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Page 1 of 19 - Financial Management- II (Mr Gokhale)

Jamnalal Bajaj Institute of Mgmt Studies

Date: 14 Apr 06

Professor: Mr Sandeep Gokhale,

Telephone: Email: [email protected]

Recommended Books:

Lecture Plan

Lec No Topic Corporate Finance

Capital Restructuring

Investment Analysis

Financing Instruments

Financial Benchmarking

Treasury Options

Investment Banking

Credit Rating

IPO & Debt Restructuring

Infrastructure Financing

SICA, BIFR & DRT

Restructuring of Sick Units and asset securitisation Act

Equity, debt and business valuation

Corporate Restructuring

Joint Venture Formulations

Investment Feasibility analysis.

Financial System

FINANCIAL SYSTEM

Financial institutions Financial markets Financial instruments

Regulatory Intermediaries Non Intermediaries

Nabard

Social Banks

Banks Non banking

Investment

Inst.

Financial Inst..

Short

term

Long

term

Stock Markets

Debt markets

Money markets

Forex markets

Derivatives

mailto:[email protected]




Financial system comprises of closely inter linked players such as Financial / Investment

institutions, Banks, Capital / Money markets, Instruments, Statutory / Regulatory

authorities and financial service providers which operate with certain practices and

procedures.

The function of a financial system is to establish a bridge between the Surplus sector

(savings) and the Deficit sector (businesses) so as to ensure a faster credit delivery

mechanism with an ultimate goal, to accelerate the rate of economic development.

Efficient financial markets are defined as the absence of information based gain (called

Insider Trading – trading in the stock market by management, etc, say due to fore knowledge of impact of

impending announcement of any financial decision, results, merger, etc), correct valuation of assets,

maximisation of convenience and minimisation of transaction cost.

Investment Financing (Concept to Closure)

Any investment is made only when 100% Financial Closure is achieved. (Financial Closure

means – confirmed availability of cash and commitments by prospective lenders for balance financing needs

of the project. Say, if a project requires Rs 200 Cr investment, Rs 50 Cr may be available in cash and various

lending agencies may have committed themselves to finance the balance Rs 150 Cr. If this 150 Cr has not

been committed or Cash is not available, then financial closure is not achieved).

Investment financing decisions are affected by the prevailing economic environment.

Falling import duty rates courtesy WTO and related EXIM policies have affected the

viability and funding of many projects. High import duties provided cushion for

inefficiencies of local manufacturers. But now, with import duties having been drastically

reduced, very little cushion is available. Add to that benefits in some countries like, low

cost of power and some other raw materials, higher productivity of workers (despite higher

wages) and low tax structure, some local businesses have become unviable.

Relaxed regulations governing Inward and Outward Foreign Direct Investment have also

opened a window of opportunity to finance the projects through low cost Dollar funding on

the strength of Natural Hedging Option available with so many companies. While foreign

currency debts have been available for as low as 2-3% per annum, there was a risk of

depreciation of Indian Rupee and possible debt servicing problems of dollar denominated

debts. Such debts needed to be hedged which cost the companies another 2% or so, thus

paring off large part of the gains. However, companies like Infosys and Hindalco, which

have large FE earnings, are naturally hedged against such risks. (Their earnings being in dollars,

movement of dollar either way would not affect their debt servicing capacity/ratio. If dollar appreciates

causing increased debt servicing in rupee terms, so will their earnings and vice versa).

Financial Sector Reforms have also led to broadening of choice of investment options.

There are Private Banks, Financial Institutions, autonomous PSU banks, ADRs, GDRs,

investment in foreign companies, etc.

Valuation of Business – Valuation of business (and therefore financing requirement) differ

on the basis of nature of business. In a Green Field Project (a new project erected on a virgin




hitherto non industrial land), funding requirement is gradual on the basis of progress of project.

There is generally long gestation period. A Green Field project runs the risk of

business/demand cycle turning upside down by the time the project goes on steam in two or

three years. In case of Mergers and Acquisitions acquisition costs may be higher.

