Capital Investment and Financial Decisions

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UNIT 1 NATURE OF LONG TERM
FINANCIAL DECISIONS
Objectives
The objectives of this unit are to :
explain the basics of financial decisions and spell out the distinguishing
features and interlinkages between financing and investment decisions of
the firm.
describe and illustrate the primary objectives of financial decision making.
discuss the cardinal principles of financial decisions.
explain and illustrate the concepts of time value of money.
explain and illustrate the computation of the implied rate of interest,
implied principal amount and annuities in borrowing and lending
transactions.
narrates the basic factors influencing long term financial decisions.
Structure
1.1
Introduction
1.2
Nature of Financial Decisions

1.2.1 Investment Decisions
1.2.2 Financing Decisions
1.2.3 Dividend Policy Decisions
1.2.4 Inter-relationship amongst these Decisions
1.3
Wealth Maximisation Objective

1.3.1 Value Maximisation vs Wealth Maximization
1.3.2 Objective of Maximization of Profit Pool
1.3.3 Other objectives and Value Maximization Objective
1.3.4 Net present value rule
1.3.5 VMO and NPV rule
1.4
Cardinal principles of Financial Decision
1.5
Time value of Money

1.5.1 Compounded Value
1.5.2 Discounted Value
1.6
Determination of Implied interest Rates, Implied Principal Amount and

Annuities
1.6.1 Determination of Implied Interest Rate
1.6.2 Determination of the Implied Principal Amount
1.6.3 Determination of Annuities
1.7
Basic Factors Influencing Long term financial Decisions
1.8
Summary
1.9
Key Words
1.10 Self Assessment Questions

1.11
Further Readings
1.12 Answers
1
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Overview of Financial
Decisions
1.1 INTRODUCTION
Role and responsibilities of a finance manager have under gone a remarkable
transformation during the last four decades. Unlike the past, finance manager
plays pivotal role in planning the quantum and pattern of fund requirements,
procuring the desired amount of funds on reasonable terms, allocating funds so
pooled among profitable outlets and controlling the uses of funds. Since all
business activities involve planning for and utilization of funds, finance manager
must have clear conception of the financial objectives of his firm and cardinal
principles of financial decisions. Against this back drop, we shall discuss the
basics of financial decisions; nature of long term financing and investment
decisions; NPV Rule; time value of money; determination of implied interest
rates, implied principal amount and annuities and basic factors influencing long
term financial decisions.
1.2 NATURE OF FINANCIAL DECISIONS

Financial decisions refer to decisions concerning financial matters of a business
concern. Decisions regarding magnitude of funds to be invested to enable a
firm to accomplish its ultimate goal, kind of assets to be acquired, pattern of
capitalization, pattern of distribution of firms, income and similar other matters
are included in financial decisions. A few specific points in this regard are
(a) Financial decisions are taken by a finance manager alone or in conjunction
with his other management colleagues of the enterprise.
(b) A finance manager is responsible to handle all such problems as involve
financial matters.
(c) The entire gamut of financial decisions can be classified in three broad
categories: Investment Decisions, Financial Decisions and Dividend Policy
Decisions.
1.2.1 Investment Decisions

Investment decisions, the most important financial decision, is concerned with
determining the total amount of assets to be held in the firm, the make-up of
these assets and the business risk complexion of the firm as perceived by the
investors. The salient features of investment decisions are as follows:
(i) The investment decision are of two types, viz, long term investment
decisions and short term investment decisions.
(ii) Long term investment decision decides about the allocation of capital to
investment projects whose benefits accrue in the long run. It is concerned
with deciding :
What capital expenditure should the firm make?
What volume of funds should be committed?
How should funds be allocated as among different investment
opportunities?
(iii) Short terms investment decision decides about allocation of funds as among
cash and equivalents, receivables and inventories.
(iv) A firm may have a number of profitable investment proposals in hand. But
owing to paucity of funds, finance manager should be meticulous in
choosing the most profitable one.
(v) Thrust of financial decisions is on building suitable asset mix.
1.2.2 Financing Decision

2
In Financing decision, finance manager has to decide about the optimal
financing mix. It is concerned with how to raise money for business so as to
maximize value of the firm. Highlights of financing decisions are as follows:
Nature of Long Term

Financial Decision
(i) Question of making financing decision arise as soon as decision regarding

investment outlets is made. At times investment decision follows financing
decision.
(ii) A finance manager has to decide the appropriate mix of debt and equity
in such a way that wealth of the shareholders is maximized.
(iii) A finance manager is supposed to delve into the following issues requiring
financing decisions:
(a) From which sources are funds available?
(b) To what extent are funds available from these sources?
(c) What is the cost of funds presently used?
(d) What is the expected cost of future financing?
(e) What instruments should be employed to raise funds and at what time?
(f) Should firm approach financial institutions for securing funds?
(g) What will be the terms and conditions on which the funds will be
raised from different sources?
(h) What will be the nature of underwriting arrangements?
(i) What innovations can be made in raising funds from wide variety of
sources?
(iv) A finance manager has to be in constant touch with financial markets.
(v) Financing decisions are primarily concerned with capital structure or debt
equity compositions.
1.2.3 Dividend Policy Decision

Dividend policy decision decides about allocation of business earnings between
payment to shareholders and retained earnings. A part of the profits is
distributed amongst shareholders and other part is retained for growth of the
company. A few specific points in this regard are as follows:
(i) Closely related to the issue of raising finance is the issue of distribution of
profits, which is effectively a source of total fund requirements. This
constitutes the area of dividend decisions.
(ii) Although both growth and dividends are desirable, these two goals are
conflicting: a higher dividend rate means less retained earnings and
consequently, a slower rate of growth in earnings and stock prices.
(iii) For maximizing the shareholders wealth, the finance manager has to strike
a satisfactory compromise between the two.
(iv) Prudent finance manager takes dividend decision in the light of investors
preferences, liquidity position of the firm, stability of earnings of the
firm, need to repay debt, restrictions in debt contracts, access to capital
markets etc.
(v) Dividend policy decision is integral part of financing decisions.
1.2.4 Inter-relationship Amongst these Decisions

The interrelationship between three types of financial decisions centres around
the following issues:
(a) Which decision comes first investment or financing?
One often wonders whether the financing decision comes first or the
investment decision. The difficulty with such a question is that any answer in
favour of the one or the other is bound to be wrong. For example, why would
Decisions
any management want to raise any capital unless it had some kind of project
already in mind? Alternatively, how can a management consider undertaking a
new project unless it already had some ideas as to how it is going to raise the
necessary finances? So how does one decide which comes first? Chicken or
the egg? The answer in our context is somewhat simpler than the moot
question concerning the egg and its parent. The two decisions are in reality
simultaneous. In fact neither decision by itself makes sense without the other.
There would be no financing decisions to make in the absence of investment
decisions and vice versa.
(b) Investment Decision Vs Financing Decision- Fundamental Difference
This, however, is not to imply that the line dividing the two is fuzzy. In fact,
conceptually the two kinds of decisions are quite different and it is important to
recognize them as such. What is the fundamental difference between the two ?
Evidently, both, financing as well as investment decisions involve a certain
selection of cash flows. Typically, a financing decision involves accepting cash
today (inflows) from the capital market and repaying the same together with
interest or dividend subsequently over a period of time (outflows). On the
other hand, an investment decision involves investing the cash today in the
product market (outflow) and receiving a stream of earnings (inflows)
subsequently. Now, the cash invested in the product market is, in fact, the cash
which is raised from the capital market.
(c) Relationship through NPV
If after paying all lenders their interest and shareholders their normally expected
dividends, some surplus is left, obviously, it will belong to the shareholders
thereby increasing their wealth. Usually, however, it is extremely cumbersome,
though not impossible, to match the cash flows arising from the financing
decisions and the cash flows accruing from the investment decisions on a
period basis on account of the possible mismatch between their timings. It is
therefore far simpler to capture the financing cash flows through their cost (of
capital and to use this rate for discounting the operating cash flows. Under this
framework, obtaining a positive net present value (NPV) implies the same thing
as minimizing the cost of capital. The point becomes further clear if we take
another look at the NPV formula i.e.
NPV=Co+C1/(1+r) where C0 and C1 are cash flows occuring at time 0 and 1
A close look into the formula would readily show that r and NPV are
inversely related. A higher r would mean lower NPV and vice versa. The r
being the rate of discount which normally represents cost of capital. It clearly
highlights the interlinkage between the financing and the investment decisions
and provides an explicit justification of the NPV rule as the basic rule of
financial decision making.
Activity 1
(a) Identify forces than brought about fundamental change in role and
responsibilities of a finance manager in India.
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(b) Write down two sets of cash flows; one representing a financing scheme
and the other an investment scheme.
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Nature of Long Term

Financial Decision
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(c) Show the IRR of the Financing Scheme.
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(d) Discount the cash flows of the investment scheme using the above IRR
as the discount rate.
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(e) NPV formula captures the interlinkages between investment andfinancing
decision. Explain, with examples.
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1.3 WEALTH MAXIMISATION AND MAXIMISATION

OF PROFIT POOL OBJECTIVES
In a highly competitive environment, financial objective of a firm should be set
within the framework of corporate objective of sustainable competitive edge. As
such Wealth maximization objective has come to be widely recognized criterion
with which the performance of a business enterprise is evaluated. The word
wealth refers to the net present worth of the firm. Net present worth is the
difference between gross present worth and the amount of capital investment
required to achieve the benefits. Gross present worth represents the present
value of expected cash flows discounted at a rate which reflects their
certainty or uncertainty. Thus, wealth maximization objective (WMO) as
decisional criterion suggests that any financial action giving positive NPV
should be accepted. Algebraically, net present value can be expressed as
follows:
NPV
(W)
A1
A2
An
+
+
C
2
(1 + k)
(1 + K)
(1 + k)n
where
W = net present worth
A1,A2An = the stream of benefits expected to occur over a period of time
K = appropriate discount rate to measure risk
C = initial outlay required to acquire the asset
n = time
The objective of wealth maximization removes the following limitations of profit
maximization objective (all such actions increasing income and cutting down
costs should be undertaken):
Decisions
(i) The term profit as used in the profit maximization goal is vague.
(ii) it ignores time value factor.
(iii) It ignores risk factor.
The wealth maximization objective has the advantage of exactness and
unambiguity and also takes care of time value and risk factors.
1.3.1 Value Maximisation is Wealth Maximisation

The owner of the business employs a manager to look after his business
interests. In case of a publicly held company, a manager is expected to act in
the best interest of the shareholders, who are the owners of the business. Now,
what is in the best interest of the shareholders? This depends on what the
shareholders want. Assuming the shareholders to be economically rational
beings, it appears reasonable to assume that in general they want to get as rich
as possible through their stake in the business. In other words, they want to
maximize their wealth i.e. market value of shareholding. They are assumed to
trade their wealth so as to obtain their desired consumption patterns. Further,
they are assumed to choose the risks associated with the consumption pattern
chosen by them (for example, lending your money may give you a consumption
pattern which is less risky, whereas investing, your money in a security or
share may give you a consumption pattern with higher risk). In the final
analysis, shareholders seek to maximize their return for a given level of risk or
minimize their risk for a given level of return.
1.3.2 Objective of Maximization of Profit Pool:

In his endeavour to foster overall objective of sustainable competitive edge over
the rivals, finance manager has to focus on value maximization-not only
maximization of shareholders value but also stakeholders value. Additional
value accrues only with efforts that maximize profit pool. A profit pool can be
defined as the total profits earned in an industry at all points along the
industrys value chain. It includes disaggregation of processes, mapping of the
value chain beyond the confines of legal entities, adoption of flexible
organizational structures and creation of net-worked organisations. Main
highlights of this objective are:
(i) Profit pool concept is based on the concept of looking beyond the core
business.
(ii) Shape of a profit pool reflects the competitive dynamics of a business.
(iii) Profit concentrations emanate from actions and interactions of companies
and customers.
(iv) A profit pool is not stagnant.
(v) A profit pool map answers the most pertinent question where and how is
money being made.
(vi) Profit pool may prompts the management to examine how same profit
sources exert influence over others and shape competition.
1.3.3 Other Objectives and Value Maximisation Objective
There are many other objectives which are assumed to compete with Value
Maximisation Objective (VMO). In fact there are a whole lot of researchers
who interview practicing managers and show that the managers often have a
whole lot of other legitimate objectives other than the VMO. These are often
enumerated as maximizing return on investment, maximizing profit after taxes,
maximizing sales, maximizing the market share of their products and so on. It is
often held that very few managers in fact agree to pursue value maximisation
of their firms as an explicit objective.
A little reflection reveals the intrinsic weakness of such studies. For example,
one researcher asked a manager who held maximization of market share as the
corporate objective, as to whether he would like his company to capture 100%
market share by pricing below costs. Clearly if market share maximization is
the prime objective, he should have no objection to such a proposition. And yet
it would be a poor manager indeed who goes for such an opinion. Clearly, his
desire to maximize market share even at cost of profits in the short terms,
must have been triggered off by the possibility of attaining a monopolistic
position so that profits in the long term can be maximized. Similarly, a manager
who maximizes sales may be operating under the assumption, that such a
course of action would eventually lead to enhanced profits in the long run, if
not immediately. Other objectives such as maximization of return on investment
or profit before taxes etc. are at any rate linked to the wealth maximization
criteria directly or indirectly. We can see that what are constructed as
objective as other than VMO are in fact merely short term operational
strategies for maximizing wealth of the shareholders in the long run.
Nature of Long Term

Financial Decision
1.3.4 Net Present Value Rule

Wealth maximization objective gives Net Present Value (NPV) rule as the most
basic rule of financial decision making. To make as investment decision, you
compare the returns on the investment with what the financial markets are
offering. The NPV rule really provides you with a simple way of making that
comparison. By computing the present value of an investment you are finding
out what the investment is worth today. On comparing the present value of an
investment with its initial outlay, you arrive at the net present value which may
be positive or negative. The concept of NPV, in the form of a simple
algebraic formula, may be stated as follows:
NPV = C1/(1+r) - C O
Where CO stands for initial cash outlay, C1 for the cash that with be received
from the investment in one years time, r for is the discount rate. The discount
rate r should include an appropriate premium for risk.
As a rule, an investment is worth making if it has a positive NPV. If an
investments NPV is negative, it should be rejected.
Example:
X invests Rs.70,000 in a piece of land. There are three proposals before him
for its sale:
A
Rs.75,000
B
Rs.77,000
C
Rs.80,000
His expectation of income is 10%. When he should sell his price of land ? By
applying NPV Rule, the results will be as follows:
NPV = C1/(1+r) co
NPV1 =
75,000
70,000 = 1817.50
(1 + 0.1)
NPV2
NPV3 =
77 , 000
70 , 000 = 0
(1 + 0 . 1 )
80,000
70,000 = 2727 .27
(1 + 0.1)
7
Decisions
Applying the NPV rule, X will invest in land only where the land will sell for
Rs.80,000 next year and not where the land will sell for either Rs.75,000 or
Rs.77,000. positive NPV is the logic.
One might ask here: Is this NPV rule valid for firms also? The answer is
yes, as long as the objective of the firm is value maximization.
1.3.5 VMO and NPV Rule

It clearly emerges form the foregoing discussion that a manager can help the
shareholders by making all business decisions in such a manner that the
shareholders stake in the business is maximized. This would essentially mean
that the managers would invest in all such investment opportunities where the
present value of the expected future cash inflows exceeds the current level of
investment, so that this excess of the present value of inflows over the initial
investment enhances the total market value of the shares belonging to the
shareholders.
It should be clear that if the New Present Value (NPV) of an investment were
to be negative, the investors would be better off by investing their funds
elsewhere. Thus the manager must invest the shareholders funds only in
ventures which yield positive NPV such that the value of their shares is
maximized. Let us suppose that the market value of a firms share is Rs.100.
Let us further assume that the shareholders of the firms expect to earn a
return of 20% per annum from their investment in the firm. If the
management of the firm fails to earn Rs.20 per share, the market mechanism
would ensure that the price of the firms share drops. How much will the drop
be? It depends on the level of the firms earnings. If the earnings level falls to
say Rs.15 per share over a period of time, the price of the share would drop
to Rs.75. why? This is because, given the earnings per share of Rs.15 of the
firm, the shareholders can continue to earn their expected level of 20% return
only if the price of the share fell to Rs.75. this drop in the price of the share
would however lower the wealth of the shareholders. Hence, the manager must
ensure that the funds are invested in ventures which would be able to generate
enough surplus to meet the expectations of the shareholders. thus, the principal
objective in business becomes the maximization of the shareholders wealth.
Activity 2
(a) Map out profit pool for a transport industry.
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(b) The market price of a companys share falls. What could be the possible
reasons?
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(c) Investors in a capital market revise their expectation of return from a
particular company from 20% to 24% on account of that company having
undertaken some risky ventures recently. Would the market price of that
companys share go up or go down ? why?
8
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Nature of Long Term

Financial Decision
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(d) On account of certain government concessions to a particular company, its
financial performance is expected to improve in the future. Would the
market price of the companys share go up or go down? Why?
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(e) A firm has decided to set up a steel plant. What sources of funds would
you suggest to the firm for funding the plant?
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1.4 CARDINAL PRINCIPLES OF FINANCIAL

DECISIONS:
A finance manager in his attempt to maximize corporate value of the firm must
keep in view the following basic considerations while making financial decisions:
(i) Strategic Principle:

According to this principle, financial decisions of a firm should be tethered
to the overall corporate objectives and strategies.
(ii) Optimization Principle:

Thrust of financial decisions should be on intensive use of available funds
and for that purpose, proper balance between fixed and working capital should
be sought.
(iii) Risk Return Principle

Maintaining suitable balance between risk and return is the crux of financial
decision making. Given the product-market strategy, return and risk are the
function of decision relating to size of the firm, kinds of assets to be acquired,
types of funds to be employed, extent of funds to be kept in liquid form, etc.
(iv) Marginal Principle:

According to this principle, a firm should continue to operate upto the point
where its marginal revenue is just equal to its marginal cost.
(v) Suitability Principle:

Focus of this principle is on creating an asset by a financial instrument
of the same approximate maturity.
(vi) Flexibility Principle:

According to this principle, financial plan of a firm should be capable to
being changed in sync with changing environment.
Decisions
(vii) Timing Principle:

Timing should be crucial consideration in financial decisions. Investment
and financing decisions should be taken at a time that enable the
organisation to seize market opportunities and minimize cost of raising funds.
1.5 TIME VALUE OF MONEY

Suppose you are given an option to receive Rs.100 today or Rs.100 a year
from today, which option would you choose? Of course, Rs.100 today. Why?
Could it be that Rs.100 today represents greater certainty than Rs.100 a year
from now? Possibly. But this element or risk associated with Rs.100 a year
from now could be eliminated or largely reduced through suitable promises,
insurance against default and so on, so that you may disregard the possibility of
such default. So you are required to make your choice once again. Would you
still choose to receive Rs.100 today rather than a year form now? Why ?
May be you are afraid that Rs.100 a year from now might be worth much less
than Rs.100 today on account of inflation. Let us suppose, for the sake of
argument, that you are living in an economy which is free from inflation. You
may be promised Rs.100 worth of goods today, instead of cash and the same
amount of goods a year from now, so that you are effectively protected against
inflation. What would your choice be ? Still Rs.100 today why ? A good reason
can be that you could collect your Rs.100 today, put it in the fixed deposit in
the bank for a year, and collect Rs.110 a year from now, assuming that the
bank gives you 10% interest on your deposit. Thus you would be better off by
Rs.10 than you would have been if you had received Rs.100 a year later.
The next question could be, why should the bank give you 10% interest on
your deposit? The obvious reason is that cash is a scarce resource and the
bank is, therefore, prepared to give you a rental (Rs.10) in return for your
allowing them the use of your capital (Rs.100) for a year. Needless to say,
the bank would not have agreed to give you Rs.10 for using your capital for a
year, if it did not expect to earn more than Rs.10 by investing Rs.100 elsewhere
during the year. Thus in this case, Rs.10 represents the time value of Rs.100
for a period of one year, i.e. 10% per annum. Of course, the real time value
of money would depend on the total amount of money available in the economy
and the investment opportunities available in the economy and so on.
Time value of money or time preference for money is one of the central ideas
is finance. Money has a time value because of the following reasons:
(i) Individuals generally prefer current consumption.
(ii) An investor can profitably employ a rupee received today to give him a
higher value to be received tomorrow.
(iii) Future is uncertain.
(iv) Inflationary pressures make the money received in future of lesser
purchasing power.
Thus, there is preference of having money at present than at a future point of
time. This automatically means:
(i) That a person will have to pay in future more for a rupee received today.
(ii) A person may prefer to accept less today for a rupee to be received in
future.
They are called as compounded value and discounted value.
10
1.5.1 Compounded Value
Nature of Long Term

Financial Decision
The process of finding the future value of a payment or receipt or series of

payments or receipts when applying the concept of compound interest is known
as compounding. It is also called terminal value.
Present Cash to Future Cash
Let us now understand the concept of terminal value. Given that the time value
of money (say interest rate) is 10% per annum, what will be the value of
Rs.100 one year from today? Obviously Rs.110. Thus the terminal (or
compounded) value of Rs.100 at the rate of 10% a year from now is equal to
Rs.110.
How did you arrive at the terminal value of Rs.110? whether you were aware
of it or not, you multiplied Rs.100 by 0.10 (being 10%) and added the result to
Rs.100, to obtain Rs.110.
In mathematical terms:
Terminal value of Rs.100 @ 10% at the end of one year is equal to 100 +
0.10 x 100 = 100 x 1.1 = Rs.110.
Similarly, can you now find out the terminal value of Rs.100 at the rate of 10%
two years from today?
(Hint : First find out the terminal value of Rs.100 one year from now, which
will be Rs.110. now find out the terminal value of Rs.110 a further one year
hence.)
In mathematical terms, this would be equal to 100 x 1.1 x 1.1 = 100 x 1.12 =
Rs.121
In general then, the terminal value of an amount p, at a rate of r per period,
and for n periods from today will be
p (1+r) (1+r) (1+r) . n times = p (1+r)n
Note: (1+r)n is known as the Terminal Value factor n periods hence, at the
compound rate of r per period.
In case of multiple period compounding
r
A = P 1 +
mn
Where
A
m
P
r
n
=
=
=
=
=
Amount after n period

number of times per year compounding is made
Amount in the beginning of period
Interest rate
Number of years for which compounding is to be done
1.5.2 Discounted Value

Deposit Rs.100 and take back Rs.110 after one year stated in a numerical
way means that Rs.100 is the present value of Rs.110 to be received a year
hence. In case of discounted value, we estimate the present worth of a future
payment/instalment or series of payments adjusted for the time value of money.
11
Decisions
Future Cash to Present Cash

At the rate of 10% per annum, what will be the present (or discounted) value
of Rs.110 to be received one year from now? Clearly, this will be Rs.100. how
was this arrived at?
By dividing Rs.110 by 1.1 (Remember: Rs.110
Rs.100 one year hence @ 10%).
was the terminal value of
Similarly, what will be the present value of Rs.100 to be received one year
hence, @ 10% per annum? This will be Rs.9.90909, arrived at by dividing
Rs.100 by by 1.1.
In mathematical terms:
Present value of Rs.100 to be received one year hence, @ 10% per annum =
100/1.1=90.90909.
Similarly, the present value of rs. 100 to be received two years. Hence, @
10% per annum = (100/1.1)/1.1=100(1.1)2 =82.64463.
In general then the present value of an amount P to be received in n
periods hence, at the rate or r per period will be =P/(1+r)n.
Note: 1/(1+r)n is shown as the present value factor for an amount received n
periods hence, at the discount rate of r per period.
Activity 3
(a) A sum of Rs.1,000 is placed in the savings account of a bank at 5 percent
interest rate. Find the sum at the end of two years.
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(b) An investor has an Opportunity of receiving Rs.1,000, Rs.1,500, Rs.800,
Rs.1,100 and Rs.400 respectively at the end of one through five year. Find
the present value of this stream of uneven cash flows, if the investors
interest rate is 8 present?
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(c) You can get an annual rate of interest of 13 percent on a public deposit
with a company. What is the effective rate of interest if the compound is
done (a) half yearly (b) quarterly and (c) weekly.
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12
Nature of Long Term
Financial Decision
1.6 DETERMINATION OF IMPLIED INTEREST

RATES, IMPLIED PRINCIPAL AMOUNT AND
ANNUITIES
In this subsection, the process of determination of implied interest rates, implied
principal amount and annuities is explained.
1.6.1 Determination of Implied Interest Rates

Suppose you borrow Rs.100 for one year and the lender asks you to repay
Rs.120 one year later. What is the interest rate implied by your borrowing?
Clearly 20%. This is because at the end of one year, you are required to repay
the principal of Rs.100 as well as the interest of Rs.20.
However, suppose the lender offers you any one of the following repayment
schedules for having borrowed Rs.100 now:
Repayment Schedule
Repay at the end of
Repay at the end of
Repay at the end of
Repay at the end of
Repay at the end of
Repay at the end of
1st year = Rs.

2nd year = Rs.
3rd year = Rs.
4th year = Rs.
5th year = Rs.
6th year = Rs.
1
20
20
120
2
20
20
20
120
3
45
90
4
70
60
5
95
30
(Repay in perpetuity)
6
95
5
5
5
30
7
20
20
20
20
20
20
20
What is the interest rate implied in each of the above repayment schedules? Is
it 20% for all the schedules? At this stage you may find it more difficult to
provide an answer. It may, however, be relatively simpler to answer the
question for schedules 1,2 and 7 intuitively.
In case of schedule 1, Rs.20 is paid towards interest at the end of first year
since the loan is fully outstanding. Similarly Rs.20 is paid again at the end of
second and third years, at which time the principal of Rs.100 is also repaid.
Similarly, in case of schedule 2, the principal amount is fully repaid only at the
end of fourth year, till which time the interest of Rs.20 is being paid at the
end of every year. In case of schedule 7, the principal is never repaid and
hence the interest of Rs.20 is being paid at the end of every year for ever,
thus, in all these cases the implied interest rate remains 20% per annum.
For repayment schedules from 3through 6, a similar interpretation is possible,
through this would be somewhat more difficult. Consider, for example, schedule
4. in this case, at the end of first year half of the principal is repaid. However
since the entire principal is outstanding for the whole of first year, the interest
accrued is Rs.20. this together with half the principal being repaid at the end of
the first year amounts to Rs.70. Thus, only Rs.50 is outstanding as long for the
second year so that the interest accrued on this amount at the rate of 20% in
the second year is only Rs.10. The outstanding loan of Rs.50 is fully paid the
end of second year so that the total repayment at the end of second year is
Rs.60. Thus, the interest rate implied in this case is also 20%.
(Can you provide similar interpretations for schedules 3,5 and 6? You should be
able to see that in all these cases the implied interest rate is 20% per annum).
It should be readily apparent that one may arrive at an infinite number of such
repayment schedules all of which imply an interest rate of 20% per annum. In
the absence of prior information on the interest rate, how can one determine
13
Decisions
what interest rate is implied in a given loan scheme? One must have a more
structured and systematic approach to determine the implied interest rate, given
a loan amount and its repayment schedule.
Let us consider schedule 3. The Schedule represents a repayment of Rs.45 at
the end of first year and Rs.90 at the end of second year, against a loan of
Rs.100 now. The interest rate may be defined as that rate at which the present
value of the repaid amounts exactly equal Rs.100 Let this rate be equal to r.
Thus we must have:
100 = 45/(1 + r) + 90/(1 + r)2
(Note : 45/(1 + r) represents the present value of Rs.45 to be paid one year
later and 90/(1 + r) represents the present value of Rs.90 to be paid two
years later, at the rate of r per annum).
The value of r can be determined from the above equation using the hit and
trial method without much difficulty. In this case, it can be found that when r =
0.20, the equation is exactly satisfied, so that the interest rate implied in this
case is confirmed to be 20%.
You have studied that Internal Rate of Return (IRR) is the rate at which the
present value of the inflows exactly equals the initial outflow. In the above
example, the initial borrowing (inflow) is 100 and the repayments (outflows) at
the end of the first and second years are Rs.45 and Rs.90, respectively. At the
rate of 20%, the present value of outflows exactly equals the initial inflow.
Thus, for the set of cash flows represented by Rs. 100, in time zero, -45 at the
end of the first year, and -90 at the end of second year respectively (plus sign
is for the inflow and minus sign is for the outflow), the implied rate of interest
is equal to 20%. In other words, interest rate implied in a typical loan scheme
which involves an initial inflow (borrowing) followed by subsequent outflows
(repayments) is just like the IRR of the cash flows associated with the loan
scheme.
1.6.2 Determination of the Implied Principal Amount

Let us assume that a prospective borrower approaches you for a loan. He is
confident of being able to pay you Rs.193 for four years starting a year from
today. Assuming that your desired rate of interest is 20% per annum, how
much amount would you be prepared to lend him today?
In the light of our discussion above, it should be clear that the amount you
should lend, should exactly equal the present value of the annual stream of
Rs.193 for four years discounted at the rate of 20%. Let us assume that the
amount you would be prepared to lend is P.
Mathematically, we must have:
P = 193/(1.2) + 193/(1.2)2 + 193/(1.2)3 +193/(1.2)4 = 500
Thus, you should be prepared to lend Rs.500 in the above case. The same
logic may be employed to determine what is called fair price of a share in the
market. Let us suppose you expect a company to pay you dividends worth
Rs.20, 30 and 40 at the end of one, two and three years from today,
respectively. Further suppose you wish to hold the share for only three years
and you expect to be able to sell the share at the end of the third year for
Rs.120 how much would you be prepared to pay for the share of such a
company today? Clearly, we must employ the same technique as above and
14
find out the present value of the inflows, namely Rs.20 at the end of first year,
Rs.30 at the end of second year and 160 at the end of third year (Rs.40 worth
of dividends plus Rs.120 from the sale of the share) at a rate which you
expect to earn on your investment. Let us assume that you wish to earn 25%
on this investment as you consider the proposition somewhat risky (assuming
that higher the risk, higher the return expected). The present value of the
above inflows when discounted at 25% yields about Rs.117, which is the
amount you should be willing to pay for a single share of the company
mentioned above.
Nature of Long Term

Financial Decision
1.6.3 Determination of Annuities

Let us assume that you borrow Rs.100 at an interest of 20% per annum for a
period of two years. However, you wish to repay the loan in two equal annual
installments (also knows an annuities). What should be this installment?
(If your answer is Rs.50, it is obviously wrong. Guess why?).
Let us assume that each installment amount equals X. We have a cash flow
pattern of the kind + 100 in time zero, X at the end of first year and x at the
end of second year respectively.
According to the IRR rule, we must have:
100 = X/(1.2) + X/(1.2)2, or 100 = 0.833 X + 0.694 X or X = 100/1.527 = 65.49.
Activity 4
(a) In the above example, the repayments commenced one year later. What
would you do if annual repayments were to commence as soon as loan
was received, i.e. from time zero onwards, instead of from the end of first
year onwards?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
(b) In the annuity example given above, can you find out the annuity payments
if the repayment period were three years or four years or five years?
What will be the annuities, if the payments were to commence
immediately?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
(c) Given the cash flows + 500, -100, -200, -300, -400 in period 0,1,2,3 and 4,
respectively. Calculate the Implied rate of interest.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
15
Decisions
1.7 BASIC FACTORS INFLUENCING LONG TERM

FINANCIAL DECISIONS
A finance manager has to exercise great skill and prudence while taking longterm financial decisions since they effect the financial health of the enterprise
over a long period of time. It would, therefore, be in fitness of things to take
the decisions in the light of external and internal factors as discussed below.
External factors
External factors refer to environmental factors that bear upon operations of a
business enterprise. These factors are beyond the control and influence of
management. The following external factors enter into long term financial
decision making process:
(i) State of economy-i.e. phase of trade cycle.
(ii) Institutional structures of capital markets (Developed or undeveloped).
(iii) State regulations in financing (Debt Equity Norms, Dividend Payment
Restrictions etc.
(iv) Taxation policy.
(v) Expectations of Investors in terms of safety, liquidity and profitability.
(vi) Lending policies of financial institutions.
Internal Factors
Internal factors comprise those factors which are related with internal
conditions of the firm, as listed below:
(i) Nature of business
(ii) Size of Business
(iii) Age of the firm
(iv) Ownership structure
(v) Asset structure of the firm
(vi) Liquidity position of the firm
(vii) Expected return, cost and risk
(viii)Probabilities of regular and steady earnings
(ix) Attitude of management
It is practically inexpedient to consider all the factors at a time since they are
antagonistic to each other. A prudent and skillful manager strives to strike a
proper balance among these factors in the light of income, risk, control and
flexibility factors.
1.8 SUMMARY
Investment decisions pertains to choice of outlets in which funds are to be
deployed so as to maximize value of the firm where as financing decisions
concern with funding of the outlets and dividend policy decision shed light on
allocation of net earnings between retention and distribution.
16
The objective of a firm is to maximize the wealth of its shareholders. The

wealth of the shareholders is measured through the market value of their
shares. The Market value of a firms share is nothing but the present value of
its future earnings, discounted at the rate of return expected by its
shareholders. In order to maximize the shareholders wealth, only those
projects which yield a positive NPV are accepted.
A rupee today is not equal to a rupee tomorrow. This is so because the rupee
can be put to some productive use during the intervening period and thus made
to earn. Like any limited resources, capital does not come free. It has a cost,
which is termed as the time value of money. The mechanism by which we
equate a rupee today with a rupee tomorrow is by bringing both the rupees on
a common date, either today or tomorrow. Reducing them to todays value is
called their present value. Similarly, reducing them to tomorrows value is
known as terminal value. The former involves discounting the future rupee to
the present at the appropriate cost of money, while the letter involves
compounding the rupee today to a future date.
Nature of Long Term

Financial Decision
Finance manager has to exercise great skill and prudence to strike a proper
balance amongst external and internal factors influencing financial decisions.
1.9 KEY WORDS

Annuity is an equalized stream of cash flows over a period of time.
Capital Market is where financial instruments are bought or sold.
Capital Structure is the composition of a firms capital in terms of debt and
equity.
Cost of Capital is a term used to refer to the weighted average of the cost of
debt and equity.
Equity represents the share of an investor in a business.
Internal Rate of Return (IRR) is the rate at which the present value of a
stream of cash inflows equals the initial outflow, so that the Net Present Value
(NPV) of the set of given cash flows equals zero.
Net Present Value is the difference between the present values of cash
inflows and cash outflows, when cash inflows are discounted at a suitable rate.
Present Value is value obtained when future cash flows are discounted to the
present at a certain rate.
Terminal Value is the value obtained when current cash flows are
compounded to the future at a certain rate.
Time Value of Money refers to the instrinsic value of money on account of
its alternate use potential.
Financial Decisions refer to decisions concerning financial matters of a
business concern.
Investment Decisions refer to assets mix or utilization of funds.
Financing Decisions refer to capital structure or optimal financing mix.
Dividend Policy Decisions decide about allocation of business earnings.
1.10 SELF-ASSESSMENT QUESTIONS

1)
Why is Time Value of Money independent of inflation and risk?

