Chapter 1 - Project Identification and Feasibility What is a project?

A project is a specific, finite task to be accomplished in order to generate cash flows. It is a proposal for capital investment to develop facilities to provide goods and services. The proposal may be for setting up a new unit, for expansion or improvement of existing facilities. The project however has to be amenable for analysis and evaluation as an independent unit. The stages of project selection The identification of project ideas is followed by a preliminary selection stage on the basis of their technical, economic and financial soundness. The objective at this stage is to decide whether a project idea should be studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a prefeasibility study or opportunity study. For the purpose of screening and priority fixation, project ideas are developed into prefeasibility studies. refeasibility studies give output of plant of economic si!e, raw material re"uirement, sales realisation, total cost of production, capital input# output ratio, labour re"uirement, power and other infrastructure facilities. Feasibility Study After ensuring that a project idea is suitable for implementation, a detailed feasibility study giving additional information on financing, breakdown of cost of capital and cash flow is prepared. The feasibility study should contain all technical and economic data that are essential for the evaluation of the project. $. %efore dealing with any specific aspect, feasibility study should public policy with respect to the industry. For example, to evaluate the prospects

for investing in the telecom market, a firm should consider the following aspects of the &ew Telecom olicy' (able networks will be allowed to provide data and voice services subject to licensing. Inter connectivity between cable and basic service provider allowed. )omestic monopoly of )oT for long distance calls will end by *anuary $, +,,,. For giving the licenses, almost -+ . weightage will be given to license fees, $/ . for rural development, $,. for network rollout and 0. for indigenisation. +. It should specify output and alternative techni"ues of production in terms of process choice and ecology friendliness, choice of raw material and choice of plant si!e. 0. The feasibility study, after listing and describing alternative locations, should specify a site after necessary investigation. 1. The study should include a layout plan along with a list of buildings, structures and yard facilities by type, si!e and cost. /. 2ajor and auxiliary e"uipment by type, si!e and cost along with specification of sources of supply for e"uipment and process know3how has to be listed. 4. The study has to identify supply sources and present estimates, costs for transportation, services, water supply and power. The "uality and dependence of raw materials and their source of supply have to be investigated and presented in the feasibility study. -. The feasibility study should include financial data. It should cover preliminary estimates of sales revenue, capital costs and operating costs for different alternatives along with their profitability. Feasibility study

should present estimates of working capital re"uirement to operate the unit at a viable level. 5. An essential part of the feasibility study is the schedule of implementation and estimates of expenditure during construction. The feasibility study is followed by project report firming up all the technical aspects such as location, factory lay3out specifications and process techni"ues design. In a way, project report is a detailed plan of follow3up of project through various stages of implementation.

(hapter + 3 2arket Appraisal Introduction Analysis of demand for the product proposed to be manufactured re"uires collection of data and preparation of estimates. 2arket appraisal involves' reparing a description of the product, its major uses, scope of the market,

possible competition from substitutes, special features of the product proposed to be manufactured in regard to "uality and price which would result in consumer preference for the product in relation to competitive products 6stimating existing and future demand and supply of the products proposed to be manufactured Assessing likely competition in future and special features of the product which may enable it to meet competition. Identifying export possibilities and compiling comparative data on manufacturing costs. The (IF and F7% prices and landed cost of the proposed product have to stated. It is also necessary to identify principal customers and state particulars of any firm arrangements entered into with them. 8elling arrangements contemplated in terms of direct sales or through distributors or dealers have to be classified. After collection of the data, the existing position has to be assessed to ascertain whether unsatisfied demand exists. 8ince cash projections are to be made, possible future changes in the volume and pattern of supply and demand have to be estimated. This would help in assessing the long term prospects of the unit. 6stimation of demand re"uires the determination of the total demand for a product and the share that can be captured by the unit through appropriate marketing strategies.

Methods of de and forecasting The commonly used methods of demand forecasting are trend, regression and end3use method. Trend Method The trend method assumes that the behaviour of the variable would continue in the same direction and magnitude as in the past. In this method, it is useful first to draw a graph to ascertain whether a linear or an exponential trend is appropriate for projection. The assumption under linear trend is that the variable would increase by a constant amount, whereas in exponential it will change by a constant percentage amount. 9raphing the data will help to decide which period to choose and what type of form be used for forecasting. 7nly after analysis of past data the trend line should be fitted. Regression Approach In regression approach the factors influencing the variables that are to be forecast have to be identified. In this method we have the dependent variable and the explanatory or independent variable. The dependent variable is the one subject to forecasting. The explanatory variables are those which cause changes in the dependent variable. If rate of inflation is to be forecast, the independent variables may be money supply, per capita availability of food grains and rate of monetisation of the economy. 8pecification or identification of factors is crucial in forecasting by regression approach. In multiple regression we have more than one explanatory variable. The regression coefficients should have the right sign arid be statistically significant. The actual value of dependent variable and the estimated value should be close to each other for the sample period. This is reflected in the value of :+, the s"uare of the multiple correlation coefficient Limitations and Advantages of Trend and Regression Methods

The trend is a catch all approach. It takes into account the impact of all variables influencing the dependent variable. In trend method the need for independently forecasting the explanatory variable does not arise, as the values of ;t; at a future period are known. In the case of regression the explanatory variables have to be forecast independently. The main advantage of regression method is that it enables the estimation of turning points, whereas the trend method cannot predict the turning points. :egression method is more accurate than the trend method because it takes into account causal factors. In actual practice forecasts by both methods may be attempted. End-Use Method In this method the users of the product proposed to be manufactured, are identified. An intensive study of the past and present situation and a thorough assessment of the future prospects of the various end user industries is made to determine the expected levels of production for the various end user industries. A study of the consumption norms for each end user industry in respect of the product for which forecasts are needed is also made. <owever, provision should be made for changes in the norms as a result of technological change or emergence of substitute products. The end use approach enables customer industry3wise demand forecasts and it is easy to evaluate any discrepancy in the forecasts with the actual value. The method is appropriate for intermediate industrial products such as steel and caustic soda. )emand projections and estimates are made by agencies of government as well as industry associations. Among the government agencies, the )irectorate 9eneral of Technical )evelopment and the lanning (ommission may be mentioned. 8everal associations of manufacturers make estimates. In regard to small scale sector, the )evelopment (ommissioner for 8mall 8cale

Industries, the &ational 8mall Industries (orporation and the 8mall Industries 8ervices Institute provide valuable market information about projects and products. 8everal private consultants undertake market surveys for a fee.

(hapter 0 3 Technical Appraisal

!bjecti"es of technical appraisal Technical appraisal is primarily concerned with the project concept covering technology, design, scope and content of the plant as well as inputs and infrastructure facilities envisaged for the project. 6valuation of industrial projects is undertaken to compare and evaluate alternative variants of technology, of raw materials to be used, of production capacity, of location and of local production versus import. %asically, the project should be able to deliver marketable product from the resources deployed, at a cost which would leave a margin ade"uate to service the investment and plough3back a reasonable amount to enable the enterprise to consolidate its position. Technical appraisal has a bearing on the financial viability of the project as reflected by its ability to earn satisfactory return on the investment made and to service e"uity and debt. Project Concept - Project concept comprises various important aspects such as plant capacity, degree of integration, facilities for by-product recovery and flexibility of the plant. Accurate assessment of plant capacity on a sustained basis is of crucial importance. Capacity of Plant 3 (apacity of a plant depends on several factors such as product specification, product mix and raw material composition. It is indeed difficult to assess capacity. For instance paper plant capacity varies with grammage. In a textile mill, capacity varies with the composition of yarn of different counts. The daily production in a sugar mill depends on sugar content of the cane= and annual production on the length of the crushing season. The extent and degree of integration and facilities for by3product recovery also affect si!e of project investment and profitability. An integrated textile mill with cotton as a starting material would re"uire larger investment

and is more profitable than an un3integrated mill of the same capacity producing fabric from grey cloth. 8ometimes additional investment would improve the profitability enormously. In a caustic soda plant, recovery of chlorine and hydrogen no doubt re"uires additional investment but improves profitability as compared to a plant producing just caustic soda. #"aluation of Technology - 7utstanding features of technology process, engineering design and plant and machinery are established facts and can be checked from published information on the process or from prospective collaborators# consultants and on the basis of similar plants in operation elsewhere. <owever, considerable skill is re"uired in evaluating the claims of emergent technology, products and e"uipment design. The design and layout of the plant in technical appraisal should ensure ease of operation and convenience of maintenance and uncomplicated expansion of the stream capacity, should the need arise. Above all, in technical appraisal one should be alert and apply trained and informed skills. For example, the availability of soft water is essential for a textile processing plant. It is on record that a public sector textile process plant was set up without checking the "uality of water. The result was a large additional investrnent to cure water. Inputs - In technical appraisal, inputs are scrutinised for availability and "uality dependability. If there are seasonal variations, especially, in the case of agricultural inputs, variations in price have to be checked. 8imilarly power "uality has to be checked in terms of variation in supply voltage and in3line current fre"uency and duration of blackouts. Finally, the "uality and availability of water which shows seasonal trends especially in case of a project re"uiring water as an input should be checked.

$ocation 3 >hile it is easy to enumerate desirable factors to be taken into account while determining location, in practice various constraints dictate location away from the ideal one. The ideal factors are, of course, proximity to the market and inputs, preferably where well developed infrastructure exists. In some industries effluent disposal facility is necessary. ollution control restricts the use of steam boilers while power scarcity restricts the installation of induction furnaces, which are environment friendly. Antipollution regulations may also force the choice of large si!e plants to curtail noise pollution or to install anti3 vibration e"uipment with adverse impact on costs. Interdependence or the Para eters or Project 3 Finally, the technical appraisal of the individual project may be supplemented by a supplementary review of the project in terms of interdependence of the basic parameters of the project which are, plant si!e, location and technology. A small integrated paper plant using bagasse, paddy husk or straw without need to recover process chemicals may be more viable than large integrated paper mill re"uiring forest based raw material, water and effluent disposal system. 8ometimes undependable supply of basic inputs could spell disaster. 8everal mini steel plants set up in a big way in ;-7s were out of business as a result of lack of steel scrap from imports, which was due to foreign exchange crisis. The implementation of the project has cost and time over3run implications. The scheduling of construction and the identification of potential causes of delay form an important part of the technical aspects of the project appraisal. The schedule of construction depends mainly on the speed of civil construction works, delivery period of e"uipment, as well as the efficiency of the management to tie up various ends in a coordinated and speedy manner. 8ince an overrun In the pre3commissioning time invariably leads to overrun in cost and conse"uential problems, it is important that timing of construction is realistically planned. For all main physical elements of the projects, from

project concept, obtaining 9overnment approvals, tying3 up financial arrangements, engineering design, land ac"uisition, building construction, procurement of e"uipment, its erection and testing to final commissioning, there must be realistic time schedules and a coherent arrangement, which leads to the completion of the project on most economical basis. ?se of scheduling techni"ues like 6:T and ( 2 and proper adherence to them is an essential aspect to be insisted upon in technical appraisal. Project Charts and $ayouts 3 roject charts and layouts have to be prepared to define the scope of the project and provide the basis for detailed project engineering. These are general functional layout, material flow diagram, production line diagram, utility layout and plant layout. 9eneral functional layout should facilitate smooth and economical movement of raw materials, work3in3process and finished goods. 2aterial flow diagram presents flow of materials, utilities, intermediate products, final products, scrap and emissions. roduction line diagram establishes the progress of production from one machine to another with description, location, space re"uired, need for power and utilities and distance from the next section. ?tility layout shows the principal consumption points of power, water and compressed air, which helps in the installation of utility supply. Finally, plant layout identifies the exact location of each piece of e"uipment determined by proper utilisation of space leaving scope for expansion, smooth flow of goods to minimise production cost and safety of workers. Cost of Production 3 6stimates of production costs and projection of profitability is the concluding part of the technical appraisal. (ost of production is worked out taking into account the build up of capacity utilisation, consumption norms for various inputs and yields and recovery of by3 products. In estimating production, a general build3up starting with 1, percent and reaching a normal level of 5, percent in three to four year@s time is provided. In practice capacity utilisation may fall short of estimated levels

on account of defective plant and machinery, inade"uate operating skills, inade"uacy of raw materials, shortage of power and lack of demand. The cost of production and profitability estimates take into account the level of production in different years and product3mix Awhich are dependent on market potential, prices, marketing strategy, technical constraints relating to process and plant facilities, and operators; efficiencyB, norms of raw material consumption Aincluding provision for wastageB, power and fuel re"uirement, their costs, salaries and wages, repairs and maintenance, administrative overheads, selling expenses Aincluding product promotionB and interest on borrowings. Ade"uate provision is made for higher expenses in the initial years for technical troubles, higher wastages and lower yields, lower operating efficiency and higher selling costs. <ere, too, comparison with similar projects is useful. The profitability estimates should be on a realistic selling price. In a competitive market, penetration price for a new producer will have to be lower than the current price of an established manufacturer.

Chapter 4 - Financial Appraisal ntrod!ction

Financial appraisal is concerned with assessing the feasibility of a new proposal for investment for setting up a new project or expansion of existing productive facilities. This involves an assessment of funds re"uired to implement the project and the sources of the same. The other aspect of financial appraisal relates to estimation of operating costs and revenues, prospective li"uidity and financial returns in the operating phase. In appraising a project, the project;s direct benefits and costs are estimated at the prevailing market prices. This analysis is used to appraise the viability of a project as well as to rank projects on the basis of their profitability. It may be noted that financial appraisal is concerned with the measurement of profitability of resources invested in the project without reference to their source. For the purpose of appraisal it is necessary to make estimates relating to working results in case of existing concerns, cost of the project and means of financing. Financial projections for a ten3year period have also to be made. "or#ing Res!lts of E$isting Units In the case of an existing unit, it is desirable to make an assessment of its latest financial position. For this purpose, its latest audited balance sheet and profit and loss statement as well as the balance sheets for the last five years have to be analysed. In case an audited balance sheet as on a fairly recent date is not available, a proforma balance sheet and profit and loss statement certified by the management may be examined. The latest balance sheet and profit and loss account may be analysed with a view to ascertaining, whether the concern is under#over capitalised, whether the borrowings raised are not out of proportion to its paid up capital and

reserves, how the current liabilities stand in relation to current assets, whether the gross block has been properly depreciated and has not been shown at an inflated value, whether there is any inter3locking of funds with associate companies and whether the concern has been ploughing back profits into the business and building up reserves.

Cost of the Project The capital cost of the project whether it pertains to expansion or a new project should be shown under, aB Cand and site developments, bB %uildings, cB lant and machinery,

dB Technical know3how fees, eB 6xpenses on foreign technicians and training of Indian technicians abroad, fB 2iscellaneous fixed assets, gB hB reliminary and pre3operative expenses, rovision for contingencies and

iB 2argin money for working capital. It has to be ensured that all these items are covered in the cost and the expenditure under each item is reasonable. As a part of the process of an appraisal of the capital cost of the project, it is desirable to compare the cost of the project with the cost of a similar project or by the information about cost that may be gathered in respect of other units in the same industry with comparable installed capacity and other common technical features. %o!rces of Finance The usual sources of finance for a project are' 6"uity capital, term loan, deferred payment, unsecured loans from promoters and internal accruals in the case of an existing unit. A balance has to be struck between debt and e"uity. A debt e"uity ratio of $'$ is considered ideal but it is relaxed upto +'$ in suitable cases. Further relaxation in debt e"uity is made in the case of capital intensive projects. All long3term loans#deferred credit are treated as debt while e"uity

includes free reserves. 6"uity is arrived after deducting carried forward losses in the case of an existing unit. It is important that no gap is left in financing patterns. 7therwise it will result in delays in implementation of the project. A condition is stipulated by financial institutions that the promoters shall arrange for funds to meet any over run in the cost of the project. >hile the emphasis of financial institution is on the viability of the project they generally stipulate by way of security, a first legal charge on fixed assets of the company ranking pari passu with the charge if any, in favour of other financing institutions.