Acquisitions normally come at a steep premium to prevailing share prices. There is a

tendency for the shares to appreciate steeply whenever any take over is in offing. But

business risks are much lesser in this case. Another down side is that there is little time

available to arrange funds. Worst is the case of biddings. In case of biddings, as is the case

with Indian Govt Disinvestment programme, entire money (to the tune of a few hundred to

thousands of crores) is to be paid within 48 hours of opening of bids. No company has such

enormous liquidity and in case of arrangement of loan through banks, there is a high

commitment fees to be paid even if loan is not taken. (Since paucity of time is well recognised, bids

are normally opened on Friday evening so that additional two days ie Saturday and Sunday are also

available to the successful bidder). Brown Field Projects (Expansion of existing project- Capacity

expansion, like Reliance is doing right now with its Jamnagar Refinery) have a lower capital cost due

to saving of around 20% due to utilisation of existing facilities.

While projects in production and service sectors are lot easier and faster to implement, they

carry considerable business risk after commissioning. Umpteen number of businesses wind

up within a few years of starting due to change in business environment. There could be

policy changes, unexpected competition may enter, duty and tax structure could suddenly

change, or there may be change in demand for the product due to technological innovation,

etc.

But, case with Infrastructure projects is just the reverse. They are in public domain. These

projects face enormous amount of uncertainty in the gestation phase due to problems in

land acquisition, PILs, environmental clearances, etc. But once the project goes on steam,

thereafter it is on auto pilot mode with minimum running expenses, minimum maintenance

and long term growing revenue model. There is rarely any competition to such projects

either. Thus, business risk is Nil.

Just see how the business models can get distorted over the time. A company, India Foils

Ltd, which is located in West Bengal and is into manufacturing of Aluminium foils for

industries like Pharma, cigarettes, etc, was doing well till some years back. There was 90%

import duty on Aluminium sheets and 135% on Aluminium foils. Thus, company was

enjoying a protection of 45% on its manufacturing costs against import of foils. Over the

years, duty has been reduced on both items to just 5%. Thus, there is no duty differential

now to give it protection from foreign imports. Energy costs in India are approx Rs 5-6 per

unit. Aluminium foils have almost 60% manufacturing cost as energy cost. Energy cost in

places like Dubai is just 25-30 paise per unit. Thus, companies like Dubal Ltd (Dubai

Aluminium Ltd) enjoy huge cost advantage compared to India Foils Ltd. There is literally

nothing that can be done to save India Foils Ltd from going to BIFR.

Considering the Aluminium manufacturing process, where Alumina is extracted from

Bauxite ore by a chemical process, it is worthwhile for our Aluminium companies to shift

their energy intensive Alumina to Ingot/sheet/foil conversion process to Dubai. They can




export the Alumina and import finished product at just 5% duty. It will give them

tremendous savings. Indian Aluminium companies are also enjoying the benefits of vertical

integration. They own the full value chain, from Bauxite mines (India has second highest

reserves of Bauxite in the world) to power generation capacity to finished goods conversion

plants. Currently Indian companies are reaping huge profits because while international

price of Aluminium is @ $600 per ton, their production cost is just $ 80 to 100 per ton

only. They also have captive power generation capacities where they generate power for as

low as just 60 paise unit. But it would be good idea to shift their energy intensive processes

to Dubai and sell the power thus rendered surplus to State Govts at Rs 3/- to Rs 4/- per unit.

That will give them lot more profits.

Thus, valuations of business differ from situation to situation.

Corporate Investment Structuring

Corporate investment structuring is based on following parameters:

1. Ball park figure of investment capability

(a) Investment Capability

(b) Borrowing Power

(c) Equity Injection Ability

(d) Non-balance sheet recourse financing

2. Industry identification

3. Investment vehicle

4. Investment location

5. Firm up cost of project

6. Structure means of financing

7. Establish viability

The first step in corporate investment restructuring is assessment of Investment Capacity

of the firm. Like in the case of Housing Finance, lending institutions need to assess the

repayment capability of the borrower. The process of assessment is amazingly similar in

both the cases. Money will be lent on the basis of following: -

Strength of Existing Balance Sheet – Various figures like Reserves and Surplus, annual

profits, cash and inter corporate investments, equity holding of the promoters in the

company, current debt equity ratio (levering), DSCR, etc, give a hint as to how much of

own funds can be raised by the company.

There are three important mile stones in equity holding in the company. 26%, 51% and

76%. Some one holding 26% equity has tremendous nuisance value as he can effectively

block all the special resolutions which require ¾ majority. Thus, no corporate restructuring




can take place without his consent. 51% holding gives power to ensure own nominees on

the board and thus control the company operations. 76% holding gives absolute powers and

freedom of operation. Now, in case any firm’s holding in the company is between these

mile stone figures, excess holding over lower mile stone adds no value to his control over

the company. Thus, he can dilute his holding to the next lower mile stone level and

generate additional cash (own funds) for investment in the new venture.

