account for the share of FIs in the total company financing............... Where the assistence is large or where the project is complex...................... .............. 11 ............................. b) Comment on the Role of Banks in Term Finance................................... hardly any large project in the corporate sector can materialise.................... .................................................................. the relative contribution of FI’s has significantly declined mainly due to entry of commercial banks in term financing business and growing financial disintermeditation resulting in greater reliance of the corporates on stock market.........5.

........................................................................ . ...... .............. .............................................................................................................. As such............... a system of syndication or participation in lending at the instance of lenders and borrowers should be introduced........................ 3................................................. .................................................... f) Role of External sources in Company Financing... In view of increasing competition in the financial sector.................................................. the consortium lending should be disposed with............................................. 12 ....................... They are also required to ensure operational flexibility and adequate internal autonomy in the matters of loan sanctioning and internal administration. .......................................................................... In its place................ Narasimham to suggest reforms in the financial sector.................................. ....... 1.............................................................................. 2.............................................................. The sweep of the reform process extends logically to the FIs sector also....................................... g) Conversion option...... pressure on the availability of concessional finance and progressive deregulation of interest rates.6 REFORMS IN THE DFIS SECTOR Consequent upon the poor performance of the economy.............................. 13........................ As a measure of enhancing competition and ensuring a level playing field......................................... It is necessary to distance state level institutions from their respective state Governments to ensure that they function on business principles.............. 6............................................................ ...... 4..... In an attempt to making a systematic effort in the direction of reforms............................. The present system of consortium lending is operating like a cartel..................... 5..................................................... Financing Through FIs .......... Government constituted a committee in 1991 under the chairmanship of M........................................... ....... DFIs are required to become more and more competitive.... Recommendations of Narasimham Committee Relating to DFIs: The following are some of the important recommendations of the Narasimham Committee in respect of Development Financial Institutions.............. efficient and profitable.... The present system of cross holding of equity and cross representation on the boards of DFIs should be done away with......................................................Financing Decisions a d) Write note on the Interest Rates in India.......................... Government has embarked upon initiating reforms from the beginning of nineties of the last century..................................... DFIs should seek to obtain their resources from the market on competitive terms and their privileged access to concessional finance through SLR and other arrangements should gradually be phased out over a period of three years.................................... ............................................................................................ . the IDBI should retain only its apex and refinancing role and that its direct lending function be transferred to a separate institution which could be incorporated as a company.......... e) Examine the link between sanctions and disbursements...........

FIs are also required to maintain stipulated standards in respect of capital adequacy. 1996. IRBI and SCICI) raised an amount of Rs. In respect of corporate take overs. so that the contaminated portion of their portfolio is taken off the books. DFIs should also be covered by the operations of the Asset Reconstruction Fund (ARF).. there is lot of ground yet to be covered by the government towards implementing the recommendations of Narasimham Committee to ensure competition. Action taken by the Government: Based on the recommendations of the Committee. IFCI. DFIs should lend support to existing management who have a record of conducting the affairs of the company in a manner beneficial to all concerned including the shareholders. unless in their opinion the prospective new management is likely to promote the interest of the company better. distancing DFIs from their sponsors are all to be implemented. 4. ICICI.f. As per these regulations. Further. 9. April 1995. 13 . During the last two years alone viz.e. The Board for Financial Supervision (BFS) started supervising the DFIs w. 2. And those FIs having dealings with agencies abroad were required to achieve a norm of 8 per cent by March 31. 1994. IFCI. ICICI. 1997 and similarly the IRBI was converted into a company and was renamed as Industrial Investment Bank of India (IIBI) Ltd. operational flexibility and superior performance. 10. SIDBS. on April 15. IDBI. hitherto applied to the commercial banks. free of any extraneous pressures. 8. asset classification and provisioning requirements. 1995-96 and 1996-97.7. The operations of the DFIs in respect of loan sanctions should be the sole responsibility of the institutions themselves based on a professional appraisal of the technical and economic aspects of the project. The prudential and capital adequacy norms. 5. the six All India Financial Institutions (Companies of IDBI. SCICI Ltd. There is reorganisation in some of the FIs intending to face emerging challenges in the liberalized environment. while the rest were required to attain 8 per cent norm by March 31. are now made applicable to the FIs also. In doing so. income recognition. and evaluation of the promoter’s competence and integrity and the financing and other aspects of the proposal. was merged with ICICI Ltd. consortium lending.579 crore from the capital market. The recommendations of the committee regarding the creation of asset reconstruction fund. the Government has taken the following measures: 1. Additional amounts have been sanctioned towards capitals of Certain DFIs. it is also necessary to permit DFIs to enter the area of working capital finance. the FIs are expected to exercise their individual professional judgement. ensuring a level playing field. 19. The Unfinished Agenda: As it appears. There should be no room for behest lending of any kind. they also insist on the borrowers the same market discipline. While the entry of commercial banks into the provision of term finance is the first of necessary steps. 3. IRBI and Exim Bank were advised to achieve a capital adequacy norm of 4 per cent by March 31.. 1995. they were permitted to approach capital market. It is logical to assume that when the FIs raise such large amounts of funds from the market.

.......... But essentially..... The implementation of the recommendations of Narasimham Committee would go a long way in this regard............. Nevertheless.......................... Activity 3 a) Mention important Recommendations of Narasimham committee............... its importance has diminished remarkably in recent years.......................................... piecemeal and at times even hesitant... form and industry...... calling for a still greater attention by the Government...... The increasing presence of commercial banks in this area has further radicalised the scene of industrial finance..... The approach is suggestive of incrementalism rather than a sequencing of reform as part of an integrated programme........ b) What is the unfinished Agenda...................... Financing Through FIs 13................D.. Aspects pertaining to the lending norms such as project appraisal..................... the agenda is still unfinished..................... disbursal procedures.... the authorities have taken several steps on different aspects of the recommendations............... interest rate.... However.. It was noted that the FIs in India tailored its process of industrial finance to the needs of the corporate sector.....Financing Decisions In a lecture arranged by the A...” Even after a lapse of 5 years.................................. Shroff Memorial Trust...... FIs are criticised by industrial units mainly because of these norms and the cumbersome procedures they are following in disbursing the loan applications............... Financing by FIs has also assumed significance in the total financing position of companies.... The discussion in this unit began with tracing out the historical setting leading to the founding of various FIs in the country............... Bombay.............. With the entry of commercial banks into the term finance area... ........... Narasimham remarked as follows (after two years of the submission of committee’s report on ‘Financial Sector Reforms’): “Since the submission of the report...................................... .................................................. In view of increasing competition in the financial sector..... institution..... conversion option and post sanction monitoring are also discussed in this unit............................................................................. It is pertinent to suggest that the committee’s various recommendations should be compared with a Jig-saw puzzle where the picture becomes complete only when all the pieces are in place and until such time a piecemeal approach to the problem would not help us to obtain the full benefits of the exercise... This was followed by the assessment of overall position of sanctions and disbursements by the FIs as also according to sector.... profitable and operationally flexible........... there is lot ground yet to be covered by our FIs. security................. the latter ceased to be the prerogative of term-lending institutions................. repayment schedule....................... .................... efficient..........7 SUMMARY Attempt has been made in this unit to highlight the significance of financing extended to industrial units by Financial institutions.......... .. ........ Nearly one-fifth of the external resource requirements are being met now by the FIs....................................... 14 .. the approach has been somewhat ad hoc.... FIs are required to become more and more competitive.. ......... pressure on the availability of concessional finance and progressive deregulation of interest rates................. As a matter of fact..... The discussion underlined for financing its industrial development programmes...

1: Assistance Sanctioned and Disbursed by All FIs (Rs.93 1993 .6 684804.65 1970 .0 2468. Source : Report on Development Banking in India. 15 .0 14.2 Growth rate % — — — — 11.3 15.9 9576.3 7713.6 23. should there be restrictions on the form and type of assistance sanctioned by FIs in the country? Briefly discuss the soft loan scheme of IDBI.3 23.0 9640.2 25.3 17.92 1992 .82 1982 . 3. Can you suggest any modifications to the existing procedure? What is post sanction monitoring? How is monitoring exercised by FIs in India? Bring out the role of nominee-directors in the industrial units.0 17. Table 13.2000 Cumulative upto endMarch 2000 Sanctions 118.0 32.75 1975 .1 Growth rate % — — — — 27.4 2934.5 13.81 1981 .13. What are the recent trends in the financing of industrial units? Are they going in healthy direction? Briefly highlight the procedures and norms followed by the FIs in extending credit.87 1987 .7 63. Should we continue this practice? “Convertibility clause is a drag on the Financing facility provided by Indian Financial Institutions”.7 38442. IDBI.96 1999 .91 1991 . 7.3 33528. 2.89 1989 .0 3281.6 6181747.5 1296.84 1984 .8 2. 6. in crore) Year 1964 .1 15.7 9. Highlight the important recommendations of Narasimham Committee relating to DFI sector.9 43.0 4937.1 19254.85 1985 . 9.1 5578.0 41010.94 1994 .4 1847.7 4623.7 33282.4 24.7 7102.88 1988 .9 14.9 26. 5.8 59663.4 12810.9 4195.5 25.83 1983 .3 4.1 1916. Comment.5 — Disbursements 90.7 18.9 2352. 1999-2000 Mumbai.86 1986 .4 16.5 15.7 6548.7 26629.0 11386.3 36. 4.2 45.90 1990 .2 8138.9 7061.2 4354065.0 3366.9 26.7 5708.6 14429.6 24. Are you satisfied with the way government is implementing them? In the present day scenario.4 3618.6 33.5 — 8.7 22443.1 67618.7 33.9 23258. Bring out the significance of term lending organisations in the financing of industries.0 1043407.4 3138.95 1995 .8 SELF ASSESSMENT QUESTIONS 1.1 16259.6 48.9 27.80 1980 .

3 476699. Source: Report on Development Banking in India.1) 616149.2 297323.4) 23309.0) 58746 (18.9 265950.6 17116.3 399505.4 860787.3 4080.1 (10.8 (71. Source: Report on Development Banking in India.3 1546.1 4969637.8 323282.0) State-Level 5046498 (95.9 1914572.6 Financing Through FIs Institution All-India Development Banks IDBI IFCI ICICI SIDBI IIBI Sub-Total Specialised Financial Institutions IVCF ICICI Venture TFCI Sub-Total Investment Institutions LIC UTI GIC Sub-Total State-level Institutions SFCs SIDCs Sub-Total Grant-Total 1474.1 109361.1 623900.9 4354065.2 Cumulative Disbursements upto March 2000 1348938.2 86695.6 1063606. in crore) Form of Assistance Rupee Loans All-India Dev. 16 .3 (61.2: Decisions Institution-Wise Assistance Sanctioned and Disbursed by All FIs (Rs.1 531222.3 (4.1) 3263.5) 531222.1 (0.2 6181747.4) 506914.5 (38.8 (100.1 * Including assistance to small scale sector upto end-March 1990.1 207940. Table 13.3 11561.2 (100.9) Foreignency Loans Underwriting and direct subscription Total * Figures in the brackets indicate percentages to total assistance.6 554084.1 72525.9 100898. 1999-2000 Mumbai.7 167998.6) 1063506.0 1141987.2 19435.2 (6.Financing Table 13.2 (12.4 25692.3) 4969637. in crore) Cumulative sanctions upto March 2000 1988112.2 330345.9 430141.3 (100.2 433948.0) Investment Institutions 307723. IDBI.6 4710. Mumbai.4) 14339 (4. IDBI. Banks 3531949.1 390042.3: Form-Wise Assistance (Cumulative) Sanctioned by FIs By the end of March 2000 (Rs.0) 755883.2) Guarantees 314384. 1999-2000.

0 1991-92 1993-94 1994-95 1998-99 1999-00 2000-01 Source: RBI Bulletins..N. 2002 11.3 13. Basu. Sai Publications.9 715894. Vinod Batra.M. Mumbai. Institute for Financial Management and Research. Printwell Publishers..8 2. S. Reserve Bank of India. Rao.2 299285.K. Management of Indian Financial Institutions.7 944851. IDBI. Simha.6 4. Report of the Narasimham Committee on The Financial System.4 1.6 279291. December 1997.V. Madras. RBI. 1996. 1997 and September. Himalaya Publishing House. Bombay.0 196127. 1987. Srivastava. Printwell. S. Report on Development Banking in India. 1970. Vikas Publications. Prasad.1 524411.V. Corporation Finance in India. Delhi. Development Banking in India. Jaipur. B.4: Industry-wise Cumulative Assistance Sanctioned by All Financial Institutions by March end 2000 Industry Textiles Chemicals Chemical Products Fertilizers Refineries or Oil Exploration Basic Metals Electrical & Electronic Equipment Infrastructure Services Total (Including Others) Rs.6 2. R. Guntur. Theory and Practice of development Banking: A Study in the Asian Context. Crore) 3594 3689 1584 4115 4322 4642 As % of External Services 19.4 5938759. G. 1991.. January and October. Report on Currency and Finance.8 18. 1995-96. 2001. 1991.8 Table 13. 17 . and Venkataramaiah. 1965.Table 13.8 3. K.5: Share of 71s (Excluding Banks and Foreign 71s) in the company financing Year Net Borrowings from 71s (Rs. 1997. 1976. Asia Publishing House.1 676552.L.7 As % of Total Services 14. Development Banking in India. Institutional Financing of Economic Development in India. Mumbai. Mumbai. Report on Trend and Progress of Banking in India..9 FURTHER READINGS Sethuraman T. 1986. 1996-97.. in Crore 541631.6 2.1 1.1 1. Mumbai. Jaipur. Bank Finance to Industries.

In this unit.2. when we also say finance mix is irrelevant in valuation of firm (Modigliani and Miller Theory). Also. It was noted earlier that firms typically raise money in the form of equity or debt.1 14.4 14.UNIT 14 OTHER MODES OF FINANCING Objectives The objectives of this unit are to: provide an understanding of non-traditional sources of long-term financing.2.1 14.to acquire fixed assets and to run the operations of the units. Before we discuss these sources. who want to take risk while investing money.2. debt scores over fresh equity issue since banks and financial institutions are easily approachable than approaching 1 . Business units require funds for two reasons . In fact. firms also raise money through preference capital and convertible debt instruments. You would by now know why financial managers spend lot of time on this issue particularly. Several factors influence the need for funds and typically a growing firm needs more funds year after year.3 14. firms retain substantial part of the profit to meet their requirement. Equity is risk capital and brought by owners. While retained earning provide convenience (easy to tap). we discussed how a firm can raise money from capital market and institutions.5 14. Structure 14. firms take additional debt from institutions and other sources regularly.6 Non Traditional Services of Short-term Financing Summary Self-Assessment Questions Further Readings 14. debt is found to be important source of capital next to retained earnings. let us quickly review the financing options available before a firm and what is the need for additional non-conventional sources of finance.2 Introduction Non Traditional of Sources Long-term Financing 14. Debt holders are less interested on the future prospects of the company but they are interested to know whether the company would be liquid enough to pay interest and principal on the due date.4 Leasing and Hire-Purchase Suppliers’ Credit Asset Securitization Venture Capital 14. focus on non-traditional sources of short-term financing. Fixing a broad mix and then choosing different sources of capital is an important job of financial managers.2 14.1 INTRODUCTION Raising funds is an important activity of finance managers. In between the equity and debt.3 14.2. Debt holders are typically risk-averse investors. we will look into other alternative sources of funds. While equity capital is raised not so frequently. In the previous units. and hence want safety but willing to provide funds at a lower rate of return. In terms of convenience also. debt is often believed cost effective particularly for tax reasons.

operational lease and financial lease. Typically. small movable equipment. While operational lease is not considered a source of finance. Some of the assets that are normally acquired under operational lease arrangement are computers. A hire-purchase transaction 2 . During the period of lease. financial lease is used when the assets are required permanently or for a long period. Suppose a firm gets an extra order for which it requires some additional equipment. vehicles. etc. say three weeks and at the end of the three weeks. if a firm wants to buy a patent or brand. Hire-purchase is similar to financial lease. the lessee has to pay lease rent to the lessor. a particular source of funds is tapped. the finance managers tap non-conventional source of funds. which in turn contributes to the sales of the firm for a long-term. Instead of borrowing and acquiring assets. Such additional equipment can be taken on lease for few days. Normally. Often.Financing Decisions capital market for equity issue. such source of finance is not available for many investments. During the period of lease. the investment needs may not be large enough for the financial managers to approach banks or financial institutions.1 Leasing and Hire-Purchase Firms need finance to acquire assets. it is possible for firms to acquire the assets on lease. There are two types of leasing .2. which have long-term impact on the earnings of the company. They look for alternative source of finance under these circumstances. Finance managers choose a particular source of capital after considering the following issues: a) b) c) d) e) Whether the duration for funds required and funds available match? What is the size of funds requirement? What is the risk involved in the investments for which funds are demanded? Whether the funds are required urgently? What is the current and future financial markets scenario? Finance managers look for constantly alternative sources of funding and depending on the demand and nature of funds. the firm which acquired the assets on lease (called lessee) can use the assets but it is not the owner of the asset. Lessee is not entitled for any depreciation whereas lessor can claim depreciation for the assets for tax purpose. generators. it requires long-term funds for such acquisition. 14. For instance.2 NON-TRADITIONAL SOURCES OF LONGTERM FINANCING Long-term finance is raised when the need for funds is for more than one year. we will discuss four such sources of alternative long-term finance available for the firms. long-term finance is required for acquisition of fixed assets having a life more than one year or investments. the equipment is returned to the owner. In the following sections. Equity issue involves considerable amount of legal and other formalities and also there is no assurance that investors will be interested in putting their money in the company. 14. Some time. While equity and debt are conventional source of finance. Operational lease is used when the assets are used for temporary period and the asset is returned at the end of the short period. We will discuss some of the non-conventional source of funds in this unit. the assets are ultimately purchased by the firm from the lessor at a nominal value. They are (a) Leasing and Hire-purchase (b) Suppliers’ Credit (c) Asset Securitization and (d) Venture capital. The ownership rests with the company which provided the assets on lease.

Illustration: Suppose a firm requires an asset worth of Rs. a firm wants to buy 10 lorries. leasing companies will take longer time to process such lease application since the risk involved in funding such assets is fairly high. Present value of annuity of Rs. If the need of firm is much lower. c) Cost: It is difficult to say whether lease cost will be lower than borrowing cost but it is possible in certain cases due to tax impact. which qualifies for income tax deduction but there is no depreciation benefit. Hence. Since each installment consists of interest as well as principal. Since the ownership of the asset rests with the lessor. In other words. 2174. On the other hand. b) Size of Loan: Many banks and financial institutions fix certain minimum loan amount. The net outflow will be thus much lower. Other Modes of Financing 3 .000. In other words.00. at the end of the fixed term of hire. Leasing company funds assets of any value. the leasing companies are willing to take additional risk while processing the lease application. you can wind up Rs. the lessor will pass on the impact of the tax shield to the lessee by fixing lower lease rent. it pays interest and also claims depreciation. financial leases with an option to buy the asset at the end of the lease term can be called a hire-purchase transaction.is usually defined as one where the hirer (user) has. While interest is eligible for tax deduction.20 at an interest rate of 0. Suppose. The following example explains the issue further. If the assets leased are special type assets.00. When a firm borrows money and then acquires the assets. a consortium of leasing companies funds such acquisition. Typically. it pays lease rent. 1. it is possible to fix a lease rental such that it is equal to borrowing to both lessor (borrower) and lessee (lender). whose re-sale value is low. depreciation benefit is claimed by the lessor and in all probability. the amount paid towards principal will not qualify for income tax deduction. it can be done with in two or three days through lease transaction. when a firm acquires an asset on lease. the interest and principal paid over the five years are to be separated. an option to buy the asset at a token value. It means by paying Rs. firms use lease for acquiring certain type of assets. 1.83% per month for 60 months is equal to Rs. The bank requires the firm to repay the loan with interest in 60 equated monthly installment (EMI) at the rate of Rs. The level of legal documentation is also fairly simple. Acquisition of computers and other such electronics items like Air-conditioning can be done within a day. 1 lakh loan you have taken today with an interest rate of 10%. it doesn’t make sense to borrow more and keep the cash idle. 2124.70. There are several reasons given below: a) Easy Procedure: Acquiring an asset through a lease transaction is much simpler than borrowing money from a bank or financial institution for acquiring the same asset. In other words. 2174. However. Both interest and depreciation can be claimed as deduction under income tax. If the requirement of funds is large. in borrowing the end use of the funds will not differentiate the loan application processing. you can acquire the asset in a very short period of time through lease transaction.000 and it can raise the funds at 10% for five years from a bank. Leasing companies have developed fairly simple procedure to process lease application.20 every month for the next 60 months. So the basic question is why firms acquire assets on financial lease and why someone wants to buy an asset and then lease the same to another firm.

695 4850. 48985.0 Lease Rent Net of Tax 58975.99 21876. 32768.82 12020. the after tax cost of the asset is as follows: Year 1 2 3 4 5 Interest 9269.0 Present value of Lease Rent 33486.64 23570. However.78 9521. if the lessee firm is not tax paying entity.66 The present value of cost net of tax shield at a discount rate of 10% is equal to Rs.39 99999.40 25496.09 In other words.40 25496.782 1329.49 18493.96 3399.38 8249.00 If the life of the asset is also 5 years and the asset qualifies a depreciation rate of 25%.672 6472.2 31756. 1.65 Total 25496.40 127482.77 1083. Further.782 1329.76 17925. 7561 per month for five years and at the end is willing to transfer the asset to you at a nominal cost of Re.2 31756.62 24167.644 7570.01 Tax Shield @ 35% 10244.27 345. the present value of lease rent net of tax is as follows: Year 1 2 3 4 5 Total Lease Rent 90732 90732 90732 90732 90732 453660 Tax Shield 31756.414 3619.491 5693.8 58975. Suppose a leasing company is willing to provide the asset on lease at a lease rental of Rs.8 294879.8 58975.91 19802.91 10669.16 48985.355 Cost net of Tax Shield 19025.8 58975.40 25496.644 7570. the depreciation schedule is as follows: Year 1 2 3 4 5 Opening Balance Depreciation Closing Balance 100000 80000 64000 51200 40960 20000 16000 12800 10240 8192 80000 64000 51200 40960 32768 Let us assume that the asset is sold at the end of 5 years at Rs.8 58975.015 Depreciation 20000 16000 12800 10240 8192 Total 29269.Financing Decisions The values of interest and principal are as follows: Year 1 2 3 4 5 Total Interest 9269. then there is no actual tax benefit from 4 . both lease and borrowing leads to same effect.40 25496.491 5693.35 Principal 16226. the actual lease rent may be higher or lower depending on the cost of funds to the lessor and tax shield the lessor get on leasing the asset.2 158781. If the firm pays income tax at the rate of 35%.41 13859.72 9008.414 3619.2 31756.2 31756.27 15320.924 3332.859 6188.015 27482.

.....52 5428..................... Though leasing is not a major source of finance............. Students desiring to know more on this may refer some specialized book on Lease Finance (Vinod Kothari.................................. There are also mega international lease transactions called cross-broader leasing........ Transport companies like shipping companies........ Wadhwa and Company.. air-lines also acquire their assets through lease transactions.....31 5428....... whose percentage on total assets is significant are Reliance Capital.................... Some of the prominent companies that use leasing extensively are ONGC..............depreciation and in that process.. ................................ the cost of owning the asset will go up.......................... Larsen & Toubro..... IPCL..... Thus..................... Evaluate whether it is cheaper than borrowing Rs................ ........ Asian Paints.................................. Companies like ONGC hire most of the drilling equipment on lease and hence the lease amount is significant........................................................ Today................Do you agree with this statement? ........................... Table 14................57 2001-02 1433.......... Companies that prominently use leased assets.......... Siemens..........1: Value of Lease Rent and Leased Assets of BSE-100 Index Companies (Rupees in Crores) Year Lease Rent Value of Leased Assets 1998-99 593... ................ there are several types of leasing............................................ 1 lakh from a local leasing company...........00 6940................................86 1999-00 778....... in a situation where the tax rates of lessor and lessee are different and the cost of funds to lessor and lessee are different. .. etc........ .... Lease Financing and Hire Purchase................... The table values show an increasing trend in the value of leased assets over the years and also more than three time increase in the value of lease rent.................... Shipping Corporation of India...................... Summarise your findings below: ..........................09 2002-03 1950.............. .... Activity 2 Collect the details of lease/hire-purchase instalment per Rs..... then lease may be cost effective. 5 .................52 Other Modes of Financing Activity 1 “Leasing is nothing but borrowing and acquiring the asset” ........................ IPCL........... and BHEL............................................................................................................ 1 lakh at an interest rate of 10% and buying the asset... Lease finance is likely to grow in the future due to its flexibility and convenience............... The following table shows the value of leased assets and lease rent (including operating lease rent) paid by BSE-100 index companies during the last five years.. Reliance Industries.......................72 4819.....34 2000-01 798............................................................ Since lease transactions also attract some additional taxes like sales tax.................. Indian companies today acquire assets through lease finance..............................99 7300....... borrow decision......... one has to consider such additional costs in evaluating lease vs................................. Nagpur).

there is no guarantee that housing finance 6 . The process of selling makes the concept slightly different from simple bill discounting concept. the supplier of equipment acts as a lender or lessor. First of all. it brings liquidity to an illiquid asset. it reduces the cost. Securitization assumes importance in this context. The growth of the housing finance company is thus restricted to its ability to raise additional funds. the firm receives profit. With this new cash flow. it is possible that the supplier may be a cash rich company or may get funds at a much lower rate than the buyer. Suppose the housing finance company gets some more loan applications say for Rs. the company which acquires the assets neither take bank loan nor approach has leasing company for credit but directly takes the credit from the supplier of the equipment. For instance. if the pension funds give loan to housing finance company. suppliers provide short period of credit. 20 cr. 100 cr. and in this special case. Suppose a housing finance company has Rs. It is the process through which an asset (fixed or current) is converted into financial claim. During the first six months. Suppose a group of pension companies is willing to buy Rs. the credit rating of the supplier is far above than the credit rating of buyer or seller may be in another country where the interest rates are low. 100 cr. the equipment suppliers provide long-term credit and accept the payment for the supply of equipment over a longer period of time say 5 to 8 years. the housing finance company can finance new loans without making any fresh borrowing. The value of the securities is improved by taking credit rating and often through insurance cover. In addition. Let us explain the concept with a simple example. In that process. 14. it accepts the loan proposals and lent Rs. Under this. at an average interest rate of 10% and the duration of the loan is 15 years. which are tradeable in the market through listing. Under securitization. Securitization improves operating cycle of the capital in the sense the housing finance company can recycle the capital several times and finance more houses without borrowing on its book. the suppliers provide long-term credit. Every time when the cycle is completed. The logic is fairly simple. it is also called asset-backed securities or mortgagedbacked securities. The concept is very popular in housing finance. They can also sell such receivables through securitization. the buyer need not approach any other agency for credit. an intermediary agency is created.Financing Decisions 14. In other words. Thus. In other words. Normally. You might wonder why pension funds or other companies prefer to buy housing loans instead of investing or lending to housing finance company.2. in seventh month. The company has to look for new source of finance to fund the new loan proposals since it has already invested the entire capital and converted them into illiquid long-term 15 years receivables. It other words.2. The question is how it is superior to other forms of acquiring the assets. which initially buys the illiquid asset and against that it issues securities.3 Asset Securitization Securitization is fairly a simple concept.2 Suppliers Credit The concept of supplier credit is fairly simple and in existence for a long time. 15-years receivables from the housing finance company discounting the receivables at say 9%. There are specialised government agencies to provide funds to the suppliers in order to improve the export sales or to help a particular sector. For instance. Since there is no intermediary to fund the acquisition between the seller and buyer. there is no need for the suppliers to stuck with such huge long-term receivables because they can get finance under certain specific scheme against such receivables. Though suppliers provide long-term credit to the buyers. 100 cr. the housing finance company has sold its 15-year illiquid receivables and raised money against it.