Differentiate Present Value and Terminal Value.
17
Decisions
2)
What is Net Present Value? How is the NPV rule related to the wealth
maximization objectives of a firm?
3)
What is IRR ? How does it relate to financing decisions? Can you use it
for investment decisions of the accept/reject type?
4)
What is Investment Decisions? How is it different from financing

decisions?
5)
Bring out the factors influencing long-term financial decisions of the firm ?
6)
Obtaining Positive NPV implies the same thing as minimizing the cost of
capital Explain with examples.
7)
Project a and B require equal amount of investment. Project a will yield

Rs.3,000. 4,000 and 5,000 in the first, second and third years, respectively,
project B, however, will yield Rs.5,000, 4,000 and 3,000, respectively in the
first, second and third years. Which project is superior? Why
8)
What will be the monthly time adjusted interest rate which is equivalent to
an annual interest rate of 15%?
Hint : if annual rate = R, and equivalent quarterly rate = r, We will have :
(1 + R) = (1 + r) 4.
9)
A client goes to the bank and borrows Rs.12,000. the Bank Manager
requires the client to repay Rs.6,000 at the end of every year for three
years. What interest rate was the client charged? What would be the
interest rate if the Manager had instead asked the client to repay in five
annual installments of Rs.4,000 at the beginning of every year starting from
the date of borrowing?
10) Mr. X is considering to invest Rs.1 lakh in a project which is expected to

result in a net cash flow of Rs.20,000 at the end of each year for 8 years.
Mr. X will have to borrow the amount required for investment at the rate
of 12% per annum. Should he undertake the project ?
11) Suppose Govinda is currently earning Rs.50,000. Next year he will earn
Rs.60,000. Govinda is profligate and wants to consume Rs.75,000 this year.
The current interest rate is 10%. What will be Govindas consumption
potential by next year if he consumes according to his desires this year?
12) Amir is a miser. He currently earns Rs.50,000 and will earn Rs,40,000 next
year. He plans to consume only Rs.20,000 this year. The current interest
rate is 10%. What will be Amirs consumption potential next year?
13) It is estimated that a firm has a pension liability of Rs.1 million to be paid
in 24 years. To assess the value of the firms stock, financial analyst
wants to discount this liability back to the present. If the discount rate is
16%, what is the present value of this liability?
14) Consider a firm with a contract to sell a capital asset for Rs.70,000.
Payment is to be received at the end of 2 years. The asset costs
Rs.60,000 to produce. Given that the interest rate is 10%, did the firm
make a profit on this item? That is the interest rate at which the firm
breaks even?
15) You have won the Nagaland State Lottery. Lottery officials offer you the
choice of the following alternate payouts:
Alternate 1 : Rs.10,000 1 year from now
Alternate 2 : Rs.20,000 5 years from now
Which should you choose if the discount rate is
a) 0% ?
b) 10% ?
c) 20% ?
18
16) You are considering to make an offer to buy some land for Rs.25,000 Your
offer will be to pay Rs.5,000 down and for the seller to carry a contract
for the remaining Rs.20,000. you would like to pay off the contract over
six years at an interest of 18 per cent per year. For the first year, you
wish to pay interest only each month. For the remaining five years, you
are willing to pay off the contract in equal monthly installments. What will
be your monthly payment for years 2 through 6 if the seller agrees to your
terms?
Nature of Long Term

Financial Decision
17) Sukhdev wants to save money to meet two objectives. First, he would like
to be able to retire twenty years from now and have a retirement income
of Rs.30,000 per year for at least ten years. Second he would like to
purchase a plot of land five years from now at an estimated cost of
Rs.15,000. He can afford to save only Rs.5,000 per year for the first five
years. Shkhdev expects to earn 10 per cent per year on average from
investments over the next thirty years. What must his minimum annual
savings be from years 6 through 20 to meet his objectives?
18) Deepak has asked your advice on the following problem. He has a
mortgage loan on the family home that was made several years ago when
interest rates were lower. The loan has a current balance of Rs.30,000
and will be paid off in twenty years by paying Rs.270 per month. He has
discussed paying off the loan ahead of schedule with an officer of the
bank holding the mortgage. The bank is willing to accept Rs.27,000 right
now to pay it off completely. What advice would you offer to Deepak?
19) Which decisions comes first-investment or financing?
20) Explain, briefly, the nature and types of financial decisions.
1.11 FURTHER READINGS

Ross, A. Stephen and Randolph W. Westerfield, 1988. Corporate finance,
Times Mirror Missouri (Chapter 3).
Schall, Lawrence D. and Charles W. Haley, 1986. Introduction to Financial
Management, McGraw Hill, New York (Chapters 1, 2, 4 & 5).
Van Horne, C. James, 1985. Financial Management and Policy, Prentice-Hall
of India, New Delhi (Chapter 1).
Weston, J. Fred and Eugene F. Brigham, 1986. Managerial Finance, the
Dryden Press (Chapters 1,2,4 & 6).
Chandra, Prasanna, Financial Management Theory and practice, Tata
McGraw, New Delhi-1994 (Chapter 4).
Pandey, I.M., Financial Management, Vikas Publishing House, New Delhi
1993 (Chapter 1 & 8).
Srivastava, R.M., Financial Management Pragati Prakashan, Srivastava,
R.M. Financial Management and policy Himalaya Publishing House, Mumbai
2003 (Chapter 1)
Maheshwari, S.N., Financial Management Principles and Practice,
Sultan Chand & sons-1996 (chapter 1&2).
1.12 ANSWERS
Activity 3
(a) Rs.1102.50
19
Decisions
(b) Rs.3921.60
(c) 13.42%, 13.65%, 13.86%
Activity 4
(b) First part Rs.47.47, Rs.38.63 and Rs.33.44
Second part-Rs.39.56. Rs.32.19 and Rs.27.87
(c) Approximate -2)
Self assessment Questions/Exercises.
7. Prosecute B
8. 1.17.1.
9 first Part 23.51. Second Part-20/.
10 No. Negative NpV Rs.648
20
UNIT 2 COST OF CAPITAL
Objectives
provide conceptual understanding of the cost of capital and its variants.
illustrate the computation of cost of specific courses of long-term finance
viz. long term debt and debentures, preference shares, equity shares, and
retained earnings.
discuss and illustrate the various weighting approaches and the Weighted
Average Cost of Capital (WACC).
examine the utility of cost of capital
Structure
2.1
Introduction
2.2
Concept of Cost of Capital
2.3
2.2.1
Components of Cost of Capital
2.2.2
Classification of Cost of Capital
Computing Cost of Capital of Individual Components

2.3.1
Cost of Long-term Debt
2.3.2
Cost of Preference Capital
2.3.3
Cost of Equity Capital
2.3.4
Cost of Retained Earnings
2.4
Weighted Cost of Capital
2.5
Significance of Cost of Capital
2.6
Some misconceptions about the Cost of Capital
2.7
Summary
2.8
Keywords
2.9
Self Assessment Questions
2.10
Further Readings
2.11
Answers
Appendix 2.1: Share Valuation with Constant Growth in Dividends
2.1 INTRODUCTION
The Cost of Capital is an important financial concept. It links the companys
long-term financial decisions with the shareholders value as determined in the
market place. Two basic conditions must be fulfilled so that the companys cost
of capital can be used to evaluate new investment:
1)
The new investments being considered have the same risks as the typical
or average investment undertaken by the firm.
2)
The financing policy of the firm remains unaffected by the investments that
are being made.
In this unit, we shall dilate upon the concept of the cost of capital and its
classification, the process of computing cost of capital of individual components,
weighted cost of capital, significance of cost of capital and a few
misconceptions about the cost of capital.
1
Decisions
2.2 CONCEPT OF COST OF CAPITAL

The term cost of capital refers to the minimum rate of return that a firm must
earn on its investments so as to keep the value of the enterprise infact. It
represents the rate of return which the firm must pay to the suppliers of capital
for use of their funds.
The following are the basic characteristics of cost of capital :
i)
Cost of Capital is really a rate of return, it is not a cost as such.
ii)
A firms cost of capital represents minimum rate of return that will result
in at least maintaining (If not increasing) the value of its equity shares.
iii) Cost of Capital as a rate of return is calculated on the basis of actual cost
of different components of capital.
iv) It is usually related to long-term capital funds.
v)
In operational terms, Cost of Capital in terms of rate, of return is used as

discount rate, used to discount the future cash inflows so as to determine
their present value and compare it with investment outlay.
vi) Cost of Capital has three components:

a) Return at Zero Risk Level.
b) Premium for Business Risk.
c) Premium for Financial Risk.
The cost of capital may be put in the form of the following equation:
K = ro + b + f
Where
K =
ro =
b
=
f
=
Cost of Capital
Return at zero risk level (Risk free returns)
Premium for business risk
Premium for financial risk
Thus,
a)
Cost of Capital with Business Risk > Cost of Capital with no risk; and
b)
Cost of Capital with financial risk > Cost of Capital with Business Risk >
Cost of Capital with no risk.
2.2.1 Components of Cost of Capital

A firms cost of capital comprises three components:
Return at Zero Risk Level : This refers to the expected rate of return
when a project involves no risk whether business or financial.
Purchasing power risk arises due to changes in purchasing power of
money.
Money Rate Risk means the risk of an increase in future interest rates.
Liquidity risk means the ability of a supplier of funds to sell his shares/
debentures bonds quickly.
2.2.2 Classification of Cost of Capital

Cost of Capital can be classified as follows:
1)
2
Explicit Cost and Implicit Cost : Explicit cost is the discount rate that
equate the present value of the expected incremental cash inflows with the
present value of its incremental cash out flows. Thus, it is the rate of
return of the cash flows of financing opportunity. In contrast, implicit cost
is the rate of return associated with the best investment opportunity for the
firm and its shareholders that will be foregone if the project presently
under consideration by the firm were accepted. In a nutshell, explicit costs
relate to raising of funds while implicit costs relate to usage of funds.
2)
Average Cost and Marginal Cost : The average cost is the weighted
average of the costs of each components of funds. After ascertaining costs
of each source of capital, appropriate weights are assigned to each
component of capital. Marginal cost of capital is the weighted average
cost of new funds raised by the firm.
3)
Future Cost of Capital : Future cost of capital refers to the expected

cost to be incurred in raising new funds while historical cost represents
cost of capital incurred in the past in procuring funds for the firms. In
financial decision making future cost of capital is relatively more relevant.
4)
Specific Cost and Combined Cost : The costs of individual components

of capital are specific cost of capital. The combined cost of capital is the
average cost of capital as it is inclusive of cost of capital from all sources.
In capital budgeting decisions, combined cost of capital is used for
accepting /rejecting the investment proposals.
Cost of Capital
Activity I
1)
Define the following :

i)
Explicit Cost
iii) Average Cost
ii) Cost of Capital
iv) Marginal Cost
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
Discuss various types of risks associated with the concept of Cost of

Capital.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3)
State how can Cost of Capital help a firm in converting its future cash
inflows in its present value.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.3 COMPUTING COST OF CAPITAL OF

INDIVIDUAL COMPONENTS
Computation of cost of capital from individual sources of funds helps in
determining the overall cost of capital for the firm. There are four basic
sources of long-term funds for a business firm:
i)
Long-term Debt and Debentures,
Decisions
ii)
Preference Share Capital,
iii) Equity Share Capital,

iv) Retained Earnings
Though all of these sources may not be tapped by the firm for funding its
activities, each firm will have some of these sources in its capital structure.
The specific cost of each source of funds is the after-tax cost of financing.
The procedure for determining the costs of debt, preference and equity capital
as well as retained earnings is discussed in the following sub-sections.
2.3.1 Cost of Long-Term Debt

Cost of long-term debt represents the minimum rate of return that must be
earned on debt financed investments if the firms value is to remain intact.
Long-term debt may be issued at par, at premium or discount. It may be
perpetual or redeemable. The technique of computation of cost in each case
has been explained in the following paragraphs.
(a) The formula for computing the Cost of Long-term debt at par is
K d = (1 T) R
where
Kd = Cost of Long-Term Debt
T = Marginal Tax Rate
R = Debenture Interest Rate
Example, if a company has issued 10% debentures and the tax rate is 60%,
the cost of debt will be
(1 - .6) 10 = 4%
(b) In case the debentures are issued at premium or discount, the cost of the
debt should be calculated on the basis of net proceeds realized. The
formula will be as follows.
Kd =
I
(1 T)
Np
Where
Kd =
Cost of debt after tax
Annual Interest Payment
Np =
Net Proceeds of Loans
Tax Rate
Example, a company issues 10% irredeemable debentures of Rs. 1,00,000. The

company is in 60% tax bracket.
Rs. 10,000
Cost of debt at par
=
=
Rs.1,00,000
4%
Rs. 10,000
Cost of debt issued at =
Rs. 90,000
10% discount
4
(1 .60)
4.44%
(1 .60 )
Rs. 10,000
Cost of debt issued at =
Rs.1,10,000
Cost of Capital
(1 .60)
10% Premium
=
3.63%
(c) For computing cost of redeemble debt, the period of redemption is

considered. The cost of long-term debt is the investors yield to maturity
adjusted by the firms tax rate plus distribution cost. The question of yield
to maturity arises only when the loan is taken either at discount or at
premium. The formula for cost of debt will be
I + Discount
mp
In case of
premium Premium
mp
)
3 (I T) 3 100
p + nP
2
where
mp =
maturity period
nominal or par value
np =
net proceeds i.e. (Par value - Discount + Premium)
Example, a firm issued 1,000, 10% debentures, each of Rs. 100 at 5%

discount. The debentures are to be redeemed in the beginning of 11th year.
The tax rate is 50%.
5,000
10
3 100 (1 .5)
1,00,000 + 95,000
2
10,000 +
10,500
3 50 = 5.385%
97,500
(d) In case of underwriting and other issuing costs, they are adjusted in the
same way as discount is being adjusted in net proceeds and other
calculations.
Example, A company raised loan by selling 2,500 debentures with 10% rate of
interest at premium at Rs. 5 per debenture (Par value = Rs. 100), redeemable
in the 11th year. Underwriting and other issuance costs amounted to 3% of the
proceeds. The tax rate is 50%
(
(
25,000
12,500
10
7,875
10
2,50,000 + 2,54,25
2
)
3 (1 .5) 3 100
Decisions
25,000 1250 + 788

2,52,313
.5 100
4.865%
(e) Yield to maturity method of computing cost of debt capital is an

approximation method. A better method is that which converts yield to
maturity into a discount rate. James C. Van Horne says the discount
rate that equates the present value of the funds received by the firm, net
of underwriting and other costs with the present value of expected
outflows. These outflows may be interest payments, repayment of
principal or dividends. It may symbolically be written as:
n
(cash outflows)t
np = S
t = 1 (1 + K)t
where
np
(Cash outflows)
= net amount available for use

= amount of interest after tax + amount of repayment
of principal
= time period
= discount rate
t
K
Example, A company has issued 11% debentures for Rs. 2,00,000. The
underwriting, brokerage and other issuance costs amount to Rs. 10,000. The
terms of debenture issue provide for repayment of principal in 5 equal
installments starting at the end of the first year. The tax rate is 60%.
Cash inflow
= Rs. 2,00,000 - Rs. 10,000

= Rs. 1,90,000
Cash Outflows
Year
Installment
Rs.
Interest
Rs.
Total
Rs.
Discount
Factor
14%
Present
Value
Discount
Factor
12%
Present
Value
40,000
22,000
62,000
.877
54374
.893
55366
40,000
17,600
57,600
.769
44294
.797
37875
40,000
12,200
53,200
.675
35910
.712
30744
40,000
8,800
48,800
.592
28890
.630
25175
40,000
4,400
44,400
.519
23044
.576
186512
12% +
(195067 190000)
(195067 186512)
12 % +
5067
8555
195067
(14 12)
2 = 13 . 184 %
(f) Effective cost of debt is lower than the interest paid to the creditors
because the firm can deduct interest amount from its taxable income. The
higher the tax rate, the lower the effective interest rate on debt and lower
the cost of debt. Let us take an example.
6
There are two firms, A and B. The firm A has no debt and is totally financed
by equity capital. The firm B has Rs. 200 lakhs outstanding debt and pays an
interest rate of 10 per cent. The firms net income after-taxes is calculated
using three tax rates, 0, 25 and 50 per cent and the resulting values of net
incomes are compared. Assume that the earnings before interest and taxes of
both firms is Rs. 100 lakhs each.
Cost of Capital
Tax Rates and Effective Cost of Debt

Rs. in lakhs
0% tax rate
Firm A
25% tax rate
50% tax rate
Firm B
Firm A
Firm B
Firm A
Firm B
Earnings before- 100

interest and taxes
100
100
100
100
100
Interest
20
20
20
Taxable income
100
80
100
80
100
80
Taxes
25
20
50
40
Net income after

taxes (NIAT)
100
80
75
60
50
40
(a)
Difference
(b)
Effective rate
20
15
10
10%
7.5%
5%
Notes :
a) NIAT of firm A - NIAT of firm B.
b) (a) ' Rs. 200 lakhs of outstanding debt of firm B.
If no taxes were paid, the only difference between the net incomes of the two
firms would be the interest expense incurred by the firm B. As the tax rate
increases, this difference diminishes. In the case of 0% tax rate, we can say
that the effective rate of debt is 10% (Rs. 20 / Rs. 200). In the case of 25%
and 50% it is 7.5% and 5%, respectively.
A simple formula for computing the cost of debt may be stated as follows:
Effective cost of debt
= Interest rate x (1.0 - tax rates)
Substituting the data from the above example.
1)
Effective cost of debt at 0% tax rate
= 10% x (1.0 - 0.00)
= 10%
2)

= 10% x (1.0 - 0.25)
= 7.5%
4)

= 10% x (1.0 - 0.50)
= 5%
A more generalised way of calculating the cost of debt capital is to find out the
discount rate which equates the present value of post tax interest and principal
repayments with the net proceeds of the debt issue i.e. (Par value x no. of
bonds Issue floatation cost). Mathematically this relationship can be expressed
as follows:
Decisions
n I (I - T)
R
Np =
+
+
n
t
t = 1 (1 + K) t (1 + k)
Where : np = net amount realised on debt issue
I = Annual interest payment
T = Tax rate applicable
R = Redemption Value
n = Maturity period of debt.
In the above eq. solving for K would yield the cost of debt capital. For solving
the above equation an approximation can be used which yield fairly close value.
(R - NP)
n
(R + NP) / 2
I (1 - T) +
K
Amortisation of the Cost of issue: Since the issue floation cost is tax deductible
cost and can be amortised evenly over the duration of debt finance, the cost of
debt capital would be K in the following equation.
t
n I (I - T) - (R - NP)
R
n
+
Np =
t
(1 + K)
(1 + k)n
t =1
An approximation for K is as follows
K
I (1 - T) +
(R-P)
n
(1 - T)
(R + P)/2
Activity 2
1.
A firm intends to issue 1,000, 10% debentures each of Rs. 100. What is the
cost of debt if the firm desires to sell at 5% premium. The tax rate is 50%.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.
A firm issues 1,000, 10% debentures of Rs. 100 each at a premium of 5%

with a maturity period of 10 years. The tax rate is 50%. Find the cost
of capital.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3.
A company raises loan of Rs. 2,50,000 by 10% debentures at 5% discount

for a period of ten years, underwriting costs are 3% and tax rate is 50%.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.3.2 Cost of Preference Capital
Cost of Capital
Cost of preference share capital represents the rate of return that must be
earned on preferred stocks financed investments to keep the earnings available
to residual stockholders unchanged. Cost of preference shares can be
estimated by dividing the dividend stipulated per share by the current market
price of the share.
Dividend
Cost of Preference Capital =
Face Value - Issue Cost
Example, A Company is planning to issue 9% preference shares expected to
sell at Rs. 85 par value. The costs of issuing and selling the shares are
expected to be Rs. 3 per share.
The first step in finding out the cost of the preference capital is to determine
the rupee amount of preference capital is to determine the rupee amount of
preference dividends, which are stated as 9% of the share of Rs. 85 par
value. Thus 9% of Rs. 85 is Rs. 7.65. After deducting the floatation costs,
the net proceeds are Rs. 82 per share.
Thus, the cost of preference capital :
Dividend per share
Net proceeds after selling
Rs. 7.65
= 9.33%
Rs. 82
Now, the companies can issue only redeemable preference shares. Cost of
capital for such shares is that discount rate which equates the funds available
from the issue of preference shares with the present values of all dividends
and repayment of preference share capital. This present value method for cost
of preference share capital is similar to that used for cost of debt capital; the
only difference is that in place of interest, stated dividend on preferences
share is used. The cost of preference capital which is redeemable is the value
of KP in the following equation
NP =
t =1
KP
(1 + KP)
R
n
(1 + KP)
D + (R NP) / N
( R + NP) / 2
2.3.3 Cost of Equity Capital

Cost of equity capital is the cost of the estimated stream of net capital outlays
desired from equity sources E.W. Walker.
According to James C. Van Horne, cost of equity capital can be thought of as
the rate of discount that equates the present value of all expected future
dividends per share, as perceived by investors at the margin as in the current
market price per share.
9
Decisions
In a nutshell, it is the discount rate which equates present value of all expected
dividends in future with net proceeds per share/current market price. It
represents the minimum rate of return that must be earned on new equity stock
financed investment in order to keep the earnings available to the existing
residual owners of the firms unchanged.
Cost of equity capital is by for the most difficult to measure because of the
following reasons:
i)
The cost of equity is not the out of pocket cost of using equity capital.
ii)
The cost of equity is based upon the stream of future dividends as

expected by shareholders (very difficult to estimate).
iii) The relationship between market price with earnings is known. Dividends
also affect the market value (which one is to be considered).
The following are the approaches to computation of cost of equity capital:
(a) E/P Ratio Method : Cost of equity capital is measured by earning price
ratio. Symbolically,
Eo
(current earnings per share)
x 100
Po
(current market price per share)
The limitation of this method are:

Earnings do not represent real expectations of shareholders.
Earnings per share is not constant.
Which earnings-current earnings or average earnings (Not clear).
The method is useful in the following circumstance:
The firm does not have debt capital.
All the earnings are paid to the shareholders.
There is no growth in earnings.
(b) E/P Ratio + Growth Rate Method : This method considers growth in
earnings. A period of 3 years is usually being taken into account for
growth. The formula will be as follows.
Eo (1+b)3
Po
3
Where (1+b) = Growth factor, where b is the growth rate as a percentage
and estimated for a period of three years.
Example, A firm has Rs. 5 EPS with 10% growth rate of earnings over a
period of 3 years. The current market price of equity share is Rs. 50.
Rs.5 (1 + .10)3
Rs.50
Rs.5(1.331)
50
100
100 =
6.665
100
50
= 13.31%
10
(c) D/P Ratio Method : Cost of equity capital is measured by dividends

price ratio. Symbolically,
Do (Dividend per share)
x 100
Po
(Market price per share)
Example, the market price of equity share is Rs. 15 and dividend rate is 15%
(Par value Rs. 10 per share)
Rs. 1.5
x 100 = 10%
Rs. 15
Cost of Capital
The following are the assumptions

i)
The risk remains the unchanged.
ii)
The investors give importance to dividend.
iii) The investors purchase the shares at par value.

Under this method, the future dividend streams of a firm, as expected by the
investors, are estimated. The current price of the share is used to determine
shareholders expected rate of return. Thus, if K is the risk-adjusted rate of
return expected by investors, the present value of future dividends, discounted
by Ke would be equal to the price of the share. Thus,
D1
D2
D3
Dn
P = + + +
(1+Ke) 1
(1+Ke) 2
(1+Ke) 3
(1+Ke) n
where,
P
= price of the share
D1Dn
= dividends in periods 1,2,3,n,
Ke = the risk adjusted rate of return expected by equity investors.
Given the current price P and values for future dividends Dt, one can
calculate Ke by using IRR procedure. If the firm has maintained some regular
pattern of dividends in the past, it is not unreasonable to expect that the same
pattern will prevail in future. If a firm is paying a dividend of 20% on a share
with a par value of Rs. 10 as a level perpetual dividend, and its market price is
Rs. 20, then
P=
D
Ke
20 =
Ke =
2
Ke
2
= 10%
20
(d) D/P + Growth Rate Method : The method is comparatively more

realistic as
i)
it considers future growth in dividends,
ii) it considers the capital appreciation.

This method is based on the assumption that the value of a share is the present
value of all anticipated dividends, which it will give over an infinite time horizon.
The firm is here viewed as a going concern with an infinite life.
Thus,
Po =
D1
D1
or Ke =
+ g
Ke g
PO
Where,
Po
D1
Ke
g
=
=
=
=
current price of the equity share

per share dividend expected at the end of year 1
risk adjusted rate of return expected on equity shares.
constant annual rate of growth in dividends and earnings.
11
Decisions
The derivation of the formula has been given in Appendix 2.1.

The equation indicates that the cost of equity share can be found by dividing
the dividend expected at the end of the year 1 by the current price of the
share and adding the expected growth rate.
Example, Raj Textiles Ltd. Wishes to determine its cost of equity capital, Ke.
The prevailing market price of the share is Rs. 50 per share. The firm
expects to pay a dividend of Rs. 4 at the end of the coming year 1998. The
dividends paid on the equity shares over the past six years are as follows:
Year
1997
1996
1995
1994
1993
1992
Dividend (Rs.)
3.80
3.62
3.47
3.33
3.12
2.97
The firm maintained a fixed dividend payout from 1986 onwards. The annual
growth rate of dividends, g, is approximately 5 per cent. Substituting the data
in the formula,
Rs. 50
Ke
Rs.4
Ke 0.05
Rs. 4
+ 0.05
Rs. 50
= 0.80 + 0.05 = 13%

The 13% cost of equity share represents the return expected by existing
shareholders on their investment so that they should not disinvest in the share
of Raj Textiles Ltd. And invest elsewhere.
(e) Realised Yield Method : One of the difficulties in using D/P Ratio and
E/P Ratio for finding out Ke is to estimate the rate of expected return.
Hence, this method depends on the rate of return actually earned by the
shareholders. The most recent five to ten years are taken and the rate of
return is calculated for the investor who purchased the shares at the
beginning of the study period, held it to the present and sold it at the
current prices. This is also the realized yield by the investor. This yield is
supposed to indicate the cost of equity share on the assumption that the
investor earns what he expects to earn. The limiting factors to the
usefulness of this method are the additional conditions that the investors
expectation do not undergo change during the study period, no significant
change in the level of dividend rates occurs, and the attitudes of the
investors towards the risk remain the same. As these conditions are rarely
fulfilled, the yield method has limited utility. In addition, the yield often
differs depending on the time period chosen.
12
(f) Securitys Beta Method : An investor is concerned with the risk of his
entire portfolio, and that the relevant risk of a particular security is the
effect that the security has on the entire portfolio. By diversified
portfolio we mean that each investors portfolio is representative of the
market as a whole and that the portfolio Beta is 1.0. A securitys Beta
indicates how closely the securitys returns move with from a diversified
portfolio. A Beta of 1.0 for a given security means that, if the total value
of securities in the market moves up by 10 per cent, the stocks price will
also move up, on the average by the 10 per cent. If security has a beta
of 2.0, its price will, on the whole, rise or fall by 20 per cent when the
market rises or falls by 10 per cent. A share with 0.5 beta will rise by
10 per cent, when the market drops by 20 per cent.
Cost of Capital
A beta of any portfolio of securities is the weighted average of the betas of

the securities, where the weights represent the proportions of investments in
each security. Adding a high beta (beta greater than 1.0) security to a
diversified portfolio increases the portfolios risk, and adding a low beta (beta
less than zero) security to a diversified security reduces the portfolios risk.
How is beta determined? the beta co-efficient for a security (or asset) can be
found by examining securitys historical returns relative to the returns of the
market. Since, it is not feasible to take all securities, a sample of securities is
used. In United States, such compilation of beta co-efficient is provided by
companies, such as Value Line or Merill Lynch. The Capital Asset Pricing
Model (CAPM) uses these beta co-efficients to estimate the required rate of
returns on the securities. The CAPM specifies that the required rate on the
share depends upon its beta. The relationship is:
Ke = riskless rate + risk premium x beta
Where, Ke = expected rate of return.
The current rate on government securities can be used as a riskless rate. The
difference between the long-run average rate of returns between shares and
government securities may represent the risk premium. During 1926-1981, this
was estimated in USA to be 6 per cent. Beta co-efficients are provided by
published data or can be independently estimated.
The beta for Pan Ams stock was estimated by Value Line to be 0.95 in 1984.
Long-term government bond rates were about 12 per cent in November 1984.
Thus the required rate of return on Pan Ams stock in November 1984 was:
Required Rate = 12% + 6% x 0.95
= 17.7%
The use of beta to measure the cost of equity capital is definitely a better
approach. The major reason is that the method incorporates risk analysis,
which other methods do not. However, its application remains limited perhaps
because it is tedious to calculate Beta value. Nevertheless, as the competition
intensifies and the availability of funds and their cost become a challenge,
finance mangers will need this or similar approaches.
Activity 3
1.
A firm has Rs. 3 EPS and 10% growth rate of earnings over a period of
3 years. The current market price of equity share is Rs. 100. Compute the
cost of equity capital.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
13
Decisions
2.
The current dividend paid by the company is Rs. 5 per share, the market
price of the equity share is Rs. 100 and the growth rate of dividend is
expected to remain constant at 10%. Find out the cost of capital.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3.
A firm issues 8% non-redeemable preference shares of Rs. 10 each for

Rs. 1,00,000, underwriting costs are 6% of the sale price. Compute the
cost of capital if shares are issued at discount of 2.5 percent and the
premium of 5%.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.3.4 Cost of Retained Earnings:

Corporate managers and some analysts normally consider the funds retained in
the firm as cost free funds because it does not cost anything to the firm to
make use of a part of its earnings not distributed to the shareholders.
However, this is not true. It definitely cost the shareholders something and this
is an opportunity cost representing sacrifice of the dividend income which the
shareholders would have otherwise received it and invested the same elsewhere
to earn a return thereon. Thus, the minimum cost of retained earnings is the
cost of equity capital (Ke).
Ezra Solomon suggested the concept of external yield to measure cost of
retained earnings.
Algebraically, the approach can be explained as:
d1
+ G (1 TR) (1 B)
P0
= Ke (1-TR) (1-B)
where
Ke = Cost of equity capital based on dividend growth method
TR = Shareholders Tax Rate
B
= Percentage Brokerage cost
Example
A firms cost of equity capital is 12% and Tax rate of majority of shareholders
is 30%. Brokerage is 3%.
= 12% (1-0.30) (1-0.03)
= 8.15%
2.4 WEIGHTED COST OF CAPITAL

Weighted cost of capital, also known as composite cost of capital, overall cost
of capital or weighted marginal cost of capital, is the average of the costs of
each sources of funds employed by the firm, properly weighted by the
proportion they hold in the capital structure of the firm.
14
Cost of Capital
2.4.1 Choice of Weights

The weights to be employed can be book values, market values, historic or
target. Book value weights are based on the accounting values to assess the
proportion of each type of fund in the firms capital structure. Market value
weights measure the proportion of each type of financing at its market value.
Market value weights are preferred because they approximate the current value
of various instruments of raising funds employed by the company.
Historic weights can be book or market weights based on actual data. Such
weights, however, would represent actual rather than desired proportions of
various types of capital in the capital structure. Target weights, which can also
be based on book or market values, reflect the desired capital structure
proportions. In the firms historic capital structure is not much different from
optimal or desired capital structure, the cost of capital is both the cases is
mostly similar. However, from a strictly theoretical point of view, the target
market value weighting scheme should be preferred.
Marginal weights are determined on the basis of financing mix in additional
new capital to raised for investments. The new capital raised will be the
marginal capital. The propositions of new capital raised will be the marginal
weights.
Activity 4
1)
How is the cost of retained earnings computed?

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
List out three types of weights which may be used for computing weighted
average cost of capital of the firm.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.4.2 Computation of The Weighted Cost of Capital

Example
A firm has the following capital structure and after tax costs for the different
sources of funds used:
Source of Funds
Amount Rs.
Proportion %
After tax cost %
Debt
20,00,000
20
4.50
Preference Shares
10,00,000
10
9.00
Equity Shares
30,00,000
30
11.00
Retained Earnings
40,00,000
40
10.00
1,00,00,000
100
15
Decisions
On the basis of book value, the cost of equity capital will be calculated as
follows:
Method of Funds
Proportion%
Cost %
Weighted cost %
Debt
20
4.50
0.90
Preference Shares
10
9.00
0.90
Equity Shares
30
11.00
3.30
Retained Earnings
40
10.00
4.00
9.10%
Example 2: Quality products is a consumer products company with wellestablished brand names. The cost of capital of quality products is estimated
at the end of 1996 for use in evaluating investment proposals in 1997. The
data for Quality Products Ltd. are as follows:
Financial data for Quality Products Ltd.
Rs. 0000
Source
Book Value Rs. Market Value Rs. Current Interest rate %
Debentures (71/2%)
45
29
13.2
Debentures (91/2%)
50
42
13.2
Debentures (14%)
75
78
13.2
Other debt
210
192
13.2
Total debt
380
341
13.2
Preference shares (7%)
20
10
14.0
Equity shares
720
824
Equity Share Data Years

1991
1992
1993
1994
1995
1996
Dividend per share
1.45
1.60
1.77
2.05
2.28
2.48
Earnings per share
2.97
3.73
4.21
4.83
4.86
4.95
Price per share
24.00
50.000
Explanatory Notes
Interest rates on the three debentures issues were set at the rate (13.2%)
on the recently issued debentures of the firm which is selling close to par.
This was considered to be the best estimate.
Other debt includes different types of loans from financial institutions and
other privately placed debentures.
Market value is based on interest rates provided in the firms annual
report.
Preference share is Rs. 100 par: current market price is Rs. 50 per share.
Since the firms dividend and earnings have been growing steadily since, 1991,
the constant growth model can be used to estimate cost of equity. Though
dividends have grown at a slightly higher rate than earnings, one may assume
that shareholders would expect them to grow at the same earnings (10.8%).
Also assume, on the basis of the past record that the shareholders expect a
dividend of Rs. 2.60 in 1997. Thus:
16
Ke
Cost of Capital
D
= + g
P
Rs. 2.60
= + 0.108
Rs. 50
= 16%
If the investors expect the dividends to grow at the higher rate (11.3%), the
cost of equity capital works out to 16.5%.
Applying the beta method, we obtain a somewhat higher number. Beta for
Quality Products is assumed to be 0.85. Interest rate on government bonds
(riskless rate) in 1996 would be, say, 12 per cent. The market risk premium
is 6%.
Thus
Ke
= Riskless rate + Risk premium x beta

= 12% + 6% x 0.85
= 17.1%
Thus, the cost of capital for Quality Products Ltd:

Amount Rs.
Weight
Cost
Weight x Cost
Debt
341
0.29
7.1
2.1
Preference Shares
10
0.01
14.0
0.1
Equity Shares
824
0.70
17.0
11.9
Total
1175
1.00
17.0
14.9
Weighted Average Cost of Capital : 14.1%
Explanation
Market values of debt, preference and equity shares are used.
Current interest rate on debt is adjusted for tax rate of 46 per cent, which
is the firms effective rate 13.2% (1-0.46) = 7.1%
Current preference dividend rate of 14% is used.
Activity 5
1)
Compare Beta value of equity shares of any one company listed on Indian
stock exchanges and list out the problems you faced in this regard.
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
...................................................................................................................
Compute overall cost of capital of an Indian company of your choice. List
out the steps you took for this purpose and the problems faced by you.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
17
Decisions
3)
Try to know from the Finance Manager of an Indian Company:

i)
Do they compute the overall cost of capital of their company?

.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
ii) For what purpose?

.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
iii) If not, why not?
.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
2.5 SIGNIFICANCE OF COST OF CAPITAL

The determination of the firms cost of capital is important because
i)
Cost of capital provides the very basis for financial appraisal of new
capital expenditure proposals and thus serves as acceptance criterion for
capital expenditure projects.
ii)
Cost of capital helps the managers in determing the optimal capital

structure of the firm.
iii) Cost of capital serves as the basis for evaluating the financial performance
of top management.
iv) Cost of capital also helps in formulating dividend policy and working capital
policy
v)
Cost of capital can serve as capitalization rate which can be used to

determine capitalization of a new firm.
Activity 6
1)
List three uses of Cost of Capital.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
What is Weighted Average Cost of Capital?

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
18
3)
The following details are available:

Equity (Expected Dividend 12%)
Tax Rate
10% Preference
8% Loan
Cost of Capital
Rs. 10,00,000
50%
Rs. 5,00,000
Rs. 15,00,000
You are required to calculate Weighted Average Cost of Capital.

...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
2.6 SOME MISCONCEPTIONS ABOUT COST OF

CAPITAL
The cost of capital is a central concept in financial management linking the
investment and financing decisions. A few misconceptions in this regard are as
follows:
i)
The concept of cost of capital is academic and impractical
ii)
It is equal to the dividend rate.
iii) Retained earnings are either cost free or cost significantly less than
external equity.
iv) Depreciation has no cost.
v)
The cost of capital can be defined in terms of an accounting based

manner.
vi) If a project is heavily financed by debt, its weighted average cost of

capital is low.
2.7 SUMMARY
The cost of capital of a firm is mainly used to evaluate investment projects. It
represents minimum acceptable rate of return on new investments. The basic
factors underlying the cost of capital for a firm are the degree of risk
associated with the firm, the taxes it must pay, and the supply of and demand
of various types of financing.
In estimating the cost of capital, it is assumed that, (1) the firms are acquiring
assets which do not change their business risk, and (2) these acquisions are
financed in such a way as to leave the financial risk unchanged. In order to
estimate the cost of capital, we must estimate rates of return required
by investors in the firms securities, including borrowings, and average those
rates according to the market values of the various securities currently
outstanding.
While the cost of debt and preference capital is the contractual interest/dividend
rate (adjusted for taxes), the cost of equity capital is difficult to estimate.
Broadly, there are six approaches to estimate the cost of equity, namely, the E/
P method, E/P + Growth method, D/P method, D/P + Growth method, Realised
yield method and using the Beta co-efficient of the share. Weighted cost of
capital is computed by assigning book weights or market weight.
19
Decisions
2.8 KEY WORDS

Cost of Capital is the minimum rate of return that must be earned on
investment to maintain the value of firm.
Marginal Weights are determined on the basis of financing mix of additional
capital.
Cost of Equity Capital is the discount rate which equates present value of all
expected dividends in future with net proceeds per share / current market
price.
Business Risk is a possibility and the firm will not be able to operate
successfully in the market.
Financial Risk is the possibility that the firm will not earn sufficient profits to
make payment of interest on loans and/or to pay dividends.
2.9 SELF-ASSESSMENT QUESTIONS/EXERCISES

1)
Why is the cost of capital considered as the minimum acceptable rate of

return on an investment?
2)
In using the cost of capital to evaluate investment projects, why is it

necessary to assume that the acceptance of projects and the financing
structure would not attract the business and financial risks?
3)
How is the Cost of Debt Capital ascertained? Give examples.
4)
You have just been communicated, since we are going to finance this
project with debt, its required rate of return should only be the cost of
debt. Do you agree or disagree? Explain.
5)
How will you calculate the Cost of Preference Share Capital?
6)
Which method of calculating the cost of equity shares would be most

appropriate for the following firms:
a) A profitable firm that has never paid a dividend, but has had steady
growth in earnings.
b) An electricity company that has paid a dividend every year for the
last eighty years.
c) A firm that has grown very rapidly until two years ago, when
capacity problems in the industry produced severe price cutting in the
firms major product line. At the same time management decided to
invest heavily in facilities to manufacture a new product. So far, the
manufacturing process has not worked properly. The firm lost Rs. 5
crores last year, and the price of its equity share has dropped by 20
per cent.
20
7)
How would you find the cost of capital for proprietorship or partnership
firm? Can you thing of any ways to do this? List them.
8)
Retained earnings are cost free comment.
9)
Discuss various uses of the concept of Cost of Capital.
10) Determine the cost of capital for the following securities. These are
issued by different firms and the tax rate is 40 per cent.
a) A seven-year debenture with a coupon interest of 10 per cent. The
debentures matures in five years and has a current market price of
Rs. 90 as against its par value of Rs. 100.
Cost of Capital
b) A preference share pays 7 per cent dividend. Par value is Rs. 100
per share and its current market price is Rs. 80.
c) The historical average rate of return earned by equity shareholders of
the firm C has been about 17% per year until very recently. The
dividends of the firm have grown at an average rate of 13% per year
over the same period. The financial Express and another financial
fortnightly have issued a report indicating the problems of the firm
with governments regulatory agencies and forecasted that dividends
and earnings of the firm will grow at no more than the overall growth
rate of the economy which is 5 per cent. The dividends are likely to
be Rs. per share. The price of the firms share adversely reacted to
the report dropping from Rs. 100 to Rs. 50.

Gitman, Lawrence J. 1985, Principles of Managerial Finance. Harper and
Row Publishers, Singapore, Fourth Edition.
Schall, Lawrence D and Haley Charles W. 1986, Introduction to Financial
Management, McGraw Hill Book Company, New York, London, New Delhi,
Fourth (International Students) Edition.
Van Horne James W., Financial Management and Policy, Prentice Hall Inc.
Englewood Cliffs, New Jersy.
Chandra, P. 1995, Fundamentals of Financial Management, Tata McGraw
Hill, New Delhi.
Maheshwari, S.N. 1996, Financial Management Principles and Practices,
Sultan Chan & Sons, New Delhi.
Srivastava, R.M. 2002, Financial Management, Pragati Prakashan, Meerut.
(Chapter 17).
Srivastava, R.M. 2003, Financial Management and Policy, Himalaya
Publishing House (Chapter 13)
2.11 ANSWERS
Activity 2
i) 4.76%
ii) 4.64%
iii) 5.62%
Activity 3
i)
3.99
ii) 15%
iii) 8.11% and 8.73%
Activity 6
iii) 7.67%
21
Decisions
Appendix 2.1: Share Valuation with Constant Growth in Dividends

Assuming so the most recent dividend, and that g is the growth rate in dividend
Do (1+g)1
Do (1+g)2
Po = +
(1+Ke)1
(1+Ke)2
Do(1+g)a
+ ............ (1)
(1+Ke) a
Multiplying each side of the equation by (1+Ke)/(1+g) and subtracting the

resulting equation from (1),
Po (1+Ke)
- Po
1+g
= Do
Do(1+g) a
.(2)
(1+Ke) a
As Ke is assumed to be greater than g, the second term on the right hand side
of (2) is zero, Thus
1+Ke
Po ( - 1) = Do
1+g
(3)
Po (Ke g) = Do (1 + g)
D1
Po =
Ke-g
.(4)
Premium for Financial Risk : It refers to the risk arising out of pattern
of capitalization. In general, it may be said that a firm having a higher debt
content in its capital structure is more risky as compared to a firm which
has a comparatively low debt content.
Besides financial risk and business risk, the following risks also affect the
cost of capital;
Premium for Business Risk : Business risk is the possibility that the
firm will not be able to operate successfully in the market. Greater the
business risk, the higher will be the cost of capital. It is generally
determined by the capital budgeting decisions.
22
UNIT 3 CAPITAL STRUCTURE DECISIONS
Objectives
The objectives of this unit are to:
define and distinguish capital structure
explain briefly the important Characteristics of various long term sources of
funds.
dilate upon the criteria for determining pattern of capital structure.
analyse EBIT-EPS and ROI-ROE relationship.
examine critically theories of capital structure-decision
identify the factors influencing capital structure decision
evaluate the relevance of debt equity ratio in public enterprises.
Structure
3.1
Introduction
3.2
Conceptual Framework
3.3
Characteristics of Important long term sources of Funds
3.4
Criteria for determining pattern of Capital Structure
3.5
Risk and Capital Structure
3.6
3.5.1
EBIT EPS Analysis
3.5.2
ROI ROE Analysis
Theories of Capital Structure Decision

3.6.1 Net Income Approach
3.6.2
Net Operating Income Approach
3.6.3
M-M Approach
3.6.4
Traditional Approach
3.7
Factors Influencing Pattern of Capital Structure
3.8
Relevance of Debt-equity ratio in Public enterprises
3.9
Summary
3.10
Key words
3.11
Self Assessment Questions/Exercises
3.12
Further Readings
3.1 INTRODUCTION
Planning the capital structure is one of the most complex areas of financial
decision making because of the inter-relationships among components of the
capital structure and also its relationship to risk, return and value of the firm.
For a student of finance, the term capital usually denotes the long-term funds
of the firm. Debt capital and ownership capital are the two basic components
of capital. Equity capital, as one of the components of capitalization, comprises
equity share capital and retained earnings. Preference share capital is another
distinguishing component of total capital. In this unit, characteristics of important
long-term sources of funds, EBIT-EPS analysis, ROI-ROE analysis, factors
influencing capital structure, theories of capital structure decision, etc are
narrated briefly. In the end, relevance of debt-equity ratio in public enterprises
is also discussed.
1
Decisions
3.2 CONCEPTUAL FRAMEWORK

According to Gerstenberg, capital structure refers to the make up of a firms
capitalization. In other words, it represents the mix of different sources of
long-term funds. E.F. Brigham defines the term as the percentage share of
each type of capital used by the firm-Debt, preference share capital and equity
capital (equity share capital paid up plus retained earnings). According to
E.W.Walker, concept of capital structure includes the following:
The proportion of long-term loans;
The proportion of equity capital and
The proportion of short-term obligations
In general, the experts in finance define the term capital structure to
include only long-term debt and total Stockholders investment.
Financial structure means the composition of the entire left hand side (liabilities
side) of the balance sheet. Financial structure refers to all the financial
resources marshelled by the firm. It will include all forms of long as well as
short-term debts and equity.
Thus, practically speaking, there is no difference between the capital structure
(as defined by walker) and financial structure.
In brief,
Capital structure = proportions of all types of Long-Term capital
Financial structure = Proportions of all types of Long-Term and Short-Term capital
Capitalisation = Total Long-Term capital
3.3 CHARACTERISTICS OF IMPORTANT

LONG-TERM SOURCES OF FUNDS
The four major sources of Long-Term funds in a firm are equity(or ordinary)
shares preference shares, retained earnings and long term debt. Many financial
analysts and managers tend to think of preference shares as a substitute of
debt, as the amount of dividend to be paid is fixed. The difference is that the
preference dividend, unlike debt interest, is not a tax- deductible expense. It
does not have a fixed maturity date. Preference shareholders have a prior
claim to receive income from the firms earning through dividends. Convertible
debentures have the features of both debt and equity capital.
The main focus in the discussion that follows is on deciding the mix of debt
and equity which a firm should employ in order to maximize shareholder
wealth. Because of the secondary position relative to debt, suppliers of equity
capital take greater risk and therefore, must be compensated with higher
expected returns. The distinguishing characteristics of debt, preference share
capital, equity share capital and Retained Earnings are summarized in Table 3.1.
3.4 CRITERIA FOR DETERMINING PATTERN OF

CAPITAL STRUCTURE
While choosing a suitable pattern of capital structure for the firm, finance
manager should keep into consideration certain fundamental principles. These
principles are militant to each other. A prudent finance manager strikes golden
mean among them by giving proper weightage to them.
2
Capital Structure
Decisions
Table 3.1: Characteritics of Long-Term Sources of Funds

Debt
Preference Share Capitals
Equity share
capital
Retained
Earnings
1. Firm must
pay back
money with
interest.
1. Preference dividends are limited

in amount to rate specified in
the agreement.
1. Money is
raised by
selling
ownership
rights.
1. Lower
amount of
money for
current
dividends
but can
increase
future
dividends.
2. Interest rate
is based on
risk of
Principal and
interest
payments as
perceived by
lenders
2. Dividends are not legally required

to be paid. But dividend on
equity shares can not be paid
unless preference shareholders are
paid dividend. Now payment of
dividend to preference
shareholders for a number of
years gives them the voting
rights.
2. Value of the
share is
determined
by investors.
2. Shareholders
forgo
dividend
income but
they do not
lose
ownership
rights, if
new equity
shares are
issued.
3. Amount of
money to be
repaid is
specified by
debt contract.
3. No maturity but usually callable
3. Dividends are
not
contractually
payable. No
maturity.
3. Funds are
internal No
need for
external
involvement.
4. Lenders can
take action to
get their
money back
4. Usually no voting rights except

as per (2) above.
4. Voting rights
can create
change in
ownership.
4. Cost of
issuing
securities is
avoided.
5. Lenders get
preferred
treatment in
liquidation
5. Preference share-holders come

next, when lenders are paid in
liquidation.
5. Equity
shareholders
get the
residual
assets
prorata after
lenders &
preference
shareholders
claims are
met in
liquidation.
5. It is related
to dividend
policy
decisions.
6. Interest
payments are
tax-deductable
6. preference Dividends are not taxdeductable.
6. Equity
dividends are
not taxdeductable,
3.4.1
Cost Principle:
According to this principle, ideal pattern of capital structure is one that tends to
minimize cost of financing and maximize the value per share. Cost of capital is
subject to interest rate at which payments have to be made to suppliers of
funds and tax status of such payments. Debt capital is cheaper than equity
capital from both the points of view. According to this, the use of debt capital
in the financing process is immensely helpful in raising income of the company.
3.4.2
Risk Principle:
This principle suggests that such a pattern of capital structure should be
Decisions
designed so that the firm does not run the risk of bringing on a receivership
with all its difficulties and losses. Risk principle places relatively greater
reliance on common stock for financing capital requirements of the corporation
and forbids as far as possible the use of fixed income bearing securities.
3.4.3
Control Principle:
While designing sound capital structure for the firm and for that matter
choosing different types of securities, finance manager should also keep in mind
that controlling position of residual owners remains undisturbed. The use of
preferred stock as also bonds offers a means of raising capital without
jeopardizing control. Management desiring to retain control must raise funds
through bonds and preference capital.
3.4.4
Flexibility Principle:
According to flexibility principle, the management should strive for such

combinations of securities that enable it to maneuver sources of funds in
response to major changes in need for funds. Not only several alternatives are
open for assembling required funds but also bargaining position of the
corporation is strengthened while dealing with the suppliers of funds (through
bonds).
3.4.5
Timing Principle:
Timing is always important in financing more particularly in a growing concern.

