Financial Mgmt International Finance 12

FINANCIAL MANAGEMENT&

INTERNATIONAL FINANCE

THE INSTITUTE OFCOST AND WORKS ACCOUNTANTS OF INDIA

12, SUDDER STREET, KOLKATA - 700 016

FINALGROUP - IIIPAPER - 12

STUDY NOTES

First Edition : May 2008

Directorate of StudiesThe Institute of Cost and Works Accountants of India12, Sudder Street, Kolkata - 700 016

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SYLLABUSPaper 12: Financial Management & International Finance

(One Paper: 3 hours:100 marks)

OBJECTIVES

Understand the scope, goals and objectives of Financial Management. To provide expert knowl-edge on concepts, methods and procedures involved in using Financial Management for mana-gerial decision-making.Learning Aims

� Understand and apply theories of financial management

� Identify the options available in financial decisions and using appropriate tools for stra-tegic financial management

� Identify and evaluate key success factors in the financial management for organisationas a whole

� Evaluate strategic financial management options in the light of changing environmentsand the needs of the enterprise

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

� 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%

5. Financial Strategy 15%

6. Investment Decisions 15%

7. Project Management 10%

8. International Finance 10%

9. Sources of International Finance 5%

10. International Monetary and Financial System 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 financialoperations

2. Financial Management Decisions

� Capital structure theories and planning

� Cost of capital

� Designing 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 terms of setting corporate objectives, funds management –national and international

� Contemporary developments – WTO, GATT, Corporate Governance, TRIPS, TRIMS, SEBIregulations 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 adapt-ability, 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 valuesfor 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

� Designing Capital Structure

� The impact of taxation, potential changes in economic factors and potentialrestrictions 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 parityand 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 CapitalMarket

� International Financial Services and Insurance: Important issues and features

PAPER - 12FINANCIAL 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

of Financial Strategies 26-27

Section 8 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 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 StrategySection 1 Introduction to Financial Stratgy 118-122

Section 2 Financial & Non-Financial Objectives of

different organization 123-145

Section 3 Alternative Financing Strategy in the context of

Regulatory Requirement 146-148

Section 4 Modeling and Forecasting Cash Flows and

Financial Statements 149-150

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

Models and Forecasts 151-154

Section 7 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 FinanceSection 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 1 Rising Funds in Foreign Markets And Investment

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 287-289

Section 4 International Financial Services and Insurance :

Important Issues and Features 290-295


1FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

STUDY NOTE - 1

OVERVIEW OF FINANCIAL MANAGEMENT

SECTION- 1

FINANCE AND RELATED DISCIPLINES

• 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

This Section include

1.1. FINANCE AND RELATED DISCIPLINES

1.1.1 Finance refers to funds required for a business or an activity. ‘Finance’ requirementsof an enterprise is not ‘one time’ but recurring. The discipline of financial manage-ment 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 special-ized discipline, integrating knowledge from many diverse fields as explained furtherin this chapter. The head of finance, also called Chief Financial Officer (CFO) mustposses 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 dealswith various factors of production, the returns available on each of them, costs andrevenues and so on. A fundamental knowledge of Economics is essential for the fi-nance manager to understand the macroeconomic environment in which an organiza-tion operates and the micro economic or firm level impact of macro economic environ-ment.

FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE2


1.3. ACCOUNTING

1.3.1 Accounting is the recording of financial transactions of an organization and is basedon several principles, conventions and legal requirement. It provides the basic datafor financial analysis. It helps the Finance Manager analyse, understand and inter-pret the implications of finance decision on the profitability and viability of the enter-prise 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, relyingheavily on mathematical models and therefore, in certain areas of finance such asanalytics or risk modelling, knowledge of mathematics and statistics have become es-sential. 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 contributetowards its competitiveness, sustainability and profitability. A finance manager hasto understand, plan and manage cost, through appropriate tools and techniques in-cluding budgeting and Activity Based Costing.

1.6. LAW

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

1.7. TAXATION

1.7.1 A sound knowledge in taxation, both direct and indirect, is expected of a finance man-ager, as all financial decisions are likely to have tax implications. Tax planning is animportant function of a finance manager. Some of the major business decisions are basedon the economics of taxation. A finance manager should be able to assess the tax ben-efits before committing funds. Present value of the tax shield is the yardstick alwaysapplied by a finance manager in investment decisions..


1.8. TREASURY MANAGEMENT

1.8.1 Treasury has become an important function and discipline, not only in banks, but inevery organization. Every finance manager should be well grounded in treasury op-erations, which is considered as a profit center. It deals with optimal management ofcash flows, judiciously investing surplus cash in the most appropriate investment av-enues, anticipating and meeting emerging cash requirements and maximizing theoverall returns. It helps in judicial asset liability management. It also includes, wher-ever necessary, managing the price and exchange rate risk through derivative instru-ments. 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 financialassistance provided to corpoates has become very customized and innovative. Duringthe early and late 80’s, commercial banks mainly used to provide working capital loansbased on certain norms and development financial institutions like ICICI, IDBI, andIFCI used to provide long term loans for project finance. But, in today’s context, thesedistinctions no longer exist. Moreover, the concept of development financial institu-tions also does not exist any longer. The same bank provides both long term and shortterm finance, besides a number of innovative corporate and retail banking products,which enable corporates to choose between them and reduce their cost of borrowings. Itis 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 thanksto Government’s liberalized investment norms in this sector.

1.10. INSURANCE

1.10.1 Evaluating and determining the commercial insurance requirements, choice of prod-ucts and insurers, analyzing their applicability to the needs and cost effectiveness, tech-niques, ensuring appropriate and optimum coverage, claims handling, etc. fall withinthe 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 anddebt funds from international markets, in the form of Global Depository Receipts (GDRs),American Depository Receipts (ADRs) or External Commercial Borrowings (ECBs) anda number of hybrid instruments like the convertible bonds, participatory notes etc., Accessto international markets, both debt and equity, has enabled Indian companies to lowerthe cost of capital. For example, Tata Motors raised debt at less than 1% from the inter-national capital markets recently by issuing convertible bonds. Finance managers areexpected to have a thorough knowledge on international sources of finance, mergerimplications with foreign companies, Leveraged Buy Outs(LBOs), acquisitions abroad



and international transfer pricing. The implications of exchange rate movements onnew project viability have to be factored in the project cost and projected profitabilityand cash flow estimates. This is an essential aspect of finance manager’s knowledge.Similarly, protecting the value of foreign exchange earned, through instruments likederivatives, is essential for a finance manager as the volatility in exchange rate move-ments 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 thefinance function. Proper identification of risks, installation of appropriate risk controlmeasures, risk transfer mechanisms through hedging, insurance, etc. are key responsi-bilities of a finance executive. A finance manager has to deal with three types of riskviz., price risk, interest rate risk and exchange rate risk. Price risk is all about fluctua-tions in commodity prices going up or coming down, interest rate risk is all aboutinterest rates moving up or down and exchange rate risk means volatility in exchangerates. For managing each of these types of risks, appropriate hedging tools have to beused. Knowledge of such tools is a pre-requisite for a finance manager. Besides theknowledge, the cost of using such tools should not be more than the benefits. Also, thetiming 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 allpervading. A finance manager needs to know how to integrate finance and costing withoperations through software packages including ERP. The finance manager takes anactive part in assessment of various available options, identifying the right one and inthe 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 anorganization,, he or she becomes an important executive,, taking a broader view andcaters to a wider range of stakeholders. A sound knowledge in general managementprinciples and strategy confers significant advantage and enhances the financeprofessional’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 towork 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 EssentialSkills”, 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 roundrole.


1.15. SOFT SKILLS

1.15.1 Any senior executive in today’s competitive business world is expected to have con-siderable proficiency in various soft skills. The most important of these is communica-tion – both verbal and non-verbal.

1.15.2 The article titled “You’re On” shows the importance of possessing good presentationskills 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 thrivesas a CFO, however, without having much more. As Scott Simmons, vice president of CristAssociates, a Chicago-based recruiter, puts it: “No company wants just a really good financeperson anymore; they want someone who can go beyond that.”

But exactly what are those other essential skills? What capabilities, talents, and expertiseshould be in a CFO’s toolbox no matter what industry or company he works for or chal-lenges she may face?

To hear CFOs tell it, “toolbox” may be the wrong metaphor: magician’s bag of tricks is morelike it. There’s nothing easy about mastering the soft skills they say are essential, and whichseem 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 aboutpeople — communicating with them, developing them, empowering them, and listening tothem,” says Charles H. Noski, retired CFO of AT&T and Northrup Grumman. “If you dothose things well, it will contribute to your success as an executive, whether you’re a CFO ornot.” Patience, experience, and a solid dose of intuition can help you round out your finan-cial 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. Over-load 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 FranklinCovey, tells his staff to stop producing any information they deem unimportant and “see ifanyone notices.” That advice has led to a 40 percent reduction in the volume of data re-ported over the past two years. For example, “rather than having a budget-versus-actualanalysis sliced five different ways, we slice it two different ways, and rather than have 15different inventory reports we have 10,” Young says.



Young also takes a merciless approach to his E-mail inbox. He glances at it several times aday but doesn’t respond to any messages until the end of the day unless they are clearlyurgent. That establishes a very high bar — Young says he leaves about 60 percent of hismessages unopened.

Frank Gatti, CFO of ETS, also relies on a strict E-mail hierarchy. “Not all E-mails are of equalimportance,” he says. Aside from those sent by his CEO, “investors and bondholders comefirst. Respond quickly even if you don’t have all the facts, just to let them know you’ll getback 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 noaspiring finance chief can be without. “The CEO connection is the single most importantthing a CFO must understand and maintain,” says David Johnson, CFO of The HartfordFinancial Services Group. While a sound strategy will depend on myriad interpersonal fac-tors, Johnson says he thinks a critical element is candor, which is key to becoming a trustedadviser to the CEO.

“You need to know what your CEO’s hot buttons are: what’s important to him, what is hebeing judged against, what’s his value system?” says Tony Panos, a consultant who devel-oped 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 helpinghim meet his goals.”

But what about managing up to a dictatorial CEO? The advice is the same, Panos says, buthe recommends looking a bit deeper for motive. “People who are dictatorial tend to havesome level of fear driving them. Start by looking at what those fears are and how you canmitigate them.”

The Art of Saying No

CFOs are often labeled as the original “Dr. No,” and in fact they may be more likely thanother senior executives to put the kibosh on ill-advised plans or projects. But many CFOsagree that a thumbs down, or any form of unwelcome news, can be delivered professionallyand with a little less sting.

One way is to “help people feel like they’re coming to a decision together,” says Bright Hori-zons Family Solutions CFO Elizabeth Boland, by giving them the facts and the potential risksrather than a final answer. Richard Fearon, CFO of Eaton Corp., says that listening canmake all the difference. “You just need to hear the idea through so that no one feels short-changed,” he says. In a well-managed company, he adds, the CFO won’t have to play theheavy 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 isnot even worth talking about.” She counsels patience. “We try to talk through all possiblerevenue opportunities,” she says, “before saying it won’t work.” When all else fails, says


Fearon, you simply turn the tables. “I just ask what the person would do if he or she owned100 percent of Eaton.”

Vetting Vendors

Third-party consultants, contractors, and service providers have become essential in this eraof increased regulation and outsourcing. And thanks to Sarbanes-Oxley, not only has “reli-ance 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 basedlargely on who was the low bidder. But now that public-company CFOs face a potentialpersonal 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 selectionprocess,” he says.

That means digging deep on references. Ideally, have a technical person on your staff findout exactly how a consultant handled, say, a software conversion at the reference’s com-pany and what complications ensued, says Bright Horizons’s Boland. Then ease into therelationship slowly, signing up for only a short project to start. Build in time for unexpectedproblems.

Setting out detailed, measurable expectations can help guide the relationship. “You don’twant to micromanage what you’ve outsourced, so you need to have the right reference pointsto measure them against,” says ETS’s Gatti. He recommends asking the vendor for an easy-to-read dashboard showing early warning signs for problems, along with more-detailedweekly or monthly reports.

Finally, realize that managing vendors now carries the additional burden of being respon-sible, at least to a degree, for the quality of their internal controls. “It’s bad enough trying tomonitor your own internal controls,” Stephen Bainbridge, a law professor at the Universityof California, said at a recent symposium. But overseeing another company is “more difficultand 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’sno substitute for real vision.

“We participate in or lead some of the most complex decisions an enterprise can make, soone of our jobs is to see the consequences of all those paths that others can’t see,” says TheHartford’s Johnson. And that, says Robert Mittelstaedt, dean of Arizona State University’sbusiness school and board member at two public companies, requires being “analytic enoughto constantly think about ‘what-if’ scenarios.” After all, CFOs “are better versed than any-one 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 honea CFO’s powers of perception is trouble, and the more the better. “Until things go very



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 compa-nies in bankruptcy as an investment banker, Johnson has seen his fair share of crises. Heactually reads forensic audit reports of disasters at other companies to help keep him on histoes.

Legal Ease

The last thing any company needs is a lawsuit. But in Corporate America, they come withthe 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 thatare used for ‘usual’ business [that is, customer contracts, NDAs, option agreements, and soon]. Then, whenever something is out of the ordinary, or someone requests a substantial changeto 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, an80-location nursing-home operator, mandated that only the CFO and the in-house counselwere allowed to sign. But Stephan avoided bottlenecks by pledging to turn around any docu-ments very quickly — often in the same day.

Having a good working relationship with your counsel — whether inside or outside — can bea safeguard in itself. In fact, says John Iino, a partner at Reed Smith LLP and co-chair of thefirm’s Corporate & Securities practice group, lawyers are most efficient “when they are keptclose to the internal decision makers.” Only then, he adds, can they help companies “draw theline between legal compliance and financial compliance” in such areas as executive-compen-sation disclosure. Stephan worked close enough with his inside counsel, in fact, that he be-came adept at spotting legal red flags.

Of course, there are times when outside counsel must be called in. This is especially true, saysJamison, “if you are in a defensive posture — say, a customer threatens to sue or you getsubpoenaed 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 inyour best interest. And you want to avoid anyone with a tendency to overlawyer or who’s justout 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 com-munication techniques work with which audiences can help finance shine, both within andoutside the company.

But honing your skills as a public face of the organization requires a bit of homework. Beforehis company went public in March, Steffan Tomlinson, CFO of Aruba Networks, listened in on


some 20 conference calls and kept a log of questions asked by analysts so that he wouldknow just what to expect when Aruba held its first call. From that, he learned that “tone andtenor mean a lot, especially over the phone,” and “how you answer questions about com-petitors is telling.” He says that when executives on one of the calls he listened in on stumbledover 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 saysit’s critical to stay focused. “You get very routine about how you do your presentations andwhat 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’veworked with many CFOs who aren’t CPAs but became CFOs because they were able tosynthesize financial information into something useful,” says Bruce R. Evans, a managingpartner at private-equity firm Summit Partners. Offer a few select bar charts and graphswhen possible, instead of tables of numbers. And don’t talk too much. “Even when the workbehind something is extremely complex,” says Gatti, “your audience really just needs toknow the headlines.”

Leading by Example

As the head of the finance department, the CFO must lead and inspire — and know when toget his hands dirty.

It is a delicate balance, says Joseph E. Esposito, recently retired CFO of Concord, Massachu-setts-based SolidWorks Corp. “You have to demonstrate that you are a leader, but withoutinterfering.” That means offering the guidance and counsel of a top executive, he says, butletting your employees do their day-to-day jobs. Boland echoes that idea: “As CFO, you’vegot the title and authority to be involved, but you have to make other functions feel likeyou’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 projectleader. As a CPA, he says, there have been many times when he’s been able to lead a techni-cal project, such as dealing with stock-options accounting, and that when he has done so ithas come as a big relief to his staff. “To them, something like that is just a big pain in theneck,” 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 encourageothers 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



The stammering, the sweating, the laptop that freezes and leaves the speaker stranded at thepodium: presentations like this are the stuff of nightmares. Today, finance executives are pre-senting to everyone from employees to equity analysts, and they’re taking steps to avoid suchdisastrous trips to the microphone.

According to corporate-presentation coaches, the CFO is a major client these days — not tomention a major challenge. “It started with the whole stock-market run-up, when all theinvestor activity put the CFO in the spotlight,” says Deirdre Peterson, a New York-basedcommunications trainer who says she’s been coaching more finance executives than everlately. “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 thehard financial news about a company, whether good or bad. Finance executives convey thosemessages in traditional forums such as board meetings, departmental gatherings, and indus-try conferences, as well as, frequently, over the telephone in news interviews and earningscalls with analysts. “There’s a sense of credibility about the financial picture when you’re hear-ing the numbers from the CFO,” says Timothy Cage, also a New York-based communicationscoach.

Some of the presentation challenges finance executives face are universal. “The most glaringproblem I see is a lack of connection with the audience,” says Cage. “What to a busy executivemay seem like a professional, brisk, coherent approach comes across as cold, aloof, uninter-ested, and uninteresting.” Dan MacLean, a senior faculty member at Communispond, a NewYork communications training company, agrees. “Most people don’t come across the way theythink they do,” he says. The ubiquitous technique of videotaping speakers and allowing themto 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. “CFOshave 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 deliverthe words that gives them their impact.”

Then there’s the seemingly dry material. “Compared to a marketing presentation, where thematerial 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 andmarketing executives, who may receive more presentation training, CFOs often don’t learnintonation and gesturing techniques for capturing audiences.

“It’s Not Intuitive”

Kevin Gregory sought out communications training in 2002, after he ascended to the financechief’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 callsand “mini road shows” with investors, Gregory says he now represents the company to the


outside world once a week on average. He has learned to maintain an awareness of thelistener’s perspective when preparing a presentation. “It’s easy to jump into a discussion andassume that there’s a certain level of understanding that’s just not there” when addressingunfamiliar groups, he says. “If you just start drilling down immediately, you’re going to loseeverybody. 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 recit-ing 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 inFort Worth, learned the importance of effective presentations during his 15-year tenure at Gen-eral Electric Co., where he listened to such speaking legends as former CEO Jack Welch andformer finance chief Dennis Dammerman. In the time between leaving GE and landing hiscurrent 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 updramatically,” says Johnson. Especially after moving into “a leadership role like CFO or high-level controller, the ability to speak to large groups is critical.” At Carter & Burgess, which hasa workforce of around 2,300, Johnson says that training employees through presentations savessignificant time and effort. Giving a targeted talk about the bottom-line benefits of facilitiesleasing, for example, helps him avoid answering dozens of questions on the subject later.

Between training sessions and investor meetings, Johnson says, he sometimes finds himselftalking to groups as often as three times a week. “There’s such an incredible jump in the impactyou have when you’re an effective speaker,” says the CFO. “And it doesn’t take a lot of effortto 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 needto hear?” suggests Communispond’s Dan MacLean.

Focus on delivery. “Voice quality matters,” says trainer Deirdre Peterson. Especially on thephone, 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 confi-dence 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 PowerPointa little too much power.”


SECTION -2

SCOPE OF FINANCIAL MANAGEMENT

• 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, deploythem in the organization’s business activities, efficiently allocating resources, ensuringrisk-return trade-off, invest surplus funds in securities, generate revenue through op-erations and handle the returns by reinvesting and for meeting out the repayment obli-gations.

2.2. EXPANDING SCOPE OF FINANCIAL MANAGEMENT

2.2.1 Financial Management today covers the entire gamut of activities and functions givenbelow. The head of finance is considered to be important ally of the CEO in most orga-nizations 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 inmind 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 ;



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 chap-ters.



SECTION -3PLANNING ENVIRONMENT

• Planning Environment


3.1.PLANNING ENVIRONMENT

3.1.1 The Financial planning environment is becoming more and more dynamic and hasbeen undergoing a sea change in the last few years, mainly on account of globaliza-tion, and better investor awareness. The initiatives of regulators such as the SecuritiesExchange Board of India (SEBI) have only contributed to bring about better disclo-sure, 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 All these call for a more demanding and adaptive planning system, that is responsiveto a competitive business environment.


SECTION - 4KEY DECISIONS OF FINANCIAL MANAGEMENT

• 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 andare 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 choiceof business one wants to be in, an entrepreneur has to develop an investment plan toallocate the funds on various assets, such as land & buildings, plant and machinery,distribution outlets, infrastructure, brand building, research and development, technol-ogy 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 termbenefit or have the potential to become a major problem and financial burden, it is im-portant to accord sufficient time and effort in making these decisions. The choice ofdecision with regard to technology for manufacture of a product, location, configura-tion of machinery, and so on have business implications and have a major bearing onthe profitability and viability of an organization. Most of the times, the decisions areirreversible. The size of the investment, the likely returns and risks associated with theproject 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 moneyrequired to be earmarked also forms part of capital budgeting as margin money is longterm fund.

4.3. CAPITAL STRUCTURE

4.3.1 The next step after identifying an attractive investment opportunity and estimatedthe size of the investment required is working out the sources of funds also called asmeans of financing.

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FINANCIAL MA NAGEMENT & INTERNATIONAL FINANCE

4.3.2 There are two major forms of capital: (1) Equity (own funds), and (2) Debt (borrowedfunds). A major decision is the mix of these two types of funds, widely known as thedebt-equity ratio. Decisions on various related factors such as the optimum ratio, choiceof specific instruments, the capital markets the organization should access to raise thefunds, the timing (see box), pricing of securities, etc. will need to be addressed.

Meltdown worries Wockhardt; IPO review likelyBusiness Line, 23rd Jan.2008Mumbai, Jan. 22. With nine days to go for the opening of Wockhardt Hospital’s initial publicoffering (IPO), the management is concerned over the dramatic developments in the stockmarket. “We will review developments and take a call,” Mr Habil Khorakiwala, Chairman ofWockhardt Hospitals Ltd told media persons, in response to queries whether the IPO wouldbe deferred.Steering clear of stating whether the management was looking at deferring the IPO, he reiter-ated that the company would take an appropriate decision when there is more clarity. Cur-rently, the situation is fluid, he said, on a day when the market witnessed shares plummetingnearly 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, thenext major decision is with regard to managing the day-to-day or short term operatingcycle, popularly called the working capital cycle.

4.4.2 Working capital involves managing the current assets (inventories, debtors, market-able securities and cash) and current liabilities (short-term debt, trade creditors, andprovisions).

4.4.3 The important decisions in relation to working capital revolve around the various com-ponents of working capital given above, such as the optimum level of inventory hold-ing, credit granting decisions, cash management (both deficits and surplus), arrangingfor 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 shouldmeet a number of criteria and expectations of different shareholders. Managing cash,providing for expansion and growth, satisfying expectations on dividend yields, creat-ing 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 evolvedand followed, which will balance the requirements of the different types of investorsand the requirements of the business. Some firms follow stable dividend policy-i.e pay-ing the same rate of dividend irrespective of the profits. There are other firms whichfollow a variable dividend policy where the rates of dividend are varied depending onthe availability of profits. Some firms do not distribute any dividend in cash but givebonus shares which has implications on the capital structure of the company. There-fore, the decision has to be taken carefully as it has long term financial implications onthe company.


SECTION - 5EMERGING ROLE OF FINANCE MANAGERS IN INDIA

• 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 tohave 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 func-tions within Financial Management, headed by a CFO, in smaller organizations, theCFO 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 merefinance function of securing and managing funds to encompass the following, to namea 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 posi-tions 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 acomprehensive view of the competence required and the extreme pressures a CFOfaces in a dynamic and exceedingly demanding business environment. The articlehighlights how Robert Blakely and an army of accountants turned fraud-riddenWorldCom into a clean MCI.

18



Extreme Makeover

How Robert Blakely and an army of accountants turned fraud-ridden WorldCom intosqueaky-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 Capellascalled on the evening of April 10, 2003. Creditors of the bankrupt telecommunications giantwere meeting with Capellas and his team in New York the following day, and he wantedBlakely 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 tocome — 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 noway we could talk,” says Blakely. “By the time [Capellas] arrived, all the senior creditors werethere.” The fact that he wasn’t formally on the payroll didn’t keep the CFO-in-waiting waitingfrom rolling up his sleeves and starting negotiations, which quickly grew acrimonious. “Basi-cally, 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 remainingpoints of Blakely’s employment contract. At noon, “We shook hands and I said, ‘Yep, I’m onboard,’ ” says Blakely.

They returned to the fray. Finally, by 8:30 in the evening, the WorldCom team had convinced90 percent of the creditor groups to exchange most of their bonds for shares of stock in thereorganized company.

For the new CFO, that first 12-hour day was a harbinger of things to come. Raising WorldComfrom the ashes of the biggest fraud — and bankruptcy — in U.S. corporate history, to emerge inApril 2004 as the rechristened MCI Inc., boasting a clean set of books and a mere $5 billion ofdebt, would require many more 12-hour-plus days. Restating the company’s financials, a chorethat began before Blakely’s arrival, would take more than a year and a half to complete. Inter-nal controls had to be overhauled, new directors named, and a new set of corporate-gover-nance 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. Andsomehow, 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 thelate 1990s, the CFO led Houston-based Tenneco Inc., a $13 billion energy conglomerate, througha massive restructuring. Later, he made major improvements to internal controls and risk man-agement at Lyondell Chemical Co., another Houston company. But nothing could have pre-pared him adequately for WorldCom, which declared bankruptcy in July 2002, not long afterthe disclosure of the fraud that drove CFO Scott Sullivan and CEO Bernard Ebbers from thecompany (see “Fall and Rise,” at the end of this article). (Full disclosure: both Blakely andSullivan were recipients of CFO Excellence awards.) “No one has that kind of turnaroundexperience,” says Blakely, “because it has never been done before.”

That challenge was enough to lure Blakely out of retirement, where racing high-performancemotorcycles apparently didn’t provide enough of an adrenaline rush. “What intrigued me


about [WorldCom] was that it was an opportunity to pull everything together that I hadlearned in my career,” he says. “I don’t like stable situations. Some might say that I’m a crisisjunkie.”

The Mother of All Audits

It was easy for Blakely to indulge his habit at WorldCom. Even with the majority of creditorson board, the most difficult tasks required to exit bankruptcy still lay ahead. Hardest of all wasrestating results for three years — 2000, 2001, and 2002 — and filing audited financial state-ments. Not only was $11 billion of fraud cooked into the books, but years of shoddy record-keeping and incompetent accounting clouded nearly every entry.

Blakely and his finance team hoped they could complete the audit by July 2003, three monthsafter he was hired, but it took nearly that long just to size up the task. “It was more complexthan anyone imagined,” he says. Eventually, the team realized they had to reconstruct thefinancial statements from scratch. “I went back to Michael [Capellas] and told him that it lookedmore like July 2004 than July 2003,” says Blakely. But it would have to be done faster: bank-ruptcy court judge Arthur Gonzalez had already set February 28, 2004, as the deadline foremerging from bankruptcy.

Reinforcements were needed. WorldCom already had 500 to 600 employees working full-timeon the restatement, as well as 200 to 300 staffers from KPMG, the company’s auditor. WorldComturned to Deloitte & Touche for more help, and the accounting firm responded with some 600professionals, culled from offices across the country. At the peak of the audit work, in late2003, WorldCom had about 1,500 people working on the restatement, under the combinedmanagement of Blakely and five controllers.

The finance team started with the billing systems and reran all the revenue, deciding on theproper accounting. Then it redid all the cash applications and rebuilt the income statementsfrom there. It also reassessed every acquisition Ebbers had made since 1992 in the course oftransforming 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 goback and reconstruct records to decide whether or not pooling of interest was the proper ac-counting at the time,” says Blakely. In all, they found, WorldCom had overvalued severalacquisitions by a total of $5.8 billion.

The difficulty of the audit work was compounded by the sorry state of WorldCom’s records. Insome 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’steam made more than 3 million new or revised entries.

But even with Deloitte’s help, WorldCom couldn’t finish the audit before Judge Gonzalez’sFebruary 2004 deadline. It was forced to request a 60-day extension. “To bring [the audit] toclosure 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 wouldserve as a foundation for future financial statements. MCI executives planned a signing cer-emony for March 11, at a previously scheduled meeting of the board. But later on the 10th,

20



company personnel and KPMG discovered two significant errors in the deferred tax bal-ances, which rippled through about 100 pages of the 192-page document. Dave Schneeman,vice president of general accounting, and Jim Renna, vice president of controls andremediation, led a small team that worked through the night to make the necessary fixes. “Icalled at midnight, and they said they were making progress,” says Blakely. “I called againat 6:00 a.m. the next day, and they said they had just finished, and I cried,” he admits.

To WorldCom’s investors, the story told by the restated results was a real tearjerker. Sullivanand Ebbers had claimed a pretax profit for 2000 of $7.6 billion; the reality, according to therestatement, was a loss of $48.9 billion (including a $47 billion write-down of impaired as-sets). For 2001, WorldCom had reported a pretax profit of $2.4 billion; the restatement showeda 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 withthe 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 wasable to go undetected for so long. As a result of Ebbers’s acquisition spree, WorldCom hadalso acquired a slew of accounting systems that were integrated loosely, if at all. By Blakely’sreckoning, there were 60 billing platforms and more than 20 accounts-receivable systems.The numbers rolled up from the various operating units to the company’s former headquar-ters in Clinton, Mississippi. There, it was easy for accounting staffers to simply change thenumbers.

“It was a very low-tech fraud in a sense,” says Richard Breeden, a former SEC chairman andMCI’s court-appointed corporate monitor. “If [a WorldCom employee] didn’t like the figurehe got, he just changed it.” He says it was not unknown for accountants at headquarters tocome to the office and find Post-it notes on their computer monitors telling them to changenumbers. Breeden says that in some quarters, imaginary revenue was added to the booksusing 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 concentratedat the top. In his report of recommended reforms, he noted that Ebbers ruled with “nearlyimperial reign.” “The attitude at the company was that orders were to be followed, and itwas clear that anybody that didn’t would be fired,” says Breeden. Along with the big stickcame a few carrots. A generous stock-option plan was supplemented by a $238 million “em-ployee-retention program” that was dipped into and doled out at the discretion of Ebbersand Sullivan. “It was basically a slush fund to give out quiet money,” says Breeden. Sullivanwrote personal checks for $10,000 to some employees, he says, and gave $10,000 more to


their wives.

Breeden and Blakely say that the fraud involved fewer than 50 people, mostly those whorolled up the financial statements in Clinton. When managers at operating units saw theconsolidated financials, they were surprised how well the rest of the company seemed to bedoing when the numbers they reported were so poor.

Dennis Beresford, a former chairman of the Financial Accounting Standards Board whonow chairs MCI’s audit committee, led one of two internal investigations into the fraud. He’sconvinced that everyone involved has been removed from the company. Beresford saysWorldCom asked about 50 executives in the finance department to leave after the investiga-tion showed they either took part in the accounting 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 falsestatements to regulators. Those crimes could carry a sentence of up to 25 years in prisonunder federal sentencing guidelines, but Sullivan hopes to get less in exchange for his testi-mony in the trial against Ebbers that is scheduled to begin in November. Former controllerDavid Myers and accounting executives Betty Vinson and Troy Normand have also pleadedguilty and are cooperating with authorities.

Do the Right Thing

Impressive as it was, cleaning up the fraud wasn’t enough to restore the confidence ofWorldCom’s customers; Blakely had to make sure that nothing remotely like Sullivan’s ma-nipulations could ever happen again. In July 2003, WorldCom’s largest customer, the federalgovernment, had barred it from bidding on federal contracts while it reviewed whether thecompany should be placed on an “excluded parties” list. “Getting that [ban] lifted was thehighest priority,” says Blakely. “If the government doesn’t want to do business with you, whyshould anyone else?”

The two main concerns identified by the General Services Administration, which administersthe list, were controls and ethics. Indeed, KPMG, which succeeded Arthur Andersen asWorldCom’s auditor, had identified 96 control issues, and a separate assessment by Deloittezeroed in on several other “high risk” areas. With help from both accounting firms, Blakely’sfinance team put together a “heat map” that listed high-priority risk areas, and then wentabout fixing them. The solutions included adding basic checks and balances such as segrega-tion of duties among finance staffers, limited access, and documented policies. The companythen implemented a much more stringent, and inclusive, policy for closing the books. “It isimpossible to completely eliminate the possibility of fraud,” says Blakely. But, he says, thehundreds 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-gover-nance practices ever adopted. As part of WorldCom’s $750 million cash and stock settlementwith 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 recommenda-tions, including the separation of the CEO and chairman roles, and the required removal of

22



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 acceptthem.”

As for ethics training, MCI put the entire company of 50,000 employees through a coursedesigned 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 DardenSchool. Not surprisingly, MCI is trying to keep ethics in the foreground. Large banners pro-claiming the company’s “guiding principles” festoon the halls of its Ashburn, Virginia, head-quarters. They include such mottos as “Everyone should feel comfortable to speak his or hermind” and “Do the right thing.” The principles are also printed on the back of employeesecurity badges.

All these measures were enough to convince the government that MCI had reformed. LastJanuary, it lifted the debarment just in time for the renewal of a contract worth as much as $400million.

There would be more to celebrate. On April 20, the company emerged from bankruptcy, offi-cially 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 thismonth. “A lot of people didn’t think we could get it done,” says Beresford. “It took a Herculeaneffort to get to that point.” (Not to mention the $800 million in fees MCI spent during its so-journ in Chapter 11, for lawyers, accountants, appraisers, tax experts, and other consultants.)

But the work on the controls isn’t finished. Like most companies, MCI is busy documenting itscontrols in compliance with Section 404c of the Sarbanes-Oxley Act. More than 60 people areworking on the project, and PricewaterhouseCoopers is providing outside assistance. “We’vestill 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 Al-Chalabi, managing director of San Francisco-based telecom research firm RHK Inc. Comparedwith archrivals AT&T and Sprint, MCI has lower margins, pays more (as a percentage of totalrevenues) to other carriers in access fees, and has the fastest-declining revenues (17 percent inthe 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 SBCCommunications, which are looking to provide enterprise telecom services to small and mid-size businesses — a key customer base for MCI. And another setback came in June, when afederal court ruled that Baby Bells no longer had to lease access to their local networks to thelikes 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 $52million profit for Q1 2003. The company said it would cut 7,500 jobs, or 15 percent of itsworkforce. But Al-Chalabi says reducing head count alone won’t solve MCI’s problems. He


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 ob-tain operating efficiencies. “They have a thousand or more systems that all need to be sup-ported,” 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 ofthe Baby Bells. Yet Al-Chalabi notes that these potential buyers can already buy long-haulcapacity very cheaply, without buying the MCI cow. Also, he says, “the Baby Bells still havehuge 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 dramaticallychange their ways.”

MCI isn’t ruling out a sale. But Blakely, who admits 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 $300million in positive cash flow each quarter. A large portion of Internet traffic flows over MCI’snetwork, and the company still has more than 20 million customers. Blakely says MCI will beprofitable 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 almostentirely about the operations of the business.” That hadn’t happened since he was elected tothe board in July 2002, he says. “Just to be able to sit around and talk about strategy is wonder-ful.”

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 andchanges its name to WorldCom.

1998: WorldCom’s $40 billion acquisition of MCI is the largest merger in corporate history atthe time.

1999-2000: WorldCom and Sprint, the nation’s third-largest long-distance company, agree tomerge. The deal is later blocked by antitrust regulators and abandoned.

March 2002: WorldCom receives a request for information from the Securities and ExchangeCommission on accounting procedures and loans to officers.

April 2002: WorldCom CEO Ebbers resigns as the SEC probe intensifies. Vice chairman JohnSidgmore 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 terms of out-

24



standing debt. Former Salomon Smith Barney analyst Jack Grubman admits to attendingWorldCom board meetings.

August 2002: Sullivan and former controller David Myers are arrested and charged with secu-rities 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 isnamed CFO.

May 2003: WorldCom settles charges with the SEC and agrees to pay $750 million in finesand retribution.

October 2003: Bankruptcy court judge Arthur Gonzalez approves WorldCom’s reorganiza-tion plan.

March 2004: Sullivan pleads guilty to criminal charges. Ebbers is formally charged withfraud. WorldCom files its restated 2002 10-K, which includes a write-down of $80 billion ingoodwill, assets, and property.

April 2004: WorldCom exits bankruptcy and changes its name to MCI.


SECTION - 6EARNINGS DISTRIBUTION POLICY

• Earnings Distribution Policy


6.1. EARNINGS DISTRIBUTION POLICY

6.1.1 As already mentioned, distribution of earnings in the form of dividends is an impor-tant financial management decision. It is a function of a number of factors such as thefollowing:

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 growthplans 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.

26



SECTION- 7

COMPLIANCE OF REGULATORY REQUIREMENTS INFORMULATION OF FINANCIAL STRATEGIES

• Compliance of Regulatory Requirements in Formulation of Financial Strategies


7.1. COMPLIANCE OF REGULATORY REQUIREMENTS IN FORMULATION OF FINANCIAL STRATEGIES

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

7.1.2 Raising finance through IPO or SPO: IPO refers to Initial Public Offering; the firsttime a company comes to public to raise money. SPO refers to seasonal public offer-ing, the second and subsequent time a company raises money from the public di-rectly. There are regulatory guidelines prescribed by SEBI regarding the entire processof going public which includes disclosure to public regarding the potential use of thecash, financial projections and percentage of shares offered to various stakeholdersetc. Similarly, every time a company wants to access the capital market, either forraising finance through debt or equity, these regulatory compliances have to be metwhere finance manager will play a key role in providing the necessary informationboth at the time of raising resources and also at regular intervals subsequently there-after.

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 equitycapital. This is technically known as capital reduction, which again requires regulatorycompliances prescribed by SEBI and Companies Act.

7.1.4 Credit rating: Whenever a company wants to raise money through debt, or througha 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 wholeexercise of initiating the rating process, providing the relevant information and an-swering 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 ofreasons like importing equipment, setting up of foreign offices, travel of sales and


other company employees etc. Similarly, a company may receive remittances of for-eign exchange for exports made. In either of these situations, the rules and regulationsrelating to foreign exchange transactions needs to be complied with by the Financemanager, on behalf of the organization. It involves some filing of returns in the pre-scribed format..

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

7.1.7 Project financing: If a company goes for major project financing option, involvingmultiple agencies like suppliers, contractors etc, there are a number of requirementsfor the various stakeholders and financiers like consortium of banks, private equityplayers, etc. Finance manager plays an important role in complying with the require-ments of various agencies involved in the exercise.

28



SECTION - 8

SOURCES OF FINANCE - LONG TERM, SHORT

TERM AND INTERNATIONAL

• 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 re-quires 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 goodperformance 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:

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.

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

8.3. DEBT

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


8.3.2 Short-term debt is in the form of:

a. Working capital Loans from commercial banks for financing working capital re-quirements: Cash credit, overdrafts, loans, purchase or discounting of bills Etc; Theseare 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.

8.3.3 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 gov-ernments

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 depositoryreceipts, American depository receipts, private placements, loans from internationalagencies such as International Finance Corporation, and so on.

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

30



SECTION - 9

EXCHANGE RATE - RISK AGENCIES INVOLVEDAND PROCEDURE FOLLOWED

IN INTERNATIONAL FINANCIAL OPERATIONS

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


9.1. EXCHANGE RATE - RISK AGENCIES INVOLVED AND PRO-CEDURE FOLLOWED IN INTERNATIONAL FINANCIAL OP-ERATIONS

9.1.1 Foreign exchange transactions require some special records to be maintained as per theregulations. At every stage in the international trade process, the finance manager hasto comply with some regulatory and reporting requirement. For example, opening of aletter of credit in the context of exports or imports. Here, the finance manager has todeal with the bank, submitting the requisite documents for ensuring the opening ofletter of credit. Proper trade documents have to be submitted. Foreign exchange remit-tances have to be complied with. They have to be accounted in line with the require-ments of law and accounting standards. Tax treatment is different in some cases andthey have to be adhered to such as withholding tax, tax exemption criteria etc;

31FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE

STUDY NOTE - 2FINANCIAL MANAGEMENT DECISIONS

SECTION - 1CAPITAL STRUCTURE THEORIES

AND PLANNING

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 capitalstructure of the company.