The lender has no control on the business of borrower. the pension company can ask a credit rating agency to assess the quality of loans. lending will block the funds of pension funds for a long-term whereas an investment in securitized asset brings liquidity for the funds invested. Finance & Development.company will lend money to quality loan proposals. the risk is reduced considerably. For example. Figure 14. So it is a rare case of win-win situation for both the housing finance company and pension fund investors. raise longterm resources by securitizing their future receivables. On the other hand. By securitizing. already several securitization deals have taken place. There are several variation of this model but the essential principle is to protect the interest of investors. which essentially creates liquidity for these kinds of securities. Though this concept is yet to become popular in India. there are many investors who are looking for such investments. Other Modes of Financing Structure of a typical future flow securitization Designated Customers (obligors) Future receivables Product payment Trust (collection account/fiscal agent) Principal and interest Future product Excess collections Special Purpose Vehicle Securitized Notes Investor Proceeds Right to collect future receivables Offshore Borrower in developing country (originator) Figure 14. It is possible for manufacturing or service firms to raise long-term funds through securitization. It is possible for companies producing commodities. whose balance sheet is very weak and no financial institutions would be willing to lend money to such companies. While securitization as a concept was developed to help finance companies to covert their loans into liquid assets. which collects the money and distributes to the holders of such securities. Companies like Reliance Petroleum have done such securitization.1: Structure of Future Flow Securitization Source: Suhas Ketkar and Dilip Ratha. The amount thus raised can be used to strengthen long-term or permanent working capital needs of the firms or invest in fixed assets to expand the capacity.1 shows the structure of future flow securitization. the company actually sells the receivables to the intermediary agency (called Special Purpose Vehicle or SPV). many electricity boards. it is now extensively used in several other business situations. in buying the existing loan. In this process. where the demand is predictable. “Securitization of Future Flow Receivables: A Useful Tool for Developing Countries”. have raised long-term funds at a cheaper interest rate by securitizing future receivables of some good clients. In addition. Like pension fund. March 2001 7 .

..... The venture capitalist is................................. such as buy-back of the stake of the venture capitalist by the promoters.......................... Signing of a term sheet by both parties is a statement of good faith and is not an obligation until an agreement is signed by the parties..... You can get the details from business magazines and economic dailies which periodically report such details..................................... approach venture capitalists for assistance.................. ...................................................... or during a merger or acquisition transaction. in the normal course of business.............. 14......... ........ The venture capitalist is an investor who guides the project through its different stages of growth by identifying avoidable pitfalls and directs the business along possible avenues of growth.......... venture capital is a equity finance................................ ............................................. This includes verification of whether the project is in the area of their investment and a review of the promoters of the business......................... which find it difficult to raise funds from banks and other financial institutions............. a partner who brings much more than money to the project... Many projects.... the probability of failure is also high......4 Venture Capital While leasing/hire-finance.................... It sets out the broad terms and conditions of investment and is signed by both the venture capitalist and the proposed venture capital investee...... The venture capitalist will........ often set up to commercialise a novel idea........ Activity 4 Why securitization is not popular in India? Find the details from some of your friends working for financial services company or bank............................................. high-growth projects...........................2.................................................................... suppliers’ credit or securitization are debt financing........................ Venture capitalists conduct a preliminary project appraisal.... The returns to the venture capitalist are from the handful of the projects........ This could be in several ways................. disinvestment of the investment at time of an IPO......... which are high-risk with the potential to give extraordinarily high returns over a period ranging from three to seven years............................... 8 ... .... If the venture capitalists are interested in the project they offer a term sheet to the promoters. . It is normally subject to satisfactory completion of due diligence review and signing of legal documents such as an equity subscription agreement....................................... like to have a 20% to 50% stake in the company invested in......... where the investor mentors and advises the promoters of the business in which the investment has been made...... which succeed............................................................. The returns to the venture capitalist are at the time of disinvestment from the venture backed unit.. Venture capital is investment in early-stage. Venture capitalists receive several proposals for investment................................................................. therefore....... Venture capital investment is “hands-on” investment..................................................... ......... The term sheet is a summary of the proposed principal terms and conditions of a venture capital investment....................................... The risk factor being high.............................. .................... ......................... Venture capital investment is generally in equity or quasi-equity instruments in unlisted companies...............Financing Decisions Activity 3 Briefly discuss any one Securitization deal completed in India..............

........ since the venture capitalist does not expect all investments to do well. They must believe that they can succeed... particularly in the initial stages of the project.... In fact sometimes.. ... but that is not typical of venture capital financing).. the entire investment would be written off.......................................... The venture capitalist will look at different aspects of the projects............ A venture capitalist does not take any collateral or guarantee (there have been cases of risk financiers who have asked for personal guarantees of the promoters............ there must be a definite chance that it can be successful.. The venture capitalist would like to maximize the upside potential in any project.. . A venture capitalist is most concerned about the ability of the entrepreneurs to adapt to different circumstances.. Some venture capitalists visit the projects every week.............. The venture capitalist often visits the project frequently......... The promoters must be committed and have a passion for their project........... The project must have the potential to be commercially viable................... This does not stop at appointing a member to the Board of Directors of the company and attending Board meetings regularly.. the entire project can be in jeopardy. even spending half-a-day in each visit........ he would like the few that do well to give above average returns..... the project may be excellent....... If the project does well.. but if the venture capitalist feels that the promoters lack the required skills..................... In many cases cash inflows in initial years are ploughed back into the business.................A venture capitalist will look for a project that has potential for great returns.. Some of these aspects are the integrity and ability of the promoters and key management. it must be marketable.......... A venture capitalist looks for very great returns in say five years time........... Further................................................ the market potential and strategy for sale. This is not very surprising as venture investment is akin to a partnership.... if it fails........................... They must believe that they can do something different or differently........ The project should be feasible and though it may be risky................................. This is one of the reasons why most venture capitalists do not invest in many projects at a time. good and bad. They are closely involved in the operations of the investee............ Other Modes of Financing 9 .......... despite having phenomenal potential.... A professional venture capitalist would validate all the data included in business plans.. which run successfully today? ............ the project may get rejected....... so it is important that the investment makes commercial sense....... Ultimately the investor wants a financial return...... The project must be feasible.. .................. the venture capitalist would like to have higher than normal returns as compared to other financial investors in a project.. ie it must meet an existing requirement or fill a gap in the market or it must have the potential to create a market....... and would like to exit from a project at a time when he can get a maximum return on his investment in the project... If the partners in the project are not in agreement or have different ways of functioning..................... A venture capitalist will also scan the project in great depth........................ This is not surprising...... The venture capitalist backs the promoter first and then the project...... the venture capitalist would get good returns....... It must have the potential for commercial success............ Activity 5 Collect the details of any one projects funded by venture capital company....... Professional venture capitalists mentor projects they invest in........... the details of the project..

. the factor assumes the risk of the debts going “bad”....... The factor cannot call upon its client-firm whose debts it has purchased to make good the loss in case of default in payment due to financial distress.... the factoring agency or the factor..in this case......... In non recourse factoring..... an alternative to in-house management of receivables...... effects payments to its client firm on these days (irrespective of whether or not it has received payment or not) and also assumes the credit risks associated with the collection of the accounts. the factor can insist on payment from its client if a part of the receivables turns bad for any reason other than financial insolvency....................... .. For rendering these services........ thus....... However............. Depending upon the inherent requirements of the clients... The complete package of factoring services includes (1) sales ledger administration.......... but broadly speaking.... The option for exit is difficult to exercise whereas instruments like commercial papers enable both lenders and borrowers to move out of the relationship in a short period of time.......... We will review briefly some of these new methods in this section............3 NON-TRADITIONAL SERVICES OF SHORTTERM FINANCING As in the case of long-term finance....... Factoring involves an outright sale of the receivables of a firm by another firm specialising in the management of trade credit.......... a) Commercial Paper: Companies with good credit rating can raise money directly from the market for working capital purpose by issuing commercial papers............................... In recourse factoring................. .... called the factor... factoring service can be classified as (a) Non-recourse factoring....... b) Factoring Service: Factoring is essentially a management (financial) service designed to help firms better manage their receivables... Many banks and cash rich companies participate in commercial papers...... Since lender and borrower meet directly................ .. even banks are willing to invest money in commercial papers........ Factoring is......Financing Decisions Activity 6 Do you have any idea that fits venture capital funding? If yes........................................................................................ which are issued by high-quality companies.. the cost of commercial paper borrowing will be lesser than working capital loan................ .. new methods of financing are also be used to raise funds for working capital.............. However.... Later on you can prepare a detailed business plan. in recent time.............. Why firms issue commercial paper and other invest in commercial paper? As discussed earlier.. it is. the factor charges a fee which is usually expressed as a percentage of the total value of the receivables factored.... the terms of factoring contract vary............ a way of off-loading a firm’s receivables and credit management on to some one else ......... briefly discuss the idea here....... 14........ and (b) recourse factoring........... Commercial papers are unsecured notes but negotiable and hence liquid..... the factoring firm can insist upon the firm whose receivables were purchased to make good any of the receivables that prove to 10 ............ and (3) risks control.................... loan typically binds both lender and borrower for a period................ (2) finance......... Under a typical factoring arrangement a factor collects the accounts on the due dates.................. in fact.. Since they are liquid............. firms can raise short-term finance from banks and other investors......

.... 2000 cr............................ under what conditions will it be cheaper than other sources of finance? Explain how Securitization is considered as a source of finance? Who are the typical investors for such papers?: Suppose you are working for a venture capital company............ Canbank Factor and SBI Factor... .... How is factoring different from that of traditional bill discounting scheme? 11 6...... 3.... the risk of bad debt is not transferred to the factor................ .... have done an annual turnover of nearly Rs............................. it may also be cheaper. Finance managers have to bring innovative financial products that satisfy different segments of investors..... The job is as challenging as selling products to consumers................................................................. Asset Securitization is suitable when a firm wants to raise funds against future receivables or against some existing illiquid assets............... Commercial paper and factoring are two prominent sources through which firms can raise short-term funds in addition to traditional source of short-term finance like bank loan................ Many foreign and private banks have also started providing the factoring services............... ............................................. we discussed three such sources of long-term finance namely leasing/hire-purchase....4 SUMMARY Apart from traditional sources of finance like debt and equity from institutions and others.......................................... 4.5 SELF-ASSESSMENT QUESTIONS 1......................... 2.......... Collect the details of factoring service schemes they provide for different types of companies. ...........................be bad and unrealisable.............. Other Modes of Financing 14..... .. Venture capital is most suitable for high risk venture where venture capitalist is willing to put equity capital and assumes risk provided the project has a scope for high return...... when do you chose lease finance? Is lease finance cheaper than other sources of finance? If so............................................... these additional sources of finance are often used to leverage cost advantage and in some cases to gain flexibility......... and venture capital...... Activity 7 Visit the branch office of Canbank Factor or SBI Factor in your city or their web site.......... In this unit.................................................... 14......................... Leasing definitely scores over others in terms of flexibility and in special cases....... the two factoring companies.................... What are the things you will look into a proposal that comes to you for venture capital funding? Is it possible to get funds from venture capitalist for all kinds of projects? Explain.... How is lease finance different from that of equity or debt finance? In evaluating funding options........................................................................ However......... While traditional source of finance contribute significant part of capital................................................... 7. and they are growing at an attractive rate.......... ............... ...... finance managers today look into several non-traditional sources of finance........... 5........ The reasons for raising finance from such non-traditional sources are cost advantage and flexibility..... asset securitization..

John Wiley & Sons. Hyderabad. Richard. Wadhwa and Company. ICFAI.6 FURTHER READINGS Bygrave. Vinod Kothari. Venture Capital and Private Equity. Vinod Kothari. Himalaya Publishing House. 2003. Securitisation: The Financial Instrument of the New Millennium. New York Sengupta A K and Kaveri V S. 12 . Euromoney. Mumbai. Macmillan India. Financial Times/ Pitman. Naresh Kumar. Academy of Financial Services. Problems and Prospects. Venture Capital Handbook. Commercial Paper. Calcutta. Josh.Financing Decisions 14. London Gupta. (Ed). Lease Financing and Hire Purchase. Willam et. New Delhi Lerner. Nagpur. Handbook of Leasing. Deep and Deep Publication. al. Lease Financing: Concepts and Practice. International Factoring in India: Issues. Financial Management and Policy. Hire Purchase and Factoring. New Delhi Sriram K. London Felix. R M Srivastava.

5 15. As such dividend policy is the most important single area of decision making by the management for a finance manager. 15. Structure 15.6 15. provision for sufficient reserves to finance future expansion programmes of the enterprise and to absorb the shock of business vicissitudes and provision of sufficient resources for retiring old bonds and redeeming other debts call for effective management of income. They are briefly discussed below. their assumptions and criticism. Distribution of fair amount of dividend to shareholders.13 Introduction Dividend Theories Walter’s Model Gordon’s Model Modigliani-Miller Hypothesis Procedure of Paying Dividends Types of Dividends Factors Influencing the Dividend Policy Dividend Stability Deciding the Dividend Payout Ratio Summary Self Assessment Questions Further Readings 15.2 a) b) DIVIDEND THEORIES theories which consider divided policy as of no relevance.UNIT 15 MANAGEMENT OF EARNINGS Objectives Objectives of this Unit are to: discuss the dividend theories.7 15. are not unanimous in this regard. as evidenced from their theories. Efficacious management of income strengthens the financial position of the enterprise and enables the firm to withstand seasonal fluctuation and business oscillations.1 INTRODUCTION Success of an enterprise rests not only on optimal utilization of funds but also on efficient management of income produced by business operations. 1 Dividend theories can broadly be classified into two groups: . Action taking in this area affects growth rate of a firm and so also its value.3 15. and which consider divided policy as a relevant variable to enhance shareholder’s wealth.1 15.11 15.8 15. helps in enlisting the support of the shareholders in future and finally facilitates in procuring resources from different avenues of capital market.2 15.4 15.10 15. nevertheless opinions of the financial wizards.9 15. throw light on practical issues of dividend policy.12 15.

0 0 + (. His model is based on the following assumptions: 1. The firm has a very long infinite life. The firm’s internal rate of return. without opting for new debt or equity. The following is the Walter’s formula to determine the market price (P) per share: D (EPS – D) r K K The above formula can also be written as: D K (EPS – D) r/K K The above equation gives the sum of the present value of future stream of dividends (D/K). but any given values of EPS.10 = Rs. and the D assumed to remain constant forever in determining a given value. 10 When pay out ratio = 0% D = Rs.0) . The basic data and computations are given in table 15.1: Dividend Policy and the Value of Share BASIC DATA Growth Firm (r > k) R = 16% K = 10% EPS = Rs. 2. The discount value is equal to the firm’s cost of capital (K) The effect of dividend policy on the firm’s share value is explained in the following illustration 1 using Walter’s model. are constant.10) (10. 100 per cent of earnings are either distributed as dividends or reinvested internally. 4.08/. Walter emphasizes that dividend policy is a critical factor affecting the firm’s value.10) (10. 10 Declining Firm (r < k) R = 8% K = 10% EPS = Rs.0) .16/. 10 D = Rs. 0 0 + (10/. and cost of capital.10) (10.3 WALTERS MODEL Professor James E. and capital gains resulted by reinvestment of retained earnings (EPS-D) at the firm’s internal rate of return (r). 0 P = 0 + (.1 based on Walter’s formula: Table 15. According to him. 100 = Rs. The firm finances new investments through retained earnings. dividend policy hinges on firm’s internal rate of return (r) and the cost of capital (k).0) .Strategic Financing Decisions 15.10 Normal Firm (r = k) R = 10% K = 10% EPS = Rs. 5. The values of earnings per share (EPS) and dividends per share (D) may be changed to determine results. 160 2 = Rs. Initial earnings and dividends remain constant forever.10 D = Rs. 3. 80 .

130 = Rs.08/. 100 = Rs. As a result.10) (10 . 90 When pay out ratio = 80% D = Rs.10) .10) (10 .10 D = Rs. 5 5 + (.10) (10 .10) (10 . 10 P = 10 + (.3) . They may have investments with returns equal to cost of capital. 3 3 + (10/. 8 8 + (. 100 = Rs.10 D = Rs. or declining firm.10) (10 . These firms can be indifferent to any dividend payout ratio. despite varying pay out ratios. and cost of capital. to maximize the share value.16/.10 D = Rs. 100 Thus.10 D = Rs.10) (10 . normal firm.3) .10) (10 .1 that firm’s value will be maximized when then firms reinvest 100 percent of earnings.5) . Walter’s model brings out that dividend policy does help maximize shareholder’s value.10) (10 . 100 = Rs.3) . 3 3 + (. choosing a zero dividend policy 1. it can be note from Table 15.10) (10 .10) (10 . 112 = Rs.10) (10 .8) .5) . 100 = Rs. 3 P = 3 + (. 5 5 + (10/. 96 When pay out ratio = 100% D = Rs.10) . 8 P = 8 + (.16/. 86 When pay out ratio = 50% D = Rs. 3 .8) .10 = Rs.10 D = Rs.8) . 10 10 + (rs/. It can be observed from the table 15. as there is no optimum policy.08/. 100 = Rs.10 D = Rs.10 Management of Earnings D = Rs. Growth Firms: Growth firms have very good investment opportunities with returns greater than their respective cost of capital.10 = Rs.10 = Rs. The optimum dividend policy for these firms is as follows. So the dividend policy differs depending on whether the firm falls into the category of growth firm.10) (10 .16/. 10 10 + (10/. 142 = Rs.10) .10 D = Rs.1 that the share value remains constant. 8 8 + (10/. 5 P = 5 + (. if used properly depending on its internal rate of return.10 = Rs. Normal Firms: Over a period of time firms may not find unlimited investment opportunities with returns higher than their cost of capital.5) .08/.When pay out ratio = 30% D = Rs.16/.

However the firm’s cost of capital changes with its risk. without resorting to either debt or new equity. the Macro Economic Changes in the economy. No External Financing: Walter’s model is mixing both dividend policy and investment policy by assuming that investment opportunities will be financed only with retained earnings. which is real life may not hold good.1 too supports this proposition. Further. 15. firms choose from among the most profitable to less profitable projects. By assuming the discount rate as constant. because they can reinvest them at a higher rate than the return available to the firm. Such firms can at best declare 100 dividend payout to enhance shareholders’ value.4 GORDON’S MODEL Myron Gordon developed a popular Model relating dividend policy and the firm’s value. Accordingly. based on the following assumptions: The firm has only equity capital. similar to Walter’s model. which is not correct in practice. and no debt. Because. as is the case with Walter’s model. Criticism of Walter’s Model: Though Walter’s model has been successful in highlighting the role of firms return and cost of capital in determining the dividend policy. The firm and its stream of earnings are perpetual. Firm’s discount rate is constant. the value of share can be obtained by the following equation: Po D1 K -g The above equation can also be expressed as: 4 Po = EPS (I – b) K . the market value of a firm’s share will be equal to the present value of future stream of dividends payable for that share. According to the Gordon’s model. as long as their respective rate of return is more than or equal to the firm’s cost of capital. the model has been critisised for its following un-realistic assumptions. remains constant. Constant Opportunity Cost of Capital: Another assumption of Walter’s model. leading to a constant growth rate of earnings. Constant Rate of Return: Walter’s Model assumes a constant rate of return. and investment policy will be sub optimal.Strategic Financing Decisions Declining Firms: These firms may not have investment alternatives giving returns atleast equal to the cost of capital. Walter’s modal ignores the effect of risk on the firm’s value. Firm’s internal rate of return is constant. This assumption mixes dividend and investment policy. The retention ratio. the present value of the firm’s income changes inversely with its cost of capital. The discount rate is higher than growth rate. The data in Table 15. With these restrictions the firm’s dividend policy. which may not hold good is constant opportunity cost of capital. The corporate taxes are nil. Even this assumption is also incorrect. Only retained earnings will be used for financing expansion. once decided.br .

to boost the shareholder’s wealth. essentially due to the similar asumptions made by both of then. normal. b=70% G=br=(.09 k = .16)=. internal rate of return.12 Deaclining Firm (r < k) r = .12 – .7)(. 450 = Rs. the investors may be willing to pay higher price for the share that pays higher early dividends. It can be seen that for normal firms whose discount rate is equal to their internal rates of return.12 – . When dividend policy is considered in this context. in which the implication of dividend policy for growth.7)(. less risky. Illustration: In the following 15.084 Po = 12 (1 – . and the firm cost of equity (which is also cost of capital in the absence of debt) in deciding the value of the share. 100 = Rs.12 k = . as each firm’s value remains the same irrespective of any pay out ratio adopted. and declining firms. In such situation.12 EPS = Rs.09)=. normal. The investors prefer dividend to capital gains because dividends are easier to predict.7)(. The growth firms do well by retaining maximum portion of their earnings to increase the shareholders’ value. The results in the illustration can be explained as: (a) If the firm’s internal rate of returnis less than its discount rate. Because. and declining firms. the 100 percent pay out will maximize the share holder’s wealth. The promoters can even think of partial or full dis-investment. Retention Ratio. retaining earnings is not useful for the shareholder’s value maximization. Then even those firms having the rate of return equal to their respective discount rates cannot be indifferent to the divident policy.16 k = .12 EPS = Rs.2 the implications of dividend policy are shown under Gordon’s Model for Growth. the shareholders are denied the opportunity to invest at higher or at least at rates equal to the discount rate.12 EPS = Rs. Gordon adds that uncertainty increases with futurity. is explained. Therefore.112 G=br=(.063 = Rs. Table 15. Gordon concludes that dividend policy does effect the firm’s value.7) . However. because the opportunities available to the shareholders are less attractive when compared to those available to the growth firm’s.12 Management of Earnings Pay-out ratio (1-b) = 30%. the discount rate cannot be assumed to be constant.7) . the dividend policy is of no significance. and do not involve timing decisions.112 Po = 12 (1 – .The second equation highlights the relationship of earnings.12)=.12 Normal Firm (r = k) r = . other things remaining constant. Due to uncertainty.7) . The conclusions drawn by Gordon’s Model are akin to those of Walter’s Model. if the firm’s discount rate is less then to the prevailing rate of return in the market.063 Po = 12 (1 – . The influence of dividend policy on the value of share and therefore on the firm’s value can be understood by observing the following illustration.12 – .084 G=br=(. by retaining earnings in the firm to invest at a lower rate of return. 63 5 .2: Dividend Policy and the Value of Share Growth Firm (r > k) r = . dividends policy.

8 = Rs. 100 = 10.009 = Rs. The investors can forecast future prices and dividends with certainty.4) . the rate of return will be equal to the discount rate which are same for all shares in the long term.16)=. the price of each share must adjust so that the rate of return. The firm has a fixed investment policy.12)=.4)(.046 G=br=(.12 – .12 – .064 Po = 12 (1 – . will not affect the firm’s value M-M’s model is based on the following assumption: The capital markets are perfect. or they are same on both dividend income and capital gains so that investors do not prefer one over other. Given the investment policy. will not increase with futurity. the value of share can be calculated as: Po = D1 + P1 1+ R D1 + P1 1+ K = 6 .4) . 104 = 10.12 – .12 – .048 G=br=(. 86 Pay-out ratio = 90%.4)(.12)=.1)(.009 Po = 12 (1 – .5 MODIGLIANI – MILLER HYPOTHESIS Modigliani and Miller (M–M) proposed an interesting model which concludes that dividend policy does not affect the firm’s value. The risk. Either taxes do not exist.016 Po = 12 (1 – .012 Po = 12 (1 – . 97 15.1)(. information is available freely.036 Po = 12 (1 – . and Retention Ratio = 40% G=br=(.12 – .012 Po = 12 (1 – .Strategic Financing Decisions Pay-out ratio = 60%.016 G=br=(. According to this model.1) .012 G=br=(. which have to be identical for all shares. investors behave rationally. When the above assumptions operate in capital market.12 – . and Retention Ratio = 10% G=br=(. and transaction and floatation costs do not exist.4)(. and one discount rate is appropriate for all securities and all time periods. according to them.1)(.16)=. based on dividends and capital gains.12)=. they hold.036 = Rs. 100 = Rs. on each share will be equal to its discount rate. the rate of return for one period can be computed as follows: R = D1 + (P1 – Po) Po Similarly. hinges only on its earnings which result from its investment policy. M-M believed that the equality would take place through the process of switching from low yield shares to high yield shares. decision of retention and pay-out. 129 = Rs.1) . Consequently. The firm’s value.8 = Rs.1) .4) .09)=.

Using the following equation M–M show that the value of the firm will be unaffected by its dividend policy: Npo = n D1 + (n + m) P1 – mP1 1+ k = n D1 + (n + m) P1 – (I1. 50 each.00. What will be the price of its share at the end of the year if(a) dividend is not paid and (b) dividend is paid as above? Vikas is expecting to earn a net profit Rs. and has investment opportunities of Rs. The discount rate is 12 percent. or both.X1 + nD1) 1+ k = (n + m) (P1 – I1 + X2) 1+ k Where: N = M = I1 = X1 = Number of shares outstanding Number of new shares to be sold by the firm at time 1 at price P1 Total amount of investment during time period 1. 1. Illustration 3: Vikas WSP LTD has 10 lakh outstanding shares.000 in the current year. Firms can pay dividends and raise funds by issuing new shares to take up investments. When the firm is paying dividend its share value will be adjusted by the market to the extent of dividend amount. Answer the above question using M–M model. The firm is planning to pay Rs. 4 or dividend per share. Decide how many new shares should be issued. = P1 = 50 (1+. Also find out the value of the firm.12) – 0 = Rs. with the market price of Rs.00.56 7 . Total net profit of the firm during time period 1. Price of the share at the end of the current year can be determined with following equation: Po = D1 + P1 1+ k ² P1 = Po (1+K) – D1 The value of Vikas share when dividend is not paid. However the value of the firm remains same irrespective of the dividend policy. and the firm has to issue more number of shares to finance its investments. or new equity capital.000 during the period. It can be observed that the firm has the flexibility of paying dividend and raising funds by isuing new equity shares. allowing the flexibility of financing new investments with retained earnings. 60.50. The M–M hypothesis is explained in the following illustration.The value of the firm can be obtained by multiplying both sides of the above equation with number of shares outstanding: V = Npo = n (D1 + P1) (1 + k) Management of Earnings M–M model does not make a restrictive assumption of financing new investments only with retained earnings like Walter’s and Gordon’s models for the issuance of new shares.