Sectoral Analysis for Investment

Suppose a company has lot of spare cash. Question is where to invest? Whether to diversify

or to remain within the core competency? Both options have their plus and minus. World

over the views have been different. While West has been restricting itself to core

competency area, like Siemens in control systems, the countries in the Pacific Rim and

Asia have been diversifying into even non related businesses. Take the case of Korean

companies like Hundai. In most cases such diversification has not been very successful.

Following factors are considered during Sectoral analysis for investment:

(a) Existing organisational core competencies

(b) Demand / supply equilibrium

(c) Level of protection

(d) Key financial ratios

(e) Indirect Tax structure

(f) Scalability

(g) Backward / forward integration

(h) Risk balancing

(i) Flocking mentality

It has been generally observed that unrelated diversification of business leads to destruction

of shareholder value. Even McKinsey came out with a paper against diversification into

unrelated sectors. But in case of Arvind Mills, an extremely successful company in 1980s,

capacity expansion led to almost closure. Company was advised by McKinsey to expand

capacity to the level of 30% of world Denim Cloth requirement at the cost of Rs 3000 Cr.

Post expansion, there was tremendous competition from countries like Philippines, Brazil,

etc and there was idle capacity in plant. Company is barely able to trudge back to life now.

In India, in yester years, reasons for diversification into other businesses were different.

During the License Permit Raj, expansion of existing business was not allowed. Thus, there

was little option but to diversify in whatever area possible in order to grow. Since every

thing was controlled and profit margins were humongous, business risks were almost nil.

Raymond diversified into Steel and cement. But, it later sold these businesses and is now

concentrating in its core competency – Textiles. (There is yet another attempt to diversify now).

Another question is – What is the core competency? What is the core competency of HLL?

It is manufacturing Soaps or Shampoos or what? It is neither. It is purchasing almost Rs

2000 Cr worth of a chemical for its processes. Backward integration into manufacturing




this particular chemical can earn the company a minimum of Rs 200 Cr a year. But then the

core competency of HLL is not in manufacturing but in Retail, sales and distribution.

Conversely, core competency of Reliance is project execution. They can execute any

project on a very aggressive time and cost schedule. Their initial foray into setting up the

chain for distribution of their WLL mobiles was a disaster and had to be withdrawn.

Similarly, they have been very slow to make their presence felt in retailing of Petroleum

products. Reliance foray into retail chain is to be watched. Birla is into production of

commodities.

Question here is why did Reliance made its foray into retail chain sector? Apparently,

scalability was in mind. (Scalability is referred to as capacity to multiply business growth). While

most of the business segments have already got crowded, this is one segment which is still

beyond organised players. It is only matter of time before companies like Walmart etc

make their entry into India. Reliance wanted to have First Mover’s advantage in this

segment.

It requires a different mind set for the project execution and retail chain. Thus, every

system or organisation has its own areas of strength and competency.

Risk Balancing – Many mergers and acquisitions are done with the purpose of risk

balancing. Take the case of BHP – Benetton merger in US. While BHP is a coal mining

company, Benetton is a Steel company. This vertical integration has mitigate the business

risks for both companies, released the synergy value and improved the profitability of the

merged company. Reliance with its expanding refining capacity will have to do crude risk

balancing.

There is a big question mark over Reliance Refineries product marketability. During the

cracking process of the crude oil, four primary products, Petrol, Diesel, Naptha, and

Kerosene are produced in almost equal proportion and the cost of the three is also almost

equal. (Price differential between petrol, diesel and even Kerosene is result of govt duty structure. Such

differential does not exist in any other country). Thus, there is not enough market in the world for

Diesel. With a 70 million ton refinery, where will the diesel be marketed?

Flocking is a tendency that needs to be avoided. Seeing a profitable business, many others

invest in the same. It is here that late movers suffer huge losses as margins thin down by

the time their projects go on steam.

Investment Vehicle (Method by which to invest)

Selection of investment vehicle is another issue. Whether to invest as expansion of existing

business or to launch a new company? There are various factors that need to be considered

before arriving at the decision:

(a) Strategic Positioning

(b) Group control / promoter funding.




(c) Depreciation as tax shield.

(d) Sales tax implications.

(e) Wage structure parity.

(f) Joint venture / foreign equity.

(g) Synergy with existing businesses.

(h) Size / risk of new projects.

(i) Better terms of funding.