Financial projections For the purpose of determining the profitability of the project and the ability of the company to service its loans and give a reasonable return on the e"uity capital, estimates of cost of the project, profitability, cash flow and projected balance sheets have to be prepared in the proforma given in Annexure $ for ten years. These are inter related and are prepared on the basis of the estimated cost of the project, sources of finance envisaged and various assumptions regarding capacity utilisation, availability of inputs and their price trends and selling price. The important assumption that should be scrutinised carefully before making estimates are capacity build up, raw material cost, estimate of wages and salaries, cost of utilities, estimate of administrative expense, selling price assumed and provisions made for depreciation and statutory taxes. Derification of profitability is the core of proper appraisal of the project. The entrepreneur may be naturally tempted to present a bright picture but it is the task of financial appraisal to verify the estimates. It is to be ensured that the profits projected are realistic. In case of new units, any sharp build up of capacity within a year or two will be unwarranted especially if the product is new. The "uantum of raw materials and utilities estimated to be consumed to obtain a particular "uality#"uantum

of end product is the core of cost of manufacture estimates and should tally with the performance guarantees furnished by the collaborators#machinery suppliers. In case of multiproduct firms, the product mix is decided on the basis of contribution of each product, utilisation of plant capacity as well as market. Annual increases in wages and salaries should be about five percent. :epairs and maintenance will have to be provided keeping in view the type of industry and the number of shifts to be worked. )epreciation of fixed assets should be provided as per income tax rules. The selling price should be fixed keeping in view the present domestic price of the product. The profitability projections are closely linked to the schedule of implementation. 7n the basis of profitability projections, cash flow and projected balance

Eval!ation of Cash Flo& and Profita'ilit( Financial appraisal uses two popular methods and two discounted cash flow techni"ues to evaluate the cash flows and profitability of investment. The methods should have three properties to lead to consistently correct decisions. First, it should consider all cash flows over the entire life of a project= secondly, it should take into account the time value of money and finally it should help to choose a project from among mutually exclusive projects, which maximise the value of the firm@s stock. The two popular methods are the simple rate of return and pay back period. They employ annual data at their nominal value. They do not take into account the life span of the project but rely on one year. The discounted cash flow techni"ues take into consideration the project;s entire life and the time factor by discounting the future inflows and outflows to their present value. %imple Rate or Ret!rn Method 8imple rate of return is the ratio of net profit in a normal year to the initial investment in terms of fixed and working capital. If one is interested in e"uity alone the profitability of e"uity can be calculated. The simple rate of return could be presented as,

: E AF F GB# I E :e EF#H where % & Si ple rate of return on total in"est ent :e E 8imple rate of return on e"uity capital

F E &et profit in a normal year after depreciation, interest and taxes G E Annual interest charges I E Total investment comprising of e"uity and debt= and H E 6"uity capital invested. Normal year is a representative year in which capacity utilisation is at technically maximum feasible level and debt repayment is still under way. The simple rate of return helps in making a "uick assessment of profitability, particularly of projects with short life. Its shortcoming is that it leaves out the magnitude and timing of cash flows for the rest of the years of a project;s life. For evaluation, accurate data is re"uired. In its absence simple rate of return may be incorrect 8imple rate of return method is more suitable for financial analysis of existing units. It is not suitable for optimising investment Pa(-)ac# Period ay3back period for a project, measures the number of years re"uired to recover a project;s total investment from the cash flows it generates. It is the expected number of years re"uired to recover the original investment If we consider a project with an investment of :s. /,,,,,,, and an expected cash flow of :s. $,,,,,,, per year for $, years, the pay3back period is given by, Paybac' Period & Initial In"est ent !utlay ( )nnual Cash Flo*

E /,,,,,,,#$,,,,,,, E / years The pay3back period shows that the project;s initial investment is recovered in five years. 6ven if cash flows are not uniform, the pay3 back period can be calculated easily by adding together cash flows until the investment is recovered. The method is easy to calculate and emphasises the li"uidity

aspect of investment. The shorter the pay3back period the "uicker is the recovery of initial investment %ut it leaves out the time pattern of the cash flows within the pay3back period. It leaves out the cash flows after the pay back period. Actually, it is biased against project which yield higher returns in later years. The payback period method is not suitable for evaluation of alternatives and to make systematic comparison. *CF Techni+!es The discounted cash flow A)(FB methods provide a more objective basis for evaluating investment proposals. They take into account both the magnitude and timing of expected cash flows in each period of a project;s life. The two methods are the internal rate of return and the present value method. They take into account time value of money and a rupee today is more valuable than a rupee tomorrow. nternal Rate of Ret!rn , RRI:: for an investment proposal is the discount rate that e"uates the present value of future cash inflows to the initial cost of the project. In the I:: method the discount rate is unknown. %y definition, I:: is the rate of discount that reduces net present value of a project to !ero. The I:: method finds the specific discount rate that e"uates the present value of the expected cash flows to the initial cost of the project. There is a value of I::, which will cause the sum of discounted cash flows to e"ual the initial cost of the project making the & D e"ual to !ero. This value is defined as I::. I:: is represented by that rate, r, such that

TE ,

IAt# A$ F rBtJ

E ,

where At is the cash flow for period t Anet inflow or outflowB and n is the last period in which cash flow is expected. If investment occurs at time ,, the above e"uation can be expressed as The future cash flows Al through An are discounted by r to e"ual the initial investment at time ,, A,. If initial investment is :s. $5 lakhs, annual cash flows are :s. /.- lakhs, for five years= the problem can be expressed as' A, E A$# A$FrB F A+# A$FrB+ F K An# A$FrBn $5,,,,,,, E /,-,,,,,# A$FrB F /,-,,,,,# A$FrB+ F /,-,,,,,# A$FrB0 F /,-,,,,,# A$FrB1 F /,-,,,,,# A$FrB/ The internal rate of return, r is $-./- percent. >hen I:: is employed, the selection of a project is decided by comparing it with a re"uired rate of return or cut3off or hurdle rate. The project is accepted only if it exceeds the re"uired rate of return, leaving a surplus after paying for the capital. This surplus will accrue to the firms shareholders by increasing the value of the company;s stock. If I:: is less than the cost of capital, the project will impose a cost and results in reduction of the value of the stock. .et Present /al!e ,.P/- Method This is the present value of future cash flows, discounted at the appropriate cost of capital, minus the cost of investment. All future cash flows from the project are discounted to present value using the re"uired rate of return. To calculate the net present value find the present value of expected net cash flows of an investment discounted at an appropriate interest rate, and subtract n from it the initial cost of the project. The net present value A& DB of an investment proposal is, & D E At# A$ F kBt
TE ,

where k is the re"uired rate of return. An investment proposal is accepted if the sum of discounted cash flows is !ero or more. If not, it is rejected. The present value of cash inflows should exceed the present value of cash outflows. If we use the I:: example, the net present value with an assumed re"uired rate of return of $+ per cent would be, & D E 3$5,,,,,,, F /,-,,,,,# A$.$+B F /,-,,,,,# A$.$+B + F /,-,,,,,# A$.$+B0 F /,-,,,,,# A$.$+B1 F /,-,,,,,# A$.$+B/ E 3$5,,,,,,, F +,,/1,-,, E +,/1,-,, >hen the & D is !ero, the project would cover all re"uired operating and financial costs but it has no excess returns. >hen the firm chooses a !ero & D project, the firm becomes larger but its value does not change. If a project;s & D is !ero or positive the project is acceptable and if the & D is negative, the project is unacceptable. The two )(F techni"ues, the I:: and & D lead to the same acceptance or rejection decisions. I:: method is similar to the & D method. Instead of a minimum acceptable rate of return being defined as an input, a rate of return is calculated which balances the cash inflows over time with the cash outflows overtime. I:: is estimated by an iterative process. If I:: is greater than the minimum acceptable rate of return, the project is deemed to be profitable. Estimating Cost of Capital &ith Capital Asset Pricing Model In the analysis so far, the company;s cost of capital was used to discount the forecasted cash flows of the new project. 2any companies estimate the rate of return re"uired by investors in their securities. Towards this purpose the company;s cost of capital is used to discount cash flows in all new projects.

This is not an accurate method since the risk of existing assets of a company may differ from the risk of new project assets. 8ince investors re"uire a higher rate of return from a very risky company, such a company will have a higher cost of capital and will set a higher discount rate for its new investment opportunities. The cost of capital or re"uired rate of return on the project would be the same as the one on company;s existing assets if the risk is the same. The company;s cost of capital is the correct discount rate for projects that have the same risk as the company;s existing business. If the project risk differs from the risk on existing assets, the project has to be evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which it is put. The capital asset pricing model can be used for estimating the company;s cost of capital. 6ach project should be evaluated at its own opportunity cost of capital. (apital asset pricing theory tells us to invest in any project offering a return that more than compensates for the project;s beta which measures the amount that investors expect the stock price to change for each one percent additional change in the market risk. The discount rate increases as project beta increases. <owever, firms re"uire different rates of return from different categories of investment. The higher the beta risk associated with an investment the higher the expected rate of return must be to compensate investors for assuming risk. The (A 2 provides a framework for analysing the relationship between risk and return. The (A 2 holds that there is a minimum re"uired rate of return even if there are no risks, plus a premium for all non3diversifiable risks associated with investment combined. To calculate the company;s cost of capital the beta of its assets has to be ascertained. %ut the beta cannot be plugged into the capital asset pricing model to find the company;s cost of capital because the stock;s beta reflects rojects should be evaluated as portfolios and there is a reduction of risk when they are so

both business and financial risk. The beta has to be adjusted to remove the effect of financial risk since borrowing increases the beta Aand expected returnB of its stock. A more reliable estimate is an average of estimated betas for a group of companies in the same industry. >hile estimating project betas, fudge factors to discount rates to offset bad outcomes of a project should be avoided. In cases where project beta cannot be calculated directly, identification of the characteristics of high and low beta assets Afor instance cyclical investments are high beta investmentB would help to figure out effect on cash flows. Finally, operating leverage should be assessed since high fixed production charges are like fixed financial charges resulting in an increase in beta. The expected rate of return calculated from the capital asset pricing model r E rf F Arm 3 rfB A>here r is discount rate, rf interest rate on risk free asset like treasury bill, r m expected returnB can be plugged into standard discounted cash flow formulaB.

D (t# A$ F rB E (t# I$ F rf F A rm 3 rf BJt

t
TE , TE ,

The capital asset pricing model values only the cash flow for the first period ($. rojects, however, yield cash flows for several years. If the risk adjusted rate r is used to discount the cash flow, we assume that cumulative risk increases at a constant rate. The assumption will hold when the project;s beta is constant or risk per period is constant. Financial Anal(sis An integral aspect of financial appraisal is financial analysis, which takes into account the financial features of a project, especially source of finance.

Financial analysis helps to determine smooth operation of the project over its entire life cycle. The two major aspects of financial analysis are li"uidity analysis and capital structure analysis. For this purpose ratios are employed which reveal existing strengths and weaknesses of the project Li+!idit( Ratios Ci"uidity ratios or solvency ratios measure a project;s ability to meet its short3 term obligations. Two ratios are calculated to measure li"uidity, the current ratio and "uick ratio. Current %atio' The current ratio is defined as current assets Icash, bank balances, investment in securities, accounts receivable Asundry debtorsB and inventoriesJ divided by current liabilities Iaccounts payable Asundry creditorsB, short term loans from banks, creditors and advances from customersJ. It is computed by, Current ratio & Current )ssets( Current $iabilities The current ratio measures the assets closest to being cash over those liabilities closest to being payable. It is an indicator of the extent to which short term creditors are covered by assets that are expected to be converted to cash in a period corresponding to the maturity of claims. A current ratio $./ to $., is considered acceptable. Acid Test or 0!ic# Ratio1 Since inventories among current assets are not uite li uid, the uick ratio excludes it. !he uick ratio includes only assets "hich can be readily converted into cash and constitutes a better test of li uidity. +uic' %atio & ,Current )ssets - In"entories-( Current $iabilities A "uick ratio of $'$ is considered good from the viewpoint of li"uidity. Capital %tr!ct!re Anal(sis

Cong3term solvency ratios measure the project;s ability to meet long term commitments to creditors. ;(reditors; claims on a firm;s income arise from contractual obligations, which must be honoured. The larger the amount of these claims the higher the chances of their not being met. Cegal action may be initiated to enforce the fulfilment of the claims. The two long3term solvency ratios are debt utilisation ratio and coverage ratio. .ebt /tilisation %atio0 )ebt utilisation ratio measures a firm;s degree of indebtedness, which measures the proportion of the firm;s assets financed by debt relative to the proportion financed by e"uity. )ebt includes current liabilities and long term debt. (reditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditor;s losses in the event of li"uidation. The owners prefer higher levels either to magnify earnings or to retain control. .ebt %atio & Total .ebt( Total )ssets

.ebt #1uity %atio0 )ebt e"uity ratio is the value of total debt divided by the book value of e"uity. In calculation of debt, short3term obligations of less than one3year duration are excluded. )ebt 6"uity :atio E Cong Term Ciabilities# 8hareholders 6"uity 8ometimes debt e"uity ratio is referred to as debt capitalisation ratio.

Fi2ed )ssets Co"erage %atio0 Two other ratios relating to long term stability used by development finance institutions A)FIsB in appraisal of projects are fixed assets coverage ratio and debt coverage ratio. The fixed assets coverage ratio shows the number of times fixed assets cover loan.

Fi2ed )ssets Co"erage %atio & 3et Fi2ed )ssets( Ter

$oan

.ebt Co"erage %atio0 The debt coverage ratio measures the degree to which fixed payments are covered by operating profits. The ratio emphasis the ability of the project to generate ade"uate cash flow to service its financial charges, Anon3operating expensesB. )ebt coverage ratio measures the number of times earnings cover the payment of interest and repayment of principal. A debt coverage ratio of + is considered good. )8(: E A AT F )epreciation F other non3cash charges F interest on term loan B# AInterest on term loan F repayment of term loanB. The above formula takes into account the effect of taxes on the profits expected. <ence it gives a realistic picture of the ability to meet obligations.