56 m = Rs.00.000 – 40.00.00.000 – (60.50. The companies pay a special tax of 10 percent of the profits distributed which is similar to tax deduction at source. 5. The current long-term capital gains tax rate is 20 percent. 8 . model. 52 m = I – (X–nD1) Rs. Number of new shares to be issued to finance new investments: When dividend is not paid: MP1 = I – (X–Nd1) Rs.000 M–M further state that the firm need not have only equity capital to hold their model true.00. 52 m = Rs.50.000) Rs. They conclude that their hypothesis of dividend irrelevance holds good even if the firm raises debt capital instead of equity capital. Normally dividends are clubbed with ordinary income for tax purpose which is taxed at a higher rate when compared to the capital gains. 90.00.000 M = 1.00.00.000 1.000 = Rs.Strategic Financing Decisions Vikas share value when dividend is paid: = P1 = 50 (1+. 1.12 = Rs.00.00.000-00) Rs.00. The above conclusions are based on several restrictive assumptions of M.12 When dividend is paid: = 5.50.000 – (60.12) – 4 = Rs. 52 m = Rs.12 = 5. However.60.00.000 1.000 Value of the firm: Npo = 0 + (10.30. 1. they put forth their indifference hypothesis with reference to leverage. For this. 1.M. Therefore investors may prefer shares with high dividend pay out. to maximize their wealth.714 When dividend is paid: Rs. From the tax point of view the shareholders prefer the dividends. In most of the countries both of them are taxed albeit at different rates. in India the dividend income is tax free in the hands of investors from the financial year 1998-1999. as discussed below: Tax Differential: M–M made a simplistic assumption of no taxes or same rate on both dividends and capital gains but the reality is far from the assumption. 5.000 M = 2. The divided policy may effect the value of a share if those assumptions are relaxed and the market imperfections are considered.60.000 + 16074) 56 – (56x160714) 1 + . 56 m = Rs. 52.60.00.

as a policy. because the share value of two firms with identical investment policies. Therefore. These views are not convincing to many researchers. According to them. business risk and future earrings cannot be different. Their views are akin to the birdin-hand argument of Gordon who argues that the discount rate increases with uncertainty. Diversification: Even under the conditions of certainty. makes the retention of earnings a favourable option. These statements attract greater attention if they are accompanied by dividend announcement. The process of monitoring the company and the manager’s performance involves significant costs and also leads to uncertainty in future share prices. when they are indifferent between dividend and capital gains.e. As a result. The shareholders have to pay brokerage and often incidental costs to sell their shares. But in reality. timing of selling the share to encash the capital gains in lieu of dividend income becomes difficult. They also assume that the shareholders can sell a small portion of their shares in lieu of dividend. if a firm’s earnings are expected to grow in the future and if the firm does not announce increase in the dividend payment. the argument of same discount rate for all firms may not hold good because of investors’ preference for a diversified portfolio of securities. However. the process of raising fresh capital from the capital market involves significant expenses in terms of floatation costs which may be in the range of 6 to 10 percent of capital raised. investors try to reduce uncertainly to some extent through dividends. the value of the firm may increase if it pays higher dividends instead of retaining them. To fulfil their desire share holders like the firm to distribute the earnings to invest in other firms. the investors may use higher discount rate for firms with high retention ratios compared to firms which pay high dividends by accessing external financing to meet their requirements. Therefore. In practice. Management of Earnings 9 . the share value may not reach realistic value. companies tend to maintain dividend payments. The preference for a steady stream of income in the form of dividends by a section of investors also strengthen this argument. suggesting the preference of shareholders for higher dividend payment. Uncertainty And Preference for Dividend: M–M profess that the dividend policy continues to be irrelevant even under the conditions of uncertainly. But reality is for from that assumption. the transaction costs vary inversely with the sale value of shares i.. companies do not share complete information with shareholders. Transaction and Monitoring Costs: M–M model assume that transaction costs do not exist.Floatation Costs: M–M assume that the cost of retained earnings and external financing are same. despite changing earnings. shareholders may prefer dividend income to capital gains. Thus. unless the earnings change by a significant proportion. As a percentage. higher the value of shares sold lower the percentage of transaction costs and vice versa. shareholders may not attach enough importance to such views of growth in future earnings. For example. Therefore. Existence of Perfect Capital Market: M–M assume that there exists a perfect capital market where information is freely available and future share prices are known with certainty. To disseminate information to the share holders about the future earnings a company can make statements to create a favourable impression. the higher cost of external financing. As such.

though occasional stock dividends of higher percentage in the name of bonus shares are popular in India. if they receive. For example. For example. Companies may also choose stock dividends instead of cash dividend. will not expect similar pay outs in future. In a particular year. Once declared the dividends become a current liability of the firm. So. They increase the number of shares. there will not be transfer of funds even in the books of accounts. 10 . It is not uncommon in West to popular the payment of regular stock dividends of around 5 percent.. but will not bring fresh funds to the firm. Such practice is not in India so far. Lakme Ltd. There are some other non cash dividends. Investors naturally. But a stock dividend leads to capitalization of reserves equal to the sum of new shares at par value. Buyers get the dividend from the seller if the shares are bought “cum dividends”. It only connotes that the companies can maintain similar payments in future also.7 TYPES OF DIVIDENDS Several types of dividends exist in practice. Stock dividends are very similar to stock splits. For that purpose. By offering reinvestment opportunity to the shareholders. which is subject to the ratification by the shareholders in the annual general meeting. The dividends are payable to those investors whose names appear in the shareholders list of the firm. it will declare the extra dividend as special dividend indicating that they are not liable to be repeated. Companies usually pay ‘Regular cash dividends’. The buyers can get the shares transferred in their name before the record date. to the shareholders. has been offering discounts on its products. the buyers should return the dividend. it is common to pay dividends quarterly which is rare in India. In some western countries. the company can fulfil both payment of dividends and issuing of new share for additional capital simultaneously.6 PROCEDURE OF PAYING DIVIDENDS The dividends can be declared only by the board of directors.Strategic Financing Decisions 15. Reliance Industries Ltd. In case of a stock split the face value (par value) will be reduced to increase the number of shares. These may be paid once a year or more times in a year spllitting the amount. if a company pays a higher dividend and it believes that such payment is not possible in future. on a particular date announced in advance for that purpose.. In some countries companies encourages shareholders to reinvest their dividends continuously. and will reduce values per share. 15. by allowing some discount. on prevailing market price. In the process the company can also save the floatation costs of issuing new shares. Here the word regular does not convey any legal obligation of the company to compulsorily pay dividends. and discounts fall in this category. dividends are set at such a level that a firm can pay even during the years of poor performance. corporate gifts. and Max India Ltd are distributing around 1000 percent as special dividends out of profits made by selling part of their businesses. If the shares are bought on “ex dividend” basis. They can be paid only out of profits (after providing depreciation) of the current or past years. which is normally called record date.

At times.15. Under the circumstances. who are the owners of the company. The minority groups may switch over to other companies which meet their expectations. the directors may tend to meet the expectations of the dominant groups of the shareholders. companies neither follow 100 percent retention nor 100 percent distribution of their earnings. and the implications of following a particular dividend policy. In case of closely-held companies. The current long-term capital gains tax rate is 20 percent. firm may use the earnings to distribute as dividends. it may use major portion or all earnings to finance the new projects. 11 . They are firm’s expected rate of return on new investment opportunities. compared to those who depdn on dividens as regular income. Expectations of Shareholders: No doubt dividend decision is the prerogative of the company directors. They may do so after considering the relative costs and benefits of internal and external financing. New Investments: If new investments are not available to the firm with attractive rates of return and it is not willing to retire the debt. which is similar to uniform tax rate irrespective of the individual shareholder’s tax slab. control of management. Share holders having sources of other regular income may not attach much weightage to regular dividend. Various factors should be considered while finalizing the dividend policy. In real life. and the portion to be retained either for liquidity needs or for investments. whether projects with good returns are available or not. if the firm finds good investment opportunities. So. Thus due importance will be given to the share holders’ expectations with regard to dividends. In many countries capital gains are treated favourable with a lower tax rate when compared to dividends. liquidity and debt servicing. Institutional investors are exempt from both capital gains tax. it is hardly possible to gather their views on expected dividend policy. the capital gains and dividend income are not treated as same for tax purpose in most countries. This can be found in case of new and fast growing companies with profitable ventures. shareholders expectations. institutional investors who buy large blocks of stocks prefer regular dividen to meet their own dividend obligations. However the situation is reverse in India. Shareholders’ preference for dividend or capital gains hinges on their economic status and tax rates applicable to dividends and capital gains.8 FACTORS INFLUENCING THE DIVIDEND POLICY Management of Earnings A firm choosing a dividend policy will have to decide about the portion of earning to be distributed as dividends. tax rates on dividends. the companies pay 10 percent tax on the distributed earnings. In a growing economy. with the hope of investing in future. Taxes: As explained in the dividend theories. Therefore. But. and capital gains legal considerations. firms may retain earnings in liquid assets. investors may prefer shares with high dividend pay-out. at times companies should formulate its dividend policies keeping the target groups of shareholders in mind. and they appoint the directors. since dividends are tax-free to the shareholders from 1998-99. However. even if profitable investments are not available currently. it is easy to ascertain the expectations of the shareholders to adopt a dividend policy of their choice. and tax on dividends. Similarly. they only represent the shareholders. Instead of the shareholders. access to the capital market. in case of companies with large number of shareholders distributed across the country.

The firms may prune the dividend rate in such periods until they are able to access the capital market as per their expectations. DPS Year 12 Figure 15. (b) Lenders may put restrictions on dividend payment to protect their interests when the firm is experiencing liquidity or profitability problems.Strategic Financing Decisions Legal Restrictions on Paying Dividends: The companies have to follow certain legal norms while deciding the dividend payments. When a company pays dividend and raises new equity capital. the shareholding of the management group may come down as a percentage. 15. the control aspiration will affect the dividend policy.9 DIVIDEND STABILITY Companies normally dislike to change their dividend policies too often. Control: The existing management group normally tries to continue their control on the company. when the capital markets are in a highly depressed state. companies may fail to do so. Thus. Some of the restrictions are: (a) The companies Act provides that dividend shall be paid only out of the current profits or past profits after providing for depreciation. EPS Rs. Relationship between earnings per share and dividend per share is noticable in figure 15. unless they increase their share holding proportionately. the Central Government is empowered to allow any company to pay dividend for any financial year out of the profits of the company without providing for depreciation. But.1: Relationship between EPS & DPS .1. Access to Capital Market: In spite of policy to distribute high dividends and raise new capital to finance the new investments. Even the share holders value stable dividends higher than fluctuating one. They are: Stable dividend per share or rate Stable dividend pay-out ratio. The dividends follow a very slow but steady up ward or downward trend over a period of time. If they are unwilling to increase their shareholding they may retain more earnings to finance the projects. Stable Dividend per Share: Most companies prefer to pay a fixed amount per share as dividend per share. regardless of fluctuations in the earnings. There are three forms of stable dividends. and Stable dividend per share plus extra dividend.

retained earnings. Considering the above facts.It is easy to follow this policy when the earnings are stable. Temporary shifts in earning will not reflect in dividend payments. Residual Dividend Policy: Comapnies can finance their investments through funds from debt market. Stable Pay Out: Some companies may follow the policy of paying a fixed portion of earnings as dividends. Once the company finalizes the investment and the target debt equity ratio. it will secure the debt funds accordingly. and equity capital. Research indicates that companies paying stable dividends will be preferred by the investors. In this policy internal financing is automatic and it removes the trouble of over or under payment of dividends. To smoothen the dividend payments companies dig into their reserves to pay the constant dividend in years of low earnings. So they tend to be overcautious in recommending dividend hikes. Managers dislike to reduce the dividends. managers dislike 13 . If they change wildly. and therefore dividend per share varies accordingly. However. Companies seldom follow this policy. As a result the share values may change wildly. Dividend changes indicate significant changes in the long-term earnings. if they do not represent any change from the current dividend policy of the respective firms. and also pays an extra dividend in years of high profits. D1 = target dividend = target ratio x EPS1 then. if a firm decides on a target pay out ratio. dividends will be smoothened over a period of time. Then the dividends entirely depend on the current year earnings. Management of Earnings 15. companies find it difficult to maintain stable dividends. According to Linter. The earnings left over in the process with be distributed as dividends. In that components the management will decide on how much to meet from retained earnings and capital market by selling new shares. Very few companies follow this method as policy.10 DICIDING THE DIVIDEND PAY OUT RATIO Based on a survey of corporate managers John Linter emphasized the following points with reference to dividend policies: Firms pursue long-term target dividend pay out ratios. the change in dividend will be equal to = D1–Do = target change = target ratio X EPS1 – Do Any firm following a constant pay out ratio will be paying different amounts of dividends whenever earnings change. Stable Dividend per Share plus extra Dividend: In this method the company pays a stable regular dividend. Managers do not attach much significance to dividend declarations. the dividend in the next fiscal will be equal to a constant proportion of earnings per share (EPS). Linter developed a simple model to explain the dividend payments. According to the model. The equity component will comprise of retained earnings and new equity shares.

“If it is all very well saying that I can sell shares to cover cash needs. 15. What is the informational content of dividends? Discuss its its influence on share value. This model suggests that dividend hinges on both current earnings and dividend of the previous year.M’s irrelevance hypothesis. preferring. but that may mean selling at the bottom of the market. 15. therefore giving more importance to dividends.90 + . Examine the M. with several restrictive assumptions. The Walter’s model suggests to take the dividend decision based on firms rate of return and its discount factor. Discuss. dividends. In practice. smooth progression instead. firms have been found pursuing are stable dividend policy and they consider several factors before deciding on dividend payout rate. Critically evaluate its assumptions.Strategic Financing Decisions changing dividends. What are the different pay out methods? How do shareholders react to these methods? Distinguish between bonus shares and share split. investors can avoid that risk” discuss.12 SELF ASSESSMENT QUESTIONS What are the factors which influence management’s decision to pay dividend of a certain amount? Discuss the implications of making dividends tax free. but indicates that risk increases with futurity. Some of Indian studies also confirm the Linet’s hypothesis. and market price? Between 1971 and 1995 one could explain about two thirds of the variation in TEP Ltd’s dividend changes by the following equation: DT – Dt–2 = –0. Do you agree with Walter’s dividend model ? Discuss its relevance and limitations. 14 . If the company pays a regular dividend.54 (–34 EPSt–Dt–1). Gordon expresses similar moves. dividend change as per Linter may conform to the following model: (D1–Do = adjustment rate) (target change) = adjustment rate (target ratio X EPS1 – Do) Through this model firms can slowly move towards their respective target pay outs instead of repeatedly changing dividends. Therefore. “Risky companies tend to have lower target pay out ratios and more gradual adjustment rates” do you agree? Give reasons. What is their impact on earnings per share.11 SUMMARY The annual earnings of firm can be paid as dividend or retained for investments increase the firm’s value. M–M hypothesis indicates the irrelevance of dividend policy to enhance the firm’s value.

D. Pandey I.. Financial Management. Management of Earnings 15 . New Jersey. Mc Graw Hill Inc.A.. L. Printice Hall Inc. Mumbai. Tata Mc Graw Hill Ltd. Principles of Corporate Finance. New Delhi Brealy R. James W.. and Stewart C. New York. Financial Management and Policy. 7 ed.. Myers. New Delhi. Himalaya Publishing House. and Halley C. M Financial Management. 2003.15. Financial Management and Policy. 4 ed. Schall.W. Vikas. R M Srivastava.13 FURTHER READINGS Van Hore.

7 16. and the implementation of innovative financial instruments and processes.8 16. John Finnerty (1988) offers a comprehensive and lucid definition of financial engineering as follows: "Financial engineering involves the design. The users of financially engineered products include investors including institutional investors like pension funds. The meaning and characteristics of debt and equity instruments are well known.9 Introduction Factors Contributing to Financial Engineering Financial Engineering Process Financial Engineering in Fixed Income Securities Financial Engineering in Equity Products Financial Engineering in Derivatives Summary Self-Assessment Questions Further Readings 16. corporates. If you place these two instruments along risk-reward line. But it is something like mixing individual chemicals in 1 .UNIT 16 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 16. Applying this general meaning of engineering. who need moderate risk and return can choose 'preference shares'. employees and government.1 16.6 16. consumers. Is there any alternative to this financially engineered product? Yes. These two are plain vanilla products. they can be placed at two extreme points.5 16. Many financially engineered products are in between these two products or decomposing the risk and return or changing them to the level users want. Debt carries low risk and hence low return.2 16. it carries lower risk but also lower return. Compared to equity. 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. 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.4 16. the development. We provide you a quick and intuitive understanding of financial engineering concept. 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. banks and financial institutions. suppliers.1 INTRODUCTION In general.3 16. Equity carries high risk and hence high expected return. So. and the formulation of creative solutions to problems in finance". 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. an investor.

provide an opportunity to share the reward if the equity price goes up without risking your capital when the company is not doing well. A financially engineered product may be innovative today but it may eventually become a common product in the future. 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). which are optionally convertible. it make sense for companies to issue zero-coupon bonds. Convertible debenture is another financially engineered product that is in existence for a long time. The plain vanilla product is sole proprietorship or partnership with unlimited liability. Equity with a limited liability is financially engineered product. here is a product. Options are again financially engineered product. Small investors wanting to show the income as regular income will buy the same in primary market whereas high net 2 . The investors. if you buy a zero coupon bond in the secondary market. Since the plain vanilla structure put a limitation on the growth of the company. 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.Strategic Financing Decisions your home to prepare cough syrup instead of buying formulated product. Why users of financial products or solutions want some value-added products? An understanding of such needs will be useful to appreciate the role of financial engineering and the products and solutions that come out of financial engineering. engineering produces products or in some cases solutions that add value to the users.2 FACTORS CONTRIBUTING TO FINANCIAL ENGINEERING As stated above financial. every one will exploit the opportunity. the market has created similar product called option (call and put option). agree to compensate the investors who take risk by paying premium. In other words. we need a structure in which many investors can participate but management is vested only with few. there is a need to restrict the liability of investors. They are to be different and add value to users. 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. Though Finnerty definition requires 'innovation' as an essential characteristic of financial engineering. While convertible debentures or bonds are financially engineered product by the company. In other words. For instance. These factors are briefly discussed below: (1) Tax Advantage: If there is a way to save tax or defer tax. Financial Engineering 16. Convertible debentures. not all engineered products are innovative. which decomposes the risk and return of the equity and passes on the return only to the investor. John Finnerty (1988) identified eleven factors that are primarily responsible for financial innovation. Often financial engineering helps to develop such products. 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. Since there is no guarantee that managers will manage the business well. Of course. who get return. It again decomposes risk and return and hand over return to one set of investors and risk to another set of investors. 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.

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. Thus. mutual fund is a financially engineered structure to get tax advantage and of course. However floating rate brings new problem and issuers are exposed to higher cost of borrowing. if a firm issues debenture for 7-year period. A swap transaction can shift such risk from company to counter party. While operating leasing is a plain vanilla product. and you will get truly financially engineered product to handle transaction cost. 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. financial leasing is an engineered product.worth investors will buy from secondary market. which latter bear. 3 (3) (4) . For instance. Risk Reallocation: Financial engineering plays a major role in this respect too. We briefly discussed this point in introduction. For instance. you can create an environment in which you can trade 'risk'!! We will see more examples in subsequent sections. say 99-years with call and put options and in that process tremendous transaction cost is reduced. 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. Employee Stock Option (ESOP) is a financial innovative product. For instance. many companies have done 'sale and lease back' transactions to exploit loopholes in tax laws. (2) Reduced Transaction Cost: Financial products and solutions come with high transaction cost. etc. Mutual funds is also tax-efficient medium through which you can change the character of the income from one to another. 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. Some years back. You can convert capital gains into dividend and vice versa. which in turn invest the money in bonds and receive interest income. Like this. Add more features to take care of various concern like changes in credit rating. Of course. There are several other examples. which often used to gain certain tax advantage. 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. An alternative is issue of fairly a long-term bond. it is also a vehicle through which investors can achieve diversification at low investment. which swaps part of salary for equity such that the value of equity increases only if mangers perform well. fixed interest rate bond is plain instrument in which both investors and issuer are exposed to interest rate risk. you can still show the income as capital gain by choosing certain schemes. Through financial engineering. it is possible to reallocate the risk to different parties and of course such reallocation comes with a price. The life of such products or solutions is generally short but opportunities come regularly. if you invest in bond market fund. Similarly. which was plugged subsequently. Reduced Agency Cost: Agency relationship between promoter/managers and other shareholders/stakeholders creates certain cost. A floating rate bond takes away the risk. a non-tax paying company and tax paying investors can save tax by investing in preference shares.

which allow companies to issue shares in US and other markets without attracting such high level of regulations.Strategic Financing Decisions (5) Increased Liquidity: Liquidity reduces the cost and improves efficiency of pricing. If regulation removes certain restrictions and allows competition. (9) (10) Accounting Benefits: Accounting regulation requires certain items to be treated in a particular way. Academic Work: Sometime new and value added products are developed as a matter of academic exercise and subsequently someone finds it useful. Liquidity is affected due to rigidity and inability to assess the risk level. both make life complex. In that process. Financial engineering can help these two parties to swap their risk appetite on interest rate volatility. For instance. Zerocoupon 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. real assets in general are less liquid compared to financial assets. which give option to enter and exit at anytime and of course with certain cost (entry and exit load). many companies have reduced salary by converting a part of salary into stock option (ESOP) but not recognized as expense. Technological development in computational finance today makes it possible to develop such products and allow users to trade risk and return. 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. All interest rate derivatives are outcome of such volatile behaviour of interest rates. Another example. Bonds linked to commodity prices shift such price risk from those riskaverse players to those who are willing to take up such risk. which reduces level of risk and also transaction cost. profit and profitability increase. For instance. Depository and electronic-trading are positive side of regulations. Insurance is another highly regulated industry but you can witness so many products offered by them. Through securitization. Financial Engineering (6) (7) (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. RBI puts lot of restrictions on companies raising deposits from public. you have to be more innovative to keep the interests of investors. Land is not as liquid as bonds issued by a company dealing in buying and selling of land. If regulation puts certain restrictions. Loan portfolio is less liquid if some banks want to sell the loan portfolio compared to stocks and bonds of the bank. Regulatory or Legislative Factors: Regulation or deregulation. is openend mutual funds. (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. you have to be equally innovative to compete and retain your investors. 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. Equity and bonds of leasing companies are more liquid than assets funded by leasing companies. 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. 4 . financial engineering can improve the liquidity. ADR and GDR are financially engineered products. Mutual funds are introducing several new products within regulation to attract investors and tap new sources of funds. Earlier when there were no regulation on treatment of stock option.

................................................. List down the process you have applied in developing new product............... Like car manufacturers......................... 5 ........................................................................................ the next stage is pricing of the product................. an open-end fund gives liquidity compared to close-end funds but still investors have to fulfil so many formalities to get the money.. ................................ which increase its value to users................................. The process starts with identification or realization of some needs............... Finally........ At this stage.............. Sometime.......... ....................................... Activity 2 Suppose you are in a large bank specialising consumer loans..... complex model building exercise is used............. a structured derivative product requires high level of mathematical modeling............................................................................ . .................................. 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.3 FINANCIAL ENGINEERING PROCESS Financial engineering process is no different from the process that any firm follows in developing new value added products or services................................ .................................................................................... For instance........ At the stage of pricing..... ....... ............ Corporate finance managers have to look for ways to reduce cost of capital or reduce the risk arising out of operating activities....... ................... The next stage is testing of the product so check whether the desired result is achieved.......... It is quiet possible that you may add one more feature to the existing products....... 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...... Examine whether they have issued any security other than plain equity and bonds.............Activity 1 Visit the web site of few large Indian and US companies and see their annual report..................................... .................................................... Cheque book facility to mutual funds holder takes away so many formalities relating to redemption and provide instance liquidity............................................................................ 16........... For example........ So............................................................................. You are asked to develop a new product to achieve 20% growth in consumer loans.. ...................... the product is launched or solutions are provided either directly or after some test marketing.................................. it is quiet possible that the price paid by the customer may be more than the benefit derived out of the product.................................................................. Examine the existing products available and then develop a new product. depending on the product requirement...................................................... Once the need is identified..... Treasury managers of banks while talking to clients can get ideas for new product or solutions................. an initial sketch of the product is developed.. you may have to run some simulation exercise to verify how the product will produce results under various simulated future scenario.............. Sometime such needs are known but many times............................................................... the product may be restructured again so as to make it attractive to the users................................... Sometime it involves simple verification with the users or some senior managers' assessment... Once the product is perfected....

When the rate declines. it may not be always possible for the company to adjust the end product price. This will hurt the profitability of the company particularly cause distress if the company also has fixed interest rate debt. there will be a floor rate and cap rate for such issues. when the interest rate moving upward. What about the users of such commodities. 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%). For example. That is. For instance. the asset side risk (also called business or operating risk) is very high. the market prices of bonds move up and down based on changes in the market interest rates.. metals and oils? They are also exposed to price risk. interest liability will be lower when the price of input moves upward. A typical floating rate bond contains a float part and fixed part. Prices of commodities. they can tackle different types of risk. which takes away the interest rate risk. metal. which may not be assessable at the time of investment. it can be bank rate or LIBOR + fixed premium say 4% or 2%. a pure fixed interest paying debt will add more problems. oil. When the prices of input moves up. the instrument. if the prices of the products crash. are highly volatile and producers of these products are exposed to high level of risk. a commodity producer or oil company is exposed to considerable amount of commodity or oil price risk. the bank rate or LIBOR also moves up and hence investors get higher interest rate. Instead of fixing the float to Bank Rate or LIBOR. In other words. 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. if the interest rate of such floating bond is 4%+changes in oil price or price index.4 FINANCIAL ENGINEERING IN FIXED INCOME SECURITIES Financial Engineering Fixed income securities have seen large-scale innovation and new products. Naturally. If the price increases by 3%. It is resolved by linking floating rate with the commodity price index. in a balance sheet context. Similarly. by and large. retains. it may hurt the business considerably. zero-coupon bond and convertible bonds are some of the early part of new products. the characteristics of debt but it brings some equity flavour into the instrument. float part effectively handles the interest rate risk. if the issuer and investor fix the float to some other value.Strategic Financing Decisions 16. In other words. Inverse floating rate bonds. Thus. for these companies. Similarly. the bond holders will get a return of 4% only if the price remains same. then bond holders will get 7%. Another major innovation in bonds was floating rate bond. it creates value when price moves upward. the investors will get higher interest rate when the market price of the commodity moves up and gets lower return when the prices fall. the investors of fixed interest rate bonds loose money as the prices of bonds decline. In the above case if the floor is 4% and cap is 10%. So. 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. etc. For some reasons. Normally. As was mentioned in the introduction of the Unit. when the price 6 . borrowers are not stuck with higher interest liability. 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. A number of subsequent innovations on floating rate bond aim to deal with different types of risk. That is. While debt creates such adverse effect in a falling prices. For instance. where interest is linked to commodity price changes but in a inverse direction. A zero-coupon 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. When the interest rate moves upward in the market.

