International Financial Management Notes.pdf 4v1u4g

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

FINAL GROUP - III PAPER - 12 STUDY NOTES

THE INSTITUTE OF COST AND WORKS ANTS OF INDIA 12, SUDDER STREET, KOLKATA - 700 016

First Edition : May 2008

Published by :

Directorate of Studies The Institute of Cost and Works ants of India 12, Sudder Street, Kolkata - 700 016

Printed at : Swapna Printing Works Private Limited 52, Raja Rammohan Sarani, Kolkata - 700 009 E-mail : [email protected]

Copyright of these Study Notes is reserved by the Institute of Cost and Works ants of India and prior permission from the Institute is necessary for reproduction of the whole or any part thereof.

SYLLABUS Paper 12: Financial Management & International Finance (One Paper: 3 hours:100 marks) OBJECTIVES Understand the scope, goals and objectives of Financial Management. To provide expert knowledge on concepts, methods and procedures involved in using Financial Management for managerial decision-making. Learning Aims

Understand and apply theories of financial management



Identify the options available in financial decisions and using appropriate tools for strategic financial management



Identify and evaluate key success factors in the financial management for organisation as a whole



Evaluate strategic financial management options in the light of changing environments and the needs of the enterprise



Determining the optimal financial strategy for various stages of the life-cycle of the enterprise



Critically assess the proposed strategies

Skill set required Level C: Requiring all six skill levels - knowledge, comprehension, application, analysis, synthesis, and evaluation CONTENTS 1.

Overview of Financial Management

10%

2.

Financial Management Decisions

15%

3.

Financial Analysis & Planning

10%

4.

Operating and Financial Leverages

5.

Financial Strategy

15%

6.

Investment Decisions

15%

7.

Project Management

10%

8.

International Finance

10%

9.

Sources of International Finance

5%

International Monetary and Financial System

5%

10.

5%

1. Overview of Financial Management

Finance and Related Disciplines



Scope of Financial Management,



Planning environment



Key decisions of Financial Management



Emerging role of finance managers in India



Earnings distributions policy



Compliance of regulatory requirements in formulation of financial strategies



Sources of finance – long term, short term and international



Exchange rate – risk agencies involved and procedures followed in international financial operations

2. Financial Management Decisions

Capital structure theories and planning



Cost of capital



Deg Capital Structure



Capital budgeting



Lease financing



Working capital management



Financial services



Dividend and retention policies



Criteria for selecting sources of finance, including finance for international investments



Effect of financing decisions on Balance Sheet and Ratios



Financial management in public sector



Role of Treasury function in of setting corporate objectives, funds management – national and international



Contemporary developments – WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBI regulations as amended from time to time

3. Financial analysis & planning

Funds flow and cash flow analysis



Financial ratio analysis -Ratios in the areas of performance, profitability, financial adaptability, liquidity, activity, shareholder investment and financing, and their interpretation.



Limitations of ratio analysis



Identification of information required to assess financial performance



Effect of short-term debt on the measurement of gearing.

4. Operating and financial leverages

Analysis of operating and financial leverages



Concept and nature of leverages operating risk and financial risk and combined leverage



Operating leverage and Cost volume Profit analysis – Earning Before Interest and Tax (EBIT) and Earning Per Share (EPS), indifference point.

5. Financial Strategy

Financial and Non-Financial objective of different organizations



Impact on Investment, finance and dividend decisions



Sources and benefits of international financing



Alternative Financing strategy in the context of regulatory requirements



Modeling and forecasting cash flows and financial statements based on expected values for variables – economic and business



Sensitivity analysis for changes in expected values in the models and forecasts



Emerging trends in financial reporting

6. Investment Decisions

Costs, Benefits and Risks analysis for projects



Linking investment with customer’s requirements



Deg Capital Structure



The impact of taxation, potential changes in economic factors and potential restrictions on remittance on these calculations



Capital investment real options



Venture Capital financing



Hybrid financing / Instruments

7. Project Management

Project Identification and Formulation



Identification of Project opportunities



Project Selection Consideration and Feasibility Studies



Project appraisal & Cost Benefit analysis



Source of Project Finance & Foreign Collaboration

8. International Finance Minimization of risk,

Diversification of risk



Forward and futures,



Forward rate agreements



Interest rate swaps



Caps, floors and collars



Parity theorems



FDI



Money market hedge



Options.

9. Sources of International Finance

Rising funds in foreign markets and investments in foreign projects



Forward rate agreements and interest rate guarantees



Transaction, translation and economic risk, Interest rate parity, purchasing power parity and the Fisher effects



Foreign Direct Investment

10. International Monetary and Financial System

Understanding the International Monetary System



Export and Import Practices



International Financial Management: Important issues and features, International Capital Market



International Financial Services and Insurance: Important issues and features

PAPER - 12 FINANCIAL MANAGEMENT AND INTERNATIONAL FINANCE Contents Study Note - 1 Overview of Financial Management Section

Particulars

Page No

Section 1

Finance and Related Disciplines

1-11

Section 2

Scope of Financial Management

12-13

Section 3

Planning Environment

14

Section 4

Key Decisions of Financial Management

15-16

Section 5

Emerging Role of Finance Managers in India

17-24

Section 6

Earning Distribution Policy

25

Section 7

Compliance of Regulatory Requirements in Formulation

Section 8

of Financial Strategies

26-27

Sources of Finance- Long Term, Short Term and

28-29

International Section 9

Exchange rate - Risk Agencies Involved and Procedure followed in International Financial Operations

30

Study Note - 2 Financial Management Decisions Section 1

Capital Structure Theory and Planning

31-37

Section 2

Cost of Capital

38-42

Section 3

Capital Budgeting

43-60

Section 4

Lease Financing

61-63

Section 5

Working Capital Management

64-75

Section 6

Financial Services

76-78

Section 7

Dividend and Retention Policies

79-81

Section 8

Criteria For Selecting Sources of Finance

82-83

Section 9

Effect of Financing Decisions on Balance Sheet and Ratios

84-85

Section 10

Financial Management in Public Sector

86

Section 11

Role of Treasury Function

87-90

Section 12

Contemporary Developments

91-94

Study Note - 3 Financial Analysis and Planning Section 1

Fund Flow Analysis

95-99

Section 2

Cash Flow Analysis

100-105

Section 3

Financial Ratio Analysis

106-110

Study Note - 4 Capital Budgeting Section

Particulars

Page No

Section 1

Cost-Volume-Profit Analysis

111-113

Section 2

Concept and Nature of Leverages

114

Section 3

Operating and Financial Leverages

115-117

Study Note - 5 Financial Strategy Section 1

Introduction to Financial Stratgy

Section 2

Financial & Non-Financial Objectives of different organization

Section 3

123-145

Alternative Financing Strategy in the context of Regulatory Requirement

Section 4

118-122

146-148

Modeling and Forecasting Cash Flows and Financial Statements

149-150

Section 5&6 Sensitivity Analysis for changes in expected values in the Section 7

Models and Forecasts

151-154

Emerging Trends in Financial Reporting

155-168

Study Note - 6 Investment Decisions Section 1

Cost, Benefits and Risks Analysis for Projects

169-171

Section 2

Real Options in Capital Investement Decisions

172-176

Section 3

Venture Capital Financing

177-187

Section 4

Hybrid Financing / Instruments

188-199

Study Note - 7 Project Management Section 1

Overview of Project Management

200-201

Section 2

Project Identification and Formulation

202-204

Section 3

Identification of Project Opportunities

205-206

Section 4

Project Selection Considerations and Feasibility

207-210

Section 5

Project Appraisal and Cost Benefit Analysis

211-216

Section 6

Source of Project Finance & Foreign Collaboration

217-220

Study Note - 8 International Finance Section 1

Risk Assessment and Management

221-222

Section 2

Interest Rate Risk

223-226

Section 3

Forward Rate Agreement

227-230

Section 4

Interest Rate Swaps

231-234

Section 5

Interest Rate Caps, Floors And Collars

235-236

Section 6

Options

237-243

Section 7

Comprehensive Illustration on Risk Management Through Derivative Products

244-256

Study Note - 9 Sources of International Finance Section

Particulars

Section 1

Rising Funds in Foreign Markets And Investment

Page No

In Foreign Projects

257-259

Section 2

Forward Rate Agreement And Interest Rate Guarantees

260-262

Section 3

Exposures in International Finance

263-265

Section 4

Foreign Direct Investment

266-268

Study Note - 10 International Monetary Fund and Financial System Section 1

Understanding International Monetary System

269-280

Section 2

Import and Export Procedures and Practices

281-286

Section 3

International Financial Management:Important Issues and Features,International Capital Market

Section 4

287-289

International Financial Services and Insurance : Important Issues and Features

290-295

STUDY NOTE - 1 OVERVIEW OF FINANCIAL MANAGEMENT

SECTION- 1 FINANCE AND RELATED DISCIPLINES This Section include • • • • • • • • • • • • • •

Basic Concepts of Finace and Relatid Desciplines Case Study Finance and Related Disciplines Costing Taxation Treasury Management Banking Insurance International Finance Risk Management Information Technology Management Soft Skills Case Study

1.1. FINANCE AND RELATED DISCIPLINES 1.1.1

Finance refers to funds required for a business or an activity. ‘Finance’ requirements of an enterprise is not ‘one time’ but recurring. The discipline of financial management as a separate and distinct subject of study has evolved over a period of time. The subject has its origins in Economics. However, it has today grown into a specialized discipline, integrating knowledge from many diverse fields as explained further in this chapter. The head of finance, also called Chief Financial Officer (CFO) must posses adequate skills and exposure in the following areas.

1.2. ECONOMICS 1.2.1

The mother discipline relating to human’s economic endeavors is Economics. It deals with various factors of production, the returns available on each of them, costs and revenues and so on. A fundamental knowledge of Economics is essential for the finance manager to understand the macroeconomic environment in which an organization operates and the micro economic or firm level impact of macro economic environment.

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OVERVIEW OF FINANCIAL MANAGEMENT

1.3. ING 1.3.1

ing is the recording of financial transactions of an organization and is based on several principles, conventions and legal requirement. It provides the basic data for financial analysis. It helps the Finance Manager analyse, understand and interpret the implications of finance decision on the profitability and viability of the enterprise on a time frame.

1.4. MATHEMATICS AND STATISTICS 1.4.1

Today’s world of finance has become a lot more sophisticated and complex, relying heavily on mathematical models and therefore, in certain areas of finance such as analytics or risk modelling, knowledge of mathematics and statistics have become essential. Financial modeling has become a separate subject by itself.

1.5. COSTING 1.5.1

Cost efficiency is a major strategic advantage to a firm, and will greatly contribute towards its competitiveness, sustainability and profitability. A finance manager has to understand, plan and manage cost, through appropriate tools and techniques including budgeting and Activity Based Costing.

1.6. LAW 1.6.1

A sound knowledge of legal environment, corporate laws, business laws, Import Export guidelines, international laws, trade and patent laws, commercial contracts, etc. are again important for a finance executive in a globalized business scenario. The guidelines of Securities and Exchange Board of India [SEBI] for raising money from the capital markets are an example. Similarly, now many Indian corporates are sourcing from international capital markets and get their shares listed in the international exchanges. This calls for sound knowledge of Securities Exchange Commission guidelines, various listing requirements of international stock exchanges operating in different countries etc.,.

1.7. TAXATION 1.7.1

2

A sound knowledge in taxation, both direct and indirect, is expected of a finance manager, as all financial decisions are likely to have tax implications. Tax planning is an important function of a finance manager. Some of the major business decisions are based on the economics of taxation. A finance manager should be able to assess the tax benefits before committing funds. Present value of the tax shield is the yardstick always applied by a finance manager in investment decisions..

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

1.8. TREASURY MANAGEMENT 1.8.1

Treasury has become an important function and discipline, not only in banks, but in every organization. Every finance manager should be well grounded in treasury operations, which is considered as a profit center. It deals with optimal management of cash flows, judiciously investing surplus cash in the most appropriate investment avenues, anticipating and meeting emerging cash requirements and maximizing the overall returns. It helps in judicial asset liability management. It also includes, wherever necessary, managing the price and exchange rate risk through derivative instruments. In banks, it includes design of new financial products from existing products.

1.9. BANKING 1.9.1

Banking has completely undergone a change in today’s context. The type of financial assistance provided to corpoates has become very customized and innovative. During the early and late 80’s, commercial banks mainly used to provide working capital loans based on certain norms and development financial institutions like ICICI, IDBI, and IFCI used to provide long term loans for project finance. But, in today’s context, these distinctions no longer exist. Moreover, the concept of development financial institutions also does not exist any longer. The same bank provides both long term and short term finance, besides a number of innovative corporate and retail banking products, which enable corporates to choose between them and reduce their cost of borrowings. It is imperative for every finance manager to be up-to date on the changes in services & products offered by banking sector including several foreign players in the field thanks to Government’s liberalized investment norms in this sector.

1.10. INSURANCE 1.10.1 Evaluating and determining the commercial insurance requirements, choice of products and insurers, analyzing their applicability to the needs and cost effectiveness, techniques, ensuring appropriate and optimum coverage, claims handling, etc. fall within the ambit of a finance manager’s scope of work & responsibilities.

1.11. INTERNATIONAL FINANCE 1.11.1 Capital markets have become globally integrated. Indian companies raise equity and debt funds from international markets, in the form of Global Depository Receipts (GDRs), American Depository Receipts (ADRs) or External Commercial Borrowings (ECBs) and a number of hybrid instruments like the convertible bonds, participatory notes etc., Access to international markets, both debt and equity, has enabled Indian companies to lower the cost of capital. For example, Tata Motors raised debt at less than 1% from the international capital markets recently by issuing convertible bonds. Finance managers are expected to have a thorough knowledge on international sources of finance, merger implications with foreign companies, Leveraged Buy Outs(LBOs), acquisitions abroad

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

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OVERVIEW OF FINANCIAL MANAGEMENT

and international transfer pricing. The implications of exchange rate movements on new project viability have to be factored in the project cost and projected profitability and cash flow estimates. This is an essential aspect of finance manager’s knowledge. Similarly, protecting the value of foreign exchange earned, through instruments like derivatives, is essential for a finance manager as the volatility in exchange rate movements can erode in no time all the profits earned over a period of time.

1.12. RISK MANAGEMENT 1.12.1 Modern business is fraught with various types of risks and is an integral part of the finance function. Proper identification of risks, installation of appropriate risk control measures, risk transfer mechanisms through hedging, insurance, etc. are key responsibilities of a finance executive. A finance manager has to deal with three types of risk viz., price risk, interest rate risk and exchange rate risk. Price risk is all about fluctuations in commodity prices going up or coming down, interest rate risk is all about interest rates moving up or down and exchange rate risk means volatility in exchange rates. For managing each of these types of risks, appropriate hedging tools have to be used. Knowledge of such tools is a pre-requisite for a finance manager. Besides the knowledge, the cost of using such tools should not be more than the benefits. Also, the timing of judgement is a crucial aspect in this respect.

1.13. INFORMATION TECHNOLOGY 1.13.1 Information technology is the order of the day and is now driving all businesses. It is all pervading. A finance manager needs to know how to integrate finance and costing with operations through software packages including ERP. The finance manager takes an active part in assessment of various available options, identifying the right one and in the implementation of such packages to suit the requirement.

1.14. MANAGEMENT 1.14.1 Of course, a finance professional when matures and moves up in the hierarchy of an organization,, he or she becomes an important executive,, taking a broader view and caters to a wider range of stakeholders. A sound knowledge in general management principles and strategy confers significant advantage and enhances the finance professional’s overall performance. 1.14.2 Above all, he or she is expected to possess significant skills in people management. Modern management is all about managing talent, motivating people and ability to work as a team and influencing people, both within and outside the organization. 1.14.3 Refer to the articles given at the end of the chapter. The article titled, “The Essential Skills”, gives a comprehensive overview of the skills of a Chief Financial Officer (CFO). The role of a CFO, in India and elsewhere, has metamorphed into a more all round role.

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1.15. SOFT SKILLS 1.15.1 Any senior executive in today’s competitive business world is expected to have considerable proficiency in various soft skills. The most important of these is communication – both verbal and non-verbal. 1.15.2 The article titled “You’re On” shows the importance of possessing good presentation skills a CFO is expected have and the type of audience he / she has to handle today.

1.16 CASE STUDY The Essential Skills To ascend to (and remain in) the CFO’s office, you need much more than financial acumen. Alix Stuart, CFO Magazine, November 1, 2007 No one becomes a CFO without possessing the commensurate finance skills. No one thrives as a CFO, however, without having much more. As Scott Simmons, vice president of Crist Associates, a Chicago-based recruiter, puts it: “No company wants just a really good finance person anymore; they want someone who can go beyond that.” But exactly what are those other essential skills? What capabilities, talents, and expertise should be in a CFO’s toolbox no matter what industry or company he works for or challenges she may face? To hear CFOs tell it, “toolbox” may be the wrong metaphor: magician’s bag of tricks is more like it. There’s nothing easy about mastering the soft skills they say are essential, and which seem to boil down to clairvoyance, X-ray vision, and the ability to bend time. Ultimately, however, there is a common theme. “Once you get past the technical skills, it’s all about people — communicating with them, developing them, empowering them, and listening to them,” says Charles H. Noski, retired CFO of AT&T and Northrup Grumman. “If you do those things well, it will contribute to your success as an executive, whether you’re a CFO or not.” Patience, experience, and a solid dose of intuition can help you round out your financial acumen with the following tricks of the trade. Time Benders Every executive knows all too well that a 24-hour day can feel woefully insufficient. Overload may be a way of life in finance, but there are ways to cut through the clutter. Stephen D. Young, CFO of time-management consulting firm and accessory-maker Franklin Covey, tells his staff to stop producing any information they deem unimportant and “see if anyone notices.” That advice has led to a 40 percent reduction in the volume of data reported over the past two years. For example, “rather than having a budget-versus-actual analysis sliced five different ways, we slice it two different ways, and rather than have 15 different inventory reports we have 10,” Young says.

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OVERVIEW OF FINANCIAL MANAGEMENT

Young also takes a merciless approach to his E-mail inbox. He glances at it several times a day but doesn’t respond to any messages until the end of the day unless they are clearly urgent. That establishes a very high bar — Young says he leaves about 60 percent of his messages unopened. Frank Gatti, CFO of ETS, also relies on a strict E-mail hierarchy. “Not all E-mails are of equal importance,” he says. Aside from those sent by his CEO, “investors and bondholders come first. Respond quickly even if you don’t have all the facts, just to let them know you’ll get back to them when you do.” Managing Up Every CFO has to deal with a CEO, and figuring out how to make the boss happy is a skill no aspiring finance chief can be without. “The CEO connection is the single most important thing a CFO must understand and maintain,” says David Johnson, CFO of The Hartford Financial Services Group. While a sound strategy will depend on myriad interpersonal factors, Johnson says he thinks a critical element is candor, which is key to becoming a trusted adviser to the CEO. “You need to know what your CEO’s hot buttons are: what’s important to him, what is he being judged against, what’s his value system?” says Tony Panos, a consultant who developed and teaches a class on managing up for one of Cornell University’s extension schools. “Anything you suggest should fit into that. You should demonstrate how you are helping him meet his goals.” But what about managing up to a dictatorial CEO? The advice is the same, Panos says, but he recommends looking a bit deeper for motive. “People who are dictatorial tend to have some level of fear driving them. Start by looking at what those fears are and how you can mitigate them.” The Art of Saying No CFOs are often labeled as the original “Dr. No,” and in fact they may be more likely than other senior executives to put the kibosh on ill-advised plans or projects. But many CFOs agree that a thumbs down, or any form of unwelcome news, can be delivered professionally and with a little less sting. One way is to “help people feel like they’re coming to a decision together,” says Bright Horizons Family Solutions CFO Elizabeth Boland, by giving them the facts and the potential risks rather than a final answer. Richard Fearon, CFO of Eaton Corp., says that listening can make all the difference. “You just need to hear the idea through so that no one feels shortchanged,” he says. In a well-managed company, he adds, the CFO won’t have to play the heavy very often, because bad ideas will usually be weeded out before they get to his door. Sometimes, of course, the CFO will have to say no. The toughest situations, in Boland’s view, are those in which the lack of revenue potential “makes it really evident that a proposal is not even worth talking about.” She counsels patience. “We try to talk through all possible revenue opportunities,” she says, “before saying it won’t work.” When all else fails, says

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Fearon, you simply turn the tables. “I just ask what the person would do if he or she owned 100 percent of Eaton.” Vetting Vendors Third-party consultants, contractors, and service providers have become essential in this era of increased regulation and outsourcing. And thanks to Sarbanes-Oxley, not only has “reliance on third-party vendors reached a new extreme,” says Jeff Burchill, CFO of FM Global, but so has the complexity of deciding which firms to hire. In the past, the decision was based largely on who was the low bidder. But now that public-company CFOs face a potential personal liability regarding the quality of financial reporting, “price may not even come up,” Burchill says. Consequently, CFOs often have to be “personally involved in the selection process,” he says. That means digging deep on references. Ideally, have a technical person on your staff find out exactly how a consultant handled, say, a software conversion at the reference’s company and what complications ensued, says Bright Horizons’s Boland. Then ease into the relationship slowly, g up for only a short project to start. Build in time for unexpected problems. Setting out detailed, measurable expectations can help guide the relationship. “You don’t want to micromanage what you’ve outsourced, so you need to have the right reference points to measure them against,” says ETS’s Gatti. He recommends asking the vendor for an easyto-read dashboard showing early warning signs for problems, along with more-detailed weekly or monthly reports. Finally, realize that managing vendors now carries the additional burden of being responsible, at least to a degree, for the quality of their internal controls. “It’s bad enough trying to monitor your own internal controls,” Stephen Bainbridge, a law professor at the University of California, said at a recent symposium. But overseeing another company is “more difficult and more expensive.” Develop X-ray Vision The CFO is in a unique position to have a window into every aspect of a company, but that’s no substitute for real vision. “We participate in or lead some of the most complex decisions an enterprise can make, so one of our jobs is to see the consequences of all those paths that others can’t see,” says The Hartford’s Johnson. And that, says Robert Mittelstaedt, dean of Arizona State University’s business school and board member at two public companies, requires being “analytic enough to constantly think about ‘what-if’ scenarios.” After all, CFOs “are better versed than anyone about the financial implications of any of those risks,” he says. Many CFOs are analytic by nature, of course, but Johnson says that what really helps hone a CFO’s powers of perception is trouble, and the more the better. “Until things go very

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wrong in ways that were completely unanticipated, you don’t develop those skills,” he says. And he should know. Having helped clean up fraud at Cendant and worked with companies in bankruptcy as an investment banker, Johnson has seen his fair share of crises. He actually reads forensic audit reports of disasters at other companies to help keep him on his toes. Legal Ease The last thing any company needs is a lawsuit. But in Corporate America, they come with the territory. Patent infringement, employee discrimination, workers’ compensation, and, perhaps scariest of all, securities class-action cases are all a fact of life. The real issue is risk avoidance, and there are some simple safeguards, says Cynthia Jamison, national director of CFO Services for Tatum LLC. For example, “Have routine legal forms that are used for ‘usual’ business [that is, customer contracts, NDAs, option agreements, and so on]. Then, whenever something is out of the ordinary, or someone requests a substantial change to normal policy, call a lawyer.” Bill Stephan, the former CFO of Harborside Healthcare, added another layer of protection. “We had a policy that no field personnel could enter into contracts.” Instead, the company, an 80-location nursing-home operator, mandated that only the CFO and the in-house counsel were allowed to sign. But Stephan avoided bottlenecks by pledging to turn around any documents very quickly — often in the same day. Having a good working relationship with your counsel — whether inside or outside — can be a safeguard in itself. In fact, says John Iino, a partner at Reed Smith LLP and co-chair of the firm’s Corporate & Securities practice group, lawyers are most efficient “when they are kept close to the internal decision makers.” Only then, he adds, can they help companies “draw the line between legal compliance and financial compliance” in such areas as executive-compensation disclosure. Stephan worked close enough with his inside counsel, in fact, that he became adept at spotting legal red flags. Of course, there are times when outside counsel must be called in. This is especially true, says Jamison, “if you are in a defensive posture — say, a customer threatens to sue or you get subpoenaed for a court appearance.” That’s when the CFO’s skills come in handier than ever. “It’s just like managing anything else,” says Stephan. “You want someone who is working in your best interest. And you want to avoid anyone with a tendency to overlawyer or who’s just out to win points.” If you don’t, you’ll regret it when the bills come in, he adds. Street Talk Increasingly, a wide range of stakeholders want direct access to the CFO. Knowing what communication techniques work with which audiences can help finance shine, both within and outside the company. But honing your skills as a public face of the organization requires a bit of homework. Before his company went public in March, Steffan Tomlinson, CFO of Aruba Networks, listened in on

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some 20 conference calls and kept a log of questions asked by analysts so that he would know just what to expect when Aruba held its first call. From that, he learned that “tone and tenor mean a lot, especially over the phone,” and “how you answer questions about competitors is telling.” He says that when executives on one of the calls he listened in on stumbled over certain questions, their company was soon described by an analyst as faltering. Frequent calls, road shows, and meetings can be a grind, but Boland of Bright Horizons says it’s critical to stay focused. “You get very routine about how you do your presentations and what you think people want to know,” she says. “Try to hear what they’re really asking.” If the audience is internal, be prepared to forgo finance jargon in favor of plain English. “I’ve worked with many CFOs who aren’t As but became CFOs because they were able to synthesize financial information into something useful,” says Bruce R. Evans, a managing partner at private-equity firm Summit Partners. Offer a few select bar charts and graphs when possible, instead of tables of numbers. And don’t talk too much. “Even when the work behind something is extremely complex,” says Gatti, “your audience really just needs to know the headlines.” Leading by Example As the head of the finance department, the CFO must lead and inspire — and know when to get his hands dirty. It is a delicate balance, says Joseph E. Esposito, recently retired CFO of Concord, Massachusetts-based SolidWorks Corp. “You have to demonstrate that you are a leader, but without interfering.” That means offering the guidance and counsel of a top executive, he says, but letting your employees do their day-to-day jobs. Boland echoes that idea: “As CFO, you’ve got the title and authority to be involved, but you have to make other functions feel like you’re an assistant, that you’re there to make them look good.” There are times, however, when the pressure is such that a CFO must step into the fray. Esposito has found that a particularly effective approach is to jump in as a short-term project leader. As a A, he says, there have been many times when he’s been able to lead a technical project, such as dealing with stock-options ing, and that when he has done so it has come as a big relief to his staff. “To them, something like that is just a big pain in the neck,” he says, “since many have never seen it before and may never see it again.” At the same time, sometimes it’s the little things that count. For ETS’s Gatti, for example, leading by example means getting his expense reports in on time so that he can encourage others to do the same. Alix Nyberg Stuart is a senior writer at CFO. You’re On! Sharpening your presentation skills. Kate O’Sullivan, CFO Magazine July 01, 2004

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The stammering, the sweating, the laptop that freezes and leaves the speaker stranded at the podium: presentations like this are the stuff of nightmares. Today, finance executives are presenting to everyone from employees to equity analysts, and they’re taking steps to avoid such disastrous trips to the microphone. According to corporate-presentation coaches, the CFO is a major client these days — not to mention a major challenge. “It started with the whole stock-market run-up, when all the investor activity put the CFO in the spotlight,” says Deirdre Peterson, a New York-based communications trainer who says she’s been coaching more finance executives than ever lately. “Now they’re in the spotlight because they’re being scrutinized.” For both outsider and insider audiences, today’s CFO is often the one expected to deliver the hard financial news about a company, whether good or bad. Finance executives convey those messages in traditional forums such as board meetings, departmental gatherings, and industry conferences, as well as, frequently, over the telephone in news interviews and earnings calls with analysts. “There’s a sense of credibility about the financial picture when you’re hearing the numbers from the CFO,” says Timothy Cage, also a New York-based communications coach. Some of the presentation challenges finance executives face are universal. “The most glaring problem I see is a lack of connection with the audience,” says Cage. “What to a busy executive may seem like a professional, brisk, coherent approach comes across as cold, aloof, uninterested, and uninteresting.” Dan MacLean, a senior faculty member at Communispond, a New York communications training company, agrees. “Most people don’t come across the way they think they do,” he says. The ubiquitous technique of videotaping speakers and allowing them to watch themselves is a powerful — if often painful — tool for trainers to illustrate this point. But there are dangers, like information overload, that are more specific to the CFO. “CFOs have a ton of information to present, and their tendency is to want to display it all and, frankly, bore the audience to tears,” says MacLean. “Investors need the information, but not all of it.” Finance executives may “think a lot about what they’re going to say, but it’s how they deliver the words that gives them their impact.” Then there’s the seemingly dry material. “Compared to a marketing presentation, where the material could be about ideas, image, or a new program,” says Peterson, a CFO may find that “just walking through the numbers can get really boring really quickly.” And unlike sales and marketing executives, who may receive more presentation training, CFOs often don’t learn intonation and gesturing techniques for capturing audiences. “It’s Not Intuitive” Kevin Gregory sought out communications training in 2002, after he ascended to the finance chief’s job at ProQuest Co., a $470 million electronic-content publisher based in Ann Arbor, Michigan. “For a lot of people, myself included, presenting is not intuitive,” says Gregory. “And I had not had a lot of experience with it in the controller role.” With a schedule that lately has included a number of shareholder and analyst phone calls and “mini road shows” with investors, Gregory says he now represents the company to the 10

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outside world once a week on average. He has learned to maintain an awareness of the listener’s perspective when preparing a presentation. “It’s easy to jump into a discussion and assume that there’s a certain level of understanding that’s just not there” when addressing unfamiliar groups, he says. “If you just start drilling down immediately, you’re going to lose everybody. You need to start with the overall premise and then work through the specifics.” It is vital to set a tone that’s tailored to your particular audience, says Peterson. Investors, especially, “don’t want overt spin.” While the CFO’s approach must be “more than just reciting the numbers,” she says, “it can’t become too promotional, either.” David S. Johnson, CFO of Carter & Burgess Inc., an engineering and architectural firm based in Fort Worth, learned the importance of effective presentations during his 15-year tenure at General Electric Co., where he listened to such speaking legends as former CEO Jack Welch and former finance chief Dennis Dammerman. In the time between leaving GE and landing his current post in 1998, Johnson took a course from Communispond to hone his skills. “As you move from one job to the next, the amount of presenting you have to do goes up dramatically,” says Johnson. Especially after moving into “a leadership role like CFO or highlevel controller, the ability to speak to large groups is critical.” At Carter & Burgess, which has a workforce of around 2,300, Johnson says that training employees through presentations saves significant time and effort. Giving a targeted talk about the bottom-line benefits of facilities leasing, for example, helps him avoid answering dozens of questions on the subject later. Between training sessions and investor meetings, Johnson says, he sometimes finds himself talking to groups as often as three times a week. “There’s such an incredible jump in the impact you have when you’re an effective speaker,” says the CFO. “And it doesn’t take a lot of effort to do it right.” Say What? Some speaking tips from the experts. Know the audience. Instead of “What do I want to say?” think “What does the audience need to hear?” suggests Communispond’s Dan MacLean. Focus on delivery. “Voice quality matters,” says trainer Deirdre Peterson. Especially on the phone, keep listeners alert with “verbal flags like ‘our top priority’ or ‘the key thing.’ ” Don’t just read figures off a page or a computer screen. “It looks like the CFO lacks confidence in the numbers,” notes communications coach Timothy Cage. Keep PowerPoints basic. Don’t “get too complex with animation and flying bullet points,” says MacLean. Emphasize important points and skip the extras. “Sometimes we give PowerPoint a little too much power.”

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SECTION -2 SCOPE OF FINANCIAL MANAGEMENT This Section include

• •

Scope of Financial Management: Expanding Scope of Financial Management:

2.1. SCOPE OF FINANCIAL MANAGEMENT 2.1.1

Financial Management is all about acquisition of funds from financial markets, deploy them in the organization’s business activities, efficiently allocating resources, ensuring risk-return trade-off, invest surplus funds in securities, generate revenue through operations and handle the returns by reinvesting and for meeting out the repayment obligations.

2.2. EXPANDING SCOPE OF FINANCIAL MANAGEMENT 2.2.1

Financial Management today covers the entire gamut of activities and functions given below. The head of finance is considered to be important ally of the CEO in most organizations and performs a strategic role. His responsibilities include: a. estimating the total requirements of funds for a given period. b. raising funds through various sources, both national and international, keeping in mind the cost effectiveness; c. investing the funds in both long term as well as short term capital needs; d. funding day-to-day working capital requirements of business; e. collecting on time from debtors and paying to creditors on time; f.

managing funds and treasury operations

g. Ensuring a satisfactory return to all the stake holders; h. paying interest on borrowings; i.

repaying lenders on due dates;

j.

maximizing the wealth of the shareholders over the long term.

k. Interfacing with the capital markets ;

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OVERVIEW OF FINANCIAL MANAGEMENT

l.

Awareness to all the latest developments in the financial markets;

m. Increasing the firm’s competitive financial strength in the market & n. Adhering to the requirements of corporate governance. The above aspects of Financial Management are covered in greater details under different chapters.

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SECTION -3 PLANNING ENVIRONMENT This Section include

•

Planning Environment

3.1. PLANNING ENVIRONMENT 3.1.1

The Financial planning environment is becoming more and more dynamic and has been undergoing a sea change in the last few years, mainly on of globalization, and better investor awareness. The initiatives of regulators such as the Securities Exchange Board of India (SEBI) have only contributed to bring about better disclosure, transparency and governance.

3.1.2 The planning environment is governed by a. Investors b. Legal requirements c. Lenders such as financial institutions and banks d. Tax laws e. Competitors f.

External influences such as foreign exchange movements

g. Regulators such as the Reserve Bank of India and SEBI , etc; 3.1.3

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All these call for a more demanding and adaptive planning system, that is responsive to a competitive business environment.

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SECTION - 4 KEY DECISIONS OF FINANCIAL MANAGEMENT This Section include

• • • • •

Key Decisions of Financial Management: Capital Budgeting: Capital Structure Working Capital Management Dividend:

4.1. KEY DECISIONS OF FINANCIAL MANAGEMENT 4.1.1

The key or major areas of financial decisions are discussed briefly in this chapter and are covered in greater detail in subsequent chapters and modules.

4.2. CAPITAL BUDGETING 4.2.1

This is the most paramount decision any business has to take. After making the choice of business one wants to be in, an entrepreneur has to develop an investment plan to allocate the funds on various assets, such as land & buildings, plant and machinery, distribution outlets, infrastructure, brand building, research and development, technology know-how and so on. As capital is budgeted and allocated for these various assets, this decision is referred to as capital budgeting.

4.2.2

As capital budgeting decisions have a long term impact and can confer a long term benefit or have the potential to become a major problem and financial burden, it is important to accord sufficient time and effort in making these decisions. The choice of decision with regard to technology for manufacture of a product, location, configuration of machinery, and so on have business implications and have a major bearing on the profitability and viability of an organization. Most of the times, the decisions are irreversible. The size of the investment, the likely returns and risks associated with the project or investment and the timing of investments need to be carefully evaluated.

4.2.3

A careful analysis of the requirement of working capital needs and the margin money required to be earmarked also forms part of capital budgeting as margin money is long term fund.

4.3. CAPITAL STRUCTURE 4.3.1

The next step after identifying an attractive investment opportunity and estimated the size of the investment required is working out the sources of funds also called as means of financing.

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OVERVIEW OF FINANCIAL MANAGEMENT 4.3.2

There are two major forms of capital: (1) Equity (own funds), and (2) Debt (borrowed funds). A major decision is the mix of these two types of funds, widely known as the debt-equity ratio. Decisions on various related factors such as the optimum ratio, choice of specific instruments, the capital markets the organization should access to raise the funds, the timing (see box), pricing of securities, etc. will need to be addressed. Meltdown worries Wockhardt; IPO review likely Business Line, 23rd Jan.2008 Mumbai, Jan. 22. With nine days to go for the opening of Wockhardt Hospital’s initial public offering (IPO), the management is concerned over the dramatic developments in the stock market. “We will review developments and take a call,” Mr Habil Khorakiwala, Chairman of Wockhardt Hospitals Ltd told media persons, in response to queries whether the IPO would be deferred. Steering clear of stating whether the management was looking at deferring the IPO, he reiterated that the company would take an appropriate decision when there is more clarity. Currently, the situation is fluid, he said, on a day when the market witnessed shares plummeting nearly 13 per cent during the day and trading being stopped for an hour.

4.4. WORKING CAPITAL MANAGEMENT 4.4.1

After raising funds and creating facilities that can be put to use over the long term, the next major decision is with regard to managing the day-to-day or short term operating cycle, popularly called the working capital cycle.

4.4.2

Working capital involves managing the current assets (inventories, debtors, marketable securities and cash) and current liabilities (short-term debt, trade creditors, and provisions).

4.4.3

The important decisions in relation to working capital revolve around the various components of working capital given above, such as the optimum level of inventory holding, credit granting decisions, cash management (both deficits and surplus), arranging for short-term requirements of funds, and so on.

4.5. DIVIDEND 4.5.1

Dividend decisions are again critical for an organization. The dividend payout should meet a number of criteria and expectations of different shareholders. Managing cash, providing for expansion and growth, satisfying expectations on dividend yields, creating sufficient reserves, adhering to rules governing transfer of profits to reserves etc., need to be factored in while deciding on dividends. Dividend policy needs to be evolved and followed, which will balance the requirements of the different types of investors and the requirements of the business. Some firms follow stable dividend policy-i.e paying the same rate of dividend irrespective of the profits. There are other firms which follow a variable dividend policy where the rates of dividend are varied depending on the availability of profits. Some firms do not distribute any dividend in cash but give bonus shares which has implications on the capital structure of the company. Therefore, the decision has to be taken carefully as it has long term financial implications on the company.

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SECTION - 5 EMERGING ROLE OF FINANCE MANAGERS IN INDIA This Section include

• •

Emerging Role of finance managers in India Turnaround of MCI Inc, USA

5.1. EMERGING ROLE OF FINANCE MANAGERS IN INDIA 5.1.1

As mentioned in the beginning of this module, a finance professional is expected to have adequate and up-to-date knowledge in a vast array of subjects.

5.1.2

While large organizations have a multitude of executives manning different functions within Financial Management, headed by a CFO, in smaller organizations, the CFO is expected to don different roles, including that of a company secretary.

5.1.3

The key challenges for a modern finance manager in India has changed from a mere finance function of securing and managing funds to encom the following, to name a few important areas: 1. Planning investments 2. Mergers, acquisitions, takeovers, and restructuring 3. Performance management 4. Treasury management 5. Portfolio management 6. Risk management 7. Corporate governance etc;

5.1.4

Indian finance professionals are respected across the globe and today occupy top positions in several organizations, including MNCs.

5.2. TURNAROUND OF MCI INC, USA 5.2.1

The article titled “Extreme Makeover”, given at the end of the chapter, provides a comprehensive view of the competence required and the extreme pressures a CFO faces in a dynamic and exceedingly demanding business environment. The article highlights how Robert Blakely and an army of ants turned fraud-ridden WorldCom into a clean MCI.

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Extreme Makeover How Robert Blakely and an army of ants turned fraud-ridden WorldCom into squeaky-clean MCI. (Joseph McCafferty, CFO Magazine, July 01, 2004) Robert Blakely had yet to accept the job as CFO of WorldCom Inc. when CEO Michael Capellas called on the evening of April 10, 2003. Creditors of the bankrupt telecommunications giant were meeting with Capellas and his team in New York the following day, and he wanted Blakely by his side. On the table: how to settle some $35 billion in outstanding debt. Blakely, who would already be in town for a meeting of the trustees of Cornell University, agreed to come — after, that is, he and Capellas hammered out an employment contract in the morning. But the next day, bad weather delayed Capellas’s flight from Washington, D.C. “There was no way we could talk,” says Blakely. “By the time [Capellas] arrived, all the senior creditors were there.” The fact that he wasn’t formally on the payroll didn’t keep the CFO-in-waiting waiting from rolling up his sleeves and starting negotiations, which quickly grew acrimonious. “Basically, it was hand-to-hand combat all day,” recalls Blakely. At 11:30 a.m., he and Capellas slipped out of the negotiations to work through the remaining points of Blakely’s employment contract. At noon, “We shook hands and I said, ‘Yep, I’m on board,’ ” says Blakely. They returned to the fray. Finally, by 8:30 in the evening, the WorldCom team had convinced 90 percent of the creditor groups to exchange most of their bonds for shares of stock in the reorganized company. For the new CFO, that first 12-hour day was a harbinger of things to come. Raising WorldCom from the ashes of the biggest fraud — and bankruptcy — in U.S. corporate history, to emerge in April 2004 as the rechristened MCI Inc., boasting a clean set of books and a mere $5 billion of debt, would require many more 12-hour-plus days. Restating the company’s financials, a chore that began before Blakely’s arrival, would take more than a year and a half to complete. Internal controls had to be overhauled, new directors named, and a new set of corporate-governance policies adopted. Even though the fraud directly involved fewer than 50 employees, every one of the company’s 50,000 workers worldwide had to undergo ethics training. And somehow, while all this was being done, the business had to keep moving forward. The 62-year-old Blakely brought badly needed turnaround experience to WorldCom. In the late 1990s, the CFO led Houston-based Tenneco Inc., a $13 billion energy conglomerate, through a massive restructuring. Later, he made major improvements to internal controls and risk management at Lyondell Chemical Co., another Houston company. But nothing could have prepared him adequately for WorldCom, which declared bankruptcy in July 2002, not long after the disclosure of the fraud that drove CFO Scott Sullivan and CEO Bernard Ebbers from the company (see “Fall and Rise,” at the end of this article). (Full disclosure: both Blakely and Sullivan were recipients of CFO Excellence awards.) “No one has that kind of turnaround experience,” says Blakely, “because it has never been done before.” That challenge was enough to lure Blakely out of retirement, where racing high-performance motorcycles apparently didn’t provide enough of an adrenaline rush. “What intrigued me 18

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about [WorldCom] was that it was an opportunity to pull everything together that I had learned in my career,” he says. “I don’t like stable situations. Some might say that I’m a crisis junkie.” The Mother of All Audits It was easy for Blakely to indulge his habit at WorldCom. Even with the majority of creditors on board, the most difficult tasks required to exit bankruptcy still lay ahead. Hardest of all was restating results for three years — 2000, 2001, and 2002 — and filing audited financial statements. Not only was $11 billion of fraud cooked into the books, but years of shoddy recordkeeping and incompetent ing clouded nearly every entry. Blakely and his finance team hoped they could complete the audit by July 2003, three months after he was hired, but it took nearly that long just to size up the task. “It was more complex than anyone imagined,” he says. Eventually, the team realized they had to reconstruct the financial statements from scratch. “I went back to Michael [Capellas] and told him that it looked more like July 2004 than July 2003,” says Blakely. But it would have to be done faster: bankruptcy court judge Arthur Gonzalez had already set February 28, 2004, as the deadline for emerging from bankruptcy. Reinforcements were needed. WorldCom already had 500 to 600 employees working full-time on the restatement, as well as 200 to 300 staffers from KPMG, the company’s auditor. WorldCom turned to Deloitte & Touche for more help, and the ing firm responded with some 600 professionals, culled from offices across the country. At the peak of the audit work, in late 2003, WorldCom had about 1,500 people working on the restatement, under the combined management of Blakely and five controllers. The finance team started with the billing systems and reran all the revenue, deciding on the proper ing. Then it redid all the cash applications and rebuilt the income statements from there. It also reassessed every acquisition Ebbers had made since 1992 in the course of transforming an obscure long-distance start-up into a global communications powerhouse — 12 major deals and several smaller ones, worth $70 billion. “In some instances, we had to go back and reconstruct records to decide whether or not pooling of interest was the proper ing at the time,” says Blakely. In all, they found, WorldCom had overvalued several acquisitions by a total of $5.8 billion. The difficulty of the audit work was compounded by the sorry state of WorldCom’s records. In some instances, Post-it notes were attached to journal entries in lieu of proper documentation. The FBI had taken documents that had to be tracked down and retrieved. In the end, Blakely’s team made more than 3 million new or revised entries. But even with Deloitte’s help, WorldCom couldn’t finish the audit before Judge Gonzalez’s February 2004 deadline. It was forced to request a 60-day extension. “To bring [the audit] to closure was devilishly hard, because it’s so complex. It just kept going on and on,” says Blakely. Finally, on March 10, Blakely’s team finished a version of the 10-K restatement that would serve as a foundation for future financial statements. MCI executives planned a g ceremony for March 11, at a previously scheduled meeting of the board. But later on the 10th, FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

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OVERVIEW OF FINANCIAL MANAGEMENT

company personnel and KPMG discovered two significant errors in the deferred tax balances, which rippled through about 100 pages of the 192-page document. Dave Schneeman, vice president of general ing, and Jim Renna, vice president of controls and remediation, led a small team that worked through the night to make the necessary fixes. “I called at midnight, and they said they were making progress,” says Blakely. “I called again at 6:00 a.m. the next day, and they said they had just finished, and I cried,” he its. To WorldCom’s investors, the story told by the restated results was a real tearjerker. Sullivan and Ebbers had claimed a pretax profit for 2000 of $7.6 billion; the reality, according to the restatement, was a loss of $48.9 billion (including a $47 billion write-down of impaired assets). For 2001, WorldCom had reported a pretax profit of $2.4 billion; the restatement showed a pretax loss of $15.6 billion. For the year 2002, the company was $9.2 billion in the red, pretax. Blakely claims WorldCom’s restated 2002 10-K is the most complex document ever filed with the Securities and Exchange Commission. He calls it “my Mount Everest” and keeps a copy, signed by the major participants, in a glass-door cabinet next to his desk. The audit, he says, “is the hardest thing I have done in my career.” Total cost to complete it: a mind-blowing $365 million. Hush Money The audit provided new insights into the nature and the magnitude of the fraud at WorldCom. In fact, the same complexity that made the audit so difficult was one reason the fraud was able to go undetected for so long. As a result of Ebbers’s acquisition spree, WorldCom had also acquired a slew of ing systems that were integrated loosely, if at all. By Blakely’s reckoning, there were 60 billing platforms and more than 20 s-receivable systems. The numbers rolled up from the various operating units to the company’s former headquarters in Clinton, Mississippi. There, it was easy for ing staffers to simply change the numbers. “It was a very low-tech fraud in a sense,” says Richard Breeden, a former SEC chairman and MCI’s court-appointed corporate monitor. “If [a WorldCom employee] didn’t like the figure he got, he just changed it.” He says it was not unknown for ants at headquarters to come to the office and find Post-it notes on their computer monitors telling them to change numbers. Breeden says that in some quarters, imaginary revenue was added to the books using consolidated entries in big, round numbers that “didn’t even look real.” Breeden also describes a command-and-control structure with a lot of power concentrated at the top. In his report of recommended reforms, he noted that Ebbers ruled with “nearly imperial reign.” “The attitude at the company was that orders were to be followed, and it was clear that anybody that didn’t would be fired,” says Breeden. Along with the big stick came a few carrots. A generous stock-option plan was supplemented by a $238 million “employee-retention program” that was dipped into and doled out at the discretion of Ebbers and Sullivan. “It was basically a slush fund to give out quiet money,” says Breeden. Sullivan wrote personal checks for $10,000 to some employees, he says, and gave $10,000 more to

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their wives. Breeden and Blakely say that the fraud involved fewer than 50 people, mostly those who rolled up the financial statements in Clinton. When managers at operating units saw the consolidated financials, they were surprised how well the rest of the company seemed to be doing when the numbers they reported were so poor. Dennis Beresford, a former chairman of the Financial ing Standards Board who now chairs MCI’s audit committee, led one of two internal investigations into the fraud. He’s convinced that everyone involved has been removed from the company. Beresford says WorldCom asked about 50 executives in the finance department to leave after the investigation showed they either took part in the ing fraud or should have known about it. “We had too many people who looked the other way,” he says. In March, Sullivan agreed to plead guilty to securities fraud, conspiracy, and giving false statements to regulators. Those crimes could carry a sentence of up to 25 years in prison under federal sentencing guidelines, but Sullivan hopes to get less in exchange for his testimony in the trial against Ebbers that is scheduled to begin in November. Former controller David Myers and ing executives Betty Vinson and Troy Normand have also pleaded guilty and are cooperating with authorities. Do the Right Thing Impressive as it was, cleaning up the fraud wasn’t enough to restore the confidence of WorldCom’s customers; Blakely had to make sure that nothing remotely like Sullivan’s manipulations could ever happen again. In July 2003, WorldCom’s largest customer, the federal government, had barred it from bidding on federal contracts while it reviewed whether the company should be placed on an “excluded parties” list. “Getting that [ban] lifted was the highest priority,” says Blakely. “If the government doesn’t want to do business with you, why should anyone else?” The two main concerns identified by the General Services istration, which isters the list, were controls and ethics. Indeed, KPMG, which succeeded Arthur Andersen as WorldCom’s auditor, had identified 96 control issues, and a separate assessment by Deloitte zeroed in on several other “high risk” areas. With help from both ing firms, Blakely’s finance team put together a “heat map” that listed high-priority risk areas, and then went about fixing them. The solutions included adding basic checks and balances such as segregation of duties among finance staffers, limited access, and documented policies. The company then implemented a much more stringent, and inclusive, policy for closing the books. “It is impossible to completely eliminate the possibility of fraud,” says Blakely. But, he says, the hundreds of added controls will greatly diminish the chances of it reoccurring. MCI was also forced to implement what is likely the most stringent set of corporate-governance practices ever adopted. As part of WorldCom’s $750 million cash and stock settlement with the SEC, it agreed to accept all the recommendations of the court-appointed monitor. Breeden’s 150-page report on corporate governance, “Restoring Trust,” lists 78 recommendations, including the separation of the CEO and chairman roles, and the required removal of

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OVERVIEW OF FINANCIAL MANAGEMENT

one board member each year to make room for a new director. “Some [of the requirements] go beyond what is reasonable,” contends Beresford. “But we have no choice but to accept them.” As for ethics training, MCI put the entire company of 50,000 employees through a course designed for it by professors at New York University’s Stern School of Business. In addition, 90 executives attended a two-day ethics program at the University of Virginia’s Darden School. Not surprisingly, MCI is trying to keep ethics in the foreground. Large banners proclaiming the company’s “guiding principles” festoon the halls of its Ashburn, Virginia, headquarters. They include such mottos as “Everyone should feel comfortable to speak his or her mind” and “Do the right thing.” The principles are also printed on the back of employee security badges. All these measures were enough to convince the government that MCI had reformed. Last January, it lifted the debarment just in time for the renewal of a contract worth as much as $400 million. There would be more to celebrate. On April 20, the company emerged from bankruptcy, officially taking the name MCI Inc., with its debt slashed from $41 billion to $5.8 billion, and with $6 billion in cash reserves. Its stock was scheduled to begin trading again on Nasdaq this month. “A lot of people didn’t think we could get it done,” says Beresford. “It took a Herculean effort to get to that point.” (Not to mention the $800 million in fees MCI spent during its sojourn in Chapter 11, for lawyers, ants, appraisers, tax experts, and other consultants.) But the work on the controls isn’t finished. Like most companies, MCI is busy documenting its controls in compliance with Section 404c of the Sarbanes-Oxley Act. More than 60 people are working on the project, and PricewaterhouseCoopers is providing outside assistance. “We’ve still got a long summer ahead to get to where we need to be,” says Blakely. Was It Worth It? Right now, MCI is trailing the field. “They are third in a race of three,” says Muayyad AlChalabi, managing director of San Francisco-based telecom research firm RHK Inc. Compared with archrivals AT&T and Sprint, MCI has lower margins, pays more (as a percentage of total revenues) to other carriers in access fees, and has the fastest-declining revenues (17 percent in the past year alone, year over year). “I don’t know if MCI was worth saving,” says Al-Chalabi. The company will also have to fend off competition from Baby Bells like Verizon and SBC Communications, which are looking to provide enterprise telecom services to small and midsize businesses — a key customer base for MCI. And another setback came in June, when a federal court ruled that Baby Bells no longer had to lease access to their local networks to the likes of MCI at deep discounts, increasing MCI’s cost to provide consumer long distance. In May, MCI announced a $388 million loss for the first quarter of 2004, compared with a $52 million profit for Q1 2003. The company said it would cut 7,500 jobs, or 15 percent of its workforce. But Al-Chalabi says reducing head count alone won’t solve MCI’s problems. He 22

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points out that the company has a patchwork of networks left over from the acquisitions — the same problem that plagued the finance department — which impedes its efforts to obtain operating efficiencies. “They have a thousand or more systems that all need to be ed,” says Al-Chalabi. “That increases the number of suppliers they have to deal with, and there is a lot of duplication in the systems.” All of these factors have fed speculation that MCI will put itself up for sale, likely to one of the Baby Bells. Yet Al-Chalabi notes that these potential buyers can already buy long-haul capacity very cheaply, without buying the MCI cow. Also, he says, “the Baby Bells still have huge amounts of debt. I’m not sure they are in a position to do a big purchase right now.” That could be bad news for MCI. “I don’t think they can stand alone with the current trend,” says Al-Chalabi. “They’ll either be part of another company, or they’ll have to dramatically change their ways.” MCI isn’t ruling out a sale. But Blakely, who its that the industry is in rough shape, thinks that the company can stand on its own. He is quick to point out that it generates $300 million in positive cash flow each quarter. A large portion of Internet traffic flows over MCI’s network, and the company still has more than 20 million customers. Blakely says MCI will be profitable in the second half of this year. Focusing on the future is a luxury MCI hasn’t had for a long time. At a recent board meeting, Dennis Beresford noticed something he calls “astonishing”: “The conversation was almost entirely about the operations of the business.” That hadn’t happened since he was elected to the board in July 2002, he says. “Just to be able to sit around and talk about strategy is wonderful.” Fall and Rise 1985: Bernard Ebbers becomes CEO of long-distance provider Long Distance Discount Service (LDDS). 1995: LDDS acquires telecom provider Williams Telecom Group (WilTel) for $2.5 billion and changes its name to WorldCom. 1998: WorldCom’s $40 billion acquisition of MCI is the largest merger in corporate history at the time. 1999-2000: WorldCom and Sprint, the nation’s third-largest long-distance company, agree to merge. The deal is later blocked by antitrust regulators and abandoned. March 2002: WorldCom receives a request for information from the Securities and Exchange Commission on ing procedures and loans to officers. April 2002: WorldCom CEO Ebbers resigns as the SEC probe intensifies. Vice chairman John Sidgmore takes over. June 2002: CFO Scott Sullivan is fired. The SEC formally charges the company with fraud. July 2002: WorldCom files for Chapter 11 bankruptcy, the largest ever filed in of out-

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standing debt. Former Salomon Smith Barney analyst Jack Grubman its to attending WorldCom board meetings. August 2002: Sullivan and former controller David Myers are arrested and charged with securities fraud. November 2002: Former Compaq chief Michael Capellas is named CEO of WorldCom. April 2003: 90% of creditors agree to WorldCom’s reorganization plan. Robert Blakely is named CFO. May 2003: WorldCom settles charges with the SEC and agrees to pay $750 million in fines and retribution. October 2003: Bankruptcy court judge Arthur Gonzalez approves WorldCom’s reorganization plan. March 2004: Sullivan pleads guilty to criminal charges. Ebbers is formally charged with fraud. WorldCom files its restated 2002 10-K, which includes a write-down of $80 billion in goodwill, assets, and property. April 2004: WorldCom exits bankruptcy and changes its name to MCI.

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FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

SECTION - 6 EARNINGS DISTRIBUTION POLICY This Section include

•

Earnings Distribution Policy

6.1. EARNINGS DISTRIBUTION POLICY 6.1.1

As already mentioned, distribution of earnings in the form of dividends is an important financial management decision. It is a function of a number of factors such as the following: a. past trend a. potential future earnings b. requirements for funds in the immediate future c. past dividend payout record of the company d. shareholders expectations or preference e. liquidity position of the company as dividends entail cash outgo f.

The proclivity of the management to retain management control by financing growth plans through internal funding which will mean increased retained earnings.

g. Industry benchmark. h. Analysts expectations etc 6.1.2

The topic is covered in greater detail in a subsequent chapter.

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

25

OVERVIEW OF FINANCIAL MANAGEMENT

SECTION- 7 COMPLIANCE OF REGULATORY REQUIREMENTS IN FORMULATION OF FINANCIAL STRATEGIES This Section include

•

Compliance of Regulatory Requirements in Formulation of Financial Strategies

7.1. COMPLIANCE OF REGULATORY REQUIREMENTS IN FOR MULATION OF FINANCIAL STRATEGIES 7.1.1

The two major regulatory authorities are the Reserve Bank of India (RBI) and the Securities Exchange Board of India (SEBI). The regulations in the Companies Act, Income tax Act etc are more for governance and compliance than for strategy. RBI mainly regulates the commercial banks which in turn may influence the policies of a company. Some of the situations a finance manager has to face, which requires regulatory compliance are:

7.1.2

Raising finance through IPO or SPO: IPO refers to Initial Public Offering; the first time a company comes to public to raise money. SPO refers to seasonal public offering, the second and subsequent time a company raises money from the public directly. There are regulatory guidelines prescribed by SEBI regarding the entire process of going public which includes disclosure to public regarding the potential use of the cash, financial projections and percentage of shares offered to various stakeholders etc. Similarly, every time a company wants to access the capital market, either for raising finance through debt or equity, these regulatory compliances have to be met where finance manager will play a key role in providing the necessary information both at the time of raising resources and also at regular intervals subsequently thereafter.

7.1.3

Capital structure changes: Today, companies are permitted to buy their own shares. The finance manager, some times, for strategic reasons, decide to reduce the equity capital. This is technically known as capital reduction, which again requires regulatory compliances prescribed by SEBI and Companies Act.

7.1.4

Credit rating: Whenever a company wants to raise money through debt, or through a new instrument, the instrument has to be rated by a credit rating agency like CRISIL, ICRA etcas per the SEBI guidelines. Similarly, company also has to be rated. The whole exercise of initiating the rating process, providing the relevant information and answering the queries of the rating agencies, will be the responsibility of the CFO.

7.1.5

Foreign exchange transactions: A company needs foreign exchange for a variety of reasons like importing equipment, setting up of foreign offices, travel of sales and

26

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

other company employees etc. Similarly, a company may receive remittances of foreign exchange for exports made. In either of these situations, the rules and regulations relating to foreign exchange transactions needs to be complied with by the Finance manager, on behalf of the organization. It involves some filing of returns in the prescribed format.. 7.1.6

Derivative transactions: Whenever a company uses derivatives for hedging, there are ing and disclosure requirements to be complied with as per Companies Act & GAAP ing, ing standards of ICAI and the international ing standards. For example, hedge ing has to be maintained and profits/losses due to hedging should be reported.

7.1.7

Project financing: If a company goes for major project financing option, involving multiple agencies like suppliers, contractors etc, there are a number of requirements for the various stakeholders and financiers like consortium of banks, private equity players, etc. Finance manager plays an important role in complying with the requirements of various agencies involved in the exercise.

