FM Course Outline & Materials-Thappar Univ

FINANCIAL MANAGEMENT
Faculty: Dr. S K Chaudhuri
4
Financial Management
Course Outline
Instructor: Dr. S K Chaudhuri

E-Mail: skchaudhuri@ipeglobal.com
Course Objectives
Financial Management course is designed to enable the students understand and

learn tools and techniques of financial decision making. In particular, the course will
focus on the following topics:
Finance functions and goals within the framework of overall business
strategies and creating shareholder value
Working capital management and financing
DCF techniques and their applications in capital investment decisions
Various means of raising funds in domestic and international markets and the
factors underlying the capital structure planning and dividend decision
Introduction to mergers & acquisitions and valuation
Pedagogy
The course will be delivered through lectures, exercises and case studies. Emphasis
will be given on application of Excel in financial analysis.
Examination and Grading
Component Max. Duration Weight

Three quizzes* 30 minutes each 30%
Assignments 20%
Term-End Examination 3 hours 50%
* There will be no make-up quiz.
Suggested Text Books
1. James C Van Horne : Financial Management and Policy, 12th Edition (VH)
2. Brealey & Myers : Principles of Corporate Finance
2. Prasanna Chandra : Financial Management: Theory and Practice, 6th Ed.
(PC)
4. I. M. Pandey : Financial Management
5
Course Outline (Duration of each session: 1 hour)
Session Topics Handout/Exercise Cases/Assignments

Nos.
1-10 Integrating business and Creating Shareholder Case studies
finance goals – challenges of Value 1. Financial
finance manager Balancing Score Card Performance
Shareholder value creation EVA as a Analysis - Ashok
Financial performance analysis Performance Measure Leyland
– EVA as performance indicator Deferred Tax Assignment
Liabilities and Assets Select a company and
analyse the financial
performance
11-14 Time value of money and DCF Formulae & exercises
techniques
Risk and return concept
15 - 19 Working capital management & Working Capital Case studies
financing Management 2. ABC Watches Ltd
Money market instruments Operating Statement 3. Jupiter Export
Exercise House
Money Market
Instruments
20-25 Capital budgeting – application Exercises on capital Case studies
of DCF techniques budgeting 4. Joy Chemicals
Typical investment decisions
(e.g., mutually exclusive
projects; machine replacement
decisions)
Financial appraisal of projects
by financial institutions
26 - 29 Cost of capital CAPM and Estimation Assignment
CAPM and estimation of cost of of Beta Select a company and
equity Beta of Unquoted estimate share beta
Adjusted present value Stock based on NSE/BSE
technique Exercise on WACC data from website
APV Calculation
30 - 34 Domestic capital market and Types of Market Case studies

instruments (right/bonus issues; Credit Rating: An 5. RIL issues of 100
buy-back of shares; various Overview Year Yankee Bond
debt instruments) Rating of a 6. GDR issue by
Raising funds in international manufacturing & VSNL
market (GDR/ADR; syndicated financing Company
loans; export credit agencies;
euro-bonds and foreign bonds)
Capital structure planning
Credit rating (what is it? rating
methodology)
6
Session Topics Handout/Exercise Cases/Assignments
Nos.
35 Dividend policy (guiding factors; Exercises
DDM models of share
valuation)
36-40 Mergers & acquisition Case studies
Valuation (accounting & DCF 7. Three Unilever tea
methods) Companies to
Merge
7
CREATING SHARE HOLDER VALUE*
The corporate history is abound with cases to show how companies embark on rapid
sales growth, report happy bottom line and earning per share, and then experience
perils of growth. History also suggests that not all growth companies with long-term
payoffs are rewarded in the stock market. Over the last one decade or so,
academicians and professionals have therefore put more emphasis on value creation
for shareholders in crafting the business strategies. No matter what growth strategies
are pursued by the companies, they must pass through the benchmark of
shareholder value creation.
It is a common practice to estimate shareholder value in terms of forecasted free
cash flows, which are operating cash flows prior to finance-related cash flows like
interest or dividend payments. When free cash flows are discounted by firm’s overall
cost of capital, appropriate for the business and financial risks, we obtain what is
knows a value of the firm. The shareholder value is determined by deducting market
value of outstanding debt capital from the total value of the firm.
The case for why management should pursue the objective of shareholder value
creation is comparatively straightforward. Management is often characterized as
balancing the interests of various corporate constituencies such as employees,
customers, suppliers, debt-holders, and stockholders. The company’s continued
existence depends upon a financial relationship with each of these parties.
Employees want competitive wages. Customers want high quality at a competitive
price. Suppliers and debt-holders each have financial claims that must be satisfied
with cash when they fall due. Stockholders as residual claimants of the firm look for
cash dividends and the prospect of future dividends which is reflected in the market
price of the stock.
If the company does not satisfy the financial claims of its constituents, it will cease to
be a viable organization. Employees, customers and suppliers will simply withdraw
their support. Thus, a going concern must strive to enhance its cash-generating
ability. The ability of a company to distribute cash to its various constituencies
depends on its ability to generate cash from operating its businesses and on its
ability to obtain any additional funds needed form external sources.
Debt and equity financing are the two basic external sources. The company’s ability
to borrow today is based on projections of how much cash will be generated in the
future. Borrowing power and the market value of the shares both depend on a
company’s cash-generating ability. The market value of the shares directly impacts
the second source of financing, that is, equity financing. For a given level of funds
required, the higher the share price, the less dilution will be borne by current
shareholders. Therefore, management’s financial power to deal effectively with
corporate claimants also comes form increasing the value of the shares.
In recent years, emphasis has also been put on value-based management. It is an
approach to management that aligns a company’s overall aspirations, analytical
techniques and management processes to focus management decision making on
the key drivers of value. The appended exhibit illustrates the key drivers of
shareholder value.
*
Notes prepared by Dr. S K Chaudhuri, Professor, IMI
8
Shareholder Value – Key Drivers
Strategy Development
Management
Operating Investment Financing
Decisions
• Sales Growth • Value • Working Capital • Cost of

Value Drivers • Operating Profit Growth Investment Capital
Margin Duration • Fixed Capital
• Income Tax Rate
Components of Cash Flow from

Value Discount Rate Debt
Operation
Corporate Objective Creating Shareholder

Value Shareholder Returns
• Dividends
• Capital Gains
1
BALANCING THE SCORE-CARD*
Despite the widespread adoption of total-quality programmes in recent years, far too
many companies still measure performance exclusively or primarily by the latest
financial results, isolating their senior managers from what is happening in the
market-place.
“It is like steering a ship by its wake”. Confesses one senior executive describing
how his business measured its performance. The management tended to
concentrate on narrow financial measures that lagged rather than led the company’s
underlying performance. The unfortunate result: Pressure to make the latest
financial figures look good was leading to worse customer service with an adverse
impact on the company’s future.
In contrast, many of the most advanced companies today seek a more long-range
focus by measuring progress against key performance indicators in four main areas:
(1) Financial How well is the company creating shareholder value?

(2) Customer How well is the company serve its customers?
(3) Process How well is the company performing key internal business
processes in terms of quality, speed and productivity?
(4) Learning What improvements and innovations is the company making in its
services and products?
Taken together, these four categories provide a more complete and balanced picture
of the business issues that determine long-term success.
A key task for the managers is the development of a vision and objectives for the
organization, covering not only financial results but also other factors such as how
the business will compete. Performance measures should play a pivotal role in
implementing the business strategy by monitoring whether the full range of strategic
objectives is being achieved.
Well-constructed performance measures also send signals to those whose
performance is being measured. Competition to-day is not just about cost - it is
increasingly about quality, speed and service to the customer. It is also about
learning faster than the competition.
Bottom- up and top-down analysis
Designing such performance measures requires both bottom-up and top-down

analysis. Without both, there is a risk that either the measurement is not grounded in
the strategic objectives of the organization and therefore drives behaviour in the
wrong direction, or that the strategic measurement bears no relation to the business
activities of the organization and cannot be used to manage effectively.
For most managers, one of the most difficult challenges is leaning to measure
customer service in a new way. Customer measures must be based on what the
customer actually values as well as how the business appears to the customer. For
*
Brian Taylor, C. Graham and C. Stafford, Cross border, Winter 1994.
1
example, if on-time shipment is critical, then what ought to be measured is the time of
arrival at the customer’s premises - not the time the lorry leaves the depot.
Measure results, not training
The same philosophy applies to measuring such areas as organizational learning.

The key is not how many people are trained, but the results. In areas like quality, the
rate of improvement is critical. For example, a high-tech company might measure
how fast it can halve the number of rejects in new product lines. At the bank, the
measure might be the speed at which it matches competitor’s products, thus
reducing any potential advantage for competitors.
Care is essential when applying such measurements. The objective is not simply to
maximize every score - the aim is to assess where the business is now and where it
needs to be for each score. The focus must be on:
• Targets;
• Trends;
• Action;
• Forecasting.
No more than 25 parameters should be measured. If too many measures are used,
it is likely that balance will be lost and it will be impossible to focus on the most
important ones. Care should be taken, however, not to reduce lower-level data into
meaningless ratios.
Word to the wise
There are a number of pitfalls to avoid when developing a performance-

measurement system:
• Don’t use new measures to reward or punish immediately - they take tine to
become embedded in the corporate culture.
• Don’t ignore important areas because they are difficult to measure.
• Don’t look for quick, standard solution
• Don’t underestimate the cultural change needed.
Far-reaching impact
The successful redesign of a company’s performance measures can have substantial

and far-reaching effects on how senior executives think about business performance
and on the decisions they make. Take the case of one manufacturing company that
had used earnings per share as its almost exclusive measure of performance. In its
revised list of priorities, earnings per share dropped to last place, preceded by
customer satisfaction, cash flow, manufacturing effectiveness and innovation. The
reasoning: It is these measures, rather than earnings per share, that truly anticipate
the trend in business.
Finally remember that measuring performance is an aid to management, not a
substitute for it. The objective is to focus management attention on the key
measures of business performance that provide a basis for judging the short-term
and long-term health of the business.
2
EVA AS A PERFORMANCE MEASURE*
A surge in shareholder activism has put increasing pressure on companies to
consistently maximize shareholder value. However, this raises the important question of
how senior executives should measure an organization’s progress in meeting this goal.
In particular, the question concerns defining measures of corporate financial
performance that correlates highly with shareholder wealth. This issue is also concerned
with motivating managers to do what is best for shareholders. The central idea in most
organizations is to tie managerial compensation to measures of financial performance
that are linked closely to changes in shareholder wealth. In theory, this should motivate
managers to maximize shareholder value.
The most direct financial performance measurement is the business’s stock price.
However, stock prices can be limited in their usefulness. The litmus test for any
performance measure is whether it accurately reflects the decisions taken by
management. A good performance measure must, therefore, be responsive to a
manager’s actions and decisions. In this sense, stock prices (or, for that matter, stock
returns) are often ineffective in assessing past performance because they reflect the
expectations of all future decisions. In fact, stock prices are not necessarily that
responsive to the actions of even the most senior-executive in a company. As one goes
further down the organization, the problem becomes even more severe as lower-level
employees have even less impact on the stock price.
Economic Value Added (EVA), like other performance measures, attempts to resolve the
tension between the need for a performance measure that is both highly correlated with
shareholder wealth and responsive to the actions of a company’s managers. The term
EVA is a registered trademark of a New York based consulting firm, Stern Stewart & Co.
If an enterprise’s objective is to maximize the value of the shareholders’ claim to the
assets, then this is quite easily done. A company will meet this objective if it does two
things: invest only in new projects that are expected to create value and retain only
projects that create value on an on-going basis.
To this end, finance theory offers managers a simple guide to choosing capital
investments through the net present value (NPV) rule. That is, by investing in projects
that have positive NPVs, the company will create value. However, when managers seek
such a well-defined rule for evaluating their ongoing investments, they are often met with
frustration. In fact, most organizations are forced to rely on financial measures such as
total sales, total earnings or even rates of return on their net assets as a means of
differentiating between the ‘peaches’ and the ‘lemons’ in their business. However,
assessing performance based on these measures can often distort the investment
behaviour of management away from that of their shareholders’ wishes.
Investment distortions typically arise because a manager is not ‘charged’ for the capital
he or she uses, or even rewarded for the shareholder value created. This is where the
fundamental contribution of EVA comes into play. It rewards managers for the earnings
they generate net of the amount of capital employed to reap these earnings. In this vein,
EVA is defined as:
EVA = NOPAT – (KW x Net Assets)

Where, NOPAT = net operating profit after-tax
KW = weighted average cost of capital and
Net Assets = book value of assets, or net capital deployed
*
(Adapted) Todd Milbourn, Mastering Finance, Financial Times, 1998.
3
If managerial compensation is tied to EVA, then the manager’s inclination to consume
capital is now tempered by the fact that he or she must pay a capital charge evaluated at
the weighted average cost of capital on the net capital he or she uses.
The goal of a good financial performance measure is to ask how well a company has
performed in terms of generating operating profits over a period, given the amount of
capital tied up to generate those profits. EVA is novel in that it provides an answer to this
question. The idea is that the business’s financiers could have liquidated their
investment in the company and put the liberated capital to some other use. Thus, the
financiers’ opportunity cost of capital must be subtracted from operating profits to gauge
the organization’s financial performance. In this spirit EVA views NOPAT as a
representation of operating profit and subtracts a capital charge that views the economic
book value of assets in place as a measure of the capital provided to the company by its
financiers.
4
DEFFERED TAX LIABILITY AND ASSET
Dr. S K Chaudhuri
The need for deferred tax accounting arises because companies often postpone or pre-
pay taxes on profits pertaining to a particular period. This is caused by the timing
differences in booking some items of revenue and expenses in the profit and loss
statement and in the tax-return1. The Accounting Standard 22 issued by the Institute of
Chartered Accountants of India deals with the subject. In this appendix, we only explain
them with numerical examples.
DEFERRED TAX LIABILITY
A common situation that creates deferred tax liability is when amount and timing of
depreciation charges for accounting and tax purposes differ2. To appreciate the tax
effect of timing difference in depreciation charges, consider a company which has
purchased a machine at Rs. 150 million. Suppose the machine is eligible for 100 percent
depreciation in the first year of operation for tax purpose, but the management decides
to depreciate the machine on a straight-line basis over three years for accounting
purpose. We further assume that the company will earn profit before depreciation and
tax of Rs. 200 million each year and the corporate tax rate is 40 percent. Table 1
presents all the calculations.
As evident from the first-year calculations in Table 1, deferred tax liability occurs when
higher tax expense is reported in the profit and loss statement than what is actually due.
In our example, tax expense as per book profit is Rs. 60 million whereas as per tax-
return the amount due is much less, Rs. 20 million only. This has lead to reporting of
additional tax outgo of Rs. 40 million. To overcome this problem, a deferred tax account
is created in the liability section of the balance sheet; this deferred tax account maintains
a running total of differences between taxes reported and taxes actually due. Under the
present system of presentation, taxes due are shown separately as current tax.
We may further note that when the company slows or ceases procuring new assets (as
assumed in our example for the second and third years), there will eventually be a
reversal, i.e. reported tax will be less than is actually due and deferred tax will become
negative. In our example, reported tax in the second year is Rs. 60 million while actual
amount to be paid in the same year stands at Rs. 80 million (see Table 1). The actual
tax outgo in the second year is higher because the company has fully depreciated the
machine in the previous year and it has not added any new asset. So, the company has
no depreciation to be set off against taxable income in the second and third years. As a
result, tax return shows higher tax amount and the deferred tax turns into negative in the
second and third years. By the end of the third year, deferred tax account shows nil
balance. In a different scenario, if the company continues to invest in depreciable assets,
deferred tax reversal may be delayed indefinitely.
1
Deferred tax is not the same thing as taxes payable. While taxes payable are tax payments due within the
year, deferred taxes are due for reversal at some indefinite future date.
2
Apart from depreciation, there are other examples of tax effect of timing differences leading to deferred
tax liability. For example, tax law permits charging advertisement expenses in year it is incurred, but
companies normally prefers to amortise the expenses over a couple of years. Similarly, pre-issue expenses,
or expenses on research and development, or expenses incurred on mergers and acquisitions are allowed to
be written off over a fixed period of years for tax purpose, but the company may decide to stretch the write
off over a longer period.
5
Table 1: Illustrative calculation of deferred tax liability
(Rs. Millions) Year Year Year