........ Alternatively.... Those investors. ....... Such that series 20 will mature at the end of 10 years and the face value is equal to principal and last instalment interest.. 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. 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......... In essence............. figure out why other companies like Essar Oil failed to replicate such innovation........ 7 ..... who have surplus for 6 months...................... To overcome this and also to create some additional liquidity...................................... series 1 will mature at the end of 6 months and the face value of the same is equal to first interest payment................ Interestingly.. those who have surplus for 12 months will invest in series 2.................... 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................... You may be wondering why no one bothers to develop such instruments for consumers....... But the problem is... 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.. ...... then interest liability will be more.. Can you create Zero-coupon bond (ZCB) from an interest-paying bond? There is nothing impossible before financial engineer.... As was discussed earlier.... foreign exchange risk is transferred from the company to others.... all investors of ZCB get benefit more than what they would get otherwise for investing money for such term. In other words................ you can peg the interest rate to the changes in foreign exchange rate fluctuations.............................. Of course.. Thus you will be getting 20 cash inflows.. Those who are looking for regular income can sell the baby bonds while retaining the mother bond......... investors who are looking for regular investments that will avoid such instrument................ will invest in series 1................. any risk can be handled. Also... .......... Examine convertible debentures issues of Reliance and figure out how it helped them to achieve high growth without diluting their stake. It is possible to issue a bond in one currency............................... It works like this....... 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)............of input moves downward...................... Activity 3 Reliance Industries has successfully leveraged convertible debentures for expansion..... financial engineering developed several innovative products in debt instrument.............. tax treatment for such baby bonds was also one of the reasons for such innovations........ issuers of such zero-coupon bonds have started issuing baby bonds...... ........................................ restructured and transferred from a person who is not willing to take such risk to a person who is willing to assume such risk.......... Series 2 will mature at the end of 12 months and the face value is equal to second interest payment.... They can invest in the bonds and shares of those companies until financial engineers come out with a product..... That is................ pay interest in another currency and repay in a different currency. which are also zero-coupon bonds....... If you carefully look into interest-paying bond................ We mentioned earlier that zero-coupon bond is one of the earliest innovations.... etc........ who are ultimately affected by the prices..........

Typically. Such voting right has a value.Strategic Financing Decisions 16. 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. the shareholder will get one Class B shares. a suitable compensation either in the form of discount in offer price or additional dividend is offered to the subscribers. it is somewhat equal to buyback of shares or selling puts. 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. those who are interested in control stake would go for exchange. these products are designed to carry high risk. For instance. some companies may issue such shares in the future. In other words. which has 100 voting rights per share and no dividend). 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. One of the basic characteristics of common stock is voting rights that it gets for the holders. 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. 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. 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 8 . a few attempts have been made to reduce the risk or share the risk and change some of the basic characteristics of the instruments. Voting rights give the shareholders to participate in key decisions to the extent of their stake in the company. This basic characteristic of the equity has been changed and voting rights value is swapped for additional dividend by issuing different classes of shares. However. it is generally considered that non-voting or lowvoting shares increase the agency cost since promoters are trying to retain their control without investing an equal amount. companies may issue non-voting or low-voting shares for ESOP. 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. Unlike co-operative form of organization in which each shareholder gets only one vote irrespective of share that the shareholder contributes. Naturally. 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 (eg. you get 1000 votes and your friend gets 100 shares. it is now possible for the public limited company in India to issue non-voting shares. 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. While the uses of such instruments could be many. For every 10 shares of Class A surrendered. when companies issue such non-voting shares. Sometime. Initially. For instance if you have 1000 shares and your friend has 100 shares. common stocks holders' votes equal to number of shares that the shareholder possess. Nevertheless. promoters would subscribe Class B shares whereas most small investors would prefer Class A shares.5 FINANCIAL ENGINEERING IN EQUITY PRODUCTS Financial Engineering Equity product witnessed limited innovations since by definition. If you closely observe the basic characteristics of the instruments. the risk associated with equity shares is considerably reduced by issuing such shares. For instance. under Indian law. Sometime. Though so far no company has issued such shares.

plantation. For example. Normally. say once in a month . both parties have to negotiate for the reversal of the contract. SBI Mutual fund could invest 100000 shares in Infosys and create 100000 Class A and 100000 Class B stripes against the investment in Infosys. speculators will prefer Class B or SCORE component.that is. However. Financial engineers designed options contract which allows buyer of 9 . For instance.6 FINANCIAL ENGINEERING IN DERIVATIVES The contribution of financial engineering on derivatives is substantial. 16.promoted by fly-by-night operators. futures (both commodity and financial futures). it is easy to get in and get out of the contract. bonds. 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). futures are highly liquid and available on large number of financial products like stocks. In fact. To manage the price risk. the producers gain in such situation. Of course. For example. Yet another innovation from mutual funds and investment bankers is splitting the total return of equity into two components and trade them separately. Both parties are exposed to price risk if they decide to transact periodically. the parties forgo the opportunity to exploit the price advantage. currencies and commodities like coffee. which are a derivative instrument. Forward is a plain vanilla instrument that gives birth to derivatives through financial engineering. etc. it is possible to trade in organized exchanges and because it is traded in exchanges. While small investors prefer Class A or PRIME. While futures resolve basic problem of liquidity while allowing parties to 'lockin' the price today so that there is no price risk. Companies like Intel have issued 'put option' instead of puttable common shares. Forward performs almost all requirements of both parties of transactions but there are certain limitations. every derivative instrument is the outcome of financial engineering. 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. Good companies gain by charging more premium for such shares because of less risk associated with such shares. which often will be expensive. Because of standardization. offer this facility. producer will supply one month wheat every month based on the price prevailing in the market. Today. To appreciate the contribution of financial engineering on managing risk through derivatives. The Class A is called PRIME and Class B is called SCORE. there is no easy way for getting in and getting out of the forward contract. cotton. Forward is an agreement between the two parties entered today with all terms of contracts agreed today but settled at a future period. the buyer will continue to pay higher price even the current market price is much lower. For instance. producers and consumers have started transacting in forward market. Hence when the prices move up or down. cash market transaction creates certain problems. Future is a standardized forward contract entered between two parties and traded in the exchange. such exchanges take place when the parties transact and such trades are called cash market trades. There is no loss to the company since the shareholders will not exercise their right if the company performs well. if one of the parties wants to get out of the contract before the settlement date. They are also available on metals and energy products. However. Market is a place where goods. products or services are exchanged. the producers continue to sell at lower price while buyers' gain in such a situation. let us go back to the origin of such developments. if the prices move up. one of the parties gain and other incur loss. On the hand. In other words.

.................................... Financial engineering is an exciting field............. acquisition and corporate restructuring.................. ............. it is possible to quantify risk and return of any new products and also price them with the help of these models. . ..................... .... 10 .. 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....................... Buyers of option........................................................................................................................................................... Activity 4 Visit internet and find out the details of some exotic derivatives like weather derivative and write a brief report on the same............................................. etc.......... Black-Scholes Option Pricing Model....... ............ ............................................. who take positive side of the risk........................................................................ Producers buy put option.............................. Swaps are similar to futures but the difference is it is a series of futures........ Such innovations are seen in bonds.... Swaption is another variation of swaps contract and it brings option element into swaps............................................................................................. Option contracts split the risk into positive and negative and allow parties to take whatever they like................................ equity..........................7 SUMMARY Financial engineering like any other engineering has brought several new products and solutions to the market.............. Financial engineers have developed several such variations and you will have an opportunity to learn them in derivative courses............. 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................................................................. which gives them a right to buy at a predetermined price... which attracts some of the best human resources........................................................................ Consumers buy call option............................................................................................... Today.................................................................... They exercise the right only when the price is more than the predetermined price.................. derivatives................................................ who take negative side of the risk....................................................... It has completely changed the financial market today........................... Suppose your company has borrowed money in the US but your exports are primarily to Europe..................................... and also in other fields like merger.............................................................. Financial Engineering 16........................................... It also provides mechanism to price such combinations by developing various pricing models for futures and options......... . are expected to pay a price or premium to sellers of option...........Strategic Financing to retain the option Decisions the benefit of price movement while avoiding loss..... ................................................. Some of the models are cost-of-carry model............... .............. ................................................... which gives them a right to sell at a predetermined price and producers exercise their right when the price moves downward............... ............ binominal model....... The profession is also highly rewarding........... It is possible that you can swap dollar loan with Euro currency loan so that your foreign exchange risk is reduced.......................

9 FURTHER READINGS Finnerty. Vipul K. Financial Engineering: A Complete Guide to Financial Innovoation.. 4. 14-33. Financial Management. 3. 6. December 1986. 16. Discuss innovation that took place in equity products and explain what they achieved. Marshall. 459-71. What is non-voting share? How is it useful to the company and investors? 7. Miller. Pp. Finanical Innovation: The Last Twenty Years and the Next.16.C.F and Bansal. 1995.. Pp. Prentice Hall.New Delhi. S P. List down with examples any five variables that contribute new products development. What is financial engineering? Do you feel financial engineers play an economic role in the society? 2.. Englewood Cliffs. Journal of Financial and Quantitative Analysis... 1996. R. Winter 1988. Briefly discuss the financial engineering process that you will follow while developing new products or solutions. and Tufano P. Explain how fixed income securities are used to manage product price risk. New Jersey.8 SELF-ASSESSMENT QUESTIONS 1. J. Financial Engineering in Corporate Finance: An Overview. F. John. Cases in Financial Engineering: Applied Studies of Financial Innovation. What is the use of derivatives? Is it an instrument designed for speculators or useful to others too? 8. Perold A. Mason. M H. Explain any two derivative products and show the value addition in them. 11 . Printice-Hall of India. D. Merton. 5.

UNIT 17 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 17.1 17.2 17.3 17.4 17.5 17.6 17.7 17.8 17.9 Introduction Corporate form of Business Organization Demand for Information Transparency and Disclosure Corporate Governance Investor Service Summary Self-Assessment Questions Further Readings

Appendix : Corporate Governance Report of Infosys Technologies Ltd.

17.1

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 mix of debt and equity. Generally the equity holders are the promoters, the directors and their relatives, Government, sometimes 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. Table 17.1 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

1

Strategic Financing Decisions

range from Rs. 30 crores to 4000 crores. The number of equity shares issued run into millions and in some cases in billions. To get better understanding of who actually controls the company, we need to look into the shareholding pattern data of these companies. Table 17.2 presents the percentage of equity holding by different categories of equity shareholders of these nifty 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. 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. These two tables thus highlight the fact that number of investors are large 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.

17.2

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. The Companies 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 17.1 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.

2

Table 17.1: Equity shares and capital of NSE 50 companies
Company Name A B B Ltd. Associated Cement Cos. Ltd. B S E S Ltd. Bajaj Auto Ltd. Bharat Heavy Electricals Ltd. Bharat Petroleum Corpn. Ltd. Britannia Industries Ltd. Cipla Ltd. Colgate-Palmolive (India) Ltd. Dabur India Ltd. Digital Globalsoft Ltd. Dr. Reddy'S Laboratories Ltd. G A I L (India) Ltd. Glaxosmithkline Con.Healthcare Ltd. Glaxosmithkline Pharmaceuticals Ltd. Grasim Industries Ltd. Gujarat Ambuja Cements Ltd. H C L Technologies Ltd. H D F C Bank Ltd. Hero Honda Motors Ltd. Hindalco Industries Ltd. Hindustan Lever Ltd. Hindustan Petroleum Corpn. Ltd. HDFC I C I C I Bank Ltd. I T C Ltd. Indian Hotels Co. Ltd. Indian Petrochemicals Corpn. Ltd. Infosys Technologies Ltd. Larsen & Toubro Ltd. Mahanagar Telephone Nigam Ltd. Mahindra & Mahindra Ltd. N I I T Ltd. National Aluminium Co. Ltd. Oriental Bank Of Commerce Ranbaxy Laboratories Ltd. Reliance Industries Ltd. Satyam Computer Services Ltd. Shipping Corpn. Of India Ltd. State Bank Of India Steel Authority Of India Ltd. Sun Pharmaceutical Inds. Ltd. Tata Chemicals Ltd. Tata Iron & Steel Co. Ltd. Tata Motors Ltd. Tata Power Co. Ltd. Tata Tea Ltd. Videsh Sanchar Nigam Ltd. Wipro Ltd. Zee Telefilms Ltd. Eq. Capital (Rs. Crores) 42.38 171.13 137.83 101.19 244.76 300 25.9 59.97 135.99 28.58 32.98 38.26 845.65 45.38 74.48 91.69 155.27 57.58 282.05 39.94 92.46 220.12 338.83 244.41 612.66 247.51 45.12 249.05 33.12 248.67 630 116.01 38.65 644.31 192.54 196.72 1395.92 62.91 282.3 526.3 4130.4 46.52 180.7 369.18 319.83 197.91 56.22 285 46.51 41.25 No. of Shares 42381675 170929944 137725666 101183510 244760000 300000000 25904276 59972349 135992817 285749934 32980532 76515948 845651600 45380621 74475000 91669685 155189921 287884290 282045713 199687500 92481325 2201243793 339330000 244414492 613034404 247511886 45114695 248225622 66243078 248668756 630000000 116008599 38649279 644309628 192539700 185452098 1396377536 314542800 282302420 526298878 4130400545 93048478 180638651 367771901 319784387 197897864 56219857 285000000 232563992 412505012

Investors Relations

3

Strategic Financing Decisions

Table 17.2: Shareholding pattern of Nifty companies (in %), March 2003
Company Name ABB ACC BSES Bajaj Auto BHEL BPCL Britannia Industries Cipla Colgate-Palmolive (India) Dabur India Digital Globalsoft Dr. Reddy'S Laboratories G A I L (India) Glaxosmithkline Con. Health Glaxosmithkline Pharma Grasim Industries Gujarat Ambuja Cements H C L Technologies H D F C Bank Hero Honda Motors Hindalco Industries Hindustan Lever HPCL HDFC I C I C I Bank I T C Indian Hotels Co. Indian Petrochemicals Corpn. Infosys Technologies Larsen & Toubro Mahanagar Telephone Nigam Mahindra & Mahindra N I I T National Aluminium Co. Oriental Bank Of Commerce Ranbaxy Laboratories Reliance Industries Satyam Computer Services Shipping Corpn. Of India State Bank Of India Steel Authority Of India Sun Pharmaceutical Inds. Tata Chemicals Tata Iron & Steel Co. Tata Motors Tata Power Co. Tata Tea Videsh Sanchar Nigam Wipro Zee Telefilms Promoters 52.11 0.00 58.22 29.17 67.72 66.20 47.00 39.94 51.00 78.34 50.61 26.02 67.34 40.00 48.83 20.42 27.51 77.04 24.41 52.00 24.37 51.56 51.01 0.00 0.00 0.00 37.38 79.98 28.42 0.00 56.25 26.26 31.25 87.15 66.48 32.05 46.52 20.74 80.12 0.00 85.82 71.75 30.56 26.41 32.21 32.54 29.48 71.12 83.90 51.77 Institutions 30.47 45.48 28.13 21.07 29.83 27.72 28.37 24.85 11.93 11.61 33.85 35.20 9.42 34.19 26.56 38.23 38.45 10.55 30.49 31.05 38.15 26.03 37.01 59.70 59.74 48.00 27.24 8.38 48.44 44.09 31.29 43.79 41.97 7.47 16.67 35.85 27.76 56.27 11.17 82.40 9.73 17.37 26.39 34.34 35.03 33.95 34.03 9.36 4.40 33.53 Cor. Bodies 1.10 18.26 0.48 13.52 0.52 1.39 1.98 2.22 1.01 1.09 1.37 1.90 0.36 3.54 1.50 5.80 3.55 4.12 1.16 2.01 3.19 0.84 3.14 2.37 4.93 0.85 2.33 2.11 1.01 20.04 0.74 5.61 7.42 3.59 1.71 1.00 1.67 2.34 2.90 1.79 0.69 2.69 5.03 6.78 9.87 2.35 3.21 2.80 1.78 3.28 Others 17.42 54.52 13.65 49.76 2.44 6.08 24.63 35.21 37.07 10.04 15.54 38.77 23.23 25.81 24.61 41.36 34.04 12.41 45.09 16.95 37.48 22.42 11.98 40.30 40.26 52.00 35.37 11.64 23.14 55.91 12.46 29.94 26.78 5.38 16.85 32.10 25.72 22.99 8.71 17.60 4.45 10.88 43.05 39.25 32.76 33.51 36.49 19.52 11.70 14.70

4

Investors Relations

Corporate

Capital Market Institu Finance Function Managers

Primary / Secondary

Functional Managers

S

Figure 17.1: 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. There are several ways in which the management or promoters can assure the 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.

17.3

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 worth while 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 creatibility 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 may be much more in detail and confidential compared to the information provided to the outsiders. The customers, particularly the consumers of durable goods or vehicles or IT products, would be interested in knowing whether the

5

This is for the fact that the risk and return of a firm are dependent on the following: (i) the social. He continuously tracks the company for information and analyzes the company accordingly and informs the public on buy and hold strategies. So they keep a watch on the performance of the company. investment and dividend. the risk associated with their returns and accordingly take their investment or portfolio decision. company-specific factors which are important to any company. managers. such as financial performance. policies of government which have influence on the industry. 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. political stability. The analyst demand information to publish reports on the performance of the company and to rate its debt payment capacity. This involves control of managerial behaviour so as to guide managerial activities towards the maximisation of shareholders' wealth. as also to design contracts and mechanisms for controlling the behaviour of managers. growth rate of gross domestic product (GDP). even if it is at the expense of other parties involved in the activities of a concern. investors would be able to calculate the expected returns of securities of different firms. and orient the managerial behaviour towards realising the objectives of a firm. higher incomes and higher profits or through transfer of wealth from other parties involved in the corporate activity such as creditors. shareholders and investors demand information for the purpose of safeguarding their interest in the corporate firm. decisions relating to financing. On the other hand.Strategic Financing Decisions company would exist in near future to provide them the service for the product they purchased. Second. 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. i. Hence. shareholders and potential investors require information so as to help them to make the investment decision. (ii) (iii) Once the investment decision is made. Accordingly. The small investors simply do not have the time to keep track of the companies latest information. and demand and supply factors and. such as social harmony. First. With the knowledge of these factors. 6 . 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.e. information whose disclosure does not affect the firm's future cash flows. So they would be constantly watching the company’s performance for the same. Thus. such as labour conditions in the industry. and policies of the government. the chances are that they might lose their jobs and also lose wages. Moreover they would not be able to analyze the information as usefully as the experienced analysts do. political and macroeconomic factors which are common to belonging to differents all companies industries. they demand all information that is non-proprietary. Because if the firm is not doing well. inflation rate. relations with other countries. money supply. Towards this end. We know that the objective of existing shareholders is to maximise their expected utility or wealth. the industry factors which are common to all companies in a particular industry. they would like the management to take decisions which would increase their wealth either through achieving higher sales. 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. the demand for information by small and retail investors differs from that of the experienced analysts. changes in the top management. they wish to safeguard their interest and want to limit the possibilities for expropriation by all other parties.

... ................................................................................... 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............... Once the company accepts the listing agreements........................... Whereas the former wants the firm to reveal both value enhancing as well as value diminishing information. Basically the investor demands can be classified into three basic categories.. . find out whether they are satisfied with the role of SEBI and Stock Exchanges in improving disclosure standards............................ expects the firm to reveal only the value enhancing information and not to reveal the value diminishing information...................... 1) Transparency and Disclosure 2) Good corporate governance 3) Investors Service Each of these are discussed in detail in the following sections........ ........................................ the latter................ Such conflicts can be seen as amount existing groups of promoters........... However................................................ 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........................ ...................... we should also note that the demand for disclosure of corporate information of prospective shareholders differs from that of existing investors............................. SEBI has also brought several regulations and guidelines for market participants and intermediaries to protect the interest of investors...................................................... ............................................................... The requirement that the company form of organization has to be registered under the companies Act........................... The investors' interests are protected by the Securities Exchange and Board of India (SEBI).................................. the company's shares get listed in the stock exchange....................................... Investors Relations 7 .......... ....................................... They also demand the management of the company to disclose information that maximises the value of the firm................................... There are several agencies engaged in protecting the interest of small investors and other stakeholders........ 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........ Also................................ institutional shareholders and public shareholders....................................... Activity 1 Check with some of your friends who invest in stocks on the information that they require/use while selecting the stocks for investments......................................... This is done to ensure that the financial statements represent true and fair view of the financial position of the company...................................employees....................... 1956 is the first protection to investors and others................................. SEBI had laid down some listing requirements for the companies seeking to raise money from the small investors or public............................ .. customers and government......................................

Investors.Strategic Financing Decisions 17. and non-adherence to standards may lead to disciplinary action against them by the professional bodies. Further. If investors perceive that a company is not 8 . under such circumstances. require on average a high return. The corporate control market forces also influence the firms' decision of disclosure. In this process. 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. and the timing of information release to the public. However. Given the uncertainty about the product quality. the distribution of expected returns and importantly. the capital market ends up in a situation where there are only high risk offers. Under these circumstances. The labour market forces also exert pressure on the management to disclose information to the public. For example. success of the projects and the cost of being perceived as a 'lemon'. investors revise their required return upwards.4 TRANSPARENCY AND DISCLOSURE Companies typically do not make available information on a day to day basis because of strategic reasons. professional managers are governed by a set of standards of behaviour or a code of conduct which are determined by professional bodies. When 'good' issues are withdrawn from the market. the companies disclose summary of information periodically for various purposes. Thus. This can be due to either external or internal forces. This is necessary because the investors have no foresight about returns and the quality of the product. checks such as (i) reputation of the firm. they may be perceived by investors as 'lemon'. At the same time. costs associated with corporate disclosures and the regulatory forces (Refer Figure 17. managers would not be willing to take steps that damage their reputation of competence. as they would have no idea as to which firm's projects are good or bad. and (iv) legal penalties. which force some firms to withdraw from the market. In the instance of non-disclosure by corporate firms.2) Market forces which influence the decision of corporate firms may relate to the capital. as well as their reputation. And firms may be apprehensive. (ii) reputation of the management. This higher required return may force the issuers of capital to withdraw from the market as the net present value of the project would be negative. Some firms may make overly optimistic forecasts about the future cash flows associated with a project. Corporate disclosure of information is determined by the market forces. the investors may not be able to assess the risk and returns on the projects undertaken by the firms. (iii) third-party assessment and clarification. forces in the labour market prompt the managers to disclose information which improves their prospects. and huge costs involved in collection and dissemination of such information to all the users. if the projects are implemented with resources mobilised at a higher cost. They may issue different instruments which meet the requirements of investors. labour and corporate control market. Corporate firms compete with each other in the capital market for resources. that in the absence of the authentic information. Hence. capital market forces exert pressure on firms to provide information relating to the instruments offered. terms of instruments. and there would be no investors ready to supply the resources. The various forms of raising finance have been discussed in the earlier sections. act as deterrents for firms to make these overly optimistic forecasts. corporate firms have an incentive to supply the information that they believe will enable them to raise capital on the best available terms. and their effective implementation by the managing director and his team of managers. The efficient working of a concern depends on the soundness of the policies determined by the board of directors. on the projects for which the capital is being raised.

Englewoodcliffs. who continuously explore the opportunities for takeovers. Similarly. (ii) litigation costs.Decision by Firms Investors Relations Market Forces Information Available to External Parties Regulatory Forces Decision by non firm Information Sources. as they can acquire the stocks of the company at the existing prices. make attempts to take over the company by actively buying the securities of the company in the secondary market. brokerage houses. Financial Statement Information. have to bear in mind the costs incurred by the firm as well as the costs borne by investors in performing such task. (iii) political costs.2: Factors Influencing the Information Set Available to External Parties Source: Foster. It is not possible for firms to collect all the information on a continuous basis. the corporate predators and raiders. 1986. for example. (iv) competitive disadvantage costs. the prices of a company's securities may be under priced.24. p. they may attempt to take over the controlling stake of the company. These costs include: (i) collection and processing costs. However. Firms. even when the investors do not have information about its good future prospects. 17. and (v) additional constraints on management decisions. Prentice-Hall International. The costs associated with corporate disclosures also influence the time and extent of disclosure of information. 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. Corporate firms as well as users of information incur the costs of collection of information. Litigation costs arise when the corporate has to face a dispute in a legal forum. 9 . This perception of non-controlling stakeholders is influenced by their private information. as it involves unlimited resources. run efficiently and identify ways in which its functioning can be improved. The corporate management has to make decisions on what information is to be collected and at what frequency. Thus. Under such circumstances. under such circumstances. if any. Such private information gives them an advantage. Collection and processing costs include the costs borne by both the suppliers and users of financial information. managers are forced to improve not only their working but also the level of information disclosure. This forces the managers to reveal the information about the prospects of the company to the outsiders. while computing the costs of collecting and processing information. both human and financial. George. The decision on information collection is often based on the assessment of costs and benefits associated with such information. The prompt public release of information as well as corrective information. and industry trade associations Fig. can reduce the potential losses to shareholders and the potential exposure of the firm and its management in subsequent litigations. At times. while computing the benefits of information production and processing. New Jersey. 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 secondly. through the threat of actions of corporate predators and raiders.

in India. investor associations and other interest groups. and industry and trade associations as to what to disclose and when to disclose. recommend standard practices to be followed in the preparation of balance sheets. unless firms provide some information pertaining to their research and development activities or new products. and the Department of Company Affairs under the Ministry of Finance. However. income or sales by individual lines of business. the Institute of Chartered Accountants of India. this level includes the Securities and Exchange Board of India (SEBI). through conducting seminars and publication of discussion papers and in-depth analysis. Typically. Companies also choose to disclose voluntarily information like the 10 . they may reduce the lead time with which competitors learn about developments within the company. These professional bodies include industrial and trade associations. break down of major customers and forecasts of gross margin. and judicial branches of the government. irrespective of whether the firms disclose the information or not. 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. These agencies are often delegated with the authority of overseeing the adherence of rules and procedures by corporate firms. For example. The legislative and executive define the manner in which the corporate has to disclose information. when they perceive that they have an advantage over competitors in these areas.Strategic Financing Decisions 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 resources from the corporate to the other constituents of society through fiscal and other measures. Competitive disadvantage costs arise when firms choose to reveal a portion of proprietary information. For instance. The legislative makes laws which are enforced by the executive. Disclosure of certain types of information by managers imposes constraints on their behaviour and may lead to a conflict between their efficiency and reputation. new products. the capital market is not likely to support a new share offering. they face a difficult situation when they want to raise new capital. the firm stands to experience a reduction in its value. not all information disclosed by the companies are mandated by regulation. The judiciary exerts influence on the disclosure practices by its rulings. (ii) level two includes government regulatory bodies. (iv) level four includes lobbying groups that attempt to influence the decisions made by the parties in the above three levels. (iii) level three includes private sector regulatory bodies such as Accounting Standard Board. from time to time. legislative. Regulatory forces also influence the disclosure and timing of release of information by firms. The decisions of corporate firms and decisions of sources other than corporate firms influence each other. In such a situation. A number of regulatory agencies govern the functioning of corporate and regulate their information disclosure. cash flow statements and profit and loss accounts. influence the decisions of both the corporate firms and non-firm information sources such as brokerage houses. described above. The market forces and regulatory forces. advertising expenditure. and Stock Exchanges. the Company Law Board. Professional bodies. if they do provide detailed information. firms choose to keep strategic information such as information on research and development. In these circumstances. and yet. However. Such agencies can be broadly discussed under four levels: (i) level one consists of the executive. firms may choose accounting methods that they perceive will reduce the likelihood of large profit increase being reported in any one year. As discussed briefly in the earlier sections.