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

27

OVERVIEW OF FINANCIAL MANAGEMENT

SECTION - 8 SOURCES OF FINANCE - LONG TERM, SHORT TERM AND INTERNATIONAL This Section include

• • • •

Sources of capital Sources of Equity Debt International Sources

8.1. SOURCES OF CAPITAL 8.1.1

To enable investments and creation of assets and infrastructure, an organization requires funds. As already mentioned, the two major forms of capital are: (1) Equity (owners’ or shareholders’ funds), and (2) Debt (loans or borrowings). Both can be raised from both public and private sources.

8.2. SOURCES OF EQUITY 8.2.1

Equity shareholders are the owners of an enterprise and enjoy the rewards of good performance of the company and affected by risks faced by the company However,. their liability is limited to their shareholding in the company.

8.2.2

Equity is in the form of:

8.2.3

a.

Equity capital

b.

Preference Capital and

c.

Internal accruals or retained earnings also known as ‘Reserves & Surplus’, i.e., plowing back of profits rather than distributing them to shareholders.

Preference Share Capital: It is a hybrid of equity capital and debt, and combines the features of the two in of returns and risks. More details of equity are covered in subsequent chapters.

8.3. DEBT 8.3.1

28

Debt can be in form of either long term or short term. Long term are generally in the form of a. Term loans and b. Debentures.

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

8.3.2

8.3.3

Short-term debt is in the form of: a.

Working capital Loans from commercial banks for financing working capital requirements: Cash credit, overdrafts, loans, purchase or discounting of bills Etc; These are called fund-based. There are also non fund-based limits such as letter of credit, guarantee etc;

b.

Trade credits: Credits given by suppliers of materials and services

c.

Other sources.

Other sources of debt include the following: a.

Suppliers’ credit

b.

Lease finance

c.

Hire purchase

d.

Unsecured loans and deposits

e.

Deferred credit

f.

Subsidies, concessions, tax deferrals and waivers given by State and Central governments

g.

Commercial paper

h.

Factoring

Subsidies are in the form of Quasi equity. Grants are treated as Capital Receipts.

8.4. INTERNATIONAL SOURCES 8.4.1

Finance can be raised from international sources in the form of Global depository receipts, American depository receipts, private placements, loans from international agencies such as International Finance Corporation, and so on.

8.5.0

The article titled “An Overview of Project Finance” in the Reader gives a comprehensive picture of the various sources of finance.

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

29

OVERVIEW OF FINANCIAL MANAGEMENT

SECTION - 9 EXCHANGE RATE - RISK AGENCIES INVOLVED AND PROCEDURE FOLLOWED IN INTERNATIONAL FINANCIAL OPERATIONS This Section include

•

Exchange rate - risk agencies involved and procedure followed in international financial operations:

9.1. EXCHANGE RATE - RISK AGENCIES INVOLVED AND PROCEDURE FOLLOWED IN INTERNATIONAL FINANCIAL OPERATIONS 9.1.1

Foreign exchange transactions require some special records to be maintained as per the regulations. At every stage in the international trade process, the finance manager has to comply with some regulatory and reporting requirement. For example, opening of a letter of credit in the context of exports or imports. Here, the finance manager has to deal with the bank, submitting the requisite documents for ensuring the opening of letter of credit. Proper trade documents have to be submitted. Foreign exchange remittances have to be complied with. They have to be ed in line with the requirements of law and ing standards. Tax treatment is different in some cases and they have to be adhered to such as withholding tax, tax exemption criteria etc;

30

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

STUDY NOTE - 2 FINANCIAL MANAGEMENT DECISIONS

SECTION - 1 CAPITAL STRUCTURE THEORIES AND PLANNING This Section includes

Theory of Capital Structure



Agency Theory



Conclusions

1.1 THEORY OF CAPITAL STRUCTURE 1.1.1

One of the key elements of financial analysis of a company is to look at the capital structure of the company.

1.1.2

Companies potentially have a choice between various sources of funding, right from short-term bank overdrafts to perpetual equity. How can an organization choose between the alternatives, and add value by strategic financing decisions is called capital structuring.

1.1.3

The capital structure of a company can be expressed in the form of a number of ratios for comparison between companies or over a period of time. The main ratios are: a. b. c. d. e. f.

1.1.4

Gearing Net gearing Leverage (gross) Leverage (tangible) Leverage (tangible including contingents) Debt / Equity or Debt / (Debt + Equity)

The traditional view was that the cost of equity and the cost of loan capital are determined independently. It is expected that as it represents a more risky investment, the cost of equity would be greater than the cost of loan capital. Accordingly, the more highly geared the company becomes, i.e., the more loan capital vis-à-vis equity it obtains, the lower its cost of capital. There must be a cut-off point to this process otherwise all organizations would be looking for total debt financing. Therefore, at some stage the proportion of loan capital increases the level of risk to the potential lender as well as the equity holders. This increased level of risk would cause the overall cost of capital to rise. Thus, it can be assumed that a rational organization will

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

31

FINANCIAL MANAGEMENT DECISIONS have a time tested mechanism to have an ideal mix of debt and equity to keep the cost of capital in control. 1.1.5

Look at the following illustration: Company

A

B

C

Debt

0

5000

7000

8%

Interest

Equity

10000

5000

7000

50%

Tax

Total

10000

10000

10000

PBIT

1000

1000

1000

0

400

560

PBT

1000

600

440

Tax

500

300

220

PAT

500

300

220

ROE

5.00%

6.00%

7.33%

Interest

In the above example, though all the three companies have the same total capital requirement, due to the difference in debt equity mix, company C, with higher amount of debt, has been able to enhance the ROE to 7.33%. But, in the subsequent year, let us say that the PBIT falls to 400, only Company A will be able to survive. 1.1.6

When it is definitely advantageous for a company to have as much a debt as possible, then why do companies stop short of having a heavily geared capital structure? The answer probably lies in the high costs of debts also associated with possible bankruptcy. due to increased liability in times of slow down in operations.

1.1.7

Bankruptcy costs can be classified into two types:

1.1.8

32

1. Direct costs: Legal fees ing fees Costs associated with a trial (expert witnesses) 2. Indirect costs: Reduced effectiveness in the market. Lower value of service contracts, warranties, decreased willingness of suppliers to provide trade credit. Loss of value of intangible assets - e.g., patents, human capital. The years in which EBIT drops, the company would not be able to get tax relief immediately and the cash cost of debt would be quite high. Further, if the company had no reserves to meet its interest commitments, it would default on its repayment obligations and might be forced into liquidation. The higher the debt / equity ratio, the more likely a default on debt payments. Such a possibility will in turn lead to penal interest being charged by the lenders.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

1.1.9

Therefore, in order to maximize value by altering capital structure, organizations should balance the present value of the tax advantage of debt against the present value of the costs of higher gearing, viz., liquidation costs and higher interest rates.

1.1.10 Modigliani and Miller (MM) developed a very complex and rigorous theory in 1958, which argued that except at extreme levels of gearing, the capital structure has very little effect on the overall cost of capital. The theory states that the total value of the firm depends on its expected performance and its risk and is completely independent of the way in which it is financed.

1.2 AGENCY THEORY 1.2.1

The managers or directors who are responsible for the day tio day operations of the business are the Agents of the owners viz; Shareholders. The agency theory model of financial strategy looks at not only maximizing value, but also the potential for conflict between managers and investors. The agency theory considers what happens when the market mechanisms fail to operate effectively and managers, who act as agents for the shareholders, are not necessarily motivated to act in the best interest of the shareholders.

1.2.2

In order to guard against this kind of an opportunistic behaviour of the managers, investors take steps to minimize the costs associated with the separation of ownership and control by various means such as having external auditors, non-executive directors, accepting covenants in loan agreements which effectively restrict managers’ potential actions etc;

1.3 CONCLUSIONS 1.3.1

It is difficult to determine the optimal capital structure a company should adopt. The optimal capital structure for an actual company has never been specified, nor has the precise cost of capital for any given capital structure. Decisions concerning a company’s capital structure are a matter of judgment. There must be ideally a decent spread between cost of capital and Return on capital employed. The higher the spread the better is the ultimate profitability.

1.3.2

Where a company expects sufficient level of taxable profits, the company should take on appropriate amount of debt to reduce the tax liability. Thus, it may be practicable for low-risk businesses such as utilities to accept relatively more debt. However, companies with a high degree of volatility in earnings and cash flows will have to pay higher rates of interest due to the higher risk of default. Such companies have to rely more on equity finance. Companies in their early stages of development will also be unwilling to take on a high debt.

1.3.3

The short article given at the end of the chapter throws some further light on the concepts discussed in this chapter.

1.3.4

The student is also advised to read the article titled “Stock Market Development and Corporate Finance Decisions” included in the Reader.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

33

FINANCIAL MANAGEMENT DECISIONS Value Creation is a continuous process by way of:

Constantly measuring the cost of debt, cost of equity, weighted-average cost of capital and assessing the optimal capital structure; Adjusting the costs of debt and equity for leverage; Ratings and debt pricing; Corporate taxation and capital structure; and Profitability and process improvements for achieving operational efficiently. Illustration of Capital structure Design Total Capital

300000

Sources

Cost

Weight

9%

33%

100000

67%

200000

Debt Equity Total

Amount

300000

Number of equity shares Tax rate

2000 40%

EBIT Interest EBT Tax EAT EPS

100000 9000 91000 36400 54600 27.3

EPS at Different levels of EBIT

34

EBIT

EPS

100000

27.3

60000

15.3

65000

16.8

70000

18.3

75000

19.8

80000

21.3

85000

22.8

90000

24.3

95000

25.8

105000

28.8

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

EPS at Different levels of Debt to Equity Debt/equity-EPS

27

0.1

22

0.2

24

0.3

26

0.4

30

0.5

35

0.6

42

0.7

54

EPS at Different levels of interest rates Cost of debt

EPS

9%

27.30

8%

27.60

10%

27.00

11%

26.70

12%

26.40

13%

26.10

14%

25.80

15%

25.50

Interpret the above tables, explaining the relationship between EBIT/EPS and the drivers of EPS, namely, EBIT, Debt to equity ratio and the cost of debt. You can construct similar tables on impact of tax and EPS etc. Case Study What Do We Know about the Capital Structure of Privately Held Firms? Evidence from the Surveys of Small Business Finance by Rebel A. Cole, 2007. May 2008 Published by U.S. Small Business istration’s Office of Advocacy Introduction This paper seeks to shed light on what factors determine the capital structure at privately held firms. The capital structure decision—a fundamental issue facing financial managers— is, in its simplest form, the selection of a ratio of debt to equity for the firm. This seemingly simple decision about the best mixture of capital sources to be employed in financing the firm’s operation and growth has confounded researchers since the seminal “capital structure irrelevance” theory of Modigliani and Miller (1958).

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

35

FINANCIAL MANAGEMENT DECISIONS Existing empirical studies that test capital structure theories have relied on data from large corporations that issue complex financial securities for both debt and equity. Unresolved is the question of whether these theories are useful for understanding the capital structure of small privately held firms, which are primarily limited in their external borrowing to financial intermediaries such as banks, finance companies, and other business lending institutions. Using data from a set of four nationally representative samples of small businesses surveyed for the Federal Reserve Board and the Small Business istration over a 15-year period, this study contributes to the capital structure literature in at least three important ways. First, it provides results from the first test of two major competing hypotheses—the peckingorder theory and the trade-off theory—based upon data from small privately held U.S. firms. This previously unaddressed segment of the market provides a new laboratory for reexamining the findings from prior studies that examine publicly traded firms. The focus on private firms eliminates the “noise” introduced by more complicated securities, such as preferred stock and convertible bonds, reducing the errors-in-variable problems associated with empirical studies of capital structure at larger firms. Second, the study provides new evidence of the degree of leverage used by small privately held companies and how their use of leverage differs from small publicly traded firms. Samples of data on small privately held firms are compared with data on small publicly traded firms taken from the Compustat database. Third, the study presents new evidence on how the use of financial institutions influences capital structure, testing whether firms that obtain financial services from a larger pool of financial institutions are able to employ more leverage. Overall Findings This study tests predictions from the two competing theories, using descriptive statistics and then more sophisticated multivariate techniques to disentangle various forces influencing the capital structure decision. The results tend to favor the pecking-order theory over the trade-off theory. The analysis reveals that firm size is perhaps the most important determinant of leverage, with firm age also significant. Unprofitable and riskier firms consistently use greater leverage. These findings are consistent with predictions from the peckingorder theory. Highlights

The population of small businesses in the United States is not a homogeneous group. From 1987 through 2003, the median ratio of total loans to total assets ranged from a high of 25.1 percent in 1993 to a low of 7.4 percent in 2003, while the median ratio of total liabilities to total assets ranged from a high of 47.4 percent in 1993 to a low of 27.5 percent in 2003. The distribution of these leverage ratios is heavily skewed by bookvalue insolvent firms—firms reporting that their liabilities exceeded their assets. This is evident from the mean leverage ratios, which are significantly larger in each year than the corresponding medians.



Compared with small publicly traded firms, small privately held firms exhibit similar leverage ratios in aggregate, but not by industry—contradicting a key prediction of the trade-off theory, which posits “target leverage ratios” that differ across industrial classifications.

36

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE



Firm size is perhaps the most important determinant of leverage. Larger firms consistently use less leverage than smaller firms, whether size is measured by total assets, annual sales, or total employment.



Firm age also is a significant determinant of leverage. Older firms use significantly less leverage than younger firms. This is consistent with the pecking-order theory but inconsistent with the trade-off theory.



Profitability influences leverage. Splitting firms into profitable and unprofitable groups reveals that unprofitable firms consistently use greater leverage than profitable firms. This s the pecking-order theory and goes against the trade-off theory.



More liquid firms use less leverage, consistent with the notion from the pecking-order theory that financial slack is valuable and enables firms to avoid issuing debt.



Riskier firms consistently use greater leverage, no matter how risk is measured. This contradicts the trade-off theory but is consistent with the pecking-order theory.



Firms obtaining financial services from a larger number of bank and nonbank financial institutions employ more leverage.



Multivariate results indicate no significant differences in capital structure attributable to race, ethnicity, or gender, if other firm characteristics are controlled for. These results are inconsistent with other studies that purport to find evidence of discrimination against minority-owned firms.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

37

FINANCIAL MANAGEMENT DECISIONS

SECTION - 2 COST OF CAPITAL This Section includes

Cost of capital - Key Concepts



Cost of Debt Capital



Cost of Equity Capital



Dividend discount model



Capital Asset Pricing Model



Weighted Average Cost of Capital



Illustrations

2.1 COST OF CAPITAL-KEY CONCEPTS 2.1.1 Cost of capital refers to a rate which represents the average cost at which a firm raises its finances. It is also called the discount rate or hurdle rate and represents the vital link between financing and investment decisions of a firm. 2.1.2 Cost of capital is very important as it represents the minimum return that a firm expects in all its investment projects. It is used to discount the future cash flows from a project to arrive at the Net Present Value. Incorrect computation of cost of capital leads to wrong investment decisions. 2.1.3 Cost of capital is composed of cost of equity capital, preference share capital and cost of debt capital

2.2 COST OF DEBT CAPITAL 2.2.1 Cost of debt capital is the interest rate charged by the lender. 2.2.2 It can also be estimated by dividing the total interest paid by the average debt. Cost of debt is always computed post tax as interest payable on the debt is tax deductible.

2.3 COST OF EQUITY CAPITAL 2.3.1 Dividend rate is not the cost of equity capital as it is normally understood. 2.3.2 Cost of equity represents the expected return that a firm has to pay to its present and prospective shareholders. 2.3.3 Cost of equity is determined by two methods: (a) Dividend discount model and (b) Capital asset pricing model (CAPM)

2.4 DIVIDEND DISCOUNT MODEL 2.4.1 Under the dividend discount model, cost of equity is inferred from the current share price of a firm, which represents the present value of the future expected dividends 38

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

from a firm. For dividend discount model, we need the expected future dividend stream, its growth rate and the present share price to infer the cost of equity which equates the present value of the future dividend stream to the current share price. Cost of equity = [D1/P + G], Where, D1 is the expected next year’s dividend, P is the present share price, and G is the growth rate in dividends.

2.5 CAPITAL ASSET PRICING MODEL 2.5.1 The Capital asset pricing model is the most widely used method for determining cost of equity capital. 2.5.2 Capital asset pricing model is based on the following principles: a. Equity share holders have to be paid the minimum risk free rate of return [Rf] and a risk . b. The risk free rate of return represents the rate of interest on a government security, typically a treasury bill. c. The risk has two components; the market risk [Rm] which is the average long term return from the stock market, typically computed based on the long term returns on a market index like the sensex, minus the risk free rate of return [Rf] and the Beta. d. Beta represents the systematic risk component for a firm, measured as the rate of change of share price returns with reference to the market returns (sensex returns). e. Beta measures the sensitivity of a share price with reference to the market. f. Systematic risk is also known as the non-diversifiable risk which the shareholders can not diversify through a portfolio. Hence, the shareholders have to be compensated for this. Non-diversifiable risk affects all the firms in the system. g. Diversifiable risk is company specific risk, which the shareholders can diversify, hence need not be compensated for. h. Beta varies from company to company. i.

A beta less than 1 typically means less risky stocks and greater than 1 represents an aggressive stock.

j.

A beta less than 1, means when the market fluctuates, the share price fluctuates less than the market.

k. A beta more than 1, means that the share price rises or falls at a rate higher than the market rate of change

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

39

FINANCIAL MANAGEMENT DECISIONS 2.5.3 Under capital asset pricing model, Cost of equity= Rf + beta (Market risk ) Cost of equity = Rf + beta(Rm-Rf)

2.6 WEIGHTED AVERAGE COST OF CAPITAL 2.6.1 The cost of equity capital and cost of debt capital are multiplied by the market value weights to arrive at the weighted average cost of capital [WACC]. 2.6.2 Market value weights means the current market value of the debt and equity is used to arrive at the weights and not the book value of debt and equity. This is because the WACC should represent the minimum expected rate that a firm should provide to both its present and prospective shareholders. 2.6.3 WACC also varies depending on the mix of debt of equity of a firm i.e the financial leverage of a firm.

2.7 ILLUSTRATIONS Cost of debt: 1. If the pre-tax cost of debt is 12% and the tax rate is 40%, what is the post tax cost of debt? The post tax cost of debt= Pretax cost of debt X (1-tax rate) Post tax cost of debt= 12% X (1-49%) = 7.20% 2. A firm pays an interest of 27 lakhs and its balance sheet shows an opening balance of debt of 50 lakhs and closing balance of debt of 100 lakhs? If the tax rate is 40%, what is its post tax cost of debt? The pre tax cost of debt equals = [interest/average debt] Average debt = (50+100)/2 = [27/75] =36% Post tax cost of debt = 0.36 X (1-.40) = 21.6% Cost of equity Dividend discount model 3. Dividends just paid by a firm amounts to Rs. 24 per share and the growth rate in dividends is expected to be 5%. If the current share price is Rs.120, what is the cost of equity? Cost of equity = [D1/P] + G D1=Expected dividend next year=24 X (1.05)=25.2 Cost of equity = (24/120)+.05= 25% Capital Asset Pricing Model Cost of equity=Rf + beta (Rm-Rf) 40

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

4. The risk free rate of return for an economy is 8% and the expected return from equity market is 18%. The beta of ABC Company is 1.2. What is its cost of equity? Cost of equity =Rf + beta (Rm-Rf) = 8%+1.2(18%-8%) =8% + 1.2(10%) = 20% Weighted Average Cost of Capital (WACC) 5. Compute the weighted average cost of capital from the following data: Capital structure of a company Rs 1 ordinary shares

12

million

8% preference shares

6

million

7.2

million

Bank loan Total

25.2

Other data: Market price

Ordinary shares

2.25

Rupees

Market price

8% preference shares

0.92

Rupees

Tax rate

0.3

Beta

1.75

Risk free rate of interest

0.08

Market risk

0.04

Interest cost of the year

1055640

Loan at the start of the year

Type of finance

8

million

Market value

Cost

Weightage

WC

27.00

15.00%

67.98%

10.20%

Pref shares

5.52

8.70%

13.90%

1.21%

Bank loan

7.20

9.72%

18.13%

1.76%

Share capital

39.72

13.17%

The weighted average cost of capital is 13.17% Note:

• Cost of share capital is computed using Capital Asset Pricing Model FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

41

FINANCIAL MANAGEMENT DECISIONS

• Cost of preference share is arrived at by dividing preference dividend by the current market price (.08/.92)

• Cost of debt is arrived at by dividing the interest by average debt Glossary of

• • • • • • • • • • • • •

42

Hurdle rate Discount rate Weighted average cost of capital Risk free rate of return Risk Beta Systematic risk Unsystematic risk Diversifiable risk Non-diversifiable risk Portfolio Dividend discount model Post tax cost of debt

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

SECTION - 3 CAPITAL BUDGETING This Section includes

Capital Budgeting



Need to Control Capital Assets



Investment and Return



Time Value of Money



Future Value of Money



Present Value



Capital Budgeting Process



Investment or Project Appraisal



Investment Criteria



Cost of Capital



An Illustration



ing Rate of Return



Net Present Value



Internal Rate of Return



Profitability Index



DSCR



Effect of Taxes



Effect of Inflation



Uncertainty in Cash Flows



What-If & Sensitivity Analysis



An Illustration

3.1 CAPITAL BUDGETING 3.1.1

The concept of Capital Budgeting is also known as Investment Appraisal. It is basically concerned with Resource Optimization. It is also referred to as Capital expenditure with reference to Projects. Projects may be of different types such as new projects, expansion projects, diversification projects or modernization projects. Capital Budgeting is also gaining importance due to increased level of M & As.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

43

FINANCIAL MANAGEMENT DECISIONS 3.1.2

Capital Budgeting assumes tremendous importance for an organization for the following reasons: a. By committing resources to a project, an organization gets committed to a particular process or technology. b. Huge capital outlay c. Long gestation periods d. Decisions are strategic and generally irreversible.

3.1.3

Capital Budgeting is the cost of capacity resources that organizations purchase and use for years to make goods and provide services. Capital assets create these capacityrelated costs.

3.1.4

Cost commitments associated with long-term assets create the following types of risks for an organization: a. Remain even if the asset does not generate the anticipated benefits b. Reduce an organization’s flexibility.

3.1.5

Therefore, organizations approach investments in long-term assets with considerable care and caution.

3.2 NEED TO CONTROL CAPITAL ASSETS 3.2.1

Organizations have developed specific tools to control the acquisition and use of long-term assets because: a. Organizations are usually committed to long-term assets for an extended time, creating the potential for:

Excess capacity that creates excess costs Scarce capacity that creates lost opportunities

b. The amount of money committed to the acquisition of capital assets is usually quite large. c. The long-term nature of capital assets creates technological risk. 3.2.2

Capital budgeting is a systematic approach to evaluating an investment in a capital asset.

3.3 INVESTMENT AND RETURN 3.3.1

The fundamental evaluation issue in dealing with a long-term asset is whether its future benefits justify its initial cost.

3.3.2

Investment is the monetary value of the assets the organization gives up to acquire a long-term asset.

3.3.3

Return is the increased future cash inflows attributable to the long-term asset.

3.3.4

Investment and return form the foundation of capital budgeting analysis, which focuses on whether the expected increased cash flows (return) will justify the investment in the long-term asset.

44

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

3.3.5

It has impact on opportunity loss if not planned timely or alternative options are not weighed properly.

3.4 TIME VALUE OF MONEY 3.4.1

Time value of money (TVM) is a central concept in capital budgeting.

3.4.2

As money can earn a return: –

Its value depends on when it is received.

– Using money has a cost in the form of lost opportunity to invest the money in another investment alternative. 3.4.3

In making investment decisions, the problem is that investment is made much ahead of expected future return. We need an equivalent basis to compare the cash flows that occur at different points in time.

3.4.4

As money has a time-dated value, the critical idea underlying capital budgeting is: “Amounts of money spent or received at different periods of time must be converted into their value on a common date in order to be compared”.

3.5 FUTURE VALUE OF MONEY 3.5.1

As money has time value, it is better to have money now than in the future. Having Rs.100 today is more valuable than receiving Rs.100 in the future because the Rs.100 on hand today can be invested to grow to more than Rs.100.

3.5.2

The future value (FV) is the amount that today’s investment will be after earning a stated periodic rate of return for a stated number of periods.

3.5.3

For one period: FV=PV x (1+r)

3.5.4

The formula for a future value is FV=PV x (1+r)n

3.5.5

As investment opportunities usually extend over multiple periods, we need to compute future value over several periods.

3.6 PRESENT VALUE 3.6.1

Analysts call a future cash flow’s value at time zero as present value. The process of computing present value is called discounting. We can rearrange the FV formula to compute the present value: FV = PV x (1 + r)n PV = FV/(1 + r)n or PV = FV x (1 + r)-n

3.7 CAPITAL BUDGETING PROCESS 3.7.1

The Capital Budgeting process consists of the following steps: a. Identification of potential investment opportunities b. Collecting relevant data on investments & returns

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45

FINANCIAL MANAGEMENT DECISIONS c. Evaluation using various criteria. d. Selection e. Project implementation without time or cost overrun. f. Performance Review at periodical intervals.

3.8 INVESTMENT OR PROJECT APPRAISAL 3.8.1

Investment appraisal consists of the following steps: 1. Forecast of project costs and benefits for a reasonable time frame, 2. Ascertaining the project risk wrt competition, Technology, Consumer preferences, market including international currency fluctuations., 3. Estimating the cost of capital, weighted average cost of capital, mix of capital, 4. Application of suitable investment criteria by adopting proper means of financing 5. Analysing managerial strengths, capabilities, project and profitability sensitivity to any changes, regulations governing the project implementation etc;

3.9 INVESTMENT CRITERIA 3.9.1

The following are the most commonly used criteria to appraise investments: 1. Payback period 2. ing Rate of Return 3. Net Present Value (NPV) 4. Internal Rate of Return (IRR) 5. Profitability Index 6. Debt Service Coverage Ratio (DSCR)

3.9.2

The above investment criteria, their advantages and limitations are discussed subsequently in the chapter.

3.10 COST OF CAPITAL 3.10.1 The cost of capital is the interest rate used for discounting future cash flows. It is also known as the risk-adjusted discount rate. 3.10.2 The cost of capital is the return the organization must earn on its investment to meet its investors’ return requirements. 3.10.3 The organization’s cost of capital reflects:

46

–

The amount and cost of debt and equity in its financial structure

–

The financial market’s perception of the financial risk of the organization’s activities

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

3.11 AN ILLUSTRATION 3.11.1 Arctic Ice creams: To show how each of these methods works and alternative perspectives, we apply each to Arctic Ice creams as it considers the purchase of a new automatic Ice cream machine: a. Cost: Rs.70,000 b. Life: five years c. Benefit: expanded capacity and reduced operating costs would increase Arctic’s net profits by Rs.20,000 per year d. Arctic’s cost of capital is 10% e. The new machine would be sold for Rs.10,000 at the end of five years

3.12 PAYBACK CRITERION 3.12.1 The payback period is the number of periods needed to recover a project’s initial investment: a. Arctic’s initial investment of Rs.70,000/- is recovered midway between years 3 and 4 b. The payback period for this project is 3.5 years 3.12.2 Many people consider the payback period to be a measure of the project’s risk as: a. The organization has unrecovered investment during the payback period b. The longer the payback period, the higher the risk c. Organizations compare a project’s payback period with a target that reflects the organization’s acceptable level of risk d.

It also has relevance to technology changes.

3.12.3 Problems with the Payback method: The payback criterion has two problems: 1. It ignores the time value of money. Some organizations use the discounted payback method, which computes the payback period but uses discounted cash flows. 2. It ignores the cash outflows that occur after the initial investment and the cash inflows that occur after the payback period. 3.12.4 Despite these limitations, some surveys show that the payback calculation is the most used approach by organizations for capital budgeting. This popularity may reflect other considerations, such as bonuses that reward managers based on current profits, that create a preoccupation with short-run performance

3.13 ING RATE OF RETURN 3.13.1 Analysts compute the ing rate of return by dividing the average ing income by the average level of investment. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

47

FINANCIAL MANAGEMENT DECISIONS 3.13.2 Analysts use the ing rate of return to approximate the return on investment. 3.13.3 The increased annual income that Arctic’s will report related to the new Ice cream Machine will be Rs.8000 (Rs.20,000 – Rs.12,000 of depreciation). The average income will equal the annual income since the annual income is equal each year. 3.13.4 The average investment is Rs.40,000 [(Rs.70,000 + 10,000) / 2]. 3.13.5 The ing rate of return for the investment is computed as: Rs.8,000 / Rs.40,000 = 20%. 3.13.6 If the ing rate of return exceeds the target rate of return, then the project is acceptable. 3.13.7 Like the payback method the ing rate of return method has a drawback: By averaging, it does not consider the timing of cash flows. 3.13.8 This method is an improvement over the payback method in that it considers cash flows in all periods.

3.14 NET PRESENT VALUE 3.14.1 The Net Present Value (NPV) is the sum of the present values of a project’s cash flows. This is the first method considered that incorporates the time value of money. 3.14.2 The steps used to compute an investment’s net present value are as follows: 1. Choose the appropriate period length to evaluate the investment proposal. The period length depends on the periodicity of the investment’s cash flows. The most common period used in practice is one year. Analysts also use quarterly and semiannual periods. 2. Identify the organization’s cost of capital, and convert it to an appropriate rate of return for the period length chosen in step 1. 3. Identify the incremental cash flow in each period of the project’s life. 4. Compute the present value of each period’s cash flow using the organization’s cost of capital as the discount rate. 5. Sum the present values of all the periodic cash inflows and outflows to determine the investment project’s net present value. 6. If the project’s net present value is positive, the project is acceptable from an economic perspective 3.14.3 To determine the NPV of Arctic’s investment: 1. The period length is one year. All cash flows are stated annually. 2. Arctic’s cost of capital is 10% per year. As the period chosen in step 1 is annual, no adjustment is necessary to the rate of return. 3. The incremental cash flows are:

48

a.

Rs.70,000 outflow immediately

b.

Rs.20,000 inflow at the end of each year for five years FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

c.

Rs.10,000 inflow from salvage at the end of five years It is useful to organize the cash flows associated with a project on a time line to help identify and consider all the project’s cash flows systematically.

4. The present value of the cash flows when the organization’s cost of capital is 10% are: a.

For a five-year annuity of Rs.20,000, PV = Rs.75,816

b.

For the Rs.10,000 salvage in 5 years, PV = Rs.6,209

5. To sum the present values of all the periodic cash flows and determine NPV. The PV of the cash inflows (from step 4) is Rs.82,025. As the investment of Rs.70,000 takes place at time zero, the PV of the total outflows is Rs.(70,000). The NPV of this investment project is Rs.12,025. 6. As the NPV is positive, Arctic should purchase the Ice cream Machine. It is economically desirable

3.15 INTERNAL RATE OF RETURN 3.15.1 The Internal Rate of Return (IRR) is the actual rate of return expected from an investment. 3.15.2 The IRR is the discount rate that makes the investment’s net present value equal to zero. If an investment’s NPV is positive, then its IRR exceeds its cost of capital. If an investment’s NPV is negative, then it’s IRR is less than its cost of capital. 3.15.3 By trial and error, or the use of a financial calculator or spreadsheet software, we find that the IRR in Arctic’s is 16.14%. As a 16.14% IRR > 10% cost of capital, the project is desirable. 3.15.4 IRR has some disadvantages: a. It assumes that a project’s intermediate cash flows can be reinvested at the project’s IRR. It is frequently an invalid assumption. b. It can create ambiguous results, particularly:

When evaluating competing projects in situations where capital shortages prevent the organization from investing in all positive NPV projects



When projects require significant outflows at different times during their lives

3.15.5 Moreover, because a project’s NPV summarizes all its financial elements, using the IRR criterion is unnecessary when preparing capital budgets. Still, it is a widely used capital budgeting tool.

3.16 PROFITABILITY INDEX 3.16.1 The profitability index is a variation of the net present value method. 3.16.2 It is used to make comparisons of mutually exclusive projects with different sizes and is computed by dividing the present value of the cash inflows by the present value of the cash outflows. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

49

FINANCIAL MANAGEMENT DECISIONS 3.16.3 A profitability index of 1 or greater is required for the project to be acceptable. 3.16.4 Recall that with Arctic’s, the present value of the cash inflows was Rs.82,025 and the present value of the cash outflows was Rs.70,000. 3.16.5 Therefore, the profitability index for that project was 1.17 (Rs.82,025/Rs.70,000). 3.16.6 It is possible for project A to have a higher profitability index while project B has a higher NPV. An organization must determine how to choose when the criteria give conflicting results.

3.17.DSCR 3.17.1 Coverage available to the lender to obtain interest on loan and repayment of debt. 3.17.2 DSCR =

Pr ofit before long term Interest & Depreciation and after tax Long term Interest + Long term Re payments

3.18 EFFECT OF TAXES 3.18.1 In practice, capital budgeting must consider the tax effects of potential investments. The exact effect of taxes on the capital budgeting decisions depends on tax legislation, which is specific to a tax jurisdiction. 3.18.2 In general, the effect of taxes is twofold: a. Organizations must pay taxes on any net benefits provided by an investment. b. Organizations can use the depreciation associated with a capital investment to reduce income and offset some of their taxes. The rate of taxation and the way that legislation allows organizations to depreciate the acquisition cost of their longterm assets as a taxable expense varies over time and by jurisdiction.

3.19 EFFECT OF INFLATION 3.19.1 Inflation is a general increase in the price level. 3.19.2 To for inflation we must adjust future cash flows so that we can compare Rs. of similar purchasing power. Similarly, we discounted future cash flows to the present using an appropriate discount rate to for the time value of money. 3.19.3 We discount each cash flow by the appropriate discount rate and the expected inflation rate. 3.19.4 If Arctic’s expected inflation of 2.5%, the combined discount rate would be 1.1275% = 1.10 x 1.025.

3.20 UNCERTAINTY IN CASH FLOWS 3.20.1 Capital budgeting analysis relies on estimates of future cash flows. 3.20.2 As estimates are not always realized, many decision makers like to know how their estimates affect the decision they are making. 50

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

3.20.3 Estimating future cash flows is an important and difficult task. This is important because many decisions will be affected by those estimates. Difficult because these estimates will reflect circumstances that the organization may not have previously experienced. 3.20.4 Most cash flow estimation is incremental. This means that it is based on previous experience. For example, based on manufacturer claims, a new machine might be expected to decrease costs by 10%. 3.20.5 Many organizations assume that learning will systematically reduce the costs of a new system or process. 3.20.6 Cash flows related to sales of a new product are often estimated based on past experiences with similar products. 3.20.7 The forecast usually starts with previous experience and makes adjustments.

3.21 WHAT-IF & SENSITIVITY ANALYSIS 3.21.1 Two other approaches to handling uncertainty are what-if and sensitivity analysis: a. In the Arctic’s example, Arctic might ask, “What must the cash flows be to make this project unattractive?” b. Fortunately, computer spreadsheets make questions like this easy to answer. 3.21.2 Most planners today use personal computers and electronic spreadsheets for capital budgeting. 3.21.3 The planner can set up a computer spreadsheet to make changes to the estimates of the decision’s key parameters. 3.21.4 If the analysis explores the effect of a change in a parameter on an outcome, we call this investigation a what-if analysis. For example, the planner may ask, “What will my profits be if sales are only 90% of the plan?” 3.21.5 A planner’s investigation of the effect of a change in a parameter on a decision, rather than on an outcome, is called a sensitivity analysis. For example, the planner may ask, “How low can sales fall before this investment becomes unattractive?”

3.22 RISK ANALYSIS 3.22.1 Risks relates to: – Implementation – Market – Financial 3.22.2 Keep the end result of the model in mind, i.e., the ability to vary the key drivers of the model results [Sensitivity Analysis]. 3.22.3 The purpose is to de-risk the project through simulation of probable results – Sensitivity analysis: Variation in key parameters and impact on profitability – Scenario analysis – Simulation – Break-even analysis: Minimum level of operation FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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FINANCIAL MANAGEMENT DECISIONS

3.23 AN ILLUSTRATION Tristar Foods is planning to introduce a new food chain for the production and distribution of corn oil. The company has already spent Rs. 20000 in the analysis of the project. The new department may use the existing warehouse which could otherwise be rented out for Rs.15000 a year. The marketing task will be carried out by the existing manpower but a part of total cost Rs. 20000, will be allocated to the new food chain department. The rest of the details are shown in the table. Input data Cost of new machine Salvage value of new machine Production (lts. Per day) Working days per year Working life of machine (years) Income per lt. (net) Salvage value of old machine Warehouse cost Allocated cost of marketing/year Increase in working capital Depreciation rate Corporate tax rate Capital gains tax rate Opportunity cost of capital(Debt) Post tax cost of debt

150,000 10,000 300 300 6 0.80 5,000 15,000 20,000 5,000 25% 30% 30% 12.5% 8.8%

ESTIMATION OF CASHFLOWS YEAR

0

1

2

3

4

5

6

COST OF NEW MACHINE (150,000) SALVAGE VALUE (OLD MACHINE) 5,000 CHANGE IN WORKING CAPITAL (5,000) 5,000 SALVAGE VALUE (NEW MACHINE) 10,000 REVENUE 72,000 72,000 72,000 72,000 72,000 72,000 WAREHOUSE COST (15,000) (15,000) (15,000) (15,000) (15,000) (15,000) DEPRECIATION (37,500) (37,500) (37,500) (37,500) TAXABLE PROFIT 34,500 34,500 34,500 34,500 72,000 72,000 CAPITAL GAINS TAX (1,500) (3,000) CORPORATE TAX (10,350) (10,350) (10,350) (10,350) (21,600) (21,600) PROFIT AFTER TAX 24,150 24,150 24,150 24,150 50,400 50,400 CASHFLOWS (151,500) 46,650 46,650 46,650 46,650 35,400 47,400 NPV IRR

52

52,394.39 19.83%

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Sensitivity analysis Production per day 52,394.39 -755.55 3040.87 22023.00 25819.42 29615.85 37208.69 44801.54 48597.97

230 235 260 265 270 280 290 295

19.83% 0.09 0.09 0.14 0.14 0.15 0.17 0.18 0.19

Sensitivity analysis Contribution Per litre 52,394.39 -33025.16 -18788.57 -4551.98 9684.62 23921.21 38157.80

0.50 0.55 0.60 0.65 0.70 0.75

19.83% 0.01 0.04 0.08 0.11 0.14 0.17

Production per day and contribution per litre 52,394.39 230 235 260 265 270 280 290 295

0.50

0.55

0.60

0.65

0.70

0.75

-66243.87 -63871.11 -52007.28 -49634.52 -47261.75 -42516.22 -37770.69 -35397.92

-55329.15 -52719.11 -39668.90 -37058.86 -34448.82 -29228.73 -24008.65 -21398.61

-44414.43 -41567.11 -27330.52 24483.20 -21635.89 -15941.25 -10246.61 -7399.29

-33499.71 -30415.12 -14992.14 11907.55 -8822.95 -2653.76 3515.43 6600.02

-22584.99 -19263.12 -2653.76 668.11 3989.98 10633.72 17277.47 20599.34

-11670.27 -8111.12 9684.62 13243.76 16802.91 23921.21 31039.50 34598.65

Notes: 1.

There are three types of costs that need to be considered in the above case. i. The initial feasibility study cost is a sunk cost and hence to be ignored ii. The ing allocated cost of 20000, should again be ignored as it is not incremental iii. The warehouse cost is an opportunity cost and hence should be included

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

53

FINANCIAL MANAGEMENT DECISIONS 2. 3. 4. 5. 6.

The working capital investment is released in the last year of the project The post tax cost of debt is taken as interest is tax deductible The first sensitivity table shows the impact of changes in production per day on the NPV and IRR The second sensitivity table shows the impact of changes in contribution per liter on the NPV and IRR The third table shows a combination of production and contribution on NPV Scenario Analysis Variables Production Contribution Investment Cost of debt

Scenario-1

Scenario-2

Scenario-3

250 0.6 170000 0.14

290 0.75 160000 0.13

310 0.85 150000 0.125

Note: Scenario analysis goes beyond sensitivity analysis. A number of variables representing one scenari o are changed and the impact on the final result is studied. Scenario Summary Current Values:

Pessimistic

most likely

optimistic

300 0.80 150,000 12.5%

250 0.60 170,000 14.0%

290 0.75 160,000 13.0%

310 0.85 150,000 12.5%

52,394.39 19.83%

(51,775.61) -1.66%

21,603.66 13.59%

74,698.39 24.20%

Changing Cells: Production Contribution Investment Cost of debt Result Cells: NPV IRR

Note: The scenario summary shows the results under best case and worst case scenario. 2 MIRR Check the reinvestment assumption of IRR 0 1 2 3 4 5 IRR MRR

54

-100000 45000 49000 20000 30000 25000 24%

=Mirr (Cashflow range, guess rate, reinvestment rate)

19%

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Note: Modified internal rate of return takes into a different reinvestment rate, other than the internal rate of return. Normal IRR assumes that the intermediate cash flows are reinvested at the IRR. In a falling interest rate scenario, this assumption may not hold good. Hence, a modified internal rate of return is to be used. The above illustration shows how this can be done in using the Excel function. Monte carlo simulation: Simulation is used to quantify risk in of probability of achieving a target NPV or IRR. Simulation is done for capturing the different possible outcomes and determining the probability of a particular event happening. In the example given below, the estimated probabilities associated with different cash flows of a project are given. These probabilities can be subjective probabilities. Using random numbers, a large number of cash flows are selected to construct a distribution of results. The simulation is takes into all possible outcomes. Monte Carlo Simulation Year

Probability

Cashf lows

0

0.20 0.20 0.60

-2400.00 -2365.00 -2200.00

1

0.30 0.50 0.20

275.00 352.60 450.00

2

0.30 0.60 0.10

460.00 525.13 675.00

3

0.20 0.70 0.10

600.00 714.06 900.00

4

0.10 0.80 0.10

775.00 960.75 1100.00

5

0.10

1100.00

0.80

1461.07

0.10

1500.00

Monte Carlo Simulation:

Illustration of Project Simulation



Cash flows and associated probabilities are the required inputs



The purpose is to quantify risk

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

55

FINANCIAL MANAGEMENT DECISIONS Convert probability to cumulative probability Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Cumulative Probability P



Cash flows

0.00 0.20 0.60 0.20

0.00 0.20 0.80 1.00

-2400 -2365 -2200 -2200

P



Cash flows

0 0.3 0.5 0.2

0.00 0.30 0.80 1.00

275.00 352.60 450.00 450.00

P



Cash flows

0.00 0.30 0.60 0.10

0.00 0.30 0.90 1.00

460.00 525.13 675.00 675.00

P



Cash flows

0.00 0.20 0.70 0.10

0.00 0.20 0.90 1.00

600.00 714.06 900.00 900.00

P



Cash flows

0.00 0.10 0.80 0.10

0.00 0.10 0.90 1.00

775.00 960.75 1100.00 1100.00

P



Cash flows

0.00 0.10 0.80 0.10

0.00 0.10 0.90 1.00

1100.00 1461.07 1500.00 1500.00

Generation of random numbers: The random numbers are used to pick the different combination of cash flows. Each selection produces an IRR to form the IRR distribution.

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FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Trial No Random no Investmen Cash flow- Cash flow- Cash flow- Cash flow- Cash flow- ORR 1

0.13

-2400.00

275.00

460.00

600.00

960.75

1461.07 0.13

2

0.33

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

3

0.39

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

4

0.98

-2200.00

450.00

675.00

900.00

1100.00

1500.00 0.25

5

0.47

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

6

0.73

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

7

0.76

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

8

0.48

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

9

0.66

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

10

0.23

-2365.00

275.00

460.00

714.06

960.75

1461.07 0.15

11

0.92

-2200.00

450.00

675.00

900.00

1100.00

1500.00 0.25

12

0.75

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

13

0.36

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

14

0.72

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

15

0.45

-2365.00

352.60

525.13

714.06

960.75

1461.07 0.16

From the simulated IRRs, the average and standard deviation of IRR is computed. With average, standard deviation and the expected IRR as given below, the normal distribution tables are referred to obtain the probability of achieving different IRRs. For example, as given below, the probability of achieving an IRR of 14 percent is 68%. Quantification of risk expected irr

z

0.14 0.15 0.16 0.17 0.18 0.19 0.20 0.21 0.24 0.29 0.03

-0.4664 -0.2353 -0.0043 0.2268 0.4579 0.6890 0.9200 1.1511 1.8444 3.0000 -3.0000

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Probability 0.68 0.59 0.50 0.41 0.32 0.25 0.18 0.12 0.03 0.001 0.999

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FINANCIAL MANAGEMENT DECISIONS Case Study Internal Rate of Return: A Cautionary Tale Tempted by a project with high internal rates of return? Better check those interim cash flows again. The McKinsey Quarterly, McKinsey & Co. October 20, 2004 Maybe finance managers just enjoy living on the edge. What else would explain their weakness for using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooks and academics have warned that typical IRR calculations build in reinvestment assumptions that make bad projects look better and good ones look great. Yet as recently as 1999, academic research found that three-quarters of CFOs always or almost always use IRR when evaluating capital projects. (John Robert Graham and Campbell R. Harvey, “The Theory and Practice of Corporate Finance: Evidence from the Field,” Duke University working paper presented at the 2001 annual meeting of the American Finance Association, New Orleans.) Our own research underlined this proclivity to risky behavior. In an informal survey of 30 executives at corporations, hedge funds, and venture capital firms, we found only 6 who were fully aware of IRR’s most critical deficiencies. Our next surprise came when we reanalyzed some two dozen actual investments that one company made on the basis of attractive internal rates of return. If the IRR calculated to justify these investment decisions had been corrected for the measure’s natural flaws, management’s prioritization of its projects, as well as its view of their overall attractiveness, would have changed considerably. So why do finance pros continue to do what they know they shouldn’t? IRR does have its allure, offering what seems to be a straightforward comparison of, say, the 30 percent annual return of a specific project with the 8 or 18 percent rate that most people pay on their car loans or credit cards. That ease of comparison seems to outweigh what most managers view as largely technical deficiencies that create immaterial distortions in relatively isolated circumstances. ittedly, some of the measure’s deficiencies are technical, even arcane, but the most dangerous problems with IRR are neither isolated nor immaterial, and they can have serious implications for capital budget managers. When managers decide to finance only the projects with the highest IRRs, they may be looking at the most distorted calculations — and thereby destroying shareholder value by selecting the wrong projects altogether. Companies also risk creating unrealistic expectations for themselves and for shareholders, potentially confusing investor communications and inflating managerial rewards. (As a result of an arcane mathematical problem, IRR can generate two very different values for the same project when future cash flows switch from negative to positive (or positive to negative). Also, since IRR is expressed as a percentage, it can make small projects appear more attractive than large ones, even though large projects with lower IRRs can be more attractive on an NPV basis than smaller projects with higher IRRs.) We believe that managers must either avoid using IRR entirely or at least make adjustments for the measure’s most dangerous assumption: that interim cash flows will be reinvested at the same high rates of return.

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The Trouble with IRR Practitioners often interpret internal rate of return as the annual equivalent return on a given investment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a true indication of a project’s annual return on investment only when the project generates no interim cash flows — or when those interim cash flows really can be invested at the actual IRR. When the calculated IRR is higher than the true reinvestment rate for interim cash flows, the measure will overestimate — sometimes very significantly — the annual equivalent return from the project. The formula assumes that the company has additional projects, with equally attractive prospects, in which to invest the interim cash flows. In this case, the calculation implicitly takes credit for these additional projects. Calculations of net present value (NPV), by contrast, generally assume only that a company can earn its cost of capital on interim cash flows, leaving any future incremental project value with those future projects. IRR’s assumptions about reinvestment can lead to major capital budget distortions. Consider a hypothetical assessment of two different, mutually exclusive projects, A and B, with identical cash flows, risk levels, and durations — as well as identical IRR values of 41 percent. Using IRR as the decision yardstick, an executive would feel confidence in being indifferent toward choosing between the two projects. However, it would be a mistake to select either project without examining the relevant reinvestment rate for interim cash flows. Suppose that Project B’s interim cash flows could be redeployed only at a typical 8 percent cost of capital, while Project A’s cash flows could be invested in an attractive follow-on project expected to generate a 41 percent annual return. In that case, Project A is unambiguously preferable. Even if the interim cash flows really could be reinvested at the IRR, very few practitioners would argue that the value of future investments should be commingled with the value of the project being evaluated. Most practitioners would agree that a company’s cost of capital — by definition, the return available elsewhere to its shareholders on a similarly risky investment — is a clearer and more logical rate to assume for reinvestments of interim project cash flows. When the cost of capital is used, a project’s true annual equivalent yield can fall significantly — again, especially so with projects that posted high initial IRRs. Of course, when executives review projects with IRRs that are close to a company’s cost of capital, the IRR is less distorted by the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10 percent or more above their company’s cost of capital, these may well be significantly distorted. Ironically, unadjusted IRRs are particularly treacherous because the reinvestment-rate distortion is most egregious precisely when managers tend to think their projects are most attractive. And since this amplification is not felt evenly across all projects, managers can’t simply correct for it by adjusting every IRR by a standard amount. (The amplification effect grows as a project’s fundamental health improves, as measured by NPV, and it varies depending on the unique timing of a project’s cash flows.) How large is the potential impact of a flawed reinvestment-rate assumption? Managers at one large industrial company approved 23 major capital projects over five years on the basis of IRRs that averaged 77 percent. Recently, however, when we conducted an analysis with the reinvestment rate adjusted to the company’s cost of capital, the true average return fell to just 16 percent. The order of the most attractive projects also changed considerably. The top-ranked

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FINANCIAL MANAGEMENT DECISIONS project based on IRR dropped to the tenth-most-attractive project. Most striking, the company’s highest-rated projects — showing IRRs of 800, 150, and 130 percent — dropped to just 15, 23, and 22 percent, respectively, once a realistic reinvestment rate was considered. Unfortunately, these investment decisions had already been made. Of course, IRRs this extreme are somewhat unusual. Yet even if a project’s IRR drops from 25 percent to 15 percent, the impact is considerable. What to Do? The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet given its widespread use, it is unlikely to be replaced easily. Executives should at the very least use a modified internal rate of return. While not perfect, MIRR at least allows s to set more realistic interim reinvestment rates and therefore to calculate a true annual equivalent yield. Even then, we recommend that all executives who review projects claiming an attractive IRR should ask the following two questions. 1. What are the assumed interim-reinvestment rates? In the vast majority of cases, an assumption that interim flows can be reinvested at high rates is at best overoptimistic and at worst flat wrong. Particularly when sponsors sell their projects as “unique” or “the opportunity of a lifetime,” another opportunity of similar attractiveness probably does not exist; thus interim flows won’t be reinvested at sufficiently high rates. For this reason, the best assumption — and one used by a proper discounted cash-flow analysis — is that interim flows can be reinvested at the company’s cost of capital. 2. Are interim cash flows biased toward the start or the end of the project? Unless the interim reinvestment rate is correct (in other words, a true reinvestment rate rather than the calculated IRR), the IRR distortion will be greater when interim cash flows occur sooner. This concept may seem counterintuitive, since typically we would prefer to have cash sooner rather than later. The simple reason for the problem is that the gap between the actual reinvestment rate and the assumed IRR exists for a longer period of time, so the impact of the distortion accumulates. (Interestingly, given two projects with identical IRRs, a project with a single “bullet” cash flow at the end of the investment period would be preferable to a project with interim cash flows. The reason: a lack of interim cash flows completely immunizes a project from the reinvestment-rate risk.) Despite flaws that can lead to poor investment decisions, IRR will likely continue to be used widely during capital-budgeting discussions because of its strong intuitive appeal. Executives should at least cast a skeptical eye at IRR measures before making investment decisions. The authors, John C. Kelleher and Justin J. MacCormack, are consultants in McKinsey’s Toronto office. They wish to thank Rob McNish for his assistance in developing this article.

© CFO

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SECTION - 4 LEASE FINANCING This Section includes

What is Lease Financing?



Why Lease Financing?



Operating Leases



Financial Leases

4.1 WHAT IS LEASE FINANCING ? 4.1.1 Leasing is a form of debt financing which provides for the effective acquisition of the asset. Unlike debt or equity financing, leasing is typically identified with specific assets. The risk to the lessor is minimized when the lessee does not meet the contractual obligations. The lessor, as the legal owner of the asset, has a stronger legal right to reclaim the asset.

4.2 WHY LEASE FINANCING ? 4.2.1 A common misconception is that leasing allows the use of an asset without a company having recourse to its own funds. Lease payments are based on the price of the asset plus an interest factor. It is also unlikely that the lessor would advance a loan for the total cost unless the proposed lessee had other assets or equity to offer as collateral to the loan. 4.2.2 The commonly used lease are: 1. Operating Leases 2. Financial Leases a. Rental Lease b. Net lease c. Direct lease d. Leveraged lease 4.2.3 Lease financing is resorted to for both the right and wrong reasons. The right reasons for leasing are: a. b. c. d. e. f.

Short-term leases are convenient Cancellation options are available Maintenance is provided Standardization leads to low costs Tax shields can be used Avoiding the alternative minimum tax

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FINANCIAL MANAGEMENT DECISIONS 4.2.4 The wrong reasons for leasing are: a. Leasing avoids capital expenditure controls b. Leasing preserves capital c. Leases may be off balance sheet financing d. Leasing effects book income

4.3 OPERATING LEASES 4.3.1 An Operating Lease normally includes both financing and maintenance services. Normally the lessor agrees to maintain and service the asset, the costs of which are built into the lease payments. Further, an operating lease is one where an asset is leased or hired for a period of time less than its useful life. The lessor expects to recover costs in subsequent renewal payments or on disposal. 4.3.2 An Illustration: Acme Limo has a client who will sign a lease for 7 years, with lease payments due at the start of each year. The following table shows the NPV of the limo if acme purchases the new limo for $75,000 and leases it out for 7 years.

Initial Cost Maintenance, insurance, selling and istration costs Tax shield on costs Depreciation tax shield Total NPV @ 7% = - $98.15 Break-even rent (level) Tax Break-even rent after-tax NPV @ 7% = - $98.15

Years 0 -75 -12

1

2

3

4

5

6

-12

-12

-12

-12

-12

-12

4.2 0 -82.8

4.2 5.25 -2.55

4.2 8.4 0.6

4.2 5.04 -2.76

4.2 3.02 -4.78

4.2 3.02 -4.78

4.2 1.51 -6.29

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

0 Initial cost -75 Maintenance, insurance, selling, -12 and istrative costs Tax shield on costs 4.2 Depreciation tax shield 0 Total -82.8 NPV @ 7% = - $98.15 Break even rent(level) 26.18 Tax -9.16 Break even rent after-tax 17.02 NPV @ 7% = - $98.15 62

1

2

Year 3

-12

-12

-12

-12

-12

-12

4.2 5.25 -2.55

4.2 8.4 0.6

4.2 5.04 -2.76

4.2 3.02 -4.78

4.2 3.02 -4.78

4.2 1.51 -6.29

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

26.18 -9.16 17.02

4

5

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4.4 4.4.1

FINANCIAL LEASES A financial lease is one which lasts for the whole of an asset’s estimated useful life and where the lessee in effect takes on all the risks and benefits associated with ownership. In effect, a financial lease is the purchase of an asset financed by the lessor as lender. Such leases are now required to be shown on the balance sheet as assets at fair value and as liabilities for future lease payments.

An Illustration from the lender’s perspective and conditions Cost of the asset Depreciation rate Tax Lease period IRR of lessor

1000 20% WDV 40% 5 Years 25%

What will be the lease rental to be recovered assuming that the lessor es on the entire tax shield benefit to the lessee in the form of lower lease rentals? Step 1 is to calculate the present value of tax shield on depreciation Step-1 Present value of depreciation tax shield

Step-2 Step-3

Year

Depreciation

Balance

Taxshield

1

200

800

80.00

2

160

640

64.00

3

128

512

51.20

4

102

410

40.96

5

82

328

32.77

PV of depreciation tax shield

158.69

PV of residual value

107.37

Lease rental to be recovered

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

733.94

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SECTION - 5 WORKING CAPITAL MANAGEMENT This Section includes

Working Capital



The Elements of Working Capital



Management of Working Capital



The Management of Current Assets



The Management of Current Liabilities

5.1 WORKING CAPITAL 5.1.1 The importance of working capital in the operations of a company is very high. Typically, organizations on an average have over 40% of their total capital invested in working capital. Unlike the investments in fixed assets which are often subject to rigorous investment appraisal decisions, the investment in working capital is taken based on a series of apparently diversified factors such as sales, production, purchasing, inventories, receivables and cash. However, all these decisions may have a consequence on the level of investment in working capital and hence on the overall capital employed by the company. Therefore, a comprehensive and coordinated policy is needed alongside appropriate monitoring. 5.1.2 A study has found that financial managers spend more than one-third of their time on managing working capital. 5.1.3

5.2

While management of investments in projects is only during periods of project implementation, the management of working capital is round the clock on all 365 days in a year. l:

THE ELEMENTS OF WORKING CAPITAL

5.2.1The management of working capital is of equal importance in both manufacturing and service industries. The main difference lies in the fact that whereas a manufacturer may have funds tied up in physical stocks of raw materials, work-in-process. finished goods and receivables, a service organization may have funds tied up mainly in work-in-process, i.e., work done but not yet invoiced to the customer and receivables. 5.2.2

64

Working Capital is the fund required to the cost of production and expenses on sales, distribution and istration required prior to the receipt of the cash from the sale of finished goods or service. Thus a company which has a longer lead time between production and sale will require a greater investment in working capital. The money spent on these items has to be quickly turned around into cash through the sale of output to customers who subsequently pay us. The profit at the end of such FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

operating cycle enables the firm to pay interest on the loans and also a dividend to the equity shareholders. 5.2.3

Definitions of working capital vary. Gross Working Capital is the Total of all Current Assets. Net Working Capital is defined as the difference between Current Assets and Current Liabilities.

5.2.4

Current Assets have short life span and swift transformation into other asset forms. They comprise of the following: a. Inventories b. Consumable store

5.2.5

c.

Debtors

d.

Bank balance and cash.

The elements of current liabilities are: a. Creditors towards purchases and expenses b. Bank overdraft c. Accrued charges d. Tax liabilities e. Dividend liabilities f. Even Bank Borrowings towards working capital is considered as ‘Current liabilities (though secured creditors) as they are generally payable on demand.

5.2.6

The working capital cycle is given below:

Sales

Finished Goods

Debtors

Labour

Cash

Expenses

W-I-P Stocks

Purchases Creditors

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FINANCIAL MANAGEMENT DECISIONS 5.2.7

The working capital as a figure conveys nothing. The same working capital in two companies does not necessarily imply the same cash position. In order to determine the extent of liquidity of the working capital, the composition of the working capital, the percentage of each element to the total, and the real current nature of the asset have to be carefully studied and properly assessed. Based on a study of past requirements and performance, a forecast of future requirements has to be made.

