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Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 2 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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
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Jamnalal Bajaj Institute of Mgmt Studies
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
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Jamnalal Bajaj Institute of Mgmt Studies
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
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Jamnalal Bajaj Institute of Mgmt Studies
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
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Jamnalal Bajaj Institute of Mgmt Studies
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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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Jamnalal Bajaj Institute of Mgmt Studies
(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
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
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Jamnalal Bajaj Institute of Mgmt Studies
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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 9 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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
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Jamnalal Bajaj Institute of Mgmt Studies
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).
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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.
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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.
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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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 14 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 15 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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?
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 16 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
• 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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 17 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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”)
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 18 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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.
Mgmt study material created/ compiled by - Commander RK Singh [email protected]
Page 19 of 19 - Financial Management- II (Mr Gokhale)
Jamnalal Bajaj Institute of Mgmt Studies
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.