......... companies would be hesitating to provide information.. McKinney in one of their surveys (2000) reported that investors are willing to pay more for companies with good governance. holding formal evaluation of directors........ However. . the market share of the business.. One such latest requirement is the introduction of the Clause 49 on corporate governance code..... and a large proportion of director's pay in the form of stock options................. Apart from this the listing requirement had also been tightened... For instance.................... directors hold significant stockholdings in the company.......... every company wanting to get listed in the stock exchange will have to disclose the corporate governance systems and procedures existing within the company......... than for the shares of a company with similar financial performance but poorer governance practices........................... However....... There has been tremendous improvement in the last few years in the disclosure level of the Indian companies... And the premium the investors would be willing to pay for well-governed companies........... Only the performance of L&T was made known to the companies.......................... business they are operating...... which would reveal their competitive advantage to the competitors.. segment reporting.................... A well governed company is defined as having a majority of outside directors on board with no management ties......... objective.... This is because when companies are able to keep their investor well informed about the way the business is done in a transparent manner.................. the annual reports of the year ending March 2000 and March 2003.social services performed by them.... 2001)............ Identify major changes that you have seen on the items disclosed by the company.... Detailed aspect discussion on this made had been made in the next section...... the ICAI introduced a new accounting standard on Segment Reporting (AS-17) with effect from 2001. . companies are supposed to disclose their financial information based on the different segments............... For instance....... .. the company philosophy. No investor would want to do away his investment from such a company.. differed by country...........................................................5 CORPORATE GOVERNANCE Corporate governance plays an important role in building a good relationship with the investors....... Prior to 2001...... prior to 2001 investors did not know whether L&T was performing well in their cement or construction segment...... this would definitely present a positive image....... This is because as per this standard.... As reported........... Investors Relations 17..... In addition............ (Monks. investors did not know whether companies were performing good in all the segments in which they were operating........ for example... And listing requirements demanded more information from the companies........ Activity 3 Compare for any one company...... revealing the related party transactions................ they reported............ This is mainly due to the new accounting standards introduced by the ICAI like consolidation of accounts.... ..... 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............... revealing the intangible asset valuation etc................. as sated earlier......... 11 . and being responsive to investor's requests for information on governance issues....... Accordingly...... the investors were willing to pay 18 percent more for the shares of a wellgoverned UK or US company........... most companies still do not provide this information despite being made mandatory by claiming that they are single segment company........................ etc...

................................. In fact............ Though most of the information discussed above is filed with the stock exchanges...................... . 3............................... 17.......... It would help resolve the agency cost of debt and equity.................. Activity 4 Find and write a brief report on events that lead to appointment of Cadbury Committee on Corporate Governance in the UK......... 4.................... ............ 2............ We had seen that companies gain a substantial advantage by transparent policies and disclosure practices.................... It can...Strategic Financing Decisions However......................................................................... become a necessary condition in the highly competitive world................................ for the year 2003 as required under clause 49 is given in Appendix to this Unit... in order to sustain the good relationship earned.............................................................................6 INVESTOR SERVICE In the earlier sections we had discussed about the importance of companies maintaining a good relation with the investors........................................................................... particularly when the market has become global................ It can attract more and more investors........................... However......... 12 ........... as the systems are transparent and the performance of the company is well revealed..................... Further they must also attend to the queries of the investors promptly and provide them a better service..... . It can help retain the existing investors................ Some information are sent to the interested parties on demand... however........................ The quarterly returns filed with the stock exchange have to be made available in their website as well.............................. But why does it become a necessary condition? Corporate governance can do a lot of things for the better performance of the company: 1.................................... the existence of corporate governance by itself does not become a sufficient condition for the better performance of a firm..................................... Activity 5 Find from your stock market investor friend whether he or she is happy with the corporate governance set up of Indian companies.............................. Companies like Infosys could be shown as a good example for maintaining good corporate governance.......... .... 5. ................. 6........... .................... this is also mandatory by regulation.................... Lenders would not be hesitating to lend to such companies............... implying raising capital would be easier......................................... Good corporate governance helps the company to evaluate the better investment decisions................................... ... Suppliers would be willing to deal with such companies......................................... information in the annual report are sent to the shareholders by post..... . The corporate governance report of the Infosys Technologies Ltd... the companies need to provide the right information at the right time at the right place............................................................. The better practice has been that companies these days provide almost all information in their websites........

......................... for instance the website of Infosys technologies covers almost all information filed with the regulatory agencies.................................................... 11................................ .............................................................................. Method of voting by proxy 9. .. the details of the same are also given................................................ Information on dividend payment 7............................................................. 1..................................................................................................... As part of the annual reports............................ .............. ......... 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......................................................................................................................... Listing in stock exchanges 6............................. Plant locations Investors are comfortable dealing with companies that furnish the maximum information for the shareholders and also provide them good service.................................................... 12............ ..................... What are the alternative avenues available to investors and what is the role of SEBI in handling investors grievances? ..... ........................................................................................ Dates on which the quarterly returns are to be released 3........... Activity 6 List down the procedure to be followed when a shareholder has grievance against the company........................................................................... companies furnish the following details which are useful to investors.................................................................................................. Financial calendar specifying the dates of holding the annual general meeting 2........................................................... Shareholding pattern of the company 10...................................................... The number of shareholders present in the company supplying the different range of shares held...........Some good governance companies provide a lot of these information in a systematic manner in their websites................... The addresses of the companies and the head office 5................................ . Details about the investor grievances committee 8....................................................in) and visit EDIFAR link and write a brief note on EDIFAR and its usefulness to investors..... Dates of book closure for different purposes like share transfer and dividend payment 4........... ........................ ..sebi.................................................. Share transfer procedures................................................................ 13....................................... ....... . Though all the share trading is performed these days in the demat mode...................................................................... ............ Investors Relations 13 ........................gov.................................................................................... Activity 7 Visit SEBI's web site (www............................................

List them and their roles. Regulation of Corporate Accounting and Reporting in India. Why is that the investor relationship gains more importance in corporate form of business organization rather than the other forms of business structures. Who are the stakeholders of a company? 2. 7. we have seen that most companies get liquidated in the process of cheating the investors. University of Calcutta. list down in what aspects they differ. "Redesigning Corporate Governance Structures and Systems for the Twenty First Century" Corporate Governance Journal 9(3).Monks. July: pp." Some companies not only state their philosophies in just letter but they act on it as well. G. Find out about 5 companies who have been rated as 'Good Corporate Governance' company and examine their investor relationship. (2001). Are the information provided by these companies to the investors differ to a great extent? If so. 142-147. World Press. Core (2001).). Hence. The raison d'être of every corporate body is to ensure predictability. Bhabatosh Banerjee (2002). Lucien Gardiol.Strategic Financing Decisions 17. 131159. Tuchschmid (1999). Do you think corporate governance matter in investor relationship? 6. 17. maintaining a good relationship with the investors and performing the operations in the most transparent manner helps the companies in the long term.customers. 8. vendors and the society-at-large. What are the regulatory agencies that govern the disclosure of information by companies.7 SUMMARY Mr. Robert A. 441-456. Birgul Caramanolis-coteli. employees. Corporate Financial Reporting (Eds. 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. investors. Calcutta. What type of information is demanded by the different type of stakeholders including the shareholders? 5. If the companies do not sustain such long-term good relationship. sustainability and profitability of revenues year after year. Rajna Gibson Asner Nils S. This translates to bringing a high level of satisfaction to five constituencies -. John E.9 FURTHER READINGS Bhabatosh Banerjee and Arun Kumar Basu (2001). "A review of the empirical disclosure literature: discussion" Journal of Accounting and Economics 31. 14 . "Three Surveys on Corporate Governance" Mckinsey Quarterly. How does the information demanded by the inside shareholders differ from the retail or external investors? 17. Narayanamurthy of Infosys stated that "The primary purpose of corporate leadership is to create wealth legally and ethically. 4. how? 3. Does it really matter or apply for other forms of business organizations? If so. Having a mission statement. Calcutta. What are the forces that drive for information from the company? 4. "Are Investors Sensitive to the Quality and the Disclosure of Financial Statements?" European Financial Review 3. No.8 SELF-ASSESSMENT QUESTIONS 1. Paul Coombes and Mark Watson (2000).

Stenberg. Ubha D. Deep & Deep Publications. Healy. "The Stakeholder Concept: A Mistaken Doctrine" Working Paper. "Information asymmetry. (2002). University of Leeds. Krishna G. (1999). Elaine.Paul M. corporate disclosure. Investors Relations 15 . Corporate Disclosure Practices. 405-440. Palepu (2001). Centre for Business and Professional Ethics. and the capital markets: A review of the empirical disclosure literature" Journal of Accounting and Economics 31.S.

its policies and the manner in which it deals with various stakeholders. These recommendations are intended to take effect as revisions to the Combined Code on Corporate Governance. and indeed goes beyond all these recommendations on corporate governance. This led to the publication of the Vi Report in France in 1995. Consequently. The recommendations of these two reports are aimed at strengthening the existing framework for corporate governance in the UK. Compliance with these is generally not mandated by law. Infosys' compliance with these requirements is presented in this chapter. ownership and governance of the company is an important part of corporate governance. published in the UK in 1992. Donaldson. The General Motors Board of Directors Guidelines in the US and the Dey Report in Canada proved to be influential in the evolution of other guidelines and codes. was a landmark. Your company fully complies with. Besides directors and auditors. 16 . across the world. it has also laid down new accountability standards for security analysts and legal counsels. the Confederation of Indian Industry (CII) took the lead in framing a desirable code of corporate governance in April 1998. Chairman. Accordingly. and to enhance the trust and confidence of the stakeholders. various countries have issued recommendations for corporate governance. The recommendations were accepted by SEBI in December 1999. This was followed by the recommendations of the Kumar Mangalam Birla Committee on Corporate Governance. regulations and laws. Corporate governance guidelines and best practices have evolved over a period of time. It is about how an organization is managed. This committee was appointed by the Securities and Exchange Board of India (SEBI). This improves pubic understanding of the structure. This is perceived to be the most significant change to the federal securities law since the 1930s. form part of the systematic review of corporate governance being undertaken in UK and Europe.Strategic Financing Decisions Appendix: Corporate Governance Report of Infosys Technologies Ltd. This report boldly advocated the removal of cross-shareholdings that had formed the bedrock of French capitalism for decades. Dyer the past decade. This includes its corporate and other structures. timely and accurate disclosure of information regarding the financial situation. The Sarbanes-Oxley Act. and are now enshrined in Clause 49 of the Listing Agreement of every Indian stock exchange. In India. Infosys Technologies Limited Corporate Governance report for the year ending March 2003 '1 hope to challenge corporate America to Look beyond rules." William H. which was signed by the US President George W Bush into law last July has brought about sweeping changes in financial reporting. its culture. Securities and Exchange Commission. Further. performance.SEC speaks) Corporate governance is about commitment to values and about ethical business conduct. Enhancing the effectiveness of the non-executive directors and switching the key audit relationship from executive directors to an independent audit committee are part of this. the organization is able to attract investors. This is in light of recent corporate failures. The Higgs report on non-executive directors and the Smith report on audit committees. activities and policies of the organization. although codes that are linked to stock exchanges sometimes have a mandatory content. USA (Remarks at the practicing law institute . The Cadbury Report on the financial aspects of corporate governance. both published in January 2003. and Look to the principles upon which sound business is based.

the Department of Company Affairs. Our corporate governance philosophy is based on the following principles: 1. we comply with the Euro shareholders Corporate Governance Guidelines 2000.In addition. which are fully comprised of independent directors. These guidelines are intended to align the interests of the directors and the management with those of the company shareholders. Corporate Governance Guidelines Over the course of many years. Make a clear distinction between personal conveniences and corporate resources. When in doubt. Have a simple and transparent corporate structure driven solely by the business needs. Japan and the United Kingdom. Satisfy the spirit of the law and not just the letter of the law. 6. 2. The government has not made it mandatory yet for Indian companies. Corporate governance standards should go beyond the law. the board has developed corporate governance guidelines to help fulfill its corporate responsibility to various stakeholders. Further. Government of India. constituted a nine-member committee under the chairmanship of Naresh Chandra. former Indian ambassador to the US. it allows the hoard to make decisions that are independent of the company management. and reports of compliance with the respective corporate governance standards. 7. which overseas how the management serves and protects the long-term interests of all the stakeholders of the company We believe that an active. Communicate externally in a truthful manner. At the core of our corporate governance practice is the board. Canada. Majority of our board .in their national languages . Further. well-informed and independent board is necessary to ensure the highest standards of corporate governance. a nomination and an audit committee. we have a compensation. This ensures that the board will have the necessary authority and practices in place to review and evaluate the company operations as and when needed. to examine various corporate governance issues. 3. and the recommendations of the Conference Board Commission on Public Trusts and Private Enterprises in the US. a note on Infosys' compliance with the corporate governance guidelines of six countries . Prance. These guidelines may be changed from time to time by the board in order to effectively achieve its stated objectives. 4. about how we run our company internally 5. We also endeavour to enhance long term shareholder value and respect minority rights in all our business decisions. The committee has submitted its report to the government. Be transparent and maintain high degree of disclosure levels. disclose. Comply with the laws in all the countries in which we operate. Further. Your company's compliance with these recommendations is listed in the course of this chapter We believe that sound corporate governance is critical to enhance and retain investor trust. As a part of Infosys' commitment to follow global best practices. Our disclosures always seek to attain the best practices in international corporate governance. Germany. Your company also adheres to the UN Global Compact Programme.is presented in the chapter entitled Financial statements prepared in substantial compliance with GAAP requirements of Australia.8 out of 15 . Accordingly we always seek to attain our performance rules with integrity The Board extends its fiduciary responsibilities in the widest sense of the term. Investors Relations 17 .are independent members. Management is the trustee of the shareholders' capital and not the owner.

R. and the number of outside directorships held by each of the directors.Strategic Financing Decisions A) BOARD COMPOSITION 1. Table 1 gives the composition of Infosys' board. President and Managing Director . There are clear demarcations of responsibility and authority between the three. and eight are independent directors. S. he is also responsible for all board matters. President and Managing Director is responsible for corporate strategy. Nilekani. external contacts and other management matters. Table 1: Composition of the board. a chief Executive Officer (CEO). brand equity. Five of the executive directors are founders of the company The board believes that the current size is appropriate based on the company present circumstances. planning. The board consists of fifteen members. He is also responsible for achieving the annual business plan. N. and a Chief Operating Officer (COO) and Deputy Managing Director . CEO and the COO The current policy of the company is to have a chairman and chief Mentor Mr. In addition. The CEO. He also interacts with global thought-leaders to enhance the leadership position of Infosys. The board periodically evaluates the need for increasing or decreasing its size. Nandan M. he continues to interact with various institutions to highlight and to help bring about the benefits of IT to every section of society As chairman of the board. and to separate the board functions of governance and management. Responsibilities of the Chairman. Size and Composition of the Board The current policy is to have an appropriate mix of executive and independent directors to maintain the independence of the board. The Chairman and Chief Mentor is responsible for mentoring Infosys' core management team in transforming the company into a world-class.Mr. Narayana Murthy. and external directorships held during FY 2003 2. seven of whom are executive or whole-time directors. Gopalakrishnan.Mr. nextgeneration organization that provides state-of-the-art technology-leveraged business solutions to corporations across the world. 18 .

in the opinion of the company's board of directors. they will be between 40 and 60 years of age. but are eligible for re-appointment upon completion of their term. Broad Definition of Independent Directors According to Clause 49 of the Listing Agreement with Indian stock exchanges. and participate in all board and applicable committee meetings. the membership term is limited by the retirement age for the members. quality and human resources is essential. skills and experience for the board as a whole as well as its individual members. COO. The same is provided in the Audit charter section of this Annual Report. 3. skills and experience required to manage and guide a high-growth.The COO and Deputy Managing Director is responsible for all customer service operations. They will not be relatives of an executive director or of an independent director. Generally. Membership Term The board constantly evaluates the contribution of its members. Board members are expected to rigorously prepare for. Each board member is expected to ensure that their other current and planned future commitments do not materially interfere with the member responsibility as a director of Infosys. and qualifies the retiring members for re-appointment. performance and targets. Executive directors are appointed by the shareholders for a maximum period of five years at a time. The nominations committee makes recommendations to the board on the induction of any new member. Infosys adopted a much stricter definition of independence as required by the NASDAQ listing rules and the Sarbanes-Oxley Act. software company deriving revenue primarily from G-7 countless. and recommends to shareholders their re-appointment periodically as per statute. The board delegates the screening and selection process involved in selecting the new directors to the nominations committee. would interfere with the exercise of independent judgment in carrying Out the responsibilities of a director. technology. Board members are expected to possess the expertise. Investors Relations 19 . Selection of New Directors The board is responsible for the selection of any new director. They are generally not expected to serve in any executive or independent position in any company that is in direct competition with Infosys. Expertise in strategy. new initiatives. 6. The nominations committee of the board recommends such appointments and / or reappointments. which consists exclusively of independent directors. However. 4. an independent director means a person other than an officer or employee of the company or its subsidiaries or any other individual having a material pecuniary relationship or transactions with the company which. Board Membership Criteria The nominations committee works with the entire board to determine the appropriate characteristics. finance. hitech. but retire by rotation as per law. US. CEO. The Chairman. He is also responsible for technology. the other executive directors and the senior management make periodic presentations to the board on their responsibilities. 5. The current law in India mandates the retirement of one-third of the board members (who are liable to retire by rotation) every year. Non-executive directors do not have a specified term. acquisitions and investments. attend.

10. which is the age of superannuation for the employees of the company. except for the latest 1999 Stock Option Plan. 20 . as well as to develop plans for interim succession for any of them. The age limit for serving on the board is 65 years. CEO and COO. The compensation committee makes a quarterly appraisal of the performance of the executive directors based on a detailed performance-related matrix. The board.the sum of which is within the limit of 0. or whose prime objective is that of benefiting society Independent directors are not expected to serve on the boards of competing companies. The compensation payable to independent directors and the method of calculation are disclosed separately in the financial statements. may more frequently review succession planning. All board-level compensation is approved by shareholders. or are key economic institutions of the nation. the maximum age of retirement of all executive directors is 60 years. Independent directors are also not eligible for stock options under these plans. The number of outside directorships held by each director of Infosys is given in Table 1 above. Memberships of other Boards Executive directors are excluded from serving on the board of any other entity. as required. in case of an unexpected occurrence. Board Compensation Review The compensation committee determines and recommends to the board the compensation payable to the directors. the 1998 Stock Option Plan and the 1999 Stock Option Plan. unless these are corporate or government bodies whose interests are germane to the future of the software business. 9. there are no limitations on them save those imposed by law and good corporate governance practices. 1956. The annual compensation of the executive directors is approved by the compensation committee. Remuneration of the executive directors consists of a fixed component and a performance incentive. Their continuation as members of the board upon superannuation / retirement is determined by the nominations committee.Strategic Financing Decisions 7. Retirement Policy Under this policy. and separately disclosed in the financial statements. 8. Compensation payable to each of the independent directors is limited to a fixed amount per year as determined and approved by the board . Table 2a gives the compensation of each director. calculated as per the provisions of the Companies Act. Other than this. Succession Planning The nominations committee constantly works with the board to evolve succession planning for the positions of the Chairman.5% of the net profits of the company for the year. and Table 2b gives the grant of stock options to directors. Those executive directors who are founders of the company have voluntarily excluded themselves from the 1994 Stock Offer Plan. within the parameters set by the shareholders at the shareholders meetings.

Narayana Murthy Nandan M.19 1. 2012 The above options were issued at fair market value. Nilekani S.19 – – – – – – – – 0. Larry Pressler Rama Bijapurkar Claude Smadja K. 2002 ** Resigned effective April 12.) 3.12 0. Omkar Goswami Sen.13 0. Dinesh S.19 0.01 0. Shibulal T. D.19 0.12 0.13 0. crore Notice period (in months) 6 6 6 NA NA NA NA NA NA NA NA 6 6 6 NA 6 N.25 0. Gopalakrishnan Deepak M.000 Grant price (in Indian Rs.01 NA 0.19 0. Jitendra Vir Singh ** Dr.333.12 0.R.13 0.17 Investors Relations in Rs.73 0.12 0. Satwalekar Prof. 21 .01 0.18 3.17 Performance incentive/bonus – – – – – – – – – – – – – – – – Commission payable – – – 0. V. Marti G. Mohandas Pai Phaneesh Murthy • Srinath Batni * Resigned on July 23.65 Expiry date July 09.28 0.Table 2a: Cash compensation to the directors for FY 2003 Name of directors Salary 0.25 0.12 – – – – – Sitting fees (in months) – – – 0. Table 2b: Grant of stock options to directors during FY 2003 Name of director Claude Smadja Number of options (1999 ESOP) 2.30 0.12 0.19 0.13 0.01 0.19 0.01 0. Subrahmanyam Philip Yeo Prof.19 1.18 3.73 0.01 – – – – – Total 0.12 0.13 0. 2003 None of the above is eligible for any severance pay. The options granted will vest over a period of four years from the date of grant.13 0.01 0.12 0.

July 10. 2. Gopalakrishnan Deepak M. Bangalore. capital budgets.Strategic Financing Decisions B) BOARD MEETINGS 1. Shibulal T. October 10. 2002 and January 10. Satwalekar Prof. it welcomes the presence of managers who can provide additional insights into the items being discussed. Omkar Goswami Sen. Dinesh S. or when required for transacting business. India. 2003 Number of board meetings held 6 6 6 6 6 6 6 6 6 6 6 6 6 6 3 6 Number of board meetings attended 6 6 6 6 5 3 5 5 5 5 4 6 5 6 3 5 Whether attended last AGM Yes Yes Yes Yes Yes No Yes Yes Yes Yes No Yes Yes Yes Yes Yes 22 . investors grievance and investment committees. Subrahmanyam Philip Yeo Prof. nomination. additional meetings are held. 2003. The information regularly supplied to the board includes: annual operating plans and budgets. Independent directors are expected to attend at least four board meetings in a year. Every board member is free to suggest the inclusion of items on the agenda. and also on the occasion of the annual shareholders' meeting. June 8. 2002. The Chairman of the board and the company secretary draft the agenda for each meeting. V. general notices of interest. Larry Pressler Rama Bijapurkar Claude Smadja K. Availability of Information to the Members of the Board The board has unfettered and complete access to any information within the company. 2002. quarterly results of the company and its operating divisions or business segments. Jitendra Vir Singh ** Dr. Most board meetings are held at the company registered office at Electronics City. When necessary. Marti G. Committees of the board usually meet the day before the formal board meeting. The board meets at least once a quarter to review the quarterly results and other items on the agenda. along with explanatory notes. R. 2002. 2002 ** Resigned effective April 12. At meetings of the board. 2002. Scheduling and Selection of Agenda Items for Board Meetings Dates for the board meetings in the ensuing year are decided in advance and published as part of the Annual Report. minutes of meetings of audit. 2002 (coinciding with last year Annual General Meeting of the shareholders). D. Mohandas Pai Phaneesh Murthy * Srinath Batni * Resigned on July 23. declaration of dividend. December 8. as well as abstracts of circular resolutions passed. Nasrayana Murthy Nandan M. and distribute these in advance to the directors. Nilekani S. These were on April 10. Table 3: Number of board meetings and the attendance of directors during FY 2003 Name of directors N. updates. There were six board meetings held during the year ended March 31. compensation. and to any employee of the company.

any of the executive directors or the management being present. any material effluent or pollution problems. subsidiaries. Independent Directors' Discussion The board's policy is to regularly have separate meetings with independent directors to update them on all business-related issues and new initiatives. significant development on the human resources front. details of foreign exchange exposure and the steps taken by management to limit the risks of adverse exchange rate movement. Materially Significant Related Party Transactions There have been no materially significant related party transactions.e. 2003. any materially relevant default in financial obligations to and by the company or substantial non-payment for goods sold by the company. subsidiary or relatives except for those disclosed in the financial statements for the year ended March 31. brand equity or intellectual property. pecuniary transactions or relationships between Infosys and its directors. transactions that involve substantial payment towards goodwill. the executive directors and other senior management personnel make presentations on relevant issues. In addition. demand. of investments.information on recruitment and remuneration of senior officers just below the board level including appointment or removal of CFO and company secretary. without the chairman. materially important litigations. Investors Relations 23 . In such meetings. 3. fatal or serious accidents or dangerous occurrences. sale of material nature. any issue which involves possible public or product liability claims of a substantial nature. prosecution and penalty notices. show cause. 4. the independent directors of the company will meet periodically in executive session i. management. which is not in the normal course of business. and non-compliance of any regulatory statutory nature or listing requirements as well as shareholder services such as non-payment of dividend and delays in share transfer. details of any joint venture or collaboration agreement. assets.

Larry Pressler Mr. It is given below. The investment committee and the share transfer committee consist of all executive directors. the National Stock Exchange (N5E) and the Bangalore Stock Exchange (BgSE). Mumbai (or the BSE). The Blue Ribbon Committee set up by the US Securities and Exchange Commission (SEC) recommended that every listed company adopt an audit committee charter. it is listed on the NASDAQ. The board is responsible for the constituting. Satwalekar. assigning. the investors grievance committee. Infosys is listed on the stock Exchange. Normally all the committees meet four times a year except the investment committee and the share transfer committee. The audit committee of Infosys comprises six independent directors. in consultation with the company secretary of the company and the committee chairman. the compensation committee.the audit committee. Rams Bijapurkar Dr. compensation and nominations committees last for the better part of a working day Recommendations of the committee are submitted to the full board for approval. Deepak M. They are: Mr. Clause 49 of the Listing Agreement makes it mandatory for listed companies to adopt an appropriate audit committee charter. Omkar Goswami Sen.Strategic Financing Decisions C) BOARD COMMITTEES Currently. determines the frequency and duration of the committee meetings. Marti G. In India. The investors grievance committee is composed of an independent. the board has six committees . The chairman of the board. The first three consist entirely of independent directors. which has been adopted by NA5DAQ. Audit Committee In India. the nominations committee. Typically the meetings of the audit. The quorum for meetings is either two members or one-third of the members of the committees. In the US. 1. and it delegates these powers to the nominations committee. non-executive chairman and some executive and non-executive directors. which meet as and when the need arises. the investment committee and the share transfer committee. Subrahmanysm 24 . In its meeting on May 27. whichever is higher. Infosys' audit committee adopted a charter which meets the requirements of Clause 49 of the Listing Agreement with Indian stock exchanges and the SEC. Choirmon Ms. 2000. Claude Smadja Prof. co-opting and fixing of terms of service for committee members to various committees.