5.3 MANAGEMENT OF WORKING CAPITAL 5.3.1

Characteristics of Current Assets:

The following two characteristics of current assets must be borne in mind: a.

Asset life span

b.

Swift transformation into other asset forms

The above qualities have certain implications: a.

Decisions pertaining to working capital management are repetitive and frequent.

b.

The difference between profit and present value is insignificant.

c.

The close interaction among working capital components implies that efficient management of one component can not be undertaken without simultaneous consideration of others. For example, a company having a large accumulation of finished goods may have to provide more liberal credit or a relaxed credit collection norms to be applied.

5.3.2

Factors influencing Working capital requirement:

Factors influencing Working Capital requirement are: a.

Nature of business

b.

Seasonality of operations

c.

Production policy

d.

Market conditions

e.

Conditions of purchase and sales.

5.3.3

Working Capital Policy:

The two important issues in formulating working capital policy are: a.

What should ratio of current assets to sales be?

b.

What should the ratio of short term financing to long term financing be?

To increase the effectiveness of working capital, the time taken in the working capital cycle of conversion of raw materials into cash again has to be reduced to a minimum. As changes in the volume of sales affect working capital requirement, these changes in sales should be factored in in determining working capital. 66

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

The volume of materials to be held in stock is determined mainly by the rate of consumption, suppliers delivery period and the economic order quantity. Credit to customers, credit available from suppliers, etc. also should be kept in view in forecasting working capital requirement. 5.3.4

Estimation of Working Capital requirement:

In estimating the working capital requirement, it is very important to have a clear understanding of the working capital cycle time. The working capital cycle time is nothing but the sum total of the time taken by various activities involved from the time an order is placed by a customer till the goods manufactured are billed to the customers and money is realized from the customer at the bank. The longer the working capital cycle time, more is the working capital required and vice versa. It is the responsibility of the finance manager to ensure that adequate care is taken in working out normal time required in the various activities comprising the current assets cycle time.

5.4 THE MANAGEMENT OF CURRENT ASSETS 5.4.1

Current assets are those which can be expected to be turned over into cash within a reasonable period of time ,however not over a year.. In most companies, current assets represent more than 40% of the total assets and the control of this large and volatile investment warrants considerable attention.

5.4.2

The total amount of current assets required by an organization is related to the volume of sales and output. If a company increases its sales, it will require a higher level of stocks to service production and sales facilities and a higher level of debtors to maintain the increased sales volume.

5.4.3

However, management still has some discretion over the level of current assets at any particular level of output, though a risk-return trade-off is involved. The lower the level of current assets, the more profitable the company will be (as asset turnover will be increased), but there will also exist a higher risk of running short of stocks or cash in the event of an unexpected increase in demand or claim from a supplier.

5.4.4

Similarly, a reduced level of debtors may increase the asset turnover of the company, but adversely affect profits through a drop in sales. A credit policy is part of a company’s ‘marketing mix’ and they may lose sales to competitors who may offer more attractive credit .

5.4.5

The general rule with current assets is to determine the minimum required quantity at the expected level of output and add a safety margin to cover any contingencies, the size of the safety margin being dependent on management’s attitude to risk.

5.4.6

Managing Stocks:

The amount of capital employed that is ‘locked up’ in stocks will affect profitability. However, a certain level of stocks is necessary for the following reasons: a.

Materials and parts can be purchased at a lower rate when purchased in large lots and anticipated increases in material costs may be avoided.

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FINANCIAL MANAGEMENT DECISIONS b.

Reserve or safety stocks are required to avoid a costly situation of stock-outs and consequent stoppages of production and interruption in deliveries. In process industries, shut down and re-start of a plant are complex and time-consuming operations and also would result in higher wastages and increased cost of production.

c.

The length of production time cycles can vary. In pharmaceutical industry, for example, a batch may spread over a few days from start to completion.

d.

The production flows from different manufacturing stages will not match and the imbalance is adjusted through intermediate stock holdings. This is especially true in large automobile factories, where final finished product is basically an assembly of components and sub-assemblies produced in a large section of shops in the factory and also bought from outside.

e.

The order pattern is not even. Orders arrive in irregular flows and to maintain customer goodwill quick deliveries are essential. This applies to any jobbing industry.

f.

There may be difficulties in forecasting future demand patterns.

g.

Economies of scale may be lost.

If all the stages of production from buying of raw materials to the final demand of the customers could be synchronized, then there would be no need for stocks to be kept at any stage in the production – distribution system. This is the principle on which concepts such as Just-in-time (JIT) manufacturing builds upon. Essential to such approaches are advanced manufacturing technology, particularly flexible manufacturing systems and continuous flow where it is possible to reduce the set-up costs between batches and eliminate the need for stock-holding to match production rates. The main characteristics of controlling stocks usually involve some of the following variables: a.

Demand or usage, and the rate of usage.

b.

Delivery rate

c.

Cost of buying or making one unit

d.

Cost of storing one unit during unit time

e.

Cost of being out of stock

f.

Re-order lead time

g.

Risk of non availability when in need,

h.

Batch size related cost.

Inventories can be effectively managed by monitoring actual performance through various financial turnover ratios, and employing techniques such as Just-in-time (JIT), Material Resource Planning (MRP), and Total Quality Management (TQM). Other tools for Inventory Management are: –

ABC Analysis

–

Standardization and Variety Reduction

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–

Value Engineering

–

Controls through Bar coding, RFID

–

Performance management

5.4.7

Managing Receivables and Credit:

The amount of a company’s funds ‘locked up’ in debtors at any time is determined by the following: a. b. c. d. e.

The volume of sales The credit policy The efficiency of debt collection The occurrence of bad debts. Industry bench marks.

It has been observed that for manufacturing companies, about 20% of the company’s assets may be held as debtors. An increase in sales will automatically lead to an increase in the level of debtors if the credit are maintained. Consequently there will be a need for an increase in the level of finance for debtors and it is also likely that increased sales will place demands on production and purchasing which in turn may require additional funds. Further, it is likely that there will be an increase in the doubtful debt provision and discounts. The factors in Credit Management are: 1.

of payment: – – – – –

2.

Cash Credit Consignment Bill of Exchange Letter of Credit

Credit Policy Variables: – – – –

Credit standards Credit Period Cash Discount Collection Effort

Credit Evaluation is important and the following techniques can be employed:

Traditional: – Character – Capacity – Capital – Collateral – Conditions

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FINANCIAL MANAGEMENT DECISIONS

Numerical credit scoring



Employing specialist agencies

Sources of information for credit evaluation are the financial statements of the customers, Bank references, referrals and past experience. Financial ratios such as average age of debts outstanding, and collection period can be used to monitor debtors. Customer profitability should be worked out to decide upon the most profitable customers, and those consuming significant resources of the organization. Credit granting is an important decision and should be handled by a duly authorised senior executive specifically designated for the purpose. 5.4.8

Short-term Investments:

If a company has a surplus of cash and does not expect this surplus to be used in the near future it should invest the funds in the short-term money market, such as bank deposits, inter-corporate loans and treasury bills. The security of funds is more important than the return achieved out of investing such funds. 5.4.9

Management of Cash:

Cash is a non-earning asset, and therefore, the natural policy is to minimize it. Any surplus should be suitably invested. Short- and medium-term cash flow forecasts may be used for predicting fluctuations in cash flow. The cost of holding cash is not only the profit that could have been earned had the funds been put to other uses, but also the depreciation due to inflation and possible changes in exchange rates. However, there are some good reasons for holding cash: a. b. c. d. e.

Transactional purposes As collateral for bankers against borrowings Precautionary motive to meet uncertainties and emergencies Funds for speculation Cash balances help improve a company’s credit rating.

Essentially the efficient management of cash is the synchronization of the cash flows. This is achieved not only by the careful management of the cash conversion cycle but also the management of the float (the time taken to clear and deposit cheques – includes mail float, processing float in the company and clearing float). 5.5.0

The Management of Current Liabilities:

5.5.1Current liabilities are all the debts owed by a company which are due for payment within a reasonable period of time but not over a year. However, while they exist, they represent the short-term financing of the company. 5.5.2 a.

70

There are two possible approaches to the modeling of current liabilities: They may be ignored and instead the financing costs incorporated into the appropriate current asset. For example, the creditors can be incorporated into the inventory model.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

b.

5.5.3

They may be incorporated into the short-term finance element, i.e., cash. This requires the treatment of short-term finances as multiple elements and thus programming techniques are appropriate. Managing Creditors:

Trade credit is a major source of short-term funds for most companies. However, the level of trade credit, like all forms of financing, must not be taken beyond the capacity of the company’s cash flow to service the payment requirements when they fall due. To control credit, a company should monitor the average age of s payable and match these payments with receivables in their cash budget. Some suppliers offer cash discounts and unless a company is very short of funds it is usually a sound rule to accept discounts whenever possible. 5.6.0

A higher current ratio is not always a good indicator as it amounts to ineffective utilization of funds.

5.7.0

Very efficient finance person will keep an eye always on Asset liability management (ALM) so as to balance short term and long term assets and liabilities prudently.

5.8.0

The articles appended at the end of chapter will further illustrate some of the concepts discussed in the chapter.

Keeping Receivables Rolling At DSC Logistics, ‘’keep ‘em moving’’ applies to orders and payments as well as to warehousing and delivery. Third in a series of articles on using software to improve the order-to-cash cycle. Marie Leone, CFO.com, May 25, 2004 At logistics and supply-chain company DSC Logistics, chief financial officer JoAnn Lilek recognizes that “one key to making money in logistics is business process automation.” Lilek’s affection for automation extends to the order-to-cash cycle, in which she includes order entry, invoicing, s receivable, dispute resolution, collection, and cash application. By her lights, automating that cycle reduces costly, time-consuming errors, boosts collections, and improves working capital. Those three improvements would be important to any business — but they’re especially important for a company like DSC whose profits depend on high transaction volume. As a third-party logistics manager, DSC arranges the shipment, warehousing, and delivery of goods, and settles s all along the way. Tens of thousands of business transactions through DSC’s systems every month, so management has developed a keen appreciation for quick and error-free order-to-cash processes. DSC is private, and Lilek won’t reveal hard numbers associated with order-to-cash lapses or improvements, but she contends that the $300 million company uses its $6 million information technology budget “effectively.” What’s more, adds the finance chief, some of the company’s s receivable upgrades have improved the general-ledger processes of its customers. In fact, says chief information officer Jon Fieldman, integrating the flow of data between DSC and its customers is like implementing a merger because it “tied us so tightly together.”

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FINANCIAL MANAGEMENT DECISIONS Close customer , it happens, is how the company began. In 1960, Jim McIlrath was fired from a cold-storage company for arguing with the owner over expanding the business to help customers warehouse dry goods. McIlrath started his own business on Chicago’s South Side — Dry Storage Corp., or DSC — whose current chief executive officer is his daughter Ann Drake. Window on Receivables Close customer , in IT , often means data visibility — which is “a very relevant piece” of the order-to-cash cycle, says Lilek. Two years ago, Fieldman introduced a Web-based tool from Viewlocity that gives customers a window on their part of DSC’s supply chain. Customers can search and filter order and inventory information in near real time; date-time stamps enable them to examine the history or check up on the status of any order. After adding transparency to their supply chain, Lilek and Fieldman turned to the august business practice of invoicing. In some cases, their goal was to eliminate paper invoices; in other cases, it was to banish invoices altogether. Paperless s receivable had plenty of takers among DSC’s clientele. Most of its customers are Fortune 500 retailers and manufacturers — such as Kimberly-Clark, Multifoods, GeorgiaPacific, Unilever, and Kellogg’s — that already use electronic data interchange (EDI) to transfer transaction information. As for freeing the process from invoices completely, one approach is to use EDI 214 data, which can automatically update a customer’s supply chain system with shipment status information. A customer would integrate EDI 214 into its payable system, then link to DSC’s s receivable system, part of JD Edwards’ OneWorld enterprise resource planning (ERP) system. After the two systems are synched up, payment , carrier rates, and any other parameters are fed into the customer’s system. When a customer places an order, the carrier’s delivery of the appropriate goods initiates an EDI 214 transmission to the customer; the customer’s system then automatically authorizes a payment to DSC. Price discrepancies are kicked out for investigation. Looking for Trouble Although discrepancies must be investigated manually, Lilek insists that the greater the amount of automation in the s receivable process, the fewer the instances of manual intervention — and the less time and money spent researching and correcting errors. Exorcising manual postings from the order-to-cash cycle, she adds, is fundamental to good ing, especially in a business with a high volume of transactions. Lilek contends, however, that improving “data matching” is even more important to the order-to-cash cycle. Data matching refers to linking a payment with its corresponding invoice number and order number — which are usually different. That’s another reason Lilek favors eliminating invoices entirely: no invoice number means that only the order number need be linked to the customer’s remittance. 72

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It took time to build the three-part information technology system that keeps DSC humming. In 1998, Fieldman and his team integrated DSC’s proprietary warehouse management system, which tracks and manages orders and inventory for 30 U.S.-based distribution centers, with a customized transportation system from i2 Technologies. In 2003, the company completed the integration of the OneWorld ERP software, tying the entire system together by running the applications on multiple AS/400 servers. The effort was shepherded by both IT and operations executives because many of the changes were driven by customers who believed that improving DSC’s order-to-cash cycle would benefit them, too. For example, now that transactions are pushed through DSC’s system faster and with fewer errors, its customers enjoy faster, less-error-prone settlement. Beyond Order-to-Cash Lilek believes that one of DSC’s business strengths is maintaining consistent processes from department to department across the company. During the next year, she wants to exploit the company’s order-to-cash technology to pursue other business-process goals. For instance, eventually she’d like to eliminate the paper check-cutting process when DSC must pay its own suppliers. Today, a manager for the general ledger tells an ing staffer that a batch of invoices needs to be reviewed and posted, and that checks need to be cut and mailed. In an automated scenario, it would be DSC’s financial system that was loaded with payment and other invoicing criteria. An invoice submitted for payment would prompt an electronic funds transfer if all the criteria were met. The bigger challenge would be getting DSC and its suppliers to adopt such a system, says Lilek, but she has high hopes — she’s been through something like this before. Small Is Big Baby-food maker Milnot/Beech-Nut keeps up with the industry’s big boys by holding down trade-spending costs. Second in a series of articles on using software to improve the order-to-cash cycle. Marie Leone, CFO.com May 18, 2004 “Small is big here.” That catchphrase, for Beech-Nut baby food, applies to more than tiny taste buds and strained peas, according to Alain Souligny, chief financial officer of BeechNut parent Milnot Holding Corp. “As a small company, we try very hard to stay ahead of changes in the marketplace, so that we can use [the head start] as a competitive edge,” asserts Souligny. And Milnot/Beech-Nut — a privately held St. Louis company whose 2003 revenues totaled $175 million — needs every edge it can get; its competitors include $25 billion Novartis, makers of Gerber baby food, and $71 billion Nestle, which manufactures Carnation evaporated milk. One way Milnot/Beech-Nut keeps ahead of the competition is by using technology to improve the order-to-cash cycle. Not only do those improvements s receivable, says

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FINANCIAL MANAGEMENT DECISIONS Souligny, but they also help alleviate the endemic industry problems related to trade spending — the costs that manufacturers incur when they rebate retailers for product promotions. “Short pays” are one such problem. Retailers who know they’re due a rebate from a manufacturer will push through an unauthorized invoice reduction — a short pay — rather than wait for the reimbursement. Without proper communication between the two parties, the manufacturer can be stuck with numerous partially paid invoices that must be manually reconciled by its s receivable department. Automation would go a long way to solve the problem, if only the industry could agree on a single communication conduit. Wal-Mart, for example, demands that Milnot/Beech-Nut use electronic supply-chain technology from A2 Automation; US Food Service requires that the company use technology from EFS Network; and other customers insist on a direct connection by electronic data interchange (EDI). Until that (far-off) day when communication systems are standardized, says Souligny, Milnot/ Beech Nut’s strategy is to get its own house in order by removing surprises from the order, invoice, and trade-spending processes — what he calls “the perfect order.” That means having enough product to fill each order completely; making shipments and deliveries on time; invoicing accurately; following through with timely receivables collection and posting; and eliminating customer disputes and unexpected deductions. Milnot/Beech-Nut’s tactical response was to improve the efficiency of back-office operations and trade-spending planning, and to build a data warehouse that would enable the company to measure profitability at the customer and product level. In 1998 Milnot/Beech-Nut began an enterprise-resource-planning (ERP) project based on a Ross iRenaissance enterprise system. Although Souligny believes that the project could have been completed within 18 months, a failed merger attempt with H.J. Heinz Co. that dragged on from 1999 through 2000 stalled the implementation. The company completely replaced its legacy system only this year. This year Milnot/Beech-Nut completed the transition from its legacy enterprise system to iRenaissance enterprise-resource-planning (ERP) software from Ross Systems Inc. Data from the Ross system is extracted, standardized, and sent to the company’s home-grown executive information system, which aggregates sales and operational data, including the coveted customer-profitability/product-profitability metrics. Ed Roe, director of information systems, is in the process of outsourcing all EDI communications to Transcentric, so sales director Tim McCreery and corporate controller Connie Huck can focus on trade-spending issues. McCreery and Huck’s finance/operations team has partnered with Minneapolis-based Gelco Trade Management Group to develop a deduction management system. Although the team continues to work with Gelco to tweak the software, Milnot/Beech-Nut executives say that the Web-based application is already slashing the istrative costs of processing customer deductions. In addition, McCreery and Huck are setting up a feed of syndicated industry data into the trade management system so they’ll be able to calculate the return on investment of individual trade programs. 74

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In recent years Milnot/Beech-Nut has pumped $500,000 annually into hardware and software purchases, says Souligny, and the smart application of IT dollars has helped the company’s information systems remain sleek. Roe runs the department with just one other employee, and the company’s total annual MIS budget is less than 1 percent of sales.. Souligny points out that the net effect of the order-to-cash process improvements — including reductions in headcount and trade spending, as well as improved cash collection — have almost offset the cost of running Milnot’s corporate finance department. In the past year, he adds, trade-spending costs for the company’s Beech-Nut brand were reduced by 3.8 percent &mdash a $4.2 million saving — while the brand grew market share by one percentage point. Increased control over trade-promotion spending reduced monthend customer deductions by $1.5 million compared with the previous year. Souligny also confirms improved invoice accuracy, but he’ll need more historical data to quantify the improvement. Souligny says that the company still needs to work on its customer scorecard — a ranking Milnot/Beech-Nut’s top 25 customers by sales. “The scorecard is the ultimate test” for the order-to-cash cycle, he notes, because executives can easily drill down to the root causes of difficulties with order completion, on-time shipments, sales increases, or profit contributions. Milnot/Beech-Nut’s investments in the order-to-cash cycle have an eye on that not-so-distant future when “manufacturers will be fully responsible for managing their inventory” at the retail level, according to Souligny. Someday soon, he believes, his customer reps will automatically know when a grocery store is low on, say, jars of banana supreme, and ship out just the right amount the next hour. Improving Milnot/Beech-Nut’s order-to-cash cycle is just the beginning, adds the finance chief. Souligny says he’s glad to be at a smaller outfit where IT projects can be fast-tracked and management doesn’t get caught up in big-company politics. It seems “small is big” for Souligny, too.

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SECTION - 6 FINANCIAL SERVICES This Section includes

Financial Services



Banking Services



Asset Management



Hedge fund management



Custody Services



Insurance



Intermediation or advisory services



Conglomerates

6.1 FINANCIAL SERVICES 6.1.1

The term Financial services refers to services provided by the finance sector. The finance sector encomes a broad range of organizations that deal with the sourcing, availability and management of money. Among these organizations are commercial banks, investment banks, asset management companies, credit card companies, insurance companies, consumer finance companies, stock brokerages, mutual and investment funds.

6.2 BANKING SERVICES 6.2.1

The primary operations of banks include the following: a. Keeping money of depositors safe while also allowing withdrawals when needed. b. Provide personal loans, commercial loans, and mortgage loans (typically loans to purchase a home, property or business) Popularly known as retail banking. c. Issuance of credit cards and processing of credit card transactions and billing. d. Issuance of debit cards for use as a substitute for cheques. e. Allow financial transactions at branches or through Automatic Teller Machines (ATMs). ATMs can be through their own network or by arrangements with other banks. f. Provide wire transfers of funds and electronic fund transfers between banks. g. Facilitation of standing orders and direct debits, so that payments for bills can be made automatically.

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h. Provide overdraft agreements for the temporary advancement of the Bank’s own money to meet monthly spending commitments of a customer in their current . i.

Provide a Banker’s cheque guaranteed by the Bank itself and prepaid by the customer.

j.

Notary service for financial and other documents.

k. Provide safe deposit lockers for safe keeping of valuables. l.

provide insurance services and products.

m. Provide trade credits, guarantees, bills collection, etc. for business and commerce. 6.2.2 Capital market banks underwrite debt and equity, assist company deals , through their advisory services,), and restructure debt into structured finance products.

6.3 ASSET MANAGEMENT 6.3.1 Asset management is the term usually given to describe companies which run collective investment funds.

6.4 HEDGE FUND MANAGEMENT 6.4.1

Hedge funds often employ the services of “prime brokerage” divisions at major investment banks to execute their trades.

6.5 CUSTODY SERVICES 6.5.1

Custody services and securities processing is a kind of ‘back-office’ istration for financial services.

6.6 INSURANCE 6.6.1 Insurance brokerage: Insurance brokers shop for insurance (generally corporate property and casualty insurance) on behalf of customers. 6.6.2 Insurance underwriting: Personal lines insurance underwriters generally underwrite insurance for individuals, a service still offered primarily through agents and insurance brokers. Underwriters may also offer similar commercial lines of coverage for businesses. Activities include insurance and annuities, life insurance, retirement insurance, health insurance and property and casualty insurance. 6.6.3 Reinsurance is insurance sold to insurers themselves, to protect them from catastrophic losses.

6.7 INTERMEDIATION OR ADVISORY SERVICES 6.7.1

Stock brokers (private client services) and discount brokers: Stock brokers assist investors in buying or selling shares. Primarily internet-based companies are often referred to as discount brokerages, although many now have branch offices to assist clients. These brokerages primarily target individual investors.

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6.8 CONGLOMERATES 6.8.1A financial services conglomerate is a financial services firm that is active in more than one sector of the financial services market e.g. life insurance, general insurance, health insurance, asset management, retail banking, wholesale banking, investment banking, etc. 6.8.2

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A key rationale for the existence of such businesses is the existence of diversification benefits that are present when different types of businesses are aggregated. As a consequence, economic capital for a conglomerate is usually substantially less than economic capital is for the sum of its parts.

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SECTION - 7 DIVIDEND AND RETENTION POLICIES This Section includes

Dividend Policy



Bird in the hand’ theory



Dividends and Taxes



Agency theory



Signalling theory

7.1 DIVIDEND POLICY 7.1.1

As already stated elsewhere in this chapter, Dividend policy is an area in which management can affect the financing structure of the company. The questions that come up generally while discussing dividend policy are: a. Why do companies pay dividend at all? b. Whether changing dividend policy could perhaps add value? c. Which dividend policy they should adopt – maximum distribution or maximum retention? d. How should the dividend be increased from year to year? e. When should management cut or skip dividends?

7.1.2

Dividend policy theories can be classified into four groups: 1. ‘Bird in the hand’ theory 2. Dividends and taxes 3. Agency theory 4. Signalling theory

7.2 BIRD IN THE HAND’ THEORY 7.2.1

This is the earliest model of dividend policy propounded by Gordon in 1959. This held that a dividend today is worth more than a potential capital gain in the future (two in the bush!). It relied on the initial concept in which all capital market securities were simply valued according to their income yield. The consensus was, the higher the risk, the higher should be the income yield.

7.2.2

There was no concept of return being only partly made up of dividend income and the rest capital gain. Dividend income was believed to be the total return from a share, and capital preservation the best that could be hoped for.

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Proponents of the theory argued that investors viewed future earnings as uncertain and felt less uncertain about dividends, and applied a lower discount rate to dividends than to the capital gain element of their returns. This argument implies that companies with high dividend yields should have greater market values than companies with low dividend payouts, all other things being equal. This argument is flawed, as the risk of a company is determined by its operating risk. As is the case with capital structure, if corporate taxes are ignored, the choice of dividend policy will have no impact on the business risk of a company and hence on its market value.

7.3 DIVIDENDS AND TAXES 7.3.1

It can be proved that the choice of dividend policy is irrelevant to firm value if we follow the argument of Miller and Modigliani (M & M) (1961). They assumed the existence of perfect markets and also assumed that the company’s choice of dividend policy does not affect the decision as to whether or not particular projects or investments should be undertaken. The issue here is whether changing the dividend policy of a firm will add or subtract value, assuming the investment strategy remains unchanged.

7.3.2

M & M showed that, with perfect capital markets, dividend policy, as with capital structure, could not be altered to add value to a firm. However, in exactly the same way as with capital structure, once we assume inefficiencies in markets and in particular tax, this irrelevancy of dividend policy no longer holds.

7.4 AGENCY THEORY 7.4.1

As in the case of capital structure, high dividends can be a means for managers to persuade investors that they were not frittering away the free cash flow.

7.5 SIGNALLING THEORY 7.5.1

The basic idea of the theory is that managers use dividends as a signal to investors about the future prospects of the firm.

7.5.2

M & M suggested that dividends might convey information about companies’ future earnings if management pursued a policy of stable dividends and used a change in the dividend payout ratio to signal a change in their views about the firm’s future profitability. This approach also has relevance in to the problems inherent in the separation of ownership and control. In this type of model, managers have significant inside information about the company that they cannot (or do not wish to) on to outside shareholders – for example better estimates of future earnings. Such a situation, where one group is better informed than another is known as one of ‘information asymmetry’. In this type of situation, corporate dividends may be management’s most cost-effective way of reducing the investor uncertainty about the company’s value which has been created by information asymmetry. In other words, ‘Dividends can thus be thought of as management forecasts of future earnings substantiated by cash’ (Healy and Balepu, 1988).

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7.5.3

Why should dividends be considered the most cost-effective way of signaling information? One argument is that earnings forecasts, or other more direct signals of future profitability, are hedged around with legal constraints and auditing requirements. So, companies with genuinely good prospects will be able to differentiate themselves from companies with poor prospects and which might wish to give false signals. Also, dividends are a highly visible form of signal compared with other types of forecast, such as debt/equity ratios which, in market value , change from day to day.

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SECTION - 8 CRITERIA FOR SELECTING SOURCES OF FINANCE This Section includes

Issues facing business



Internal financing



Decision on Choice of Capital



Source of Finance

8.1 ISSUES FACING BUSINESS 8.1.1

The four major issues a company faces in selecting an appropriate source of finance for a new investment are:

1. Can the company raise the finance required from internal sources or does it have to resort to external borrowings? 2. If external financing is required, what should it be – debt or equity? 3. Where to raise the external debt or equity? 4. Cost of each of the available source of finance.

8.2 INTERNAL FINANCING 8.2.1

In evaluating availability of internal financing, the company has to take into several factors such as the following:

a. The current cash holding of the company, including short-term investments, cash required to current operations and the surplus available for the new investment. b. Estimate cash flows with the help of a cash budget. c. Improve working capital management to enhance cash position. However, efforts in this direction should not lead to negative effects in the concerned areas such as loss of customer or supplier goodwill and production stoppages due to stock-outs.

8.3 DECISION ON CHOICE OF CAPITAL 8.3.1

The first point to consider is the extent of funding required. The other relevant factors to be considered are:

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2. The current capital gearing of the company. 3. Availability of good asset security for lenders. 4. Risk, in of volatility of operating profit, associated with the business the company is in. 5. Operating leverage, i.e., the proportion of fixed costs. 6. Impact of large issue of shares such as dilution of earnings per share (EPS) and loss of voting control. 7. The current state of equity markets.

8.4 SOURCE OF FINANCE 8.4.1

Equity Finance:

Issues such as whether equity should be raised through a rights issue, public issue or private placement need to be evaluated from the angles of legal requirements, market conditions, promoters’ willingness to dilute their holding etc;. 8.4.2Debt Finance: The major considerations in raising new debt finance are, the of the loan, rates of interest – whether fixed or floating, the market standing of the company, currency in which the loan is issued, and the covenants attached to the loan proposal by the lenders.

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SECTION - 9 EFFECT OF FINANCING DECISIONS ON BALANCE SHEET AND RATIOS This Section includes

Effect of Financing Decisions on Balance Sheet and Ratios

9.1.0

Financing decisions like debt or equity or leasing, have an impact on the balance sheet and consequently on the ratios. The higher the amount of debt, higher will be the interest cost, but this will be to some extent off-set by the lower tax outflow. The capital structure decision will not have any impact on the earnings before interest and taxes [EBIT], but will have an impact on the Earnings after tax [EAT]. EBIT is known as operating profit .

9.1.1

Dupont control chart and the family of ratios The relationship among all the ratios is very well depicted in the following diagram, which is known as the Dupont control chart. Dupont control chart (Shareholders point of view) PAT/EQUITY

PAT/SALES (cost mgt)

×

SALES/TA (Asset mgt)

×

TA/EQUITY (leverage mgt)

9.1.2

The above chart can be used to summarize the performance of any company. It says that the Return on equity[ROE] is a function of Return on sales[net profit margin], asset turnover and leverage[debt to equity ratio measured as total assets to equity]

9.1.3

The first two ratios namely, the net profit margin and asset turnover will not be affected by the capital structure decisions. It is margin times the turnover, which defines the business performance of the company. It is driven by the efficiency with which a company manages its revenue, costs and assets. An efficient company can manage higher levels of revenue with relatively lower levels of investment in assets.

9.1.4

The final ratio namely, the ROE, is influenced by the financing decision, namely the debt to equity ratio, measured by total assets to equity. If this ratio is 1, it means, it is 100 percent financed by equity.

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9.1.5

An illustration of Dell computers and Compaq. ROE Dell Compaq

1995 33% 22%

1996 58% 22%

1997 90% 22%

1995 5.10% 5.40%

1996 6.70% 6.60%

1997 7.70% 7.50%

Asset turnover Dell Compaq

1995 2.83 2.38

1996 3.02 1.99

1997 3.4 1.82

Leverage Dell Compaq

1995 2.3 1.69

1996 2.89 1.69

1997 3.46 1.61

Net Profit Margin Dell Compaq

Dell computers performance in the year 1997 is mainly influenced by superior asset turnover and higher leverage. Companies resort to lease financing for leaving the capital structure intact. This is why, leasing is known as off-balance sheet financing. But in today’s context, the present value of future lease payables is taken as debt and considered for debt to equity ratio. ing standards on lease transactions disclosure requires present value of future lease payables to be shown as debt.

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SECTION - 10 FINANCIAL MANAGEMENT IN PUBLIC SECTOR This Section includes

Financial Management in Public Sector

10.1.0 Public sector firm’s equity is contributed by the government. They function with social objective. Normally, they have a low debt to equity ratio as the public sector gets in the form of equity from the government. In India, the majority of public sector companies had very high equity component and very low Earnings per share. 10.1.1 The general emphasis in public sector is financial concurrence. Since it involves public money, public sector financial management is very strictly controlled through procedures and sanctions and audit, both internal and external. The finance manager is oriented more towards managing audit requirements, parliamentary compliances and other regulatory procedures. 10.1.2 In the post 1991 era of liberalization, Indian public sector companies were exposed to market discipline. Government started disinvesting the shares in public sector, the public sector shares were listed in the stock exchanges and many public sector companies started raising capital through initial public offerings. So, in today’s context, most of the earlier discussed financial management principles will be applicable to public sector. 10.1.3 The performance of public sector should be measured by financial as well as non-financial measures. The non-financial measures will be used to measure the extent to which the public sector has achieved social objectives like employment generation and Corporate Social Responsibility (CSR). Public sector today, is governed by the principle called value for money, which is a comprehensive measure that links both financial and nonfinancial measures.

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SECTION - 11 ROLE OF TREASURY FUNCTION This Section includes

Introduction



Scope of Treasury Management Function



The key treasury challenges

11.1 INTRODUCTION 11.1.1 For finance and treasury functions, the agenda is changing fast. Change is being forced with rapid economic developments, globalizing industries and competition, new technologies and revolutionary changes in the regulatory environment. As well as responding to these forces, finance and treasury functions are under pressure to add value to the organization through their operations and contribute to achieving strategic goals. 11.1.2 With significant developments that have taken place in the financial markets in the recent years affecting volatility in exchange rates and accentuating liquidity constraints, corporates have started paying closer attention to the treasury and foreign exchange (forex) management. Corporate treasury function is playing a pivotal role in financial risk management; exposure management and the use of hedging strategies are now all seen as essential requirements.. 11.1.3 The concept of corporate treasury is defined through a comparison of traditional and emergent roles. The management ants’ main task in cementing the treasury’s strategic role are: a. to facilitate communications and understanding of strategic possibilities; b. to aid implementation through the use of diagnostics, and c. the development of gap and sustaining strategies. 11.1.4 These emerging strategies are linked by one fundamental objective ie., to attract and retain competitively sought-after investor capital or, in other words, increase shareholder wealth. In a world where investor capital has more choice and mobility than ever before, the key to corporate survival and growth lies in organizational change initiatives that will contribute directly to the economic value of the firm and its ability to satisfy the financial return requirements of its investors. Increasingly, treasury and treasury management practices are being aligned with and integrated into, the business strategies of organizations. It should not be surprising to see corporate treasury and treasury strategies involved in organizational change.

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FINANCIAL MANAGEMENT DECISIONS 11.1.5 Therefore, whilst ensuring the effective management of all forms of risks, treasury managers must also be able to use and apply financial products in order to maximize profit. With the ever-increasing range and complexity of financial instruments available, treasury managers must constantly update their skills in order to effectively undertake their crucial duties.

11.2 SCOPE OF TREASURY MANAGEMENT FUNCTION 11.2.1 In today’s context, the scope of treasury management function is quite vast, and it continues to expand, as can be seen from the following listing. A treasury manager should be able to understand and appreciate the links between business strategy, organization and finance/treasury. 1. Cash and Liquidity Management: a. Cash flow dynamics, cash flow forecasting , cash flow valuations b. Short-term funding investment investments c. Cash Management: transactions, pooling and netting d. Working Capital Management e. Using Debt Instruments 2.

Foreign Exchange Risk Management a. International Economics and International Finance b. International Financial Markets and Instruments c. Foreign Exchange: Swaps and Forwards d. Vanilla and Exotic Foreign Exchange Options

3. Financial Risk Management: a. Interest and Currency Risks b. Interest Rates: Forwards, Futures and Options c. Interest Rate Swaps and applications d. Managing Currency Risks with Forward, Futures, Options and Swaps 4. Macroeconomic Policy Environment: a. Understanding of macroeconomic policies b. Understanding of how macroeconomic policies affect prices and costs in the economy c. Current scenario and future outlook for India and globally 5. Other aspects in Treasury Management: a. Role in ing policy formation eg. Forex transactions, Mutual Fund Investments, etc. b. Formation of Policies and Processes (Investment, Forex Management, ing, etc.) c. ing Policies on recognition of Treasury Transactions

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d. ing Standards on various foreign Exchange techniques under US and Indian GAAP e. Taxation issues, eg. withholding tax on interest paid on overseas borrowings, treatment of capital gains/loss on investments, etc.

11.3 THE KEY TREASURY CHALLENGES 11.3.1 The world is increasingly global in level of connectivity and every day the pace of information moves faster than the one before. Treasury is at the heart of the organization and directly challenged by these external forces. The challenges include the following (extracted from Accenture’s Brochure on Treasury management services): Expanding risk coverage The range of risks that the treasury function is now expected to cover has expanded. As well as traditional risks such as foreign exchange, funding, liquidity and counterparty risk, the treasury function is increasingly likely to manage commodity price risk, insurance and pension risks. Ensuring the policy is still relevant The treasury policy is the road map for the treasury function and it must keep pace with overall business strategy ensuring that the appropriate risks are identified, the right processes are in place for managing and mitigating those risks and that roles and responsibilities are clearly defined and communicated. Performance reporting Reporting and measuring performance is often seen as an additional burden on the overstretched treasury department. Well thought out metrics and indicators, along with a robust reporting framework, can not only be used to measure the performance of the function, but can also help drive high performance. Reducing the risk of operational errors The treasury function frequently manages complex, high-value transactions under tight time constraints, which can create the potential for operational errors leading to significant financial loss. An operational risk framework that captures, categorizes and analyzes loss events is pertinent to both the banking and corporate world. Achieving a clear view of the global cash position Organizations operate on a progressively global basis. As a result it becomes increasingly challenging to manage a central view of all banking arrangements. Depending on the relative autonomy of different business units, it may not always be practical simply to rationalize all global s. Other cash management methods—such as payment factories and in-house banking— may offer a more successful solution. Enabling timely and accurate cash flow forecasts Having an accurate and timely view of the global cash position is vital for effective cash flow planning, and requires effective communication between business units. The

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FINANCIAL MANAGEMENT DECISIONS treasurer may also provide valuable input into the longer term forecasting and budgeting processes and must work closely with the finance function. Meeting strategic plans Creating a funding program that is sufficiently flexible and responsive to achieve strategic objectives requires the corporate treasury function to make sure that its knowledge and understanding of the group business plans are consistent with the level, diversity, nature and maturity of the debt program it has in place. Optimizing Return on Investment With far more options available than simple bank deposits, the treasury function has to ensure that it is using the right instruments and investment methods that can fit both the risk profile and the required level of returns within the appropriate time frame. 11.3.2 High-performance treasury functions drive operational excellence throughout all levels of the organization. They are streamlined and flexible. They manage risk effectively, and they are able to contribute to the achievement of strategic business goals at the same time as ensuring that all statutory duties are met and compliance obligations are fulfilled. 11.4.0 The article titled “Treasury Organisation: Picking the Right Model”, published by HSBC’s Guide to Cash and Treasury Management in Asia Pacific 2004, appended at the end of chapter will further illustrate some of the concepts discussed in the chapter. STRATEGIC DETERMINANTS OF THE CAPITAL STRUCTURE: Main Aim: Maximising Market valuation of the firm. •

Asset Liability (ST/LT) mis-match should not be there;

•

Nature of Industry: Funding of Seasonal needs may deviate from above theory;

•

Degree of competition; More weightage on Equity if more volatile, low entry barriers, high degree of competition etc;

•

Obsolescence: If high, Capital Structuring needs to be more conservative;

•

Product Life Cycle; At venture stage, Equity is more preferred;

•

Financial policy: Management policy on Maximum D/E, DSCR, Div Pay-out…etc

•

Past and Current Capital Structure: It is not a day-to-day decision on the debt equity mix changes; it is altered not in Short term. It is only a Medium Term policy;

•

Dilution of ownership by issuance of more equity exposes for take-over;

•

Credit Rating;

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SECTION - 12 CONTEMPORARY DEVELOPMENTS This Section includes

•

WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBI regulations

12.1 WTO, GATT, CORPORATE GOVERNANCE, TRIPS, TRIMS, SEBI REGULATIONS In 1947, 23 countries signed the General Agreement on Tariffs and Trade (GATT) in Geneva. To GATT, countries must adhere to Most Favored Nation (MFN) clause, which requires that if a country grants a tariff reduction to one country; it must grant the same concession to all other countries. This clause applies to quotas also. 12.1.1 The new organization, known as the World Trade Organization (WTO), has replaced the GATT since the Uruguay Round accord became effective on January 1, 1995. Today, WTO’s 135 for more than 95% of world trade. The five major functions of WTO are:

• • • • •

istering its trade agreements Being a forum for trade negotiations Monitoring national trade policies Providing technical assistance and training for developing countries Cooperating with other international organizations

Under the WTO, there is a powerful dispute-resolution system, with three-person arbitration . Some of the major features of WTO and GATT are:

• World Trade Organization (WTO), was formed in 1995, head quartered at Geneva, Switzerland

• It has 152 member states • It is an international organization designed to supervise and liberalize international trade

• It succeeds the General Agreement on Tariffs and Trade • It deals with the rules of trade between nations at a global level • It is responsible for negotiating and implementing new trade agreements, and is in charge of policing member countries’ adherence to all the WTO agreements, signed by the bulk of the world’s trading nations and ratified in their parliaments.

• Most of the WTO’s current work comes from the 1986-94 negotiations called the Uruguay Round, and earlier negotiations under the GATT. The organization is

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FINANCIAL MANAGEMENT DECISIONS currently the host to new negotiations, under the Doha Development Agenda (DDA) launched in 2001.

• Governed by a Ministerial Conference, which meets every two years; a General Council, which implements the conference’s policy decisions and is responsible for day-to-day istration; and a director-general, who is appointed by the Ministerial Conference. 12.1.2 The General Agreement on Tariffs and Trade (GATT)

• GATT was a treaty, not an organization. • Main objective of GATT was the reduction of barriers to international trade through the reduction of tariff barriers, quantitative restrictions and subsidies on trade through a series of agreements.

• It is the outcome of the failure of negotiating governments to create the International Trade Organization (ITO).

• The Bretton Woods Conference had introduced the idea for an organization to regulate trade as part of a larger plan for economic recovery after World War II. As governments negotiated the ITO, 15 negotiating states began parallel negotiations for the GATT as a way to attain early tariff reductions. Once the ITO failed in 1950, only the GATT agreement was left.

• The functions of the GATT were taken over by the World Trade Organization which was established during the final round of negotiations in early 1990s 12.1.3 Trade-Related Investment Measures (TRIMs)

• TRIMs are the rules a country applies to the domestic regulations to promote foreign investment, often as part of an industrial policy.

• It is one of the four principal legal agreements of the WTO trade treaty. • It enables international firms to operate more easily within foreign markets. • In the late 1980’s, there was a significant increase in foreign direct investment throughout the world. However, some of the countries receiving foreign investment imposed numerous restrictions on that investment designed to protect and foster domestic industries, and to prevent the outflow of foreign exchange reserves.

• Examples of these restrictions include local content requirements (which require that locally-produced goods be purchased or used), manufacturing requirements (which require the domestic manufacturing of certain components), trade balancing requirements, domestic sales requirements, technology transfer requirements, export performance requirements (which require the export of a specified percentage of production volume), local equity restrictions, foreign exchange restrictions, remittance restrictions, licensing requirements, and employment restrictions. These measures can also be used in connection with fiscal incentives. Some of these investment measures distort trade in violation of GATT Article III and XI, and are therefore prohibited. 92

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12.1.4. Trade Related Aspects of Intellectual Property Rights (TRIPS)

• TRIPS is an international agreement istered for the first time by the World Trade Organization (WTO) into the international trading system

• It sets down minimum standards for many forms of intellectual property (IP) •

regulation. Till date, it remains the most comprehensive international agreement on intellectual property

• It was negotiated at the end of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) in 1994.

• TRIPS contains requirements that nations’ laws must meet for: copyright rights, including the rights of performers, producers of sound recordings and broadcasting organizations; geographical indications, including appellations of origin; industrial designs; integrated circuit layout-designs; patents; monopolies for the developers of new plant varieties; trademarks; trade dress; and undisclosed or confidential information. TRIPS also specify enforcement procedures, remedies, and dispute resolution procedures.

• In 2001, developing countries were concerned that developed countries were insisting on an overly-narrow reading of TRIPS, initiated a round of talks that resulted in the Doha Declaration: a WTO statement that clarifies the scope of TRIPS; stating for example that TRIPS can and should be interpreted in light of the goal “to promote access to medicines for all.” Securities and Exchange Board of India (SEBI) The burgeoning growth of the stock markets in India has necessitated the establishment of a separate regulating agency for the securities market. Accordingly, Indian Government has ed the Securities & Exchange Board of India Act, 1992 to provide the establishment of the Securities & Exchange Board of India on the lines of Securities Exchange Commission of USA to protect the interests of investors in securities and to promote the development of and to regulate the securites market.

• SEBI is an autonomous body created by the Government of India in 1988 and given statutory form in 1992 with the SEBI Act 1992.

• • • • • • •

Its Head office is in Mumbai and has regional offices in Chennai, kalkota, and Delhi. SEBI is the regulator of Securities markets in India. SEBI has to be responsive to the needs of three groups, which constitute the market: the issuers of securities the investors the market intermediaries. SEBI has three functions rolled into one body quasi-legislative, quasi-judicial and quasiexecutive.

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• It drafts regulations in its legislative capacity, it conducts investigation and enforcement action in its executive function and it es rulings and orders in its judicial capacity.

• Though this makes it very powerful, there is an appeal process to create ability. There is a Securities Appellate Tribunal which is a three member.

• A second appeal lies directly to the Supreme Court. SEBI’s functions also include:

• promoting investors’ education; • training of intermediaries of secuities markets, • prohibiting fradulent and unfair trade practices relating to dealings in securities, • prohibiting insider trading in securities, • regulating substantial acquisition of shares and take-overs of companies etc. In pursuance of its powers SEBI has formulated guidelines and regulations relating to:

• • • • • • • • • • • • • • • • •

merchant bankers, bankers to an issue, registrars to issue, share transfer agents, debentures trustees, underwriters, FIIs, insider trading, registration of brokers, guidelings of portfolio management services, capital adequacy guidelines, guidelines for mutual funds, guidelines for asset management companies, guidelines relating to disclosure and investor protection, book building, substantial acquisition of shares and takeovers, depositories and participants etc.

Students may go through the relevant websites for latest information on SEBI.

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STUDY NOTE - 3 FINANCIAL ANALYSIS AND PLANNING

SECTION - 1 FUNDS FLOW ANALYSIS This Section includes

Funds flow analysis



Factors which affect Flow of Funds



Purpose of funds flow analysis



Converting Balance Sheet into Funds Flow Statement



Sources of Funds



Classification of Source of Funds



Application of Funds



Presentation of fund flow statement



Sources of information for fund flow statement



Funds flow analysis (summary)

1.1 FUNDS FLOW ANALYSIS 1.1.1

Funds Flow analysis is carried out to examine whether Asset liability management is properly done with respect to both short term and long term funds.

1.1.2

This technique explains the changes between opening and closing values of assets and liabilities during a specified period of time.

1.1.3

The changes take place due to flow of funds as a result of transactions caused by various financial decisions. Some examples are given below: a. Change in Asset value could be due to purchase of fresh assets or sale of assets or both. b. Change in Debtors could be due to collection of cash or further sales to Debtors or both.

1.2 FACTORS WHICH AFFECT FLOW OF FUNDS 1.

Financial Decisions a. Sourcing (Financing) b. Application (Investment)

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3.

Performance of Business a. Profit is an important source of fund earned through performance of business operations b. Decline in Sales affects the internal generation adversely. ing Policies: a. Changes in Inventory Valuation

1.3 PURPOSE OF FUNDS FLOW ANALYSIS 1.3.1

1.4

The following questions are answered by funds flow analysis: a. Where from the funds came? b. Where did the funds go? c. How did the organisation finance its working capital? d. How much funds were diverted from long term to short term and short term to long term? e. Are projects undertaken in the previous years get additional funds? f. Is there any change in the financial policy? g. How much of operational efficiency contributing to capital needs of the company.

CONVERTING BALANCE SHEET INTO FUNDS FLOW STATEMENT Sources

Application

Increase in Liabilities

Increase in assets

- Long-term

- Long-term

- Short-term

- Short-term

Decrease in assets

Decrease in Liabilities

- Long-term

- Long-term

- Short-term

- Short-term

1.5 SOURCES OF FUNDS 1.5.1

Sources of funds are given below: a. Increase in Equity b. Increase in Debt c. Increase in Reserves & Surplus d. Decrease in Fixed Assets e. Decrease in Debtors f. Decrease in Inventory g. Increase in Current Liabilities

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1.6 CLASSIFICATION OF SOURCE OF FUNDS 1.6.1

The Sources can be classified as Internal Sources and External Sources.

1.6.2

Internal Sources constitute mainly the Profits of the organization or sale of assets or investments. Funds generated through internal sources are an indication of strength of an organization.

1.6.3

External source can be in the form of equity or debt. External debt source can be further classified in to long term and short term sources.

1.7 APPLICATION OF FUNDS 1.7.1

Funds generated and sourced can be applied the following ways: a. Investment in fixed assets b. Increase in debtors & other current assets c. Repayment of long term debt d. Decrease in current liabilities e. Financing cash Loss in business operation f. Payment of Dividend/Taxes

1.8 PRESENTATION OF FUND FLOW STATEMENT 1.8.1

Fund flow statement can be presented in the following three formats; 1. Total resources basis 2. Working capital basis(Impact on working capital) 3. Cash basis(Impact on cash)

1.9 SOURCES OF INFORMATION FOR FUND FLOW STATEMENT a.

Balance sheet (shows net effect)

b.

Balance Sheet and Profit and loss (shows net effect plus some important flows like dividends)

c.

Balance sheet, Profit and loss and schedules (shows much more of details)

1.10 FUNDS FLOW ANALYSIS (SUMMARY) 1.

Flexible approach tailored to a situation

2.

The Art of asking significant questions

3.

Where shall we put our funds to best use in the interests of shareholders?

4.

Where shall we able to get funds for taking advantage of opportunities?

5.

Constant shifting of funds in sources and uses is what is happening in an organization

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Changes in balance sheet captures the net effect Selling on credit shifts funds from finished goods to debtors Flow of funds help in appraising the impact of the management decision made during a certain period Funds means shift in economic values

Illustration of funds statement: Year 1

Year 2

Change

231.00

245.70

14.70

0

14.7

450.80 807.10 1170.70 2659.60 11070.40 6410.70 4659.70 574.80 260.90 8155.00

314.90 843.50 1387.10 2791.20 11897.70 6618.50 5279.20 735.20 362.30 9167.90

-135.90 36.40 216.40 131.60 827.30 207.80 619.50 160.40 101.40 1012.90

135.9 0 0 0 0 207.8 0 0 0 0

0 36.4 216.4

Liabilities Notes payable s payable

65.30 571.20

144.50 622.80

79.20 51.60

79.2 51.6

0 0

Accrued taxes

346.30

275.00

-71.30

0

71.3

Short term debt Current maturities Total current liabilities Long term debt Deferred taxes Deferred credits Total liabilities Common stock Share Retained earnings Total equity

433.70 30.40 1446.90 1542.50 288.40 27.00 3304.80 1627.70 2.80 3219.70 4850.20

544.30 50.80 1637.40 1959.90 405.30 36.30 4038.90 1644.10 27.70 3457.20 5129.00

110.60 20.40 190.50 417.40 116.90 9.30 734.10 16.40 24.90 237.50 278.80

110.6 20.4

0 0

417.4 116.9 9.3

0 0 0 0 0 0 0 0

Total

8155.00

9167.90

1012.90

Cash Marketable securities s receivable Inventories Total Current assets Gross Plant and equipment Accumulated depreciation Net plant and equipment Investments Other assets Total Assets

Source Application

16.4 24.9 237.5

160.4 101.4

0 1427.9

98

827.3

1427.9

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Sources of Funds

Amount

%

Decrease in Marketable Securities

135.9

10%

Depreciation

207.8

15%

Notes payable

79.2

6%

s payable

51.6

4%

Short term debt

110.6

8%

20.4

1%

Long term debt

417.4

29%

Deferred taxes

116.9

8%

Deferred credits

9.3

1%

Common stock

16.4

1%

Share

24.9

2%

237.5

17%

1427.9

100%

Cash

14.7

1%

s receivable

36.4

3%

Inventories

216.4

15%

Plant and equipment

827.3

58%

Investments

160.4

11%

Other assets

101.4

7%

Increase in

Current maturities

Retained earnings Total Application of funds Increase in

Decrease in Accrued taxes

0% 71.3

5%

1427.9

100%

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SECTION - 2 CASH FLOW ANALYSIS This Section includes

Cash flow analysis



Purpose



Format for cash flow analysis



Preparation of cash flow statement

2.1 CASH FLOW ANALYSIS 2.1.1

Cash Flow Statement reports the cash receipts and cash payments of an organization during a particular period.

2.1.2

Cash Flow Analysis aims to answer the following questions: 1. Why my company has not increased the dividend despite 50% growth in the profit? Where the profit has gone? 2. Is it a good company to lend money since several big companies delay their payment of interest and principal? 3. What the company has done with the money it raised through equity and debt for expansion? Have they used the money exactly for the expansion? ing statements fail to give a clear reply to all these questions and hence the need to analyse cash flow for answers to above questions.

2.2 PURPOSE 2.2.1

The various purposes of Cash Flow Analysis are given below: 1. ing statements conceal more than what they reveal to the readers who are not familiar with the ing system; Cash flow statement is free from such complexities. 2. ing statements are prepared on the basis of accrual and hence the profit figure shown in the P & L is only an expected profit; Cash Profit computed under the Cash Flow statement is a realized profit of the year. 3. Readers of the cash flow statement can know the sources and uses of cash and also study whether the firm has adequate cash to meet some of its liabilities.

2.2.2

Importance of Cash Flow Analysis to Investors: “Corporate earnings reports communicate, at best, only part of the story. And, their most critical omission - in recognition that insufficient cash resources are a major cause of corporate problems

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particularly in inflationary times - is their failure to speak to a corporation’s cash position. Indeed, in my view, cash flow from operations is a better measure of performance than earningsper-share. What should be considered is more revealing analytical concepts of cash flow or cashflow-per-share, which reflect the total cash earnings available to management, - that is earnings before expenses such as depreciation and amortization are deducted. An even more sophisticated - and, in my opinion, more informative - analytical tool is free cash flow which considers cash flow after deducting such spiraling corporate costs as capital expenditures”.- Harold Williams (a former chairman of the SEC). 2.2.3

Importance of Cash Flow Analysis to Lenders: “Banks lend cash to their clients, collect interest in cash, and require debt repayment in cash. Nothing less, just cash. Financial statements, however, usually are prepared on an accrual basis, not on a cash basis. And projections? Same thing. Projected net income, not projected cash income. Yet, cash repays loans. Therefore, we are compelled to shift our focus if we truly wish to assess our client’s ability to pay interest and repay debt. We must turn our attention to cash, working through the roadblocks thrown up by accrual ing, to properly evaluate the creditworthiness of our client”. (RMA Uniform Credit Analysis, Philadelphia, Robert Morris Associates, 1982).

2.3 FORMAT FOR CASH FLOW ANALYSIS 2.3.1

The format for cash flow analysis is given below: Activities

Cash Inflow

Cash Outflow

Operating Activities Investment Activities Financing Activities 2.3.2

Cash flow from Operating Activities: 1.

2.

Cash Generated from Operations –

Cash Receipts from Customers

–

Less: Cash paid to suppliers & other operating expenses

–

Less: Interest Paid

–

Less: Income Tax Paid

Cash flow from extraordinary Items –

Less: Extraordinary Items

3. Net Cash from / used in operating activities 2.3.3

Cash flow from Investment Activities: 1. Loan and Advances 2. Interest & Dividend Received

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2.3.4

2.3.5

3. Proceeds on sale of investments 4. Proceeds on sale of fixed assets 5. Less: – Purchase of fixed assets – Investments in subsidiaries – Investments in trade investments – Loans and Advances repaid – Investments on Current Assets Cash flow from Financing Activities: 1. Proceeds from issue of Share Capital 2. Proceeds from Long-term Borrowings 3. Less: – Repayment of Loans – Dividend Paid Legal Requirements: 1. Clause 32 of Listing Agreement between the company and Stock Exchange has been amended and listed companies are now required to provide Cash Flow Statement along with Balance Sheet and Profit & Loss . The format provided in the Listing Agreement is ing oriented and of little use to ordinary readers. 2. IAS - 7 has recommended a simple Cash Flow Format

2.4 PREPARATION OF CASH FLOW STATEMENT 2.4.1 2.4.2 2.4.3

Cash flow statement is similar to funds flow statement, and it can be as detailed as required. But, extraction of this statement from balance sheet captures the net effect. Cash from operations needs to be explained. Cash from operations:

• Profit for the year + • Non-cash expenses+/• Changes in current assets/current liabilities other than cash 2.4.4

An illustration is given below: Sundry Debtors Opening Balance

10000

Closing Balance

30000

Sales

102

100000

Cash received from debtors

80000

cost of goods sold

60000

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Sundry debtors a/c Balance b/d

10000

Sales

100000

Total

110000

Cash

80000

Closing balance

30000 110000

Profit and loss cost of goods sold

60000

Profit

40000

Total

100000

sales

100000 100000

Cash form operation Profit

40000

-Increase in sundry debtors

-20000

Cash from operation

20000

Cash Flow Statement Sources of cash

2000

1999

Cash balance in the beginning of the year

54.08

92.51

502.34 126.83 0.29

583.52 -9.07 0.01

Reserves & Surplus Depreciation Write off of Miscellaneous Expenses Add: Dec.in CA & Inc in CL Reduction in Inventories Reduction in Sundry Debtors Reduction in Loans and Advances Increase in Current Liabilities More Provisions made Less: Inc.in CA & Dec in CL Increase in Inventories Increase in Sundry Debtors Increase in Loans and Advances made Decrease in Current Liabilities Reduction in Provisions made Cash From Operations

55.88 28.86 118.84 94.35

48.39 218.96

83.63 139.39

87.31 394.63

648.49

415.75

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Increase Share Capital Secured Loans Received during the year Unsecured Loans Received during the year Sale of Fixed Assets Conversion of Capital WIP in Fixed Assets Investments realised TOTAL CASH INFLOW

60.50 85.48

13.54 77.94

4.68 853.23

599.74

323.95

APPLICATION OF CASH Decrease in Share Capital Secured Loans discharged Unsecured Loans discharged Purchases of Fixed Assets Increase in Capital WIP Investments made during the year

493.30

155.62 74.21 315.83

TOTAL CASH OUTFLOW

817.25

545.66

35.98

54.08

Cash balance at the end of the year 2.4.5

Derived Cash Flows: Derived cash flows Net Operating Profit + Depreciation EBITDA +/- Changes in current assets/liabilities Operating cash flow - Taxes paid -Interest paid -current portion of long term debt Discretionary cash flow -Dividends paid Cash flow before long-term uses(CBLTU) +/-Net expenditure on fixed assets(PPE) +/-Net expenditure on investments +Non-core income +/- Other long term assets +/- Other long term liabilities +/- Exceptional/extraordinary income or expense Cash flow after investing activities +/- Share capital +/- Long-term debt +/- Short-term debt Cash flow after financing activities =Change in cash

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2.4.6 Cash flow analysis (other dimensions): Net Operating Profit + Depreciation EBITDA +/- Changes in current assets/liabilities Operating cash flow -Taxes paid Operating free cash flow -Interest paid Free cash flow -Dividends Residual free cash flow 2.4.7

Key questions with cash flow statements: 1. What is the trend in cash flow from operations? 2. Are the cash from operations adequate for routine and important expenses? 3. Compare operating cash flow with capital expenditure 4. What are the other major cash needs? 5. How are these needs met? 6. Take a balanced view 7. Whether short term and long term funds are balanced properly?