Maneuverability principle is sought to be adhered in choosing the types of funds
so as to enable the company to seize market opportunities and minimize cost of
raising capital and obtain substantial savings. Important point that is to be kept
in mind is to make the public offering of such securities as are greatly in
demand. Depending on business cycles, demand of different types of securities
oscillates. Equity share during boom is always welcome.
Activity 1
1)
What is capital structure? How is it different from financial structure?

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
Bring out in brief, characteristics of equity share capital

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3)
List out sources of long term finance used by a company of India origin.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
4)
Discuss the criteria for determining pattern of capital structure.

...................................................................................................................
...................................................................................................................
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Capital Structure
Decisions
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3.5 RISK AND CAPITAL STRUCTURE:

A firms capital structure should be developed keeping in view risk focus because
the risk affects the value of the firm. Risk can be considered in two ways:
a)
The capital structure should be consistent with the business risk of the
firm, and
b)
The capital structure results in a certain level of financial risk to the firm.
Business risk is the relationship between the firms sales and its earnings before
interest and taxes (EBIT). In general, the greater the firms operating leverage
i.e. the use of fixed operating costs-the higher is the business risk. In addition
to operating leverage, revenue stability and cost stability also affect the business
risk of the firm. The revenue stability means the variability of the firms sales
revenues which depends on the demand and the price of the firms products.
Cost stability refers to the relative predictability of input prices such as labour
and material. The more predictable these prices are the less is the business
risk. Business risk varies among firms. Whatever their lines of business, the
business risk is not affected by capital structure decisions. In fact, capital
structure decisions are influenced by the business risk. Firms with high
business risks, tend to have less fixed operating costs. Let us take an example
to illustrate the implications of business risk for capital structure decisions.
Example
Raj Cosmetics Ltd., engaged in the process of planning its capital structure, has
obtained estimates of sales and associated levels of EBIT. The sales
forecasting group feels that there is a 25 percent chance that sales will be Rs.
4,00,000 a 50 percent chance that sales will be Rs. 6,00,000 and 25 percent
the sales will total Rs. 8,00,000. These data are summarised Table 3.2.
Table 3.2: Estimated sales and Associated levels of EBIT
(000)
Probability of Sales
0.25
0.50
0.25
Sales
400
600
800
-Variable operating costs (50% of Sales)
200
300
400
200
200
100
200
200
-Fixed Operating Costs

Earnings before interest and taxes (EBIT)
The EBIT data, i.e. Rs.0,100 or 200 thousands at probability levels of 25%,
50% and 25% respectively reflect the business risk of the firm and has to be
taken into consideration when designing a capital structure.
The firms capital structure affects the firms financial risk arising out of the
firms use of financial leverage which is reflected in the relationship between
EBIT and EPS. The more fixed cost financing, i.e. debt and preference capital
in the firms capital structure, the greater is the financial risk. Suppliers of
funds will raise the cost of funds if the financial risk increases . Let us take
an example to illustrate this point.
Raj Cosmetics Let. Is now considering seven alternative capital structure.
Stated in terms of debt ratio) i.e. Percentage of debt in the total capital) these
are 0,10,20,30,40,50, and 60, per cent. Assume that (1) the firm has no current
5
Decisions
liabilities, (2) that its capital structure currently contains all equity (25,000 equity
shares are outstanding at Rs. 20 par value), and (3) the total amount of capital
remains constant at Rs.5,00,000.
Table 3.3: Capital Structure Associated with Alternative Debt Ratios
Debt Ratio%
Total Assests
(Rs.000)
Debt (Rs. 000)
Equity (Rs. 000)

4=2-3
4 = 23
Equity Shares
outstanding
(Numbers 000)
5 = (4 4 Rs. 20)
500
500
25.00
10
500
50
450
22.50
20
500
100
400
20.00
30
500
150
350
17.50
As debt increases, the interest rate also increase with the increase in financial
leverage (i.e. debt ratios). Hence the total interest on all debt also increase (as
successive debenture issues carry higher interest rates) as shown in Table 3.4.
Table 3.4: Interest amount at Various levels of Debt
Capital Structure
% of Debt 1
Debt (Rs.000)
(1)
Interest Rate
on all debt % (2)
Interest amount
(Rs.000) (3 = 1*2)
0.0
0.00
10
50
9.0
4.50
20
100
9.5
9.50
30
150
10.0
15.00
40
200
11.0
22.00
50
250
13.5
33.75
60
300
15.5
49.50
3.5.1 EBIT-EPS Analysis for Capital Structure

Using the levels of EBIT in table 3.2, number of equity shares in the columns
5 of table 3.3. and interest values calculated in table 3.4, the calculation of
EPS for debt ratios of 0,30, and 60 percent respectively is shown in Table 3.5.
the effective tax rate is assumed to be 40 percent.
Table 3.5: Calculation of EPS for alternative Debt ratio
Probability
When Debt ration =
Less Interest (Table 3.4)
Earnings after taxes
Less Taxes (0.40)
EPS (25,000) shares (table 3.3)
When Debt ration = 30%
EBIT
Less Interest
Earnings before taxes
Less Taxes (0.40)

EPS (17,500 shares)
0.25
0.50
0.25
0.00
0.00
0.00
0.00
0.00
0.00
100.00
0.00
100.00
40.00
60.00
2.40
200.00
0.00
200.00
80.00
120.00
4.80
0.00
15.00
(15.00)
(6.00)
(9.00)
(0.51)
100.00
15.00
85.00
34.00
51.00
2.91
200.00
15.00
185.00
74.00
111.00
6.34
When Debt ratio = 60%
EBIT
Less Interest
0.00
49.50
(49.50)
(19.80) (a)
(29.70)
2.97
Earnings before taxes

Less Taxes (0.40)
EPS (10,000 Shares)
100.00
49.50
50.50
20.20
30.30
3.03
200.00
49.0
150.50
60.20
90.30
9.03
Capital Structure
Decisions
Notes: a ) It is assumed that the firm received the tax benefits from its loss in
the current period, as a result of carrying forward and setting off the loss
against in the following periods.
Following the same procedure as in Table 3.5 we may obtain EPS for other
debt ratios. Table 3.6 gives expected EPS at 50% probability level (to be
viewed as typical level ) for seven alternative debt ratios along with the
Standard deviation and co-efficient of variation of expected EPS.
Table 3.6: Expected EPS, Standard. Deviation and Co-efficient of variation of EPS at
50% probability level for alternative debt ratios
Capital structure
debt ratio (%)
Expected EPS
(Rs.)
(1)
Standard deviation of
EPS (Rs.)
(2)
Co-efficient of
variation
(2) + (1) = (3)
2.40
1.70
0.71
10
2.55
1.88
0.74
20
2.72
2.13
0.78
30
2.91
2.42
0.83
40
3.12
2.83
0.91
50
3.18
3.39
1.07
60
3.03
4.24
1.40
Notes: The standard deviation () represents the square root of the sum of the
product of each deviation from the mean of expected value squared and the
associated probability of occurrence of each outcome. This is the most common
statistical measure of assets risk.
The co-efficient of variation is calculated by dividing the standard deviation for
an asset by its mean or expected value. The higher the co-efficient of
variation, the risker is the asset.
Table 3.6 shows that as the firms financial leverage increases, its co-efficient
of variation of EPS also increases, signifying that the higher level of risk is
associated with higher levels of financial leverage.
The relative risk of the two of the capital structures at debt ratio=0% and 60%
respectively is illustrated in Figure 3.1 by showing the subjective probability
distribution of
EPS associated with each of them. As the expected level of EPS increase with
increasing financial leverage, the risk also increases which is reflected in the
relative dispersion of each of the distributions. As the higher levels of financial
EPS increase. There are chances that there will be negative EPS depending on
the probabilities of occurrence of the expected results.
7
Decisions
Probability
Debt ratio = 0%
Debt ratio
. . .. . .
5 4 3 2 1
. . . . . . . .
1
Figure 3.1: A Graphic Presentation of Probability Distribution of EPS at Alternative Debt

Ratios.
The EBIT EPS analysis helps in choosing the capital structure which
maximizes EPS over the expected range of EBIT. Since EBIT is one of the
major factors which affects the market value of the firms shares, EPS can as
well be used to measure the effect of various capital structure on shareholders
wealth. The relationship between EBIT and EPS of the firm to analyse the
effect of capital structure on results to the shareholders has been graphically
shown in Figure 3.2 where data from Table 3.7 are used.
Table 3.7 : EBIT-EPS Coordinates (Selected Capital Structures)
Capital structure debt ratio (%)
EBIT
Rs.1,00 000
Rs.2,00,000
Earnings per share

0
2.40
4.80
30
2.91
6.34
60
303
9.03
.
9.
8.
7.
6.
5.
4.
3.
2.
1.
0. . . . . . . . . . . . . . . . . . .
10
50
100
150
EBIT (Rs. 000)
Figures 3.2: A Graphic comparison of selected structures for Raj Cosmetics Ltd.
Expected earnings before interest and taxes are assumed to be constant
because only the effect of financing costs such as interest and preference
dividends on equity shareholders earnings is to be analysed. Thus, the business
risk is assumed constant.
Capital Structure
Decisions
Graphically, the risk of each capital structure can be seen in the context of the
financial break even point. (i.e. EBIT-axis intercept). Below the x-axis,
negative EPS would result. The higher the financial break even point and the
steeper the slope of the capital structure line, the greater the financial risk.
The assessment of the capital structure can also be made by using ratios.
With increased financial leverage, the ability of the firm to service its debt
decreases. Thus, the times Earned Interest Ratio (i.e. EBIT divided by interest)
ratio also measures firms financial leverage and associated risk.
3.5.2 ROI-ROE Analysis

In the preceding section, we looked at the relationship between EBIT and EPS.
Pursuing a similar type of analysis, we may look at the relationship between
the ROI and ROE for different levels of financial leverage.
Example:
Raj Ltd., which requires an investment outlay of Rs. 200 lakhs, is considering
two capital structures propositions:
Capital Structure X
(Rs. in lakhs)
Capital Structure Y
(Rs. in lakhs)
Equity 200
Debt 0
Equity 100
Debt 100
Tax rate = 50 percent

Cost of Debt = 12 percent
Based on the above information, the relationship between ROI and ROE would
be as shown in Table 3.8.
Table 3.8: Relationship between ROI and ROE under capital structures X and Y
Particulars
ROI
EBIT
Int.
Profit
before tax
Profit
after tax
Tax
Return on
Equity
Capital Structure X
5%
10%
15%
20%
25%
10
20
30
40
50
0
0
0
0
0
10
20
30
40
50
5
10
15
20
25
5
10
15
20
25
2.5%
5.0%
7.5%
10.0%
12.5%
Capital Structure Y
5%
10%
15%
20%
25%
10
20
30
40
50
10
10
10
10
10
0
10
20
30
40
0
5
10
15
20
0
5
10
15
20
0.0%
5.0%
10.0%
15.0%
20.5%
Return on Equity is equity earnings divided by Net worth. Looking at the

relationship between ROI and ROE, we find that
(1) The ROI under capital structure X is higher than the ROE under capital
structure Y (ROI is less than the cost of Debt).
(2) The indifference value of ROI is equal to the cost of Debt.
(3) The ROE under capital structure X (ROI is more than the cost of Debt).
Decisions
Mathematically this relationship can be expressed as:

ROE = [ROI + (ROI-r) D/E] (1-t)
Where r = Cost of Debt
D/E = Debt- Equity Ratio
t = tax rate
Applying the above equation when D/E Ratio is 1, we may calculate the value
of ROE for two values of ROI namely, 15 percent and 20 percent.
ROI = 15% ROE = [15+(15-10) 1]0.5 = 10 %
ROI = 20% ROE = [20+(220-10) 1]0.5 = 15%
The results are the same as we see in Table 3.8.
Activity 2
1.
Leverage decision is the same as capital structure decision. Do you agree?

Give one reason.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2.
Distinguish between EBIT and EPS.

...................................................................................................................
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...................................................................................................................
...................................................................................................................
3.
Collect the figures of any company and do the EBIT-EPS analysis by

making necessary assumptions.
...................................................................................................................
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...................................................................................................................
4.
With a real company example make ROI-ROE analysis.

...................................................................................................................
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3.6 THEORIES OF CAPITAL STRUCTURE

A firm should try to maintain an optimum capital structure with a view to
maintaining financial stability. The optimum capital structure is obtained when
the market value per equity share is the maximum. In order to achieve the goal
of identifying an optimum debt-equity mix, it is necessary for the finance
manager to be familiar with the basic theories underlying the capital structure
of corporate enterprises.
10
1.
N I Approach
2.
NOI Approach
3.
MM Approach
4.
Traditional Approach
Capital Structure
Decisions
Common assumptions of the theories of capital structure decision are as

follows:
(i) Preference share capital is merged with debt. The firm employs only debt
and equity capital.
(ii) There are no corporate taxes.
(iii) EBIT is not expected to grow.
(iv) The firms total financing remains constant.
(v) The business risk does not change with the growth of business firm.
(vi) All investors have the same subjective probability distribution of the future
expected earnings for a given firm.
3.6.1 Net Income (NI) Theory

According to this approach, capital structure decision is relevant to the
valuation of the firm in as much as change in the pattern of capitalization
brings about corresponding change in the overall lost of capital and total value
of the firm. This theory, also known as fixed ke theory, was propounded by
David Durand.
The critical assumptions of this theory are
(i) There are no corporate taxes.
(ii) The debt content does not change risk perception of the investors.
(iii) The cost of debt is less than the cost of equity.
The theory works like this.
As the proposition of cheaper debt funds in the capital structure increases,
the weighted average cost of capital decreases and approaches the cost of
debt.
This theory recommends 100% debt financing is optimal capital structure.
The following are the strengths of NoI approach:
(i) it tries to explain the effects of borrowings on overall cost of capital.
(ii) It explains and emphasizes on favourable financial leverage.
(iii) However, the theory ignores the risk consideration.
3.6.2 Net Operating Income (NoI) approach

This approach, also propounded by Durand, is just opposite of Net Income (NI)
approach. According to this approach overall cost of capital and value of the
firm are independent of capital structure decision and change in degree of
financial leverage does not bring about and change in value of the firm and
cost of capital.
The approach is based on the following assumptions:
(i) The overall cost of capital (kO) remains constant for all degrees of debt
equity mix or leverage.
(ii) There are no corporate taxes.
(iii) The market capitalizes the value of the firm as a whole.
(iv) The advantage of debt is set off exactly by increase in the equity
capitalization rate.
11
Decisions
According to the NOI Approach, the value of a firm can be determined by

the following equation;
V=
EBIT
KO
Where:
V
KO
EBIT
= Value of firm;
= Overall cost of capital
= Earnings before interest and tax.
Thus, according to Net Operating Income (NOI) Approach, any capital

structure will be optimum.
The following are the strengths of NOI approach:
(i) it emphasizes on the role of NOI in the determination of total value of the
firm,
(ii) According to this theory, new investment proposals should be based on
NOI approach
This theory seems to ignore the behavioral aspect of financing function of
management.
3.6.3 Modigilian- Miller (MM) Theory

The Modigiliani-Miller (MM) approach is similar to the Net Operating Income
(NOI) approach. It supports the NOI approach providing behavioural
justification for the independence of the total valuation and the cost of capital
of the firm from its capital structure. In other worlds, MM approach maintains
that the weighted average cost of capital does not change with change in the
capital structure of the firm.
The following are the three basic propositions of the MM approach:
(i) The overall cost of capital (KO) and the value of the firm (V) are
independent of the capital structure.
(ii) The cost of equity (KE) is equal to capitalization rate of a pure equity
stream plus a premium for the financial risk.
(iii) The cut-off rate for investment purposes is completely independent of the
way in which an investment is financed.
The MM approach is subject to the following assumptions:
1.
Capital markets are perfect.
2.
All firms within the same class will have the same degree of business
risk.
3.
All investors have the same expectation of a firms net operating income
(EBIT).
4.
The dividend pay-out ratio is 100%.
5.
There are no corporate taxes. However, this assumption was removed

later.
The arbitrage process is the operational justification of MM hypothesis. The

term Arbitrage refers to an act of buying an asset or security in one market
having lower price and selling it is another market at a higher price. The
consequence of such action is that the market price of the securities of the
two firms exactly similar in all respects except in their capital structures can
not for long remain different in different markets. Thus, arbitrage process
12
restores equilibrium in value of securities. This is because in case the market
value of the two firms which are equal in all overvalued firm would sell their
shares, borrow additional funds on personal account and invest in the
undervalued firm in order to obtain the same return on smaller investment
outlay. The use of debt by the investor for arbitrage is termed as home made
or personal leverage.
Capital Structure
Decisions
The following are limitations of MMs theory(i) Rates of interest are not the same for the individuals and the firms.
(ii) Transactional costs are involved.
(iii) Home made leverage is not perfect substitute for corporate leverage.
(iv) The effectiveness of arbitrage process is limited.
Since corporate taxes do exist, MM agreed in 1963 that the value of the firm
will increase and overall cost of capital will deciline because of tax deductability
of interest payments. A levered firm should have, therefore, a greater market
value as compared to an unlevered firm. The value of the levered firm would
exceed that of the unlevered frim by an amount equal to the levered firms
debt multiplied by the tax rate. The formula isVi = Vu + Bt
Where
Vi
Vu
B
t
:
=
=
=
=
Value of levered firm

Value of an unlevered firm
Amount of Debt and
Tax rate
3.6.4 Traditional Approach

The traditional theory assumes changes in Ke at different levels of debt equity
rate. It is the middle of the two extremes of NI and NOI.
Beyond a particular point of debt-equity mix, ke rises at an increasing rate.
There are three stages:Stage I
Introduction of debt-Net Income rises; cost of equity capital rises

because of risk but less than earnings rate leading to decline in
overall cost of capital and increase in Market value.
Stage II Further Application of debt: cost of equity capital rises-net income

debt cost increases value same.
Stage III Further Application of debt cost of equity capital is very high
value goes down.
Example
Raj Cosmetics Ltd. has estimated the following rates of return (Column (3) of
the Table 3.9. Table 3.9 also gives the seven capital structures from the
debt ratios ranging from 0% to 60% and expected EPS in Rs. (from Table
3.6).
From these data, it is possible to work out the expected share values in each
of the alternative capital structures. Calculations are set out in column 4 of the
Table 3.9.
13
Decisions
Table 3.9: Calculation of Share Value Estimate Associated with Alternative Capital
Structures for Raj Cosmestics Ltd.
Capital structure
debt ratio (%)
Estimated required
rate of return Esti.
by the Co.)
(3)
Estimated Share
Value (Rs.)
(1)
Expected EPS
(Rs.) (From
Table 3.6)
(2)
0
10
20
30
40
50
60
2.40
2.55
2.72
2.91
3.12
3.18
3.03
0.115
0.117
0.121
0.125
0.140
0.165
0.190
20.87
21.79
22.48
23.28
22.29
19.27
15.95
(4)
Table 3.9 shows that the maximum share value occurs at the capital structure
associated with the debt ratio of 30%. This is the optimal capital structure. It
is noticeable that EPS is maximized at 50% debt ratio, while the share value
is maximized at 30% debt ratio. This discrepancy arises because EPS
maximization approach does not consider the risk as reflected in required rates
of return.
In addition to the analysis of the EBIT-EPS, required rates of returns and share
value, certain other factors are also taken into account in determining the
capital structure for the firm. These are listed below:
Adequacy of cash flow to service debt and preference shares
Having stable and predictable revenues
Limitations imposed by previous contractual obligations
Management Preference and attitudes towards risk
Assessment of the firms risk by financial institutions and other agencies
Capital market conditions and investor preferences
Considerations of corporate control.
Activity 3
1)
In what manner are the corporate taxes relevant to capital structure

decision?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
Contrast traditional and M-M position regarding optimal capital structure.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3)
Name of single most important factor which determines the capital

structure of a company.
...................................................................................................................
...................................................................................................................
...................................................................................................................
14
...................................................................................................................
4)
Try to know from Finance Manager of any two companies:

i)
Capital Structure
Decisions
What is their present capital structure?

.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
ii) What are the factors which determine their capital structure?
.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
iii) Do they intend to change their capital structure in the near future ?
why?
.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
5)
Show arbitrage process with an example.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
3.7 FACTORS INFLUENCING PATTERN OF

CAPITAL STRUCTURE
Following are the major factors which should be kept in view while determining
the capital structure of a company:
(1) Size of Business

Smaller firms confront tremendous problems in assembling funds because of
their poor creditworthiness. Investors feel loath in investing their money in
securities of these firms. Lenders prescribe highly restrictive terms in lending.
In view of this, special attention should be paid to maneuverability principle.
This is why common stock represents major portion of this capital in smaller
concerns. Larger concerns have to employe different types of securities to
procure desired amount of funds of reasonable cost because they find it very
difficult to raise capital at reasonable cost of demand for funds is restricted to
a single source.
(2) Form of Business Organisation

Control principle should be given higher weightage in private limited companies
where ownership is closely held in a few hands. This may not be so imminent
in the case of public limited commanies whose shareholders are large in
number. In proprietorship or partnership form of organisation, control is
undoubtedly an important consideration because control is concentrated in a
proprietor or a few partners.
15
Decisions
(3) Nature of Enterprise

Business enterprises which have stability in their earnings or which enjoy
monopoly regarding their products may go for debentures or preference shares
since they will have adequate profits to meet the recurring cost of interest/fixed
dividend. This is true in case of public utility concerns. On the other hand,
companies which do not have this advantage should rely on equity share capital
to a greater extent for raising their funds. This is, particularly, true in case of
manufacturing enterprises.
(4) Stability of earnings

With greater stability in sales and earnings a company can insist on the fixed
obligation debt with less risk. But a company with irregular income will not
choose to burden itself with fixed charge. Such company should depend
upon the sale of stock to raise capital.
(5) Age of Company

Younger companies generally find it difficult to raise capital in the initial years
because of greater uncertainty involved in them and also because they are not
known to suppliers of funds. It would therefore, be worthwhile for such
companies accord to higher weightage to maneuverability factor. In a sharper
contrast to this, established companies with good earnings record are always in
comfortable position to raise capital from whatever sources they like. Leverage
principle should be insisted upon in such concerns.
(6) Purpose of Financing

In case funds are required for some directly productive purposes the company
can afford to raise the funds by issue of debentures. On the other hand, if
the funds are required for non-productive purposes, providing more welfare
facilities to the employees the company should raise the funds by issue of
equity shares.
(7) Market Sentiments

Times of boom investors generally want to have absolute safety. In such cases,
it will be appropriate to raise funds by issue of debentures. At other periods,
people may be interested in earnings high speculative incomes; at such times, it
will be appropriate to raise funds by issue of equity shares.
(8) Credit Standing

A company with high credit standing has greater ability to adjust sources of
funds upwards or downwards in response to major changes in need for funds
than one with poor credit standing. In the former case the management should
pay greater attention to maneuverability factor.
(9) Period of Finance

The period for which finance is required also affects the determination of
capital structure of companies. In case, funds are required, say, for 5 to 10
years, it will be appropriate to raise them by issue of debentures. However, if
the funds are required more or less permanently, it will be appropriate to raise
them by issue of equity shares.
(10) Legal Requirements
16
Companies Act, Banking Co. Act etc. influence the capital structure
considerations. The relative weightage assigned to each of these factors will
very widely from company to company depending upon the characteristics of
the company, the general economic conditions and the circumstances under
which the company is operating. Companies issue debentures and preference
shares to enlarge the earnings on equity shares, while equity shares are issued
to serve as a cushion to absorb the shocks of business cycles and to afford
flexibility. Of course, greater the operating risk, the less debt the firm can use,
hence, in spite of the fact that the debt is cheaper the company should use it
with caution.
Capital Structure
Decisions
(11) Tax Considerations

The existing taxation provision makes debt more advantageous in relation to
stock capital in as much as interest on bonds is a tax deductible expense
whereas dividend is subject to tax. In view of prevailing corporate tax rates in
India, the management would wish to raise degree of financial leverage by
placing greater reliance on borrowing.
3.8 RELEVANCE OF DEBT EQUITY RATIO IN

PUBLIC ENTERPRISES
It is generally argued that the practical significance of the debt-equity ratio is
limited in the case of public enterprises in many countries because most of the
loans are derived from the government itself or from public sector financial
institutions. The government as the owner as well as the lender, has access to
all the information it needs about the financial health of the enterprise and does
not need to refer to any favourable ratio to derive confidence before making
loans to it. Even when the public enterprises are allowed to borrow from
private banks or from foreign financial institutions, there is a government
guarantee in one from or another that the loans will be removed and lightened
by adoption of an appropriate policy measures.
Since all this has the effect of making institutional arrangements for sharing risk
and thus reducing the disadvantages of debt, a case could be made for
justifying higher debt-equity ratios for public enterprises. A few observations in
this regard are made as under :
(a) Since not all of the public enterprise are wholly owned and financed
(through loans) by government and there are many joint ventures, so that
institutional arrangements for diluting risks are not always available to these
enterprises, it has to be appreciated that in real life, public enterprises have
to face the bias of the lending agencies (local or foreign) towards this
measure of the strength of their capital structure.
(b) In most of the countries public enterprises ministries e.g. planning and
finance, for a critical scrutiny and appraisal of their proposals. In any
case, the government owned financial institutions can be should be
expected to raise points also at the risk of further lending to an enterprise,
the debt-equity ratio of whose capital structure is not in line with the
normal or which does not appear to be quite sound in context of its
financial prospects. Many of the worthwhile plans of investment in public
enterprises, whether for replacement and rehabilitation of existing assets or
for expansion and diversification, require significant amounts of foreign
exchange. If these resources are arranged from foreign lending agencies
like the world Bank/IDA, the creditors make it a point to specify
adherence to a range of healthy debt-equity ratios (and also to a
conservative dividend disbursement policy) till their loans are repaid.
(c) It is also desirable from the enterprises own point of view to see that a
sufficiently high proportion of equity is maintained in its capital structure
because it should enable it some freedom of action in the matter of
retaining its earnings for its self-financed projects or for financing a part
17
Decisions
of its working capital, provided, of course, that it is in the happy position of

making profits. In the case of other enterprises which operate at a loss
(whether because of government imposed pricing policies or because of
their inefficiencies), there is usually a demand for concerting at least a part
of their loan capital into equity capital. When such proposals are being
formulated and examined, the question of a reasonable or proper debt-equity
ratio for the type of enterprises under consideration is raised sooner or later.
(d) With an inappropriately high debt-equity ratio, the initial cost of a project/
manufacturing facility put up by a public enterprise has the effect of
increasing the fixed costs of operation through the capitalization of interest
during construction. This is likely to place the enterprise in a
disadvantageous position vis--vis its competitions and can lead to a vicious
cycle of accumulation of losses, under utilization of capacity, low morale of
workers and management inefficiencies, short-term (and strategically
unsuitable) solutions and further losses. Having once been trapped in this
situation, it is difficult indeed for the enterprise to extricate itself and
rehabilitate its capital structure, particularly when the Government
departments ministries are not very prompt in analyzing the causes of these
problems and providing the requisite reliefs.
(e) There cannot be must argument with the proposition that, in long run, the
equity portion of a public enterprise must not be regarded as a device of
cash convenience and as a no-cost input, because it certainly has an
opportunity cost for the economy as a whole. Public enterprises have, as a
general rule, to operate under pricing and operating policies dictated by
their owner governments socio-economic (and political) objectives. Debtequity ratio is one device by which the enterprise can be considered to
have been compensated for its expenses/losses on meeting these additional
obligations.
(f) If a certain range of debt-equity ratios is adopted for enterprise in a
particular sector of the economy, it can result in fixing a concessional rate
of interest/return on the capital mix (loan at market rate plus equity at zero
percent).
It may, thus, be concluded that the view that the practical significance of the
debt-equity ratio is limited in the case of public enterprise is not based on a
complete appreciation of all the factors in which these enterprises have to
operate in many developing countries. While the private sector analogy in this
respect may have to be qualified suitably when applied to the public enterprise
situation in a particular country, it will remain a useful indicator, both with the
administrative ministers and with the enterprise managements, to assess the
strength of their capital structures.
Activity 4
1)
Bring out five factors that influence capital structure.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
2)
Debt Equity Ratio is not relevant for public enterprises Comment.

...................................................................................................................
...................................................................................................................
...................................................................................................................
18
...................................................................................................................
3.9 SUMMARY
Capital Structure
Decisions
A firms capital structure is determined by the mix of long-term debt and equity
it uses in financing its operations. Financial structure means the composition of
the entire left hand side of the balance sheet. The basic differences in debt
(including preference shares) and equity capital are in respect of the voting
rights, the claims on income and assets, and the tax treatment. Timing,
flexibility, cost, risk and control principles are the criteria for determining patter
of capital structure.
A firms capital structure should be consistent with its business risk and result
in an acceptable financial risk. The EBIT-EPS analysis can be used to evaluate
various capital structure in the light of the degree of financial risk and the
returns to the equity shareholders. The EBIT-EPS analysis shows how the
desirable capital structure gives the maximum EPS.
The mathematical relationship between ROI is
[(ROE + ROI r) D/E] (1-t)
NI and NOI theories of capital structures are extreme. The MM analysis
suggests that the optimal capital structure does not matter and that as much
debt as possible should be used because the interest is tax-deductible. The MM
hypothesis is criticized because of its unreal assumptions. Tax adjustment makes
it more realistic.
The traditional approach to capital structure indicates that the optimal capital
structure for the firm is one in which the overall cost of capital is minimized
and the share value is maximized.
The cost of debt increases beyong a certain level of leverage.
Certain qualitative considerations such as cash flow, corporate control,
contractual obligations, managements risk tolerance, etc. are taken into
consideration while determining the capital structure.
The practical significance of Debt-Equity ratio for public enterprises is limited
and has different perspectives.
3.10 KEYWORDS
Capital Structure is the proportions of all types of long-term capital. Financial
Structure is the proportions of all types of long-term and short-term capital.
EBIT = Earnings before Interest and taxes.
EPS = Earnings per share
NI Approach says more usage of debt will enhance the value of the firm.
NOI Approach says that the total value of the firm remains constant
irrespective of the debt-equity mix. Arbitrage refers to an act of buying a
security in one market having lower price and selling it in another market at a
higher price. The consequence of such action is that the market price of the
securities will become the same.
19
Decisions
3.11 SELF ASSESSMENT QUESTIONS/EXERCISES

1.
What is a firms capital structure? How is it different from financial

structure?
2.
Under the traditional approach to capital structure, what happens to the

cost of debt and cost of equity as the firms financial leverage increases?
3.
Explain ROI-ROE analysis.
4.
Explain the EBIT-EPS approach to the capital structure. Are maximizing

value and maximizing EPS the same?
5.
Khosla Ltd. had made the following forecast of sales, with the
associated probability of occurrence.
Sales Rs.
2,00,000
3,00,000
4,00,000
Probability
0.20
0.60
0.20
The company has fixed operating costs of Rs.1,00,000 per year and variable
operating costs represent 40% of sales. The existing capital structure consists
of 25,000 equity shares of Rs. 10 each. The market place has assigned the
following discount rates to risky earnings per share.
Co-efficient of variation of EPS
.43
.47
.51
.56
.60
.64
Estimated Required Returns %

15
16
17
18
22
24
The company is considering changing its capital structure by increasing debt in

the capital structure vis--vis capital. Different debt ratios are considered, given
here with the estimate of the required interest rate on all debt.
Debt Ratio
20%
40%
60%
Interest on all debt

10%
12%
14%
The tax rate is 40% percent.

a) Calculate the expected earnings per share, the standard deviation of
EPS and the co-efficient of variation of EPS for the three proposed
capital structures.
b) Determine the optimal capital structure, assuming (i) maximization of
ePS and (ii) maximization of share value.
c) Construct a graph showing relationship in (b).
6.
Critically examine various theories of capital structure.
7.
Narrate the factors influencing capital structure.
8.
Explain the criteria for determining pattern of capital structure.
9.
Discuss the relevance of debt-equity ratio for Indian Public Enterprises.
10. Assume the figures of an Indian company and examine the relevance of
MMs theory of capital structure.
20
Capital Structure
Decisions
Dani, Hemant R. 1973, Balance Sheets and How to Read Them. Hemant R.
Dani, Bombay,
Gitman Lawerence J. 1985, Principles of Managerial Finance Fourth Edition.
Haper & Row Publishers, Singapore, New York.
Schall Lawerence D & Haley Charles W. 1986, Introduction to Financial
Management Fourth (International student) edition, Mc-Graw Hill Book Co.,
New York.
Srivastava, R,M,, 2002 Financial Management, Pragati Prakash, Meerut.
Srivastava R.M. 2003 Financial Management and Pragati Himalaya
Publishing Housing Mumbai.
Chandra, P., 1995 Fundamentals of Financial Management Tata McGraw,
New delhi.
Maheshwari, S.N., 1993 Financial Management Sultan chand & Sons.
Upadhyaya, K.M., 1985 Financial Management Kalyani Publishers, Ludhiana.
Pendey, I.M., 1993 Financial Management.
21
UNIT 4 PROJECT PLANNING
Objectives
The objectives of this unit are:
to provide an understanding of nature and types of projects,
to throw light on project life cycle,
to explain how project work is planned.
Structure
4.1
Introduction
4.2
Nature of a Project
4.3
Classification of Projects
4.4
The Project Life Cycle
4.5
Project Management Defined
4.6
Planning Project Work

4.6.1 Initial Project Coordination
4.6.2 System Integration
4.6.3 Sorting Out the Project
4.6.4 The Work Breakdown Structure and Linear Responsibility Charts
4.7
Summary
4.8
Self-Assessment Questions
4.9
Further Readings
4.1 INTRODUCTION
Effective management of projects is key to the progress of an economy
because development itself is the outcome of a series successfully managed
projects. This is why project management is receiving greater attention in
developing countries like ours, so as to avoid project schedule slippages and
cost overruns, a project needs to be meticulously planned, effectively
implemented and professionally managed in order to accomplish the objectives
of time, cost and performance. This demands fairly good understanding of
nature and types of projects, project life cycle and concept of project
management.
4.2 NATURE OF A PROJECT

The term project has a wider meaning to include a set of activities. For
example, construction of a house is a project. It includes many activities like
digging of foundation pits, construction of foundations, construction of walls,
construction of roof, fixing of doors and windows, fixing of sanitary fitting,
wiring etc. Further, project is the non-routine nature of activities.
In fact, a project is an organized programme of pre-determined group of
activities that are non-routine in nature and that must be completed within the
given time limit. It is a non-routine, non-repetitive, one-off undertaking, normally
with discrete time, financial and technical performance goals.
The distinguishing features of a project are :
Purpose: A project is usually a one-time activity with a well-defined set of
desired end results. It can be divided into subtasks that must be
accomplished in order to achieve the project goals. The project is complex
Investment Decisions
Under Certainty
enough that the subtasks require careful coordination and control in terms of
timing, precedence, cost, and performance. The project itself must often be
coordinated with other projects being carried out by the same parent
organization.
Life Cycle : Like organic entites, projects have a life cycle. From a slow
beginning they progress to a buildup of size, then peak, begin a decline, and
finally must be terminated. (Also like other organic entities, they often resist
termination.) Some projects end by being phased into the normal, ongoing
operations of the parent organization.
Single Entity : A project is one entity and is normally entrusted in one
responsibility centre while the participants in the project are many.
Interdependencies : Projects often interact with other projects carried out
simultaneously by their parent organization; but projects always interact with
the parents standard, ongoing operations. While the functional departments
of an organization (marketing, finance, manufacturing, and the like) interact
with one another in regular, patterned ways, the patterns of interaction
between projects and these departments tend to be changing. Marketing may
be involved at the beginning and end of a project, but not in the middle.
Manufacturing may have major involvement throughout. Finance is often
involved at the beginning and accounting (the controller) at the end, as well
as at periodic reporting times. The project manager must keep all these
interactions clear and maintain the appropriate interrelationships with all
external groups.
Uniqueness : Every project has some elements that are unique. No two
construction or R&D projects are precisely alike. Though it is clear that
construction projects are usually more routine than research and development
projects, some degree of customization is a distinct feature of a project. In
addition to the presence of risk, as noted above, a project may be unique in
nature, which can not be completely reduced to routine. The project
managers importance is emphasized because, as a devotee of management
by exception, the manager will find there are a great many exceptions to
manage by.
Complexity : A rich project represents complex set of activities pertaining
to diverse areas. Technology survey, choice of the appropriate technology,
procuring the appropriate machinery and equipment, hiring the right kind of
people, arranging the financial resources, execution of the projects in time by
proper scheduling of various activities contribute to the complexity of the
project.
Team Work : Successful completion of a project calls for teamwork. The
team is constituted of members who are specialists in relevant fields.
Risk and Uncertainty : Risk and uncertainty are inherent in every project.
However, degree of risk and uncertainty will depend on how a project
passes through its various life cycle phases.
Customer Specific : A project has always to be customer specific so as to
cater to the needs of customers. As such, the organization should go for
projects that are suited to customers.
4.3 CLASSIFICATION OF PROJECTS

Much of what project will comprise and consequently its management depends
essentially on the category it belongs to. Projects can be categorized according
to type of activity, location, time, ownership, size and need.
According to Type of Activity : Under this category, projects can be

classified as industrial and non-industrial projects Industrial projects are set
up for the production of some goods. Non-Industrial projects comprise
health care projects, educational projects, irrigation projects, soil conservation
projects, highway projects etc.
Project Planning
According to Location : Location wise, projects can be categorized as

national and international projects. National projects are those set up in the
national boundaries of a country, while international projects are set up by
the government of private sector across the globe.
According to Completion Time : Projects under this category can be
divided into two types, viz; normal and crash projects. In case of normal
projects there is no time constraint. Crash projects are those which are to
be completed within a stipulated time, even at the cost of ending up with a
higher project cost.
According to Ownership : Projects under this category can be grouped
into public, private and joint sector projects. Public sector projects are
owned by the Government. In private sector projects ownership is in the
hands of the project promoters and investors. Joint sector projects are
those in which ownership is shared by the Government and private
entrepreneurs.
According to Size : Based on size, there may be three categories of
projects, viz; small, medium and large. As per the present guideline of the
Government, projects with investment on plant and machinery upto Rs. 1
crore are classified as small and those with investment in plant and
machinery above Rs. 100 crores are categorized as large scale projects.
Those with investment limit between these groups are medium scale projects.
According to Need : Based on the need for the project, projects can be
classified as new balancing, expansion, modernization, replacement,
diversification, backward integration and forward integration projects.
4.4 THE PROJECT LIFE CYCLE

Most projects go through similar stages on the path from origin to completion.
We define these stages, as shown in Figure 4.1, as the projects life cycle. The
projec is born (its start-up phase) and a manager is selected, the project team
and initial resources are assembled, and the work program is organized. The
work gets under way and momentum quickly builds. Progress is made. This
continues until the end is in sight. But completing the final tasks seems to take
an inordinate amount of time, partly because there are often a number of parts
that must come together and partly because team members drag their feet
for various reasons and avoid the final steps.
% Project competition
100
Slow finish
Quick momentum
Slow start
Time
Figure 4.1: The Project Cycle
Under Certainty
The pattern of slow-rapid-slow progress toward the project goal is common.