Interest Co"erage %atio0 The interest coverage ratio measures the number of times interest expenses are earned or covered by profits. Interest (overage :atio E A&et rofit before taxes F interestB# Interest

Mar'et 4alue %atios0 2arket value ratios relate the company;s share price to its earnings and book value per share. These ratios are a performance index of the company and indicate the investor@s perception of the company;s performance and future prospects. Price #arnings %atio0 #6 ratio relates the per share earnings to price of the share. # 6 :atio E 2arket rice er 8hare #6arning er 8hare

#6 ratios are computed for firms as well as for the market. #6 ratios are higher for companies with high growth prospects and lower for riskier companies. Mar'et(5oo' 4alue %atio0 The ratio of market price of the share of the company to its book value per share gives an indication of how investors regard the company. 9enerally if the returns on assets are high, these shares sell at higher multiples of book value than those with low return. %ook value per share is the sum of net worth Apaid up capital plus reservesB divided by number of shares outstanding. %ook value per share E Total &et >orth# &o. of shares outstanding Mar'et(5oo' %atio ,M(5 %atio-0 If the market price per share is divided by book value, we get the market book A2#%B ratio. 5rea' #"en Point ,5#P-0 An essential aspect of financial appraisal is the determination of %6 . ?nless it is determined, other measures make no sense. To calculate and project cash flows it is important to assess the %6 . %reak3even is that level of production and sales at which total revenues are exactly e"ual to operating costs. %6 occurs at that production level at which net operating income Asales3operating costB is !ero. It indicates the volume necessary for profitable operation of the project. >ith the help of break3even analysis the "uantity re"uired to be produced at a given sales price per unit to cover total fixed cost and variable cost can be found. If %6 is too high, the price assumed for the output may have to be reviewed. In summary, the viability of a project can be assessed with the help of break3even analysis. For the purpose of break even analysis, the conventional income statement has to be classified into fixed and variable costs. An example of conventional

income statement is presented in Table +, which is classified into fixed and variable expenses.

Table +' Illustrative (onventional Income 8tatement &et 8ales Cess' (ost of goods sold' 2aterials Cabour Manufacturing e2p6 :s. $,5,,,,, 4,,,,, 17897::: $,4/,,,, $ess0 !perating e2penses 8elling expenses Cess' 2iscellaneous expenses rofit <=7::: /1,,,, 0,,,, -+,,,, L,,,,, -/,,,, ;7<97::: :s. 4,,,,,,,

Table 0'$ )erivation of %6 from Income 8tatement For deriving %6 , it is necessary to recast the income statement in Table0'$ into fixed and variable costs. tems of cost 2aterials Cabour 2anufacturing expenses 8elling expenses Administrative expenses 2iscellaneous expenses +,,,, $,,,, 0,,,, +,,,,,, 14,,,, $4,,,, 5,,,, 04,,,, /1,,,, $,,,,,,, Fi$ed ----------/aria'le $,5,,,,, 4,,,,, L/,,,, Total $,5,,,,, 4,,,,, $,L/,,,,

$,45,,,, &et profit Total 8ales

0,4,,,,,

/,+5,,,, -+,,,, 4,,,,,,,

It may be seen from the above statement that for a sale of :s. 4,,,,,,, the variable cost is :s. 0,4,,,,, i.e., 4, per cent of sales. It means that on every rupee of sales, 4, paisa is spent on variable costs and the balance of 1, paisa A1,. B is left to meet the fixed cost. To find the total sales re"uired to meet the fixed cost of :s, $,45,,,, tile total fixed cost is divided by 1, per cent. Sales re1uired to E :s. 1,+,,,,, The volume of :s, 1,+,,,,, is known as the break3even sales volume which must be achieved if loss is to be avoided. The profit status at this level is, 8ales Cess' Dariable costsA4,. on salesB 2argin available for fixed expenses rofit &il :s.1,+,,,,, +,/+,,,, $,45,,,, eet fi2ed cost & ,17=>7::: ? 1::-( ;:

The computation of break3even sales volume can be summarised as, 5rea' -e"en sales "olu e & Total Fi2ed Cost( ,1 @ Total 4ariable Cost( Total Sales 4olu e%6 E F# A$ M D#8B

where F is fixed cost D is variable cost 8 is sales volume. 8ubstituting the figures mentioned above, 5rea'e"en Sales 4olu e & 17=>7:::( ,<7=:7:::( =7::7:::E $,45,,,,#A$ 3 .4,B

E $,45,,,,# .1 E :s. 1,+,,,,, If :s. 4,,,,,,, sales can be regarded as normal for a month, Astandard sales volumeB capacity utilisation rate at which the project must operate in order to ;break3even; can be calculated. This will be %reakeven 8ales Dolume N $,,# 8tandard 8ales Dolume E 1,+,,,,, N$,,# 4,+,,,,, E -,. At capacities lower than -, percent, project is bound to incur losses. 7n the other hand, it will make profits at levels above the -, per capacity utilisation. The ;break3 even; capacity represents the capacity utilisation rate to be achieved to make the project viable. The normal rate for capacity utilisation is about /, percent.

(hapter / 3 6conomic Appraisal 6conomic appraisal of a project deals with the impact of the project on economic aggregates. >e may classify these under two broad categories. The first deals with the effect of the project on employment and foreign exchange and second deals with the impact of the project on net social benefits or welfare. 6mployment effect >hile assessing the impact of a project on employment, the impact on unskilled and skilled labour has to be taken into account. &ot only direct employment, but also indirect employment should be considered. )irect employment refers to the new employment opportunities created within the project and first round of indirect employment concerns job opportunities created in projects related on both input and output sides of the project under appraisal. 8ince indirect employment is to be counted, additional investment needed in projects with forward and backward linkage effects also should be counted. Total employment effect Adirect and indirectB is, OTe E *7T # It where OTe E total employment effect *7T E total number of new job opportunities It E total investment Adirect and indirectB &et foreign exchange effect

A project may be export oriented or reduce reliance on imports. In such cases an analysis of the effects of the project on balance of payments and import substitution is necessary. The assessment of project on the country;s foreign exchange is done in two stages= first, balance of payments effects of the project and second, import substitution effect of a project. For this purpose, net foreign exchange flows are calculated as per the proforma in Annexure +. The proforma enables the analysis of li"uidity of a project in terms of foreign exchange. The annual net flows as well as the net impact over the economic life of the project have to be found. The import substitution effect of a project measures the estimated savings in foreign exchange owing to the curtailment of imports of the items of production of which has been taken up by the project. (IF values are used in calculation of import substitution effect. &et foreign exchange effect of the project includes the net foreign exchange flow in 8tatement 0 and the import substitution effect. The analysis of net foreign exchange effect may be done for the entire life of the project or on the basis of a normal year. If two or more projects are compared on the basis of their net foreign exchange effect, the annual figure should be discounted to their present value. 8ocial cost benefit analysis Another aspect of economic appraisal is social cost benefit analysis. (ost benefit analysis is concerned with the examination of a project from the view point of maximisation of net social benefit. >hile cost benefit analysis originated to evaluate public investment, it is also used in project appraisal. (ost benefit appraisal of a project proposes to describe and "uantify the social advantages and disadvantages of a policy in terms of a common monetary unit An enterprise or project adopting cost benefit analysis approach has, as its objective function, net benefits to society whereas the objective function of

a private project is net private benefit or profit. &et social benefit entails that gains and $osses be valued in a common unit. The unit should reflect society;s strength of preference for each outcome. The economist uses as a measure of this preference, the consumer@s willingness to pay A>T B for a good. This will be partly reflected in the price he pays for the goods. In many cases the prices are not observable or are distorted. In these circumstances cost benefit analysis must seek surrogate prices or shadow prices to measure what the society will be willing to pay if there is a market. &et social benefits are found by deducting from >T to the maximisation of social utility or social welfare. the compensation re"uired Athe costB. 2aximisation of net benefit should be finally e"uivalent

Chapter = - Choice of Securities

ntrod!ction To meet $ong3term re"uirements for funds, securities are issued to public Aissue of capitalB by firms in the corporate sector and public sector. 8ecurities represent claims on a stream of income and#or particular assets. )ebentures are debt securities and there is a wide range of them. 6"uity shares in corporate sector or privatised public sector undertakings are ownership securities. reference share is a hybrid security that entails a mixture of both ownership and creditorship privileges. Issue of capital which was regulated by the (apital Issues A(ontrolB Act, $L1was repealed on 2ay +L,$LL+. The issue of capital and pricing of issue have become free of prior approval. *e'ent!res *efinition and .at!re The issue of debentures by public limited companies is regulated by (ompanies Act $L/4. )ebenture is a document, which either creates a debt or acknowledges it. )ebentures are issued through a prospectus. A debenture is issued by a company and is usually in the form of a certificate, which is an acknowledgement of indebtedness. They are issued under the company;s seal. )ebentures are one of a series issued to a number of lenders. The date of repayment is invariably specified in the debenture. 9enerally debentures are issued against a charge on the assets of the company. )ebentures may, however, be issued without any such charge. )ebenture holders have no right to vote in the meetings of the company. 2inds of *e'ent!res 5earer .ebentures0

They are registered and are payable to its bearer. They are negotiable instruments and are transferable by delivery. Registered *e'ent!res1 They are payable to the registered holder whose name appears both on debenture and in the register of debenture holders maintained by the company. :egistered debentures can be transferred but have to be registered again. :egistered debentures are not negotiable instruments. A registered debenture contains a commitment to pay the principal sum and interest. It also has a description of the charge and a statement that it is issued subject to the conditions endorsed therein. %ec!red *e'ent!res )ebentures, which create a charge on the assets of the company, which may be fixed or floating, are known as secured debentures. Unsec!red or .a#ed *e'ent!res )ebentures, which are issued without any charge on assets, are unsecured or naked debentures. The holders are like unsecured creditors and may sue the company for recovery of debt. Redeema'le *e'ent!res &ormally debentures are issued on the condition that they shall be redeemed after a certain period. They can, however, be reissued after redemption under 8ection $+$ of (ompanies Act $L/4. Perpet!al *e'ent!res >hen debentures are irredeemable they are called perpetual. Converti'le *e'ent!res #f an option is given to convert debentures into e uity shares at stated rate of exchange after a specified period, they are called convertible

debentures. #n our country the convertible debentures are very popular. $n conversion, the holders cease to be lenders and become o"ners. )ebentures are usually issued in a series with a pari passu Aat the same rateB clause which entitles them to be discharged rateably though issued at different times. &ew series of debentures cannot rank pari passu with old series unless the old series provides so. &ew debt instruments issued by public limited companies are participating debentures, convertible debentures with options, third party convertible debentures, convertible debentures redeemable at premium, debt e"uity swaps and !ero coupon convertible notes. Participating .ebentures They are unsecured corporate debt securities, which participate in the profits of a company. They might find investors if issued by existing dividend paying companies. Converti'le *e'ent!res &ith 3ptions They are a derivative of convertible debentures with an embedded option, providing flexibility to the issuer as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue. Third Part( Converti'le *e'ent!res They are debt with a warrant allowing the investor to subscribe to the e"uity of a third firm at a preferential price vis3a3vis the market price. Interest rate on third party convertible debentures is lower than pure debt on account of the conversion option. Converti'le *e'ent!res Redeema'le at a Premi!m

(onvertible debentures are issued at face value with a put op entitling investors to later sell the bond to the issuer at a premium. They are basically similar to convertible debentures but embody less risk. *e't-e+!it( %&aps )ebt3e"uity swaps are an offer from an issuer of debt to swap it for e"uity. The instrument is "uite risky for the investor because the anticipated capital appreciation may not materialise. *eep *isco!nt )onds They are designed to meet the long term funds re"uirement of the issuer and investors who are not looking for immediate return and can be sold with a long maturity of +/30, years at a deep discount of the face value of debentures. I)%I deep discount bonds for :s. $ lakh repayable after +/ years were sold at a discount price of :s. +,-,,#3. 4ero Co!pon Converti'le .ote A !ero coupon convertible note can be converted into shares. If choice is exercised investors forego all accrued and unpaid interest. The !ero coupon convertible notes are "uite sensitive to changes in interest rates. %ec!red Premi!m .otes ,%P.- &ith *etacha'le "arrants 8 &, which is issued along with a detachable warrant, is redeemable after a notified period, say four to seven years. The warrants attached to it ensure the holder the right to apply and get allotted e"uity shares, provided 8 & is fully paid. There is a lock3in period for 8 & during which no interest will be paid for the invested amount The 8 & holder has an option to sell back he 8 & to the company at par value after the lock3in period. If the holder exercises this option, no interest#premium will be paid on redemption. In case the 8 & holder holds it further, the holder will be repaid the principal amount along

with additional amount of interest# premium on redemption in instalments, as decided by the company. The conversion of detachable warrant into e"uity shares will have to be done within the time limit notified by the company. Floating %ate 5onds The yield on the floating rate bond is linked to a benchmark interest rate like the prime rate in ?8A or CI%7: in 6urocurrency market. The 8tate %ank of India;s floating rate bond issue was linked to maximum interest on term deposits, which was $, percent. Floating rate is "uoted in terms of a margin above or below the benchmark rate. The floor rate in 8%I case was $+ percent. Interest rates linked to the benchmark ensure that neither the borrower nor the lender suffers from the changes in interest rates. >hen rates are fixed, they are likely to be ine"uitable to the borrower when interest rates fall subse"uently, and the same bonds are likely to be ine"uitable to the lender when interest rates rise subse"uently. Warrants A warrant is a security issued by a company granting the holder of the warrant the right to purchase a specified number of shares at a specified price any time prior to an expirable date. >arrants may be issued with debentures or e"uity shares. The specific rights are set out in the warrant. The main features of a warrant are number of shares entitled, expiration date, and stated price#exercise price. The exercise price is $, to 0, percent above the prevailing market price. >arrants have a secondary market. The minimum value of a warrant represents the exchange value between current price of the share and the shares purchased at the exercise price. >arrants have no floatation costs and when they are exercised the firm receives additional funds at a price lower than the current market, yet above those prevailing at issue time. &ew or growing firms and venture capitalists issue warrants. They are also issued in mergers and ac"uisitions. )ebentures issued with warrants, like convertible debentures carry lower coupon rates.

nterest and 5ield on *e'ent!res &o matter what happens, interest payments and repayment of principal at maturity have to be made to debenture holders. %ut they would be irrational if they ignore alternative investments that bring in a higher return. If the investor knows the price of a debenture and its characteristics, be can infer a rate of return called Gield to 2aturity AGT2B. Gield means the return on investment at current market price. It is expressed as ,%ate of return ? Face "alue-( Current Mar'et Price E Gield percent The yield works out more than the rate of interest if market price is below par value= and less than the rate of interest when the market price is higher than par value. :isky debentures have to pay higher yields to maturity to attract investors. Gield to maturity is more significant than the coupon rate to debenture investors. If the debenture is selling at a discount, its market price is below its face value. Its yield to maturity exceeds coupon rate. If it is selling at a premium, the market price is above its face value and the coupon rate is higher than yield to maturity. Gield to maturity and average rate of return compounded annually to maturity refer to effective rate of return if held to maturity. Advantages of de'ent!res Fro the co pany point of "ie*0

$. The cost of debentures is lower than that of e"uity or preference capital because the interest on debentures is tax deductible. <ence the effective post tax cost of debentures is lower.