1.1.2 Companies potentially have a choice between various sources of funding, right fromshort-term bank overdrafts to perpetual equity. How can an organization choosebetween the alternatives, and add value by strategic financing decisions is calledcapital structuring.

1.1.3 The capital structure of a company can be expressed in the form of a number of ratiosfor comparison between companies or over a period of time. The main ratios are:

a. Gearingb. Net gearingc. Leverage (gross)d. Leverage (tangible)e. Leverage (tangible including contingents)f. Debt / Equity or Debt / (Debt + Equity)

1.1.4 The traditional view was that the cost of equity and the cost of loan capital aredetermined 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, themore highly geared the company becomes, i.e., the more loan capital vis-à-vis equityit obtains, the lower its cost of capital. There must be a cut-off point to this processotherwise all organizations would be looking for total debt financing. Therefore, atsome stage the proportion of loan capital increases the level of risk to the potentiallender as well as the equity holders. This increased level of risk would cause theoverall cost of capital to rise. Thus, it can be assumed that a rational organization will

� Theory of Capital Structure

� Agency Theory

� Conclusions

This Section includes

FINANCIAL MANAGEMENT & INTERNATIONAL FINANCE32

FINANCIAL MANAGEMENT DECISIONS

have a time tested mechanism to have an ideal mix of debt and equity to keep the costof 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

Interest 0 400 560

PBT 1000 600 440

Tax 500 300 220

PAT 500 300 220

ROE 5.00% 6.00% 7.33%

In the above example, though all the three companies have the same total capital require-ment, due to the difference in debt equity mix, company C, with higher amount of debt, hasbeen able to enhance the ROE to 7.33%. But, in the subsequent year, let us say that the PBITfalls 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? Theanswer probably lies in the high costs of debts also associated with possible bank-ruptcy. due to increased liability in times of slow down in operations.

1.1.7 Bankruptcy costs can be classified into two types:

1. Direct costs:� Legal fees� Accounting 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 suppli-

ers to provide trade credit.� Loss of value of intangible assets - e.g., patents, human capital.

1.1.8 The years in which EBIT drops, the company would not be able to get tax reliefimmediately and the cash cost of debt would be quite high. Further, if the companyhad no reserves to meet its interest commitments, it would default on its repaymentobligations 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 topenal interest being charged by the lenders.


1.1.9 Therefore, in order to maximize value by altering capital structure, organizationsshould balance the present value of the tax advantage of debt against the presentvalue 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 verylittle effect on the overall cost of capital. The theory states that the total value of thefirm depends on its expected performance and its risk and is completely independentof 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 thebusiness are the Agents of the owners viz; Shareholders. The agency theory model offinancial strategy looks at not only maximizing value, but also the potential for conflictbetween managers and investors. The agency theory considers what happens whenthe market mechanisms fail to operate effectively and managers, who act as agents forthe shareholders, are not necessarily motivated to act in the best interest of theshareholders.

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 ownershipand control by various means such as having external auditors, non-executive directors,accepting covenants in loan agreements which effectively restrict managers’ potentialactions etc;

1.3 CONCLUSIONS

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

1.3.2 Where a company expects sufficient level of taxable profits, the company should takeon appropriate amount of debt to reduce the tax liability. Thus, it may be practicablefor 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 payhigher rates of interest due to the higher risk of default. Such companies have to relymore on equity finance. Companies in their early stages of development will also beunwilling to take on a high debt.

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

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



Value Creation is a continuous process by way of:

� Constantly measuring the cost of debt, cost of equity, weighted-average cost of capitaland 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 Amount

Debt 9% 33% 100000

Equity 67% 200000

Total 300000

Number of equity shares 2000

Tax rate 40%

EBIT 100000Interest 9000EBT 91000Tax 36400EAT 54600EPS 27.3

EPS at Different levels of EBIT

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


EPS at Different levels of Debt to Equity

Debt/equity-EPS 270.1 220.2 240.3 260.4 300.5 350.6 420.7 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 ofEPS, namely, EBIT, Debt to equity ratio and the cost of debt. You can construct similar tableson impact of tax and EPS etc.

Case Study

What Do We Know about the Capital Structure of Privately Held Firms? Evidence fromthe Surveys of Small Business Finance

by Rebel A. Cole, 2007.

May 2008

Published by U.S. Small Business Administration’s Office of Advocacy

Introduction

This paper seeks to shed light on what factors determine the capital structure at privatelyheld 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 seeminglysimple decision about the best mixture of capital sources to be employed in financing thefirm’s operation and growth has confounded researchers since the seminal “capital structureirrelevance” theory of Modigliani and Miller (1958).



Existing empirical studies that test capital structure theories have relied on data from largecorporations that issue complex financial securities for both debt and equity. Unresolved isthe question of whether these theories are useful for understanding the capital structure ofsmall privately held firms, which are primarily limited in their external borrowing to financialintermediaries such as banks, finance companies, and other business lending institutions.

Using data from a set of four nationally representative samples of small businesses surveyedfor the Federal Reserve Board and the Small Business Administration 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—thepeckingorder theory and the trade-off theory—based upon data from small privately heldU.S. firms. This previously unaddressed segment of the market provides a new laboratoryfor reexamining the findings from prior studies that examine publicly traded firms. Thefocus on private firms eliminates the “noise” introduced by more complicated securities,such as preferred stock and convertible bonds, reducing the errors-in-variable problemsassociated with empirical studies of capital structure at larger firms.

Second, the study provides new evidence of the degree of leverage used by small privatelyheld 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 publiclytraded firms taken from the Compustat database.

Third, the study presents new evidence on how the use of financial institutions influencescapital structure, testing whether firms that obtain financial services from a larger pool offinancial institutions are able to employ more leverage.

Overall Findings

This study tests predictions from the two competing theories, using descriptive statistics andthen more sophisticated multivariate techniques to disentangle various forces influencingthe capital structure decision. The results tend to favor the pecking-order theory over thetrade-off theory. The analysis reveals that firm size is perhaps the most important determinantof leverage, with firm age also significant. Unprofitable and riskier firms consistently usegreater 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 ahigh of 25.1 percent in 1993 to a low of 7.4 percent in 2003, while the median ratio oftotal liabilities to total assets ranged from a high of 47.4 percent in 1993 to a low of 27.5percent in 2003. The distribution of these leverage ratios is heavily skewed by bookvalueinsolvent firms—firms reporting that their liabilities exceeded their assets. This is evidentfrom the mean leverage ratios, which are significantly larger in each year than thecorresponding medians.

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


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

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

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

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

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

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

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



SECTION - 2COST OF CAPITAL

2.1 COST OF CAPITAL-KEY CONCEPTS2.1.1 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 linkbetween financing and investment decisions of a firm.

2.1.2 Cost of capital is very important as it represents the minimum return that a firmexpects in all its investment projects. It is used to discount the future cash flows froma project to arrive at the Net Present Value. Incorrect computation of cost of capitalleads to wrong investment decisions.

2.1.3 Cost of capital is composed of cost of equity capital, preference share capital and costof 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. Costof 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 andprospective 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 shareprice of a firm, which represents the present value of the future expected dividends

� 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



from a firm. For dividend discount model, we need the expected future dividendstream, its growth rate and the present share price to infer the cost of equity whichequates 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 costof 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] anda risk premium.

b. The risk free rate of return represents the rate of interest on a government security,typically a treasury bill.

c. The risk premium has two components; the market risk premium[Rm] which is theaverage long term return from the stock market, typically computed based on thelong term returns on a market index like the sensex, minus the risk free rate ofreturn [Rf] and the Beta.

d. Beta represents the systematic risk component for a firm, measured as therate of change of share price returns with reference to the market returns (sensexreturns).

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 shareholderscan not diversify through a portfolio. Hence, the shareholders have to be compen-sated 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 representsan aggressive stock.

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

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



2.5.3 Under capital asset pricing model,

Cost of equity= Rf + beta (Market risk premium)

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 valueweights 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 usedto arrive at the weights and not the book value of debt and equity. This is becausethe WACC should represent the minimum expected rate that a firm should provideto 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 financialleverage 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 ofdebt?

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 ofdebt of 50 lakhs and closing balance of debt of 100 lakhs? If the tax rate is 40%, whatis 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 individends is expected to be 5%. If the current share price is Rs.120, what is the cost ofequity?

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)


4. The risk free rate of return for an economy is 8% and the expected return from equitymarket 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

Bank loan 7.2 million

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 premium 0.04

Interest cost of the year 1055640

Loan at the start of the year 8 million

Type of finance Market value Cost Weightage WC

Share capital 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%

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



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

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

Glossary of terms

• Hurdle rate

• Discount rate

• Weighted average cost of capital

• Risk free rate of return

• Risk premium

• Beta

• Systematic risk

• Unsystematic risk

• Diversifiable risk

• Non-diversifiable risk

• Portfolio

• Dividend discount model

• Post tax cost of debt


SECTION - 3CAPITAL BUDGETING

3.1 CAPITAL BUDGETING

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

� 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

� Accounting 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




3.1.2 Capital Budgeting assumes tremendous importance for an organization for thefollowing reasons:

a. By committing resources to a project, an organization gets committed to a particularprocess 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 anduse for years to make goods and provide services. Capital assets create these capacity-related costs.

3.1.4 Cost commitments associated with long-term assets create the following types of risksfor 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 considerablecare and caution.

3.2 NEED TO CONTROL CAPITAL ASSETS

3.2.1 Organizations have developed specific tools to control the acquisition and use oflong-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 usuallyquite 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 itsfuture benefits justify its initial cost.

3.3.2 Investment is the monetary value of the assets the organization gives up to acquire along-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 focuseson whether the expected increased cash flows (return) will justify the investment inthe long-term asset.


3.3.5 It has impact on opportunity loss if not planned timely or alternative options are notweighed 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 inanother investment alternative.

3.4.3 In making investment decisions, the problem is that investment is made much aheadof expected future return. We need an equivalent basis to compare the cash flows thatoccur 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 theirvalue 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. HavingRs.100 today is more valuable than receiving Rs.100 in the future because the Rs.100on 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 astated 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 computefuture value over several periods.

3.6 PRESENT VALUE3.6.1 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 tocompute 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 PROCESS3.7.1 The Capital Budgeting process consists of the following steps:

a. Identification of potential investment opportunities

b. Collecting relevant data on investments & returns



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 sensitivityto 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. Accounting 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 discussedsubsequently 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 alsoknown as the risk-adjusted discount rate.

3.10.2 The cost of capital is the return the organization must earn on its investment to meetits investors’ return requirements.

3.10.3 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


3.11 AN ILLUSTRATION

3.11.1 Arctic Ice creams:

To show how each of these methods works and alternative perspectives, we apply each toArctic Ice creams as it considers the purchase of a new automatic Ice cream machine:

a. Cost: Rs.70,000b. Life: five yearsc. Benefit: expanded capacity and reduced operating costs would increase Arctic’s

net profits by Rs.20,000 per yeard. 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 initialinvestment:

a. Arctic’s initial investment of Rs.70,000/- is recovered midway between years 3and 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 theorganization’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 paybackmethod, which computes the payback period but uses discounted cash flows.

2. It ignores the cash outflows that occur after the initial investment and the cashinflows that occur after the payback period.

3.12.4 Despite these limitations, some surveys show that the payback calculation is the mostused approach by organizations for capital budgeting. This popularity may reflectother considerations, such as bonuses that reward managers based on current profits,that create a preoccupation with short-run performance

3.13 ACCOUNTING RATE OF RETURN

3.13.1 Analysts compute the accounting rate of return by dividing the average accountingincome by the average level of investment.



3.13.2 Analysts use the accounting 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 creamMachine will be Rs.8000 (Rs.20,000 – Rs.12,000 of depreciation). The average incomewill 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 accounting rate of return for the investment is computed as: Rs.8,000 / Rs.40,000 = 20%.

3.13.6 If the accounting rate of return exceeds the target rate of return, then the project isacceptable.

3.13.7 Like the payback method the accounting rate of return method has a drawback: Byaveraging, 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 cashflows 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. Theperiod length depends on the periodicity of the investment’s cash flows. The mostcommon period used in practice is one year. Analysts also use quarterly andsemiannual periods.

2. Identify the organization’s cost of capital, and convert it to an appropriate rate ofreturn 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’scost of capital as the discount rate.

5. Sum the present values of all the periodic cash inflows and outflows to determinethe investment project’s net present value.

6. If the project’s net present value is positive, the project is acceptable from aneconomic 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:

a. Rs.70,000 outflow immediately

b. Rs.20,000 inflow at the end of each year for five years


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 lineto 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. ThePV of the cash inflows (from step 4) is Rs.82,025. As the investment of Rs.70,000takes place at time zero, the PV of the total outflows is Rs.(70,000). The NPV of thisinvestment project is Rs.12,025.

6. As the NPV is positive, Arctic should purchase the Ice cream Machine. It iseconomically desirable

3.15 INTERNAL RATE OF RETURN

3.15.1 The Internal Rate of Return (IRR) is the actual rate of return expected from aninvestment.

3.15.2 The IRR is the discount rate that makes the investment’s net present value equal tozero. If an investment’s NPV is positive, then its IRR exceeds its cost of capital. Ifan 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 findthat the IRR in Arctic’s is 16.14%. As a 16.14% IRR > 10% cost of capital, the projectis desirable.

3.15.4 IRR has some disadvantages:

a. It assumes that a project’s intermediate cash flows can be reinvested at the project’sIRR. It is frequently an invalid assumption.

b. It can create ambiguous results, particularly:

� When evaluating competing projects in situations where capital shortagesprevent 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 theIRR criterion is unnecessary when preparing capital budgets. Still, it is a widely usedcapital 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 andis computed by dividing the present value of the cash inflows by the present valueof the cash outflows.



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 andthe 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 hasa higher NPV. An organization must determine how to choose when the criteriagive conflicting results.

3.17.DSCR3.17.1 Coverage available to the lender to obtain interest on loan and repayment of debt.

3.17.2paymentsRetermLongInteresttermLong

taxafterandonDepreciati&InteresttermlongbeforeofitPrDSCR

+=

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 toreduce income and offset some of their taxes. The rate of taxation and the way thatlegislation allows organizations to depreciate the acquisition cost of their long-term 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 account 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 presentusing an appropriate discount rate to account for the time value of money.

3.19.3 We discount each cash flow by the appropriate discount rate and the expected inflationrate.

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 theirestimates affect the decision they are making.


3.20.3 Estimating future cash flows is an important and difficult task. This is importantbecause many decisions will be affected by those estimates. Difficult because theseestimates will reflect circumstances that the organization may not have previouslyexperienced.

3.20.4 Most cash flow estimation is incremental. This means that it is based on previousexperience. For example, based on manufacturer claims, a new machine might beexpected to decrease costs by 10%.

3.20.5 Many organizations assume that learning will systematically reduce the costs of anew system or process.

3.20.6 Cash flows related to sales of a new product are often estimated based on pastexperiences 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 makethis 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 ofthe decision’s key parameters.

3.21.4 If the analysis explores the effect of a change in a parameter on an outcome, we callthis investigation a what-if analysis. For example, the planner may ask, “What will myprofits 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, ratherthan 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 ofthe 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



3.23 AN ILLUSTRATION

Tristar Foods is planning to introduce a new food chain for the production and distributionof corn oil. The company has already spent Rs. 20000 in the analysis of the project. The newdepartment may use the existing warehouse which could otherwise be rented out for Rs.15000a year. The marketing task will be carried out by the existing manpower but a part of total costRs. 20000, will be allocated to the new food chain department. The rest of the details are shownin the table.

Input data

Cost of new machine 150,000Salvage value of new machine 10,000Production (lts. Per day) 300Working days per year 300Working life of machine (years) 6Income per lt. (net) 0.80Salvage value of old machine 5,000Warehouse cost 15,000Allocated cost of marketing/year 20,000Increase in working capital 5,000Depreciation rate 25%Corporate tax rate 30%Capital gains tax rate 30%Opportunity cost of capital(Debt) 12.5%Post tax cost of debt 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 52,394.39

IRR 19.83%


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 ignoredii. The accounting 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

Production per day and contribution per litre

52,394.39 0.50 0.55 0.60 0.65 0.70 0.75

230 -66243.87 -55329.15 -44414.43 -33499.71 -22584.99 -11670.27

235 -63871.11 -52719.11 -41567.11 -30415.12 -19263.12 -8111.12

260 -52007.28 -39668.90 -27330.52 -14992.14 -2653.76 9684.62

265 -49634.52 -37058.86 24483.20 11907.55 668.11 13243.76

270 -47261.75 -34448.82 -21635.89 -8822.95 3989.98 16802.91

280 -42516.22 -29228.73 -15941.25 -2653.76 10633.72 23921.21

290 -37770.69 -24008.65 -10246.61 3515.43 17277.47 31039.50

295 -35397.92 -21398.61 -7399.29 6600.02 20599.34 34598.65

Sensitivity analysis

Production per day

52,394.39 19.83%230 -755.55 0.09235 3040.87 0.09260 22023.00 0.14265 25819.42 0.14270 29615.85 0.15280 37208.69 0.17290 44801.54 0.18295 48597.97 0.19

Sensitivity analysis

Contribution Per litre

52,394.39 19.83%0.50 -33025.16 0.010.55 -18788.57 0.040.60 -4551.98 0.080.65 9684.62 0.110.70 23921.21 0.140.75 38157.80 0.17



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

2. The working capital investment is released in the last year of the project3. The post tax cost of debt is taken as interest is tax deductible4. The first sensitivity table shows the impact of changes in production per day on the

NPV and IRR5. The second sensitivity table shows the impact of changes in contribution per liter on the

NPV and IRR6. The third table shows a combination of production and contribution on NPV

Scenario Analysis

Variables Scenario-1 Scenario-2 Scenario-3

Production 250 290 310Contribution 0.6 0.75 0.85Investment 170000 160000 150000Cost of debt 0.14 0.13 0.125

Scenario Summary

Current Values: Pessimistic most likely optimistic

Changing Cells:

Production 300 250 290 310Contribution 0.80 0.60 0.75 0.85Investment 150,000 170,000 160,000 150,000Cost of debt 12.5% 14.0% 13.0% 12.5%

Result Cells:

NPV 52,394.39 (51,775.61) 21,603.66 74,698.39IRR 19.83% -1.66% 13.59% 24.20%

Note: The scenario summary shows the results under best case and worst case scenario.

2 MIRR

Check the reinvestment assumption of IRR

0 -1000001 450002 490003 200004 300005 25000

IRR 24%

MRR =Mirr (Cashflow range, guess rate, reinvestment rate) 19%


Monte Carlo Simulation:

� Illustration of Project Simulation

� Cash flows and associated probabilities are the required inputs

� The purpose is to quantify risk

Note: Modified internal rate of return takes into account a different reinvestment rate, otherthan the internal rate of return. Normal IRR assumes that the intermediate cash flows arereinvested 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 thiscan be done in using the Excel function.

Monte carlo simulation: Simulation is used to quantify risk in terms of probability of achievinga target NPV or IRR. Simulation is done for capturing the different possible outcomes anddetermining the probability of a particular event happening. In the example given below, theestimated probabilities associated with different cash flows of a project are given. Theseprobabilities can be subjective probabilities. Using random numbers, a large number of cashflows are selected to construct a distribution of results. The simulation is takes into account allpossible outcomes.

Monte Carlo Simulation

Year Probability Cashf lows

0 0.20 -2400.000.20 -2365.000.60 -2200.00

1 0.30 275.000.50 352.600.20 450.00

2 0.30 460.000.60 525.130.10 675.00

3 0.20 600.000.70 714.060.10 900.00

4 0.10 775.000.80 960.750.10 1100.00

5 0.10 1100.00

0.80 1461.07

0.10 1500.00



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

Convert probability to cumulative probability

Year 0 CumulativeProbability

P CP Cash flows

0.00 0.00 -24000.20 0.20 -23650.60 0.80 -22000.20 1.00 -2200

Year 1 P CP Cash flows

0 0.00 275.000.3 0.30 352.600.5 0.80 450.000.2 1.00 450.00


0.00 0.00 460.000.30 0.30 525.130.60 0.90 675.000.10 1.00 675.00


0.00 0.00 600.000.20 0.20 714.060.70 0.90 900.000.10 1.00 900.00


0.00 0.00 775.000.10 0.10 960.750.80 0.90 1100.000.10 1.00 1100.00


0.00 0.00 1100.000.10 0.10 1461.070.80 0.90 1500.000.10 1.00 1500.00


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 distributiontables are referred to obtain the probability of achieving different IRRs. For example, as givenbelow, the probability of achieving an IRR of 14 percent is 68%.

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

Quantification of risk

expected irr z Probability

0.14 -0.4664 0.680.15 -0.2353 0.590.16 -0.0043 0.500.17 0.2268 0.410.18 0.4579 0.320.19 0.6890 0.250.20 0.9200 0.180.21 1.1511 0.120.24 1.8444 0.030.29 3.0000 0.0010.03 -3.0000 0.999



Case Study

Internal Rate of Return: A Cautionary Tale

Tempted by a project with high internal rates of return? Better check those interim cashflows again.

The McKinsey Quarterly, McKinsey & Co.

October 20, 2004

Maybe finance managers just enjoy living on the edge. What else would explain their weaknessfor using the internal rate of return (IRR) to assess capital projects? For decades, finance textbooksand academics have warned that typical IRR calculations build in reinvestment assumptionsthat make bad projects look better and good ones look great. Yet as recently as 1999, academicresearch found that three-quarters of CFOs always or almost always use IRR when evaluatingcapital projects. (John Robert Graham and Campbell R. Harvey, “The Theory and Practice ofCorporate Finance: Evidence from the Field,” Duke University working paper presented at the2001 annual meeting of the American Finance Association, New Orleans.)

Our own research underlined this proclivity to risky behavior. In an informal survey of 30executives at corporations, hedge funds, and venture capital firms, we found only 6 who werefully aware of IRR’s most critical deficiencies. Our next surprise came when we reanalyzedsome two dozen actual investments that one company made on the basis of attractive internalrates of return. If the IRR calculated to justify these investment decisions had been corrected forthe measure’s natural flaws, management’s prioritization of its projects, as well as its view oftheir overall attractiveness, would have changed considerably.

So why do finance pros continue to do what they know they shouldn’t? IRR does have itsallure, offering what seems to be a straightforward comparison of, say, the 30 percent annualreturn of a specific project with the 8 or 18 percent rate that most people pay on their car loansor credit cards. That ease of comparison seems to outweigh what most managers view aslargely technical deficiencies that create immaterial distortions in relatively isolatedcircumstances.

Admittedly, some of the measure’s deficiencies are technical, even arcane, but the mostdangerous problems with IRR are neither isolated nor immaterial, and they can have seriousimplications for capital budget managers. When managers decide to finance only the projectswith the highest IRRs, they may be looking at the most distorted calculations — and therebydestroying shareholder value by selecting the wrong projects altogether. Companies also riskcreating unrealistic expectations for themselves and for shareholders, potentially confusinginvestor communications and inflating managerial rewards. (As a result of an arcanemathematical problem, IRR can generate two very different values for the same project whenfuture cash flows switch from negative to positive (or positive to negative). Also, since IRR isexpressed 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 smallerprojects with higher IRRs.)

We believe that managers must either avoid using IRR entirely or at least make adjustments forthe measure’s most dangerous assumption: that interim cash flows will be reinvested at thesame high rates of return.


The Trouble with IRR

Practitioners often interpret internal rate of return as the annual equivalent return on a giveninvestment; this easy analogy is the source of its intuitive appeal. But in fact, IRR is a trueindication of a project’s annual return on investment only when the project generates no interimcash 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, themeasure will overestimate — sometimes very significantly — the annual equivalent returnfrom the project. The formula assumes that the company has additional projects, with equallyattractive prospects, in which to invest the interim cash flows. In this case, the calculationimplicitly takes credit for these additional projects. Calculations of net present value (NPV), bycontrast, generally assume only that a company can earn its cost of capital on interim cashflows, leaving any future incremental project value with those future projects.

IRR’s assumptions about reinvestment can lead to major capital budget distortions. Consider ahypothetical assessment of two different, mutually exclusive projects, A and B, with identicalcash flows, risk levels, and durations — as well as identical IRR values of 41 percent. Using IRRas the decision yardstick, an executive would feel confidence in being indifferent towardchoosing between the two projects. However, it would be a mistake to select either projectwithout examining the relevant reinvestment rate for interim cash flows. Suppose that ProjectB’s interim cash flows could be redeployed only at a typical 8 percent cost of capital, whileProject A’s cash flows could be invested in an attractive follow-on project expected to generatea 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 practitionerswould argue that the value of future investments should be commingled with the value of theproject being evaluated. Most practitioners would agree that a company’s cost of capital — bydefinition, 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 executivesreview projects with IRRs that are close to a company’s cost of capital, the IRR is less distortedby the reinvestment-rate assumption. But when they evaluate projects that claim IRRs of 10percent 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 distortionis 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 correctfor it by adjusting every IRR by a standard amount. (The amplification effect grows as a project’sfundamental health improves, as measured by NPV, and it varies depending on the uniquetiming of a project’s cash flows.)

How large is the potential impact of a flawed reinvestment-rate assumption? Managers at onelarge industrial company approved 23 major capital projects over five years on the basis ofIRRs that averaged 77 percent. Recently, however, when we conducted an analysis with thereinvestment rate adjusted to the company’s cost of capital, the true average return fell to just16 percent. The order of the most attractive projects also changed considerably. The top-ranked



project based on IRR dropped to the tenth-most-attractive project. Most striking, the company’shighest-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 somewhatunusual. Yet even if a project’s IRR drops from 25 percent to 15 percent, the impact isconsiderable.

What to Do?

The most straightforward way to avoid problems with IRR is to avoid it altogether. Yet givenits widespread use, it is unlikely to be replaced easily. Executives should at the very least use amodified internal rate of return. While not perfect, MIRR at least allows users to set morerealistic 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 IRRshould ask the following two questions.

1. What are the assumed interim-reinvestment rates? In the vast majority of cases, anassumption that interim flows can be reinvested at high rates is at best overoptimistic and atworst flat wrong. Particularly when sponsors sell their projects as “unique” or “the opportunityof a lifetime,” another opportunity of similar attractiveness probably does not exist; thus interimflows won’t be reinvested at sufficiently high rates. For this reason, the best assumption — andone used by a proper discounted cash-flow analysis — is that interim flows can be reinvestedat the company’s cost of capital.

2. Are interim cash flows biased toward the start or the end of the project? Unless the interimreinvestment rate is correct (in other words, a true reinvestment rate rather than the calculatedIRR), the IRR distortion will be greater when interim cash flows occur sooner. This conceptmay seem counterintuitive, since typically we would prefer to have cash sooner rather thanlater. The simple reason for the problem is that the gap between the actual reinvestment rateand the assumed IRR exists for a longer period of time, so the impact of the distortionaccumulates. (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 interimcash flows. The reason: a lack of interim cash flows completely immunizes a project from thereinvestment-rate risk.)

Despite flaws that can lead to poor investment decisions, IRR will likely continue to be usedwidely during capital-budgeting discussions because of its strong intuitive appeal. Executivesshould 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


SECTION - 4LEASE FINANCING

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 contractualobligations. The lessor, as the legal owner of the asset, has a stronger legal right to reclaimthe asset.

4.2 WHY LEASE FINANCING ?

4.2.1 A common misconception is that leasing allows the use of an asset without a companyhaving recourse to its own funds. Lease payments are based on the price of the assetplus an interest factor. It is also unlikely that the lessor would advance a loan for thetotal cost unless the proposed lessee had other assets or equity to offer as collateral tothe loan.

4.2.2 The commonly used lease terms are:

1. Operating Leases2. Financial Leases

a. Rental Leaseb. Net leasec. Direct leased. Leveraged lease

4.2.3 Lease financing is resorted to for both the right and wrong reasons. The right reasonsfor leasing are:

a. Short-term leases are convenientb. Cancellation options are availablec. Maintenance is providedd. Standardization leads to low costse. Tax shields can be usedf. Avoiding the alternative minimum tax

� What is Lease Financing?

� Why Lease Financing?

� Operating Leases

� Financial Leases




4.2.4 The wrong reasons for leasing are:a. Leasing avoids capital expenditure controlsb. Leasing preserves capitalc. Leases may be off balance sheet financingd. 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 builtinto the lease payments. Further, an operating lease is one where an asset is leased orhired for a period of time less than its useful life. The lessor expects to recover costs insubsequent 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 thestart of each year. The following table shows the NPV of the limo if acme purchases thenew limo for $75,000 and leases it out for 7 years.

Year

0 1 2 3 4 5 6

Initial cost -75Maintenance, insurance, selling, -12 -12 -12 -12 -12 -12 -12and administrative costsTax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51

Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29

NPV @ 7% = - $98.15Break even rent(level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16

Break even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02NPV @ 7% = - $98.15

Years0 1 2 3 4 5 6

Initial Cost -75Maintenance, insurance, -12 -12 -12 -12 -12 -12 -12selling andadministration costsTax shield on costs 4.2 4.2 4.2 4.2 4.2 4.2 4.2Depreciation tax shield 0 5.25 8.4 5.04 3.02 3.02 1.51Total -82.8 -2.55 0.6 -2.76 -4.78 -4.78 -6.29NPV @ 7% = - $98.15Break-even rent (level) 26.18 26.18 26.18 26.18 26.18 26.18 26.18Tax -9.16 -9.16 -9.16 -9.16 -9.16 -9.16 -9.16Break-even rent after-tax 17.02 17.02 17.02 17.02 17.02 17.02 17.02NPV @ 7% = - $98.15


4.4 FINANCIAL LEASES4.4.1 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 andas liabilities for future lease payments.

An Illustration from the lender’s perspective

What will be the lease rental to be recovered assuming that the lessor passes on the entire taxshield 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

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

Step-2 PV of residual value 107.37

Step-3 Lease rental to be recovered 733.94

Terms and conditions

Cost of the asset 1000Depreciation rate 20% WDVTax 40%Lease period 5 YearsIRR of lessor 25%



SECTION - 5WORKING CAPITAL MANAGEMENT

� 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 investedin working capital. Unlike the investments in fixed assets which are often subject torigorous investment appraisal decisions, the investment in working capital is takenbased on a series of apparently diversified factors such as sales, production, purchasing,inventories, receivables and cash. However, all these decisions may have a consequenceon the level of investment in working capital and hence on the overall capital employedby the company. Therefore, a comprehensive and coordinated policy is neededalongside appropriate monitoring.

5.1.2 A study has found that financial managers spend more than one-third of their timeon managing working capital.

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

5.2 THE ELEMENTS OF WORKING CAPITAL

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

5.2.2 Working Capital is the fund required to support the cost of production and expenseson sales, distribution and administration required prior to the receipt of the cash fromthe sale of finished goods or service. Thus a company which has a longer lead timebetween production and sale will require a greater investment in working capital. Themoney spent on these items has to be quickly turned around into cash through thesale of output to customers who subsequently pay us. The profit at the end of such


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

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

c. Debtors

d. Bank balance and cash.

5.2.5 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:

Cash

Sales

Debtors

Labour

Expenses W-I-P Stocks

Purchases

Creditors

FinishedGoods



5.2.7 The working capital as a figure conveys nothing. The same working capital in twocompanies does not necessarily imply the same cash position. In order to determinethe 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 assethave to be carefully studied and properly assessed. Based on a study of pastrequirements 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 efficientmanagement of one component can not be undertaken without simultaneousconsideration of others. For example, a company having a large accumulation offinished goods may have to provide more liberal credit terms or a relaxed creditcollection 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 cycleof conversion of raw materials into cash again has to be reduced to a minimum. As changesin the volume of sales affect working capital requirement, these changes in sales should befactored in in determining working capital.


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 inforecasting working capital requirement.

5.3.4 Estimation of Working Capital requirement:

In estimating the working capital requirement, it is very important to have a clearunderstanding of the working capital cycle time. The working capital cycle time is nothingbut the sum total of the time taken by various activities involved from the time an order isplaced by a customer till the goods manufactured are billed to the customers and money isrealized from the customer at the bank. The longer the working capital cycle time, more isthe working capital required and vice versa.

It is the responsibility of the finance manager to ensure that adequate care is taken inworking out normal time required in the various activities comprising the current assetscycle 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 areasonable period of time ,however not over a year.. In most companies, currentassets represent more than 40% of the total assets and the control of this large andvolatile investment warrants considerable attention.

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

5.4.3 However, management still has some discretion over the level of current assets at anyparticular level of output, though a risk-return trade-off is involved. The lower thelevel of current assets, the more profitable the company will be (as asset turnover willbe increased), but there will also exist a higher risk of running short of stocks or cashin 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 acompany’s ‘marketing mix’ and they may lose sales to competitors who may offermore attractive credit terms.

5.4.5 The general rule with current assets is to determine the minimum required quantityat 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 andanticipated increases in material costs may be avoided.



b. Reserve or safety stocks are required to avoid a costly situation of stock-outs andconsequent stoppages of production and interruption in deliveries. In processindustries, shut down and re-start of a plant are complex and time-consumingoperations 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 theimbalance is adjusted through intermediate stock holdings. This is especially true inlarge automobile factories, where final finished product is basically an assembly ofcomponents and sub-assemblies produced in a large section of shops in the factoryand also bought from outside.

e. The order pattern is not even. Orders arrive in irregular flows and to maintaincustomer 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 thecustomers could be synchronized, then there would be no need for stocks to be kept at anystage in the production – distribution system. This is the principle on which concepts suchas Just-in-time (JIT) manufacturing builds upon. Essential to such approaches are advancedmanufacturing technology, particularly flexible manufacturing systems and continuous flowwhere it is possible to reduce the set-up costs between batches and eliminate the need forstock-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 variousfinancial turnover ratios, and employing techniques such as Just-in-time (JIT), MaterialResource Planning (MRP), and Total Quality Management (TQM).

Other tools for Inventory Management are:

– ABC Analysis

– Standardization and Variety Reduction


– 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 thefollowing:

a. The volume of salesb. The credit policyc. The efficiency of debt collectiond. The occurrence of bad debts.e. Industry bench marks.

It has been observed that for manufacturing companies, about 20% of the company’s assetsmay be held as debtors.

An increase in sales will automatically lead to an increase in the level of debtors if the creditterms are maintained. Consequently there will be a need for an increase in the level offinance for debtors and it is also likely that increased sales will place demands on productionand purchasing which in turn may require additional funds. Further, it is likely that therewill be an increase in the doubtful debt provision and discounts.

The factors in Credit Management are:

1. Terms of payment:

– Cash– Credit– Consignment– Bill of Exchange– Letter of Credit

2. 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



� 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 usedto monitor debtors. Customer account profitability should be worked out to decide upon themost profitable customers, and those consuming significant resources of the organization.

Credit granting is an important decision and should be handled by a duly authorised seniorexecutive 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 nearfuture 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 thereturn 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 surplusshould be suitably invested. Short- and medium-term cash flow forecasts may be used forpredicting fluctuations in cash flow.

The cost of holding cash is not only the profit that could have been earned had the fundsbeen put to other uses, but also the depreciation due to inflation and possible changes inexchange rates.

However, there are some good reasons for holding cash:

a. Transactional purposesb. As collateral for bankers against borrowingsc. Precautionary motive to meet uncertainties and emergenciesd. Funds for speculatione. Cash balances help improve a company’s credit rating.

Essentially the efficient management of cash is the synchronization of the cash flows. Thisis achieved not only by the careful management of the cash conversion cycle but also themanagement 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 paymentwithin a reasonable period of time but not over a year. However, while they exist, theyrepresent the short-term financing of the company.

5.5.2 There are two possible approaches to the modeling of current liabilities:

a. They may be ignored and instead the financing costs incorporated into the appropriatecurrent asset. For example, the creditors can be incorporated into the inventory model.


b. They may be incorporated into the short-term finance element, i.e., cash. This requiresthe treatment of short-term finances as multiple elements and thus programmingtechniques are appropriate.

5.5.3 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 thecapacity 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 accounts payable and matchthese payments with receivables in their cash budget. Some suppliers offer cash discountsand unless a company is very short of funds it is usually a sound rule to accept discountswhenever possible.

5.6.0 A higher current ratio is not always a good indicator as it amounts to ineffectiveutilization 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 conceptsdiscussed in the chapter.

Keeping Receivables Rolling At DSC Logistics, ‘’keep ‘em moving’’ applies to orders andpayments as well as to warehousing and delivery. Third in a series of articles on usingsoftware 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 Lilekrecognizes 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 includesorder entry, invoicing, accounts 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 especiallyimportant for a company like DSC whose profits depend on high transaction volume. As athird-party logistics manager, DSC arranges the shipment, warehousing, and delivery ofgoods, and settles accounts all along the way. Tens of thousands of business transactionspass through DSC’s systems every month, so management has developed a keen appreciationfor quick and error-free order-to-cash processes.

DSC is private, and Lilek won’t reveal hard numbers associated with order-to-cash lapses orimprovements, but she contends that the $300 million company uses its $6 million informationtechnology budget “effectively.” What’s more, adds the finance chief, some of the company’saccounts 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 DSCand its customers is like implementing a merger because it “tied us so tightly together.”



Close customer contact, it happens, is how the company began. In 1960, Jim McIlrath wasfired from a cold-storage company for arguing with the owner over expanding the businessto help customers warehouse dry goods. McIlrath started his own business on Chicago’sSouth Side — Dry Storage Corp., or DSC — whose current chief executive officer is hisdaughter Ann Drake.

Window on Receivables

Close customer contact, in IT terms, often means data visibility — which is “a very relevantpiece” of the order-to-cash cycle, says Lilek.

Two years ago, Fieldman introduced a Web-based tool from Viewlocity that gives customersa window on their part of DSC’s supply chain. Customers can search and filter order andinventory information in near real time; date-time stamps enable them to examine the historyor check up on the status of any order.

After adding transparency to their supply chain, Lilek and Fieldman turned to the augustbusiness practice of invoicing. In some cases, their goal was to eliminate paper invoices; inother cases, it was to banish invoices altogether.

Paperless accounts receivable had plenty of takers among DSC’s clientele. Most of its customersare Fortune 500 retailers and manufacturers — such as Kimberly-Clark, Multifoods, Georgia-Pacific, Unilever, and Kellogg’s — that already use electronic data interchange (EDI) totransfer 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 statusinformation. A customer would integrate EDI 214 into its account payable system, then linkto DSC’s accounts receivable system, part of JD Edwards’ OneWorld enterprise resourceplanning (ERP) system.

After the two systems are synched up, payment terms, carrier rates, and any other parametersare fed into the customer’s system. When a customer places an order, the carrier’s deliveryof the appropriate goods initiates an EDI 214 transmission to the customer; the customer’ssystem then automatically authorizes a payment to DSC. Price discrepancies are kicked outfor investigation.

Looking for Trouble

Although discrepancies must be investigated manually, Lilek insists that the greater theamount of automation in the accounts receivable process, the fewer the instances of manualintervention — and the less time and money spent researching and correcting errors. Exorcisingmanual postings from the order-to-cash cycle, she adds, is fundamental to good accounting,especially in a business with a high volume of transactions.