Anyone who has watched the construction of a home or building has observed
this phenomenon. For the most part, it is a result of the changing levels of
resources used during the successive stages of the life cycle. Figure 4.2 depicts
project effort, usually in terms of man-hours or resouces expended per unit of
time (or number of people working on the project) plotted against time, where
time is broken up into the several phases of project life. Minimal effort is
required at the beginning-when the project concept is being developed and is
being subjected to project selection processes.
If this hurdle is passed, activity rate increases as planning is done, and the real
work of the project gets under way. This rises to a peak and then begins to
taper off as the poject nears completion, finally ceasing when evaluation is
complete and the project is terminated. In some cases, the effort may never
fall to zero because the project team, or at least a cadre group, may be
maintained for the next appropriate project that comes along. The new project
will then emerge.
The ever-present goals of performance, time, and cost are the major
considerations throughout the projects life cycle. Early in the life cycle,
performance takes precedence. Team members focus on how to achieve the
projects performance goals. We refer to the specific methods adopted to reach
these goals as the projects technology because these methods require the
application of a science or art.
Level of effort
Peak effort level
Planning, scheduling,
Monitoring, control
Conception
Evaluation &
termination
Time
Selection
Figure 4.2: Time distribution of project effort
When the major how problems are solved, project workers sometimes get
preoccupied with improving performance, often beyond the levels required by
the original specifications. This search for additional performance delays the
schedule and pushes up the costs.
The middle stages of the life cycle are typified by a growing concern with cost
control. During the latter stages of the life cycle, focus of attention is on time.
With projects nearing completion, there tends to be more flexibility in cost and
efforts are directed towards bringing things into conformity with the approved
schedule-as much as possible, even if it means cost penalties.
It would be a great source of comfort if one could predict with certainty, at the
start of a project, how the performance time, and cost goals would be met. In
a few cases, for example routine construction projects, we can generate
reasonably accurate predictions, but often we cannot. There may be
considerable uncertainty about our ability to meet project goals. The
crosshatched portion of Figure 4.2 illustrates this uncertainty.
Project Planning
Activity 1
a)
Identify activities that constitute a project

...................................................................................................................
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...................................................................................................................
...................................................................................................................
b)
List out five national projects

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...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
List out five international projects

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...................................................................................................................
d)
List out four stages of a national project.

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...................................................................................................................
...................................................................................................................
...................................................................................................................
e)
Identify four major elements that constitute an international project plan.

...................................................................................................................
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4.5 PROJECT MANAGEMENT DEFINED

Project management is the process of identifying project opportunities,
formulating profitable project profiles, procuring funds for project implementation,
scheduling of project activities in such a way as to complete the project within
the minimum possible time/cost, and monitoring of the project after its
implementation.
Defining what is to be done and ensuring that it is done and performed as
desired within time and cost budgets fixed for it through a modular work
approach, using organizational and extra-organizational resources is what project
management has to achieve.
5
Under Certainty
4.6 PLANNING PROJECT WORK

Project planning as represents a set of six planning sequences. First comes
preliminary coordination where the various parties involved in the project get
together and make preliminary decisions about what will be achieved (project
objectives) and by whom. These preliminary plans serve as the basis for a
detailed description of the various tasks that must be undertaken and
accomplished in order to acieve the objectives of the project. In addition, the
very act of engaging in the preliminary planning process increases the
members commitment to the project.
These work plans are used for the third and fourth sequences, deriving the
project budget and schedule. Both the budget and the schedule directly reflect
the detail (or lack of it) in the project work plan, the detail description of
projects tasks. The fifth planning sequence is a precise-description of all project
status reports, when they are to be produced, what they must contain, and to
whom they will be sent. Finally, plans must be developed that deal with project
termination, explaining in advance how the project pieces will be redistributed
once its purpose has been completed.
But before we begin, we assume that the purpose of planning is to facilitate
accomplishment of its objectives. The world is full of plans that never become
deeds. The planning techniques covered here are intended to smooth the path
from idea to accomplishment. It is a complicated process to manage a project,
and plans act as a map of this process. The map must have sufficient detail to
determine what must be done next but be simple enough that workers are not
lost in a welter of minutiae.
4.6.1
Initial Project Coordination
It is a crucial that the projects objectives be clearly tied to the overall vision
and mission of the firm. Senior management should define the firms intent in
undertaking the project, outline the scope of the project, and describe the
projects desired end results. Without a clear beginning, project planning can
easily go astray. It is also vital that a senior manager should call an initial
coordinating meeting and be present as a visible symbol of top managements
commitment to the project.
At the meeting, the project is discussed in sufficient detail the potential
contributors develop a general understanding of what is needed. If the project
is one of many similar projects, the meeting will be quite short and routine, a
sort of touching base with other interested units. If the project is unqiue in
most of its aspects, extensive discussion may be required.
Whatever be the process, the outcome must be that : (1) technical objectives
are established (though perhaps not cast in concrete), (2) basic areas of
performance responsibility are accepted by the participants, and (3) some
tentative schedules and budgets are spelt out. Each individual/unit accepting
responsibility for a portion of the project should agree to deliver; by the next
project meeting a preliminary but detailed, plan about how that responsibility will
be accomplished. Such plans should contain descriptions of the required tasks,
budgets, and schedules.
These plans are then reviewed by the group and combined into a composite
project plan. The composite plan, still not completely firm, is approved by each
participating group, by the project manager, and then by senior organizational
management. Each subsequent approval hardens the plan somewhat, and
when senior management has endorsed it, any further changes must be made
by processing a formal change order. However, if the project is not large or
complex, informal written memoranda can substitute for the change order. The
main point is that no significant changes in the project are made, without
written notice, following top managements approval. The definition of
significant depends on the specific situation and the people involved.
Project Planning
Project Plan Elements

Given the project plan, approvals really amount to a series of authorizations.
The project manager is authorized to direct activities, spend monies (usually
within preset limits), request resources and personnel, and start the project on
its way to completion. Senior managements approval not only signals its
willingness to fund and support the project, it also notifies sub-units in the
organization that they may commit resources to the project.
The process of developing the project plan varies from organization to
organization, but any project plan must contain the following elements:
Overview: This is a short summary of the objectives and scope of the project.
It is directed to top management and contains a statement of the goals of the
project, a brief explanation of their relationship to the firms objectives, a
description of the managerial structure that will be used for the project, and a
list of the major milestones in the project schedule.
Objectives: This contains a more detailed statement of the general goals noted
in the overview section. The statement should include profit and competitive
aims as well as technical goals.
General Approach: This section describes both the managerial and the
technical approaches to the work. The technical discussion describes the
relationship of the project to available technologies. For example, it might note
that this project is an extension of work done by the company for an earlier
project. The subsection on the managerial approach takes note of any deviation
from routine procedure, for instance, the use of subcontactors for some parts of
the work.
Contractual Aspects: This critical section of the plan includes a complete list
and description of all reporting requirements, customer-supplied resources, liaison
arrangements, advisory committees project review and cancellation procedures,
proprietary requirements, any specific management agreements (eg., use of
subcontractors), as well as the technical deliverables and their specifications and
delivery schedule. Completeness is a necessity in this section. If in doubt about
whether an item should be included or not, the wise planner will include it.
Schedules : This section outlines the various schedules and lists all milestone
events. The estimated time for each task should be obtained from those who
will do the work. The project master schedule is constructed from these inputs.
The responsible person or department head should sign off on the final, agreedon schedule.
Resources: There are two primary aspects to this section. The first is the
budget. Both capital and expense requirements are detailed by task, which
makes this a project budget. One-time costs are separated from recurring
project costs. Second, cost monitoring and control procedures should be
described. In addition to the usual routine cost elements, the monitoring and
control procedures must be designed to cover special resource requirements for
the project, such as special machines, test equipment, laboratory usage or
construction, logistics, field facilities and special materials.
7
Under Certainty
Personnel : This section lists the expected personnel requirements of the

project. Special skills, types of training needed, possible recruiting problems,
legal or policy restrictions on work-force composition, and any other special
requirements, such as security clearances, should be noted here. It is helpful to
index personnel needed for the project schedule. This makes clear when the
various types of contributors are needed and in what numbers. These
manpower projections are important element of the budget, so the personnel,
schedule, and resources sections can be cross-checked with one another to
ensure consistency.
Evaluation Methods : Every project should be evaluated against standards
and by methods established at the projects inception. This section contains a
brief description of the procedure to be followed in monitoring, collecting,
storing, and evaluating the history of the project.
Potential Problems: Sometimes it is difficult to convince planners to make a
serious attempt to anticipate potential difficulties. One or more such possible
disasters as subcontractors default, technical failure, strikes, bad weather,
sudden required breakthroughs, critical sequences of tasks, tight deadlines,
resource limitations, complex coordination requirements, insufficient authority in
some areas, and new, complex, or unfamiliar tasks are certain to occur. The
only uncertainties are which ones will occur and when. In fact, the timing of
these disasters is not random. There are times, conditions, and events in the life
of every project when progress depends on subcontractors, or the weather, or
coordination, or resource availability, and plans to deal with unfavourable
contingencies should be developed early in the projects life cycle. Some
Project managers disdain this section of the plan on the grounds that crises can
not be predicted. Further, they claim to be very effective fire fighters. It is
quite possible that when one finds such a Project manager, one has discovered
an arsonist. No amount of current planning can solve the current crisis, but
pre planning may avert some.
These are the elements that constitute the project plan and are the basis for a
more detailed planning of the budgets, schedules, work plan, and general
management of the project. Once this basic plan is fully developed and
approved, it is disseminated to all interested parties.
4.6.2
Systems Integration
System integration (sometimes called systems engineering) plays a crucial role

in the performance aspect of the project. We are using this phrase to include
any technical specialist in the science or art of the project who is capable of
performing the role of integrating the technical disciplines to achieve the
customers objectives. As such, systems integration is concerned with three
major objectives.
Performance: Performance is what a system does. It includes system
design, reliability, maintainability, and reparability. Obviously, these are not
separate, independent elements of the system, but are highly interrelated
qualities. Any of these system performance characteristics is subject to
over-design as well as undersign but must fall within the design parameters
established by the client. If the client approves, we may give the client
more than the specifications require simply because we have already
designed to some capability, and giving the client an overdesigned system is
faster and less expensive than delivering precisely to specification. At
times, the aesthetic qualities of a system may be specified, typically
through a requirement that the appearance of the system must be
acceptable to the client.
8
Effectiveness: The objective is to design the individual components of a
system to achieve the desired performance in a optimal manner. This is
accomplished throught the following guideline: Require no component
performance specification unless necessary to meet one or more systems
requirements. Every component requirement should be traceable to one or
more systems requirements. Design components to optimize system
performance, not the performance of a subsystem.
Project Planning
Cost: Systems integration considers cost to be a design parameter, and

costs can be accumulated in several areas. Added design cost may lead to
decreased component cost, leaving performance and effectiveness
otherwise unchanged. Added design cost may yield decreased production
cost, and production cost may be trade-off against unit cost for materials.
Value engineering examines all these cost trade-offs and is an important
aspect of systems integration. It can be used in any project where the
relevant cost trade-offs can be estimated. It is simply the consistent and
thorough use of cost/effectiveness analysis. For an application of value
engineering techniques applied to disease control projects.
Systems integrations plays a major role in the success or failure of any project.
If a risky approach is taken by system integration, it may delay the project. If
the approach is too conservative, we forego opportunities for enhanced project
capabilities or advantageous project economics. A good design will take all
these trade-offs into account in the initial stages of the technical approach. And
it will avoid locking the project into a rigid solution with little flexibility or
adaptability in case problems occur later on or changes in the environment
demand changes in project performance or effectiveness.
4.6.3
Sorting Out the Project
In order to ensure a successful completion of a Project we need to know

exactly what is to be done, by whom, and when. All activities required to
complete the project must be precisely delineated and coordinated. The
necessary resources must be available when and where they are needed, and
in the correct amounts. Some activities must be done sequentially, but some
may be done simultaneously. If a large project is to come in on time and within
cost, a great many things must happen when and how they are supposed to
happen. In this section, we propose a simple method to assist in sorting out and
planning all this detail.
To accomplish any specified project, there are several major activities that must
be completed. First, list them in the general order in which they would normally
occur. A reasonable number of major activities might be anywhere between
two and twenty. Break each of these major activities into two to twenty
subtasks. There is nothing sacred about the two to twenty limits. Two is the
minimum possible breakdown and twenty is about the largest number of
interelated items that can be comfortably sorted and scheduled at a given level
of task aggregation. Second, preparing a network from this information, is much
more difficult if the number of activities is significantly greater than twenty.
Sometimes a problem arises because some managers tend to think of outcomes
(events) when planning and other think of specific tasks (activities). Many mix
the two. The problem is to develop a list of both activities and outcomes that
represents an exhaustive, non redundant set of results to be accomplished
(outcomes) and the work to be done (activities) in order to complete the project.
The procedure proposed here is a heirarchical planning system. First, the goals
must be specified. This will aid the planner in identifying the set of required
activities for the goals to be met, the project Action Plan. Each activity has an
Under Certainty
outcome (event) associated with it, and these activities and events can be
decomposed into sub-activities and sub-events, which may, in turn, be
subdivided again. The Project Plan is the set of these Action Plans. The
advantage of the Project Plan is that it contains all planning information in one
document.
4.6.4
The Work Breakdown Structure and Linear Responsibility Charts
The Work Breakdown Structure (WBS) used in project management is a type

of Gozinto chart and is constructed directly from the projects Action Plans.
The WBS may also be perceived as an organization chart with tasks
substituted for people as shown in Figure 4.3. It pictures a project subdivided
into heirarchical units of tasks, work packages, and work units. The end results
is a collection of work units each of which is relatively short in time span.
Each has definite beginning and ending points along with specific criteria for
evaluating performance. Each part of the project down to the smallest subtask
elements is budgetable in terms of money, man hours, and other requisite
resources. Each is a single, meaningful job for which individual responsibility
can be assigned. Each can be scheduled as one of the many jobs that the
organization must undertake and complete.
Organisation Responsibility
Work Breakdown Structure

(WBS)
Facility
Defined by
responsibility structre
Organisation
Divisional
responsibility centre
Departmental
responsibility
centre
Responsibility
Engineering
Departmental
responsibility
centre
Location
Location
Section 1
Section 2
Material
Responsibility
Construction
Departmental
responsibility
centre
Installation
Responsibility
Inspection
Inspection
Figure 4.3: Responsibility/WBS relationship

Source:
Lavold, G.D., Developing and Using the Work Breakdown Structure, in

Cleland D.I., and W.R. King. Project Management Handbook, Van Nostrand
Reinhold, 1983.
In constructing the WBS, it is wise to contact the managers and workers who
will be directly responsible for each of the work packages. These people can
develop a hierarchical plan for the package delegated to them.
The WBS can be used to illustrate how each piece of the project is tied to the
whole in terms of performance, responsibility, budgeting, and scheduling. The
following general steps explain the procedure for designing and using the WBS
10
as it would be used on a large project. For small or moderate-size projects,
some of the steps might be skipped, combined, or handled less formally than
our explanation indicates, particularly if the project is of a type familiar to the
organization.
1)
Using information obtained from the people who will perform the work,
break project tasks down into successively finer levels of detail. Continue
the decomposition of work until all meaningful tasks have been identified
and each task can be individually planned, scheduled, budgeted, monitored,
and controlled.
2)
For each such work element:
Project Planning
Make up a work statement that includes the necessary inputs, the

specification reference, particular contractual stipulations, and specific end
results to be achieved. List any vendors, contract, and subcontractors who
are or may be involved. Identify detailed end item specifications for each
work element regardless of the nature of the end item, whether hardware,
software, test results, reports, etc.
Establish cost account numbers.
Identify the resource needs, such as manpower, equipment facilities,
support, funds, and materials. Cost estimators can assist the Project
Manager in constructing a task budget composed of costs for materials,
manufacturing operations, freight, engineering, contingency reserves, and
other appropriate charges.
List the personnel and organizations responsible for each task. It is helpful
to construct a linear responsibility chart (sometimes called a responsibility
matrix) to show who is responsible for what. This chart also shows critical
interfaces between units that may require special managerial coordination.
With it, the Project Manager can keep track of who must approve what
and who must report to whom.
3)
The WBS, budget, and time estimates are reviewed with the people or
organizations who have responsibility for doing or supporting the work. The
purpose of this review is to verify the WBSs accuracy, budget, schedule,
and to check interdependency of tasks, resources, and personnel. The
WBS may be revised as necessary, but the planner must be sure to check
significant revisions with all individuals who have previously made inputs.
When agreement is reached, individuals should sign off on their individual
elements of the project plan.
4)
Resource requirements, time schedules, and subtask relationships are now

integrated to form the next higher level of the WBS; and so it continues at
each succeeding level of the WBS hierarchy. Thus, each succeeding level
of the WBS will contain the same kinds of information regarding resources,
budgets, schedules, and responsibilities as the levels below it. The only
difference is that the information is aggregated to one higher level.
5)
At the uppermost level of the WBS, we have a summary of the project

budget. For the purpose of pricing a proposal, or determining profit and
loss, the total project budget should consist of four elements: direct budgets
from each task as described above; an indirect cost budget for the project,
which includes general and administrative overhead costs (G&A), marketing
costs, potential penalty charges and other expenses not attributable to
particular tasks; a project contigency reserve for unexpected
emergencies; and any residual, which includes the profit derived from the
project, which may, on occasion, be intentionally negative.
6)
Similarly, schedule information and milestone events can be aggregated into

a project master schedule. The master schedule integrates the many
different schedules relevant to the various parts of the project. It is
11
Under Certainty
comprehensive and must include contractual commitments, key interfaces

and sequencing, milestone events, and progress reports. In addition, a time
contingency reserve for unforeseeable delays should be included.
This series of steps complete the use of the WBS as a project planning
document. The WBS is also a key document for implementing, monitoring,
and controlling the project. The remaining steps concern its use for these
purposes.
7)
One can now compare required task performance and outputs specified in
the WBS with those specified in the basic project plan in order to identify
potential misunderstandings, problem, and schedule slippages, and then
design corrective actions.
8)
As the project is carried out, step by step, the Project Manager can
continually examine actual resource use, by work element, work package,
task, and so on up to the full project level. By comparing actual against
planned resource usage to a given point in time, the Project Manager can
identify problems, harden the estimates of final cost, and make sure that
relevant corrective actions have been designed and are ready to implement
if needed. It is necessary to examine resource usage in relation to results
achieved because, while the project may be over budget, the results may
be further along than expected. Similarly, the expenses may be exactly as
planned, or even lower, but actual progress may be much less than
planned.
9)
Finally, the project schedule must be subjected to the same comparisons as

the project budget. Actual progress is compared to scheduled progress, by
work element, package, task, and complete project, to identify problems
and take corrective action. Additional resources may be brought to those
tasks behind schedule so as to expedite them. These added funds may
come out of the budget reserve or from other tasks that are ahead of
schedule.
4.7 SUMMARY
For any developing economy new investments in greenfield projects, expansion
of existing projects, diversification etc. is an integral part of the strategy to
move towards higher rate of growth. All this requires resources and strategy to
allocate resources as resources are always in short supply. Apart from
allocating resources the various resources has to be coordinated. All this
requires a specialized technique known as project management & planning. In
this unit we have discussed about the unique features of the project, the project
life cycle which represents the relationship between time and project completion
and also depicts the rate of progress with respect to time. In the next section
we have discussed about the various elements which has to be kept in
consideration while planning the project work we had talked about work
Breakdown Structure which shows how each piece of the project is tied to the
whole in terms of performance, responsibility, budgeting and scheduling.
4.8 SELF ASSESSMENT QUESTIONS
12
1)
What are the six component planning sequences of project planning?
2)
Any successful project plan must contain nine key elements. List these
items and briefly describe the composition of each.
3)
What are the basic guidelines for systems design that assure that individual
components of the system are designed in an optimal manner?
4)
What are the general steps for managing each work package within a
specific project?
5)
What percentage of the total project effort do you think should be devoted
to planning? Why?
6)
Why do you suppose that the coordination of the various elements of the
project is considered the most difficult aspect of project implementation?
7)
What kinds of problem areas might be included in the project plan?
8)
What is the role of systems integration in project management? What are

the three major objectives of systems integration?
9)
In what ways may the WBS be used as a key document to monitor and
control a project?
Project Planning
10) Describe the process of subdivision of activities and events which compose
the tree diagram known as the Work Breakdown Structure or Gozinto
chart. Why is the input of responsible managers and workers so important
an aspect of this process?

Goodman, L.J., Project Planning and Management, Pergamon Press, 1990.
Harrisons, F.L., Advanced Project Management, Gower Publicing, Hants,
England, 1981.
Kerridge A.E. and Vervalin C.H., Project Management, Gulf Publishing
Company, Houston, 1986.
Machiraju, H.R., Project Finance, Vikas Publishing House Pvt. Ltd., New
Delhi 1996.
International Project Management Year Book, Butterworth, London, 1985.
Martin, CC, How to make it work, American Management Association, 1976.
Project Management Journal, Project Management Institute, USA, August, 1984.
13
UNIT 5 CAPITAL BUDGETING DECISIONS
Objectives
to explain nature and utility of Capital Budgeting,
to provide an understanding of the process of evaluation of Investment proposals,
to discuss various tools of ranking of Investment proposals.
Structure
5.1
Nature of Capital Budgeting
5.2
Utility of Capital Budgeting
5.3
Investment Proposals and Administrative Aspects
5.4
Choosing among Alternative Proposals
5.5
Estimating cash flows from Capital Budgeting
5.6
Evaluating Investment Proposals

5.6.1
Payback Method
5.6.2
Return on Asset Method (ROA)
5.6.3
Present Value Method
5.6.4
Internal Rate of Return Method
5.6.5 Profitability Index (PI)
5.7
Capital Budgeting Methods in Practice
5.8
Summary
5.9
5.10 Further Readings
5.1 NATURE OF CAPITAL BUDGETING

Capital budgeting is a managerial technique of planning capital expenditures
whose benefits are expected to extend beyond one year, such as expenditure
on acquisition of new buildings, improvement of existing buildings, replacement
of plant and machinery, acquisition of new facilities, new machines, etc.
Permanent addition to working capital, R&D expenditure are also regarded as
capital expenditures.
Capital budgeting technique involves matching of expected net cash inflows
from the project with anticipated cost of the project these two components of
capital budgeting technique are determinant of investment outlay.
5.2 UTILITY OF CAPITAL BUDGETING

Capital budgeting is the most potent technique employed in assessing financial
viability of projects and for that matter, allocating prudently the funds among
the projects by providing useful guidelines in identifying useful projects and
ranking them in terms of economic desirability to choose the most promising
one. Thus, it helps a firm in strenghthening its financial health and so also its
competitive position.
Capital budgeting also acts as a planning and control device. As a planning tool,
it helps the managements to determine long-term capital requirements and
timings of such requirements. It also serves as a control device when it is
employed to control expenditures.
Investment
Decisions
However,
capital
Under Certainty
budgeting as a technique of decision-making suffers from the

problems involved in predicting future cash benefits, cost of capital. Further, it
fails to take cognizance of total consequences of the decision.
5.3 INVESTMENT PROPOSALS AND ADMINISTRATIVE

ASPECTS
Capital budgeting process involves several steps. The first step in the capital
budgeting process is to assemble a list of proposed new investments, together
with the data necessary to appraise them. Although practices vary from firm
to firm, proposals dealing with asset acquisitions are frequently grouped
according to the following four categories:
1.
Replacements of existing/old projects.
2.
Expansion: additional capacity in existing product lines.
3.
Growth: new product lines.
4.
Other (for example, pollution control equipment)
Other important aspects of capital budgeting involve administrative matters.

Approvals are typically required at higher levels within the organization as we
move away from replacement decisions and as the sums involved increase.
One of the most important functions of the board of directors is to approve the
major outlays in a capital budgeting program as well as the total capital budget
for each planning period. Such decisions are crucial for the future well-being
of the firm.
The planning horizon for capital budgeting programs varies with the nature of
the industry. When sales can be forecast with a high degree of reliability for
10 to 20 years, the planning period is likely to be correspondingly long; electric
utilities are an example of such an industry. Also, when the product-technology
developments in the industry require an 8-to-10-year cycle to develop a new
major product, as in certain segments of the aerospace industry, a
correspondingly long planning period is necessary.
After a capital budget has been adopted, funding must be scheduled.
Characteristically, the finance department is responsible for scheduling and
acquiring funds to meet scheduled requirements. The finance department is
also primarily responsible for cooperating with the operating divisions to
compile systematic records on the uses of funds and the installation of
equipment purchased. Effective capital budgeting programs require such
information as the basis for periodic review and evaluation of capital
expenditure decisions - the feedback and control phase of capital budgeting,
often called the post-audit review.
The foregoing represents a brief overview of the administrative aspects of
capital budgeting; the analytical problems involved are considered in the
following paragraphs.
5.4 CHOOSING AMONG ALTERNATIVE PROPOSALS

In most firms, there are more proposals for projects than the firm is able or
willing to finance. Some proposals are good, others are poor, and methods
must be developed for distinguishing between the good and the poor.
Essentially, the end product is a ranking of the proposals and a cutoff point for
determining how far down the ranked list to go.
2
Capital Budgeting
Decisions
In part, proposals are eliminated because some are mutually exclusive.
Mutually exclusive proposals are alternative methods of doing the same job. If
one piece of equipment is chosen, other will not be required. Thus, if there is
a need to improve the materials handling system in a chemical plant, the job
may be done either by conveyer belts or by forklift trucks. The selection of
one method makes it unnecessary to use the others: They are mutually
exclusive items.
Independent projects are those that are being considered for different kinds of
tasks that need to be accomplished. For example, in addition to the materials
handling system, the chemical firm may need equipment to package the end
product. The work would require a packaging machine, and the purchase
of equipment for this purpose would be independent of the equipment
purchased for materials handling. The firm may undertake any or all
independent projects.
Finally, projects may be contingent. For example, there may be only one way
to build a football stadium but two ways of housing it (in a metal structure or a
geodesic dome). Because the stadium and its housing are contingent, the
analysis requires that we consider them together. Hence, we would want to
compare the stadium within a metal structure with the alternative of the
stadium within a geodesic dome.
To distinguish among the many proposals that compete for the allocation of the
firms capital funds, a ranking procedure must be developed. This procedure
requires calculating the estimated cash flows from the use of equipment and
then translating them into a measure of their effect on shareholders wealth.
First, we turn our attention to the problem of estimating cash flows for capital
budgeting purposes.
5.5 ESTIMATING CASH FLOWS FOR CAPITAL

BUDGETING
Cash flows for capital budgeting purposes are defined as the after-tax cash
flows for an all-equity financed firm. Algebraically, this definition is equivalent
to earnings before interest and taxes, EBIT, less the taxes the firm would pay
if it had no debt, T(EBIT), plus noncash depreciation charges, W dep.
W Cash flow = W EBIT - T (W EBIT) + W depreciation
Note that this definition of cash flows is unaffected by the firms financing
decision, for example the amount of debt which it uses. Consequently, the
investment decision and the financing decision are kept separate when we use
this definition of cash flows for capital budgeting purposes.
We focus on how the firms cash flows will be changed. Table 5.1 provides
an example of a pro-forma income statement which can be used to illustrate a
cash flow calculation.
To arrive at the change in after-tax cash flows created by the project, we start
with increased revenues, WR, then subtract out all items which are expensable
for tax purposes (WVC + WFCC + Wdep). The result is taxable income,
assuming the firm has no debt. Next, we subtract the change in taxes and add
back the change in depreciation because depreciation is not a cash outflow.
The appropriate algebraic expression is:
W Cash flow = (W R - W VC - W FCC - W dep) - T(W R - W VC - W FCC W dep) + W dep.
Under Certainty
Capital Budgeting
Decisions
Table 5.1 Pro-forma Income Statement
Description
Symbol
Amount
Change in sales revenue
WR
Change in variable operating cost
W VC
-90,000
Change in fixed cash costs
W FCC
-10,000
Change in depreciation
W dep
-15,000
Change in earings before interest and taxes
W EBIT
30,000
Change in interest expense
W rD
-5,000
Change in earings before tax
W EBT
25,000
Change in taxes (@T=40%)
W tax
-10,000
Change in net income
W NI
15,000
Rs.145,000
This equation can be simplified as follows:

W Cash flow = (1T) (W R W VC W FCC W Dep) + W Dep
Note that the term in brackets is the same as the change in earings before
interest and taxes, WEBIT; hence, the equation becomes:
WCash flow = (1-T) WEBIT + Wdep.
Substituting in the numbers from Table 5.1, we have:
WCash flow = (1 - .4)(Rs.145,000 - Rs.90,000 - Rs.10,000 - Rs.15,000) + Rs.15,000
= .6 (Rs.30,000) + Rs.15,000
= Rs.33,000
The procedure described above starts with revenues at the top of the income
statement and then works down to obtain the definition of cash flows for
capital budgeting purposes. Alternately, one can start at the bottom of the
income statement, with changes in net income (WNI) and build upward to
arrive at the same definition. Sometimes this approach is easier to use. The
algebraic expression for the change in cash flows is
WCash flow-W NI+Wdep+(1 - T)W rD
Activity 1
a) Identify expenditures that are considered in Capital Budgeting technique.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
b) List out steps involved in evaluating investment proposals.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
c) Explain why net cash flows after tax is considered for decision making.
...................................................................................................................
...................................................................................................................
...................................................................................................................
4
...................................................................................................................
d)
Explain how depreciation is treated while considering investment proposals.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
5.6 EVALUATING INVESTMENT PROPOSALS

The point of capital budgeting - indeed, the point of all financial analysis - is to
make decisions that will maximize the value of the firm. The capital
budgeting process is designed to answer two questions: (1) Which of several
mutually exclusive investments should be selected? (2) How many projects, in
total, should be accepted?
Among the many methods used for evaluating investment proposals, five are
discussed here.
1.
Payback method (or payback period): Number of years required to

return the original investment.
2.
Return on assets (ROA) or return on investment (ROI): An

average rate of return on assets employed.
3.
Net present value (NPV) method: Present value of expected future

cash flows discounted at the appropriate cost of capital, minus the cost of
the investment.
4.
Internal rate of return (IRR) method: Interest rate which equates the
present value of future cash flows to the investment outlay.
5.
Profitability Index (PI): It shows the relative profitability of any project,

or the present value of benefits per rupee of costs.
General Principles
When comparing various capital budgeting criteria, it is useful to establish some
guidelines. What are the properties of an ideal criterion? The optimal decision
rule should have four characteristics:
1.
It will select from a group of mutually exclusive projects the one which
maximizes shareholders wealth.
2.
It will appropriately consider all cash flows.
3.
It will discount the cash flows at the appropriate market-determined

opportunity cost of capital.
4.
It will allow managers to consider each project independently from all

others. This has come to be known as the value additivity principle.
The value additivity principle implies that if we know the value of separate
projects accepted by management, then simply adding their values, V will give
us the value of the firm. If there are N projects, then the value of the firm
will be:
n
N
V = v j , j = 1,...N
j=1
This is a particularly important point because it means that projects can be

considered on their own merit without the necessity of looking at them in an
infinite variety of combinations with other projects.
5
Investment
Decisions
Table
5.2 gives
Under Certainty
the cash flows for four mutually exclusive projects. They all
have the same life, five years, and they all require the same investment outlay,
Rs.1,500. Once accepted, no project can be abandoned without incurring the
outflows indicated. For example, Project A has negative cash flows during its
fourth and fifth years. Once the project is accepted these expected cash
outflows must be incurred. An example of a project of this type is a nuclear
power plant. Decommissioning costs at the end of the economic life of the
facility can be as large as the initial construction costs and they must be taken
into account.
Table 5.2: Cash Flows of Four Mutually Exclusive Projects
Cash Flows (Rs.)
Year
PVIF@10%
-1,500
-1,500
-1,500
-1,500
1.000
150
150
300
.909
1,350
300
450
.826
150
450
450
750
.751
-150
1,050
600
750
.683
-600
1,950
1,875
900
.621
The last column of Table 5.2 shows the appropriate discount factor for the
present value of cash flows, assuming that the appropriate opportunity cost of
capital is 10 percent. Since all four projects are assumed to have the same
risk, they can be discounted at the same interest rate.
Now we turn our attention to the actual implementation of the five abovementioned capital budgeting techniques (1) the payback method, (2) the return
on assets, (3) the net present value,(4) the internal rate of return, (5)
Profitability Index. We shall see that only one technique - the net present value
method - satisfies all four of the desirable properties for capital budgeting
criteria.
5.6.1
Payback Method
The payback period is the number of years required to recover the initial
capital outlay on a project. The payback periods for the four projects in Table
5.2 are given below.
Project A, 2-year payback
Project B, 4-year payback
Project C, 4-year payback
Project D, 3-year payback.
If management were adhering strictly to the payback method, then Project A
would be chosen as the best among the four mutually exclusive alternatives.
Even a casual look at the numbers indicates that this would be a bad decision.
The difficulty with the payback method is that it does not consider all cash
flows and it fails to discount them. Failure to consider all cash flows results in
ignoring the large negative cash flows which occur in the last two years of
Project A. Failure to discount them means that management would be
indifferent between the following two cash flow patterns:
6
Capital Budgeting
Decisions
Cash Flows
Year
0
1
2
G*
-1,000
100
900
-1,000
900
100
because they have the same payback period. Yet no one with a positive
opportunity cost of funds would choose Project G because Project G* returns
cash much faster.
The payback method also violates the value additivity principle. Consider the
following example. Projects 1 and 2 are mutually exlusive but Project 3 is
independent. Hence, it is possible to undertake Projects 1 and 3 in
combination, 2 and 3 in combination, or any of the projects in isolation.
The only arguments in favour of using the payback method is that it is easy to
use, but with the advent of pocket calculators and computers, we feel that
other more correct capital budgeting techniques are just as easy to use.
5.6.2
Return on Assets (ROA)
The return on assets (ROA) which is also sometimes called the return on
investment (ROI)is an average rate of return technique. It is computed by
averaging the expected cash flows over the life of a project and then dividing
the average annual cash flow by the initial investment outlay. For example, the
ROA for Project B in Table 5.2 is computed from the following definition:
n
ROA = cash flow/n Io
t = 0
where
Io = Initial cash outlay = Rs.1,500
n = Life of the project = 5 years.
Substituting in the correct numbers from Table 5.2, we have
Rs.- 1,500 + Rs. 0 + Rs. 0 + Rs. 450 + Rs. 1,050 + Rs. 1,950
ROA =
Rs. 1,950
Rs.1,500
5
Rs. 390
= 26%
Rs.1,500
The ROAs for the four projects are