+. )ebenture financing does not lead to dilution of control since debentures do not carry voting rights. %. #rrespective of the price level, debentures carry a fixed financial burden. !his "ould be attractive to a company "hich expects its income level to go up substantially in the future. Fro the in"estorAs point of "ie*0

$. They earn a stable rate of return +. They enjoy priority in the event of li"uidation 0. They generally enjoy a fixed maturity period *isadvantages of de'ent!res From the compan(6s point of vie&

$. The debenture interest and capital repayment are obligatory payments. +. )ebenture financing increases the financial risk associated with the firm. This may increase the cost of e"uity t the company. From the investor6s point of vie& $. The interest on debentures is taxable +. )ebentures do not carry voting rights E+!it( %hares 6"uity shares represent proportionate ownership of a company. This right is expressed in the form of participating in the profits of a going company and sharing the assets of a wound up company. 6"uity shares have the lowest priority claim on earnings and assets of all securities issued. A company may

pay dividend if if it generates earnings and has no pressing internal needs for them. The firm has no fixed obligation to pay periodic dividends. 8hares have unlimited potential for dividend payments and share appreciation. They also provide cushion against losses from the pointof view iof the creditors. To the extent the e"uity is higher the credit worthiness of the firm is higher. This should have a favourable effect on the rating of its debentures, lower its cost of debt and increase its future ability to raise debt. 2aintaininig a reserve borrowing capacity is essential to overcome operating problems. In contrast, owners of debentures and preference shares enjoy an assured return in the form of interest and dividend. As a result of this risk, investors are unwilling to invest in e"uity shares unless they offer a rate of return sufficiently high to induce investors to assume the possible loss. /oting rights The (ompanies@ Act deals with the voting rights of a shareowner. An e"uity shareowner has a right to vote on every resolution placed before the company. The voting rights are proportional to the share owners share of paid3up capital of the company. All shares carry proportionate rights. &o (ompany can issue shares that carry voting rights disproportionate to the rights attached to the holders of other issues. Doting rights cannot, however, be exercised in respect of shares on which a call or any other sum due to the company has not been paid. It may be noted that the word ;capital; in share capital is used to mean nominal, authorised or issued or paid3up capital. Nominal or Authorised &apital is the maximum capital the 2emorandum envisages for the company unless it is changed. The 2emorandum also specifies the division of authorised capital into shares of fixed amount.

#ssued capital is the nominal value of shares offered for public subscription. In case all shares offered for public subscription are not taken up. The portion subscribed, is subscribed capital that is less than issued capital. Paid-up &apital is the share capital paid3up by shareowners or which is credited as paid3up on the shares. Par 'alue is the face value of a share. It does not tell anything about the value of shares. (ook 'alue is determined by deducting total liabilities including preference shares from total assets and the difference, which is e"ual to shareholder e"uity with the number of e"uity shares outstanding. #1uity Shares *ith .etachable Warrants )etachable warrants are issued along with fully paid e"uity shares, which will entitle the warrant holder to apply for a specified number of shares at a determined price. )etachable warrants are separately listed with the stock exchanges and traded separately. The terms and conditions relating to issue of e"uity shares against warrants are determined by the company.

Cash *ividends A stable cash dividend payment was believed to be the basis for the increase in company;s share prices. A growth3oriented firm retains as much capital as possible for internal financing. (apital appreciation rather than dividends is what an investor has to look for in their case. 7ld established firms tend to pay out large proportion of their earnings as dividend. 5onus Shares ,or stoc' di"idends%onus shares are dividends paid on shares instead of cash. %onus shares are issued by capitalising reserves. >hile net worth remains the same in the balance sheet its distribution between shares and surplus is altered.

)lteration or Share Capital If the Articles of Association authorise limited company can AIB increase share capital by issue of new shares, A+B consolidate and divide all or any part of its share capital into shares of larger amount, A0B convert fully paid3up shares into stock or vice versa, A1B subdivide shares into shares of smaller amount and A/B cancel shares which have not been subscribed Adoes not constitute reduction of share capitalB. ?nder 8ection L/, notice of alteration of capital should be sent to :egistrar of (ompanies A:7(B within 0, days. ncrease in %!'scri'ed Capital Increase in the subscribed capital of a company may occur by allotment of further shares and by conversion of debentures or loans into shares. Increase in subscribed capital by issue of new shares should be offered in proportion to existing shares held by shareholders. Co posite Issues (omposite issues consist of rights and public issues. The 86%I guidelines provide for issues to public by existing companies being tI priced differentially as compared to rights share holders. Advantages of e+!it( From the compan(6s point of vie& $. It represents permanent capital. There is no obligation for repayment. +. There is no fixed obligation for payment of dividends. 0. It increases the creditworthiness of the company. In general, the larger the e"uity base of the company, the higher is the ability to obtain credit. From the investor6s point of vie& $. 6"uity usually earns a higher rate of interest than other instruments. +. Income from e"uity is exempt from tax. 0. 6"uity shareholders have voting rights that enable them to have controlling power in the company.

*isadvantages of e+!it( From the compan(6s point of vie& $. The cost of e"uity capital is usually the highest. +. 6"uity dividends are not tax deductible 0. The cost of issuing e"uity is higher than the cost of issuing other types of securities due to expenses like brokerage, underwriting commission, advertisement, etc. 1. It results in dilution of control over the company. From the investor6s point of vie& $. Though the e"uity shareholders have voting power, the real control exercised by them is often weak because they are disorganised. +. 6"uity shareholders cannot insist on the payment dividend. 0. They enjoy the lowest priority in the payment of dividend and the repayment of capital. 1. 6"uity prices fluctuate wildly, making e"uity investment risky.

Preference shares .at!re reference shares carry preferential rights in comparison with ordinary shares. As a rule, preference shareholders enjoy a preferential right to dividend. As regards capital, it carries on the winding up of a company a preferential right to be repaid the amount of capital paid3 up on such shares. Cu ulati"e and 3on-cu ulati"e reference shares are of two types, cumulative and non3 cumulative. In the case of cumulative preference share, if there is no profit in any year, the arrears of dividend are carried forward and paid in the following years out of

profits, before any dividend is paid on ordinary shares. &o such carry forward provision exists for non3 cumulative preference shares. Participating Preference %hares If the articles of association provide that a preference share holder will also have the right to participate in surplus profits or surplus assets on the li"uidation of a company or in both, such preference share holders would be called participating preference shareholders. Redeema'le preference shares :edeemable preference shares are paid back to the shareholder out of the profits or out of the proceeds of new issue of shares. %ut in the case of irredeemable preference shares the amount that is fully paid is never returned. The shares have to state clearly that they are redeemable. It should be noted that redeemable preference shares are not shares in the strict sense of the term. 8ince they are repayable, they are similar to debentures. 7nly fully paid shares are redeemed. >here redemption is made out of profits, a (apital :edemption :eserve Account is opened to which a sum e"ual to the nominal amount of the shares redeemed is transferred. It is treated as paid3up share capital of the company. F!ll( Converti'le C!m!lative Preference %hare ,E+!ipref6"uipref is a very recent introduction A$LL0B into the market It consists of two parts, A and %. art A is convertible into e"uity shares automatically and compulsorily on the date of allotment. investors. (onversion into e"uity shares after the lock3in period will take place at a price which would be 0, percent lower than the average market price calculated on art % will be redeemed at par#converted into e"uity shares after a lock3in period at the option of the

the basis of monthly high and low price of the share in the preceding six months including the month of conversion. The dividend on fully convertible cumulative preference share is fixed and paid on the art % of the share. ?pon conversion of each part of the e"uipref shares, the face value of it will stand reduced proportionately and the e"uipref shares are deemed to have been redeemed to the extent of each part on the respective dates of conversion. Preference Shares *ith Warrants )ttached 6ach preference share carries a certain number of warrants entitling the holder to apply for e"uity shares for cash at ;premium; at any time in one or more stages between the third and fifth year from the date of allotment. If the warrant holder fails to exercise his option, the unsubscribed portion will lapse. The holders of warrants will be entitled to all rights#bonus shares that may be issued by the company. From the date of allotment, the preference shares with warrants attached would not be transferred#sold for a period of three years. Transfer of %hares A transfer of shares is complete as soon as the name of the transferee is substituted in place of transferor in the register of members. The procedure on transfer of share or debenture has been laid down in 8ections $,5, $$, and $$$ of the (ompanies Act. There are two kinds of transfer' AaB a transfer under a proper instrument of transfer duly stamped and executed by the transferor and transferee and AbB transmission by operation of law. Transfer means a transaction by the act of the parties whereas transmission means a transaction by operation of law. Transmission occurs on death or bankruptcy of owner. Another form of transfer of shares is blank transfer. It must be made in prescribed form and delivered to the company for registration within the prescribed time.

Advantages of preference shares From the compan(6s point of vie& $. There is no obligation to pay preference dividend. +. There is no redemption liability in case of perpetual preference shares. 0. reference capital is generally regarded as a Iart of net worth. <ence it increases the creditworthiness of the firm. 1. They do not usually carry voting rights. <ence they do not lead to dilution of control from the promoters. From the investor6s point of vie& $. It earns a stable dividend rate. +. reference dividend has been exempted from income tax. *isadvantages of Preference Capital From the compan(6s point of vie& $. As compared to debt capital, it is more expensive, because the dividend paid to preference shareholders is not tax deductible. +. Though it is not obligatory to pay preference dividends, skipping them may seriously affect the image of the firm. From the investor6s point of vie& $. They cannot enforce the right to dividend. +. The rate on preference dividend is usually not very high.

Chapter B - Ter

$oans

Term loans, also referred to as term finance, represent a source of debt finance which is usually payable in more than a year but less than ten years. They are employed to finance ac"uisition of fixed assets and working capital margin.

8ources of term loans' )evelopment Finance Institutions Industrial .e"elop ent 5an' of India ,I.5IThe Industrial )evelopment %ank of India AI)%IB which was established in $L41 under an Act of arliament, is the principal financial institution for providing credit and other facilities for development of industry .It also promotes or develops industrial units, co3ordinates working of institutions engaged in financing, and assisting development of such institutions. I)%I has been providing direct financial assistance to large and medium industrial units and also helping small and medium industrial concerns through banks and state level financial institutions. Industrial Credit and In"est ent Corporation of India ,ICICIIndustrial (redit and Investment (orporation of India AI(I(IB was established in $L// as a public limited company to encourage and assist industrial units in the country .It provides term loans in Indian and foreign currencies, underwrites issues of shares and debentures, makes direct subscription to the issues and guarantees payment for credit made by others. Industrial Finance Corporation of India ,IFCIThe Industrial Finance (orporation of India AIF(IB was set up under a statute in $L15 but has been converted into a public limited company to give flexibility to its operations. IF(I provides to industrial units, project finance, financial services and promotional services. ?nder its project finance,

financial assistance is available to units in the corporate and cooperative sectors for new units, expansion, diversification and modernisation programme in the form of rupee loans and foreign currency loans, underwriting and direct subscription to shares, debentures, guarantees for deferred payments and foreign currency loans. State Finance Corporations ,SFCsAt the state level, 8tate Financial (orporations have been set3up under 8tate Financial (orporations Act $L/$. Along with the all India financial institutions, they form an integral part of the development financing institutions in the country. There are $5 8F(s in the country. They provide financial assistance to small and medium enterprises by term loan, direct subscription to e"uity#debentures, discounting of bills of exchange and guarantees. 8F(s also provide e"uity type assistance under the special capital and seed capital schemes to entrepreneurs having viable projects but lacking ade"uate funds of their own. S all Industries .e"elop ent 5an' or India ,SI.5I8mall Industries )evelopment %ank of India has been established in $L5L to function as an apex bank for tiny and small scale industries. It functions as the principal financial institution for promotion, financing and development of industrial concerns in small scale sector and also coordinates functions of institutions engaged in promotion, financing and developing industrial concerns in small scale sector. From $LL0 8I)%I is extending direct assistance to small3scale units. 8uch assistance of above :s. /, lakhs is given on a selective basis. 8I)%I will also participate with selected commercial banks in financing small3scale projects so that working capital will be fully tied up in the case of jointly financed projects. 6"uipment finance targeted at well run existing units will be extended to take up modernisation and technology upgradation. Touris Finance Corporation of India $td ,TFCI-

TF(I was sponsored by IF(I which commenced operations in $L5L to sanction project loans, lease assistance and direct subscription to shares. Apart from the conventional tourism projects in the hospitality segments, assistance sanctioned by TF(I has enabled non conventional tourism projects like amusement parks, car rental services and air taxi passenger facilities. nvestment nstit!tions Institutions like ?TI, CI( and 9I( and its subsidiaries also provide term loans. Commercial )an#s Apart from these financial institutions, commercial banks also can sanction term loans. )orro&ing From Financial nstit!tions Term loans can be raised from financial institutions. The decision as to which financial institution should be approached depends on industry, location of the unit and si!e of project cost. For example, for projects in tourism, TF(I has to be approached. Foreign Currency $oans fro Financial Institutions

>herever imported machinery and e"uipment is necessary, the financial institutions provide the necessary foreign exchange loan after assessing the viability of the project The foreign currency loans are part of various lines of credit for financing projects based on imported plant and e"uipment. The loan covers (IF value of the capital goods and the know3how fees. Interest rate depends on the rate applicable to the foreign currency funds utilised by the financial institution. IF(I, I)%I and I(I(I grant foreign currency loans. The promoters or merchant bankers retained by them should make an appraisal of the project to satisfy that it is viable. Techni"ues described in the earlier chapters have to be applied. The next step would be design of capital structure. The choice of debt and e"uity has to be made on the basis of the

cost of capital and the ability of the unit to yield a re"uired rate of return. %efore weighing how much of debt and e"uity, promoters; contribution has to be taken into account. Capital ncentives !hey are part of e uity. !he viability of the project should ho"ever, be judged independent of the uantum and availability of capital incentives. Application for Term Loans <aving determined the promoters; contribution, the approximate amount of term loan has to be determined. Assume that the project cost is :s. $ crore and promoters contribution is at ++./ percent The debt e"uity ratio, of let us say, +'$ is to be applied That would give debt of :s. 44 lakhs and e"uity of 00 lakhs. 7ut of e"uity of :s. 00 lakhs, promoters; contribution of ++./ percent of project cost or :s. ++./ lakhs should be deducted. That would leave e"uity to be raised at :s. $,./ lakhs and loan to be raised at :s. 44 lakhs. The merchant banker has also to ensure that the project adheres to the guidelines for financing of industrial projects. After verification that the project would be eligible for term loan, a preliminary meeting should be fixed with the financial institution. If the )FI agrees to consider the proposal, the application for term loan along with the check list of information to be supplied, has to be obtained. The loan application re"uires details of promoters, background, technical skills, relevant experience and financial soundness. The market research study for the project has to establish the contribution of the project to existing and estimated demand. Aspects on technical, financial and economic appraisal are covered. (ash flow statement for a seven to ten year period is re"uired. The land for the project, plans for building and "uotations for the machinery from two manufacturers have to be obtained. The actual production process has to be depicted. Finally, working capital re"uirements have to be estimated and a

commercial bank should be approached. 8ome preliminary understanding with the bank would be necessary before going ahead with the application for term loan. The, merchant banker;s involvement would also enable him to state that he has exercised due diligence in the exercise of his obligation under various regulations. Along with the loan application, memorandum, articles of association, certificate of incorporation, latest annual report and statement of accounts if any, have to be filed. 8imilarly, documents are to be enclosed for the guarantor company if the loan is guaranteed. The final structure of financing emerges after taking into account debt3e"uity ratio, debt service coverage ratio and security margin. The debt e"uity ratio is 0' $ for 8mall industrial units and +' $ for medium and large units. >hile computing debt e"uity ratio, unsecured loans from friends and relatives and capital incentives are considered a part of e"uity. )ebt e"uity ratio by and large constitutes an upper limit. The financial institution determines the proportion of debt in capital structure on the basis of the nature of the project Acapital intensive or otherwiseB, the ability of the project to service debt in reasonable time and the priority of the industry in government policy into which the project falls. .ebt Ser"ice Co"erage %atio ,.SC%The payment of interest and repayment of principal within the stipulated time is measured by )8(:. 9ross cash accruals are related to project liability in respect of interest and payment of installment towards principal. The gross cash accruals should normally be $.4 to + times to assure that the project has inherent strength and potential to service debt. Security Margin The term loan is sanctioned against the security of fixed assets. 8ecurity margin represents the excess value of fixed assets over the term loan.