Responsibilities of the Audit Committee 2. Review and pre-approve all related party transactions in the Company for this purpose. including the internal auditors and the independent auditor .1 2. or investment banking services. The committee oversees the work carried out in the financial reporting process . and the effective use of all audit resources.6 2. and the board of directors Meet four times every year or more frequently as circumstances require.and notes the processes and safeguards employed by each. Legal services and expert services unrelated to the audit.1.by the management. investment advisor. Internal audit outsourcing services. Appraisal or valuation services. 2.2 Provide an open avenue of communication between the independent auditor. fairness opinions. Consider and review with the independent auditor and the management: (a) The adequacy of internal controls including computerized information system controls and security. Financial information system design and implementation. and (b) Related findings and recommendations of the independent auditor and internal auditor together with the management's responses. internal auditor.4 2. Broker or dealer. Investors Relations 2. pre-approve all non-auditing services to be provided by the independent auditor to the Company For the purpose of this clause. and Any other service that the BoD determines is impermissible. "non-auditing services" shall mean any professional services provided to the Company by the independent auditor.1 Audit Committee Charter 1. the committee may designate one member who shall be responsible for pre-approving related party transactions.3 2.5 2. Review with the independent auditor the co-ordination of audit efforts to assure completeness of coverage.7 25 .8 Consider and if deemed fit. compensate and oversee the work of the independent auditor (including resolving disagreements between management and the independent auditors regarding financial reporting) for the purpose of preparing or issuing an audit report or related work. Appoint. timely and proper disclosures and the transparency integrity and quality of financial reporting. or contribution-inkind reports. reduction of redundant efforts. 2. Management functions or human resources. other than those provided to the company in connection with an audit or a review of the financial statements of the Company and includes (but is not limited to): – – – – – – – – – Bookkeeping or other services related to the accounting records of financial statements of the Company. The audit committee may ask members of the management or others to attend meetings and provide pertinent information as necessary Confirm and assure the independence of the external auditor and objectivity of the internal auditor. Primary Objectives of the Audit Committee The primary objective of the audit committee (the "committee") of Infosys Technologies Limited (the "Company") is to monitor and provide effective supervision of the management's financial reporting process with a view to ensure accurate. Actuarial services.

21 As appropriate. member qualifications and activities. 2.16 Review. 2.17 Provide oversight and review at least annually of the Company risk management policies. 2. internal auditor and the independent auditor: (a) Significant findings during the year. structure. including the status of previous audit recommendations.25 Consider and review with the management. 2.22 Review its own charter. 2.24 Establish procedures for receiving. 2. including any significant suggestions for improvements provided to management by the independent auditors.18 Review the Company compliance with employee benefit plans.14 Review.26 Report periodically to the BoD on significant results of the foregoing activities. accounting or other advisors. any legal matters that could have a significant impact on the Company financial statements. 26 .9 Review and discuss with the management and the independent auditors. approve and monitor the code of ethics that the Company plans for its senior financial officers. institute special investigations with full access to all books. respectively with the SEC. 2. 2. the unedited quarterly operating results in the Company quarterly earnings release.13 Oversee compliance with the requirements of the SEC and SEBI. including its investment policies. retaining and treating complaints received by the Company regarding accounting. records. using professional standards and procedures for conducting such reviews.19 Oversee and review the Company policies regarding information technology and management information systems. as the case maybe. (b) Any difficulties encountered in the course of audit work including any restrictions on the scope of activities or access to required information. the annual audited financial statements and quarterly unaudited financial statements. 2. including the Company's disclosures under "Management Discussion and Analysis of Financial Condition and Results of Operations" prior to filing the Company Annual Report on Form 20-F and Quarterly Results on Form 6-K. processes and membership requirements. internal accounting controls or auditing matters and procedures for the confidential.20 If necessary. 2.12 Review before release. faculties and personnel of the Company 2.10 Direct the Company independent auditors to review before filing with the SEC the Company interim financial statements included in Quarterly Reports on Form 6-K. 2. 2. (c) Any changes required in the planned scope of the internal audit plan.15 Review management monitoring of compliance with the Company standards of business conduct and with the Foreign Corrupt Practices Act.23 Provide a report in the Company proxy statement in accordance with the rules and regulations of the SEC. 2. anonymous submission by employees of concerns regarding questionable accounting or auditing matters. 2. for disclosure of auditor's services and audit committee members. 2.Strategic Financing Decisions 2.11 Conduct a post-audit review of the financial statements and audit findings. in conjunction with counsel. 2. obtain advice and assistance from outside legal.

and reviewing reports submitted to the audit committee by the independent auditors in accordance with the applicable SEC requirements. Each member will be able to read and understand fundamental financial statements. by majority vote. 4. the committee may consider limiting the term of the audit committee service. knowledgeable. significant new accounting policies. and. Composition of the Audit Committee 3. and degree of aggressiveness or conservatism of the company accounting principles and underlying estimates. in person or by telephone conference call. This includes such issues as the clarity of the company's financial disclosures. dedicated. All possible measures must be taken by the committee to ensure the objectivity and independence of the independent auditors. with a view to bringing in fresh insight.1 The committee has the ultimate authority and responsibility to select. Investors Relations – – – – 27 . replace the independent auditors in accordance with law. actively engaging in dialogues with the auditors with respect to any disclosed relationships or services that may impact their objectivity and independence and I or recommend that the full BoD take appropriate action to ensure their independence. evaluate. and an appropriate representative of Financial Management and Accounting. in addition to BoD responsibilities. encouraging the independent auditors to open and frank discussions on their judgments shout the quality. where appropriate. The duties and responsibilities of a member are in addition to those applicable to a member of the BoD. including significant adjustments. carrying out the attest function in conformity with US GAAS. These include: – – reviewing the independent auditors' proposed audit scope. management judgment and accounting estimates. either by the full BoD or by the members themselves. not just the acceptability of the company accounting principles as applied in its financial reporting. to perform an interim financial review as required under Statement of Auditing Standards 71 of the American Institute of Certified Public Accountants and also discuss with the committee or its chairman. At least one of the members shall be a "Financial Expert" as defined in Section 407 of the Sarbanes-Oxley Act. and other significant decisions made by the management in preparing the financial disclosure and audited by them. by automatic rotation or by other means. The members of the committee shall be elected by the BoD and shall continue until their successors are duly elected. In recognition of the time burden associated with the service and. Relationship with Independent and Internal Auditors 4. They should be diligent. One of the members shall be elected as the chairman. approach and independence. in accordance with the NASOAQ National Market Audit Committee requirements.1 The committee shall consist solely of 'independent' directors (as defined in (i) NASOAQ Rule 4200 and (ii) the rules of the Securities and Exchange Commission) of the Company and shall be comprised of a minimum of three directors. the matters described in SAS 61. interested in the job and willing to devote a substantial amount of time and energy to the responsibilities of the committee. Communications with the Committee. as amended by SAS 90 Audit Committee Communication prior to the company filing of its Form 6-K (and preferably prior to any public announcement of financial results). obtaining from the independent auditors periodic formal written statements delineating all relationships between the auditors and the company consistent with applicable regulatory requirements and presenting this statement to the BoD.3. and disagreements with management.

3 In addition to preparing the report in the Company proxy statement in accordance with the rules and regulations of the SEC.1 The committee charter should be published in the annual report once every three years and also whenever any significant amendment is made to the charter. regardless of irregularities or problems. and the committee has satisfied its responsibilities in compliance with its charter – – – – 5. Disclosure Requirements 5. 5.3 The committee shall secure compliance that the BoD has affirmed to the NASD / Amex Stock Exchange on the following matters.1 The Committee shall meet at least four rimes a year 6. Disclosures relating to non-independent members. believes that the company's financial statements are fairly presented in conformity with Generally Accepted Accounting Principles ("GAAP") in all material respects.2 The internal auditors of the company are in the best position to evaluate and report on the adequacy and effectiveness of the internal controls. with the committee. a formal mechanism should be created to facilitate confidential exchanges between the internal auditors and the committee. the independent auditors have discussed with the committee their judgments of the quality of those principles as applied and judgments referred to the above under the circumstances. Meetings and Reports 6. 5. consistent with the committee's charter.2 The committee shall disclose in the company Annual Report whether or not. the members of the committee have discussed among themselves.2 The Committee will meet separately with the CEO and separately with the CEO of the Company at such times as are appropriate to review the financial affairs of the Company The audit committee will meet separately with the independent auditors and internal auditors of the Company at such times as it deems appropriate (but not less than quarterly) to fulfill the responsibilities of the Audit Committee under this Charter 6.Strategic Financing Decisions 4. and Review of the committee charter. with respect to the concerned fiscal year: – the management has reviewed the audited financial statements with the committee. Keeping in view the need for the internal auditors' independence from management in order to remain objective. 28 . in reliance on the review and discussions conducted with management and the independent auditors pursuant to the requirements above. Financial literacy and financial expertise of members. 5. as required in terms of the relevant NASD I Amex rules: – – – – Composition of the committee and independence of committee members. the information disclosed to the committee as described above. without the management or the independent auditors being present. the committee will summarize its examinations and recommendations to the Board of Directors as may be appropriate. 6. including a discussion of the quality of the accounting principles as applied and significant judgments affecting the company financial statements.4 The committee shall report to shareholders as required by the relevant rules of the Securities and Exchange Commission ("SEC") of the United States. The work carried out by each of these auditors needs to be assessed and reviewed with the independent auditors and appropriate recommendations made to the BoD.

son-in-law. parents. or $200. 2003.2 Financial Expert 'Financial Expert' means one. a director who is a partner in. "Immediate family" includes a person's spouse.1 Independent Member In order to be 'independent'. comptroller or 1. Marti G. Definitions 8. These were held on April 9. Larry Pressler Rama Bijapurkar Claude Smadja No. of meetings held 4 4 4 4 4 4 No. who has through education and experience as a public accountant or auditor or a principal financial officer. or non-discretionary compensation in the current year or any of the past five years. July 9. a director who is employed as an executive of another entity where any of the company's executives serve on that entity compensation committee for the current year or any of the past five years. or from which the company received.000 during the previous fiscal year. a director who is a member of the immediate family of an individual who is. employed by the corporation or any of its affiliates as an executive officer. and anyone who resides in such person home. sister-in-law. a director who accepts any compensation from the company or any of its affiliates in excess of $60. and a shareholder owning or controlling 20% or more of the company voting securities.7. siblings. 2002. Delegation of Authority 7. Investors Relations – – – – – 8.1 The committee may delegate to one or more designated members of the committee the authority to pre-approve audit and permissible non-audit services. Satwalekar Prof. daughter-in-law. or a controlling shareholder or an executive officer of. 8. a director who has been a former partner or employee of the independent auditor who worked on the company audit engagement in the current year or any of the past five years. 2002. 29 . in any of the past five years. Subrahmanyam Dr. whichever is more.2 Table 4: Audit Committee Attendance during FY 2003 Name of audit committee member Deepak M. members should have no relationship with the company that may interfere with the exercise of their independence from the management and the company The following persons are not considered independent: – – a director who is employed by the company or any of its affiliates for the current year or any of the past five years. Omkar Goswami Sen.000. provided such pre-approval decision is presented to the full audit committee at its scheduled meetings. any for-profit business organization to which the company made. children. benefits under a tax-qualified retirement plan. payments (other than those arising solely from investments in the company securities) that exceed 5% of the company or business organization's consolidated gross revenues for that year. 2002 and January 9. father-in-law. other than compensation for board service. mother-in-law. October 9. brother-in-law. in any of the past three years. or has been. of meetings attended 4 4 4 4 4 4 Four audit committee meetings were held during the year.

1 . The independent auditors are responsible for performing an independent audit of the company financial statements in accordance with the generally accepted auditing standards.3 Audit Committee Report for the year ended March 31. In conducting such reviews. and an understanding of audit committee functions. In this context. sufficient and credible. experience in preparing or auditing financial statement of comparable companies and in applying generally accepted accounting principles in connection with the accounting for estimates. The committee is also responsible to oversee the processes related to the financial reporting and information dissemination. in order to ensure that the financial statements are true. In addition. The company auditors provided to the committee the written disclosures required by Independence Standards Board Standard No. Management represented to the committee that the company financial statements were prepared in accordance with Generally Accepted Accounting Principles. as amended by SAS 90 . experience with internal accounting controls. of the accounting principles. not just the applicability. 2003 Each member of the committee is an independent director. and Clause 49 of the Listing Agreement with the relevant Indian stock exchanges. The committee also reviewed the internal controls put in place to ensure that the accounts of the company are properly maintained and that the accounting transactions are in accordance with prevailing laws and regulations.'Independence discussions with audit committees'. according to the definition laid down in the audit committee charter given above. the committee found no material discrepancy or weakness in the internal control systems of the company The committee also reviewed the financial and risk management policies of the company and expressed its satisfaction with the same. 30 . accruals and reserves. in the absence of the management (whenever necessary).Communication with audit committees. The committee also discussed with the auditors other matters required by the Statement on Auditing Standards No. Relying on the review and discussions conducted with the management and the independent auditors. and for issuing a report thereon. an understanding of generally accepted accounting principles and financial statements. the reasonableness of significant judgments and the clarity of disclosures in the financial statements. the committee discussed with the company auditors the overall scope and plans for the independent audit. correct. the committee recommends to the board the appointment of the company internal and statutory auditors. Management is responsible for the company internal controls and the financial reporting process. After review. The committee discussed with the auditors.6 1 (SAS 61).Strategic Financing Decisions principal accounting officer of a company (or from a position involving similar functions). 1. the audit committee believes that the company financial statements are fairly presented in conformity with Generally Accepted Accounting Principles in all material aspects. the company's audited financial statements including the auditor's judgments about the quality. The committee's responsibility is to monitor these processes.Audit committee communication. the committee expressed its satisfaction on the independence of both the internal and the statutory auditors. based on which the committee discussed the auditors' independence with both the management and the auditors.

Omkar Goswami Mr. The audited financial statements prepared as per US GAAP and to be included in the company Annual Report on Form-20F for the fiscal year ended March 31. 2003 2. 2004. Compensation Committee The compensation committee of Infosys consists entirely of non-executive. The committee secured compliance that the board of directors has affirmed to the NASOAQ stock exchange. for the financial year ending March 31. Subrahmanyam. 2003) Mr. In conclusion. Chartered Accountants. and a review of the audit charter. which has been provided in the Financial statements prepared in accordance with US GAAF section of this Annual Report. 2003 be accepted by the board as a true and fair statement of the financial health of the company. Based on the committee discussion with management and the auditors and the committee's review of the representations of management and the report of the auditors to the committee. Satwalekar Prof. The committee has also issued a letter in line with recommendation No. as the statutory and independent auditors of the company for the fiscal year ending March 31. independent directors: Prof. Sd/Bangalore April 9. Chairman Dr. and that that the necessary resolutions for appointing them as auditors be placed before the shareholders. 2004. disclosures relating to non-independent members. Philip Yea Investors Relations Deepak M. and 2. The committee has recommended to the board the appointment of Bharat S. Satwalekar Chairman. The committee has also recommended to the board the appointment of KPMG as independent auditors of the company for the US GAAP financial statements. Deepak M. and concluded that there was no such materially significant service provided. Raut & Co. The committee recommended the appointment of internal auditors to review various operations of the company. The audited financial statements prepared as per Indian GAAP for the year ended March 31. Audit committee 31 . and determined and approved the fees payable to them. Marti C. 2003 be filed with the Securities and Exchange Commission. Jitendra Vir Singh (resigned effective April 12. financial literacy and financial expertise of members. the committee is sufficiently satisfied that it has complied with its responsibilities as outlined in the Audit committee charter. the committee has recommended to the board of directors that: 1. under the relevant rules of the exchange on composition of the committee and independence of the committee members. 9 of the Blue Ribbon Committee on audit committee effectiveness.Moreover.. the committee considered whether any non-audit consulting services provided by the auditor's firm could impair the auditor's independence.

Strategic Financing Decisions

2.1 Compensation Committee Charter Purpose The purpose of the compensation committee of the board of directors (the "Board") of Infosys Technologies Limited (the "Company") shall be to discharge the Board responsibilities relating to compensation of the Company executive directors and senior management. The committee has overall responsibility for approving and evaluating the executive directors and senior management compensation plans, policies and programs of the Company The compensation committee is also responsible for producing an annual report on executive compensation for inclusion in the Company proxy statement. Committee membership and organization The compensation committee will be appointed by and will serve at the discretion of the Board. The compensation committee shall consist of no fewer than three members. The members of the compensation committee shall meet the (i) independence requirements of the listing standards of the NASDAQ, (ii) non-employee director definition of Rule 16b-3 promulgated under Section 16 of the Securities Exchange Act of 1934, as amended, and (iii) the outside director definition of Section 162(m) of the Internal Revenue Code of 19B6, as amended. The members of the compensation committee will be appointed by the Board on the recommendation of the nomination committee. Compensation committee members will serve at the discretion of the Board. Committee responsibilities and authority The compensation committee shall annually review and approve for the CEO and the executive directors and senior management of the Company (a) the annual base salary, (b) the annual incentive bonus, including the specific goals and amount, (c) equity compensation, (d) employment agreements, severance arrangements, and change in control agreements I provisions, and (e) any other benefits, compensation or arrangements. The compensation committee in consultation with the CEO, shall review the performance of all the executive directors each quarter basis on the basis of detailed performance parameters set for each of the executive directors at the beginning of the year. The compensation committee may, from time to time, also evaluate the usefulness of such performance parameters, and make necessary amendments. The compensation committee is responsible far administering the Company stock option plans, including the review and grant of eligible employees under the plans. The compensation committee may also make recommendations to the board with respect to incentive compensation plans. The compensation committee may form subcommittees and delegate authority to when appropriate. The compensation committee shall make regular reports to the Board. The compensation committee shall review and reassess the adequacy of this charter annually and recommend any proposed changes to the Board for approval.

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The compensation committee shall annually review its own performance.

2.2 Table 5: Compensation committee attendance during FY 2003
Name of audit committee member Prof. Marti G. Subrahmanyam Deepak M. Satwalekar Philip Yeo Prof. Jitendra Vir Singh Dr. Omkar Goswami No. of meetings held 4 4 4 4 4 No. of meetings attended 4 4 3 4 4

Investors Relations

Four compensation committee meetings were held during the year ended March 31, 2003: on April 9, 2002, July 9, 2002, October 9, 2002 and January 9, 2003.

The compensation committee shall have the sole authority to retain and terminate any compensation consultant to be used by the Company to assist in the evaluation of CEO, executive directors or senior management compensation and shall have the sole authority to approve the consultant's fees and other retention terms. The compensation committee shall also have the authority to obtain advice and assistance from internal or external legal, accounting or other advisors. 2.3 Compensation Committee Report for the year ended March 31, 2003 The committee reviewed the performance of all executive directors and approved the compensation payable to them for fiscal 2004, within the overall limits approved by the shareholders. The committee also reviewed and approved the compensation proposed for all the management council members for fiscal 2004. The committee also reviewed the grant of stock options on a sign-on and regular basis to various employees of the company during the year. The committee believes that the proposed compensation and benefits, along with stock options, are adequate to motivate and retain the senior officers of the company The committee took on record the compensation committee charter in its meeting held on October 9, 2002. Save as disclosed, none of the directors had a material beneficial interest in any contract of significance to which the company or any of its subsidiary undertakings was a party, during the financial year. Sd/– Bangalore April 9, 2003 3. Nominations Committee The nominations committee of the board consists exclusively of the following non-executive, independent directors: Mr. Claude Smadja, Chairman Sen. Larry Pressler Prof. Jitendra Vir Singh (resigned effective April 12, 2003) Mr. Philip Yeo 3.1 Nominations Committee Charter Purpose The purpose of the nominations committee is to ensure that the board of directors is properly constituted to meet its fiduciary obligations to shareholders and the Company To carry Out this purpose, the nominations committee shall: (1) assist the board by identifying prospective director nominees and to select / recommend to the board the director nominees for the next annual meeting of shareholders; (2) oversee the evaluation of the board and management; and (3) recommend to the board, director nominees for each committee.

Prof. Math G. Subrahmanyam Chairman, compensation committee

33

Strategic Financing Decisions

Committee Membership and Organization The nominations committee shall be comprised of no fewer than two (2) members. The members of the nominations committee shall meet the independence requirements of the NASDAQ. The members of the nominations committee shall be appointed and replaced by the board. Committee Responsibilities and Authority Evaluate the current composition, organization and governance of the board and its committees as well as determine future requirements and make recommendations to the board for approval. Determine on an annual basis, desired board qualifications, expertise and characteristics. and conduct searches for potential board members with corresponding attributes. Evaluate and propose nominees for election to the board. In performing these tasks, the Committee shall have the sole authority to retain and terminate any search firm to be used to identify director candidates. Oversee the board performance evaluation process including conducting surveys of director observations, suggestions and preferences. Form and delegate authority to subcommittees when appropriate. Evaluate and make recommendations to the board concerning the appointment of directors to board committees, the selection of board committee chairs, and proposal of the board slate for election. Evaluate and recommend termination of membership of individual directors in accordance with the board governance principles, for cause or for other appropriate reasons. Conduct an annual review on succession planning, report its findings and recommendations to the board, and work with the board in evaluating potential successors to executive management positions. Coordinate and approve board and committee meeting schedules. Make regular reports to the board. Review and re-examine this charter annually and make recommendations to the board for any proposed changes. Annually review and evaluate its own performance. In performing its responsibilities, the Committee shall have the authority to obtain advice, reports or opinions from internal or external counsel and expert advisors.
3.2 Table 6: Nominations committee attendance during FY 2003
Name of compensation committee members Claude Smadja Philip Yeo Prof. Jitendra Vir Singh Sen. Larry Pressler Number of meetings held 4 4 4 4 Number of meetings attended 4 3 4 4

Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002, October 9, 2002 and January 9, 2003.

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3.3 Nominations Committee Report for the year ended March 31, 2003 During the year, Mr. Phaneesh Murthy resigned from the directorship of the company and the same was taken on record. Also the comittee took on record the resignation of Prof. Jitendra Vir Singh effective April 12, 2003. The committee approved the induction of Mr. Sridar Iyengar as an additional director of the company and also recommended his induction into audit committee. The committee discussed the issue of the retirement of members of the board as per statutory requirements. As a third of the members have to retire every year based on their date of appointment, Messrs. Srinath Batni, Sen. Larry Pressler, Omkar Goswami and Rama Bijapurkar will retire in the ensuing Annual General Meeting. The committee has recommended the resolution for re-appointment of the retiring directors by the shareholders. Sd/Bangalore April 9, 2003 4. Investors Grievance Committee The investors grievance committee is headed by an independent director, and consists of the following directors: Mr. Philip leo, Chairman Ms. Rama Bijapurkar Mr. K. Dinesh Mr. Nandan M. Nilekani Mr. S. 0. Shibulal
4.1 Table 7: Investors grievance committee attendance during FY 2003
Name of compensation committee members Philip Yeo Rama Bijapurkar Nandan M. Nilekani K. Dinesh S. D. Shibulal Number of meetings held 4 4 4 4 4 Number of meetings attended 3 3 4 4 4

Investors Relations

Claude Smadja Chairman, nominations committee

Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002, October 9, 2002 and January 9, 2003.

4.2 Investors Grievance Committee Report for the year ended March 31, 2003 The committee expresses satisfaction with the company performance in dealing with investors grievance and its share transfer system. It has also noted the shareholding in dematerialised mode as on March 31, 2003 as being 99.18%. Sd/Bangalore April 9, 2003

Rama Bijapurkar Member, investors grievance committee

35

Strategic Financing Decisions

5. Investment Committee The investment committee consists exclusively of executive directors: Mr. N. R. Narayana Murthy, Chairman Mr. Nandan M. Nilekani Mr. S. Gopalakrishnan Mr. K. Dinesh Mr. S. D. Shibulal Mr. T. V Mohandas Pai Mr. Phaneesh Murthy (resigned on July 23, 2002) Mr. Srinath Batni Investment Committee Report for the year ended March 31, 2003 The committee has the mandate to approve investments in various corporate bodies within statutory limits and the powers delegated by the hoard. During the year, the committee approved an investment of USS 2.5 million (Rs. 12.25 crore) in Progeon Limited, majority owned subsidiary of Infosys. Sd/Bangalore April 9, 2003 6. Share Transfer Committee The share transfer committee consists exclusively of executive directors: Mr. Nandan M. Nilekani, Chairman Mr. K. Dinesh Mr. S. 0. Shibulal Share transfer committee report for the year ended March 31, 2003 The committee has the mandate to approve all share transfers. During the year, the committee approved transposition with respect to 200 shares and transmissions with respect to 4,800 shares. Sd/Bangalore April 9, 2003

N. R. Narayana Murthy Chairman, investment committee

Nandan M. Nilekani Chairman, share transfer committee

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the board of directors is responsible for monitoring risk levels according to various parameters. the Government and the Press The chairman. The audit committee provides the overall direction on the risk management policies. as well as members of the management council. the CEO and the COO. evaluates and decides the annual compensation for officers of the company from the level of associate vice president. and the management council is responsible for ensuring implementation of mitigation measures. Risk Management The company has an integrated approach to managing the risks inherent in various aspects of its business. Employees. but excluding members of the management council. As part of this approach. Board interaction with Clients. and various governments. The compensation committee of the board administers the 1998 and the 1999 Stock Option Plans. if required. Formal Evaluation of Officers The compensation committee of the board approves the compensation and benefits for all executive board members. Another committee headed by the CEO reviews. in consultation with the CPO. according to Indian GAAP and US GAAP financials. Institutional Investors. media. Management’s Discussion and Analysis This is given as separate chapters in this Annual Report. 2.D) MANAGEMENT REVIEW AND RESPONSIBILITY 1. handle all interactions with investors. respectively Investors Relations 37 . 4. 3. The CEO and the COO manage all interaction with clients and employees.