1 2 3
Accounting profit and taxation
Profit before depreciation and tax 200 200 200
Less: Depreciation @ 33.33% 50 50 50
Profit before tax 150 150 150
Less: Provision for taxation @ 40% 60 60 60
Profit after tax 90 90 90
Tax-return profit and taxation
Less: Depreciation @ 100% 150 0 0
Less: Provision for taxation @ 40% 20 80 80
Difference in taxation 40 (20) (20)
Presentation in Profit & Loss Account
Less: Depreciation @ 33.33% 50 50 50
Less: Provision for taxation
Current tax (involves cash payment) 20 80 80
Deferred tax (non-cash charge) 40
Deferred tax reversal (20) (20)
Total 60 60 60
In retrospect, deferred tax liability serves the purpose of a reserve, which will be draw
down in the future years to meet the company’s higher tax liability in those years.
6
DEFERRED TAX ASSET
When does a company create deferred tax asset? Deferred tax asset is created when a
company is in effect pre-paying taxes. For instance, provisions made at the discretion of
management, e.g., provision for bad debts, may not be fully allowed by the tax
authorities. In this case, tax expense in the profit and loss account is less than the
amount allowed for tax purpose. To reconcile the difference, the accountant is required
to create deferred tax assets in the assets section of the balance sheet.
Another example is when a company may charge off taxes, duties, cess, fees, etc.
against income during a year on accrual accounting basis but they are allowed for tax
purpose in the subsequent year on payment basis. Such instances also lead to creation
of deferred tax asset tax expense in the profit and loss statement happens to be more
than the actual tax due.
Deferred tax assets should be recognised and carried forward only to the extent that
there is a reasonable certainty that sufficient future taxable income will be available
against which such deferred tax assets, i.e., pre-paid tax can be set off.
DEFERRED TAX LIABILITY - DEBT OR EQUITY?3
In terms of presentation, deferred tax liability (net of deferred tax asset) is placed on the
liability side of the balance sheet below the loan funds. Though its position in the
balance sheet gives an impression that deferred tax liability is a debt item, analysts are
often confused whether to treat the deferred tax liability as debt or equity, or neither, in
financial analysis.
There are different view points regarding how deferred tax liability is to be treated for
financial analysis. One view point is that deferred tax liability must be added to equity
since there is no definite time period for its reversal. In this sense, it is more like ‘equity’
than ‘debt’. But as mentioned earlier, when the company slows or ceases procuring new
assets there will eventually be a reversal of deferred tax liability, i.e. reported tax will be
less than is actually due and deferred tax will become negative. In that case, deferred
tax liability is more akin to ‘debt’ than ‘equity’. Thus, analyst is required to take a view on
whether reversal of deferred tax liability will eventually take place or it will be delayed for
indefinite period.
Some analysts propose that the current period deferred tax (a non-cash charge) should
be added back to profit; the argument is that profit is understated because of
overstatement of taxes. Yet some others favour deducting deferred tax liability from net
fixed assets. The logic here is that excess tax depreciation over book depreciation leads
to decrease in assets valuation rather than creation of a liability.
3
For further discussion refer to James C Van Horne, Financial Management & Policy, 12th Edition,
Pearson Education
7
Balance Sheet
Page 1
(Rs. crores) 2005-06 2006-07 Change
Sources of Funds
Share capital (face value of Re.1) 122.16 132.39 8.4%
Reserves and surplus 1,290.29 1,762.18 36.6%
Less : Revaluation reserve 23.95 22.96 -4.1%
Less : Misc. expenditure not w/o 7.31 24.42
Tangible networth 1,381.20 1,847.20 33.7%
Deferred tax liability (net) 179.69 196.93 9.6%
Equity capital 1,560.89 2,044.12 31.0%
Secured loans 184.69 360.22 95.0%
Unsecured loans 507.24 280.18 -44.8%
Debt capital 691.93 640.40 -7.4%
Total 2,252.82 2,684.52 19.2%
Linking Balance Sheet & Profit & Loss Account (2006-07) Application of Funds
Fixed assets
Net Fixed Gross block (less revaluation reserve) 2,114.55 2,597.24 22.8%
(Rs. Crores) Assets Less : Depreciation 1,195.23 1,313.16
1,521.57 Net block 919.33 1,284.08 39.7%
Add : Capital work-in-progress 141.42 237.49
Equity Capital Investment Net fixed assets 1,060.74 1,521.57 43.4%
Debt
1,829.27 + Employed 221.09 Investments 368.18 221.09 -39.9%
214.85 = + 640.40 = 2,684.52 Current assets, loans and advances
2,044.12 Raw materials 272.83 385.34 41.2%
Stores, spares & tools 36.63 42.91 17.1%
Net Current
Sub-total 309.46 428.24 38.4%
Assets
Retained Sales + Work-in-progress 143.73 109.51 -23.8%
941.86
profit other income Finished goods 449.37 532.57 18.5%
214.85 7,262.48 Total inventories 902.56 1,070.32 18.6%
Debtors more than six months 15.65 69.60 344.8%
Other debtors 413.34 458.36 10.9%
Less : Prov for doubtful debts (4.65) (5.09)
Dividend & Profit minus Sundry debtors 424.34 522.88 23.2%
tax on dividend after tax Expenditure Cash and bank 602.88 434.94 -27.9%
226.43 441.28 6,821.20 Loans and advances 302.64 669.58 121.2%
Total current assets 2,232.41 2,697.71 20.8%
Less : Current liabilities and provisions
Creditors for goods 691.98 1013.71 46.5%
Acceptances 353.97 419.98 18.6%
Interest accrued but not due 5.83 5.21 -10.7%
Other current liabilities 95.11 212.73 123.7%
Total current liabilities 1146.90 1651.63 44.0%
Provisions 261.62 104.23 -60.2%
Total current liab & prov. 1408.52 1755.86 24.7%
Net current assets 823.90 941.86 14.3%
Total 2252.82 2684.52 19.2%
Contingent liabilities* 713.60 801.33 12.3%
* Bulk of it represents contingent liabilities on account of bills discounted.
8
Profit & Loss Statement Financial Analysis Unit 2005-06 2006-07
Page 2 A1. Productivity (Assets management)
(Rs. In crores) 2005-06 2006-07 Change 1. Capital (or total assets) turnover = (net sales + other income) ÷ total assets times 2.355 2.705
Net sales1 5,247.66 7,168.18 36.6% 2. Fixed assets turnover = net sales ÷ net fised assets times 4.947 4.711
Materials consumed 4,133.62 5,493.78 32.9% 3. Working capital management:
Stores and tools consumed 34.23 37.89 10.7% 3.1 Inventory turnover = net sales ÷ inventories (times) times 5.814 6.697
Employee cost 403.89 480.70 19.0% Inventory holding in days = days in a year ÷ inventory turnover days 63 55
Power & fuel cost 41.41 45.44 9.7% 3.2 Receivable turnover = net sales ÷ receivables (times) times 12.367 13.709
Repairs and maintenance 45.38 54.85 20.9% Days sales ourstanding (DSO) = days in a year ÷ receivable turnover days 30 27
Other expenses 35.55 2.39 -93.3% 3.3 Gross operating cycle in days = inventory holding days + DSO days 93 82
Stock adjustments (300.60) (48.98) 3.4 Liquidity position:
Cost of goods sold (excld depreciation) 4,393.47 6,066.06 38.1% 3.4.1 Current ratio = current assets ÷ current liabilities & provisions times 1.58 1.54
Gross Profit 854.19 1,102.12 29.0% 3.4.2 Quick ratio = (current assets - inventories) ÷ current liabilities & provisions times 0.94 0.93
Research and development 19.74 29.49 49.4% 3.4.3 Cash ratio = (cash & marketable securities) ÷ current liabilities & provisions times 0.69 0.37
Selling, general & administrative expenses 294.39 369.95 25.7% A2. Labour Productivity
EBITDA 540.07 702.69 30.1% 4. Sales per employee = gross sales ÷ number of employees Rs. m 5.21 6.99
Add : Other income 57.17 94.31 65.0% 5. Value added per employee = (net sales - materials/stores/etc.) ÷ no. of employees Rs. m 0.91 1.35
Less : Depreciation, amortization & impairment 126.01 150.57 19.5% B1. Profitability
EBIT 471.23 646.42 37.2% 6. Gross profit margin = gross profit ÷ net sales % 16.28 15.38
Net interest2 40.65 28.84 -29.1% 7. Operating profit margin = EBITDA ÷ net sales % 10.29 9.80
Profit before extraordinary items 430.59 617.58 43.4% 8. Net profit margin = PAT ÷ (net sales + other income) % 6.17 6.08
Extraordinary items (21.72) 13.08 9. Return on capital (or assets) employed (ROCE) = PAT ÷ total assets % 14.53 16.44
Profit before tax (PBT) 452.30 604.51 33.7% 10. Return on equity (ROE) = PAT ÷ equity capital (tangible networth + net deferred tax liability) % 20.97 21.59
Taxation 124.98 163.22 30.6% B2. Key Elements of Expenditure
Current tax (including fringe benefit tax) 117.75 140.2 19.1% 11. Materials cost-to-sales ratio = materials ÷ net sales % 78.77 76.64
Deferred tax 7.23 23.02 218.4% 12. Employee cost-to-sales ratio= employee cost ÷ net sales % 7.70 6.71
Profit after tax (PAT) 327.32 441.29 34.8% 13. Power & fuel costs-to-sales ratio = power & fuel costs ÷ net sales % 0.79 0.63
Dividend 159.79 198.58 24.3% 14. R & D expenses-to-sales ratio = R & D expenses ÷ net sales % 0.38 0.41
Tax on dividend 22.41 27.85 15. SG&A expense-to-sales ratio = SG&A expenses ÷ net sales % 5.61 5.16
Retained profit 145.12 214.85 48.0% C. Risk Analysis
16. Business risk:
1
Break-up of sales: 16.1 Sales variability (over trailing 10years) = standard deviation sales ÷ average sales % 40.79 53.58
Vehicles-commercial 5,250.87 7,776.00 48.1% 16.2 Operating leverage = (net sales - variable costs) ÷ EBIT (excluding other income) times 2.61 2.96
Engines 135.75 152.58 12.4% 17. Financial risk:
Spare parts & others 783.78 546.84 -30.2% 17.1 Debt-equity ratio = debt capital ÷ equity capital (tangible net worth + net deferred tax liability) times 0.44 0.31
Gross sales 6,170.41 8,475.42 37.4% 17.2 Debt-to-total assets = debt capital ÷ total assets % 30.71 23.86
Less : Commission/rebate/discounts 117.30 170.70 45.5% 17.3 Inerest coverage ratio = EBIT ÷ gross interest expenses times 11.59 20.31
Sub-total 6,053.11 8,304.72 37.2% D. Growth Analysis
Less : Excise duty 805.45 1,136.54 41.1% 18. Sustainable growth rate = (year-end equity ÷ year-beginning equity) - 1 % 10.25 11.75
Net sales 5,247.66 7,168.18 36.6% E. Market Value
19. Per share data :
2
Gross interest 40.65 31.82 -21.7% 19.1 Earnings per share (EPS) = (PAT - dividend on preference shares) ÷ common shares outstanding Rs. 2.68 3.33
Less : Interest capitalised 0.00 2.98 19.2 Cash flow per share (CFPS) = (PAT + depreciation + amortization) ÷ common shares outstanding Rs. 3.71 4.47
19.3 Dividend per share (DPS) = dividend ÷ common shares outstanding Rs. 1.31 1.50
Memo item 19.4 Book value per share (BVPS) = equity capital ÷ common shares outstanding Rs. 12.78 15.44
Number of employees 11,845 12,125 2.4% 20. Price-earning (P/E) ratio = market price ÷ EPS times 15.1 11.7
Year-end market price (average of high & low) in 40.35 38.95 -3.5% 21. Price-to-cash flow ratio = market price ÷ CFPS times 10.9 8.7
(Bombay Stock Exchange) 22. Market-to-book value ratio = market price ÷ BVPS times 3.2 2.5
9
Economic Value Addition (EVA)
Page 3
(Amount in Rs. crores) 2005-06 2006-07
Year-beginning equity capital (E0) 1,415.77 1,829.27
Year-end debt capital (E1) 1,560.89 2,044.12
Average equity capital [E = (E0+E1)/2] 1,488.33 1,936.70 Key Strategies to Enhance EVA
Beginning debt capital (D0) 880.41 691.93
End debt capital (D1) 691.93 640.40
Operate : Set targets to improve ROCE
Average debt capital [D = (D0+D1)/2] 786.17 666.16
Capital employed (K = E + D) 2,274.50 2,602.86
Build : Invest capital only when return exceeds cost of capital
Debt-to-total capital (D/K) 35% 26%
Cost of equity (assumed) 15% 15%
Interest rate (gross) 5% 5% Harvest : Divest capital when returns fall below the cost of capital
Effective tax rate (t) 28% 27%
After-tax cost of debt [Kd = i*(1 - t)] 4% 3% Optimize : Restructure capital to reduce cost of capital
Cost of capital (WACC) 11% 12%
EBIT 471.23 646.42
NOPAT = EBIT x (1 - t) 341.02 471.88
Capital charges = K x WACC 252.67 313.73
EVA = NOPAT - K x WACC 88.36 158.15
10
(Rs. In crores)
Income Statement 2005-06 2006-07
Gross sales 6170.41 8475.42 Operating Cycle 2005-06 2006-07
Less : Comm/rebate/discounts 117.30 170.70
Sub-total 6053.11 8304.72 Stock of materials/stores/ etc. (Rs. Crores) 309.46 428.24
Less : Excise duty 805.45 1136.54 Consumption of materials/stores/etc. (Rs. Crores) 4,167.85 5,531.67
Net sales 5247.66 7168.18 Stock as days' consumption (A) 27.10 28.26
Materials consumed 4,133.62 5,493.78 Stock of WIP (Rs. Crores) 143.73 109.51
Stores and tools consumed 34.23 37.89 Cost of production (Rs. Crores) 4,787.32 6,329.32
Employee cost 403.89 480.70 Stock as days' cost of production (B) 10.96 6.32
Power & fuel cost 41.41 45.44 Stock of finished goods (Rs. Crores) 449.37 532.57
Repairs and maintenance 45.38 54.85 Cost of goods sold (Rs. Crores) 4,539.20 6,246.12
Research and development 19.74 29.49 Stock as days' COGS (C) 36.13 31.12
Depreciation, amortization & impairment 126.01 150.57 Inventory conversion period (A+B+C) 74.19 65.70
Other expenses 35.55 2.39 Debtors (Rs. Crores) 424.34 522.88
Sub-total 4,839.81 6,295.10 Gross sales (Rs. Crores) 6,170.41 8,475.42
Add : Opening stock of WIP 91.24 143.73 Debtors as days sales oustanding (D) 25.10 22.52
Less : Closing stock of WIP 143.73 109.51 Gross operating cycle in days (E=A+B+C+D) 99.29 88.22
Cost of production 4787.32 6329.32 Operating cyle in months 3.31 2.94
Add : Opening stock of finished goods 201.25 449.37 Creditors & acceptances (Rs. Crores) 1,045.95 1,433.69
1
Less : Closing stock of finished goods 449.37 532.57 Credit purchase in Rs. crores (materials/stores/etc.) 4,209.74 5,650.45
Cost of goods sold (COGS) 4539.20 6246.12 Credit period in months (F) 2.98 3.04
Selling, general & administration (SG&A) 294.39 369.95 Net operating cycle in months(E-F) 0.33 (0.10)
Cost of sales (COS) 4833.59 6616.07
Operating income (net sales - COS) 414.07 552.11
1
Add: Other income 57.17 94.31 Purchase of raw materials/stores/etc. (Rs. Crores) 2005-06 2006-07
EBIT 471.24 646.42 Closing stock 309.46 428.24
Interest 40.65 28.84 Add : Materials, stores & tools consumed 4,167.85 5,531.67
Profit before extraordinary exp. 430.59 617.58 Less : Opening stock 267.57 309.46
Extraordinary exp.(VRS comp.) (21.72) 13.08 Purchase of materials, stores & tools 4,209.74 5,650.45
Profit Before Tax 452.30 604.51
Taxation 124.98 163.22
Profit after tax 327.32 441.29
11
TIME VALUE OF MONEY AND DCF TECHNIQUE
• Future value of money (discrete compounding): Cn = C0 (1 + k/m)mn

• Future value of money (continuous compounding): Cn = C0 ekn
 (1 + k ) n − 1
• Future value of ordinary amount: FV = A  
 k 
 (1 + k ) n − 1
• Future value of annuity due: FV = A (1 + k )  
 k 
• Time value of money : C0 = Ct / (1 + k)t
n C
• Present value of a cash flow stream : PV = ∑ ( (1 + kt ) t
t =1
• Present value of flat, perpetual cash flows : PV = C/k

• Present value of a perpetual cash flows, growing at a constant growth rate (g) :
PV = C1 / (k - g), where C1 = C0 (1 + g) = cash flow at the end of period 1 and, k>g