Project A, - 8%
Project B, 26%
Project C, 25%
Project D, 22%
The ROA criterion chooses Project B as best. The major problem with ROA
is that it does not take the time value of money into account. We would have
obtained exactly the same ROA for Project B, even if the order of cash flows
had been reversed with Rs.1,950 received now, Rs.1,050 at the end of Year 1,
Rs.450 at the end of Year 2 and -Rs.1,500 at the end Year 5. But no one
Investment
withDecisions
a positive
Under Certainty
opportunity cost of capital would be indifferent between the

alternatives. The opposite ordering of cash flows would always be preferred.
5.6.3
Present value method
Another method based on discounted cash flow approach employed to evaluate

financial viability of investment projects is the present value method, which
involves discounting of streams of future cash earnings to present value at
required rate of return to the firm (cost of capital). For ranking projects under
this method, net present value is computed. Project with highest positive net
present value is accorded the highest priority.
The equation for calculating the net present value of a project is :
=
n
CFt
Io
(1 + K) t
t =1
Here CF1,CF2, and so forth represent the net cash flows; k is the firms cost
of capital;I0 is the initial cost of the project; and n is the projects expected life.
The net present value of Project C in Table 5.2 is calculated below by
multiplying each cash flow by the appropriate discount factor (PVIF), assuming
that the cost of capital, k, is 10 per cent.
Year
Cash Flow
PVIF
PV
-1,500
1.000
-1,500.00
150
.909
136.35
300
.826
247.80
450
.751
337.95
600
.683
409.80
1,875
.621
1,164.38
NPV = 796.28
The net present value of all four projects in Table 5.2 are:
Project A NPV = Rs. 610.95.
Project B NPV = Rs. 766.05.
Project C NPV = Rs. 796.28.
Project D NPV = Rs. 778.80
If these projects were independent instead of mutually exclusive, we would
reject A and accept B,C, and D. Why? Since they are mutually exclusive, we
select the project with the greatest NPV, Project C. The NPV of the project
is exactly the same as the increase in shareholders wealth. This fact makes it
the correct decision rule for capital budgeting purposes. The NPV rule also
meets the other three general principles required for an optimal capital
budgeting criterion. It takes all cash flows into account. All cash flows are
discounted at the appropriate market-determined opportunity cost of capital in
order to determine their present values. Also, the NPV rule obeys the value
additivity principle.
The net present value of a project is exactly the same as the increase in
shareholders wealth. To see why, start by assuming a project has zero net
present value. In this case, the project returns enough cash flow to do three
things:
8
Capital Budgeting
Decisions
1.
To pay off all interest payments to creditors who have lent money to
finance the project.
2.
To pay all expected returns (dividends and capital gains) to shareholders

who have put up equity for the project, and
3.
To pay off the original principal, I0, which was invested in the project.
Thus, a zero net present value project is one which earns a fair return to
compensate both debt holders and equity holders, each according to the returns
which they expect for the risk they take. A positive NPV project earns more
than the required rate of return, and equity holders receive all excess cash
flows because debt holders have a fixed claim on the firm. Consequently,
equity holders wealth increases by exactly the NPV of the project. It is this
direct link between shareholders wealth and the NPV definition which makes
the net present value criterion so important in decision making.
5.6.4
Internal Rate of Return Method
The internal rate of return (IRR) is defined as the interest rate that equates the
present value of the expected future cash flows, or receipts, to the initial cost
outlay. The equation for calculating the internal rate of return is :
Cf1
(1 + IRR)
Cf 2
(1 + IRR)
+ ... +
Cf n
(1 + IRR) n
Io = 0
n
CFt
Io = 0
(1 + IRR) t
t =1
Here we know the value of Io and also the values of CF1,CF2,.....CFn, but we
do not know the value of IRR. Thus, we have an equation with one unknown,
and we can solve for the value of IRR. Some value of IRR will cause the
sum of the discounted receipts to equal the initial cost of the project, making
the equation equal to zero, and that value of IRR is defined as the internal rate
of return.
The internal rate of return may be found by trial and error. First, compute the
present value of the cash flows from an investment, using an arbitrarily
selected interest rate - for example, 10 percent. Then compare the present
value so obtained with the investments cost. If the present value is higher
than the cost figure, try a higher interest rate and go through the procedure
again. Conversely, if the present value is lower than the cost, lower the interest
rate and repeat the process. Continue until the present value of the flows
from the investment is approximately equal to its cost. The interest rate that
brings about this equality is defined as the internal rate of return.
Table 5.3 shows computation for the IRR for Project D in Table 5,2 and Figure
5.1 graphs the relationship between the discount rate and the NPV of the
project.
Table 5.3: IRR for Project D
Year
Cash
Flow
Pv@10%
PV@20%
PV@25%
PV@25.4%
-1,500
1.000
-1,500.00
1.000
-1,500.00
1.000
300
.909
272.70
.833
249.90
.800
240.00
.797
239.10
450
.826
371.70
.694
312.30
.640
288.00
.636
286.20
750
.751
563.25
.579
434.25
.512
384.00
.507
380.25
750
.683
512.25
.482
361.50
.410
307.50
.404
303.00
900
.621
558.90
.402
361.80
.328
295.20
.322
289.80
1650
778.80
219.75
-1.500.00 1.000
14.70
-1,500.00
-1.65
NPV
Under Certainty
Capital Budgeting
Decisions
Rs. 2,000
Rs. 1,00
IRR = 25.4%
0
10%
20%
30%
40%
50%
Rs. -1,000
If K, then NPV Rs. -1,500
Rs. -2,000
Figure 5.1: NPV of Project D at Different Discount Rates
In Figure 5.1 the NPV of Project Ds cash flows decreases as the discount
rate is increased. If the discount rate is zero, there is no time value of money
and the NPV of a project is simply the sum of its cash flows. For Project D,
the NPV equals Rs.1,650 when the discount rate is zero. At the opposite
extreme, if the discount rate is infinite, then the future cash flows are valueless
and the NPV of Project D is its current cash flow, Rs.1,500. Somewhere
between these two extremes is a discount rate which makes the NPV equal to
zero. In Figure 5.1, we see that the IRR for Project D is 25.4 per cent. The
IRRs for each of the four projects in Table 1 are given below.
Project A IRR = - 200%
Project B IRR =
20.9%
Project C IRR =
22.8%
Project D IRR =
25.4%
If we use the IRR criterion and the projects are independent, we accept any
project which has an IRR greater than the opportunity cost of capital, which is
10 percent. Therefore, we would accept Projects B, C, and D. However,
since these projects are mutually exclusive, the IRR rule leads us to accept
Project D as best.
Profitability Index (PI)

Another method that is used to evaluate projects is the profitability index (PI),
or the benefit/cost ratio, as it is sometimes called:
Present value methods had the merit of simplicity in as much as it helps the
management in choosing the most profitable proposal. Further, while evaluating
and ranking projects it focuses on one of the primary objectives of a firm, i.e.,
increasing value of the firm.
However, main drawback of this approach is that it does not take into
consideration size of investment outlay and net cash benefits together while
ranking projects. This may at times lead to faulty decisions.
10
Profitability Index (PI) method has come to be employed to overcome the above
drawback and to ensure rational investment decision by establishing relationship
between the present values of the net cash inflows and net investment outlay.
The equation to compute PI of a project is :
n
CIFt
(I + K) t
PV benefits
t=0
PI =
=
n
PV Costs
COFt
(I + K) t
t=0
Here CIFt represents the expected cash inflows, or benefits, and COFt
represents the expected cash outflows, or costs. The PI shows the relative
profitability of any project, or the present value of benefits per rupee costs.
The PI for Project C, based on a 10 percent cost of capital is:
Similarly:
Project A PI = 0.59
Project B PI = 1.51
Project D PI = 1.52
A project is acceptable if its PI is greater than 1.0, and the higher the PI, the
higher the project ranking. Mathematically, the NPV, the IRR, and the PI
methods must always reach the same accept/reject decisions for independent
projects: If a projects NPV is positive, its IRR must exceed k and its PI must
be greater than 1.0. However, NPV, IRR, and PI can give different rankings
for pairs of projects. This can lead to conflicts between the three methods
when mutually exclusive projects are being compared.
Activity 2
a)
Contact Finance Managers of five PSUs and five Indian Companies to find
out the existing capital budgeting evaluation methods used by them.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
Approach Finance Managers of three MNCs to ascertain what methods

are used to evaluate the projects.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
Explain why.
i)
Future Net Cash flows are discounted

.............................................................................................................
.............................................................................................................
.............................................................................................................
.............................................................................................................
ii) Expected Investment outlay is not discounted

.............................................................................................................
.............................................................................................................
.............................................................................................................
............................................................................................................. 11
Under Certainty
5.7 CAPITAL BUDGETING METHODS IN PRACTICE

The above discussion leads us to conclude that IRR, NPV and PI methods will
result in the same decision, except in certain cases involving mutually exclusive
projects or non-normal cash flows. The question that arises which capital
budgeting techniques do firm actually use in practice. Lawrence Gitman and
John Forester conducted a survey to help answer this question.
Gitman and Forester received 103 usable responses from a survey sent to 268
major companies known to make large capital expenditures. They found that
the responsibility for capital budgeting analysis generally rests with the finance
department. The respondents also stated that defining projects and estimating
their cash flows were the most difficult and the most critical steps in the
capital budgeting process.
Table 5.4 summarizes the capital budgeting methods used by the respondent
firms. The results indicate a strong preference for discounted cash flow (DCF)
capital budgeting techniques, that is, NPV, IRR, and PI, with the dominant
method being IRR. However, the heavy use of ROA and payback as primary
ranking techniques indicates that not all U.S. firms were technologically up to
part in an economic sense.
Table 5.4: Capital Budgeting Methods Used
Method
Number
Primary
Percent
Secondary
Number
Percent
IRR
60
53.6%
13
14.0%
ROA
28
25.0
13
14.0
NPV
11
9.8
24
25.8
Payback period
10
8.9
41
44.0
PI
2.7
2.2
112
100.0%
93
100.0%
Total
It may also be noted that almost all the respondents used at least two methods
in their analysis, and as evidenced by the 112 primary methods from 103
respondents, some firms use more than one primary method. Although the
questionnaire did not bring this point out, we suspect that many of the analysts
of firms which use the IRR as the primary method recognize its drawbacks,
yet use it anyway because it is easy to explain to non-financial executives but
use NPV as a check on IRR when evaluating mutually exclusive or non-normal
projects. It is also doubtful the payback method can be used as a liquidity and/
or risk indicator, hence to help choose among competing projects whose NPVs
and/or IRRs are close together. One interesting, and encouraging note is that
when compared with earlier surveys, Gitman and Forester found that the
discounted cash flow methods are gaining in usage.
As regards the use of assessment methods employed by Indian corporates,
study of 100 medium and large scale companies conducted in 1994, reveals that
Indian Companies have started using discounting techniques more than nondiscounting approaches. Although some companies are still using payback period
approach, it is the net present value technique which is used quite widely,
particularly by companies which have high sales volume and large-paid-up
capital. Small and new companies are still relying on traditional approach like
pay-back period.
12
Capital Budgeting
Decisions
5.8 SUMMARY
For any economy/company there are many avenues of investments, but one
cant go and invest in all of these avenues. This gives rise to problem of
selection of a particular project out of the many available. Here capital
budgeting techniques play an important role in deciding which project to select
& which to reject. Capital budgeting technique involves matching of expected
net cash inflows from the project with anticipated cost of the project. Capital
budgeting techniques are broadly classified in two categories. Discounted and
non discounted the major difference between these two is that in former the
future cash flows are discounted at appropriate discount rate (usually cost of
capital) to get net present value of future cash flows.

1)
Are there conditions under which a firm might be better off if it chose a
machine with a rapid payback rather than one with the largest rate of
return?
2)
Company X uses the payback method in evaluating investment proposals

and is considering new equipment whose additional net after-tax earnings
will be Rs.150 a year. The equipment costs Rs.500, and its expected life
is ten years (straight-line depreciation). The company uses a three-year
payback as its criterion. Should the equipment be purchased under the
above assumptions?
3)
What are the most critical problems that arise in calculating a rate of
return for a prospective investment?
4)
What other factors in addition to rate of return analysis should be

considered in determining capital expenditures?
5)
A firm has an opportunity to invest in a machine at a cost of Rs.6,56,670.

The net cash flows after taxes from the machine would be Rs.2,10,000 per
year and would continue for five years. The applicable cost of capital for
this project is 12 percent.
a) Calculate the net present value for the investment.
b) What is the internal rate of return for the investment?
c) Should the investment be made?

Besant C. Raj A, Public Enterprises Investment Decisions in India: A
Managerial Analysis., Macmillan Company of India Ltd., New Delhi, 1977.
Dhankar Raj S., An Appraisal of Capital Budgeting Decision Mechanism
in Indian Corporates Management Review, NMIMS, Mumbai, July
December, 1995.
Murty, G.P., Capital Investment decisions in Indian Industry, Himalaya
Publishing House, Bombay 1985.
Porwal, L.S., Capital Budgeting in India, Sultan Chand and Sons New
Delhi, 1976.
R.M. Srivastava, Financial Management and Policy, Himalaya Publishing
House, Mumbai, 2003
13
UNIT 6 ECONOMIC APPRAISAL
Objectives
to understand the concept and scope of economic appraisal,
to study the social cost-benefit analysis technique,
to study the application of social cost-benefit technique in project appraisal,
to examine the role of non-financial constrains in project appraisal.
Structure
6.1 Aspects of Economic Appraisal
6.2 Employment Effect
6.3 Foreign Exchange Effect
6.4 Social Cost-Benefit Analysis
6.4.1 Objectives
6.4.2 Market Imperfections
6.4.3 Externalities
6.4.4 Redistribution
6.5 Project Choice
6.6 Net present Value and.Input Constraints
6.7 Internal Rate of Return
6.8 Other Criteria
6.9 Non-financial Constraints
6.10 Summary
6.1
ASPECTS OF ECONOMIC APPRAISAL
Economic appraisal of a project deals with the impact of the project on economic
aggregates. We may classify these under two broad categories. The first deals with the
effect of the project on employment and foreign exchange and second deals with the
impact of the project on net social benefits or welfare.
6.2
EMPLOYMENT EFFECT
While assessing the impact of a project on employment, the impact on unskilled and
skilled labour has to be taken into account. Not only direct employment, but also indirect
employment should be considered. Direct employment refers to the new employment
opportunities created within the project and first round of indirect employment concerns
job opportunities created in projects related on both input and output sides of the project
under appraisal. Since indirect employment is to be counted, additional investment needed
in projects with forward and backward linkage effects also should be counted. Total
employment effect (direct and indirect) is.
where
ZTc = total employment effect.
JOT = total number of new job opportunities.
IT = total investment (direct and indirect)
6.3 FOREIGN EXCHANGE EFFECT
A Project may be export oriented or reduce reliance on imports. In such cases
an analysis of the effects of the project on balance of payments and import
substitution is necessary. The assessment of project on the countrys foreign
exchange is done in two stages; first, balance of payments effects of the
project and second, imports substitution effect of a project. For this purpose,
net foreign exchange flows are calculated as per the proforma in statement 1.
The proforma enabled the analysis of liquidity of a project in terms of foreign
exchange. The annual net flows as well as net impact over the economic life
of the project have to be found.
Statement 1
Proforma for Estimate of Foreign-Exchange Flows of a Project
(In foreign exchange)
Item
Year
0
I. Foreign-exchange inflows (FI)

A. Direct inflow
1. Foreign equity capital
2. Term loan
3. Foreign aid or grant
4. Goods or equipment on Deferred payment
5. Exports of goods or Services
6. Other
B. Indirect inflow
(for linked projects)
7. Capital
8. Terms loans in cash and in kind
9. Foreign aid or grant
10. Export of goods or services
11. Others
II. Foreign exchange Outflows (FO)
A. Direct outflow
12. Survey, technical consultancy,
engineering fees
13. Import of capital goods,equipment,
machinery, replacements.
14. Import of raw materials, Components, parts
and semi finished goods
15. Imported goods purchased from domestic market
16. Construction and installation charges
17. Direct charges on imports of raw materials,
Intermediates and replacements
18. Salaries payable in foreign exchange
19. Repayment of term loans
20. Royalty, know-how and patent rights
21. Repatriation of profits and capital
22. Others
B. Indirect outflow
Under Certainty
Economic Appraisal
(for linked projects)
23. Import of capital goods, equipment,

machinery.
24. Import of raw materials, intermediates and
replacements.
25. Imported goods purchased from domestic market
26. Others
III. Net foreign-exchange flow (I-II)(positive +, negative -)
FE0
FE1
FE2
FE3
FE4
FE5
The import substitution effect of a project measures the estimated savings in

foreign exchange owing to the curtailment of imports of the items of production
of which has been taken up by the project. CIF values are used in calculation
of import substitution effect.
Net foreign exchange effect of the project includes the net foreign exchange
flow in part III statement 1 and the import substitution effect.
The analysis of net foreign exchange effect may be done for the entire life of
the project or on the basis of a normal year. If two of more projects are
compared on the basis of their net foreign exchange effect, the annual figure
should be discounted to their present value.
6.4 SOCIAL BENEFIT ANALYSIS

6.4.1
Objectives
Another aspect of economic appraisal is social cost-benefit analysis. Cost

benefit analysis is concerned with the examination of a project from the
viewpoint of maximization of net social benefit. While cost-benefit analysis
originated to evaluate public investment, it is also used in project appraisal.
Earlier, project appraisal covered only private costs and benefits, at present,
social costs and benefits are also reckoned.
Cost-benefit appraisal of a project proposes to describe and quantify the social
advantages and disadvantages of a policy in terms of a common monetary unit.
An enterprise or project adopting cost benefit analysis approach has, as its
objective function, net benefits to society whereas the objective function of a
private project is net private benefit or profit. Net social benefit entails that
gains and losses be valued in a common unit. The unit should reflect societys
strength of preference for each outcome. The economist uses as a measure of
this preference, the consumers willingness to pay (WTP) for a good. This will
be reflected in the price he pays, though not fully.
In many cases the prices are not observable or are distorted. In these
circumstances cost-benefit analysis must seek surrogate prices or shadow
prices to measure what the society would be willing to pay if there is a
market? Net social benefits are found by deducting from benefits (WTP)
compensation required (cost). Social costs and benefits and private costs and
benefits differ because of market imperfections, externalities and income
distribution.
2
6.4.2
Market Imperfections
Private costs and profits reflect social costs and benefits only under perfect
competition. Since markets were largely regulated and prices were administered
earlier in our country, resources used by private sector were underpriced. The
recent phenomenon of deregulation, which has freed several resources prices
from control, may lead in future to near approximation of conditions in perfect
competition. For instance, foreign exchange rate is now determined by markets.
Since 1991, the interest on debentures is not fixed by government. In several
markets regulation and administrated prices are being lifted.
6.4.3
Externalities
The difference between private costs and benefits and social costs and benefits
arises mainly because of economic effects a transaction has on third parties.
The effects may be benefits or costs. A project, for instance, when it creates
infrastructural facilities like roads, the area adjacent may be benefited. Such
benefits are, however, not included in assessing the benefits arising out of the
project. Actually, such benefits are invariably underprovided and subsidies may
have to be paid to ensure their provision.
On the other hand, a project may have harmful environmental effects. Such
costs are not internalized and not paid for by consumers or producer. As a
result, costs are imposed on society, which are not accounted for. The activity
in question may also be over-extended.
The problem of externalities relating to environmental effects received impetus
from the thesis propounded by World Bank that prudent environmental policies
may often make poor countries less poor. Not only is sound environmental
policy essential for durable development but many of the policies that improve
the environment will also strengthen development. They are also powerfully
re-distributive since it is often the poor that suffer from environmental
degradation.
The cure for poverty is development. Development may also cure some kinds
of pollution. Given the right technologies, developing countries can decouple
some kinds of pollution from economic growth with beneficial effects on the
economy.
6.4.4
Redistribution
Strictly from the viewpoint of the promoter or owner, it is of no consequence

as to how the projects benefits are distributed among society. But to society or
government, it is essential to have information as to who benefits from the
investment in various projects. For instance, industrial projects are put forward
and promoted whether in private or public sector to alleviate poverty and
improve income distribution. All our five-year plans have poverty alleviation as
their basic objective. It is, however, not appreciated that the provision of
opportunities through industrial projects cannot be availed of by the poor. The
poor are unskilled and illiterate and do not have the skills that factory type of
employment demands. To benefit the poor, emphasis should be on provision of
opportunities through Grih Udyog (cottage industry) or rural cooperatives an on
repetitive tasks which demand little skill, such as textile printing, assembly and
agro-material processing. The structure of investment should not be to elongate
the productive process or make it indirect. Our plans have not been able to
relieve poverty because projects promoted are of the factory type. They are
not suitable for integrating poor into market oriented activity.
3
Under Certainty
6.5 PROJECT CHOICE

So far, it has been shown that cost-benefit analysis proceeds on the explicit
basis that a project or policy is deemed socially worthwhile if its benefits
exceed the costs it generates. The appropriate formula for expressing the social
worth whileness of a project has not been discussed in detail, nor have
guidelines been offered for assisting the choice among alternative projects.
Lastly, constraints on the objective function have not been incorporated.
The Choice Context
The necessary condition for the adoption of a project is that discounted benefits
should exceed discounted costs. This rule can be stated as:
GPV(B)>GPV(K)
or
NPV(B)>0
where GPV(B) refers to the GROSS PRESENT VALUE of benefits, and
NPV(B) refers to the NET PRESENT VALUE of benefits, so that
NPV(B) = GPV(B)-GPV(K)
The present values are calculated at the relevant social discount rate. A social
discount rate may be considered equivalent to the opportunity cost of public
investments. It can also be seen in terms of an accounting price which reflects
the societys trade-off of the present benefits against the future benefits.
Formulated in this way, the worth of a project is expressible as a unique
absolute magnitude, with costs and benefits measured in the same units. In
practice, however, the rule will require some modification in the light of the
constraints on the objective function and allowances for risk and uncertainty.
The types of choice facing the decision-maker can be classified as follows:
i)
Accept-reject. Faced with a set of independent projects and no constraint

on the number which can be undertaken, the decision-maker must decide
which, if any, is worth while. The decision rule should enable him to accept
or reject each individual project.
ii)
Ranking. If some input, such as capital, is limited in supply it may well be

that all acceptable projects cannot be undertaken. In this case, projects
must be ranked or ordered in terms of that objective function. The decision
rule for accept-reject situations cannot be easily generalised to cover these
situations.
iii) Choosing among exclusive projects. Frequently, projects are not

independent of each other. One form of interdependence exists when one
project can only be undertaken to the exclusion of another project- e.g.
two different ways of achieving the same objectives. The projects are then
mutually exclusive and the decision rule must enable the decision-maker
to choose between the alternatives.
A special case of mutual exclusion exists when any given project can be
undertaken now or in a later period. There is a problem in choosing the optimal
point in time to start the project. This is the problem of time-phasing and,
once again, the decision rule should offer guidance on this issue.
6.6 NET PRESENT VALUE AND INPUT CONSTRAINTS

Since constraints on the resource available for investment are always present in
the public sector, it is worth looking a little closer at the effect of such
constraints on the net present value rule. The problem is to rank projects in
4
Economic Appraisal
order of preference and to select the optimal combination of projects such that
the total combined cost exhausts the budget. It is tempting to think that ranking
by NPVs will achieve this result, but it does not. Consider the following simple
example.
Project
Cost
(K)
Benefits
(B)
B-K
B/K
100
200
100
2.0
50
110
60
2.2
50
120
70
2.4
Suppose a capital constraint of 100 exists and that the constraint operates only
for the one year in which capital expenditure is incurred. Ranking by NPV
gives the ordering X, Z, Y so that X would be the only project selected, net
benefits being 100 and the budget being exhausted. But inspection of the table
shows that Y and Z could be adopted, with a combined NPV of 130 for the
same cost.
To avoid this problem, projects should be ranked by their benefit-cost ratios-i.e.
by GPV/K, at the predetermined discount rate.
6.7 INTERNAL RATE OF RETURN

The present value requires the use of some predetermined discount rate to
discount future benefits and costs. An alternative rule is to calculate the
discount rate, which would give the project a NPV of zero, and then to
compare this solution rate with the pre-determined social discount rate. In
other words, the benefit and cost streams are presented in equation form:
T
Bt
Ko
t
t = 1 (1i)
where i is the rate of discount which solves the equation, and we continue to
assume that all capital costs are incurred in the initial period.
The rate i is given various names: the solution rate, the yield, the internal
rate of return and the marginal efficiency of investment (or of capital, though
the latter is confusing given that we are dealing with changes in the capital
stock). Once i is determined, the rule for accept-reject and for ranking is to
adopt any project which has an internal rate of return in excess of the
predetermined social discount rate. As with the NPV rule, then it remains
essential to choose some acceptable discount rate.
One minor drawback of the IRR approach is that the solution rate cannot be
computed quickly. The reason is simply that the IRR is the solution to a
polynomial equation. Thus, if the life of the projects is T years, the problem is
to find i in the equation
B1
(1 + i)1
B2
(1 + i) 2
+ ... +
Bn
(1 + i) T
= Ko
Solutions will not be obvious and the usual approach is to proceed in an

iterative fashion, guessing at the likely rate and entering various rates into the
equation untill two sides of the equations are equal.
Investment
TheDecisions
IRR is further
Under Certainty
complicated when used to compare mutually exclusive

projects. It is not necessarily the case that the best project is the one with the
highest IRR. Consider the two projects in Table 6.1, X and Y, each with a life
of ten years.
Table 6.1
Project
Cost
Benefits
IRR
NPV at 8%
X
Y
Y-X
1
2
1
(p.a.)
0.2
0.36
0.16
15%
12%
9%
0.34
0.42
__
On the IRR rule, X is preferred to Y, but on the NPV rule, Y is preferred to

X. The IRR rule is misleading here since it discriminates against Y because of
the size of the capital outlay. To avoid this problem it is necessary to calculate
the rate of return on the hypothetical project Y-X-i.e. on the difference
between the capital outlays. Since the IRR on Y-X is in excess of the
subjective rate of 8 percent, used in the example, the larger project is to be
preferred to the former.
Thus the mutually exclusive context requires a two-part rule to the effect that a
project Y be accepted if and only if
iy >r
and
i (y-x) >r
where i is the IRR and r the predetermined rate. The rule is usually described
as the incremental yield approach, or Fishers rate of return over cost;
originating, as so much of investment theory has, with Irving Fishers The
Theory of Interest.
Present Value versus Internal Rate of Return

A very considerable literature has been devoted to the relative merits of the
two approaches so far described. The consensus appears to favour the adoption
of present value rules, at least for public investment decisions. The reasons for
dissatisfaction with the IRR approach are numerous:
i)
Sensitivity to Economic Life: Where projects with different economic

lives are being compared, the IRR approach will possibly inflate the
desirability of a short-life project, the IRR being a function both of the time
periods involved and the size of capital outlay. NPV, on the other hand, is
not affected by absolute magnitudes of outlay. Thus, Rs.1 invested now has
an IRR of 100 percent if it cumulates to Rs.2 at the end of the year.
Compare this to a Rs.10 investment, which cumulates to Rs.15:i.e. an IRR
of 50 percent, but a NPV of Rs.5. The IRR rule would rank the former
project above the latter.
ii)
Sensitivity to Time Phasing of Benefits: Frequently projects may not

yield benefits for many years (dams, nuclear power stations) they have
long gestation periods. The IRR will tend to be lower on such projects
when compared to projects with a fairly even distribution of benefits over
time, even though the NPV of the former project may be larger. The
problem here is essentially the same as that in (i) above: IRR will give
ranking to projects which bunch the benefits into the early part of their
economic lives relative to other projects.
iii) Mutual Exclusivity: It has already been noted that IRR needs to be
supplemented by an additional rule in situations of mutual exclusion.
Economic Appraisal
iv) Administrative Acceptability: The argument is sometimes advanced
against NPV and in favour of IRR that decision-makers are familiar with
the idea of a rate-of-return, even if they were previously used to wrong
concepts, such as undiscounted returns-to-cost percentage ratios. This
problem is not a serious one, however, and can be overcome by suitable
expositional aids for decision-makers. The NPVs rule, on the other hand,
may require that a range of NPVs be indicated, corresponding to the range
of probabilities. Clearly, decision-makers in search of unique answers may
find the prospect more frustrating.
v)
Multiple Roots: In computing the IRR it is quite possible to obtain more

than one solution rate. The reason for this is simple, once it is realised that
the IRR is the solution to a polynomial equation. If the polynomial is of
degree n, there will be n roots, i.e. n solution rates. Clearly, if a project
has two situations, say 10 percent and 15percent, and the social discount
rate is 12percent, there appears to be no clear-cut criterion for acceptance
or rejection. This objection is considered by many to preclude the use of
IRR as a decision rule.
vi) Change in the Discount Rates: It has been argued that the social
discount rate may change over time. The calculation of a unique IRR in
these circumstances would not permit of an easy comparison. Thus the
IRR many be 15 percent, with the social discount rate rising from, say 12
to 18 percent over the project life. No simple criterion of acceptability
exists in these circumstances. The NPV rule, however, does enable
discount-rate changes to be incorporated easily into the calculation.
Overall, then, the balance of favour is with the net present value rule for
deciding upon projects. The circumstances in which rate of return rules are
misleading may not be many or widespread, but they are significant enough to
indicate that the problems are best avoided by the use of the more
straightforward present value criterion.
6.8 OTHER CRITERIA

Although most practical cost-benefit analyses use the IRR or NPV
normalisation procedure, it is sometimes the case that alternative approaches
are used. This section looks briefly at these rules.
i)
Annual Value or annuity approach. Given a stream of money benefits B1,

B2, , Bn, these benefits have a present value, PV(B). Corresponding to
the stream of benefits will be an annuity, AB, which, when discounted, will
have the same present value as B1 + B2 + Bn, so that PV(AB) =
PV(B). Similarly, there will be an annuity corresponding to the stream of
costs, AK, so that the decision rule is:rank by AB-AK. Clearly, from the
definition of the annuity, the result cannot differ from the present value
rule.
ii)
Payback, a rule, which has little, or nothing to recommend it but which is

still widely used, especially in private industry. The rule is simple. Establish
some maximum acceptable time horizon, T*, by which, if benefit flows do
not cover all cost flows in the period, the project is rejected: i.e. accept it
if
t = T*
(B t C t ) > O
t=0
Clearly, the rule makes no allowance for projects with long gestation periods,
the selection of T* usually being arbitrary. The failure to discount net benefit
Investment
Decisions
flows
ignores
Under Certainty
the argument for social discount rates. Indeed, payback implies a

zero discount rate to T* and an infinite rate thereafter.
iii) Benefit-cost ratios. One of the most popular decision rules particularly in
the early years of applied cost-benefit analysis, was the use of benefit-cost
ratios. The general rules become:
i)
Accept a project if
GPV (B)
>1
K
ii) In face of rationing, rank by the ratio GPV(B)K.

iii) In choosing between mutually exclusive projects, select the project with
the highest ratio.
There are numerous difficulties with this rule. One fundamental point is that no
rule should be sensitive to the classification of a project effect as a cost rather
than a benefit, and vice versa. Thus, all costs can be treated as negative
benefits and all benefits as negative costs. For the NPV rule it should be
obvious that the outcome will be the same however the division is made. But
the benefit-cost ratio rule will be affected by this division since it will affect the
magnitudes which are entered as denominator and as numerator. Thus if a
project has (discounted) benefits of 10, 20 and 30 units, and costs of 10 and
20, the benefit-cost ratio is 2.0. But if the cost 0f 10 is treated as negative
benefit, the ratio becomes 50/20=2.5. On the other hand, benefits minus costs
(i.e. NPV) remains the same, at 30 units, regardless of the transfer.
Apart from being sensitive to the classification of costs and benefits, the ratio
rule is incorrect when applied to mutually exclusive contexts. Thus, a project
costing 100 units, with discounted benefits of 130, has a NPV of 30. This is to
be preferred to a project costing 40 with benefits of 60, a NPV of 20. But in
ratio terms, B is preferred since B has a ratio of 1.5 compared to As 1.3.
6.9 NON-FINANCIAL CONSTRAINTS

As one writer has remarked, Economic policy is rarely concerned with the
attainment of the best of all possible worlds. Rather, it seeks to improve
economic welfare in the face of constraints. Public investments are usually
subject to constraints other than purely budgetary ones. Clearly, any public
investment agency works with a limited overall budget, and this in turn is
constrained in part by the total public expenditure budget. The latter can be
altered by changes in general policy concerning the investment-consumption
allocation pattern, and will itself be constrained by anti-cyclical policies,
measures to deal with the balance of payments, and so on. The allocation to
department will depend upon the social priorities established by the government
of the day, so that budgetary constraints can themselves be thought of as being
largely politically determined. In short, a government social welfare function will
be in operation in respect of the allocation of funds to departments. If this
welfare function is well defined, the cost-benefit analyst need not be suboptimising when dealing with project selection within a budget constraint. Thus,
investment in a new hospital may have as its opportunity cost a new education
establishment. If funds have been properly allocated, however, there should be
no possibility of the hospital. In practice, of course, government welfare
functions are not so well defined, nor could they be in the absence of unique
measures of comparability between diverse outcomes such as health and
education.
At the level of ranking project within a sub-budget, however, political constraints

still operate. Some projects may never come to the attention of the analyst
Economic Appraisal
because they have been screened out for political reasons. This screening
process may be perfectly efficient if it reflects higher-level political objectives
such as income-class equity, or regional balance. It seems a useful rule then to
require that constraints should be determined at an appropriately high
political level. Effectively what happens then is that the constraints become part
of the objective function, which is no longer, defined solely in terms of
efficiency benefits. But there may be a tendency to accept un-questioningly
constraints imposed at lower levels of the political hierarchy. The reason for
acceptance is usually that it greatly simplifies the problem, often eliminating
complete directions of policy. The problem, however, is that once the analysts
himself question the constraints he appears to be overstepping the bounds of his
predefined function. This is the problem met before-with equity considerations,
with normative discount rates and now with the acceptance or otherwise of
political constraints. It is general problem of defining the limits of advice, of
finding the dividing line between adviser and decision-maker.
6.10 SUMMARY
Whenever a new project is started it has both internal and external impact.
Internal impact is specific to the firm an agency which is setting up the project,
i.e. increase in cash flows etc. The external impact is the influence of the
project on the economy as a whole, the employment generation, taxes and
duties paid to government. import substitution, export generation etc. Another
area where any project has an impact is social cost of the project. Sometimes
the projects have an positive social cost and sometimes negative e.g. toxic
affluents generated by industries. Therefore while selecting a project not only
the financial consideration has to be taken in account but also the overall
impact it has on economy as a whole has to be take into consideration.

1)
Make an economic appraisal of Prime Ministers Rural Road Project.
2)
Make an social cost benefit analysis of Golden Quadrangle National

Highway Project.
3)
List out the various factors you will take into consideration while doing a
social cost benefit analysis for only project.

Dasgupta A.K. and D.W. Pearce, Cost-Benefit Analysis, Macmillan,
London.
Dhankar Raj S., Managing Public Sector undertakings Finance Westvill
Publishing House, New Delhi.
Mishan E.J., Cost-Benefit Analysis, George Allen & Unwin Ltd., London.
House, Mumbai, 2003.
UNIT 7 PROJECT MONITORING AND
CONTROL
Objectives
to provide an understanding of how the monitoring system is designed,
to explain concept of control and its various types,
to focus on types of control Processes,
to throw light on designing of control system.
Structure
7.1
7.2
7.3
7.4
7.5
7.6
7.7
Introduction
Designing of the Monitoring System
How to Collect Data
Information needs and the Reporting Process
Report Types
Project Control
Types of Control Processes
7.7.1 Cybernetic Control
7.7.2 Go/No-go Control
7.7.3 Post Control
7.8
7.9
7.10
7.11
7.12
7.13
7.14
7.15
Design of Control System

Control of creative Activities
Progress Review
Personnel Reassignment
Control of Input Resources
Summary
Further Readings
7.1 INTRODUCTION
Monitoring is collecting, recording, and reporting information concerning any and
all aspects of project performance that the project manager or others in the
organization wish to know. In our discussion it is important to remember that
monitoring, as an activity, should be kept quite distinct from controlling (which
uses the data supplied by monitoring to bring actual performance into
approximate congruence with planned performance), as well as from evaluation
(through which judgements are made about the quality and effectiveness of
project performance).
7.2 DESIGNING OF THE MONITORING SYSTEM

The first step in setting up any monitoring system is to identify the key factors
to be controlled. Clearly, the project manager wants to monitor performance,
cost, and time but must define precisely which specific characteristics of
performance, cost, and times should be controlled and then establish exact
boundaries within which control should be maintained. And there may also be
other factors of importance worth noting, at least at certain points in the life of
the project. for example, the number of labour hours used, the number or
Under Certainty
extent of engineering changes, the level of customer satisfaction, and similar

items may be worthy of note on individual projects.
But the best source of items to be monitored is the project Action Plan actually, the set of Action Plans that describe what is being done, when, and
the planned level of resource usage for each task, work package, and work
unit in the project. The monitoring system is a direct connection between
planning and control. If it does not collect and report information on some
significant element of the plan, control can be faulty or missing. The measured
and reported to the control system, but it is not sufficient. For example, the
project manager might want to know about changes in the clients attitudes
toward the project. Information on the morale of the project team might be
useful in preparing for organizational or personnel changes on the project.
These two latter items may be quite important, but are not reflected in the
projects action plan.
Unfortunately, it is common to focus monitoring activities on data that are easily
gathered - rather than important - or to concentrate on objective measures
that are easily defended at the expense of softer, more subjective data that
may be more valuable for control. Above all, monitoring should concentrate
primarily on measuring various facets of output rather than activity. It is crucial
to remember that effective project managers are not primarily interested in how
hard their project teams work. They are interested in results.
Given all this, performance criteria, standards, and data collection procedures
must be established for each of the factors to be measured. The criteria and
data collection procedures are usually set up for the life of the project. The
standards themselves, however, may not be constant over the projects life.
They may change as a result of altered capabilities within the parent
organization or a technological breakthrough made by the project team; but,
perhaps more often than not, standards and criteria change because of factors
that are not under the control of the project manager.
Next, the information to be collected must be identified. This may consist of
accounting data, operating data, engineering test data, customer reactions,
specification changes, and the like. The fundamental problem in this regard is to
determine precisely which of all the available data should be collected. It is
worth repeating that the typical determinant for collecting data too often seems
to be simply the ease with which it can be gathered. Of course, the nature of
the required data is dictated by the project plan, as well as by the goals of the
parent organization, and by the fact that it is desirable to improve the process
of managing projects.
Therefore, the first task is to examine the project plans in order to extract
performance, time, and cost goals. These goals should relate to some fashion to
each of the different levels of detail; that is, some should relate to the project,
some to its tasks, some to the work packages, and so on. Data must be
identified that measure achievement against the goals, and mechanisms designed
for gathering and storing such data. Similarly, the process of developing and
managing projects should be considered and steps taken to ensure that
information relevant to the diagnosis and treatment of the projects
organizational infirmities and procedural problems are gathered.
7.3 HOW TO COLLECT DATA
Given that we know what type of data we want to collect, the next question is
how to collect this information. At this point in the construction of a monitoring
system, it is necessary to define precisely what pieces of information should be
gathered and when. In most cases, the project manager has options. questions
then arise. Should cost data be gathered before or after some specific event?
Is it always mandatory to collect time and cost information at exactly the same
point in the process? What do we do if a specific piece of desirable data is
difficult to collect because the data source (human) fears reporting any
information that might contribute to a negative performance evaluation? What
do we do about the fact that some use of time is reported as hours charged
to our project, and we are quite aware that our project has been charged for
work done on another project that is over budget? Are special forms needed for
data collection? Should we set up quality control procedures to ensure the integrity
of data transference from its source to the project information system? Such
questions merely indicate the broad range of knotty issues that must be handled.
Project Monitoring and

Control
A large proportion of the data collected may take one of the following forms,
each of which is suitable for some types of measures.
1.
Frequency Counts : A simple tally of the occurrence of an event. This

type of measure is often used for complaints, number of times a project
report is late, bugs in a computer program and similar items. The data
are usually easy to collect and are often reported as events per unit time
or events as a percent of a standard number.
2.
Raw Numbers : Dates, hours, physical amounts of resources used, and

specifications are usually reported in this way. These numbers are reported
in a wide variety of ways, but often as direct comparisons with an
expected or standard number. Also, variances are commonly reported as
the ratios of actual to standard. Comparisons on ratios can also be plotted
as a time series to show changes in system performance.
3.
Subjective Numeric Ratings : These number are subjective estimates,

usually of a quality, made by knowledgeable individuals or groups. They
can be reported in most of the same ways that objective raw numbers are,
but care should be taken to make sure that the numbers are not
manipulated in ways only suitable for quantitative measures. Ordinal
rankings of performance are included in this category.
4.
Indicators: When the project manager cannot measure some aspect of

system performance directly, it may be possible to find an indirect measure
on indicator. The speed with which change orders are processed and
changes are incorporated into the project is often a good measure of team
efficiency. Response to change may also be an indicator of the quality of
communications on the project team. When using indicators to measure
performance, the project manager make sure that the linkage between the
indicator and the desired performance measure is as direct as possible.
5.
Verbal Measures : Measures for such performance characteristics as

quality of team member cooperation, morale of team members, or
quality of interaction with the client frequently take the form of verbal
characterization. As long as the set of characterizations is limited, and the
meanings of the individual terms are consistently understood by all, these
data serve their purposes reasonably well.
After data collection has been completed, reports on project progress should be
generated. These include project status reports, time/cost reports, and variance
reports, among others. Causes and effects should be identified and trends
noted. Plans, charts, and tables should be updated on a timely basis. Where
known, comparables should be reported, as should statistical distributions of
previous data if available. Both help the project manager (and others) to
interpret the data being monitored.
The purpose of the monitoring system is to gather and report data. The purpose
of the control system is to act on the data. To aid the project controller, it is
Under Certainty
helpful for the monitor to carry out some data analysis. Significant variances
from plan should be highlighted or flagged so that they cannot be overlooked
by the controller. The methods of statistical quality control are very useful for
determining what size variances are significant and sometimes even help in
determining the probable cause(s) of variances. Where causation is known, it
should be noted. Where it is not known, an investigation may be in order. The
decisions about when an investigation should be conducted, by whom, and by
what methods are the prerogative of the project controller, although the actual
investigation may be conducted by the group responsible for monitoring.
In creating the monitoring system, some care should be devoted to the issues
of honesty and bias. The former is dealt with by setting in place an internal
audit. The audit serves the purpose of ensuring that the information gathered is
honest. No audit, however, can prevent bias. All data are biased by those who
report them, advertently or inadvertently. The controller must understand this
fact of life. The first issue is to determine whether or not the possibility of bias
in the data matters significantly. If not, nothing need be done. Biased findings and
correcting activities are worthwhile only if data with less or no bias are required.
There is some tendency for project monitoring systems to include an analysis
directed at the assignment of blame. This practice has doubtful value. While
the managerial dictum rewards and punishments should be closely associated
with performance has the ring of good common sense, it is actually not good
advice. Instead of motivating people to better performance, the practice is more
apt to result in lower expectations. If achievement of goals is directly measured
and directly rewarded, a tremendous pressure will be put on people to
understate goals and to generate plans that can be met or exceeded with
minimal risk and effort.
7.4 INFORMATION NEEDS AND THE REPORTING