Lilek contends, however, that improving “data matching” is even more important to theorder-to-cash cycle. Data matching refers to linking a payment with its corresponding invoicenumber and order number — which are usually different. That’s another reason Lilek favorseliminating invoices entirely: no invoice number means that only the order number need belinked to the customer’s remittance.


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, witha customized transportation system from i2 Technologies. In 2003, the company completedthe integration of the OneWorld ERP software, tying the entire system together by runningthe applications on multiple AS/400 servers.

The effort was shepherded by both IT and operations executives because many of the changeswere driven by customers who believed that improving DSC’s order-to-cash cycle wouldbenefit them, too. For example, now that transactions are pushed through DSC’s systemfaster 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 fromdepartment to department across the company. During the next year, she wants to exploitthe 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 DSCmust pay its own suppliers. Today, a manager for the general ledger tells an accountingstaffer that a batch of invoices needs to be reviewed and posted, and that checks need to becut and mailed.

In an automated scenario, it would be DSC’s financial system that was loaded with paymentterms and other invoicing criteria. An invoice submitted for payment would prompt anelectronic funds transfer if all the criteria were met. The bigger challenge would be gettingDSC and its suppliers to adopt such a system, says Lilek, but she has high hopes — she’sbeen through something like this before.

Small Is Big

Baby-food maker Milnot/Beech-Nut keeps up with the industry’s big boys by holdingdown trade-spending costs. Second in a series of articles on using software to improve theorder-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 tinytaste buds and strained peas, according to Alain Souligny, chief financial officer of Beech-Nut parent Milnot Holding Corp.

“As a small company, we try very hard to stay ahead of changes in the marketplace, so thatwe 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 — needsevery edge it can get; its competitors include $25 billion Novartis, makers of Gerber babyfood, and $71 billion Nestle, which manufactures Carnation evaporated milk.

One way Milnot/Beech-Nut keeps ahead of the competition is by using technology to improvethe order-to-cash cycle. Not only do those improvements support accounts receivable, says



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 amanufacturer will push through an unauthorized invoice reduction — a short pay — ratherthan wait for the reimbursement. Without proper communication between the two parties,the manufacturer can be stuck with numerous partially paid invoices that must be manuallyreconciled by its accounts receivable department.

Automation would go a long way to solve the problem, if only the industry could agree ona single communication conduit. Wal-Mart, for example, demands that Milnot/Beech-Nutuse electronic supply-chain technology from A2 Automation; US Food Service requires thatthe company use technology from EFS Network; and other customers insist on a directconnection 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 meanshaving enough product to fill each order completely; making shipments and deliveries ontime; 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 operationsand trade-spending planning, and to build a data warehouse that would enable the companyto measure profitability at the customer and product level.

In 1998 Milnot/Beech-Nut began an enterprise-resource-planning (ERP) project based on aRoss iRenaissance enterprise system. Although Souligny believes that the project could havebeen completed within 18 months, a failed merger attempt with H.J. Heinz Co. that draggedon from 1999 through 2000 stalled the implementation. The company completely replaced itslegacy system only this year.

This year Milnot/Beech-Nut completed the transition from its legacy enterprise system toiRenaissance enterprise-resource-planning (ERP) software from Ross Systems Inc. Data fromthe Ross system is extracted, standardized, and sent to the company’s home-grown executiveinformation system, which aggregates sales and operational data, including the covetedcustomer-profitability/product-profitability metrics.

Ed Roe, director of information systems, is in the process of outsourcing all EDIcommunications to Transcentric, so sales director Tim McCreery and corporate controllerConnie Huck can focus on trade-spending issues. McCreery and Huck’s finance/operationsteam has partnered with Minneapolis-based Gelco Trade Management Group to develop adeduction management system.

Although the team continues to work with Gelco to tweak the software, Milnot/Beech-Nutexecutives say that the Web-based application is already slashing the administrative costs ofprocessing customer deductions. In addition, McCreery and Huck are setting up a feed ofsyndicated industry data into the trade management system so they’ll be able to calculate thereturn on investment of individual trade programs.


In recent years Milnot/Beech-Nut has pumped $500,000 annually into hardware and softwarepurchases, says Souligny, and the smart application of IT dollars has helped the company’sinformation 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 — includingreductions in headcount and trade spending, as well as improved cash collection — havealmost 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 werereduced by 3.8 percent &mdash a $4.2 million saving — while the brand grew market shareby one percentage point. Increased control over trade-promotion spending reduced month-end customer deductions by $1.5 million compared with the previous year. Souligny alsoconfirms improved invoice accuracy, but he’ll need more historical data to quantify theimprovement.

Souligny says that the company still needs to work on its customer scorecard — a rankingMilnot/Beech-Nut’s top 25 customers by sales. “The scorecard is the ultimate test” for theorder-to-cash cycle, he notes, because executives can easily drill down to the root causes ofdifficulties 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-distantfuture when “manufacturers will be fully responsible for managing their inventory” at theretail level, according to Souligny. Someday soon, he believes, his customer reps willautomatically know when a grocery store is low on, say, jars of banana supreme, and shipout just the right amount the next hour.

Improving Milnot/Beech-Nut’s order-to-cash cycle is just the beginning, adds the financechief. Souligny says he’s glad to be at a smaller outfit where IT projects can be fast-trackedand management doesn’t get caught up in big-company politics. It seems “small is big” forSouligny, too.



SECTION - 6FINANCIAL SERVICES

� 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 fi-nance sector encompasses a broad range of organizations that deal with the sourcing,availability and management of money. Among these organizations are commercialbanks, investment banks, asset management companies, credit card companies, insur-ance companies, consumer finance companies, stock brokerages, mutual and invest-ment 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 topurchase 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 otherbanks.

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 bemade automatically.


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

i. Provide a Banker’s cheque guaranteed by the Bank itself and prepaid by the cus-tomer.

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 theiradvisory 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 collec-tive investment funds.

6.4 HEDGE FUND MANAGEMENT

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

6.5 CUSTODY SERVICES

6.5.1 Custody services and securities processing is a kind of ‘back-office’ administration forfinancial services.

6.6 INSURANCE

6.6.1 Insurance brokerage: Insurance brokers shop for insurance (generally corporate prop-erty and casualty insurance) on behalf of customers.

6.6.2 Insurance underwriting: Personal lines insurance underwriters generally underwriteinsurance for individuals, a service still offered primarily through agents and insurancebrokers. Underwriters may also offer similar commercial lines of coverage for busi-nesses. 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 catastrophiclosses.

6.7 INTERMEDIATION OR ADVISORY SERVICES

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



6.8 CONGLOMERATES

6.8.1A financial services conglomerate is a financial services firm that is active in more thanone sector of the financial services market e.g. life insurance, general insurance, healthinsurance, asset management, retail banking, wholesale banking, investment banking,etc.

6.8.2 A key rationale for the existence of such businesses is the existence of diversificationbenefits that are present when different types of businesses are aggregated. As a conse-quence, economic capital for a conglomerate is usually substantially less than economiccapital is for the sum of its parts.


SECTION - 7DIVIDEND AND RETENTION POLICIES

� 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 whichmanagement can affect the financing structure of the company. The questions that comeup 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 heldthat a dividend today is worth more than a potential capital gain in the future (two inthe bush!). It relied on the initial concept in which all capital market securities weresimply 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 therest capital gain. Dividend income was believed to be the total return from a share, andcapital preservation the best that could be hoped for.



7.2.3 Proponents of the theory argued that investors viewed future earnings as uncertain andfelt less uncertain about dividends, and applied a lower discount rate to dividends thanto the capital gain element of their returns. This argument implies that companies withhigh dividend yields should have greater market values than companies with lowdividend payouts, all other things being equal. This argument is flawed, as the risk of acompany is determined by its operating risk. As is the case with capital structure, ifcorporate taxes are ignored, the choice of dividend policy will have no impact on thebusiness 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 wefollow the argument of Miller and Modigliani (M & M) (1961). They assumed the existenceof perfect markets and also assumed that the company’s choice of dividend policy doesnot affect the decision as to whether or not particular projects or investments should beundertaken. The issue here is whether changing the dividend policy of a firm will addor subtract value, assuming the investment strategy remains unchanged.

7.3.2 M & M showed that, with perfect capital markets, dividend policy, as with capitalstructure, could not be altered to add value to a firm. However, in exactly the same wayas with capital structure, once we assume inefficiencies in markets and in particulartax, 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 topersuade 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 investorsabout the future prospects of the firm.

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


7.5.3 Why should dividends be considered the most cost-effective way of signalinginformation? One argument is that earnings forecasts, or other more direct signals offuture profitability, are hedged around with legal constraints and auditing requirements.So, companies with genuinely good prospects will be able to differentiate themselvesfrom 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 terms, change from day to day.



SECTION - 8CRITERIA FOR SELECTING SOURCES OF FINANCE

� 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 fora new investment are:

1. Can the company raise the finance required from internal sources or does ithave 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 accountseveral factors such as the following:

a. The current cash holding of the company, including short-term investments,cash required to support current operations and the surplus available for thenew 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 concernedareas such as loss of customer or supplier goodwill and production stoppagesdue 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 tobe considered are:

1. The cost of finance.


2. The current capital gearing of the company.

3. Availability of good asset security for lenders.

4. Risk, in terms of volatility of operating profit, associated with the businessthe 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 privateplacement 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 terms of the loan, rates of interest– whether fixed or floating, the market standing of the company, currency in which the loan isissued, and the covenants attached to the loan proposal by the lenders.



SECTION - 9

EFFECT OF FINANCING DECISIONS ONBALANCE SHEET AND RATIOS


� 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 sheetand consequently on the ratios. The higher the amount of debt, higher will be the inter-est cost, but this will be to some extent off-set by the lower tax outflow. The capitalstructure 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 oper-ating 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 thatthe Return on equity[ROE] is a function of Return on sales[net profit margin], assetturnover 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 affectedby the capital structure decisions. It is margin times the turnover, which defines thebusiness performance of the company. It is driven by the efficiency with which a companymanages its revenue, costs and assets. An efficient company can manage higher levelsof 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 thedebt to equity ratio, measured by total assets to equity. If this ratio is 1, it means, it is 100percent financed by equity.


ROE 1995 1996 1997Dell 33% 58% 90%Compaq 22% 22% 22%

Net Profit Margin 1995 1996 1997Dell 5.10% 6.70% 7.70%Compaq 5.40% 6.60% 7.50%

Asset turnover 1995 1996 1997Dell 2.83 3.02 3.4Compaq 2.38 1.99 1.82

Leverage 1995 1996 1997Dell 2.3 2.89 3.46Compaq 1.69 1.69 1.61

Dell computers performance in the year 1997 is mainly influenced by superior asset turnoverand higher leverage.

Companies resort to lease financing for leaving the capital structure intact. This is why, leasingis known as off-balance sheet financing. But in today’s context, the present value of future leasepayables is taken as debt and considered for debt to equity ratio. Accounting standards onlease transactions disclosure requires present value of future lease payables to be shown asdebt.

9.1.5 An illustration of Dell computers and Compaq.



SECTION - 10

FINANCIAL MANAGEMENT IN PUBLIC SECTOR

10.1.0 Public sector firm’s equity is contributed by the government. They function with socialobjective. Normally, they have a low debt to equity ratio as the public sector gets sup-port in the form of equity from the government. In India, the majority of public sectorcompanies 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 publicmoney, public sector financial management is very strictly controlled through proce-dures and sanctions and audit, both internal and external. The finance manager is ori-ented more towards managing audit requirements, parliamentary compliances and otherregulatory procedures.

10.1.2 In the post 1991 era of liberalization, Indian public sector companies were exposed tomarket discipline. Government started disinvesting the shares in public sector, the pub-lic sector shares were listed in the stock exchanges and many public sector companiesstarted raising capital through initial public offerings. So, in today’s context, most of theearlier 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-finan-cial measures. The non-financial measures will be used to measure the extent to whichthe public sector has achieved social objectives like employment generation and Corpo-rate Social Responsibility (CSR). Public sector today, is governed by the principle calledvalue for money, which is a comprehensive measure that links both financial and non-financial measures.


� Financial Management in Public Sector


SECTION - 11ROLE OF TREASURY FUNCTION

� 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 forcedwith rapid economic developments, globalizing industries and competition, newtechnologies and revolutionary changes in the regulatory environment. As well asresponding to these forces, finance and treasury functions are under pressure to addvalue to the organization through their operations and contribute to achieving strategicgoals.

11.1.2 With significant developments that have taken place in the financial markets in therecent 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 financialrisk management; exposure management and the use of hedging strategies are now allseen as essential requirements..

11.1.3 The concept of corporate treasury is defined through a comparison of traditional andemergent roles. The management accountants’ main task in cementing the treasury’sstrategic 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 andretain competitively sought-after investor capital or, in other words, increase shareholderwealth. 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 thatwill contribute directly to the economic value of the firm and its ability to satisfy thefinancial return requirements of its investors. Increasingly, treasury and treasurymanagement practices are being aligned with and integrated into, the business strategiesof organizations. It should not be surprising to see corporate treasury and treasurystrategies involved in organizational change.



11.1.5 Therefore, whilst ensuring the effective management of all forms of risks, treasurymanagers must also be able to use and apply financial products in order to maximizeprofit. With the ever-increasing range and complexity of financial instruments available,treasury managers must constantly update their skills in order to effectively undertaketheir 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 itcontinues to expand, as can be seen from the following listing. A treasury managershould 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 valuationsb. Short-term funding investment investmentsc. Cash Management: transactions, pooling and nettingd. Working Capital Managemente. Using Debt Instruments

2. Foreign Exchange Risk Managementa. International Economics and International Financeb. International Financial Markets and Instrumentsc. Foreign Exchange: Swaps and Forwardsd. Vanilla and Exotic Foreign Exchange Options

3. Financial Risk Management:a. Interest and Currency Risksb. Interest Rates: Forwards, Futures and Optionsc. Interest Rate Swaps and applicationsd. Managing Currency Risks with Forward, Futures, Options and Swaps

4. Macroeconomic Policy Environment:a. Understanding of macroeconomic policiesb. Understanding of how macroeconomic policies affect prices and costs in the

economyc. Current scenario and future outlook for India and globally

5. Other aspects in Treasury Management:a. Role in accounting policy formation eg. Forex transactions, Mutual Fund

Investments, etc.b. Formation of Policies and Processes (Investment, Forex Management, Accounting,

etc.)c. Accounting Policies on recognition of Treasury Transactions


d. Accounting Standards on various foreign Exchange techniques under US andIndian 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 ofinformation moves faster than the one before. Treasury is at the heart of the organizationand 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. Aswell as traditional risks such as foreign exchange, funding, liquidity and counterpartyrisk, 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 withoverall business strategy ensuring that the appropriate risks are identified, the rightprocesses are in place for managing and mitigating those risks and that roles andresponsibilities are clearly defined and communicated.

Performance reporting

Reporting and measuring performance is often seen as an additional burden on theoverstretched treasury department. Well thought out metrics and indicators, along witha robust reporting framework, can not only be used to measure the performance of thefunction, but can also help drive high performance.

Reducing the risk of operational errors

The treasury function frequently manages complex, high-value transactions under tighttime constraints, which can create the potential for operational errors leading tosignificant financial loss. An operational risk framework that captures, categorizes andanalyzes 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 increasinglychallenging to manage a central view of all banking arrangements. Depending on therelative autonomy of different business units, it may not always be practical simply torationalize all global accounts. Other cash management methods—such as paymentfactories 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 cashflow planning, and requires effective communication between business units. The



treasurer may also provide valuable input into the longer term forecasting and budgetingprocesses and must work closely with the finance function.

Meeting strategic plans

Creating a funding program that is sufficiently flexible and responsive to achieve strategicobjectives requires the corporate treasury function to make sure that its knowledge andunderstanding of the group business plans are consistent with the level, diversity, natureand 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 toensure that it is using the right instruments and investment methods that can fit boththe 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 levelsof 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 thesame time as ensuring that all statutory duties are met and compliance obligations arefulfilled.

11.4.0 The article titled “Treasury Organisation: Picking the Right Model”, published by HSBC’sGuide to Cash and Treasury Management in Asia Pacific 2004, appended at the end ofchapter 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 equitymix 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;


SECTION - 12CONTEMPORARY DEVELOPMENTS


• 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) inGeneva. To join 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 grantthe 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 replacedthe GATT since the Uruguay Round accord became effective on January 1, 1995. Today,WTO’s 135 members account for more than 95% of world trade. The five major functionsof WTO are:

• Administering 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-personarbitration panel. 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 internationaltrade

• 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 incharge of policing member countries’ adherence to all the WTO agreements, signedby 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 theUruguay 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.

• Governed by a Ministerial Conference, which meets every two years; a GeneralCouncil, which implements the conference’s policy decisions and is responsible forday-to-day administration; and a director-general, who is appointed by the MinisterialConference.

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 throughthe reduction of tariff barriers, quantitative restrictions and subsidies on trade througha series of agreements.

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

• The Bretton Woods Conference had introduced the idea for an organization toregulate trade as part of a larger plan for economic recovery after World War II. Asgovernments negotiated the ITO, 15 negotiating states began parallel negotiationsfor 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 whichwas 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 foreigninvestment, 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 investmentthroughout the world. However, some of the countries receiving foreign investmentimposed numerous restrictions on that investment designed to protect and fosterdomestic industries, and to prevent the outflow of foreign exchange reserves.

• Examples of these restrictions include local content requirements (which requirethat locally-produced goods be purchased or used), manufacturing requirements(which require the domestic manufacturing of certain components), trade balancingrequirements, domestic sales requirements, technology transfer requirements, exportperformance requirements (which require the export of a specified percentage ofproduction volume), local equity restrictions, foreign exchange restrictions, remittancerestrictions, licensing requirements, and employment restrictions. These measurescan also be used in connection with fiscal incentives. Some of these investmentmeasures distort trade in violation of GATT Article III and XI, and are thereforeprohibited.


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

• TRIPS is an international agreement administered for the first time by the WorldTrade 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 intellectualproperty

• It was negotiated at the end of the Uruguay Round of the General Agreement onTariffs 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 broadcastingorganizations; geographical indications, including appellations of origin; industrialdesigns; integrated circuit layout-designs; patents; monopolies for the developers ofnew plant varieties; trademarks; trade dress; and undisclosed or confidentialinformation. TRIPS also specify enforcement procedures, remedies, and disputeresolution procedures.

• In 2001, developing countries were concerned that developed countries were insistingon an overly-narrow reading of TRIPS, initiated a round of talks that resulted in theDoha Declaration: a WTO statement that clarifies the scope of TRIPS; stating forexample that TRIPS can and should be interpreted in light of the goal “to promoteaccess 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 aseparate regulating agency for the securities market. Accordingly, Indian Government haspassed the Securities & Exchange Board of India Act, 1992 to provide the establishment of theSecurities & Exchange Board of India on the lines of Securities Exchange Commission of USAto protect the interests of investors in securities and to promote the development of and toregulate the securites market.

• SEBI is an autonomous body created by the Government of India in 1988 and givenstatutory 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 quasi-executive.



• It drafts regulations in its legislative capacity, it conducts investigation and enforcementaction in its executive function and it passes rulings and orders in its judicialcapacity.

• Though this makes it very powerful, there is an appeal process to create accountability.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.


STUDY NOTE - 3FINANCIAL ANALYSIS AND PLANNING

SECTION - 1FUNDS FLOW ANALYSIS

� 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 isproperly 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 andliabilities 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 variousfinancial decisions. Some examples are given below:

a. Change in Asset value could be due to purchase of fresh assets or sale of assets orboth.

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)



FINANCIAL ANALYSIS AND PLANNING

2. Performance of Businessa. Profit is an important source of fund earned through performance of business op-

erationsb. Decline in Sales affects the internal generation adversely.

3. Accounting Policies:a. Changes in Inventory Valuation

1.3 PURPOSE OF FUNDS FLOW ANALYSIS

1.3.1 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.

1.4 CONVERTING BALANCE SHEET INTO FUNDS FLOWSTATEMENT

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


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 orinvestments. Funds generated through internal sources are an indication of strength ofan organization.

1.6.3 External source can be in the form of equity or debt. External debt source can be furtherclassified 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 account (shows net effect plus some important flowslike dividends)

c. Balance sheet, Profit and loss account 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



6. Changes in balance sheet captures the net effect7. Selling on credit shifts funds from finished goods to debtors8. Flow of funds help in appraising the impact of the management decision made during

a certain period9. Funds means shift in economic values

Illustration of funds statement:

Year 1 Year 2 Change Source Application

Cash 231.00 245.70 14.70 0 14.7

Marketable securities 450.80 314.90 -135.90 135.9 0Accounts receivable 807.10 843.50 36.40 0 36.4Inventories 1170.70 1387.10 216.40 0 216.4Total Current assets 2659.60 2791.20 131.60 0Gross Plant and equipment 11070.40 11897.70 827.30 0 827.3Accumulated depreciation 6410.70 6618.50 207.80 207.8Net plant and equipment 4659.70 5279.20 619.50 0Investments 574.80 735.20 160.40 0 160.4Other assets 260.90 362.30 101.40 0 101.4Total Assets 8155.00 9167.90 1012.90 0

LiabilitiesNotes payable 65.30 144.50 79.20 79.2 0Accounts payable 571.20 622.80 51.60 51.6 0

Accrued taxes 346.30 275.00 -71.30 0 71.3

Short term debt 433.70 544.30 110.60 110.6 0Current maturities 30.40 50.80 20.40 20.4 0Total current liabilities 1446.90 1637.40 190.50Long term debt 1542.50 1959.90 417.40 417.4 0Deferred taxes 288.40 405.30 116.90 116.9 0Deferred credits 27.00 36.30 9.30 9.3 0Total liabilities 3304.80 4038.90 734.10 0Common stock 1627.70 1644.10 16.40 16.4 0Share premium 2.80 27.70 24.90 24.9 0Retained earnings 3219.70 3457.20 237.50 237.5 0Total equity 4850.20 5129.00 278.80 0

Total 8155.00 9167.90 1012.90 0

1427.9 1427.9


Sources of Funds Amount %

Decrease in Marketable Securities 135.9 10%

Depreciation 207.8 15%

Increase in

Notes payable 79.2 6%

Accounts payable 51.6 4%

Short term debt 110.6 8%

Current maturities 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 premium 24.9 2%

Retained earnings 237.5 17%

Total 1427.9 100%

Application of funds

Increase in

Cash 14.7 1%

Accounts receivable 36.4 3%

Inventories 216.4 15%

Plant and equipment 827.3 58%

Investments 160.4 11%

Other assets 101.4 7%

Decrease in 0%

Accrued taxes 71.3 5%

1427.9 100%



SECTION - 2CASH FLOW ANALYSIS

� 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 organizationduring 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 pay-ment of interest and principal?

3. What the company has done with the money it raised through equity and debt forexpansion? Have they used the money exactly for the expansion?

Accounting statements fail to give a clear reply to all these questions and hence theneed 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. Accounting statements conceal more than what they reveal to the readers who arenot familiar with the accounting system; Cash flow statement is free from suchcomplexities.

2. Accounting statements are prepared on the basis of accrual and hence the profitfigure shown in the P & L account is only an expected profit; Cash Profit computedunder 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 alsostudy 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 criticalomission - in recognition that insufficient cash resources are a major cause of corporate problems


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 earnings-per-share. What should be considered is more revealing analytical concepts of cash flow or cash-flow-per-share, which reflect the total cash earnings available to management, - that is earningsbefore 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 cashflow 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 accrualbasis, not on a cash basis. And projections? Same thing. Projected net income, not projectedcash income. Yet, cash repays loans. Therefore, we are compelled to shift our focus if we trulywish to assess our client’s ability to pay interest and repay debt. We must turn our attention tocash, working through the roadblocks thrown up by accrual accounting, to properly evaluate thecreditworthiness of our client”. (RMA Uniform Credit Analysis, Philadelphia, Robert MorrisAssociates, 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. Cash Generated from Operations

– Cash Receipts from Customers

– Less: Cash paid to suppliers & other operating expenses

– Less: Interest Paid

– Less: Income Tax Paid

2. 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



3. Proceeds on sale of investments4. Proceeds on sale of fixed assets5. Less:

– Purchase of fixed assets– Investments in subsidiaries– Investments in trade investments– Loans and Advances repaid– Investments on Current Assets

2.3.4 Cash flow from Financing Activities:1. Proceeds from issue of Share Capital2. Proceeds from Long-term Borrowings3. Less:

– Repayment of Loans– Dividend Paid

2.3.5 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 Statementalong with Balance Sheet and Profit & Loss Account. The format provided in theListing Agreement is accounting 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 Cash flow statement is similar to funds flow statement, and it can be as detailed asrequired. But, extraction of this statement from balance sheet captures the net effect.

2.4.2 Cash from operations needs to be explained.2.4.3 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 100000

Cash received from debtors 80000

cost of goods sold 60000


Sundry debtors a/c

Balance b/d 10000 Cash 80000

Sales 100000 Closing balance 30000

Total 110000 110000

Profit and loss account

cost of goods sold 60000 sales 100000

Profit 40000

Total 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

Reserves & Surplus 502.34 583.52Depreciation 126.83 -9.07Write off of Miscellaneous Expenses 0.29 0.01

Add: Dec.in CA & Inc in CLReduction in Inventories 55.88Reduction in Sundry Debtors 28.86Reduction in Loans and AdvancesIncrease in Current Liabilities 118.84 48.39More Provisions made 94.35 218.96

Less: Inc.in CA & Dec in CLIncrease in Inventories 83.63Increase in Sundry Debtors 87.31Increase in Loans and Advances made 139.39 394.63Decrease in Current LiabilitiesReduction in Provisions made

Cash From Operations 648.49 415.75



Increase Share CapitalSecured Loans Received during the year 60.50 13.54Unsecured Loans Received during the year 85.48 77.94Sale of Fixed AssetsConversion of Capital WIP in Fixed Assets 4.68Investments realised

TOTAL CASH INFLOW 853.23 599.74

APPLICATION OF CASH

Decrease in Share CapitalSecured Loans dischargedUnsecured Loans dischargedPurchases of Fixed Assets 323.95 155.62Increase in Capital WIP 74.21Investments made during the year 493.30 315.83

TOTAL CASH OUTFLOW 817.25 545.66

Cash balance at the end of the year 35.98 54.08

2.4.5 Derived Cash Flows:

Derived cash flows

Net Operating Profit+ DepreciationEBITDA+/- Changes in current assets/liabilitiesOperating cash flow- Taxes paid-Interest paid-current portion of long term debtDiscretionary cash flow-Dividends paidCash 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 expenseCash flow after investing activities+/- Share capital+/- Long-term debt+/- Short-term debtCash flow after financing activities=Change in cash


2.4.6 Cash flow analysis (other dimensions):

Net Operating Profit+ DepreciationEBITDA+/- Changes in current assets/liabilitiesOperating cash flow-Taxes paidOperating free cash flow-Interest paidFree cash flow-DividendsResidual 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?



SECTION - 3FINANCIAL RATIO ANALYSIS

� 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 accounting is to communicate financial information toenable users to take reasonable decisions. Accounting is the activity of identifying,measuring, recording and reporting on the resources and performance of an enter-prise based on financial parameters.

3.1.2 While recognizing that financial information is a vital part of information for man-agement decision making it is equally important to recognize that true analysis willnecessitate looking behind and beyond the figures to ascertain what is actually repre-sented. “Drawing quick conclusions is to be resisted as the information must be related tothe situation in which the enterprise is, in terms of its competitive environment or stage ofdevelopment”. (– Bowman and Asch, 1987). Decisions have to be taken only after prop-erly interpreting the financial data to the specific needs of the case under consider-ation.

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 includean analysis of the following:a. Capital structureb. Asset deploymentc. Liquidity


d. Utilizatione. Expensesf. Coverageg. Profitabilityh. Analysis from different stakeholders’ perspectivei. 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 Extent of diversion of long term funds to short term assets and vice versaInventory/Current assetsReceivables/Current assets Feel for the application of funds in these areasLoans&Advances/Current assets

Analysis of liquidity

Current Ratio Ability to meet the immediately maturing obligationsQuick Ratio

Analysis of Utilisation

Sales/Total assets Efficiency in utilising assetsSales/Fixed assets Achieving higher turnover for a given level of investmentSales/Current assets Optimising investmentsSales/Inventory Monitor idle fundsSales/Debtors

Operating CycleInventory Days Efficiency in utilising assetsDebtors Days Monitor idle funds

Ratio Summary

Analysis of expense

Raw material cost/salesPower & Fuel cost/sales Keep track of the trend in expensesEmployee cost/sales and exercise cost contorlSelling and adm/salesOperating cost/sales

Analysis of coverage

Interest coverage Ability to service lenders

Analysis of Profitability

Return on investment Overall performance evaluation from business point of viewReturn on sales Efficiency in cost management and margin realisationReturn on equity Performance evaluation from equity shareholders point of view

Analysis-Shareholders perspective

Earnings Per Share Performance evaluation from equity shareholders point of viewPrice/Earnings Market perception and valuation

Dividend Yield



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, Debtcapacity, 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 + DepreciationInterest payments

Times interest earned EBIT _Interest payments

Total coverage EBI-Tax/(interest + instalment)


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 (Analysisfrom 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 itsmulti-product, multi-location businesses, and it has retained its pre-eminence over theyears as an important framework for reviewing performance. It is a break-down of ROEand ROA into component ratios:

ROA = (EBIT – Taxes) / AssetsROE = (EBIT – Taxes - Interest) / EquityROA = (Sales / Assets) x [(EBIT – Taxes) / Sales]

Asset Turnover x Profit MarginROE = (Assets/Equity) x (Sales/Assets) x [(EBIT–T)/Sales] x [(EBIT–T-I)/(EBIT-T)]

Leverage Asset Turnover Profit Margin Debt burden



3.4 LIMITATIONS OF RATIO ANALYSIS

3.4.1 Financial ratio analysis and comparison of same with benchmark figures has its limita-tions due to a number of factors. These include the following:

1. Variations in accounting policies among various companies2. Window dressing3. Lack of understanding of basic principles4. Current economic and industry scenario5. Interpretation of results6. changes made in groupings in expenses in different years and most importantly7. Ratios change from company to company based on the mix of capital and the struc-

turing of capital even when the level of revenue mains the same.

3.4.2 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 extentof correlation among various ratios. It may be noted that ‘one swallow does not make asummer’.

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 givenbelow:

1. The company’s Annual Report: This is the most vital source, as it offers a wealth ofinformation about a company’s performance. The Directors’ Report; Managementdiscussion on business environment and prospects, Report on corporate governance,Auditor’s Report with qualifications if any; audited Balance Sheet; audited Profit &Loss Account; Schedules & Notes to accounts; Accounting policies; Trend analysisand 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, SalesTax, PF Departments etc.

5. Information provided to Banks and financial institutions.

6. Information available with industry bodies and trade associations, Chambers of Com-merce etc.

7. Information published in financial newspapers and magazines by experts in the in-dustry etc.

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


STUDY NOTE - 4CAPITAL BUDGETING

SECTION - 1COST-VOLUME-PROFIT ANALYSIS

� Cost-Volume-Profit Analysis

� Assumptions of CVP Analysis:

� Benefits of CVP:



1.1 COST-VOLUME-PROFIT ANALYSIS

1.1.1 Cost-Volume-Profit (CVP) Analysis, also known as Break-even Analysis is a Short-TermPlanning and Analysis Tool. It is widely used in financial analysis, especially to see thelevel at which a unit has to operate to cover its fixed costs and subsequently get intoprofit 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 accu-rately 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 certaintyAny change between assumption and actual on above assumptions would tilt the CVPconsiderably.

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.


CAPITAL BUDGETING

3. Assists in focusing on the impact that changes in costs (variable and fixed) have onprofits.

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 becommitted and the resultant investment decisions to be made.

1.4 CVP ANALYSIS: A SIMPLE ILLUSTRATION

Fixed costs (F) = Rs.40,000Selling price per unit (P) = Rs.10Variable cost per unit (V) = Rs.6Tax 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 expenses0 = Rs.10X – Rs.6X – Rs.40,000Rs.10X – Rs.6X = Rs.40,000Rs.4X = Rs.40,000X = 10,000 units

2. Break-even point in Rs. sales is:10,000 x Rs.10 or Rs.100,000This can be shown with a variable-costing income statement.Sales (10,000 x Rs.10) Rs.100,000Less: Variable expenses (10,000 x Rs.6) 60,000Contribution margin Rs. 40,000Less: Fixed expenses 40,000Profit before taxes 0Less: Income taxes 0Profit after taxes 0

======1.5.0 Alternative approach to solving break-even point in sales price:

Let X equal break-even sales in rupeesOperating income = Sales revenue - Variable expenses - Fixed expenses0 = X - 0.6X – Rs.40,000X - 0.6X = Rs.40,0000.4X = Rs.40,000X = Rs.100,000

Note: V is the variable cost percentage which is obtained by:


6.010

6

UnitpericePrSelling

UnitperCostVariable ==

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


CAPITAL BUDGETING

SECTION - 2CONCEPT AND NATURE OF LEVERAGES

� 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 usrecall how the simple crowbar was used to illustrate a fundamental, but eminently use-ful concept.

2.1.2 Consider the example of a young boy using a pole to move a heavy stone. He places oneend of the pole under the edge of the stone. He supports the pole on a brick placed closeto the stone. He pushes downwards at the other end of the pole. This helps him movethe stone easily.

2.1.3 The pole that the boy uses is a lever. The downward force he applies at one end of thepole is called the effort and the stone he lifts is referred to as the load. The pole wassupported at the point of resting on the brick called fulcrum. By using a small effort theboy 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 toas Operating Leverage and Financial Leverage, arising out of the fixed costs in anorganization’s cost structure.


SECTION - 3OPERATING AND FINANCIAL LEVERAGES

� 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 operat-ing 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 equalchange in PBIT.

3.1.3 Consider the following example:

Assume that a company has the following projected income statement (given earlier inChapter 1):

Rs.Sales 100,000Less: Variable expenses 60,000Contribution margin 40,000Less: Fixed expenses 30,000Income before taxes 10,000

======Degree of Operating Leverage (DOL) = Rs.40,000/Rs.10,000 = 4.0Now suppose that sales are 25% higher than projected. What is the percentage changein profits?Percentage change in profits = DOL x percentage change in salesPercentage change in profits = 4.0 x 25% = 100%

Verification:Rs.

Sales 125,000Less: Variable expenses 75,000Contribution margin 50,000Less: Fixed expenses 30,000Income before taxes 20,000

======


CAPITAL BUDGETING

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

OutputinChangePercentage

PBIRinChangePercentageDOL =

F)VP(Q

)VP(Q

−−−=

PBIT

onContributi=

3.1.5 As we know, PBIT is nothing but Profit Before Interest and Tax. This can be expressedby the following equation:

PBIT = Q x (P – V) – F

Where, Q denotes the quantity produced and sold, P the selling price per unit, V thevariable 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 maybe 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:

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

PBITinChangePercentage

EPSChangeinPercentageDFL =

Company A B C

Debt 0 5000 7000 8% Interest

Equity 10000 5000 7000 50% Tax

Total 10000 10000 10000

PBIT 1000 1000 1000

Interest 0 400 560

PBT 100 600 440

Tax 500 300 220

PAT 500 300 220

ROE 5.00% 6.00% 7.33%


3.2.4 It flows from the definition of PBIT given above that PAT (Profit After Tax) can berepresented 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:

N

PATEPS =

Where, N = Number of outstanding equity shares.

In case there is any preferred dividend Dp, then,

N

DATEPS p−Π

=

3.2.6 DFL and Financial Risk: Financial Risk here is basically the variability in EPS, that maybe 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 lever-ages.

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

outputinChangePercentage

EPSinChangePercentageDTL =

DTL = DOL x DFL

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


FINANCIAL STRATEGY

STUDY NOTE - 5FINANCIAL STRATEGY

SECTION - 1INTRODUCTION TO FINANCIAL STRATEGY


1.1. WHAT IS FINANCIAL STRATEGY?

1.1.1 Financial strategy is a topic of importance to middle and senior line managers, whoface regularly a multiplicity of financial issues in their organisation. A sound financialstrategy seeks to answer:

a. How does a Chief Financial Officer (CFO) determine the long-term target capitalstructure?

b. When to form holding and subsidiary structure or branch offices or subsidiariesoverseas?

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 andrepurchase 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 tothe common objective of maximising shareholder value?

h. How much should one pay for a company? ?

i. What is the best way to fight a hostile bid?

1.1.2 Strategic financial decisions are based on rigorous cash-flow forecasts, together withaccurate 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 leveragedbuyouts

� Concept of Financial Strategy


c. asset restructuring, such as takeovers, mergers and acquisitions, spin-offs andequity carve-outs

d. credible and compelling communication with shareholders

e. developing a strong culture where all decision makers are motivated to createvalue

f. understanding how to increase the value of the company by appropriate invest-ment

g. developing knowledge about the financial markets – particularly how the marketsperceive 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 inthe context of lending and investing decisions.

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

k. understanding how the organization should measure financial performance inter-nally and how the financial performance is assessed by stakeholders in a globalcontext.

l. Benchmarking strategies with competitors in Industry globally without restrict-ing Comparisons to only local players.

BEST PRACTICES IN CREATING A STRATEGIC FINANCE FUNCTION

An SAP/APQC Collaboration

In the wake of recent accounting scandals and in the increasingly competitive business envi-ronment, many CFOs and the finance organizations they lead have started to take on newstrategic roles within the enterprise. They are aiming at enforcing stricter control processes toensure legal and regulatory compliance, offering strategic insights into the internal and exter-nal business environment, and connecting the business strategy with daily operations throughperformance tracking.

The trend toward a more strategic role is echoed by the responses of participants in recentresearch conducted by APQC, an internationally recognized nonprofit organization that pro-vides best-practice research, metrics, and measures. The participants indicated that, three yearsdown the road, they anticipate spending 30% more time on decision support and manage-ment. According to the same research, however, in spite of their aspirations, participants havenot made much progress toward a greater strategic role. Finance organizations, no matter whattheir size, report to APQC that they still spend almost two-thirds of their time on transactionprocessing and controls and only one-third on decision support and management.


FINANCIAL STRATEGY

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

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

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

One global consumer products company took a two-step approach to a more strategic pathfor finance. In the first step, the company developed a more efficient cash management,accounts payable, and accounts 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 globalreach to maximize cash management efficiency, foreign exchange exposure, and the globalsupply chain to help fund growth, participate in new marketing and distribution arrange-ments, 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 rightinformation to drive the right choices between different variables. To help determine whetheryour finance function is moving toward a strategic approach, take a moment and decide whetheryour system does the following:

• Accelerates closing processes through automation, workflow, and collaboration

• Improves business analysis and decision support by providing historical and for-ward-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


• Increases effectiveness of compliance efforts through comprehensive auditing, deeperreporting, and management of internal controls (Sarbanes-Oxley)

In addition, a truly integrated systemic foundation should help you achieve the fol-lowing:

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

• Monitor the performance of strategic key success factors using external and internalbenchmarks

• Use tools that support a financial planning process that integrates global strategicplanning 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 yourfinancial software provides the following:

• A single source for financial information (a prerequisite for managing business pro-cesses beyond financials more effectively)

• More timely access to accurate data, improving communication between finance andoperations

• Increased alignment between front- and backoffice applications, enabling manage-ment to better administer and track business strategy and decisions

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

• Improved security and controls and reduced risk of contractual and regulatory non-compliance

• Improved predictability, particularly with budget

One CFO admitted, “Until we began to appreciate the importance of simplicity in thinkingthrough our finance function and making it more strategic, we did not realize the way thattechnology can help you deal with complexity, and allow you to achieve the strategic goalsfinance should achieve.”