Mr. along with segmental information. As per Article 122 of the Articles of Association. Financial Express and the Udayavani (a regional body of Bangalore). The board has recommended the re-election of all the retiring directors. is eligible and is offering himself for appointment as independent director of the company The detailed resumes of all these directors are provided in the notice to the Annual General Meeting. offer themselves for re-election at the Annual General Meeting of shareholders. and their transcripts are pasted an the website soon thereafter. Investors’ Grievances and Share Transfer As mentioned earlier. Details of Non-compliance There has been no non-compliance of any legal requirements by the company nor has there been any strictures imposed by any stock exchange. The proceedings of the Annual General Meeting is web-cast live an the Internet to enable shareholders across the world to view the proceedings.Strategic Financing Decisions E) SHAREHOLDERS 1. 2003. the company has a board-level investors grievance committee to examine and redress shareholders' and investors' complaints. 2. SEBI or SEC. For matters regarding shares transferred in physical form. quarterly reports which contain audited financial statements under Indian GAAP and unaudited financial statements under US GAAP. who was appointed as an additional director with effect from April 10. on any matters relating to the capital market over the last three years. Sridar Iyengar. share certificates. Larry Pressler. the quarterly and annual results are generally published in The Economic Times. The details of shares transferred and nature of complaints are provided in the following chapter an Additional information to shareholders. The status an complaints and share transfers is reported to the full board. The archives of the video are also available an the company home page far future reference to all the shareholders. etc. Disclosures Regarding Appointment or Re-appointment of Directors According to the Articles of Association. The Times of India. Their address is given in the section on Shareholder information. one-third of the directors retire by Rotarian and. 5. In addition. if eligible. Any specific presentations made to analysts and others are also posted an the company website. Srinath Batni. Omkar Goswami and Rama Bijapurkar will retire in the ensuing Annual General Meeting. 38 . are pasted on the company website (w Earnings calls with analysts and investors are broadcast live on the website. Moreover. Quarterly and annual financial statements. change of address. the company's registrar and share transfer agent. Business Line. shareholders should communicate with Karvy Consultants Limited. 4. along with additional information. Sen. Communication to Shareholders Since June 1997. General Body Meetings Details of the last three Annual General Meetings are given in Table 8. Infosys has been sending to each shareholder. dividends. Business Standard. Messrs. 3.

the auditor's certificate is given as an annexure to the Directors' report. 2003. Postal Ballots For the year ended March 31. However.G. the company has voluntarily decided to comply with the provisions of postal ballot for all the resolutions placed before the shareholders in the AGM to be held on June 14. 2002 1500 hrs Date. there have been no ordinary or special resolutions passed by the company's shareholders that require a postal ballot. India J. National Science Seminar Complex. 2001 Date May 27. 7. 2003. N. Indian Institute of Science. Bangalore. India 6. Indian Institute of Science. 41/3 M.Table 8: Date. 2002 June 8. Road. 2001 Time 1500 hrs 1500 hrs Venue Taj Residency Hotel. 41/3 M. Tata Auditorium. Tata Auditorium. Bangalore. Auditor’s Certificate on Corporate Governance As required by Clause 49 of the Listing Agreement. time and venue of the last EGM Date February 22. Bangalore. 2000 June 2. N. Goad. The detailed instructions are provided in the notice to the Annual General Meeting. time and venue of the last three AGMs Financial year (ended) March 31. India J.G. National Science Seminar Complex. Bangalore. 2000 March 31. India Investors Relations March 31. 39 . 2003 Time 1500 hrs Venue Taj Residency Hotel.

3 – Independence standards for consulting and other entities are affiliated to audit firms Recommendation 2. – Complied with. 3 and 4 which deal with auditorcompany relationship. The committee had since submitted its report to the government.4 – Compulsory audit partner rotation Recommendation 2. – Complied with. auditing the auditors and independent directors . The report contains five chapters. Chapters 2. Recommendation 2. – Complied with.1 – Setting-up of independence quality review board Independent directors: Role. remuneration and training Recommendation 4. the committee recommends an abbreviated list of disqualifications for auditing assignments which includes: Prohibition Prohibition Prohibition Prohibition Prohibition Prohibition of any direct financial interest in the audit client of receiving any loans and I or guarantees of any business relationship of personal relationships of service or cooling off period of undue dependence on an audit client – Complied with.1 – Definition of an independent director – Complied with.5 – Auditor’s disclosure of contingent liabilities Recommendation 2. – Complied with. as we do not have any proposal to replace the auditors. – Complied with.8 – Auditor’s annual certification of independence The audit committee receives the certification of independence from both the internal and statutory auditors every year. – Complied with. The audit committee consisting fully of independent directors recommends the appointment of replacement of auditors. – Complied with.2 – Proposed disciplinary mechanism for auditors – Not applicable 40 Recommendation 4. – Not applicable – Complied with. Recommendation 2.6 – Auditor’s disclosure of qualifications and consequent action Recommendation 2. Recommendation 3.10 – CEO and CFO certification of annual audited accounts Auditing the auditors Recommendation 3. – Not applicable – Complied with.1 – Disqualifications for audit assignments – In line with the international best practices. – complied with.7 – Management’s certification in the event of auditor’s replacement Not applicable.2 – List of prohibited non-audit services Recommendation 2. – Complied with.role. Recommendation 2. Naresh Chandra to examine the auditor-company relationship. The auditor-company relationship Recommendation 2. – Complied with. remuneration and training is relevant to your company The chapter one is an introductory section and chapter 5 relates to regulatory changes.Strategic Financing Decisions F) COMPLIANCE WITH THE RECOMMENDATIONS OF THE REPORT OF THE COMMITTEE ON CORPORATE AUDIT AND GOVERNANCE (NARESH CHANDRA COMMITTEE) The Government of India by an order dated the 21st August 2002 constituted a high level committee under the Chairmanship of Mr. The Government of India has not yet made it mandatory for the Indian companies. The Company’s Act is yet to be amended by the government to seek special resolution of the shareholders in case of a replacement of an auditor. Your company has substantially complied with most of these recommendations. – Complied with.2 – Percentage of independent directors .9 – Appointment of auditors Recommendation 2.

9 – Remuneration of non-executive director Recommendation 4. – At present.8 – Audit committee charter Recommendation 4.7 – Independent directors on audit committee of listed companies – Complied with. The presentations made at various investors conferences are available on the web.5 – Tele-conferencing and video conferencing Recommendation 4.4 – Disclosure on duration of board meetings / committee meetings – Complied with. Investors Relations Recommendation 4.3 – Minimum board size of listed companies Recommendation 4. during the board meetings. Going forward.Recommendation 4.6 – Additional disclosure to directors At present.10 – Exempting non-executive directors from certain liabilities Recommendation 4. we submit a summary of all the press releases issued during a quarter. the company would send a compy of all press releases as well as the investor presentations to all the directors.11 – Training of independent directors – Complied with. Recommendation 4. Recommendation 4. to all the external board members. – Not applicable – Not applicable – Not applicable 41 . – Is being complied with from January 2003 meetings. the law does not permit this.

These changes along with fast changing demographies of work force. reorganization of capital and financial reconstruction. ASEAN.UNIT 18 FINANCIAL RESTRUCTURING Objectives The objectives of this unit are to: provide an understanding of concept. emergence of new trade blocks. Structure 18. formation of WTO and far reaching changes in global trading regulations prescribed by it. carve-outs.4 18. provide an understanding of criteria for determining exchanges rate. dismantling of the erstwhile USSR. familial and cultural values of people and rapidly moving customers tastes have not only 1 . integration of world financial markets at unprecedented reforms across the East European and South Asian Countries. the North American Market. spin-offs.12 18.14 18.8 18.1 INTRODUCTION The world has witnessed tectonic and tumultuous changes during the last two decades in terms of unification of Germany. cataclysmic change in personal.9 18. explain leveraged buyout.11 18. growing economic inter dependencies and globalization of markets. following economic liberalization.7 18.15 18.2 18. explain concept. etc.10 18.6 18. free flow of capital and knowledge. greater interactions among different financial systems of different countries. and path breaking proliferation and convergence of technologies.5 18.16 Introduction Corporate Restructuring Financial Restructuring Assessing Merger as a Source of a Value Addition Formulating Merger and Acquisition Strategy Regulation of Mergers and Takeovers in India Takeover Strategies – Indian Experience Divestitures Characteristics of and Pre-requisities to Leveraged Buyout Success Leveraged Recapitalization Reorganization of Capital Financial Reconstruction Summary Key Words Self-Assessment Questions Further Readings 18. assess merger as a source of value addition. forms and motives of mergers.3 18.1 18. explain process entailed in formulating merger and acquisition strategy. throw light on divestiture and its financial assessment. motives and dimensions of corporate restructuring. realignment of economic forces such as the unification of the European Community. faster growth in world trade. rising economic power of Japan and NICs in the world market. social. leveraged recapitalization.13 18.

While planning for restructuring. privatization and globalization and to ensure their survival Indian corporate giants such as Tatas. asset mix and organization so as to enhance the value of the firm and attain competitive edge on sustainable basis. the management should specify what type of business the firm can do most effectively.2 CORPORATE RESTRUCTURING A. Reliance. Dabur India having acquired three comanies in the UAE and Bangladesh and Mahindra & Mahindra is scouting for a tractor plant in Europe. Wipro acquired Nerve Wire. the strategy of restructuring their assets. 285 842 858 872 1208 524 447 395 290 Financial Restructuring 18. Thus. capital structure. 2 . Table 18. A V Birla group acquired four companies. Concept of Restructuring Corporate Structuring is a process of redefining the basic line of business and discovering a common thread for the firm’s existence and consolidation. restructuring is a process by which a corporate enterprise seeks to alter what it owes. pursued.1: Mergers & Acquisitions Year 1991 1992 1993 1994 1995 1996 2000 2001 2002 No. products. To meet competitive challenges from the foray of multinationals following liberalization. Essar group acquired a 3 MT Steel Plant in Thailand. Those business/ market areas which offer little or no potential should be removed from the basic business structure. This it does after making a detailed analysis of itself at a point of time. market. business enterprises across the globe embarked on programmes of restructuring and alliance spree Global deal volume during the historic mergers and alliance wave of 1995 to 2000 totalled more than $12trillion. of late. Others having unsatisfactory earnings. market and manpower resulting in spate of mergers and acquisitions in recent years (Table 18. technologies. Motives for Restructuring Corporate enterprises are motivated to restructure themselves in view of the following forces: The Government policy of liberalization. 2003 has seen the biggest ever rush of Indian corporates acquiring foreign firms. A V Birlas.1). privatization and globalization spurred many Indian organizations to restructure their product mix. poor competitive position or management incapability should also be discontinued. Indeed.Strategic Financingbusiness complexities increased Decisions but also rendered global business scenario much more volatile and fairly competitive. HLL. B. At times restructuring would radically alter a firm’s product market mix. SBI have. To cope with the incredible opportunities and enhance share owners’ wealth. refocus itself to specific tasks performance.

.... Convertibility of rupee has encouraged many medium – sized companies to operate in the global market....... Some companies are suffering because of inefficient management........ New business embraced by companies in the past had to be dropped because of their irrelevance in the changed environment................... divestitures................ ....... Market Restructuring: This involves decisions regarding product – market positioning to suit the changed situations............................ These alterations have a significant impact on the firm’s balance sheet or by exploiting unused financial capacity........... 3 .............................. etc............................................................................... . quality and delivery................ C............................................. organizations are motivated to reorganize their financial structure for improving the financial strength and improving operating performance...................................... outsourcing non-value adding activities and subcontracting............ Many organizations pursued the strategy of accessing new market and customer segment....................................................................... mergers........... 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... so as to meet the competitive challenges in terms of cost.... leveraged recapitalization............................................ You may please note that a good restructuring exercise consists of a mixture of all these. Dimension of Restructuring Corporate restructuring is a broad umbrella that covers the following: Financial Restructuring: This involves decisions pertaining to acquisition............................................. Technological Restructuring: This involves decisions pertaining to redesigning the business process through revamping existing technologies.. b) Name three top business groups in India which embarked on restructuring programmes............. Another plausible reason for restructuring is improved management................................................. Revolution in information technology facilitated companies to adopt new changes in the field of communication for improving corporate performance.................... At times..................... Activity 1 a) List out the five primary forces that forced Indian corporates to engage in restructuring exercises................................... ..... ............................................. Wrong diversification and divisionalization strategy has led many organizations to revamp themselves......................... decentralization and delayering............................ ....................................................... .............. ........... reorganization of capital...... ....... Product divisions which do not fit into company’s care business are being divested...... leveraged buyout......................................... Improved productivity and cost reduction have necessitated downsizing of the workforce......... Such companies opted for change in top management............................................. downsizing...technologies etc......................

if one company survives and others lose their independent entity. Forward merger refers to moving closer to the ultimate customer. But if a new company comes into existence because of merger. recapitalization. both the companies retain their separate legal entity. GEC with EEC are examples of Horizontal Merger. reorganization of capital and financial re-construction. Thus. operations which are outside the ordinary course of business. Takeover is the purchase by one company of a controlling interest in the share capital of another existing company. A takeover is resorted to gain control over a company while companies are amalgamated to derive advantage of scale of operations. it is a case of ‘Absorption’. B. asset mix. While the former was mostly into foods.3 FINANCIAL RESTRUCTURING Financial Restructuring A. Concept of Financial Restructuring Financial restructuring is the process of reorganizing the company by affecting major changes in ownership pattern. Vertical Merger may be backward. Conglomerate Merger Conglomerate Merger is a fusion in unrelated lines of business.Strategic Financing Decisions 18. Backward merger refers moving closer to the source of raw materials in their beginning form. Mergers and Takeovers Concept A company intending to acquire another company may buy the assets or stock or may combine with the latter. Let us dilate upon each of these aspects. 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. Chabria. achieve rapid growth and expansion and build strong managerial and technological competence so as to ensure higher value to shareowners. Kumar Mangalam Birla and London based Swaraj Paul. forward or both ways. divestitures. Khaitan. DU Pont acquired a chain of stores that sold chemical products at the retail level for increased control and influence of its distribution. The main reason for this type of merger is to seek diversification for the surviving company. leveraged. Indian takeover kings are R P Goenka. A case in point is the merger of Brooke Bond Lipton with Hindustan Lever. curve-outs. As a result of a merger. In takeover. Merger of Renusagar Power Supply and Hindalco is a case in point. 4 . it is a process of ‘Amalgamation’. with Atlas Telecom. financial restructuring covers many things such as the mergers and takeovers. Merger of Hindustan Lever with TOMCO and Global Telecom Services Ltd. Thus. Forms Horizontal Merger A horizontal merger is one that takes place between two firms in the same line of business. spinoffs. acquisition of an organization is accomplished either through the process of merger or through the takeover route. Vertical Merger Vertical Merger takes place when firms in successive stages of the same industry are integrated. the latter was into detergents and personal care. The survivor acquires the assets as well as liabilities of the merged company.

Merger of Reliance Petrochemicals with Reliance Industries was aimed at enhancing shareholders’ value by realizing significant synergies of both the companies. 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 comapnies and achieve competitive edge over the rivals. 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. a small company may be hesitant to launch a new product with a high potential market because of high risk exposure to the projects. which merged with the loss-making Godrej Innovative Chemicals is an example of reverse merger. a company prone to wide cyclical swings may be able to minimize the degree of instability in its earnings and improve its performance. Recent alliance between Max India and GIST–Brocades has made to covert potential competitor into a partner. The fear of increasing competitive resulting from the tie up between Procter and Gamble and Godrej Soaps forced Hindustan Lever to merge with TOMCO. Also the merger may open up opportunities that neither firm would pursue otherwise. Similarly. 5 . advertising and finance which are common to both organizations. Godrej soaps. 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. For example. reduction of cost. Recent alliances of Jenson and Nicholson India Ltd. the reverse merger of ICICI into ICICI Bank. Nearly two-thirds of the giant public corporations in the USA are the outcome of mergers and acquisitions. with Carl Scheneek A G. Similarly. Reverse merger can also occur when regulatory requirements need one to become one kind of company or another. 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. increased efficiency. amalgamation of Asea Ltd with Asea Browns Bover (ABB) was intended to avail of the benefits of rationalization and synergy effects. By merging with relatively more stable enterprise. To Speed Up Diversification Many companies join together to reduce business risk through diversification of their operations. In fact. and J K Corporation with Mitel of Canada are examples of acquisition based on diversification motive. 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.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. Motives for Mergers To Avail Operating Economics Firms are merged to derive operating economies in terms of elimination of duplicate facilities. the potential loss will not be as significant to the surviving company as to the small one. mergers and takeovers have played pivotal role in the growth of most of the leading corporations of the world.

R P Goenka. took place to get hold of the controlling interest through open offer of market prices. capital structure or working capital position. To Strengthen Controlling Power Acquisition of profit making companies by Indian businessmen like Kumar Mangalam Birla. etc. Tie-ups between HCL and HP Ltd. it may seek merger with a firm endowed with sapient and savvy management.Strategic Financing Decisions Latest To Access to Technology Financial Restructuring Many organizations have. Such firms often turn to mergers financed by cash as a way of redeploying their capital. unlevered cash rich company a firm may present a consolidated picture of the financial position that will be more appealing to potential investors. A company embarking on the expansion programme may find its difficult to satisfy its requirements owing to temporary imbalance in its cash flows. To Utilize Surplus Funds At times. finance manager of a firm must ensure that this step would add value to the firm. Ruias. Khaitan. Tata-IBM. Maruti-Suzuki alliance. 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. Caltex alliance with IBP were made essentially to secure latest technology. Hence. DCM Data and Control Data of USA. Management of such firms may be tempted to acquire another company shares. Tata Tea and Tetelay of USA and Onida and JVC have been made to exploit tremendous market opportunities of foreign countries. a firm in a mature industry having generated a substantial amount of cash may not find adequate profitable investment opportunities. Ratan Tata. 18. Ranbaxy Laboratories and Eli Lilly. There is an economic gain only if the two firms are worth more together than apart. Hindustan Motors and General Motors. To Widen Market Base In recent few years large number of firms forged alliances with specific purpose of globalising the firm’s products. G P Goenka. Parle and Coco-Cola. Modis. 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. Mukesh Ambani. forged alliances with foreign firms so as to gain access to latest product technology cheaply. For this purpose he has to follow the procedure laid down below: (i) Determine if there is an economic gain from the merger. Tata Telecom tie up with AT&T. Piramals. To Strengthen Financial Position Another cogent motive for the merger may be to mitigate the financial problem. 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). of late. Thus. 6 Gain = Pvxy – (Pvx+Pvy) . By joining with a stable.4 ASSESSING MERGER AS A SOURCE OF VALUE ADDITION While taking decision whether to acquire a firm. Merger of Renu Sagar Power Supply and Hindal Co and ICICI with ICICI Bank are cases in point.

550 crore – Rs. In real life. Y has captured Rs. Thus. firm’s X’s worth in the beginning is Pv = Rs. therefore. 30 crore of Rs. Example 1 Firm X has a value of Rs. be: NPV = Rs. 550 crore Suppose that Firm Y is bought for cash. the cost of acquiring Y is equal to the cash payment minus Y’s value as a separate entity. 30 crore = Rs. Firm X’s gain will. 50 crore Pvxy = Rs. Net gain of X’s owners is NPV = Wealth with merger – Wealth without merger = (Pvxy–cash) – Pvx = (Rs. 100 crore = Rs. 20 crore In other words. 100 crore Gain = W Pvxy = Rs. Its worth after the merger comes to Pv = Rs. 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. The cost of merger is: Cost = Cash paid – Pvy = Rs. 30 crore. 50 crore. If the sellers receive N shares. 50 crore – Rs. It is measured by the difference between the gain and cost. Thus. say for Rs.(ii) Determine the cost of acquiring firm Y. 130 crore to Y’s stockholders. Cost = Cash paid – Pvy (iii) Determine the net present value to X of a merger with Y. 30 crore Note that the owners of firm Y are ahead by Rs. Merging the two would allow cost savings with a present value of Rs. 400 crore. If payment is made in cash. cost depends on the value of the shares in new company received by the shareholders of the selling company. 130 crore – Rs. and Y has a value of Rs. each worth Pxy. 400 crore = Rs. In such a situation. 400 crore and then it has to pay out Rs. the cost is: Cost = NX Pxy – Pvy 7 . 20 crore In the above procedure. It should be noted that it would be incorrect to undertak emerger analysis on the basis of forecast of the target firm’s furture 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. the target firm’s market value (Pvy) is taken into consideration along with the changes in cash flow that would result from the merger. compensation is usually paid in stock. 100 crore. 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. it would be advisable to go ahead with the merger. This is the gain from the merger. 130 crore. NPV = gain – cost = W Pvxy – (Cash–Pvy) If the difference is positive. Thus. This is for the fact that there are chances of large errors in valuing a business. Pvx = Rs. 50 crore merger gain. 400 crore.30 crore) – Rs. 400 crore Pvy = Rs. Y’s gain will be X’s cost.

10 lakh. the apparent cost may not be the true cost.000 = 0. The acquired firm (Firm X) would........ 2 may be restated as: Px = (Pexy)(Ex+Ey)/Sx+Sy(Erx) ... the relevant financial details of the two firms prior to the merger announcement are: X Market Price per share Number of shares Market value of the firm Rs. (2) The earnings per share of the combined firm is denoted as: EPSxy = Ex+Ey/Sx+Sy(Erx) .. (4) Solving Eq.. like that the price per share of the combined firm is atleast equal to the price per share of the firm X. 50..00...000 = Rs.000 However.....000 Rs... Accordingly. is equal to: Cost = aPvxy – Pvy In the above example...... (3) Here Erx represents the number of shares of firm X given in lieu of one share of firm Y..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.Strategic Financing Decisions Let us consider an example: Financial Restructuring Example 2 Firm X is planning to acquire firm Y..000 + 1. 4 for Erx yields: Erx = –Sx/Sy + (Ex+Ey) (Pexy)/PxSy Let us explain the process of determination of exchange rate with the help of an example: 8 .. Pxy = Px . At the announcement it ought to go up...50.000 Rs.25. 40 Rs.000 X 100 – 10..... The apparent cost of acquiring firm Y is: 125.. when Y’s shareholders get a fraction of the share capital of the combined firm. 2. the share of Y in the combined entity will be: a = 12. (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 ... X’ stock price in Rs... 10 lakh The merger deal is expected to bring gains which have a present value of Rs. 100 Rs. 25..50. Firm X offers 125.... 100 before the merger announcement...000....000/5.. therefore. Eq.00.. 50 lakh Y Rs. The true cost..000 shares to the shareholders of firm Y....000 shares in exchange for 250.

6 Y Rs. E Number of outstanding shares.0 (b) Minimum exchange ratio from the point of view of the Y shareholders: ERy = PySx / (Pxy) Exy – PySy = 4X5lakh/2X (14lakhX1. 4 lakh Rs. 2 lakh Rs. P Rs. 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.05) – 4X2lakh = 20 lakh/14. 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. 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. market prices may not be very reliable.70 lakh – 8 lakh = 0. it does not take into consideration the difference in the growth rate of earnings of the two firms. the earning power of a firm. market price per share and book value per share.3 Criteria for Determining Exchange Ratio Commonly used criteria for establishing exchange ratio are earnings per share (EPS). it may be noted that book values do not reflect changes in purchasing power of money as also true economic values. There is also possibility of manipulation of market process by those having a vested interest. As regards utility of book value per share as the basis for determining exchange ratio. Further. gains stemming out of merger and the differential risks associated with the earnings of the two firms. Market price per share can also be the basis for determining exchange ratio. 10 lakh Rs.Example 3 X corporation is contemplating to acquire Y corporation. S Market price per share. 5 lakh Rs. However. EPS cannot be the basis if it is negative. This measure is very useful where the shares of the firms are actively traded. 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: (a) Maximum exchange ratio from the Point of the shareholders of X corporation ERx = –Sx/Sy + PExy (Exy)/PxSy = –5 lakh/2 lakh + 3X 14lakh/6X2lakh = 1. Otherwise. Financial information about the firms are setout below: X Total current earnings. 9 . Earnings per share reflect.

negotiate with the prospective firm and integrate the firm. Broadly speaking. Some of these factors are listed below: 10 . Such a study is done to make sure that the firm possesses the necessary competence to carry out the acquisition programme successfully. only 23 percent of the mergers ended up recovering the costs incurred in the deal. perform post-acquisition tasks and monitor acquisition results. much less shimmering synergistic heights of glory.5 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. show that during a given 10-year period. Assessing Corporate Competence A detailed and dispassionate study of the firm’s own capabilities should form an integral part of acquisition planning. acquisition strategy should be developed along the following lines: 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. Studies made by Mc Kinsey & Co. 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. Locating Companies to Acquire Before undertaking search process the central management should consider a number of factors which have their significant bearing on the aquisition. 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. 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.Strategic Financing Decisions Some of the recent major takeovers in the Indian Corporate world are: : : : : : : : : : : Modern Foods INDAL Hindustan Zinc Shaw Wallace CMC Ashok Leyland Calcutta Electric Supply Company Ner Ve Wire India World DLF Cement Financial Restructuring HLL HINDALCO Sterlite Industries Chhabrias Tatas Hindujas Goenkas Wipro Satyam Gujarat Ambuja 18.