If g= -ve, then PV = C1 / (k+g)
• Present value of an annuity (A) :
PV = A/(1+k)1 + A/(1 + k)2 + . . . + A / (1 + k)n
A[1 − 1 /(1 + k ) n ]
PV = = A.a
k
[1 − 1 /(1 + k ) n ]
where, a = annuity factor =
k
A (annuity) = PV x 1/a = PV x CRF, where CRF = 1/a = capital recovery factor
• Effective rate of interest : r = [1 + (k/m)]m - 1,
where, k = annual rate of interest
m= frequency with which compounding is done in a year
• Yield-to-maturity of a fixed-income security
P = C1/(1+k)1 + C2 /(1 + k)2 + . . . + Cn/ (1 + k)n + M/(1+k)n
where P = current price of a bond
Cn = coupon payment in period n
M = maturity value
k = internal rate of return (IRR) = yield-to-maturity
• If P = face value of the bond, YTM = coupon rate
If P > face value , YTM < coupon rate
If P < face value, YTM > coupon rate
• In case of periodic coupon payment (i.e., monthly, quarterly or say, half-
yearly), annualised YTM would be greater than that of a similar bond with
annual payment of coupon
12
EXERCISE ON PRESENT VALUE CONCEPT & DCF CALCULATIONS
1. As winner of a breakfast cereal competition, you can choose one of the following
prizes:
a) $ 100,000 now
b) $ 180,000 at the end of 5 years
c) $ 11,400 a year forever
d) $ 19,000 for each of 10 years
e) $ 6500 next year and increasing thereafter by 5% a year forever
If the interest rate is 12 percent, which is the most valuable prize ?
2. Kangaroo Autos is offering free credit on a new $ 10,000 car. You pay $1000 down
and then $ 300 a month for the next 30 months. Turtle Motors next door does not
offer free credit but will give you $ 1000 off the list price. If the rate of interest is 10
percent a year, which company is offering the better deal ?
3. You own an oil pipeline which will generate a $ 2 million cash return over the
coming year. The pipeline’s operating costs are negligible and it is expected to last
for a very long time. Unfortunately, the volume of oil shipped is declining, and cash
flows are expected to decline by 4 percent per year. The discount rate is 10
percent.
a) What is the present value of the pipeline’s cash flows if its cash flows are
assumed to last forever?
b) What is the present value of the cash flows if the pipeline is scrapped after
20 years ?
4. For an investment of $ 1000 today, the Tiburon Finance Company is offering to pay
you $1600 at the end of 8 years. What is the annually compounded rate of interest
? What is the continuously compounded rate of interest?
5. You have just read an advertisement reading, “Pay us $ 100 a year for 10 years
and we will pay you $ 100 a year thereafter in perpetuity”. If this is a fair deal, what
is the rate of interest?
6. Sanchez Hydraulics Company has outstanding a 14 percent coupon bond with
three years to maturity. Interest payments are made semi-annually. Assume a face
value of $ 100.
a) If the market price of the bond is $ 104, what is the yield to maturity? If it
were $ 97, what would be the yield? If it were $100 what would be the
yield?
b) If the bond’s yield were 12 percent, what would be its price? If it were 15
percent? 14 percent?
c) Instead of a coupon bond, suppose it were a zero coupon, pure discount
instrument. If the yield were 14 percent, what would be the market price ?
(Assume semiannual compounding)
7. Delphi Products Corporation currently pays a dividend of $2 per share and this
dividend is expected to grow at a 15 percent annual rate for 3 years, then at a 10
13
percent rate for the next 3 years, after which it is expected to grow at a 5 percent
rate forever.
a) What value would you place on the stock if an 18 percent rate of return
were required?
b) Would your valuation change if you expected to hold the stock only 3
years?
8. A company is considering two different makes of a machine. The projected cash

flows associated with each option are as given below. Which make (cheap or
quality machine) should the company prefer? Assume that discount rate is 15
percent.
Cash Flows for the Cheap and Quality Machines
Year Cheap Machine Quality Machine

0 - $ 12,000 - $ 22,000
1 7,000 8,000
2 7,000 8,000
3 7,000 8,000
4 - 8,000
5 - 8,000
9. A private power producer has offered the following tariff (i.e., price of electricity)
schedule for the coming 5 years:
Year 2000 2001 2002 2003 2004

Tariff
3.25 3.50 3.60 3.75 4.00
(Rs./Kwh)
Suppose you are interested to pay a constant (or flat, or levelized) price per kwh in
each year during the 5-year period under consideration. What price would you ask
for? Assume that your opportunity cost of money is 16 percent.
10. An analyst intends to value a company in terms of the future cash generating
capacity. He has projected the following after-tax cash flows:
Year 0 1 2 3 4 5 6
Cashflows 867 1,379 -6054 -1068 3,258 5,716 11,193
(Rs. million)
It is further estimated that beyond 6th year, cash flows will perpetuate at a constant
growth rate of 8% per annum.
(a) What is the value of the company in terms expected future cash flows? You
may assume a cost of capital of 15% for your calculation.
(b) The company has outstanding debt of Rs.60,000 million and cash/bank
balance of Rs.5,000 million. Calculate shareholder value per share, if the
number of outstanding shares is 850 million.
14
SOLUTION TO SELECT PROBLEMS
1. a) PV = $ 100,000
b) PV = 180,000 / 1.125 = $102,137
c) PV = 11,400 / 0.12 = $95,000
d) PV = 19,000 [Annuity factor, 12%, t = 10]

PV = 19,000 [5.650]
PV = $107,350
e) PV = 6,500 / (0.12 - 0.05) = $92,857
Prize (d) is the most valuable because it has the highest present value.
2. The fact that Kangaroo Autos is offering “free credit” tells us what the cash
payments are; it does not change the fact that money has time value. With
compounding, a 10 percent annual rate of interest is equivalent to a monthly rate
of 0.8 percent
(1 + rannual) = (1 + rmonthly)12
With rannual = 0.10 rmonthly = 0.008
The present value of the payments to Kangaroo Autos is:

$1,000 + $300 [Annuity factor, 0.8%, t= 30]
The annuity factor is given by :
$1,000 + 300 {[1/0.008] - [1/0.008 (1.008)30]} = $8973
A car from Turtle Motors costs $9000 cash. Therefore Kangaroo Autos offers the
better deal, i.e., the lower present value of cost.
3. a) This calls for the growing perpetuity formula with a negative growth rate, g = -
4% :
PV = 2 / [0.10 - (-0.04)] = 2 / 0.14 = $14.29 million.
b) The pipeline’s value at year 20 (i.e., at t = 20), assuming its cash flows
last forever, is :
PV20 = C21 / (r - g) = C1 (1+g)20 / (r - g)

With C1 = 2, g = -0.4, and r = 0.10
PV20 = 2 (1 - 0.04)20 / (0.14) = 0.884 / 0.14 = $6.314
Next, we have to convert this amount to PV today, and subtract it from the
answer to part a:
PV = 14.29 - 6.314 / (1.1)20 = $13.38
4. To find the annual rate (r), we solve the following future value equation :
15
1000 (1 + r)8 = 1600
Using trial and error, or logarithms, r = 0.0605 or 6.05%. This is equivalent to

5.87% continuously compounded (e0.0587 = 1.0605).
5. One way to approach this problem is to solve for the present value of (1) $100 a
year for 10 years and (2) $100 a year in perpetuity, with the first cash flow at year
11. If this is a fair deal, these present values must be equal, and thus we can
solve for the interest rate, r.
The present value of $100 for 10 years is :
PV = 100 {[1/r] - [1/r (1+r)10]}
The present value, as of year 10, of $100 a year forever is :
PV10 = 100 / r
At t = 0, this present value is :
PV = [1/(1+r)10] [100/r]
Equating these two expressions for present value, we have :

100 { [1/r] - [1/r (1+r)10]} = [1/(1+r)10] [100/r]
Using trial and error, we find that r = 7.18%. Notice that the interest rate is such
that your $100 payment doubles in 10 years.
6. a)
$104 = $7 /(1+r)1 + $7 /(1+r)2 + . . . + $7 /(1+r)6 +$100 /(1+r)6

r = semiannual yield = 6.18%
R = annualised yield = 6.18 x 2 = 12.36%
When, Price = $97, r = 7.64% R = 15.28%

When, Price = $100, r=7% R = 14%
b)
Price = Present value of semiannual cashflows, discounted at 6%
= $7 x 0.9434 + $7x 0.8900 + $7 x 0.8396 + $7 x 0.7921 + $7 x
0.7473 + $107 x 0.7050
= $104.92
When, Yield = 15%, Price = $ 97.65

When, Yield = 14%, Price = $100.00
c) Price = $100 / (1 + 0.07)6 = $100 x 0.6663 = $66.63
16
7. a)
END OF DIVIDEND PRESENT VALUE OF

DIVIDENDS @18%
Year 1 $ 2.00 (1.15) = $ 2.30 x 0.84746 = $ 1.95
2
Year 2 2.00 (1.15) = 2.64 x 0.71818 = 1.90
3
Year 3 2.00 (1.15) = 3.04 x 0.60863 = 1.85
Year 4 3.04 (1.10) = 3.34 x 0.51579 = 1.73
2
Year 5 3.04 (1.10) = 3.68 x 0.43711 = 1.61
3
Year 6 3.04 (1.10) = 4.05 x 0.37043 = 1.50
Total = $10.53
Year 7 dividend = $ 4.05 (1.05) = $4.25

Present value of dividends, expected to grow at 5% forever, at the end of year
6 = 4.25 / (0.18 - 0.05) = $32.69
Present value at t = 0 of the perpetual stream of dividends
= $32.69 x 0.37043 = $12.11
Market value of stock = $10.53 + $12.11 = $22.64
b) Present value of expected dividend to be received at end of year 1, 2, 3 = $1.95

+ $1.90 + $1.85 = $5.70
Expected market price of stock at the end of year 3

= $3.34 x 0.84746 + $ 3.68 x 0.71818 + $4.05 x 0.60863 +
$32.69 x 0.60863
= $2.83 + $2.64 + $2.46 + $19.90 = $27.83
Present value of expected market price (at t = 0)
= $27.83 x 0.60863
= $ 16.94
Total value = $16.94 + $5.70 = $22.64. Thus, the value is the same for an
investor with a 3-year time horizon.
17
WORKING CAPITAL MANAGEMENT
The concept of working capital is used in two ways. Gross working capital refers to the
firm’s investment in current assets. Net working capital means the difference between
current assets and current liabilities, and therefore, represents that position of current
assets, which the firm has to finance either from long-term funds and/or bank
borrowings.
A firm is required to invest in current assets for a smooth, uninterrupted production and
sale. How much a firm will invest in current assets will depend on its operating cycle.
Operating cycle is defined as the time duration, which the firm requires to manufacture
and sell the product and collect cash. (see the Exhibit). Thus operating cycle refers to
the acquisition of resources, conversion of raw materials into work-in-process into
finished goods, conversion of finished goods into sales and collection of sales. Larger
the operating cycle, larger the investment in current assets. In practice, firms are allowed
to acquire resources on credit. To that extent, firm’s need to raise working finance is
reduced. The term net operating cycle is used for the difference between operating cycle
(or gross operating cycle) and the payment deferral period (or the period for which
creditors remain outstanding).
The manufacturing cycle (that is conversion of raw material into work-in-process into
finished goods) is a component of operating cycle, and therefore, it is a major
determinant of working capital requirement. Manufacturing cycle depends on the firm’s
choice of technology and production policy. The firm’s credit policy is another factor,
which influences the working capital requirement. It depends on the nature and norms of
business, competition and the firm’s desire to use it as a marketing tool. The
requirement for working capital finance will be reduced to the extent the firm is able to
exploit the credit extended by suppliers. Depending on the possible availability of
working capital finance and its own profitability, a firm may carry more or less investment
in current assets than warranted by technical factors.
The firm’s decision about the level of investment in current assets involves a trade-off
between risk and return. When the firm invests more in current assets it reduces the risk
illiquidity but loses in terms of profitability since the opportunity of the earning from the
excess investment in current assets is lost. The firm therefore is required to strike a right
balance.
Typically, the current assets of a firm are supported by a combination of long-term and
short-term sources of financing. The following sources of finance more or less
exclusively support current assets: accruals, trade credit, and working capital advance
by commercial banks, public deposits, and inter-corporate deposits, short-term loans
from financial institutions, rights debentures for working capital, commercial paper and
factoring.
18
Exhibit : Operating or Cash - To - Cash Cycle (Illustration)
2.0
3.8 months
months
(Sales)
Debtor Creditors
s
&
Cash
Sales
Raw
Materi
Finishe l
d W–I–
2.7 months
G d P
(Consumptio
0.4 month
(Cost of 2.5 months
(Cost of
Length of Operating Cycle

= (2.7 + 2.5 + 0.4 + 2) – 3.8
= 3.8 months
19
OPERATING STATEMENT
(Rs. in lakhs)
Estimation for the year ended/ending
1 2 3 4
Last 2 years Actuals Current yr Following year
estimates projections
1 2 3 4
1. Gross Sales
i) Domestic Sales
ii) Export Sales
Total
2. Less excise duty
3. Net Sales (1 - 2)
4. Expenditure
i) Raw materials (including stores and
other items used in the process of
manufacture)
ii) Other spares
iii) Power and fuel
iv) Direct labour (Factory wages and
salaries)
v) Other manufacturing expenses
vi) Depreciation
vii) Sub-Total (i to vi)
viii) Add : Operating stocks in-process
ix) Deduct : Closing stocks-in-process
x) Cost of production
xi) Add : Opening stock of finished
goods
xii) Deduct closing stock of finished
goods
xiii) Cost of sales
5. Selling, general and admin expenses
6. Sub-Total
7. Operating profit before interest (3 - 6)
8. Interest
9. Operating profit after interest (7 - 8)
10. Add non-operating income/ sub-tract
net operating expense
11. Profit before tax/loss (9 + 10)
12. Provision for taxes
13. Net profit /loss (11 - 12)
20
WORKING CAPITAL ESTIMATION
ILLUSTRATIVE CALCULATIONS
ESTIMATION OF OPERATING CYCLE
(Rs. in million) Current Yr Projection

1. Purchase of raw materials (credit) 4,653 6,091
2. Opening stock of raw materials 523 827
3. Closing stock of raw materials 827 986
4. Raw materials consumed (1+2-3) 4,349 5,932
5. Direct labour 368 498
6. Depreciation 82 90
7. Other manufacturing expenses 553 704
8. Total cost (4+5+6+7) 5,352 7,224
9. Opening stock of WIP 185 325
10. Closing stock of WIP 325 498
11. Cost of production (8+9-10) 5,212 7,051
12. Opening stock of finished goods 317 526
13. Closing stock of finished goods 526 995
14. Cost of goods sold (11+12-13) 5,003 6,582
15. Selling, admn and general expenses 304 457
16. Cost of sales (14+15) 5,307 7,039
(Rs. in million) Current Yr Projection

Sales 6,087 8,006
Debtors 735 1,040
Creditors 454 642
Operating Cycle Calculation

(day) Current Yr Projection
69 61
2. WIP 23 26
3. Finished goods 38 55
4. Inventory conversion period (1+2+3) 130 142
5. Debtors conversion period 44 47
6. Gross operating cycle (4+5) 174 189
7. Credit purchase period 36 38
8. Net operating cycle (6-7) 138 151
9. No. of cycles in a year 2.6 2.4
21
ESTIMATION OF WORKING CAPITAL REQUIREMENT
1. Estimated level of activity:

Production of completed units 104,000
Work-in-progress 4,000
2. Unit cost (Rs./unit)
Raw materials 80
Direct wages 30
Overheads 60
Total cost 170
Selling price 200
3. Stock of raw materials one week consumption

4. Valuation of stock of WIP 50% completion stage in respect of conversion cost.
5. Finished goods stock in units 8,000
6. Credit period for debtors 8 week
7. Credit period for purchase 4 week
8. Lag in payment in wages 1.5 week
9. Required cash at bank (Rs.) 25,000
Stock of raw materials [104000/52 x 80] 160000

Work-in-progress [4000 x Rs. (80 + 30/2 + 60/2)] 500,000
Stock of finished goods [8000 x Rs. 170] 1,360,000
Sub-Total 2,020,000
Debtors [(104000 x 8/52) x Rs. 170] 2,720,000
Cas 25,000
Total current assets 4,765,000
Less:
Creditors [(104000 x 4/52) x Rs. 80] (640,000)
Liabilities on account of wages [(104000 x 1.5/52) x Rs. 30] (90,000)
Net working capital requirement 4,035,000
22
ABC Watches Ltd.
(Bank Financing of Working Capital)*
ABC Watches Ltd. currently enjoys fund based facilities to the tune of $ 6.8 million from
its consortium of banks. The company has put up a proposal to enhance the funding limit
to $ 9.4 million for the financial year 1998-99. In what follows is presented the
assessment by one member bank of consortium of what funding facilities will be
provided to the company. The summary of credit risk analysis done by same member
bank of consortium is given in the Appendix.
Bank Financing
For the year ending March 1999, ABC has projected sales and net profit as follows:
Net Sales $ 34.91 million (FY 98: $ 28.46 million)
Net Profit $ 2.79 million (FY 98: $ 1.83 million)
The increase in sales represents an increase of 22.66% as against a 41% increase in
FY 98 and an increase of 53% in FY 97. Given the strengths of the brand name, selling
and distribution network, past performance and the potential of the market, this is
considered to be distinctly achievable.
Based on the above projections and the data submitted by the company, the company’s
Maximum Permissible Bank Finance for FY99 is determined as given under:
$ million
1. Total Current Assets 17.2
2. Total Current Liabilities 2.9
(Other than Bank Borrowings)
3. Working Capital Gap 14.3
4. Minimum Stipulated Net Working Capital 3.6
(25% of Working Capital Gap)
5. Actual/Projected Net Working Capital 4.9
6. Item 3-4 10.7
7. Item 3-5 9.4
8. Maximum Permissible Bank Finance 9.4
(Lower of Items 6&7)
The requirement of current assets has been worked out on the basis of the following:
Current Assets Calculation Basis Actual FY 98