&ormally, the term loan is -/ percent of the value of fixed assets. The security margin is +/ percent. Term loans are granted subject to the following terms and conditions. $. (lean title to land as security. +. Insurance of assets, building and machinery separately. 0. 8crutiny of Articles of Association to ensure that it does not contain any restrictive clause against covenants of the financial institutions. 1. Cien on all fixed assets. /. ersonal and corporate guarantees of major shareholders and associates concerns. 4. ?ndertaking from promoters to finance shortfalls in funds#cost over3run. -. Approval of appointment of managerial personnel by )FI. 5. Further capital expenditure only on the approval of )FI. L. ayment of dividend and issue of bonus shares subject to the approval of financial institution. $,.?ndertaking for non3disposal of promoters; shareholding for a period of 0 years. After the loan is sanctioned the re"uirements to be met are, $. Acceptance of terms and conditions of loans +. )eposit of legal charges 0. )etails of plot of land for project 1. 8earch report and title deeds for the land /. 9eneral body resolutions for creation of charge over assets= 4. pollution clearance -. Cegal documents to create a charge on proposed assets 5. ersonal guarantees and undertakings along with income tax and wealth tax clearance of the prompters and directors L. Architect and auditor;s certificate for civil construction.

%efore the loan is disbursed, documents have to be executed and submitted. 8tamp duty and registration fees have to be paid, subscribed and paid3up capital to be brought in by the promoters as re"uired by the )FI and creation and registration of charge on the present and future assets of the company. After these re"uirements are complied with, disbursements are made on the basis of assets created at site. There has to be a security matching every disbursement starting with land and buildings. %alance after security margin is paid by the )FI. As machines arrive term loan is disbursed at -/ percent of their value, the che"ue being made in the name of the supplier. In the case of large projects, disbursements are need3based. In such cases, promoters have to bring in their entire contribution first. In some cases after the term loan is sanctioned, a bridge loan is granted against a bank guarantee. The bank, in turn, disburses the loan in parts ensuring that machines or assets are on site. This is done in special cases where it is physically not possible to inspect each machine as it arrives because of locational factors or to overcome procedural problems such as establishing clean title, pollution clearance, which re"uire time.

)d"antages of Ter Fro

$oans

the Co pany point of "ie*0

$. In post tax terms, the cost of term loans is less than that of e"uity or preference capital. +. Term loans do not lead to dilution of control, as the lenders do not have voting rights. Fro the lenderAs point of "ie*0

$. Term loans carry fixed rate of interest and have a definite maturity period. +. Term loans represent secured lending 0. Term loans carry several restrictive covenants to protect the interest of the lender. .isad"antages of Ter Fro $oans

the co pany point of "ie*0

$. The interest and principal repayment are obligatory. Their non payment may threaten the existence of the firm. +. Term loan contracts carry restrictive covenants that restrict the managerial freedom. Further, they entitle the lenders to put their nominees on the board of the borrowing company. 0. Term loans increase the financial risk of the firm. This in turn raises the cost of e"uity to the company. Fro the lenderAs point of "ie*0 $. Term loans do not carry voting rights. Term loans are not represented by negotiable securities. AThey need to be securitised, to overcome this limitation.B

(hapter 5 3 Issue of A):s and 9):s ) erican .epository %eceipts .efinition0 An A): is a certificate issued by an American bank, which represents a foreign stock share, held on deposit. 8ince the bank holds the stock, it is e"uivalent to trading the foreign stock. !rigin and 3ature0 Introduced to the financial markets in $L+-, an American )epository :eceipt AA):B is a stock, which trades in the ?nited 8tates but represents a specified number of shares in a foreign corporation. A):s are bought and sold on American markets a just like regular stocks, and are issued#sponsored in the ?8 by a bank or brokerage. A):s were introduced as a result of the difficulty buying shares in other countries, which trade at different prices and currency values. For this reason ?8 banks simply purchase a large lot of shares from the company, bundles the shares into groups and reissues them on the &G86, A26P, or &A8)AH. The depository bank sets the ratio of ?8 A):s per home country share. This ratio can be anything less than or greater than $. The reason they do this is because they wish to price the A): at a value that can be easily purchased by individual investors yet convey substantial value to the stock. A majority of A):s range between Q$, and Q$,, per share. If, in the home country, the shares are worth considerably less, then each A): would represent several real shares. "h( do companies !se A*Rs7

$. (ompanies may have capital demands that outstrip the availability of financing at home. It gives more ?8 exposure and allows them to tap into the rich &orth American e"uity markets.

+. Increasing the si!e of the market for its shares that may increase or stabilise the share price. 0. They also enhance the image of the company;s products or services. 1. For those companies who are truly global, it allows buyers of the company;s products and services to also invest in the company. The following are a few Indian companies whose A):s are being traded on the American 6xchanges. %ajaj Auto Cimited )r. :eddy;s Caboratories Ctd Finolex (ables Cimited 9reat 6astern 8hipping (o. Ctd. Tata 6ngineering and Cocomotive (o. Ctd. Didesh 8anchar &igam Ctd AD8&CB Types of ).%s $. /nsponsored0 These are issued by one or more depositories in response to market demand but without a formal agreement with the foreign issuer. These are becoming less common. C6 Sponsored' These A):s are issued by a depository appointed by the foreign issuer under a )eposit Agreement. There are three levels of sponsored A):s' a. $e"el I0 They trade on the ?.8. 7T( market but cannot be used to raise capital. The foreign issuer does not have to comply with 86( disclosure. b. $e"el II and III0 These are for foreign issuers who want a listing on a recognised exchange and the ability to raise capital in the ?.8. c6 Pri"ate Place ent .epository %eceipt' These allow foreign companies to have easy access to the ?.8. private placement market with Hualified Institutional %uyers.

5enefits of ).%s to in"estors0 3 Abundant 8election 3 6asier than buying foreign shares 3 6ntitled to the same information disclosure as holders of the underlying security 3 All notices and reports are issued in 6nglish 3 All issuers must report by ?.8. standards 3 8implicity 3 8afety 3 )enominated in ?.8. dollars 3 Ci"uidity 3 ?.8. research is available

8lo'al *epositor( Receipts 3ature and .efinition0 9lobal depository receipts A9):sB are essentially instruments created by overseas depository banks which are authorised by issuing companies in India to issue outside the country. 9):s are issued to non3resident investors against the shares of the issuing companies held with the nominated domestic custodian banks. They are negotiable certificates that usually represent a company;s publicly traded e"uity and are denominated in ?8 dollars. They are listed on a 6uropean 8tock 6xchange3often Cuxembourg, but Condon is also used. 6ach depository receipt represents a multiple number or fraction of the underlying share or alternatively the shares correspond to the 9): in a fixed ratio say of $ 9): E $, shares. The price of 9):s reflects the price performance of the underlying shares. 9):s can be redeemed at the price of the corresponding shares of the issuing company ruling on the date of redemption. For all good purposes, 9):s can be treated as direct investment in the issuing companies. There are however, ceilings on foreign e"uity participation. 9):s simplify cross3border trading and settlement, enhance li"uidity, minimise transaction costs, accommodate legal restrictions or direct ownership of shares, realise tax advantages and broaden investor base. Per ission for Issue0 An applicant company seeking 9overnment;s approval in this regard should have consistent track record for good performance Afinancial or otherwiseB for a minimum period of 0 years. This condition would be relaxed for infrastructure projects such as power generation, telecommunication, petroleum exploration and refining, ports, airports and roads. Clearance Re+!irements a.B RIn rinciple ApprovalR by )6A for issue of 9):#F((%.

b.B Approval by FI % in the case of Industries#activity that is outside the purview of Annex III items or cases involving foreign e"uity beyond /$. foreign e"uity after the proposed 9): issue. c.B Approval from )epartment of (ompany Affairs under the provisions of (ompanies Act, if necessary. d.B Any other mandatory approval under 9overnment Caws, if any, like I2( approval for joint venture, (abinet approval etc. e.B RFinal ApprovalR by )6A for issue parameters where other mandatory approvals are involved, )6A;s final approval will be granted only after other approvals are obtained by the 9): issuing company. /se of D.%s The proceeds of the 9):s can be used for financing capital goods imports, capital expenditure including domestic purchase#installation of plant, e"uipment and building and investment in software development, prepayment or scheduled repayment of earlier external borrowings, and e"uity investment in *Ds in India. %estrictions <owever, investment in stock markets and real estate will not be permitted. (ompanies may retain the proceeds abroad or may remit funds into India in anticipation of the use of funds for approved end uses. Any investment from a foreign firm into India re"uires the prior approval of the 9overnment of India. )d"antages of D.% for the Issuer0 The share price of the company may stabilise because of the widening of the market. The image of the issuer is also enhanced in the global market. 6uro issues cost less than domestic rights issue. (ompanies making 6uro issues may have understanding with depository bank resulting in certain voting pattern. The Indian (ompany does not bear any foreign exchange risk since the securities are denominated in

rupees. 7n the other hand, it receives the proceeds of 6uro3issue in foreign currency. 6uro3issues are easier to administer since dealings are with a single shareholder, the custodian depository bank. )d"antages to the In"estor0 In regard to the investors, they enjoy the benefits of international diversification while avoiding long delays in settlement and transfer of shares, confusing trade and tax practices. 9):s are "uoted in dollars and dividends are paid in dollar, free of foreign exchange risk. They enable the foreign investor to avoid restriction on purchase and holding of individual company;s shares. 9):s are "uite as li"uid as the underlying shares and they can be exchanged for shares. 9): transactions do not involve the foreign investor in 86%I approval as a foreign investor. Finally, 9):s are attractive to foreign investors because the returns are large.

Chapter 9 - Lease Finance

ntrod!ction Cease finance has emerged as a source of financing project cost over the last few years. Cease finance is a cheap and flexible means of financing as compared to term loans from financial institutions. >hile the investor or lender in conventional financing looks to the cash flow from the issuers; overall business to provide the return on investment or loan, in lease finance, the investor or lender looks principally to the cash flow from the specific assets or collection of assets in which their funds are invested, for these returns. *efinition and .at!re Cease is a rental agreement that extends for a year or more and involves a series of fixed payments. 9enerally, firms own fixed assets and report them in their balance sheet. For carrying on economic activity or organising production, the access or use of e"uipment and building is important than their ownership. Ceasing achieves the separation of ownership from economic use. Traditionally, firms obtained use of assets by buying them. <owever, an alternative is to lease e"uipment. Actually, anything can be had on lease and in advanced countries +/ percent of all new capital e"uipment ac"uired by business is at lease. There are two parties to a lease. The user of the asset is the lessee who makes periodic payments to the owner of the asset who is called the lessor. Cease agreements contain an option to the lessee to purchase the asset at fair market value at the end of the lease period. The burden of costs the lessee or lessor have to bear differ according to the type of lease. The lessor is responsible for

maintenance, insurance and payment of property taxes in the case of a full service lease. The lessee is responsible for these costs under a net lease. The terms of the lease as well as the rights of the lessee vary from lease to lease. For instance, operating leases are short3term leases and can be terminated at the lessee;s option prior to the end of the contract period. Among long term leases are financial or capital leases which extend over the estimated useful economic life of the asset and cannot be cancelled by the lessee before the expiry of the lease. >here they are cancellable, the lessee has to reimburse the lessor for any losses occasioned by the cancellation. Ceasing industry consists mainly of finance and leasing companies who are lessors. 8everal banks have added leasing activity to their business. Finance companies undertake leasing as one of their activities. T(pes of Leases There are four kinds of leases' Sale and $ease 5ac' ?nder this lease a firm that owns the asset Abuilding, land and e"uipmentB sells the asset and simultaneously executes an agreement to lease the asset back for a specified period on specific terms. The sale and lease back instrument is an alternative to mortgage. The firn which sells the assets is the lessee. It receives the purchase price put by the buyer or the lessor. The seller3 lessee retains the use of the assets. The lease payments under sale and lease back are set so as to return the full purchase price to the investor3lessor while providing a specified rate of return on the lessor;s outstanding investment. 3perating Lease They are also called service leases and provide for the lessor to maintain and service the leased asset and the cost of such maintenance is built into the lease payment. 7perating leases are fre"uently not fully amortised. The lessor

expects to recover the full investment costs through subse"uent rental payments, leases or sale of leased e"uipment. 7perating leases fre"uently contain a cancellation clause which gives the lessee the right to cancel the lease. Structuring of the !perating $ease The e"uipment leased under an operational lease has an established use or an active second hand market. The e"uipment is leased for relatively short periods of around six months to a year or two years. Conger duration is adopted for ships and aircraft. In view of these factors, the cost of e"uipment is not sought to be fully recovered by the lessor through rental from a single lessee. The e"uipment may be given on lease to a succession of lessors over the economic life of the e"uipment The lessor may also sell the e"uipment in second hand market. Finally, in cases where the lessor activities are restricted to a given range of e"uipment, he may be able to offer attractive lease terms reflecting his purchase discounts, lower maintenance cost and expertise in the range of e"uipment he specialises.

Financial or Capital $ease Financial or capital lease involves a long term commitment between lessor and lessee. The lease duration is generally e"ual to half of the expected life of the asset. %ut financial lease differs from operating lease in three respects' They do not provide for maintenance service They can not be cancelled They are fully amortised.

The e"uipment is selected by the firm that uses it AlesseeB and negotiates the price and delivery terms with the manufacturer. The user firm negotiates with the leasing unit to buy the e"uipment from the manufacturer or distributor and after purchase the lease agreement is executed by the user. The lease payment is a fixed obligation of the lessee and apart from amortising the cost of asset, leaves a return to the lessor. Financial Lease A financial lease is a long term agreement, generally extending over the estimated economic life of the asset. ?nder the agreement, the lessor agrees to finance the use of the e"uipment by the lessee over a time period and is generally not subject to cancellation by the lessee before the end of the base lease period. Financial lease is a source of finance for the ac"uisition of the e"uipment. 8igning a financial lease contract is like borrowing money. Financial leases are also called full payout leases as they enable a lessor to recover his investment in the lease and make a profit. Leveraged lease A leveraged lease is arranged when the e"uipment is very costly. Ceveraged leases are financial leases in which the lessor borrows a part of the purchase price of the leased asset, using lease contract as the security of the loan. In the leveraged lease, the cost of the leased asset is financed by issuing debt and

e"uity claims against the asset and the future lease payments. The leveraged lease has a longer maturity owing to its high value. 9enerally, there are three parties in the leveraged lease, which include the lessor, the lessee and the lender of funds. The lessor provides e"uity funds and is generally termed as e"uity participant and the lender is called the debt participant. >hile the lessee pays rentals without much difference of the nature of the lease, the lessor receives leveraged lease rentals after debt service, taxes and other expenses. The lessor obtains maximum tax shelter under the leveraged lease such as complete tax benefits of depreciation as owner of the e"uipment despite limited e"uity participation. The funds borrowed to finance the cost of the assets are of nonrecourse nature i.e. the debt is secured by a first charge on the e"uipment or lien on lease rentals beyond which the lessor is not liable for the debt obligation. The agreement may, however, create a lien on other assets for realisation of debt from the lessor. The cost of the lease depends upon the weighted cost of the capital. :e"uirements for a leveraged lease are, aB The existence of a large value e"uipment providing for substantial depreciation, bB The inability of either the lessee or a single lessor to utilise depreciation in good time, cB The availability of a lender willing to extend funds to the user on the strength of user;s credit rating dB The existence of e"uity investors AlessorsB with potentially large tax outflow. )d"antages of $easing0 Short Ter 0 7perating leases are short term which constitute a convenient means of obtaining the use of an asset for a relatively short period of time. They also relieve the lessee of product obsolescence.