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SECTION - 3 FINANCIAL RATIO ANALYSIS This Section includes

Analysis of Financial Performance



Financial ratio analysis



Dupont Control Chart



Limitations of ratio analysis



Identification of information required to assess financial performance

3.1 ANALYSIS OF FINANCIAL PERFORMANCE 3.1.1 The main task of financial ing is to communicate financial information to enable s to take reasonable decisions. ing is the activity of identifying, measuring, recording and reporting on the resources and performance of an enterprise based on financial parameters. 3.1.2 While recognizing that financial information is a vital part of information for management decision making it is equally important to recognize that true analysis will necessitate looking behind and beyond the figures to ascertain what is actually represented. “Drawing quick conclusions is to be resisted as the information must be related to the situation in which the enterprise is, in of its competitive environment or stage of development”. (– Bowman and Asch, 1987). Decisions have to be taken only after properly interpreting the financial data to the specific needs of the case under consideration. 3.1.3 The common techniques of financial analysis are: a. Profitability analysis b. Ratio analysis c. Funds flow analysis d. Cash flow analysis

3.2 FINANCIAL RATIO ANALYSIS 3.2.1 Ratios are worked out in a number of areas relating to an organization. These include an analysis of the following: a. Capital structure b. Asset deployment c. Liquidity 106

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

d. e. f. g. h. i.

Utilization Expenses Coverage Profitability Analysis from different stakeholders’ perspective Shareholder wealth creation Ratio Summary

Areas of concern for management

Purpose

Analysis of Capital structure Debt/Equity

Assess Financial risk and debt capacity

Analysis of deployment of funds Fixed assets/Long term funds Inventory/Current assets Receivables/Current assets Loans&Advances/Current assets

Extent of diversion of long term funds to short term assets and vice versa Feel for the application of funds in these areas

Analysis of liquidity Current Ratio Quick Ratio

Ability to meet the immediately maturing obligations

Analysis of Utilisation Sales/Total assets Sales/Fixed assets Sales/Current assets Sales/Inventory Sales/Debtors Operating Cycle Inventory Days Debtors Days Analysis of expense Raw material cost/sales Power & Fuel cost/sales Employee cost/sales Selling and /sales Operating cost/sales

Efficiency in utilising assets Achieving higher turnover for a given level of investment Optimising investments Monitor idle funds

Efficiency in utilising assets Monitor idle funds Ratio Summary

Keep track of the trend in expenses and exercise cost contorl

Analysis of coverage Interest coverage

Ability to service lenders

Analysis of Profitability Return on investment Return on sales Return on equity

Overall performance evaluation from business point of view Efficiency in cost management and margin realisation Performance evaluation from equity shareholders point of view

Analysis-Shareholders perspective Earnings Per Share Price/Earnings Dividend Yield

Performance evaluation from equity shareholders point of view Market perception and valuation

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3.2.1 Some of the important financial ratios and their formulas are given below: Ratio

Calculation

Capital Structure

Debt is long term debt, and Equity is shareholders’ funds. Measures long term solvency and risk, Debt capacity, Financial leverage, Trading on equity

Debt equity ratio

Long term debt + Value of Leases Equity

Long term debt ratio

Long term debt_____ Long term debt + Equity

Total debt ratio

Total Liabilities Total Assets

Asset deployment Fixed assets/long term funds Current assets/total assets - Inventory/current assets - Receivables/current assets - Cash/current assets Efficiency Ratios Asset Turnover ratio

Sales / Average total assets

Net Working Capital Turnover ratio

Sales / Average Net Working Capital

Inventory Turnover ratio

Cost of Goods sold / Average Inventory

Days’ sales in inventory

Average Inventory___ Cost of Goods sold / 365

Average Collection period

Average Receivables / Average daily sales

Coverage Cash Coverage ratio

EBIT + Depreciation Interest payments

Times interest earned

EBIT _ Interest payments

Total coverage

EBI-Tax/(interest + instalment)

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Profitability Ratios Net Profit Margin

(EBIT – tax) / Sales

Return on assets

(EBIT – tax) / Average total assets

Return on equity (ROE)

PAT / Equity

Return on Sales (ROS)

PAT / Sales

Return on investment (ROI)

PBIT / Capital employed

Payout ratio

Dividends / Earnings

Plowback ratio

1 - Payout ratio

Liquidity Ratios Net Working Capital to Total assets

Net Working Capital / Total assets

Current Ratio

Current Assets / Current Liabilities

Quick Ratio

Current Assets less Inventories/Current Liabilities

Cash Ratio

Cash + Marketable securities / Current Liabilities

Market Value Ratios (Analysis from Shareholder’s perspective) Earnings Per Share (EPS)

Profit after tax/No. of. Equity shares

Price Earnings (P/E) Ratio

Market Price/EPS

Dividend Yield

Dividend per share/Market price

Market to book ratio

Stock price / Book value per share

Tobins Q

Market Value of assets / Estimated replacement cost

3.3 DUPONT CONTROL CHART 3.3.1

The Dupont Corporation developed in 1930s a reporting system for management of its multi-product, multi-location businesses, and it has retained its pre-eminence over the years as an important framework for reviewing performance. It is a break-down of ROE and ROA into component ratios: ROA ROE ROA ROE

= (EBIT – Taxes) / Assets = (EBIT – Taxes - Interest) / Equity = (Sales / Assets) x [(EBIT – Taxes) / Sales] Asset Turnover x Profit Margin = (Assets/Equity) x (Sales/Assets) x [(EBIT–T)/Sales] x [(EBIT–T-I)/(EBIT-T)] Leverage Asset Turnover Profit Margin Debt burden

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3.4 LIMITATIONS OF RATIO ANALYSIS 3.4.1

Financial ratio analysis and comparison of same with benchmark figures has its limitations due to a number of factors. These include the following: 1. 2. 3. 4. 5. 6. 7.

3.4.2

Variations in ing policies among various companies Window dressing Lack of understanding of basic principles Current economic and industry scenario Interpretation of results changes made in groupings in expenses in different years and most importantly Ratios change from company to company based on the mix of capital and the structuring of capital even when the level of revenue mains the same.

It is therefore suggested that a longer term view is taken by doing a trend analysis, looking at comparative / benchmark industry performance, and evaluating the extent of correlation among various ratios. It may be noted that ‘one swallow does not make a summer’.

3.5 IDENTIFICATION OF INFORMATION REQUIRED TO ASSESS FINANCIAL PERFORMANCE 3.5.1

Information is available in a number of places and number of sources. These are given below: 1. The company’s Annual Report: This is the most vital source, as it offers a wealth of information about a company’s performance. The Directors’ Report; Management discussion on business environment and prospects, Report on corporate governance, Auditor’s Report with qualifications if any; audited Balance Sheet; audited Profit & Loss ; Schedules & Notes to s; ing policies; Trend analysis and past performance data; etc. 2. Company’s website. 3. Company’s filings with statutory authorities such as Registrar of Companies, SEBI, RBI etc 4. Company’s returns filed with various authorities such as Income Tax, Excise, Sales Tax, PF Departments etc. 5. Information provided to Banks and financial institutions. 6. Information available with industry bodies and trade associations, Chambers of Commerce etc. 7. Information published in financial newspapers and magazines by experts in the industry etc.

3.5.2

A financial analyst should look at multiple sources of information to obtain as much information as possible to enable completeness as well as cross-validation.

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STUDY NOTE - 4 CAPITAL BUDGETING

SECTION - 1 COST-VOLUME-PROFIT ANALYSIS This Section includes

Cost-Volume-Profit Analysis



Assumptions of CVP Analysis:



Benefits of CVP:



Time Value of Money

1.1 COST-VOLUME-PROFIT ANALYSIS 1.1.1

Cost-Volume-Profit (CVP) Analysis, also known as Break-even Analysis is a Short-Term Planning and Analysis Tool. It is widely used in financial analysis, especially to see the level at which a unit has to operate to cover its fixed costs and subsequently get into profit mode.

1.2 ASSUMPTIONS OF CVP ANALYSIS 1.2.1

A number of assumptions are commonly made with respect to CVP analysis: 1. The analysis assumes a linear revenue function and a linear cost function. 2. The analysis assumes that price, total fixed costs and unit variable costs can be accurately identified and remain constant over the relevant range. 3. The analysis assumes that what is produced is sold. 4. For multiple-product analysis, the sales mix is assumed to be known. 5. The selling prices and costs are assumed to be known with certainty Any change between assumption and actual on above assumptions would tilt the CVP considerably.

1.3 BENEFITS OF CVP 1.3.1

The benefits of CVP Analysis are given below: 1. Assists in establishing prices of products. 2. Assists in analyzing the impact of volume on short-term profits.

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CAPITAL BUDGETING 3. Assists in focusing on the impact that changes in costs (variable and fixed) have on profits. 4. Assists in analyzing how the mix of products affects profits. 5. Absorption of Fixed Cost and the stage when the additional Fixed costs have to be committed and the resultant investment decisions to be made.

1.4 CVP ANALYSIS: A SIMPLE ILLUSTRATION Fixed costs (F) = Rs.40,000 Selling price per unit (P) = Rs.10 Variable cost per unit (V) = Rs.6 Tax rate = 40% 1. What is the break-even point in units? 2. What is the break-even point in Rs.? 1. Let X = break-even point in units Operating income = Sales revenue - Variable expenses - Fixed expenses 0 = Rs.10X – Rs.6X – Rs.40,000 Rs.10X – Rs.6X = Rs.40,000 Rs.4X = Rs.40,000 X = 10,000 units 2. Break-even point in Rs. sales is: 10,000 x Rs.10 or Rs.100,000 This can be shown with a variable-costing income statement. Sales (10,000 x Rs.10) Rs.100,000 60,000 Less: Variable expenses (10,000 x Rs.6) Contribution margin Rs. 40,000 40,000 Less: Fixed expenses Profit before taxes 0 0 Less: Income taxes Profit after taxes 0 ====== 1.5.0 Alternative approach to solving break-even point in sales price: Let X equal break-even sales in rupees Operating income = Sales revenue - Variable expenses - Fixed expenses 0 = X - 0.6X – Rs.40,000 X - 0.6X = Rs.40,000 0.4X = Rs.40,000 X = Rs.100,000 Note: V is the variable cost percentage which is obtained by: 112

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Variable Cost per Unit 6 = = 0 .6 Selling Pr ice per Unit 10 1.6.0

Assume that a company has the following projected income statement: Rs. Sales

100,000

Less: Variable expenses

60,000

Contribution margin

40,000

Less: Fixed expenses

30,000

Income before taxes

10,000 ======

Break-even point in Rs. (R): R = Rs.30,000/0.4 = Rs.75,000 Margin of Safety = Rs.100,000 – Rs.75,000 = Rs.25,000

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CAPITAL BUDGETING

SECTION - 2 CONCEPT AND NATURE OF LEVERAGES This Section includes

The basic concept of Leverage



Use of Leverages in Finance

2.1 THE BASIC CONCEPT OF LEVERAGE 2.1.1

The concept of leverage has its origins in Science, more specifically in Physics. Let us recall how the simple crowbar was used to illustrate a fundamental, but eminently useful concept.

2.1.2

Consider the example of a young boy using a pole to move a heavy stone. He places one end of the pole under the edge of the stone. He s the pole on a brick placed close to the stone. He pushes downwards at the other end of the pole. This helps him move the stone easily.

2.1.3

The pole that the boy uses is a lever. The downward force he applies at one end of the pole is called the effort and the stone he lifts is referred to as the load. The pole was ed at the point of resting on the brick called fulcrum. By using a small effort the boy was able to lift a large load.

2.1.4

Thus, a lever is a simple machine that makes it easier to move a load.

2.2 USE OF LEVERAGES IN FINANCE 2.2.1

In financial management we shall discuss two important types of leverages, referred to as Operating Leverage and Financial Leverage, arising out of the fixed costs in an organization’s cost structure.

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SECTION - 3 OPERATING AND FINANCIAL LEVERAGES This Section includes

Operating Leverage Financial Leverage Combined Leverage

3.1 OPERATING LEVERAGE 3.1.1

Operating Leverage arises from the presence of fixed operating costs. The fixed operating costs considered here include costs such as depreciation, salaries, property taxes, and advertising expenses, but do not include interest charges or financing costs.

3.1.2

With fixed operating expenses, a small change in sales will result in more than equal change in PBIT.

3.1.3

Consider the following example: Assume that a company has the following projected income statement (given earlier in Chapter 1): Rs. Sales 100,000 Less: Variable expenses 60,000 Contribution margin 40,000 30,000 Less: Fixed expenses Income before taxes 10,000 ====== Degree of Operating Leverage (DOL) = Rs.40,000/Rs.10,000 = 4.0 Now suppose that sales are 25% higher than projected. What is the percentage change in profits? Percentage change in profits = DOL x percentage change in sales Percentage change in profits = 4.0 x 25% = 100%

Verification: Sales Less: Variable expenses Contribution margin Less: Fixed expenses Income before taxes

Rs. 125,000 75,000 50,000 30,000 20,000 ======

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CAPITAL BUDGETING 3.1.4

Operating leverage is measured by Degree of Operating Leverage (DOL).

DOL =

3.1.5

Percentage Change in PBIR Percentage Change in Output

=

Q( P − V ) Q( P − V ) − F

=

Contributi on PBIT

As we know, PBIT is nothing but Profit Before Interest and Tax. This can be expressed by the following equation: PBIT = Q x (P – V) – F Where, Q denotes the quantity produced and sold, P the selling price per unit, V the variable cost per unit, and F the fixed cost.

3.1.6

DOL and Business Risk: Business Risk here is basically the variability in PBIT, that may be caused by variability in sales and production costs.

3.2 FINANCIAL LEVERAGE 3.2.1

Financial leverage arises from the use of fixed cost financing. With fixed cost financing, a small change in PBIT will result in more than equal change in EPS (earnings per share).

3.2.2

Consider the following example: Company

A

B

C

Debt

0

5000

7000

8%

Interest

Equity

10000

5000

7000

50%

Tax

Total

10000

10000

10000

PBIT

1000

1000

1000

0

400

560

PBT

100

600

440

Tax

500

300

220

PAT

500

300

220

ROE

5.00%

6.00%

7.33%

Interest

3.2.3 Financial leverage is measured by Degree of Financial Leverage (DFL).

DFL =

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Percentage Changein EPS Percentage Change in PBIT

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3.2.4 It flows from the definition of PBIT given above that PAT (Profit After Tax) can be represented as follows: PAT

= (PBIT – I) (1 – T) = [Q x (P – V) – F – I] (1 – T)

3.2.5 It is well known that EPS is given by the following equation:

EPS =

PAT N

Where, N = Number of outstanding equity shares. In case there is any preferred dividend Dp, then,

EPS = 3.2.6

ΠAT − D p N

DFL and Financial Risk: Financial Risk here is basically the variability in EPS, that may be caused by financial leverage, which itself is due to the variability in PBIT.

3.3 COMBINED LEVERAGE 3.3.1

Combined or total leverage refers to the combination of operating and financial leverages.

3.3.2

Combined / Total leverage is measured by Degree of Total Leverage (DTL).

DTL =

Percentage Change in EPS Percentage Change in output

DTL = DOL x DFL 3.3.3

DTL and Total organization Risk: The Operating and Financial Leverages may be combined in different proportions to off-set the negative of each and achieve an overall desirable level of risk exposure.

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FINANCIAL STRATEGY

STUDY NOTE - 5 FINANCIAL STRATEGY

SECTION - 1 INTRODUCTION TO FINANCIAL STRATEGY This Section includes

Concept of Financial Strategy

1.1. WHAT IS FINANCIAL STRATEGY? 1.1.1

Financial strategy is a topic of importance to middle and senior line managers, who face regularly a multiplicity of financial issues in their organisation. A sound financial strategy seeks to answer: a. How does a Chief Financial Officer (CFO) determine the long-term target capital structure? b. When to form holding and subsidiary structure or branch offices or subsidiaries overseas? c.

When and how should a company go public?

d. Is it better to take a company private in a leveraged buyout or to borrow money and repurchase stock? e.

Can a CFO use derivatives in structuring acquisitions and share buybacks?

f.

How does a CFO benefit out of doing business in other countries?

g. Above all, how can a CFO make sure that everyone in the company contributes to the common objective of maximising shareholder value? h. How much should one pay for a company? ? i. 1.1.2

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What is the best way to fight a hostile bid?

Strategic financial decisions are based on rigorous cash-flow forecasts, together with accurate estimation and management of risk. It focuses on shareholder value creation, explore ways of increasing that value – both real and perceived – through: a.

astute choice of financing methods

b.

financial restructuring, such as recapitalisations, share buybacks and leveraged buyouts

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c.

asset restructuring, such as takeovers, mergers and acquisitions, spin-offs and equity carve-outs

d.

credible and compelling communication with shareholders

e.

developing a strong culture where all decision makers are motivated to create value

f.

understanding how to increase the value of the company by appropriate investment

g.

developing knowledge about the financial markets – particularly how the markets perceive the CFO’s decisions and how CFO can change their perceptions

h.

appreciating the financial strategy issues that affect the organisation.

i.

undertaking financial analysis of the organisation and interpreting the results in the context of lending and investing decisions.

j.

assessing the financial risks that the organization faces, in particular credit, interest and foreign exchange risk and adopting risk-hedging strategies that suit the risk profile of the organisation.

k.

understanding how the organization should measure financial performance internally and how the financial performance is assessed by stakeholders in a global context.

l.

Benchmarking strategies with competitors in Industry globally without restricting Comparisons to only local players.

BEST PRACTICES IN CREATING A STRATEGIC FINANCE FUNCTION An SAP/APQC Collaboration In the wake of recent ing scandals and in the increasingly competitive business environment, many CFOs and the finance organizations they lead have started to take on new strategic roles within the enterprise. They are aiming at enforcing stricter control processes to ensure legal and regulatory compliance, offering strategic insights into the internal and external business environment, and connecting the business strategy with daily operations through performance tracking. The trend toward a more strategic role is echoed by the responses of participants in recent research conducted by APQC, an internationally recognized nonprofit organization that provides best-practice research, metrics, and measures. The participants indicated that, three years down the road, they anticipate spending 30% more time on decision and management. According to the same research, however, in spite of their aspirations, participants have not made much progress toward a greater strategic role. Finance organizations, no matter what their size, report to APQC that they still spend almost two-thirds of their time on transaction processing and controls and only one-third on decision and management.

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FINANCIAL STRATEGY

The difficulty in evolving the finance role lies in bridging the current gap between the finance function that emphasizes greater efficiency and the finance function that becomes a partner in managing the business. The best companies have found that reaching the goal of a more strategic finance function warrants a two-step approach, as follows: 1.

These companies improve the efficiency of the various functions that come under the finance umbrella and, in the process, free up corporate resources for other activities. As one global treasury manager put it, “We must develop a finance function that is as efficient as it can be, replicate it globally, and then use it effectively to help us quickly establish brands and enter new markets.” Companies like this one choose a variety of approaches to streamline and automate finance functions while ensuring that they keep customers happy (in the case of shared-services arrangements).

2.

With the efficiency of the transaction and control functions assured, these companies can turn to devising a more strategic approach for finance – giving finance not only more of a decision-making responsibility in risk management and compliance but also a proactive role in managing the daily cash position and thus increase resources for quick strategic moves.

One global consumer products company took a two-step approach to a more strategic path for finance. In the first step, the company developed a more efficient cash management, s payable, and s receivable group of functions in its worldwide operations, based on greater transparency of information. In the second step, the company developed “straight-through processing” along every level of the finance function, leveraging its global reach to maximize cash management efficiency, foreign exchange exposure, and the global supply chain to help fund growth, participate in new marketing and distribution arrangements, and comply with worldwide regulations. CONCLUSION: A CHECKLIST FOR A STRATEGIC FINANCE FUNCTION The best companies, and their CFOs, recognize the importance of ready access to the right information to drive the right choices between different variables. To help determine whether your finance function is moving toward a strategic approach, take a moment and decide whether your system does the following:

•

Accelerates closing processes through automation, workflow, and collaboration

•

Improves business analysis and decision by providing historical and forward-looking views, including benchmarks

•

Deploys performance management tools that analyze the company and its resources

•

Maximizes cash flow through improved billing, receivables, collections, payments, and treasury management

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•

Increases effectiveness of compliance efforts through comprehensive auditing, deeper reporting, and management of internal controls (Sarbanes-Oxley) In addition, a truly integrated systemic foundation should help you achieve the following:

•

Develop a closed-loop management process of strategy formulation, communication of goals, and measurement

•

Monitor the performance of strategic key success factors using external and internal benchmarks

•

Use tools that a financial planning process that integrates global strategic planning and specific operational planning problems in a closed-loop process In a similar way, you can also determine whether you are on the right track if your financial software provides the following:

•

A single source for financial information (a prerequisite for managing business processes beyond financials more effectively)

•

More timely access to accurate data, improving communication between finance and operations

•

Increased alignment between front- and backoffice applications, enabling management to better ister and track business strategy and decisions

•

Reduced cost of compliance with industry regulations (U.S. Financial ing Standards Board and Sarbanes-Oxley)

•

Improved security and controls and reduced risk of contractual and regulatory noncompliance

•

Improved predictability, particularly with budget

One CFO itted, “Until we began to appreciate the importance of simplicity in thinking through our finance function and making it more strategic, we did not realize the way that technology can help you deal with complexity, and allow you to achieve the strategic goals finance should achieve.” Are You a Strategic CFO? As far as they’ve come, many senior finance executives still have the nagging feeling that they could be doing more. Lisa Yoon, CFO.com January 11, 2006 Bean counter. Numbers cop. Chief financial officers have long outgrown those stereotypes;

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FINANCIAL STRATEGY today a more appropriate description might be business partner, strategist, first deputy to the CEO. Yet as far as they’ve come, many senior finance executives still have the nagging feeling that they could be doing more. Dan Chenoweth, a Denver-based business consultant and former finance executive, believes there are several reasons why finance chiefs don’t always play a big enough role at the strategy table: •

First is the lingering self-perception of being the “reporter”; some CFOs don’t view themselves as a partner with the rest of the senior team.

•

Another reason is the famous finance-chief personality — reserved, reactive, even ive in the strategic-planning process.

•

Finally, says Chenoweth, CFOs still tend to view their ultimate responsibility as fiduciary — saving company funds and reining in spending — rather than taking on the broader role of value creator.

That CFOs have these characteristics and self-perceptions is “an increasingly invalid generalization,” maintains Steve Wasko, chief financial officer of Northbrook, Illinois-based Nanosphere Inc. He points to a shift in management philosophy from a model centered around the chief executive, in which senior managers carried out the CEO’s vision, to today’s increasingly teamoriented approach, in which the CFO and other senior managers help shape the company’s direction and run the show. Melissa Cruz, CFO of Waltham, Massachusetts-based BladeLogic, takes a more abstract view: “The role of the CFO is about imagining the future with the management team,” she explains, “and then translating that into financial action.” Chenoweth does agree that there has been a “profound change” in the role of CFOs in recent years, but adds that they could “do more to blow their own horn at the strategy table.” “Do you still see CFOs with green eyeshades?” says Wasko. “Absolutely. But companies that have such CFOs are at a disadvantage.”

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SECTION - 2 FINANCIAL & NON-FINANCIAL OBJECTIVES OF DIFFERENT ORGANIZATIONS This Section includes

Introduction



The Need for a Range of Performance Measures



Financial vs. Non-Financial Measures



Stakeholders of an organization



Non-Financial Performance Indicators



Shareholder impact of non-financial objectives



Conclusion

“It is not possible to manage what you cannot control and you cannot control what you cannot measure!” - Peter Drucker. “We consider the advantages and disadvantages of stakeholder-oriented firms that are concerned with employees and suppliers as well as shareholders compared to shareholderoriented firms. Societies with stakeholder-oriented firms have higher prices, lower output, and can have greater firm value than shareholder-oriented societies. In some circumstances, firms may voluntarily choose to be stakeholder-oriented because this increases their value. Consumers that prefer to buy from stakeholder firms can also enforce a stakeholder society. With globalization entry by stakeholder firms is relatively more attractive than entry by shareholder firms for all societies”. - Abstract of Report tilted “Stakeholder Capitalism, Corporate Governance and Firm Value” by Franklin Allen, University of Pennsylvania, Elena Carletti, Center for Financial Studies, and Robert Marquez, Arizona State UniversityAugust 4, 2007

2.1. INTRODUCTION 2.1.1

Inexorable change is the order of the day, and conventional theories and business practices are not providing the necessary guidance and for decision-making. Change in every aspect and in the entire outlook is a constant factor. Business leaders are dissatisfied with the traditional measurement tools as organizations today increasingly perform in real time environment. New tools are being developed to measure the outcome of changes and their effective contribution to the bottom-line.

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FINANCIAL STRATEGY

2.1.2

The three roles of measurement are: a. Effectiveness – Are we doing the right things? b. Efficiency – Are we doing them well? c.

2.1.3

Excellence – Are we doing them consistently, responsively to meetc h a n g i n g requirements

Why do we measure? a. To know current status, degree of achievement and how far to go for ultimate goals to be achieved; b. For strategic alignments to communicate and reinforce messages to employees on company focus, direction and targets. c.

For strategic learning: to know what works and what does not work & to take better decisions: • to identify pockets of excellence practices and universalize them • to identify relationships between measures • measurement is the trigger for excellence in performance & continuous improvement • Strategic Management control of cost

2.1.4

Measurement system of performance has to progress from being reactive to being proactive and finally to be responsive, as the right metrics drive world class performance. Criteria of success are different from product to process, company perspective to stakeholder perspective, revenue to reputation and financial to nonfinancial.

2.2. THE NEED FOR A RANGE OF PERFORMANCE MEASURES 2.2.1

Organisational control is the process whereby an organisation ensures that it is pursuing strategies and actions which will enable it to achieve its goals.

2.2.2

As to the selection of a range of performance measures which are appropriate to a particular company, this selection ought to be made in the light of the company’s strategic intentions which will have been formed to suit the competitive environment in which it operates and the kind of business that it is. It is generally in line with the long term vision, mission and strategies of the company.

2.2.3

For example, if technical leadership and product innovation are to be the key source of a manufacturing company’s competitive advantage, then it should be measuring its performance in this area relative to its competitors. If a service

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company decides to differentiate itself in the marketplace on the basis of quality of service, then, amongst other things, it should be monitoring and controlling the desired level of quality. The focus thus lies on quality and not just volume at any cost or price. 2.2.4

Whether the company is in the manufacturing or the service sector, in choosing an appropriate range of performance measures it will be necessary, however, to balance them, to make sure that one dimension or set of dimensions of performance is not stressed to the detriment of others. While most companies will tend to organise their ing systems using common ing principles, they might differ widely in the choice, or potential choice, of performance indicators.

2.2.5

Authors from differing management disciplines tend to categorise the various performance indicators that are available as follows:

2.2.6

competitive advantage

flexibility

financial performance

resource utilisation

quality of service

innovation

These six generic performance dimensions fall into two conceptually different categories. Measures of the first two reflect the success of the chosen strategy, i.e., ends or results. The other four are factors that determine competitive success, i.e., means or determinants.

2.2.7

Another way of categorising these sets of indicators is to refer to them either as upstream or as downstream indicators, where, for example, improved quality of service upstream leads to better financial performance downstream.

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FINANCIAL STRATEGY

Table 1. Upstream Determinants and Downstream Results

Performance Dimensions Competitiveness

Financial Performance

Types of Measures Relative market share and position Sales growth, Measures reg customer base Profitability, Liquidity, Capital Structure, Market Ratings, etc. Reliability, Responsiveness, Appearance,

Quality of Service

Cleanliness, Comfort, Friendliness, Communication Courtesy, Competence, Access, Availability, Security etc.

Flexibility Resource Utilisation Innovation

Volume Flexibility, Specification and Speed of Delivery Flexibility Productivity, Efficiency, etc. Performance of the innovation process, Performanc of individual innovations, etc.

Source: “Performance Measurement in Service Businesses” by Lin Fitzgerald, Robert Johnston, Stan Brignall, Rhian Silvestro and Christopher Voss, page 8.

2.3. FINANCIAL VS. NON-FINANCIAL MEASURES 2.3.1 In many companies across the world, the familiar way is to view everything in of the bottom line. In this sort of corporate environment, financial indicators remain the fundamental management tool and could be said to reflect the capital market’s obsession with profitability as almost the sole indicator of corporate performance. Opponents of this approach suggest that it encourages management to take a number of actions which focus on the short term at the expense of investing for the long term. It results in such action as cutting back on R & D revenue expenditure in an effort to minimise the impact on the costs side of the current year’s P & L, or calling for information on cost benefit on expenses at too frequent intervals so as to be sure that targets are being met, both of which actions might actually jeopardise the company’s overall performance rather than improve it. 2.3.2 Presently, there is a realization among managers that because of the pre-eminence of money measurement in the commercial world, the information derived from the many stages preceding the preparation of the annual s, such as budgets, standard 126

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

costs, actual costs and variances, are actually just a one dimensional view of corporate activity. Increasingly, a large number of managers have recognized in recent years that a big part of a company’s true value depends upon intangible factors such as organizational knowledge, customer satisfaction, product innovation and employee morale, rather than on physical assets like machinery or real estate. While companies recognize the importance of these intangible factors, understanding and measuring their role in value creation poses a formidable challenge. Human resources departments may know how to tabulate payroll for a certain plant, for instance, but if asked to measure the motivation of its employees, they would probably be on uncertain ground. And yet, employee motivation and turnover are as crucial to that plant’s profitability as the size of its payroll. That is the reason, employees are now called as ‘resources’ and the personnel department is called as human resources department. 2.3.3 Companies attach high value to financial performance. One reason could be that businesses have been tracking such performance longer than they have been trying to monitor how they are doing in areas such as employee satisfaction. Still, despite the importance of financial performance, executives ranked four other areas as being more important for future value generation: Employee satisfaction, supplier performance, product innovation and customer satisfaction. 2.3.4 The ability to manage alliances is seen as another crucial driver of future value. There are massive gaps between what executives believe are key drivers of future economic value and their organizations’ ability to measure performance in these areas. The biggest gap is in the customer category, which indicates that companies are still wrestling with ways to measure customer loyalty and satisfaction. Companies are also giving more weightage to assess how well they are managing alliances and fostering employee satisfaction as executives believe that both these areas are crucial drivers of future value. 2.3.5 Unless organizations come to grips with these issues, its performance measures will fail to its strategic objectives. Lack of good performance measures, could fail a good strategy. Besides, if companies track their performance in these key areas, this could lead to more dependable disclosure of their future prospects. It has also been found that with higher transparency and disclosure, the company’s cost of capital could go down due to reduced risk for investors.

2.4. STAKEHOLDERS OF AN ORGANIZATION 2.4.1 Few people would argue with the idea that commercial businesses’ aim to make profits and that decisions in these businesses are focused around how best to achieve this objective. The desire to be profitable need not, however, be all embracing and in practice it can be seen that companies are likely to pursue a wide range of objectives, which are both financial and non-financial in nature. 2.4.2 The first thing to note is that the suggestion that companies seek to make profits is a little imprecise. Does this mean that profit is sought at all costs, that maximising profit is the sole aim, or that managers/owners are happy with a specific “satisfactory” level

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FINANCIAL STRATEGY of profit? The exact answer will vary between businesses, as the priorities of owners and managers differ, but it is possible to establish some basic guidelines. 2.4.3 It is useful to that although a company is a separate entity in the legal sense, in reality it is made up of a collection of individuals and interest groups, all of whom have personal objectives to fulfil. Management will constantly be trying to balance the return to these groups e.g., shareholders or employees and discussion on corporate objectives really comes down to a compromise which takes of what the different groups are seeking. Consequently some objectives may be financial in nature, such as a rise in earnings per share, whilst others will be non-financial e.g., shorter working hours, or an increase in the level of waste recycling in a manufacturing process. 2.4.4 A useful starting point for analysing non-financial objectives, is to specify the variety of stakeholders which may seek to influence company objectives, because they are affected by a company’s operations. The list includes: 2.4.5 Equity investors: In other words the owners of the business, who will be looking for a decent financial return on their investment. 2.4.6

Creditors: This group will want to ensure that the business maintains the liquidity at reasonable level required to repay its dues on time.

2.4.7

Customers: Who will be concerned about product/service quality, price adherence to delivery schedule.

2.4.8

Employees: Improved working atmosphere and conditions of work will be important to this group and so they may have a mix of financial and non-financial concerns.

2.4.9

Managers: Whose personal objectives may to some extent conflict with those of the owners. For example, a manager may seek to increase staff levels, as a way of increasing his personal status, but this may be lead to reduced profits.

2.4.10 The community at large: Communities are affected by company activities in a number of ways such as the use of land in a local area, the potential for pollution from effluents, commercial sponsorship of community projects and the impact of business activity on local transport systems. Corporate Social Responsibility (CSR) is very important for each company to fulfill its social obligations. 2.4.11 Government, both Central State, are interested in higher tax revenues from the corportes so that the Government can project a better budget estimates and actuals. 2.4.12 Faced with such a broad range of interest groups, managers are likely to find that they cannot simultaneously maximise profits and the wealth of their shareholders whilst also keeping all the other parties happy. In this situation, the only practical approach is to try and work to satisfy the various objectives rather than maximise any individual one. Adopting such a strategy means, for example, that the company might earn a satisfactory return for its shareholders, whilst at the same time paying reasonable wages to satisfy employees, and avoiding polluting the environment, hence being a “good 128

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citizen.” As a result, profit is no longer the sole corporate objective, and the pursuit of non-financial objectives has begun to be increasingly important, as part of a portfolio of corporate objectives which spread right out into the community of which they are a part.

2.5. NON-FINANCIAL PERFORMANCE INDICATORS 2.5.1

Professor Robert Kaplan of Harvard Business School in The Evolution of Management ing states : “..... if senior managers place too much emphasis on managing by the financial numbers, the organisation’s long term viability becomes threatened.” That is, to provide corporate decision makers with solely financial indicators is to give them an incomplete set of management tools.

2.5.2

The case is two-fold: that firstly not every aspect of corporate activity can be expressed in of money and secondly that if managers aim for excellence in their own aspects of the business, then the company’s bottom line will take care of itself.

2.5.3 Some of the important measures are given below : 1.

Balanced Score Card (BSC) : offers four perspectives A. Financial: How do we look to our owners B. Customer: How do customers see us C. Internal: What we must excel at D. Business development: How can we develop business further

BSC puts strategy and vision at centre and not control. The BSC drives performance throughout the organization. 2. Bench Marking 3. Economic Value Addition 4. Market Value Addition 5. Employee Value Addition 2.5.4

The non-financial indicators relate to the following functions: a. manufacturing and production b. sales and marketing c.

human resouces

d. research and development e.

the environment

f.

systems

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FINANCIAL STRATEGY 2.5.4

Therefore, whether a company is a manufacturer or a service provider, to be successful, its management should ensure that: a. products move smoothly and swiftly through the production cycle without any interruption or delay; b. warranty repairs are kept to a minimum and turned round quickly c.

suppliers’ delivery performance is constantly monitored

d. quality standards are continually reviewed and upgraded e.

sales orders are effected without backlog

f.

customer satisfaction assessment yardsticks are reviewed regularly

g. labour turnover statistics are analysed so as to identify managerial weaknesses h. R & D costs are kept at reasonable levels i. 2.5.5

the ing and finance departments understand the needs of business

A representative list of performance measures is given below:

1. Manufacturing and Production Indicators: a. Production process:

• indicators deriving from time and motion studies • production line efficiency • ability to change the manufacturing schedule in line with the changes in marketing plan

• reliability of component parts of the production line • production line repair record • keeping failures of finished goods to a minimum • ability to produce against the marketing plan • product life cycle • introducing concepts such as ‘kaizan’ for continuous improvement in processes b. Production quality:

• measurement of scrap

130

•

tests for components, sub-assemblies and finished products

•

fault analysis

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•

“most likely reasons” for product failures

•

actual failure rates against target failure rates

•

complaints received against the quality assurance testing programme

•

annualised failures as a % of sales value

•

failures as a % of units shipped

•

various indicators of product / service quality

•

various indicators of product / service reliability

•

going to the extent of ‘six sigma’ analysis to ensure quality.

c. External relationships with suppliers:

•

inventory levels and timing of deliveries

•

“just in time” inventory control measurements

•

stock turnover ratio

•

weeks stocks held

•

suppliers delivery performance

•

analysis of stock-outs

•

parts delivery service record

•

% of total requests supplied in time

•

% supplied with faults

•

quality and pricing when compared to supplies to competitors from the same sources

d. Sales delivery and service:

•

shipments vs. first request date

•

average no. of days shipments delayed

•

action taken report on response time between enquiry and execution

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•

measurements based on “staying close to the customer”

•

complaints rework

•

re-packaging / ease of opening

•

quality of packaging materials

•

customer satisfaction analysis

•

price of products comparisons

•

unsuccessful visit reports and analysis to find causes & effect remedies

•

monitoring repeated lost sales by individual salesmen

•

sales commission analysis

•

monitoring of enquiries and orders

•

sales per 100 customers

•

“strike rate” - turning enquiries into orders

•

analysis of sales by product line

•

by geographical area

•

by individual customer

•

by salesmen

•

matching sales orders against sales shipments - mismatch analysis

•

backlog of orders analysis

•

flash reports on sales

•

publication of sales teams performance internally

•

analysis of basic salaries and sales commissions

•

share of the market against competitors

•

share of new projects in the industry

•

new product / service launch analysis

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•

time to turn around repairs

•

delays in delivering to customers and level of customer goodwill

•

value of warranty repairs to sales over a period of time

3. People:

•

head count control

•

head count by responsibility

•

mix of staff analysis

•

mix of business analysis vs. staff personnel needs

•

skilled vs. non skilled

•

management numbers vs. operations staff

•

own labour / outside contractor analysis

•

workload activity analysis

•

vacancies existing and expected

•

labour attrition rate

•

labour turnover vs. local economy

•

% of overtime worked to total hours worked

•

absence from work

•

staff morale

•

cost of recruitment

•

number of applicants per advert

•

number of employees per advertising campaign

•

staff evaluation techniques

•

evaluation of staff development plans

•

monitoring of specific departments, eg. ing

•

speed of reporting to internal managers vs. HQ

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•

accuracy of reporting as measured by misallocations and mispostings

•

monitoring of departments performance long term

•

pay and conditions vs. competition

•

level of motivation and morale

•

employee satisfaction index analysis

4. Research and Development:

• evaluation vs. basic R&D objectives, strategic objectives and project objectives • product improvement against potential market acceptance • R&D against technical achievement criteria, against cost and markets • R&D priority vs. other projects • R&D vs. competition • R&D technical milestones • analysis of market needs over the proposed product / service life of R&D outcome

• top management audit of R&D projects • major programme milestones • failure rates of prototypes • control by visibility - releases, eg. definition release, design release, trial release, manufacturing release, first shipment release, R&D release

• competitor focus and market segment analysis before finalizing on outcome of R&D 5. Environment:

• work place environment yardsticks • cleanliness • tidiness • pollution and effluent disposal mechanism and effectiveness • catering facilities vs. competition • other facilities vs. competition

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• compliance with legal requirements • contribution to society • education, medical and other facilities provided to the society

2.6. SHAREHOLDER IMPACT OF NON-FINANCIAL OBJECTIVES 2.6.1

The impact of the pursuit of non-financial objectives upon shareholder wealth is not clear cut. There are many writers who would argue that companies which pursue a wide range of objectives find that they create for themselves a very positive public image and this serves to increase shareholder wealth. Others would argue that community type projects simply add to costs and thus erode profit, thereby reducing shareholder wealth. In reality, the truth probably lies somewhere between these two extremes. Carefully selected projects, particularly those which are community related, may well serve as a form of indirect advertising and raise the corporate profile and associated shareholder wealth. Other projects may simply represent a gesture of goodwill, on which no return is either sought or earned.

2.6.2

For example, suppose that a company decides to pursue an image of high product quality as a secondary objective. The aim is clearly non-financial in nature, but it will involve spending money on quality control and management projects which could add to costs and reduce profits. There is substantial research evidence from people like Juran, which suggests that “quality is free”. In other words, the gains from higher sales levels and reduced costs of warranty claims exceed the costs of the investment in quality improvements. Where this is the case, then the shareholders actually gain from the fact that the company has chosen to pursue a non-financial objective.

2.6.3

In other cases, the shareholder impact will be much more difficult to identify. Some companies have a very good reputation in of the facilities which they provide for employees. Such provision clearly costs money and absorbs funds which could be used elsewhere within a business and so it might be easy to take the view that pursuit of the objective of employee welfare is detrimental to shareholders. In fact, it may work that such policies serve to reduce staff turnover rates and increase productivity. It is quite possible for the aggregate benefits from such a policy to exceed the costs, so that shareholders see profits rise over the longer term. As with many things, whether a strategy has a positive or negative effect depends upon the time frame within which it is being judged.

2.7. CONCLUSION 2.7.1

Financial costs incurred for non-financial aspects such as quality, R&D, employee welfare etc may reduce the bottom-line in profit statements but would in the long run improve shareholder wealth.

2.7.2

The pursuit of non- financial objectives is associated with all types of organisations. To seek non-financial objectives is not to ignore the financial, but merely to acknowl-

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FINANCIAL STRATEGY edge that no single aim is of overriding importance. At the same time, non- financial objectives do not necessarily conflict with the financial and can in fact serve to prosper the interests of shareholders. A strong public image and good publicity must be important too, including, for example, for the Missionaries of Charity or the Ramakrishna Mission. The difficulty lies in reaching the right balance, which keeps shareholders happy but also allows other interest groups to believe that a company also has their interest at heart as well. The good manager must learn to be good at juggling. BusinessInsight (10/1/2003) CFO Project Volume 2 By Paul A.Boulanger, Accenture Business insight is the capability of organizing and analyzing financial, operational, and external information, enabling decision-makers to understand and act, before their competitors, to create sustainable shareholder value. Gone are the days when it was a major exercise for Unilever to identify and assess the performance of the 1,600 brands that comprised its global portfolio. As part of a new corporate growth strategy, the global portfolio has been reduced to 400 key brands, and a new data warehouse has been implemented. Global, regional, and national brand managers now have access to consistent data on sales performance and changes in customer awareness and attitude toward each brand. This information enables brand management to readily identify when and where to target promotional investments. Procurement directors have access to a rich data set of global vendor spend information upon which to predicate vendor negotiations. Unilever significantly increased the transparency of critical information in the areas of procurement, brand management, customer management, and finance. The results? A •2.1 billion reduction in direct procurement costs, a global view of the health of 400 key brands, and a single view of its most strategic (and most profitable) customers. The company also gained a single-stream reporting process by consolidating three different processes for producing financial, management, and category reports. Now all reports tally, eliminating substantive reconciliation at all levels of the business. At a time when Unilever needed to boost its share price and profitability, the transformation of its performance reporting capabilities (with Accenture’s help) enabled the enterprise to achieve dramatic improvements. During a time of flat industry performance, Unilever realized both top-line growth and increased shareholder value. A Critical and Growing Need The need to use performance management information effectively has been articulated for years. However, we are at a pivotal point in the evolution of performance management. It is more critical than ever for enterprises to address these capabilities. Decisions made now, capabilities constructed now, will shape a company’s competitive position for years to come.

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Why now? Four primary drivers are galvanizing organizations to address their use of information to drive business results. First, most companies have made little progress. Their executives are deeply dissatisfied with their organizations’ ability to leverage information for competitive advantage. Second, companies are experiencing unprecedented demands for ability in the current regulatory and economic environment. They require increased insight into the real drivers of business results. Third, technology is now at the stage where it can deliver on the vision promised for years. And last but not least, their competitors are moving. Recall the “pep” talk given to the salesmen in the movie Glengarry Glen Ross: “We’re adding a little something to this month’s sales contest. As you all know, first prize is a Cadillac El Dorado. Anybody want to see second prize? Second prize is a set of steak knives. Third prize is you’re fired.” The stakes are rising. Being unable to generate the competitive advantages that effective access to information can deliver is an increasingly dangerous position. Organizations and their executives are deeply dissatisfied with the state of their performance management information capabilities. Corporations are increasingly awash in information, yet continue to struggle in creating real “insight” to drive performance. There are several reasons for this continued struggle. Many companies have implemented enterprise resource planning (ERP) systems in ways that have not facilitated the generation of useful information. Accenture recently conducted a survey of 163 companies that had implemented ERP systems. The mean number of instances (separate and distinct implementations of the same software across regions or business units) was eight, with 32 percent having implemented from six to more than 20 distinct instances. This distributed ERP implementation strategy has resulted in disparate, disconnected sources of operational information. Further, with the decentralized governance of IT manifest in many companies, individual groups have driven their own development of data warehouses and data marts, contributing to increased fragmentation of information with little progress toward a “single version of the truth.” At some large companies, the data architecture is so fragmented that no one will take ability. The response is armies of analysts using batteries of spreadsheets, manually generating performance information. The cost of this analyst function within finance alone can exceed 0.5 percent of revenue. Also propelling the need for business insight is the regulatory and economic environment. Corporations are experiencing unprecedented demand for ability. The Sarbanes-Oxley Act in the United States is demanding that executives understand exactly what their companies’ financial results are saying and communicate these results clearly to the market. The signoff required of U.S. CEOs and CFOs is more than credits and debits. Rather, it is about understanding that reported business results are fairly represented based on personal knowledge. This translates into reporting transparency — being able to explain cause-and-effect relationships behind business results. Further, as markets continue to struggle and the investment environment languishes, companies that can increase the depth of their disclosure will create higher confidence and valuation in the market. According to a variety of analysts, as baby boomers retire and begin consuming their wealth, they will be replaced by a smaller generation, ending a savings and investment bulge. Analysts portend that we will see this in the next 10 years, putting downward pressure on stocks. Falling prices will force companies to provide even more useful information to attract investors. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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FINANCIAL STRATEGY One of the more compelling reasons for companies to actively pursue the development of business performance management capabilities is that technology is now at the stage where it can deliver on the vision promised for years. Integration technologies such as Kalido and Informatica have advanced to the point where they can more easily establish a common performance management language without remediating frontline transaction systems and compromising flexibility at the local business level. Business analytics applications now contain out-of-the-box functionality with the richness to develop metrics management, deliver online self-service reporting, and an intuitive discovery process through drill-down and information exploration that is useful to frontline managers and executives alike. Lastly, your competitors are moving. Leveraging information to derive business insight is becoming a significant competitive advantage. While there are far more instances of companies that have not made substantive progress than of progressive companies that have developed the capability to leverage information to their advantage, there are examples that should give executives pause: •

A global downstream oil producer was operating in 125 countries with several hundred separate operating companies having their own IT systems and reporting tools. It was unable to report consistent and timely information across operating units. By developing a performance management capability, key management information such as customer profitability could be segmented to better business decision-making at a country level while enabling data to be aggregated for regional and global reporting. As a result of improved customer profiling and reporting, the business unit increased its profitability and delivered overall savings of $140 million annually to the parent company.

•

Based on this success, the company applied the concept to its retail division, where it was experiencing intense competition for fuel sales and eroding profit margins. Non-fuel sales needed to be increased to generate higher margins and growth. However, disparate IT systems made the company unable to access product performance or category management information. By implementing a common reporting solution, category managers got a standard view of sales from thousands of retail sites. The results revealed that 20 percent of non-fuel items generated 94 percent of sales. Armed with these data, the company achieved a 10-percentage-point increase in non-fuel sales and gross margins.

•

In the aftermath of a major acquisition, another global oil producer needed to integrate its existing lubricants business with the newly acquired company. At the same time, it wanted to shift management focus from cost-plus to a value-based approach similar to that used in consumer packaged good companies. By deploying a performance management capability, the company created a common information resource while maintaining regional autonomy for local reporting requirements. A centralized reporting solution was implemented rapidly across the global organization to meet the information requirements of the finance, supply chain, and marketing functions. Web-based tools were used for the business units to submit data and for general istration. Standard and ad hoc reports enabled consistent and comparative analysis of key measures so that the merged business could be managed effectively, both globally and locally. A successful integration of the two businesses after the acquisition realized significant synergy savings.

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The Continued Evolution Companies are coalescing around a vision for management information that has a variety of common elements. Generally agreed-upon characteristics of an effective decision- capability start with housing information using a common taxonomy at a level of common use. A major chemical company worked to define common units of measure, product codes, customer codes, and other key data elements globally. This enabled the company to define economic value created by products in geographic regions by key customers and by a variety of other dimensions. Commonality must be ed by processes used to compile information so that it is trusted as accurate. Tight integration with source systems, strong central governance, and internal controls are all part of ensuring that when end s access information, they believe it to be true. Too often, review meetings start with a discussion around the veracity of the performance at hand. Moving up the hierarchy of needs requires organizations to construct information-aggregation processes that ensure integrity. High-integrity information enables an organization to divest of competing sources of the same topical information. Eliminating redundant data marts and reporting processes ensures that management is working off of a single version of the truth, a critical but elusive capability for many companies. Lastly, information is aggregated to benefit decision-makers. Given that decision-making happens at all levels of an organization, an effective performance management information environment provides broad access to a wide community of s through self-service and intuitive portals that facilitate the discovery process without extraneous aggregation effort. Many companies have yet to achieve these basics. However, leading practice continues to evolve. Increasingly, technologies are available that enable companies to leverage information delivery techniques, such as alerts and data visualization, which increase the speed of recognition and assimilation. Companies also are developing performance management capabilities that a cascading metrics approach; they’re hardwiring strategy to operations with information architecture constructed around a common view of how the business is to be managed. Corporate strategy is manifested in how frontline operations are measured. Information is increasingly forward-looking, with everything positioned in of where we will be rather than where we have been. Content is evolving as well. The line is blurring between financial and operational information, embedding in information delivery tools the ability to rapidly derive cause-and-effect relationships between business drivers and business results. No longer is the P&L important; the drivers behind the P&L are what is measured and managed. As information services evolve, the potential to include external information increases, providing both information and context. Managers should feel differently about a 500-basis-point drop in operating margin if they know that five of their top competitors experienced a greater decrease during the same period. The power of infusing a company’s internal information with external information that measures shifts in cross-company supply chains, industry direction, and competitors’ positions has the potential to be the single biggest evolution in management information since the development of the database (see Figure 1).

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Economic Projections Financial News Equity Markets

P&L Statement Balance Sheet Cash Flow Statement

Debt Markets

Turnover Satisfaction

Revenue Reporting Cost Center Statments Cost by Category

Financials

Skill Coverage Training Staffing Plans

Markets/ Customers

Employess 360 0 Insight

Production Volumes Quality Yields

Vendors/ Suppliers

Operations

Rework Costs Capacity

Competitors

Safety

Market Dynamics Industry Trends

Substitute Technologies New Technologies

Market Dynamics Customer News Market Share Share of Customer Spend Cost to Serve Customer Profitability Market Dynamics New Technologies Vendor News Share of Vendor Sales Global Vendor Spend Analysis

Competitor News Competitor Wins/ Losses

Accenture 2002. All Rights reserved

Figure 1: Critical Performance Information Components The ability to leverage information to create insight into business performance will create competitive advantages in cost structure, go-to-market strategy, and supply chain management that separate successful businesses from those getting the steak knives, or worse. Business insight is the capability of efficiently organizing and analyzing financial, operational, and external information, enabling decision-makers to understand and act, before their competitors, to create sustainable shareholder value. Executives use enhanced information capabilities to add value in all key management processes. Strategic decision-making occurs with more accurate and relevant information. Organizations are better aligned through the communication and monitoring of key value drivers. Product portfolios and profitability are optimized. Customer offerings, product cross-selling approaches, and pricing strategies are tailored according to superior segmentations and analyses of sales information and customer behavior. Marketing effectiveness is improved based on the impact of a customers’ lifetime value. Credit policies are better managed on the basis of customers’ total global relationship with the business. Supply chains become more visible, allowing global and regional sourcing strategies to be pursued. Working capital and taxes are minimized and global foreign exchange positions optimized. 140

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Responding to the Challenge How do companies begin to develop the capability to better leverage information and create competitive advantage? With a focus on business value. The first, and perhaps most important, best practice for achieving business insight is to base the design of business insight capabilities on a rigorous analysis of what drives value in your organization. What information needs to be at the fingertips of decision-makers to keep them better informed, help them make better decisions faster, and to tactical performance reviews? In many organizations, technical architecture and data availability determine what information decision-makers have access to. However, the best results are achieved when the decision-makers’ information needs drive the information strategy, rather than the information that is readily available to IT. The information needs of critical management processes come first, followed by what content to include (see Figure 2). The process of analyzing your competitors, for example, could include not only the traditional competitive wins and losses but also market dynamics and industry trends — valuable external information that provides context for future action. The information needs of each management process and the resulting content required drive the most appropriate access and delivery channels and, finally, data management and technical architecture. Value comes first, with technology being an enabler, not a destination. Figure 1: Critical Performance Information Components The ability to leverage information to create insight into business performance will create competitive advantages in cost structure, go-to-market strategy, and supply chain management that separate successful businesses from those getting the steak knives, or worse. Business insight is the capability of efficiently organizing and analyzing financial, operational, and external information, enabling decision-makers to understand and act, before their competitors, to create sustainable shareholder value. Executives use enhanced information capabilities to add value in all key management processes. Strategic decision-making occurs with more accurate and relevant information. Organizations are better aligned through the communication and monitoring of key value drivers. Product portfolios and profitability are optimized. Customer offerings, product cross-selling approaches, and pricing strategies are tailored according to superior segmentations and analyses of sales information and customer behavior. Marketing effectiveness is improved based on the impact of a customers’ lifetime value. Credit policies are better managed on the basis of customers’ total global relationship with the business. Supply chains become more visible, allowing global and regional sourcing strategies to be pursued. Working capital and taxes are minimized and global foreign exchange positions optimized. Responding to the Challenge How do companies begin to develop the capability to better leverage information and create competitive advantage? With a focus on business value. The first, and perhaps most important, best practice for achieving business insight is to base the design of business insight capabilities on a rigorous analysis of what drives value in your organization. What information

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FINANCIAL STRATEGY needs to be at the fingertips of decision-makers to keep them better informed, help them make better decisions faster, and to tactical performance reviews? In many organizations, technical architecture and data availability determine what information decision-makers have access to. However, the best results are achieved when the decision-makers’ information needs drive the information strategy, rather than the information that is readily available to IT. The information needs of critical management processes come first, followed by what content to include (see Figure 2). The process of analyzing your competitors, for example, could include not only the traditional competitive wins and losses but also market dynamics and industry trends — valuable external information that provides context for future action. The information needs of each management process and the resulting content required drive the most appropriate access and delivery channels and, finally, data management and technical architecture. Value comes first, with technology being an enabler, not a destination.

Management Processes Information Needs Strategy Development Supply Chain Optimization

Product Portfollo Management Treasury Management

Customer Relationship Management

Performance Management

Credit Management Compliance/Risk Management

Information Content Financial

Market/ Customets

Vendors/ Suppliers

Operations

Competitors

Employees

Information Access and Delivery Repoting Application

Analytic Application

Contextual Visual Information Presentation

Access/ Security/ Distribution Categorization

Data Management Data Model

Policies and Procedures

Interfaces

Data Population

Reference Data

Data Retention

Technical Architecture Storage

Application Accenture 2002. All Rights reserved

Figure 2: Value-Driven Information Architecture Development For companies that have yet to develop business insight capabilities, there are a number of responses. First, respond with urgency. Management needs to take decisive action, making tough decisions, driving development and adoption of a common framework for performance management, isolating those elements that are truly business-unit or region specific, and standardiz-

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ing cross-company. Demand adherence to a corporate standard and create governance structures to manage data standards, IT development, and other critical success factors. Second, respond with entirety. Address the entire management cycle. Integrate strategic planning, business planning, and target setting with performance management. Companies must become more disciplined in holding the organization able for stated operating objectives and the capability developments associated with investment. This implies that performance management is grounded in targets, plans, and initiatives built into business plans. Companies that develop performance information capabilities divorced from planning processes miss the opportunity to strengthen ability and focus. Many mid-level managers complain of having to prepare voluminous reports in response to seemingly random corporate queries. If, rather, there is agreement on what will be measured at each level of the organization, and those measures cascade from and relate to the corporate strategy, and they are the basis for both planning/forecasting and performance reporting, management discussion and query tends to have greater focus and impact, and responses require less organizational effort. Third, respond with vision. Develop a three- to five-year target information architecture for your business to decision-makers’ information requirements, then be prepared to adapt the plan as the business evolves. Be able to dissect and articulate the plan for various components. Armed with a performance management framework and prioritized view of information, have an end state in mind for how the enterprise will manage data. What will be held consistent corporate-wide rather than allowed to vary by business or geography? How will data ownership be assigned in the organization and what processes are required to maintain quality, controls, and integrity? Have a view as to how legacy applications will integrate with a central data store. What integration technologies will be required? Develop an understanding of what performance management applications will be employed and how they will interact with the data repository. Will you need an activity-based costing engine to derive product and customer profitability, or will more simplistic allocation schemes be employed? How will your planning applications integrate with your performance reporting applications? Have a plan for how information will be distributed throughout the organization. How will standard reporting be automated and pushed out to the organization? How will online analytical processing (OLAP) technologies be employed to streamline and high-powered analytics? Only by having a vision that informs investment in specific capabilities, coupled with a coherent program that governs project direction toward a common goal, will you create an integrated information architecture that dramatically improves the organization’s access to and use of information (see Figure 3).

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Reporting and Analysis

Workflow

Applications Planing/Modeling Budgeting/Forecasting Consolidation ABC/Dimenensional Profitability

External Reporting Internal Reporting /Analysis Ad Hoc Query/OLAP Scoreboards/Dashboards

Collaboration

Information Hub

Reference Data

/ DevI Tools

Security

Source Systems

Integration Technologies ERP/Legacy Application

KPI Definitions Reporting Hierachies Data Standards Book/Tax COAs

External Data Unstructured Data

Figure 3: Components of Information Architecture Lastly, respond with action. Start taking the steps now to move your company in the right direction. A number of short-term actions can be taken to begin developing the competence in managing an enterprise performance information capability. Begin by moving the organization toward common management metrics and planning processes. Establish corporate key operating metrics. Drive management discussions around these metrics, and demand that individual components of the business use metrics aligned with the stated corporate metrics. While this concept has been an established leading practice for over a decade, many companies have yet to take this crucial step. For performance reporting and analytics, determine the most urgent management process information needs and start there. For some organizations, procurement processes yield significant, measurable value from improved information. In the Unilever example, customer and product profitability were determined to be of high value as well. Create a positive case study within a specific management process to serve as an internal reference for the power of improved decision . With your data architecture, begin the process of creating a common taxonomy. Start with the most valuable elements, such as customers. Launch projects to standardize data companywide and institute organization control and data ownership. Drive consolidation and rationalization of data stores, controlling the rampant development of data warehouses and data marts. Constrain IT budget expenditures that do not align with the target end state. This may mean forcing individual groups to postpone the gratification of constructing their one-off reporting tools. Drive toward an integration standard. Select, pilot, and demonstrate the power of an integration technology. In operational applications, allow for variation across division and geogra144

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

phy where required, but control nonessential variation in application development and data structures. These short-term measures can begin to shift the organization’s thinking about the management of information and create the discipline associated with leading practice performance information. Looking Forward at Last For far too long, performance management and reporting has been a backward-looking exercise or a guessing game. Finance executives have analyzed the impact of prior decisions and results to determine how future plans should be developed to improve results or decrease risks. They have monitored trends for key business drivers and attempted to identify the causes of variance in operating performance. Business insight allows you to look ahead. In the near term, you can easily identify trends, key drivers, and other factors that influence chosen business strategies. You can make capital allocation decisions to develop an investment portfolio aligned with your strategies. Longer term, a robust business insight capability delivers even more, placing CFOs front and center as the chief executive’s primary strategy resource. Based on corporate positions and projections of the major factors driving strategy, you can create long-term business strategies. Business insight enables you to choose appropriate industries in which to compete, and it enables you to identify the major factors that will influence your company’s ability to grow, compete, and remain profitable. Equally important, you can develop credible early warning systems that identify challenges when company positions are incorrect. As the chief financial steward of a nimble organization, you will more effectively deliver the critical information that decision-makers and frontline operators need to make faster, more effective decisions. Based on better insight into internal and external business circumstances, your company will understand, act, and prevail, conquering competitors and creating significant (and sustainable) shareholder value.