• Raw Materials (Imported) 3.31 months consumption 3.47 months consumption
• Raw Materials (Indigenous) 3.10 months consumption 2.90 months consumption
• Consumable Spares 9.44 months consumption 12.64 months consumption
• Stocks in process 0.83 months cost of 0.65 months cost of production
production
• Finished Goods 3.03 months cost of sales 3.24 months cost of sales
• Debtors 35 days sales 51 days sales
*
Prepared by Dr S K Chaudhuri for Class room discussion.
23
While inventory levels as on FY97 had increased substantially to 5 months, they were
down to about 3.5 months in FY98 and although the company has forecast marginal
improvement in inventory levels, the figure is expected to remain in the high range on
account of vendor locations, transit time, customs clearance and other factors.
Receivable days are forecast to be down to the 35 day range (FY98 / 51 days) as was
the trend till FY97. This is expected to be achievable as the present high level is on
account of a temporary “credit period” scheme that ABC has introduced for certain
dealers. High finished goods inventories are required in view of the number of styles
manufactured, the number of stock points where the stocks are based and the
geographical distance which is covered by the sales network. However, ABC’s
concentration on inventory management and control has led to a steady decline in
holding levels from 4.56 months in FY97 to 3.24 months in FY 98, and projected at 3.03
months in the current year. This is considered to be achievable in line with the
improvements made thus far.
The Lead Bank of the consortium is also in the process of analysing the data and the
same will be discussed in the consortium meeting, expected to be held very soon.
Notes:
1. The lending method used in calculating MPBF is the first method of lending.
2. Banks are no longer bound to follow any of the methods of lending prescribed by
earlier RBI.
24
Appendix: Credit Risk Analysis
ABC’s financials have been audited by A F Fergusson and Co. who has raised no
qualifications to the report.
Profit & Loss Account FY 97 FY 98

($ million) (Actuals) (Actuals)
Net Sales 20.13 28.46
Depreciation 0.80 0.90
Operating profit before interest 1.73 3.16
Interest Expense 1.85 2.42
Operating profit after interest (0.12) 0.74
Net Profit 0.82 1.83
Sales
For FY98, ABC achieved net sales of $ 28.46 million (2.03 million watches sold) as
compared to sales in FY97 of $ 20.13 million (1.58 million watches sold). This growth of
41.40% was higher than the projected figure of $ 26.86 million. As a consequence of
this, ABC has increased its market share in the organised quartz analog market segment
to approximately 25%. The hold over the market has been achieved as a result
of a clever marketing strategy in terms of pricing of products. With Titan gradually
phasing out of the sub-$ 60 range and ABC concentrating its models in that range, any
possible price overlap has been eliminated, while the companies have established a
presence in all the existing price segments of the organised market. Further, new ranges
such as the Digital range and the high end Vista/Indlo ranges of watches had been
added to sales and increased per unit realisations from $ 12.73 to $ 14.02. In addition,
strategic tie-ups with large corporate houses during the festive seasons facilitated bulk
sales.
Profitability
Fuelled by the overall increase in sales for FY98, the company made an operating profit
before interest of $ 3.16 million (PY $ 1.73 million). Although, Gross margin was virtually
unchanged at 46.90% (PY 46.91%), control over Selling, General and Administrative
expenses led to an increase in Operating Profit Margin to 11.12% (PY 8.58%). Interest
Expense increased as a result of higher interest rates but the performance of the
company was sufficient to offset these temporary phenomena as reflected in an increase
in net profit to $ 1.83 million (PY $ 0.82 million). Net Marging increased to 6.42% (PY
4.06%).
The performance was also a reflection of the ongoing benefits enjoyed by the industry in
terms of reduction in import duties, whereby there was
- a reduction in movement part duties from 70% to 25%;

- in cases/straps/dials & hands from 85% to 50%;
- certain raw materials from 50% to 25%;
- reduction in duties on certain specified capital goods imports from 35% to
35%.
25
Further reduction is expected by the industry in the ensuing budget as a part of GOI’s
ongoing drive to assist the industry in phasing out the ‘grey’ market.
Leverage / Cash Flow
Despite the increase in Net Worth, leverage has increased marginally to 1.86 (PY 1.80)
due to an increase in short term debt. The figure, however, remains at acceptable levels
due to the company’s adequate Net Worth of $ 12.68 million (PY $ 10.86 million).
The overall increase in sales and control of inventory levels was instrumental in
generating Gross Cash profits of $ 12.94 million (PY $7.96 million) which were adequate
to absorb the cash operating expenses of $ 9.23 million (PY $ 6.94 million). This
resulted in cash after operations of $ 3.72 million (PY $ 1.05 million).
Positive contribution of miscellaneous cash income of $ 0.64 million helped in absorbing

the interest expense of $ 2.37 million (PY $ 1.77 million) resulting in Net Cash Income of
$ 1.98 million (PY $ 0.31 million).
This was, however, not enough to absorb the additional capital expenditure of $ 2.90
million and other long term investments (comprising deposits with customs /excise /
landlords, etc.) of $ 1.19 million resulting in a financial requirement of $ 2.11 million (PY
$ 0.64 million) which was supplemented by increase in short term debt.
Balance Sheet FY 96 FY 97 FY 98
Current Ratio 3.07 1.96 1.48
Leverage 1.58 1.80 1.86
Days Receivables 27 30 51
Days Payable 97 69 111
Days Inventory 408 297 225
Net Worth ($ million) $ 10.04 11.27 12.68
The current ratio has reduced from a high of 3.07 in FY 96 to the present 1.48 (FY 98).
The ratio is now well within acceptable norms. Marketable securities increased from $
2.31 million (PY) to $ 2.72 million (this comprises mainly $ 0.45 million worth equity
shares and triple option convertible debentured of Reliance Petrochemicals Ltd. (PY $
0.36 million) and $1.89 million worth units of the Unit Trust of India (PY $ 1.55 million).
Receivables at 51 days have shown a considerable increase over the last year (30 days)
and are a reflection of a credit scheme that ABC has introduced for select dealers
whereby 30-45 days credit period is being offered to them.
Payable days have also increased significantly to 111 days from 69 days (FY 97). ABC
enjoys a 60-90 days interest free credit period from parent company. While the tenor of
this interest free period used to be maximum of 60 days till last year, there has been a
greater degree of credit from the parent company as the size of the business has grown
and the increase in payables is testimony of the same.
Days Inventory which was an area of concern in FY 96 (408 days) and had improved to
297 days in FY 97 has improved further to 225 days. Indigenisation of certain
components has played a significant role in the improvement. Additionally, ABC has
26
strategic tie-ups with certain corporate houses during festive seasons and has been able
to plan production schedules accordingly. The consolidation of the brand name has also
resulted in consistent sales of certain models leading to lower inventory levels.
The inventory figure, though reducing, is still high on account of :

- The wide range of models which are being assembled.
- Large number of retail outlets to stock finished products. ABC has to keep
ready stock of all finished models at all the outlets as it is difficult to
estimate demand of all the outlets.
Projections
An analysis of the company’s projected performance for FY 99 vis-a-vis that of the
previous year is as follows:
$ (million) FY ‘98 FY ‘99

Actuals Projections
Net Sales 28.46 34.91
Depreciation 0.90 1.26
NPAT 1.83 2.79
Current Ratio 1.48 1.41
Leverage 1.86 1.52
Net worth 12.68 15.48
The company has projected an increase in sales of 23%. Given its performance in the
previous year (sales up 41%), and the position that ABC enjoys in the market, this figure
appears achievable. The position of strength has coupled with control over General and
Admin. Expenses and phased indigenisation been responsible for improvements in
margins. Additionally, the increase in sales have led to benefits in terms economies of
scale which have manifested themselves in terms of better operating margins. With the
company improving its liquidity position, the company has been in a position to switch its
dependence of sources from long term to short term finances. ABC’s future appears
bright in view of the backing of strong promoters, state of the art technology, excellent
selling and distribution network, a wide product range well accepted in the market place
and above all a healthy net worth.
27
Jupiter Export House§
Jupitar Export House (JEH), a partnership firm, was formed in June 1997 for
manufacturing readymade garments. The firm did not do any business until October
2004 when it started negotiations with overseas buyers for regular export business. Over
a short span of time, JEH could export garment to different countries namely Spain,
England, Denmark, Norway, Canada, and USA.
The partners did not have any past experience in manufacturing or export of readymade
garments. They established manufacturing facilities first using their own capital and
thereafter taking a term loan (Rs.0.30 crores to be repaid in 36 monthly instalments
starting from January 2006) from its bank. JEH approached bank for term loan only after
getting good response from overseas buyers. The firm appointed
professional/experienced personnel to run the business and meet commitments to the
customers.
JEH achieved export sales of Rs.0.30 crores during 2004-05 against the target of
Rs.0.75 crores on account of delay in start of manufacturing of garments (Table 1).
During the current year (2005-06), the firm already achieved sales of Rs.2.29 crores up
to October 2005 and it had confirmed orders of more than Rs.2.30 crores to be executed
in the next three months. The sales for the entire current year were estimated to be
Rs.6.00 crores and that for 2006-07 projected at Rs.10.00 crores. In terms of profit
margin (PBT-to-sales ratio), JEH earned 2.50 percent in 2004-05. The margin was
estimated to remain around the same level during 2005-06 but projected to increase
along with business volumes to 3.13 percent over the next year, 2006-07.
In the past, the export of readymade garments from India had shown a consistent
growth. Besides, with the end of the Agreement on Textiles and Clothing since 1st
January 2005, which facilitated the existence of quotas on apparel and textile imports in
the EU, US and Canada, the prospect for increased business volumes would go up for
all garment exporters in India. According to the National Textiles Policy 2000, the
garment export would be 50 billion US dollars by the year 2010.
In view of the growing business prospect, JEH had just submitted an application with its
banker for extension of fund based working capital limit from Rs.1.00 crores to Rs.1.75
crores for the FY 2006-07 along with renewal of non-fund based limit (bank guarantee of
Rs.0.05 crores). The firm also furnished necessary details including projected working
capital position of the firm (Table 2). Incidentally, the main partner of JEH had been an
old and valuable customer of the bank.
Questions for discussion
1. How would bank assess the permissible bank finance?
2. As a credit appraiser, would you recommend enhancement of credit limit?
§
Prepared by Dr. S K Chaudhuri (Professor, IMI, New Delhi) for class-room discussion.
28
Table 1: Financial Performance
(Rs. Crores)
Particulars 2004-05 2005-06 2006-07
(Audited) (Estimated) (Projected)
0.39 6.00 10.00
Export sales
(1.75)
Other income 0.01 0.36 0.55
0.01 0.16 0.33
Profit before tax
(0.04)
2.50 2.52 3.13
PBT/sales (%)
(5.00)
0.01 0.11 0.23
Profit after tax
(0.03)
0.04 0.22 0.32
Cash accruals
(0.10)
0.71 0.90 1.19
Tangible net worth
(0.58)
0.55 1.71 2.07
Total outside lib/TNW
(1.85)
2.21 1.53 1.35
Current ratio
(1.33)
(Figures in brackets are estimates given at the time of last sanction)
Table 2: Working Capital Position

(Rs. Crores)
Particulars 2004-05 2005-06 2006-07
(Audited) (Estimated) (Projected)
Raw Materials 0.13 0.45 0.75
(1.86) (1.00) (1.03)
Stock in Progress 0.06 0.25 0.43
(0.51) (0.49) (0.52)
Finished Goods 0.07 0.26 0.45
(0.75) (0.53) (0.55)
Receivables 0.35 0.55 0.80
(2.69) (1.10) (0.96)
Other Current Assets 0.25 0.47 0.71
Total Current Assets 0.86 1.98 3.14
Creditors 0.02 0.20 0.40
(0.18) (0.42) (0.53)
(Figures in brackets represent months holding levels)
29
Jupiter Export House (Case Analysis) *
1. SWOT Analysis
Strengths
− Long business experience of the promoter
− Confirmed order received from buying houses with samples for further business
already approved
− Incentives by the Govt. for exports like Duty Drawback, DEPG licence accrues to
the firm
Weaknesses
− The firm does not have any past background in manufacturing/export of
Readymade Garments. However, they have employed professional staff for
meeting the commitments to the customers. Besides employing trained staff, the
firm has already negotiated with buying houses for orders after getting the
samples approved.
Opportunities
− Entry of MNC’s as a result of increased globalisation, coupled with production
facilities in India also offer a good opportunity.
− Readymade Garments and Textiles industry is very growth oriented and is a
constantly expanding sector.
Threat
− Any adverse change in exchange fluctuation can adversely affect profitability of
the firm.
2. Assessed Bank Finance