Are You a Strategic CFO?

As far as they’ve come, many senior finance executives still have the nagging feeling that theycould be doing more.

Lisa Yoon, CFO.com January 11, 2006

Bean counter. Numbers cop. Chief financial officers have long outgrown those stereotypes;


FINANCIAL STRATEGY

today a more appropriate description might be business partner, strategist, first deputy tothe CEO.

Yet as far as they’ve come, many senior finance executives still have the nagging feeling thatthey could be doing more. Dan Chenoweth, a Denver-based business consultant and formerfinance executive, believes there are several reasons why finance chiefs don’t always play a bigenough role at the strategy table:

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

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

• Finally, says Chenoweth, CFOs still tend to view their ultimate responsibility as fidu-ciary — saving company funds and reining in spending — rather than taking on thebroader role of value creator.

That CFOs have these characteristics and self-perceptions is “an increasingly invalid generali-zation,” maintains Steve Wasko, chief financial officer of Northbrook, Illinois-based NanosphereInc. He points to a shift in management philosophy from a model centered around the chiefexecutive, in which senior managers carried out the CEO’s vision, to today’s increasingly team-oriented approach, in which the CFO and other senior managers help shape the company’sdirection 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 recentyears, 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 thathave such CFOs are at a disadvantage.”


SECTION - 2

FINANCIAL & NON-FINANCIAL OBJECTIVESOF

DIFFERENT ORGANIZATIONS


“It is not possible to manage what you cannot control and you cannot control what youcannot measure!” - Peter Drucker.“We consider the advantages and disadvantages of stakeholder-oriented firms that areconcerned with employees and suppliers as well as shareholders compared to shareholder-oriented 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 byshareholder firms for all societies”.

- Abstract of Report tilted “Stakeholder Capitalism, Corporate Governance and FirmValue” by Franklin Allen, University of Pennsylvania, Elena Carletti, Center for FinancialStudies, 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 businesspractices are not providing the necessary guidance and support for decision-making.Change in every aspect and in the entire outlook is a constant factor. Business leadersare dissatisfied with the traditional measurement tools as organizations today in-creasingly perform in real time environment. New tools are being developed tomeasure the outcome of changes and their effective contribution to the bottom-line.

� 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


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

2.1.3 Why do we measure?

a. To know current status, degree of achievement and how far to go for ultimategoals to be achieved;

b. For strategic alignments to communicate and reinforce messages to employeeson company focus, direction and targets.

c. For strategic learning: to know what works and what does not work & to takebetter decisions:

• to identify pockets of excellence practices and universalize them

• to identify relationships between measures

• measurement is the trigger for excellence in performance & continuousimprovement

• Strategic Management control of cost

2.1.4 Measurement system of performance has to progress from being reactive to beingproactive and finally to be responsive, as the right metrics drive world classperformance. Criteria of success are different from product to process, companyperspective to stakeholder perspective, revenue to reputation and financial to non-financial.

2.2. THE NEED FOR A RANGE OF PERFORMANCE MEASURES

2.2.1 Organisational control is the process whereby an organisation ensures that it ispursuing 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 toa particular company, this selection ought to be made in the light of the company’sstrategic intentions which will have been formed to suit the competitive environ-ment in which it operates and the kind of business that it is. It is generally in linewith 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 keysource of a manufacturing company’s competitive advantage, then it should bemeasuring its performance in this area relative to its competitors. If a service


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

2.2.4 Whether the company is in the manufacturing or the service sector, in choosing anappropriate range of performance measures it will be necessary, however, tobalance them, to make sure that one dimension or set of dimensions of performanceis not stressed to the detriment of others. While most companies will tend toorganise their accounting systems using common accounting principles, they mightdiffer widely in the choice, or potential choice, of performance indicators.

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

2.2.6 These six generic performance dimensions fall into two conceptually different cat-

egories. 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 up-

stream or as downstream indicators, where, for example, improved quality of service

upstream leads to better financial performance downstream.

competitive advantage flexibility

financial performance resource utilisation

quality of service innovation


FINANCIAL STRATEGY

Performance Dimensions Types of Measures

CompetitivenessRelative market share and position

Sales growth, Measures reg customer base

Financial PerformanceProfitability, Liquidity, Capital Structure,

Market Ratings, etc.

Quality of Service

Reliability, Responsiveness, Appearance,

Cleanliness, Comfort, Friendliness, Communication

Courtesy, Competence, Access, Availability,

Security etc.

FlexibilityVolume Flexibility, Specification and Speed of

Delivery Flexibility

Resource Utilisation Productivity, Efficiency, etc.

InnovationPerformance of the innovation process, Performanc

of individual innovations, etc.

Source: “Performance Measurement in Service Businesses” by Lin Fitzgerald, RobertJohnston, 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 termsof the bottom line. In this sort of corporate environment, financial indicators remainthe fundamental management tool and could be said to reflect the capital market’sobsession with profitability as almost the sole indicator of corporate performance.Opponents of this approach suggest that it encourages management to take a numberof 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 tominimise the impact on the costs side of the current year’s P & L, or calling for infor-mation on cost benefit on expenses at too frequent intervals so as to be sure that tar-gets are being met, both of which actions might actually jeopardise the company’soverall performance rather than improve it.

2.3.2 Presently, there is a realization among managers that because of the pre-eminence ofmoney measurement in the commercial world, the information derived from the manystages preceding the preparation of the annual accounts, such as budgets, standard

Table 1. Upstream Determinants and Downstream Results


costs, actual costs and variances, are actually just a one dimensional view of corpo-rate activity. Increasingly, a large number of managers have recognized in recentyears that a big part of a company’s true value depends upon intangible factors suchas organizational knowledge, customer satisfaction, product innovation and employeemorale, rather than on physical assets like machinery or real estate. While companiesrecognize the importance of these intangible factors, understanding and measuringtheir role in value creation poses a formidable challenge. Human resources depart-ments may know how to tabulate payroll for a certain plant, for instance, but if askedto measure the motivation of its employees, they would probably be on uncertainground. And yet, employee motivation and turnover are as crucial to that plant’sprofitability 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 thatbusinesses have been tracking such performance longer than they have been trying tomonitor how they are doing in areas such as employee satisfaction. Still, despite theimportance of financial performance, executives ranked four other areas as being moreimportant 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. Thereare massive gaps between what executives believe are key drivers of future economicvalue and their organizations’ ability to measure performance in these areas. Thebiggest gap is in the customer category, which indicates that companies are still wres-tling with ways to measure customer loyalty and satisfaction. Companies are alsogiving more weightage to assess how well they are managing alliances and fosteringemployee satisfaction as executives believe that both these areas are crucial drivers offuture value.

2.3.5 Unless organizations come to grips with these issues, its performance measures willfail to support its strategic objectives. Lack of good performance measures, could faila good strategy. Besides, if companies track their performance in these key areas, thiscould lead to more dependable disclosure of their future prospects. It has also beenfound that with higher transparency and disclosure, the company’s cost of capitalcould 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 prof-its and that decisions in these businesses are focused around how best to achieve thisobjective. The desire to be profitable need not, however, be all embracing and in prac-tice it can be seen that companies are likely to pursue a wide range of objectives, whichare 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 alittle imprecise. Does this mean that profit is sought at all costs, that maximising profitis the sole aim, or that managers/owners are happy with a specific “satisfactory” level


FINANCIAL STRATEGY

of profit? The exact answer will vary between businesses, as the priorities of ownersand managers differ, but it is possible to establish some basic guidelines.

2.4.3 It is useful to remember 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 whomhave personal objectives to fulfil. Management will constantly be trying to balance thereturn to these groups e.g., shareholders or employees and discussion on corporateobjectives really comes down to a compromise which takes account of what the differ-ent groups are seeking. Consequently some objectives may be financial in nature, suchas a rise in earnings per share, whilst others will be non-financial e.g., shorter workinghours, 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 varietyof stakeholders which may seek to influence company objectives, because they areaffected 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 adecent financial return on their investment.

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

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

2.4.8 Employees: Improved working atmosphere and conditions of work will be impor-tant 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 theowners. For example, a manager may seek to increase staff levels, as a way of increas-ing his personal status, but this may be lead to reduced profits.

2.4.10The community at large: Communities are affected by company activities in a num-ber of ways such as the use of land in a local area, the potential for pollution fromeffluents, commercial sponsorship of community projects and the impact of businessactivity on local transport systems. Corporate Social Responsibility (CSR) is very im-portant for each company to fulfill its social obligations.

2.4.11Government, both Central State, are interested in higher tax revenues from the corportesso that the Government can project a better budget estimates and actuals.

2.4.12Faced with such a broad range of interest groups, managers are likely to find that theycannot simultaneously maximise profits and the wealth of their shareholders whilstalso keeping all the other parties happy. In this situation, the only practical approachis to try and work to satisfy the various objectives rather than maximise any individualone. Adopting such a strategy means, for example, that the company might earn asatisfactory return for its shareholders, whilst at the same time paying reasonable wagesto satisfy employees, and avoiding polluting the environment, hence being a “good


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

2.5. NON-FINANCIAL PERFORMANCE INDICATORS

2.5.1 Professor Robert Kaplan of Harvard Business School in The Evolution of Manage-ment Accounting states : “..... if senior managers place too much emphasis on manag-ing by the financial numbers, the organisation’s long term viability becomes threat-ened.” That is, to provide corporate decision makers with solely financial indicators isto 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 ex-pressed in terms of money and secondly that if managers aim for excellence in theirown 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 throughoutthe 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 support


FINANCIAL STRATEGY

2.5.4 Therefore, whether a company is a manufacturer or a service provider, to be success-ful, its management should ensure that:

a. products move smoothly and swiftly through the production cycle without anyinterruption 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. the accounting and finance departments understand the needs of business

2.5.5 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 marketingplan

• 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

• tests for components, sub-assemblies and finished products

• fault analysis


• “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 samesources

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


FINANCIAL STRATEGY

2. Sales and Marketing:

• 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


• 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. Accounting

• speed of reporting to internal managers vs. HQ


FINANCIAL STRATEGY

• 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 out-come

• 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 ofR&D

5. Environment:

• work place environment yardsticks

• cleanliness

• tidiness

• pollution and effluent disposal mechanism and effectiveness

• catering facilities vs. competition

• other facilities vs. competition


• 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 notclear cut. There are many writers who would argue that companies which pursue awide range of objectives find that they create for themselves a very positive publicimage and this serves to increase shareholder wealth. Others would argue that com-munity type projects simply add to costs and thus erode profit, thereby reducingshareholder wealth. In reality, the truth probably lies somewhere between these twoextremes. Carefully selected projects, particularly those which are community related,may well serve as a form of indirect advertising and raise the corporate profile andassociated shareholder wealth. Other projects may simply represent a gesture of good-will, 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 productquality as a secondary objective. The aim is clearly non-financial in nature, but it willinvolve spending money on quality control and management projects which couldadd to costs and reduce profits. There is substantial research evidence from peoplelike Juran, which suggests that “quality is free”. In other words, the gains from highersales levels and reduced costs of warranty claims exceed the costs of the investment inquality improvements. Where this is the case, then the shareholders actually gainfrom 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. Somecompanies have a very good reputation in terms of the facilities which they providefor employees. Such provision clearly costs money and absorbs funds which could beused elsewhere within a business and so it might be easy to take the view that pursuitof the objective of employee welfare is detrimental to shareholders. In fact, it maywork 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, sothat shareholders see profits rise over the longer term. As with many things, whethera strategy has a positive or negative effect depends upon the time frame within whichit is being judged.

2.7. CONCLUSION

2.7.1 Financial costs incurred for non-financial aspects such as quality, R&D, employeewelfare etc may reduce the bottom-line in profit statements but would in the long runimprove 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-


FINANCIAL STRATEGY

edge that no single aim is of overriding importance. At the same time, non- financialobjectives do not necessarily conflict with the financial and can in fact serve to pros-per the interests of shareholders. A strong public image and good publicity must beimportant too, including, for example, for the Missionaries of Charity or theRamakrishna Mission. The difficulty lies in reaching the right balance, which keepsshareholders happy but also allows other interest groups to believe that a companyalso has their interest at heart as well. The good manager must learn to be good atjuggling.

BusinessInsight

(10/1/2003) CFO Project Volume 2

By Paul A.Boulanger, Accenture

Business insight is the capability of organizing and analyzing financial, operational, andexternal information, enabling decision-makers to understand and act, before their com-petitors, to create sustainable shareholder value.

Gone are the days when it was a major exercise for Unilever to identify and assess the perfor-mance of the 1,600 brands that comprised its global portfolio. As part of a new corporategrowth strategy, the global portfolio has been reduced to 400 key brands, and a new datawarehouse has been implemented. Global, regional, and national brand managers now haveaccess to consistent data on sales performance and changes in customer awareness andattitude toward each brand.

This information enables brand management to readily identify when and where to targetpromotional investments. Procurement directors have access to a rich data set of global ven-dor spend information upon which to predicate vendor negotiations. Unilever significantlyincreased the transparency of critical information in the areas of procurement, brand man-agement, customer management, and finance.

The results? A •2.1 billion reduction in direct procurement costs, a global view of the healthof 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 differentprocesses 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 transformationof its performance reporting capabilities (with Accenture’s help) enabled the enterprise toachieve dramatic improvements. During a time of flat industry performance, Unilever real-ized both top-line growth and increased shareholder value.

A Critical and Growing Need

The need to use performance management information effectively has been articulated foryears. However, we are at a pivotal point in the evolution of performance management. It ismore 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.


Why now? Four primary drivers are galvanizing organizations to address their use of infor-mation to drive business results. First, most companies have made little progress. Their ex-ecutives are deeply dissatisfied with their organizations’ ability to leverage information forcompetitive advantage. Second, companies are experiencing unprecedented demands foraccountability in the current regulatory and economic environment. They require increasedinsight into the real drivers of business results. Third, technology is now at the stage where itcan deliver on the vision promised for years. And last but not least, their competitors aremoving.

Recall the “pep” talk given to the salesmen in the movie Glengarry Glen Ross: “We’re addinga little something to this month’s sales contest. As you all know, first prize is a Cadillac ElDorado. Anybody want to see second prize? Second prize is a set of steak knives. Third prizeis you’re fired.” The stakes are rising. Being unable to generate the competitive advantagesthat effective access to information can deliver is an increasingly dangerous position.

Organizations and their executives are deeply dissatisfied with the state of their performancemanagement information capabilities. Corporations are increasingly awash in information,yet continue to struggle in creating real “insight” to drive performance. There are severalreasons for this continued struggle. Many companies have implemented enterprise resourceplanning (ERP) systems in ways that have not facilitated the generation of useful informa-tion. Accenture recently conducted a survey of 163 companies that had implemented ERPsystems. The mean number of instances (separate and distinct implementations of the samesoftware across regions or business units) was eight, with 32 percent having implementedfrom six to more than 20 distinct instances. This distributed ERP implementation strategyhas resulted in disparate, disconnected sources of operational information.

Further, with the decentralized governance of IT manifest in many companies, individualuser groups have driven their own development of data warehouses and data marts, con-tributing to increased fragmentation of information with little progress toward a “singleversion of the truth.” At some large companies, the data architecture is so fragmented thatno one will take accountability. The response is armies of analysts using batteries of spread-sheets, manually generating performance information. The cost of this analyst function withinfinance 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 accountability. The Sarbanes-OxleyAct in the United States is demanding that executives understand exactly what their compa-nies’ financial results are saying and communicate these results clearly to the market. Thesignoff required of U.S. CEOs and CFOs is more than credits and debits. Rather, it is aboutunderstanding that reported business results are fairly represented based on personal knowl-edge. This translates into reporting transparency — being able to explain cause-and-effectrelationships behind business results. Further, as markets continue to struggle and the in-vestment environment languishes, companies that can increase the depth of their disclosurewill 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 smallergeneration, ending a savings and investment bulge. Analysts portend that we will see this inthe next 10 years, putting downward pressure on stocks. Falling prices will force companiesto provide even more useful information to attract investors.


FINANCIAL STRATEGY

One of the more compelling reasons for companies to actively pursue the development ofbusiness performance management capabilities is that technology is now at the stage where itcan deliver on the vision promised for years. Integration technologies such as Kalido andInformatica have advanced to the point where they can more easily establish a common per-formance management language without remediating frontline transaction systems and com-promising flexibility at the local business level. Business analytics applications now containout-of-the-box functionality with the richness to develop metrics management, deliver onlineself-service reporting, and support an intuitive discovery process through drill-down and in-formation exploration that is useful to frontline managers and executives alike.

Lastly, your competitors are moving. Leveraging information to derive business insight is be-coming a significant competitive advantage. While there are far more instances of companiesthat have not made substantive progress than of progressive companies that have developedthe capability to leverage information to their advantage, there are examples that should giveexecutives pause:

• A global downstream oil producer was operating in 125 countries with several hundredseparate operating companies having their own IT systems and reporting tools. It wasunable to report consistent and timely information across operating units. By developinga performance management capability, key management information such as customerprofitability could be segmented to support better business decision-making at a countrylevel while enabling data to be aggregated for regional and global reporting. As a result ofimproved customer profiling and reporting, the business unit increased its profitabilityand 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 wasexperiencing intense competition for fuel sales and eroding profit margins. Non-fuel salesneeded to be increased to generate higher margins and growth. However, disparate ITsystems made the company unable to access product performance or category manage-ment information. By implementing a common reporting solution, category managers gota standard view of sales from thousands of retail sites. The results revealed that 20 percentof non-fuel items generated 94 percent of sales. Armed with these data, the companyachieved 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 itsexisting lubricants business with the newly acquired company. At the same time, it wantedto shift management focus from cost-plus to a value-based approach similar to that usedin consumer packaged good companies. By deploying a performance management capa-bility, the company created a common information resource while maintaining regionalautonomy for local reporting requirements. A centralized reporting solution was imple-mented rapidly across the global organization to meet the information requirements ofthe finance, supply chain, and marketing functions. Web-based tools were used for thebusiness units to submit data and for general administration. Standard and ad hoc re-ports enabled consistent and comparative analysis of key measures so that the mergedbusiness could be managed effectively, both globally and locally. A successful integra-tion of the two businesses after the acquisition realized significant synergy savings.


The Continued Evolution

Companies are coalescing around a vision for management information that has a variety ofcommon elements. Generally agreed-upon characteristics of an effective decision-support ca-pability 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, cus-tomer codes, and other key data elements globally. This enabled the company to define eco-nomic value created by products in geographic regions by key customers and by a variety ofother dimensions.

Commonality must be supported by processes used to compile information so that it is trustedas accurate. Tight integration with source systems, strong central governance, and internalcontrols are all part of ensuring that when end users access information, they believe it to betrue. Too often, review meetings start with a discussion around the veracity of the perfor-mance at hand. Moving up the hierarchy of needs requires organizations to construct informa-tion-aggregation processes that ensure integrity. High-integrity information enables an orga-nization to divest of competing sources of the same topical information. Eliminating redun-dant data marts and reporting processes ensures that management is working off of a singleversion of the truth, a critical but elusive capability for many companies.

Lastly, information is aggregated to benefit decision-makers. Given that decision-making hap-pens at all levels of an organization, an effective performance management information envi-ronment provides broad access to a wide community of users through self-service and intui-tive portals that facilitate the discovery process without extraneous aggregation effort.

Many companies have yet to achieve these basics. However, leading practice continues toevolve. Increasingly, technologies are available that enable companies to leverage informationdelivery techniques, such as alerts and data visualization, which increase the speed of recogni-tion and assimilation. Companies also are developing performance management capabilitiesthat support a cascading metrics approach; they’re hardwiring strategy to operations withinformation architecture constructed around a common view of how the business is to be man-aged. Corporate strategy is manifested in how frontline operations are measured. Informationis increasingly forward-looking, with everything positioned in terms of where we will be ratherthan where we have been.

Content is evolving as well. The line is blurring between financial and operational informa-tion, embedding in information delivery tools the ability to rapidly derive cause-and-effectrelationships 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 con-text. Managers should feel differently about a 500-basis-point drop in operating margin if theyknow 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 mea-sures shifts in cross-company supply chains, industry direction, and competitors’ positionshas the potential to be the single biggest evolution in management information since thedevelopment of the database (see Figure 1).


FINANCIAL STRATEGY

Figure 1: Critical Performance Information Components

The ability to leverage information to create insight into business performance will createcompetitive advantages in cost structure, go-to-market strategy, and supply chain manage-ment that separate successful businesses from those getting the steak knives, or worse. Busi-ness insight is the capability of efficiently organizing and analyzing financial, operational,and external information, enabling decision-makers to understand and act, before their com-petitors, to create sustainable shareholder value.

Executives use enhanced information capabilities to add value in all key management pro-cesses. Strategic decision-making occurs with more accurate and relevant information. Orga-nizations are better aligned through the communication and monitoring of key value drivers.Product portfolios and profitability are optimized. Customer offerings, product cross-sellingapproaches, and pricing strategies are tailored according to superior segmentations and analy-ses of sales information and customer behavior. Marketing effectiveness is improved based onthe impact of a customers’ lifetime value. Credit policies are better managed on the basis ofcustomers’ total global relationship with the business. Supply chains become more visible,allowing global and regional sourcing strategies to be pursued. Working capital and taxes areminimized and global foreign exchange positions optimized.

Accenture 2002. All Rights reserved

EconomicProjections

Financial NewsEquity Markets

Debt Markets

P&L StatementBalance Sheet

Cash FlowStatement

RevenueReporting

Cost CenterStatments

Cost byCategory

MarketDynamics

Customer NewsMarket Share

Share ofCustomer Spend

Cost to ServeCustomer

Profitability

TurnoverSatisfaction

Skill CoverageTraining

Staffing Plans

ProductionVolumes

Quality Yields

Rework CostsCapacity

Safety

SubstituteTechnologies

NewTechnologies

MarketDynamics

Industry Trends

CompetitorNews

CompetitorWins/ Losses

MarketDynamics

NewTechnologiesVendor News

Share ofVendor Sales

Global VendorSpend Analysis

360 0

Insight

Employess Markets/Customers

Operations

Competitors

Vendors/Suppliers

Financials


Responding to the Challenge

How do companies begin to develop the capability to better leverage information and createcompetitive advantage? With a focus on business value. The first, and perhaps most impor-tant, best practice for achieving business insight is to base the design of business insight capa-bilities on a rigorous analysis of what drives value in your organization. What informationneeds to be at the fingertips of decision-makers to keep them better informed, help them makebetter decisions faster, and to support tactical performance reviews?

In many organizations, technical architecture and data availability determine what informa-tion decision-makers have access to. However, the best results are achieved when the deci-sion-makers’ information needs drive the information strategy, rather than the informationthat is readily available to IT. The information needs of critical management processes comefirst, followed by what content to include (see Figure 2). The process of analyzing your com-petitors, for example, could include not only the traditional competitive wins and losses butalso market dynamics and industry trends — valuable external information that provides con-text for future action. The information needs of each management process and the resultingcontent required drive the most appropriate access and delivery channels and, finally, datamanagement 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 com-petitive advantages in cost structure, go-to-market strategy, and supply chain managementthat separate successful businesses from those getting the steak knives, or worse. Businessinsight is the capability of efficiently organizing and analyzing financial, operational, and ex-ternal 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 pro-cesses. Strategic decision-making occurs with more accurate and relevant information. Orga-nizations are better aligned through the communication and monitoring of key value drivers.Product portfolios and profitability are optimized. Customer offerings, product cross-sellingapproaches, and pricing strategies are tailored according to superior segmentations and analy-ses of sales information and customer behavior. Marketing effectiveness is improved based onthe impact of a customers’ lifetime value. Credit policies are better managed on the basis ofcustomers’ total global relationship with the business. Supply chains become more visible,allowing global and regional sourcing strategies to be pursued. Working capital and taxes areminimized and global foreign exchange positions optimized.

Responding to the Challenge

How do companies begin to develop the capability to better leverage information and createcompetitive advantage? With a focus on business value. The first, and perhaps most impor-tant, best practice for achieving business insight is to base the design of business insight capa-bilities on a rigorous analysis of what drives value in your organization. What information


FINANCIAL STRATEGY

needs to be at the fingertips of decision-makers to keep them better informed, help themmake better decisions faster, and to support tactical performance reviews?

In many organizations, technical architecture and data availability determine what informa-tion decision-makers have access to. However, the best results are achieved when the deci-sion-makers’ information needs drive the information strategy, rather than the informationthat is readily available to IT. The information needs of critical management processes comefirst, followed by what content to include (see Figure 2). The process of analyzing your com-petitors, for example, could include not only the traditional competitive wins and losses butalso market dynamics and industry trends — valuable external information that provides con-text for future action. The information needs of each management process and the resultingcontent required drive the most appropriate access and delivery channels and, finally, datamanagement and technical architecture. Value comes first, with technology being an enabler,not a destination.

Figure 2: Value-Driven Information Architecture Development

For companies that have yet to develop business insight capabilities, there are a number ofresponses.

First, respond with urgency. Management needs to take decisive action, making tough deci-sions, driving development and adoption of a common framework for performance manage-ment, isolating those elements that are truly business-unit or region specific, and standardiz-

Management Processes Information Needs

CreditManagement

StrategyDevelopment

Product PortfolloManagement

Customer RelationshipManagement

Compliance/RiskManagement

PerformanceManagement

TreasuryManagement

Supply ChainOptimization

Information Content

FinancialMarket/

CustometsVendors/Suppliers Competitors Operations Employees

Information Access and Delivery

Data Management

Interfaces Data Population Storage Application

Data RetentionReference DataPolicies and Procedures

RepotingApplication

Data Model

AnalyticApplication

ContextualInformation

VisualPresentation

Access/Distribution

Security/UserCategorization

Technical Architecture

Accenture 2002. All Rights reserved


ing cross-company. Demand adherence to a corporate standard and create governance struc-tures to manage data standards, IT development, and other critical success factors.

Second, respond with entirety. Address the entire management cycle. Integrate strategic plan-ning, business planning, and target setting with performance management. Companies mustbecome more disciplined in holding the organization accountable for stated operating objec-tives and the capability developments associated with investment. This implies that perfor-mance management is grounded in targets, plans, and initiatives built into business plans.Companies that develop performance information capabilities divorced from planning pro-cesses miss the opportunity to strengthen accountability and focus. Many mid-level managerscomplain of having to prepare voluminous reports in response to seemingly random corporatequeries. If, rather, there is agreement on what will be measured at each level of the organiza-tion, and those measures cascade from and relate to the corporate strategy, and they are thebasis for both planning/forecasting and performance reporting, management discussion andquery 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 foryour business to support decision-makers’ information requirements, then be prepared to adaptthe plan as the business evolves. Be able to dissect and articulate the plan for various compo-nents. Armed with a performance management framework and prioritized view of informa-tion, have an end state in mind for how the enterprise will manage data. What will be heldconsistent corporate-wide rather than allowed to vary by business or geography? How willdata ownership be assigned in the organization and what processes are required to maintainquality, controls, and integrity? Have a view as to how legacy applications will integrate witha central data store. What integration technologies will be required? Develop an understand-ing of what performance management applications will be employed and how they will inter-act with the data repository. Will you need an activity-based costing engine to derive productand customer profitability, or will more simplistic allocation schemes be employed? How willyour planning applications integrate with your performance reporting applications? Have aplan for how information will be distributed throughout the organization. How will standardreporting be automated and pushed out to the organization? How will online analytical pro-cessing (OLAP) technologies be employed to streamline and support high-powered analytics?Only by having a vision that informs investment in specific capabilities, coupled with a coher-ent program that governs project direction toward a common goal, will you create an inte-grated information architecture that dramatically improves the organization’s access to anduse of information (see Figure 3).


FINANCIAL STRATEGY

Figure 3: Components of Information Architecture

Lastly, respond with action. Start taking the steps now to move your company in the rightdirection. A number of short-term actions can be taken to begin developing the competence inmanaging an enterprise performance information capability.

Begin by moving the organization toward common management metrics and planning pro-cesses. Establish corporate key operating metrics. Drive management discussions around thesemetrics, and demand that individual components of the business use metrics aligned with thestated corporate metrics. While this concept has been an established leading practice for over adecade, many companies have yet to take this crucial step.

For performance reporting and analytics, determine the most urgent management process in-formation needs and start there. For some organizations, procurement processes yield signifi-cant, measurable value from improved information. In the Unilever example, customer andproduct profitability were determined to be of high value as well. Create a positive case studywithin a specific management process to serve as an internal reference for the power of im-proved decision support.

With your data architecture, begin the process of creating a common taxonomy. Start with themost valuable elements, such as customers. Launch projects to standardize data companywideand institute organization control and data ownership. Drive consolidation and rationaliza-tion 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 meanforcing individual user groups to postpone the gratification of constructing their one-off re-porting tools.

Drive toward an integration standard. Select, pilot, and demonstrate the power of an integra-tion technology. In operational applications, allow for variation across division and geogra-

KPI DefinitionsReporting HierachiesData StandardsBook/Tax COAs

External ReportingInternal Reporting /AnalysisAd Hoc Query/OLAPScoreboards/Dashboards

External DataUnstructured Data

Integration TechnologiesERP/Legacy Application

Applications

Reportingand Analysis

InformationHub

ReferenceData

Workflow Collaboration

Admin/ DevITools

Security

SourceSystems

Planing/ModelingBudgeting/ForecastingConsolidationABC/Dimenensional Profitability


phy where required, but control nonessential variation in application development and datastructures.

These short-term measures can begin to shift the organization’s thinking about the manage-ment of information and create the discipline associated with leading practice performanceinformation.

Looking Forward at Last

For far too long, performance management and reporting has been a backward-looking exer-cise or a guessing game. Finance executives have analyzed the impact of prior decisions andresults to determine how future plans should be developed to improve results or decreaserisks. They have monitored trends for key business drivers and attempted to identify the causesof variance in operating performance.

Business insight allows you to look ahead. In the near term, you can easily identify trends, keydrivers, and other factors that influence chosen business strategies. You can make capital allo-cation 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 thechief executive’s primary strategy resource. Based on corporate positions and projections ofthe major factors driving strategy, you can create long-term business strategies. Business in-sight enables you to choose appropriate industries in which to compete, and it enables you toidentify the major factors that will influence your company’s ability to grow, compete, andremain profitable. Equally important, you can develop credible early warning systems thatidentify challenges when company positions are incorrect.

As the chief financial steward of a nimble organization, you will more effectively deliver thecritical information that decision-makers and frontline operators need to make faster, moreeffective decisions. Based on better insight into internal and external business circumstances,your company will understand, act, and prevail, conquering competitors and creating signifi-cant (and sustainable) shareholder value.


FINANCIAL STRATEGY

SECTION - 3

ALTERNATIVE FINANCING STRATEGY IN THECONTEXT OF REGULATORY REQUIREMENTS

This Seciton includes

3.1. REWULATORY REQUIREMENTS - WHY AND HOW ITAFFECT 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 adequatelycapitalized to meet multiple objectives. The best example would be the case of banks whichaccept deposits from the public and deploys the generated funds across various assets likecorporate and retail loans. Since public confidence is the foundation for banks survival, regu-latory authorities prescribe adequate capital for the banks to be maintained, known as theCapital 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 theRBI guidelines on the creation of necessary risk management architecture and also the guide-lines on Basel II. Capital Adequacy computation has to be done under Basel II requirementseffective March 31, 2008.

Credit risk is the risk of default from the borrowers. Operatinal risk is the risk of some of theprocedures going wrong and market risk is the risk of market volatility affecting the values ofbanks’ investments in various financial assets.

According to Basel committee norms, banks have to maintain adequate tier I capital as acushion to take care of all these risks and protect the depositors. Risk is inherent in the natureof the banking business. The Reserve Bank of India prescribes a risk weight for the variousassets of a bank like the corporate loans, retail loans and the investments in financial assetslike bonds, shares, derivatives etc. Using these weights, the risk weighted assets are com-puted. Banks have to maintain 10% capital adequacy ratio, which means that the banks tierI 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 require-ments affect the capital structure of a bank. Insurance companies are also subjected to thiskind of capital adequacy ratios. Banks and Non-banking finance companies can raise debtup to 10 times of net worth of the company.

� Rewulatory Requirements - Why and how it affect the choice of one’s CapitalStructure


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 thepromoters bring adequate money as equity contribution. Therefore, when a corporate firmgoes for borrowing for a project, it has to bring sufficient equity or deploy the internal accru-als to satisfy the requirements of the banks.

The following example illustrates this point.

NPV 52.394,39 IRR 19,83%

TRISTAR FOODS plcInput dataCost of new machine 150,000 Salvage value of new mach 10,000 Production (lts. Per day) 300 Working days per year 300 Working life of machine (ye 6 Income per lt. (net) 0.80 Salvage value of old machi 5,000 Warehouse cost 15,000 Allocated cost of marketing/ 20,000 Increase in working capital 5,000 Depreciation rate 25%Corporate tax rate 30%Capital gains tax rate 30%Opportunity cost of capital(D 12.5%Post tax cost of debt 8.8%

ESTIMATION OF CASHFLOWSYEAR 0 1 2 3 4 5 6

COST OF NEW MACHINE (150,000) SALVAGE VALUE (OLD MAC 5,000 CHANGE IN WORKING CAPI (5,000) 5,000 SALVAGE VALUE (NEW MACHINE) 10,000 REVENUE 72,000 72,000 72,000 72,000 72,000 72,000 DEPRECIATION (37,500) (37,500) (37,500) (37,500) EBIT 34,500 34,500 34,500 34,500 72,000 72,000 EBIT*(1-T) 24,150 24,150 24,150 24,150 50,400 50,400 OPEARTING CASH FLOW 61,650 61,650 61,650 61,650 50,400 50,400 CAPITAL GAINS TAX -1500 (3,000) WAREHOUSE COST (15,000) (15,000) (15,000) (15,000) (15,000) (15,000) CASHFLOWS (151,500) 46,650 46,650 46,650 46,650 35,400 47,400


FINANCIAL STRATEGY

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

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

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

� (Net operating profit before long term interest and depreciation and after tax)/(In-stalment + long term interest )

� Debt service coverage ratio protects the annual amount due to the lender namely theinterest and instalment amount. There has to be adequate coverage for this say about2.0 times.

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

=Nopat+Depreciation 61650 61650 61650 61650 50400 50400Instalment 23159 23159 23159 23159 23159 23159DSCR 2,66 2,66 2,66 2,66 2,18 2,18 2,50

• The table above shows the debt service coverage ratio and the average debt serviceratio for all the years which is 2.5. This means how much of debt is shown in thefollowing table:

Total investment 150000Debt 1,67 1,00Debt 93881,33Equity 56118,67

Instalment amountDebt 93881,33Interest 0,13Term 6,00Instalment amount 23158,63

• This table shows that a debt equity ratio of 1.67 will be optimum to support 2.5 debtservice coverage ratio. This means that the bank will lend 93881.33 and the promoterhas to bring 56118.67. Of course, generally the amounts would be rounded off tonearest reasonable lacs for ease of accounting.


SECTION - 4

MODELING AND FORECASTING CASH FLOWSAND

FINANCIAL STATEMENTS


4.1. MODELEING AND FORECASTING CASHFLOWS ANDFINANCIAL STATEMENTS

Financial strategy requires knowledge of alternatives available. The alternatives have tobe each with different new aspect adding value to the proposition. A robust financialmodel that can facilitate exploration of the consequences of the various alternative choiceswill be most useful for a finance manager to quickly understand the implications of in-creasing debt to equity ratio, or a change in tax structure and how it affects the earningsper 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 forforecasting cash flows, financial statements and valuation of the firm.

� Modeleing and Forecasting Cashflows and Financial Statements.

Sales growth 10%Current assets/Sales 15%Current liabilities/Sales 8%Net fixed assets/Sales 77%Costs of goods sold/Sales 50%Depreciation rate 10%Interest rate on debt 10.00%Interest paid on cash and marketable securities 8.00%Tax rate 40%Dividend payout ratio 40%

Year 0 1 2 3 4 5Income statementSales 1,000 1,100 1,210 1,331 1,464 1,611 Costs of goods sold (500) (550) (605) (666) (732) (805) Interest payments on debt (32) (32) (32) (32) (32) (32) Interest earned on cash and marketable securities 6 9 14 20 26 33 Depreciation (100) (117) (137) (161) (189) (220) Profit before tax 374 410 450 492 538 587 Taxes (150) (164) (180) (197) (215) (235) Profit after tax 225 246 270 295 323 352 Dividends (90) (98) (108) (118) (129) (141) Retained earnings 135 148 162 177 194 211


FINANCIAL STRATEGY

• This part of the model shows the projected income statement based the basic as-sumptions. These assumptions can include capital structure changes like debt, eq-uity, leasing etc.

Balance sheetCash and marketable securities 80 144 213 289 371 459 Current assets 150 165 182 200 220 242 Fixed assets At cost 1,070 1,264 1,486 1,740 2,031 2,364 Depreciation (300) (417) (554) (715) (904) (1,124) Net fixed assets 770 847 932 1,025 1,127 1,240 Total assets 1,000 1,156 1,326 1,513 1,718 1,941

Current liabilities 80 88 97 106 117 129 Debt 320 320 320 320 320 320 Stock 450 450 450 450 450 450 Accumulated retained earnings 150 298 460 637 830 1,042 Total liabilities and equity 1,000 1,156 1,326 1,513 1,718 1,941

• This part of the model shows the projected balance sheet based on the earlier as-sumptions

Year 0 1 2 3 4 5Free cash flow calculationProfit after tax 246 270 295 323 352Add back depreciation 117 137 161 189 220Subtract increase in current assets (15) (17) (18) (20) (22)Add back increase in current liabilities 8 9 10 11 12Subtract increase in fixed assets at cost (194) (222) (254) (291) (333)Add back after-tax interest on debt 19 19 19 19 19Subtract after-tax interest on cash and mkt. securities (5) (9) (12) (16) (20)Free cash flow 176 188 201 214 228

Valuing the firmWeighted average cost of capital 20%

Year 0 1 2 3 4 5FCF 176 188 201 214 228Terminal value 2,511Total 176 188 201 214 2,740

NPV 1,598 <-- =NPV(B56,C61:G61)Add in initial (year 0) cash and mkt. securities 80Enterprise value 1,678Subtract out value of firm's debt today -320Equity value 1,358

• The third part of the model shows how from the projected income statement andbalancesheet, 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 simulationfor quantifying risk and generating control parameters


SECTION - 5 & 6

SENSITIVITY ANALYSIS FOR CHANGES IN EXPECTEDVALUES IN THE MODELS AND FORECASTS


5.1. SENSITIVITY ANALYSIS FOR CHANGES IN EXPECTED VALUES

Sensitivity analysis refers to studying of the impact of changes on one or more variables onthe results, which can either be NPV or IRR or EPS etc. This will help in understanding thecritical variables on which the results depend. It is also one way of understanding the risksrelated to a project or policy. The following illustration shows how sensitivity analysis can beperformed 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 sensi-tive to certain aspects such as raw material price, power cost, selling price etc the man-agement has to provide adequate weightage to these aspects before the investmentdecision is frozen.

5.1.2 Likewise, the lending institutions also heavily depend on this analysis before they de-cide on lending quantum or lending itself. If a project is very sensitive to some param-eters and if the lender perceives them as critical, the decision of lending is based verymuch on that.