A close scrutiny of above factors will reveal that they are loaded in favour of investment as

part of capacity expansion rather than launching a new company. Most of the factors are

either neutral to both or in favour of capacity extension especially in cases of vertical

integration. Benefits of Brand value, Tax Shield on account of depreciation, Sales tax

implications, terms of funding, etc are all favourable.

However, strategic calculation regarding cornering of profits often prompt the companies

to launch new companies which are later merged with parent company at a later date. Take

the case of Reliance which has been following this model continuously for the last 15

years. New Pvt Ltd Company is launched instead of expansion of old company. RIL

provides most of the initial capital for the company and bears the initial business risk.

Promoters do not invest much of personal money at this stage. Once the business is close to

completion, major portion of shares is purchased by the promoters, and their families and

friends at face value through private placement. Thereafter, the company goes public and

sells share through IPO at a premium. Few years later, the companies are merged.

Cost of Project

During calculation of cost of the project following points need to be considered

Land

Civil Construction

Plant & Machinery

Misc. fixed assets

Erection and commissioning

Technical know-how fees

Preliminary & preoperative expenses

Contingencies

Total capital cost

Margin money

Total project cost

Land – Depending on the project, land cost could vary from Nil to 70% of the total cost.

Take the case of Cross Roads Mall in Mumbai. The Mall is on lease. Thus, the Balance

Sheet of the Mall does not carry any cost of land. Similarly, a BPO could obtain the space




on rent or lease and may not carry any land cost in the balance sheet. But a manufacturing

company would often carry a substantial sum as land cost in their project financing

requirement.

Civil Construction – A company which carries land in its project financing documents,

would also carry civil works needs. But even companies like Malls and BPOs which may

not have any land cost in their project financing needs also often they carry civil

construction in financing needs. Current trend is to construct the shell (bare building

without any flooring and other internal fittings) and hand over to the lessee to do the

flooring, roofing, walls etc as per its requirement after doing the wiring, lighting and

ambience as per its own special needs. Thus, these needs are to be catered for in the project

financing.

Plant & Machinery – In large projects, Plant and Machinery are often imported because

import of capital goods often works out much cheaper than local procurement, especially,

in cases where capital goods can be imported without custom duty.

There are three ways to procure the imported machinery: -

(a) DTA (Domestic Territory Area) – These are imports where entire

production is meant for local consumption. Import Duty on capital goods in

such cases is currently in the range of 20-25% inclusive of CVD (Counter

Veiling Duty - A tariff levied against imports that are subsidized by the exporting country's

government, designed to offset (countervail) the effect of the subsidy).

(b) EPCG (Export Promotion Capital Goods) Scheme – It is a scheme whereby

any person in India may import machinery and equipment without payment

of any import duties or lower rate of import duty provided he undertakes

that he will export goods within the specified period of a certain minimum

amount (This scheme targets those companies who would like to operate in

foreign as well domestic markets at the same time for various reasons and

therefore can not take benefits of EOU or SEZ schemes which prohibit

domestic sales).

As per the old rules, capital goods could be imported at 5% Customs duty

subject to an export obligation of 5 times value of capital goods over a period of

8 years. The rules were further liberalised in Exim Policy of Jan 2004. The export

obligations are now linked to the value of duty saved. In other words, the importer

of capital goods is now required to export goods worth eight times the amount of

duty saved and to be fulfilled over an eight-year period.

The Exim policy had also granted exporters the flexibility to fulfill their

export obligations by exporting any other product manufactured or services

rendered by them. Thus, if a potato chips manufacturer were to import machinery

under the EPCG, he could discharge his export obligation by shipping basmati rice

produced by him.




The scope for discharge of export obligations were even more liberalised to

include exports of products/services not just by the exporting firm concern, but

"group companies" as well.

(c) SEZ – Industries located in SEZ are completely exempt from paying any

custom duty.

But when such foreign currency exposures in the project are huge, there is a

requirement to take forward cover to eliminate the risk of any considerable

appreciation in exchange rates.

VAT benefits are also available on the plant and machinery. But, these benefits are

not available upfront. Taxes are needed to be paid upfront while procuring

machines but same can be offset against tax liabilities under VAT scheme when

production begins. Therefore, VAT benefits do not affect project financing

requirements and are not to be considered.

Misc. Fixed Assets – Miscellaneous Fixed Assets are associated assets like office building

in a Power Project.