Raw Materials : The present holding level of raw material at 1.83 months are very high
as on March, 2005 and the same has been assessed at present holding level of 1.00
month which is enough to take care of the working cycle of the firm since all the raw
materials are easily available.
Stock in Process / Finished Goods: The SIP/FG level has been estimated at present
sanction norm of 0.50 month keeping in view the process time and delivery schedule of
each export order.
Receivables: Keeping in view the time taken for shipment of goods, custom formalities
and time taken in discounting a bill, a reasonable level of 0.90 – 1.00 month has been
considered as level of receivables. The higher level is projected in view of bunching of
orders and relative small period of execution of order.
Sundry Creditors: The level of Sundry Creditors has been assessed at a level of 0.40 –
0.50 months since no supplier would be extending credit on easy terms.
*
Prepared by Dr. S K Chaudhuri (Professor, IMI, New Delhi) for class-room discussion.
30
(Rs. Crores)
Particulars 2004-05 2005-06 2006-07
Total current assets (TCA) 0.86 1.98 3.14
Other current liabilities (OCL) 0.04 0.29 0.57
Working capital gap 0.82 1.69 2.57
Net working capital 0.47 0.69 0.82
Assessed bank finance 0.35 1.00 1.75
NWC to TCA (%) 54.65 34.85 26.11
Bank finance to TCA (%) 40.70 50.51 55.73
OCL to TCA (%) 2.33 4.55 5.41
Sundry creditors to TCA (%) 2.33 4.55 5.41
Inventories to net sales (days) 59 55 56
Receivables to gross sales (days) 79 32 28
Sundry creditors to purchase (days) 9 14 17
Current Ratio 2.21 1.53 3.14
Permissible Bank Finance Based on Nayak Committee Recommendations
(Rs. Crores)
2005-06 2006-07
a) Sales projections 6.00 10.00
b) WC requirements (25% of sales) 1.50 2.50
c) Borrower’s margin (5% of sales) 0.30 0.50
d) Permissible bank finance 1.20 2.00
e) Limit requested for 1.00 1.75
Limits of Rs.1.00 crore and Rs.1.75 crores have been requested for by JEH for 2005-06
and 2006-07, which are in with the ABF method.
Keeping in view the peak level requirement of funds at any time with bunching of orders,
a stand by line of credit of Rs.0.26 crores has been recommended by the bank.
3. Rating and Interest Rate
Based on the existing guidelines for credit risk assessment, JEH is awarded rating CRA-
2 (as on 31/3/2005). Interest will be charged taking into account CRA as well as RBI
stipulated rates for export financing.
31
MONEY MARKET INSTRUMENTS∗
Treasury Bills (T-bills)
T-Bills are short term (upto one year) borrowing instruments of the Government of India.
T-Bills are auctioned by Reserve Bank of India at regular intervals. They are issued at a
discount to face value and on maturity the face value is paid to the holder. The rate of
discount and the corresponding issue price is determined at each auction. Presently,
RBI issues T-Bills for four different maturities: 14 days, 91 days, 182 days and 364 days.
Since April 1, all Treasury Bills are issued with notified amounts fixed by RBI. Non-
competitive bids are kept outside the notified amounts.
Investors with short term surpluses can buy these bills. Since these are the liabilities of
GOI, they are zero risk short-term investments at market yields for a period of their
choice. Further, two-way quotes are available in secondary market to enable anyone to
invest and exit from such investment.
The salient features of the auctioned T-Bills are:
1. The 14/91/182/364-days bills are issued for a minimum value of Rs.25,000 and
multiples thereof.
2. They are issued at a discount to face value.
3. Any person in India including individuals, firms, companies, corporate bodies,
trusts ad institutions can purchase the bills.
4. Te bills are eligible securities for SLR purposes.
5. All bids above a cut-off price are accepted and bidders are permitted to place
multiple bids quoting different prices at each auction. Till November 6, 1998, all
types of T-Bills auctions were conducted by means of ‘Multiple Price Auction’.
However, since November 6, 1998, auction of 91-days T-Bills are being
conducted by means of ‘Uniform Price Auction’. In the case of ‘Multiple Price
Auction’, method successful bidders pay their own bid prices, whereas under
‘Uniform Price Auction’ method, all successful bidders pay uniform price, i.e. the
ct-off price emerged in the auction.
6. The bills are generally issued in the form of SGL - entries in the books of
Reserve Bank of India. The SGL holdings can be transferred by issuing a SGL
transfer form. For non-SGL account holders, RBI has been issuing the bills in
scrip form.
Dated Government Securities
Governments (both central and the states) raise resources through issue of market loans
regularly. As these are the liabilities of Government of India and the State Governments
and because the repayment is made by RBI, investment in these securities is
considered safe and risk free. These securities are eligible as SLR investments. Since
the date of maturity is specified in the securities, these are known as dated Government
securities. The dated Government securities market in India has two segments: (1)
Primary Market and (2) Secondary Market. The Primary Market consists of the issuers of
the securities, viz., Central and Sate Government. The secondary market includes
commercial banks, financial institutions, insurance companies, Provident Funds, Trusts,
individuals, Primary Dealers and Reserve Bank of India. Investment in government
∗
Source: Website (www.sbidfhi.com) of SBI DFHI Ltd.
32
securities is open to all types of investors including individuals and there is a very active
secondary market.
During last few years, Government of India has issued new instruments such as Zero
Coupon Bonds, Floating Rates Bonds, Partly-paid Stocks, Capital Index Bonds, Tap
Stock, etc. The procedure for transactions in Dated Government Securities with DFHI
has been outlined in Annexure I.
Ready Forward Contracts (Repos)
Ready forward or Repos or Buyback deal is a transaction in which two parties agree to
sell and repurchase the same security. Under such an arrangement, the seller sells
specified securities with an agreement to repurchase the same at a mutually decided
future date and a price. Similarly, the buyer purchases the securities with an agreement
to resell the same to the seller on an agreed date in future at a prefixed price. For the
purchaser of the security, it becomes a Reverse Repo deal. In simple terms, it is
recognized as a buy back arrangement. In a standard ready forward transaction when a
bank sells its securities to a buyer it simultaneously enters into a contract with him (the
buyer) to repurchase them on a predetermined date and price in the future. Both sale
and repurchase prices of securities are determined prior to entering into the deal. In
return for the securities, the bank receives cash from the buyer of the securities. As the
inflow of cash from the ready forward transaction is used to meet temporary cash
requirement, such a transaction in essence is a short term cash management technique.
The motivation for the banks and other organizations to enter into a ready forward
transaction is that it can finance the purchase of securities or otherwise fund its
requirements at relatively competitive rates. On account of this reason the ready forward
transaction is purely a money lending operation. Under ready forward deal the seller of
the security is the borrower and the buyer is the lender of funds. Such a transaction
offers benefits both to the seller and the buyer. Seller gets the funds at a specified
interest rate and thus hedges himself against volatile rates without parting with his
security permanently (thereby avoiding any distressed sale) and the buyer gets the
security to meet his SLR requirements. In addition to pure funding reasons, the ready
forward transactions are often also resorted to manage short term SLR mismatches.
Internationally, Repos are versatile instruments and used extensively in money market
operations. While inter-bank Repos were being allowed prior to 1992 subject to certain
regulations, there were large scale violation of laid down guidelines leading to the
‘securities scam’ in 1992; this led Government and RBI to clamp down severe
restrictions on the usage of this facility by the different market participants. With the
plugging of loophole in the operation, the conditions have been relaxed gradually.
Apart from inter-bank repos, RBI has been using this instrument effectively for its
liquidity management, both for absorbing liquidity and also for injecting funds into the
system. Thus, Repos and Reverse Repo are resorted to by the RBI as a tool of liquidity
control in the system. With a view to absorbing surplus liquidity from the system in a
flexible way and to prevent interest rate arbitraging, RBI introduced a system of daily
fixed rate repos from November 29, 1997.
Reserve Bank of India was earlier providing liquidity support to PDs through the reverse
repo route. This procedure was also subsequently dispensed with and Reserve Bank of
India began giving liquidity support to PDs through their holdings in SGL A/C. The
liquidity support is presently given to the Primary Dealers for a fixed quantum and at the
Bank Rate based on their bidding commitment and also on their past performance. For
any additional liquidity requirements Primary Dealers are allowed to participate in the
reverse repo auction under the Liquidity Adjustment Facility along with Banks,
introduced by RBI in June 2000(Details given below).
33
The major players in the repo and reverse repurchase market tend to be banks that have
substantially huge portfolios of government securities. Besides these players, primary
dealers who often hold large inventories of tradable government securities are also
active players in the repo and reverse repo market.
Scheme of Liquidity Adjustment Facility
Pursuant to the recommendations of the Narasimham Committee Report on Banking

Reforms (Narasimham Committee II), it was decided in principle, to introduce a Liquidity
Adjustment Facility (LAF) operated through repo and reverse repo since 5th June 2000.
Under this scheme, (i) Repo auctions (for absorption of liquidity) and (ii) reverse repo
auctions (for injection of liquidity) will be conducted on a daily basis (except Saturdays).
But for the intervening holidays and Fridays, the repo tenor will be one day. On Friday,
the auctions will be held for three days maturity to cover the following Saturday and
Sunday. With the introduction of the Scheme, the existing Fixed Rate Repo has been
discontinued. The liquidity support extended to all scheduled commercial banks
(excluding RRBs) and Primary Dealers through Additional Collateralized Lending Facility
(ACLF) and refinance/reverse repos under Level II, have also been withdrawn. Export
Refinance and Collateralized Lending Facility (CLF) at Bank Rate will continue as per
the existing procedures. Like-wise, Primary Dealers will continue to avail of liquidity
support at level I at Bank Rate. The funds from the Facility are expected to be used by
the banks/pds for their day-to-day mismatches in liquidity.
Interest rates in respect of both repos and reverse repos will be decided through cut off
rates emerging from auctions on "uniform price" basis conducted by the Reserve Bank
of India, at Mumbai.
Certificate of Deposit
Certificates of Deposit (CDs) - introduced since June 1989 - are negotiable term deposit
certificates issued by a commercial banks/Financial Institutions at discount to face value
at market rates, with maturity ranging from 15 days to one year.
Being securities in the form of promissory notes, transfer of title is easy, by endorsement
and delivery. Further, they are governed by the Negotiable Instruments Act. As these
certificates are the liabilities of commercial banks/financial institutions, they make sound
investments. The market for these instruments is not very deep, but quite often CDs are
available in the secondary market.
The procedure for dealing with DFHI has been outlined in Annexure I. Important features
of CDs are given in Annexure III
Salient features of CDs are as given under:
1. CDs can be issued to individuals, corporations, companies, trusts, funds,
associates, etc.
2. NRIs can subscribe to CDs on non-repatriable basis.
3. CDs attract stamp duty as applicable to negotiable instruments.
4. Banks have to maintain SLR and CRR on the issue price of CDs. No ceiling on
the amount to be issued.
5. The minimum issue size of CDs is Rs.5 lakhs and multiples thereof.
6. CDs are transferable by endorsement and delivery.
The minimum lock-in-period for CDs is 15 days
34
Commercial Paper
The introduction of Commercial Paper (CP) in January 1990 as an additional money

market instrument was the first step towards securitisation of commercial bank’s
advances into marketable instruments. The purpose of introduction of CP was to release
the pressure on bank funds for small and medium sized borrowers and at the same time
allowing highly rated companies to borrow directly from the market.
Commercial Papers are unsecured debts of the companies. They are issued in the form
of promissory notes, redeemable at par to the holder at maturity. The market is generally
segmented into the PSU CPs, i.e. those issued by public sector unit and the private
sector CPs. Commercial papers issued by top rated companies are considered as sound
investments. As in the case of CDs, the secondary market in CP has not developed to a
large extent.
Salient features of CPs are:
1. CPs are issued by companies in the form of usance promissory note,
redeemable at par to the holder on maturity.
2. The tangible net worth of the issuing company should be not less than Rs.4
crores.
3. Working capital (fund based) limit of the company should not be less than Rs.4
crores.
4. Credit rating should be at least equivalent of P2 or higher from any approved
rating agencies and should not be more than 2 months old on the date of issue of
CP.
5. Companies are allowed to issue CP up to 100% of their fund based working
capital limits.
6. It is issued at a discount to face value.
7. CP attracts stamp duty.
8. CP can be issued for maturities between 15 days and less than one year from
the date of issue.
• CP may be issued in the multiples of Rs.5 lakh.
• No prior approval of RBI is needed to issue CP and underwriting the issue is not
mandatory.
• All expenses (such as dealers’ fees, rating agency fee and charges for provision
of stand-by facilities) for issue of CP are to be borne by the issuing company,
Call/Notice Money
Call/Notice money is the money borrowed or lent on demand for a very short period.
When money is borrowed or lent for a day, it is known as Call (Overnight) Money.
Intervening holidays and/or Sunday are excluded for this purpose. Thus money,
borrowed on a day and repaid on the next working day, (irrespective of the number of
intervening holidays) is "Call Money". When money is borrowed or lent for more than a
day and up to 14 days, it is "Notice Money". No collateral security is required to cover
these transactions.
The entry into this field is restricted by RBI. Commercial Banks, Co-operative Banks and
Primary Dealers are allowed to borrow and lend in this market. Specified All-India
Financial Institutions, Mutual Funds, and certain specified entities are allowed to access
to Call/Notice money market only as lenders. Reserve Bank of India has recently taken
35
steps to make the call/notice money market completely inter-bank market. Hence the
non-bank entities will not be allowed access to this market beyond December 31, 2000.
From May 1, 1989, the interest rates in the call and the notice money market are market
determined. Interest rates in this market are highly sensitive to the demand - supply
factors. Within one fortnight, rates are known to have moved from a low of 1 - 2 per cent
to dizzy heights of over 140 per cent per annum. Large intra-day variations are also not
uncommon. Hence there is a high degree of interest rate risk for participants. In view of
the short tenure of such transactions, both the borrowers and the lenders are required to
have current accounts with the Reserve Bank of India. This will facilitate quick and timely
debit and credit operations. The call market enables the banks and institutions to even
out their day to day deficits and surpluses of money. Banks especially access the call
market to borrow/lend money for adjusting their cash reserve requirements (CRR). The
lenders having steady inflow
Commercial Bills
Bills of exchange are negotiable instruments drawn by the seller (drawer) on the buyer
(drawee) for the value of the goods delivered to him. Such bills are called trade bills.
When trade bills are accepted by commercial banks, they are called commercial bills. If
the seller wishes to give some period for payment, the bill would be payable at a future
date (usance bill). During the currency of the bill, if the seller is in need of funds, he may
approach his bank for discounting the bill. One of the methods of providing credit to
customers by bank is by discounting commercial bills at a prescribed discount rate. The
bank will receive the maturity proceeds (face value) of discounted bill from the drawee.
In the meanwhile, if the bank is in need of funds, it can rediscount the bill already
discounted by it in the commercial bill rediscount market at the market related rediscount
rate. (The RBI introduced the Bill Market Scheme in 1952 and a new scheme called the
Bill Rediscounting Scheme in November 1970).
With a view to eliminating movement of papers and facilitating multiple rediscounting, the
RBI introduced an innovative instrument known as "Derivative Usance Promissory
Notes" backed by such eligible commercial bills for required amounts and usance period
(upto 90 days). Government has exempted stamp duty on derivative usance promissory
notes. This has indeed simplified and streamlined the bill rediscounting by Institutions
and made commercial bill an active instrument in the secondary money market.
Rediscounting institutions have also advantages in that the derivative usance promissory
note, being a negotiable instrument issued by a bank, is good security for investment. It
is transferable by endorsement and delivery and hence is liquid. Thanks to the existence
of a secondary market the rediscounting institution can further discount the bills anytime
it wishes prior to the date of maturity. In the bill rediscounting market, it is possible to
acquire bills having balance maturity period of different days up to 90 days. Bills thus
provide a smooth glide from call/overnight lending to short term lending with security,
liquidity and competitive return on investment. As some banks were using the facility of
rediscounting commercial bills and derivative usance promissory notes for as short a
period as one day merely a substitute for call money, RBI has since restricted such
rediscounting for a minimum period of 15 days.
The eligibility criteria prescribed by the Reserve Bank of India for rediscounting
commercial bill inte alia are that the bill should arise out of genuine commercial
transaction evidencing sale of goods and the maturity date of the bill should not be more
than 90 days from the date of rediscounting.
36
CASE STUDY: JOY CHEMICALS (P) LTD.*
The company being incorporated in early 1990, propose to manufacture “paracetamol” –

a basic drug (analygesic and antipyretic), used for manufacturing of tablets, capsules,
syrup, etc. The product is also used by pharmaceutical formulation manufacturers. There
is sufficient demand for the product, and the company intends to sell the product directly
to the pharmaceutical units as well as through the wholesale chemists/druggists.
Technical know-how for the manufacture of paracetamol is well established. The
detailed know-how to the promoters will be provided by an experienced consultant. Plant
and machinery and raw-material are indigenously available. The installed capacity of the
units is estimated to be 180 MT per annum.
The estimated cost of the project is Rs.63.59 lacs, and the promoters have approached
the SFC for a term loan of Rs.45.60 lacs. The promoters themselves will bring in
Rs.17.99 lacs by way of share capital.
The further details of the project are summarized in Table 1.

Table 1: Cost of Project & Means of Finance
(Rs. in lacs)
Cost of Project:
Land 1.15
Building 7.51
Plant & Machinery 31.54
Misc. Fixed Assets 11.63
Furniture and Fixtures 0.30
Preliminary and Pre-Operative Exp. 3.70
Contingencies 1.90
Margin Money for Working Capital 5.86
Total 63.59
Means of Finance
Share Capital 17.99
SFC Loan 45.60
Total 63.59
Note to Table 1:
1. Contingencies have been considered @5% on the estimated cost of building
construction.
2. The plant and machinery cost is estimated at Rs.30.33 lacs. Provision for taxes,
transportation, etc. and contingencies have been provided @4% and @5% of the cost
respectively.
3. Preliminary and Pre-operative expenses include Rs.1.50 lacs being the interest paid
during construction.
4. SFC loan is repayable in 7 years with a moratorium period of one year.
*
Prepared by Dr. S K Chaudhuri for classroom discussion.
37
Table 2: Cost of Production and Profitability Statement
(Rs. in lacs)
1 2 3 4 5 6 7 8
A. Installed 180 180 180 180 180 180 180 180
Capacity (MT)
B. Capacity 60 65 70 70 70 70 70 70
Utilization (%)
C. Cost of
Production:
1. Raw 115.4 125.06 134.68 134.68 134.68 134.68 134.68 134.68
Material
2. 1.08 1.17 1.26 1.26 1.26 1.26 1.26 1.26
Packing
Expenses
3. 0.50 0.54 0.58 0.58 0.58 0.58 0.58 0.58
Consuma
bles
4. Repair 1.59 1.67 1.75 1.83 1.92 2.02 2.12 2.23
&
Maintena
nce
5. Utilities 13.15 14.25 15.34 15.34 15.34 15.34 15.34 15.34
(Power,
Fuel, etc.)
6. Salary 4.09 4.29 4.50 4.73 4.97 5.22 5.48 5.75
& Wages
7. 1.09 1.14 1.20 1.26 1.32 1.39 1.46 1.53
Administr
ative Exp
8. 5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.67
Depreciat
ion
9. 5.70 5.29 4.48 3.66 2.85 2.04 1.22 0.41
Interest:
SFC
2.81 3.05 3.28 3.28 3.28 3.28 3.28 3.28
Bank
10. 3.20 3.46 3.73 3.73 3.73 3.73 3.73 3.73
Selling
Expenses
Total 154.32 165.59 176.47 176.02 175.60 175.21 174.82 174.46
Cost
D. Sales 159.84 173.16 186.48 186.48 186.48 186.48 186.48 186.48
E. Profit 5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02
Before Tax
F. Taxation - - 2.22 3.81 4.48 4.97 5.41 5.63
G. Profit After 5.52 7.57 7.79 6.65 6.40 6.30 6.25 6.39
Tax
H. Net Cash 11.19 13.24 13.46 12.32 12.07 11.97 11.92 12.06
Accruals
38
Notes to Table-2:
1. Raw material comprises of para chloronitro benzene, caustic soda; sulphuric acid; iron
powder; acetic anhydride; activated carbon; hydro; and hyflox.
2. Packing expenses @Rs.1 per kg.
3. Repairs and maintenance has been estimated @3% of building, plant and machinery,
and misc. fixed assets; the cost is assumed to increase by 5% each year.
4. Salaries and wages and administrative expenses are assumed to increase by 5% every
year.
5. Depreciation has been provided on a straight line basis (SLM) and at the following rates
buildings – 3.9%; plant and machinery – 12%, and misc. fixed assets – 12%.
6. Interest has been calculated @12.5% on SFC loan and @16.5% on bank borrowings for
working capital.
7. Selling expenses and commission are assumed @2% of sales revenue.
8. Sales realization has been estimated @Rs.1,48,000 per MT
Table 3: Working Capital Requirement