5.1.3 The ratios after sensitivity and before sensitivity such as IRR and ROCE would indicatethe level of sensitivity.

� Sensitivity analysis for changes in expected values


FINANCIAL STRATEGY

DataCost of capital 15%Tax rate 35%Capital Expenditure 278 millionSalvage value 30% (percent of capital expenditure)Year 0 1 2 3 4 5 6Price per unit 250.00 250.00 230.00 225.00 225.00 210.00Volume(in million) 1.20 2.10 3.00 3.00 2.20 1.40COGS(per unit) 80.00 80.00 70.00 70.00 70.00 85.00SG & A(in million) 15.00 15.75 16.75 18.00 19.25 20.50 22.00Depreciation(%) 20.00% 32.00% 19.20% 11.52% 11.52% 5.76%Wcap/Forward revenue 9.00% 9.00% 8.00% 7.00% 7.00% 7.00%DerivationsAnnual Depreciation 55.60 88.96 53.38 32.03 32.03 16.01Accumulated Depreciation 55.60 144.56 197.94 229.96 261.99 278.00Book value 278.00 222.40 133.44 80.06 48.04 16.01 0.00Working capital 27.00 47.25 55.2 47.25 34.65 20.58 0.00Salvage value 83.40Cash flow templateRevenue 300.00 525.00 690.00 675.00 495.00 294.00COGS -96.00 -168.00 -210.00 -210.00 -154.00 -119.00SG & A(in million) -15.00 -15.75 -16.75 -18.00 -19.25 -20.50 -22.00Depreciation -55.60 -88.96 -53.38 -32.03 -32.03 -16.01Profit on sale of assets 83.40Taxable income -15.00 132.65 251.29 408.62 413.72 288.47 220.39Tax 5.25 -46.43 -87.95 -143.02 -144.80 -100.97 -77.14NOPAT -9.75 86.22 163.34 265.61 268.92 187.51 143.25Depreciation 55.60 88.96 53.38 32.03 32.03 16.01Salvage value -83.40Operating Cash flow -9.75 141.82 252.30 318.98 300.95 219.53 75.86Change in working capi -27.00 -20.25 -7.95 7.95 12.6 14.07 20.58Capital Expenditure -278.00Cash from asset sale 83.40Free cash flow -314.75 121.57 244.35 326.93 313.55 233.60 179.84NPV 563.86IRR 63%

� The above financial model shows all the assumptions, derivation of cash flowsand the results namely the NPV and IRR, in the context of a capital budgetingproject

� This can be a good practice exercise for students in excel


Sensitivity analysis Cost capital and NPV

563.860.15 563.860.20 450.760.25 358.400.30 282.120.35 218.460.40 164.840.45 119.28

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

6.1.1 Capital expenditure, NPV and IRR

Sensitivity analysisCapex, NPV and IRR

563,86 63%280 562,51 62,97%300 549,02 59,66%350 515,32 52,66%400 481,61 47,00%450 447,90 42,33%500 414,20 38,39%800 211,96 23,35%

1000 77,13 17,54%1200 -57,70 13,36%

• This table shows the impact of capital expenditure changes on the results of the projectnamely the NPV and IRR

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

6.1.0 Illustration of sensitivity analysis- Cost of capital and NPV


FINANCIAL STRATEGY

• This table shows the impact of cost of capital and capital expenditure on the NPV ofthe 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 costof capital and capital expenditure with in certain boundaries so that the project doesn’tbecome unviable

6.1.2 Capital expenditure and cost of capital on NPV

Sensitivity analysis-Capex, Cost of capital and NPV

563.9 0.2 0.2 0.3 0.3 0.4280.0 562.5 449.3 356.9 280.6 216.9300.0 549.0 435.0 341.9 265.0 200.8350.0 515.3 399.1 304.3 226.0 160.7400.0 481.6 363.3 266.7 187.0 120.5450.0 447.9 327.4 229.1 148.0 80.4500.0 414.2 291.5 191.5 109.0 40.3800.0 212.0 76.3 -34.0 -124.9 -200.6

1000.0 77.1 -67.1 -184.4 -280.9 -361.11200.0 -57.7 -210.6 -334.7 -436.8 -521.6


SECTION - 7

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 pe-riod of time in the world of corporate finance. In the past, thick monthly reports tomanagement were the norm. There are still some companies who believe in quantityover quality. In many companies, managers and executives are drowning in data. Thefinance team foists reams of information on them every month, churning out huge re-ports 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 morePowerPoint slides, full of tables, thousands of numbers, and expecting them to pick outkey 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” de-tails to focus on “what really drives the business.” The need of the hour for the corpo-rate analysis team is to produce a slim booklet and the data contained inside more fo-cused, more graphical and more colorful, with major deviations against budgeted tar-gets marked in green (favourable) and red (adverse). The non-financial data and reportsshould include metrics on operational efficiency and customer satisfaction, along withprogress updates on groupwise initiatives such as the implementation of CustomerRelationship Management (CRM) software and supply chain rationalization, amongother things.

7.1.4 If this kind of more streamlined, targeted way of reporting is practised, managementcommittee and board meetings will be more productive. The top management can fo-cus not only on understanding and highlighting the relevant issues, but can also discussthe action plan.

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

� The actual state vs. the desirable state

� Information Overload

� Emerging Trends in Financial Reporting


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 orperformance management software from the likes of Cognos, Hyperion and SAS. “Bygiving managers the option of access to much more data on their own systems, youdon’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 inParis, 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 tohelp 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. Asa core competence of the finance division, it is up at the top along with matching costsagainst revenue and ensuring that taxes are paid.

7.2.2 However, it is surprising how often the process goes awry. Once companies have gonethough improvements such as standardizing data, for example, by agreeing simple defi-nitions of operating profit throughout the group, many stop there and end up produc-ing 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 ofthe number crunching themselves, management reports remain stubbornly thick andunwieldy. According to a survey of 400 large companies worldwide undertaken re-cently, 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 datathat 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 financialperformance: 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 under-stands best and what it’s most comfortable with. But that doesn’t necessarily help man-agers 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 amajor burden on finance.

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


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 producetheir own reports, monthly reporting won’t become extinct. There will always be aneed for actionable, summary-level information.

7.3.2 The summary of a report titled “Financial Reporting Supply Chain”, brought out re-cently by the International Federation of accountants is quite illuminating and is ap-pended 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 downthe volume of data produced, while putting more weight on forward-looking internal andexternal metrics such as regional sales forecasts, market share, competitor pricing and broadereconomic indicators. They have pioneered this new approach to support their growth agendawhile giving the executives interactive analysis capabilities, providing a common approach tofinancial analysis and also communication.

Unilever used a tool from a U.K. vendor, Metapraxis, Empower.NET, now, each month themanaging director and CFO of each country receive a simple, ten slide executive summarythat doubles as an interactive dashboard, through which information can be filtered and per-sonalized. 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 relevantstrategic and tactical information in a standardized format.

There have been other benefits too, not least in speed — consolidated regional data is nowreported up to group level in four days, down from eight — and the information gatheringburden on the regional finance staff is lighter.

Magyar Telekom:

When it comes to the distillation of key performance data, however, few finance executivescan match the record of Klaus Hartmann, CFO of Magyar Telekom, the HUF604 billion ($2.92billion) 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 processlarge amounts of operational and historical data according to their own needs. But that wasn’tinstalled 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 theexecutive committee soon echoed in his ears. “ ’We’re being killed by too many reports,’ theytold me. ‘It’s hard to read them all and find which ones are essential.’ ”


FINANCIAL STRATEGY

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

SUMMARY OF KEY FINDINGS

FINACIAL REPORTING SUPPLY CHAINCurrent perspective and directions

In recent years, there have been significantefforts to change and improve financial re-porting. What is the result of these change?Has the financial reports process become bet-ter or worse? Have the financial reports be-come more or less relevant, reliable and un-derstandable? What should be done next? TheInternational Federation ofAccountants(IFAC) commissioned an inde-pendent global survey of the participants inthe financial reporting supply chain to getfeedback on these questions. In June and July2007, the survey group conducted a globalsurvey that yield 341 responses from aroundthe world and from all parts of the financial

reporting supply chain, including users,preparers, auditors, standared setters andregulators. The survey group also conducted25 telephone interviews from August to Oc-tober 2007. This report is based on the find-ings of the global survey and interviews, aswell as on additional research.Participants in the survey and interviewswere asked about their opinions on four ar-eas of financial reporting supply chain:Corporate governance, the financial report-ing process, the audit of financial reports andthe usefulness of financial reports. Below isa brief overview of the findings that are dis-cussed in more detail in the report.


In recent years, there have been significantefforts to change and improve financial re-porting. What is the result of these change?Has the financial reports process become bet-ter or worse? Have the financial reports be-come more or less relevant, reliable and un-derstandable? What should be done next? TheInternational Federation ofAccountants(IFAC) commissioned an inde-pendent global survey of the participants inthe financial reporting supply chain to getfeedback on these questions. In June and July2007, the survey group conducted a globalsurvey that yield 341 responses from aroundthe world and from all parts of the financial

reporting supply chain, including users,preparers, auditors, standared setters andregulators. The survey group also conducted25 telephone interviews from August to Oc-tober 2007. This report is based on the find-ings of the global survey and interviews, aswell as on additional research.Participants in the survey and interviewswere asked about their opinions on four ar-eas of financial reporting supply chain:Corporate governance, the financial report-ing process, the audit of financial reports andthe usefulness of financial reports. Below isa brief overview of the findings that are dis-cussed in more detail in the report.

Survey Results on Corporate Governance

Corporate Governance has improved and the balance between costs and benefits has becomebetter. (See page 11.)

AREAS OF CONCERN

� Governance in name but not in spirit

� Development of a checklist mentality

� Overregulation

� Personal risk and liability for directors and management

POSITIVES

� Increased awareness that good governance counts

� New codes and standards

� Improved board structure

� Improved risk management and internal control

� 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


FINANCIAL STRATEGY

AREAS OF CONCERN

� Transition to International Financial Reporting Standards

(IFRS)

� Complying/reconciling accounts to different financialreporting standards

� Complexity of financial reporting standards

� Liability restricting process

POSITIVES

� Convergence to a single set of global financialreporting standards.

� Improvements to regulations and oversight

� Board of directors/management taking ownership offinancial reporting

� Improved internal control over financial reportingsystems

� Improved technology for preparing financial reports


� Continue convergence to one set of financial reporting standards

� Simplify and clarify financial reporting standards - more principles andfewer rules

� Ensure that boards of directors pay attention to quality of financialreports

� Provide additional education and training for preparers

Survey Results on the Financial Reporting Process

The financial reporting process has improved and balance between cost and benefits is aboutthe same. (See page 16.)

Survey Results on the Audit of Financial Reports

The audit of financial reports has improved and balance between costs and benefits is aboutthe same.(See page 22.)

POSITIVES

� Improved auditing standards and processes

� Increassed awareness, commitment and competenceof auditors and audit committees

� More risk-focused audits

� Greater auditor independence

� Improved quality review and auditor oversight


� Continue to focus on indepndence, objectivity and integrity

� Converge to one set of global, principals-based auditing standards overtime

� Ensure consistent use of audit standards and safeguarding of qualitywithin audit firms

� Improve auditor’s Communication, both internally and externally

� Consider limited/proportionate liability for auditors

� Remove barriers that limit choice of auditor

AREAS OF CONCERN

� Reduced scope for professional judgment

� Overregulation

� Liability fear leading to boilerplate audits and lack ofinnovation

� Liability auditor’s communication with external stakehold-ers

� Limited choice of audit firms

� Increased audit cost relative to perceived benefits


Survey Results on Usefulness of Financial Reports

The relevance and reliability of financial reports have improved, but the understandability offinancial reports has not improved. Respondents preferred annual reports to real time or monthlyinformation, found analyst presentations useful, and world like to have more business-driveninformation. The survey also showed mixed results about the usefulness of XBRL. In addition,paper financial reports remain useful. (See page 28)

AREAS OF CONCERN

� Reduced usefulness due to complexity

� Focus by companies on compliance instead of essence ofthe business

� Regulatory disclosure overload

� Use of fair value

� Difficult and often changing financial reporting standards

� Lack of forward looking information

POSITIVES

� Better financial information due to improvedstandards, regulation and oversight

� More disclosure and comparability in financialreports

� Improved reliability

� Increased emphasis on narrative reporting

� Easier access to financial information


� Improve communication within the financial reporting supply chain

� Include more business-driven information in financial reports

� Better align internal and external reporting

� Improve users’ 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 keyareas of the financial reporting supply chain-corporate Governance, theprocess of preparing financial reports and the audit of financial reports-have clearly improved in the last five years. Unfortunately, however,they do not feel that the products of this supply chain, the financialreports, have become more useful to them. To resolve this situation,there needs to be continuing effort made by all participants to discussand debate the purpose and objectives of financial reporting so that theinformation that is reported best suits the information needs of the widerange of users.


FINANCIAL STRATEGY

Better Performance Reporting and Analysis

Increasingly, finance and business unit managers are seeking to respond to threats and oppor-tunities 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 theircompanies amid increasing competition, regulatory oversight, and higher investor and boardexpectations. Executives need to be able to report timely, accurate data on historical perfor-mance, to be sure.

Increasingly, however, finance and business unit managers seek to respond to threats andopportunities 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 andanalyze financial information. What do their companies do well? Which stakeholders are well-or ill-served with information and analysis tools? And what barriers do companies face whentrying to improve their financial reporting and analysis capabilities?

In addition, we wanted to understand how executives’ views on these and other matters varyaccording to their companies’ strategy for finance systems technology — that is, do companiesthat have invested aggressively have different views on their ability to gather, report, andanalyze information?

To gauge finance executives’ opinions on these topics, CFO Research executed an electronicsurvey to readers of CFO magazine in November 2005. Our research program gathered a totalof 164 responses from senior finance executives — more than half of whom work for compa-nies with $1 billion or more in annual revenue. Our solicitation to participate in the survey wasfocused on senior finance executives and, as a result, respondents’ titles are typically chieffinancial 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 manufactur-ing, financial services, consumer products, and wholesale/retail trade industries particularlywell represented.

Queried on their satisfaction with the ability of their finance teams to execute a list of reportingand 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 trans-action-processing capabilities, and nearly 80 percent of respondents express this view of theirexternal reporting and regulatory compliance capabilities. It seems clear from this data thatcompanies’ investments over the last several years in basic financial management technologyand process improvements have paid off.

But management reporting and the elements most closely tied to a company’s ability to planand execute company strategy are rated less favorably by survey respondents. As shown inFigure 1, respondents express greatest dissatisfaction with their abilities to plan, budget, and


forecast, to conduct ad hoc analyses, and to support business decisions such as M&A restruc-turing, product pricing, and so on.

These results are wholly in line with recent trends in finance and in business more generally, ascompanies have responded to the pressure of heightened regulatory scrutiny and higher in-vestor expectations by investing heavily in transaction processing, basic consolidation andreporting, and compliance technology and systems.

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 post-poning investments to support forward-looking activities such as planning, budgeting, andforecasting, ad hoc decision support, and internal reporting to decision makers.

Survey data on stakeholders’ satisfaction with their access to timely and accurate performancedata shows, on one hand, a largely satisfied community of investors, executives, and managerswithin finance and business units. More than 70 percent of top executives and external users ofcompany performance information are somewhat or very satisfied with their ability to gettimely and accurate performance data, say survey respondents (see Figure 2).

Fingure 1. Forward-looking, analytical view is rated most poorly by seniorfinance executives.

How satisfied are you with your finance team’s ability to execute corefinance activities?

Dissatisfacation with execution

Planning budgeting and forcasting

Adhocanalyses and decision sup-port (eg, M&A restructuringproduct 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)


FINANCIAL STRATEGY

Less satisfied, says the survey data, are those who rely on such information — and seek tobuild on it with additional analysis — to make day-to-day operating and investment decisions.Financial systems end users and the finance and general management teams of business unitsare consistently less satisfied with their access to high-quality information. Thus, those whoare most likely to be called on to work with information to create plans, make decisions, and doother analytical work — rather than reviewing the work of others — are least satisfied with theinformation at their disposal.

In an effort to understand which pieces of management reporting and analysis are most inneed of improvement, we asked finance executives to rate how well their processes and sys-tems equip them to meet a broad array of reporting and analysis objectives. A majority ofsurvey respondents say their processes and systems to allow what-if scenario analysis and togive end users flexible desktop access to additional information needs improvement (see Fig-ure 3). Tools for static reporting on business performance and even on line-item details inbudgets and results were rated more favorably.

Figure2. Those closest to doing analytical work and making operating deci-sion are least satisfied with their access to information.

How satisfied are the following stakeholders with your comany’s ability toprovide timely, accurate, reliable information on business performance?

Executive management

External Stakeholders (eg,invenstors,analysts, and creditors

Corporate finance department

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

0% 20% 40% 60% 80% 100%

Business unit finance department

Business-unit management

End users of financial Systems


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

Figure3. Dynamic use and analysis of performance information requiresimprovement more often than static reporting capabilities

How well do your processes and technology support the follwingmanagement reporting objectives?

Allowwhat -if scenario analysis

Give end users flexible desktopaccess to additional infromation

Prepare reports usefulfor decision making

Prepare unimpeachable repots onactual business performance

Prepare timely reports on actualbusiness performance

Provideend users with line item detailon budgets and results

Needs improvement Adequate Excellent

0% 50% 100%

(Percentage of respondents)


FINANCIAL STRATEGY

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

Figure4. Tools and information required for day- to-day decisionmaking are rated poorly

How well do your processeand Systems support the following activities?

Give end users sufficient what- if analysiscapability

Provide access to non-finan cial perfor-mance information

Give decision makers the right informationat the right-time

Provideend users with familiar user interface

Comparison of planned performance versusactual performance

Allow managers to restrict end-user accessto certain information

Maintain security of financial date

09% 20% 40% 60% 80% 100%

Poorly Adequate well

Percentage of respondents


Transparency Is Everyone’s Responsibility From the University of Virginia: Both financeand non-finance executives learn that ‘’thebetter the financial reporting, the better the valu-ation.

’’Marie Leone, CFO.comJuly 30, 2004

Nearly three years after Enron filed for bankruptcy, corporate accounting scandals continue tomake headlines.

In the past few months, for example, the Securities and Exchange Commission charged SiebelSystems with violating Regulation Fair Disclosure (Reg FD) for the second time in four years;the SEC charged Lucent Technologies with “fraudulently and improperly” recognizing $1.15billion 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 TheDarden School of the University of Virginia have found a way to put such cases to good use ina course aimed at helping executives cope with the broader regulatory fallout. “Our programwill be driven by situations pulled from the headlines, so we can focus on corrective and pre-ventive measures,” asserts Mark Haskins, a professor of business administration at Darden.

The course’s intent, however, “is not to dwell on the headlines,” says Haskins, “but to use themto galvanize the conversation and understand the root causes.”

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

Figure 5. Better analysis tools yield business benefit

In your opinion, improvingwhich two of the following attributes of yourCompan’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%


FINANCIAL STRATEGY

“Financial Stewardship in a World of Financial Scrutiny” is designed to bring managers up tospeed on various “accounting shenanigans” by supplying them with a “heavy dose of finan-cial expertise,” according to the professor. To that end, the three-day session covers six financetopics: the external reporting environment; financial-statement analysis; shareholders’ infor-mation 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 theprogram 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 administra-tion professor, plan to plunge into some heavy legal territory, notably the Securities Acts of1933 and 1934, Reg FD, and the Sarbanes-Oxley Act of 2002. They intend to pay special atten-tion to the financial-statement-certifications that Sarbanes-Oxley mandates for CEOs and CFOsand on the cascading impact of those signoffs on operating managers. What’s more, the profes-sors aim to discuss financial-reporting transparency, including revenue-recognition policies,management’s disclosure and analysis, the debate on expensing stock options, and pension-fund liabilities.

But the intent of the course isn’t to provide a mastery of the rules. Instead, Haskins wantsattendees to leave the classroom with a better sense of how to spot accounting games, such asthose involving irregular revenue-recognition. The professor also hopes to help attendees de-velop 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 greaterfinancial transparency. He points out, however, that many executives forget that transparencyis not relegated to green-eyeshade types in the finance department. The responsibility for accu-rate financial reporting ripples through the entire organization — is why the course targetsmore than financial executives.

Indeed, most of the course’s participants likely will be referred to it by CFOs with holisticviews 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 divisionsor business units. On the other hand, the program isn’t likely to resonate with not-for-profitexecutives 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 No-vember 16 to November 19. The course will be based on case studies to show how executivescan make practical use of the tactics and strategies, according to Haskins, but theories of finan-cial-statement preparation and corporate valuation won’t be ignored.

Participants, who will be taught how to derive valuations for their own companies, are encour-aged to bring their employers’ financial statements to class. The valuation instruction will in-clude 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 “thebetter the financial reporting, the better the valuation.”


STUDY NOTE - 6

INVESTMENT DECISIONS

SECTION - 1COST, BENEFITS AND RISKS ANALYSIS FOR

PROJECTS

1.1. INVESTMENT APPRAISAL

1.1.1 One of the key analysis in long-term decision-making that firms must tackle is that ofcost 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 greaterthan the funds committed. In order to handle these decisions, firms have to make anassessment of the size of the outflows and inflows of funds, the lifespan of the invest-ment, the degree of risk attached, the cost of obtaining funds and return thereon. Deci-sions on investment, which take time to mature, have to be based on the returns whichthe 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 oruneconomic.

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

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.

1.1.3 Investment appraisal involves appraising the investment alternatives and selecting thebest alternatives.

� Investmwnt Appraisal

� Investment Appraisal Methods




1.1.4 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 forproductivity improvement.

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

d. Diversification – exploring new lines of business.

1.1.5 Even the projects that are unlikely to generate profits should be subjected to investmentappraisal. This should help to identify the best way of achieving the project’s aims. Forinstance, investment appraisal may help to find the cheapest way to provide a new staffcanteen, 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 thebenefits of investing large capital sums outweigh the costs of these investments. Therange of methods that business organizations use can be categorised one of two ways:traditional methods and discounted cash flow techniques. Traditional methods includethe 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 havebeen discussed in detail in Module 2.

1.2.3 Linking investment with customer requirements: Investment decisions must be relatedto the competitive advantage of the firm. The investments in technology or expansionor modernization etc must result in customer value creation. This is possible only if afirm constantly stays focused on customer value discovery and creation. The competi-tive advantage of a company can be sustained only by continuous creation of customervalue. The competition among firms is only for delivering a better customer value whencompared to that of competitors. The key challenge for a firm is to choose the rightinvestment that will ensure better customer value. Thorough market intelligence is ofparamount importance for taking an investment decision.

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

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


scientific way of orchestrating all the resources and managing the time to market effi-ciently. The company has to think long term for identification of opportunities for com-petitive advantage. Sometimes, take over of another company may be a good invest-ment opportunity. Similarly, forward integration or backward integration may be add-ing to competitive advantage through enhanced customer value.

1.2.6 Designing capital structure: When once the new investment opportunities have beenidentified, the firm needs to design an appropriate capital structure for funding theproject. Here there are several options. If the company is reasonably sure of the successof the project, its profitability and its cash flows, the company may use more of debt. Ifthe project is conceived as a new idea, the company can approach Venture Capital Fundsor Private Equity funds. The company can also raise funds through the Initial PublicOffering or Seasonal Public Offering. Optimum capital structure is hard to define. Therehas been a lot of debate about this in the finance literature. Debt is certainly a low costfund compared to equity from the perspective of risk and return. Debt cost is also lowerdue to the tax shield offered by way of interest. Equity cost is determined by the capitalasset pricing model. If we go on substituting high cost equity with low cost debt, theweighted 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 willincrease the cost of debt due to the threat of bankruptcy as debt involving fixed commit-ment becomes a threat in times of lower profitability. There is also a theory of matchingthe 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 theprojects is very essential to avoid Asset Liability mis-match. ALM is one of the keyfunctions of a finance person in any company.

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



SECTION - 2REAL OPTIONS IN CAPITAL INVESTMENT DECISIONS

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 in-vest 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 extendhis factory to another party, only he can make this decision; however, some real optionscan be sold, e.g., ownership of a vacant lot of land is a real option to develop that land inthe future. Some real options are proprietary (owned or exercisable by a single indi-vidual 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 mutuallyexclusive.

2.1.2 The terminology “real option” is relatively new, whereas business operators have beenmaking capital investment decisions for centuries. However, the description of suchopportunities as real options has occurred at the same time as thinking about such deci-sions in new, more analytically-based, ways. As such, the terminology “real option” isclosely tied to these new methods. The term “real option” was coined by Professor StewartMyers 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 Financeat the Columbia School of Business. Mauboussin uses real options to explain the gapbetween the stock market prices and the “intrinsic value” for those businesses as calcu-lated by traditional financial analysis.

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

� Introduction

� Terms 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



lent Martingale approach). Cash flows can then be discounted at the risk-free rate. Withregular DCF analysis, on the other hand, this uncertainty is accounted for by adjustingthe discount rate, using e.g. the cost of capital or the cash flows (using certainty equiva-lents). These methods normally do not properly account for changes in risk over aproject’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 assump-tions underlying their projections.

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

2.2. TERMS AND DEFINITIONS

Strategic NPV = Passive NPV + Present value of options arising from the activemanage ment of the firm’s investment opportunities

2.2.1 The terms 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 specifiedprice (the exercise price). A call option is the right to buy. A put option is the right tosell.

2. The expiration date is the date when the option matures. An American option is exer-cisable anytime until the end of the expiration date while a European option is exer-cised only at the expiration date.

3. The writer of an option contract sells the call or put option while the buyer purchasesthe option contract from the seller. For real options, the firm is the implied buyerand 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 theexercise price of the call and in-the-money when the price of the underlying assets isabove the striking price of the call. The opposite is true for a put option, which is out-of-the-money when the price of the underlying assets is above the striking price of thecall and in-the-money when the price of the underlying assets is below the strikingprice of the call.

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



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:

2.4. REAL OPTIONS IN CAPITAL INVESTMENT DECISIONS

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

P0 Price of the underlying asset PV of expected operation CFs discounted at(i.e., stock price) the project’s cost of capital

X Exercise price For call options—the initial investment.For put options—the value of the project’sassets if sold or shifted to a more valuable use

T Time until the option expires Time until the option expires or is no longeravailable

Krf Risk-free rate of interest Risk-free rate of interest (use the yield on U.S.T-bills)

Σ Standard deviation of the Project risk - standard deviation of the operunderlying asset (volatility ating cash flow as a percent of total investof stock price) ment

Symbol Factor as it relates to stock Factor as it relates to capital budgetingoption value

Option: Valued as a :

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


2.5. A COMPARISON OF OPTIONS PRICING MODELS

2.6. ILLUSTRATION OF OPTIONS APPROACH TO VALUATIONAND INVESTMENTS

Before we go into the options approach to investments, we will briefly recap the Black& scholes option pricing model.

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

Binominal Model Black-Scholes Model

Description *assumes that the time to an option’s *the binomial modelmaturity can be divided into a number estimated over anof subintervals, in each of which, there nfinite number of sub-intervalsare only two possible price changes

Advantages *easier for executives to understand *easy to calculate with tables*bigger range of applications(B-S model cannot be used in all cases)*similar in structure to a decision treebut a much more concise representationof complex relationships

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

S 50 Current stock priceX 50 Exercise pricer 5.50% Risk-free rate of interestT 5 Time to maturity of option (in years)Sigma 24% Stock volatility

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 16.64 <-- S*N(d1)-X*exp(-r*T)*N(d2)

Put price 4.62 <-- call price - S + X*Exp(-r*T): by Put-Call parity



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 iteasier for people to access their email on the road. It will cost 50 million upfront to set up theproject. You will get the exclusive right for five years and the estimated cash flow is 10 millionafter tax every year. Assuming the cost of capital to be 15 percent, what is the net present valueof this project? Simulation of cash flows indicate a standard deviation of 42% in the presentvalue of cash flows with average as 33.5. Value the rights to this products using the optionsapproach. Five year risk less rate is 5%.

NPV of the project 0 1 2 3 4 5-50 10 10 10 10 10

Cost of capital 0.15NPV ($16.48)

S 33.52 Current stock priceX 50.00 Exercise pricer 0.05 Risk-free rate of interestT 5.00 Time to maturity of option (in years)Sigma 0.65 Stock volatilityDividend yield 0.20

d1 0.62 <— (LN(S/X)+(r+0.5*sigma^2)*T)/(sigma*SQRT(T))d2 -0.83 <— d1-sigma*SQRT(T)

N(d1) 0.73 <— Uses formula NormSDist(d1)N(d2) 0.20 <— Uses formula NormSDist(d2)

Call price 1.10 <— S*exp(-yt)*N(d1)-X*exp(-r*T)*N(d2)

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

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

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

Value of Underlying $33.52Variance 0.42Time 5Dividend yield 0.2r 0.05


SECTION - 3VENTURE CAPITAL FINANCING

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. Venturecapital investments are generally made as cash in exchange for shares in the investedcompany. A venture capitalist (VC) is a person who makes such investments. A ven-ture capital fund is a pooled investment vehicle (often an LLC or LP or HNI ) thatprimarily invests the financial capital of third-party investors in enterprises that are toorisky for the standard capital markets or bank loans. VC Funding is generally for tech-nology projects such as Information Technology, Bio Technology etc. When the techno-crat entrepreneur is not able to convert his brilliant ideas into reality for want of initialcapital, VCs come into picture. VCs undertake the risk by investing on behalf of origi-nal promoters, at a very high premium. They exit when the project can stand alone onits own by divesting their stake in one of the pre-determined ways. Venture capital canalso include managerial and technical expertise.

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

� 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 terms used in Venture capital funding is appended at the end of

the chapter




3.2. WHAT IS VENTURE CAPITAL ?

3.2.1 According to International Finance Corporation (IFC), venture capital is an equity orequity featured capital seeking investment in new ideas, new companies, new produc-tion, new process or new services that offer the potential of high returns on invest-ments.

3.2.2 As defined in Regulation 2(m)of SEBI (Venture Capital Funds) Regulation , 1996 “venturecapital fund means a fund established in the form of a company or trust which raisesmonies through loans, donations issue of securities or units as the case may be andmakes 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 com-panies that have the potential for high growth. The VC may also invest in a firm that isunable 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 companiesthat would later become famous. Eastern Airlines and Xerox are the more famous ven-tures they financed. Among the early VC funds set up was the one by the RockfellerFamily which started a special fund called VENROCK in 1950, to finance new technol-ogy companies.

3.3.2 General Doriot, a professor at Harvard Business School,in 1946 set up the AmericanResearch and Development Corporation (ARD), the first firm, as opposed to a privateindividuals, at MIT to finance the commercial promotion of advanced technology de-veloped in the US Universities. ARD’s approach was a classic VC in the sense that itused only equity, invested for long term and was prepared to live with losers. ARD’sinvestment in Digital Equipment Corporation (DEC) in 1957 was a watershed in thehistory of VC financing.

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

3.4. HOW VCS DIFFER FROM BANKS

3.4.1 Conventional financing generally extends loans to companies, while VC financing in-vests 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 thechances of getting loan. On the other hand VC financing is a risk taking finance wherepotential returns outweigh risk factors.


3.4.2 Venture Capitalists also lend management support and provide entrepreneurs with manyother facilities. They even participate in the management process. VC generally investin unlisted companies and make profit only after the company obtains listing. VC ex-tend need based support in a number of stages of investments unlike single round fi-nancing by conventional financiers.

3.4.3 VC are in for the long run and rarely exit before three years. To sustain such a commit-ment 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 flowwill be generated to repay the loans. VC is not a lender but an equity partner. Selec-tively 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 littleor 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, theideal 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 capi-talists 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 centreturn compounded per annum. Most firms require large portions of equity in exchangefor start-up financing.

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

3.5. TYPES OF VCS

3.5.1 Generally there are three types of organised or institutional venture capital funds: ven-ture 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 bankholding 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 corporations7. Angels: High Net Worth individual investors8. Merchant bankers and NBFCs who specialize in “bought out” deals also fund

companies.



3.6. INCUBATORS

3.6.1 They are generally non-profit entities that provide value added advisory, informationaland certain support infrastructure which include productive office environment, financeand complementary resources. Incubators are mostly promoted by government or pro-fessional organisations seeking to develop small enterprises in a particular area. Sometimes venture capital funds also have their own incubators and companies also set upin-house incubators. Incubators support the entrepreneur in the pre-venture capital stage,that is, when he wants to develop the idea to a viable commercial proposition whichcould be financed and supported by a venture capitalist.

3.7. VC IN INDIA

3.7.1 This activity in the past was possibly done by the developmental financial institutionslike IDBI, ICICI and State Financial Corporations. These institutions promoted entitiesin 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 sourcehowever depended a lot on the market vagaries. And with the minimum paid up capi-tal requirements being raised for listing at the stock exchanges, it became difficult forsmaller 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 fiscalpolicy of GOI. In 1973 a committee on Development of small and medium enterpriseshighlighted the need to faster VC as a source of funding new entrepreneurs and tech-nology. VC financing really started in India in 1988 with the formation of TechnologyDevelopment and Information Company of India Ltd. (TDICI) - promoted by ICICI andUTI.

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 CommonwealthDevelopment Corporation viz. Credit Capital Venture Fund. At the same time GujaratVenture Finance Ltd. and APIDC Venture Capital Ltd. were started by state level finan-cial institutions. Sources of these funds were the financial institutions, foreign institu-tional investors or pension funds and high net-worth individuals. Though an attemptwas also made to raise funds from the public and fund new ventures, the venture capi-talists had hardly any impact on the economic scenario for the next eight years.

3.8. TAX BENEFITS

3.8.1 In terms of section 10(23 F) of IT Act income by exemptions way of dividend and longterm capital gains received by approved VC Companies/Funds from investment madeby 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 exemp-tion under the aforementioned section provided, among others,


(1) An application is made to Director of IT (Exemptions) by the VCC or VCF(2) VCF/VCC is registered with SEBI.(3) Not less than 80% of the fund corpus/paid up capital is invested by year 3.(4) 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 strongmanagement team - each member of the team must have adequate level of skills, com-mitment and motivation that creates a balance between members in areas such as mar-keting, finance and operations, research & development, general management, person-nel management and legal and tax issues.

3.9.2 A viable idea - establish the market for the product or service, why customers will pur-chase the product, who the ultimate users are, who the competition is and the projectedgrowth of the industry. Business plan: the plan should concisely describe the nature ofthe business, the qualifications of the members of the management team, how well thebusiness 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 ar-ithmetical 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 aboverequirements in mind while submitting the business plan.

3.10. THE VC PHILOSOPHY3.10.1 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 theyinvest in besides helping them reach IPO stage when valuations are favourable. VCFshelp entrepreneurs at four stages: idea generation, start-up, ramp-up and finally in theexit, which is done through M&As.

3.10.2 According to Indian Venture Capital Association, almost 41% (Rs 5146.40 m) of the totalventure capital investment is in start-up projects followed by Rs 4478.60 m in later stageprojects and only Rs 82.95 in turnaround projects . Majority have invested in only threestages of investment, indicating that most VCs in India have not started developingniches for investing with regard to the stages of projects.



3.10.3 The main difficulty in early stage funding are related to lack of exit opportunities asprobability of an IPO or buy out by of VC stake is less due to lack of understanding forevaluation of the knowledge based companies compared to the companies in the tradi-tional 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 greaterthan US$10mn. As most funds are of a private equity kind, size of investments has beenincreasing. IT companies generally require funds of about $ 5-10mn in an early stagewhich fall outside funding limits of most banks/institutions/VC funds and that is whythe government is promoting schemes to fund start ups in general and in IT in particu-lar.

Management of investee firms :

The venture funds add value to the company by active involvement in running of enter-prises in which they invest. This is called “hands on” or “pro-active” approach. Draperfalls in this category. Incubator funds like e-ventures also have a similar approach to-wards 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 thecompanies and advice on strategy, etc while the private equity funds treat their expo-sure like any other listed investment. This is partially justified, as they tend to invest inmore mature stories.

3.11. MAIN ALTERNATIVES TO VENTURE CAPITAL

3.11.1 As the strict requirements venture capitalists have for potential investments, many en-trepreneurs seek initial funding from angel investors, who may be more willing to in-vest in highly speculative opportunities, or may have a prior relationship with the en-trepreneur.

3.11.2 Furthermore, many venture capital firms will only seriously evaluate an investment ina start-up otherwise unknown to them if the company can prove at least some of itsclaims about the technology and/or market potential for its product or services. Toachieve this, or even just to avoid the dilutive effects of receiving funding before suchclaims are proven, many start-ups seek to self-finance until they reach a point wherethey can credibly approach outside capital providers such as VCs or angels. This prac-tice is called “bootstrapping”.


3.12. A GLOSSARY OF TERMS USED IN VENTURE CAPITALFUNDING 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 oftenlook for companies that are likely acquisition candidates, because the acquiring firms are oftenwilling to pay a premium to the market price for the shares.

Angel Investors

Individuals that provide venture capital to seed or early stage companies.. Business angels canusually add value through their contacts 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 fund-ing or whether management will receive extra stock. Sometimes management will agree toissue more stock to its investors if the company does not meet its benchmarks, thus compensat-ing the investor for the delay of his return.

Bridge Loans

Bridge Loans are short-term financing agreements that fund a company’s operations until itcan arrange a more comprehensive longer-term financing. The need for a bridge loan ariseswhen a company runs out of cash before it can obtain more capital investment through long-term debt or equity.

Buyout

Funds provided to enable an enterprise to acquire another enterprise or product line or busi-ness.

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 signedand the funds are transferred.



Corporate Venturing

The practice of a large company taking a minority equity position in a smaller company in arelated field.

Debt Financing

Money that business owners must pay back with interest. There are myriad types of debt fi-nancing, from simple commercial loans to bridge/swing loans in which a lender makes a short-term 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 philoso-phy, and terms 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 acorporation’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 equityof 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 thecompany — 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, thecompany might have to take on significant debt to finance the change in ownership structure.


Institutional Investors

It refers mainly to insurance companies, pension funds and investment companies collectingsavings 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.

IRRCompound Internal Rate of Return.

Lead Investor

The investor who leads a group of investors into an investment. Usually one venture capitalistwill 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 issecured by the assets of the business.

Limited Partnerships

The legal structure used by most venture and private equity funds. Usually fixed life invest-ment vehicles. The general partner or management firm manages the partnership using policylaid down in a Partnership Agreement. The Agreement also covers, terms, fees, structures andother items agreed between the limited partners and the general partner.

LiquidationThe sale of the assets of a portfolio company to one or more acquirors when venture capitalinvestors 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 anexit — usually in an initial public offering the lock-up period is determined by the underwrit-ers.

Management Buy-in (MBI)

Purchase of a business by an outside team of managers who have found financial backers andplan to manage the business actively themselves.

Management Buy-out (MBO)

Funds provided to enable operating management to acquire a product line or business, whichmay be at any stage of development, from either a public or private company.



Mezzanine Financing

Financing for a company expecting to go public usually within 6 –12 months; usually so struc-tured to be repaid from proceeds of a public offerings, or to establish floor price for publicoffer.

Minority Enterprise Small Business Investment Companies (MESBICS)

MESBICs (Minority Enterprise Small Business Investment Companies) are government-char-tered venture firms that can invest only in companies that are at least 51 percent owned bymembers of a minority group or persons recognized by the rules that govern MESBICs to be“economically disadvantaged.”