Acquiring a loss making firm may not ensure success unless the acquiring firm is equipped with a skilled management. Kitching’s study reveals that acquisition with market shares of less than 5 percent for diversification moves had failure rates of over 50 percent. 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. low capital bases with fully depreciated assets or with large tracts of real estate or securities. Success has been reported mostly in horizontal acquisitions. Profitability of Acquisitions: Success of acquisition also depends upon profitability of the firm being acquired.1. 4. be in firms are not available for sale or require the payment of such a premium as to make their acquisitions unattractive. In the same way. the Exporter’s 11 . this should not deter management from going ahead with its plan of acquiring overseas firms. local tax patterns and financial market requirements. management makes a determined effort to ensure that the new acquisition achieves the results expected of it quickly. the acquiring firm should ascertain what the potential firm can be for the organization which it cannot do on its own. Higher the market share. 5. had a lower overall failure rate than all forms of acquisition except horizontal purchases. The possibility of success increases with increase in size of the acquisitionbecause acquisition of a large firm is likely to bring about material change in corporate performance. Keeping in view the above factors. Choice of Company: A firm keen to takeover another company should look for companies with high growth potential and shortlist firms with large assets. Financial data in particular is not reliable in some countries due to varying accounting conventions and standards. Size of Purchase: The size of an acquired firm in relation to the acquirer is an important determinant of acquisition success. It may. 3. therefore. Type of Diversification: Success of acquisition also depends on form of diversification. For large purchases. non-competing firms and from various international publications like International Yellow Pages. Market Share: Another variable influencing acquisition success is the market share. what it cannot do itself. legal procedures involved in acquisition must begin through in detail. Commercial data are not readily available everywhere. However. which tend to be in low technology industries. Acquisition of highly promising organizations may be resisted by the host country governments. 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. marketing-inspired diversifications appeared to offer the lowest risk. where the company purchased belonged to the same product-market as the acquirer. Further. greater the success of acquisition move. The desired information can be gathered particularly through information service organizations such as Business International and Economic Intelligence Unit. capable of handling such situations. 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. 2. Pure conglomerate acquisitions. Success rate in the case of vertical integrations has been relatively lower. but acquisitions motivated by the desire to take advantage of a common technology had the highest failure rate of all. what the organization can do for the potential firm.

wage and incentive structure. and plant management competence. communication channels. It should also be found out if there have been instances of bad buying. may also stifle competition and encourage monopoly and monopolist corporate behavior. pricing. In India. 18. large stock write offs. sales force and its composition. merger and acquisition are regulated through the provision of companies Act 1956. Departmentation of the firms. major suppliers and materials supplied by them. job evaluation etc. production control. It will also be useful to scan the current organizational structure and climate of the perspective firms. quality. It may be helpful to appraise research and development capability of managing production lines and competence in distributing products. Therefore. extent of delegation of authority. critical bottlenecks. Appraisal of Operation of the Potential Candidates The task force should scan the location of the plants of the company. operating capacity and actual capacity being used. importers and other kinds of business in world markets. past year business performance. management structure. stores procedures. Identification of major competitors and their market share are source of the critical aspects the must receive attention of the evaluator. 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.’ Evaluator should assess the operations of the firm from marketing point of view. consumer loyalty. stage in life cycle. production costs in relation to sale price. replacement needs. fixed assets. most of the countries have their own legal frame work to regulate the merger and acquisition activities.Strategic Financing Decisions Encyclopaedia and Directories of manufacturers. the Foreign exchange regulation . 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. Financial Restructuring Evaluating the Prospective Candidtates for Acquisition After identifying firms according to the specification. prices being charged and alternative sources. volume of production by product line. nature of consumers. overstocking. ownership. product range. Thus. labour unions and their relations with management. current policies of the firm pertaining to product. capital base. markets served in terms of the share held. The following aspects should receive attention of the evaluator: General Background of the Potential Candidates The background information of each of the identified companies about the nature of business. packaging. its machines and equipments and their productivity. inventory management policies. slow ‘moving stock. promotion and distribution and recent changes therein. their skills. It will also be useful to undertake detailed appraisal of the product purchasing organization and its competence. the monopolies and restrictive trade practices (MRTP) Act 1969. The focus of the study should be on strength of labour. sales policy. geographical distribution of consumers should be kept in view. channels of distribution.6 REGULATION OF MERGERS AND TAKE OVERS IN INDIA 12 Mergers and acquisition may lead to exploitation of minority share holders.

3. 13 . banks and few individuals may get most of the benefits because of their accessibility to the process of the take-over deal market. The offer has been approved by at least 90 percent of the shareholders when transfer is involved within four months of making the offer. 2. It may be too late for small investor before he knows about the proposal. The companies act guidelines for take over are to ensure full disclosure about the merger and take over and to protect the interests of the share holders. The company act provides that a purchaser can force the minority shareholders to sell their shares if. 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. Financial Institutions. 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. the income tax Act 1961. 1. Disclosure: The offer should disclose the detailed terms of offer in details of existing holding. or group of individuals or individuals acquires the share of another company in excess of the limits should take the approval of the share holders and the Government. 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. 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. the control group needs to be informed when ever such holding exceeds 10 percent.Act (FERA) 1973. However. Guidelines for Takeovers: A listing agreement of the stock exchange contains the guidelines of takeovers. and the securities and exchange board of India (SEBI) also regulates mergers and acquisition (take over). Offer Document: The offer document should contains the offer and financial information. 4. When ever the company. 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. The offer has been made to the shareholders of the company. 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. Hostile take over is said to have taken place in case if 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 share holders. The salient features of the guildelines are: 1.

It can modify the scheme if it deems fit so. A minimum of 75 percent of share holders and creditors in separate meetings by voting in person or by proxy must accord approval to the scheme. 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 share holders board of directors and the company law board before affecting the merger. Financial Restructuring Information to the Stock Exchange: The acquiring and acquired companies should inform the stock exchange where they are listed about the merger. legal staff.Strategic Financing Decisions Legal Procedures: The following in the legal procedure for merger or acquisitions laid out in the Companies Act 1956. Shareholders and Creditors Meetings: The individual companies should hold corporate meetings of their shareholders and creditors for approving the merger scheme. The notice of meeting should be sent to them at least 21 days in advance. The high court would convene the meeting of the shareholders and creditors to approve the amalgamation proposal. However. 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. 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. This is generally done by the firm’s top management. These securities will be listed on the stock exchange. 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. Approval of Board of Directors: The Board of Directors of the individual companies should approve the draft proposal for merger and authorize the management to further to pursue the proposal. 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. bankers and even outside consultants who specialise in recommending workable corporate unions. 14 . Filling of the Court Order: After the court order its certified true copies will have to be filled with the Registrar of companies. 18. 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.7 TAKE OVER STRATEGIES: INDIAN EXPERIENCE The take over strategies involve successful identification and takeover of another corporation.

if the consideration price to be paid is more than the current market price is at premium.000 tonnes of soaps and detergents. “Wheel” washing power. Lever quickly saw an opportunity in taking over and reviving a sick company viz. This would enable the acquiring company to have the controlling right of the acquired company. its share holders have to pay considerations to the shareholders of the company under acquisition. The Rs. Lever’s successful answer to Nirma challenge was produced by Stephen. Home products and Sunrise Chemicals. When a company wants to acquire another company. There is also a unique case of Shivalik cellulose a Gujarat based paper plant which was set up in seventies. 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. This consideration is the value of the shares or assets of the company under acquisition.460 million turn over (1992) company and Lever’s Rs. But that did not deter Lever from 10. There are several methods of wealth maximisation of share holders.200 tones of soaps that Stephen had capacities for when lever started the lease. it is found in many of the acquisitions that the current market value is minimum consideration to be offered. 200 crore company today rolls out more than 50. but turned sick though it was a paper plant. 6 crore and its Rs. The right kind of consideration to be paid its current market value of the firm under acquisition. Detergent Bar Manufacturer jon.000 tones soap plant has kicked of production recently. 20.000 million. 1993.000 tones of detergents and 7. The shareholders’ wealth is interpreted by different people in different ways. its outstanding debts stood at Rs. Lever turned the paper plant into a 30. The high point of stephen’s success game four years ago is in the forefront of Lever war against Nirma. Taking Shivalik on a 24 years lease with an option to buy after five years. The govt. The company was not in attractive shape. we must have a way to evaluate mergers and acquisitions. Stepehn Chemicals a Punjab based soaps and detergents firm. In the afternoon of 9th March 1993 Tata Oil Mill company Ltd (TOMCO) informed the Bombay stock exchange about its intention to merge with the Hindustan Lever Ltd. The Stephen acquisition was followed by a chain of other sick units which Lever snapped up and quickly revived. Some competitors of Lever think that it will eliminate 15 . The evaluator of acquisition should analyse the price paid for acquisition and its impact on the share holders wealth. a soap company in Rajakot. The Board of Directors of the two companies approved the merger on 19th March. 4.As financial analyst. However. got tough in 1969 with the MRTP Legislation making takeover virtually impossible. Over the years and till the mid fifties Lever similarly acquired sick factories at various other sites. 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. 3 crore capital had been wiped out by losses.250 tones. The premium may be paid because of the under valuation of the shares or as an incentive to the share holders of the company under acquisition. TOMCO is Rs. Lever was interested. Lever would control one-third of three million tonnes soaps and detergents markets by this merger. The tools and techniques for the evaluation of mergers are also used in support of the executive judgement and political process in corporations.

in the recent half a dozen mergers and acquisitions.Strategic Financing Decisions competition. With the new take over code.83 16.146 Sterlite Industries by targeting 20 percent stock in the former one. Indian Aluminum targeted the Rs.83 Raasi Cements 410.75 percent stake in RCL. Moti. the Indian corporates are experiencing the wave of merger and acquisitions. The Rs. 162 crore Pennar Aluminum. 35.28 percent from Mr. 59. In Pharmaceuticals.31 13. 200 crore Merind. 1. the Rs. the 501 range of laundry soaps range have been re-launched. Nihar and Tomco’s eau de cologne. 400 crore wockhard targeted Rs. 2. This is an ideal opportunity to take over without the government intervention. The cement Industry saw a major restructuring bid as the Rs. 1. The Chennai based cements major India Cements Ltd. 349 crore Raasi Cements. 66 million for the first six months of 1992-1993.342/. It was Lever’s nearest rival but lagged much beind in the eighties. geographical reach and distribution network. 832 crore India Cements managed to take over the Rs.14 percent from a Chennai based shar broking Financials 1996-97 (Rs. The management of Lever. It is strong in South. The political uncertainty and the slow down of industrial production have depressed the share prices to levels where acquisition have become viable. Later it acquired 8. manufacturing locations. They are no more interested in protecting the existing promoters. 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. B. Procter and Gamble.58 64. Merger would have many benefits for Tomco which is reported to have incurred a loss of Rs. Indian Cements Ltd.20 22.99 Financial Restructuring 16 EPS (Rs) .V. Already most of Tomco’s brands Hamam.400 stockists and nine million outlets. The market for corporate control has exploded.P.19 42. with merger and acquisitions being accepted as means of corporate restructuring and redirecting capital towards efficient management.65 82. The new legal frame work govering the merger and take over opened the doors to hostile take over. Imeediately alarmed by this.K. 8.50 126. felt that the merger would result into a strategic fit in many areas such as brand positioning. Tomco take over has helped on capitalizing on new brand like Tomco hair Oil. A number of attempts by management to revive Tomco through diversification did not succeed. Crores) India Cements Sales Gross Profit Net Profit Equity 632. Raju ICL originally held 9. however.34 12. M. Now the financial institutions are also ready to sell their stock at good prices. Tomco has four manufacturing plants and large distributive network covering 2. (ICL) has pulled off a quite coup in its bid to acquire Raasi Cement Ltd by winning over the fighting main promoter and chairman Dr.000 crore TATA GROUP the Rs. Raju.23 percent from APIDC and 1.162 crore Indian Aluminum was targeted by Rs.11 crore LAKME from the Rs.crore Hindustan Lever resurfaced with the negotiated acquisition of the Rs.

................................................... ........ Dr.. 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? ............................................................................................. 2000 crore by market source) struck here over past few months........................................................................................................ The take over bazaar is brimming over with companies waiting to be picked up... ....................... ICL now plan to go ahead with an open offer to mop up 20 percent at the earlier offered price of Rs..................................... the strength of sheer size and unique competitive advantage....... ........ ................................ 17 ......................firm....................... ................................................... the benefits of a successful acquisition are powerful...................................................... But how does the bidder for takeover know before hand whether the acquisition he is targeting will be worth the price he has to pay? Corporate India is in the grip of a new wave of mergers............... ................................................................................................................................................. The volume of mergers & acquisitions deal in the country is no match for similar deals currently struck abroad............................... ......... ...................... .................................................. is planning to merge Modern Fertilizers Ltd.... The promoters of RCL sold their 32 percent equity to ICL................................................................................................................................................................................................................................................................................................................................. ......... offering dominant market share............. This will increase the total Stake in Raasi to nearly 78 percent..........................................” 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......................... 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................................................................................ ............................................................................... 300............. v Raju........... Activity 1 Bharat Chemicals Ltd........................ .......................................................................................................................... ................ One International Mega deal the recently aborted one is between Glaxo and Smithkilne Beecham will dwarf the total value of deal (roughly estimated at Rs................................... Bharat Chemicals has approached you to advise in this regard.................................................. ICL and its associates on the verge of picking up 8 percent from a transport contractor who is also an the board of Raasi..................... The regulations should be modified to protect the technocrat entrepreneurs and the government should seriously consider of introducing the buy back of shares......... B....................................................... ................................ It is take over time again if you read the pink papers.................................................................................................... ..............................

Divestiture strategy is pursued generally by highly diversified firms who 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. as determined above. Establish the discount rate for the unit on the basis of cost of capital of some firms engaged in the same line of business. Sale of its cement division by Coromandel Fertilizers Ltd. is an example of divestiture.9 CHARACTERISTICS OF AND PRE-REQUISITIES TO LEVERAGED BUYOUT SUCCESS Leveraged buyout (LBO) is an important form of financial restructuring which represents transfer of an ownership consummated heavily with debt. division or a plant to someone else. Before taking a final decision. 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. A large proposition of the purchase price in debt financed. to support expansion of the remaining busines. finance manager should assess if its is in the interest of the firm to do so. A V Birla group divested a publicly announced paper and chemicals project and a sea water magnesia unit in Visakapatnam and MRPL a petrochemicals Joint Venture with HPCL.8 DIVESTITURES Financial Restructuring While mergers and acquisitions lead to expansion of business in some way or the other. LBO involves an acquisition of a division of a company or sometime other sub unit. Characteristics of LBO 1. Divestiture as form of corporate restructuring signifies the transfer of ownership of a unit. Compute the unit’s present value. 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. divestiture move involves some sort of contraction of business. so as to strengthen its core business.Strategic Financing Decisions 18. it entails the acquisition of an entire company. using the discount rate. 18 2. The debt is secured by the assets of the enterprise involved. For instance. Divesting such businesses frees resources that can be used to reduce debt. At times. the decision rule will be: PD > VOP = Sell the unit PD = VOP = Be indifferent PD < VOP = Retain the unit 18. or to make acquisitions that materially strengthen the company’s competitive position in one or more of the remaining core business. Hence. to India Cements Ltd. 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. . 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.

3. viz. The Finance Consultant prepares projections for the Food division on the assumption that it will be run independently by the Four executives. The sale is to the management of the division being sold. the Food division of MML is acquired by an independent company run by the four key executives. Chemical. 2. the first several years are key. after 5 years they will own a healthy company with a moderate debt. They are able to come up with only Rs. involve increased financial burden. 24 lakh in the equity if this project. For the first several years. It is designed to be paid down. The business unit involved invariably becomes a privately held company. The debt is not intended to be permanent. the equity owners are playing a high-risk game and the principle of leverage being a double-edged weapon becomes evident. 5. of course. Thus. Thus. 170 lakh) and equity (Rs. which is funded through debt to the tune of Rs. Another potential 19 . predictable operating cash flows. 4. LBO permits going private with only moderate equity. Fertilizers and Food. 240 lakh. 4. 6. this may be attractive because sale of such assets provides cash for debt service in the initial years. The company must have stable. The consultant works out that cash flows of the division can support debt of Rs. 6 lakh in personal capital among them. 30 lakh. two forms of funds are employed: Debt (Rs. In the above case. 30 lakh). The assets of the acquired division are used to secure a large amount of debt. 190 lakh. the interest burden declines resulting in improved operating earnings. Example 5 Modern Manufacturing Ltd. The equity holders are. cash flows must be dedicated to debt service. It has also located a private investor who is ready to invest Rs. in case of sharp rise. They approach a finance consultant for financial assistance for the project. MML has decided to sell the division if it gets Rs. The four top divisional executives are willing to acquire the division through a leveraged buyout. 220 lakh in cash. 5. residual owners. The company must have a several year window of opportunity where major expenditures can be deferred. Cement. If the company has subsidiary assets that can be sold without adversely impacting the core business. Leveraged buyouts are cash purchases. Highly competent and experienced management is critical to the success of LBO. as opposed to stock purchases. 200 lakh it finds a finance company that is willing to lend Rs. 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 any LBO. Often it is a company having gone through a heavy capital expenditure programme and whose plant is modern. If the company can repay debt regularly. 170 lakh for the project. Thus. If things move as per plans and the debt is serviced according to schedule. The replacement value of the assets is Rs. Pre-requisites to Success of LBO 1. If the division is liquidated. The Company desires to divest the Food Division. The assets of this division have a book value of Rs. the assets would fetch only Rs. The company should have adequate physical assets and/or brand names which in times of need may lead to cash flows. 3. 340 lakh. (MML) has four divisions. 170 lakh and equity participation of Rs.

LR allows company to remain public unlike LBO which converts public traded company into private one. the management of the parent company can concentrate on its main business.10 LEVERAGED RECAPITALIZATION Another kind of financial restructuring is leveraged recapitalization (LR). their proportional ownership of the company increases sharply. spin-offs can motivate managers to perform better. the same depends on whether a majority stake is sold so that the new company operates independently. often by means of dividedn. internal organization changes may take place which may lead to improvements in operating performance. If the businesses are independent. Although carve-outs share many of the virtues of spin-offs. independent company by detaching part of a parent company’s assets and operations. 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. LR has been found to have a salutary effect on management efficiency due to high leverage and a greater equity stake.Strategic Financing Decisions problem with the need to service debt is the focus on short-run profitability. LR is a process of raising funds through increased leverage and using the cash so raised to distribute to equity owners. Investors feel relieved from the worry that funds will be siphoned from one business to support unprofitable capital investment another. 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. Under the discipline of debt. scale and diversification. Spin-offs widen investors’ choices by allowing them to invest in just one part of the business. it is easier to see the value and performance of each and reward managers accordingly. As a result. Spin-Offs A spin-off. In increases the competence of core business and keeps away the unwanted activities resulting in improved profitability of the parent company. By spinning-off those businesses which do not fit the company’s core competence. as a form of restructuring. Spin-off is considered as a way of protecting the Crown Jewel from a predator. In this transaction. Carve outs result in new cash flows. 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. This may have telling effect on the long-term survival and success of the organization. 20 . Announcement of a spin-off is generally greeted as good news by investors who reward the focus and penalize scope. More important. Shares in the new company are distributed to the parent company’s stockholders. Financial Restructuring 18. management and other insiders do not participate in the payout but take additional shares instead. As for the potentiality of LR as a means of value addition to the company. involves creation of a new. 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. However.

e. 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 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. the firm needs cash to take them up. think of reducing fixed burden of debt financing through voluntary extinction of bonds. therefore. In reorganization of capital a firm attempts to reduce total debt by reducing fixed charges through raising fresh equity share capital. Despite careful financial planning. Among these reasons. Extinction Through Refunding Refunding means substituting old bonds by new bond issue. the firm extinguishes the bonded debt absolutely. It is only when receipts exceed costs. however. to avoid bonds carrying unfavourable terms. Firm may. But when the equity is higher. the management should proceed ahead with refunding operation otherwise the idea of refunding must be dropped. When bonds are redeemed. Generally. Through redemption. the firm may take recourse to refunding as a means of reducing its cost of capital. Accordingly. viz. 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. It is an adjustment of gearing i. Also. debt-equity ratio of the company so as to maximize the wealth of the share owners. fluctuation of interest rates need to avoid unwanted leverage or to eliminate a bond issue carrying prohibitively restrictive features and similar other situations. extinction through redemption and extinction through conversion.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. extinction through refunding. The management may also use refunding to consolidate several existing bond issues to simplify their management. (i) voluntary setting aside of moneys 21 . the cost of serving also tends to be higher which can be reduced by relying more on debt for financing further expansion programmes. The actual price is fixed taking into account par value of the bond plus a reasonable premium. this redemption price is greater than the par value of the bond. The management uses this method to take advantage of cheaper sources of financing. Accordingly he must.18. Extinction Through Redemption Redemption is the actual paying of the debt. as in capital budgeting decision. The bond indenture provides the prices which the firm pay the bondholder for a bond called for redemption before their maturity. match the costs of refunding against receipts as a result of the refunding operation. There are two methods of providing the cash. refunding is generally resorted to reduce cost of servicing debt and to improve earning per share of the firm. 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. a firm may be constrained to bring about certain adjustments in its capital structure because of changes in business climate. Sometimes. the management may be tempted to substitute old bonds by new ones. Before refunding an outstanding bond the finance manager must determine whether or not refunding is profitable.

However. In the exchange process. Valuation of the old securities and their exchange for new securities. and the overall capitalization rate of similar companies average 10 percent. While the former is done by the management as a matter of business and financial policy and not because of any agreement with bondholders. This is possible only when bond issue is convertible. management may think of keeping the firm alive by changing its capital structure. terms of the debt may be changed. In addition. For example. bondholders become owner of the firm and bonded indebtedness is wiped out. Sometimes the conversion basis is expressed by stating that the bonds are convertible into stock at some specified figure. 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. 100 which means that the stock is being valued for conversion purposes at Rs. the total debt of the firm is reduced by shifting to income. all senior claims on assets must be settled in full before a junior claim can be settled. 4 lakh. preferred stock and common stock.12 FINANCIAL RECONSTRUCTION Financial reconstruction is the recasting of firm’s capital structure to reduce the amount of fixed burden of leverage. it does not require cash to pay to the bondholders. one Rs. 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. say Rs. When a firm converts its bonds. If it appears that the reconstructed company will need new financing in the future. For example. a more conservative ratio of debt to equity may be thought of so as to provide for future financial flexibility. The conversion privillege is exercised almost without exception wholly at the option of the bondholders. the latter is made obligatory by the terms of the bond indenture. Determine new capital structure for the company to reduce fixed charges so that there will be an adequate coverage margin. bondholders must receive the par value of their bonds in another security before there can be any distribution to preferred stockholders. 18. 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. total value of Rs. if future earnings of a company are expected to be Rs. (ii) (iii) 22 . Extinction Through Conversion Financial Restructuring 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. 40 lakh would be set for the company. Before deciding about conversion finance manager must examine the impact of the transaction on the market value of the stock as the decision criterion. The total valuation figure arrived at in step 1 sets an upper limit on the amount of securities that can be issued. Formulation of reconstruction plan involves three steps: (i) Determine total valuation of the company by capitalization of prospective earnings. 100 a share. When bonds are converted into stock. Rate of conversion is provided in debt indenture. To reduce these fixed charges. 1000 par value bond may be exchanged for 10 shares of the stock. In general. bonds.Strategic Financing Decisions received from earnings 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.

higher growth. 6 lakh in new debentures and Rs. speedy diversification. 18 lakh in debentures for Rs. Thus. may take the form of horizontal. or 25 percent of the total common stock of the reconstructed company. larger market base. technological and organizational in nature. In a harsh reconstruction. 4 lakh in stock in the reconstructed company. debt instruments may be exchanged for common stock in the newly reconstructed company and the old common stock may be eliminated completely. and that preferred stock holders exchange their securities for Rs. takeovers. leveraged recapitalization and financial reconstruction. advantage of complementary resources. 40 After deciding about the ‘appropriate’ capital structure for the company. 56 If the total valuation of the company is to be Rs.The existing capital structure of a company undergoing reconstruction is given as under: Rs. 12 lakh in income bonds. the new securities have got to be allocated. access to latest technology. The most cogent reasons for merger are economies of scale. in lakhs Debentures 18 Subordinated debentures 6 Preferred stock 12 Common stock equity (book value) 20 Total Rs. 23 .6 lakh in securities for preferred stock. leveraged buyouts. as significant forms of financial restructuring. in lakhs Debentures 6 Income bonds 12 Preferred stock 6 Common stock 16 Total Rs. the debentureholders exchange their Rs. have become a major force in the economic and financial milieu all over the world. Divestiture decisions are driven by a variety of motives such as raising capital. 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. A divestiture represents sale of division or plant or unit of one firm to another. 18.13 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. strong financial position and so on. acquisitions. Thus. that the subordinated debentureholders exchange their Rs. spin-offs. Corporate restructuring exercises were financial. conglomerate and reverse. vertical. Mergers. divestitures. the following could be the new capital structure: Rs. 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. 40 lakh. 12 lakh of common stockholders would then be entitled to Rs. which subsume both absorption and consolidation. exchange claim is settled in full before a junior claim is settled. Much depends on negotiation between the management and claimholders. Mergers.

14 KEY WORDS Absorption: refers to a situation where a company survives and others lose their identity. 5. 18. 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. Spin-offs: involve creation of a new. predictable operating cash flows and should have adequate physical assets and/or brand names. What are the driving forces for mergers & acquisitions? Discuss various steps involved in a merger. determination of total valuation of the company. strategic realignment and efficiency gain. division or a plant to some one else. 7. management should scan their financial desirability systematically and rationally. What are the regulatory provisions in India regarding mergers and acquisitions? How would you assess merger as a source of value addition? What is the cost of a merger from the point of the acquiring company? How would you determine the present value of a merger from the point of view of the acquiring company? . It is similar to LBO in as much as high degree of leverage is incorporated in the company. viz. Financial reconstruction process involves three main steps. Divestiture: signifies the transfer of ownership of a unit. Since divestitures have become common. LR allows the company to remain public unlike LBO which converts public traded Company into private one. 24 What is corporate restructuring? What motivates an enterprise to engage in restructuring exercise? Discuss various forms of mergers. The firm going for LBO must have stable. Take over: is the purchase by one company of a controlling interest in the share capital of another existing company. 4.Strategic Financing Decisions curtailment of losses.15 SELF ASSESSMENT QUESTIONS 1. It is a cash purchase as opposed to stock purchase. Leveraged Recapitalization: is a process of raising funds through increased leverage and using the cash so raised to distribute to equity owners. independent company by detaching part of a parent company’s assets and operations. LBO as a form of restructuring represents transfer of an ownership consummated heavily with debt. LR is a process of raising funds through increased leverage and using the cash so raised to distribute to equity owners. At times. 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. 2. Amalgamation: refers to a situation where a new company comes into existence because of merger. However. Financial Restructuring 18. Leveraged buyout: represents transfer of an ownership consummated heavily with debt. 6. 3.

Brigham. Prentice Hall Publishing Company.M. Virginia. 25 . 1978 Prasanna Chandra. 1998 John J. Financial Decision Making. 64 30 lakh Market Price per share Number of outstanding shares Rs. 11. Myers.16 FURTHER READINGS James C. Financial Management and Policy. K. Restructuring and Corporate Finance.S. 2002 Richard A. Compute the true cost of the merger from the view point of Divya Sugar Mills. New Delhi. The relevant financial information are: Divya Sugar Mills Shubhra Sugar Mills Rs. Brealey and Stewart C. Financial Management. 40 lakh 20 lakh Rs. Ltd. Van Horne. Takeovers. Siu. 140 40 lakh The merger is expected to generate gains which have a present value of 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? 18. N. Principles of Corporate Finance. Managerial Fiannce. 30 Smriti Electronics Rs. Tata Mc Graw Hill Public Company Ltd. Under what circumstances does a firm reorganize its capital? What are the various techniques of reorganization of capital? Divya Sugar Mills plans to acquire Shubhra Sugar Mills. Fred Weston. Illinois. Dolly Electronics is contemplating to merge Smriti Electronics. upper saddle River. 2001 R. Weston. 1978 J.J. 12.5. The following data are available: Dolly Electronics Total Current Earnings..A. 2003. What are the important bases for determining the exchange ratio? What are the salient features of divestitures? How would you assess divestiture programme of a company? What is leveraged buy out? How is it different from leveraged recapitalization? Distinguish between spin-offs and carve-outs. 2000 J. 9. Himalaya Publishing House. 400 lakh. Hinsdace. 13. The exchange rate agreed to is 0. Tata Mc Graw Hill Public Company Ltd. 10. Chung and J..F. Srivastava. S Market Price per share. 100 lakh 40 lakh Rs. Prentice Hall of India Pvt. Dryden Press. Prentice-Hall. Financial Management Policy. New Delhi. P Rs. E Number of outstanding shares.. Eugene F. Mumbai.8. Hompton. 14. New Delhi.

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