(Rs. in lacs)
articulars Period Margin Amount Bank Loan
(Norm)
Raw Material 1 Month 25% 9.62 7.21
Work-in-Process 1 Week 25% 2.50 1.88
Finished Goods 1 Week 25% 2.63 1.97
Receivables ½ Month 10% 6.66 5.99
Working Expenses 1 Month 100% 1.50
st
1 Year 22.91 17.05
nd
2 Year 24.82 18.47
rd
3 Year 26.73 19.89
Notes to Table 3:
1. Work-in-process cost includes: raw material; packing expenses; consumables; repairs

and maintenance; and utilities and fuel.
2. Finished goods are valued in term of the cost elements mentioned (1) above plus:
salaries and wages; and administrative expenses.
3. Receivables are estimated in terms of half-a-month sales
4. Working expenses include: utilities; salary and wages; and administrative expenses.
39
Table 4: Cash Flow Statement
(Rs. in lacs)
Const. 1 2 3 4 5 6 7 8
Period
A. Sources of Funds
1. Profit before tax - 5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02
but after dep.
2. Depreciation - 5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.67
3. Increase in 17.99 - - - - - - - -
share capital
4. Increase in 45.6 - - - - - - -
Term Loan
5. Increase in - 17.05 1.42 1.42 - - - - -
Bank borrowing
Total – A 63.59 28.24 14.66 17.10 16.13 16.55 16.94 17.33 17.69
B. Application of Funds:
1. Increase in 54.03 - - - - - - - -
Fixed Assets
2. Preliminary & 3.70 - - - - - - - -
Pre-operative Exp.
3. Repayment of - - 6.51 6.51 6.51 6.51 6.51 6.51 6.51
Term Loan
4. Increase in - 22.91 1.91 1.91 - - - - -
Current Assets
5. Taxation - - - 2.22 3.81 4.48 4.97 5.41 5.63
6. Dividend - - - 1.80 1.80 1.80 1.80 1.80 1.80
Total – B 57.53 22.91 8.42 12.44 12.12 12.79 13.28 13.72 13.97
C. Surplus/ (Deficit) (A- 5.86 5.33 6.24 4.66 4.01 3.76 3.66 3.61 3.72
B)
D. Opening Cash - 5.86 11.19 17.43 22.09 26.10 29.86 33.52 37.13
Balance
E. Closing Cash 5.86 11.19 17.43 22.09 26.10 29.86 33.52 37.18 40.85
Balance
40
JOY CHEMICALS (P) LTD.
BREAK-EVEN SALES (1ST YEAR)

(Amount in Rs. Lacs)
A. Variable Cost B. Semi Variable & Fixed Cost
Material 115.44 Repairs and Maintenance 1.59
Packing Exp. 1.08 Salary & Wages 4.09
Consumables 0.50 Administrative Exp. 1.09
Utilities 13.15 Depreciation 5.67
Interest on Working Capital 2.81 Interest on Term Loan 5.70
Selling Exp. 3.20
Total-A 136.18 Total-B 18.14
Contribution Margin
= Sales – Variable Cost
= 159.84 – 136.18
= 23.66
Break-Even Sales
Semi − Variable & Fixed Cost

= x Sales
Contribution
= (18.14x159.84)/23.66
= 122.55
Capacity Sales
= (159.84x100)/60
= 266.40
Break-Even As % Capacity
= (122.55x100)/266.4
=46%
41
JOY CHEMICALS (P) LTD.
Calculation of IRR (Amount in Rs. Lacs)

YEAR 0 1 2 3 4 5 6 7 8
Capital Cost -56.23
Inc. in Working Cap. -22.91 -1.91 -1.91
Profit Before Tax 5.52 7.57 10.01 10.46 10.88 11.27 11.66 12.02
Depreciation 5.67 5.67 5.67 5.67 5.67 5.67 5.67 5.67
Interest 8.51 8.34 7.76 6.94 6.13 5.32 4.50 3.69
Salvage Value 31.96
NCF Before Tax -56.23 -3.21 19.67 21.53 23.07 22.68 22.26 21.83 53.34
Tax 2.22 3.81 4.48 4.97 5.41 5.63
NCF After Tax -56.23 -3.21 19.67 19.31 19.26 18.20 17.29 16.42 47.71
IRR Before Tax = 25.50%

IRR After Tax = 21.75%
Notes:
1. Capital Cost
Project Cost 63.59
Less: Interest Paid 1.50
during Construction
Less: Margin Money for 5.86
Working Capital
Total 56.23
2. Salvage Value
Land (100%) 1.15
rd
Building (1/3 ) 2.50
Plant & Mach (5%) 1.58
Working Capital (100%) 26.73
Total 31.96
42
CAPM & ESTIMATION OF BETA
The Capital Asset Pricing Model (CAPM) states that, under certain restrictive
assumptions, the required return for a share of a company is given by
R = Rf + β (Rm - Rf)
Where,
Rf = risk-free rate of return

Rm = return on market portfolio
β = share beta
Higher the value of beta, greater is the risk and, hence, greater is expected return on the
company’s share.
Beta is a measure of the responsiveness of the excess returns for a share (in excess of
the risk-free rate) to those of the market, using some broad-based index (such as BSE
200) as a surrogate for the market portfolio. If the historical relationship between share
returns and those for the market portfolio is believed to be a reasonable proxy for the
future, one can use past returns to compute beta for a stock. In USA, firms like Value
Line Investment Survey, Standard & Poor’s Stock Reports and Merril Lynch provide
historical beta information on a large member of publicly traded stocks.
The risk-free rate can be approximated by the return on treasury (government) bonds.
However, one needs to subtract the risk-premium of treasury bonds over treasury bills.
(i.e. short-term government borrowing) to get a risk-free rate relevant for estimating cost
of equity, which in turn determines the discount rate for long-term investment projects.
Exhibit A: Characteristic Line for Wipro
A B C D E F G H I J K
1 Sl. Month Log Return Log Return
2 No. Ending S&P CNX500 Wipro
3 1 31-Jan-00 1.90% 34.72%
4 2 29-Feb-00 10.74% 43.01%
5 3 31-Mar-00 -16.71% -26.05%
6 4 28-Apr-00 -18.77% -42.70% Wipro
7 5 31-May-00 -2.78% -45.85%
8 6 30-Jun-00 12.33% 50.16% Equation of Fitted Line:
9 7 31-Jul-00 -13.29% -25.28% ri =0 .0347 +2.4975 * rm
10 8 31-Aug-00 7.53% 30.67% 70%
11 9 29-Sep-00 -12.79% -26.20%
12 10 31-Oct-00 -8.59% -10.69% 40%
13 11 30-Nov-00 6.09% 6.55%
Stock Return (ri)
Characteristic
14 12 29-Dec-00 -2.53% -16.88% Line
15 13 31-Jan-01 7.78% 16.03% 10%
16 14 28-Feb-01 -1.61% -7.44%
17 15 30-Mar-01 -23.11% -59.56% -50% -20% 10% 40%
-20%
18 16 30-Apr-01 0.89% 12.61%
19 17 31-May-01 4.90% 12.30%
20 18 29-Jun-01 -7.16% -17.43% -50%
21 19 31-Jul-01 -3.14% 7.60%
22 20 31-Aug-01 -1.32% -0.60%
-80%
23 21 28-Sep-01 -15.24% -29.18%
24 22 31-Oct-01 7.11% 3.65% Market Return (rm)
25 23 29-Nov-01 10.49% 30.55%
26 24 31-Dec-01 -0.70% 4.43%
27 25 31-Jan-02 2.21% 3.11%
43
Exhibit B: Regression Analysis to Estimate Wipro Beta
A B C D E F G H I J
1 Month Log Return Log Return
2 Ending S&P CNX 500 Wipro
3 31-Jan-00 1.90% 34.72%
4 29-Feb-00 10.74% 43.01%
5 31-Mar-00 -16.71% -26.05%
6 28-Apr-00 -18.77% -42.70%
7 31-May-00 -2.78% -45.85%
8 30-Jun-00 12.33% 50.16%
9 31-Jul-00 -13.29% -25.28%
10 31-Aug-00 7.53% 30.67%
11 29-Sep-00 -12.79% -26.20%
12 31-Oct-00 -8.59% -10.69%
13 30-Nov-00 6.09% 6.55%
14 29-Dec-00 -2.53% -16.88%
15 31-Jan-01 7.78% 16.03%
16 28-Feb-01 -1.61% -7.44%
17 30-Mar-01 -23.11% -59.56%
18 30-Apr-01 0.89% 12.61%
19 31-May-01 4.90% 12.30%
20 29-Jun-01 -7.16% -17.43%
21 31-Jul-01 -3.14% 7.60%
22 31-Aug-01 -1.32% -0.60%
23 28-Sep-01 -15.24% -29.18%
24 31-Oct-01 7.11% 3.65%
25 29-Nov-01 10.49% 30.55%
26 31-Dec-01 -0.70% 4.43%
27 31-Jan-02 2.21% 3.11%
28
29
30 SUMMARY OUTPUT
31 Regression Statistics A
32 Multiple R 0.8814
33 R Square 0.7768
34 Adjusted R Square 0.7671
35 Standard Error 0.1363 (Std.Error)^2 x [(n - 2) / n]
36 Observations 25
37
38 ANOVA
39 df SS MS F Significance F B
40 Regression 1 1.4863 1.4863 80.0404 0.0000
41 Residual 23 0.4271 0.0186
42 Total 24 1.9133
43
44 Coefficients Standard Error t Stat P-value Lower 95% Upper 95% Lower 95.0% Upper 95.0% C
45 Intercept 0.0347 0.0280 1.2418 0.2268 -0.0231 0.0925 -0.0231 0.0925
46 X Variable 1 2.4975 0.2792 8.9465 0.0000 1.9200 3.0750 1.9200 3.0750
47
48 RESIDUAL OUTPUT Beta
49 Square of
50 Observation Predicted Y Residuals D Residuals Calculation of Residual Variance
51 1 0.0821 0.2652 0.0703
52 2 0.3030 0.1271 0.0161 Sum of Square of Residuals ( ? ei2 ) 0.4271
53 3 -0.3825 0.1220 0.0149 No. of Observations (n) 25
54 4 -0.4340 0.0070 0.0000 Residual Variance ( ? ei2 / n) 0.0171
55 5 -0.0348 -0.4238 0.1796 Residual Standard Deviation 0.1307
56 6 0.3428 0.1589 0.0252
57 7 -0.2972 0.0444 0.0020
58 8 0.2229 0.0838 0.0070
59 9 -0.2847 0.0227 0.0005 Excel Functions for Regression Statistics
60 10 -0.1798 0.0729 0.0053
61 11 0.1868 -0.1214 0.0147 =INTERCEPT(C3:C27,B3:B27) 0.0347
62 12 -0.0285 -0.1402 0.0197 =SLOPE(C3:C27,B3:B27) 2.4975
63 13 0.2290 -0.0687 0.0047 =RSQ(C3:C27,B3:B27) 0.7768
64 14 -0.0055 -0.0689 0.0047
65 15 -0.5423 -0.0533 0.0028
66 16 0.0569 0.0691 0.0048
67 17 0.1570 -0.0340 0.0012
68 18 -0.1441 -0.0302 0.0009
69 19 -0.0437 0.1197 0.0143
70 20 0.0017 -0.0077 0.0001
71 21 -0.3458 0.0540 0.0029
72 22 0.2123 -0.1758 0.0309
73 23 0.2967 0.0088 0.0001
74 24 0.0172 0.0271 0.0007
75 25 0.0899 -0.0588 0.0035
44
BETA OF UNQUOTED STOCK
To adjust beta for difference in capital structure (i.e., leverage), we may

follow the steps given below :
Step 1 :
Unlever the levered beta using the following formula :
βu = βL
[1 + (1-T) x D/E)
Where,
βu = unlevered beta
βL = estimated levered beta
D/E = debt-to-equity ratio
T = corporate tax-rate
Step 2 :
Lever the unlevered beta (obtained in Step 2) taking into account D/E
ratio of the proposed investment as well as tax-rate applicable to this
new investment :
βL = βu [1 + (1 - T) x D/E]
45
EXERCISE ON ESTIMATION OF WACC
ABC Co. has two divisions - Health Foods and Specially Metals. Each of these divisions
employs debt equal to 30% of its total capital requirements, with equity capital used for
the balance. The current borrowing rate is 15% and the company’s tax rate is 40%. The
Co. wishes to establish a hurdle rate (minimum required rate) of return for each division.
The hurdle rates will be used to evaluate capital investment proposals of the respective
divisions.
The Co. has thought about using CAPM in estimating cost of equity. It has identified two
proxy companies, with the following details:
Proxy Co. Beta Debt-to-total Capital Tax Rate

for
Health Foods 0.90 0.50 0.40
Speciality Metals 1.25 0.30 0.40
The risk free rate presently is 12% and the expected return on the market portfolio is
around 18%.
You are required to calculate :
a) After-tax cost of borrowing

b) Cost of equity for each division
c) Minimum required rate of return (for screening investment proposals) for
each division.
46
Suggested Answer
a) After-tax cost of borrowing = 15*(1 - .40) = 9%
b) Cost of equity for each division
Beta calculation for Health Foods division
Beta (unlevered) = .90/[1+(1 - .40)*1] Note D/E = 1

= .5625
Beta (levered) = .5625*[1+(1 - .40)*3/7] Note D/E =
3/7
= .7071
Beta calculation for Speciality Metals division
Beta = 1.25
The proxy company's beta will be used since debt-equity ratio and tax rate of
the proxy co. and the division are same.
Cost of equity for Health Foods division
Ke(HF) = 12 + .7071*(18 - 12) = 16.24%
Cost of equity for Speciality Metals division
Ke(SM) = 12 + 1.25*(18 - 12) = 19.50%
c) Min. required rate of return for each division
For Health Foods division = 9*.30 + 16.24*.70 = 14.07
For Speciality Metals division = 9*.30 + 19.50*.70 = 16.35
47
Adjusted Present Value (APV) - An Illustration
Cost of the Machine (Rs.) 2,000,000

After-Tax Cash Savings
(Rs.) 400,000
per annum for 8 years
All-Equity Financing Cost 13%
Annuity Factor = -PV(.13,8,1) 4.7988

Un-livered NPV = -2,000,000+400,000*PV -80,480
Debt Financing 1,000,000

Cost of Borrowing 10%
Repayment of Principal in 8 instalments 125,000
Tax Rate 40%
Tax Savings on Interest Payment
Outstanding
Debt at
Beginning of Interest Tax PV Factor
Year Yr. @10% Savings @10% PV
1 1,000,000 100,000 40,000 0.9091 36,364
2 875,000 87,500 35,000 0.8264 28,926
3 750,000 75,000 30,000 0.7513 22,539
4 625,000 62,500 25,000 0.6830 17,075
5 500,000 50,000 20,000 0.6209 12,418
6 375,000 37,500 15,000 0.5645 8,468
7 250,000 25,000 10,000 0.5132 5,132
8 125,000 12,500 5,000 0.4665 2,333
Total 133,254
APV = NPV + Tax Savings 52,774
48
TYPES OF MARKETS
Security markets
Primary market Secondary market
Public issue Exchange
Private placement Over-the-counter
Derivative market
Exchange Over-the-counter
Security markets
Money market Capital market
49
STRUCTURED OBLIGATION*
(RIICO Bond Issue for RSEB)
The Instrument
Face Value - Rs. 5,00,000/-