PIPEPrivate Investment in Public Equities. Investments by a private equity fund in a publiclytraded 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 generallyilliquid and thought of as a long-term investment. As they are not listed on an exchange, anyinvestor wishing to sell securities in private companies must find a buyer in the absence of amarketplace. In addition, there are many transfer restrictions on private securities. Investors inprivate securities generally receive their return through one of three ways: an initial publicoffering, 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 byreplacing 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 publicoffering can be either an issuer offering or an offering by a group that has purchased the issuer’ssecurities in the public markets.


Secondary Purchase

Purchase of stock in a company from a shareholder, rather than purchasing stock directly fromthe company.

Seed Capital

Money used to purchase equity-based interest in a new or existing company. A venturecapitalist’s return usually comes from preferred stock, a share of profits, royalties or capitalappreciation of common stock. Most venture capitalists look for companies with high growthpotential.

Series A Preferred Stock

The first round of stock offered during the seed or early stage round by a portfolio company tothe venture investor or fund. This stock is convertible into common stock in certain cases suchas an IPO or the sale of the company. Later rounds of preferred stock in a private company arecalled Series B, Series C and so on.

Small Business Investment Companies (SBIC)

SBICs (Small Business Investment Companies) are lending and investment firms that are li-censed by the federal government. The licensing enables them to borrow from the federal gov-ernment to supplement the private funds of their investors. Some of these funds engage only inmaking 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.

SyndicationThe process whereby a group of venture capitalists will each put in a portion of the amountof money needed to finance a small business.

Term Sheet

A non-binding agreement setting forth the basic terms and conditions under which an invest-ment will be made. The Term Sheet is a template that is used to develop more detailed legaldocuments.

Turnaround

This word is used to describe businesses that are in trouble and whose management will causethe 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 venturecapitalist’s return usually comes from preferred stock, a share of profits, royalties or capitalappreciation of common stock. Most venture capitalists look for companies with high growthpotential.



SECTION - 4HYBRID FINANCING / INSTRUMENTS

4.1. INTRODUCTION

4.1.1 The term hybrid instrument is not precisely defined. Generally, it is used to refer tofinancial instruments that blend characteristics of both debt and equity markets. Con-vertible bonds are an example. They are debt instruments that have an imbedded op-tion allowing the holder to exchange them for shares of the issuing company’s stock atthe end of the given period. For this reason, their market prices tend to be influenced byboth interest rates as well as the convertible price and proportion. Another examplewould be a structured note linked to some equity index. These take many forms. Typi-cal would be a five year note. It is a debt instrument issued by a corporation or sover-eign, but instead of paying interest, it returns the greater of principal plus the priceappreciation 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) orEquity Default Swaps (EDS).

4.1.3 Some people extend the definition of hybrid instrument to encompass instruments thatstraddle other market sectors. According to this definition, a quanto option or a volatil-ity future would be considered a hybrid.

4.1.4 The terms “hybrid securities,” “hybrid products” or simply “hybrids” are all synonymsfor “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 con-vertible to be exchanged for some other security. Usually, conversion is at the securityholder’s option, but a mandatory convertible security requires conversion, usually ac-cording to pre-determined and mutually agreed terms and time schedule.

� Introduction

� Convertible Bonds and Warrants

� The origin of venture capital

� How VCs differ from banks

� Types of VCs



4.2.2 Most convertibles are either convertible preferred stock or convertible bonds issued bya company and convertible to that company’s common stock any time after lapse of aprescribed 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 bondplus a call option.

4.2.4 Convertible securities have a par value, and their yield is quoted as a percentage ofpar. Each security may be converted into a fixed number of common shares. Thatnumber is the security’s conversion ratio. For example, if a convertible bond’s conver-sion ratio is 12.5, and the bond has a par value of USD 1,000, then each USD 80 of parvalue can be converted into a single share. This number is called the conversion price:

4.2.5 Convertibles routinely have an anti-dilution provision, which adjusts the conversionratio as appropriate in the event of a stock split or stock dividend. Some convertibleshave a conversion ratio that changes according to a fixed schedule. For example, a con-vertible bond’s conversion ratio might be 12.5 for the bond’s first five years and thendrop to 11 after that.

4.2.6 As is typical of hybrid securities, convertibles can be difficult to value. Also, convert-ibles may have additional embedded options or features. Many are callable after a fewyears of call protection. When called, holders are forced to either surrender the securityfor the call price or convert them. If they convert, the transaction is called a forced con-version. Some convertibles have a put feature, allowing holders to return the security tothe 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 beif it were stripped of its conversation feature. This reflects the security’s future cashflows, current interest rates, the issuer’s credit quality and any other features such asput or call provisions other than the conversion option. Investment value isn’t generallyobservable in the marketplace, but it is a useful notion that can be ascribed a value usingstandard bond pricing or financial engineering methodologies.

4.2.8 A convertible’s conversion value (or parity value) is the value that could be realized byimmediately converting the convertible to common stock. It is easily calculated as:

conversion value = (conversion ratio) current stock price [2]

4.2.9 These notions viz.I investment value and conversion value—are important because aconvertible’s market price should always exceed both quantities. Otherwise, arbitragerswill step in and start accumulating the convertible, thereby driving up its market price.The two quantities are often quoted as premiums:

[1]



The net surplus is the gain in the arbitration process.

4.2.10 Obviously, both premiums 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 invest-ment value is fairly flat at higher stock prices but drops off as the stock price falls. Thisreflects the fact that the credit quality of the issuer is likely to fall with a marked declinein the stock price. The conversion value is a simple linear function of stock price. Theconvertible’s market price is also plotted.

4.2.12 Convertible securities exhibit four different modes of behavior depending on the levelof the underlying stock price and the credit quality of the issuer. Practitioners tend todistinguish between four modes of behavior of a convertible bond, depending uponthe level of the underlying stock and the issuer’s credit quality. Usage is hardly stan-dardized, but we may distinguish between the following modes of behavior. These arealso indicated in Exhibit 1:

a. distressedb. bustedc. hybrid-like, andd. equity-like

Price Behavior of a Convertible SecurityExhibit 1

underlying stock price

Convertible market price

investment value

Val

ue

Conversion Value

"busted" orbond-like

hybrid-oroption-like equity-likedistressed

[3]

[4]


4.2.13 Convertible’s behavior is equity-like when its conversion value exceeds its investmentvalue, and the bond behaves like an in-the-money option. Its value fluctuates almostdirectly with the underlying stock price.

4.2.14 The convertible’s behavior is hybrid- or option-like at lower stock prices where theconversion value is less than the investment value but there is still a reasonable likeli-hood of the stock price rising enough to make conversion attractive. In this state, theconvertible exhibit’s truly hybrid behavior. Its market price is sensitive to the underly-ing 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 isalmost worthless. Here, the convertible is called busted. Its behavior is much like a non-convertible bond or other fixed income instrument. Its market price fluctuates withinterest rates and the issuer’s credit quality.

4.2.16 Finally, if the issuer becomes financially troubled, its credit rating will fall well belowinvestment grade and the stock price will plummet to very low levels. Here the conver-sion feature is all but irrelevant. The convertible is a distressed security whose marketprice 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 frequentlymis-priced in the market. Convertible arbitrage is a market neutral trading strategy thatseeks to profit from such mis-pricings. Due to several internal and external factors al-tering the fortunes of the issuer between the issue date and conversion date, any or allabove possibilities are unavoidable.

4.3. PREFERRED STOCK

4.3.1 Preferred stock is a hybrid corporate security. It represents an equity interest in theissuing company. Unlike common stock, which pays a variable dividend depending on thecorporation’s earnings, preferred stock pays a fixed quarterly dividend based on a statedpar value. For example, an XYZ corporation might issue preferred stock with a par value ofRs 50.00 and paying a quarterly 2% dividend. This would translate into a Rs 1.00 dividendpaid each quarter.

4.3.2 Most corporations do not issue preferred shares. Those that do, often issue multipleclasses of preferred shares over time. There are three naming conventions used for dis-tinguishing between the different preferred issues of a corporation :

1. Annualized dividend: the shares in our example would be called XYZ Rs 4.00 pre-ferred.

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 thecorporation’s third preferred issuance, they would be called XYZ preferred C.



4.3.3 With fixed dividends, preferred shares resemble fixed income instruments. As theydon’t mature, they most resemble a perpetuity. Preferred shareholders generally don’thave voting rights. Also, the board of directors have less of a fiduciary obligation topreferred shareholders than to common shareholders. Some Delaware court decisionshave 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. Interestpayments are an expense, so they are tax deductible for the corporation. Dividends aredistributions of earnings, so they are not tax deductible. Also, depending on the investor’stax 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 prevailinginterest rates. Generally, the issuer will set the preferred’s dividend yield so it issues ata price close to par. After issuance, the preferred shares trade in the stock market justlike common stock. Credit rating agencies rate preferred stocks based on the issuingcorporation’s ability to pay dividends. Market prices of highly rated issues tend to fluc-tuate with interest rates. Prices of lower rated issues - just like prices of lower ratedbonds - 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 preferreddividends. If the issuer is liquidated, creditors must be paid in full before preferredstockholders can receive anything. However, preferred shares are superior to commonshares. No dividends may be paid to holders of common stock unless dividends topreferred shareholders are also paid in full. In liquidation, preferred shareholders areentitled 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 dividendpayments cannot force the firm into bankruptcy. However, while dividends are notbeing paid, mandatory restrictions may be placed on management and preferred share-holders may be granted the right to vote for a number of board members. Because it isdependent 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, itmust eventually be made up to investors. No dividends can be paid to common stock-holders until all missed dividends have been paid to preferred stockholders. If pre-ferred shares are issued with no obligation to make up missed dividends, the shares arecalled 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 premium above par. In a typical arrangement, shares are notcallable for the first few years following issuance but can be called, perhaps with amonth’s notice, any time thereafter. As with callable bonds, the price behavior of call-able preferreds depends on whether the call option is in-the-money or out-of-the-moneyas well as the financial strength of the issuer.

4.3.10 Most preferred stock is issued with a sinking fund provision that requires that the is-suer set aside funds to gradually retire the issue over time.


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 beingfixed, floats with specified interest rates according to some formula.

b. Convertible preferred stock has an embedded option that allows the holder to ex-change each preferred share for a specified number of common shares. Convertiblepreferred is usually callable. This allows the issuers to call the stock and force pre-ferred 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 divi-dend if the common stock dividend exceeds some specified value. Today, this fea-ture is rare.

4.4. TRUST PREFERRED SECURITIES

4.4.1 Trust preferred securities (TruPS) are cumulative preferred stock issued by bank hold-ing companies through a special purpose vehicle. The special purpose vehicle is whollyowned by the bank holding company and is usually a trust. It sells the TruPS to inves-tors and uses the proceeds to purchase a subordinated note from the bank holdingcompany. This becomes its sole asset and cash flows from the note largely mirror thedividends 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 leastfive years without creating an event of default or acceleration.

4.4.2 From a tax standpoint, TruPS have a significant advantage over the direct issuance ofpreferred shares. This is because dividends on preferred shares are not deductible as abusiness expense, but interest on a subordinated note is. In this regard, the TruPS be-haves like debt. In another regard, it behaves like equity.

4.4.3 Initially, TruPS were only issued by larger bank holding companies. This changed in2000, 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 ofcapital for small and medium sized bank holding companies.

4.4.4 TruPS are also issued by insurance holding companies and REITS. Those securitieshave 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 equityderivative, 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 theproduct 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 toprovide another protection against some possible event relating to some reference as-set. With a credit default swap, the reference asset is a debt instrument and protection is



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 dra-matic decline in the price of that stock. For example, the equity default swap mightprovide protection against a 70% decline in the stock price from its value when theequity default swap was initiated. The event being protected against is called the trig-ger event or knock-in event.

4.5.3 Other than the difference in the type of event being protected against, a credit defaultswap and equity default swap are structured identically. There are two parties to theagreement. Maturities are for several years, with five years being typical. The partybuying 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, theequity default swap terminates, and the protection seller makes a specified payment tothe 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 servesonly to make the equity default swap more analogous to a credit default swap. Its roleis 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 Americandigital put. A difference is that the option premium is paid in installments that ceasewhen the option is triggered. It is more useful to think of the equity default swap as anextension of the credit default swap concept. When a credit default swap is triggered bya 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, triggerevents will almost always be associated with some sort of deterioration in thecorporation’s credit. For example, if an equity default swap is triggered by a 70% de-cline in the stock price, it provides protection against less severe corporate impairmentthan that which a credit default swap protects against. In this regard, the equity defaultswap truly behaves as a form of hybrid between a credit derivative and an equity de-rivative.

4.5.5 Equity default swap are quoted as spreads over Libor. As an equity default swap ismore likely to be triggered than a credit default swap, they generally trade at higherspreads than credit default swap.

4.5.6 Equity default swaps have a number of advantages over credit default swaps. Theirtrigger events are easier to define—there is generally little ambiguity as to whether agiven 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, recoveryrates are fixed for equity default swaps while they must somehow be determined for acredit default swap following an actual default. Finally, credit default swaps are lim-ited in that they protect against only the most severe form of corporate impairment.Equity default swaps can be structured with various trigger levels loosely correspond-ing to various degrees of corporate impairment.


4.5.7 Equity default swaps are employed in ways similar to credit default swaps. They maybe used to structure synthetic CDO’s. Some, CDOs use them exclusively. These arecalled equity collateralized obligations or ECOs.

4.5.8 As long-dated far out-of-the-money options, equity default swaps pose financial engi-neering challenges. One approach is to employ techniques of equity derivatives pric-ing. The other is to use techniques of credit derivatives pricing. Equity default swapsclearly present an opportunity to arbitrage between equity derivatives markets andcredit derivatives markets, which should cause convergence in pricing. Research onpricing methodologies is ongoing.

4.5.9 Equity default swaps can be structured with multiple reference stocks. These structuresmay 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 needsof 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 ofthe 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 theaccompanying debt.

6 Warrants usually provide for fewer common shares than do convertibles.

7 Bonds with warrants typically have much higher flotation costs than do convertibleissues.

8 Bonds with warrants are often used by small start-up firms. Why?



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, theninvests 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 lowrate.

5 Information asymmetry: company knows its future prospects better than outsideinvestors

5.1 Outside investors think company will issue new stock only if future prospectsare 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” byissuing 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 iswhat 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 withoutplacing the firm in default.

5 Most preferred stocks prohibit the firm from paying common dividends when thepreferred is in arrears.

6 Usually cumulative up to a limit.

7 Some preferred stock is perpetual, but most new issues have sinking fund or callprovisions which limit maturities.

8 Preferred stock has no voting rights, but may require companies to place preferredstockholders on the board (sometimes a majority) if the dividend is passed.

9 Is preferred stock closer to debt or common stock? What is its risk to investors?To issuers?


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 tobe exercised?

Generally, a warrant will sell in the open market at a premium 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 provi-sions 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 astock’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 thewarrants are issued.

As warrants lower the cost of the accompanying debt issue, should all debt be issued withwarrants?

No. As we shall see, the warrants have a cost which must be added to the coupon interestcost.



What is the expected return to the bond- with-warrant holders (and cost to the issuer) ifthe 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 opportunitycost 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 4 5 6 19 20

+1,000 -100 -100 -100 -100 -100 -100

-587.50 -1,000 -687.50 -1,100

Input the cash flows and calculate IRR = 14.7%. This is the pre-tax cost of the bond andwarrant package.

The cost of the bond with warrants package is higher than the 12% cost of straight debtbecause part of the expected return is from capital gains, which are riskier than interestincome.

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 toexercising warrant holders.

But, bondholders previously transferred wealth to existing stockholders, in the form of a lowcoupon rate, when the bond was issued.

At the time of exercise, either more or less wealth than expected may be transferred from theexisting 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 issueis 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.


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 onthe 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 support 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 exer-cised. Debt would remain outstanding.


PROJECT MANAGEMENT

STUDY NOTE - 7

PROJECT MANAGEMENT

SECTION - 1OVERVIEW OF 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 sub-stantial outlay of resources in terms of capital, time and effort. For these reasons, it hasto be both conceived and executed timely, properly and cost effectively. While its suc-cess can bring long-term rewards, its failure can lead to disastrous consequences. Anycost or time overrun in the project implementation is a sign of sickness from the begin-ning.

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 performancemeasures in project management are:

1. Cost

2. Time

3. Project performance, i.e., whether the project successfully meets the targets anddelivers desired results.

� What is Project Management?

� Project Performance

� Steps in Project Management



1.2.2 Project cost refers to the cost of capacity resources that organizations purchase anduse for years to make goods and provide services. Cost commitments associated withlong-term assets create risk for an organization and remain even if the asset does notgenerate the anticipated benefits and also reduce an organization’s flexibility. There-fore, organizations should approach investments in long-term assets with consider-able care. Both excess capacity and imbalance in capacity in any section of the pro-duction process would result in serious financial and operational implications. Thecost of production would increase much higher and thereby project would becomeunviable.

1.2.3 Organizations have developed specific tools to control the acquisition and use of long-term assets because organizations are usually committed to long-term assets for anextended time, which creates the potential for either excess capacity that creates excesscosts or scarce capacity that creates lost opportunities.

1.3. STEPS IN PROJECT MANAGEMENT

1.3.1 Project management encompasses 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 stakehold-ers

4. Project Execution or Implementation: Converting the thoughts and proposals intoreality.

5. Project Review


2.3. PHASE II: RECONNAISSANCE AND PRELIMINARY PROJECTDESIGN / 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 identificationof its main features, such as location, type of participants, main activities, size, timing,organizational structure, and management system. It may be called a project reconnais-sance 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 alter-natives available.

The output of the phase is a full description and costing of the project, together with aproposed 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.


PROJECT MANAGEMENT

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.


SECTION - 3IDENTIFICATION OF PROJECT OPPORTUNITIES

3.1. PROJECT IDENTIFICATION - WHAT ARE THEOPPORTUNITIES?

3.1.1 After identifying the opportunities and short listing of projects out of several availableoptions that are of interest to a company, the next stage is to consolidate these andexamine the relationships between them for the long term benefit of the company. Itshould 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 investmentshould be to further enhance the sustainable competitive advantage of the organiza-tion, and achieving its long-term objectives and goals. This should be the acid-test toevaluate any opportunity.

3.1.2 The key tasks are:

1. List all opportunities that have already arisen based on detailed study and analysisof options.

2. Undertake further consultation if required to expand and clarify opportunities andensure that the opportunities identified reflect the desired company outcomes.

3. Consolidate and categorise opportunities.

4. Identify relationships and linkages between opportunities and projects.

3.1.3 Projects should be categorised by industry and type of project. Types of project can becategorised 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 itsavailable resources to its best potential.

� Project identification - What are the opportunities?

� Project pre-feasibility assessment - Are the opportunities realistic?



PROJECT MANAGEMENT

It is also important at this stage that project task forces are well thought about, in-cluding potential names of participants.

3.2. PROJECT PRE-FEASIBILITY ASSESSMENT - ARE THEOPPORTUNITIES REALISTIC?

3.2.1 Having identified projects and opportunities, undertaken a brief assessment and de-termined a list of priority projects, the next stage is to undertake a pre-feasibilityassessment 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 layoutproject document template. Information consolidated for each project would typicallyinclude:

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 thiscase they should be shelved in favour of more feasible or realistic projects. The outputwill be a series of project information sheets used for internal/external action planningor 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 pur-suing.


SECTION - 4PROJECT SELECTION CONSIDERATIONS

ANDFEASIBILITY STUDIES

4.1. WHAT IS A FEASIBILITY REPORT?

4.1.1 Feasibility report is an analytical tool used during the project planning process whichshows how a project would operate under a set of assumptions, the technology usedand the financial aspects. It also gives an outline description of the recommended solu-tion and explains the reasons for selection.

4.1.2 It is conducted during the deliberation phase of project development before financingis secured. The study is the first time in a project development process that the piecesare assembled to see if they perform together to create a technical and economicallyfeasible 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 afeasibility study, the group decides not to proceed, there is no need to create a projectplan. The perceived objectivity of the evaluation is an important factor in the credibilityplaced on the study by potential investors and financiers. The study beings out thepossible future outcome under presently prevailing factors, both financial and economi-cal.

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 andtime consuming effort. Before the potential members invest in a proposed business pro-posal, they must determine if it can be economically feasible, financially viable andthen decide if investment advantages outweigh the costs and risks involved. Often con-struction project operations involve risks with which the members are unfamiliar. Thefeasibility study allows groups to preview potential project outcomes and to decide if

� What is a Feasibility Report?

� Why Prepare Feasibility Studies?

� The Conceptual Stage

� The Pre - Feasibility Report

� The Feasibility Report



PROJECT MANAGEMENT

they should continue. It is an integral part in developing any project. The purpose ofthe feasibility study is to explore the project in enough detail for the interested partiesand stakeholders to make a commitment to proceed with the development of theproject.

4.2.2 Feasibility studies are useful and valid for many kinds of projects. An evaluation of anew business venture both for new groups and established businesses, is the most com-mon, but not the only usage. Studies can help groups to expand existing services, buildor remodel facilities, change methods of operation, add new products, or even mergewith another business. A feasibility study assists decision makers whenever they needto consider alternative development opportunities.

4.2.3 Although the cost of conducting a study may seem high, they are relatively insignifi-cant compared with the total project cost. The small initial expenditure on a feasibilitystudy can help to protect larger capital investments. On the contrary, applying the les-sons gained from a feasibility report can significantly lower the project costs. Feasibilitystudy permits planners to outline their ideas on paper before implementing them. Thiscan reveal errors in project design, before their implementation negatively affects theproject. The study also presents the risks and returns associated with the project so theprospective members can evaluate them. There is no correct rate of return a projectneeds to obtain before a group decides to proceed. The acceptable level of return andappropriate risk rate will vary case to case depending on industry, size of investment,geographical location, government policies, changes in market conditions, changes ineconomic factors etc

4.2.4 The study is not conducted as a forum merely to support a desire that the project willbe 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 thepromoters’ time, efforts and money.

4.2.5 The creation of a Feasibility study, although part of the project cycle, contains a pro-cess 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 theconstruction project. Often groups proceed directly to the feasibility study and over-look the importance in making the first decision with deliberation. Take the time todetermine if a feasibility study is appropriate. Careful consideration whether to con-duct a feasibility study will save much time and money and increase the study valueonce completed. Moreover if this decision is conducted thoughtfully, the group willprobably have established a procedure for decision-making. Then the decisions thatthe group needs to make later in the development process will probably come easierand the likelihood of it being correct will be greater.


4.3.2 The principal parameters of the conceptual study are mostly assumed and/or fac-tored. Accordingly the level of accuracy is low. Flow sheet development, cost estima-tion and construction scheduling are often based on limited data, test work and engi-neering 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 war-ranted. 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 ofthe project. This can begin with the “back-of-the-envelope” calculations and proceedthrough a formal pre–feasibility study for complex projects. The purpose of this phaseis to establish whether a project looks likely to happen and calculate the potential costof carrying out the full feasibility study. It also serves the purpose of initiating widerpublic interest. Sufficient work has to be completed to develop the project and process-ing parameters for equipment selection, consumables, flow sheet, production and de-velopment schedule.

4.4.2 The degree of detail carried out in the pre-feasibility study will be dependent on thenature and type of the scheme. The economic analysis from a pre-feasibility study is ofsufficient accuracy to assess various development options and the overall project vi-ability. However, these cost estimates and engineering parameters are typically not con-sidered 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 adecision on whether to proceed to the full feasibility study phase and will have the jobof raising investment to carry this out. As the pre-feasibility study itself would takeinto account all salient aspects, it would enable the promotes to take proper judgmenton 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. Theprincipal parameters for a feasibility report are based on sound and complete engi-neering and design work.


PROJECT MANAGEMENT

4.5.2 Although all studies must start with certain assumptions, they must be closer to real-ity to give a value to the study. A feasibility study presents the environment wherethe project will occur and describe its scope. The description also includes the needfor the project and how the group can accomplish the goals. The scope also includesthe key elements of all aspects of the project. Potential reaction by competitors shouldbe included in the study.

4.5.3 The study also includes the rationale for scenario selection. Both worst-case possibili-ties and optimistic scenarios are compared. Comparative results from scenarios are pre-sented in tables. Possible economic outcomes should be a prominent part of a feasibil-ity study. Operating costs and net revenues are factors that show if the project is eco-nomically 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 members and other investors,project technology, potential legal and governmental setbacks, management and labourresources and time-critical factors. Most importantly, the feasibility study enables mem-bers to make constructive, informed decisions on whether to proceed with, revise, orabandon the project.

4.5.5 Simply put the feasibility study is a formal technical report that is used by the companyto determine whether the proposed project is capable of being developed at a sufficientreturn to justify the capital and managerial resources that must be committed to theproject.

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-feasibilityreport, but the level and detail and accuracy for each objective are stringent. Detailedcalculations have to be worked out to develop the flow sheet development, equipmentselection, consumables, power consumption, material consumption, drawing, construc-tion schedule and capital and operating cost estimates.


SECTION - 5PROJECT APPRAISAL AND COST BENEFIT 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. verify the procedures of the project formulation team;3. recommend the conditions which will ensure that the project objectives are met;

and4. 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 ofthe report. The form of appraisal will vary according to the type of project. For produc-tion-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 imple-menting agency and of project beneficiaries when appropriate;

3. Commercial, for example, procurement and marketing arrangements;

� Project appraisal

� Users of Project Reports

� Contents of Project Reports

� Means of Financing


� Investment Criteria

� What-If & Sensitivity Analysis

� Risk Analysis



PROJECT MANAGEMENT

4. Social, for example, sociological factors and expected impact of the project oncertain groups (such as ethnic minorities and women);

5. Institutional, for example, organization and management arrangements, the require-ment for arrangements of technical assistance, project monitoring and evaluation;

6. Economic, for example, project costs to the national economy and the size and dis-tribution of benefits.

5.1.4 The format and content of any appraisal report changes with the agency, bank, or cor-poration concerned, and is their internal reference document. Thus, its reflects theirviews and not those of the project formulation team. It is on the basis of this report thatthe project is formally approved. It is also the reference document for the implementa-tion agreement and subsequent evaluation made. Though the format might changefrom one institution to another, the basic criteria is same. It is to assess the project’sviability, profitability, repaying capability, socio-economic factors and above all thepromoters’ background and their commitment to the project.

5.2. USERS OF PROJECT REPORTS

5.2.1 The users 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 Account, Cash Flow Statement

c. Appraisal Criteria and Financial Viability


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. Administration 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


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 fu-ture benefits justify its investment.

5.5.2 Investment is the monetary value of the assets the organization gives up to acquire along-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 focuseson whether the expected increased cash flows (return) will justify the investment in thelong-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 toany changes, regulations governing the project implementation etc;

5.6. INVESTMENT CRITERIA

5.6.1 The various investment criteria normally employed in project appraisal are:

� Payback period

� Accounting Rate of Return

� Net Present Value


� Internal Rate of Return

� Profitability Index

� Debt Service Coverage Ratio (DSCR)

5.6.2 Cost of Capital:

The cost of capital is the interest rate used for discounting future cash flows. It is alsoknown as the risk-adjusted discount rate. The cost of capital is the return the organiza-tion 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 activi-ties

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 futurecash flows is an important and difficult task. This is important because many decisionsare 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. Theproject planner can set up a computer spreadsheet to make changes to the estimates ofthe decision’s key parameters.

5.7.2 If the analysis explores the effect of a change in a parameter on an outcome, we call thisinvestigation a what-if analysis. For example, the planner may ask, “What will my prof-its 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, ratherthan 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


PROJECT MANAGEMENT

5.8.2 The analyst is expected to keep the end result of the model in mind, i.e., the ability tovary 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), Break-Even Point: No Profit or Loss, and Cost - Volume - Profit Analysis.


SECTION - 6SOURCE OF PROJECT FINANCE

&FOREIGN COLLABORATION

� Financing of large projects comes under the purview of project finance which is de-fined as the financing of a project such that the lender is prepared to look only to theearnings of the project as the source of funds from which his loan will be repaid and tothe assets of the project as collateral for the loan

� Construction of Suez Canal, expansion of North sea oilfields are earlier examples ofproject finance. International banks provide project financing for a vast range of projects,including mineral developments, toll roads, tunneling projects, theme parks, powerstations and shipping and aircraft finance

� The uniqueness of project finance is that every financial facility is specifically tailoredto suit the individual project and the needs of the parties sponsoring it.

� Project finance describes a large scale, highly leveraged financing facility establishedfor a specific undertaking whose creditworthiness and economic justification is basedon the project’s expected cash flows. It is the project’s own economics rather than itssponsor’s financial strength that determines its viability. The sponsor isolates this activ-ity, 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 identifica-tion of a whole range of risks which must be incorporated in any contract documenta-tion. Since, project finance is highly leveraged, its overall cost of finance may still belower than a company’s usual WACC.

� Non-recourse project financing happens when lenders do not at any stage during theloan period, have recourse for repayment from any cash flows other than project cashflows. These are very rare.

� Most projects are financed on a limited recourse basis

� Financing of Projects and Foreign Collaboration


6.1 FINANCING OF PROJECTS AND FOREIGN COLLABORATION


PROJECT MANAGEMENT

� The difference between without recourse and with limited recourse happens whenthe project is abandoned. On a non-recourse basis, the sponsors can walk away fromthe project without liability to repay the debt. Limited recourse financing is a moreaccurate description of most project financing involving bank lenders, where the abil-ity of lenders to look to project sponsors for repayment of debt in the event of prob-lems with the loans is restricted.

� Lenders are attracted to project finance because they receive processing and otherfees compared with other business transactions they undertake. They can be pro-tected from interest and capital repayment default by a range of covenants from thesponsor and other parties.

� Spreading specific project risk over several participating lenders lessens dependenceon 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 permis-sions and the project sponsors themselves, are obtained and these create significantcomponents to support the credit financing of the project

� The debt of the project entity is separate from the sponsor’s companies direct obliga-tions

� 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


� 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 infra-structure and facilities. This may be due to a shortage of finance in the sense thatpublic borrowing is constrained by macro economic policies

� Many governments today, in order alleviate the above situation, are encouraging theuse of private investments in services traditionally provided by the public sector. Thisis done through private finance initiative

� It has become the governments main instrument for delivering higher quality andmore cost effective public services. Its aim is to bring the private sector more directlyinto the provision of public services, with the public sector as an enabler and guard-ing the interest of the users and customers of public services.

� PFI and PPP(Public private partnership) schemes allow public bodies to contractdirectly 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 anoperator’s licences to provide specified services with a view to making a profit andhence a return on equity

� The operator generates this return on equity through revenue stream arising from theservices

� 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 members 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 openingup of the Indian Economy has thrown open investment opportunities in almost every field ofbusiness from the consumer sector to core infrastructure sectors. All these sectors are wit-nessing growing multinational interest.


PROJECT MANAGEMENT

Economic activity in India is carried out in two broad segments viz. the organized sectorand 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 andownership in the economy, remove protectional barriers, invite foreign direct and portfolioinvestment and initiate other reforms to make India a free market economy.

After India’s economic reforms and globalization measures, it has become very common forforeign companies collaborating with Indian companies and vice-versa in several industrialsectors.

The Government has also relaxed many conditions for entering into collaboration agreementswith foreign companies.

Foreign Investment Promotion Board (FIPB) under the Ministry of Commerce, is empoweredto approve even 100% foreign equity, under certain categories. Foreign companies can openbranch offices in India for specified activities and foreign institutions can operate in the Indiancapital markets. Automatic approval for investment in Indian companies is permitted by Re-serve Bank of India up to certain % of share capital depending on industry. RBI has prescribedsectoral caps for such investments in Indian companies.

Several Direct Tax reforms, trade policy measures, financial sector operational reforms havebeen initiated and continuous being relaxed more and more.

Industrial policy reforms have already started contributing for the growth of the economy ofthe country.

Students are advised to refer the websites of Reserve Bank of India, Government of India’swebsites of various ministries for more details.


STUDY NOTE - 8


SECTION - 1RISK ASSESSMENT AND MANAGEMENT

1.1. MINIMIZATION OF RISK

1.1.1 Organizations are exposed to two major types of risks namely, business risk and financerisk. Business risk arises due to industry, economy, credit and political factors, causingvolatility in sales. Finance risk can be either price risk, interest rate risk or foreign ex-change risk.

1.2. RISK DEFINED

1.2.1 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

1.2.2 In risk management, we are mainly concerned with ensuring that the downside risk isnot catastrophic. Therefore, risk mitigation has to be the main function of senior man-agement 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 adirect interpretation of its strategy. Strategy itself must address the appetite and capacity forrisk within the business and the systems and actions of the organization regarding risk should


• Minimization of risk

• Risk defined

• Risk mapping

• Financial risk



seek to attain the goals envisaged by the strategy. The process of assessing for the organizationas 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;


SECTION- 2INTEREST RATE RISK

� 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 allorganizations are at times, lenders or borrowers, this is of great importance. The usersof capital are fundamentally concerned about interest rate risk as it affects the cost ofraising 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 yearswith a bullet repayment. What is the price of the bond if the yield to maturity is 8%, 6% and10%?

• 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 principalrepayment), 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, considera bank. We can treat all positive and negative cash flows as a portfolio and if properlytime-slotted, the exposure is directly related to the absolute amount of the net cashflow for each period. If there is net surplus, the organization can lose money if theinterest rates decline and vice versa for a shortage. There is some natural reductionin overall risk if surpluses in some periods are matched by shortages in others. A tableis prepared to show the portfolio of cash surpluses and shortfalls over time. This isknown as gap analysis.



2.2.2 Duration:

The gap analysis system gives a useful overall view of the exposure, but it is not helpfulwhen considering the value of an individual asset or liability. Duration is a useful measurein 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 fiveyears.

Bond A BCoupon 3% 10%Maturity 5 5 YearsYTM 7%

Comparison of bonds A and B for different YTMS

YTM Price of A Change(%) Price of B Change(%)3% 100.00 132.065% 91.34 -9% 121.65 -8%7% 83.60 -8% 112.30 -8%

10% 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 Cash flows A PV CFA (Time)X(PVCFA)

1 3 2.80 2.802 3 2.62 5.243 3 2.45 7.354 3 2.29 9.155 103 73.44 367.19

83.60 391.73 Duration 4.69

Time Cash flows A PV CFA (Time)X(PVCFA)

1 10 9.35 9.352 10 8.73 17.473 10 8.16 24.494 10 7.63 30.525 110 78.43 392.14

112.30 473.96 Duration 4.22


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 theinterest rate risk, which can be used to compare various classes of bonds and categorize themin 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 dura-tion of the liabilities. For example, if we need to raise debt finance to proceed with aproject, by ensuring that the duration of the ‘debt portfolio’ is reasonably matched tothat of the project’s cash flows, we can reduce significantly the interest element of thetotal project risk. The matching has to be on one-to-one basis. Otherwise, aggregateamounts might tally but when average costs & returns vary, the net effect will also haveserious 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;



- 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 per-formance 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 theasset.

2.3.3 F`RAs and Interest rate futures lock in interest rates. The main difference is that FRAsare over-the-counter (OTC) deals offered by particular financial institutions while fu-ture contracts are exchange-traded. Exchange traded means the contracts can be onlytraded 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 betweena financial institution and a customer. Between OTC and exchange traded decisions, thechoice is to balance convenience against cost.

2.3.4 Hedging is the generic term used to mean reduction of financial risk, by the use offinancial products.


SECTION- 3FORWARD RATE AGREEMENT

� Forward Rate Agreement

� Futures


3.1. FORWARD RATE AGREEMENT

3.1.1 A Forward Rate Agreement (FRA) is an agreement between two parties which deter-mines the interest rate that will apply to notional loans or deposits on a predetermineddate in the future and for a specified period. It does not necessarily involve either a loanor a deposit and is simply an agreement between two parties to compensate each otherfor the difference between the agreed FRA rate and the relevant market interest rate atthe start of the notional transaction. FRAs are quoted in terms of the contract period. Forexample, ‘three against six months’ will refer to three-month period starting in threemonth’s time.

3.1.2 Illustration:

A company finds that credit extended to a major customer is longer than that obtainedfrom suppliers. In three month’s time, the company will need working capital for afurther three months. On 12 February, the BB bank writes an FRA for “three against sixmonths”(or 3 v 6) at 8%. Settlement date is 12th May. Let us compare the differenceprobable 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 is 8%

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 threemonth forward interest rate of 8%



3.1.3 The point to be noted is that the FRA does not itself involve the borrowing or lending ofmoney, it is merely a contract for a ‘difference payment’ between the two parties. In theabove example, the company actually borrows the required funds from one of its usualsources, 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 inthe FRA contract.

3.1.5 Advantages of FRAs:

• Future interest rate exposure can be hedged without commitment to a specified bor-rowing or deposit.

• Transaction can effectively be reversed at any time to the start of the FRA by takingout an equal and opposite FRA known as an offsetting position.

• FRAs are usually tailored by banks to meet the specific requirements of companies interms 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 aspecified quantity of goods of a specified quality at a specified date in the future and atan 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 changeshands 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 terms of the size of the contract andthe future settlement dates. For interest rate futures contracts the standardized size ofone contract is pounds 500000 on the LIFFE and there are only four settlement dates ayear. It is not possible to trade in fractions of contracts. Futures contract are not madedirectly with a counter party, but through a clearing house. Therefore, there is no worryabout 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 wheatthan expected this year. October wheat contracts are trading at Rs.300 and the contract size is5000 tonnes. The speculator buys 10 contracts believing that the price of wheat will rise asOctober approaches.

Situation-1

By end of September, the harvest was very poor, and the October wheat futures have risen to


Rs 325 as wheat is in scarce supply. The speculator can now book his profit without waiting tillOctober.

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 pertonne. 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 marketprice to all market participants.

3.2.7 One of the important points in the case of futures contract is that settlement is guaran-teed 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 whichcosts 7% per annum and will be rolled over (i.e. renewed) on 1 may. The borrower wantsprotection against a rise in interest rates, and considers using two three-month interest ratefuture 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 interestrate from 100

• The market expectation for June futures contract sold on 1st of feb is present spot rate of7%

• 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 priceof 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 Junecontracts



• 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(150basis 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 cashmarket, 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 17500which 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 mar-gin as the position is marked to market

• Marked to market means you close out your position by buying back a contract youhave previously sold or by selling a contract you have previously bought

• Through this process, any risk of default and system collapse are averted.


SECTION - 4INTEREST RATE SWAPS


4.1. INTEREST RATE SWAPS

4.1.1 The second product group used by corporate treasurers for managing interest rate riskis 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 flowsfor 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 interestobligations i.e they swap interest payments in such a way that it saves money for bothborrowers.

4.1.5 More than 80% to 90% of Eurobonds are launched as part of a ‘bond plus swap’ pack-age.

4.1.6 The terms of the original issue of bond is of no concern. The borrower, through swaps,can convert any inappropriate terms into favorable terms of amount, currency and in-terest rates.

4.2. SINGLE-CURRENCY SWAP

• Company A borrows 100 m at a fixed rate, although it actually wants to pay intereston a floating rate basis.

• Company B borrows 100 m, but on a floating rate basis even though it really needsa fixed rate loan.

• Both of them agree, through an intermediary bank, that A will pay floating rateinterest on 100 m to B, in return, B pays to A fixed interest on 100 m. This agreementis the single-currency swap, as only one currency is involved.

• Interest rate swaps

• Single-Currency Swap

• Cross-Currency Swap

• Rationale behind Swaps



• Since the interest payments are all in the same currency they be offset, and in prac-tice 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 bor-row 175 m swiss franc, paying fixed rate of interest. At this time, the spot exchangerate was swiss franc 1.75/us dollar 1.

• Company B borrows Swiss franc 175 m at a fixed rate, actually needing fixed rateUS dollars.