Full Funding0 Ceasing provides $,, percent of e"uipment finance. Si plicity0 A leasing agreement is simple to negotiate and administer. The documentation is "uicker as compared to ;security tied; credits such as term loans. The procedure for lease financing is much simpler than any other form of asset3backed financing. %educed cost of borro*ing0 Cease finance is highly cost effective source of funds for smaller companies. A large leasing company may be able to borrow more cheaply than a smaller operating company. Transaction costs are also lower for lessors of readily saleable assets. S*apping Ta2 Shields0 In situations where the lessor is in tax paying position vis3a3vis the lessee, the lessor can pass on a part of the benefit to the lessee through a lowering of the lease rental. 3e* Source or Funds0 Cease financing may permit a lessee to tap a new source of funds such as finance companies. $ease %entals0 Cease rental can be structured to accommodate the operational cash3flow pattern of the lessee and aid tax planning of the lease rental. As a result, lease funding may work out cheaper than a term loan. %estricti"e Co"enants0 Cease agreements are free of restrictive covenants and conditionalities as compared to term3loan agreements. Cease financing is more comprehensive. #2penses0 2ost of the expenses associated with the leased e"uipment can be built into the lease and amortised over the lease period. These expenses include delivery charges, interest on advance payments, taxes and installment payments. These expenses are generally not financed under a term loan. Ceasing can also be used in project financing with the rentals structured so as to defer lessee;s payment obligation till the asset is in commercial operation. Further, lease rentals can be structured to get maximum tax benefit. In view of the accelerated amortisation of e"uipment, the risk of obsolescence is minimised under a lease.

.ilution of #1uity0 )ilution of e"uity by the issuance of e"uity or convertible term finance can be avoided in lease financing. *isadvantages or Leasing The principal disadvantages are lessee;s forfeiture of the tax benefits of ownership and loss of residual value. In opting for a lease, the lessee may have to accept some restrictions. The lessee also assumes a higher financial obligation in the event of e"uipment being found operationally unsuitable or if lessee opts for an early termination of the lease agreement Incentives and grants available to owners of assets who are also end users are lost in the case of a lease by both lessor and lessee. Finally, in several states of the Indian ?nion, sales tax is applicable on lease rentals rendering lease finance, cost ineffective.

(hapter $, 3 >orking (apital Financing Introduction >orking capital refers to current assets and liabilities. 8trictly, it is not a part of roject Finance, which deals with financing of fixed assets. %ut working capital has to be dealt with under project finance for two reasons' first, the margin money for working capital has to be financed by long term sources and, secondly, it is seen that many a unit flounders because of inade"uate working capital. romoters have to ensure ade"uate working capital to reach breakeven point and step up capacity utilisation, if available. It is essential that such estimates are available and resources are tied up to meet the working capital re"uirements of the project.

&oncepts of "orking capital Wor'ing capital is the capital you re"uire for the working i.e. functioning of your business in the short run. Dross *or'ing capital refers to the firm@s investment in the current assets and includes cash, short term securities, debtors, bills receivables and stock AinventoriesB. It is necessary that the investment in the current assets should be neither excessive nor inade"uate. >( re"uirement of a firm keeps changing with the change in the business activity and hence the firm must be in a position to strike a balance between them. The financial manager should know where to source the funds from, in case the need arises and whereto invest in case of excess funds.

3et *or'ing capital refers to the difference between the current assets and the current liabilities. (urrent liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year and include creditors, bills payable, bank overdraft and outstanding expenses. >hen current assets exceed current liabilities it is called Positive )& and when current liabilities exceed current assets it is called Negative )&. The &et >( being the difference between the current assets and current liabilities is a "ualitative concept. It indicates'

The li"uidity position of the firm 8uggests the extent to which the >( needs maybe financed by permanent sources of funds

!perating Cycle and Cash Cycle All business firms aim at maximising the wealth of the shareholder for which they need to earn sufficient return on their operations. To earn sufficient profits they need to do enough sales, which further necessitates investment in current assets like raw materiel etc. There is always an operating cycle involved in the conversion of sales into cash. The time re"uired to complete the following se"uences of events in case of a manufacturing firm is called the operating cycle. $. (onversion of cash into raw material +. (onversion of raw material into >I 0. (onversion of >I into F9 1. (onversion of F9 into debtors and bills receivable through sales /. (onversion of debtors and bills receivable into cash 6ach component of working capital Anamely inventory, receivables and payablesB has two dimensions 3time and money. >hen it comes to managing

working capital, !ime #s *oney. Therefore, if cash is tight, one should consider other ways of financing capital investment 3 loans, e"uity, leasing etc. 8imilarly, if you pay dividends or increase drawings, these are cash outflows remove li"uidity from the business. f (o! :::::::

Then :::::: receivables receivables +debtors, -ou release cash from the cycle +debtors, -our receivables soak up cash increase your cash

&ollect faster &ollect slo"er

.et better credit +in terms of -ou duration suppliers or amount,

from resources -ou free up cash -ou consume more cash

Shift inventory +stocks, faster *ove inventory +stocks, slo"er

3perating C(cle 3f .on Man!fact!ring Firms ; 3perating C(cle 3f %ervice And Financial Firms
)6%T7:8

(A8< (A8< )6%T7:8

8T7(S 7F FI&I8<6) 977)8

7perating cycle of non3manufacturing firm like the wholesaler and retail includes conversion of cash into stock of finished goods, stock of finished

goods into debtors and debtors into cash. Also the operating cycle of financial and service firms involves conversion of cash into debtors and debtors into cash. !hus "e can say that the time that elapses bet"een the purchase of ra" material and collection of cash for sales is called operating cycle "hereas time length bet"een the payment for ra" material purchases and the collection of cash for sales is referred to as cash cycle. The operating cycle is the sum of the inventory period and the accounts receivables period, whereas the cash cycle is e"ual to the operating cycle less the accounts payable period.

7:)6: CA(6)

8T7(S A::ID68

8T7(S 9768

(A8< :6().

I&D. 6:I7)

A#(@8 :6(. 6:I7)

A#(@8 ay. eriod (A8< AI) F7: FI:2 :6(. I&D7I(6 2AT6:IAC8

7 6:ATI&9 (G(C6

(A8< (G(C6

7perating (ycle and (ash (ycle Factors infl!encing the &or#ing capital re+!irement

All firms do not have the same >( needs .The following are the factors that affect the >( needs' $. 3ature and siEe of business0 The >( re"uirement of a firm is closely related to the nature of the business. >e can say that trading and financial firms have very less investment in fixed assets but re"uire a large sum of money to be invested in >(. the fixed assets. Also a firm with a large scale of operations will obviously re"uire more >( than the smaller firm. 7n the other hand :etail stores, for example, have to carry large stock of variety of goods little investment in

The following table shows the relative proportion of investment in current assets and fixed assets for certain industries' C!rrent assets ,<Fi$ed assets ,<nd!stries

/0-10 10-%0 %0-80 80-:0 :0-90 90-50 50-20 20-30

20-30 50-20 90-50 :0-90 80-%0 %0-80 10-%0 /0-10

4otel and restaurants 6lectricity generation

and

7istribution Aluminum, Shipping #ron and Steel, basic industrial chemical !ea plantation &otton textiles and Sugar 6dible oils, !obacco !rading, &onstruction

+. Manufacturing cycle0 It starts with the purchase and use of raw materials and completes with the production of finished goods. Conger the manufacturing cycle larger will be the >( re"uirement, this is seen mostly in the industrial products. 0. 5usiness fluctuation0 >hen there is an upward swing in the economy, sales will increase also the firm@s investment in inventories and book debts will also increase, thus it will increase the >( re"uirement of the firm and vice3versa. 1. Production policy; To maintain an efficient level of production the firm@s may resort to normal production even during the slack season. This will lead to excess production and hence the funds will be blocked in form of inventories for a long time, hence provisions should be made accordingly. 8ince the cost and risk of maintaining a constant production is high during the slack season some firm@s may resort to producing various products to solve their capital problems. If they do not, then they re"uire high >(. /. Fir As Credit Policy0 If the firm has a liberal credit policy its funds will remain blocked for a long time in form of debtors and vice3versa. &ormally industrial goods manufacturing will have a liberal credit policy, whereas dealers of consumer goods will a tight credit policy. 4. )"ailability of Credit0 If the firm gets credit on liberal terms it will re"uire less >( since it can always pay its creditors later and vice3versa.

-. Dro*th and #2pansion )cti"ities0 It is difficult precisely to determine the relationship between volume of sales and need for >(. The need for >( does not follow the growth but precedes it. <ence, if the firm is planning to increase its business activities, it needs to plan its >( re"uirements during the growth period. 5. Conditions of Supply of %a* Material0 If the supply of :2 is scarce the firm may need to stock it in advance and hence need more >( and vice3 versa. L. Profit Margin and Profit )ppropriation0 A high net profit margin contributes towards the >( pool. Also, tax liability is unavoidable and hence provision for its payment must be made in the >( plan, otherwise it may impose a strain on the >(. Also if the firm@s policy is to retain the profits it will increase their >(, and if they decide to pay their dividends it will weaken their >( position, as the cash will flow out. <owever this can be avoided by declaring bonus shares out of past profits. This will help the firm to maintain a good image and also not part with the money immediately, thus not affecting the >( position. 7epreciation policy of the firm, through its effect on tax liability and retained earning, has an influence on the >(. The firm may charge a high rate of depreciation, which will reduce the tax payable and also retain more cash, as the cash does not flow out. If the dividend policy is linked with net profits, the firm can pay fewer dividends by providing more depreciation. Thus depreciation is an indirect way of retaining profits and preserving the firms >( position. Financing "or#ing Capital 8ources >orking capital may be obtained from different sources such as raising from funds from capital market through issue of shares and debentures, borrowing

from banks, directors, and shareholders and trade credit. Internal sources such as retained earnings and depreciation may be good for an established unit. In the case of a new unit, a portion of working capital, margin, may be financed by e"uity.

Core c!rrent assets To maintain the operating cycle, current assets are re"uired which vary over time. %ut a minimum level is re"uired to ensure continuous production, which is known as fixed or permanent working capital or core current assets. The core current assets represent the absolute minimum stock of raw materials, goods in process and finished goods and stores, which are in pipeline to ensure continuity of production. ?sually, banks insist that the permanent portion of the working capital re"uirement be brought by the promoters from long term sources M either e"uity or debt.

/aria'le &or#ing capital 7n the other hand, excess balance of current assets is re"uired to support varying levels of production and sales caused by seasonal factors. >hile fixed and variable components are re"uired to facilitate production and sale through operating cycle, variable working capital is re"uired to meet the li"uidity, which is temporary. The choice of sources for financing working capital has to be made on the basis of their suitability for fixed and variable components.

%o!rces of "or#ing Capital A combination of short and long term finances is used to finance to >( re"uirements. (urrent assets are normally financed by the short3term sources,

which include the following' $. )ccruals0 This includes what the firm owes to the employees. Its main components are wages and taxes. 8ince they are payable at a future date, they have been accrued but not shown as paid in the balance sheet. Till that time they serve as source of finance. They are a source of spontaneous financing. 8ince the firm pays no interest, they are regarded as a Tfree@ source of finance. +. Trade Credit0 It is a spontaneous source of financing, which constitutes +/ to /, . of short term financing. 7btaining trade credit depends on' aB 6arnings record over a period of time bB Ci"uidity position of a firm over a period of time cB :ecord of payment. dB The confidence of the suppliers 0. For s !f 5an' Finance0 %anks are the most important source of >orking (apital Finance. They give working capital advances in the following ways'

(ash (redits # 7verdrafts' ?nder this arrangement the borrower can borrow upto a fixed limit and repay it as and when he desires. Interest is charged only on the running balance and not on the sanctioned amount. A minimal chare is payable for availing this facility. Coans' They are either credited to the current account of the borrower or given to him in cash. A fixed rate of interest is charged and the loan amount is repayable on demand or in periodical installments. urchase#)iscount of %ills' A bill may be discounted with the bank and when it matures on a future date the bank collects the amount from the party who had accepted the bill. >hen a bank is short of funds it can sell or rediscount the bill on the other hand the bank with surplus funds would invest in bills. <owever, with discount rates at $03$1 per cent for L,3day paper, bill discounting is an expensive source of short3term funds.

Cetter 7f (redit' >hen an C#( is opened by the bank in favour of the customer it takes the responsibility of honoring the obligation in case the customer fails to do so. In this case though the customer provides the credit the risk is borne by the bank.

1. ublic )eposits' There are certain provisions under the (ompanies Act, $L/4 Athe ActB under which a company may accept fixed deposits from public#shareholders to meet its short term re"uirements. 8ection /5A of the Act deals with the acceptance of deposits. ursuant to the provisions of the Act, the company cannot invite, or allow any other person to invite or cause to be invited on its behalf, any deposit unless M

It is in accordance with the prescribed rules. An advertisement is issued showing the financial position of the company and The company is not in default in the repayment of any deposit or interest.

In case of non banking and non financial companies, the (entral 9overnment has issued U(ompanies AAcceptance of )epositsB :ules, $L-/@ and in case of non banking financial companies, the :eserve %ank of India has issued U&on %anking Financial (ompanies Acceptance of ublic )eposits A:eserve %ankB )irections, $LL5@ which have to be complied with along with the provisions of 8ection /5A of the Act. For its short term re"uirements, companies normally prefers to accept fixed deposits instead of taking loans from banks as the rate of interest for deposits is generally less as compared to interest charged by banks. &ormally, listed companies come out with the schemes of fixed deposits. :esponse to such listed companies from public is better as compared to unlisted companies. $i its for accepting deposits A (ompany can borrow deposits upto the extent given below'

upto +/. of the paid3up capital and free reserves of the company from the public and ?pto $,. of its paid3up capital and free reserves from its shareholders.