Erection and Commissioning – Using own project team is what most of the companies do

while commissioning a projects. However, now there are companies who specialize in

turnkey project commissioning, like Bechtel. While Bechtel is a company which does not

manufacture any goods and is only a project management team, many manufacturing

companies offer their services for commissioning their equipment and related services.

BHEL is one such company which offers turn key commissioning services for their

equipment. But such companies do not take orders for other assets like Misc Fixed Assets.

Services of companies like Bechtel often come for a premium because they also

bear the risk of any escalations and contingencies. But this is not always necessary. In

many cases they work out to be cheaper. Companies like Bechtel who commission 100s of

large project world wide are often in a better position to negotiate price than any single

company.

Thus contingencies are built into the cost of the project and are fixed.

This method is also called EPCM (Engineering, Procurement, Project Management

and Construction Services)

Preliminary & Preoperative Expenses – All pre-production period expenses, including

salaries of employees and interest costs are required to be capitalized. In projects with long

gestation period, these could be substantial. In some cases they work out to be as high as

half of the total project cost.

In case of Capital Intensive projects, EBIDTA (Gross Profit) to Sales Ratio is very

high. Capital Intensive projects have high Interest and Depreciation costs in the initial years




till the project gets fully depreciated and loans get paid off. Despite high EBIDTA to sales

ratio, profits are only marginal at the best. But once project is depreciated and loans get

paid off, profits soar. Conversely, working capital intensive projects have low EBIDTA to

sales ratio and profits remain more or less constant over the product life cycle.

Margin Money – In project financing it is the norm to finance approx 25% of the Working

Capital through long term sources. This is called Margin Money.

Adding up all the above give the Total Project Cost.

Project Financing

Firming up cost of project

Analysis of factors influencing financial projections

Financial projections

Structure means of financing

Determine cost of capital

Project NPV / IRR with Sensitivity analysis

Equity / Dividend IRR & value generation

Sanction / Term Sheet / Pre disbursement conditions

Security creation / Documentation

Once the project cost is firmed up, Financial Projections need to be analysed.

As a matter of fact this part is the MOST IMPORTANT part of any project financing

decision. While number crunching rarely goes wrong, it is the financial projection which is

a non financial aspect which often goes wrong. Projection of demand, sales price, raw

material prices, taxes and duty structure, etc is what goes wrong with majority of the failed

projects. Herd mentality in India often leads to over capacity and thereafter undercutting of

prices affects project viability. Changes in duty structures or tax concessions also affects

projects profitability. Quite often actual demand/sales do not match the projections. Take

the case of HP Printers. They sell the printers probably below their variable cost and expect

to make profits through sales of ink cartridges which are obscenely high priced. Similar

was the case with Polaroid Cameras. Cameras were inexpensive but films were very

expensive. Most of the car companies price their spares on an average 12 to 20 times their

actual cost. But little did HP realize the ingenuity of Indians in taking recourse to refills

which are up to 80% cheaper. Or take the case of those button cells. Smuggling of button

cells from Hong Kong by Couriers killed an Indian company. Thus financial projections

should be more closely scrutinized than any other aspect.

Another factor that needs close scrutiny is EBIDTA to Sales ratio that is assumed

by the borrower. This is the starting point in any project financing appraisal. When a

project report (called Investment document for Bankability) is submitted to the bank which

could be any thing between 500 to 5000 pages, a Flash Sheet is put up within 24 hrs. No

one has time to go through the whole document and investment decisions are made on the

selected critical figures. (This part will be discussed a little while later).




Any financing company has a data base from past financings about every industry’s

EBIDTA to Sales Ratio, the Best, the Worst and the Average. If a borrower is projecting a

EBIDTA/Sales ratio close to or higher than the best, same needs to be immediately

clarified with the borrower as how he based his projections on such high note. Is it that he

has got some new technology which is reducing production cost? If this is the case of just

over optimism, there is no need to look at any further figures.

Structuring Means of Financing – Every company would want to keep its Equity Low

and also DSCR (Debt Servicing Coverage Ratio) to be low. But the two normally move in

opposite direction. Thus, to keep DSCR low while Equity is low, one needs to find means

of financing whereby interest rate is very low. This is where structuring the means of

financing comes into play.

In order to convince banks to lend at below PLR (Prime Lending Rate), companies

often offer tradable warrant convertible after the production begins at slight discount to

then prevailing price. Because the equity base is low, EPS is high. Share price is

determined on the basis of industry average of PE multiples and thus share price is high.