• A has Swiss franc and B has Dollars. They agree to swap the principal amounts andthe 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 majorreasons for the lower cost of funds.

4.4.3 Name recognition: A particular borrower may be well known to investors in some mar-kets and will be able to raise funds at a cheaper rate in one currency. He can look foranother borrower who may be able to raise the currency that he needs at a lower cost inhis own country. With banks acting as intermediaries, these two parties can be broughttogether, resulting in lower cost of funds for everyone.

4.4.4 Differential risk spreads: Investors in a fixed rate market demand higher credit riskpremium as the quality falls than investors in the floating rate interest market. Floatingrate lenders might accept an increase in spread from say .25% to .75% as sufficient in-ducement to accept an ‘A-‘ quality borrower rather than ‘AA+’ one; fixed rate investorscould well demand a differential of 1.00% to 1.20% between ‘A-‘ and ‘AA+’. Lockinginto long term fixed rate involves more market risk for an investor than does an equiva-lent floating rate deal. Investors in fixed and floating instruments form clearly definedand separate sets.

4.4.5 Independent markets: Various markets for currencies and fixed/floating rates are sepa-rate and individual, and the interest rates in each are defined by supply and demand ineach market independently. Different conditions, terms or regulations can apply to thedifferent market rates.

4.4.6 All these factors, working simultaneously, show why swaps are very popular.

4.4.7 Illustrations:

Single currency swaps


• The net differential of .83% provides the motivation for a swap, assuming that com-pany A would prefer to issue floating-rate debt and company B would prefer fixedrate debt with a lower coupon

• Company A issues fixed rate debt at 7.75% and company B issues floating rate debtat LIBOR + 37 basis points

• A financial intermediary, bank, organizes a swap between the two companies-Com-pany A, which issued fixed debt at 7.75%, negotiates to pay the bank a floating rateof 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:

Fixed rate Floating rateCompany A 7.75% Libor+0.25%Company B 8.70% Libor+0.37%Difference on risk premiums 0.95% 0.12%

Net differential 0.83%

Single Currency Swap

Compan A Bank Company BPaid 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 LBank pays B -L LNet position (L-.10)% 0.15% -8.37%Cost without swap L+.25% 8.70%Gain 0.35% 0.15% 0.33%

Economics of swap

• 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 atLIBOR+25 basis points

• Company B, which has a lower credit rating, can issue fixed rate debt of the samematurity at 8.70% or floating rate at LIBOR+ 37 basis points

• The table below shows the position and savings.



4.4.8 Illustration:

Cross-currency swaps

• Company A wants Sfr 120 m, 5 year fixed. It has the choice of issuing US dollarfixed debt 7.75% or Sfr at 2.5%

• Company B, which has a lower credit rating, can issue US dollar fixed debt of thesame 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 at2.62%, 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 80m and receiving 2.15% on sfr 120 m. It also exchanges principal amounts for the lifeof the swap

• Similarly, it does a deal with B, paying the company 2.15% on sfr 120 m and receiv-ing 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 ‘pass through’

• Company A could have issued fixed sfr at 2.50% and through the swap, has achieved2.15%, a net benefit of 35 basis points

• Company B could have issued fixed US dollar at 8.70% and achieved 8.37% but hasa small amount of currency risk because it is paying 7.90% in US dollars and .47% inswiss francs. It will still go ahead with the deal as the risk is small compared to theannual saving of 33 basis points on US dollar 80 m.

• One can extend this idea of a cross currency swaps into a commodity swap involv-ing commodities like oil, gas, electricity etc

• Swap is an integral part of modern debt financing.


SECTION - 5INTEREST RATE CAPS, FLOORS AND COLLARS

� Interest rate caps

� Need to Control Capital Assets




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. Thetime between the resets is known as the tenor. In this case, the LIBOR may go up or godown 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 anunderlying 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 yearsand 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 ofthe 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 offwhen 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 underlyingfloating 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.



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 theircredit 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 de-crease, 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 % floorcontract 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 primerate multiplied by 300 million

• If the prime rate is higher than 6.5%, the lender receives no payment


SECTION - 6OPTIONS

6.1. OPTIONS

6.1.1 Options are derivative instruments that give the buyer a right to buy or sell an underly-ing asset at a specified price on or before a certain period.

6.1.2 Options are another type of financial derivative product available for risk management.6.1.3 Options help manage contingent risks, which means risks to which we will be exposed

if a particular event or situation happens.6.1.4 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 willcreate considerable foreign exchange risk.

6.1.5 Options are traded on exchanges. The Chicago Board Options Exchange(CBOE) wasthe first registered securities exchange for the trading of options.

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 whichcan be a share, bond or interest rate or commodity.

• Parties: There are two main parties in an option contract, namely the buyer and theseller or the writer. The buyer of the option has the right but no obligation and theseller 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, theoption expires on a specified date.

• Option premium: To obtain the right to buy or sell, the option buyer has to paycertain amount of money which is known as the option price or premium which canalso be called the value of the option.

• 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




spot price 500Exercise price 600Option premium 20Profit -20

Call option[Buyer]

• 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 threemonth’s time and its today’s price is 500. He expects that the price will be above 600in three months to come.

• Option premium 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 tobuy this asset at 600 as in the market it is available for 500. Option has value onlywhen 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 casethe conditions are favorable and incur only the premium cost in case things are notfavorable. This is the most unique feature of the option which is it protects thebuyer from the downside while leaving the upside potential in tact.

• The pay off table shows the relationship between the spot price and the net cashflows from an option.

• Pay off table of a call option buyer:

6.3. TYPES OF OPTIONS

6.3.1 Call option: Call option is the right to buy an underlying asset at the strike price on orbefore a certain time. Call option is entered into when a buyer anticipates that the priceof the underlying is likely to increase in future.

6.3.2 Put option: Put option is the right to sell an underlying asset at the strike price on orbefore a certain time. Put option is entered into when a buyer anticipates that the priceof the underlying is likely to go down in future.

6.3.3 Premium is the price paid by the option buyer to the option seller upfront.

6.4. ILLUSTRATIONS USING PAY OFF DIAGRAMS OF RISKMANAGEMENT THROUGH OPTIONS


• 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 in-

creases over and above the strike price.

Net pay off

500 550 600 650 700 750

Prof

it

100

80

60

40

20

0

-20

-40

Net pay off

Sold Call option

Spot price Net pay off500 -20520 -20540 -20560 -20580 -20600 -20620 0640 20660 40680 60700 80



• In the above case, the seller of the call option gains when spot price is below thestrike price and starts loosing when the spot price is above the strike price as thebuyer of the option will exercise his option. The seller of the call option expects theprice to go down. He collects the option premium upfront which is his gain

Put option buyer:

• Put option is the right to sell an asset at a predetermined price, known as the exer-cise 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

spot price 500Exercise price 600Option premium 20Profit 80

Put option[Buyer]

Spot price Net pay off500 80520 60540 40560 20580 0600 -20620 -20640 -20660 -20680 -20700 -20

20

10

0

-10

-20

-30

-40

-50

-60

0 20 40 60 80 100 120 140 160 180

Price of underlying

Pro

fit

Pay-off diagram at option expiration

Price of underlying

• Sell option, so gain the premim

• Lose if price of underlying risesand option in-the-money

• Maximum gain when option ex-pires worthless, gain premium


• As long as the spot price is below the strike price, the buyer of the put option gainsand when once the spot price is above the strike price, the loss is restricted to onlythe option premium paid as the buyer of the put option has only the right and notthe obligation to sell.

6.5. SUMMARY

6.5.1 The diagram below shows the summary of different payoff diagrams of option buyerand 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 putoption, the buyer has the potential to obtain unlimited benefits if the conditions arefavorable while restricting the loss to only the option premium.

6.5.3 In the case of the seller of a call or put option known as the writer of the option, there isa possibility of unlimited loss but the writer collects the premium upfront.

6.5.4 It is possible to be an option buyer and seller at the same time which opens up thepossibility of infinite number of combinations and pay offs to be engineered by aninvestor. This discipline is known as financial engineering.

6050403020100-10-20

6050403020100-10-20

Call and put optionsBought call

Bought put

Sold call Sold put

Price of underlying Price of underlying

Price of underlying Price of underlying

201001020-30-40-50-60

20100-10-20-30-40-50-60

Pro

fit

0 20 40 60 80 120 140 160 180

0 20 40 60 80 120 140 160 180 0 20 40 60 80 120 140 160 180

0 20 40 60 80 120 140 160 180

Pro

fit

Pro

fit

Pro

fit



6.6. OPTION VALUATION

6.6.1The price of an option is the option premium. At any point in time, the buyer or seller ofthe 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 andBlack and Scholes models.

6.6.3Option value is driven by a number of variables, as explained below:

• 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

6.6.4 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 exer-cised is small, and so its value

• Sd, the volatility

• The higher the volatility, the chances of spot price being much higher or lowerat expiry than now is relatively high and hence the higher value of the option

• T, Time to expiry

• The longer the option has to run, the greater the chance that the price will endup above the exercise price, so as t gets longer, the option value goes higher

• R, the risk free interest rate

• This is to account for the time value of money


S 25 Current stock price

X 25 Exercise pricer 6.00% Risk-free rate of interestT 0.5 Time to maturity of option (in years)sd 30% Stock volatilityCall price C= SN(x)-Ke-rtN(x-sd?t)

d1 0.2475 <—(LN(S/X)+(r+0.5*sd^2)*T) (sd*SQRT(T))d2 0.0354 <— -sd*SQRT(T)N(d1) 0.597 <— Uses formula NormSDist(d1)N(d2) 0.5141 <— Uses formula NormSDist(d2)Call price 2.47 <— S*N(d1)-X*exp(-r*T)*N(d2)Put price 1.73 <— call price - S + X*Exp(-r*T): by Put-

Callparity

6.7. OPTION VALUATION MODEL-THE BLACK AND SCHOLESMODEL



SECTION - 7

COMPREHENSIVE ILLUSTRATION ONRISK 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

� Comprehensive illustration on risk management through derivative products


Order value 2.5 million

Spot rate in August 1.75 1.6 1.75 1.6000 000 000 000

No hedge taken 1429 1563 0 0

Forward sale 1.6539 1512 1512 83 -51

Option bought 1.675 at 2.03 C 1475 1545 46 -18

Cost of call option 18

If we get the order If we do not get the order

• 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 thisstrategy

• 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 anddeliver in which case if the rate is 1.75, the company will gain 83000 and if the spot rateis 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. Thiswould 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 marketand if the spot rate is below 1.675/1, the call option lapses and we get the receipts lessthe initial cost of 18000.

• If the spot rate is above 1.675/1, then after the initial cost of 1475, regardless of the thenspot rate, since the loss in the receipt due to the higher spot rate is exactly matched by thegain on the call option

• If the company doesn’t get the order, the maximum it can loose is only the option pre-mium, which is 18000.



• One can note that the maximum loss is 51000 under the forward contract and under theoptions approach, it is 18000

• The final decision, whether to go for forward or option, depends on the probability ofgetting the order. If this probability is very high, forward would be a better option and ifthere is very low probability of getting the order, it is better to go for option.

Futures trading - why the panel may be flummoxed

The futures platforms offered not only a firm and timely indication of the prices to expect atharvest 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 theMinister for Agriculture, Mr Sharad Pawar, came to the end of his reply, a question wasraised from the Left benches about the Government’s position on the forward markets. Inreply, Mr Pawar mentioned that an expert committee appointed under the Chairmanship ofProf Abhijit Sen had been deliberating the issue for 14 months and was yet to submit itsreport, 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 callfor a meeting of experts on the subject and take a final decision on the future of futurestrading, in the light of the severe opposition to these markets reflected during the discussionsin the Rajya Sabha and in the recommendations of the Standing Committee on Agricultureon the subject. Coming from a politician and statesman of Mr Pawar’s vintage, this was anunusual statement.

Even presuming that Prof Sen’s panel had failed to show the necessary alacrity in respectingthe time schedule, it would be unfair to decide the issue outside the Committee and punishthe innocent market and the farmers for no fault of theirs.


Further, one wonders why the Minister took the trouble of appointing a Committee if heknew 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 thegovernment was making to ensure food security, by restricting exports and facilitating im-ports, and the mechanisms of CACP (Minimum Support Prices), Food Corporation of India(FCI) and the Public Distribution System (PDS). This, by itself, suggested that the govern-ment was thinking more of the traditional means of ensuring food security rather than ex-perimenting with innovative and little understood mechanisms.

The statement by the Minister of Agriculture seems to have made Prof Sen’s position evenmore difficult. Last year, at about the same time, the matter of the utility, or otherwise, of thefutures markets was brought to him for examination. Even though the terms of reference ofthe Committee did not so suggest, it was obvious that the government was apprehensiveabout what the futures market could bring in.

It was quite clear that the futures market was an unwanted baby — of a different genderfrom the licence-permits-quota type of market systems that the government had carefullynourished till then. Prof Sen’s problem was that the baby was indeed of a different genderbut, despite the crude attempts at getting rid of it, was alive and kicking and threatened thebasic structure of the traditional agricultural marketing policies based on CACP-FCI-PDS.

Terms of reference

The terms of reference of the Abhijit Sen Committee, as distinct from the unwritten agendaof 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 in-creased.

It was not the case that the futures market possibly had an inflationary effect. The problemwas that forward trading and the futures markets resurrected by the NDA government goagainst the Central Government’s policies since Independence in respect of commodity mar-kets based on Minimum Support Prices, procurement from Food Corporation of India andthe Public Distribution System in the name of the weaker sections.

The opposition of the Left parties to the futures markets came essentially from the convictionthat it belonged to the wrong — liberal — gender. It was hoped that the Sen Committeewould give them the authority to abort it.

The mandate of the Sen Committee is simple enough. It is intriguing why the Committee is



taking such a long time to submit a report which, it had been thought, could be submitted injust 90 days. The problem seems to be as follows. The Committee found little evidence tosuggest any links between market price hike and volatility that could be directly linked to theoperations of the futures markets.

Under these circumstances, all that the Committee had to do was to make recommendationsabout how the performance of the futures markets could be further improved by sanitisingthe spot markets, improving finance to the commodity markets and promoting farmers’ re-sponse by facilitating it.

Uncomfortable facts?

It is not that the panel was to study the desirability or otherwise of lifting/continuing the banon the futures trade. The futures trade was resurrected in 1993 and, at least, three multi-commodity exchanges are doing pretty well with geometrical expansion of the volume oftransactions.

Further, it shook up established notions that the commodity market should be eternally basedon three pillars of CACP, FCI and PDS.

The Commission for Agricultural Costs and Prices (CACP) that would help determine theMinimum Support Prices; Statutory Minimum Prices are also, by corollary, the procurementprices;

The Food Corporation of India (FCI) that manages procurement of foodgrains and their con-duit to different States; and

The Public Distribution System (PDS) that would ensure retail distribution according to deci-sions taken by the Government.

If the Committee submitted its honest findings the government would be forced to permit thenormal delivery of the futures market infant. The problem for the Committee, probably, isthat that would raise a number of very inconvenient questions that would make the candidrecommendations unpalatable to the Government.

What purpose would the CACP serve in a situation where the futures market platformsoffered not only a firm and timely indication of the prices to expect at the harvest but alsoprovided an ironclad assurance, as also insurance, that farmers would be able to collect theprices? Further, since the commodity markets in India provide warehousing facilities, bank-ing and finance, insurance as also negotiable warehousing receipts, what function would beleft to justify the existence of Food Corporation of India, which had become notoriouslyunpopular 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 aseparate PDS network for the benefit of the weaker sections of the population? Would thatpurpose not be better served by simply mailing the targeted people food stamps or smart-cards, which would also obviate the substantial diversion of foodgrains from the PDS sys-tem?


(The author is founder, Shetkari Sanghatana and Member of Parliament — Rajya Sabha. Heis also a member of the Abhijit Sen Committee on Futures Trading, and can be reached [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 comesfrom the machine and part from the experience and capability of the driver.

In finance, derivatives are financial instruments whose value changes according to thechanges in fundamental variables. Just like the Americans have heard about the term ‘sub-prime’ for the last 12 months, Indians too have heard a lot about derivatives for the lastmonth or so. Futures, forwards, options, swaps and what not? Financial products based onsuch 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 morecrucial. “It is like a race car, part of the performance comes from the machine and part fromthe experience and capability of the driver,” tells Mr Omer Hevlin, Sales Director (Asia),SuperDerivatives (www.superderivatives.com). SuperDerivatives is the benchmark for de-rivatives pricing and the leading provider of multi-asset front-office systems, risk manage-ment, revaluation and online options trading solutions.

Indian banks such as Centurion Bank of Punjab have leveraged their expertise to managemulti-asset portfolios of exotic options and structured products and calculate exposure inreal time. But that’s not enough. “Because they are still running their risk using TV (terminalvalues), rather than real time rates and volumes,” Mr Hevlin told Business Line in course ofan e-mail interaction from Singapore.

Excerpts from the interview:

Derivatives market is often shrouded in conscious secrecy or veiled transparency. Rightfrom 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 fullyunderstand the risks involved. Our goal is to lift the veil of secrecy and bring transparency toderivative pricing and valuation by empowering any market participant to obtain pricesthat 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 Indiancompanies?

We believe that the position taken by a corporate needs to be well analysed and risks have tobe clearly anticipated.

How can a product meant to serve as an insurance against fluctuating currency backfire?



The product needs to be used by professionals. It is like a race car, part of the performancecomes 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 andunique?

Prior to the advent of SuperDerivatives, options practitioners faced two major obstacles. Thefirst one was price opacity. Practitioners could use the ubiquitous Black-Scholes formula toprice vanilla options and with the same framework price all exotic options, although it waswell known that the Black-Scholes approach produced prices significantly different than theactual market prices.

The leading traders from the top investment banks were able to compensate for Black-Scholes deficiencies by leveraging their experience in the market together with their vastcomputational resources to accurately price options - and those prices were closelyguarded.

Closely guarded prices, isn’t that dangerous?

Thousands of less experienced professionals who traded options regularly - mostly fromthe buy-side (corporations and investment funds) - lacked the tools and expertise to pricethem accurately. As a result, the buy-side was dependent on the sell-side (banks) for tradedesign, price fairness and post-trade revaluation for complying with accounting standardsin their P&L reporting. The inability to price options accurately made many people on thebuy-side less active in options and severely limited the benefits that options could providethem 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 andinfrastructure to support options business activity. Missing were effective solutions forpricing, analysis, market data feed, risk management and more. Only a few of the world’slargest 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 inthe forex derivatives market?

The marked-to-market losses in India are estimated to be between Rs 12,000 to 20,000crore 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 oftalent entering the derivatives sphere?

The participants need to have a complete understanding of the extent of risk/losses thatthey would be exposed to when they enter into a structure.


More specialised courses need to be introduced by the educational institutions/organisations. Professional and well-trained staff needs to be handling the treasury func-tions in small and medium enterprises (SME) which is currently not the case. For example:A person handling finance and accounts 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 andvolumes, same goes for their Greeks and credit exposure. (The Greeks are a collection ofstatistical values expressed as percentages that give the investor an overall view of how aunderlying asset has been performing. These statistical values can be helpful in decidingwhat options strategies are best to use.)

Training, of course, would help as derivatives is an evolving market with products beingintroduced in the market on a regular basis. Hence, staying on top of the situation wouldhelp containing risks.

They need to be aware of issues like the volume input they are using to evaluate their risksis based on ATM volumes (an option is At-The-Money if the strike price is the same as thecurrent price of the underlying security on which the option is written) volumes which arenot enough for deep OTM options (Out-of-The-Money are those that would be worthless ifthey expired today).

What are the ‘must checks’ that companies should ensure before entering into deriva-tives contracts?

Do have the capability to assess future exposure of each deal and compare it to valid creditclient before signing 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 addressclients 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 whichare based on bank rates so that traders can control prices/volumes/spread on a real timebasis.

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.



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 thisweek—and how the financial system will change as a result. We start with how finan-ciers—and their critics—have laboured under a delusion

“A COMPANY for carrying out an undertaking of great advantage, but nobody to knowwhat it is.” This lure for the South Sea Company, published in 1720, has a whiff of the 21stcentury about it. Modern finance has promised miracles, seduced the brilliant and thegreedy—and wrought destruction. Alan Greenspan, formerly chairman of the Federal Re-serve, said in 2005 that “increasingly complex financial instruments have contributed to thedevelopment of a far more flexible, efficient, and hence resilient financial system than the


one that existed just a quarter-century ago.” Tell that to Bear Stearns, Wall Street’s fifth-largest 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 inevitableconsequence of the laissez-faire philosophy that allowed financial services to innovate andspread almost unchecked. This has created a complex, interdependent system prone toconflicts of interest. Fraud has been rampant in the sale of subprime mortgages. Spurredby pay that was geared to short-term gains, bankers and fund managers stand accused ofpocketing bonuses with no thought for the longer-term consequences of what they weredoing. Their gambling has been fed by the knowledge that, if disaster struck, someoneelse—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 boomsand busts every ten years or so. But the past decade has been plagued by them. It has beenpocked by the Asian crisis, the debacle at Long-Term Capital Management, a super-brainyhedge fund, the dotcom crash and now what you might call the first crisis ofsecuritisation. If the critics are right and something in finance is broken, then there will bepressure to reregulate, to return to what Alistair Darling, Britain’s chancellor of the exche-quer, calls “good old-fashioned banking”. But are the critics right? What really wentwrong with finance? And how can it be fixed?

Happy days

The seeds of today’s disaster were sown in the 1980s, when financial services began apattern of growth that may only now have come to an end. In a recent study MartinBarnes of BCA Research, a Canadian economic-research firm, traces the rise of the Ameri-can financial-services industry’s share of total corporate profits, from 10% in the early1980s to 40% at its peak last year (see chart 1). Its share of stockmarket value grew from6% to 19%. These proportions look all the more striking—even unsustainable—when younote that financial services account for only 15% of corporate America’s gross value addedand a mere 5% of private-sector jobs.

Money machineFinance industry profits and gross value added As%US Corporate total

Profits

85Source :BCA Resarch

50

40

30

20

10

01980 90 95 2000 05 07

1



At first this growth was built on the solid foundations of rising asset prices. The 18 years to2000 witnessed an unparalleled bull market for shares and bonds. As the world’s centralbanks tamed inflation, interest rates fell and asset prices rose (see chart 2). Corporaterestructuring, wage competition and a revolution in information technology boostedprofits. 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 firmsmade 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 growthsince then has been weaker than in any cycle since the 1950s, barring the double-dip recov-ery in 1980-81. Stephen King and Ian Morris of HSBC point out that growth in consumerspending, 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. Aservice industry that, in effect, exists to help people write, trade and manage financial claimson future cashflows raced ahead of the real economy, even as the ground beneath it fellaway.

The industry has defied gravity by using debt, securitisation and proprietary trading to boostfee 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 higherleverage, has quintupled. In addition, the industry has combined computing power andleverage to create a burst of innovation. The value of outstanding credit-default swaps, forinstance, has climbed to a staggering $45 trillion. In 1980 financial-sector debt was only a


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 theirown accounts. Goldman Sachs is using about $40 billion of equity as the foundation for $1.1trillion of assets. At Merrill Lynch, the most leveraged, $1 trillion of assets is teetering onaround $30 billion of equity. In rising markets, gearing like that creates stellar returns onequity. 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 consumer-price inflation. In more regulated times, credit controls or the gold standard restricted thecreation of credit. But recently central banks have in effect conspired with the banks’ urge toearn fees and use leverage. The resulting glut of liquidity and financial firms’ thirst for yieldled 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 financialassets’ habit of growing during booms. By lodging their extra assets as collateral, the inter-mediaries can put them to work and borrow more. Tobias Adrian, of the Federal ReserveBank of New York, and Hyun Song Shin, of Princeton University, have shown that since the1970s, debts have grown faster than assets during booms. This pro-cyclical leverage can feedon itself. If financial groups use the borrowed money to buy more of the sorts of securitiesthey lodged as collateral, then the prices of those securities will go up. That, in turn, enablesthem to raise more debt and buy more securities.

Indeed, their shareholders would punish them if they sat out the next round—as ChuckPrince let slip only weeks before the crisis struck, when he said that Citigroup, the bank hethen headed, was “still dancing”. Mr Prince has been ridiculed for his lack of foresight. Infact, he was guilty of blurting out finance’s embarrassing secret: that he was trapped in adance 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 createabundant credit will also destroy it. Most things attract buyers when the price falls. But notnecessarily securities. Because financial intermediaries need to limit their leverage in a fallingmarket, 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 turnsuntil 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 hugepay 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.



Yet pay—or at least bad management—probably made this crisis worse. Trades determinebonuses 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 banksworst hit by the crisis had failed to oversee traders or take a broad view of risk across theirfirms. Perhaps, with proper incentives, managers would have done better.

Alan Johnson, a consultant who designs pay packages for Wall Street, predicts that in futuresenior executives will face the prospect of some of their bonuses being contingent on thebank’s performance over several years. Yet to the extent that many senior bankers are paidin shares they cannot immediately sell, they already are. And to the extent that Bear Stearns’semployees 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 prod-uct of the deregulation of finance misses an important point. The worst excesses in thesecuritisation mess are encrusted precisely where regulation sought to protect banks andinvestors from the dangers of untrammelled credit growth. That is because regulations offernot 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. Ifthe market leads to losses, the chances are they will have enough capital to cope. Yet this rulesets up a perverse incentive to create structures free of the capital burden—such as creditsthat last 364 days, and hence do not count as “permanent”. The hundreds of billions ofdollars in the shadow banking system—the notorious SIVs and conduits that have causedthe banks so much pain—have been warehoused there to get round the rules. Spain’s bank-ing regulator prudently said that such vehicles could be created, but only if the banks putcapital aside. So far the country has escaped the damage seen elsewhere. When reformedcapital-adequacy rules are introduced, this is an area that will need to be monitored rigor-ously.

It is the same with rating agencies, the whipping boys of the crisis. Most bonds used to beissued by companies, and to judge something AAA was straightforward. Perhaps back thenit 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 pass off poor credit as AAA, becausethey 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 partlybecause the last phase of its growth was founded on unsustainable leverage, and partlybecause the value of the underlying equities and bonds is unlikely to grow as it did in the1980s 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 washalf 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 betterunderstood—and smaller. That is financial progress. It is a pity that it comes at such a cost.


STUDY NOTE - 9

SOURCES OF INTERNATIONAL FINANCE

SECTION - 1

RISING FUNDS IN FOREIGN MARKETS ANDINVESTMENTS IN FOREIGN PROJECTS

1.1 RISING FUNDS IN FOREIGN MARKETS AND INVESTMENTSIN FOREIGN PROJECTS

1.1.1 Foreign or international capital market offers a good opportunity for domestic firms toraise finances. These markets include the US, UK, Japan etc. Since 1991, after governmentof India introduced financial liberalization policies, a number of Indian companies tookadvantage of this opening up in international capital markets. The global investors,who are seeking portfolio diversification, see investment in Indian stocks or bonds as aprofitable avenue on the basis of risk adjusted return.

1.1.2 The main advantage of sourcing from international capital markets is the lower cost offunds, besides enriched brand image. For example, Tata motors, borrowed recently at0% interest from international capital market.

1.1.3 There are different instruments through which an Indian firm can raise money fromthese 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 papersare marketed in international capital markets to attract global investors. They hold thesepapers which are listed in the international stock exchanges like the New york stockexchange, NASDAQ exchange, the Luxemburg exchange etc. Hence, these instrumentsare very liquid and tradable across international exchanges. Similarly, there are Americandepository receipts (ADRs) which are mainly traded in the American exchanges. TheGDRs can also be traded in the Indian exchanges.

1.1.4 The other popular instrument is the Euro bonds. These are debt instruments, whichcarry a rate of interest (coupon). Many Indian companies raised funds from the Japanesemarket at 1 to 2% rate of interest.

1.1.5 There are innovations in the way Euro bonds can be structured to suit the requirementsof the investors. Euro Convertible Bonds [ECBs] are hybrid instruments. Initially a debt

� Rising funds in foreign markets and investments in foreign projects

This Study Note includes



instrument bearing a coupon with a convertibility clause which entitles the owner toconvert these debt instruments into equity instruments. This convertibility options makesthese instruments very popular in a booming capital market context. For example, if acompany’s share is likely to do very well in the next three years, its current share pricebeing Rs.400 which is expected to go up to Rs.800, it may issue an ECB at 1% rate ofinterest with an option to the investor for converting these bonds into equity shares atsay Rs.500 after three years.

1.1.6 Many of these instruments can be used to raise finances in US dollars, Euro (the earlierFrench francs, German mark, Italian lira, etc.).

1.1.7 More importantly, the process of going global or raising money in international capitalmarkets is a useful learning experience in global reporting standards and internationalbench marking. The typical process involves appointment of an investment banker,who prepares a detailed document for the road shows to be organized across theworld, marketing the issue to the well informed international investors. The reportingof financial results should confirm to international accounting standards. It helps incorporate valuation and helped Indian companies discover their true value.There has to be proper documentation regarding the proposed use of funds andfinancial projections. The funds have to be used only for the purposes for whichthey were raised. RBI has come out with very strict circulars and guidelines on thisaspect.

1.1.8 There will be a book building process where different investors bid for these Indianpapers. The entire book building process helps in better price discovery. This process isnow practiced even for domestic IPOs and SPOs.

1.1.9 There are also international stock exchanges which prescribe very strict listingrequirements. The listing discipline has helped Indian companies to improve theirstandards 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 partiesinvolved in international capital money markets.

1.1.11 If the funds are raised in foreign currencies, the companies are exposed to exchangerate risk and interest rate risk. There is also the possibility of realizing a lower value dueto the superior bargaining power of the international investors.

1.1.12 Many of the Indian companies raised money from international capital markets andused this money to prepay domestic debts, which created problems for the Indian bankswhich have lent money to these companies. The government has come up with end usemonitoring provisions to manage these risks, besides putting an overall cap on theamount of money that can be raised from the international capital markets by way ofGDRs, ECBs etc.

Factors influencing the development of accounting in a particular country:• Economic environment;


• Legal environment;

• Political environment;

• Capital markets;

• Cultural environment;

• Educational environment;

• Ethical environment;

• Social environment; and

• Others;

All are interlinked.



SECTION - 2

FORWARD RATE AGREEMENT AND INTERESTRATE GUARANTEES

2.1 BASICS OF FOREIGN EXCHANGE2.1.1 The foreign exchange market is the organizational framework within which individu-

als, companies, banks and brokers buy and sell foreign currencies. It has two levels; theinter-bank or wholesale market and the client or retail market. It is not a physical placebut an electronic network of banks, foreign exchange brokers and dealers. It is a 24-hour market.

2.1.2 Spot rate:

In the spot market, currencies are bought or sold for immediate delivery, which in prac-tice means settlement in two working days. The exchange rate at which the currenciesare 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 cur-rency for a specified amount of another currency at some future date. For example, ifyou know that you will be receiving USD 500000 in six month’s time, you can get aquote for a forward exchange rate in six months between USD/INR and book a sixmonth forward contract at this rate so that you will know how much you will get ex-actly without any uncertainty. Through forward rates, risks due to foreign exchangerate fluctuations can be managed.

2.2 FORWARD RATE AGREEMENT AND INTEREST RATEGUARANTEES

2.2.1 Forward rate agreement [FRAs] is a contract agreeing to buy or sell foreign exchange ata predetermined rate of exchange. They are also known as derivative contracts andinstruments for hedging or managing exchange rate risk caused by the volatility inforeign exchange rates. So, an importer wants to freeze the exchange rates at the currentlevel 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 theconversion rate of exchange right now. The recent fluctuations in the rupee dollar ex-change rate has wiped out the profits of many small textile mills in Tiruppur, in


� Basics of foreign exchange� Forward rate agreement and interest rate guarantees� Advantages and disadvantages of using forward contracts� Interest rate guarantees


Tamilnadu. Similarly, there was a substantial reduction in the profit of Infosys andother major software exporters in 2007 due to exchange rate volatility. A forward rateagreement to some extent saved the companies in these situations. The importer or theexporter enters into a FRA with the banks or foreign exchange dealers.

2.3 ADVANTAGES AND DISADVANTAGES OF USINGFORWARD 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 ratesmay 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 surewhat 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 reducedreturn 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 pos-sibility of benefiting from higher interest rates. In these circumstances, interest-rateguarantee products can be very useful. An Interest-Rate Guarantee is a product, whichcan be very useful in these circumstances. Basically, it is an option on a Forward-RateAgreement. It allows you a period of time during which you have the right to buy aForward-Rate Agreement at a set price. The guarantee protects you against a fall ininterest rates while giving you the freedom to enjoy a better return if rates increase. Ifyou want this guarantee you will need to pay a higher premium.

2.4.2 Illustration:

Suppose you will have a deposit of $1,000,000 for a 6-month period beginning in 3months’ time. You want to protect your firm against lower interest rates and guaranteea minimum return of 5%. You can buy an Interest-Rate Guarantee at this rate of 5%. Letus 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 Guar-antee and will receive a compensation for the 0.5% difference in interest rates sothat your 5% return is protected.



• In 3 months’ time the 6-month Libor sets at 5.5%. You choose not to use your guar-antee and instead you will deposit your funds at the higher rate. In these circum-stances the Interest-Rate Guarantee protected you against lower interest rates andalso 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 yourrequirement.

• Interest rate guarantees are available for all major currencies and different maturi-ties

• One can get Interest-Rate Guarantees from a bank other than the one who holds thecash. Interest-Rate Guarantee can be used for any cash held or expected to have.

The price of your Interest-Rate Guarantee will depend on:

o the guaranteed rate;

o how long you want the Option for; and

o How often interest rates are changing.


SECTION - 3

EXPOSURES IN INTERNATIONAL FINANCE

3.1 EXPOSURES IN INTERNATIONAL FINANCE

3.1.1 Irrespective of the nature of overseas activities, organizations need to understand andwhere appropriate, control the degree of foreign exchange variability to which they areexposed. To do this, each organization must develop an organizational framework whichgenerates 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 bemeasured?

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. Accounting of international transactions in line wit Indian and International GAPPaccounting 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 inrelevant exchange rates is known as the foreign exchange risk. Transaction exposurearises from changes in cash flows that result from a firm’s existing contractual obliga-tions 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


� Exposures in international finance

� Transaction exposure

� Translation exposure

� Economic exposure

� Forecasting foreign exchange rates

� Interest rate parity

� Purchase power parity

� Fisher effect



types of transaction exposures are loans denominated in overseas currencies, purchasesfrom overseas companies and dividends from overseas subsidiaries.

3.3 TRANSLATION EXPOSURE

3.3.1 This is also known as accounting exposure. This arises from the need to translate theforeign currency financial statements of overseas subsidiaries into the home currencyin order to prepare a set of group financial statements in the home currency. An ex-ample would be an Indian company with a US subsidiary. In order to prepare the fullaccounts for the Indian company, the accounts of the US subsidiary will need to betranslated into INR. Every time the accounts are translated, a uniform INR/USD ex-change rate will be used, usually year end or an average for the accounting period. Dueto this translation, the reported values may be different, though there are no cash flowimplications. The company has to strictly follow the Accounting Standards prescribedin this regard. Students are advised to have knowledge on all the latest AccountingStandards.

3.4 ECONOMIC EXPOSURE

3.4.1 It is also called operating or strategic exposure. It measures the change in the presentvalue of the firm resulting from any change in the future operating cash flows of thefirm caused by an unexpected change in exchange rates. The change in value dependson the effect of the exchange rate change on future sales volume, prices or costs.

3.4.2 Economic exposure can be thought of as encompassing transaction exposure, but gen-erally takes a long term perspective, in that it looks at the whole operation of a com-pany and how cost and price competitiveness could be affected by movements in ex-change rates. For example, a company manufacturing Luxury cars in India for sale toUS will be exposed to transaction risk on all sales to the US denominated in USD whenrupee strengthens. However, the Indian company will also be economically exposed.Over time, the Indian company will be exposed to shifts in the INR/USD exchangerate. If the competitors of the Indian based manufacturer area all based in US, any in-crease of the INR/USD exchange rate will increase sales prices in US, which may meanloss 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: Fundamentalapproaches and technical approaches. One of the fundamental approaches is known asthe four way equivalence model or parity conditions. There are four relationships thatunderpin international exchange rates: purchase power parity theory, fisher effect, in-terest 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 ratesfor securities of similar risk and maturity should be equal to the difference between


forward and spot rates of exchange. i.e the forward premium or discount is equal to theinterest rate differential. If the forward premium or discount is not equal to the interestdifferential, there are opportunities for risk free arbitrage. This parity condition meansthat a country with a lower interest rate than another should value its forward currencyat a premium in terms 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 spotrate 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 113USD 150 in one year, at an annual rate of 10%=USD 165Forward 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 whereverit is available in the world, otherwise opportunities for arbitrage will arise; that is peoplewill try and buy the product in the cheaper market and sell it in the more expensivemarket to make a profit. Translated into a more general parity theory, this means thatthe general level of prices, when converted to a common currency, will be the same ineach country, price changes due to inflation in one country are compensated by a changein exchange rate so that the real cost of products remain the same. If the inflation rate inUK is 8% and that in USA is 5% and the spot rate is USD 1.5=1 GBP, we would expectthe GBP to deteriorate against the USD by, on average, 3% a year. So in a year’s timeyou 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: arequired real rate of return and an inflation premium, equal to the expected rate ofinflation. 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 fromcountries with low rates of return to countries with high rates of return. If real rates ofinterest are thought to be the same worldwide, the difference in nominal interest ratesbetween countries should be due to differences in inflation rates.The fisher effect and purchasing power parity theory together make up the interna-tional fisher effect, which holds that interest rate differentials between countries shouldbe reflected in the expectation of the future spot rate of exchange. Purchase power par-ity theory states that a rise in the home country’s inflation rate will also be accompaniedby a devaluation of the home country’s currency.



SECTION - 4

FOREIGN DIRECT INVESTMENT

4.1 FOREIGN DIRECT INVESTMENT

4.1.1 FDI (Foreign Direct Investment) has become a key component of national develop-ment strategies for almost all the countries over the Globe. FDI is considered to be anessential tool for jump-starting economic growth through bolstering of domestic capi-tal, productivity and employment. Reliance on FDI is rising heavily due to its all roundcontributions to the economy. The important effect of FDI is its contributions to thegrowth of the economy. FDI has an impact on country’s trade balance, Increasing labourstandards and skills, transfers of new technology and innovative ideas, Improving in-frastructure, skills and the general business climate.

4.1.2 FDI is considered to be the lifeblood for economic development as far as the develop-ing nations are concerned. FDI to developing countries in the 1990s was the leadingsource of external financing. The rise in FDI volume was accompanied by a markedchange in its composition. That is investment taking the form of acquisition of existingassets (mergers and acquisitions) grew much more rapidly than investment in newassets 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 inter-ests of the investor in a company, which is in a different nation distinct from the investor’scountry of origin.

4.2.2 A parent business enterprise and its foreign affiliate are the two sides of the FDI relation-ship. Together they comprise an MNC. The parent enterprise through its foreign directinvestment effort seeks to exercise substantial control over the foreign affiliate company.‘Control’ as defined by the UN, is ownership of greater than or equal to 10% of ordinaryshares or access to voting rights in an incorporated firm. For an unincorporated firm oneneeds to consider an equivalent criterion. Ownership share amounting to less than thatstated above is termed as portfolio investment and is not categorized as FDI.