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SECTION - 3 ALTERNATIVE FINANCING STRATEGY IN THE CONTEXT OF REGULATORY REQUIREMENTS This Seciton includes

Rewulatory Requirements - Why and how it affect the choice of one’s Capital Structure

3.1. REWULATORY REQUIREMENTS - WHY AND HOW IT AFFECT THE CHOICE OF ONE’S CAPITAL STRUCTURE 3.1.1 Banks and financial institutions: Regulatory requirements are required to be complied with to ensure that a firm is adequately capitalized to meet multiple objectives. The best example would be the case of banks which accept deposits from the public and deploys the generated funds across various assets like corporate and retail loans. Since public confidence is the foundation for banks survival, regulatory authorities prescribe adequate capital for the banks to be maintained, known as the Capital Adequacy Ratio (CAR). Banks allocate resources across various assets throug their lending operations. In the process, banks are exposed to various types of risks which are broadly classified into three types, Credit Risk, Operational Risk and Market Risk. Banks are also expected to comply with the RBI guidelines on the creation of necessary risk management architecture and also the guidelines on Basel II. Capital Adequacy computation has to be done under Basel II requirements effective March 31, 2008. Credit risk is the risk of default from the borrowers. Operatinal risk is the risk of some of the procedures going wrong and market risk is the risk of market volatility affecting the values of banks’ investments in various financial assets. According to Basel committee norms, banks have to maintain adequate tier I capital as a cushion to take care of all these risks and protect the depositors. Risk is inherent in the nature of the banking business. The Reserve Bank of India prescribes a risk weight for the various assets of a bank like the corporate loans, retail loans and the investments in financial assets like bonds, shares, derivatives etc. Using these weights, the risk weighted assets are computed. Banks have to maintain 10% capital adequacy ratio, which means that the banks tier I capital in the form of equity shares, will go up as the value of risk weighted assets go up. This way the banks depositors are protected. This is an example of how regulatory requirements affect the capital structure of a bank. Insurance companies are also subjected to this kind of capital adequacy ratios. Banks and Non-banking finance companies can raise debt up to 10 times of net worth of the company. 146

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3.1.2 Debt to equity ratio prescribed by banks Many times banks prescribe the minimum debt to equity ratio for projects to ensure that the promoters bring adequate money as equity contribution. Therefore, when a corporate firm goes for borrowing for a project, it has to bring sufficient equity or deploy the internal accruals to satisfy the requirements of the banks. The following example illustrates this point.

TRISTAR FOODS plc Input data Cost of new machine Salvage value of new mach Production (lts. Per day) Working days per year Working life of machine (ye Income per lt. (net) Salvage value of old machi Warehouse cost Allocated cost of marketing/ Increase in working capital Depreciation rate Corporate tax rate Capital gains tax rate Opportunity cost of capital(D Post tax cost of debt ESTIMATION OF CASHFLOWS YEAR

150,000 10,000 300 300 6 0.80 5,000 15,000 20,000 5,000 25% 30% 30% 12.5% 8.8%

0

1

COST OF NEW MACHINE (150,000) SALVAGE VALUE (OLD MAC 5,000 CHANGE IN WORKING CAPI (5,000) SALVAGE VALUE (NEW MACHINE) REVENUE DEPRECIATION EBIT EBIT*(1-T) OPEARTING CASH FLOW CAPITAL GAINS TAX -1500 WAREHOUSE COST CASHFLOWS (151,500)

NPV IRR

2

3

4

5

72,000 (37,500) 34,500 24,150 61,650

72,000 (37,500) 34,500 24,150 61,650

72,000 (37,500) 34,500 24,150 61,650

72,000 (37,500) 34,500 24,150 61,650

72,000

(15,000) 46,650

(15,000) 46,650

(15,000) 46,650

(15,000) 46,650

(15,000) 35,400

72,000 50,400 50,400

6

5,000 10,000 72,000 72,000 50,400 50,400 (3,000) (15,000) 47,400

52.394,39 19,83%

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The above example, as discussed earlier, shows the cash flows for a project with NPV and IRR.



What should be the amount of debt and equity for this project which requires 150000 as investment?



A bank may decide to fix the debt that they are willing to lend to this project based on the debt service coverage ratio. Debt service coverage ratio is computed as follows:



(Net operating profit before long term interest and depreciation and after tax)/(Instalment + long term interest )



Debt service coverage ratio protects the annual amount due to the lender namely the interest and instalment amount. There has to be adequate coverage for this say about 2.0 times.



Let us say that the bank prescribes an average debt service coverage ratio of 2.5 times for this project and wants to know how much of debt it can finance and how much of equity the promoter has to bring in

=Nopat+Depreciation Instalment DSCR

61650 23159 2,66

61650 23159 2,66

61650 23159 2,66

61650 23159 2,66

50400 23159 2,18

50400 23159 2,18

2,50

• The table above shows the debt service coverage ratio and the average debt service ratio for all the years which is 2.5. This means how much of debt is shown in the following table: Total investment Debt Debt Equity Instalment amount Debt Interest Term Instalment amount

1,67 93881,33 56118,67

150000 1,00

93881,33 0,13 6,00 23158,63

• This table shows that a debt equity ratio of 1.67 will be optimum to 2.5 debt service coverage ratio. This means that the bank will lend 93881.33 and the promoter has to bring 56118.67. Of course, generally the amounts would be rounded off to nearest reasonable lacs for ease of ing.

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SECTION - 4 MODELING AND FORECASTING CASH FLOWS AND FINANCIAL STATEMENTS This Section includes

Modeleing and Forecasting Cashflows and Financial Statements.

4.1. MODELEING AND FORECASTING CASHFLOWS AND FINANCIAL STATEMENTS Financial strategy requires knowledge of alternatives available. The alternatives have to be each with different new aspect adding value to the proposition. A robust financial model that can facilitate exploration of the consequences of the various alternative choices will be most useful for a finance manager to quickly understand the implications of increasing debt to equity ratio, or a change in tax structure and how it affects the earnings per share or any other chosen objective. 4.1.1

An illustration:

The illustration given below shows how a given set of assumptions can be used to model for forecasting cash flows, financial statements and valuation of the firm. Sales growth Current assets/Sales Current liabilities/Sales Net fixed assets/Sales Costs of goods sold/Sales Depreciation rate Interest rate on debt Interest paid on cash and marketable securities Tax rate Dividend payout ratio Year Income statement Sales Costs of goods sold Interest payments on debt Interest earned on cash and marketable securities Depreciation Profit before tax Taxes Profit after tax Dividends Retained earnings

10% 15% 8% 77% 50% 10% 10.00% 8.00% 40% 40% 0 1,000 (500) (32) 6 (100) 374 (150) 225 (90) 135

1

2

3

4

1,100 1,210 1,331 1,464 (550) (605) (666) (732) (32) (32) (32) (32) 9 14 20 26 (117) (137) (161) (189) 410 450 492 538 (164) (180) (197) (215) 246 270 295 323 (98) (108) (118) (129) 148 162 177 194

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

5 1,611 (805) (32) 33 (220) 587 (235) 352 (141) 211

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FINANCIAL STRATEGY •

This part of the model shows the projected income statement based the basic assumptions. These assumptions can include capital structure changes like debt, equity, leasing etc.

Balance sheet Cash and marketable securities Current assets Fixed assets At cost Depreciation Net fixed assets Total assets

1,070 (300) 770 1,000

1,264 1,486 1,740 2,031 2,364 (417) (554) (715) (904) (1,124) 847 932 1,025 1,127 1,240 1,156 1,326 1,513 1,718 1,941

Current liabilities Debt Stock Accumulated retained earnings Total liabilities and equity

80 320 450 150 1,000

88 320 450 298 1,156

•

80 150

144 165

213 182

97 320 450 460 1,326

289 200

106 320 450 637 1,513

371 220

117 320 450 830 1,718

459 242

129 320 450 1,042 1,941

This part of the model shows the projected balance sheet based on the earlier assumptions

Year Free cash flow calculation Profit after tax Add back depreciation Subtract increase in current assets Add back increase in current liabilities Subtract increase in fixed assets at cost Add back after-tax interest on debt Subtract after-tax interest on cash and mkt. securities Free cash flow

0

1

2

3

4

5

246 117 (15) 8 (194) 19 (5) 176

270 137 (17) 9 (222) 19 (9) 188

295 161 (18) 10 (254) 19 (12) 201

323 189 (20) 11 (291) 19 (16) 214

352 220 (22) 12 (333) 19 (20) 228

1 176

2 188

3 201

4 214

176

188

201

214

5 228 2,511 2,740

Valuing the firm Weighted average cost of capital

20%

Year FCF Terminal value Total

0

NPV Add in initial (year 0) cash and mkt. securities Enterprise value Subtract out value of firm's debt today Equity value

150

1,598 <-- =NPV(B56,C61:G61) 80 1,678 -320 1,358

•

The third part of the model shows how from the projected income statement and balancesheet, one can arrive at the free cash flows to value the equity of the firm

•

This model can be subjected to sensitivity analysis, scenario anlaysis and simulation for quantifying risk and generating control parameters

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

SECTION - 5 & 6 SENSITIVITY ANALYSIS FOR CHANGES IN EXPECTED VALUES IN THE MODELS AND FORECASTS This Section includes

Sensitivity analysis for changes in expected values

5.1. SENSITIVITY ANALYSIS FOR CHANGES IN EXPECTED VALUES Sensitivity analysis refers to studying of the impact of changes on one or more variables on the results, which can either be NPV or IRR or EPS etc. This will help in understanding the critical variables on which the results depend. It is also one way of understanding the risks related to a project or policy. The following illustration shows how sensitivity analysis can be performed on a model of projected cash flows for capital budgeting. 5.1.1

Sensitivity analysis helps in decision making. When a project proves to be very sensitive to certain aspects such as raw material price, power cost, selling price etc the management has to provide adequate weightage to these aspects before the investment decision is frozen.

5.1.2

Likewise, the lending institutions also heavily depend on this analysis before they decide on lending quantum or lending itself. If a project is very sensitive to some parameters and if the lender perceives them as critical, the decision of lending is based very much on that.

5.1.3

The ratios after sensitivity and before sensitivity such as IRR and ROCE would indicate the level of sensitivity.

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Data Cost of capital 15% Tax rate 35% Capital Expenditure 278 million Salvage value 30% (percent of capital expenditure) Year 0 1 2 3 Price per unit 250.00 250.00 230.00 Volume(in million) 1.20 2.10 3.00 COGS(per unit) 80.00 80.00 70.00 SG & A(in million) 15.00 15.75 16.75 18.00 Depreciation(%) 20.00% 32.00% 19.20% Wcap/Forward revenue 9.00% 9.00% 8.00% 7.00% Derivations Annual Depreciation 55.60 88.96 53.38 Accumulated Depreciation 55.60 144.56 197.94 Book value 278.00 222.40 133.44 80.06 Working capital 27.00 47.25 55.2 47.25 Salvage value Cash flow template Revenue 300.00 525.00 690.00 COGS -96.00 -168.00 -210.00 SG & A(in million) -15.00 -15.75 -16.75 -18.00 Depreciation -55.60 -88.96 -53.38 Profit on sale of assets Taxable income -15.00 132.65 251.29 408.62 Tax 5.25 -46.43 -87.95 -143.02 NOPAT -9.75 86.22 163.34 265.61 Depreciation 55.60 88.96 53.38 Salvage value Operating Cash flow -9.75 141.82 252.30 318.98 Change in working capi -27.00 -20.25 -7.95 7.95 Capital Expenditure -278.00 Cash from asset sale Free cash flow -314.75 121.57 244.35 326.93 NPV 563.86 IRR 63%

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4 225.00 3.00 70.00 19.25 11.52% 7.00%

5 225.00 2.20 70.00 20.50 11.52% 7.00%

6 210.00 1.40 85.00 22.00 5.76%

32.03 229.96 48.04 34.65

32.03 261.99 16.01 20.58

16.01 278.00 0.00 0.00 83.40

675.00 -210.00 -19.25 -32.03

495.00 -154.00 -20.50 -32.03

413.72 -144.80 268.92 32.03

288.47 -100.97 187.51 32.03

300.95 12.6

219.53 14.07

294.00 -119.00 -22.00 -16.01 83.40 220.39 -77.14 143.25 16.01 -83.40 75.86 20.58

313.55

233.60

83.40 179.84



The above financial model shows all the assumptions, derivation of cash flows and the results namely the NPV and IRR, in the context of a capital budgeting project



This can be a good practice exercise for students in excel

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

6.1.0 Illustration of sensitivity analysis- Cost of capital and NPV

0.15 0.20 0.25 0.30 0.35 0.40 0.45

•

Sensitivity analysis Cost capital and NPV 563.86 563.86 450.76 358.40 282.12 218.46 164.84 119.28

The above table shows the impact of cost of capital on the NPV of the project. It shows that even if the cost of capital becomes 45%, the project is viable and shows a positive NPV

6.1.1 Capital expenditure, NPV and IRR

280 300 350 400 450 500 800 1000 1200

Sensitivity analysis Capex, NPV and IRR 563,86 63% 562,51 62,97% 549,02 59,66% 515,32 52,66% 481,61 47,00% 447,90 42,33% 414,20 38,39% 211,96 23,35% 77,13 17,54% -57,70 13,36%

•

This table shows the impact of capital expenditure changes on the results of the project namely the NPV and IRR

•

It can be seen that the NPV turns negative only when the investment touches 1200

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FINANCIAL STRATEGY 6.1.2 Capital expenditure and cost of capital on NPV Sensitivity analysis-Capex, Cost of capital and NPV 563.9 280.0 300.0 350.0 400.0 450.0 500.0 800.0 1000.0 1200.0

•

154

0.2 562.5 549.0 515.3 481.6 447.9 414.2 212.0 77.1 -57.7

0.2 449.3 435.0 399.1 363.3 327.4 291.5 76.3 -67.1 -210.6

0.3 356.9 341.9 304.3 266.7 229.1 191.5 -34.0 -184.4 -334.7

0.3 280.6 265.0 226.0 187.0 148.0 109.0 -124.9 -280.9 -436.8

0.4 216.9 200.8 160.7 120.5 80.4 40.3 -200.6 -361.1 -521.6

This table shows the impact of cost of capital and capital expenditure on the NPV of the project. It can be seen that at 1200 capital expenditure and a cost of capital of 20%, the project becomes unviable. This will help in controlling the variables, namely cost of capital and capital expenditure with in certain boundaries so that the project doesn’t become unviable

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

SECTION - 7 EMERGING TRENDS IN FINANCIAL REPORTING This Section includes

The actual state vs. the desirable state



Information Overload



Emerging Trends in Financial Reporting

7.1. THE ACTUAL STATE VS. THE DESIRABLE STATE 7.1.1

Management Information System (MIS) has gained tremendous importance over a period of time in the world of corporate finance. In the past, thick monthly reports to management were the norm. There are still some companies who believe in quantity over quality. In many companies, managers and executives are drowning in data. The finance team foists reams of information on them every month, churning out huge reports stuffed with rows and columns of numbers. It is like a data dump.

7.1.2

Finance executives basically report everything, giving other executives 40 or more PowerPoint slides, full of tables, thousands of numbers, and expecting them to pick out key messages and key information. It is generally too much to take on board.

7.1.3

The internal reporting process needs to be overhauled, stripping out “irrelevant” details to focus on “what really drives the business.” The need of the hour for the corporate analysis team is to produce a slim booklet and the data contained inside more focused, more graphical and more colorful, with major deviations against budgeted targets marked in green (favourable) and red (adverse). The non-financial data and reports should include metrics on operational efficiency and customer satisfaction, along with progress updates on groupwise initiatives such as the implementation of Customer Relationship Management (CRM) software and supply chain rationalization, among other things.

7.1.4

If this kind of more streamlined, targeted way of reporting is practised, management committee and board meetings will be more productive. The top management can focus not only on understanding and highlighting the relevant issues, but can also discuss the action plan.

7.1.5

Ultimately, organizations should adopt a more “interactive” model of management reporting. They should move financial data out of the general ledger into a data warehouse, putting the onus on managers and executives themselves to sift the data and create their own customized reports and “what if” analyses. That way, all that will be left to be circulated on a monthly basis will be a standard top layer of information — “the bare essentials.”

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FINANCIAL STRATEGY 7.1.6

This vision is shared by plenty of finance executives around the world. Many, in fact, have already spent time and money addressing it, investing in business intelligence or performance management software from the likes of Cognos, Hyperion and SAS. “By giving managers the option of access to much more data on their own systems, you don’t have to have such a voluminous package on a monthly basis,” says Daniel Bednar, deputy CFO of Bureau Veritas, a •1.4 billion inspection and testing agency based in Paris, which rolled out a SAS Information Delivery Portal in 2001.

7.1.7

“The role of finance should not be simply to consolidate and report the numbers, but to help people understand what is going on in the business and make the right decisions”.

7.2. INFORMATION OVERLOAD 7.2.1

Of course, improving decision-making is the raison d’etre of management reporting. As a core competence of the finance division, it is up at the top along with matching costs against revenue and ensuring that taxes are paid.

7.2.2

However, it is surprising how often the process goes awry. Once companies have gone though improvements such as standardizing data, for example, by agreeing simple definitions of operating profit throughout the group, many stop there and end up producing monthly reports that are mere “memorandums of data”.

7.2.3

Even with the recent proliferation of software tools that allow managers to do much of the number crunching themselves, management reports remain stubbornly thick and unwieldy. According to a survey of 400 large companies worldwide undertaken recently, finance teams report an average of 132 metrics to senior management each month. That is far too many. “Most management reporting has become a function of the data that is available, rather than the information that is actually needed”.

7.2.4

What’s more, such reporting tends to put too much emphasis on historical financial performance: in the sample cited above, 83 metrics were financial and 49 operational. The preponderance of financial measures is to be expected as it is what finance understands best and what it’s most comfortable with. But that doesn’t necessarily help managers who could use better insights into trends and exceptions within their businesses. In addition, the cost of preparing, analyzing and checking this information is often a major burden on finance.

7.2.5

The reporting also has to be standardized for a time period and the reporter/ reportee link also to be properly established. Too much of tinkering and doing it too frequently would defeat the whole purpose.

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7.3. EMERGING TRENDS IN FINANCIAL REPORTING 7.3.1

Even with this push to pare down data and to give managers the ability to produce their own reports, monthly reporting won’t become extinct. There will always be a need for actionable, summary-level information.

7.3.2

The summary of a report titled “Financial Reporting Supply Chain”, brought out recently by the International Federation of ants is quite illuminating and is appended at the end of the chapter.

The Numbers Game: Unilever: This the reason, for example, why the finance team at Unilever are making efforts to cut down the volume of data produced, while putting more weight on forward-looking internal and external metrics such as regional sales forecasts, market share, competitor pricing and broader economic indicators. They have pioneered this new approach to their growth agenda while giving the executives interactive analysis capabilities, providing a common approach to financial analysis and also communication. Unilever used a tool from a U.K. vendor, Metapraxis, Empower.NET, now, each month the managing director and CFO of each country receive a simple, ten slide executive summary that doubles as an interactive dashboard, through which information can be filtered and personalized. What was once a thick, static batch of reports is now stated to be lean and dynamic. It has become a one-stop shop for information, a way for senior managers to find all relevant strategic and tactical information in a standardized format. There have been other benefits too, not least in speed — consolidated regional data is now reported up to group level in four days, down from eight — and the information gathering burden on the regional finance staff is lighter. Magyar Telekom: When it comes to the distillation of key performance data, however, few finance executives can match the record of Klaus Hartmann, CFO of Magyar Telekom, the HUF604 billion ($2.92 billion) Hungarian telecom firm formerly known as Matáv. Like its parent, Deutsche Telekom, the company uses SAP’s Business Information Warehouse, the data warehousing core of mySAP Business Intelligence, that enables managers to process large amounts of operational and historical data according to their own needs. But that wasn’t installed until January of this year. When Hartmann arrived at the firm in November 2000, finance was going to town with a string of hefty, standardized reports. Complaints from the executive committee soon echoed in his ears. “ ’We’re being killed by too many reports,’ they told me. ‘It’s hard to read them all and find which ones are essential.’ ”

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FINANCIAL STRATEGY So Hartmann set himself an ambitious target: to condense key monthly financial and nonfinancial data into a single sheet of double-sided A4 paper. For a while the experiment succeeded, but after a few complaints of strained eyes Hartmann relented, switching to a threepage summary using a larger type size. The document includes income statements for all four lines of business — fixed line, mobile services, data services and internet services — showing variance against forecasts; a group cash flow statement; a full capex breakdown; and key operational data such as tariffs and minutes of usage. In PowerPoint format, the presentation runs to around a dozen slides, but the three-page hard copy is still in use today, despite a groupwide move away from paper-based reporting. As Hartmann observes, “some people like to have something in their hands, a document they can leaf through.”

FINACIAL REPORTING SUPPLY CHAIN Current perspective and directions SUMMARY OF KEY FINDINGS

In recent years, there have been significant efforts to change and improve financial reporting. What is the result of these change? Has the financial reports process become better or worse? Have the financial reports become more or less relevant, reliable and understandable? What should be done next? The International Federation of ants(IFAC) commissioned an independent global survey of the participants in the financial reporting supply chain to get on these questions. In June and July 2007, the survey group conducted a global survey that yield 341 responses from around the world and from all parts of the financial

158

reporting supply chain, including s, preparers, auditors, standared setters and regulators. The survey group also conducted 25 telephone interviews from August to October 2007. This report is based on the findings of the global survey and interviews, as well as on additional research. Participants in the survey and interviews were asked about their opinions on four areas of financial reporting supply chain: Corporate governance, the financial reporting process, the audit of financial reports and the usefulness of financial reports. Below is a brief overview of the findings that are discussed in more detail in the report.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

In recent years, there have been significant efforts to change and improve financial reporting. What is the result of these change? Has the financial reports process become better or worse? Have the financial reports become more or less relevant, reliable and understandable? What should be done next? The International Federation of ants(IFAC) commissioned an independent global survey of the participants in the financial reporting supply chain to get on these questions. In June and July 2007, the survey group conducted a global survey that yield 341 responses from around the world and from all parts of the financial

reporting supply chain, including s, preparers, auditors, standared setters and regulators. The survey group also conducted 25 telephone interviews from August to October 2007. This report is based on the findings of the global survey and interviews, as well as on additional research. Participants in the survey and interviews were asked about their opinions on four areas of financial reporting supply chain: Corporate governance, the financial reporting process, the audit of financial reports and the usefulness of financial reports. Below is a brief overview of the findings that are discussed in more detail in the report.

Survey Results on Corporate Governance Corporate Governance has improved and the balance between costs and benefits has become better. (See page 11.)

POSITIVES

AREAS OF CONCERN



Increased awareness that good governance counts



Governance in name but not in spirit



New codes and standards



Development of a checklist mentality



Improved board structure



Overregulation



Improved risk management and internal control



Personal risk and liability for directors and management



Increased disclosure and transparency

FURTHER IMPROVEMENTS

Continue to focus on behavioral and cultural aspects of Governance



Review existing rules



Further Improve quality of directors



Better relate remuneration to performance



Expand view from compliance Governance to business Governance

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FINANCIAL STRATEGY Survey Results on the Financial Reporting Process The financial reporting process has improved and balance between cost and benefits is about the same. (See page 16.) POSITIVES

AREAS OF CONCERN



Convergence to a single set of global financial reporting standards.



Improvements to regulations and oversight



Board of directors/management taking ownership of financial reporting



Improved internal control over financial reporting systems



Improved technology for preparing financial reports



Transition to International Financial Reporting Standards (IFRS)



Complying/reconciling s to different financial reporting standards



Complexity of financial reporting standards



Liability restricting process

FURTHER IMPROVEMENTS

Continue convergence to one set of financial reporting standards



Simplify and clarify financial reporting standards - more principles and fewer rules



Ensure that boards of directors pay attention to quality of financial reports



Provide additional education and training for preparers

Survey Results on the Audit of Financial Reports The audit of financial reports has improved and balance between costs and benefits is about the same.(See page 22.) POSITIVES

AREAS OF CONCERN



Improved auditing standards and processes



Reduced scope for professional judgment



Increassed awareness, commitment and competence of auditors and audit committees



Overregulation



Liability fear leading to boilerplate audits and lack of innovation



Liability auditor’s communication with external stakeholders



Limited choice of audit firms



Increased audit cost relative to perceived benefits



More risk-focused audits



Greater auditor independence



Improved quality review and auditor oversight

FURTHER IMPROVEMENTS

160



Continue to focus on indepndence, objectivity and integrity



Converge to one set of global, principals-based auditing standards over time



Ensure consistent use of audit standards and safeguarding of quality within audit firms



Improve auditor’s Communication, both internally and externally



Consider limited/proportionate liability for auditors



Remove barriers that limit choice of auditor

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Survey Results on Usefulness of Financial Reports The relevance and reliability of financial reports have improved, but the understandability of financial reports has not improved. Respondents preferred annual reports to real time or monthly information, found analyst presentations useful, and world like to have more business-driven information. The survey also showed mixed results about the usefulness of XBRL. In addition, paper financial reports remain useful. (See page 28) POSITIVES

AREAS OF CONCERN



Better financial information due to improved standards, regulation and oversight



More disclosure and comparability in financial reports



Improved reliability



Increased emphasis on narrative reporting



Easier access to financial information



Reduced usefulness due to complexity



Focus by companies on compliance instead of essence of the business



Regulatory disclosure overload



Use of fair value



Difficult and often changing financial reporting standards



Lack of forward looking information

FURTHER IMPROVEMENTS

Improve communication within the financial reporting supply chain



Include more business-driven information in financial reports



Better align internal and external reporting



Improve s’ access to electronic date, for example, XBRL



Encourage short-form reporting focusing on the material issues

Next Steps The results of this survey are clear. Participants feel that the three key areas of the financial reporting supply chain-corporate Governance, the process of preparing financial reports and the audit of financial reportshave clearly improved in the last five years. Unfortunately, however, they do not feel that the products of this supply chain, the financial reports, have become more useful to them. To resolve this situation, there needs to be continuing effort made by all participants to discuss and debate the purpose and objectives of financial reporting so that the information that is reported best suits the information needs of the wide range of s.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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FINANCIAL STRATEGY Better Performance Reporting and Analysis Increasingly, finance and business unit managers are seeking to respond to threats and opportunities more quickly and to reallocate resources more authoritatively and dynamically. Sam Knox and Celina Rogers, CFO Research Services February 21, 2006 A forward-looking and analytical view — the ability to conduct what-if analyses, for example — goes to the heart of much of what finance and business unit managers need to manage their companies amid increasing competition, regulatory oversight, and higher investor and board expectations. Executives need to be able to report timely, accurate data on historical performance, to be sure. Increasingly, however, finance and business unit managers seek to respond to threats and opportunities more quickly and to reallocate resources more authoritatively and dynamically. In this study, we sought to explore finance executives’ views on their ability to report and analyze financial information. What do their companies do well? Which stakeholders are wellor ill-served with information and analysis tools? And what barriers do companies face when trying to improve their financial reporting and analysis capabilities? In addition, we wanted to understand how executives’ views on these and other matters vary according to their companies’ strategy for finance systems technology — that is, do companies that have invested aggressively have different views on their ability to gather, report, and analyze information? To gauge finance executives’ opinions on these topics, CFO Research executed an electronic survey to readers of CFO magazine in November 2005. Our research program gathered a total of 164 responses from senior finance executives — more than half of whom work for companies with $1 billion or more in annual revenue. Our solicitation to participate in the survey was focused on senior finance executives and, as a result, respondents’ titles are typically chief financial officer (30 percent), vice president or director of finance (33 percent), and controller (16 percent). Respondents come from a broad cross-section of industries, with the manufacturing, financial services, consumer products, and wholesale/retail trade industries particularly well represented. Queried on their satisfaction with the ability of their finance teams to execute a list of reporting and analysis activities, senior finance executives say they are broadly satisfied with their teams’ performance. Fully 86 percent of respondents are somewhat or very satisfied with their transaction-processing capabilities, and nearly 80 percent of respondents express this view of their external reporting and regulatory compliance capabilities. It seems clear from this data that companies’ investments over the last several years in basic financial management technology and process improvements have paid off. But management reporting and the elements most closely tied to a company’s ability to plan and execute company strategy are rated less favorably by survey respondents. As shown in Figure 1, respondents express greatest dissatisfaction with their abilities to plan, budget, and

162

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

forecast, to conduct ad hoc analyses, and to business decisions such as M&A restructuring, product pricing, and so on. These results are wholly in line with recent trends in finance and in business more generally, as companies have responded to the pressure of heightened regulatory scrutiny and higher investor expectations by investing heavily in transaction processing, basic consolidation and reporting, and compliance technology and systems.

Fingure 1. Forward-looking, analytical view is rated most poorly by senior finance executives. How satisfied are you with your finance team’s ability to execute core finance activities? Dissatisfacation with execution Planning budgeting and forcasting Adhocanalyses and decision (eg, M&A restructuring product pricing etc. Management reporting Financialconsolidation External reporting

Tramsaction processing Regulatory compliance 09%

20%

40%

(Percentage of respondents choosing “some what dissatisfied” or “very dissatisfied “on it satisfaction scale)

Companies may well be taking on sophisticated information and analysis initiatives in stages, investing first in systems and processes for historically oriented reporting activities and postponing investments to forward-looking activities such as planning, budgeting, and forecasting, ad hoc decision , and internal reporting to decision makers. Survey data on stakeholders’ satisfaction with their access to timely and accurate performance data shows, on one hand, a largely satisfied community of investors, executives, and managers within finance and business units. More than 70 percent of top executives and external s of company performance information are somewhat or very satisfied with their ability to get timely and accurate performance data, say survey respondents (see Figure 2).

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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FINANCIAL STRATEGY

Figure2. Those closest to doing analytical work and making operating decision are least satisfied with their access to information. How satisfied are the following stakeholders with your comany’s ability to provide timely, accurate, reliable information on business performance? Executive management External Stakeholders (eg,invenstors, analysts, and creditors Corporate finance department

Business unit finance department

End s of financial Systems

Business-unit management

0%

20%

40%

60%

80%

100%

(Pencentage of respondents choosing “somewhat satisfied or very Satisfied on 1-5 satisfaction scale)

Less satisfied, says the survey data, are those who rely on such information — and seek to build on it with additional analysis — to make day-to-day operating and investment decisions. Financial systems end s and the finance and general management teams of business units are consistently less satisfied with their access to high-quality information. Thus, those who are most likely to be called on to work with information to create plans, make decisions, and do other analytical work — rather than reviewing the work of others — are least satisfied with the information at their disposal. In an effort to understand which pieces of management reporting and analysis are most in need of improvement, we asked finance executives to rate how well their processes and systems equip them to meet a broad array of reporting and analysis objectives. A majority of survey respondents say their processes and systems to allow what-if scenario analysis and to give end s flexible desktop access to additional information needs improvement (see Figure 3). Tools for static reporting on business performance and even on line-item details in budgets and results were rated more favorably.

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FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

Figure3. Dynamic use and analysis of performance information requires improvement more often than static reporting capabilities How well do your processes and technology the follwing management reporting objectives? Allowwhat -if scenario analysis Give end s flexible desktop access to additional infromation Prepare reports useful for decision making Prepare unimpeachable repots on actual business performance Prepare timely reports on actual business performance Provideend s with line item detail on budgets and results 100%

50%

0% Needs improvement

Adequate

Excellent

(Percentage of respondents)

In a separate question on broader finance system issues — including security and access privileges and performance tracking against plans — analytical, ad hoc analysis capabilities emerged again as a source of dissatisfaction. While a majority of respondents say their systems maintain suitable security and 44 percent give high ratings to their control over end access, a solid majority give poor performance ratings to both their what-if analysis capabilities and to their access to non-financial performance information (see Figure 4).

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FINANCIAL STRATEGY

Figure4. Tools and information required for day- to-day decision making are rated poorly How well do your processeand Systems the following activities?

Give end s sufficient what- if analysis capability Provide access to non-finan cial performance information Give decision makers the right information at the right-time Provideend s with familiar interface

Comparison of planned performance versus actual performance Allow managers to restrict end- access to certain information Maintain security of financial date 09%

20% Poorly

40%

60%

Adequate

80%

100%

well

Percentage of respondents

A majority of respondents call for improving the timeliness of information, and more than onethird say broader sources of information (that is, more types of information) is a top area for improvement that would deliver business benefit (see Figure 5). But respondents’ call for easier analysis again comes through loud and clear in the data, as 71 percent say improving the ease of analysis of their performance data would yield the greatest business benefit.

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Figure 5. Better analysis tools yield business benefit In your opinion, improvingwhich two of the following attributes of your Compan’s financial information would yield the greatest business benefit?

Ease of analysis Timeliness of information

Breadth of information

Accuracy of information

Level of detail Auditability of information

0%

20%

40%

60%

80%

(Percentage of respondents; respondentswere allow to choose two items)

Transparency Is Everyone’s Responsibility From the University of Virginia: Both finance and non-finance executives learn that ‘’thebetter the financial reporting, the better the valuation. ’’Marie Leone, CFO.comJuly 30, 2004 Nearly three years after Enron filed for bankruptcy, corporate ing scandals continue to make headlines. In the past few months, for example, the Securities and Exchange Commission charged Siebel Systems with violating Regulation Fair Disclosure (Reg FD) for the second time in four years; the SEC charged Lucent Technologies with “fraudulently and improperly” recognizing $1.15 billion of revenues in 2000; and a Pentagon official told Congress that “significant deficiencies” have been found in Halliburton’s handling of billions of dollars of government work in Iraq. What happens next to executives at those companies is anyone’s guess. But professors at The Darden School of the University of Virginia have found a way to put such cases to good use in a course aimed at helping executives cope with the broader regulatory fallout. “Our program will be driven by situations pulled from the headlines, so we can focus on corrective and preventive measures,” asserts Mark Haskins, a professor of business istration at Darden. The course’s intent, however, “is not to dwell on the headlines,” says Haskins, “but to use them to galvanize the conversation and understand the root causes.”

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FINANCIAL STRATEGY “Financial Stewardship in a World of Financial Scrutiny” is designed to bring managers up to speed on various “ing shenanigans” by supplying them with a “heavy dose of financial expertise,” according to the professor. To that end, the three-day session covers six finance topics: the external reporting environment; financial-statement analysis; shareholders’ information needs; the Securities and Exchange Commission’s Reg FD; company-valuation criteria; and creating shareholder value. That’s a lot to cram into a short course, Haskins acknowledges. He explains, however, that the program isn’t meant to be an exhaustive exploration of the topics but rather a discussion of “key insights derived from big issues.” To be sure, Haskins and his co-instructor, Kenneth Eades, also a Darden business istration professor, plan to plunge into some heavy legal territory, notably the Securities Acts of 1933 and 1934, Reg FD, and the Sarbanes-Oxley Act of 2002. They intend to pay special attention to the financial-statement-certifications that Sarbanes-Oxley mandates for CEOs and CFOs and on the cascading impact of those signoffs on operating managers. What’s more, the professors aim to discuss financial-reporting transparency, including revenue-recognition policies, management’s disclosure and analysis, the debate on expensing stock options, and pensionfund liabilities. But the intent of the course isn’t to provide a mastery of the rules. Instead, Haskins wants attendees to leave the classroom with a better sense of how to spot ing games, such as those involving irregular revenue-recognition. The professor also hopes to help attendees develop skills to handle the internal pressure to “make the numbers at all costs.” Like other reform proponents, Haskins believes that the new corporate reality demands greater financial transparency. He points out, however, that many executives forget that transparency is not relegated to green-eyeshade types in the finance department. The responsibility for accurate financial reporting ripples through the entire organization — is why the course targets more than financial executives. Indeed, most of the course’s participants likely will be referred to it by CFOs with holistic views of financial reporting, according to the professor. The range of attendees, Haskins thinks, will include finance chiefs, sales and marketing executives, and general managers of divisions or business units. On the other hand, the program isn’t likely to resonate with not-for-profit executives or owners of small family businesses because of its focus on public-company topics. New this year to Darden’s executive-education curriculum, the course will be held from November 16 to November 19. The course will be based on case studies to show how executives can make practical use of the tactics and strategies, according to Haskins, but theories of financial-statement preparation and corporate valuation won’t be ignored. Participants, who will be taught how to derive valuations for their own companies, are encouraged to bring their employers’ financial statements to class. The valuation instruction will include the use of net-present-value, internal-rate-of-return, and cash-flow analyses. In the end, however, Haskins hopes that students should come away with a firm understanding that “the better the financial reporting, the better the valuation.”

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STUDY NOTE - 6 INVESTMENT DECISIONS

SECTION - 1 COST, BENEFITS AND RISKS ANALYSIS FOR PROJECTS This Section includes

Investmwnt Appraisal



Investment Appraisal Methods

1.1. INVESTMENT APPRAISAL 1.1.1

One of the key analysis in long-term decision-making that firms must tackle is that of cost benefit analysis before a decision is taken to commit funds by purchasing land, buildings, machinery and so on, in anticipation of being able to earn an income greater than the funds committed. In order to handle these decisions, firms have to make an assessment of the size of the outflows and inflows of funds, the lifespan of the investment, the degree of risk attached, the cost of obtaining funds and return thereon. Decisions on investment, which take time to mature, have to be based on the returns which the investments will make. Capital budgeting is obviously a vital activity in business. Vast sums of money can be easily wasted if the investment turns out to be wrong or uneconomic.

1.1.2

The main stages in the capital budgeting cycle can be summarised as follows:

1.1.3

1.

Identifying project(s).

2.

Forecasting investment needs.

3.

Appraising the suitable alternatives.

4.

Selecting the best out of alternatives.

5.

Committing the expenditure.

6.

Monitoring the project at periodical intervals

7.

variance analysis; and

8.

timely corrective steps.

Investment appraisal involves appraising the investment alternatives and selecting the best alternatives.

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1.1.5

Capital expenditure projects can be classified into four broad categories: a.

New Projects

b.

Modernisation - replacing old or obsolete assets to keep pace with technology for productivity improvement.

c.

Expansion - increasing capacity of existing products to meet increase in demand;

d.

Diversification – exploring new lines of business.

Even the projects that are unlikely to generate profits should be subjected to investment appraisal. This should help to identify the best way of achieving the project’s aims. For instance, investment appraisal may help to find the cheapest way to provide a new staff canteen, even though such a project may be unlikely to earn profits for the company.

1.2. INVESTMENT APPRAISAL METHODS 1.2.1

One of the most important steps in the capital budgeting cycle is working out if the benefits of investing large capital sums outweigh the costs of these investments. The range of methods that business organizations use can be categorised one of two ways: traditional methods and discounted cash flow techniques. Traditional methods include the Average Rat e of Return (ARR) and the Payback method; discounted cash flow (DCF) methods use Net Present Value (NPV) and Internal Rate of Return techniques.

1.2.2

Various aspects of the above investment appraisal techniques and risk analysis have been discussed in detail in Module 2.

1.2.3

Linking investment with customer requirements: Investment decisions must be related to the competitive advantage of the firm. The investments in technology or expansion or modernization etc must result in customer value creation. This is possible only if a firm constantly stays focused on customer value discovery and creation. The competitive advantage of a company can be sustained only by continuous creation of customer value. The competition among firms is only for delivering a better customer value when compared to that of competitors. The key challenge for a firm is to choose the right investment that will ensure better customer value. Thorough market intelligence is of paramount importance for taking an investment decision.

1.2.4

The process of customer value creation starts with customer value discovery. This means that a firm should be listening to the customer’s voice. There has to be systems and procedures for capturing the customer’s requirements. It will include market research, focus group interviews and constant engagement and interaction management. There has to be a systematic way of capturing this voice. This exercise is done for identification of value gap i.e. in the current product features, where is the value gap for the customer.

1.2.5

When once this is done, the R & D department has to design and develop a prototype for mass production. Here, the company needs project management skills. It is a very

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scientific way of orchestrating all the resources and managing the time to market efficiently. The company has to think long term for identification of opportunities for competitive advantage. Sometimes, take over of another company may be a good investment opportunity. Similarly, forward integration or backward integration may be adding to competitive advantage through enhanced customer value. 1.2.6

Deg capital structure: When once the new investment opportunities have been identified, the firm needs to design an appropriate capital structure for funding the project. Here there are several options. If the company is reasonably sure of the success of the project, its profitability and its cash flows, the company may use more of debt. If the project is conceived as a new idea, the company can approach Venture Capital Funds or Private Equity funds. The company can also raise funds through the Initial Public Offering or Seasonal Public Offering. Optimum capital structure is hard to define. There has been a lot of debate about this in the finance literature. Debt is certainly a low cost fund compared to equity from the perspective of risk and return. Debt cost is also lower due to the tax shield offered by way of interest. Equity cost is determined by the capital asset pricing model. If we go on substituting high cost equity with low cost debt, the weighted average cost of capital will be very low with 90% debt and 10% equity. But, the point to be noted is that beyond a certain point, every additional unit of debt will increase the cost of debt due to the threat of bankruptcy as debt involving fixed commitment becomes a threat in times of lower profitability. There is also a theory of matching the capital structure of a company to the product life cycle and investments.

1.2.7

Long Term and Short Term investment decisions and matching similar funds for the projects is very essential to avoid Asset Liability mis-match. ALM is one of the key functions of a finance person in any company.

1.2.8

Taxation is an important aspect that needs to be considered in the feasibility analysis of projects. For example, setting up factories in backward areas will entitle a tax holiday for a firm which can save a lot of money. Similarly, starting a firm in Free Trade Zone or locating the factory in a Tax Haven country etc are ways of tax planning which can significantly alter the economics of a project. Of late, Special Economic Zones are gaining importance due to special tax concessions enjoyed by them.

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SECTION - 2 REAL OPTIONS IN CAPITAL INVESTMENT DECISIONS This Section includes

Introduction



and Definitions



Factors which affect the Value of an Option



Real Options in Capital Investment Decisions



A Comparison of Options Pricing Models



Illustration of options approach to valuation and investments

2.1. INTRODUCTION 2.1.1

A real option is the right, but not the obligation, to undertake some business decision, typically the option to make a capital investment. For example, the opportunity to invest in the expansion of a firm’s factory is a real option. In contrast to financial options, a real option is not often tradeable - e.g. the factory owner cannot sell the right to extend his factory to another party, only he can make this decision; however, some real options can be sold, e.g., ownership of a vacant lot of land is a real option to develop that land in the future. Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive.

2.1.2

The terminology “real option” is relatively new, whereas business operators have been making capital investment decisions for centuries. However, the description of such opportunities as real options has occurred at the same time as thinking about such decisions in new, more analytically-based, ways. As such, the terminology “real option” is closely tied to these new methods. The term “real option” was coined by Professor Stewart Myers at the MIT Sloan School of Management.

2.1.3

The concept of real options was popularized by Michael J. Mauboussin, the chief U.S. investment strategist for Credit Suisse First Boston and an adjunct professor of Finance at the Columbia School of Business. Mauboussin uses real options to explain the gap between the stock market prices and the “intrinsic value” for those businesses as calculated by traditional financial analysis.

2.1.4

Additionally, with real option analysis, uncertainty inherent in investment projects is usually ed for by risk-adjusting probabilities (a technique known as the Equiva-

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lent Martingale approach). Cash flows can then be discounted at the risk-free rate. With regular DCF analysis, on the other hand, this uncertainty is ed for by adjusting the discount rate, using e.g. the cost of capital or the cash flows (using certainty equivalents). These methods normally do not properly for changes in risk over a project’s lifecycle and fail to appropriately adapt the risk adjustment. More importantly, the real options approach forces decision makers to be more explicit about the assumptions underlying their projections. 2.1.5

In business strategy, real options have been advanced by the construction of option space, where volatility is compared with value-to-cost. Latest advances in real option valuation are models that incorporate fuzzy logic and option valuation in fuzzy real option valuation models.

2.2. AND DEFINITIONS Strategic NPV

2.2.1

=

ive NPV + Present value of options arising from the active manage ment of the firm’s investment opportunities

The used in the study of real options are given below: 1.

An option is a right to buy or sell a particular good for a limited time at a specified price (the exercise price). A call option is the right to buy. A put option is the right to sell.

2.

The expiration date is the date when the option matures. An American option is exercisable anytime until the end of the expiration date while a European option is exercised only at the expiration date.

3.

The writer of an option contract sells the call or put option while the buyer purchases the option contract from the seller. For real options, the firm is the implied buyer and the market is the implied seller. No actual contract is traded.

4.

A call option is out-of-the-money when the price of the underlying assets is below the exercise price of the call and in-the-money when the price of the underlying assets is above the striking price of the call. The opposite is true for a put option, which is outof-the-money when the price of the underlying assets is above the striking price of the call and in-the-money when the price of the underlying assets is below the striking price of the call.

5.

Buyers may hold a long (buy) or short (write) position in the option.

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2.3. FACTORS WHICH AFFECT THE VALUE OF AN OPTION 2.3.1

The factors which affect the value of an option are given below:

Symbol

Factor as it relates to stock option value

Factor as it relates to capital budgeting

X

Price of the underlying asset (i.e., stock price) Exercise price

T

Time until the option expires

Krf

Risk-free rate of interest

Σ

Standard deviation of the underlying asset (volatility of stock price)

PV of expected operation CFs discounted at the project’s cost of capital For call options—the initial investment. For put options—the value of the project’s assets if sold or shifted to a more valuable use Time until the option expires or is no longer available Risk-free rate of interest (use the yield on U.S. T-bills) Project risk - standard deviation of the oper ating cash flow as a percent of total invest ment

P0

2.4. REAL OPTIONS IN CAPITAL INVESTMENT DECISIONS

Option: wait & learn more before investing

call

default during construction (staged investment)

a series of put options

alter operating scale (expand, restart)

call

alter operating scale (contract, shut down)

put

abandon

put

switch inputs or outputs

call + put

grow and build-on previous investments

call

Krf =

174

Valued as a :

in all cases, this is the risk-free rate as measured by the return on U.S. T-bills closest to option expiration.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

2.5. A COMPARISON OF OPTIONS PRICING MODELS Binominal Model

Black-Scholes Model

Description

*assumes that the time to an option’s maturity can be divided into a number of subintervals, in each of which, there are only two possible price changes

*the binomial model estimated over an nfinite number of sub-intervals

Advantages

*easier for executives to understand *bigger range of applications (B-S model cannot be used in all cases) *similar in structure to a decision tree but a much more concise representation of complex relationships

*easy to calculate with tables

Disadvantages *more than one or two sub-intervals requires computer simulation *not easy to explain to executives

*not easy to explain to executives

2.6. ILLUSTRATION OF OPTIONS APPROACH TO VALUATION AND INVESTMENTS Before we go into the options approach to investments, we will briefly recap the Black & scholes option pricing model. S X r T Sigma

50 50 5.50% 5 24%

d1

0.7759 <-- (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))

d2

0.2282 <-- d1-sigma*SQRT(T)

N(d1)

0.7811 <-- Uses formula NormSDist(d1)

N(d2)

0.5903 <-- Uses formula NormSDist(d2)

Call price Put price

Current stock price Exercise price Risk-free rate of interest Time to maturity of option (in years) Stock volatility

16.64 <-- S*N(d1)-X*exp(-r*T)*N(d2) 4.62 <-- call price - S + X*Exp(-r*T): by Put-Call parity

The above model shows the price of call option and put option, whose values are mainly driven by the current price, the exercise price, the risk free rate of interest and the volatility, namely the standard deviation of the stock price or the underlying

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2.6.1 Applying Black and Sholes model for capital investments You are interested in acquiring the exclusive rights to market a new product that will make it easier for people to access their email on the road. It will cost 50 million upfront to set up the project. You will get the exclusive right for five years and the estimated cash flow is 10 million after tax every year. Assuming the cost of capital to be 15 percent, what is the net present value of this project? Simulation of cash flows indicate a standard deviation of 42% in the present value of cash flows with average as 33.5. Value the rights to this products using the options approach. Five year risk less rate is 5%. NPV of the project Cost of capital NPV

0 -50 0.15 ($16.48)

Value of Underlying

1 10

2 10

3 10

4 10

5 10

$33.52 0.42 5 0.2 0.05

Variance Time Dividend yield r S X r T Sigma Dividend yield

33.52 50.00 0.05 5.00 0.65 0.20

Current stock price Exercise price Risk-free rate of interest Time to maturity of option (in years) Stock volatility

d1 d2

0.62 -0.83

<— (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T)) <— d1-sigma*SQRT(T)

N(d1) N(d2)

0.73 0.20

<— Uses formula NormSDist(d1) <— Uses formula NormSDist(d2)

Call price

1.10

<— S*exp(-yt)*N(d1)-X*exp(-r*T)*N(d2)

176



In this model, it is the same Black and Scholes that has been used along with dividends



Dividends are the returns from assets which needs to be incorporated into the model



In this case, it is 20% which is nothing (1/5), 5 is the life of the asset, namely the option

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

SECTION - 3 VENTURE CAPITAL FINANCING This Section includes



Introduction What is Venture Capital ? The origin of venture capital



How VCs differ from banks



Types of VCs





Incubators VC in India Tax benefits



How VC’s Invest in a Venture ?



The VC Philosophy Main alternatives to venture capital A Glossary of used in Venture capital funding is appended at the end of the chapter







3.1. INTRODUCTION 3.1.1

Venture capital is a type of private equity capital typically provided by professional, outside investors to new, high risk, high return and high-potential projects. Venture capital investments are generally made as cash in exchange for shares in the invested company. A venture capitalist (VC) is a person who makes such investments. A venture capital fund is a pooled investment vehicle (often an LLC or LP or HNI ) that primarily invests the financial capital of third-party investors in enterprises that are too risky for the standard capital markets or bank loans. VC Funding is generally for technology projects such as Information Technology, Bio Technology etc. When the technocrat entrepreneur is not able to convert his brilliant ideas into reality for want of initial capital, VCs come into picture. VCs undertake the risk by investing on behalf of original promoters, at a very high . They exit when the project can stand alone on its own by divesting their stake in one of the pre-determined ways. Venture capital can also include managerial and technical expertise.

3.1.2

Most venture capital comes from a group of wealthy investors, investment banks and other financial institutions that pool such investments or partnerships. This form of raising capital is popular among new companies, or ventures, with limited operating history, who cannot raise funds through a debt issue. The downside for entrepreneurs is that venture capitalists usually get a say in company decisions, by having a position in the Board of the company, in addition to a portion of the equity.

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3.2. WHAT IS VENTURE CAPITAL ? 3.2.1

According to International Finance Corporation (IFC), venture capital is an equity or equity featured capital seeking investment in new ideas, new companies, new production, new process or new services that offer the potential of high returns on investments.

3.2.2

As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996 “venture capital fund means a fund established in the form of a company or trust which raises monies through loans, donations issue of securities or units as the case may be and makes or proposes to make investments in accordance with these regulations.

3.2.3

Thus venture capital is the capital invested in young, rapidly growing or changing companies that have the potential for high growth. The VC may also invest in a firm that is unable to raise finance through the conventional means.

3.3. THE ORIGIN OF VENTURE CAPITAL 3.3.1

In the 1920’s & 30’s, the wealthy families provided the start up money for companies that would later become famous. Eastern Airlines and Xerox are the more famous ventures they financed. Among the early VC funds set up was the one by the Rockfeller Family which started a special fund called VENROCK in 1950, to finance new technology companies.

3.3.2

General Doriot, a professor at Harvard Business School,in 1946 set up the American Research and Development Corporation (ARD), the first firm, as opposed to a private individuals, at MIT to finance the commercial promotion of advanced technology developed in the US Universities. ARD’s approach was a classic VC in the sense that it used only equity, invested for long term and was prepared to live with losers. ARD’s investment in Digital Equipment Corporation (DEC) in 1957 was a watershed in the history of VC financing.

3.3.3

While in its early years VC may have been associated with high technology, over the years the concept has undergone a change and as it stands today it implies pooled investment in unlisted companies.

3.4. HOW VCS DIFFER FROM BANKS 3.4.1

Conventional financing generally extends loans to companies, while VC financing invests in equity of the company. Conventional financing looks to current income i.e. dividend and interest, while in VC financing returns are by way of capital appreciation. Assessment in conventional financing is conservative i.e. lower the risk, higher the chances of getting loan. On the other hand VC financing is a risk taking finance where potential returns outweigh risk factors.

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3.4.2

Venture Capitalists also lend management and provide entrepreneurs with many other facilities. They even participate in the management process. VC generally invest in unlisted companies and make profit only after the company obtains listing. VC extend need based in a number of stages of investments unlike single round financing by conventional financiers.

3.4.3

VC are in for the long run and rarely exit before three years. To sustain such a commitment VC and private equity groups seek extremely high returns, a return of about 30% per annum. A bank or an FI will fund a project as long as it is sure that enough cash flow will be generated to repay the loans. VC is not a lender but an equity partner. Selectively VCs provide conditional loans also in addition to Equity.

3.4.4

Venture capitalists take higher risks by investing in an early-stage company with little or no history and they expect a higher return for their high-risk equity investment. Internationally, VCs look at an internal rate of return (IRR) of 40% plus. In India, the ideal benchmark is in the region of an IRR of 25% for general funds and more than 30% for IT-specific funds. With respect to investing in a business, institutional venture capitalists look for average returns of at least 40 per cent to 50 per cent for start-up funding. Second and later stage funding usually requires at least a 20 per cent to 40 per cent return compounded per annum. Most firms require large portions of equity in exchange for start-up financing.

3.4.5

The VC approach is called ‘hockey-stick) concept. It means, in the initial years, the project profitability will tend to be lower and would slowly pick up there after year after year. This curve resembles hockey stick. In the initial years, the term lenders will lose patience and would pressurize for payments. Whereas, the VCs would extend enough during this period.

3.5. TYPES OF VCS 3.5.1

Generally there are three types of organised or institutional venture capital funds: venture capital funds set up by angel investors, that is, high net worth individual investors; venture capital subsidiaries of corporations and private venture capital firms/ funds. Venture capital subsidiaries are established by major corporations, commercial bank holding companies and other financial institutions.

3.5.2

Venture funds in India can be classified on the basis of the type of promoters: 1. Financial institutions led by ICICI ventures, RCTC, ILFS, etc. 2. Private venture funds like Indus, etc. 3. Regional funds: Warburg Pincus, JF Electra (mostly operating out of Hong Kong). 4. Regional funds dedicated to India: Draper, Walden, etc. 5. Offshore funds: Barings, TCW, HSBC, etc. 6. Corporate ventures : Venture capital subsidiaries of corporations 7. Angels: High Net Worth individual investors 8. Merchant bankers and NBFCs who specialize in “bought out” deals also fund companies.

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3.6. INCUBATORS 3.6.1

They are generally non-profit entities that provide value added advisory, informational and certain infrastructure which include productive office environment, finance and complementary resources. Incubators are mostly promoted by government or professional organisations seeking to develop small enterprises in a particular area. Some times venture capital funds also have their own incubators and companies also set up in-house incubators. Incubators the entrepreneur in the pre-venture capital stage, that is, when he wants to develop the idea to a viable commercial proposition which could be financed and ed by a venture capitalist.

3.7. VC IN INDIA 3.7.1

This activity in the past was possibly done by the developmental financial institutions like IDBI, ICICI and State Financial Corporations. These institutions promoted entities in the private sector with debt as an instrument of funding.

3.7.2

For a long time funds raised from public were used as a source of VC. This source however depended a lot on the market vagaries. And with the minimum paid up capital requirements being raised for listing at the stock exchanges, it became difficult for smaller firms with viable projects to raise funds from public.

3.7.3

In India, the need for VC was recognised in the 7th five year plan and long term fiscal policy of GOI. In 1973 a committee on Development of small and medium enterprises highlighted the need to faster VC as a source of funding new entrepreneurs and technology. VC financing really started in India in 1988 with the formation of Technology Development and Information Company of India Ltd. (TDICI) - promoted by ICICI and UTI.

3.7.4

The first private VC fund was sponsored by Credit Capital Finance Corporation (CFC) and promoted by Bank of India, Asian Development Bank and the Commonwealth Development Corporation viz. Credit Capital Venture Fund. At the same time Gujarat Venture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level financial institutions. Sources of these funds were the financial institutions, foreign institutional investors or pension funds and high net-worth individuals. Though an attempt was also made to raise funds from the public and fund new ventures, the venture capitalists had hardly any impact on the economic scenario for the next eight years.

3.8. TAX BENEFITS 3.8.1

In of section 10(23 F) of IT Act income by exemptions way of dividend and long term capital gains received by approved VC Companies/Funds from investment made by way of equity shares in a VC undertakings are exempt from tax.

3.8.2

IT rules amended on 18th July 1995 introduced a rule 2(D) which allowed tax exemption under the aforementioned section provided, among others,

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(1) (2) (3) (4)

An application is made to Director of IT (Exemptions) by the VCC or VCF VCF/VCC is ed with SEBI. Not less than 80% of the fund corpus/paid up capital is invested by year 3. The VCC/VCF does not invest more than 5% of paid up capital/fund corpus in one VC undertaking. (5) VCC/VCF does not invest more than 40% in equity capital of one VC undertak ing.

3.9. HOW VC’S INVEST IN A VENTURE ? 3.9.1

A Venture Capitalist looks at various aspects before investing in any venture. A strong management team - each member of the team must have adequate level of skills, commitment and motivation that creates a balance between in areas such as marketing, finance and operations, research & development, general management, personnel management and legal and tax issues.

3.9.2

A viable idea - establish the market for the product or service, why customers will purchase the product, who the ultimate s are, who the competition is and the projected growth of the industry. Business plan: the plan should concisely describe the nature of the business, the qualifications of the of the management team, how well the business has performed, and business projections and forecasts.

3.9.3

Unique Selling Proposition (USP) must be well defined;

3.9.4

Early entrant advantage has to be clearly established;

3.9.5

Return on Investment has to be in geometrical progression year after year vis-à-vis arithmetical progression in normal projects;

3.9.6

Exit option must be well provided for in the proposal itself

3.9.7

So while approaching a venture fund one needs to be fully prepared and keep the above requirements in mind while submitting the business plan.