PROCESS
Everyone concerned with the project should be tied into the project reporting
system. The monitoring system ought to be so constructed that it addresses
every level of management, but reports need not be of the same depth or at
the same frequency for each level. Lower-level personnel have a need for
detailed information about individual tasks and the factors affecting such tasks.
Report frequency is usually high. For the senior management levels, overview
reports describe progress in more aggregate terms with less individual task
detail. Reports are issued less often. At times it may be necessary to move
information among organizations, as illustrated in Figure 7.1, as well as among
managerial levels.
Reports must contain data relevant to the control of specific tasks that are
being carried out according to a specific schedule. The frequency of reporting
should be great enough to allow control to be exerted during or before the
period in which the task is scheduled for completion.
In addition to the criterion that reports should be available in time to be used

for project control, the timing of reports should generally correspond to the
timing of project milestones. This means that project reports may not be issued
periodically-excepting progress reports for senior management. There seems to
be no logical reason, except for tradition, to issue weekly, monthly, quarterly,
etc., reports. Few projects require attention so neatly consistent with the
calendar. This must not be taken as advice to issue reports every once in a
while. Reports should be scheduled in the project plan. They should be issued
on time. The report schedule, however, need not call for periodic reports.
Consultant
V
V
Steering
Committee
V.P.
Ventures

Control
Company
Marketing
Technical
Assistant
Project
Manager
Project
Manager
Denotes information flow

Figure 7.1: Reporting and information flows between organisations working on a
common project
Identification of project milestones depends on who is interested. For senior

management, there are only a few milestones even in large projects. For the
project manager, there may be many critical points in the project schedule at
which major decisions must be made, large changes in the resource base must
be initiated, or key technical results achieved. The milestones relevant to lower
levels relate to finer detail and occur with higher frequency.
The nature of the monitoring reports should be consistent with the logic of the
planning, budgeting, and scheduling systems. The primary purpose is, of course,
to ensue achievement of the project plan through control. There is, therefore,
little reason to burden operating members of the project team with extensive
reports on matters that are not subject to control - at least not by them. The
scheduling and resource usage columns of the project Action Plan will serve as
the key to the design of project reports.
There are many benefits of detailed reports delivered to the proper people on a
timely basis. Among them are :
Mutual understanding of the goals of the project.
Awareness of the progress of parallel activities and of the problems
associated with coordination among activities.
More realistic planning for the needs of all groups and individuals working
on the project.
Understanding the relationships of individual tasks to one another and to the
overall project.
Early warning signals of potential problems and delays in the project.
Minimizing the confusion associated with change by reducing delays in
communicating the change.
Faster management action in response to unacceptable or inappropriate
work.
Higher visibility to top management, including attention directed to the
immediate needs of the project.
Keeping the client and other interested outside parties up to date on project
status, particularly regarding project milestones and deliverables.
Under Certainty
7.5 REPORT TYPES

For the purposes of project management, we can consider three distinct types
of reports: routine, exception, and special analysis. The routine reports are those
issued on a regular basis; but, as we noted above, regular does not necessarily
refer to the calendar. For senior management, the reports will usually be
periodic, but for the project manager and lower-level project personnel,
milestones may be used to trigger routine reports.
At times, it may be useful to issue routine reports on resource usage
periodically, occasionally on a weekly or even daily basis.
Exception reports are useful in two cases. First, they are directly oriented to
project management decision making and should be distributed to the team
members who will have prime responsibility for decisions or who have a clear
need to know. Second, they may be issued when a decision is made on an
exception basis and it is desirable to inform other managers as well as to
document the decision - in other words, as part of a sensible procedure for
protecting oneself.
Special analysis reports are used to disseminate the results of special studies
conducted as part of the project or as a response to special problems that arise
during the project. Usually they cover matters that may be of interest to other
project manager, or make use of analytic methods that might be helpful on
other projects. Studies on the use of substitute materials, evaluation of
alternative manufacturing processes, availability of external consultants,
capabilities of new software, and descriptions of new governmental regulations
are all typical of the kind of subjects covered in special analysis reports.
Distribution of these reports is usually made to anyone who might be interested.
The real message carried by project reports is in the comparison of activity to
plan and of actual output to desired output. Variances are reported by the
monitoring system, and responsibility for action rests with the controller.
Because the project plan is described in terms of performance, time, and cost,
variances are reported for those same variables. Project variance reports
usually follow the same format used by the accounting department, but at times
they may be presented differently.
This variance report shows the ratio of the material estimated to the material
used in projects. As a result of this information, the program manager decides
that it would be less expensive for the company to carry small inventories in a
few of the commonly used high alloys, and to estimate (and price) material use
closer to actual expectations.
The Earned Value Chart
Thus far, we have covered monitoring for parts of projects. The monitoring of
performance for the entire project is also crucial because performance is the
raison detre of the project. Individual task performanxce must be monitored
carefully because the timing and coordination between individual tasks is
important. But overall project performance is the crux of the matter and must
not be overlooked. One way of measuring overall performance is by using an
aggregate performance measure called earned value.
A serious difficulty in comparing actual expenditures against budgeted or

baseline expenditures for any given time period is that the comparison fails to
take into account the amount of work accomplished relative to the cost
incurred. The earned value of work performed for those tasks in progress is
found by multiplying the estimated percent completion for each task by the
planned cost for that task. The result is the amount that should have been
spent on the task thus far. This can then be compared with the actual amount
spent. A graph such as that shown in Figure 7.2 can be constructed and
provides a basis for evaluating cost and performance to date. If the planned
(baseline) total value of the work accomplished is in balance with the planned
cost (i.e., minimal scheduling variance), then top management has no particular
need for a detailed analysis of individual tasks. Thus the concept of earned
value combines cost reporting and aggregate performance reporting into one
comprehensive chart.

Control
Rupees
Cost Schedule Plan

(Baseline)
Actual
Cost
Total
Variance
Schedule
Variance
Spending Variance
of Cost Overrun
(quantity and price)
Value Completed
1
Time Varience
(10 day delay)
Figure 7.2: Earned value Chart
Three variances can be identified on the earned value chart. The spending
variance is the actual cost less the value completed, the schedule variance is
the value completed less the baseline plan, and the total variance is the sum of
the two: actual less planned cost. Top management, as mentioned above, is
usually most concerned with the schedule (or time) variance, whereas the
project controller is probably concerned with the spending variance (cost
overrun) and the controller of the parent will track the total variance. The
project manager is concerned with all the three, of course.
If the earned value chart shows a cost overrun or performance under-run, the
project manager must figure out what to do to get the system back on target.
Options include such things as borrowing resources for activities performing
better than expected, or holding a meeting of project team members to see if
anyone can suggest solutions to the problems, or perhaps, notifying the client
that the project may be late or over budget.
Activity 1
Managing Director of a Pharmaceutical of Company has approached you to
design the monitoring system for his organization.
a) List out the steps that you would take to design the monitoring system for
the organization.
......................................................................................................................
......................................................................................................................
7
Under Certainty
b) How would you collect the required data for monitoring purposes?
.....................................................................................................................
.....................................................................................................................
c) What information would you provide in your Report to the Managing
Director?
.....................................................................................................................
.....................................................................................................................
7.6 PROJECT CONTROL

Nature of Control
Control is the act of comparing the planned performance with the actual and
reducing the difference between the two. It is also the last element in the
implementation cycle of planning-monitoring-controlling. Information is collected
about system performance, compared with the desired (or planned) level, and
action taken if actual and desired performance differ sufficiently that the
controller (manager) wishes to decrease the difference. Note that reporting
performance, comparing the differences between desired and actual
performance levels, and accounting for why such differences exist are all parts
of the control process.
Objectives of control are :
1.
The regulation of results through the alteration of activities.
2.
The stewardship of organizational assets.
Most discussions of the control function are firmly focused on regulation. The
project manager needs to be equally attentive to both regulation and
conservation. The Project Manager is shepherd of the organizations resources.
The project manager must guard the physical assets of the organization, its
human resources, and its financial resources. The processes for conserving
these three different kinds of assets are different.
Types of Control
Physical Asset Control
Physical asset control requires of the use of these assets. It is concerned with
the asset maintenance, whether preventive or corrective. At issue also is the
timing of maintenance or replacement as well as the quality of maintenance.
If the project uses considerable amount of physical equipment, the project
manager also has the problem of setting up maintenance schedules in such a
way as to minimize interference with the ongoing work of the project. It is
critical to accomplish preventive maintenance prior to the start of that final
section of the project life cycle known as the Last Minute Panic (LMP).
Physical inventory, whether equipment or material, must also be controlled. It
must be received, inspected (or certified), and possibly stored prior to use.
Records of all incoming shipments must be carefully validated so that payment
to suppliers can be authorized. The same precautions applicable to goods from
external suppliers must also be applied to suppliers from inside the organization.
Even such details as the project library, project coffee maker, project room
furniture, and all the other minor bits and pieces should be accounted,
maintained, and conserved.
8
Human Resource Control

Control
Human resouces also need both regulation and conservation. Stewardship of

human resources requires controlling and maintaining the growth and
development of people. Projects provide particularly fertile ground for cultivating
people. Because projects are unique, differing one from another in many ways,
it is possible for people working on projects to gain a wide range of experience
in a reasonably short time.
Measurement of physical resource conservation is accomplished through the
familiar audit procedures. The measurement of human resource conservation is
far more difficult. Such devices as employee appraisals, personnel performance
indices, and screening methods for appointment, promotion, and retention are not
particularly satisfactory devices for ensuring that the conservation function is
being properly handled. The accounting profession has worked for some years
on the development of human resource account, and while their efforts have
produced some interesting ideas, human resource accounting is not well
accepted by the accounting profession.
Financial Resource Control
Though accountants have not succeeded in developing acceptable methods for
human resource accounting, their work on techniques for the conservation (and
regulation) of financial resources have most certainly resulted in excellent tools
for financial control. This is the best developed of the basic area needing
control. It is difficult to separate those control mechanisms aimed at
conservation of financial resources from those focused on regulating their use.
Most financial controls do both. Capital investment, controls work to
conserve the organizations assets by insisting that certain conditions be met
before capital can be expended, and those same conditions usually regulate the
use of capital to achieve the organizations goals of a high return on its
investments.
The techniques of financial control, both conservation and regulation, are well
known. They include current asset controls. These controls are exercised
through a series of analyses and audits, conducted by the accounting/controller
function for the most part. Representation of this function on the project team
is mandatory. The structure of the techniques applied to projects does not differ
appreciably from those applied to the general operation of the firm, but the
context within which they are applied is quite different. One reason for the
differences is that the project is accountable to an outsider - an external client,
or another division of the parent firm, or both at the same time.
7.7 TYPES OF CONTROL PROCESSES

No matter what our purpose in controlling a project, there are three basic types
of control mechanisms that we can use: cybernetic control, go/no-go control,
and post control. In this section we will describe these three types of control
and briefly discuss the information requirements of each.
7.7.1
Cybernetic Control
Cybernetic, or steering control is by far the most common type of control

system. (Cyber is the Greek work from helmsman.) The key feature of
cybernetic control is its automatic operation.
Figure 7.3 shows that a system is operating with inputs being subjected to a
process that transforms them into outputs. It is this system that we wish to
control. In order to do so, we must monitor the system output. This function is
Outputs
y
Process
k
Sensor
V
Comparator
Effector
and
Decision
maker
V V
Inputs V
x
Under Certainty
V
V
Standards
Figure 7.3: A cybernetic control system
performed by a sensor that measures one or more aspects of the output,

presumably those aspects one wishes to control. Measurements taken by the
sensor are transmitted to the comparator, which compares them with a set of
predetermined standards. The difference between actual and standards. The
difference between actual and standard is sent to the decision maker, which
determines whether or not the difference is of sufficient size to deserve
correction. If the difference is large enough to warrant action, a signal is sent
to the effector, which acts on the process or on the inputs to produce output
that conform more closely to the standard.
A cybernetic control system that acts to reduce deviations from standard is
called a negative feedback loop. If the system output moves away from
standard in one direction, the control mechanism acts to move it in the opposite
direction. The speed or force with which the control operates is, in general,
proportional to the size of the deviation from standard. The precise way in
which the deviation is corrected depends on the nature of the operating system
and the design of the controller.
7.7.2
Go/No-go Controls
Go/No-go controls take the form of testing to see if some specific precondition
has been met. This type of control can be used on almost every aspect of a
project. For many facets of performance, it is difficult to know that the
predetermined specifications for project output have been met. The same is
often true of the cost and time elements of the project plan.
It is, of course, necessary to exercise judgement in the use of go/no-go
controls. Certain characteristics of output may be required to fall within
precisely determined limits if the output is to be accepted by the client. Other
characteristics may be less precisely defined. In regard to time and cost, there
may be penalties associated with nonconformance with the approved plans.
Penalty clauses that make late delivery costly for the producer are often
included in the project contract. At times, early delivery can also carry a
penalty. Cost overruns may be shared with the client or totally borne by the
project.
The project plan, budget, and schedule are all control documents, so the project
manager has a predesigned control system complete with pre-specified
milestones as control checkpoints. Control can be exercised at any level of
detail that is supported by detail in the plans, budgets, and schedules. The parts
of a new jet engine, for instance, are individually checked for quality
conformance. These are go/no-go controls. The part passes or it does not, and
every part must pass its own go/no-go test before being used in an engine.
10
While cybernetic controls are automatic and will check the operating systems
continuously or as often as designed to do so, go/no-go controls operate only
when the controller uses them. In many cases, go/no-go controls function
periodically, at regular, preset intervals. The intervals are usually determined by
clock, calendar, or the operating cycles of some machine system. Such periodicity
makes it easy to administer a control system, but it often allows errors to be
compounded before they are detected. Things begin to go awry just after a
quarterly progress check, for instance, and by the time the next quarterly check
is made, some items may be seriously out of control. Project milestones do not
occur at neat, periodic intervals; thus, controls should be linked to the actual
plans and to the occurrence of real events, not simply to the calendar.

Control
For an early warning system to work, it must be clearly understood that a

messenger who brings bad news will not be shot, and that anyone caught
sweeping problems and mistakes under the rug will be. An important rule for
any subordinate is the Prime Law of Life on a project : Never let the boss be
surprised!
7.7.3
Post-control
Post-controls (also post-performance controls or post-project controls) are

applied after the fact. One might draw parallels between post-control and
locking the barn after the horse has been stolen, but post-control is not a vain
attempt to alter what has already occurred. Instead, it is a full recognition of
George Santayanas observation that Those who cannot remember the past are
condemned to repeat it. Cybernetic and go/no-go controls are directed toward
accomplishing the goals of an ongoing project. Post-control is directed toward
improving the chances for future projects to meet their goals.
Post-control is applied through a relatively formal document that is usually
constructed with four distinct sections.
a)
The Project Objectives : The post-control will contain a description of

the objectives of the project. Usually, this description is taken from the
project proposal, and the entire proposal often appears as an appendix to
the post-control report. As reported here, project objectives include the
effects of all change orders issued and approved during the project.
Because actual project performance depends in part of uncontrollable
events) strikes, weather, failure of trusted suppliers, sudden loss of key
employees, and other acts of God), the key initial assumptions made during
the preparation of the project budget and schedule should be noted in this
section. A certain amount of care must be taken in reporting these
assumptions. They should not be written with a tone that makes them
appear to be execuses for poor performance. While it is clearly the
prerogative, if not the duty, of every project manager to politically protect
himself, he or she should do so in moderation to be effective
b)
Milestones, Checkpoints, and Budgets : This section starts with a full

report of project performance against the planned schedule and budget.
This can be prepared by combining and editing the various project status
reports made during the projects life. Significant deviations of actual
schedule and budget from planned schedule and budget should be
highlighted. Explanations of why these, deviations occurred will be offered
in the next section of the post-control report. Each deviation can be
identified with a letter or number to index it to the explanations. Where the
same explanation is associated with both a schedule and budget deviation,
as well often be the case, the same identifier can be used.
c)
The Final Report on Project Results : Note that in the previous

section, when significant variations of actual from planned project
performance were indicated, no distinction was made between favourable
11
Under Certainty
and unfavourable variations. Like the tongue that invariably goes to the
sore tooth, project managers focus their attention on trouble. While this is
quite natural, it leads to complete documentation on why some things went
wrong and title or no documentation on why some things went particularly
well. Both sides, the good and the bad, should be chronicled here.
Not only do most projects result in outputs that are more or less satisfactory,
most projects operate with a process that is more or less satisfactory. The
concern here is not on what the project did but rather on how it did it.
Basically descriptive, this part of the final report should cover project
organization, an explanation of the methods used to plan and direct the project,
and a review of the communication networks, monitoring systems, and control
methods, as well as a discussion of intraproject interactions between the various
working groups.
Recommendations for Performance and Process Improvement: The
culmination of the post-control report is a set of recommendations covering the
ways future projects for improving. Many of the explanations appearing in the
previous section are related to one-time happenings, sickness, weather, strikes,
the appearance of a new technology, etc., that themselves are not apt to affect
future project-although other different one-time events may effect them. But
some of the deviations from plan were caused by happenings that are very
likely to recur. Provision for such things can be factored into future project
plans, thereby adding to predictability and control.
Just as important, the process of organizing and conducting projects can be
improved by recommending the continuation of managerial methods and
organizational systems that appear to effect, together with the alteration of
practices and procedures that do not. In this way, the conduct of projects will
become smoother, just as the likelihood of achieving good results, on time and
on cost, is increased.
Activity 2
President of an MNC has asked you to develop control system for his
organization:
a)
List out the activities that you would cover while developing control system
for the organization.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
List out the various assets of the organization that would require control.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
List out the three basic types of control mechanisms that you would
employ in the organization.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
12
7.8 DESIGN OF CONTROL SYSTEMS

Control
Irrespective of the type of control used, there are some important questions to
be answered while designing any control system: who sets the standards? How
realistic are the standards? How clear are they? Will they achieve the projects
goals? What output, activities, behaviours should be monitored? Should we
monitor people? What kinds of sensors should be used? Where should they be
placed? How timely must be monitoring be? How rapidly must it be reported?
How accurate must sensors be?
If the control system is to be acceptable to those who will use it and those
who will be controlled by it, the system must be designed so that it appears to
be sensible. Standards must be achievable by the mechanical systems used.
Control limits must be appropriate to the needs of the client, that is, not merely
set to show how good we are. Like punishment, rewards and penalties should
fit the crime.
In addition to being sensible, a good control system should also possess some
other characteristics as set out below :
The system should be flexible. Where possible, it should be able to react to
and report unforseen changes in system performance.
The system should be cost-effective. The cost of control should never
exceed the value of control. As we noted above, control is not always less
expensive than scrap.
The control system must be truly useful. It must satisfy the real needs of
the project, not the whims of the project manager.
The system must operate in a timely manner. Problems must be reported
while there is still time to do something about them, and before they
become large enough to destroy the project.
Sensors and monitors should be sufficiently accurate and precise to control
the project within limits that are truly functional for the client and the
parent organization.
The system should be as simple to operate as possible.
The control system should be easy to maintain. Further, the control system
should signal the overall controller if it goes out of order.
The system should be capable of being extended or otherwise altered.
Control systems should be fully documented when installed and the
documentation should include a complete training program in system
operation.
No matter how designed, all of the control systems described above use
feedback as a control process. Let us now consider some more specific
aspects of control. To a large extent, the Project Manager is trying to anticipate
problems or catch them just as they begin to occur. The Project Manager
wants to keep the project out of trouble because upper management often
bases an incremental funding decision on a review of the project. This review
typically follows some particular milestone and, if acceptable, leads to a followon authorization to proceed to the next review point. If all is not going well,
other technological alternatives may be recommended; or if things are going
badly, the project may be terminated. Thus, the project manager must monitor
and control the project quite closely.
The control of performance, cost, and time usually requires different input data.
To control performance, the project manager may need such specific
documentation as engineering change notices, test results, quality checks,
13
Under Certainty
rework tickets, scrap rates, and maintenance activities. For cost control, the
manager compares budgets to actual cash flows, purchase orders, labour hour
charges, amount of overtime worked, absenteeism, accounting variance reports,
accounting projections, income reports, cost exception reports, and the like. To
control the schedule, the project manager examines bench mark reports,
periodic activity and status reports, exception reports, PERT/CPM networks,
Gantt charts, the master project schedule, earned value graphs, and probably
reviews the Action Plans.
Some of the most important analytical tools available to the project manager to
use in controlling the project are variance analysis and trend projection.
Earned value analysis was also described earlier. On occasion it may be
worthwhile, particularly on large projects for the project manager to calculate a
set of critical ratios for all project activities. The critical ratio is.
(Actual Progress/Scheduled Progress) x (Budgeted Cost/Actual Cost)
If this ratio is exactly one, then the activity is probably on target. If the ratio
differs from one, then the activity may need to be investigated. The closer the
ratio is to one, the less important is the investigation. Consider Table 7.1 for
example.
We can see that the first task is being scheduled but below budget. If delay is
no problem for this activity, the project manager need take no action. The
second task is on budget but its physical progress is lagging. Even if there is
slackness in the activity, the budget will probably be overrun. The third task is
on schedule but cost is running higher than budget, creating another probable
cost overrun. The fourth task is on budget but ahead of schedule. A cost
saving may result. Finally, the fifth task is on schedule and is running under
budget, another probable cost saving.
Task 4 and 5 have critical ratios greater than one and might not concern some
project manager but the thoughtful manager would like to know why they are
doing so well (and the project manager may also want to check the information
system to validate the unexpectedly favourable findings). The second and third
activities need attention, and the first task may need attention also. The project
manager may set some critical-ratio control limits intuitively.
Table 7.1: (Actual Progress/Scheduled Progress) x (Budget Cost/Actual Cost)
Task
Number
Actual
Progress
Scheduled
Progress
Budgeted
Cost
Actual
Cost
Critical
Ratio
(2
3)
(6
4)
1.0
(2
3)
(6
4)
.67
(3
3)
(4
6)
.67
(3
2)
(6
6)
1.5
(3
3)
(6
4)
1.5
7.9 CONTROL OF CREATIVE ACTIVITIES

Some brief attention should be paid to the special case of controlling research
and development projects, design projects, and similar processes that depend
intimately on the creativity of individuals and teams. First, the more creativity
involved, the greater the degree of uncertainty surrounding outcomes. Second,
14
too much control tends to inhibit creativity. Control is not necessarily the enemy
of creativity; nor, popular myth to the contrary, does creative activity imply
complete uncertainty. While the exact outcomes of creative activity may be
more or less uncertain, the process of getting the outcome is usually not
uncertain.

Control
In order to control creative projects, the project manager must adopt one or
some combination of three general approaches to the problem: (1) progress
review, (2) personnel reassignment, and (3) control of input resources.
7.10 PROGRESS REVIEW

The progress review focuses on the process of reaching outcomes rather than
on the outcomes per se. Because the outcomes are partially dependent on the
process used to achieve them - uncertain though they may be - the process is
subjected to control. For example, in the case of research projects the
researcher cannot be held responsible for the outcome of the research, but can
most certainly be held responsible for adherence to the research proposal, the
budget, and the schedule. The process is controllable even if the precise results
are not.
7.11 PERSONNEL REASSIGNMENT

This type of control operates in a very straightforward way. Individuals who
are productive are retained. Those who are not to be retained are moved to
other jobs or to other organizations. Problems with this technique can arise
because it is easy to create an elite group. While the favoured few are highly
motivated to further achievement, everyone else tends to be demotivated. It is
also important not to apply control with too fine an edge. While it is not
particularly difficult to identify those who falls in the top and bottom quartiles of
productivity, it is usually quite hard to make clear distinctions between people in
the middle quartiles.
7.12 CONTROL OF INPUT RESOURCES

In this case, the focus is of efficiency. The ability to manipulate input resources
carries with it considerable control over output. Obviously, efficiency is not
synonymous with creativity, but the converse is equally untrue. Creativity is not
synonymous with extravagant use of resources.
The results flowing from creative activity tend to arrive in batches.
Considerable resource expenditure may occur with no visible results, but then,
seemingly all of a sudden, many outcomes may be delivered. The milestones
for application of resource control must, therefore, be chosen with great care.
The controller who decides to withhold resources just before the fruition of a
research project is apt to become an ex-controller.
Sound judgement argues for some blend of these three approaches when
controlling creative projects. The first and third approaches concentrate on
process because process is observable and can be affected. But process is not
the matter of moment; results are. The second approach requires us to
measure (or at least to recognize) output when it occurs. This is often quite
difficult. Thus, the wise project manager will use all three approaches: checking
process and method, manipulating resources, and culling those who cannot or do
not produce.
15
Under Certainty
7.13 SUMMARY
Project is a set of complex interelated activities. A bottleneck at any one of the
stages has an impact on the completion schedule of other stages, therefore for
any project a monitoring system is a must. The frequency and the type of
monitoring as well as data collection for monitoring will vary from project to
project. Project monitoring reports are basically of three types 1) Routine, 2)
Exception, 3) Special Analysis.
Project control is the act of comparing the planned performance with the actual
and reducing the difference between the two. Project control has three domains
1) Physical Asset Control, 2) Human Resource Control, 3) Financial Resource
Control.

1)
What is the purpose of control? To what is it directed?
2)
What are the three main types of control systems? What questions should
a control system answer?
3)
What tools are available to the project manager to use in controlling a

project? Identify some characteristics of a good control system.
4)
What is the mathematical expression for the critical ratio? What does it tell
a manager?
5)
How might the project manager integrate the various control tools into a
project control system?
6)
How could a feedback control system be implemented in project

management to anticipate client problems?
7)
Define monitoring. Are there any additional activities that should be part of
the monitoring function?
8)
Calculate the critical ratios for the following activities and indicate which
activities are probably on target and which need to be investigated.
9)
16
Activity
Actual
Progress
Scheduled
Progress
Budgeted
Cost
Actual Cost
4 days
4 days
Rs. 60
Rs. 40
3 days
2 days
Rs. 50
Rs. 50
2 days
3 days
Rs. 30
Rs. 20
1 day
1 day
Rs. 20
Rs. 30
2 days
4 days
Rs. 25
Rs. 25
Give the following information, which activities are on time, which are
early, and which are behind schedule?
Activity
Budgeted Cost
Actual Cost
Critical Ration
Rs. 60
Rs. 40
1.0
Rs. 25
Rs. 50
0.5
Rs. 45
Rs. 30
1.5
Rs. 20
Rs. 20
1.5
Rs. 50
Rs. 50
0.67

Control
Cleland, D.I., and W.R. King, Systems Analysis and Project management,
MC Graw Mill, 1983.
Kerridge, A.E. and vervalin C.H., Project Management, Gulf Publishing,
London, 1986.
Wadsworth, M.D., Project Management Controls, Prentic Hall, 1982.
17
UNIT 8 CAPITAL BUDGETING DECISIONS
AND THE CAPITAL ASSET
PRICING MODEL
Objectives
Objectives of the Units are :
to examine the relevance of risk in capital budgeting decisions,
to understand the application and usefulness of capital asset pricing model
in capital budgeting decisions,
to study the certainty equivalent and risk adjusted discounting rate
approaches.
Structure
8.1 Introduction
8.2 Capital Asset Pricing Model
8.3 Measuring Betas and Capital Asset
8.4 Stability of Betas over Time
8.5 Business and Financial Risk
8.6 What determines Asset Betas
8.7 Discounted Cash Flow Approach
8.8 Summary
8.1 INTRODUCTION
Long before the development of capital asset pricing theory1, which says that
the equilibrium rates of return on all risky assets are a function of their
covariance with the market portfolio; smart financial managers adjusted for risk
in capital budgeting. They realized intuitively that, if other things being equal,
risky projects are less desirable than safe ones. Therefore, they demanded a
higher rate of return from risky projects or they based their decisions on
conservative estimates of the cash flows.
Various rule of thumb are often used to make these risk adjustments. For
example, many companies estimate the rate of return required by investors in
its securities and use this required rate of return to discount the cash flows on
all new projects. Since investors require a higher rate of return from a very
risk company, such a firm will have a higher company cost of capital and will
set a higher discount rate for its new investment opportunities.
You can use the capital asset pricing model as a rule of thumb for estimating
the companys cost of capital. For instance ABC Ltd. has a beta of 1.38, the
risk free rate is 7.8 per cent and expected market risk premium 8.3 per cent
then, the corresponding expected rate of return would be 203 or about 20 per
cent. Therefore, according to the company cost of capital rule, ABC should
have been using a 20 per cent discount rate to compute project net present
values2.
1
2
CAPM was first developed by William Sharpe in 1963, 64, and later on developed by
J.Mossin, 1963, J. Lintner, 1965, F. Black, 1972.
ABC did not use any significant amount of debt financing. Thus its cost of capital is the
rate of return investors except on its common stock.
Under Uncertainty
This is a step in the right direction. Even though we cant measure betas or
the market risk premium with absolute precision, it is still reasonable to assert
that ABC faced more risk than the average firm and, therefore, should have
demanded a higher rate of return from its capital investments.
But the company cost of capital rule can also get a firm into trouble if the new
projects are more or less risky than its existing business. Each project should
be evaluated at its own opportunity cost of capital. This is a clear implication
of the value-additivity principle. For a firm composed of assets A and B, firm
value will be:
Firms value=PV(AB)=PV(A)+PV(B)= sum of separate asset values.
Here PV(A) and PV(B) are valued just as if they were mini-firms in which
stock-holders could invest directly. Note: Investors would value A by discounting
its forecasted cash flows at a rate reflecting the risk of A. They would value
B by discounting at a rate relfecting the risk of B. The two discount rates
will, in general, be different.
(required return)
Security market line showing
Required return on project
20.3
Company cost of capital
7.8
Project beta
Average beta of the firms assets = 1.38
Figure 8.1: Relationship between required return and Project Beta
Figure 8.1 exhibits a comparison between the company cost of capital rule and
the required return under the capital asset pricing model. ABCs company cost
of capital is about 20 per cent. This is the correct discount rate only if the
project beta is 1.38. In general, the correct discount rate increases as project
beta increases. ABC should accept projects with rates of return above the
security market line relating required return to beta.
If the firm considers investing in a third project C, it should also value C as if
it were a mini-firm. That is, it should discount the cash flows of C at the
expected rate of return investors would demand to make a separate investment
in C. The true cost of capital depends on the use to which the capital is put.
8.2 CAPITAL ASSET PRICING MODEL (CAPM)

CAPM approach is used to estimate risk adjusted discount rate for making
investment decisioins. It is a theory about how the prices of risky financial
assets (securities) are determined in the capial market.
Capital asset pricing theory tells us to invest in any project offering a return
that more than compensates for the projects beta. This means that ABC
should have accepted any project above the upward-sloping market line in
Figure 8.1. If the project had a high beta ABC needed a higher prospective
return than if the project had a low beta. Now contrast this with the company
cost of capital rule, which is to accept any project regardless of its beta as
long as it offers a higher return than the companys cost of capital. In terms
of Figure 8.1, it tells ABC to accept any project above the horizontal cost-ofcapital line-that is, any project offering a return of more than 20 per cent.
Capital Budgeting Decisions

and the Capital Asset
Pricing Model
It would be silly to suggest that ABC should demand the same rate of return
from a very safe project as from a very risky one. If ABC used the company
cost of capital rule, it would reject many good low-risk projects and accept
many poor high-risk projects. It is also fully to suggest that, just because XYZ
Ltd. has a low company cost of capital, it is justified in accepting projects that
ABC would reject. If you followed such a rule to its seemingly logical
conclusion, you would think it possible to enlarge the companys opportunities by
investing a large sum in risk free securities. That would make the common
stock safe and create a low company cost of capital.
The notion that each company has some individual discount rate or cost of
capital is widespread, but far from universal. Many firms require different
returns from different categories of investment. Discount rates might be set
for different investment purposes as given below :
Category
Discount Rate Percent
Speculative ventures
New product
Expansion of existing business
Cost improvement, known technology.
30
20
15 (Company cost
of capital)
10
In brief, the main insights of CAPM are :

Investors need be rewarded for systematic risk only because insystematic
risk can be reduced to zero through diversification of investment profolio.
A securitys systematic risk is measured by beta value.
The required rate of return on a security depends on riskless rate of
interest the market risk premium and the securitys beta value.
8.3 MEASURING BETAS AND CAPITAL ASSET

Now the question arises how to use beta pricing model to help cope with risk in
capital budgeting situation the main problem in how to estimate the discount rate.
r = rf + P (rm - rf)
r = Discounting rate
rf = Risk free rate
rm = Market rate of return
P = Project beta
And in order to do that you have to figure out the project beta. It is a difficult
problem so much so that many people hope it will go away if they ignore it.
They may go away but unfortunately the problem wont - any investment
decision that is made contains an implicit assumption about project risk.
Under Uncertainty
We will start by reconsidering the problems you would encounter in using beta
to estimate a companys cost of capital. It turns out that beta is difficult to
measure accurately for an individual firm, much greater accuracy can be
achieved by looking at an average of similar companies. But then we have to
define the similar. Among other things we will find that a firms borrowing
policy affects its stocks beta. It would be incorrect, for example, to average
the beta of a company which has borrowed heavily and the one which has not,
although, they may have similarity otherwise.
The companys cost of capital is the correct discount rate for projects that
have the same risk as the companys existing business but not for those that
are safer or riskier than the companys average. The problem is to judge the
relative risk of the projects available to the firm. In order to handle that
problem, we will need to dig a little deeper and look at what features make
some investments riskier than others.
There is still another complication: project betas can shift over time. Some
projects are safer in youth than in old age, others are riskier. In this case,
what do we mean by the project beta? There may be a separate beta for
each year of the projects life. To put it another way, can we jump from the
capital asset pricing model, which looks out one period into the future, to the
discounted-cash-flow formula for valuing long-lived assets? Most of the time it
is safe to do so, but you should be able to recognize and deal with exceptions.
Capital asset pricing theory supplies no mechanical formula for measuring and
adjusting for risk in capital budgeting. These tasks of financial management will
be among the last to be automated. The best a financial manager can do is to
combine an understanding of the theory with good judgement and a good nose
for hidden clues.
Suppose that you were considering an across-the-board expansion by your firm.
Such an investment would have about the same degree of risk as the existing
business. Therefore, you should discount the projected flows at the company
cost of capital. To estimate that, you could begin by estimating the beta of the
companys stock.
Table 8.1
Sharpe and Cooper divided stocks into risk classes according to their betas in one
5-year period (class 10 contains high betas, class 1 contains low betas). They then
looked at how many of these stocks were in the same risk class 5 years later.
Risk
Percent in Same Risk

Class 5 Years Later
Percent Within Class

5 Years Later
10
35
69
18
54
16
45
13
41
14
39
14
42
13
40
16
45
21
61
40
62
W.F. sharpe and G.M. Cooper, Risk-Return Classes of New York Exchange Common
Stocks, 1931-1967, Financial Analysis Journal, 28:46-54, 81 (March-April 1972)
Pricing Model
Company return
Market return
Figure 8.2: Estimating Beta
An obvious way to measure the beta of a stock is to look at how its price has
responded in the past to market movements. We may plot monthly rates of
return of Company against market returns for the same months. We may fit a
line through the points. Beta is the slope of the line (See Figure 8.2). It could
vary from one period to the other. If we use the past beta of a stock to
predict its future beta, we would, in most cases, not have been too far off.
8.4 STABILITY OF BETAS OVER TIME

Of course, evidence from two (carefully selected) stocks is not worth much,
but betas appear to be reasonably stable. An extensive study of stability was
provided by Sharpe and Cooper3. They divided stocks into 10 classes according
to the estimated beta in that period. Each class contained one-tenth of the
stocks in the sample. The stocks with the lowest betas went into class1.
Class 2 contained stocks with slightly higher betas, and so on. They then
looked at the frequency with which stocks jumped from one class to another.
The more jumps, the less stability. You can see from Table - 8.1 that there is
a marked tendency for stocks with very high or very low betas to stay that
way. If you are willing to stretch the definition of stable to include a jump to
an adjacent risk class, then from 40 to 70 percent of the betas were stable
over the subsequent 5 years.
One reason that these estimates of beta are only imperfect guides to the future
is that the stocks may genuinely change their market risk. However, a more
important reason is that the betas in any one period are just estimates based on
a limited number of observations. If good company news coincides by chance
with high market returns, the stocks beta will appear higher than if the news
coincides with low market returns. We can twist this the other way around.
If a stock appears to have a high beta, it may be because it genuinely does
have a high beta, or it may be because we have over estimated it.
Under Uncertainty
This explains some of the fluctuation in betas observed by Sharpe and Cooper.
Suppose a companys true beta really is stable. Its apparent (estimated) beta
will fluctuate from period to period due to random measurement errors. So the
stability of true betas is probably better than Sharpe and Coopers results seem
to imply.
Asset Betas and Equity Betas

Think again of what the company cost of capital is and what it is used for.
We define it as the opportunity cost of capital for the firms existing assets;
we use it to value new assets which have the same risk as the old ones. The
right beta for calculating the company cost of capital is the beta of the firms
existing assets, its asset beta.
Let us take a simple balance sheet with assets on the left and debt and equity
on the right.
Asset value
Debt Value (D)

Equity value (E)
Asset value
Firm value
(V)
Note that the values of debt and equity add up to firm value (D + E = V), and
that firm value equals asset value.
Stockholders own the firms equity but they cant claim all of the asset value;
they have to share it with debt holders. The debt holders receive part of the
cash flows generated by the firms assets, and they may bear part of the
assets risks. (For example, if the assets turn out to be worthless, there will be
no cash to pay stockholders or debt holders.) But debt holders of big firms
such as TISCO bear much less risk than stockholders. Debt betas are
typically close to zero-close enough that for large blue-chip companies many
financial analyst just assume debt=0. But we want the asset beta, asset. How
do we get it?
Suppose you buy all the firms securities - 100 per cent of the debt and 100
percent of the equity. You would own the assets lock, stock, and barrel. You
wouldnt have to share the firms asset value with anyone; every rupee of cash
the firm pays out would be paid out to you. You wouldnt share the risks with
anyone else, either; you bear them all. Thus the beta of your debt plus equity
portfolio would equal the firms asset beta.
The beta of this hypothetical portfolio is just a weighted average of the debt
and equity betas4.
asset = portfolio = debt
debt
equity
+ equity
debt + equity
debt + equity
Calculating LMN Ltd. Asset Beta and Companys Cost of Capital

Now that we know how to derive the beta of a firms assets from the beta of
its stock, we can return to the problem of figuring out companys cost of
capital. Say LMN Ltd. common stock is 0.36 and its common stock
accounted for 35 percent of its market value. The remaining 65 percent
consisted of debt and preferred stock. To keep matters simple we will just
4
10
Here we ignore certain tax complications. If debt interest generates valuable tax savings,
then the formula for asset changes somewhat.
lump the preferred stock in with the debt and assume both are risk-free. This
gives us the following estimates for the beta of LMNs assets:
asset = debt = debt

Pricing Model
debt
equity
+ equity
debt + equity
debt + equity
= 0(.65) + .36(.35) = .13

Of course, this is a very low number. The reason for this is that LMMs stock
beta is low (only 0.36) despite its heavy use of debt and correspondingly high
financial risk. When the financial risk is removed, we find the remaining
business risk to be small.
With a risk-free rate of 7.8 per cent and an expected market risk premium of
8.3 percent, LMNs cost of capital is
r =
rf+asset (rm-rf)
= .078 + .13(.083) .089, or 8.9 per cent.