4.3 CLASSIFICATION OF FOREIGN DIRECT INVESTMENT

4.3.1 Foreign direct investment may be classified as Inward or Outward.


� Foreign Direct Investment:

� Definition of Foreign Direct Investment

� Classification of Foreign Direct Investment


4.3.2 Foreign direct investment, which is inward, is a typical form of what is termed as ‘in-ward 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 ofexistent regulations, loans at low rates of interest and specific grants. The idea behindthis is that, the long run gains from such a funding far outweighs the disadvantage ofthe income loss incurred in the short run. Flow of Inward FDI may face restrictionsfrom 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 investmentabroad”. In this case it is the local capital, which is being invested in some foreignresource. Outward FDI may also find use in the import and export dealings with aforeign country. Outward FDI flourishes under government backed insurance at riskcoverage.

4.3.5 Illustration

‘G’ company Ltd, is a company that manufactures a specialized computer game in In-dia and sells it within the euro zone in France and Germany. Its major competitor inthese markets is a Japanese supplier of the same game. All sales are invoiced in the localcurrency, and the selling price is set at the beginning of the year. It usually takes threemonths between the sale of a game and the receipt of the currency proceeds.80% ofsales to France and Germany can be predicted in terms of amount and date. There is a15% 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 Russianrouble has been subject to sudden devaluations against the INR.

The management team of ‘G’ company has come to you for advice. It has heard aboutcurrency transaction, translation and economic exposure and would like to know ifthese are an issue for the company.

Required:

1) Locate examples of the three types of foreign exchange exposure in the scenario andadvise suitably.

2) Suggest which hedging techniques might be available for ‘G’ Company and thequestions that you would ask the management team in order to establish whichtechniques would be most appropriate.



1 Transaction exposure On sales to Germany and France as in euro;Sales price set at beginning of the year and timedelay between sale and receipt

Translation exposure May be with the Russian subsidiary if anytransactions are in roubles, although we aretold that they are in INR

Economic exposure Japanese competitor; if yen weakens against theINR, its products will be cheaper relative to ‘G’company.Russian subsidiary sales will be susceptible tostrong INR as may make the product too expensivefor the local market

2 Possible hedging techniques Do nothing.Cover forward for specific contracts as 80% certainUse options for the balance

Questions to ask What is management team’s approach to risk?If risk averse, will want to use forward to lock in

4.3.6 Solution:


STUDY NOTE - 10INTERNATIONAL MONETARY FUND AND

FINANCIAL SYSTEM

SECTION - 1UNDERSTANDING INTERNATIONAL

MONETARY SYSTEMThis 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 follow-ing 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 globaltrade

e. Technology is a great enabler in fostering international trade and scaling up of op-erations


INTERNATIONAL MONETARY FUND AND FINANCIAL SYSTEM

f. Globally, there is a trend towards elimination of all trade barriers and facilitateuninterrupted global trade

g. Loss due to exchange fluctuations if not prevented or unattended immediately woulderode 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-orientedeconomies in Asia, the creation of a single European market, trade liberalization throughregional trading blocs, such as European union, the world’s joint mechanism, such asthe world trade organization, have all impacted and facilitated the growth of interna-tional trade.

1.1.3 In 1989, Mexico significantly liberalized its foreign direct investment regulations to al-low 100% foreign ownership. The North American Free Trade Agreement of 1994 ex-tends the areas of permissible foreign direct investment and protects foreign investorswith 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 havebeen 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 goodsand services with each other. The underlying assumption is that some countries canproduce some types of goods more efficiently than other countries. Hence, the theory ofcomparative advantage assumes that all countries are better off when each one special-izes in the production of those goods which it can produce more efficiently and buysthose goods which other countries produce more efficiently. It neutralizes the cost andbenefits more effectively.

1.2.3 The theory of factor endowments

Countries are endowed differently in their economic resources. Columbia is more effi-cient in the production of coffee and the US is more efficient in the production of com-puters. Colombia has the oil, weather and abundant supply of unskilled labor necessaryto produce coffee more economically than the US. Differences in these national factorendowments 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 againstother 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 patternson the basis of stages in a product’s life. In the context of international trade, the theoryassumes that certain products go through four stages: Introduction and export, interna-tional production, intense foreign competition and imports.


1.2.5 Trade control

The possibility of a foreign embargo on sales of certain products and the needs ofnational defense may cause some countries to seek self sufficiency in some strategiccommodities. Political and military questions constantly affect international trade andother international business operations. Tariffs, import quotas and other trade barri-ers are three primary means of protectionism. This is where a country’s economicreforms and liberalization really support 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) inGeneva. To join 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 thesame 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 replacedthe GATT since the Uruguay Round accord became effective on January 1, 1995. Today,WTO’s 135 members account for more than 95% of world trade. The five major func-tions of WTO are:

a. Administering 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. Cooperating with other international organizations

1.3.3 Under the WTO, there is a powerful dispute-resolution system, with three-person arbi-tration panel. 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 interna-tional 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 incharge of policing member countries’ adherence to all the WTO agreements, signedby 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 theUruguay Round, and earlier negotiations under the GATT. The organization is cur-rently the host to new negotiations, under the Doha Development Agenda (DDA)launched in 2001.



h. Governed by a Ministerial Conference, which meets every two years; a GeneralCouncil, which implements the conference’s policy decisions and is responsible forday-to-day administration; and a director-general, who is appointed by the Minis-terial Conference.

1.3.4 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 throughthe reduction of tariff barriers, quantitative restrictions and subsidies on trade througha series of agreements.

c. It is the outcome of the failure of negotiating governments to create the InternationalTrade Organization (ITO).

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

e. The functions of the GATT were taken over by the World Trade Organization whichwas 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 for-eign 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 investmentthroughout the world. However, some of the countries receiving foreign invest-ment imposed numerous restrictions on that investment designed to protect andfoster domestic industries, and to prevent the outflow of foreign exchange reserves.

e. Examples of these restrictions include local content requirements (which requirethat locally-produced goods be purchased or used), manufacturing requirements(which require the domestic manufacturing of certain components), trade balanc-ing requirements, domestic sales requirements, technology transfer requirements,export performance requirements (which require the export of a specified percent-age of production volume), local equity restrictions, foreign exchange restrictions,remittance restrictions, licensing requirements, and employment restrictions. Thesemeasures can also be used in connection with fiscal incentives. Some of these in-vestment measures distort trade in violation of GATT Article III and XI, and aretherefore prohibited.


1.5 TRADE RELATED ASPECTS OF INTELLECTUAL PROPERTYRIGHTS (TRIPS)

a. TRIPS is an international agreement administered for the first time by the WorldTrade Organization (WTO) into the international trading system.

b. It sets down minimum standards for many forms of intellectual property (IP) regu-lation.

c. Till date, it remains the most comprehensive international agreement on intellec-tual property.

d. It was negotiated at the end of the Uruguay Round of the General Agreement onTariffs 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 broadcast-ing organizations; geographical indications, including appellations of origin; in-dustrial designs; integrated circuit layout-designs; patents; monopolies for the de-velopers of new plant varieties; trademarks; trade dress; and undisclosed or confi-dential information. TRIPS also specify enforcement procedures, remedies, and dis-pute resolution procedures.

f. In 2001, developing countries were concerned that developed countries were insist-ing on an overly-narrow reading of TRIPS, initiated a round of talks that resulted inthe Doha Declaration: a WTO statement that clarifies the scope of TRIPS; stating forexample that TRIPS can and should be interpreted in light of the goal “to promoteaccess 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 thatreduces intra-regional barriers to trade in goods, services, investment and capital. Thereare more than 50 such arrangements at the present time. There are five major forms ofeconomic cooperation among countries: Free trade areas, customs unions, commonmarkets, economic unions and political unions.

1.6.2 The North American Free Trade Agreement (NAFTA) among US, Canada and Mexicois an example of Free trade areas where member countries remove all trade barriersamong themselves.

1.6.3 Under the customs union arrangement, member nations not only abolish internal tariffsamong themselves but also establish common external tariffs.

1.6.4 In a common market type of agreement, member countries abolish internal tariffs amongthemselves and levy common external tariffs. The also allow the free flow of all factorsof production, such as capital, labor and technology.

1.6.5 The economic union combines common market characteristics with harmonization ofeconomic policy. Member nations are required to pursue common monetary and fiscalpolicies.



1.6.6 Political union combines economic union characteristics with political harmony amongthe member countries.

1.7 MOTIVES FOR FOREIGN INVESTMENT

1.7.1 The product life cycle theory, the portfolio theory and the oligopoly model have beensuggested as bases for explaining and justifying foreign investment.

1.7.2 Product life cycle theory explains changes in the location of production. After success-ful launch of new products, companies shift the manufacturing base to other countriesfor lowering costs and retain the margin. This is what is witnessed in India today, whichhas become the destination for low cost outsourcing. For eg. South India is called De-troit of US due to many MNC automobile companies setting up their production facili-ties there.

1.7.3 Portfolio theory indicates that a company is often able to improve its risk-return perfor-mance by holding a diversified portfolio of assets. This theory represents another ratio-nale 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 invest-ments to exploit their quasi monopoly advantages. The advantage of an MNC over alocal company may include technology, access to capital, differentiated products builton 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 itsresidents and foreign residents over a specified period, which includes exports and im-ports of goods and services, cash receipts and payments, gifts, loans, and investments.Residents may include business firms, individuals and government agencies. The bal-ance of payments helps business managers and government officials to analyze acountry’s competitive position and to forecast the direction of pressure on exchangerates. 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 inassets, liabilities and net worth during a specified period. Transactions between domes-tic and foreign residents are entered in the balance of payments as either debits or cred-its. Transactions that earn foreign exchange are often called credit transactions and rep-resent sources of funds. Transactions that expend foreign exchange are called debit trans-actions and represent use of funds. A country incurs a ‘surplus’ in its balance of pay-ments if credit transactions exceed debit transactions or if it earns more abroad than itspends. On the other hand, a country incurs a ‘deficit’ in its balance of payments if debittransactions 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. Predict pressure on foreign exchange rates


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 accounts

The international monetary fund (IMF) classifies balance of payments transactions into fivemajor groups:

a. Current account: merchandise, services, income and current transfers

b. Capital account: Capital transfers, non-produced assets, non financial assets

c. Financial account: Direct investments, portfolio investments and other investments

d. Net errors and omissions

e. Reserves and related items: These are government owned assets which include mon-etary gold, convertible foreign currencies, deposits, and securities. The principle con-vertible currencies are the US dollar, the British pound, the euro, and the JapaneseYen for most countries. Credit and loans from the IMF are usually denominated inspecial drawing rights (SDRs). Sometimes called ‘paper gold’ SDRs can be used asmeans of international payment.

INTERNATIONAL ORGANISATIONS AND ACCOUNTING STANDARDS

Many accounting professionals perceive standardization to be too strict and inflexible to pro-vide the information users 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 accounting organizations in 9countries; now grown to over 70 countries; over 100 professional accounting organiza-tions;

IASC develops and publishes IASs. IASC also promotes these standards for wide internationalacceptance;

Some countries use IASs as their national accounting rules and others use them as basis fortheir own accounting rules; MNCs voluntarily use IASs for secondary set of financial state-ments;

• European Union (EU): Founded on 25/3/57, is the Association of European States, whenBelgium, France, West Germany, Italy, Luxembourg and Netherlands signed the Treaty ofRome. Treaty was free movement of labour, capital and goods among member countriesby 1992, without any tariff or barrier.

Now EU imports and exports more than any single country in the world; with US as majortrading partner; there are 15 member countries now;

4th Directive:



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 thatwould 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 accounting and reporting and economic development.

In countries such as India, Canada and Australia, Foreign Investments need governmentapproval. In US and Switzerland, even domestic investments need government approval.

OECD guidelines provide for “Disclosure of information” in financial statements. There ex-ists open and cooperative relationship among the various organizations seeking to set inter-national accounting 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 worldwideand 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 rela-tions and brings out publications on international accounting and reporting issues.

INTERNATIONAL FEDERATION OF ACCOUNTANTS (IFAC)

IFAC established in 1977 if for development of accounting profession and works to achieveinternational technical, ethics and education pronouncements for the profession.

Other organizations are:

ASIA-PACIFIC ECONOMIC COOPERATION

NORDIC FEDERATIN OF ACCOUNTANTS

ASSOCIATION OF SOUTHEAST ASIAN NATIONS

1.9 INTERNATIONAL MONETARY SYSTEM

1.9.1 The international monetary system consists of laws, rules, institutions, instruments andprocedures which involve international transfer of money. These elements affect for-


eign exchange rates, international trade and capital flows and balance of paymentadjustments. Foreign exchange rates determine prices of goods and services acrossnational boundaries. These exchange rates also affect international loans and foreigninvestment. Hence, the international monetary system plays a critical role in the fi-nancial management of multinational business and economic policies of individualcountries.

1.9.2 Foreign exchange system

a. A global company’s access to international capital markets and its freedom to movefunds across national boundaries are subject to a variety of national constraints.

b. These constraints are frequently imposed to meet international monetary agreementson determining exchange rates.

c. Constraints may also be imposed to correct the balance of payments deficit or topromote national economic goals.

d A foreign exchange rate is the price of one currency expressed in terms of anothercurrency. A fixed exchange rate is an exchange rate which does not fluctuate orwhich changes within a predetermined band. The rate at which the currency isfixed or pegged is called ‘par value’. A floating or flexible exchange rate fluctuatesaccording 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 ex-change 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 afloating rate system.

b. A depreciation is a decrease in the value of a currency against other currencies undera floating rate system.

c. A revaluation is an official increase in the value of a currency by the government ofthat currency under a fixed rate system.

d. A devaluation is an official reduction in the par value of a currency by the govern-ment of that currency under a fixed rate system.



1.10.1 Currency boards

A currency board is a monetary institution that only issues currency to the extent it is fullybacked 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 ofits notes and coins in circulation

c. A self correcting balance of payments mechanism where a payment deficit automati-cally 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 govern-ment to follow a responsible fiscal policy.

f. Countries like Mauritius, Hong Kong, Estonia, Argentina, Lithuania, Bulgaria andBosnia 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 interna-tional monetary system called the gold standard. Under this regime, countries use gold as amedium 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 exchangerates for the major currencies of the world. The value of currencies fluctuated very widely. Thegreat depression of 1929-32 and the international financial crisis of 1931, further prevented therestoration of gold standard. Governments started devaluing their currencies to support ex-ports.

Fixed exchange rates: 1945-73:

a. The Bretton woods agreement was signed by representatives of 44 countries in 1944to establish a system of fixed exchange rates.

b. Under this system, each currency was fixed by government action within a narrowrange of values relative to gold or some currency of reference. US dollar was usedfrequently as a reference currency to establish the relative prices of all other curren-cies

c. At this conference, they agreed to establish a new monetary order, which centeredon IMF and IBRD (World Bank).

d. IMF provides short term balance of payment adjustment loans, while the world bankmakes long term development and reconstruction loans.

e. The agreement emphasized the stability of exchange rates by adopting the conceptof fixed but adjustable rates.


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 duringthe 1960s and early 1970s.

b. In 1971, most major currencies were permitted to fluctuate. US dollars fell in valueagainst a number of major currencies. Several countries caused major concern by im-posing some trade and exchange controls which was feared that such protective mea-sures might become widespread to curtain international commerce.

c. In order to solve these problems, the world’s leading trading countries, called the ‘Groupof 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 eventsaffecting the international monetary order. Oil crisis of 1973, loss of confidence in US dollarbetween 1977 and 1978, second oil crisis in 1978, formation of European monetary system in1979, 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 monetarycooperation, secure financial stability, facilitate international trade, promote high em-ployment and sustainable economic growth, and reduce poverty.

b. Oversees the global financial system by following the macroeconomic policies of itsmember countries, in particular those with an impact on exchange rates and the bal-ance of payments.

c. Offers financial and technical assistance to its members, making it an international lenderof last resort. Countries contributed to a pool which could be borrowed from, on atemporary 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 over-haul plan that could lead to the eventual sale of a little over 400 tons of its substantialgold supplies.

b. The board of IMF has proposed a new framework for the fund, designed to close aprojected $400 million budget deficit over the next few years.

c. The budget proposal includes sharp spending cuts of $100 million until 2011.

Membership qualifications:

a. Any country may apply for membership to the IMF. The application will be consideredfirst by the IMF’s Executive Board.



b. After its consideration, the Executive Board will submit a report to the Board of Gov-ernors of the IMF with recommendations (the amount of quota in the IMF, the formof payment of the subscription, and other customary terms and conditions of mem-bership) in the form of a “Membership Resolution”.

c. After the Board of Governors has adopted the “Membership Resolution,” the appli-cant state needs to take the legal steps required under its own law to enable it to signthe IMF’s Articles of Agreement and to fulfill the obligations of IMF membership.

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 votingweight, 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 bythe Executive Board and are linked to formulas that include many variables such as thesize of a country in the world economy.

g. IMF established rules and procedures to keep participating countries from going toodeeply into balance of payments deficits. Those countries with short term paymentdifficulties 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 agreeto fix their exchange rates or employ only one currency to carry out all transactions. Full Euro-pean monetary union was achieved in 2002, which enabled 15 EU countries to carry out trans-actions with one currency through one central bank under one monetary policy. A single cur-rency called the EURO was adopted.


SECTION - 2IMPORT AND EXPORT PROCEDURES & PRACTICES

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 backedwith extensive documentation, inspection and assessment procedures. The number of inter-mediaries involved in the process is also numerous.

This chapter, therefore, only provides a glimpse of the process. The student is well advised torefer 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 im-ported by certain types of importers under certain types of licences. Importers are divided intothree categories for the purpose of import licensing:

1. actual users; An actual user applies for and receives a licence to import any item or anallotment of an imported item as required for his own use, not for business or trade inthat item.

2. registered exporters; defined as those who have a valid registration certificate issuedby an export promotion council, commodity board or other registered authority des-ignated by the Government for purposes of export-promotion.

3. others.

The two types of actual user licence are:

1. general currency area licences which are valid for imports from all countries, exceptthose countries from which imports are prohibited;

2. specific licences which are valid for imports from a specific country or countries. Asidefrom the types of licences listed, the Open General Licence is perhaps the most liber-alized type of licence available for certain items and certain types of importers.


� Procedures for Imports� Export Procedures



Licences are valid for 24 months for capital goods and 18 months for raw materials compo-nents, consumable and spares, with the licence term renewable. Import licences may be ob-tained from the director general of foreign trade (Office of Chief Controller of Imports andExports, Ministry of Commerce, Udyog Bhawan, New Delhi 110011). Traders are advised toconsult the Handbook of Procedures which is published by the Ministry of Commerce and ispart of the Import and Export Policy for further details.

2.1.2 The importer importing the goods has to follow prescribed procedures for import byship/air/road. There is separate procedure for goods imported as a baggage or bypost.

2.1.3 Bill of Entry

1. This is a very vital and important document which every importer has to submitunder section 46. The Bill of Entry should be in prescribed form.

2. Bill of Entry should be submitted in quadruplicate – original and duplicate for cus-toms, triplicate for the importer and fourth copy is meant for bank for making remit-tances.

3. A BIN (Business Identification Number) is allotted to each importer and exporterw.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 anEC (Import Export code) number issued by DGFT was required to be mentioned onBill 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 infor-mation should be submitted. – Chapter 3 Para 6 and 7 of CBE&C’s Customs Manual, 2001.


2.1.5 Electronic submission under EDI system – Where EDI system is implemented, formalsubmission 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 signedpaper 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 arechecked 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. Regu-lar importers and Custom House Agents keep current account with Customs depart-ment. The duty can be debited to such current account, or it can be paid in cash/DDthrough TR-6 challan in designated banks.

After payment of duty, if goods were already examined, delivery of goods can be taken fromcustodians (port trust) after paying their dues.

2.2 EXPORT PROCEDURES

2.2.1 Documents Required: Certain documentation takes place while exporting from In-dia. Special documents may be required depending on the type of product or destina-tion. Certain export products may require a quality control inspection certificate fromthe Export Inspection Agency. Some food and pharmaceutical product may require ahealth or sanitary certificate for export.

Shipping Bill/ Bill of Export is the main document required by the Customs Authorityfor 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 account with designated bank for credit of duty drawback claims

3. Register licenses / advance license / DEPB etc. at the customs station, if exports areunder 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 ‘NilDuty’ assessment is also an assessment.

6. Shipping Bill or bill of export should be submitted in quadruplicate. If drawback claimis 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 inGreen colour.

b. Shipping Bill for export of dutiable goods - this should be yellow colour



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 - itshould 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 Num-ber, 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 creditetc. are also to be submitted.

Usually the Shipping Bill is of four types and the major distinction lies with regard to the goodsbeing 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 mentionedbelow:

� Customs Declaration Form - It is prescribed by the Universal Postal Union (UPU) andinternational apex body coordinating activities of national postal administration. It isknown by the code number CP2/ CP3 and to be prepared in quadruplicate, signed bythe sender.

� Despatch Note, also known as CP2. It is filled by the sender to specify the action to betaken by the postal department at the destination in case the address is non-traceable orthe parcel is refused to be accepted.

� Prescriptions regarding the minimum and maximum sizes of the parcel with its maxi-mum 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 circum-ference 0.9 m./ 2.00 m.

Maximum weight: 10 kg usually, 20 kg for some destinations.

2.2.6 Excise formalities at the time of Export - If the goods are cleared by manufacturer forexport, the goods are accompanied by ARE-1 (earlier AR-4):

� This form should be submitted to customs authorities.


� 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 ofexport’.

� The bond executed by Manufacturer-exporter with excise authorities is released onlywhen ‘proof of export’ is accepted by Maritime Commissioner or Assistant Commis-sioner, where bond was executed.

� Duty drawback formalities - If the exporter intends to claim duty draw back on hisexports, he has to follow prescribed procedures and submit necessary papers.

� He has to make endorsement of shipping bill that claim for duty drawback is beingmade.

� 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 standsfor ‘Statutory Declaration Form’). SDF form is to be used where shipping bills are pro-cessed electronically in customs house, while GR form is used when shipping bills areprocessed manually in customs house.

2.2.7 Other documents required for export - Exporter also has to prepare other docu-ments 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 Coun-cils have been set up to promote and develop exports. (e.g. Engineering Export Promo-tion Council, Apparel Export Promotion Council, etc.) Exporter has to become memberof the concerned Export Promotion Council and obtain RCMC - Registration cum mem-bership Certificate.

Terms used in the trade

� Commercial invoice - Issued by the seller for the full realisable amount of goods as pertrade term.

� Consular Invoice - Mainly needed for the countries like Kenya, Uganda, Tanzania,Mauritius, New Zealand, Burma, Iraq, Ausatralia, Fiji, Cyprus, Nigeria, Ghana, Zanzi-bar etc. It is prepared in the prescribed format and is signed/ certified by the counsel ofthe importing country located in the country of export.



� Customs Invoice - Mainly needed for the countries like USA, Canada, etc. It is pre-pared on a special form being presented by the Customs authorities of the importingcountry. It facilitates entry of goods in the importing country at preferential tariffrate.

� Legalised/ Visaed Invoice - This shows the seller’s genuineness before the appropri-ate 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 invoicethat the goods are of a particular origin or manufactured/ packed at a particularplace and in accordance with specific contract. Sight Draft and Usance Draft areavailable for this. Sight Draft is required when the exporter expects immediate pay-ment 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 rela-

tion. It certifies that the ship or the aircraft carrying the goods has not touched thosecountry(s).

� Weight Note - Required to confirm the packets or bales or other form are of a stipu-lated 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 andare available.

� Certificate of Chemical Analysis - It is required to ensure the quality and grade ofcertain 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, ma-

rine 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 an-

tiques.� Transhipment Bill - It is used for goods imported into a customs port/ airport in-

tended for transhipment.� Shipping Order - Issued by the Shipping (Conference) Line which intimates the ex-

porter about the reservation of space of shipment of cargo through the specific vesselfrom a specified port and on a specified date.

� Cart/ Lorry Ticket - It is prepared for admittance of the cargo through the port gateand 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 isprepared by the concerned shed and is sent to the exporter.

� Short Shipment Form - It is an application to the customs authorities at port whichadvises short shipment of goods and required for claiming the return.

Shipping Advice - It is prepared in aligned document to be used to inform the overseascustomer about the shipment of goods.


SECTION - 3

INTERNATIONAL FINANCIAL MANAGEMENT:

IMPORTANT ISSUES AND FEATURES,

INTERNATIONAL CAPITAL MARKET

3.1 INTERNATIONAL FINANCIAL MARKETS

3.1.1 International financial markets are a major source of funds for international transac-tions. Most countries have recently internationalized their financial markets to attractforeign business.

3.1.2 Internationalization involves both a harmonization of rules and a reduction of barriersthat will allow for the free flow of capital and permit all firms to compete in all mar-kets.

3.2 EUROCURRENCY MARKETS

3.2.1 Eurocurrency market consists of banks that accept deposits and make loans in foreigncurrencies outside the country of issue. These deposits are commonly known asEurocurrencies. Thus, US dollars deposited in London are called Eurodollars; Britishpounds deposited in New York are called Eurosterling, etc.

3.2.2 Eurocurrency markets are very large, well organized and efficient. They serve a num-ber of valuable purposes for multinational business operations. Eurocurrencies are aconvenient money market device for MNCs to hold their excess liquidity. They are amajor source of short term loans to finance corporate working capital needs and for-eign trade.

3.3 ASIAN CURRENCY MARKET

3.3.1 In 1968, an Asian version of the Eurodollar came into existence with the acceptance ofdollar denominated deposits by commercial banks in Singapore, which was an ideal


� International Financial Markets

� Eurocurrency markets

� Asian Currency market

� International capital markets

� International banking



location for the birth of the Asian currency market due to its excellent communicationnetwork, important banks and a stable government.

3.3.2 Asian currency market developed when the Singapore branch of the bank of Americaproposed 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 internationalequity market. The New York Stock Exchange, the NASDAQ, the London stock ex-change and the Tokyo stock exchange are the world’s four biggest markets, measuredin 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 currencyof 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 cur-rency of that country. Dollar denominated bonds sold in New york by a Mexican firm areforeign bonds are foreign bonds, but should be registered with the US securities ExchangeCommission.

c. Eurobonds: These are bonds underwritten by an international syndicate of brokers andsold simultaneously in many countries other than the country of the issuing entity. Theseare 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 inwhose currency it is denominated.

3.5 INTERNATIONAL BANKING

3.5.1 International banking has grown with the unprecedented expansion of economic activ-ity since the world war.

3.5.2 International banks perform many vital tasks to help the international transactions ofmultinational companies. They finance foreign trade and foreign investment, under-write international bonds, borrow and lend in the Eurodollar market, organize syndi-cated loans, participate in international cash management, solicit local currency depos-its and loans and give information and advice to clients.

3.5.3 Interbank clearing house systems: There are three key clearing house systems of inter-bank fund transfers which transfer funds between banks through wire and facilitateinternational trade.

a. The clearing house interbank payments system(CHIPS): This is used to move dollars amongNew York offices of about 150 financial institutions that handle 95 percent of all foreign-exchange trades and almost all Eurodollar transactions.


b. The clearing house payments assistance system(CHPAS): This began its operations in 1983and provides services similar to those of CHIPS. It is used to move funds among Londonoffices of most financial institutions.

c. The Society for Worldwide Interbank Financial Telecommunications (SWIFT): It is an in-terbank communication network which carries messages for financial transactions. It rep-resents a common denominator in the international payment system and uses the latestcommunication technology. It has reduced multiplicity of formats used by banks in dif-ferent 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 ladingand a letter of credit.

2. Documentation in foreign trade is supposed to assure that the exporter will receive thepayment and the importer will receive the merchandise. Many of these documents areused 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 topay a specified amount of money at a specified time. Through the draft, the exporter mayuse its bank as the collection agent on accounts that the exporter finances.

4. A bill of lading is a shipping document issued to an exporting firm or its bank by a com-mon carrier which transports goods. It is simultaneously a receipt, contract and a docu-ment of title. As a receipt, the bill of lading indicates that specified goods have been re-ceived by the carrier. As a contract, it is evidence that the carrier is obliged to deliver thegoods to the importer in exchange for certain charges. As a document of title, it establishesownership of the goods. Bill of lading can be used to insure payment before the goods aredelivered.

5. Letter of credit is a document issues by a bank at the request of an importer. In this, thebank agrees to honor a draft drawn on the importer if the draft accompanies specifieddocuments such as the bill of lading. The importer asks that his local bank write a letter ofcredit. In exchange for the bank’s agreement to honor the demand for payment that re-sults from the import transactions, the importer promises to pay the bank the amount ofthe transaction and a specified fee. A letter of credit is advantageous to both exporters andimporters because it facilitates foreign trade.



SECTION - 4INTERNATIONAL FINANCIAL SERVICES AND

INSURANCE: IMPORTANT ISSUES AND FEATURES

4.1 INTRODUCTION

4.1.1 The term financial services refers to services provided by the finance industry. Thefinance industry encompasses a broad range of organizations that deal with the man-agement of money. Among these organizations are commercial banks, investment banks,asset management companies, credit card companies, insurance companies, consumerfinance 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 HOMEMARKET FOR INTERNATIONAL FINANCIAL SERVICES (IFS)IN INDIA

4.2.1 A little appreciated aspect of India’s impressive growth from 1992 onwards is that ithas resulted in even faster integration of India with the global economy and financialsystem. 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 accel-eration 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 preventedfrom making portfolio investments abroad on any significant scale by the system of


� 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:


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 stillpreclude that possibility.

4.2.3 Despite the controls that remain, these substantially increased two-way flows reflect anincrease 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 customersand by global customers in India. Demand for IFS from both has been growing expo-nentially. Cumulative two-way flows in 1992–2005 were a multiple of such flows in1947–92. 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 indepen-dence and India embarking on ‘serious’ reforms. We have made up for six lost decadesof economic interaction with the world in a decade and a half. Still, what has happenedover 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 isevocatively being suggested, and if India continues to open up the economy on bothtrade 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) hasbeen analogous to that for software exports: i.e., a sterile relationship between Indianproducers and foreign customers of ‘support services’. However, in the case of IFS,India is itself a large, fast growing customer of IFS. Conservative estimates of IFS con-sumption in India just a few years out, amount to $48 billion a year. That is more thanthe 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 totake into account two features:

1. IFS demand is driven by increases in gross two-way financial flows that have oc-curred in transactions with the rest of the world. It is not driven by net flows. De-mand for IFS by Indian customers – as well as foreign firms trading with and in-vesting in India – is driven by imports and exports. India-related purchases of IFSare related to inbound and outbound FDI/FPI.

2. The annual growth of gross flows has accelerated dramatically in recent years. India’sexternal linkages have been transformed since 1991–92. But that transformation hasbeen more radical since 2002. The Indian economy is now exhibiting signs of a ‘take-off’ both in growth and even more rapidly in its globalisation (or integration withthe world economy).

Hong Kong and China



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 arecloser to Hong Kong than to Singapore). But, as a colonial artifice, Hong Kong’s role as an IFCwas compromised, if not damaged, as China opened up and connected itself to the worldthrough Shanghai and Beijing.

Since the 1980s, China has not required its economic partners to deal with it exclusivelythrough Hong Kong. With the gradual rise of Shanghai as an IFC, Hong Kong’s role as anIFC serving China is diminishing, although it is unlikely to be completely eclipsed. At thesame time ASEAN regional finance has gravitated decisively toward Singapore.

4.4 THE IMPACT OF GLOBALIZATION ON IFS DEMAND ANDON IFCS

4.4.1 When the economy of a country or region (e.g., the EU or ASEAN) engages with theworld through its current and capital accounts, a plethora of IFS are purchased aspart-and-parcel of these cross-border transactions. The hinterland effect of a rapidlygrowing 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 globaleconomic powers is likely (as in the US, EU and ASEAN) to provide the same raisond’etre for these two economies evolving their own IFCs to interface with those thatserve other regions. History suggests that no country or regional economy can becomeglobally significant without having an IFC of its own. But the emergence of IFCs has notalways been a tale of growth potential and start-up followed by prolonged competitivesuccess in exporting IFS to global markets.

4.4.3 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 theIndian economy with the world economy. As such integration deepens it triggers avariety of needs for IFS. For example:

1. Current account flows involve payments services, credit and currency risk manage-ment.

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 diligenceby lawyers and accountants, risk management, etc.

3. Issuance of securities outside the country involves fees being paid by Indian firmsto 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. Thisapplies in both directions: foreign investors require IFS to protect the market valueof their exposure in India while Indian investors require the same services to pro-tect the market value of their exposure outside the country.


5. The shift to import-price-parity (owing to trade reforms) implies that Indian firmsthat do not import or export are nevertheless exposed to global commodity priceand currency fluctuations. These firms require risk management services.

6. Many foreign firms are involved in complex infrastructure projects in India. Indianfirms are involved in infrastructure projects abroad. These situations involve com-plex IFS. The same applies to structuring and financing privatizations (especiallythose involving equity sales to foreign investors) and public–private partnershipswhich are becoming a growing feature in infrastructure development around theworld.

7. The growth of the transport industry (shipping, roads, rail, aviation, etc) involvesfinancing arrangements for fixed assets at terminals (ports, etc.) as well as for mo-bile 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 ofthe world’s biggest customers of aircraft buying roughly 40% of the world’s newoutput of planes in 2006. This requires buying 40% of the world’s aircraft financingservices.

8. Indian individuals and firms control a growing amount of globally dispersed as-sets. They require a range of IFS for wealth management and asset management.

4.4.4 Outbound FDI by Indian firms in joint ventures and subsidiaries abroad has increasedsince 2004–05 as they have globalised. Foreign investments by Indian firms began withthe establishment of organic presence, and acquisitions of companies, in the US and EUin the IT-related services sectors. Now they encompass pharmaceuticals, petroleum,automobile components, tea and steel. And, geographically, Indian firms are spreadingwell beyond the US and EU by establishing a direct presence or acquiring companies inChina, ASEAN, Central Asia, Africa and the Middle East. Such outward investmentsare funded through: draw-down of foreign currency balances held in India, capitaliza-tion of future export revenue streams, balances held in EEFC accounts, and share swaps.

4.4.5 Outward investments are also financed through funds raised abroad: e.g., ECBs, FCCBsand ADRs/GDRs. Leveraged buy-outs related to these investments and executed throughSPVs abroad are not captured in the overseas investment transactions data. The TataSteel-Corus transaction, for example, involved substantial IFS revenues going to finan-cial firms in Singapore and London.

4.4.6 When two firms across the globe agree to undertake current or capital account buy–selltransactions, the associated IFS are usually bought by the firm with better access to highquality, low cost IFS. Consider the example of an Indian firm exporting complex engi-neering goods to a firm in Germany. It can contract and invoice in: INR, USD or EUR.Because India has limited IFS capabilities, and a stunted currency trading market, thetransaction is likely to be contracted in INR or USD. But the German importer generatesrevenues in EUR. It has to buy INR or USD to pay the Indian firm. It may have to use acurrency derivative (future, forward or option) to cover the risk of a movement in theexchange rate of the INR or USD vs. the EUR between placing the order and receivingthe goods. This would typically be done in London.



4.4.7 However, if India had a proper currency spot and derivatives market, the Indianexporter would be able to invoice in EUR. Local IFS demand would be generated bythis local firm converting locked-in future EUR revenues into current INR revenues ata known exchange rate. Indian exporters are not as flexible as they wish to be in theirchoice of the INR or of global currencies for invoicing (i.e., USD, JPY, EUR or GBP) – oreven 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 aresold by an Indian exporter, and a German importer pays IFS charges in London forconverting EUR into INR and managing the exchange risk, the net price received by theIndian exporter is lower. When the Indian exporter sells in EUR, and local IFS are pur-chased 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 andrecognise charges for IFS being purchased or sold as part and parcel of contractual struc-tures on the current or the capital account. For this reason, the standard BoP data grosslyunderstate the size and importance of the global IFS market. Focusing on the transac-tional aspects of trade flows would tend to understate IFS demand since this tends toignore the risk management business which rides on trade flows.

4.5 PROJECTIONS FOR REVENUE POTENTIAL OF MUMBAI ASAN IFC

4.5.1 The median (base case) projections involve IFS demand in India rising from $ 13 billionin 2006 to $ 48 billion in 2015. A low-case assumption would see IFS consumption risingfrom US$ 6.6 to nearly US$ 24 billion over the same period. A more optimistic (but notimplausible) ‘high-case’ assumption would see it grow from US$ 19.7 to nearly US$ 72billion.

4.6 INSURANCE

4.6.1 Finance and insurance have much in common. Each provides its customers with toolsfor managing risks. The valuation techniques in both finance and insurance are for-mally same: The fair value of a security and an insurance policy is the discounted ex-pected value of the future cash flows they provide to their owners. The definition of riskis 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 fundamentalconcepts: risk pooling and risk transfer.

4.6.2 Since the early 1990’s, we have seen substantial convergence between finance and in-surance. A shortage of property and liability insurance in the 1980s forced many corpo-rate insurance customers to consider alternatives to traditional insurance, such as self-insurance, captive insurers, and contingent borrowing arrangements to finance losses.Investment bankers and insurance brokers provided many of these alternatives. Thedemand for catastrophe insurance in the 1990s led to the development of options andfutures for this type of insurance. Investment banks, sometimes with insurance com-pany or insurance broker partners, formed subsidiaries to offer catastrophe and otherhigh-demand coverage through new financing arrangements.


4.6.3 Life insurers have developed products with embedded options on stock portfolios. In-surers have begun to use structured securities, such as bonds with indexed coupons, intheir investment portfolios.

4.6.4 Thus, in the 1990s, financial markets offered products for managing risks traditionallyhandled by insurers. The high demand for catastrophe insurance on property startedthe movement. We now see convergence in the investment markets as well as in variousnew alliances, partnerships and joint ventures.

4.7 INTEGRATION AND GLOBALIZATION OF FINANCIAL SERVICES

4.7.1 C hanging customer needs, more knowledgeable and demanding customers, new tech-nology, liberalization, deregulation, and a combination of other forces are blurring thelines between financial products, institutions, sectors, and countries. Regulators are re-sponding to market pressures by allowing more inter-sectoral competition. Banks, se-curities firms, insurance companies, and other financial intermediaries increasingly com-pete with each other by offering similar products and services and by entry into fieldspreviously reserved for one sector only.

4.7.2 Financial services integration occurs when financial products and services tradition-ally associated with one class of financial intermediaries are distributed by another classof financial intermediaries.

4.7.3 Financial services convergence is the tendency of financial products and services tradi-tionally one sector to take on characteristics traditionally observed with financial prod-ucts and services of another financial services sector.

4.7.4 Convergence occurs through customer demand across traditional sector lines. Examplesinclude the introduction by insurance companies of variable (unit linked) life and annu-ity products that contain both insurance and securities features. Another burgeoningarea is the banking industry’s creation of securitized mortgage and corporate debt port-folios, which involves packaging a group of mortgages or other loans into marketablesecurities that are sold to investors.

4.7.5 As banks, securities firms, and insurers construct products and offer services that re-semble the features of their competitors, product convergence will be an important driv-ing force toward financial services integration.

4.7.6 This integration gave birth to financial services conglomerates. A Financial servicesconglomerate is a firm or group of firms under common control which offers financialservices that extend beyond the traditional boundaries of any one sector. The two mostcommonly discussed arrangements are bancassurance and universal banks.

4.7.7 Bancassurance describes arrangements between banks and insurers for the sale of in-surance through banks, wherein insurers are primarily responsible for production andbanks are primarily responsible for distribution.

4.7.8 Universal banks are financial intermediaries that typically offer commercial and in-vestment banking services, and also insurance.

Financial Mgmt International Finance 12

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