3.10. THE VC PHILOSOPHY 3.10.1 As against Bought out deals (BODs) , VCs carry out very detailed due diligence and make 2-7 year investments. The VCs also hand-hold and nurture the companies they invest in besides helping them reach IPO stage when valuations are favourable. VCFs help entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in the exit, which is done through M&As. 3.10.2 According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the total venture capital investment is in start-up projects followed by Rs 4478.60 m in later stage projects and only Rs 82.95 in turnaround projects . Majority have invested in only three stages of investment, indicating that most VCs in India have not started developing niches for investing with regard to the stages of projects.

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INVESTMENT DECISIONS 3.10.3 The main difficulty in early stage funding are related to lack of exit opportunities as probability of an IPO or buy out by of VC stake is less due to lack of understanding for evaluation of the knowledge based companies compared to the companies in the traditional sectors. Some such VCs are: ICICI ventures, Draper, SIDBI and Angels. Funding growth or mezzanine funding till pre IPO : The size of investment is generally less than US$1mn, US$1-5mn, US$5-10mn, and greater than US$10mn. As most funds are of a private equity kind, size of investments has been increasing. IT companies generally require funds of about $ 5-10mn in an early stage which fall outside funding limits of most banks/institutions/VC funds and that is why the government is promoting schemes to fund start ups in general and in IT in particular. Management of investee firms : The venture funds add value to the company by active involvement in running of enterprises in which they invest. This is called “hands on” or “pro-active” approach. Draper falls in this category. Incubator funds like e-ventures also have a similar approach towards their investment. However there can be “hands off” approach like that of Chase. ICICI Ventures falls in the limited exposure category. In general, venture funds who fund seed or start ups have a closer interaction with the companies and advice on strategy, etc while the private equity funds treat their exposure like any other listed investment. This is partially justified, as they tend to invest in more mature stories.

3.11. MAIN ALTERNATIVES TO VENTURE CAPITAL 3.11.1 As the strict requirements venture capitalists have for potential investments, many entrepreneurs seek initial funding from angel investors, who may be more willing to invest in highly speculative opportunities, or may have a prior relationship with the entrepreneur. 3.11.2 Furthermore, many venture capital firms will only seriously evaluate an investment in a start-up otherwise unknown to them if the company can prove at least some of its claims about the technology and/or market potential for its product or services. To achieve this, or even just to avoid the dilutive effects of receiving funding before such claims are proven, many start-ups seek to self-finance until they reach a point where they can credibly approach outside capital providers such as VCs or angels. This practice is called “bootstrapping”.

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3.12. A GLOSSARY OF USED IN VENTURE CAPITAL FUNDING IS AP PENDED AT THE END OF THE CHAPTER.

Venture Capital Glossary Acquisition The act of one company taking over controlling interest in another company. Investors often look for companies that are likely acquisition candidates, because the acquiring firms are often willing to pay a to the market price for the shares. Angel Investors Individuals that provide venture capital to seed or early stage companies.. Business angels can usually add value through their s and expertise. Benchmarks Benchmarks are performance goals against which a company’s success is measured. Often, they are used by investors to help determine whether a company will receive additional funding or whether management will receive extra stock. Sometimes management will agree to issue more stock to its investors if the company does not meet its benchmarks, thus compensating the investor for the delay of his return. Bridge Loans Bridge Loans are short-term financing agreements that fund a company’s operations until it can arrange a more comprehensive longer-term financing. The need for a bridge loan arises when a company runs out of cash before it can obtain more capital investment through longterm debt or equity. Buyout Funds provided to enable an enterprise to acquire another enterprise or product line or business. Capital Gain When an investor sells a stock, bond or mutual fund at a higher price than he or she paid for it. Capital Under Management The amount of capital available to a management team for venture investments. Closing The final event to complete the investment, at which time all the legal documents are signed and the funds are transferred. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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INVESTMENT DECISIONS Corporate Venturing The practice of a large company taking a minority equity position in a smaller company in a related field. Debt Financing Money that business owners must pay back with interest. There are myriad types of debt financing, from simple commercial loans to bridge/swing loans in which a lender makes a shortterm loan in anticipation of equity financing at a later stage in the development of a business. Due Diligence The investigation and evaluation of a management team’s characteristics, investment philosophy, and and conditions prior to committing capital to the fund. Equity Financing Selling an interest in your business to an outside party to raise money. Equity Offerings Raising funds by offering ownership in a corporation through the issuing of shares of a corporation’s common or preferred stock. Executive Summary Executive Summary refers to a synopsis of the key points of a business plan. Exit The sale or exchange of a significant amount of company ownership for cash, debt, or equity of another company. Exit Route The method by which an investor will realize an investment. Follow-On A subsequent investment made by an investor who has made a previous investment in the company — generally a later stage investment in comparison to the initial investment. Fund Of Funds An investment vehicle designed to invest in a diversified group of investment funds. Going Private The repurchasing of all of a company’s outstanding stock by employees or a private investor. As a result of such an initiative, the company stops being publicly traded. Sometimes, the company might have to take on significant debt to finance the change in ownership structure.

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Institutional Investors It refers mainly to insurance companies, pension funds and investment companies collecting savings and supplying funds to markets, but also to other types of institutional wealth (e.g. endowment funds, foundations etc.). IPO (Initial Public Offering) Issue of shares of a company to the public by the company (directly) for the first time. IRR Compound Internal Rate of Return. Lead Investor The investor who leads a group of investors into an investment. Usually one venture capitalist will be the lead investor when a group of venture capitalists invest in a single business Leveraged Buy-out (LBO) An acquisition of a business using mostly debt and a small amount of equity. The debt is secured by the assets of the business. Limited Partnerships The legal structure used by most venture and private equity funds. Usually fixed life investment vehicles. The general partner or management firm manages the partnership using policy laid down in a Partnership Agreement. The Agreement also covers, , fees, structures and other items agreed between the limited partners and the general partner. Liquidation The sale of the assets of a portfolio company to one or more acquirors when venture capital investors receive some of the proceeds of the sale. Lock-Up Period The period an investor must wait before selling or trading company shares subsequent to an exit — usually in an initial public offering the lock-up period is determined by the underwriters. Management Buy-in (MBI) Purchase of a business by an outside team of managers who have found financial backers and plan to manage the business actively themselves. Management Buy-out (MBO) Funds provided to enable operating management to acquire a product line or business, which may be at any stage of development, from either a public or private company.

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INVESTMENT DECISIONS Mezzanine Financing Financing for a company expecting to go public usually within 6 –12 months; usually so structured to be repaid from proceeds of a public offerings, or to establish floor price for public offer. Minority Enterprise Small Business Investment Companies (MESBICS) MESBICs (Minority Enterprise Small Business Investment Companies) are government-chartered venture firms that can invest only in companies that are at least 51 percent owned by of a minority group or persons recognized by the rules that govern MESBICs to be “economically disadvantaged.” PIPE Private Investment in Public Equities. Investments by a private equity fund in a publicly traded company, usually at a discount. Portfolio company The company or entity into which a fund invests directly. Private Equity Private equities are equity securities of companies that have not “gone public” (in other words, companies that have not listed their stock on a public exchange). Private equities are generally illiquid and thought of as a long-term investment. As they are not listed on an exchange, any investor wishing to sell securities in private companies must find a buyer in the absence of a marketplace. In addition, there are many transfer restrictions on private securities. Investors in private securities generally receive their return through one of three ways: an initial public offering, a sale or merger, or a recapitalization. Raising Capital It refers to obtaining capital from investors or venture capital sources. Recapitalization The reorganization of a company’s capital structure. A company may seek to save on taxes by replacing preferred stock with bonds in order to gain interest deductibility. Return On Investment (ROI) The internal rate of return on an investment. Secondary Public Offering This refers to a public offering subsequent to an initial public offering. A secondary public offering can be either an issuer offering or an offering by a group that has purchased the issuer’s securities in the public markets.

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Secondary Purchase Purchase of stock in a company from a shareholder, rather than purchasing stock directly from the company. Seed Capital Money used to purchase equity-based interest in a new or existing company. A venture capitalist’s return usually comes from preferred stock, a share of profits, royalties or capital appreciation of common stock. Most venture capitalists look for companies with high growth potential. Series A Preferred Stock The first round of stock offered during the seed or early stage round by a portfolio company to the venture investor or fund. This stock is convertible into common stock in certain cases such as an IPO or the sale of the company. Later rounds of preferred stock in a private company are called Series B, Series C and so on. Small Business Investment Companies (SBIC) SBICs (Small Business Investment Companies) are lending and investment firms that are licensed by the federal government. The licensing enables them to borrow from the federal government to supplement the private funds of their investors. Some of these funds engage only in making loans to small businesses or invest only in specific industries. The majority, however, are organized to make venture capital investments in a wide variety of businesses. Syndication The process whereby a group of venture capitalists will each put in a portion of the amount of money needed to finance a small business. Term Sheet A non-binding agreement setting forth the basic and conditions under which an investment will be made. The Term Sheet is a template that is used to develop more detailed legal documents. Turnaround This word is used to describe businesses that are in trouble and whose management will cause the business to become profitable so they are no longer in trouble. Venture Capital Money used to purchase equity-based interest in a new or existing company. A venture capitalist’s return usually comes from preferred stock, a share of profits, royalties or capital appreciation of common stock. Most venture capitalists look for companies with high growth potential.

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SECTION - 4 HYBRID FINANCING / INSTRUMENTS This Section includes

Introduction



Convertible Bonds and Warrants



The origin of venture capital



How VCs differ from banks



Types of VCs

4.1. INTRODUCTION 4.1.1

The term hybrid instrument is not precisely defined. Generally, it is used to refer to financial instruments that blend characteristics of both debt and equity markets. Convertible bonds are an example. They are debt instruments that have an imbedded option allowing the holder to exchange them for shares of the issuing company’s stock at the end of the given period. For this reason, their market prices tend to be influenced by both interest rates as well as the convertible price and proportion. Another example would be a structured note linked to some equity index. These take many forms. Typical would be a five year note. It is a debt instrument issued by a corporation or sovereign, but instead of paying interest, it returns the greater of principal plus the price appreciation on the S&P 500 index over the life of the instrument, or principal.

4.1.2

Other examples of hybrids are preferred stock, Trust Preferred Securities (TruPS) or Equity Default Swaps (EDS).

4.1.3

Some people extend the definition of hybrid instrument to encom instruments that straddle other market sectors. According to this definition, a quanto option or a volatility future would be considered a hybrid.

4.1.4

The “hybrid securities,” “hybrid products” or simply “hybrids” are all synonyms for “hybrid instruments”.

4.2. CONVERTIBLE BONDS AND WARRANTS 4.2.1

A convertible security or convertible is a hybrid security with a provision for the convertible to be exchanged for some other security. Usually, conversion is at the security holder’s option, but a mandatory convertible security requires conversion, usually according to pre-determined and mutually agreed and time schedule.

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4.2.2

Most convertibles are either convertible preferred stock or convertible bonds issued by a company and convertible to that company’s common stock any time after lapse of a prescribed time, at the security holder’s option.

4.2.3 A warrant is a long-term call option. A convertible bond consists of a fixed rate bond plus a call option. 4.2.4 Convertible securities have a par value, and their yield is quoted as a percentage of par. Each security may be converted into a fixed number of common shares. That number is the security’s conversion ratio. For example, if a convertible bond’s conversion ratio is 12.5, and the bond has a par value of USD 1,000, then each USD 80 of par value can be converted into a single share. This number is called the conversion price: [1]

4.2.5 Convertibles routinely have an anti-dilution provision, which adjusts the conversion ratio as appropriate in the event of a stock split or stock dividend. Some convertibles have a conversion ratio that changes according to a fixed schedule. For example, a convertible bond’s conversion ratio might be 12.5 for the bond’s first five years and then drop to 11 after that. 4.2.6

As is typical of hybrid securities, convertibles can be difficult to value. Also, convertibles may have additional embedded options or features. Many are callable after a few years of call protection. When called, holders are forced to either surrender the security for the call price or convert them. If they convert, the transaction is called a forced conversion. Some convertibles have a put feature, allowing holders to return the security to the issuer at a pre-determined price on certain dates.

4.2.7

A convertible’s investment value is what the market value of the convertible would be if it were stripped of its conversation feature. This reflects the security’s future cash flows, current interest rates, the issuer’s credit quality and any other features such as put or call provisions other than the conversion option. Investment value isn’t generally observable in the marketplace, but it is a useful notion that can be ascribed a value using standard bond pricing or financial engineering methodologies.

4.2.8

A convertible’s conversion value (or parity value) is the value that could be realized by immediately converting the convertible to common stock. It is easily calculated as: conversion value = (conversion ratio) current stock price

4.2.9

[2]

These notions viz.I investment value and conversion value—are important because a convertible’s market price should always exceed both quantities. Otherwise, arbitragers will step in and start accumulating the convertible, thereby driving up its market price. The two quantities are often quoted as s:

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[3]

[4]

The net surplus is the gain in the arbitration process. 4.2.10 Obviously, both s should be positive. 4.2.11 Exhibit 1 illustrates how a convertible’s market price depends upon the underlying stock price. Both the investment value and conversion value are plotted. The investment value is fairly flat at higher stock prices but drops off as the stock price falls. This reflects the fact that the credit quality of the issuer is likely to fall with a marked decline in the stock price. The conversion value is a simple linear function of stock price. The convertible’s market price is also plotted. Price Behavior of a Convertible Security Exhibit 1

Convertible market price

Value

investment value Conversion Value

"busted" or hybrid-or distressed bond-like option-like

equity-like

underlying stock price 4.2.12 Convertible securities exhibit four different modes of behavior depending on the level of the underlying stock price and the credit quality of the issuer. Practitioners tend to distinguish between four modes of behavior of a convertible bond, depending upon the level of the underlying stock and the issuer’s credit quality. Usage is hardly standardized, but we may distinguish between the following modes of behavior. These are also indicated in Exhibit 1: a. b. c. d. 190

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4.2.13 Convertible’s behavior is equity-like when its conversion value exceeds its investment value, and the bond behaves like an in-the-money option. Its value fluctuates almost directly with the underlying stock price. 4.2.14 The convertible’s behavior is hybrid- or option-like at lower stock prices where the conversion value is less than the investment value but there is still a reasonable likelihood of the stock price rising enough to make conversion attractive. In this state, the convertible exhibit’s truly hybrid behavior. Its market price is sensitive to the underlying stock price, interest rates, implied volatilities and the issuer’s credit quality. 4.2.15 At still lower stock prices, the conversion option is so far out-of-the-money that it is almost worthless. Here, the convertible is called busted. Its behavior is much like a nonconvertible bond or other fixed income instrument. Its market price fluctuates with interest rates and the issuer’s credit quality. 4.2.16 Finally, if the issuer becomes financially troubled, its credit rating will fall well below investment grade and the stock price will plummet to very low levels. Here the conversion feature is all but irrelevant. The convertible is a distressed security whose market price fluctuates primarily with the credit quality of the issuer. 4.2.17 As convertibles can be so difficult to value, there is a perception that they are frequently mis-priced in the market. Convertible arbitrage is a market neutral trading strategy that seeks to profit from such mis-pricings. Due to several internal and external factors altering the fortunes of the issuer between the issue date and conversion date, any or all above possibilities are unavoidable.

4.3. PREFERRED STOCK 4.3.1 Preferred stock is a hybrid corporate security. It represents an equity interest in the issuing company. Unlike common stock, which pays a variable dividend depending on the corporation’s earnings, preferred stock pays a fixed quarterly dividend based on a stated par value. For example, an XYZ corporation might issue preferred stock with a par value of Rs 50.00 and paying a quarterly 2% dividend. This would translate into a Rs 1.00 dividend paid each quarter. 4.3.2

Most corporations do not issue preferred shares. Those that do, often issue multiple classes of preferred shares over time. There are three naming conventions used for distinguishing between the different preferred issues of a corporation : 1.

Annualized dividend: the shares in our example would be called XYZ Rs 4.00 preferred.

2.

Annualized dividend yield: the shares in our example would be called XYZ 8% preferred.

3.

A letter indicating the order of issuance: If the shares in our example were the corporation’s third preferred issuance, they would be called XYZ preferred C.

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INVESTMENT DECISIONS 4.3.3

With fixed dividends, preferred shares resemble fixed income instruments. As they don’t mature, they most resemble a perpetuity. Preferred shareholders generally don’t have voting rights. Also, the board of directors have less of a fiduciary obligation to preferred shareholders than to common shareholders. Some Delaware court decisions have treated the board’s obligation to preferred shareholders as purely contractual.

4.3.4

Preferred stock differs from fixed income instruments in their tax treatment. Interest payments are an expense, so they are tax deductible for the corporation. Dividends are distributions of earnings, so they are not tax deductible. Also, depending on the investor’s tax jurisdiction, dividends may be taxed differently from interest income.

4.3.5

When it is first issued, preferred stock is priced by the market based on prevailing interest rates. Generally, the issuer will set the preferred’s dividend yield so it issues at a price close to par. After issuance, the preferred shares trade in the stock market just like common stock. Credit rating agencies rate preferred stocks based on the issuing corporation’s ability to pay dividends. Market prices of highly rated issues tend to fluctuate with interest rates. Prices of lower rated issues - just like prices of lower rated bonds - tend to fluctuate with the issuing corporation’s fortunes.

4.3.6

Preferred stock is subordinate to all the issuing corporation’s fixed income obligations. If the issuer is not current on the fixed income obligations, it can pay no preferred dividends. If the issuer is liquidated, creditors must be paid in full before preferred stockholders can receive anything. However, preferred shares are superior to common shares. No dividends may be paid to holders of common stock unless dividends to preferred shareholders are also paid in full. In liquidation, preferred shareholders are entitled to at least their par value before common shareholders can receive anything.

4.3.7

Unlike fixed income instruments, failure of a corporation to make preferred dividend payments cannot force the firm into bankruptcy. However, while dividends are not being paid, mandatory restrictions may be placed on management and preferred shareholders may be granted the right to vote for a number of board . Because it is dependent on dividends not being paid, this is called contingent voting.

4.3.8

Most preferred stock is cumulative. This means that, if a dividend is ever missed, it must eventually be made up to investors. No dividends can be paid to common stockholders until all missed dividends have been paid to preferred stockholders. If preferred shares are issued with no obligation to make up missed dividends, the shares are called non-cumulative.

4.3.9

Callable preferred stock has an embedded option allowing the issuer to call shares, either at par or at a slight above par. In a typical arrangement, shares are not callable for the first few years following issuance but can be called, perhaps with a month’s notice, any time thereafter. As with callable bonds, the price behavior of callable preferreds depends on whether the call option is in-the-money or out-of-the-money as well as the financial strength of the issuer.

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4.3.11 There are a number of other variations on preferred stock: a.

Adjustable-rate preferred stock (ARPS) has a dividend yield that, instead of being fixed, floats with specified interest rates according to some formula.

b. Convertible preferred stock has an embedded option that allows the holder to exchange each preferred share for a specified number of common shares. Convertible preferred is usually callable. This allows the issuers to call the stock and force preferred shareholders to choose between accepting either par value or common shares. This is called a forced conversion. c.

Participating preferred stock pays a regular fixed dividend plus an additional dividend if the common stock dividend exceeds some specified value. Today, this feature is rare.

4.4. TRUST PREFERRED SECURITIES 4.4.1

4.4.2

4.4.3

4.4.4

Trust preferred securities (TruPS) are cumulative preferred stock issued by bank holding companies through a special purpose vehicle. The special purpose vehicle is wholly owned by the bank holding company and is usually a trust. It sells the TruPS to investors and uses the proceeds to purchase a subordinated note from the bank holding company. This becomes its sole asset and cash flows from the note largely mirror the dividends payable on the TruPS. The note has an initial maturity of at least 30 years. Dividends are paid quarterly or semi-annually. Dividends may be deferred for at least five years without creating an event of default or acceleration. From a tax standpoint, TruPS have a significant advantage over the direct issuance of preferred shares. This is because dividends on preferred shares are not deductible as a business expense, but interest on a subordinated note is. In this regard, the TruPS behaves like debt. In another regard, it behaves like equity. Initially, TruPS were only issued by larger bank holding companies. This changed in 2000, when several institutions issued TruPS, which were pooled in a CDO. Since then, the TruPS CDO market has grown dramatically and has become a significant source of capital for small and medium sized bank holding companies. TruPS are also issued by insurance holding companies and REITS. Those securities have also been packaged in CDOs.

4.5. EQUITY DEFAULT SWAP 4.5.1 An equity default swap (EDS) is a form of OTC derivative. While technically an equity derivative, it behaves like a hybrid of a credit derivative and an equity derivative. The name “equity default swap” may seem peculiar—how can equity default? The answer is that the product is named by analogy with credit default swaps (CDSs), whose structures it mimics. 4.5.2

As with a credit default swap, an equity default swap is a vehicle for one party to provide another protection against some possible event relating to some reference asset. With a credit default swap, the reference asset is a debt instrument and protection is

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INVESTMENT DECISIONS provided against a possible default or other credit event. With an equity default swap, the reference asset is some company’s stock and protection is provided against a dramatic decline in the price of that stock. For example, the equity default swap might provide protection against a 70% decline in the stock price from its value when the equity default swap was initiated. The event being protected against is called the trigger event or knock-in event. 4.5.3

Other than the difference in the type of event being protected against, a credit default swap and equity default swap are structured identically. There are two parties to the agreement. Maturities are for several years, with five years being typical. The party buying protection pays the other a fixed periodic coupon for the life of the agreement. The other party makes no payments unless the trigger event occurs. If it does occur, the equity default swap terminates, and the protection seller makes a specified payment to the protection buyer. This is calculated as follows: notional amount (1 – recovery rate)

[1]

where the notional amount is simply a dollar sum. In formula [1], recovery rate serves only to make the equity default swap more analogous to a credit default swap. Its role is similar to the recovery rate that would be realized on a defaulted debt obligation. However, the recovery rate for an equity default swap is fixed—typically at 50%. 4.5.4

An equity default swap is similar to a deep out-of-the-money, long-dated American digital put. A difference is that the option is paid in installments that cease when the option is triggered. It is more useful to think of the equity default swap as an extension of the credit default swap concept. When a credit default swap is triggered by a corporate default, that corporation’s stock price will typically have fallen to almost 0. Because equity default swap triggers are set for such steep stock price declines, trigger events will almost always be associated with some sort of deterioration in the corporation’s credit. For example, if an equity default swap is triggered by a 70% decline in the stock price, it provides protection against less severe corporate impairment than that which a credit default swap protects against. In this regard, the equity default swap truly behaves as a form of hybrid between a credit derivative and an equity derivative.

4.5.5

Equity default swap are quoted as spreads over Libor. As an equity default swap is more likely to be triggered than a credit default swap, they generally trade at higher spreads than credit default swap.

4.5.6

Equity default swaps have a number of advantages over credit default swaps. Their trigger events are easier to define—there is generally little ambiguity as to whether a given stock price has or has not fallen to a specified lever, but with credit default swaps, there can be corporate events that may or may not constitute default. Also, recovery rates are fixed for equity default swaps while they must somehow be determined for a credit default swap following an actual default. Finally, credit default swaps are limited in that they protect against only the most severe form of corporate impairment. Equity default swaps can be structured with various trigger levels loosely corresponding to various degrees of corporate impairment.

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4.5.7

Equity default swaps are employed in ways similar to credit default swaps. They may be used to structure synthetic CDO’s. Some, CDOs use them exclusively. These are called equity collateralized obligations or ECOs.

4.5.8

As long-dated far out-of-the-money options, equity default swaps pose financial engineering challenges. One approach is to employ techniques of equity derivatives pricing. The other is to use techniques of credit derivatives pricing. Equity default swaps clearly present an opportunity to arbitrage between equity derivatives markets and credit derivatives markets, which should cause convergence in pricing. Research on pricing methodologies is ongoing.

4.5.9

Equity default swaps can be structured with multiple reference stocks. These structures may have a first to “default” or nth to “default” trigger.



It is the Composition of Debt and Equity in the ‘Means of Financing’ the financial needs of the company. What is Debt and Equity? What is leverage? Does it or Does it not affect Cost of Capital? Is it relevant in the valuation of the firm?

There are different methods and approaches to analyse the capital structure & the valuation of the firm.

EXERCISES & ILLUSTRATIONS : Recap the differences between warrants and convertibles: 3

Warrants bring in new capital, while convertibles do not.

4

Most convertibles are callable, while warrants are not.

5

Warrants typically have shorter maturities than convertibles, and expire before the accompanying debt.

6

Warrants usually provide for fewer common shares than do convertibles.

7

Bonds with warrants typically have much higher flotation costs than do convertible issues.

8

Bonds with warrants are often used by small start-up firms. Why?

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INVESTMENT DECISIONS How do convertibles help minimize agency costs? 4

Agency costs are due to conflicts between shareholders and bondholders 4.1 Asset substitution (or bait-and-switch). Firm issues low cost straight debt, then invests vests in risky projects 4.2 Bondholders suspect this, so they charge high interest rates 4.3 Convertible debt allows bondholders to share in upside potential, so it has low rate.

5

Information asymmetry: company knows its future prospects better than outside investors 5.1 Outside investors think company will issue new stock only if future prospects are not as good as market anticipates 5.2 Issuing new stock send negative signal to market, causing stock price to fall

6

Company with good future prospects can issue stock “through the back door” by issuing convertible bonds 6.1 Avoids negative signal of issuing stock directly 6.2 Since prospects are good, bonds will likely be converted into equity, which is what the company wants to issue How does preferred stock differ from common stock and debt?

4

Preferred dividends are specified by contract, but they may be omitted without placing the firm in default.

5

Most preferred stocks prohibit the firm from paying common dividends when the preferred is in arrears.

6

Usually cumulative up to a limit.

7

Some preferred stock is perpetual, but most new issues have sinking fund or call provisions which limit maturities.

8

Preferred stock has no voting rights, but may require companies to place preferred stockholders on the board (sometimes a majority) if the dividend is ed.

9

Is preferred stock closer to debt or common stock? What is its risk to investors? To issuers?

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What are the advantages and disadvantages of preferred stock financing? 4

Advantages 4.2 Dividend obligation not contractual 4.3 Avoids dilution of common stock 4.4 Avoids large repayment of principal

5

Disadvantages 5.2 Preferred dividends not tax deductible, so typically costs more than debt 5.3 Increases financial leverage, and hence the firm’s cost of common equity

Assume that the warrants expire 10 years after issue. When would you expect them to be exercised? Generally, a warrant will sell in the open market at a above its value if exercised (it can’t sell for less). Therefore, warrants tend not to be exercised until just before expiration. In a stepped-up exercise price, the exercise price increases in steps over the warrant’s life. Because the value of the warrant falls when the exercise price is increased, step-up provisions encourage in-the-money warrant holders to exercise just prior to the step-up. Since no dividends are earned on the warrant, holders will tend to exercise voluntarily if a stock’s payout ratio rises enough. Will the warrants bring in additional capital when exercised? When exercised, each warrant will bring in the exercise price, $25. This is equity capital and holders will receive one share of common stock per warrant. The exercise price is typically set some 20% to 30% above the current stock price when the warrants are issued. As warrants lower the cost of the accompanying debt issue, should all debt be issued with warrants? No. As we shall see, the warrants have a cost which must be added to the coupon interest cost.

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INVESTMENT DECISIONS What is the expected return to the bond- with-warrant holders (and cost to the issuer) if the warrants are expected to be exercised in 5 years when P = $36.75? The company will exchange stock worth $36.75 for one warrant plus $25. The opportunity cost to the company is $36.75 - $25.00 = $11.75 per warrant. Bond has 50 warrants, so the opportunity cost per bond = 50($11.75) = $587.50. Here are the cash flows on a time line: 0

1

+1,000 -100

4

5

6

-100 -100

-100 -587.50 -687.50

19

20

-100

-100 -1,000 -1,100

Input the cash flows and calculate IRR = 14.7%. This is the pre-tax cost of the bond and warrant package. The cost of the bond with warrants package is higher than the 12% cost of straight debt because part of the expected return is from capital gains, which are riskier than interest income. The cost is lower than the cost of equity because part of the return is fixed by contract. When the warrants are exercised, there is a wealth transfer from existing stockholders to exercising warrant holders. But, bondholders previously transferred wealth to existing stockholders, in the form of a low coupon rate, when the bond was issued. At the time of exercise, either more or less wealth than expected may be transferred from the existing shareholders to the warrant holders, depending upon the stock price. At the time of issue, on a risk-adjusted basis, the expected cost of a bond-with-warrants issue is the same as the cost of a straight-debt issue. Assume the following convertible bond data: 20-year, 10.5% annual coupon, callable convertible bond will sell at its $1,000 par value; straight debt issue would require a 12% coupon. Call protection = 5 years and call price = $1,100. Call the bonds when conversion value > $1,200, but the call must occur on the issue date anniversary. P0 = $20; D0 = $1.48; g = 8%. Conversion ratio = CR = 40 shares. 198

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What conversion price (Pc) is built into the bond? Pc

= Par Value / No. of shares received. = 1000 / 40 = $25

Like with warrants, the conversion price is typically set 20%-30% above the stock price on the issue date. Implied Convertibility Value: As the convertibles will sell for $1,000, the implied value of the convertibility feature is $1,000 - $887.96 = $112.04. The convertibility value corresponds to the warrant value in the previous example. What is the formula for the bond’s expected conversion value in any year? Conversion value = CVt = CR(P0)(1 + g)t. t=0 CV0

= 40($20)(1.08)0 = $800.

t = 10 CV10 = 40($20)(1.08)10 = $1,727.14. What is meant by the floor value of a convertible? What is the floor value at t = 0? At t = 10? The floor value is the higher of the straight debt value and the conversion value. Straight debt value0 = $887.96. Besides cost, what other factors should be considered? The firm’s future needs for equity capital: Exercise of warrants brings in new equity capital. Convertible conversion brings in no new funds. In either case, new lower debt ratio can more financial leverage Does the firm want to commit to 20 years of debt? Convertible conversion removes debt, while the exercise of warrants does not. If stock price does not rise over time, then neither warrants nor convertibles would be exercised. Debt would remain outstanding.

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PROJECT MANAGEMENT

STUDY NOTE - 7 PROJECT MANAGEMENT

SECTION - 1 OVERVIEW OF PROJECT MANAGEMENT This Section includes

What is Project Management?



Project Performance



Steps in Project Management

1.1. WHAT IS PROJECT MANAGEMENT? 1.1.1

The term ‘project’ refers to a major and out-of-the-ordinary activity, involving a substantial outlay of resources in of capital, time and effort. For these reasons, it has to be both conceived and executed timely, properly and cost effectively. While its success can bring long-term rewards, its failure can lead to disastrous consequences. Any cost or time overrun in the project implementation is a sign of sickness from the beginning.

1.1.2

A project, therefore, essentially means the following: 1. Commitment to process / technology. 2. Huge capital outlay 3. Long gestation 4. Decisions are strategic and generally irreversible.

1.2. PROJECT PERFORMANCE 1.2.1

The key objective of project management is resource optimization. The performance measures in project management are: 1. Cost 2. Time 3. Project performance, i.e., whether the project successfully meets the targets and delivers desired results.

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1.2.2

Project cost refers to the cost of capacity resources that organizations purchase and use for years to make goods and provide services. Cost commitments associated with long-term assets create risk for an organization and remain even if the asset does not generate the anticipated benefits and also reduce an organization’s flexibility. Therefore, organizations should approach investments in long-term assets with considerable care. Both excess capacity and imbalance in capacity in any section of the production process would result in serious financial and operational implications. The cost of production would increase much higher and thereby project would become unviable.

1.2.3

Organizations have developed specific tools to control the acquisition and use of longterm assets because organizations are usually committed to long-term assets for an extended time, which creates the potential for either excess capacity that creates excess costs or scarce capacity that creates lost opportunities.

1.3. STEPS IN PROJECT MANAGEMENT 1.3.1

Project management encomes the following steps: 1. Project Conceptualization: Identification of investment opportunities, evaluation, project identification and project formulation. 2. Project Appraisal, using various investment criteria. 3. Project Planning, including raising resources and the integration various stakeholders 4. Project Execution or Implementation: Converting the thoughts and proposals into reality. 5. Project Review

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2.3. PHASE II: RECONNAISSANCE AND PRELIMINARY PROJECT DESIGN / FEASIBILITY STUDY Step 3 - analysis/diagnosis of the situation from an overall perspective; Step 4 - analysis/diagnosis of the situation from the perspective of the stakeholders; Step 5 - assessing the future returns from the project Step 6 - outline specification of the project. The output of this phase is the preliminary design of a project, including identification of its main features, such as location, type of participants, main activities, size, timing, organizational structure, and management system. It may be called a project reconnaissance and preliminary design report and also called a project prefeasibility study.

2.4. PHASE III: PROJECT DESIGN Step 7 - detailed technical and socio-economic investigations, Step 8 - more precise definition of project objectives, targets and design criteria, Step 9 - design of individual project components, Step 10 - design of project organization, structure and management arrangements, and Step 11 - project cost and revenues estimation and financing closure proposal and alternatives available. The output of the phase is a full description and costing of the project, together with a proposed financing plan.

2.5. PHASE IV: ANALYSIS OF EXPECTED RESULTS Step 12 - financial and sensitivity analysis, Step 13 – socio-economic analysis, Step 14 – market and competitor analysis, and Step 15 - environmental impact analysis such as pollution, carbon credits, CSR etc. The output of the phase is the determination of effects and impacts of the project.

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2.6. PHASE V: PROJECT DOCUMENTATION AND SUBMISSION Step 16 - project documentation and submission. The output of the phase is the project document.

2.7. PHASE VI: NEGOTIATING THE PROJECT Step 17 - project appraisal and negotiation with all the stakeholders. The output is a project fully ready for implementation.

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SECTION - 3 IDENTIFICATION OF PROJECT OPPORTUNITIES This Section includes

Project identification - What are the opportunities?



Project pre-feasibility assessment - Are the opportunities realistic?

3.1. PROJECT IDENTIFICATION - WHAT ARE THE OPPORTUNITIES? 3.1.1

After identifying the opportunities and short listing of projects out of several available options that are of interest to a company, the next stage is to consolidate these and examine the relationships between them for the long term benefit of the company. It should also proceed in tandem with the next stage of “Where do we want to be?”, i.e., with the Strategic Vision of the organization. The purpose of any project or investment should be to further enhance the sustainable competitive advantage of the organization, and achieving its long-term objectives and goals. This should be the acid-test to evaluate any opportunity.

3.1.2

The key tasks are:

3.1.3

1.

List all opportunities that have already arisen based on detailed study and analysis of options.

2.

Undertake further consultation if required to expand and clarify opportunities and ensure that the opportunities identified reflect the desired company outcomes.

3.

Consolidate and categorise opportunities.

4.

Identify relationships and linkages between opportunities and projects.

Projects should be categorised by industry and type of project. Types of project can be categorised as: 1.

Strengthening (build on strengths and linkages, consolidating).

2.

Active marketing (seeking and attracting opportunities).

3.

Reactive (facilitating opportunities as they occur).

4.

Direct action (development initiatives).

By categorising projects like this an organisation can begin to see how it can optimise its available resources to its best potential.

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It is also important at this stage that project task forces are well thought about, including potential names of participants.

3.2. PROJECT PRE-FEASIBILITY ASSESSMENT - ARE THE OPPORTUNITIES REALISTIC? 3.2.1

Having identified projects and opportunities, undertaken a brief assessment and determined a list of priority projects, the next stage is to undertake a pre-feasibility assessment of each project to see if it will stack up.

3.2.2

For each project all available information should be gathered into a standard layout project document template. Information consolidated for each project would typically include: 1. Project title. 2. Description - outlining the intent of the project. 3. Rationale - local context. 4. Project type/linkages - broader context. 5. Resources required - skills, finance, knowledge. Technology, 6. Benefits/effects - economic, social, environmental. 7. Limitations/risks – economic, political. 8. Potential implementation task force.

3.2.3

Through this process some projects may appear to be not feasible or unrealistic. In this case they should be shelved in favour of more feasible or realistic projects. The output will be a series of project information sheets used for internal/external action planning or could be made available to prospective investors.

3.2.4

In some cases this will result in investment attraction briefs and marketing material, whilst others may result in an internal signoff that the project is viable and worth pursuing.

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SECTION - 4 PROJECT SELECTION CONSIDERATIONS AND FEASIBILITY STUDIES This Section includes

What is a Feasibility Report?



Why Prepare Feasibility Studies?



The Conceptual Stage



The Pre - Feasibility Report



The Feasibility Report

4.1. WHAT IS A FEASIBILITY REPORT? 4.1.1

Feasibility report is an analytical tool used during the project planning process which shows how a project would operate under a set of assumptions, the technology used and the financial aspects. It also gives an outline description of the recommended solution and explains the reasons for selection.

4.1.2

It is conducted during the deliberation phase of project development before financing is secured. The study is the first time in a project development process that the pieces are assembled to see if they perform together to create a technical and economically feasible concept. It is therefore, called techno-economic feasibility study.

4.1.3

The feasibility study evaluates the project’s potential for success. If after completing a feasibility study, the group decides not to proceed, there is no need to create a project plan. The perceived objectivity of the evaluation is an important factor in the credibility placed on the study by potential investors and financiers. The study beings out the possible future outcome under presently prevailing factors, both financial and economical.

4.2. WHY PREPARE FEASIBILITY STUDIES? 4.2.1

Developing any new business venture is difficult and involves large financial outlay. Taking a project from the initial idea through the operational stage is a complex and time consuming effort. Before the potential invest in a proposed business proposal, they must determine if it can be economically feasible, financially viable and then decide if investment advantages outweigh the costs and risks involved. Often construction project operations involve risks with which the are unfamiliar. The feasibility study allows groups to preview potential project outcomes and to decide if

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PROJECT MANAGEMENT they should continue. It is an integral part in developing any project. The purpose of the feasibility study is to explore the project in enough detail for the interested parties and stakeholders to make a commitment to proceed with the development of the project. 4.2.2

Feasibility studies are useful and valid for many kinds of projects. An evaluation of a new business venture both for new groups and established businesses, is the most common, but not the only usage. Studies can help groups to expand existing services, build or remodel facilities, change methods of operation, add new products, or even merge with another business. A feasibility study assists decision makers whenever they need to consider alternative development opportunities.

4.2.3

Although the cost of conducting a study may seem high, they are relatively insignificant compared with the total project cost. The small initial expenditure on a feasibility study can help to protect larger capital investments. On the contrary, applying the lessons gained from a feasibility report can significantly lower the project costs. Feasibility study permits planners to outline their ideas on paper before implementing them. This can reveal errors in project design, before their implementation negatively affects the project. The study also presents the risks and returns associated with the project so the prospective can evaluate them. There is no correct rate of return a project needs to obtain before a group decides to proceed. The acceptable level of return and appropriate risk rate will vary case to case depending on industry, size of investment, geographical location, government policies, changes in market conditions, changes in economic factors etc

4.2.4

The study is not conducted as a forum merely to a desire that the project will be successful. It is rather an objective evaluation of the project’s chance for success. Studies with both positive and negative conclusions can assist a group’s decisions. Even conclusion to drop a project based on the study would substantially save the promoters’ time, efforts and money.

4.2.5

The creation of a Feasibility study, although part of the project cycle, contains a process in itself. It consists of the following steps.

4.3. THE CONCEPTUAL STAGE 4.3.1

The conceptual study is the first level study and the preliminary evaluation of the construction project. Often groups proceed directly to the feasibility study and overlook the importance in making the first decision with deliberation. Take the time to determine if a feasibility study is appropriate. Careful consideration whether to conduct a feasibility study will save much time and money and increase the study value once completed. Moreover if this decision is conducted thoughtfully, the group will probably have established a procedure for decision-making. Then the decisions that the group needs to make later in the development process will probably come easier and the likelihood of it being correct will be greater.

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4.3.2

The principal parameters of the conceptual study are mostly assumed and/or factored. Accordingly the level of accuracy is low. Flow sheet development, cost estimation and construction scheduling are often based on limited data, test work and engineering design.

4.3.3

The result of a conceptual study typically identifies: 1. Technical parameters requiring additional examination. 2. General features and parameters of the proposed project. 3. Magnitude of capital and operating cost estimates. 4. Level of effort for project development.

4.3.4

A conceptual study is useful as a tool to determine if subsequent studies are warranted. However, it is not valid for economic design making.

4.4. THE PRE - FEASIBILITY REPORT 4.4.1

Prior to initiating a feasibility report, the group needs to sketch out possible design of the project. This can begin with the “back-of-the-envelope” calculations and proceed through a formal pre–feasibility study for complex projects. The purpose of this phase is to establish whether a project looks likely to happen and calculate the potential cost of carrying out the full feasibility study. It also serves the purpose of initiating wider public interest. Sufficient work has to be completed to develop the project and processing parameters for equipment selection, consumables, flow sheet, production and development schedule.

4.4.2

The degree of detail carried out in the pre-feasibility study will be dependent on the nature and type of the scheme. The economic analysis from a pre-feasibility study is of sufficient accuracy to assess various development options and the overall project viability. However, these cost estimates and engineering parameters are typically not considered of sufficient accuracy for final decision making or bank financing.

4.4.3

At the end of the pre-feasibility stage, the promoting organization will have to make a decision on whether to proceed to the full feasibility study phase and will have the job of raising investment to carry this out. As the pre-feasibility study itself would take into all salient aspects, it would enable the promotes to take proper judgment on the future course of action.

4.5. THE FEASIBILITY REPORT 4.5.1

The feasibility report represents the last step for evaluating a process for “go or no-go” decision and financing purposes. It presents a holistic view of the entire project. The principal parameters for a feasibility report are based on sound and complete engineering and design work.

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PROJECT MANAGEMENT 4.5.2

Although all studies must start with certain assumptions, they must be closer to reality to give a value to the study. A feasibility study presents the environment where the project will occur and describe its scope. The description also includes the need for the project and how the group can accomplish the goals. The scope also includes the key elements of all aspects of the project. Potential reaction by competitors should be included in the study.

4.5.3

The study also includes the rationale for scenario selection. Both worst-case possibilities and optimistic scenarios are compared. Comparative results from scenarios are presented in tables. Possible economic outcomes should be a prominent part of a feasibility study. Operating costs and net revenues are factors that show if the project is economically viable. The study contains pro-forma balance sheets, operating statements, benefit-cost ratios, projected cash flows, and internal rates of return for the project. These are normally based on a projection extending up to the tenure of the term loans.

4.5.4

The study includes possible project risks for potential and other investors, project technology, potential legal and governmental setbacks, management and labour resources and time-critical factors. Most importantly, the feasibility study enables to make constructive, informed decisions on whether to proceed with, revise, or abandon the project.

4.5.5

Simply put the feasibility study is a formal technical report that is used by the company to determine whether the proposed project is capable of being developed at a sufficient return to justify the capital and managerial resources that must be committed to the project.

4.5.6

The level of accuracy for a Feasibility Report is higher then the pre-feasibility report. The objectives for the feasibility report is the same as those listed for the pre-feasibility report, but the level and detail and accuracy for each objective are stringent. Detailed calculations have to be worked out to develop the flow sheet development, equipment selection, consumables, power consumption, material consumption, drawing, construction schedule and capital and operating cost estimates.

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SECTION - 5 PROJECT APPRAISAL AND COST BENEFIT ANALYSIS This Section includes

Project appraisal



s of Project Reports



Contents of Project Reports



Means of Financing



Investment and Return



Investment Criteria



What-If & Sensitivity Analysis



Risk Analysis

Important Note: Several aspects of this chapter have already been covered in Module 2 under ‘Capital Budgeting’.

5.1. PROJECT APPRAISAL 5.1.1

Project appraisal is the last step in the project cycle which involves negotiation.

5.1.2

The aims of appraisal are to: 1. evaluate the financial, economic, and social objectives of the project; 2. the procedures of the project formulation team; 3. recommend the conditions which will ensure that the project objectives are met; and 4. ensure that the proposed grant/loan/expenditure is in accordance with the overall policy framework of the financing institution. 5. assess the safety and security of funds likely to be committed to the project.

5.1.3

Project appraisal is a process of verification of the situation in the field and a scrutiny of the report. The form of appraisal will vary according to the type of project. For production-oriented projects it will normally include the following aspects: 1.

Technical, for example, engineering design and environmental matters;

2. Financial, for example, requirements for funds, the financial situation of the implementing agency and of project beneficiaries when appropriate; 3. Commercial, for example, procurement and marketing arrangements;

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PROJECT MANAGEMENT 4. Social, for example, sociological factors and expected impact of the project on certain groups (such as ethnic minorities and women); 5. Institutional, for example, organization and management arrangements, the requirement for arrangements of technical assistance, project monitoring and evaluation; 6. Economic, for example, project costs to the national economy and the size and distribution of benefits. 5.1.4

The format and content of any appraisal report changes with the agency, bank, or corporation concerned, and is their internal reference document. Thus, its reflects their views and not those of the project formulation team. It is on the basis of this report that the project is formally approved. It is also the reference document for the implementation agreement and subsequent evaluation made. Though the format might change from one institution to another, the basic criteria is same. It is to assess the project’s viability, profitability, repaying capability, socio-economic factors and above all the promoters’ background and their commitment to the project.

5.2. S OF PROJECT REPORTS 5.2.1

The s of a project report are: 1. Prospective Investors / Shareholders 2. Lenders / Creditors 3. Employees 4. Suppliers 5. Government Agencies – Ministries, FIPB, RBI, Excise, Sales Tax, Income Tax, etc.

5.3. CONTENTS OF PROJECT REPORTS 5.3.1

The contents of a project report normally are: 1. Objectives of the Project 2. Market Survey 3. Location Study 4. Technology Options and Viability 5. Economic and Financial feasibility: a. Project Cost Estimates b. Projected Balance Sheet, Profit and Loss , Cash Flow Statement c. Appraisal Criteria and Financial Viability

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6. Promoters and Management 7. Statutory compliances required to be complied with; etc 5.3.2

Elements of Project Cost The major elements of Project / Capital cost are: 1. Land and Site Development 2. Buildings and Civil Works 3. Plant & Machinery including Utilities and Services 4. Technical Consultancy Fees and know-how fees 5. Miscellaneous Fixed Assets 6. Preliminary and Pre-operative expenses and Interest during Construction 7. Provision for contingencies 8. Margin money for working capital

5.3.3

Elements of Operating Cost: 1. Materials 2. Power & Fuel 3. Labour - Wages & Salaries 4. Factory Overheads 5. istration Overheads 6. Selling & Distribution Overheads 7. Depreciation (part of Overheads) 8. Interest

5.4. MEANS OF FINANCING 5.4.1

Project plan should address the financing mix and how funds are proposed to be raised. The normal means of financing are: 1. Equity:

Share capital



Internal accruals

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PROJECT MANAGEMENT 2. Debt:

Term Loans



Debentures



Other forms of debt. This may include suppliers’ credit.

3. Other : such as subsidies, grants, interest free deferrals etc

5.5. INVESTMENT AND RETURN 5.5.1

The fundamental evaluation issue in dealing with a long-term asset is whether its future benefits justify its investment.

5.5.2

Investment is the monetary value of the assets the organization gives up to acquire a long-term asset.

5.5.3

Return is the increased future cash inflows attributable to the long-term asset.

5.5.4

Investment and return form the foundation of capital budgeting analysis, which focuses on whether the expected increased cash flows (return) will justify the investment in the long-term asset.

5.5.5

As already mentioned, investment appraisal consists of the following steps: 1. Forecast of project costs and benefits for a reasonable time frame, 2. Ascertaining the project risk wrt competition, Technology, Consumer preferences, market including international currency fluctuations., 3. Estimating the cost of capital, weighted average cost of capital, mix of capital, 4. Application of suitable investment criteria by adopting proper means of financing 5. Analysing managerial strengths, capabilities, project and profitability sensitivity to any changes, regulations governing the project implementation etc;

5.6. INVESTMENT CRITERIA 5.6.1

214

The various investment criteria normally employed in project appraisal are:

Payback period



ing Rate of Return



Net Present Value

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5.6.2



Internal Rate of Return



Profitability Index



Debt Service Coverage Ratio (DSCR)

Cost of Capital: The cost of capital is the interest rate used for discounting future cash flows. It is also known as the risk-adjusted discount rate. The cost of capital is the return the organization must earn on its investment to meet its investors’ return requirements. The organization’s cost of capital reflects:

The amount and cost of debt and equity in its financial structure



The financial market’s perception of the financial risk of the organization’s activities

5.6.3

In practice, capital budgeting must consider the tax effects of potential investments, and effects of inflation.

5.6.4

Capital budgeting analysis relies on estimates of future cash flows. Estimating future cash flows is an important and difficult task. This is important because many decisions are taken based on those estimates.

5.7. WHAT-IF & SENSITIVITY ANALYSIS 5.7.1

Two other approaches to handling uncertainty are what-if and sensitivity analysis. The project planner can set up a computer spreadsheet to make changes to the estimates of the decision’s key parameters.

5.7.2

If the analysis explores the effect of a change in a parameter on an outcome, we call this investigation a what-if analysis. For example, the planner may ask, “What will my profits be if sales are only 90% of the plan?”

5.7.3

A planner’s investigation of the effect of a change in a parameter on a decision, rather than on an outcome, is called a sensitivity analysis. For example, the planner may ask, “How low can sales fall before this investment becomes unattractive?”

5.8. RISK ANALYSIS 5.8.1

Risks relates to:

Implementation



Market



Financial

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PROJECT MANAGEMENT 5.8.2

The analyst is expected to keep the end result of the model in mind, i.e., the ability to vary the key drivers of the model results [Sensitivity Analysis].

5.8.3

The purpose is to de-risk the project through simulation of probable results:

Sensitivity analysis: Variation in key parameters and impact on profitability



Scenario analysis



Simulation techniques

Break-even analysis: Minimum level of operation (Cost Behaviour – Variable, and Fixed), BreakEven Point: No Profit or Loss, and Cost - Volume - Profit Analysis.

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SECTION - 6 SOURCE OF PROJECT FINANCE & FOREIGN COLLABORATION This Section includes

Financing of Projects and Foreign Collaboration

6.1 FINANCING OF PROJECTS AND FOREIGN COLLABORATION

Financing of large projects comes under the purview of project finance which is defined as the financing of a project such that the lender is prepared to look only to the earnings of the project as the source of funds from which his loan will be repaid and to the assets of the project as collateral for the loan



Construction of Suez Canal, expansion of North sea oilfields are earlier examples of project finance. International banks provide project financing for a vast range of projects, including mineral developments, toll roads, tunneling projects, theme parks, power stations and shipping and aircraft finance



The uniqueness of project finance is that every financial facility is specifically tailored to suit the individual project and the needs of the parties sponsoring it.



Project finance describes a large scale, highly leveraged financing facility established for a specific undertaking whose creditworthiness and economic justification is based on the project’s expected cash flows. It is the project’s own economics rather than its sponsor’s financial strength that determines its viability. The sponsor isolates this activity, a method known as ring-fencing, from its other business.



Through careful structuring, the sponsor may shift specific risk to project customers, developers and other participants, thus limiting its own financial risk



The process of sharing risk is expensive. The increased cost is caused by the identification of a whole range of risks which must be incorporated in any contract documentation. Since, project finance is highly leveraged, its overall cost of finance may still be lower than a company’s usual WACC.



Non-recourse project financing happens when lenders do not at any stage during the loan period, have recourse for repayment from any cash flows other than project cash flows. These are very rare.



Most projects are financed on a limited recourse basis

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The difference between without recourse and with limited recourse happens when the project is abandoned. On a non-recourse basis, the sponsors can walk away from the project without liability to repay the debt. Limited recourse financing is a more accurate description of most project financing involving bank lenders, where the ability of lenders to look to project sponsors for repayment of debt in the event of problems with the loans is restricted.



Lenders are attracted to project finance because they receive processing and other fees compared with other business transactions they undertake. They can be protected from interest and capital repayment default by a range of covenants from the sponsor and other parties.



Spreading specific project risk over several participating lenders lessens dependence on a single sponsor’s own credit standing.

6.1.1

How project finance is different from conventional corporate borrowing?



Project is established as a distinct, separate entity



It primarily relies on debt financing, which form nearly 60 to 70 percent of project cost, the balance being equity contributions or subordinated loans from the sponsors.



Project loans are directly linked to project assets and cash flows



The sponsor’s guarantees to lenders do not, cover all the risks.



These projects are rated by credit rating agencies



Firm commitments by various third parties, such as suppliers performance guarantees, purchasers of the project’s output, government authorities providing planning permissions and the project sponsors themselves, are obtained and these create significant components to the credit financing of the project



The debt of the project entity is separate from the sponsor’s companies direct obligations



The finance is usually for a longer period of time

6.1.2

Risks in project finance



Internal risks

Operating risk



Raw material handling risk



Completion



External risks



Country or political risk



Off take risk

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Market risk



Financial risks(foreign exchange)



Documentary risk



Force majeure risk

6.1.3

Private finance initiative



Public services, often face service demands that they can not meet for want of infrastructure and facilities. This may be due to a shortage of finance in the sense that public borrowing is constrained by macro economic policies



Many governments today, in order alleviate the above situation, are encouraging the use of private investments in services traditionally provided by the public sector. This is done through private finance initiative



It has become the governments main instrument for delivering higher quality and more cost effective public services. Its aim is to bring the private sector more directly into the provision of public services, with the public sector as an enabler and guarding the interest of the s and customers of public services.



PFI and PPP(Public private partnership) schemes allow public bodies to contract directly with the private sector organizations for the provision of capital finance.



The private sector organizations accept some of the project’s risk in return for an operator’s licences to provide specified services with a view to making a profit and hence a return on equity



The operator generates this return on equity through revenue stream arising from the services



The operator will be part of a consortium



PFI projects have the following characteristics

The contractor provides the capital investment The investments is funded by banks and other of the consortium, including the operators The contractor assumes some of the venture’s construction risks The operator is awarded an operating licence for the capital facility to provide associated services, for example hospitals and assumes operating risks The ownership of the facility is transferred to the private sector through the setting up of a separate company to build and run the project Foreign Collaboration:

India is the second largest country in Asia and the seventh largest in the world. The opening up of the Indian Economy has thrown open investment opportunities in almost every field of business from the consumer sector to core infrastructure sectors. All these sectors are witnessing growing multinational interest.

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PROJECT MANAGEMENT Economic activity in India is carried out in two broad segments viz. the organized sector and unorganized sector. The Organised sector is engaged in:

Industry;



Banking;



Defence;



Infrastructure such as Air, Road, Rail, Power, Communication, Ports, Shipping etc)

The Unorganized sector is engaged in:

Agriculture;



Retail and wholesale trade;



Road transport;



Miscellaneous service etc.

There used to be all pervasive regulatory framework controlling every aspect of corporate, industrial, trade, banking and other financial activities. The Government has in recent times, moved ahead aggressively to reduce state control and ownership in the economy, remove protectional barriers, invite foreign direct and portfolio investment and initiate other reforms to make India a free market economy. After India’s economic reforms and globalization measures, it has become very common for foreign companies collaborating with Indian companies and vice-versa in several industrial sectors. The Government has also relaxed many conditions for entering into collaboration agreements with foreign companies. Foreign Investment Promotion Board (FIPB) under the Ministry of Commerce, is empowered to approve even 100% foreign equity, under certain categories. Foreign companies can open branch offices in India for specified activities and foreign institutions can operate in the Indian capital markets. Automatic approval for investment in Indian companies is permitted by Reserve Bank of India up to certain % of share capital depending on industry. RBI has prescribed sectoral caps for such investments in Indian companies. Several Direct Tax reforms, trade policy measures, financial sector operational reforms have been initiated and continuous being relaxed more and more. Industrial policy reforms have already started contributing for the growth of the economy of the country. Students are advised to refer the websites of Reserve Bank of India, Government of India’s websites of various ministries for more details. 220

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STUDY NOTE - 8 INTERNATIONAL FINANCE

SECTION - 1 RISK ASSESSMENT AND MANAGEMENT This Section includes

•

Minimization of risk

•

Risk defined

•

Risk mapping

•

Financial risk

1.1. MINIMIZATION OF RISK 1.1.1

Organizations are exposed to two major types of risks namely, business risk and finance risk. Business risk arises due to industry, economy, credit and political factors, causing volatility in sales. Finance risk can be either price risk, interest rate risk or foreign exchange risk.

1.2. RISK DEFINED 1.2.1

1.2.2

Risk is an uncertain future outcome that will either improve or worsen our position. There are three key points to be observed: •

Risk probabilistic

•

Risk symmetrical-the outcome may be either favorable or unfavorable

•

It involves change

In risk management, we are mainly concerned with ensuring that the downside risk is not catastrophic. Therefore, risk mitigation has to be the main function of senior management team in any organization.

1.3. RISK MAPPING An organization’s attitude towards the various forms of risk to which it is exposed should be a direct interpretation of its strategy. Strategy itself must address the appetite and capacity for risk within the business and the systems and actions of the organization regarding risk should

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INTERNATIONAL FINANCE seek to attain the goals envisaged by the strategy. The process of assessing for the organization as a whole the types and degree of risk to which it is exposed is known as risk mapping.

1.4. FINANCIAL RISK 1.4.1

The following six major headings suggest themselves within the financial category 1. Credit risk 2. Cash flow risk 3. Foreign exchange risk 4. Interest rate risk 5. Commodity price risk 6. Gearing-financial and operational risk

‘Risk’, ‘Peril’ and Hazard’ ‘Peril’ is the cause of a loss; (eg. Fire) and ‘Hazard’ is the factor that may create loss (eg. Wrong wiring, improper construction etc) ‘Risk’ is the possibility of a loss due to the above factors; Degree of risk is not an absolute, independent amount. It is related to •

level of information available;

•

degree of information available;

•

interpretation of the information and

•

the perception of the entity as to the future outlook——Two different entities might interpret them differently; —better the interpretation, lesser the risk;

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SECTION- 2 INTEREST RATE RISK This Section includes

What is Interest Rate Risk?



Quantifying interest rate risk - Gap analysis



Interest rate risk management products

2.1. WHAT IS INTEREST RATE RISK? 2.1.1

Interest rate risk is the risk of gain or loss from the rise or fall of interest rates. As all organizations are at times, lenders or borrowers, this is of great importance. The s of capital are fundamentally concerned about interest rate risk as it affects the cost of raising funds thereby the profitability and viability of business.

2.1.2 Example A corporate bond with a face value of Rs. 100 and a coupon rate of 8% matures in two years with a bullet repayment. What is the price of the bond if the yield to maturity is 8%, 6% and 10%? •

Yield to maturity is the market expected rate of return for this class of bonds

•

Price of the bond is the present value of cash flows from the bond (coupon and principal repayment), discounted at the Yield to maturity rate. (a)

at 8% the price of the bond is 100

(b)

at 6% the price of the bond is 103.67

(c)

at 10% the price of the bond is 96.53

2.2. QUANTIFYING INTEREST RATE RISK - GAP ANALYSIS 2.2.1

A company may be borrowing and lending at the same time. For example, consider a bank. We can treat all positive and negative cash flows as a portfolio and if properly time-slotted, the exposure is directly related to the absolute amount of the net cash flow for each period. If there is net surplus, the organization can lose money if the interest rates decline and vice versa for a shortage. There is some natural reduction in overall risk if surpluses in some periods are matched by shortages in others. A table is prepared to show the portfolio of cash surpluses and shortfalls over time. This is known as gap analysis.