This estimate is probably low, because we arbitrarily assumed LMNs debt was
totally risk-free. If we had used debt = 0.15,
asset
= debt+ equity
= .15(.65) + .36(.35)
= .22
rf+asset(rmrf)
=.078 + .22(.083) = .097, or 9.7%
8.5 BUSINESS AND FINANCIAL RISK

A firms asset beta reflects its business risk. The difference between its equity
and asset beta reflects financial risk. More debt means more financial risk.
What would happen if LMN decided to use more debt and correspondingly less
equity? It would not affect the firms business risk. There would be no
change in the firms asset beta, and no change in the beta of a portfolio of all
the firms debt and equity security. The equity beta would change, however.
Lets go back to the formula for asset,
asset = debt
debt
equity
+ equity
debt + equity
debt + equity
and solve the formula for equity
equity = asset + ( asset debt)
debt
equity
If we assume LMNs debt is risk-free, we have

equity = .13 + (.13 0) = .36
11
Under Uncertainty
But if the company switched to 75 percent debt, equity would go up to .52.

On the other hand, if LMN paid off all its debt, we would expect to find:
equity = asset ( asset debt )
debt
equity
= .13 + (.13 - 0)
= .13
With no debt, the firms asset and equity betas would be exactly the same.
In general, the observed equity beta depends on the firms asset beta, asset, the
spread between the asset and debt betas, asset - debt, and the ratio of debt to
equity. Figure 8.3 plots the relationship assuming risk free debt (debt =0).
, Beta
Effect of financial leverage on
equity, the beta of the firms
common stock. The higher
the debt-equity ratio, the
higher equity. When the firm
uses no debt (E=0), equity =
asset
asset; asset measures the
business risk of the firms
0
assets. Note that this figure
is drawn assuming risk-free
debt (debt=0).
D/E = 0
equty
D/E, Debtequity ratio
Figure 8.3: Effect of Financial Leverage on of equity
In many ways we have given an oversimplified version of how financial

leverage affects equity risks and returns. We have said nothing about taxes,
for example. The finer points can wait. For now, there are really just two
points to remember. First, financial leverage creates financial risk. The beta of
the firms stock increases in proportion to the amount borrowed. Second, asset
betas can always be calculated as a weighted average of the betas of the
various debt and equity securities issued by the firm. Of course, it is the asset
beta that is relevant in capital-budgeting decisions, not the beta of the firms stock.
8.6 WHAT DETERMINES ASSET BETAS?

Stock or industry betas provide a rough guide to the risk typically encountered
in various lines of business. But an asset beta for, say, the steel industry can
take us only so far. Not all investments made in the steel industry are
typical. What other kinds of evidence about business risk might a financial
manager examine?
In some cases the asset is publicly traded. If so, we can simply estimate its
beta from past price data. For example, suppose a firm wants to analyze the
risks of holding a large inventory of copper. Because copper is a standardized,
widely traded commodity, it is possible to calculate rates of return from holding
copper and to calculate a copper beta.
12
What should we do if our asset has no such convenient price record? The
advice is to search for characteristics of the asset that are associated with high
or low betas. We wish we had a more fundamental scientific understanding of
what these characteristics are. We see business risks surfacing in capital
markets, but as yet there is no completely satisfactory theory describing how
those risks are generated. Nevertheless, some things are known.
Cyclicality
Many people intuitively associate risk with the variability of book or accounting
earnings. But much of this variability reflects diversifiable or unique risk. Lone
prospectors in search of gold look forward to extremely uncertain future
earnings, but whether or not they strike it rich is unlikely to depend on the
performance of the market portfolio. Even if they do find gold, they do not
bear much market risk. Therefore an investment in gold has a high standard
deviation but a relatively low beta.

Pricing Model
What really counts is the strength of the relationship between the firms
earnings and the aggregate earnings on all real assets. We can measure this
either by the accounting beta or by the cash-flow beta. These are just like a
real beta except that changes in book earnings or cash flow are used in place
of rates of return on securities. We would predict that firms with high
accounting or cash-flow betas should also have high stock betas - and the
prediction is correct.
This means that cyclical firms - firms whose revenues and earnings are
strongly dependent on the state of business cycle - tend to be high-beta firms.
Thus you should demand a higher rate of return from investments whose
performance is strongly tied to the performance of the economy.
Operating Leverage
We have already seen that financial leverage - in other words, the commitment
to fixed debt charges - increases the beta of an investors portfolio. In just the
same way, operating leverage - in other words, the commitment to fixed
production charges - must add to the beta of a capital project. Lets see how
this works.
The cash flows generated by any productive asset can be broken down into
revenue, fixed costs, and variable cost.
Cash flow = revenue fixed cost variable cost.
Costs are variable if they depend on the rate of output. Examples are raw
materials, sales commission, and some labor and maintenance costs. Fixed
costs are cash outflows that occur regardless of whether the asset is active or
idle - property taxes, for example, or the wages of workers under contract.
We can break down the assets present value in the same way:
PV(asset)=PV(revenue)-PV(fixed cost) - PV (variable cost)
Or equivalently:
PV(revenue)=PV(Fixed Cost)+PV(variable cost)+PV(asset)
Those who receive the fixed costs are like debtholders in the project. Those
who receive the net cash flows from the asset are like holders of levered
equity in PV(revenue).
We can now figure out how the assets beta is related to the betas of the
values of revenue and costs. We just use our previous formula with the betas
relabeled:
revenue= fixed cost
PV (fixed cos t)
+ variable cost PV(variablecost) + asset
PV(revenue)
PV (revenue)
PV (asset )
PV (revenue)
13
Under Uncertainty
In other words, the beta of the value of the revenues is simply a weighted
average of the beta of its component parts. Now the fixed-cost beta is zero by
definition: whoever receives the fixed costs holds a safe asset. The betas of
the revenues and variable costs should be approximately the same, because
they respond to the same underlying variable, the rate of output. Therefore, we
can substitute revenue for variable cost and solve for the asset beta. Remember
that fixed cost = 0.
asset
= revenue
PV(revenue) PV(variable cost)

PV(asset)
= revenue 1 +
PV(fixed cost)
PV(asset)
Thus, given the cyclicality of revenue (reflected in revenue), asset beta is

proportional to the ratio of the present value of fixed costs to the present value
of the project.
Now we have a rule of thumb for judging the relative risks of alternative
designs or technologies for producing the same product. Other things being
equal, the alternative with the higher ratio of fixed costs to project value will
have the higher project beta.
Firms or assets whose costs are mostly fixed are said to have high operating
leverage. As we have seen, the analogy between financial and operating
leverage is almost exact. The beta of the stock increases in proportion to the
ratio of debt to equity, and the beta of the asset increases in proportion to the
ratio of the value of the fixed costs to the value of the asset. Empirical tests
confirm that companies with high operating leverage actually do have high
betas.
Searching for Clues

Recent research suggests a variety of other factors that affect an assets beta.
But going through a long list of these possible determinants would take us too
far afield.
You cannot expect to estimate the relative risk of assets with any precision, but
good managers examine any project from a variety of angles and look for clues
as to its riskiness. They know that high market risk is a characteristic of
cyclical ventures and of projects with high fixed costs. They think about the
major uncertainties affecting the economy and consider how projects are
affected by these uncertainties.
8.7 DISCOUNTED CASH FLOW APPROACH

We have spent the bulk of this unit discussing how you might estimate the risk
and required return on a project. We now have to worry a little about what
happens as risk changes over the life of a project.
We have implied that an expected rate of return calculated from the capital
asset pricing model
r = rf + (rm - rf)
14
This could be plugged into the standard discounted cash flow formula as
T
PV =
t =1
Ct
(1 + r)
=
t =1

Pricing Model
Ct
[1 + rf + (rm - rf )]t
You should not take step without thinking about it first. In capital budgeting we
must usually value cash flows extending over several future periods. The
discounted cash flow formula does this is one step, but the capital asset pricing
model looks at rates of return and prices over one period at a time.
One-period projects pose no problems.
PV =
C1
1+ r
C1
1 + rf + (rm - rf )
Longer-lived assets likewise pose no problem if you have an estimate of PVt,

future value 1 period hence
PV =
C1 + PV1
1+ r
C1 + PV1
1 + rf + (rm - rf )
But suppose that your company is evaluating the construction of a nuclear

power station and asks your advice on how to calculate its present value.
Would you tell it not to bother about anything other than the cash flow in the
first period and the end-of-period value? Of course not. The end-of-period
value depends on the cash flow in later periods. You would want a formula
that explicitly took this into account. This is formally correct only if we know
that the discount rates that will prevail in future periods will be the same as
this years. Among other things, this requires the assets beta to be constant
over the assets entire future life. Only under that crucial assumption it is
strictly proper to write down the discounted cash flow formula with a single
discount rate for all future cash flows.
What does that assumption mean in practical terms? In order to answer that
question we must develop alternative formulae for calculating present value
when beta and r do vary.
Certainty Equivalents
Let us start with a single future cash flow C1. If C1 is certain, its present
value is found by discounting at the risk-free rate rf
PV =
C1
1 + rf
If the cash flow is risky, the normal procedure is to discount its forecasted
(expected) value at a risk-adjusted discount rate r which is greater than rf.5
Another approach is to ask, What is the smallest certain return for which I
would exchange the risky cash flow C1? This is called the certainty equivalent
of C1, denoted by CEQ1
Suppose that the forecasted value of the risky cash flow is Rs.1000, but that
you would be willing to trade it for a safe cash flow of as little as Rs.800.
Then Rs.800 is the certainty equivalent of the risky cash flow. You are
indifferent between an Rs.800 safe return and an expected but risky cash flow
of Rs.1000.
5
The quantity r can be less than rf for assets with negative betas. But the betas of the
assets which corporations hold are almost always positive.
15
Under Uncertainty
What is the present value of Rs.1000 forecasted cash flow? It must be the
same as the present value of a certain Rs.800, because by definition you are
indifferent between the two flows. Suppose the risk-free rate of interest is
rf = 0.08. Then
CEQ1
PV of forecasted Rs.1000 cash flow = 1 + r

f
800
= Rs. 740.74
1.08
We could have gotten the same answer by discounting Rs.1000 at a riskadjusted rate. We can figure out what the proper discount rate is. If
PV =
1000
= Rs.740.74
1+ r
then r = 0.35, or 35 per cent

Now we have two equivalent expression for PV.
PV =
As long as you look only one period into the future, the two formulas are
exactly the same. But there are important differences when the concept of
certainty equivalents is applied to cash flows generated by long-lived assets.
Relationship of Certainty Equivalent and Risk-Adjusted Discount Rate
Formulas for Long-Lived Assets
We can easily extend the concept of certainty equivalents to long-lived assets:
T
PV =
t =1
CEQ t
(1 + rf )
=
t =1
a tCt
(1 + rf ) t
where at is the ratio of the certainty equivalent of a cash flow to its expected
value (at = CEQt/Ct). Normally at will be positive, but less than 1.06.
Table 8.4
Example showing certainty equivalents implied by use of constant riskadjusted discount rate
Period
Expected
Cash
Flow = Ct
Present
Value Using
10% RiskDiscount Rate,
PV = Ct/(1.10)t
Certainty
Equilvalent
CEQt Implied
By use of
10% Discount
CEQt = Ct
0
1
2
3
4
5
-350
100
100
100
100
100
Net present value =
-350
91
83
75
68
62
1 + rf
1+ r
-350
95
89
85
80
76
at Ratio
of CEQt
TO Ct
Present Value
of CEQS at 4%
Risk-Free Rate
1.00
0.945
0.894
0.845
0.799
0.755
29
-350
91
83
75
68
62
29
Note: By using a constant risk-adjusted discount rate of 10 per cent the finance
manager is implicitly making larger deductions for risk from the later cash flows.
Notice that discounting the cash flows at 10 per cent or the certainty equivalents at
4 per cent would give NPV = 29.
16
The quantity at would be greater than 1.0 for negative-beta assets.
When we discount at a constant risk-adjusted rate rt we are implicitly making a
special assumption about the coefficients at. Consider an asset offering cash
flows in 2 periods. If the certainty equivalent and risk-adjusted discount rate
formulas are really equivalent, they should give the same present value for each
cash flow:
C1
aC
= 1 1
1+ r
1 + rf
and
C2
(1 = r) 2

Pricing Model
a 2C2
(1 + rf ) 2
But this implies that

a1
1 + rf
1 + rf
= and a 2
1= r
1= r
= (a1 ) 2
In general, you are justified in using a constant risk-adjusted discount rate r to

value the cash flow for each period only if the value of at decreases over time
at a constant rate. The formula is
at =
1 + rf
1+ r
= (a1 ) t
Using Risk-Adjusted Discount Rates An Example

Consider a project requiring Rs.350 today (t = 0) and offering expected cash
flows of Rs.100 per year for 5 years. The risk-free rate is 4 percent, the
market risk premium is 9 percent, and the estimated beta is 0.67; therefore, the
financial manager settles on a discount rate of
r = rt + (rm-rt)
= 0.04 + .67(0.09)= 0.10, or 10%
The projects net present value is calculated as
5
NPV = PV - 350 =
t=2
100
(1.10) t
350 = Rs.29
What is the finance manager implicitly assuming about the values of at? The
answer is given by Table 8.4. By using a constant discount rate the finance
manager is effectively making a much larger deduction for risk from the later
cash flows. The larger deduction is reflected in lower values for at. Notice
also that at. decreases at a constant compound rate of about 5.5. per cent per
year.
It is usually reasonable to assume that risk increases at a constant rate. For
example, if you are willing to assume that beta is constant in each future
period, then the risk borne per period will be constant but cumulative risk will
grow steadily as you look further into the future.
When You Cannot Use a Single Risk-Adjusted Discount Rate for

Long-Lived Assets
The scientists at XYZ Ltd. have come up with an electric mop, and the firm is
ready to go ahead with pilot production and test marketing. The preliminary
phase will take a year and cost Rs.125,000. Management feels that there is
only a 50 percent chance that pilot production and market tests will be
successful. If they are, then XYZ will build a Rs.1 million plant which would
generate an expected annual cash flow in perpetuity of Rs.250,000 a year after
taxes. If they are not successful, the project will have to be dropped.
17
Under Uncertainty
The expected cash flows (in thousands of Rupees) are

Co = 125
C1 = 50% chance of - 1000 and 50% chance of 0
= .5 (1000 + .5(0)= -500
Ct, for t = 2,3,...
= 50% chance of 250 and 50% chance of 0.
= +.5(250) + .5(0) = 125
Management has little experience with consumer products and considers this a
project of extremely high risk. Therefore, they discount the cash flows at 25
percent, rather than XYZs normal 10 percent standard:
500
NPV = 125
+
1.25
t=2
125
125 or Rs.125,00
(1.25) tt
This seems to show that the project is not worthwhile.

Managements analysis is open to criticism if the first years experiment
resolves a high proportion of the risk. If the test phase is a failure, then
theres no risk at all - the project is certainly worthless. If it is a success,
there could well be only normal risk from there on. That means there is a 50
percent chance that in 1 year XYZ will have the opportunity to invest in a
project of normal risk, for which the normal discount rate of 10 per cent would
be appropriate. As such, they have a 50 percent chance to invest Rs.1 million
in a project with a net present value of Rs.1.5 million:
Success->NPV = 1000 +
250
= +1500 (50% chance)
0.10
Pilot
production
and
market
tests
Failure->NPV = 0(50% chance)
Thus, we could view the project as offering an expected payoff of
.5(1500)+.5(0)=750 or Rs.750,000 at t = 1 on a Rs.125,000 investment at t = 0.
Of course, the certainty equivalent of the payoff is less than Rs.750,000 but at
would have to be very small to justify rejecting the project. For example, if the
CEQ is half the expected value (at=0.5), and the risk-free rate is 7 per cent,
the project is worth Rs.225,500;
NPV = C o +
a 1C1
1 + rf
= 125 +
0.5(750)
= 225.5, or Rs. 225,500
1.07
Not bad for a Rs.125,000 investment - and quite a change from the
negative NPV that management got by discounting all future cash flows at
25 percent.
18
A Word of Caution
We sometimes hear people say that because distant cash flows are riskier,
they should be discounted at a higher rate than earlier cash flows. Thats quite
wrong: any risk-adjusted discount rate automatically recognizes the fact that
more distant cash flows have more risk. The reason is that the discount rate
compensates for the risk borne per perid. The more distant the cash flows, the
greater the number of periods and the larger the total risk adjustment.

Pricing Model
Activity I
a)
Mention the most fundamental difference between Certainty Equivalent and

the Risk Adjusted Discount Rate approaches of incorporating risk in Project
evaluation.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
Given a choice between Certainty Equivalent and Probability Distribution

approach, to analyze risk, which one would you prefer? Why?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
Identify two critical factors that affect asset betas.

...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
d)
Given a choice between Certainty Equivalent and Probability Distribution

approach, to analyze risk, which one would you prefer? Why?
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
8.8 SUMMARY
Capital Asset Pricing Model is used to estimate risk adjusted discount rate for
making investment decisions. In order to find an appropriate discount rate it is
necessary to find project beta which may be different from the firms beta
executing that project. The beta of the assets is weighted average of debt and
equity betas. A firms asset beta reflects its business risk, whereas the
difference between its equity and asset beta reflects financial risk.
Certainly equivalent is the smallest certain return which one would exchange
for a risky cash flow. Emperically it has been found that the betas are stable
over time.
19
Under Uncertainty

1.
For a high beta Project, you should use a high discount rate to value
positive cash flows and a low discount rate to value negative cash flows.
Is this statement correct? Should the sign of the cash flow affect the
appropriate discount rate?
2.
The errors in estimating beta are so great that you might just as well
assume that all betas are one. Do you agree?
3.
A Project has a forecasted cash flow of Rs.100,000 in year 1 and

Rs.120,000 in year 2. The risk free rate is 8 percent, the estimated risk
premium on the market is 10 per cent, and the project has a beta of 0.5
If you use a constant risk adjusted discount rate, what would be:
(a) The present value of the project?
(b) The certainty-equivalent cash flows in year 1 and 2?
(c) The ratio (at) of the certainty - equivalent cash flows to the expected
cash flows in years 1 and 2?
4.
(a) PQR Ltd has the following capital structure:

Security
Debt
Preferred stock
Common stock
Beta
value
Total market
0
0.20
1.20
100,000
40,000
200,000
What is the firms asset beta (that is, beta of its stock if it were all equity
financed)?
(b) Assume the Capital Asset Pricing Model is correct. What discount rate
should PQR Ltd. set for investments that expand the scale of its
operations without changing its asset beta? Assume any new
investment is all-equity financed. Plug in numbers that are reasonable
today. Specify two discount rates, one real and one nominal.

Brigham E.F., Financial Management Theory and Practice, Dryden Press,
New York.
Levy H., Sarnat M., Financial Decision Making under Uncertainty.
Academic Press, New York.
Sharpe W.F., Alexander G.J., Bailey J.V., Investments, Prentice Hall, New
Delhi.
20
UNIT 9 PROJECT EVALUATION UNDER
RISK AND UNCERTAINTY
Objectives
to provide conceptual understanding of state of certainty, risk and uncertainty,
to explain various methods of measuring project risk.
Structure
9.1 Concept of Certainty, Risk and Uncertainty
9.2 Measurement of Project Risk :
9.2.1
Probability Distribution
9.2.2
Sensitivity Analysis
9.2.3
Scenario Analysis
9.2.4
Monte Carlo Simulation
9.2.5
Decision Tree Analysis
9.3 Summary
9.1 CONCEPT OF CERTAINTY, RISK AND

UNCERTAINTY
In the preceding chapters we considered investment decision without referring
to the risk elements in projects. Rule for acceptance or rejection of projects
was that any project with positive net present value will be accepted and the
one with the negative net present value would be rejected. However, the mere
fact that the finance manager does not know before he makes the investment
as to what would be the gains from the project indicates that uncertainty is
attached to every investment project and different projects have varying
degrees of risk. Since the valuation of the firm is very likely to be affected by
the amount of risks assumed by it in accepting a project, a finance manager
must take cognizance of risk factor while taking investment decision and
additional adjustments must be made to cover risks.
Certainty is a state of nature which arises when outcomes in terms of cash
flows are known and determinate. For example, if one invests Rs. 20,000 in
five-yearly government bonds which is expected to yield 7% tax free returns,
then the return on the investment @ 7% can be estimated quite precisely.
Thus, the outcome is known to have probability of 1.
Risk involves situations in which the probabilities of cash flows occurring are
known and these probabilities are objectively or subjectively determinable. The
main attribute of risk situation is that the event is repetitive in nature and
possesses a frequency distribution. It is the inability to predict with perfect
knowledge the course of future events that introduces risk.
In contrast, when an event is not repetitive and is unique in character and the
finance manager is not sure about probabilities of cash flows themselves,
uncertainty is said to prevail. Uncertainty is subjective phenomenon. In such a
situation no observation can be drawn from frequency distributions. Practically
no generally accepted methods could so far be evolved to deal with situation of
21
Under Uncertainty
uncertainty while there are a number of techniques to deal with risk. As such,
the term risk and uncertainty will be used interchangeably in the following
paragraphs.
Measuring the Risk of a Project

Since prime objective of a finance manager is to maximize value of the firm
and the degree of risk in a project affects the value, he must measure degree
of risk in different projects under consideration. The following paragraphs throw
light on this aspect.
9.2 MEASUREMENT OF PROJECT RISK

9.2.1
Probability Distribution
The Problem of Project Risk

As noted above, riskiness of an investment project is the variability of its
cash flows from those that are expected. The greater the variability, the riskier
project is said to be. For each project under consideration, we can make
estimates of the future cash flows. Rather than estimate only the most likely
cash-flow outcome for each year in the future, we estimate a number of
possible outcomes. In this way we are able to consider the range of possible
cash flows for a particular future period rather than just the most likely cash
flow.
An Illustration
To illustrate the formunation of multiple cash-flow forecasts for a future period,
suppose that we had two investment proposals under consideration. Suppose
further that we were interested in making forecasts for the following alternative
states of the economy : deep recession, mild recession, normal, minor boom,
and major boom. After assessing the future under each of these possible states,
we estimate the followin net cash flows for the next year :
State of the Economy
Deep recession
Mild recession
Normal
Minor boom
Major boom
Annual Cash Flows Year1

Proposal A
(Rs.)
Proposal B
(Rs.)
3,000
3,500
4,000
4,500
5,000
2,000
3,000
4,000
5,000
6,000
We see that the dispersion of possible cash flows for proposal B is greater
than that for proposal A. Therefore, we might say that it is relatively riskier. To
quantify our analysis of risk, however, we need additional information. More
specifically, we need to know the likelihood of the occurrence of various states
of the economy. Assume that our estimate of the probability of a deep
recession occurring next year is 10 per cent, of a mild recession 20 per cent,
of a normal economy 40 per cent, of a minor boom 20 per cent, and of a
major economic boom 10 per cent. Given this information, we are now able to
formulate a probability distribution of possible cash flows for proposals A and
B, as follows :
22
We can graphically depict the probability distributions, as shown in Figure 9.1.

As we see, the dispersion of cash flows is greater for proposal B than it is for
proposal A, despite the fact that the most likely outcome is the same for both
investment proposals - namely Rs. 4,000. The critical question is whether
dispersion of cash flows should be considered. If risk is associated with the
probability distribution of possible cash flows, such that the greater the
dispersion, the greater the risk, proposal B would be the riskier investment. If
management, stockholders, and creditors are averse to risk, proposal A would
then be preferred to proposal B.
State of the
Economy
Proposal A
Project Evaluation Under

Risk and Uncertainty
Proposal B
Probability
Cash Flow
(Rs.)
Probability
Cash Flow
(Rs.)
Deep recession
.10
3,000
.10
2,000
Mild recession
.20
3,500
.10
3,000
Normal
.40
4,000
.40
4,000
Minor boom
.20
4,500
.20
5,000
Major boom
.10
5,000
.10
6,000
Expectation and measurement of Dispersion: A Cash-Flow Example

The probability distributions shown in Figure 9.1 can be summarized in terms of
two parameters of the distribution: (1) the expected value and (2) the standard
deviation.
Proposal A
.4
.3
.2
.1
0
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3000
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Proposal B
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Figure 9.1: Comparison of two proposals using probability distributions of

possible cash flows.
23
Under Uncertainty
The expected value of a cash-flow probability distribution for time period t, CFt,
is defined as
n
CFt = = (CFxt ) (Pxt )
x =1
where CFxt is the cash flow for the xth possibility at time period t, Pxt is the
probability of that cash flow occurring, and n is the total number of cash-flow
possibilities occurring at time period t. Thus, the expected value of cash flow is
simply a weighted average of the possible cash flows, with the weights being
the probabilities of occurrence.
The conventional measure of dispersion is the standard deviation which
completes our two-parameter description of a cash-flow distribution. The tighter
the distribution, the lower this measure will be; the wider the distribution, the
greater it will be. The cash-flow standard deviation at time period t, t , can be
expressed mathematically as where p represents the square-root sign. The
square of the standard deviation,
, is known as the variance of the
distribution.
n
t =
(CFxt - CF t ) 2 (Pxt )
x =1
The standard deviation is simply a measure of the tightness of a probability

distribution. It is a statistical measure of the variability of a distribution around
its mean. It is the square root of the variance. For a normal, bell-shaped
distribution, approximately 68 per cent of the total area of the distribution falls
within one standard deviation on either side of the expected value. This means
that there is only a 32 per cent chance that the actual outcome will be more
than one standard deviation from the mean. The probability that the actual
outcome will fall within two standard deviations of the expected value of the
distribution is approximately 95 per cent, and the probability that it will fall
within three standard deviations is over 99 per cent.
An Illustration. To illustrate the derivation of the expected value and standard
deviation of a probability distribution of possible cash flows, consider again our
previous two-proposal example.
Proposal A
Possible Cash
Flow, CFx1
(Rs)
Probability of
Occurrence, P x1
(CFx1) (P xt)
(Rs.)
(CF x1 ) CF 1 ) 2 (P x )
(Rs)
3,000
.10
300
(3,000 4,000) 2 (.10)
3,500
.20
700
(3,500 4,000) 2 (.20)
4,000
.40
1600
(4,000 4,000) 2 (.40)
4,500
.20
900
(4,500 4,000) 2 (.20)
5,000
.10
500
(5,000 4,000) 2 (.10)
= 1.00
= 4,000 = CF1
= 300,000 = s21
= (300,000)-5 = 548 = s1
24
Proposal B
Possible Cash
Flow, CFx1
(Rs)
Probability of
Occurrence, P x1
(CFx1) (P xt)
(Rs.)
2,000
3,000
4,000
5,000
6,000
.10
.20
.40
.20
.10
200
600
1600
1000
600
= 1.00
= 4,000 = CF 1
(CF x1 ) CF 1 ) 2 (P x)
(Rs)
(2,000
(3,500
(4,000
(5,500
(6,000
4,000) 2 (.10)
4,000) 2 (.20)
4,000) 2 (.40)
4,000) 2 (.20)
4,000) 2 (.10)
= 1,200,000 = s21
= (1,200,000)-5 = 1,095 = s1
The expected value of the cash-flow distribution for proposal A is Rs. 4000, the
same as for proposal B. However, the standard deviation for proposal A is Rs.
548, Thus, proposal B has a higher standard deviation, indicating a greater
dispersion of possible outcomes so we would say that it has greater risk.
Coefficient of Variation : A measure of the relative dispersion of a distribution
is the coefficient of variation (CV). Mathematically, it is defined as the ratio of
the standard deviation of a distribution to the expected value of the distribution.
Thus, it is simply a measure of risk per unit of expected value. For proposal, A,
the coefficient of variation is
CVA = Rs. 548/Rs. 4,000 = .14
While that for proposal B is
CVB = Rs. 1,095/Rs. 4,000 = .27
Because the coefficient of variation for proposal B exceeds that for proposal A,
it has a greater degree of relative risk.
Total Project Risk

If investors and creditors are risk averse and all available evidence suggests
that they are - it is necessary for management to incorporate the risk of an
investment proposal into its analysis of the proposals worth. Otherwise, capital
budgeting decisions are unlikely to be in accord with the objective of
maximizing share price. Having established the need for taking risk into
account, we proceed to measure it for individual investment proposal. But
remember that the riskiness of a stream of cash flows for a project can, and
often does, change with the length of time in the future that the flows occur. In
other words, the probability distributions are not necessarily the same from one
period to the next.
Activity 1
a) Define the following.
Certain Projects
Risky Projects
Uncertain Projects
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
25
Under Uncertainty
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
b) Try to know from some finance managers the methods that they have used
to incorporate risk while evaluating investment Projects.
...................................................................................................................
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9.2.2 Sensitivity Analysis

Intuitively, we know that most of the variables which determine a projects
cash flows are based on some type of probability distribution. We also know
that if a key input variable, such as units sold, changes, so will the projects
NPV. Sensitivity analysis indicates exactly how much NPV will change in
response to a given change in an input variable, other things remaining
constant. Sometimes called what if analysis, sensitivity analysis answers
questions such as these: What if sales are only 20,000 units rather than
25,000? What then will happen to NPV?
Sensitivity analysis begins with a base case situation based on expected input
values. To illustrate the procedure, let us consider the data given in Table 9.1,
where projected income statements for ABC Ltd. project were shown. The
values for unit sales, sales price, fixed costs, and variable costs are the
expected, or base case, values, and the resulting Rs. 11,465,923 NPV shown in
Table-9.2 is called the base case NPV. Now we ask a series of what if
questions: What if sales quantity is 20 per cent below the expected level?
What if sales prices fall? What if variable costs are 70 per cent of total
sales rather than the expected 65 percent? Sensitivity analysis is designed to
provide the decision maker with answers to questions such as these.
26
In a sensitivity analysis, we change each variable by specific percentages

above and below the base case value, calculate new NPVs, holding other
things constant, and then plot the derived NPVs against the variable in
question. Figure 9.2 shows the ABCs project sensitivity graphs for three of the
key input variables. The Table 9.3 gives the NPVs that were used to construct
the graphs. The slopes of the lines in the graphs show how sensitive NPV is to
changes in each of the inputs the steeper the slope, the more sensitive the
NPV is to the change in the variable. Here we see that the projects NPV is
very sensitive to changes in variable costs, fairly sensitive to changes in sales
volume, and relatively insensitive to changes in the cost of capital.

If we were comparing two projects, then, other things, held constant, the one
with the steeper sensitivity lines would be regarded as riskier-a relatively small
error in estimating variables such as the variable cost per unit or demand for
the product would produce a large error in the projects projected NPV. Thus,
sensitivity analysis provides useful insights into the relative riskiness of different
projects.
Table 9.1: ABC : Operating and Networking Capital Cash Flows, 1988-1993
Unit Sales
a
Sales Price
a
1988
1989
1990
1991
1992
1993
25000
25000
25000
25000
25000
25000
2000
2332
2472
2620
2777
2944
Net Sales
55000000 58300000 61800000 65500000 69425000 73600000
Variable Costsb
35750000 37895000 40170000 42575000 45126250 47840000
Fixed Cost
(Overhead)a
8000000
8480000
8988800
9528128 10099816 10705805
12500000
1250000
1250000
1250000
1250000
1250000
Depreciation
(building)d
400000
800000
720000
640000
560000
560000
Depreciation
(equipments)d
1425000
2090000
1995000
1995000
1995000
Earnings before
taxes
8175000
7785000
8676200
9511872 10393934 13244195
Taxes (46%)
3760500
3581100
3991052
4375461
4781210
6092330
Project net
income
4414500
4203900 46855148
5136411
5612724
7151865
Noncash
expensese
3075000
4140000
3965000
3885000
3805000
1810000
Cash flow from

operationsf
7489500
8343900
8650148
9021411
9417724
8961865
Addition to
NWCg
(396000)
(420000)
(444000)
(471000)
(501000) (8832000)
NWC cash flows 7093500
7923900
8206148
8550411
8916724 17793865
R&D expensesc
1988 estimate increased by an assumed 6 per cent inflation rate.
65 per cent of net sales.
If the project is accepted, ABC will amortize the Rs. 7.5 million of capitalized R&D
cost over 6 years, so it will have a noncash, deductible expenses for Rs. 7,500,000/6 =
Rs. 1,25,000 per year.
ACRS depreciation rates are follows

Year
Building
Equipment
1
5%
15%
2
10%
22%
3
9%
21%
4
8%
21%
5
7%
21%
6
7%
-
Sum of R&D expenses and depreciation on building and equipment.
Net income plus noncash expenses.
12 per cent of next years increase in sales. For example, 1989 sales are estimated at
Rs. 3.3 million over 1988 sales, so the addition to NWC in 1988 to prepare for the
1989 sales increase in 0.12 (3,300,000) = 396,000. The cumulative working capital
investment will be recovered in 1993.
27
Under Uncertainty
Table 9.2: ABC : Time Line of Consolidated Cash Flows

End-of-year net Cash Flows
1985
1986
1988
1987
1989
1990
1991
4650000 4000000 19600000 7093500 7923900 8206148 8550411
1992
1993
8916724 22961065
Payback period : 5.6 years from first outflow.

IRR : 20.4% versus a 10% cost of capital.
NPV : 11,465,923
PI : 1.5
a) Unit Sold
NPV (Rs.)
b) Variable Cost
Per Unit
NPV (Rs.)
11468
11468
-10% 25000 + 10%

(Base)
c) Cost of Capital
NPV (Rs.)
11468
-10% 1.43 + 10%

(Base)
-10% 0.10 + 10%

(Base)
Figure 9.2: Sensitivity Analysis for ABC (Thousands of Rupees)
Table 9.3
Net Present Value
Change from
Base Value
Units Sold (Rs.)
Variable Cost per Unit (Rs.)
Cost of Capital (Rs.)
-10%
7549
19416
13109
-5
9463
15442
12273
11468
11468
11468
+5
13472
7493
10692
+10
15476
3519
9946
9.2.3
Scenario Analysis
Although sensitivity analysis is widely used in industry, it does have limitations.

Consider, for example, a proposed coal mine whose NPV is highy sensitive to
changes in both output and sales prices. However, if a utility company has
contracted to buy most of the mines output at a fixed price per ton, plus
inflation adjustments, then the mining venture may not be very risky in spite of
the steep sensitivity lines. In general, a projects risk depends on both (1) its
sensitivity to changes in key variables and (2) the range of likely values of
these variables as reflected in their probability distributions. Because sensitivity
analysis considers only the first factor, it is incomplete.
A risk analysis technique which considers both the sensitivity of NPV to
changes in key variables and also the range of likely variable values is
scenario analysis. Here, the operating executives pick a bad set of
circumstances (low unit sales, low sales price, high variable cost per unit, high
construction cost, and so on) and a good set. The NPV under the bad and
good conditions would be calculated and compared to the exepcted, or base
case, NPV.
28
Table 9.4: Scenario Analysis Results Summary

Sales Volume
(Units)
Scenario
Sales
Price (Rs.)
NPV
(Thousands) (Rs.)
Worst case
5,000
1,700
22,421
Base case
25,000
2,200
11,468
Best case
40,000
2,700
50,093
As an example, let us return to the ABC project. Assume that ABC executives
are fairly confident in their estimates of all the projects cash flow variables
except price and unit sales. Further, suppose they regard a drop in unit sales
below 5,000, or a rise above 40,000 units, as being extremely unlikely. Similarly,
they expect the sales price as set in the marketplace to fall within the range of
Rs. 1,700 to Rs. 2,700. Thus, 5,000 units at a price of Rs. 1,700 defines the
lower bound or the worst case scenario, while 40,000 units at a price of Rs.
2,700 defines the upper bound or the best case scenario. Remember that the
expected, or base case, values are 25,000 units at a price of Rs. 2,200. Also,
note that the indicated sales prices are for 1988, with future years prices
expected to rise because of inflation.
To carry out the scenario analysis, we use the worst case variable values to
obtain the worst case NPV and the best case variable values to obtain the best
case NPV. Table 9.4 summarizes the results of the analysis. We see that the
base case forecasts a positive NPV; the worst case, a negative NPV; and the
best case, a very large positivie NPV. However, it is not easy to interpret this
scenario analysis, or to make a decision based on it. In our example, we can
say that there is a chance of losing on the project, but we cannot easily attach
a specific probability to this loss. Clearly, what we need is some idea about the
probability of occurrence of the worst case, the best case, the most likely case,
and all the other cases that might arise. This leads us directly to Monte Carlo
simulatioin, which is described in the next section.
9.2.4 Monte Carlo Simulation

Monte Carlo simulation, so named because this type of analysis grew out of
work on the mathematics of casino gambling, ties together sensitivities and
input variable probability distributions. However, simulation requires a relatively
sophisticated computer, coupled with an efficient financial planning software
package, while scenario analysis can be done using a hand-held calculator.
Table 9.5: Probability Distribution for ABCs Project Sales Price
Sales Price
Probability
(1)
(2)
Associated
Random Numbers
(3)
Rs. 1,700
0.05
00-04
2,000
0.20
05-24
2,200
0.50
25-74
2,400
0.20
75-94
2,700
0.05
95-99
The first step in a computer simulation is to specify a probability distribution for

each of the key variables in the analysis. To illustrate, suppose we have
estimated the probability distribution of the ABCs Project sales price as
represented by Columns 1 and 2 of Table 9.5. The expected sales price is Rs.
2,200, but the price can range from Rs. 1,700 to Rs. 2,700. The third column
gives a set of random numbers associated with each price estimate. Notice that
29
Under Uncertainty
in column 2, there is a 5 percent probability that sales price will be as low as

Rs. 1,700; therefore, 5 digits (0,1,2,3, and 4) are assigned to this price.
Twenty digits are assigned to a price of Rs. 2,000 and so on for the other
possible prices. Once the distributions and associated random numbers
have been specified for all the key variables - in other words, once a table
such as 9.5 has been set up for sales quantity, unit variable costs, construction
costs, and so on- the computer simulation can begin. These are the steps
involved:
1.
Computers have stored in them, or they can generate random numbers.

First, on Trial Run 1, the computer will select a different random number
for each uncertain variable. For example, it might select 44 for units sold,
17 for the sales price, and 16 for labour costs.
2.
Depending on the random number selected, a value is determined for each

variable. The 17 associated with the sales price indicates in Table 9.5 that
the appropriate sales price for use in the firs turn Rs. 2,000. Values for all
the other variables are set in like manner.
3.
Once a value has been established for each of the variables, the computer
generates a set of income statements and cash flows. These cash flows
are then discounted at the cost of capital (which may also be treated as a
random variable), and the result is the net present value of the project on
the computers first run.
4.
The NPV generated on Run 1 is stored in memory, and the computer then
goes on to Run 2. Here a different set of random numbers, and hence
cash flows, is used. The NPV generated in Run 2 is again stored, and the
model proceeds on for perhaps 500 runs. Modern computers can complete
this operation almost instantaneously for a vary low cost.
5.
The stored NPVs (all 500 of them) are then printed out in the form of a
frequency distribution, together with the expected NPV and the standard
deviation of this NPV.
Using this procedure, we can perform a simulation analysis on ABCs project.