This way, while the company saves on interest payment, bank gets its due through low tax

capital gains. This is the most popular method of offering sweeteners to the lenders. Then

there are other novel methods devised to suit each individual case.

Cost of Capital – After the financing is structured, cost of capital is known roughly.

Project NPV / IRR with Sensitivity analysis – NPV/IRR should be at least 400 to 500

basis points (every 100 basis points = 1%) higher than cost of capital. Any thing less and

the project is not viable.

Sensitivity analysis is done by changing the assumptions about various factors of

business like sales, cost of raw materials, duty structure, sales price etc.

Equity / Dividend IRR & value generation – There are three kinds of IRRs. What we

read earlier was Project IRR. Thereafter, there is Dividend IRR and Equity IRR.

Equity IRR means internal rate of return to all equity holders over the full term of the

project.

Sanction / Term Sheet / Pre disbursement conditions – Every project has some critical

factors which can greatly affect it. Environmental clearance for large housing projects is

one such condition which has been imposed recently. Environmental clearances are taking

upto 1 year and more. Thus, an investment in land could depreciate in the interim or some

other problems could crop up, or the company may not get the environmental clearance

itself. Therefore, unless environmental clearance is not available for the project, no bank

would disburse loan to a builder.




Investment Document for Bankability

Part - I - Introduction

Background of promoters.

Sister concerns / group activities

Group financial strengths.

Part - II The Project

(A) Technical Aspects

(i) Proposed activity

(ii) Product

(iii) Statistics on other existing/proposed units in the field

(iv) Site details

(v) Technology and process

(vi) Raw materials

(vii) Infrastructural requirements

(viii) License, permits, clearances

(ix) Capital equipment suppliers.

(x) Implementation schedule

(B) Financial Aspects

(i) Cost of project

(ii) Means of financing

(iii) Working capital requirements

(iv) Cash flow planning during construction phase

(v) Projections

(vi) Inter firm / industry ratio analysis

(vii) Sensitivity analysis

(C) Business Prospects

(i) Demand supply equilibrium

(ii) Competitor profile

(iii) Marketing strategy

Any Project Bankability document will contain above information. The document could be

500 pages or may be even 5000 pages. Once a Bankability document is filed with the bank,

a flash sheet is prepared within 24 hrs. This report is 2 or at most 3 page document. It

contains information about Promoters, Group’s activity, Group’s financial strength,

industry/product, and so on.




In 90% cases, decision regarding lending is based on flash report only. Further number

crunching exercise rarely affects lending decision.

24 hrs time is too short a time frame to analyse even 500 page report leave alone a 5000

page report. Time is not enough even flip through the report. Considering the criticality of

the report, question is where to start to make a meaningful flash report in such a short time.

As stated earlier, EBIDTA to Sales projection forms the starting point. This is followed by

analysis of factors influencing financial projections.

Each lender has sectoral, company wise, etc maximum exposure limits. Like most lender

companies do not exceed 2% of their net worth on any one group, or 6% in any one

industry sector. Once these limits are exhausted, project would be turned down even in

most deserving cases.

Infrastructural Requirements – This is another very important aspect to be examined in

some cases of financing. Take the case of power projects or refinery projects. In both cases,

products can not be stored. In case of power, electricity can not stored and therefore if

transmission grid is not ready in time, entire investment would get locked without use.

Similarly, in case of refineries, production volume is so huge that they can not store 2 days’

production. If distribution channels like pipe lines, trains, or jetties etc are not ready,

production can not start.

Raw Material Availability like coal for power plants can play havoc with project.

Implementation Schedule is another factor that can kill a project. Finance Department

would structure the financing means based on the implementation schedule. Say, for a

project stated to be completed in 2 years, finance department would set the convertibility

clause of tradable warrants at 3 years. As stated earlier, by then, share valuation would be

high, because of high EPS of the first year on a low equity base. Thus, conversion would be

at a high price and company would get good share premium. But if the implementation gets

delayed, conversion takes place before production starts at a low price and equity base

expands even before production begins. Thus, EPS would be low and consequently share

valuation would also be low.

Lender’s Participation

Direct financial support.

(a) Rupee term loans.

(b) Multilateral lines of credit.

(c) Underwriting of instruments.

(d) Direct subscription to equity capital.

(e) Issuing guarantees.

(f) Bill rediscounting.

(g) Securitisation of receivables

(h) Loan syndication.




M&A financing

Over run financing.

Financial restructuring.