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Duration:

The gap analysis system gives a useful overall view of the exposure, but it is not helpful when considering the value of an individual asset or liability. Duration is a useful measure in assessing the interest rate exposure of a specific bond or a debt instrument. Let us take the example of two bonds, namely A and B. Both instruments will mature in five years. Bond Coupon Maturity YTM

A 3% 5 7%

B 10% 5

Years

Comparison of bonds A and B for different YTMS YTM 3% 5% 7% 10%

Price of A Change(%) Price of B Change(%) 100.00 132.06 91.34 -9% 121.65 -8% 83.60 -8% 112.30 -8% 73.46 -12% 100.00 -11%

For both the bonds, the value falls as YTM increases. But, we find that Bond A is more susceptible to interest rate changes when compared to Bond B because the cash flow sequences differ. A measure that captures this sensitivity is the weighted average maturity of the bond, known as the duration. In other words, it is the average measure of time for waiting to receive the cash flows from a bond. 2.2.3

Computation of Duration: Time 1 2 3 4 5

Time 1 2 3 4 5

224

Cash flows 3 3 3 3 103

Cash flows 10 10 10 10 110

A

A

PV CFA 2.80 2.62 2.45 2.29 73.44 83.60

(Time)X(PVCFA) 2.80 5.24 7.35 9.15 367.19 391.73 Duration

4.69

PV CFA 9.35 8.73 8.16 7.63 78.43 112.30

(Time)X(PVCFA) 9.35 17.47 24.49 30.52 392.14 473.96 Duration

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Note: Duration is measured by dividing [Time X PVCFA] by PVCFA The lower the duration, less is the interest rate of that bond. Duration is a measure of the interest rate risk, which can be used to compare various classes of bonds and categorize them in order of their exposure, measured by duration. 2.2.4

The interest rate risk can be managed by matching the duration of assets with the duration of the liabilities. For example, if we need to raise debt finance to proceed with a project, by ensuring that the duration of the ‘debt portfolio’ is reasonably matched to that of the project’s cash flows, we can reduce significantly the interest element of the total project risk. The matching has to be on one-to-one basis. Otherwise, aggregate amounts might tally but when average costs & returns vary, the net effect will also have serious implications.

2.3. INTEREST RATE RISK MANAGEMENT PRODUCTS 2.3.1

There are two types of interest rate risk management products: 1. Forward rate agreements (FRAs) and interest rate futures 2. Swaps

Sources of Risk Affecting both P&L and Balance Sheet. •

•

•

Interest Rate risk; -

floating rate interest;

-

fixed rate borrowings and floating rate investments;

Exchange risk; -

need not even operate in foreign market;

-

inter-linkages between various markets.

Default risk; -

•

•

inability or unwillingness;

Liquidity risk; -

bankruptcy;

-

even profitable firm may be liquidity risk;

-

excess funds also cause for concern.

Business risk;

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•

•

•

-

internal & external;

-

strike; death of key person; break-down; obsolescence;

-

govt.policy; competition; customer preference;

Financial risk; —

like liquidity risk;

-

bankruptcy;

-

working capital structure is a reason;

Market risk/ price risk; -

depletion in value of investment due to market movements;

-

mostly due to interest rate risk and exchange risk;

Marketability risk; -

not readily marketable;

-

need not be linked to need for funds;

-

If so, non-marketability may lead to liquidity risk.

This is only illustrative and not exhaustive. 2.3.2

Derivatives:

The above products are known as derivatives. A derivative is a financial product whose performance is based on the price movement in an underlying asset; the asset might be a bond, share or lump of gold. A derivative can be bought or sold without buying the underlying the asset. 2.3.3

F`RAs and Interest rate futures lock in interest rates. The main difference is that FRAs are over-the-counter (OTC) deals offered by particular financial institutions while future contracts are exchange-traded. Exchange traded means the contracts can be only traded through the exchange i.e exchange is the counter party for every transaction, while OTC refers to bilateral trade or contract between private parties typically between a financial institution and a customer. Between OTC and exchange traded decisions, the choice is to balance convenience against cost.

2.3.4

Hedging is the generic term used to mean reduction of financial risk, by the use of financial products.

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SECTION- 3 FORWARD RATE AGREEMENT This Section includes

Forward Rate Agreement



Futures

3.1. FORWARD RATE AGREEMENT 3.1.1

A Forward Rate Agreement (FRA) is an agreement between two parties which determines the interest rate that will apply to notional loans or deposits on a predetermined date in the future and for a specified period. It does not necessarily involve either a loan or a deposit and is simply an agreement between two parties to compensate each other for the difference between the agreed FRA rate and the relevant market interest rate at the start of the notional transaction. FRAs are quoted in of the contract period. For example, ‘three against six months’ will refer to three-month period starting in three month’s time.

3.1.2

Illustration: A company finds that credit extended to a major customer is longer than that obtained from suppliers. In three month’s time, the company will need working capital for a further three months. On 12 February, the BB bank writes an FRA for “three against six months”(or 3 v 6) at 8%. Settlement date is 12th May. Let us compare the difference probable outcomes to explain FRAs.

Situation-1- On 12th May, the three month market rate is 9% The company borrows at the market rate

9%

BB bank pays the difference between 9% and 8%

-1%

The actual rate incurred by the company

8%

is

Situation-2-On 12th May, the three month market rate is 7% The company borrows at the market rate

7%

The company pays BB the difference between 7% and 8%= 1 % The actual rate incurred by the company is

8%

Essentially, by buying a three against six FRA, the company has agreed to lock in the three month forward interest rate of 8%

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INTERNATIONAL FINANCE 3.1.3 The point to be noted is that the FRA does not itself involve the borrowing or lending of money, it is merely a contract for a ‘difference payment’ between the two parties. In the above example, the company actually borrows the required funds from one of its usual sources, but the FRA ensures that the net rate of interest is fixed in advance. 3.1.4

Typically, a rate of interest and a market reference rate, usually LIBOR, are specified in the FRA contract.

3.1.5

Advantages of FRAs: •

Future interest rate exposure can be hedged without commitment to a specified borrowing or deposit.

•

Transaction can effectively be reversed at any time to the start of the FRA by taking out an equal and opposite FRA known as an offsetting position.

•

FRAs are usually tailored by banks to meet the specific requirements of companies in of both dates and amounts

3.2. FUTURES 3.2.1

A Forward trade is a contract between two parties, for one to deliver to the other a specified quantity of goods of a specified quality at a specified date in the future and at an agreed price. The goods can be commodities or financial instruments or interest rates, as was explained earlier in the case of forward rate agreements. No money changes hands at the time and buyers pay the agreed price only when they receive the goods. FRA is a type of the over the counter forward trade for shot term interest rate products.

3.2.2

The above contract is between two counter parties.

3.2.3

In the case of futures, the contract is standardized in of the size of the contract and the future settlement dates. For interest rate futures contracts the standardized size of one contract is pounds 500000 on the LIFFE and there are only four settlement dates a year. It is not possible to trade in fractions of contracts. Futures contract are not made directly with a counter party, but through a clearing house. Therefore, there is no worry about default of the counter party, as this risk is borne by the clearing house.

3.2.4

Both forward and future contracts can be closed any time before the expiry date.

3.2.5

Illustration of a future contract

In the middle of April, a speculator believes that there is going to be a worse harvest of wheat than expected this year. October wheat contracts are trading at Rs.300 and the contract size is 5000 tonnes. The speculator buys 10 contracts believing that the price of wheat will rise as October approaches. Situation-1 By end of September, the harvest was very poor, and the October wheat futures have risen to

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Rs 325 as wheat is in scarce supply. The speculator can now book his profit without waiting till October. Profit per futures contract=(325-300)* 5000=125000 Profits on 10 futures contract=125000*10=1250000 Situation-2 There was a better harvest than expected and October future prices have fallen to Rs.290 per tonne. The speculator decides to close out his position now to avoid further losses. Loss per futures contract=(290-300)*5000=50000 Loss for 10 contracts=10*50000=500000

3.2.6

Standardization makes the market liquid. Future prices act as a signal of the fair market price to all market participants.

3.2.7

One of the important points in the case of futures contract is that settlement is guaranteed by a clearing house. It completely eliminates counter party risks or default risks.

3.2.8

Illustration:

On February 1, a corporate borrower 1 million three month loan from the money market which costs 7% per annum and will be rolled over (i.e. renewed) on 1 may. The borrower wants protection against a rise in interest rates, and considers using two three-month interest rate future contracts of 500000 face value each to hedge his 1 million loan. •

The borrower sells two June futures contracts

•

A June futures contract is based on a notional three-month deposit beginning in June

•

The futures contracts are priced by subtracting the implied annualized LIBOR interest rate from 100

•

The market expectation for June futures contract sold on 1st of feb is present spot rate of 7%

•

The price of the futures contract will be 100-7=93

•

This means that the market expects no change in the interest rate

•

If the interest rate have risen to 8.5% on 1st may when the loan is rolled over, the price of the June futures contract will have fallen to 91.50, 100-8.5.

•

The borrower buys an offsetting contract at the lower price.

•

In futures contract, the borrower has to reverse the hedge by buying back tow June contracts

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INTERNATIONAL FINANCE •

If an FRA had been used, it could probably have been arranged to mature on 1st may, the required date

•

Futures were used because they were cheaper overall

•

Since each futures contract has a 500000 face value, the 1.5% increase in interest rate(150 basis points) results in a gain of:

•

2 contracts X 1.5% X 500000 X (1/4 of the year)=3750

•

When the loan is rolled over on 1st may, the borrower has to pay 8.5% in the cash market, costing 1000000 X 8.5 X (1/4)=21250 for the three month loan

•

The borrower has gained 3750 from the future hedge, so his net interest cost is 17500 which equates to 7%

•

The actual buying and selling of futures contract involves payment of margins.

•

There is an initial margin on opening the position, followed by a daily variation margin as the position is marked to market

•

Marked to market means you close out your position by buying back a contract you have previously sold or by selling a contract you have previously bought

•

Through this process, any risk of default and system collapse are averted.

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SECTION - 4 INTEREST RATE SWAPS This Section includes

• • • •

Interest rate swaps Single-Currency Swap Cross-Currency Swap Rationale behind Swaps

4.1. INTEREST RATE SWAPS 4.1.1

The second product group used by corporate treasurers for managing interest rate risk is swaps.

4.1.2

All swaps involve interest and currency.

4.1.3

A swap is an agreement between two parties to pay to each other a stream of cash flows for a set period of time, calculated on a specified basis on a fixed sum of money.

4.1.4

It means that the two parties each take out a loan and agree to pay each other’s interest obligations i.e they swap interest payments in such a way that it saves money for both borrowers.

4.1.5

More than 80% to 90% of Eurobonds are launched as part of a ‘bond plus swap’ package.

4.1.6

The of the original issue of bond is of no concern. The borrower, through swaps, can convert any inappropriate into favorable of amount, currency and interest rates.

4.2. SINGLE-CURRENCY SWAP •

Company A borrows 100 m at a fixed rate, although it actually wants to pay interest on a floating rate basis.

•

Company B borrows 100 m, but on a floating rate basis even though it really needs a fixed rate loan.

•

Both of them agree, through an intermediary bank, that A will pay floating rate interest on 100 m to B, in return, B pays to A fixed interest on 100 m. This agreement is the single-currency swap, as only one currency is involved.

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INTERNATIONAL FINANCE •

Since the interest payments are all in the same currency they be offset, and in practice only a net difference amount will be paid at each relevant date.

4.3. CROSS-CURRENCY SWAP •

Company A borrows 100 m USD at a fixed rate, although it actually wants to borrow 175 m swiss franc, paying fixed rate of interest. At this time, the spot exchange rate was swiss franc 1.75/us dollar 1.

•

Company B borrows Swiss franc 175 m at a fixed rate, actually needing fixed rate US dollars.

•

A has Swiss franc and B has Dollars. They agree to swap the principal amounts and the interest.

4.4. RATIONALE BEHIND SWAPS 4.4.1

Why do borrowers use swaps despite a lot of work?

4.4.2

Swaps are resorted only if the net result is a lower cost of funds. There are three major reasons for the lower cost of funds.

4.4.3

Name recognition: A particular borrower may be well known to investors in some markets and will be able to raise funds at a cheaper rate in one currency. He can look for another borrower who may be able to raise the currency that he needs at a lower cost in his own country. With banks acting as intermediaries, these two parties can be brought together, resulting in lower cost of funds for everyone.

4.4.4

Differential risk spreads: Investors in a fixed rate market demand higher credit risk as the quality falls than investors in the floating rate interest market. Floating rate lenders might accept an increase in spread from say .25% to .75% as sufficient inducement to accept an ‘A-‘ quality borrower rather than ‘AA+’ one; fixed rate investors could well demand a differential of 1.00% to 1.20% between ‘A-‘ and ‘AA+’. Locking into long term fixed rate involves more market risk for an investor than does an equivalent floating rate deal. Investors in fixed and floating instruments form clearly defined and separate sets.

4.4.5

Independent markets: Various markets for currencies and fixed/floating rates are separate and individual, and the interest rates in each are defined by supply and demand in each market independently. Different conditions, or regulations can apply to the different market rates.

4.4.6

All these factors, working simultaneously, show why swaps are very popular.

4.4.7

Illustrations:

Single currency swaps

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•

Company A and Company B, both wish raise US 80 M dollars for five years

•

Company A has the choice of issuing fixed rate debt at 7.75% or floating rate debt at LIBOR+25 basis points

•

Company B, which has a lower credit rating, can issue fixed rate debt of the same maturity at 8.70% or floating rate at LIBOR+ 37 basis points

•

The table below shows the position and savings. Single Currency Swap

Company A Company B Difference on risk s Net differential

Fixed rate 7.75% 8.70% 0.95%

Floating rate Libor+0.25% Libor+0.37% 0.12%

0.83%

•

The net differential of .83% provides the motivation for a swap, assuming that company A would prefer to issue floating-rate debt and company B would prefer fixed rate debt with a lower coupon

•

Company A issues fixed rate debt at 7.75% and company B issues floating rate debt at LIBOR + 37 basis points

•

A financial intermediary, bank, organizes a swap between the two companies-Company A, which issued fixed debt at 7.75%, negotiates to pay the bank a floating rate of LIBOR flat while the bank agrees to pay company A a fixed rate of 7.85%

•

The full economics of the swaps is shown in the table below:

Economics of swap Compan A Bank Company B Paid to third party investor -7.75% (L+.37%) Bank pays A 7.85% -7.75% B pays bank 8.00% -8.00% A pays bank -L L Bank pays B -L L Net position (L-.10)% 0.15% -8.37% Cost without swap L+.25% 8.70% Gain 0.35% 0.15% 0.33%

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Illustration: Cross-currency swaps

234

•

Company A wants Sfr 120 m, 5 year fixed. It has the choice of issuing US dollar fixed debt 7.75% or Sfr at 2.5%

•

Company B, which has a lower credit rating, can issue US dollar fixed debt of the same maturity at 8.70% or fixed sfr at 2.62%. It requires US 80 m for five years

•

So, A borrows US dollar 80 m for five years, paying 7.75%; B borrows sfr 120 m at 2.62%, also with a five year term. The spot rate at the time was Sfr 1.5/US dollar 1

•

The intermediary bank does a swap with A, paying the company 7.75% on USD 80 m and receiving 2.15% on sfr 120 m. It also exchanges principal amounts for the life of the swap

•

Similarly, it does a deal with B, paying the company 2.15% on sfr 120 m and receiving 7.90% on US 80 m and also exchanging principal amounts

•

The intermediary bank receives a net benefit of US dollar 15 basis points i.e 7.90%7.75%, the swiss franc side having been arranged to be a ‘ through’

•

Company A could have issued fixed sfr at 2.50% and through the swap, has achieved 2.15%, a net benefit of 35 basis points

•

Company B could have issued fixed US dollar at 8.70% and achieved 8.37% but has a small amount of currency risk because it is paying 7.90% in US dollars and .47% in swiss francs. It will still go ahead with the deal as the risk is small compared to the annual saving of 33 basis points on US dollar 80 m.

•

One can extend this idea of a cross currency swaps into a commodity swap involving commodities like oil, gas, electricity etc

•

Swap is an integral part of modern debt financing.

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

SECTION - 5 INTEREST RATE CAPS, FLOORS AND COLLARS This Section includes

Interest rate caps



Need to Control Capital Assets



Investment and Return



Time Value of Money

5.1. INTEREST RATE CAPS 5.1.1

Interest rate caps is a popular interest rate option offered by financial institutions.

5.1.2

Floating rate note is one where the interest rate is reset periodically equal to LIBOR. The time between the resets is known as the tenor. In this case, the LIBOR may go up or go down after three months. Hence, there is still the risk of the LIBOR going up.

5.1.3

An interest rate cap is designed to provide insurance against the rate of interest on an underlying floating rate note rising above a certain level, in this case the LIBOR.

5.1.4

Principal amount is 10 million USD, the tenor is 3 months, life of the cap is five years and the cap rate is 8%. This means that the maximum rate is restricted to 8%.

5.1.5

Example: On a particular reset date, the three month LIBOR interest is 9%. What is the value of the cap?



If the rate is 9%, the amount of payment involved equals 0.25 X 0.09 X 10 m = 225000



The amount to be paid is 0.25 X 0.08 X 10 m = 200000



The value of the cap equals = 25000

5.2. FLOORS AND COLLARS 5.2.1

Interest rate floors and interest rate collars are similar to caps. A floor provides a pay off when the interest rate on the underlying floating rate note falls below a certain rate. So, the lender will get a minimum.

5.2.2

A collar is an instrument designed to guarantee that the interest rate on the underlying floating rate note always lies between two levels.

5.2.3

A collar is a combination of a long position in a cap and a short position in a floor.

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INTERNATIONAL FINANCE 5.2. 4 Illustration of Caps and Floors: •

A company for five years at LIBOR plus a spread can purchase a cap at 8%

•

In effect, it is purchasing a series of call options on LIBOR with a strike price of 8%

•

A commercial lender has a 300 million portfolio of loans to commercial borrowers.

•

Borrowers pay interest based on the prime rate plus a spread that depends on their credit worthiness.

•

At January 1, 2004, the prime rate is 7%

•

The average credit spread on the loan portfolio is 150 basis points (1.5 percent)

•

Because the economy is slowing down, the lender fears that the prime rate will decrease, reducing the interest income on its loan portfolio

•

To hedge this risk, the lender pays 1200000 to a large bank for a two year 6.5 % floor contract with a 300 million notional amount

•

In any quarter for which the prime rate at the beginning of the quarter is below 6.5%, the lender receives a payment equal to the difference between the 6.5% and the prime rate multiplied by 300 million

•

If the prime rate is higher than 6.5%, the lender receives no payment

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SECTION - 6 OPTIONS This Section includes

• • • • • • •

Options Basic structure of options Types of options Illustrations using pay off diagrams of risk management through options Summary Option Valuation Option Valuation Model-The Black and Scholes Model

6.1. OPTIONS 6.1.1

Options are derivative instruments that give the buyer a right to buy or sell an underlying asset at a specified price on or before a certain period. Options are another type of financial derivative product available for risk management. Options help manage contingent risks, which means risks to which we will be exposed if a particular event or situation happens. Assume that a company has submitted a tender bid for a large, overseas contract, bids to be in US dollars. The event here is winning the award of the contract, which will create considerable foreign exchange risk. Options are traded on exchanges. The Chicago Board Options Exchange(CBOE) was the first ed securities exchange for the trading of options.

6.1.2 6.1.3 6.1.4

6.1.5

6.2. BASIC STRUCTURE OF OPTIONS 6.2.1

The following are the important basic parties and features of option contracts: •

Underlying asset: An option is a contract derived from an underlying asset which can be a share, bond or interest rate or commodity.

•

Parties: There are two main parties in an option contract, namely the buyer and the seller or the writer. The buyer of the option has the right but no obligation and the seller or writer of the option has the obligation and no right.

•

The buyer and the seller of the options have different expectations about the future.

•

Strike price: This is the price at which the buyer can either buy or sell an asset.

•

Time: the right to buy or sell is valid within a certain period. In other words, the option expires on a specified date. Option : To obtain the right to buy or sell, the option buyer has to pay certain amount of money which is known as the option price or which can also be called the value of the option.

•

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6.3. TYPES OF OPTIONS 6.3.1

6.3.2

6.3.3

Call option: Call option is the right to buy an underlying asset at the strike price on or before a certain time. Call option is entered into when a buyer anticipates that the price of the underlying is likely to increase in future. Put option: Put option is the right to sell an underlying asset at the strike price on or before a certain time. Put option is entered into when a buyer anticipates that the price of the underlying is likely to go down in future. is the price paid by the option buyer to the option seller upfront.

6.4. ILLUSTRATIONS USING PAY OFF DIAGRAMS OF RISK MANAGEMENT THROUGH OPTIONS Call option[Buyer] spot price Exercise price Option Profit

238

500 600 20 -20

•

The spot price is today’s price of the underlying asset

•

In the above example, the call buyer has the right to bye the asset at 600 in three month’s time and its today’s price is 500. He expects that the price will be above 600 in three months to come.

•

Option is the price to be paid per contract

•

If the spot price is 500, he is incurring a loss of 20 as he will not exercise his right to buy this asset at 600 as in the market it is available for 500. Option has value only when the spot price is above the exercise price. Then it is called the “in-the-money” call option otherwise, it is called the out of the money call option

•

The main advantage of option is that it gives the owner, the right to benefit in case the conditions are favorable and incur only the cost in case things are not favorable. This is the most unique feature of the option which is it protects the buyer from the downside while leaving the upside potential in tact.

•

The pay off table shows the relationship between the spot price and the net cash flows from an option.

•

Pay off table of a call option buyer:

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Spot price 500 520 540 560 580 600 620 640 660 680 700

•

Net pay off -20 -20 -20 -20 -20 -20 0 20 40 60 80

The option buyer incurs a loss of only 20 as long as the spot price is below the strike price

•

The option buyer has the right to exercise his option of buying this asset at the agreed exercise price even though the spot price is much above the strike price when the option buyer’s net pay off turns positive and keeps increasing as the spot price increases over and above the strike price. Net pay off 100

80

60

Profit

40 Net pay off 20

0 500

550

600

650

700

750

-20

-40

Sold Call option

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Pay-off diagram at option expiration 20 10

• Sell option, so gain the premim

0

• Lose if price of underlying rises and option in-the-money

0

20

40

60

80

-10

100

120

140

160

180

Price of underlying

-20

Profit

• Maximum gain when option expires worthless, gain

Price of underlying

-30 -40 -50 -60

•

In the above case, the seller of the call option gains when spot price is below the strike price and starts loosing when the spot price is above the strike price as the buyer of the option will exercise his option. The seller of the call option expects the price to go down. He collects the option upfront which is his gain

Put option buyer: •

Put option is the right to sell an asset at a predetermined price, known as the exercise price.

•

The buyer of the put option expects the price of the underlying to go down

•

The buyer of the put option protects himself against the price decrease

Put option[Buyer] spot price Exercise price Option Profit

Spot price 500 520 540 560 580 600 620 640 660 680 700

240

500 600 20 80

Net pay off 80 60 40 20 0 -20 -20 -20 -20 -20 -20

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•

As long as the spot price is below the strike price, the buyer of the put option gains and when once the spot price is above the strike price, the loss is restricted to only the option paid as the buyer of the put option has only the right and not the obligation to sell.

6.5. SUMMARY 6.5.1

The diagram below shows the summary of different payoff diagrams of option buyer and option seller, in the case of call option and put option.

6.5.2

The most important point to be noted is that in the case of a buyer of a call option or put option, the buyer has the potential to obtain unlimited benefits if the conditions are favorable while restricting the loss to only the option .

6.5.3

In the case of the seller of a call or put option known as the writer of the option, there is a possibility of unlimited loss but the writer collects the upfront.

6.5.4

It is possible to be an option buyer and seller at the same time which opens up the possibility of infinite number of combinations and pay offs to be engineered by an investor. This discipline is known as financial engineering.

Call and put options

Profit

Profit

Bought call 60 50 40 30 20 10 0 -10 0 20 40 60 80 120 140 160 180 Price of underlying -20

Sold put

20 10 0 0 20 40 60 80 120 140 160 180 10 Price of underlying 20 -30 -40 -50 -60

Profit

Profit

Sold call

Bought put 60 50 40 30 20 10 0 0 20 40 60 80 120 140 160 180 -10 Price of underlying -20

20 10 0 0 20 40 60 80 120 140 160 180 Price of underlying -10 -20 -30 -40 -50 -60

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6.6. OPTION VALUATION 6.6.1The price of an option is the option . At any point in time, the buyer or seller of the option must judge whether an option is under priced or overpriced. 6.6.2There are two popular models for determining the option value, namely the Binomial and Black and Scholes models. 6.6.3Option value is driven by a number of variables, as explained below:

6.6.4

•

Let C= call option price

•

S=current price

•

K=strike price

•

T=time to expiry

•

R=risk free rate of interest

•

Sd=standard deviation of the price of the underlying

Drivers of option value: •

S-K, the difference between the current price and the exercise price • If the strike price is more than the current price, likelihood of option being exercised is small, and so its value

•

Sd, the volatility •

•

T, Time to expiry •

•

The longer the option has to run, the greater the chance that the price will end up above the exercise price, so as t gets longer, the option value goes higher

R, the risk free interest rate •

242

The higher the volatility, the chances of spot price being much higher or lower at expiry than now is relatively high and hence the higher value of the option

This is to for the time value of money

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6.7. OPTION VALUATION MODEL-THE BLACK AND SCHOLES MODEL S

25

Current stock price

X 25 r 6.00% T 0.5 sd 30% Call price C= SN(x)-Ke-rtN(x-sd?t)

Exercise price Risk-free rate of interest Time to maturity of option (in years) Stock volatility

d1 d2 N(d1) N(d2) Call price Put price

<—(LN(S/X)+(r+0.5*sd^2)*T) (sd*SQRT(T)) <— -sd*SQRT(T) <— Uses formula NormSDist(d1) <— Uses formula NormSDist(d2) <— S*N(d1)-X*exp(-r*T)*N(d2) <— call price - S + X*Exp(-r*T): by PutCallparity

0.2475 0.0354 0.597 0.5141 2.47 1.73

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SECTION - 7 COMPREHENSIVE ILLUSTRATION ON RISK MANAGEMENT THROUGH DERIVATIVE PRODUCTS This Section includes Comprehensive illustration on risk management through derivative products



•

Daniel, the production director of UK based Hebrew & Co, is very pleased to hear that the company could receive a large order from one of its US customers.

•

They are not absolutely sure of getting the order. But there is a good chance for this order which is worth Dollar 2.5 million.

• • •

The UK supplier has to take the currency risk If the UK company gets the order, the company will be paid in the middle of August The question is what will be the spot rate then? The current rate is $1.677/1 pound and it is realistic to expect an upper rate of $1.75/1 pound in August and a lower rate of $1.60/1 pound.

•

Where will the company be if it gets the order and where it will be if it doesn’t get the order

•

The forward rate is $1.6539/1 and currency call option price for an exercise price of 1.675 is 2.03 cents

•

The following table summarizes the consequences of various alternatives, under various assumptions of the spot rate

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Order value

2.5 million If we get the order 1.75 1.6 000 000 1429 1563

Spot rate in August No hedge taken Forward sale Option bought Cost of call option

If we do not get the order 1.75 1.6 000 000 0 0

1.6539

1512

1512

83

-51

1.675 at 2.03 C

1475

1545

46

-18

18

•

If no hedge is taken and the rate is 1.75, then the company would get 2500000/ 1.75=1429000

•

If no hedge is taken and the rate is 1.60, then the company would get 2500000/ 1.60=1563000

•

If no hedge is taken and if the company doesn’t get the order, there is no risk under this strategy

•

If the company uses forward at a rate of 1.6539, the company will get 2500000/ 1.6539=1512000, whatever the spot rate is

•

If the company doesn’t get the order, it has to buy the dollars from the market and deliver in which case if the rate is 1.75, the company will gain 83000 and if the spot rate is 1.60, the company will loose 51000

•

The third strategy is to buy call option with an exercise price of 1.675 at 2.03 cents. This would mean 2500000/1.675=1492537.

•

The cost of the option is 1492537/(1.677)=18000

•

If the company gets the contract, the company will sell the dollars in the open market and if the spot rate is below 1.675/1, the call option lapses and we get the receipts less the initial cost of 18000.

•

If the spot rate is above 1.675/1, then after the initial cost of 1475, regardless of the then spot rate, since the loss in the receipt due to the higher spot rate is exactly matched by the gain on the call option

•

If the company doesn’t get the order, the maximum it can loose is only the option , which is 18000.

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One can note that the maximum loss is 51000 under the forward contract and under the options approach, it is 18000

•

The final decision, whether to go for forward or option, depends on the probability of getting the order. If this probability is very high, forward would be a better option and if there is very low probability of getting the order, it is better to go for option. Futures trading - why the may be flummoxed

The futures platforms offered not only a firm and timely indication of the prices to expect at harvest but also an ironclad assurance that farmers will be able to collect the payment. Sharad Joshi Business Line, 23.04.2008 At the end of the discussion on the price situation in the Rajya Sabha on April 17, as the Minister for Agriculture, Mr Sharad Pawar, came to the end of his reply, a question was raised from the Left benches about the Government’s position on the forward markets. In reply, Mr Pawar mentioned that an expert committee appointed under the Chairmanship of Prof Abhijit Sen had been deliberating the issue for 14 months and was yet to submit its report, though it was to have done so in its report in the stipulated two-three months. The Minister said that if the report was not submitted within the next 10 days, he would call for a meeting of experts on the subject and take a final decision on the future of futures trading, in the light of the severe opposition to these markets reflected during the discussions in the Rajya Sabha and in the recommendations of the Standing Committee on Agriculture on the subject. Coming from a politician and statesman of Mr Pawar’s vintage, this was an unusual statement. Even presuming that Prof Sen’s had failed to show the necessary alacrity in respecting the time schedule, it would be unfair to decide the issue outside the Committee and punish the innocent market and the farmers for no fault of theirs.

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Further, one wonders why the Minister took the trouble of appointing a Committee if he knew knowledgeable people who could be called for consultation. Little innovation Throughout the discussion in the Rajya Sabha, the Minister dealt at length on the efforts the government was making to ensure food security, by restricting exports and facilitating imports, and the mechanisms of CA (Minimum Prices), Food Corporation of India (FCI) and the Public Distribution System (PDS). This, by itself, suggested that the government was thinking more of the traditional means of ensuring food security rather than experimenting with innovative and little understood mechanisms. The statement by the Minister of Agriculture seems to have made Prof Sen’s position even more difficult. Last year, at about the same time, the matter of the utility, or otherwise, of the futures markets was brought to him for examination. Even though the of reference of the Committee did not so suggest, it was obvious that the government was apprehensive about what the futures market could bring in. It was quite clear that the futures market was an unwanted baby — of a different gender from the licence-permits-quota type of market systems that the government had carefully nourished till then. Prof Sen’s problem was that the baby was indeed of a different gender but, despite the crude attempts at getting rid of it, was alive and kicking and threatened the basic structure of the traditional agricultural marketing policies based on CA-FCI-PDS. of reference The of reference of the Abhijit Sen Committee, as distinct from the unwritten agenda of the Government, were benign. The Committee was appointed in March 2007 to i) study the impact of the operation of futures markets on commodity prices; ii) suggest methods to minimise such impact, and iii) recommend ways in which the farmer’s participation in the futures markets can be increased. It was not the case that the futures market possibly had an inflationary effect. The problem was that forward trading and the futures markets resurrected by the NDA government go against the Central Government’s policies since Independence in respect of commodity markets based on Minimum Prices, procurement from Food Corporation of India and the Public Distribution System in the name of the weaker sections. The opposition of the Left parties to the futures markets came essentially from the conviction that it belonged to the wrong — liberal — gender. It was hoped that the Sen Committee would give them the authority to abort it. The mandate of the Sen Committee is simple enough. It is intriguing why the Committee is

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INTERNATIONAL FINANCE taking such a long time to submit a report which, it had been thought, could be submitted in just 90 days. The problem seems to be as follows. The Committee found little evidence to suggest any links between market price hike and volatility that could be directly linked to the operations of the futures markets. Under these circumstances, all that the Committee had to do was to make recommendations about how the performance of the futures markets could be further improved by sanitising the spot markets, improving finance to the commodity markets and promoting farmers’ response by facilitating it. Uncomfortable facts? It is not that the was to study the desirability or otherwise of lifting/continuing the ban on the futures trade. The futures trade was resurrected in 1993 and, at least, three multicommodity exchanges are doing pretty well with geometrical expansion of the volume of transactions. Further, it shook up established notions that the commodity market should be eternally based on three pillars of CA, FCI and PDS. The Commission for Agricultural Costs and Prices (CA) that would help determine the Minimum Prices; Statutory Minimum Prices are also, by corollary, the procurement prices; The Food Corporation of India (FCI) that manages procurement of foodgrains and their conduit to different States; and The Public Distribution System (PDS) that would ensure retail distribution according to decisions taken by the Government. If the Committee submitted its honest findings the government would be forced to permit the normal delivery of the futures market infant. The problem for the Committee, probably, is that that would raise a number of very inconvenient questions that would make the candid recommendations unpalatable to the Government. What purpose would the CA serve in a situation where the futures market platforms offered not only a firm and timely indication of the prices to expect at the harvest but also provided an ironclad assurance, as also insurance, that farmers would be able to collect the prices? Further, since the commodity markets in India provide warehousing facilities, banking and finance, insurance as also negotiable warehousing receipts, what function would be left to justify the existence of Food Corporation of India, which had become notoriously unpopular with the farmers, most of whom see it as both inefficient and expensive? Lastly, with the procurement of the foodgrains decentralised, was it really necessary to create a separate PDS network for the benefit of the weaker sections of the population? Would that purpose not be better served by simply mailing the targeted people food stamps or smartcards, which would also obviate the substantial diversion of foodgrains from the PDS system?

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(The author is founder, Shetkari Sanghatana and Member of Parliament — Rajya Sabha. He is also a member of the Abhijit Sen Committee on Futures Trading, and can be reached at [email protected]) Derivatives are like race cars’ A derivative needs to be used by professionals. It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver. In finance, derivatives are financial instruments whose value changes according to the changes in fundamental variables. Just like the Americans have heard about the term ‘subprime’ for the last 12 months, Indians too have heard a lot about derivatives for the last month or so. Futures, forwards, options, swaps and what not? Financial products based on such complicated mechanisms will require more transparency. But while transparency is certainly an issue as is understanding, the onus is also on the taker, that is, the company or the bank on its behalf. Systems and processes then become even more crucial. “It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver,” tells Mr Omer Hevlin, Sales Director (Asia), SuperDerivatives (www.superderivatives.com). SuperDerivatives is the benchmark for derivatives pricing and the leading provider of multi-asset front-office systems, risk management, revaluation and online options trading solutions. Indian banks such as Centurion Bank of Punjab have leveraged their expertise to manage multi-asset portfolios of exotic options and structured products and calculate exposure in real time. But that’s not enough. “Because they are still running their risk using TV (terminal values), rather than real time rates and volumes,” Mr Hevlin told Business Line in course of an e-mail interaction from Singapore. Excerpts from the interview: Derivatives market is often shrouded in conscious secrecy or veiled transparency. Right from plain vanilla to exotic derivatives, what has been your experience? The market participants clearly require the right tools to arrive at the right price and fully understand the risks involved. Our goal is to lift the veil of secrecy and bring transparency to derivative pricing and valuation by empowering any market participant to obtain prices that reflect the fair market value for any derivative instrument, for any asset class. What would be your take on the understanding of financial risks taken aboard by Indian companies? We believe that the position taken by a corporate needs to be well analysed and risks have to be clearly anticipated. How can a product meant to serve as an insurance against fluctuating currency backfire?

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INTERNATIONAL FINANCE The product needs to be used by professionals. It is like a race car, part of the performance comes from the machine and part from the experience and capability of the driver. SuperDerivatives is said to have its own pricing model. What makes it so special and unique? Prior to the advent of SuperDerivatives, options practitioners faced two major obstacles. The first one was price opacity. Practitioners could use the ubiquitous Black-Scholes formula to price vanilla options and with the same framework price all exotic options, although it was well known that the Black-Scholes approach produced prices significantly different than the actual market prices. The leading traders from the top investment banks were able to compensate for BlackScholes deficiencies by leveraging their experience in the market together with their vast computational resources to accurately price options - and those prices were closely guarded. Closely guarded prices, isn’t that dangerous? Thousands of less experienced professionals who traded options regularly - mostly from the buy-side (corporations and investment funds) - lacked the tools and expertise to price them accurately. As a result, the buy-side was dependent on the sell-side (banks) for trade design, price fairness and post-trade revaluation for complying with ing standards in their P&L reporting. The inability to price options accurately made many people on the buy-side less active in options and severely limited the benefits that options could provide them and the world economy as a whole. You were talking about the second challenge. The second challenge faced by options market practitioners was a lack of systems and infrastructure to options business activity. Missing were effective solutions for pricing, analysis, market data feed, risk management and more. Only a few of the world’s largest investment banks have the internal resources to tackle those challenges in-house. According to you, what would be the total exposure of companies from Asian countries in the forex derivatives market? The marked-to-market losses in India are estimated to be between Rs 12,000 to 20,000 crore and the total market size is Rs 1,27,86,000 crore. What are the gaps in skills and competencies that you find among the fresh crop of talent entering the derivatives sphere? The participants need to have a complete understanding of the extent of risk/losses that they would be exposed to when they enter into a structure.

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More specialised courses need to be introduced by the educational institutions/ organisations. Professional and well-trained staff needs to be handling the treasury functions in small and medium enterprises (SME) which is currently not the case. For example: A person handling finance and s generally ends up taking care of treasury. Do banks too need courses in risk management? Because they are still running their risk using TV values, rather than real time rates and volumes, same goes for their Greeks and credit exposure. (The Greeks are a collection of statistical values expressed as percentages that give the investor an overall view of how a underlying asset has been performing. These statistical values can be helpful in deciding what options strategies are best to use.) Training, of course, would help as derivatives is an evolving market with products being introduced in the market on a regular basis. Hence, staying on top of the situation would help containing risks. They need to be aware of issues like the volume input they are using to evaluate their risks is based on ATM volumes (an option is At-The-Money if the strike price is the same as the current price of the underlying security on which the option is written) volumes which are not enough for deep OTM options (Out-of-The-Money are those that would be worthless if they expired today). What are the ‘must checks’ that companies should ensure before entering into derivatives contracts? Do have the capability to assess future exposure of each deal and compare it to valid credit client before g the deal. Do get the market Greeks and understand them before you sign a deal. Do follow the RBI guidelines and do not be tempted into transactions which don’t address clients underlining exposure and financial hedging needs. Do invest in sales-force education. Do equip the sales-force with advanced sales tools and real time pricing platforms which are based on bank rates so that traders can control prices/volumes/spread on a real time basis. Do be able to provide your client with a clear Term Sheet of any transaction in real time. Do know what the maximum losses are that could be incurred while entering into a deal. Do take proactive measures to cut down on losses when the view goes against you.

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INTERNATIONAL FINANCE D. MURALI KUMAR SHANKAR ROY www.InterviewInsights.blogspot.com © Copyright 2000 - 2008 The Hindu Business Line 23.04.2008 The financial system What went wrong Mar 19th 2008 From The Economist print edition

In our special briefing, we look at how near Wall Street came to systemic collapse this week—and how the financial system will change as a result. We start with how financiers—and their critics—have laboured under a delusion “A COMPANY for carrying out an undertaking of great advantage, but nobody to know what it is.” This lure for the South Sea Company, published in 1720, has a whiff of the 21st century about it. Modern finance has promised miracles, seduced the brilliant and the greedy—and wrought destruction. Alan Greenspan, formerly chairman of the Federal Reserve, said in 2005 that “increasingly complex financial instruments have contributed to the development of a far more flexible, efficient, and hence resilient financial system than the 252

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one that existed just a quarter-century ago.” Tell that to Bear Stearns, Wall Street’s fifthlargest investment bank, the most spectacular corporate casualty so far of the credit crisis. For the critics of modern finance, Bear’s swift end on March 16th was the inevitable consequence of the laissez-faire philosophy that allowed financial services to innovate and spread almost unchecked. This has created a complex, interdependent system prone to conflicts of interest. Fraud has been rampant in the sale of subprime mortgages. Spurred by pay that was geared to short-term gains, bankers and fund managers stand accused of pocketing bonuses with no thought for the longer-term consequences of what they were doing. Their gambling has been fed by the knowledge that, if disaster struck, someone else—borrowers, investors, taxpayers—would end up bearing at least some of the losses. Since the era of frock coats and buckled shoes, finance has been knocked back by booms and busts every ten years or so. But the past decade has been plagued by them. It has been pocked by the Asian crisis, the debacle at Long-Term Capital Management, a super-brainy hedge fund, the dotcom crash and now what you might call the first crisis of securitisation. If the critics are right and something in finance is broken, then there will be pressure to reregulate, to return to what Alistair Darling, Britain’s chancellor of the exchequer, calls “good old-fashioned banking”. But are the critics right? What really went wrong with finance? And how can it be fixed? Happy days 1

Money machine Finance industry profits and gross value added As% US Corporate total

50

Profits

40 30 20 10 90 85 95 1980 Source :BCA Resarch

2000

05 07

0

The seeds of today’s disaster were sown in the 1980s, when financial services began a pattern of growth that may only now have come to an end. In a recent study Martin Barnes of BCA Research, a Canadian economic-research firm, traces the rise of the American financial-services industry’s share of total corporate profits, from 10% in the early 1980s to 40% at its peak last year (see chart 1). Its share of stockmarket value grew from 6% to 19%. These proportions look all the more striking—even unsustainable—when you note that financial services for only 15% of corporate America’s gross value added and a mere 5% of private-sector jobs.

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INTERNATIONAL FINANCE At first this growth was built on the solid foundations of rising asset prices. The 18 years to 2000 witnessed an unparalleled bull market for shares and bonds. As the world’s central banks tamed inflation, interest rates fell and asset prices rose (see chart 2). Corporate restructuring, wage competition and a revolution in information technology boosted profits. A typical portfolio of shares, bonds and cash gave real annual yields of over 14%, calculates Mr Barnes, almost four times the norm of earlier decades. Financial-service firms made hay. The number of equity mutual funds in America rose more than fourfold.

But something changed in 2001, when the dotcom bubble burst. America’s GDP growth since then has been weaker than in any cycle since the 1950s, barring the double-dip recovery in 1980-81. Stephen King and Ian Morris of HSBC point out that growth in consumer spending, total investment and exports in this cycle has been correspondingly feeble. Yet, like Wile E. Coyote running over the edge of a cliff, financial services kept on going. A service industry that, in effect, exists to help people write, trade and manage financial claims on future cashflows raced ahead of the real economy, even as the ground beneath it fell away. The industry has defied gravity by using debt, securitisation and proprietary trading to boost fee income and profits. Investors hungry for yield have willingly gone along. Since 2000, according to BCA, the value of assets held in hedge funds, with their high fees and higher leverage, has quintupled. In addition, the industry has combined computing power and leverage to create a burst of innovation. The value of outstanding credit-default swaps, for instance, has climbed to a staggering $45 trillion. In 1980 financial-sector debt was only a 254

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tenth of the size of non-financial debt. Now it is half as big. This process has turned investment banks into debt machines that trade heavily on their own s. Goldman Sachs is using about $40 billion of equity as the foundation for $1.1 trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering on around $30 billion of equity. In rising markets, gearing like that creates stellar returns on equity. When markets are in peril, a small fall in asset values can wipe shareholders out. The banks’ course was made possible by cheap money, facilitated in turn by low consumerprice inflation. In more regulated times, credit controls or the gold standard restricted the creation of credit. But recently central banks have in effect conspired with the banks’ urge to earn fees and use leverage. The resulting glut of liquidity and financial firms’ thirst for yield led eventually to the ill-starred boom in American subprime mortgages.

The dance of debt The tendency for financial services to run right over the cliff is accentuated by financial assets’ habit of growing during booms. By lodging their extra assets as collateral, the intermediaries can put them to work and borrow more. Tobias Adrian, of the Federal Reserve Bank of New York, and Hyun Song Shin, of Princeton University, have shown that since the 1970s, debts have grown faster than assets during booms. This pro-cyclical leverage can feed on itself. If financial groups use the borrowed money to buy more of the sorts of securities they lodged as collateral, then the prices of those securities will go up. That, in turn, enables them to raise more debt and buy more securities. Indeed, their shareholders would punish them if they sat out the next round—as Chuck Prince let slip only weeks before the crisis struck, when he said that Citigroup, the bank he then headed, was “still dancing”. Mr Prince has been ridiculed for his lack of foresight. In fact, he was guilty of blurting out finance’s embarrassing secret: that he was trapped in a dance he could not quit. As, in fact, was everyone else. Sooner or later, though, the music stops. And when it does, the very mechanisms that create abundant credit will also destroy it. Most things attract buyers when the price falls. But not necessarily securities. Because financial intermediaries need to limit their leverage in a falling market, they sell assets (again, the system is pro-cyclical). That lowers the prices of securities, which puts further strain on balance sheets leading to further sales. And so the screw turns until those without leverage will buy. You do not need bankers to be poorly monitored or over-incentivised for such cycles to work: finance knew booms and manias long before deposit insurance, bank rescues or bonuses. And, human nature being what it is, Jérôme Kerviel, who lost Société Générale a fortune, and the staff of various loss-making, state-owned, German Landesbanks did not need huge pay to lose huge sums. The desire to show that you are a match for the star trader next door, or the bank in the next town, will do.

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INTERNATIONAL FINANCE Yet pay—or at least bad management—probably made this crisis worse. Trades determine bonuses at the end of the year, even though their real value may not become clear until later. Earlier this month a group of financial supervisors reported how managers at the banks worst hit by the crisis had failed to oversee traders or take a broad view of risk across their firms. Perhaps, with proper incentives, managers would have done better. Alan Johnson, a consultant who designs pay packages for Wall Street, predicts that in future senior executives will face the prospect of some of their bonuses being contingent on the bank’s performance over several years. Yet to the extent that many senior bankers are paid in shares they cannot immediately sell, they already are. And to the extent that Bear Stearns’s employees owned one-third of the firm, they already looked to the longer term. If altering pay cannot stop manias, can regulation? The criticism that this crisis is the product of the deregulation of finance misses an important point. The worst excesses in the securitisation mess are encrusted precisely where regulation sought to protect banks and investors from the dangers of untrammelled credit growth. That is because regulations offer not just protection, but also clever ways to make money by getting around them. Existing rules on capital adequacy require banks to put some capital aside for each asset. If the market leads to losses, the chances are they will have enough capital to cope. Yet this rule sets up a perverse incentive to create structures free of the capital burden—such as credits that last 364 days, and hence do not count as “permanent”. The hundreds of billions of dollars in the shadow banking system—the notorious SIVs and conduits that have caused the banks so much pain—have been warehoused there to get round the rules. Spain’s banking regulator prudently said that such vehicles could be created, but only if the banks put capital aside. So far the country has escaped the damage seen elsewhere. When reformed capital-adequacy rules are introduced, this is an area that will need to be monitored rigorously. It is the same with rating agencies, the whipping boys of the crisis. Most bonds used to be issued by companies, and to judge something AAA was straightforward. Perhaps back then it made sense for some investors, such as pension funds, to be obliged to buy top-rated bonds. But this rule created a boundary between AAA and other bonds that was ripe for gaming. Clever people, abetted by the rating agencies, set out to off poor credit as AAA, because they stood to make a lot of money. And they did. For a while. The financial industry is likely to stagnate or shrink in the next few years. That is partly because the last phase of its growth was founded on unsustainable leverage, and partly because the value of the underlying equities and bonds is unlikely to grow as it did in the 1980s and 1990s. If finance is foolishly reregulated, it will fare even worse. And what of all the clever and misused wizardry of modern finance? Mr Greenspan was half right. Financial engineering can indeed spread risk and help the system work better. Like junk bonds, reviled at the end of 1980s, securitisation will rebound, tamed and better understood—and smaller. That is financial progress. It is a pity that it comes at such a cost.

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STUDY NOTE - 9 SOURCES OF INTERNATIONAL FINANCE

SECTION - 1 RISING FUNDS IN FOREIGN MARKETS AND INVESTMENTS IN FOREIGN PROJECTS This Study Note includes

Rising funds in foreign markets and investments in foreign projects

1.1

RISING FUNDS IN FOREIGN MARKETS AND INVESTMENTS IN FOREIGN PROJECTS

1.1.1

Foreign or international capital market offers a good opportunity for domestic firms to raise finances. These markets include the US, UK, Japan etc. Since 1991, after government of India introduced financial liberalization policies, a number of Indian companies took advantage of this opening up in international capital markets. The global investors, who are seeking portfolio diversification, see investment in Indian stocks or bonds as a profitable avenue on the basis of risk adjusted return.

1.1.2

The main advantage of sourcing from international capital markets is the lower cost of funds, besides enriched brand image. For example, Tata motors, borrowed recently at 0% interest from international capital market.

1.1.3

There are different instruments through which an Indian firm can raise money from these global markets. The most popular one is the Global Depository Receipt (GDR), which is an equity instrument. It is like investing in Indian equity. These Indian papers are marketed in international capital markets to attract global investors. They hold these papers which are listed in the international stock exchanges like the New york stock exchange, NASDAQ exchange, the Luxemburg exchange etc. Hence, these instruments are very liquid and tradable across international exchanges. Similarly, there are American depository receipts (ADRs) which are mainly traded in the American exchanges. The GDRs can also be traded in the Indian exchanges.

1.1.4

The other popular instrument is the Euro bonds. These are debt instruments, which carry a rate of interest (coupon). Many Indian companies raised funds from the Japanese market at 1 to 2% rate of interest.

1.1.5

There are innovations in the way Euro bonds can be structured to suit the requirements of the investors. Euro Convertible Bonds [ECBs] are hybrid instruments. Initially a debt

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SOURCES OF INTERNATIONAL FINANCE instrument bearing a coupon with a convertibility clause which entitles the owner to convert these debt instruments into equity instruments. This convertibility options makes these instruments very popular in a booming capital market context. For example, if a company’s share is likely to do very well in the next three years, its current share price being Rs.400 which is expected to go up to Rs.800, it may issue an ECB at 1% rate of interest with an option to the investor for converting these bonds into equity shares at say Rs.500 after three years. 1.1.6

Many of these instruments can be used to raise finances in US dollars, Euro (the earlier French francs, German mark, Italian lira, etc.).

1.1.7

More importantly, the process of going global or raising money in international capital markets is a useful learning experience in global reporting standards and international bench marking. The typical process involves appointment of an investment banker, who prepares a detailed document for the road shows to be organized across the world, marketing the issue to the well informed international investors. The reporting of financial results should confirm to international ing standards. It helps in corporate valuation and helped Indian companies discover their true value. There has to be proper documentation regarding the proposed use of funds and financial projections. The funds have to be used only for the purposes for which they were raised. RBI has come out with very strict circulars and guidelines on this aspect.

1.1.8

There will be a book building process where different investors bid for these Indian papers. The entire book building process helps in better price discovery. This process is now practiced even for domestic IPOs and SPOs.

1.1.9

There are also international stock exchanges which prescribe very strict listing requirements. The listing discipline has helped Indian companies to improve their standards of financial reporting and disclosure.

1.1.10 Investment bankers, stock exchanges, regulatory authorities like the RBI, SEBI and SEC, foreign institutional investors, high net worth individuals are some of the parties involved in international capital money markets. 1.1.11 If the funds are raised in foreign currencies, the companies are exposed to exchange rate risk and interest rate risk. There is also the possibility of realizing a lower value due to the superior bargaining power of the international investors. 1.1.12 Many of the Indian companies raised money from international capital markets and used this money to prepay domestic debts, which created problems for the Indian banks which have lent money to these companies. The government has come up with end use monitoring provisions to manage these risks, besides putting an overall cap on the amount of money that can be raised from the international capital markets by way of GDRs, ECBs etc. Factors influencing the development of ing in a particular country: • Economic environment; 258

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•

Legal environment;

•

Political environment;

•

Capital markets;

•

Cultural environment;

•

Educational environment;

•

Ethical environment;

•

Social environment; and

•

Others;

All are interlinked.

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SECTION - 2 FORWARD RATE AGREEMENT AND INTEREST RATE GUARANTEES This Study Note includes

Basics of foreign exchange Forward rate agreement and interest rate guarantees Advantages and disadvantages of using forward contracts Interest rate guarantees

2.1 BASICS OF FOREIGN EXCHANGE 2.1.1

The foreign exchange market is the organizational framework within which individuals, companies, banks and brokers buy and sell foreign currencies. It has two levels; the inter-bank or wholesale market and the client or retail market. It is not a physical place but an electronic network of banks, foreign exchange brokers and dealers. It is a 24hour market.

2.1.2

Spot rate: In the spot market, currencies are bought or sold for immediate delivery, which in practice means settlement in two working days. The exchange rate at which the currencies are bought and sold for immediate delivery are called spot exchange rates or spot rates.

2.1.3

Forward exchange rates: A forward exchange contract is an agreement to deliver a specified amount of one currency for a specified amount of another currency at some future date. For example, if you know that you will be receiving USD 500000 in six month’s time, you can get a quote for a forward exchange rate in six months between USD/INR and book a six month forward contract at this rate so that you will know how much you will get exactly without any uncertainty. Through forward rates, risks due to foreign exchange rate fluctuations can be managed.

2.2 FORWARD RATE AGREEMENT AND INTEREST RATE GUARANTEES 2.2.1

Forward rate agreement [FRAs] is a contract agreeing to buy or sell foreign exchange at a predetermined rate of exchange. They are also known as derivative contracts and instruments for hedging or managing exchange rate risk caused by the volatility in foreign exchange rates. So, an importer wants to freeze the exchange rates at the current level in anticipation of his requirements of foreign exchange at a future date. Similarly, an exporter would like to be certain about the amount that he will receive by fixing the conversion rate of exchange right now. The recent fluctuations in the rupee dollar exchange rate has wiped out the profits of many small textile mills in Tiruppur, in

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Tamilnadu. Similarly, there was a substantial reduction in the profit of Infosys and other major software exporters in 2007 due to exchange rate volatility. A forward rate agreement to some extent saved the companies in these situations. The importer or the exporter enters into a FRA with the banks or foreign exchange dealers.

2.3 ADVANTAGES AND DISADVANTAGES OF USING FORWARD CONTRACTS 2.3.1

By entering into a forward foreign exchange contract, an Indian importer or exporter can: • Fix at the time of the contract a price for the purchase or sale of a fixed amount of foreign currency at a specified future time • Eliminate its exchange risk due to foreign exchange rate fluctuations during the period of contract • Calculate the exact INR value of an international commercial contract despite the fact that payment is to be made in the future in a foreign currency • Sometimes the spot rate at the time of receipt or payment of foreign exchange may be favorable to the importer or exporter. The benefits of such favorable spot rates may be foregone due to forward rate agreements entered into earlier.

2.4 INTEREST RATE GUARANTEES 2.4.1

Your firm will have $1,000,000 in 3 months’ time, for a 6-month period. Nobody is sure what interest rates will prevail in the future. Some analyst’s think rates will increase, others feel they will fall. You want to protect your firm against the risk of a reduced return on your funds. You can use the Forward-Rate Agreements to protect yourself, but you know that if you use Forward-Rate Agreements now you will give up the possibility of benefiting from higher interest rates. In these circumstances, interest-rate guarantee products can be very useful. An Interest-Rate Guarantee is a product, which can be very useful in these circumstances. Basically, it is an option on a Forward-Rate Agreement. It allows you a period of time during which you have the right to buy a Forward-Rate Agreement at a set price. The guarantee protects you against a fall in interest rates while giving you the freedom to enjoy a better return if rates increase. If you want this guarantee you will need to pay a higher .

2.4.2

Illustration: Suppose you will have a deposit of $1,000,000 for a 6-month period beginning in 3 months’ time. You want to protect your firm against lower interest rates and guarantee a minimum return of 5%. You can buy an Interest-Rate Guarantee at this rate of 5%. Let us see how the option would work. Two examples: •

In 3 months’ time the 6-month Libor sets at 4.5% you use your Interest-Rate Guarantee and will receive a compensation for the 0.5% difference in interest rates so that your 5% return is protected.

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SOURCES OF INTERNATIONAL FINANCE •

In 3 months’ time the 6-month Libor sets at 5.5%. You choose not to use your guarantee and instead you will deposit your funds at the higher rate. In these circumstances the Interest-Rate Guarantee protected you against lower interest rates and also allowed you to take advantage of the rise in interest rates.

The benefits: •

The guarantee will give you full protection against falling interest rates.

•

The guarantee will give you freedom to benefit if rates increase.

•

If you decide that you do not need the guarantee, you can sell it back

Features: •

You can get an Interest-Rate Guarantee whenever you need one customized to your requirement.

•

Interest rate guarantees are available for all major currencies and different maturities

•

One can get Interest-Rate Guarantees from a bank other than the one who holds the cash. Interest-Rate Guarantee can be used for any cash held or expected to have.

The price of your Interest-Rate Guarantee will depend on:

262

o

the guaranteed rate;

o

how long you want the Option for; and

o

How often interest rates are changing.

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SECTION - 3 EXPOSURES IN INTERNATIONAL FINANCE This Study Note includes

Exposures in international finance



Transaction exposure



Translation exposure



Economic exposure



Forecasting foreign exchange rates



Interest rate parity



Purchase power parity



Fisher effect

3.1 EXPOSURES IN INTERNATIONAL FINANCE 3.1.1

Irrespective of the nature of overseas activities, organizations need to understand and where appropriate, control the degree of foreign exchange variability to which they are exposed. To do this, each organization must develop an organizational framework which generates answers to the following key questions: 1. What is the exact nature of our foreign exchange exposure? 2. How can this be identified and measured? 3. Given identification and measurement of exposure, how can the degree of risk be measured? 4. What is our organization’s attitude to this risk? 5. How should we organize for foreign exchange exposure: centralize or decentralize? 6. What techniques should we use to hedge our exposure? 7. ing of international transactions in line wit Indian and International GAPP ing guidelines & stipulations.

3.2 TRANSACTION EXPOSURE 3.2.1

The risk that there will be a change in value for the organization caused by variation in relevant exchange rates is known as the foreign exchange risk. Transaction exposure arises from changes in cash flows that result from a firm’s existing contractual obligations e.g an Indian company makes a sale, denominated in euros to an Italian company. Until the Italian company pays for the sale, there is a risk that fluctuations in the INR/ EUR exchange rate will affect final amount that the Indian company receives. Other

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SOURCES OF INTERNATIONAL FINANCE types of transaction exposures are loans denominated in overseas currencies, purchases from overseas companies and dividends from overseas subsidiaries.