Coupon - 14.5% payable semi annually
Issued and redeemed - at par
Maturity - redemption in 5th, 6th and 7th years @ 30%, 30% and 40% respectively
Rating - “LAA (SO)” by ICRA
Structure
Rajasthan State Industrial Development and Investment Corporation Ltd. (RIICO) issued
bonds in January 1995 aggregating Rs. 2500 million to part finance a 1000 MW power
plant being set-up by Rajasthan State Electricity Board (RSEB) at Suratgarh. The entire
fund was then on-lent to RSEB by RIICO. The servicing of the bonds is covered by a
back-to-back arrangement. RIICO was brought in as a vehicle for the fund raising
because RSEB is restricted by the Electricity Act and also by poor investor perception of
the SEBs.
The bonds were issued in the nature of debentures. As the bonds were not secured by
any tangible assets of RIICO, stamp duty was payable on the issue of the bonds.
However, the stamp duty of 0.75 percent, was arranged to be remitted by the State
Government of Rajasthan. The bonds were not issued as promissory notes like other
central PSU bond offerings, as such an issue would attract a stamp duty of 1 percent,
which can only be remitted by the Central Government. The arrangement worked out for
RIICO carries the drawback of attracting stamp duty on transfer of bonds.
The bonds were secured by a guarantee of the Government of Rajasthan and were
backed by a pioneering and innovative payment mechanism to ensure timely and
reliable servicing which is illustrated in the next page.
An escrow account would be opened in State Bank of Bikaner and Jaipur. Electricity
dues of certain large electricity consumers, previously identified and earmarked by
RSEB, whose average billings exceed that of the interest/principal payment by adequate
margin, would be collected and transferred by RIICO directly to the escrow account. The
escrow account provides the first level of credit enhancement.
The escrow account would be checked thirty days before the due date for payment of
interest/principal to the investors and inform the Trustees. In the event of any shortfall of
funds, the Trustees would call upon Rajasthan Government to transfer funds from either
the RSEB account or out of the budgetary provision for RSEB and/or RIICO to replenish
the escrow account.
As a measure of further safety, the Bonds are covered by an unconditional and

irrevocable guarantee of Rajasthan Government. If the above mentioned transfer of
funds does not take place 20 days before the due date for payment of interest/principal,
the Trustees shall invoke the State Government Guarantee and call upon Rajasthan
Government to make up for the shortfall in the escrow account by 10 days before the
*
Note prepared by Dr. S K Chadhuri, Professor, IMI.
50
due date for payment of interest/principal to the investors. The unconditional and
irrevocable government guarantee provides the second level of credit enhancement.
Payment Mechanism
Select RSEB Consumers deposit their electricity

dues in escrow A/c
RIICO to check the Account } T-30
Funds Available ?
Yes
No
Trustees call upon GOR to bridge the

gap through transfer from RSEB A/c with
GOR and/or from budgetary provision for
RSEB/RIICO } T-30 to T-20
Timely Compliance ?
}
Yes No
Trustees call upon GOR to transfer T-20
}
requisite amount
T-10
Interest/Principal payment cheques dispatched to investors
The above mechanism was developed in order to provide high safety to the investor as
well as to achieve a lower cost of funds for the issuer. This is one of the first instances of
a power project being financed through an open market borrowing. At an interest rate of
14.5%, this was one of the lowest cost debt financing for a power project.
Marketing
The primary objective of marketing was to keep the number of investors low. The target
investors for these bonds were :
• Provident Funds, Gratuity Funds, Superannuation Funds, etc.

• Banks: Nationalised and Co-operative
• Mutual Funds
• Other Financial Institutions like Insurance companies, UTI etc.
As the PFs can invest 30% of their investible funds in PSU bonds, they were the prime
targets. The issue was timed to open in the first week of January, as the PFs receive
51
interest on special deposits from RBI (55% of the PF funds are mandatorily held in
special deposits) during this period. Banks, Mutual Funds and other Financial Institutions
were targeted to obtain large subscriptions to reduce the number of investors.
Owing to the complex structure of the issue, one-to-one meetings with large investors
were required to explain the payment mechanism of the bonds. However, the smaller (or
less sophisticated) investors based their investment decision primarily on the “LAA (SO)”
credit rating.
As the State Government guarantee cover was available only for the target amount of
Rs. 2500 million no amount of over-subscription could be retained. To avoid the
unpleasant task of refunding over-subscription, it was decided to monitor the collections
from all the centres simultaneously. Pre-marketing ensured a good response and it was
more or less evident that the issue would collect the requisite amount in the first day
itself. As soon as the total collection exceeded Rs. 2250 million, collections from centres
other than Bombay (where the monitoring was done) were suspended. The subscription
was closed as soon as the amount touched Rs. 2500 million.
Statistics
The following table gives the investor category-wise break-up of subscription.

Investor Category Amount Subscribed (Rs. millions) Percentage
Banks 1045 41.8%
Mutual Funds 50 2.0%
PFs etc. 1285 51.4 %
Other Financial Institutions 120 4.8%
Total 2500 100%
The majority of the total of 113 investors were from Bombay.

Place Amount Subscribed (Rs. million) Percentage
Bombay 1444.5 57.78
Calcutta 543.5 21.74%
Delhi 201.0 8.04%
Madras 82.5 3.30%
Bangalore 137.5 5.50%
Ahmedabad 91.0 3.64%
Total 2500 100%
Investors who invested Rs. 100 million and above.

Investors Amount invested (Rs. million)
State Bank of India 500
Union Bank of India 200
MSRTC Contributory PF 116
Birla Industries PF 110
New India Assurance Co. Ltd. 100
State Bank of Mysore 100
United Bank of India 100
UCO Bank PF 100
UCO Bank * 100
Total 1426 **
* UCO Bank was the last investor and Rs. 15 million over-subscription was refunded. They were
allotted only Rs. 85 million.
** This constitutes 57.04 percent of the targeted subscription.
52
GDR ISSUE BY VSNL *
♦ Offering of 32,130,000 GDRs

• Offered by the company : 24,330,000 GDRs
• Offered by the Govt. : 7,800,000 GDRs
(Disinvestment)
• 1 GDR = one-half of one share of VSNL
• Offer price of GDR : US $ 13.93 per GDR
• Market price of VSNL share on 21 March 1997 was Rs. 985.25 per share,
equivalent to US $ 27.46 based on market rate on such day
• Managers’ option : 5,670,000 additional GDRs
♦ Depositary - The Bank of New York
♦ Custodian - ICICI
♦ Joint global coordinators and bookrunners :
• Dresdner Kleinwort Benson
• Jardine Flemming
• Salomon Brothers International Ltd.
♦ Other details
• Listing London Stock Exchange; eligible for quotation through
⇒ Automated quotation system of LSE (“SEAQ International”)
⇒ National Association of Securities Dealers Inc.’s automated linkages
(“PORTAL Market”)
• Underwritten (severally and not jointly) by 13 managers of the offering
• Combined management and under writing commission : US $ 0.1504 per
GDR
• Selling concession : US $ 0.2257 per GDR
• GDRs are being offered and sold only outside India
• Offering is being made in the US only to qualified institutional buyers (QIBs)
under Rule 144A of SEC
• Offered shares may not be withdrawn from the deposit facility pursuant to
which the GDRs are issued until 60 days after the letter of the
commencement of the offering and the last issue date of the GDR, subject to
certain limited exceptions.
• Once withdrawn, shares cannot be redeposited under the Deposit Agreement
♦ Dividend: Cash dividends, if any, on the offered shares will be paid to the
Depositary in rupees after deduction of applicable Indian withholding taxes and will
be converted by the Depositary into dollars and paid to holders of GDRs (less the
Depository’s fees and expenses).
*
Prepared by Dr S K Chaudhuri, IMI, for class-room discussion.
53
♦ Voting rights: Holders of GDRs will have no voting rights with respect to offered
shares while they are represented by such GDRs. The Depositary will, if permitted by
law and subject to certain other conditions, exercise voting rights with respect to
shares represented by GDRs in accordance with the direction of the Board of
Directors of the company as conveyed by the Chairman thereof.
♦ Taxation: Dividends paid non-resident holders of GDRs will be subject to
withholding tax at 10%; such tax is required to be withheld at source. Any gain
realised on the sale of GDRs or shares by non-resident holder to another non-
resident holder outside India is not subject to Indian capital gains tax. Subject to any
relief provided pursuant to an applicable double taxation treaty, any gain realised on
the sale of shares to an Indian resident or inside India generally will be subject to
Indian capital gains tax.
Use of proceeds : VSNL intends to use its share of the net proceeds (the company will
not receive any proceeds from the GDRs offered by the Govt.) from the offering to
expand its international services and other telecommunications infrastructure and to
make additional investments in telecommunications projects, principally under its Ninth
Five Year Plan, as well as for general corporative purpose. VSNL has received
permission from RBI to retain a substantial portion of its net proceeds from the offering in
dollar or other currencies other than rupee, pending the use of its net proceeds, to
deposit such proceeds outside India. The company intends to deposit such proceeds
with financial institutions that are rated in the highest credit rating categories by
internationally recognised rating agencies.
54
IPCL BOND PIERCED SOVEREIGN RATING*
All external debt rating is ‘restrained by the sovereign ceiling’, currently at, for India, BB
plus (Standard & Poor) and Baa3 by Moodys. However, IPCL, a major player in the
Indian . . . . . , has pierced the sovereign rating with its $175 million euro-convertible
bond. This is the first time any Indian corporate has pierced the sovereign ceiling in any
form of external borrowing. Possibly, this was also the first time that such a deal had
been structured in the world.
The deal was structured by investment banker Goldman Sachs and has Bank of
America as the chief guarantor. BankAm will take the responsibility of meeting interest
payments to investors. BankAm’s responsibility will end with the convertible bond’s
conversion to equity. Since the US bank is shouldering this responsibility, the deal has
been awarded BankAm’s credit rating of AA minus, much higher than the Inida rating.
The deal was advised by Goldman Sachs’ Indian affiliate, Kotak Mahindra Capital
Corporation.
The $175 million convertible ($150 million offering with $25 million greenshoe) carries a
coupon of 2.5 per cent and has a five-year tenor. The pricing has been done at a 21 per
cent premium to current GDR prices and the conversion will take place at $13 per GDR,
each GDR representing three underlying shares.
*
Economic Times, 27 February 1997
55
*
RIL ISSUES 100 & 30-YEAR INTERNATIONAL BONDS
Reliance Industries Ltd. (RIL) has managed to raise $314 million through an innovative
combination of 100-year and 30-year Yankee bond issues in the international market.
For its 100-year Yankee bond issue, the first by any company in Asia, RIL managed to
raise $100 million at 355 basis points above the US treasury rate. The actual pricing of
the 100-year debt, also described as perpetual equity, is 10.25 per cent, the US treasury
rate being 6.7 per cent.
Investment bankers (Morgan Stanley Japan and Merril Lynch) had managed a good
price considering that China had made a 100-year sovereign debt issue at 350 basis
points above the US treasury rate. The company’s offer of $100 million in unsecured
notes has been over-subscribed seven times with subscriptions totalling over $700
million. The bond was sold to a large number of institutional investors in US.
The first tranche of 100-year bullet bonds for $100 million will be due for redemption in
2097, while the second tranche debt of $214 millions will mature after 30 years, with a
put option after 10 years. The 30-year debt of $214 million was priced at a coupon of
8.25 per cent, which works out to 175 basis points above the US treasury rate. Under
the 10-year put option the buyer of the bonds has the option to sell the debt back to the
company at the end of 10 years. Alternatively, the buyer could continue holding the
bonds till maturity.
According to investment bankers, only 22 issuers in the world have so far accessed the
100-year century bond. Some of the transnational corporations who have issued century
bonds are IBM, Coca Cola, Walt Disney and so on.
Why do companies issue century bonds? And what’s in it for the investor? The only
benchmark that exists now to judge the efficacy of a century bond is British War Bond
issued in 1916 at a coupon of 3.5 percent. The bond had no maturity date. Since it was
issued at a low coupon and since the interest rates have moved after that, the bond now
trades at a discount of 40 to 50 percent.
Reliance has already had bond issues of 10, 12, 20, 30 and 50 year tenures in the
international market. Most of those are quoting in the secondary market at 30 to 35 basis
points lower than the coupon rate at which they were issued. This indicates that the
bonds are going at a premium. As a group, the Reliance has raised $1.2 billion in debt
from International markets.
*
Source : Economic Times, 11 January & 19 February 1997.
56
CREDIT RATING: AN OVERVIEW*
The rating of a debt instrument is taken up by a credit rating agency either on the receipt
of a mandate or request from the issuer of the instrument or on its own, sometimes
initiated by a group of investors. The emerging markets, is likely to face if it decided to
carry out the rating as its own is considerable dependence on the secondary sources for
information. As the issuer is not interested in getting the instrument rated voluntarily,
under such circumstances, he may not interested in providing the necessary information
and clarifications. The secondary sources of information in some countries are not
reliable enough and too much dependence on them may lead to distortion and
inaccurate ratings.
A flow chart is reproduced to give an overview of the rating process followed by the
ICRA.
The rating process at ICRA usually takes about four weeks in case of an issuer whose
instruments are being rated by the agency for the first time. When some other instrument
of an issuer is rated earlier, the rating of a new instrument takes about two to three
weeks. The time frame for an exercise is also a function of the complexity of an
assessment, for instance, a multi-location, corporate entity would require greater time or
effort than a single product single location entity.
The rating exercise is taken up on receipt of basic information about the company’s
business as well as the audited annual accounts of the company for the last three to five
years. The team of rating analysts conducts preliminary research on the industry in
which the company is operating and then carries out extensive meetings and visits. The
data and information is collected from various sources and is then analyzed in a
structured report. The visits include the visit of the location of manufacturing facilities of
the site of a proposed plant, a new representative offices and the corporate office of the
issuer. The team also interacts with the executives of the company at different levels
including the chief executive to make the process more interactive.
Besides the visits and meetings within the organization of an issuer, the team of analysts
also meets with external professionals like Bankers, Auditors, appraising institutions,
suppliers, customers etc. whenever required while keeping the identity of the issuer
confidential. ICRA required its analysts to follow certain rule due to diligence
requirements and each of the analysts have to certify as a part of the report, the
compliance of such requirements. The rating report is prepared after analyzing all the
relevant facts and data collected by them from different sources. This report is circulated
in advance to the members of the Rating Committee and is further discussed at a
meeting of the Rating Committee.
The critical issues are discussed and debated and finally the Rating Committee assigns
the rating. The Rating Committee, comprising highly experienced and eminent members,
is a permanent Committee with minimum possible change in its membership which
ensures consistency in ratings assigned.
Once the rating has been assigned, it is communicated to the issuer who is also advised
the rationale for the rating assigned. If the issuer feels that there is a need for a review of
the rating assigned, an opportunity is provided to the issuer to offer additional
*
P K Choudhury, Managing Director, ICRA in Economic Times, 30 August 1994
57
information or clarifications. The Rating Committee takes up the review and its decision,
thereafter, is final.
As per the system prevailing in India, the issuer is given the option to accept or not to
accept a given rating. If the rating is accepted, the same is published along with the
rationale behind the rating. Such ratings, once accepted, are placed under continuous
surveillance for the lifetime. Depending on the performance of the issuer in the future,
the rating may be retained, placed under watch, upgraded or downgraded. Under these
circumstances, ICRA reserves the right to disclose the rating or any change in the rating
to the relevant regulatory bodies, in the public interest. The ratings given are symbolic
and easy to understand, as is evident from the appended list of ICRA’s ratings.
Rating Symbols Long-term debt-debentures, bond and preference shares
LAAA : Highest safety. Indicates fundamentally strong position. Risk factors are
negligible. There may be circumstances adversely affecting the degree of safety but
such circumstances, as may be visualised, are not likely to affect the timely payment of
principal and interest as per terms.
LAA + / LAA/ LAA -: High safety. Risk factors are modest and may very slightly. The
protective factors are strong and the prospect of timely payment of principal and interest
as per terms under adverse circumstances, as may be visualised, differs from LAAA only
marginally.
LA+/LA/LA - : Adequate safety. Risk factors are more variable and greater in periods of
economic stress.
The proactive factors are average and any adverse change in circumstances, as may be
visualised, may alter the fundamental strength and affect the timely payment of principal
and interest as per terms.
LBBB+/LBBB/LBBB - : Moderate safety. Considerable variability in risk factors. The

protective factors are below average. Adverse changes in business economic
circumstances are likely to affect the timely payment of principal and interest as per
terms.
LBB+LBB/LBB- : Inadequate safety. The timely payment of interest and principal are
more likely to be affected by present or prospective changes in business/economic
circumstances. The protective factors fluctuate in case of changes in economy/business
conditions.
LB+LB/LB- : Risk prone. Risk factors indicate that obligations may not be met when due.
The protective factors are narrow. Adverse changes in business economic conditions
could result in inability/unwillingness to service debts on time as per terms.
LC+LC/LC - : Substantial risk. There are inherent elements of risk and timely servicing of
debt obligations could be possible only in case of continued existence of favourable
circumstances.
LD : Default. Extremely speculative. Either already in default in payment of interest

and/or principal as per terms or expected to default. Recovery likely only on liquidation
or re-organisation.
Medium - term debt - including fixed deposit programmes