Recourse on Lending – There are occasions when original loan amount falls short of

requirement due to various reasons and lending institutions are forced to lend additionally

in order to save their original loan. This is called recourse on lending.

Securitisation of Receivables – Securitisation is essentially same as Bill Discounting.

However, in case of Bill Discounting, it is single bill which is discounted. In case of

Securitisation, it is series of future bills which are discounted. It could be taking over of a

car loan by one bank from original lender.

Facets of project appraisal

The important facets for project viability analysis are:

Market analysis

Technical analysis

Financial analysis

Economic analysis

Ecological analysis

Market analysis

• What is the expected growth of the industry in the near future in which

investments are sought to be made.

• What would be the market share the project will have to achieve for

financial viability.

A detailed analysis of the marketability of the products / Services proposed

to be manufactured will have to be carried out which will encompass the following:

• Consumption trends in the past and the present consumption level

• Past and present supply position

• Production possibilities and constraints

• Imports and exports

• Structure of competition

• Cost structure

• Elasticity of demand

• Consumer behaviour, intentions, motivations, attitudes.

• Distribution channels and marketing policies in use

• Administrative, technical, and legal aspects




Technical analysis

Analysis of the technical and engineering aspects of a project needs to be

done at the project formulation stage. Technical analysis seeks to determine

whether the prerequisites for the successful commissioning of the project have been

considered and reasonably good choices have been made with respect to location,

size, process, etc. the important questions raised in technical analysis are:

• Whether the preliminary tests and studies have been done

• Whether the availability of raw materials, power, and other inputs has been

established?

• Whether the selected scale of operation is optimal?

• Whether the production process chosen is suitable?

• Whether the equipment and machines chosen are appropriate?

• Whether the auxiliary equipments and supplementary engineering works

have been provided for?

• Whether provision has been made for the treatment of effluents?

• Whether the proposed layout of the site, buildings, and plant is sound?

• Whether work schedules have been realistically drawn up?

• Whether the technology proposed to be employed is appropriate from the

social point of view?

Financial Analysis

Financial analysis seeks to ascertain whether the proposed project will be

financially viable in the sense of being able to meet the burden of servicing debt and

whether the proposed project will satisfy the return expectations of those who

provide the capital. The aspects, which have to be looked into are:

• Investment outlay and cost of project

• Means of financing

• Cost of capital

• Projected profitability

• Cash flows of the project

• Projected financial position

• Level of risk

Economic Analysis

Economic analysis, also referred to as social cost benefit analysis, is

concerned with judging a project form the larger social point of view. The questions

sought to be answered in social cost benefit analysis are:

• What are the direct economic benefits and costs of the project measured in

terms of shadow (efficiency) prices. What would be impact of the project on

the distribution of income in the society?




• What would be impact of the project on the level of savings and investment

in the society?

• What would be the contribution of the project towards the fulfillment of

certain merit wants like self-sufficiency, employment, and social order.

Such analysis is often done by multilateral lending agencies like World Bank.

Lenders like Banks and Financial Institutions rarely carry out such analysis.

Ecological Analysis

In recent years, environmental concerns have assumed a great deal of

significance and rightly so. Ecological analysis should be done particularly for

major projects, which have significant ecological implications like power plants and

irrigation schemes, and environmental – polluting industries (like bulk drugs,

chemicals, and leather processing). The key questions raised in ecological analysis

is : What is the likely damage caused by the project to the environment?

Financial indicators – Lender’s perspective

(a) Cash break even point

(b) Operating break even point

(c) Debt service coverage ratio

(d) Internal rate of return and cost of capital

(e) Gross profit margin (EBIDTA / Net sales)

(f) Operating profit margin (PBT / Net sales)

(g) Return on capital employed (ROCE)

(h) Fixed asset coverage – 1.25 minimum

(i) Capital structure leveraging

(j) Economic rate of protection (ERP)

(k) Domestic resources cost (DRC)

(l) Return on net worth

(m) Free cash flow generating capacity

(n) NPV under different scenarios

(o) Door to Door tenure of debt

Cash Break Even Point is important from the perspective that if the cash break even is not

achieved in the first year itself, working capital would get eroded and therefore company

would have to approach the lending institutions for Top Up loan on working capital.

Whenever such an event happens, it will lead to share price loss. Often companies which

are not sure of achieving the Cash Break Even in the first year, do the masking of project

expenditure and save some undeclared cash for toping up the working capital as and when

required.