Therefore, maximum deposit a company can accept from public#shareholders is 0/. of its paid up capital and free reserves as mentioned above. If the company is a U9overnment (ompany@, then it can accept or renew deposits from public upto 0/. of its paid up capital and free reserves. <=ree >eserves< mean the balance in the share premium account, capital and debenture redemption reserves and any other reserves shown in the balance3 sheet of the company and created by appropriation out of the profits of the company, but does not include AiB the balance in any reserve created for repayment of any future liability or for depreciation in assets or for bad debts= and AiiB by the revaluation of any assets of the company. Period of accepting deposits A (ompany can invite#accept deposits for a period not less than 4 months and not more than 04 months from the date of acceptance of such deposits or from the date of its renewal. Therefore, a company can accept#invite deposits for a period between 4304 months. <owever, a company may accept deposits upto $,. of its paid up capital and free reserves which are repayable after three months, from the date of such deposits or renewal thereof to meet any of its short term re"uirements. )d"antages of Public .eposits fro

the Co panyAs point of "ie*0

8imple procedure for obtaining deposits &o restrictive covenants are involved &o security needs to be offered The post tax cost is fairly simple the Co panyAs point of "ie*0 7nly limited amount of funds can be raised

.isad"antages of Public .eposits fro

The maturity period being short, the funds have to repaid faster the in"estor point of "ie*0 <igher rate of interest 8hort period of maturity, normally $ to 0 years the in"estor point of "ie*0 3o security offered by the co pany The interest on public deposits is not exempt from tax

)d"antages of Public .eposits fro

.isad"antages of Public .eposits fro

96 Inter-Corporate .eposits0 They are defined as deposits made by one (ompany in another company for a period upto 4 months6 They are divided into the following types'

(all deposits' They are withdrawable by the lender after giving a day@s notice, however in real life it takes about three days. The interest on such deposits is around $4 . p. a Three3months deposit' they are taken to overcome the shortage resulting out of disruption in production, excessive imports of raw material, tax payment, delay in collection, etc. The interest in this case is normally around $5 . p.a. 8ix3months deposits' They are normally made with good borrowers and the interest rate in this case is around +, . p.a.

Important characteristics of the inters3corporate deposits market include'

Cack of regulation' It has helped to make inter3corporate deposits hassles free and hence very convenient 8ecrecy' The brokers do not reveal the names of their borrowers and

lenders, which would other wise lead to unwanted competition and underwriting of rates

Importance of personal contacts' The lending decisions in these markets are often based on personal contacts rather than reliable market

information Although deposits can be of varying maturity structures, they work best as short3term bridging instruments and not as a regular funding source.

=6 Short-Ter

$oans Fro

Financial Institutions0 The CI(, 9I( and ?TI

provide short3term loans to manufacturing companies that have a good track record. The following are the eligibility conditions if obtaining the loans'

)eclared an annual dividend of 4 . for the past / years, in some cases it is The debt e"uity ratio should not exceed +'$ The current ratio should be at least $'$ The average of the interest cover ratios for the past three years should be at

$, . over last 0 years

least +'$ The important features of the short3term loans provided by the financial institutions include'

They are unsecured and given on the basis of a demand promissory note The loan is given for a period of $ year and can be renewed for two consecutive years if the eligibility conditions are satisfied The company has to wait for at least 4 months after its repayment in order

to avail of a fresh loan B6 %ights .ebentures For Wor'ing Capital0 In order to get long term resources for working capital, the public limited companies can issue Trights@ debentures to their shareholders. The key guidelines to be followed include'

The amount of debenture issue should not exceed +, . of the gross current assets, loans and advances minus the long term loans presently available for financing working capital 7: +, . of paid up share capital, including preference capital and free reserves, whichever is the lower of the two

The debt 3 e"uity ratio including the proposed dividend issue should not They shall be first offered to Indian resident shareholders of the company ercial Paper0 Carge firms who are financially strong issue

exceed $'$

on a pro rata basis >6 Co commercial paper .It represents a short3term unsecured promissory note issued by firms of high credit rating. Its important feature include'

2aturity ranges from 4,3$5, days It is sold at a discount from its face value and redeemed at its face value. Thus the implicit interest rate is a function of si!e of the discount and the period of maturity 6ither directly placed with investors or sold through dealers ?sually bought by investors who keep it till the maturity and hence no well

developed secondary market Who can issue CP? <ighly rated (orporate %odies, primary dealers, satellite dealers and All3India financial institutions have been permitted to raise short3term resources. #ligibility of issuing CP

2inimum tangible net worth as per the latest audited balance sheet is :s. 1 crore. (ompany has been sanctioned working capital limit by bankAsB or all3India financial InstitutionAsB and %orrowal account of the company is classified as a 8tandard Asset by the financing bankAsB#institutionAsB. 2inimum (redit :ating re"uired from recognised credit rating agencies. credit rating re1uired to issue CP + is obtained from (redit :ating Information

Mini u

8pecified credit rating of

8ervices of India Ctd. A(:I8ICB, A+ in the case of Investment Information

and (redit :ating Agency of India Cimited AI(:AB and :+ in the case of (redit Analysis and :esearch Cimited A(A:6B, Maturity period of CP The ( can be issued for maturities between $/ days to $ year from the date of its issue. Mini u a ount of in"est ent and deno ination of CP The minimum amount re"uired to be invested by a single investor is atleast :s. / lakhs. It can be issued in denominations of :s. / lakh or multiples thereof. Who can act as Issuing and Paying )gent ,IP)-? 7nly a scheduled bank can act as an I A for issuance of ( . Who can in"est in CP? ( may be issued, to and, held by individuals, banking companies, other corporate bodies registered or incorporated in India and unincorporated bodies, &on3:esident Indians A&:IsB and Foreign Institutional Investors AFIIsB. <owever, investment by FIIs would be within the limits set for their investments by 8ecurities and 6xchange %oard of India A86%IB. Mode of issuance of CP ( can be issued either in the form of a promissory note or in a dematerialised form through any of the depositories approved by and registered with 86%I. As regards the existing stock of ( , the same can continue to be held either in physical form or can be dematerialised, if both the issuer and the investor agree for the same. Procedure of issuing CP 6very issuer must appoint an I A for issuance of ( . The issuer should disclose to the potential investors its financial position as per the standard market practice. After the exchange of deal confirmation between the investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for crediting the ( to the investor@s account with a depository.

Investors shall be given a copy of I A certificate to the effect that the issuer has a valid agreement with the I A and documents are in order 86 Factoring0 A factor is a financial institution set up to provide services related to management and financing of debt arising from credit sales. The important features of factoring services include'

The factors selects the account of the clients, and establishes credit limits applicable to the selected accounts It takes the responsibility for collecting the debt of accounts handled by it. For each account the factor pays to the client at the end of the credit period or when the account is collected, whichever comes earlier The factor advances the money to the client against not yet collected and not yet due debts. &ormally the amount received is -,35, . of the face value of the debt and carries an interest rate which is e"ual or a little higher than the lending rate of the commercial banks

The credit risk could be borne by the client or the factor. In India it is mostly on the recourse basis, i.e. the risk is borne by the client. The factor charges a commission which may be $3+ . of the face value of the debt factored. Advantages of factoring'

6nsures definite pattern of cash inflows from credit sales (ontinuous factoring may virtually eliminate the need for the credit and the collection department

)isadvantages of Factoring

(omparatively an expensive form of financing The factoring debt may be perceived as a sign of financial weakness

=>: Loan %(ndication

%orrowing for working capital from a single commercial bank or a consortium has restricted fund flows to corporates. Coan syndication, a method used in 6uro3dollar market is an alternative to consortium lending. The major benefits reaped by corporates, in syndication, are amount, tenor and price. The syndication method reverses the current practice where the corporate borrower faces rigid terms in a take it or leave it situation. The cost of syndication is likely to vary with credit risk. %orrowers of high credit standing are likely to get best terms. 8yndications make for efficient pricing and are administratively easier. In loan syndication, the borrower approaches several banks, which might be willing to syndicate a loan, specifying the amount and tenor for which the loan is to be syndicated. The syndicated loans are being discussed as an alternative for consortium loans for working capital. %ut they can be used for project financing, as is the practice in the 6uro3 dollar market. 7n receiving a "uery, the syndicator or the lead bank scouts for banks that may be willing to participate in the syndicate. The lead bank#syndicator assembles a management group of other banks to underwrite the loan and to market shares in it to other participating banks. The lead bank or syndicator can underscore his willingness to syndicate the loan on a firm commitment basis or on a best efforts basis. The former is akin to underwriting and will attract capital ade"uacy norms reducing the bank;s flexibility. 7nce the syndicator# lead bank receives the mandate from the borrower, a placement memorandum is prepared by the lead bank and the loan is marketed to other banks who may be interested in taking up shares. The placement memorandum helps the banks to understand the transaction and provides information about the borrower. 7n the basis of data in the placement memorandum, banks make a reasonable appraisal of the credit before deciding about the participation in the loan. 7nce the bank decides to become a member of the syndicate, it indicates the amount and the price it is

likely to charge on the loan. %ased on the information received from all participating banks, the lead bank#syndicator prepares a common document to be signed by all the members of the syndicate and the borrowing company. The document usually lists out details of the agreement with regard to tenor, interest, loan pre3payment, security, warranties and agency. >hile the borrower signs only one document, he shares separate contractual relationship with each syndicate member. The agent to the loan who is normally the lead bank# syndicator attends to all administrative work such as collection of interest and amortisation of the loan. Agent;s fees is a yearly charge. A syndicated loan would have a funded component or core component on which interest will be charged on the loan being sanctioned and a standby line of credit which would meet the adhoc increases in credit needs of borrower. Interest on the standby portion will be charged only on the amount withdrawn. <owever, a commitment fee is charged on unutilised portion. The total syndicated loan could take care of the re"uirement for project finance and working capital. The loan could dispense with the restrictions or norms of the working capital assessment. The interest charge can either be floating or fixed. Actually working capital re"uirements for, say, a five3year period, may be on a floating rate basis pegged to minimum lending rate.

Case Study 1 - Fon'an %ail*ay Corporation ,F%C*ethodology; ntervie& &ith Mr: R2 %inha? *irector? Finance? 2on#an Rail&a( Corporation:

Findings0

!he project; The Sonkan :ailway is the missing link between India;s commercial capital, 2umbai and 2angalore. The -4, Sm. line now connects 2aharashtra, 9oa and Sarnataka 3 a region of criss3crossing rivers, plunging valleys and mountains that soar into the clouds. >ith a total number of +,,,, bridges and L+ tunnels to be built through this mountainous terrain containing many rivers, the project is the biggest and perhaps most difficult railway undertaking during this century, at least in this part of the world. The various problems, had been carried out efficiently and in a very short time. The largest railway project in this part of the world in the last five decades threw up a whole range of difficulties technical, financial, emotional and psychological. The rocky 8ahyadris had to be bored through, $,/,, rivers had to be forded, a railway line had to be built out of nowhere. And sometimes, poisonous snakes and tigers had to be faced. !bjecti"e of the project The project intended to provide alternate, permanent and shorter transport facilities to this part of the country. It aimed at improving access to the fertile areas of Sonkan and thus ensure economic development of the region.

The )ppraisal %efore the project was handed over to the S:(, it was being handled by the 8outhern :ailway. A two level appraisal was followed' $. A rough estimate of the returns from the project was made. The project was expected to generate an internal rate of return AI::Bof $1 percent. +. A )etailed parts' )etailed 6ngineering 8urvey )etailed Traffic survey The 6ngineering 8urvey aimed at studying the land terrain to arrive at the optimum alignment between the starting and the end points of the rail network. For this, the following two factors were kept in mind' $B The land ac"uisition had to be minimum. That is, not too many inhabited areas were to be affected by the project. <ence, emphasis was laid on laying the track from around the inhabited areas. +B Arriving at the optimum path to minimise the cost of levelling the land. To level the land for laying the track, three things could be done' 3 %uilding bridges - %oring tunnels through the mountain - 6arthwork, i.e., either Tcutting@ the land or Tfilling@ the land The Traffic 8urvey consisted of 7rigin3)estination 8tudy A7)B. The 7) consisted of studying the industries in the catchment area, through the "uestionnaire method. It is essentially the Tend use@ method of demand forecasting. It aimed at finding out the movement of raw materials and roject :eport was prepared. This report consisted of two

finished goods into and through the project area. 6stimates were also made regarding future bulk traffic on account of the establishment of 6ssar 8teel in :atnagiri, ?sha Ispat, etc. 8imilarly, cement plants were expected to be established at 8aurashtra and hence increase the flow of traffic. #sti ated cost of the project0 The project, as estimated by the 8outhern :ailway (orporation in $L5L3L,, was expected to cost :s.54$ (rore. <owever, the government did not have the funds to meet the cost of the project. <ence the need was felt to separate the project from the government. This would enable access to the capital market. however that would essentially mean the privatisation of railways, which was not acceptable to the government. <ence the idea of Sonkan railway bonds took birth. The debt e"uity ratio for the project was fixed at 0'$. The project had not taken off for two years. In $LL$, the S:( took the project over from the 8outhern :ailway. This was on a %7T basis. roviding for the inflation for two years V$,., the project cost went up to :s. $,10 crore from :s. 54$ crore earlier. The e"uity was fixed at :s. +/, crore and the debt Aonly bondsB at :s. -/, crore. The central government roped in four state governments to subscribe to the e"uity. Accordingly, the ownership pattern of the S:( was now as follows' 2inistry of :ailways ' /$. 2aharashtra' ++. Sarnataka' $/. 9oa' 4. Serala' 4.

The interest rate on the bonds, which were tax free, was fixed at L.. This was raised to $,./. by the 2inistry of Finance in $LL+. The interest was payable even during the construction period. Thus the cost of the project rose to :s $4,, crore. There was a need for further funds, but the securities scam of $LL+ depressed the primary market for bonds too. <ence, S:( resorted to 6xternal &ommercial (orro"ings of Q$$/ million A:s. 1,L croresB. Sale and ?ease (ack was another source of finance that S:( resorted to. It sold off the already constructed railway tracks to Infrastructure Ceasing and Financial 8ervices AIC W F8B and raised :s. $,, crore. Ti e and Cost o"erruns Two important factors led to time and thus cost overruns for the project' $B 7bjection from environmental groups in 9oa' The rime 2inister ordered stoppage of work till the en"uiry by the *ustice 7jha (ommittee was completed. This delayed the project by - to 5 months. +B ?nexpected terrain' The soil structure turned out to be much more difficult than expected. Instead of the laterite soil that was expected, it turned out to be fractured rock. This delayed the project by two years. This led to major expenses by way of interest. %y now the estimated project cost had gone up to :s. +/+, crore. This was over and above the interest burden of :s. $,0, crore. Thus the total cost of the project worked out to :s. 0//, crore. The final financing structure stood as follows' 6"uity' :s. 5,, crore )ebt' :s. +-/, crore

The debt was made up of the following components' %onds' :s. ++/, crores 6(%' :s.1,L crore 8ale and lease back' :s. $,, crore 5rea'e"en Point S:( expects to breakeven in the next +, years. The reason for such a long gestation is the nature of the demand for railways. The demand being derived demand, it is very sensitive to the state of the economy and the rate of growth in basic industries. %ut the bulk traffic in the form of transport of coal, steel, cement, etc is not coming as expected. Infact it has reduced due to an overall slowdown in the economy. The cement units expected to start at 8aurashtra did not start their operations. Infact, now the cement is milled and packed at different locations. <ence the expected traffic did not materialise.

)nalysis of the Fon'an Project0 $. <ighly unfavourable debt e"uity ratio' The debt e"uity ratio of S:( stood at about /'$. This is highly unfavourable, as the high cost bonds entail a permanent burden even during the construction period. 2ore e"uity should have been raised from the state governments as the centre did not have the funds. +. The major item of expense, as seen in the WC Account of +,,,3,$ is the financing charges, mostly the interest on bonds. It stands at :s. 0+/ crore, which is 4,. of the total expenses incurred in the year. 0. The falling rupee market increased the value of the 6(% from :s. 1,L crore to :s. /+, crore Ait was swapped at this pointB. This increased the cost of finance as well as increased the principal substantially.