3.3 TRANSLATION EXPOSURE 3.3.1

This is also known as ing exposure. This arises from the need to translate the foreign currency financial statements of overseas subsidiaries into the home currency in order to prepare a set of group financial statements in the home currency. An example would be an Indian company with a US subsidiary. In order to prepare the full s for the Indian company, the s of the US subsidiary will need to be translated into INR. Every time the s are translated, a uniform INR/USD exchange rate will be used, usually year end or an average for the ing period. Due to this translation, the reported values may be different, though there are no cash flow implications. The company has to strictly follow the ing Standards prescribed in this regard. Students are advised to have knowledge on all the latest ing Standards.

3.4 ECONOMIC EXPOSURE 3.4.1

It is also called operating or strategic exposure. It measures the change in the present value of the firm resulting from any change in the future operating cash flows of the firm caused by an unexpected change in exchange rates. The change in value depends on the effect of the exchange rate change on future sales volume, prices or costs.

3.4.2

Economic exposure can be thought of as encoming transaction exposure, but generally takes a long term perspective, in that it looks at the whole operation of a company and how cost and price competitiveness could be affected by movements in exchange rates. For example, a company manufacturing Luxury cars in India for sale to US will be exposed to transaction risk on all sales to the US denominated in USD when rupee strengthens. However, the Indian company will also be economically exposed. Over time, the Indian company will be exposed to shifts in the INR/USD exchange rate. If the competitors of the Indian based manufacturer area all based in US, any increase of the INR/USD exchange rate will increase sales prices in US, which may mean loss of market share to local US Luxury car manufacturers.

3.5 FORECASTING FOREIGN EXCHANGE RATES 3.5.1

There are generally two overall approaches to forecasting exchange rates: Fundamental approaches and technical approaches. One of the fundamental approaches is known as the four way equivalence model or parity conditions. There are four relationships that underpin international exchange rates: purchase power parity theory, fisher effect, interest rate parity and expectations theory.

3.6 INTEREST RATE PARITY 3.6.1

The theory of interest rate parity states that the difference in the notional interest rates for securities of similar risk and maturity should be equal to the difference between

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forward and spot rates of exchange. i.e the forward or discount is equal to the interest rate differential. If the forward or discount is not equal to the interest differential, there are opportunities for risk free arbitrage. This parity condition means that a country with a lower interest rate than another should value its forward currency at a in of the other country’s currency. 3.6.2

Example: If the annual interest rate in UK is 13% and that in USA it is 10% and the current spot rate between the two countries is USD 1.50=GBP 1, assuming interest rate parity theory, what is the forward rate of exchange in one year ahead? GBP 100 in one year, at an annual rate of 13%=GBP 113 USD 150 in one year, at an annual rate of 10%=USD 165 Forward rate in one year=165/113=1.46 USD= 1 GBP

3.7 PURCHASE POWER PARITY 3.7.1

This is based on the common sense idea that a product should cost the same wherever it is available in the world, otherwise opportunities for arbitrage will arise; that is people will try and buy the product in the cheaper market and sell it in the more expensive market to make a profit. Translated into a more general parity theory, this means that the general level of prices, when converted to a common currency, will be the same in each country, price changes due to inflation in one country are compensated by a change in exchange rate so that the real cost of products remain the same. If the inflation rate in UK is 8% and that in USA is 5% and the spot rate is USD 1.5=1 GBP, we would expect the GBP to deteriorate against the USD by, on average, 3% a year. So in a year’s time you might expect the exchange rate to have fallen to USD 1.455/GBP 1

3.8 FISHER EFFECT 3.8.1

The Fisher effect states that the nominal interest rate is made up of two components: a required real rate of return and an inflation , equal to the expected rate of inflation. Thus, 1 + Nominal rate = (1+real rate)(1+Expected inflation rate) The fisher effect relies on the activities of the arbitrageurs, who will move capital from countries with low rates of return to countries with high rates of return. If real rates of interest are thought to be the same worldwide, the difference in nominal interest rates between countries should be due to differences in inflation rates. The fisher effect and purchasing power parity theory together make up the international fisher effect, which holds that interest rate differentials between countries should be reflected in the expectation of the future spot rate of exchange. Purchase power parity theory states that a rise in the home country’s inflation rate will also be accompanied by a devaluation of the home country’s currency.

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SECTION - 4 FOREIGN DIRECT INVESTMENT This Study Note includes

Foreign Direct Investment:



Definition of Foreign Direct Investment



Classification of Foreign Direct Investment

4.1 FOREIGN DIRECT INVESTMENT 4.1.1

FDI (Foreign Direct Investment) has become a key component of national development strategies for almost all the countries over the Globe. FDI is considered to be an essential tool for jump-starting economic growth through bolstering of domestic capital, productivity and employment. Reliance on FDI is rising heavily due to its all round contributions to the economy. The important effect of FDI is its contributions to the growth of the economy. FDI has an impact on country’s trade balance, Increasing labour standards and skills, transfers of new technology and innovative ideas, Improving infrastructure, skills and the general business climate.

4.1.2

FDI is considered to be the lifeblood for economic development as far as the developing nations are concerned. FDI to developing countries in the 1990s was the leading source of external financing. The rise in FDI volume was accompanied by a marked change in its composition. That is investment taking the form of acquisition of existing assets (mergers and acquisitions) grew much more rapidly than investment in new assets particularly in countries undertaking extensive privatization of public enterprises

4.2 DEFINITION OF FOREIGN DIRECT INVESTMENT 4.2.1

Foreign direct investment is that investment, which is made to serve the business interests of the investor in a company, which is in a different nation distinct from the investor’s country of origin.

4.2.2

A parent business enterprise and its foreign are the two sides of the FDI relationship. Together they comprise an MNC. The parent enterprise through its foreign direct investment effort seeks to exercise substantial control over the foreign company. ‘Control’ as defined by the UN, is ownership of greater than or equal to 10% of ordinary shares or access to voting rights in an incorporated firm. For an unincorporated firm one needs to consider an equivalent criterion. Ownership share amounting to less than that stated above is termed as portfolio investment and is not categorized as FDI.

4.3 CLASSIFICATION OF FOREIGN DIRECT INVESTMENT 4.3.1

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Foreign direct investment may be classified as Inward or Outward.

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4.3.2

Foreign direct investment, which is inward, is a typical form of what is termed as ‘inward investment’. Here, investment of foreign capital occurs in local resources.

4.3.3

The factors propelling the growth of Inward FDI comprises tax breaks, relaxation of existent regulations, loans at low rates of interest and specific grants. The idea behind this is that, the long run gains from such a funding far outweighs the disadvantage of the income loss incurred in the short run. Flow of Inward FDI may face restrictions from factors like restraint on ownership and disparity in the performance standard.

4.3.4

Foreign direct investment, which is outward, is also referred to as “direct investment abroad”. In this case it is the local capital, which is being invested in some foreign resource. Outward FDI may also find use in the import and export dealings with a foreign country. Outward FDI flourishes under government backed insurance at risk coverage.

4.3.5

Illustration ‘G’ company Ltd, is a company that manufactures a specialized computer game in India and sells it within the euro zone in and . Its major competitor in these markets is a Japanese supplier of the same game. All sales are invoiced in the local currency, and the selling price is set at the beginning of the year. It usually takes three months between the sale of a game and the receipt of the currency proceeds.80% of sales to and can be predicted in of amount and date. There is a 15% of net profit margin on the games. ‘G’ company has recently set up a subsidiary in Russia that will buy the games from ‘G’ company and sell them on within Russia. All transactions will be in INR. The Russian rouble has been subject to sudden devaluations against the INR. The management team of ‘G’ company has come to you for advice. It has heard about currency transaction, translation and economic exposure and would like to know if these are an issue for the company. Required: 1) Locate examples of the three types of foreign exchange exposure in the scenario and advise suitably. 2) Suggest which hedging techniques might be available for ‘G’ Company and the questions that you would ask the management team in order to establish which techniques would be most appropriate.

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SOURCES OF INTERNATIONAL FINANCE 4.3.6

Solution:

1 Transaction exposure

On sales to and as in euro; Sales price set at beginning of the year and time delay between sale and receipt

Translation exposure

May be with the Russian subsidiary if any transactions are in roubles, although we are told that they are in INR

Economic exposure

Japanese competitor; if yen weakens against the INR, its products will be cheaper relative to ‘G’ company. Russian subsidiary sales will be susceptible to strong INR as may make the product too expensive for the local market

2 Possible hedging techniques

Questions to ask

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Do nothing. Cover forward for specific contracts as 80% certain Use options for the balance What is management team’s approach to risk? If risk averse, will want to use forward to lock in

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STUDY NOTE - 10 INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM

SECTION - 1 UNDERSTANDING INTERNATIONAL MONETARY SYSTEM This Section includes

Introduction



Motives for World Trade And Foreign investment



World Trade Bodies



TRIMS



TRIPS



Trading Blocs



Motives for Foreign Investment



Balance of Payments



International Monetary System



Concepts in Foreign Exchange Rate



IMF



The European Monetary Union

1.1 INTRODUCTION 1.1.1

A sound knowledge of international financial systems is a pre-requisite for the following reasons: a.

Global trade have been on the steady increase

b.

Global opportunities have to be exploited

c.

It helps in avoiding delays in handling global trade

d. There are a number of financial intermediaries and institutions that facilitate global trade e.

Technology is a great enabler in fostering international trade and scaling up of operations

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM f.

Globally, there is a trend towards elimination of all trade barriers and facilitate uninterrupted global trade

g. Loss due to exchange fluctuations if not prevented or unattended immediately would erode the fortunes of the company. 1.1.2

The economic change witnessed by the world like the disintegration of soviet union, political and economic freedom in eastern Europe, the emergence of market-oriented economies in Asia, the creation of a single European market, trade liberalization through regional trading blocs, such as European union, the world’s t mechanism, such as the world trade organization, have all impacted and facilitated the growth of international trade.

1.1.3

In 1989, Mexico significantly liberalized its foreign direct investment regulations to allow 100% foreign ownership. The North American Free Trade Agreement of 1994 extends the areas of permissible foreign direct investment and protects foreign investors with a dispute settlement mechanism. This is an example of fostering international trade.

1.2 MOTIVES FOR WORLD TRADE AND FOREIGN INVESTMENT 1.2.1

The theories of comparative advantage, factor endowments and product life cycle have been suggested as three major motives for foreign trade.

1.2.2

Theory of comparative advantage This is the classical economic theory which explains why countries exchange their goods and services with each other. The underlying assumption is that some countries can produce some types of goods more efficiently than other countries. Hence, the theory of comparative advantage assumes that all countries are better off when each one specializes in the production of those goods which it can produce more efficiently and buys those goods which other countries produce more efficiently. It neutralizes the cost and benefits more effectively.

1.2.3

The theory of factor endowments Countries are endowed differently in their economic resources. Columbia is more efficient in the production of coffee and the US is more efficient in the production of computers. Colombia has the oil, weather and abundant supply of unskilled labor necessary to produce coffee more economically than the US. Differences in these national factor endowments explain differences in comparative factor costs between the two countries. Each country has to take advantage of its own strengths and also trade it off against other countries strenghs.

1.2.4

Product life cycle All products have a certain length of life. During this life they go through certain stages. The product life cycle theory explains both world trade and foreign investment patterns on the basis of stages in a product’s life. In the context of international trade, the theory assumes that certain products go through four stages: Introduction and export, international production, intense foreign competition and imports.

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1.2.5

Trade control The possibility of a foreign embargo on sales of certain products and the needs of national defense may cause some countries to seek self sufficiency in some strategic commodities. Political and military questions constantly affect international trade and other international business operations. Tariffs, import quotas and other trade barriers are three primary means of protectionism. This is where a country’s economic reforms and liberalization really international trade in a big way.

1.3 WORLD TRADE BODIES 1.3.1

In 1947, 23 countries signed the General Agreement on Tariffs and Trade (GATT) in Geneva. To GATT, countries must adhere to Most Favored Nation (MFN) clause, which requires that if a country grants a tariff reduction to one country, it must grant the same concession to all other countries. This clause applies to quotas also.

1.3.2 The new organization, known as the World Trade Organization (WTO), has replaced the GATT since the Uruguay Round accord became effective on January 1, 1995. Today, WTO’s 135 for more than 95% of world trade. The five major functions of WTO are: a.

istering its trade agreements

b.

Being a forum for trade negotiations

c.

Monitoring national trade policies

d. Providing technical assistance and training for developing countries e. 1.3.3

Cooperating with other international organizations

Under the WTO, there is a powerful dispute-resolution system, with three-person arbitration . Some of the major features of WTO and GATT are: a.

World Trade Organization (WTO), was formed in 1995, head quartered at Geneva, Switzerland

b.

It has 152 member states

c.

It is an international organization designed to supervise and liberalize international trade

d.

It succeeds the General Agreement on Tariffs and Trade

e.

It deals with the rules of trade between nations at a global level

f.

It is responsible for negotiating and implementing new trade agreements, and is in charge of policing member countries’ adherence to all the WTO agreements, signed by the bulk of the world’s trading nations and ratified in their parliaments.

g.

Most of the WTO’s current work comes from the 1986-94 negotiations called the Uruguay Round, and earlier negotiations under the GATT. The organization is currently the host to new negotiations, under the Doha Development Agenda (DDA) launched in 2001.

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM h.

1.3.4

Governed by a Ministerial Conference, which meets every two years; a General Council, which implements the conference’s policy decisions and is responsible for day-to-day istration; and a director-general, who is appointed by the Ministerial Conference.

The General Agreement on Tariffs and Trade (GATT) a. GATT was a treaty, not an organization. b. Main objective of GATT was the reduction of barriers to international trade through the reduction of tariff barriers, quantitative restrictions and subsidies on trade through a series of agreements. c. It is the outcome of the failure of negotiating governments to create the International Trade Organization (ITO). d. The Bretton Woods Conference had introduced the idea for an organization to regulate trade as part of a larger plan for economic recovery after World War II. As governments negotiated the ITO, 15 negotiating states began parallel negotiations for the GATT as a way to attain early tariff reductions. Once the ITO failed in 1950, only the GATT agreement was left. e. The functions of the GATT were taken over by the World Trade Organization which was established during the final round of negotiations in early 1990s.

1.4 TRADE-RELATED INVESTMENT MEASURES (TRIMS) a.

TRIMs are the rules a country applies to the domestic regulations to promote foreign investment, often as part of an industrial policy.

b. It is one of the four principal legal agreements of the WTO trade treaty. c.

It enables international firms to operate more easily within foreign markets.

d. In the late 1980’s, there was a significant increase in foreign direct investment throughout the world. However, some of the countries receiving foreign investment imposed numerous restrictions on that investment designed to protect and foster domestic industries, and to prevent the outflow of foreign exchange reserves. e.

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Examples of these restrictions include local content requirements (which require that locally-produced goods be purchased or used), manufacturing requirements (which require the domestic manufacturing of certain components), trade balancing requirements, domestic sales requirements, technology transfer requirements, export performance requirements (which require the export of a specified percentage of production volume), local equity restrictions, foreign exchange restrictions, remittance restrictions, licensing requirements, and employment restrictions. These measures can also be used in connection with fiscal incentives. Some of these investment measures distort trade in violation of GATT Article III and XI, and are therefore prohibited.

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1.5 TRADE RELATED ASPECTS OF INTELLECTUAL PROPERTY RIGHTS (TRIPS) a.

TRIPS is an international agreement istered for the first time by the World Trade Organization (WTO) into the international trading system.

b.

It sets down minimum standards for many forms of intellectual property (IP) regulation.

c.

Till date, it remains the most comprehensive international agreement on intellectual property.

d.

It was negotiated at the end of the Uruguay Round of the General Agreement on Tariffs and Trade (GATT) in 1994.

e.

TRIPS contains requirements that nations’ laws must meet for: copyright rights, including the rights of performers, producers of sound recordings and broadcasting organizations; geographical indications, including appellations of origin; industrial designs; integrated circuit layout-designs; patents; monopolies for the developers of new plant varieties; trademarks; trade dress; and undisclosed or confidential information. TRIPS also specify enforcement procedures, remedies, and dispute resolution procedures.

f.

In 2001, developing countries were concerned that developed countries were insisting on an overly-narrow reading of TRIPS, initiated a round of talks that resulted in the Doha Declaration: a WTO statement that clarifies the scope of TRIPS; stating for example that TRIPS can and should be interpreted in light of the goal “to promote access to medicines for all”.

1.6 TRADING BLOCS: TYPES OF ECONOMIC COOPERATION 1.6.1 A trading bloc is preferential economic arrangement between a group of countries that reduces intra-regional barriers to trade in goods, services, investment and capital. There are more than 50 such arrangements at the present time. There are five major forms of economic cooperation among countries: Free trade areas, customs unions, common markets, economic unions and political unions. 1.6.2 The North American Free Trade Agreement (NAFTA) among US, Canada and Mexico is an example of Free trade areas where member countries remove all trade barriers among themselves. 1.6.3 Under the customs union arrangement, member nations not only abolish internal tariffs among themselves but also establish common external tariffs. 1.6.4 In a common market type of agreement, member countries abolish internal tariffs among themselves and levy common external tariffs. The also allow the free flow of all factors of production, such as capital, labor and technology. 1.6.5 The economic union combines common market characteristics with harmonization of economic policy. Member nations are required to pursue common monetary and fiscal policies. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM 1.6.6 Political union combines economic union characteristics with political harmony among the member countries.

1.7 MOTIVES FOR FOREIGN INVESTMENT 1.7.1

The product life cycle theory, the portfolio theory and the oligopoly model have been suggested as bases for explaining and justifying foreign investment.

1.7.2

Product life cycle theory explains changes in the location of production. After successful launch of new products, companies shift the manufacturing base to other countries for lowering costs and retain the margin. This is what is witnessed in India today, which has become the destination for low cost outsourcing. For eg. South India is called Detroit of US due to many MNC automobile companies setting up their production facilities there.

1.7.3

Portfolio theory indicates that a company is often able to improve its risk-return performance by holding a diversified portfolio of assets. This theory represents another rationale for foreign investment. The diversified portfolio will include foreign assets.

1.7.4

Under the oligopoly model, the assumption is that business firms attract foreign investments to exploit their quasi monopoly advantages. The advantage of an MNC over a local company may include technology, access to capital, differentiated products built on advertising, superior management and organizational scale.

1.8 BALANCE OF PAYMENTS 1.8.1

A country’s balance of payments is defined as the record of transactions between its residents and foreign residents over a specified period, which includes exports and imports of goods and services, cash receipts and payments, gifts, loans, and investments. Residents may include business firms, individuals and government agencies. The balance of payments helps business managers and government officials to analyze a country’s competitive position and to forecast the direction of pressure on exchange rates. Government’s export import policies also mainly depend on this.

1.8.2

The balance of payments is a sources-and-uses-of-funds statement reflecting changes in assets, liabilities and net worth during a specified period. Transactions between domestic and foreign residents are entered in the balance of payments as either debits or credits. Transactions that earn foreign exchange are often called credit transactions and represent sources of funds. Transactions that expend foreign exchange are called debit transactions and represent use of funds. A country incurs a ‘surplus’ in its balance of payments if credit transactions exceed debit transactions or if it earns more abroad than it spends. On the other hand, a country incurs a ‘deficit’ in its balance of payments if debit transactions are greater than credit transactions or if it spends more abroad than it earns. Surpluses and deficits in the balance of payments are of considerable interest to banks, companies, portfolio managers and governments.

1.8.3

They are used to: a.

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Predict pressure on foreign exchange rates

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b.

Anticipate government policy actions

c.

Assess a country’s credit and political risk

d.

Evaluate country’s economic health

1.8.4 Balance of payments s The international monetary fund (IMF) classifies balance of payments transactions into five major groups: a.

Current : merchandise, services, income and current transfers

b.

Capital : Capital transfers, non-produced assets, non financial assets

c.

Financial : Direct investments, portfolio investments and other investments

d.

Net errors and omissions

e.

Reserves and related items: These are government owned assets which include monetary gold, convertible foreign currencies, deposits, and securities. The principle convertible currencies are the US dollar, the British pound, the euro, and the Japanese Yen for most countries. Credit and loans from the IMF are usually denominated in special drawing rights (SDRs). Sometimes called ‘paper gold’ SDRs can be used as means of international payment.

INTERNATIONAL ORGANISATIONS AND ING STANDARDS Many ing professionals perceive standardization to be too strict and inflexible to provide the information s need; Harmonisation is necessary as so many MNCs are doing business in numerous countries; Several international organizations dealing with the harmonization challenge: •

IASC: Founded in 1973 by agreement among professional ing organizations in 9 countries; now grown to over 70 countries; over 100 professional ing organizations;

IASC develops and publishes IASs. IASC also promotes these standards for wide international acceptance; Some countries use IASs as their national ing rules and others use them as basis for their own ing rules; MNCs voluntarily use IASs for secondary set of financial statements; •

European Union (EU): Founded on 25/3/57, is the Association of European States, when Belgium, , West , Italy, Luxembourg and Netherlands signed the Treaty of Rome. Treaty was free movement of labour, capital and goods among member countries by 1992, without any tariff or barrier.

Now EU imports and exports more than any single country in the world; with US as major trading partner; there are 15 member countries now; 4th Directive:

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM 7th Directive: 8th Directive: Mutual Recognition Directive: Directive of Dec 8, 1986 11th Directive of Feb 13, 1989 EU Cooperation with IASC: oIt is a major step in the direction of international harmonisation; oIt is to facilitate multinational companies to prepare one set of financial statements that would be accepted by stock exchanges worldwide. ORGANISATON FOR ECONOMIC COOPERATION AND DEVELOPMENT (OECD): Established on Dec 14, 1960; formed by 24 most powerful countries; HO at Paris; It is an international organization for economic research and policy analysis; It provides reports on financial ing and reporting and economic development. In countries such as India, Canada and Australia, Foreign Investments need government approval. In US and Switzerland, even domestic investments need government approval. OECD guidelines provide for “Disclosure of information” in financial statements. There exists open and cooperative relationship among the various organizations seeking to set international ing standards such as IASC and EU commission. INTERNATIONAL ORGANISATION OF SECURITIES COMMISSIONS (IOSCO) It is a private organization with the objective of integrating the securities markets worldwide and for developing financial reporting standards and their effects on securities markets. UNITED NATIONS (UN) UN studies the impact of multinational corporations on development and international relations and brings out publications on international ing and reporting issues. INTERNATIONAL FEDERATION OF ANTS (IFAC) IFAC established in 1977 if for development of ing profession and works to achieve international technical, ethics and education pronouncements for the profession. Other organizations are: ASIA-PACIFIC ECONOMIC COOPERATION NORDIC FEDERATIN OF ANTS ASSOCIATION OF SOUTHEAST ASIAN NATIONS

1.9 INTERNATIONAL MONETARY SYSTEM 1.9.1

The international monetary system consists of laws, rules, institutions, instruments and procedures which involve international transfer of money. These elements affect for-

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eign exchange rates, international trade and capital flows and balance of payment adjustments. Foreign exchange rates determine prices of goods and services across national boundaries. These exchange rates also affect international loans and foreign investment. Hence, the international monetary system plays a critical role in the financial management of multinational business and economic policies of individual countries. 1.9.2

Foreign exchange system

a. A global company’s access to international capital markets and its freedom to move funds across national boundaries are subject to a variety of national constraints. b. These constraints are frequently imposed to meet international monetary agreements on determining exchange rates. c. Constraints may also be imposed to correct the balance of payments deficit or to promote national economic goals. d A foreign exchange rate is the price of one currency expressed in of another currency. A fixed exchange rate is an exchange rate which does not fluctuate or which changes within a predetermined band. The rate at which the currency is fixed or pegged is called ‘par value’. A floating or flexible exchange rate fluctuates according to market forces. 1.9.3 Advantages of flexible exchange rate system a. Countries can maintain independent monetary and fiscal policies b. Permits smooth adjustment to external shocks c.

Central banks need not maintain large international reserves to defend a fixed exchange rate

1.9.4 Disadvantages of flexible exchange rate system a.

Unstable exchange rates can prevent free flow of trade

b.

Inherently inflationary because they remove external discipline

1.10 CONCEPTS IN FOREIGN EXCHANGE RATE a. An appreciation is a rise in the value of a currency against other currencies under a floating rate system. b. A depreciation is a decrease in the value of a currency against other currencies under a floating rate system. c. A revaluation is an official increase in the value of a currency by the government of that currency under a fixed rate system. d. A devaluation is an official reduction in the par value of a currency by the government of that currency under a fixed rate system.

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM 1.10.1 Currency boards A currency board is a monetary institution that only issues currency to the extent it is fully backed by foreign reserves. Its major attributes are: a. An exchange rate that is fixed not just by policy but by law b. A reserve requirement to the extent that a country’s reserves are equal to 100 percent of its notes and coins in circulation c. A self correcting balance of payments mechanism where a payment deficit automatically contracts the money supply and thus the amount of spending as well d. No central bank under a currency board system e. In addition to promoting price stability, a currency board also compels the government to follow a responsible fiscal policy. f.

Countries like Mauritius, Hong Kong, Estonia, Argentina, Lithuania, Bulgaria and Bosnia are countries that have adopted currency board system.

1.10.2 History of the international monetary system The pre-1914 gold standard: a fixed exchange system: In the pre-1914 era, most of the major trading nations accepted and participated in an international monetary system called the gold standard. Under this regime, countries use gold as a medium of exchange and a store of value. The gold standard had a stable exchange rate. Monetary disorder: 1914-45: a flexible exchange system: The gold standard collapsed after the First World War and ended the stability of exchange rates for the major currencies of the world. The value of currencies fluctuated very widely. The great depression of 1929-32 and the international financial crisis of 1931, further prevented the restoration of gold standard. Governments started devaluing their currencies to exports. Fixed exchange rates: 1945-73:

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a.

The Bretton woods agreement was signed by representatives of 44 countries in 1944 to establish a system of fixed exchange rates.

b.

Under this system, each currency was fixed by government action within a narrow range of values relative to gold or some currency of reference. US dollar was used frequently as a reference currency to establish the relative prices of all other currencies

c.

At this conference, they agreed to establish a new monetary order, which centered on IMF and IBRD (World Bank).

d.

IMF provides short term balance of payment adjustment loans, while the world bank makes long term development and reconstruction loans.

e.

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Breakdown of the Bretton woods system: a. The late 1940s marked the beginning of large deficits in the US balance of payments. America’s payments deficits resulted in dilution of US gold and other reserves during the 1960s and early 1970s. b. In 1971, most major currencies were permitted to fluctuate. US dollars fell in value against a number of major currencies. Several countries caused major concern by imposing some trade and exchange controls which was feared that such protective measures might become widespread to curtain international commerce. c. In order to solve these problems, the world’s leading trading countries, called the ‘Group of Ten’, produced the Smithsonian Agreement in 1971. The post 1973 dirty floating system: The exchange rate became much more volatile during this period due to a number of events affecting the international monetary order. Oil crisis of 1973, loss of confidence in US dollar between 1977 and 1978, second oil crisis in 1978, formation of European monetary system in 1979, end of Marxist revolution in 1990 and Asian financial crisis in 1997.

1.11 THE INTERNATIONAL MONETARY FUND (IMF) a. An international organization created in 1944 with a goal to foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, and reduce poverty. b. Oversees the global financial system by following the macroeconomic policies of its member countries, in particular those with an impact on exchange rates and the balance of payments. c. Offers financial and technical assistance to its , making it an international lender of last resort. Countries contributed to a pool which could be borrowed from, on a temporary basis, by countries with payment imbalances. d. It is headquartered in Washington, D.C., USA. e. The IMF has 185 member countries Current actions: a. The International Monetary Fund’s executive board approved a broad financial overhaul plan that could lead to the eventual sale of a little over 400 tons of its substantial gold supplies. b. The board of IMF has proposed a new framework for the fund, designed to close a projected $400 million budget deficit over the next few years. c. The budget proposal includes sharp spending cuts of $100 million until 2011. hip qualifications: a. Any country may apply for hip to the IMF. The application will be considered first by the IMF’s Executive Board. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM b. After its consideration, the Executive Board will submit a report to the Board of Governors of the IMF with recommendations (the amount of quota in the IMF, the form of payment of the subscription, and other customary and conditions of hip) in the form of a “hip Resolution”. c. After the Board of Governors has adopted the “hip Resolution,” the applicant state needs to take the legal steps required under its own law to enable it to sign the IMF’s Articles of Agreement and to fulfill the obligations of IMF hip. d. Similarly, any member country can withdraw from the Fund, although that is rare (Ecuador, Venezuela) e. A member’s quota in the IMF determines the amount of its subscription, its voting weight, its access to IMF financing, and its allocation of Special Drawing Rights (SDRs). f. A member state cannot unilaterally increase its quota — increases must be approved by the Executive Board and are linked to formulas that include many variables such as the size of a country in the world economy. g. IMF established rules and procedures to keep participating countries from going too deeply into balance of payments deficits. Those countries with short term payment difficulties could draw upon their reserves, defined in relation to each member’s quota.

1.12 THE EUROPEAN MONETARY UNION A monetary union is a formal arrangement in which two or more independent countries agree to fix their exchange rates or employ only one currency to carry out all transactions. Full European monetary union was achieved in 2002, which enabled 15 EU countries to carry out transactions with one currency through one central bank under one monetary policy. A single currency called the EURO was adopted.

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SECTION - 2 IMPORT AND EXPORT PROCEDURES & PRACTICES This Section includes Procedures for Imports Export Procedures



Important Note: The import and export trade of a country is governed by the country’s governmental policies, rules and regulations. Detailed procedures covering every aspect of the trade are available, and the subject is a matter of extensive study as a separate discipline. These are further backed with extensive documentation, inspection and assessment procedures. The number of intermediaries involved in the process is also numerous. This chapter, therefore, only provides a glimpse of the process. The student is well advised to refer to the relevant rules and regulations laid down by the Ministries of Finance, Commerce, and various authorities such as the Office of the Director General of Foreign Trade.

2.1 PROCEDURES FOR IMPORTS 2.1.1

Import Restrictions

Licensing, Quotas And Prohibitions: Import approval is based on compliance with procedures whereby specific items may be imported by certain types of importers under certain types of licences. Importers are divided into three categories for the purpose of import licensing: 1.

actual s; An actual applies for and receives a licence to import any item or an allotment of an imported item as required for his own use, not for business or trade in that item.

2.

ed exporters; defined as those who have a valid registration certificate issued by an export promotion council, commodity board or other ed authority designated by the Government for purposes of export-promotion.

3.

others.

The two types of actual licence are: 1.

general currency area licences which are valid for imports from all countries, except those countries from which imports are prohibited;

2.

specific licences which are valid for imports from a specific country or countries. Aside from the types of licences listed, the Open General Licence is perhaps the most liberalized type of licence available for certain items and certain types of importers.

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM Licences are valid for 24 months for capital goods and 18 months for raw materials components, consumable and spares, with the licence term renewable. Import licences may be obtained from the director general of foreign trade (Office of Chief Controller of Imports and Exports, Ministry of Commerce, Udyog Bhawan, New Delhi 110011). Traders are advised to consult the Handbook of Procedures which is published by the Ministry of Commerce and is part of the Import and Export Policy for further details. 2.1.2

The importer importing the goods has to follow prescribed procedures for import by ship/air/road. There is separate procedure for goods imported as a baggage or by post.

2.1.3

Bill of Entry

1.

This is a very vital and important document which every importer has to submit under section 46. The Bill of Entry should be in prescribed form.

2.

Bill of Entry should be submitted in quadruplicate – original and duplicate for customs, triplicate for the importer and fourth copy is meant for bank for making remittances.

3.

A BIN (Business Identification Number) is allotted to each importer and exporter w.e.f. 1.4.2001.

4.

It is a 15 digit code based on PAN of Income Tax (PAN is a 10 digit code). [Earlier an EC (Import Export code) number issued by DGFT was required to be mentioned on Bill of Entry].

2.1.4 Documents to be submitted by Importer are 1.

Invoice

2.

Packing List

3.

Bill of Landing / Delivery Order

4.

GATT declaration form duly filled in

5.

Importers / CHAs declaration duly signed

6.

Import Licence or attested photocopy when clearance is under licence

7.

Letter of Credit / Bank Draft wherever necessary

8.

Insurance memo or insurance policy

9.

Industrial License if required

10. Certificate of country of origin, if preferential rate is claimed. 11. Technical literature. 12. Test report in case of chemicals 13. Advance License / DEPB in original, where applicable 14. Split up of value of spares, components and machinery 15. No commission declaration. – A declaration in prescribed form about correctness of information should be submitted. – Chapter 3 Para 6 and 7 of CBE&C’s Customs Manual, 2001.

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2.1.5

Electronic submission under EDI system – Where EDI system is implemented, formal submission of Bill of Entry is not required, as it is generated in computer system.

2.1.6

Importer should submit declaration in electronic format to ‘Service Centre’. A signed paper copy of declaration for non-repudiability should be submitted.

2.1.7

Bill of Entry number is generated by system which is endorsed on printed check list. Original documents are to be submitted only at the stage of examination.

2.1.8

Assessment of Duty and Clearance: The documents submitted by importer are checked and assessed by Customs authorities and then goods are cleared.

2.1.9

Payment of Customs Duty - After assessment of duty, necessary duty is paid. Regular importers and Custom House Agents keep current with Customs department. The duty can be debited to such current , or it can be paid in cash/DD through TR-6 challan in designated banks.

After payment of duty, if goods were already examined, delivery of goods can be taken from custodians (port trust) after paying their dues.

2.2 EXPORT PROCEDURES 2.2.1

Documents Required: Certain documentation takes place while exporting from India. Special documents may be required depending on the type of product or destination. Certain export products may require a quality control inspection certificate from the Export Inspection Agency. Some food and pharmaceutical product may require a health or sanitary certificate for export. Shipping Bill/ Bill of Export is the main document required by the Customs Authority for allowing shipment.

2.2.2

Every exporter should take following initial steps

1. Obtain BIN (Business Identification Number) from DGFT. It is a PAN based number. 2. Open current with designated bank for credit of duty drawback claims 3. licenses / advance license / DEPB etc. at the customs station, if exports are under Export Promotion Schemes 4. Submission of Shipping Bill (export by sea or air) or Bill of export (for export by road) 5. Assessment of goods for duty - even if no duty is payable for most of exports, as ‘Nil Duty’ assessment is also an assessment. 6. Shipping Bill or bill of export should be submitted in quadruplicate. If drawback claim is to be made, one additional copy should be submitted. 2.2.3 There are five forms a.

Shipping Bill for export of goods under claim for duty drawback - these should be in Green colour.

b.

Shipping Bill for export of dutiable goods - this should be yellow colour

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM c.

Shipping bill for export of duty free goods - it should be in white colour

d.

Shipping bill for export of duty free goods ex-bond - i.e. from bonded store room - it should be pink colour

e.

Shipping Bill for export under DEPB scheme - Blue colour.

2.2.4 Requirements of Shipping Bill a. The shipping bill form requires details like name of exporter, consignee, Invoice Number, details of packing, description of goods, quantity, FOB Value etc. b. Appropriate form of shipping bill should be used. c. Relevant documents i.e. copies of packing list, invoices, export contract, letter of credit etc. are also to be submitted. Usually the Shipping Bill is of four types and the major distinction lies with regard to the goods being subject to certain conditions which are mentioned below:

Export duty/ cess



Free of duty/ cess



Entitlement of duty drawback



Entitlement of credit of duty under DEPB Scheme



Re-export of imported goods

2.2.5

Documents Required for Post Parcel Customs Clearance:

In case of Post Parcel, no Shipping Bill is required. The relevant documents are mentioned below:

Customs Declaration Form - It is prescribed by the Universal Postal Union (UPU) and international apex body coordinating activities of national postal istration. It is known by the code number 2/ 3 and to be prepared in quadruplicate, signed by the sender.



Despatch Note, also known as 2. It is filled by the sender to specify the action to be taken by the postal department at the destination in case the address is non-traceable or the parcel is refused to be accepted.



Prescriptions regarding the minimum and maximum sizes of the parcel with its maximum weight : Minimum size: Total surface area not less than 140 mm X 90 mm. Maximum size: Lengthwise not over 1.05 m. Measurement of any other side of circumference 0.9 m./ 2.00 m. Maximum weight: 10 kg usually, 20 kg for some destinations.

2.2.6

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Excise formalities at the time of Export - If the goods are cleared by manufacturer for export, the goods are accompanied by ARE-1 (earlier AR-4): This form should be submitted to customs authorities.

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The Customs Officer certifies that the goods under this form have indeed been exported.



This form has then to be submitted to Maritime Commissioner for obtaining ‘proof of export’.



The bond executed by Manufacturer-exporter with excise authorities is released only when ‘proof of export’ is accepted by Maritime Commissioner or Assistant Commissioner, where bond was executed.



Duty drawback formalities - If the exporter intends to claim duty draw back on his exports, he has to follow prescribed procedures and submit necessary papers.



He has to make endorsement of shipping bill that claim for duty drawback is being made.



G R / SDF / SOFTEX Form under FEMA - Reserve Bank of India has prescribed GR / SDF form under FEMA. “G R” stands for ‘Guaranteed Receipt’ form, while SDF stands for ‘Statutory Declaration Form’). SDF form is to be used where shipping bills are processed electronically in customs house, while GR form is used when shipping bills are processed manually in customs house.

2.2.7

Other documents required for export - Exporter also has to prepare other documents such as the following: (a) Four copies of Commercial Invoice (b) Four copies of Packing List (c) Certificate of Origin or pre-shipment inspection where required (d) Insurance policy. (e) Letter of Credit (f) Declaration of Value (g)Excise ARE-1/ARE-2 form as applicable (h) GR / SDF form prescribed by RBI in duplicate (i) Letter showing BIN Number.

2.2.8

RCMC certificate from Export Promotion Council - Various Export Promotion Councils have been set up to promote and develop exports. (e.g. Engineering Export Promotion Council, Apparel Export Promotion Council, etc.) Exporter has to become member of the concerned Export Promotion Council and obtain RCMC - Registration cum hip Certificate.

used in the trade

Commercial invoice - Issued by the seller for the full realisable amount of goods as per trade term.



Consular Invoice - Mainly needed for the countries like Kenya, Uganda, Tanzania, Mauritius, New Zealand, Burma, Iraq, Ausatralia, Fiji, Cyprus, Nigeria, Ghana, Zanzibar etc. It is prepared in the prescribed format and is signed/ certified by the counsel of the importing country located in the country of export.

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Customs Invoice - Mainly needed for the countries like USA, Canada, etc. It is prepared on a special form being presented by the Customs authorities of the importing country. It facilitates entry of goods in the importing country at preferential tariff rate. Legalised/ Visaed Invoice - This shows the seller’s genuineness before the appropriate consulate/ chamber of commerce/ embassy. It do not have any prescribed form. Certified Invoice - It is required when the exporter needs to certify on the invoice that the goods are of a particular origin or manufactured/ packed at a particular place and in accordance with specific contract. Sight Draft and Usance Draft are available for this. Sight Draft is required when the exporter expects immediate payment and Usance Draft is required for credit delivery. Packing List - It shows the details of goods contained in each parcel/ shipment. Certificate of Inspection - It shows that goods have been inspected before shipment. Black List Certificate - It is required for countries which have strained political relation. It certifies that the ship or the aircraft carrying the goods has not touched those country(s). Weight Note - Required to confirm the packets or bales or other form are of a stipulated weight. Manufacturer’s/ Supplier’s Quality/ Inspection Certificate. Manufacturer’s Certificate - It is required in addition to the Certificate of Origin for few countries to show that the goods shipped have actually been manufactured and are available. Certificate of Chemical Analysis - It is required to ensure the quality and grade of certain items such as metallic ores, pigments, etc. Certificate of Shipment - It signifies that a certain lot of goods have been shipped. Health/ Veterinary/ Sanitary Certification - Required for export of foodstuffs, marine products, hides, livestock etc. Certificate of Conditioning - It is issued by the competent office to certify compliance of humidity factor, dry weight, etc. Antiquity Measurement - Issued by Archaeological Survey of India in case of antiques. Transhipment Bill - It is used for goods imported into a customs port/ airport intended for transhipment. Shipping Order - Issued by the Shipping (Conference) Line which intimates the exporter about the reservation of space of shipment of cargo through the specific vessel from a specified port and on a specified date. Cart/ Lorry Ticket - It is prepared for ittance of the cargo through the port gate and includes the shipper’s name, cart/ lorry No., marks on packages, quantity, etc. Shut Out Advice - It is a statement of packages which are shut out by a ship and is prepared by the concerned shed and is sent to the exporter. Short Shipment Form - It is an application to the customs authorities at port which advises short shipment of goods and required for claiming the return.

Shipping Advice - It is prepared in aligned document to be used to inform the overseas customer about the shipment of goods.

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SECTION - 3 INTERNATIONAL FINANCIAL MANAGEMENT: IMPORTANT ISSUES AND FEATURES, INTERNATIONAL CAPITAL MARKET This Section includes

International Financial Markets



Eurocurrency markets



Asian Currency market



International capital markets



International banking

3.1 INTERNATIONAL FINANCIAL MARKETS 3.1.1

International financial markets are a major source of funds for international transactions. Most countries have recently internationalized their financial markets to attract foreign business.

3.1.2

Internationalization involves both a harmonization of rules and a reduction of barriers that will allow for the free flow of capital and permit all firms to compete in all markets.

3.2 EUROCURRENCY MARKETS 3.2.1

Eurocurrency market consists of banks that accept deposits and make loans in foreign currencies outside the country of issue. These deposits are commonly known as Eurocurrencies. Thus, US dollars deposited in London are called Eurodollars; British pounds deposited in New York are called Eurosterling, etc.

3.2.2

Eurocurrency markets are very large, well organized and efficient. They serve a number of valuable purposes for multinational business operations. Eurocurrencies are a convenient money market device for MNCs to hold their excess liquidity. They are a major source of short term loans to finance corporate working capital needs and foreign trade.

3.3 ASIAN CURRENCY MARKET 3.3.1

In 1968, an Asian version of the Eurodollar came into existence with the acceptance of dollar denominated deposits by commercial banks in Singapore, which was an ideal

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM location for the birth of the Asian currency market due to its excellent communication network, important banks and a stable government. 3.3.2

Asian currency market developed when the Singapore branch of the bank of America proposed that the monetary authority of Singapore relax taxes and restrictions.

3.4 INTERNATIONAL CAPITAL MARKETS 3.4.1

International capital market consists of international bond market and the international equity market. The New York Stock Exchange, the NASDAQ, the London stock exchange and the Tokyo stock exchange are the world’s four biggest markets, measured in market value.

a.

International bond market: These are bonds sold outside the country of the borrower. International bond consist of foreign bonds, Eurobonds and global bonds. The currency of issue is not necessarily the same as the country of issue.

b.

Foreign bonds: These are bonds sold in a particular national market by foreign borrower, underwritten by a syndicate of brokers from that country, and denominated in the currency of that country. Dollar denominated bonds sold in New york by a Mexican firm are foreign bonds are foreign bonds, but should be ed with the US securities Exchange Commission.

c.

Eurobonds: These are bonds underwritten by an international syndicate of brokers and sold simultaneously in many countries other than the country of the issuing entity. These are bonds issued outside the country in whose currency they are denominated.

d.

Global bonds: These are bonds which are sold both inside and outside the country in whose currency it is denominated.

3.5 INTERNATIONAL BANKING 3.5.1

International banking has grown with the unprecedented expansion of economic activity since the world war.

3.5.2

International banks perform many vital tasks to help the international transactions of multinational companies. They finance foreign trade and foreign investment, underwrite international bonds, borrow and lend in the Eurodollar market, organize syndicated loans, participate in international cash management, solicit local currency deposits and loans and give information and advice to clients.

3.5.3

Interbank clearing house systems: There are three key clearing house systems of interbank fund transfers which transfer funds between banks through wire and facilitate international trade.

a.

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The clearing house interbank payments system(CHIPS): This is used to move dollars among New York offices of about 150 financial institutions that handle 95 percent of all foreignexchange trades and almost all Eurodollar transactions.

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b.

The clearing house payments assistance system(CHPAS): This began its operations in 1983 and provides services similar to those of CHIPS. It is used to move funds among London offices of most financial institutions.

c.

The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It is an interbank communication network which carries messages for financial transactions. It represents a common denominator in the international payment system and uses the latest communication technology. It has reduced multiplicity of formats used by banks in different parts of the world. International payments can be made very cheaply and efficiently.

3.6 FINANCING FOREIGN TRADE 1.

There are three major documents involved in foreign trade, namely, a draft, a bill of lading and a letter of credit.

2.

Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise. Many of these documents are used to eliminate non completion risk, to reduce forex risk and finance trade transactions.

3.

A draft or bill of exchange is an order written by an exporter that requires an importer to pay a specified amount of money at a specified time. Through the draft, the exporter may use its bank as the collection agent on s that the exporter finances.

4.

A bill of lading is a shipping document issued to an exporting firm or its bank by a common carrier which transports goods. It is simultaneously a receipt, contract and a document of title. As a receipt, the bill of lading indicates that specified goods have been received by the carrier. As a contract, it is evidence that the carrier is obliged to deliver the goods to the importer in exchange for certain charges. As a document of title, it establishes ownership of the goods. Bill of lading can be used to insure payment before the goods are delivered.

5.

Letter of credit is a document issues by a bank at the request of an importer. In this, the bank agrees to honor a draft drawn on the importer if the draft accompanies specified documents such as the bill of lading. The importer asks that his local bank write a letter of credit. In exchange for the bank’s agreement to honor the demand for payment that results from the import transactions, the importer promises to pay the bank the amount of the transaction and a specified fee. A letter of credit is advantageous to both exporters and importers because it facilitates foreign trade.

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SECTION - 4 INTERNATIONAL FINANCIAL SERVICES AND INSURANCE: IMPORTANT ISSUES AND FEATURES This Section includes

Introduction Implications of a large, rapidly growing home market for International Financial Services (IFS) in India:



What drives the demand for IFS?



The impact of globalization on IFS demand and on IFCs: Projections for revenue potential of Mumbai as an IFC Insurance Integration and Globalization of Financial Services:





4.1 INTRODUCTION 4.1.1

The term financial services refers to services provided by the finance industry. The finance industry encomes a broad range of organizations that deal with the management of money. Among these organizations are commercial banks, investment banks, asset management companies, credit card companies, insurance companies, consumer finance companies, stock brokerages, and investment funds.

4.1.2

A detailed discussion on the subject is presented in Module 2.

4.2 IMPLICATIONS OF A LARGE, RAPIDLY GROWING HOME MARKET FOR INTERNATIONAL FINANCIAL SERVICES (IFS) IN INDIA 4.2.1

A little appreciated aspect of India’s impressive growth from 1992 onwards is that it has resulted in even faster integration of India with the global economy and financial system. There has been a rapid escalation of two-way flows of trade and investment. Since 1992, India has globalised more rapidly than it has grown, with a distinct acceleration in globalisation after 2002. Capital flows have been shaped by: (a) global investors in India (portfolio and direct); and (b) Indian firms investing abroad (direct).

4.2.2

Indian investors – corporate, institutional and individual – have as yet been prevented from making portfolio investments abroad on any significant scale by the system of

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capital controls. By the same token, Indian firms have borrowed substantially abroad. But foreign firms and individuals have yet to borrow from India. Capital controls still preclude that possibility. 4.2.3

Despite the controls that remain, these substantially increased two-way flows reflect an increase in demand-supply for IFS related to trade/investment transactions in India. Put another way, there has been an increase in IFS consumption by Indian customers and by global customers in India. Demand for IFS from both has been growing exponentially. Cumulative two-way flows in 1992–2005 were a multiple of such flows in 1947–92. The degree of ‘globalisation-integration’ that has occurred in the last 15 years, since reforms began in earnest, is much larger than in the 55 years between independence and India embarking on ‘serious’ reforms. We have made up for six lost decades of economic interaction with the world in a decade and a half. Still, what has happened over the last 15 years is a small harbinger of what is to follow over the next twenty: particularly if the current growth rate of 8% per annum is accelerated to 9–10% as is evocatively being suggested, and if India continues to open up the economy on both trade and capital flows.

4.2.4

The typical discussion about an Indian International Financial Services Centre (IFC) exporting IFS (especially made by those arguing for locating such an IFC in a SEZ) has been analogous to that for software exports: i.e., a sterile relationship between Indian producers and foreign customers of ‘ services’. However, in the case of IFS, India is itself a large, fast growing customer of IFS. Conservative estimates of IFS consumption in India just a few years out, amount to $48 billion a year. That is more than the output of many Indian industries today.

4.3 WHAT DRIVES THE DEMAND FOR IFS? 4.3.1

An understanding of what drives rapidly the growing demand for IFS in India needs to take into two features: 1.

IFS demand is driven by increases in gross two-way financial flows that have occurred in transactions with the rest of the world. It is not driven by net flows. Demand for IFS by Indian customers – as well as foreign firms trading with and investing in India – is driven by imports and exports. India-related purchases of IFS are related to inbound and outbound FDI/FPI.

2.

The annual growth of gross flows has accelerated dramatically in recent years. India’s external linkages have been transformed since 1991–92. But that transformation has been more radical since 2002. The Indian economy is now exhibiting signs of a ‘takeoff’ both in growth and even more rapidly in its globalisation (or integration with the world economy).

Hong Kong and China

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INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM Hong Kong evolved as an enclave IFC to provide IFS for traders dealing with a closed China. In the 1970s and 1980s, Hong Kong had superior institutions, and provided IFS to North Asia (China, Taiwan and Korea) as well as part of ASEAN (the Philippines and Vietnam which are closer to Hong Kong than to Singapore). But, as a colonial artifice, Hong Kong’s role as an IFC was compromised, if not damaged, as China opened up and connected itself to the world through Shanghai and Beijing. Since the 1980s, China has not required its economic partners to deal with it exclusively through Hong Kong. With the gradual rise of Shanghai as an IFC, Hong Kong’s role as an IFC serving China is diminishing, although it is unlikely to be completely eclipsed. At the same time ASEAN regional finance has gravitated decisively toward Singapore.

4.4 THE IMPACT OF GLOBALIZATION ON IFS DEMAND AND ON IFCS 4.4.1

When the economy of a country or region (e.g., the EU or ASEAN) engages with the world through its current and capital s, a plethora of IFS are purchased as part-and-parcel of these cross-border transactions. The hinterland effect of a rapidly growing national or regional economy has been a crucial driver of growth in IFCs.

4.4.2

The 21st century has yet to unfold. But the emergence of China and India as global economic powers is likely (as in the US, EU and ASEAN) to provide the same raison d’etre for these two economies evolving their own IFCs to interface with those that serve other regions. History suggests that no country or regional economy can become globally significant without having an IFC of its own. But the emergence of IFCs has not always been a tale of growth potential and start-up followed by prolonged competitive success in exporting IFS to global markets. The trajectories of IFCs can wax and wane depending on how world events unfold. Growth in Indian IFS demand is driven by the progressive, inexorable integration of the Indian economy with the world economy. As such integration deepens it triggers a variety of needs for IFS. For example:

4.4.3

1. Current flows involve payments services, credit and currency risk management. 2. Inbound and outbound FDI (as well as FPI like private equity and venture capital) involves a range of financial services including investment banking, due diligence by lawyers and ants, risk management, etc. 3. Issuance of securities outside the country involves fees being paid by Indian firms to investment bankers in IFCs around the world. 4. The stock of cross-border exposure (resulting from accumulation of annual flows) requires risk management services to cover country risk, currency risk, etc. This applies in both directions: foreign investors require IFS to protect the market value of their exposure in India while Indian investors require the same services to protect the market value of their exposure outside the country. 292

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5. The shift to import-price-parity (owing to trade reforms) implies that Indian firms that do not import or export are nevertheless exposed to global commodity price and currency fluctuations. These firms require risk management services. 6. Many foreign firms are involved in complex infrastructure projects in India. Indian firms are involved in infrastructure projects abroad. These situations involve complex IFS. The same applies to structuring and financing privatizations (especially those involving equity sales to foreign investors) and public–private partnerships which are becoming a growing feature in infrastructure development around the world. 7. The growth of the transport industry (shipping, roads, rail, aviation, etc) involves financing arrangements for fixed assets at terminals (ports, etc.) as well as for mobile capital assets with a long life: i.e., ships, planes, bus and auto fleets, taxis, etc. That is done by specialised firms engaged in ‘fleet financing’. India is now one of the world’s biggest customers of aircraft buying roughly 40% of the world’s new output of planes in 2006. This requires buying 40% of the world’s aircraft financing services. 8. Indian individuals and firms control a growing amount of globally dispersed assets. They require a range of IFS for wealth management and asset management. 4.4.4

Outbound FDI by Indian firms in t ventures and subsidiaries abroad has increased since 2004–05 as they have globalised. Foreign investments by Indian firms began with the establishment of organic presence, and acquisitions of companies, in the US and EU in the IT-related services sectors. Now they encom pharmaceuticals, petroleum, automobile components, tea and steel. And, geographically, Indian firms are spreading well beyond the US and EU by establishing a direct presence or acquiring companies in China, ASEAN, Central Asia, Africa and the Middle East. Such outward investments are funded through: draw-down of foreign currency balances held in India, capitalization of future export revenue streams, balances held in EEFC s, and share swaps.

4.4.5

Outward investments are also financed through funds raised abroad: e.g., ECBs, FCCBs and ADRs/GDRs. Leveraged buy-outs related to these investments and executed through SPVs abroad are not captured in the overseas investment transactions data. The Tata Steel-Corus transaction, for example, involved substantial IFS revenues going to financial firms in Singapore and London. When two firms across the globe agree to undertake current or capital buy–sell transactions, the associated IFS are usually bought by the firm with better access to high quality, low cost IFS. Consider the example of an Indian firm exporting complex engineering goods to a firm in . It can contract and invoice in: INR, USD or EUR. Because India has limited IFS capabilities, and a stunted currency trading market, the transaction is likely to be contracted in INR or USD. But the German importer generates revenues in EUR. It has to buy INR or USD to pay the Indian firm. It may have to use a currency derivative (future, forward or option) to cover the risk of a movement in the exchange rate of the INR or USD vs. the EUR between placing the order and receiving the goods. This would typically be done in London.

4.4.6

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However, if India had a proper currency spot and derivatives market, the Indian exporter would be able to invoice in EUR. Local IFS demand would be generated by this local firm converting locked-in future EUR revenues into current INR revenues at a known exchange rate. Indian exporters are not as flexible as they wish to be in their choice of the INR or of global currencies for invoicing (i.e., USD, JPY, EUR or GBP) – or even the choice of currencies such as the SGD or CNY for trade with ASEAN and China. If they were, that could influence the effective price received by them. When goods are sold by an Indian exporter, and a German importer pays IFS charges in London for converting EUR into INR and managing the exchange risk, the net price received by the Indian exporter is lower. When the Indian exporter sells in EUR, and local IFS are purchased for conversion of EUR receipts into INR, the price received would be higher.

4.4.8

These differences are invisible in standard BoP data, which do not separate out and recognise charges for IFS being purchased or sold as part and parcel of contractual structures on the current or the capital . For this reason, the standard BoP data grossly understate the size and importance of the global IFS market. Focusing on the transactional aspects of trade flows would tend to understate IFS demand since this tends to ignore the risk management business which rides on trade flows.

4.5 PROJECTIONS FOR REVENUE POTENTIAL OF MUMBAI AS AN IFC 4.5.1

The median (base case) projections involve IFS demand in India rising from $ 13 billion in 2006 to $ 48 billion in 2015. A low-case assumption would see IFS consumption rising from US$ 6.6 to nearly US$ 24 billion over the same period. A more optimistic (but not implausible) ‘high-case’ assumption would see it grow from US$ 19.7 to nearly US$ 72 billion.

4.6 INSURANCE 4.6.1

4.6.2

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Finance and insurance have much in common. Each provides its customers with tools for managing risks. The valuation techniques in both finance and insurance are formally same: The fair value of a security and an insurance policy is the discounted expected value of the future cash flows they provide to their owners. The definition of risk is the same: The variation of future results (cash flows) from expected values. Finally, the management of insurable and financial risks rely on the same two fundamental concepts: risk pooling and risk transfer. Since the early 1990’s, we have seen substantial convergence between finance and insurance. A shortage of property and liability insurance in the 1980s forced many corporate insurance customers to consider alternatives to traditional insurance, such as selfinsurance, captive insurers, and contingent borrowing arrangements to finance losses. Investment bankers and insurance brokers provided many of these alternatives. The demand for catastrophe insurance in the 1990s led to the development of options and futures for this type of insurance. Investment banks, sometimes with insurance company or insurance broker partners, formed subsidiaries to offer catastrophe and other high-demand coverage through new financing arrangements. FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

4.6.3

Life insurers have developed products with embedded options on stock portfolios. Insurers have begun to use structured securities, such as bonds with indexed coupons, in their investment portfolios.

4.6.4

Thus, in the 1990s, financial markets offered products for managing risks traditionally handled by insurers. The high demand for catastrophe insurance on property started the movement. We now see convergence in the investment markets as well as in various new alliances, partnerships and t ventures.

4.7 INTEGRATION AND GLOBALIZATION OF FINANCIAL SERVICES 4.7.1

C hanging customer needs, more knowledgeable and demanding customers, new technology, liberalization, deregulation, and a combination of other forces are blurring the lines between financial products, institutions, sectors, and countries. Regulators are responding to market pressures by allowing more inter-sectoral competition. Banks, securities firms, insurance companies, and other financial intermediaries increasingly compete with each other by offering similar products and services and by entry into fields previously reserved for one sector only.

4.7.2

Financial services integration occurs when financial products and services traditionally associated with one class of financial intermediaries are distributed by another class of financial intermediaries.

4.7.3

Financial services convergence is the tendency of financial products and services traditionally one sector to take on characteristics traditionally observed with financial products and services of another financial services sector.

4.7.4

Convergence occurs through customer demand across traditional sector lines. Examples include the introduction by insurance companies of variable (unit linked) life and annuity products that contain both insurance and securities features. Another burgeoning area is the banking industry’s creation of securitized mortgage and corporate debt portfolios, which involves packaging a group of mortgages or other loans into marketable securities that are sold to investors.

4.7.5

As banks, securities firms, and insurers construct products and offer services that resemble the features of their competitors, product convergence will be an important driving force toward financial services integration.

4.7.6

This integration gave birth to financial services conglomerates. A Financial services conglomerate is a firm or group of firms under common control which offers financial services that extend beyond the traditional boundaries of any one sector. The two most commonly discussed arrangements are bancassurance and universal banks.

4.7.7

Bancassurance describes arrangements between banks and insurers for the sale of insurance through banks, wherein insurers are primarily responsible for production and banks are primarily responsible for distribution.

4.7.8

Universal banks are financial intermediaries that typically offer commercial and investment banking services, and also insurance.

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