Operating Break Even Point is the next mile stone. While cash break even point does not

discount (account for) the depreciation, Operating Break Even Point does. Thus, Operating

Break Even Point is always higher than Cash B/E Point.

Fixed Asset Coverage ratio (Fixed assets procured from loan are hypothecated to the

lender) was earlier kept at 1.25. But now it can be brought down to about 1.1. Considering

that yearly interest rate is 5-6% and a moratorium period of 2 years, net credit amount

would grow to approx 1.1 times before loan repayment starts. But this is just the notional

figure. Reality is far from it. Under the current laws, lenders are rarely able to recover any

loan from fixed assets. Therefore, in real sense, a Fixed Asset Coverage Ratio of even 10

would be insufficient.

Value at Risk (VAR) – In any project, it is not always 100% that is at risk unless operating

losses accumulate over a period of time. Take for instance setting up of a multiplex in a

prime area of Mumbai. If the investment is of 300 Cr, and the multiplex is not successful, it

is not all of 300 Cr that is at risk. In the worst case scenario, multiplex building can be sold

and FSI can be sold to realize may up to 200 Cr. Thus, value at risk in this case is only Rs

100 Cr.

ERP (Economic Rate of Protection) – ERP corresponds to protection given to local

producers by imposing duty on imports. Since the landed cost of imports increases due to

levy of import duty, domestic producers remain competitive even if their selling price is

above the imported cost of same product to some extent. Currently, import duties are

reducing across the board and thus ERP today stands at max 25-30%.

Negative ERP means Export Compatible. It means that production cost of item is

less than international prices. Various export promotion scheme giving concessions on

taxes, etc are meant to push marginally positive ERP products into Negative ERP ones to

boost exports.

DRC (Domestic Resource Cost) - A measure, in terms of real resources, of the

opportunity cost of producing or saving foreign exchange. Today, the cost of one dollar in

India is approx Rs 46. However, projects where it costs up to Rs 60 to produce some thing

that can be imported or exported for one dollar are acceptable. Such higher costs of

production are justified due to necessity to have foreign exchange to meet various

requirement like oil import bill. Acceptable DRC depends on Foreign Exchange Reserve

position of the country. During the FE crisis of 1990, a DRC of even Rs 100 would have

been fairly acceptable.

Door to Door tenure of debt – Door to Door tenure of debt refers to the total tenure of

debt from date of disbursement to the date of repayment including the moratorium period

(moratorium period - when no servicing of debt, neither the interest nor the principle is

required which is often “gestation period plus one year”)




Lender’s norms

For most of the projects Lenders finance to the limit of Debt / Equity ratio of 1.5 - 1.7 : 1.

However, in case of infrastructure and other capital intensive projects, D/E ratios of 5:1 are

also common.

DSCR : > 1. 8 times

Promoters Contribution : 15 -20%

Current Ratio : > 1.25 - 1.4 times

Project Financing –Issues

Stock exchange listing & SEBI guidelines

Lender’s norms

Promoter funding/ stake / perception

Ministry of finance guidelines for offshore financing

Collateral securities

Discounting till perpetuity or fixed tenure for project and Dividend /

equity IRR

Impact of MAT (115 JB - 7.65% of book profit) with set off credits

allowed for 5 years

Tax shields / Depreciation rates – 15% with initial year additional 20%

Collateral Securities – In many cases, especially in case of new unknown promoters and

in almost all cases of private enterprises, mortgaging of project assets are not considered

adequate and finance institutions seek additional security/guarantees in terms that are not

related to project. Such securities are called collateral securities. In many cases promoters

provide personal guarantees which many do not consider to be in sync with corporate

governance norms. Why should promoters bear risk disproportional to their stake in

profits?

Tax shields / Depreciation rates – Tax shields improve profitability as well as free cash

flow. Similarly, higher depreciation rates improves free cash flow. Currently, depreciation

is allowed @15% per year on WDM basis with additional 20% (total 35%) for the first

year.




Financial Statements

• Projected balance sheet

• Projected Fund flow and cash flows

• Projected income statement

• All the above statements to be analysed for:

New investment stand alone

New investment + existing balance sheet

Existing Operations without new investment

New investments are to be merged with existing business (expansion projects) only if there

is some synergy gains expected, ie if the new investment + existing balance sheet value is

more than new investment alone and existing operations without new investments.

Interest rate structuring

Interest rate volatility

Risk based interest rate structuring

Inverted interest rates

Prime lending rate inflation based with caps

Company, project, instrument rating.

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