58
MAAA : Highest safety. The prospect of timely servicing of the interest and principal as
per terms is the best.
MAA +/MAA/MAA- : High safety. The prospect of timely servicing of the interest and
principal as per terms is high, but not as high as in MAAA rating.
MA+/MA/MA - : Adequate safety. The prospect of timely servicing of the interest and
principal is adequate. However, debt servicing may be affected by adverse changes in
the business/economic conditions.
MB+/MB/MB- : /inadequate safety. The timely payment of interest and principal are more
likely to be affected by future uncertainties.
MC+/MC/MC -: Risk prone. Susceptibility to default high. Adverse changes in

business/economic conditions could result in inability unwillingness to service debts on
time as per terms.
MD : Default. Either already in default or expected to default.
Short-term - including commercial paper
A1+/A1 : Highest safety. The prospect of timely payment of debt obligation is the best.
A2+/A2 : High safety. The relative safety is marginally lower than in A1 rating.
A3/+A3 : Adequate safety. The prospect of timely payment of interest and instalment is
adequate, but any adverse change in business/economic conditions may affect the
fundamental strength.
A4+/A4 : Risk prone. The degree of safety is low. Likely to default in case of adverse
changes in business/economic conditions.
A5 : Default. Either already in default or expected to default.
Note: The suffix of ‘+’ or ‘-’ may be used with the rating symbol to indicate the
comparative position of the instrument within the group covered by the symbol.
Thus, LAA+ lies one notch above LAA, and MAA+ lies one notch above MAA, while A1+
stands one notch above A1.
The letter ‘P’ in parenthesis after the rating symbol indicates that the debt instrument is
being issued to raise resources by a new entity for financing a new project and the rating
assumes successful completion of the project.
59
ICRA’s Rating Process - An Overview
Mandate
Initial stage
Assing rating team
Receive initial information Conduct

basic research
Fact finding and

analysis
Meetings and visits
Analysis and preparation of report
Preview meeting Rating finalisation
Rating meeting
Fresh inputs/
Assign rating clarifications
Communicate the rating and rationale
Acceptance Request for review
Surveillance Non acceptance
60
Risk Profile: GEM CABLES AND CONDUCTORS LIMITED
Highly
Favourable Average Unfavoured Risky
Favourable
(5) (4) (3) (2) (1)
A. Industry Risk
i) Industry prospects for growth 5
ii) Market position of issuer 3
iii) Marketing arrangement 3+
iv) Market image 3+
B. Operating Efficiency
i) Level of technology 4-
ii) Inventory Management 3+
iii) Receivables management 3-
iv) Expense levels 3+
v) Profitability 4
Performance in relation to
vi) 4
industry benchmarks
Earnings protection/ trend of
vii)
margins
C. Management Evaluation
i) Competence 4+
ii) Track record 4
iii) Capabilities under stress 4
iv) Organisational structure 4
v) Personnel policies 4
vi) Industrial relations 4
Level of priority for finance
vii) 4
function
Performance of group
viii) N. A
companies
D. Accounting Policies
i) Deprecation policy 4
ii) Inventory valuation 3+
iii) Contingent liabilities 3+
iv) Income recognition 4
v) Provisioning/write off N. A
vi) Other items (if any) - N. A
E. Financial Risk
61
Highly
Favourable
(5) (4) (3) (2) (1)
i) Existing financial position 4

ii) Financial flexibility 4
iii) Ability to access capital market 3+
iv) Liquidity/cashflow adequacy 3
v) Funding profile/leverage 4
General Economic
F.
Environment
i) Government policies 5
ii) Incremental competition 4
Summary
A. Industry Risk 4-
B. Operating Efficiency 4
C. Management Evaluation 4-
D. Accounting Policies 4-
E. Financial Risk 4+
F. General Economic Environment
Most critical parameters for B, C and E
assessing the repayment

capacity of proposed issue
Overall Rating CARE A for NCD of Rs.50 mn
62
Risk Profile: CREDENTIAL FINANCE LIMITED
Highly
Favourable
(5) (4) (3) (2) (1)
A. Industry Risk
i) Industry prospects for growth X
ii) Market position of issuer X
B. Operating Efficiency
i) Information Systems X
ii) Expense levels X
iii) Cost of Funds X
iv) Profitability X
C. Asset Quality
Overdues/Non Performing
i) X
Assets
ii) Credit appraisal systems X
iii) Recovery systems X
D. Management Evaluation
i) Competence X
ii) Track record X
iii) Organisational structure X
iv) Personnel policies X
E. Accounting Policies X
i) Deprecation policy X
ii) Contingent liabilities X
iii) Income recognition X
iv) Provisioning/write off -
v) Other items (if any) -
E. Financial Risk
i) Existing financial position X
ii) Financial flexibility X
Ability to access capital
iii) X
market
iv) Liquidity/cashflow adequacy X
v) Funding profile/leverage X
63
Highly
Favourable
(5) (4) (3) (2) (1)
General Economic
F.
Environment
i) Government policies X
ii) Incremental competition X
H. Capital Adequacy
Summary
A. Industry Risk 3+
B. Operating Efficiency 3
C. Asset Quality 4-
D. Management Evaluation 4-
E. Accounting Policies 4-
F. Financial Risk 4-
General Economic
G. 3+
Environment
H. Capital Adequacy 4-
Most critical parameters for B, C, F
assessing the debt servicing

capacity of the proposed
issue
FD (200 Mn) A-
Rating recommended ICD (300 mn) PR2
NCD (300 mn) A-
64
PRINCIPLES OF MERGERS & ACQUISITIONS*
Mergers and acquisitions take place because of a variety of reasons. For an acquiring
company, the reasons may be for obtaining profitable operations, for tax benefits,
benefiting from managerial or technical expertise, product diversification etc. For a
selling company, the rationale may be the need for additional finance, the prospects of
marketing or technological changes, the desire for the majority of stockholders to
dispose of their holdings, existence of an attractive purchase offer or simply as a means
of survival. Another major consideration could be the strategic stance of a business unit
in moving from the existing product line to an altogether new product line which is
perceived to be more advantageous against the backdrop of the changing comparative
and competitive global environment. However, M&A have raised important issues both
for business decisions and for public policy formulation. M & A may be critical to the
healthy expansion of business firms as they evolve through successive stages of growth
and development. Thus, entry into new product markets and into new geographical
markets by a firm may require mergers and acquisitions at some stage in the firm’s
development.
Sceptics of the efficiency argument hold that companies acquired are already efficient
and that their performance after acquisition does not improve. Moreover, the gains to
shareholders merely represent a redistribution of stakes among stakeholders. Another
view is that M & A activities represent the machinations of speculators who reflect the
frenzy of a “Casino Society”. Such speculative activities increase debt and erode equity,
resulting in an economy slipping into a highly leveraged and vulnerable state of
economic instability.
Mergers are intended to benefit both companies – the acquirer and the acquired. If the
products and markets are complementary, then M&A strengthen each other. They can
be suppliers or end-users which can provide backward or forward integration. Mergers
can also lead to elimination or reduction of competition if both companies are in the
same line of production. Mergers can save taxes and depreciation or writing off losses. If
the loss-making company is acquired by the profit-making companies.
Takeovers can be friendly or hostile. Friendly takeovers are arranged between the
companies through bargaining. Hostile takeovers are unfriendly acquisitions of shares in
a way as to hold a controlling interest in the company.
Mergers and acquisitions are expected to result in synergy. Operating synergy is mostly
in the form of cost reductions which are the result of economies of scale or economies of
scope. Economies of scale decrease the average cost through technological economies,
which affect the minimum size of the plant in an industry, or managerial economies,
which result in lower production and distribution costs. Economies of scope result from
increase in the number of products offered. A company will be able to utilize one set of
inputs to provide a broader range of products and services. Operating synergy is most
likely to accrue from horizontal merger between two companies in the same line of
business. In vertical merger (either backward with integration towards raw materials or
forward with integration towards finished products), synergistic gains result when the
merging firms are technologically or spatially proximate. Merging of group companies or
acquiring those that were engaged in related business would enhance product
scope/geographical reach.
*
Source: RBI
65
Financial synergy, on the other hand, is the impact of a merger on the cost of capital for
the merging entities. One of the financial benefits of diversification is termed as the
“coinsurance effect”. The acquisition of a company which is less responsive to
fluctuations in the economy would give the acquiring company a steady stream of
earnings. Another reason could be the acquiring company’s management belief that it
can manage the target company’s resources better. Furthermore, a target company
having transferable tax losses would be of interest to an acquiring company which could
offset its income.
M&A activities help to reduce the gestation period for launching new production facilities
and promoting new brands, strengthen product portfolios, minimize duplication in basic
research and development expenditure and expand marketing and distribution networks.
In general, they enhance the shareholder value. Thus, M&A are perceived as prudent
corporate strategy. It is necessary to recognise the importance of human resources too.
Unless human resources are properly blended in the merged entity and organisational
cross-cultures are properly acclimatized, many of the intended merger benefits will not
accrue. Generally, mergers represent a resource allocation and reallocation process in
the economy with firms responding to new investment and profit opportunities arising out
of changes in economic conditions and technological innovations. Mergers rather than
internal growth may sometimes be more efficient in terms of resource utilisation. One
reason why merger activity is concentrated in periods of high business activity seems to
be that firms are not motivated to make large investment outlays when business
prospects are not favourable. Only when future benefits accruing to a business
endeavour exceed its costs is the action warranted. M&A activities will be simulated
when such favourable business prospects are combined with changes in competitive
conditions directly motivating a new business strategy.
There are certain pitfalls associated with M&A deals, such as insufficient investigation of
the acquired company, overbidding to acquired control, too broad a diversification,
acquisition of companies in unrelated fields, etc. These would pose a potential threat to
effective implementation of such activities.
66
*
THREE UNILEVER TEA COMPANIES TO MERGE
Following the liberalisation of FERA and MRTP rules, three Unilever group companies -
Tea Estates India Ltd., Doom Dooma India Ltd. and Brooke Bond India Ltd. - are being
merged, with effect from their next financial year beginning January 01, 1993.
The merger proposal will be considered by the boards of the three companies on
Thursday. The stock exchanges at Bombay, Bangalore, Calcutta and Madras were
notified about this proposal by the three companies on Tuesday. The legal formalities
such as shareholders’ and court approvals are likely to be completed by the middle of
1993.
With the merger, the shareholding of Unilever Plc in the consolidated Brooke Bond will
go up from 39.4 percent to 49.9 percent. At present, Unilever holds a 74 percent stake in
each of the two plantation companies. These will now become divisions of the new,
amalgamated Brooke Bond India Ltd. All the three companies earlier belonged to the
former Brooke Bond group which was acquired by Unilever in 1984 through an
overseas acquisition.
The merger scheme envisages the issue of 12 shares of Brooke Bond for every 10
shares of Tea Estates and 11 for every 10 of Doom Dooma. Post-merger, the equity
capital of Brooke Bond will increase from Rs. 58.87 crore to Rs. 84.56 crore.
At the same time, its earnings per share (EPS) will improve from Rs. 5.90 (pre-merger)
to Rs. 6.10 (post-merger) - for the year ended December 1991 - thanks to the much
higher EPS of Tea Estates at Rs. 7.62 and Doom Dooma at Rs. 7.50.
Lever group officials justify the lowering of the EPS of the plantation company
shareholders consequent to the merger on the ground that they will be more than
compensated by the much higher market capitalisation of Brooke Bond shares which
enjoy a larger floating stock, better liquidity and high PE (price to earnings) multiples.
At current market prices, 10 shares of Tea Estates would be worth Rs. 1,800 and of
Doom Dooma, Rs. 1,780. These will now be equivalent to 12 shares and 11 shares of
Brooke Bond worth Rs. 3,060 and Rs. 2,805 respectively on the market.
The share exchange ratios have been worked out on the basis of internationally
accepted valuation principles with the help of Mr Arun Gandhi, senior partner, N M Raiji
& Co., chartered accountants. The valuation has been done on a ‘going concern’ basis
with a 60-percent weightage assigned to capitalisation of earnings, 20 percent to net
asset value (without any revaluation of tea estates) and 20 percent to market
capitalisation.
The Lever management views the proposed merger to be “synergistic” as it would

complement the blended and packet tea business of Brookee Bond by providing a
close, internal linkage with the tea gardens. Similarly, the plantations’ business would be
protected from cyclical ups and downs in their earnings by their integration with a
downstream blender like Brooke Bond. In fact, most tea plantation companies’
bottomlines are under severe pressure this year with the collapse of the Russian market.
*
Economic Times Nov. 11, 1992
67
Tea Estates and Doom Dooma together produce around 16.5 million kgs of tea every
year or one-fifth of the 83.7 million kgs blended and packaged by Brooke Bond.
Moreover, traditionally, Brooke Bond has been purchasing only around 30 percent of the
produce of these two group plantations with the rest being bought from other companies.
Even though this proportion may now go up, Brooke Bond will still continue to be a major
purchaser of tea from auctions. What is more, it will also sell a part of its tea under its
own banner.
Table 1
KEY FINANCIALS
Company Sales Equity Net worth (as EPS (Rs) Current market P/E
(1991) Capital at Dec. 31, 92) (1991) price (times)
(Rs./share)
Brooke Bond 700 58.87 118.4 5.90 255 43
Tea Estates 100 13.20 30.5 7.62 180 24
Doom Dooma 60 8.96 18.5 7.50 178 24
Total :
Pre-merger 860 81.03 167.4 6.36
Post- merger 860 84.56 167.4 6.10
Table 2
Company Capitalised EPS Net Asset Value * (as Market ** capitalisation
(1990,1991,1992) at Dec. 31, 92) (Oct.91-Sept.92)
Weight : 60% Weight : 20% Weight : 20%
Broke Bond 69 20 190
Tea Estates 92 23 192
Doom Dooma 83 21 177
* Estimated
** Excluding March to July 1992 which were considered to be abnormal months due to the securities
scan.
68

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FINANCIAL MANAGEMENT

Faculty: Dr. S K Chaudhuri

Instructor: Dr. S K Chaudhuri

Financial Management course is designed to enable the students understand and

Examination and Grading

Component Max. Duration Weight

Suggested Text Books

Session Topics Handout/Exercise Cases/Assignments

30 - 34  Domestic capital market and  Types of Market Case studies

• Sales Growth • Value • Working Capital • Cost of

Components of Cash Flow from

Corporate Objective Creating Shareholder

(1) Financial How well is the company creating shareholder value?

Bottom- up and top-down analysis

Designing such performance measures requires both bottom-up and top-down

Measure results, not training

The same philosophy applies to measuring such areas as organizational learning.

Word to the wise

There are a number of pitfalls to avoid when developing a performance-

The successful redesign of a company’s performance measures can have substantial

EVA = NOPAT – (KW x Net Assets)

DEFERRED TAX LIABILITY

(Rs. Millions) Year Year Year

Accounting profit and taxation

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 33.33% 50 50 50

Profit before tax 150 150 150

Less: Provision for taxation @ 40% 60 60 60

Profit after tax 90 90 90

Tax-return profit and taxation

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 100% 150 0 0

Profit before tax 50 200 200

Less: Provision for taxation @ 40% 20 80 80

Profit after tax 30 120 120

Difference in taxation 40 (20) (20)

Presentation in Profit & Loss Account

Profit before depreciation and tax 200 200 200

Less: Depreciation @ 33.33% 50 50 50

Profit before tax 150 150 150

Less: Provision for taxation

Current tax (involves cash payment) 20 80 80

Deferred tax (non-cash charge) 40

Deferred tax reversal (20) (20)

Profit after tax 90 90 90

DEFERRED TAX LIABILITY - DEBT OR EQUITY?3

• Future value of money (discrete compounding): Cn = C0 (1 + k/m)mn

• Present value of flat, perpetual cash flows : PV = C/k

PV = C1 / (k - g), where C1 = C0 (1 + g) = cash flow at the end of period 1 and, k>g

8. A company is considering two different makes of a machine. The projected cash

Year Cheap Machine Quality Machine

Year 2000 2001 2002 2003 2004

b) PV = 180,000 / 1.125 = $102,137

c) PV = 11,400 / 0.12 = $95,000

d) PV = 19,000 [Annuity factor, 12%, t = 10]

e) PV = 6,500 / (0.12 - 0.05) = $92,857

With rannual = 0.10 rmonthly = 0.008

The present value of the payments to Kangaroo Autos is:

PV = 2 / [0.10 - (-0.04)] = 2 / 0.14 = $14.29 million.

PV20 = C21 / (r - g) = C1 (1+g)20 / (r - g)

PV = 14.29 - 6.314 / (1.1)20 = $13.38

Using trial and error, or logarithms, r = 0.0605 or 6.05%. This is equivalent to

The present value of $100 for 10 years is :

30 - 34 Domestic capital market and Types of Market Case studies

For Health Foods division = 9.30 + 16.24.70 = 14.07

For Speciality Metals division = 9.30 + 19.50.70 = 16.35