1. Time overruns due to opposition from the environment groups proved very costly, as it increased the interest burden. /. The fall in the bond markets due to the <arshad 2ehta scam of $LL+ forced S:( to avail itself of 6(%s, which proved very costly in a falling rupee scenario. Steps that can be ta'en no*0 $. 6nsuring that the operating income is positive, i.e., though S:( is making losses, ensuring that it recovers atleast its variable costs. +. Augmenting income from other sources' This is necessary so that S:( can repay its debt early and hence bring down its cost of finance. 0. S:( should use the expertise it has developed in commissioning such infrastructure projects to augment its income. It should undertake more construction projects like the 8kybus project it has undertaken for Ira". 1. :oping in a private company as a minority stakeholder should not be ruled out. A company that is directly benefiting from the project can be approached to subscribe to the e"uity.

!bser"ations and conclusions0 There are certain very important practical and unexpected problems that a project manager may face. These problems need to be given due consideration when anyone is undertaking any project. $. /ncertainty of political en"iron ent0 The political environment and conse"uently the public policy with regard to sector or a project may undergo serious and adverse change. This was amply evident in the recent controversy involving 6nron (orp with regard to the )abhol ower (ompany. The project managers thus have to ensure that a healthy relationship is maintained with the policy makers and the ruling parties. +. 5ac'ground of the pro oters0 This factor plays a very important role in the ability of a project to raise finance for its project. This is applicable to term loans and more so to the capital markets. Thus, the strong image of :eliance Industries as being excellent at project implementing and getting it off the ground would help them get access to funds much more readily than to another company. 0. Mar'et .yna ics0 The ability of a firm and the ease with which it can raise funds depends on the market sentiments. For example, the current recession in the global economy has made it difficult for any company to come out with a public issue. In such an environment, an ongoing project needing more funds will find it extremely tough to raise e"uity in the dried up market. The <arshad 2ehta scam in $LL+ scared away investors from the market for some time. <ence Sonkan :ailway (orporation had to resort to 6xternal (ommercial %orrowings at a high cost. The recent terrorist attacks on >orld Trade (enter have depressed market sentiments worldwide. A firm proposing to raise e"uity capital has to trade off between time and cost overruns Aof waiting for the markets to reviveB and the decision to raise finance from other sources.

1. Ti e and cost o"erruns0 This problem may be faced by any project manager. The failure to get the project off the ground in time or delays due to external factors push the cost of a project upwards significantly. 8ometimes delays may make a project completely unviable to undertake. In the Indian context, delays may occur primarily due to the failure to get the legal approvals in time. The financial structure has to be adjusted suitably to minimise such costs. For example, a two year delay in getting the project off the ground cost Sonkan :ailway :s. $5+ crores in terms of inflation. 8imilarly, its financial structure was such that it entailed a high fixed interest burden on the project even during the construction period. 8uch problems should be avoided by devising appropriate financial structures. /. The entry of credit rating0 (redit rating has entered the roject Finance arena. Firms like 2oody;s help a project get a rating based on its viability and expected profitability. A new project should make full use of such ratings to convince the FIs, %anks and the retail investors of its viability and thus make it easier to raise finance. 4. The Dlobalisation of Project Financing0 roject financing has become truly global. The issue of A):s and 9):s makes it possible for companies to access global markets for their funds re"uirement. This also means that project appraisal and management techni"ues will have to be tuned to meet global standards. -. .e"elop ent of inno"ati"e eans of finance0 The market sentiment and legal re"uirements may force you to look beyond the traditional means of finance. This calls for creative solutions to enable the project to get funds. (ompanies should make full use of the leeway that is allowed to them by law in designing financial instruments. For example, Tatas had issued 8ecured remium &otes in $LL+. 8imilarly, the *apanese

Ceveraged Cease used by Air India to finance its aircraft purchases is an excellent innovation.

Case Study C - )ircraft Financing )t )ir India Methodology0 Interview with 2rs. radnya 7raskar, )y. 9eneral 2anager, rojects )ivision, Air India Findings0 $. Air India initiates the process of contracting foreign currency loans to finance the ac"uisition of the aircraft after signing a purchase agreement with the aircraft manufacturer. +. Air India has financed its aircraft ac"uisition programmes in the past through 6xternal (ommercial %orrowings instead of borrowings in the domestic market. The reasons for borrowing in foreign currency are as follows' AaB Air India earns a large proportion of its revenues in foreign currencies. It has therefore a natural hedge against adverse currency fluctuations, which could otherwise offset the low cost of borrowing in the international market. Air India@s low cost borrowings in the international market are protected in this manner from the impact of the virtually continuous depreciation of the Indian :upee= AbB Air India can avail of export credit guarantees given by T6xport (redit Agencies@ in the countries of aircraft manufacture, thereby achieving a more competitive cost of financing as export credit guarantees have even lower spreads than foreign currency commercial loans. 0. %efore delivery of aircraft, Air India approaches the 2inistry of Finance through the 2inistry of (ivil Aviation for their approval in principle to invite bids and contract foreign currency loans for aircraft purchase. The bids are invited from international banks # financial institutions for a suitable financing package including any innovative financing proposals for ac"uisition of aircraft. 1. Air India then evaluates the underwritten offers received in order to determine the most economic package. The term sheet submitted by the

banks # financial institutions are scrutinised and detailed discussions are held with the shortlisted banks# financial institutions wherein clarifications on their term sheets are sought. The parties are re"uested to resubmit their best possible offers. /. The revised offers are again evaluated and the recommendations submitted to the 2inistry of Finance through the 2inistry of (ivil Aviation in order to obtain 9overnment of India@s approval to arrange the financing package. The mandate is then awarded to the bank # financial institution offering the cheapest package as per the approval of the 2inistry of Finance. 4. An aircraft3financing package can either be a conventional TDanilla Coan@ or T 8tructured Financing@. -. A conventional TDanilla Coan@ package for aircraft financing normally consist of two tranches' 5. An export credit agency guaranteed tranche upto 5/. of the aircraft cost. This tranche normally carries a lower spread over CI%7: ACondon Interbank 7ffered :ateB since this tranche is guaranteed by the @6xport (redit Agencies@ of the country of the aircraft manufacturer. The lending banks accept a lower spread over CI%7: under this tranche since there is no risk exposure to either Air India or to the 9overnment of India defaulting in the transaction= and L. A (ommercial Coan tranche for the remaining $/. of the aircraft cost. In addition, this tranche is also available for financing the cost of ac"uisition of spares, workshop e"uipment and ramp e"uipment included in the aircraft project cost. AaB above. $,.%oth tranches together comprise the total aircraft financing package. The tenure of both the tranches is normally for a period of $,#$+ years and in The spread over CI%7: of this tranche is comparatively higher than the export credit agencies guaranteed tranche at

any case not exceeding $+ years. The repayment of the loan principal is in semi3annual installments. In the past the entire financing package was guaranteed by the 9overnment of India. <owever, the 9overnment has informed Air India that no guarantee can be given for financing aircraft ac"uisitions in future from *anuary $LL/ even if the airline were prepared to pay a guarantee as in the past. !ther Finance Structures )6 Gapanese $e"erage $ease ,GllAir India had also financed three aircraft Aone %-1-30,, (ombi in $L55 and two A0$,30,,s in $LL,B through *apanese Ceverage Cease A*CCB. This mode of financing gained popularity in the mid $L5,@s and early $LL,@s and was a much favoured form of financing employed by various airlines for their aircraft purchases. ?nder the *CC financing, the agent bank forms a 8pecial urpose (ompany A8 (B in *apan with an e"uity participation from a group of *apanese investors. The *apanese e"uity investors are re"uired to contribute around $/. to +/. of the aircraft cost and the balance is arranged through loans. The 8 ( borrows money from the lending banks and makes the payment to the aircraft manufacturer and thereby owns the aircraft. The aircraft is then leased to the airline by a separate agreement for a maximum period of $+ years. The airline makes regular lease payments comprising of principal and interest, which is passed on to the lending banks through the 8 (. Technically, the airline pays interest only on the loan amount and the e"uity providers mainly get their returns by claiming the depreciation in their books in addition to a marginal return from the airline. So e additional features of a Gapanese $e"erage $ease are as follo*s0

AaB The e"uity subscribers to the 8 ( are mainly *apanese corporations desirous of taking advantage of the *apanese tax laws which allow depreciation benefit on the aircraft under *CC AbB A part of the tax benefit is passed on to the airline through the mechanism of lower lease rentals, thus making the *CC very attractive as compared to traditional loans AcB The *apanese e"uity providers re"uire an indication of comfort that their contributions will be repaid and hence the Airline has to keep a deposit Ain GenB in a bank in *apan to secure this obligation AdB At the end of the lease term of $+ years, the ownership of the aircraft passes to the airline after the payment of a urchase 7ption of approximately 1/. of the original aircraft cost. A part of this payment is covered by an initial yen deposit placed with the bank structuring the deal AeB The entire payment profile is structured to minimise the cost to the airline and thus make the structure attractive AfB This structure enables the airline to keep the debt Abalance lease obligationsB off its balance sheet thus allowing it to show a better debt' e"uity position. <owever, recent accounting guidelines in India and abroad make it mandatory to disclose *CCs in the %alance 8heet AgB As the airline does not have to borrow $,,. of the aircraft cost upfront to pay the aircraft manufacturer, there is a substantial &et resent Dalue A& DB benefit in such a structure. For example, in the case of two A0$,3 0,,s financed under *CC in $LL,, Air India was re"uired only to borrow L$. of the cost to service the debt and the e"uity holders thus resulting in an upfront L. & D benefit. )ccounting Treat ent for Gapanese $e"erage $ease ,G$$The *apanese Ceverage Ceases are off %alance 8heet, i.e. neither the aircraft nor the balance lease obligations of the (orporation are shown in the %alance

8heet. All payments against the lease are debited to rofit and Coss Account and no depreciation is claimed on these aircraft. At the end of the lease period, the (ompany has an option to purchase these aircraft at 1/. of the original cost or terminate the lease as per the agreement. The (ompany will capitalise these values at the end of lease period if the option to purchase is exercised. %. )sset 5ased Financing $. Air India ac"uired two %-1-31,, aircraft in 7ct#&ov $LL4. The

9overnment of India had at that time categorically stated that no guarantee would be forthcoming for the financing package for these aircraft. Air India, therefore, arranged asset based financing with a ?8 6ximbank@s guarantee. +. &ormally the ?8 6ximbank does not allow government owned airlines to undertake asset based financing. <owever as the 9overnment of India was firm in its decision of not providing a guarantee, the ?8 6ximbank agreed to do an asset based financing structured as a Finance Cease. 0. ?nder this structure a 8pecial urpose (ompany A8 (B was set up in a tax3 free haven A%ermudaB to own the aircraft and subse"uently lease the aircraft to Air India. This enabled the ?8 6ximbank to control directly the 8 ( Ai.e. the CessorB as the shares of this 8 ( were pledged to ?8 6ximbank. 1. As this structure was asset based, the aircraft ac"uired under this financing structure together with two additional %-1-31,, aircraft ac"uired earlier were re"uired to be mortgaged to the ?8 6ximbank as security for their guarantee.

/. ?nlike a *apanese Ceveraged Cease structure, there is no e"uity contribution from the lessor as owner of the aircraft and therefore Air India could not derive any upfront benefit. 4. The ?8 6xim guaranteed lenders provided the funds to the 8 ( to enable the 8 ( to purchase the aircraft from the manufacturer. The outgo to Air India under this finance lease structure was exactly the same as under a vanilla loan. -. The interest rate on the ?8 6xim tranche of this financing was very attractive Athree3month CI%7: in ?8 dollars plus a spread of ,.,5.B. 5. The title to the aircraft will pass on to Air India on expiry of the lease term of $+ years without payment of any purchase price. L. The ?8 6ximbank insisted on a Cetter of X(omfortY from the 9overnment of India. This letter was provided after protracted negotiations with the 2inistry of Finance, the 2inistry of (ivil Aviation and the 2inistry of Caw. $,.In view of a $,,. 9overnment ownership, Air India had not faced any problem in getting guarantees from the ?8 6ximbank and the export credit agencies of the ?S, France and 9ermany. This enabled Air India to arrange loans at competitive rates. )ccounting Treat ent for )sset 5ased Financing Air India had structured the loan taken for ac"uisition of these aircraft as Finance Cease in order to give ?8 6xim %ank control over the mortgaged aircraft. Seeping with International Accounting 8tandards the two aircraft ac"uired during the year $LL43L- have been brought into the books of accounts. The new aircraft form a part of the Fixed Assets of the (ompany and the balance lease obligations are shown under Cong Term )ebt. 7nly the interest charges of the lease rent is debited to rofit and Coss Account and the principal amount of the lease rent is reduced from the balance lease obligation

i.e. loan taken for lease financing. Air India claims depreciation on these aircraft as per the standard depreciation policy adopted for all aircraft.

)nne2ure 1 Project Cost Financing and Cash Flo* Profor a for )ppraisal ,%s6 $a'hs!utflo*s , $. Cand and building +. lant and machinery 0. >orking capital Total outlay 8ources of finance $. Term loans A$B +. 6"uity capital A+B A)6 :atio $'+B (ash flow projections A:s. lakhsB Projected figures , A. 8ales :evenues %. Cess 7perating (osts' $. :aw materials +. 8alaries W wages 0. 2anufacturing expenses 1. Administration expenses /. 8ales tax V x. 6arnings before depreciation, interest and income taxAA3%B Cess' interest rofit before depreciation and income tax Cess' depreciation rofit before income tax Cess' Income tax &et profit Hear $ + 0 1 / ...$, Total Hear $ + 0 1 / ...$,

Add' )epreciation >orking capital (ash inflows Cess' (ash outflows &et cash flow

)nne2ure C0 Profor a for #sti ate of Foreign-#2change Flo*s or a Project ,In foreign e2change#tem , I6 Foreign-e2change inflo*s ,FIA: *irect inflo& $. Foreign e"uity capital +. Term loan 0. Foreign aid or grant 1. 9oods or e"uipment on deferred payment /. 6xports of goods or 8ervices 4. 7thers ): ndirect inflo& AFor linked projectsB -. (apital 5. Term loans in cash and in kind L. Foreign aid or grant $,. 6xport of goods or services $$. 7thers II Foreign e2change !utflo*s ,F!)6 .irect outflo* $ + -ear 0 1 /

$+. 8urvey, technical consultancy, engineering fees $0. Import of capital goods, e"uipment, machinery, replacements. $1. Import of raw materials, components, parts and semi3finished goods $/. Imported goods purchased from domestic market $4. (onstruction and installation charges $-. )irect charges on imports of raw materials, intermediates and replacements A ayable in foreign currencyB $5. 8alaries payable in foreign exchange $L. :epayment of term loans +,. :oyalty, know3how and patent rights +$. :epatriation of profits and capital ++. 7thers 56 Indirect outflo* ,for lin'ed projects+0. Import of capital goods, e"uipment, and machinery +1. Import of raw materials, intermediates and replacements +/. Imported goods purchased on domestic market +4. 7thers III &et foreign3exchange flow AI 3IIB Apositive F= negative 3B