As in our scenario analysis, we have simplified the illustration by specifying the
distributions for only two key variables, sales quantity and sales price. For all
the other variables, we merely specify their expected values.
In our simulation analysis, we assume that sales prices can be represented by a
continuous normal distribution. Further, suppose that the expected value is Rs.
2,200 and that the actual sales price is very unlikely to vary by more than Rs.
500 from the expected value, i.e., fall below Rs. 1,700 or rise above Rs. 2,700.
We know that in a normal distribution, the expected value plus or minus three
standard deviations will encompass virtually the entire distribution. Thus, for
sales price, three standard deviations should equal Rs. 500, so as a reasonable
approximation, we assume that ssales price = Rs. 500/3 = Rs. 166.67 = Rs. 167.
Therefore, we tell the computer that the sales price distribution is a normal
distribution with an expected value of Rs. 2,200 and a standard deviation of
Rs. 167.
Next, we assume that the estimated distribution of unit sales is also symmetric.
Further, the expected value is 25,000 units, but sales could be as high as 40,000
units, given our production capacity, but if public acceptance is poor, sales could
be as low as 10,000 units. We could have again specified a normal distribution,
but in this case, management feels that a triangular distribution, with an
expected value of 25,000 a lower limit of 10,000, and an upper limit of 40,000
is most appropriate.
30
Table 9.6: Summary of Simulation Result

Probability of NPV or IRR being Greater than the Indicated Value
(Thousands of Rupees)
0.90
NPV -1860
IRR 0.080
0.80
1825
0.119
0.70
5144
0.151
Mean
11228
0.60
0.50
0.40
8397 11393
13683
0.179 0.204
0.221
NPV Sample Statistics
Standard Deviation
10124
0.30
16516
0.242
0.20
0.10
19639 25286
0.263 0.299
Skewness
0.1
We used the Interactive Financial Planning System (IFPS) to conduct a

simulation analysis of the project. Then the key results of our simulation are
presented in Table 9.6. The top line of the table shows the cumulative
probability distribution. Suppose someone asks, What is the probability that the
project will have an NPV greater than Rs. 5,000,000? The answer is, About
70 per cent, because NPV = 5,000,000 lies between 70 and 80 percent but
much closer to 70 per cent.
The primary advantage of simulation is that it shows us the range of possible
outcomes, with attached probabilities, not just a point estimate of the NPV. The
expected NPV can be used as a measure of the projects profitability, while the
variability of this NPV as measured by sNPV can be used to measure risk. To
illustrate, the ABCs projects expected NPV is Rs. 11,288,000 and the standard
deviation of this NPV, as calculated by the computer in the simulation, is sNPV
= Rs. 10,124,000. If we assume that ABCs average project has an expected
NPV of Rs. 975,000 and sNPV = Rs. 370,000, then we can calculate the
coefficient of variation (CV) for this project and compare it with the CV of the
average project as follows:
Coefficient of variation = CV
CVProject =
NPV
Standard deviation
=
Expected NPV
Expected value
Rs.10,124,000
= 0.90
Rs.11,228,000
CVAverage Project =
Rs.370,000
= 0.38
Rs.975,000
Since the coefficient of variation is a standardized risk measure, it can be used

to compare the relative riskiness of projects which differ in size. We see that
the CV of this project is much larger than the CV of ABC average project. To
account for risk, ABC adds two percentage points to the cost of capital of such
high-risk projects as this particular project. Our analysis thus far was based on
ABC average cost of capital as 10 per cent. Therefore, we must now
reevaluate the project with a project cost of capital of 12 per cent. When
evaluated at a cost of capital of 12 per cent, the NPV of the project, using
expected values of all variables, is Rs. 8,533,722. Thus, even at the high-risk
cost of capital, the office robot project has a large positive NPV. Thus, it
appears to be acceptable.
Activity 2
A) Write two points of difference between Sensitivity Analysis and Scenario
Analysis of determination degree of risk in investment projects.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
31
Under Uncertainty
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
B) List out the five steps involved in Monte Carlo Simulation of Analyzing risk
in investment projects.
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
...................................................................................................................
9.2.5
Decision Tree Analysis
Many capital budgeting decisions are not made at a single point in time. Rather,
they consist of two or more sequential decisions, which are made as the
project progresses through stages. For example, suppose ABC is considering
the production of a product X for some other company. The capital budgeting
decision for this project will be broken down into three stages, as set forth in
Figure 9.3.
Stage 1 : At t = 0, conduct a Rs. 500,000 study of the market potential for
this product X.
Stage 2 : If it appears that a sizable market for this product X does exist, then
at t = 1, spend Rs. 1,000,000 to design and fabricate several prototype of
Product X.
Stage 3 : If reaction to the Prototype Product X is good, then at t = 2, build a
production plant with a net cost of Rs. 10,000,000. If this stage were reached,
the net payoff is expected to be either Rs. 13,000,000 or Rs. 16,000,000
depending on the state of the economy, competition, and so forth.
t=0
Time
t=1
t=2
t=3
(1)
(2)
(3)
(4)
Conditional
Probability
(5)
NPV
NPV Product
(6)
(5) x (6) = (7)
0.24
2347
563
0.24
94
23
0.32
(1409)
(450)
0.20
(500)
(100)
(16000)
0.5
(1000)
0.6
(1000)
0.8
(500)
0.5
13000
0.4
Stop
0.2
Stop
1.00 Expected NPV =
32
Figure 9.3: ABC Decision Tree (Thousands of Rs.)
Rs. 36
The diagram in Figure 9.3 is called a decision tree, a procedure often used to
analyze multi-stage, or sequential, decisions. A decision tree lays out the
analysis like the branches of a tree. In Figure 9.3, we assume that as on year
goes by between decisions and that a single net cash inflow from the project
would occur one year after the final decision to go into production. Each circle
represents a decision points, or stage. The rupee value to the left of each
decision point represents the investment required if the decision is go at that
point. Each diagonal line represents a branch of the decision tree, and each
branch has an estimated probability. For example, if ABC decides to go with
the project at Decision Point 1, it will have to spend Rs. 500,000 on a
marketing study. Management estimates that there is a probability of 0.8 that
the study will produce favourable results, leading to the decision to move on to
Stage 2, and a 0.2 probability that the marketing study will produce negative
results, indicating that the project should be cancelled after State 1. If the
project is stopped here, the cost of ABC will be Rs. 500,000 for the initial
market study.

If the marketing study is undertaken, and if it does yield positive results, then
ABC will go on to Decision Point 2 and spend Rs. 1,000,000 on the product.
Managemetn estimates (before even making the initial Rs. 500,000 investment)
that there is a 60 per cent probability that product will be useful and a 40 per
cent probability that it will not be useful. If the management accept the product,
then company would spend the final Rs. 10,000,000 while if the management do
not like it, the project would be dropped. Finally, if ABC does go into
production, the payoff is assmed to be either Rs. 16,000,000 or Rs. 13,000,000,
with each outcome having a 50 per cent probability. (Although we used only
two production outcomes for simplicity, we could have used any number of
outcomes or even a continuous distribution of outcomes.)
Column 5 of Figure 9.3 gives the conditional probability of occurrence of each
final outcome. Each conditional probability is obtained by multiplying together all
probabilities on a particular branch. For example, the probability the ABC will, if
Stage 1 is undertaken, move through Stage 2 and 3, and that a strong economy
will produce a Rs. 16,000,000 net cash inflow, is (0.8) (0.6) (0.5) = 0.24
Column 6 of Figure-9.3 gives the NPV of each final outcome. ABC has a cost
of capital of 10 per cent, and management assumes initially that all projects
have average risk. The NPV of the top (most favourable) outcome is about
Rs. 2,347,000:
NPV =
Rs. 16,000,000
(1.10) 3
Rs. 10,000,000
(1.10) 2
Rs. 1,000,000
(1.10)1
= Rs. 500,00
Other NPVs were calculated similarly

Column 7 of Figure 9.3 gives the product of the NPVs in Column 6 times the
probabilities in Column 5. The sum of the NPV products is the expected NPV
of the project. Based on the expectations set forth in Figure 9.3, and a cost of
capital off 10 per cent, the expected NPV is approx. Rs. 36,000.
Since the expected NPV is positive, should ABC initiate Stage-1? Not
necessarily, since management only assumed that the project is of average risk,
and hence used the unadjusted cost of capital to evaluate it. However, ABC
must now reconsider and decide whether this project is more, less, or as risky
as an average project. The decision tree provided a distribution of NPVs,
similar to the one we obtained using simulation analysis for the single-stage
project. With this project, there is a probability of 0.52 of losing money and a
probability of 0.32 of losing almost Rs. 1.5 million. With those high loss
33
Under Uncertainty
probabilities, and the small NPV relative to the amount required to undertake
the project, chances are good that it would be rejected.
9.3 SUMMARY
Risk involves situations in which the probabilities of cash flow occuring are
known and are objectively or subjectively determinable. The event is repetitive
in nature and the inability to accurately predict the future course of events
introduces risk. In contrast when an event is not repetitive in nature and the
probability of occurance is not determinable uncertainity is said to prevail.
There are sevral techniques to measure project risk. The most basic and widely
used technique is Standard Deviation. Another technique is Sensitivity Analysis
which measures the effect of change of variables on NPV of the project.
A risk analysis technique which considers both the sensitivity of NPV to
changes in key variables and also the range of likely variables value is Scenario
Analysis. Monte Carlo Simulation ties together sensitivities and input variable
probability distribution. Another technique is that of Decision Tree Analysis
which is used when Capital Budgeting Decisions are dependent on the outcome
of a precedent event.

1. Why should we be concerned with risk in capital budgeting? Is the
standard deviation an adequate measure of risk? Can you think of a better
measure?
2. If project A has an expected value of net present value of Rs. 20,000 and a
standard deviation of Rs. 4000, is it more risky than project B, whose
expected value is Rs. 14000 and standard deviation is Rs. 3000? Explain.
3.
a) In a probability tree approach to project risk analysis, what are initial,

conditional, and joint probabilities?
b) What are the benefits of using simulation to evaluate capital investment
projects?
4. Naughty Pine Lumber Company is evaluating a new saw with a life of two
years. The saw costs Rs. 3000, and future after-tax cash flows depend on
demand for the companys products. The tabular illustration of a probability
tree of possible future cash flows associated with the new saw is as
follows:
Year 1
Year 2
Initial
Probability
P (1)
Net
Cash
Flow
(Rs.)
.40
1500
Conditional
Probability
P (2/1)
Net
Cash
Flow
(Rs.)
.30
.40
.30
1000
1500
2000
1
2
3
2000
2500
3000
4
5
6
Branch
1.00
.60
34
1.00
2500
.40
.40
.20
1.00
a)
What are the joint probabilities of occurrence of the various branches?
b)
If the risk-free rate is 10 per cent, what is (i) the net present value of
each of the six complete branches and (ii) the expected value and standard
deviation of the probability distribution of possible net present values?
c)
Assuming a normal distribution, what is the probability that the actual net
persent value will be less than zero? What is the significance of this
probability?
5.
XYZ Inc., can invest in one of two mutually exclusive, one-year projects
requiring equal initial outlays. The two proposals have the following discrete
probability distributions of net cash inflows for the first year :
Project A

Project B
Probability
Cash Flow
Probability
Cash Flow
.20
.30
.30
.20
2000
4000
6000
8000
.10
.40
.40
.10
2000
4000
6000
8000
1.00
1.00
a) Without calculating a mean and a coefficient of variation, can you

select the better proposal, assuming a risk-average management?
b) Verify your intuitive determination.

Brealy R., Myers, Principles of Corporate Finance, McGraw Hill
Company.
VanHorne J.C., J.M. Wachowicz, Fundamentals of Financial Management,
Prentice - Hall.
Stern J.M., D.H. Chew (Jr.), The Revolution in Corporate Finance Basil
Blackwell.
Srivastava, R.M., Financial Management and Policy, Himalaya Publishing
House, 2003, Chapter 12.
35
Under Uncertainty
UNIT 10 RISK ANALYSIS IN INVESTMENT
DECISIONS
Objectives
The major objective of this unit is to discuss and show the application of some
advanced techniques of risk analysis in investment decisions.
Structure
10.1 Introduction
10.2 Stochastic Goal Programming Model
10.3 Game Theory
10.4 Expected Utility Approach
10.5 The Expected Utility Model
10.6 Summary
Appendix : A Goal Programming Model for Capital Budgeting
10.1 INTRODUCTION
Most of the literature on capital budgeting decisions has been woven around
the assumption of certainty and single goal. In unit two of this block, we have
discussed various techniques of risk analysis presuming that true certainty in
expected cash flow and the required rate of return do not exist in the real
world. However, we have continued to assume that a company has a single
objective, i.e., higher rate of return. As we know, in real world not only we
are faced with lot of uncertainty but companies tend to have multiple goals like
rate of return, sales, employment, etc. The multi-objective criteria and the
problem of risk and uncertainty could be taken care of with the help of a
stochastic goal programming model by incorporating priority coefficients for
different objectives.
10.2 STOCHASTIC GOAL PROGRAMMING MODEL

Assumptions
1.
Random variables ui are normally distributed with mean 0 and variancecovariance matrix S.
2.
a is a matrix of estimates of some unknown parameters, and it has rank >q.
3.
The non-singular variance-covariance matrix S is known since only nonsingular matrices have ordinary inverses.
Given the goals (x1, x2, , xn)we analyse the goals such that
(x1, x2, , xn) = bi
where b represents given goals.
(1)
In order to convert into a real linear functional, this may be written as:
(x1, x2, , xn)= a1x1 + a2x2 + ... + anxn = bi (2)
36
where a1, a2, ... , an are any real numbers such that is a real linear
functional.
In order to simplify the notation, we use the ideas of matrix algebra. Let x be
a column vector with components x1,x2,..., xn and let a be a row vector with
components a1, a2, ..., an then the (2) may be represented equivalently by
Axi = bi
(3)
Risk Analysis in Investment

Decisions
If a matrix A has an ordinary inverse A-1 then we have a unique solution x to

Axi = bi which is given by xi = a-1bi. Geometrically, the transformation defined
by A transforms xi into bi, whereas the transformation defined by A-1
transforms bi precisely back into xi. Therefore, if the matrix in our problem of
goal analysis has its ordinary inverse, then the solution sub-goal which attains
the given goal can be obtained by using the ordinary inverse of the matrix.
When a matrix has the ordinary inverse, (i.e. when a matrix is non-singular), it
is identical with generalized inverse of matrix.
By the generalized inverse matrix the possible solution to axi=bi is given by
Bi = axi
(4)
In the presence of linear constraints on the variables, i.e.
Bxi h,
(4.1)
xi 0.
(4.2)
The problem may be formulated in a linear programming format as follows:
Minimise
z =(Pid+t + Pid-i)
-
(5)
axi + d t - d i = bi
(5.1)
xi , d-2 d+i 0
(5.2)
when the assumption of certainty is dropped, we formulate the problem into a

generalized inverse matrix form as follows:
bi = axi + ui
(6)
in the presence of linear constraints on the variables, i.e.
Bxi < h
xi > 0
(6.1)
(6.2)
where bi refers to a given set of goals and xi are linearly related to bi

variables and ui are random variables.
The stochastic equation bi = axi + ui has the form of a linear model in reduced
form if we consider the goals bi as endogenous and jointly determined and
variable ai as exogenous variables.
Therefore, it follows from the assumptions that bi is normally distributed with
means (ax) and variance-covariance matrix S, i.e.
(b 1, b2, ... bq) = 2II)q-/2 | S |- e-q/2
(7)
where the quadratic form Q is defined as
Q = (b-ax) S -1 (b-ax)
(8)
A simple criterion function analogous to that used in the goal programming

model may be interpreted by analysing the statement b*t = axi as follows:
Let B* be an appropriately defined region which covers the point b. Such that
b e B*. Then one chooses the goals xi for which the probability that the
random vector bi = axi + ui will lie inside the region B* is maximized.
37
Under Uncertainty
Assumption I suggests that B* should be taken to be falling in defined region

and centred at b* of the form :
Q* c2
(9)
Where Q* is the quadratic form
Q* = (b b*) S-1 (b-b*)
(10)
We know that if y is normally distributed and S is non-singular then quadratic

form (10) has the chi-square distribution with q degrees of freedom. Thus B*
can be interpreted as confidence region for b at level a because if we choose
a set of goals x such that E(b) = ax = b* then the probability of b falling in
the region B* is given by a. Region B* may be restricted to be of the form
Q* = c2.
Therefore, the stochastic goal programming model may be formulated as
follows:
Minimize
Z=(K+xAx + 2px)
(11)
subject to
Bxi < h
Xi > 0
(11.1)
(11.2)
where K = b* S -1 b*, A = a S -1 a, p = a S-1 b* and A is (mxn) positive

definite if q=n, and semi positive definite if q < n.
The above stochastic goal programming models equivalent to a quadratic
programming problem in standard form since the constraints (11.1) and (11.2)
are linear, and the problem can be solved by any of the existing algorithms.
The above stochastic goal programming (11) may be formulated into a linear
programming format as follows:
Minimize
z =(Pidi+t +- Pid-i)
(12)
subject to
axi + uixi + d-i - d+t = bi
xi , d-i, d+i > 0
(12.1)
(12.2)
where Pi refer to priority coefficients and di refer to positive and negative

devotional variables.
Using (12), Lorie and Savage modified problem may be formulated under the
conditions of uncertainty as follows:1
Minimize
z=
p1d-1 + p2d-2 + p3d-3 + p2d-4 +4 p2d-5 +p4d-6
p4d-7 + p5d+4 + p6d+6 + p6d+7

Subject to
(A) Present value of investment goal
14x1 + 17x2 + 17x3 + 15x4 + 40x5 + 12x6 + 12x7 +
10x8 + 12x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-1 = 32.4
38
See Appendix for detail of Lorie and savage problem.
(13)
(13.1)
Decisions
(B) Budget ceiling goals

12x1 + 54x2 + 6x3 + 6x4 + 30x5 + 6x6 + 48x7 +
36x8 + 18x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-2 = 50.0
(13.2)
3x1 + 7x2 + 6x3 + 12x4 + 35x5 + 6x6 + 4x7 +

3x8 + 3x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-3 = 20.0
(13.3)
(C) Sales goals

14x1 + 30x2 + 13x3 + 11x4 + 53x5 + 10x6 + 32x7 +
21x8 + 12x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-4 d+4 = 70.0
(13.4)
15x1 + 42x2 + 16x3 + 12x4 + 52x5 + 14x6 + 34x7 +

28x8 + 21x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-5 = 84.0
(13.5)
(D) Employment goals

10x1 + 16x2 + 13x3 + 9x4 + 19x5 + 14x6 + 7x7 +
15x8 + 8x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-6 d+6= 40.0
(13.6)
12x1 + 16x2 + 13x3 + 13x4 + 16x5 + 14x6 + 9x7 +

22x8 + 13x9 + u1x1 + u2x2 + u3x3 + u4x4 + u5x5 +
u6x6 + u7x7 + u8x8 + u9x9 + d-7 d+7 = 40.0
(13.7)
x1, x2, ..., x9, d1, d2, ..., dn 0.
(13.8)
When ui = 0), (where i = 1,2,..., N=9)
Computational Procedure
The Wolfes algorithm of a simplex type of a quadratic problem which apply to
the stochastic goal programming problem formulated for capital budgeting
decision under uncertainty is of the following form:
Let the variables of the problem constitute the n vector x = (x1, ... xn) where
x is to be taken to be a column vector, with n x 1 matrix. If A be an m x n
matrix and b an m x 1 the linear constraints of the problem for l 0.
Minimize f (l,x) = lpx 1/2x cx
May be specified as x ), Ax = b
(14)
Where
Xi 0(j = 1, ..., n)
n
S aij xj = bi(i = 1, ..., m).
j=1
The conditions that the n vector x solve the problem for l > 0 may be written
as:
Ax=b
Cx V + Au+ pu + pl = 0
(15)
x 0, v 0
39
Under Uncertainty
or in the detached coefficient form as

x0 v0
(16)
= b
-I
=o
Constituting m x n equations in 2 n non-negative variables and m unrestricted

variables and where l is not considered as a variable.
Let z1,and z2 and w be respectively n-, x- and m component vectors.
An initial basis for this system can be formed from the coefficients z1,z2 and w
since b 0 by using the simplex method to minimize
Swt = 0.
i
Keeping v and u zero, we would discard w and unused components z1, z2; let
the remaining n components be denoted by z and their coefficients by E. The
solution of the system would be:
Ax = b
Cx - v + Au + Ez = -p
(17)
X, v,z 0.
Given a basis and basic solution satisfying (17), vx = 0 and
n
S Zk > 0, make one change of basis in the simplex procedure
K=1
minimizing the linear form
n
S
Xk
K=1
(18)
under the side condition for k=1, ..., n, if xk is in the basis, we do not admit
vk; and if vk is in the basis, we do not admit xk.
n
If S Zk > 0, then we repeat the step (18) and the form will
K=1
vanish in subsequent iterations yielding z=0. The x part of the terminal basic
solution in a solution of the quadratic programming for l.
The computational procedure, when the number of constraints is larger may be
presented in the following manner alongwith line discussed above:
Let the constraints be
A11x 1 + A 12x 2
A21x1 + A22x2 + y 2
A31x1 + A32x2 + y 3
X1, y2, y3 > 0
40
= b1
= b2
= b3
(20)
the new system of linear constraints (corresponding to 16) will be:
x1 0
A 11
A 21
A 31
C
x2
A 12
A 22
A 32
y20
y30
v10
u1
u20
u30
A 11
A12
A21
A22
A31
A32
I
-I
-I

Decisions
l
=b 1
=b 2
=b 3
p1=0
p2=0
The algorithm would proceed the same way as in (18) above. If (x1) k is in
the basis, we do not admit (v-1)k, and vice versa ; if (y-2)k is in the basis we
do not admit (u3)k, and vice versa.
However, if number of variables involved or the number of iterations required is
large, computer package programme may be used to arrive at the solution.
Our emphasis here has primarily been to suggest a model of stochastic goal
programming for capital budgeting decision problem under risk and uncertainty
and the computational procedure for its solution.
10.3 GAME THEORY

Since game theory can be used as a technique for dealing with cases of
complete ignorance of the initial probabilities of possible outcomes, the reader
might be inclined to pitch his hopes for useful guidance a little higher. Again,
he is likely to be disappointed. But before pronouncing judgement we shall
illustrate with one or two simple examples the relevant techniques known as the
two-person zero-sum game, so called for the rather obvious reason (1) that
the game is played between two persons or groups, one of which may be
nature, and (2) that there are no mutual gains to be made; the gains to one
party being exactly equal to the losses suffered by the other party.
Consider first a reservoir which is full at the beginning of the season and can
be used both for irrigation and for flood-control. Without any prior knowledge
of whether or not a flood will occur, a decision is required on the amount of
water to be released. If a little water is released now it will be good for the
harvest, but it will be ineffectual as a contribution to preventing future flood
damage. If, instead, a lot of water is released now it will make flood damage
virtually impossible, but it will damage the harvest to some extent.
Now the amount of water that can be released from the reservoir can range,
in general, from nothing at all to the whole lot. As for the flood, if it occurs it
can be either negligible or highly destructive. In order to illustrate the principle,
however, we can restrict ourselves to two possible outcomes, (b1) full flood and
(b2) no flood. The options open to the decision-maker are also to be restricted
for simplicity of exposition : they will be (a1)release one-third of the water in
the reservoir, a2 release two-thirds of the water in the reservoir, and (a3)
release all the water in the reservoir. In addition to the possible states of
nature, (b1) and (b2), and the options open to the decision maker, (a1), (a2), and
(a3), we are also assumed to have a clear idea of the quantitative result
corresponding to the particular outcome and the option adopted. If, for
example, a decision is taken to release two-thirds of the reservoir, which is
option (a2), and a full flood, (b1), happens to occur, the net benefit that is the
value of the harvest less the value of the damage done by the flood is
assumed to be known. In this example we shall assume it is equal to
Rs.140,000. Again, if instead we choose the (a3) option, that of releasing all
the water, the net benefit that arises if the full flood (b1) occurs is assumed
equal to Rs.80,000. Since there are three options, or strategies, and two
41
Under Uncertainty
possible occurrences, or states of nature, there will be altogether six possible

outcomes each identified by a net benefit figure. The scheme is depicted in
Table 10.1 below.
Table 10.1: Net benefit figures for various options and various outcome
a1
a2
a3
b1
Flood
(Rs.)
b2
No Flood
(Rs.)
130,000
140,000
80,000
400,000
260,000
90,000
A glance at the Table will convince the reader that, provided the six figures
above are all accepted as correct estimates of net benefits, option a3
requiring the release of all the water in the reservoir will never be adopted.
Whether b1 or b2 occurs the net benefits of adopting the a3 option will be
lower than those of either a1 or a2. In the Jargon, option a3 is dominated by
the other options, a fact that is revealed by the figures in the a1 row
(Rs.130,000 and Rs.400,000) and those in the a2 row (Rs.140,000 and
Rs.260,000), both sets of figures being larger than the a3 row figures
(Rs.80,000 and Rs.90,000). We could then save some unnecessary calculation
by eliminating the dominated option a3, since there are no circumstances in
which it would pay to adopt it. Nevertheless we shall retain it in this simplified
example, as the additional exercise will be useful while the additional calculation
will be slight complex.
Given no information other than in Table 10.1 we could employ either of two
standard methods to produce a decision: a maximin procedure and a minimax
procedure. We shall only illustrate the former for understanding the application
of the game theory.
The maximum procedure : If he looks along the first row of Table 10.1
showing the net revenues, Rs.130,000 and Rs.400,000, corresponding to each of
the two possible alternative states of nature, b1 and b2, when the decisionmaker chooses option a1, it will be realized that the worst that can happen is
the occurrence of b1, yielding a revenue of only Rs.130,000. Assuming that the
decision-maker is a conservative person, he will want to compare this worst
result, or minimal net revenue, that he can obtain from choosing a1 with those
minimal he might obtain if instead he adopts the a2 or a3 option. Now the
choice of a2 or b2 occurs respectively. He can then be sure of at least
Rs.140,000. Similarly if he chooses option a3 he can be sure of obtaining at
least Rs.80,000. These three row minima, Rs.130,000 for a1, Rs.140,000 for a2,
and Rs.80,000 for a3 are all shown in the third column of Table 10.2 which is
the same as Table 10.1 except for the addition of two columns.
Table 10.2: The Maximum Procedure
a1
a2
a3
42
b1
b2
Row minima
Maximin
(maximum of
row minima)
Rs.
130,000
140,000
80,000
Rs.
400,000
260,000
90,000
Rs.
130,000
140,000
80,000
Rs.
140,000
Down this third column he reads off the worst possible outcome corresponding
to each option. If he chooses a1, he can be sure of not getting less than
Rs.130,000. If he chooses a2, he can be sure of not getting less than
Rs.140,000. If he chooses a3, he can be sure of not getting less than
Rs.80,000. It will then occur to him that if he chooses any option other than
a2 he might get less than Rs.140,000; for example, if having chosen a1, b1
occurs, he will receive only Rs.130,000, whereas if he chooses a3 he will
receive only Rs.80,000 or Rs.90,000 according as event b1 or event b2 occurs.
The largest net revenue he can be sure of obtaining is, then Rs.140,000. The
maximin principle, therefore, requires that he chooses option a2 (releasing twothirds of the water in the reservoir), and assure himself of no less than
Rs.140,000.

Decisions
The guiding idea has been to pick out the maximum figure from column three,
which column contains the minimum possible net revenues corresponding to
each option. Hence the figure chosen Rs.140,000 in column four of Table 10.2
is spoken of as the Maximin.
One feature of the above example is that capital costs are taken to be constant
for each of the alternative options. This enables us to compare directly the net
revenuesannual revenues less annual loss in each of the first two columns.
If we assume instead that revenues are fixed and that costs alone vary
according to the decision made and the event which takes place, we can go
through the same sort of exercise.
An example would be the installation of a boiler in a works. Again we can
suppose three options: a1, installing a coal-fired boiler, a2, installing an oil-fired
boiler, or a3, installing a dual boiler, one that could be switched from using coal
to using oil, and vice versa, at negligible cost. Three possible occurrences are
to be considered: b1, coal prices rise relative to oil prices over the next twenty
years by an average of 25 per cent; b2, the reverse of this; and b3, the
relative prices of the two fuels remain on the average unchanged.
The outcomes of the relevant calculations are summarized in Table 10.3, the
figures being the present discounted values (in thousands of rupees) of the
streams of future costs associated with each option for each of the three
possible outcomes.
Table 10.3: Net benefit figures for various options and outcomes;
the maximum procedure
a1
a2
a3
b1
b2
b3
Row Maximum
Maximin
-13.0
-11.3
-12.8
-12.0
-12.5
-12.8
-12.0
-11.3
-12.8
-13.0
-12.5
-12.8
-12.5
By convention costs are to be regarded as negative revenues, so the figures in

Table 10.3 are all negative. Looking along the a1 row the worst outcome is 13.0. If a1 is chosen and b1 should occur, the cost would be 13. (13 is the
highest absolute figure in the row but, seen as a negative revenue and
considered algebraically, -13 is less than -12. Thus -13 is the lowest figure in
the row.) The largest costs, or the smallest gains, corresponding to options a2
and a3 are, respectively, -12.5 and -12.8-, which figures are entered in the
fourth column. Of these row minima, the maximum (or least cost) is -12.5
corresponding to option a2 which, on the maximum principle, would be the one
to be chosen. Having chosen a2, we can be sure that the cost to which the
firm can be subjected cannot exceed 12.5, this cost would be incurred if event
b2 took place. If, however, event b1 or b3 occurred the cost would be only
11.3.
43
Under Uncertainty
10.4 THE EXPECTED UTILITY APPROACH

Here we will develop a model for consumption investment decisions by
individual under conditions of uncertainty. The general problem can be
described as follows:
Consider an individual who must make a consumption - investment decision at
each of r discrete points in his lifetime. At the first decision point he has a
quantity of wealth W1 that represents the maximum possible level of
consumption during time period 1. At the beginning of period 1, W1 must be
split between current consumption C1 and investment h1=W1-C1.
At the beginning of period 2, the individuals wealth level is
_
_
W2 = h1 (1 + R2) = (W1 - C1) (1+R2)
R2 is the % expected rate of return in period 2. R2 is a random variable,
therefore, W2 is also a random variable.
At the beginning of period 2, W2 must in turn be allocated to consumption and
investment, and the consumption - investment decision problem is faced at the
beginning of each subsequent period until period r, the last period of the
individuals life at which time the entire available wealth is consumed.
The individual is assumed to derive satisfaction only from consumption and his
problems is to map out a consumption investment strategy that maximizes the
level of satisfaction provided by anticipated consumption over his lifetime.
Under uncertainty the decision problem is of course complicated by the fact
that the actual lifetime consumption sequence is to some extent unpredictable,
because as indicated above the wealth levels produced through time by
any given investment strategy are usually random variables. Thus in order to
solve the individuals sequential consumption - investment problem, we need a
theory of choice under uncertainty that defines the criteria that the individual
uses in choosing among different probability distributions of lifetime
consumptions.
10.5 THE EXPECTED UTILITY MODEL

The theory of choice under uncertainty that we apply to the consumption
investment problem is the Expected Utility hypothesis.
In general terms, the expected utility hypothesis states that when faced with a
set of mutually exclusive actions, each involving its own probability distributions
of outcomes the individual behaves as if he attaches numbers called, purely
for convenience, utilities to each outcome and then chooses that action whose
associated probability distribution of outcomes provides maximum expected
utility.
In the r period consumption - investment problem, an outcome is a complete
sequence of lifetime consumption Cr = (C1,C2,...Cr), and an action is a r
period consumption - investment strategy that produces a probability distribution
for different possible lifetime consumption sequences. But because the
consumption investment problem is just one possible application of the expected
utility model, first see the model in its most general form.
44
Since we are confronted here with how the individual ranks outcomes and
probability distribution of outcomes, just as behaviour in conformity with the
ordinary utility model. So we, have five axioms that can help produce a better
understanding of the model.

Decisions
The Axiom System

The set of axioms we use is as follows:
Axiom 1 : (Comparability) The individual can define a complete preference
ordering over the set of prospects in S; that is, for only two prospects X and Y
in S, he can say that X>Y and Y>X or X ~ Y.
Axiom 2 : (Transitivity) The ordering of prospective assumed in Axiom 1 is
also completely transitive. For example X>Y and Y>Z imply X>Z or X~Y and
Y~Z and so on.
Axiom 3 : (Strong Independence) The rankings of two prospects are not
changed when each is combined in the same way into a a gamble or
probability distribution involving a common third prospect.
If X~Y, then for any third prospect Z in S,G(X,Z:) ~ G(Y,Z:). Here
G(X,Z:) represents a gamble, that is, a random prospects, in which the
individual gets either X, with probability X, or Z, with probability 1-, and G(Y,
Z:) likewise represents a gamble that produces either Y or Z, with probabilities
and 1-. We also assume that if X>Y, then G(X,Z: ) > G(Y,Z:); or if X
Y then G(X,Z:) G(Y,Z:).
Axiom 4 : If the prospects X, Y and Z are such that either X>YZ or
XY>Z, there is a unique such that Y~G(X,Z:).
Axiom 5 : If XYZ and XUZ, and Y~G(X,Z:1) and U~G(X,Z:2) then
1 > 2 implies Y>U and 1 = 2 implies Y~U.
Intuitively it is clear that ranking random prospects which are just probability
distributions of elementary prospectus, according to expected utility requires a
utility function in which the differences between the utility levels assigned to
different elementary prospects have some meaning; that is, if the utility of a
random prospect is just the expected or average value of the separate utilities
of each of its component then elementary prospects differences in utility levels
must have meaning.
10.6 SUMMARY
As the number of variables and number of years in planning horizons increases
it becomes very tedious and cumbersome to evaluate risk in investment
decisions. To cope with a problem of this kind it is helpful to resort to
mathematical programming models which aids in determining the optimal solution
without explicitly evaluating each feasible combination. Stochastic Goal
Programming is one on them. Game theory is a technique for dealing with
cases of complete ignorance of the initial probabilities of possible outcomes.
The expected utility approach deals with consumption investment decisions
under conditions of uncertainty.
45
Under Uncertainty

1.
Discuss the capital budgeting techniques without probabilities.
2.
Describe the general formulation of a goal programming model.
3.
What is meant by utility? Do you feel financial managers should be risk

averse? Why or why not?

Agarwal J.D., Reading in Financial Management, IIF, Delhi Publication,
1994.
Hiller F.S., The Evaluation of Risk Interrelated Investments, North-Holland
Pub. Co., London.
Knight F.H., Risk, Uncertainty and Profit, University of Chicago Press,
Chicago.
46
Decisions
APPENDIX
A Goal Programing Model for Capital Budgeting
Weingartner (1963) suggested a linear programming formulation taking up Lorie
and Savage (1955) problem and suggested an optimal solution. Lorie and
Savage problem specifies for consideration nine mutually exclusive projects with
given present values of outlays for period I and II and given prsent values of
investments. The budget constraints for two periods were Rs.50 and Rs.20
respectively. The problem may be specified as follows:
Exhibit - I
Lorie-Savage Problem of Investment Proposals
Investment
Project
Period I
(Rs.)
1
2
3
4
5
6
7
8
9
12
54
6
6
30
6
48
36
18
PV of outlays
Period II
(Rs.)
PV of Investment
3
7
6
2
35
6
4
3
3
(Rs.)
14
17
17
15
40
12
14
10
12
In order to examine the effect of priority coefficients on the CBD, the GP

model (12) for the above problem is reformulated here below changing the
priority coefficients for the different objectives of the same objective set. The
different priority coefficients assumed for the following reformulated GP model
(13) are as follows:
Goals
Priority Coefficient
Net present goal (over achievement)
Budget constraint goal I
Budget constraint goal II (under achievement not desired)
Sales goal I (under achievement not desired)
Sales goal II (under achievement not desired)
Employment goal I (under achievement not desired)
Employment goal II (under achievement not desired)
Sales goal I (over achievement undesirable)
Employment goal I (over achievement not desired)
Employment goal II (over achievement not desired)
The GP model for capital budgeting decisions with modified priority coefficients
may be specified as follows:
Minimize
z=
p1d-1 + p7d-2 + p8d-3 + p2d-4 +4p3d-5 +p4d-6+

p4d-7 + p5d+4 _ p6d+6 + p6d+7,
Subject to
(A) Present value of investment goal
14x1 + 17x2 + 17x3 + 15x4 + 40x5 + 12x6 + 14x7 +
10x8 + 12x9 + d-1 = 32.4
(10)
(10.1)
47
Under Uncertainty
(B) Budget ceiling goals

12x1 + 54x2 + 6x3 + 6x4 + 30x5 + 6x6 + 48x7 +
36x8 + 18x9 + d-2 = 50.0
(10.2)
3x1 + 7x2 + 6x3 + 2x4 + 35x5 + 6x6 + 4x7 +

3x8 + 3x9 + d-3 = 20.0
(10.3)
(C) Sales goals

14x1 + 30x2 + 13x3 + 11x4 + 53x5 + 10x6 + 32x7 +
21x8 + 12x9 + d-4 d+4 = 70.0
(10.4)
15x1 + 42x2 + 16x3 + 12x4 + 52x5 + 14x6 + 34x7 +

28x8 + 21x9 + d-5 = 84.0
(10.5)
(D) Employment goals

10x1 + 16x2 + 13x3 + 9x4 + 19x5 + 14x6 + 7x7 +
15x8 + 8x9 + d-6 d+6= 40.0
12x1 + 16x2 + 13x3 + 13x4 + 16x5 + 14x6 + 9x7 +
20x8 + 13x9 + d-7 d+7 = 40.0
(10.6)
(10.7)
x1, x2, ..., x9, d-1,... d 7,d+4,d+6,d+7 0.

The optimal solution of (13) is presented in exhibit II.
Exhibit II reveals that to attain the optimal solutions for each of the seven
objectives four projects, i.e., x3, x4, x7 and x9 should be selected. The
respective units of these projects to be chosen are x3 = 2.00933, x4 = 2.65466,
x7 = 0.53334. On comparison of the solutions presented in exhibit I and exhibit
II it may be observed that the basic difference which the modified priority
coefficients made is the choice of the projects and their respective units. The
optimal solutions under the two situations remained to be almost the same
because the overall formulation with regard to different objectives and their
over achievement was the same. However, if the formulation with regard to
the under achievement and/or over achievement is also simultaneously changed
the optimal solution would also be different.
Thus, it may be concluded that a goal programing solution is certainly better
than the linear programming solution since a GP model allows (i) a
simultaneous solution of a system of complementary and conflicting objectives
rather than a single objective only, (ii) that more than any one period can be
included in the final programme of choosing projects.
48
40.0
40.0
84.0
70.0
20.0
50.0
32.4
Goal
Constraints
X 8 =0.0000
X 2 =0.0000
69.89332
56.09064
84.00012
70.00007
20.00000
50.00022
83.99997
Total
X2
X 4 =2.65466
26.12129
26.12129
32.14928
26.12129
12.05598
12.05598
34.51058
23.89194
31.85592
29.20126
5.30932
15.92796
39.81990
2.32803
1.81069
8.79478
8.27744
1.0469
12.41616
3.62138
Goal Programming Solution

X4
X7
34.15861
X 9 =0.53334
X 3 =2.00933
The GP Solution is computed on IBM 360 and involved 24 iterations.
Sales Goal I
Employment Goal II
Budget Constraint Goal II

=
Budget Constraint Goal I
Net Present Value Goal
Employment Goal I
X 7 =0.25867
Sales Goal II
X 1 =0.0000
Projects
X 6 =0.0000
Exhibit II
Goal Programming Solution with Modified Priority Coefficients
6.93342
4.26672
11.200014
6.40008
1.60002
9.60012
6.40008
X9
X 5 =0.0000
Decisions
49
UNIT 11 FINANCING THROUGH CAPITAL
MARKETS (DOMESTIC SOURCES)
Objectives
provide an understanding of money market and capital market,
highlight redeeming features of capital market,
explain different methods of raising funds by corporates through capital
market.
Structure
11.1
11.2
Introduction
11.1.1
Money Market
11.1.2
Capital Market
Methods of Procuring Finance

11.2.1
Equity shares
11.2.2
Rights Issues
11.2.3
Private Placement
11.2.4
Non Voting Shares
11.2.5
Preference Shares
11.2.6
Cumulative Convertible Preference Shares (CCP)
11.2.7
Warrants
11.2.8
Debentures
11.2.9
Bonds
11.2.10 Secured Premium Notes

11.2.11 Public Deposits
11.2.12 Bank Credit
11.2.13 Venture Capital
11.3
Summary
11.4
11.5
Further Readings
11.1
INTRODUCTION
Economic growth implies a long-term rise in per capita national output. The
basic conditions determining the rate of growth are effort, capital and
knowledge. Among these, capital formation has been recognized as the most
crucial factor in the economic growth of the developing countries. Capital
formation implies the diversion of the productive capacity of the economy to the
making of capital goods which increase future productivity capacity. The
process of capital formation, thus, involves transfer of savings from those who
have them in the hands of those who invest the same for productive purpose.
Saving & investment activities are linked by finance. Finance provides
mechanism through which savings of myriads of savers are pooled together and
are put into the hands of those able and willing to invest. The mechanism
includes a wide variety of institutions which cater, on the other hand, to the
safety, liquidity and profitability notions of the savers; and on the other to the
different types of requirements for working and fixed capital of the investors.
These insittutions are generally grouped into Money Market and Capital Market.
1
Financing Decisions
11.1.1 Money Market

Money market comprises those financial institutions which cater to the notions
of savers of high liquidity and safety along with profitability and which provide
working capital to trade and industries mainly in the form of loans and
advances. Thus, money market is reservoir of short-term funds. Money market
provides a mechanism by which short-term funds are lent out and borrowed; it
is through this market that a large part of the financial transactions of a
country are cleared. It is a place where a bid is made for short-term investible
funds at the disposal of financial and other institutions, individuals and the
Government itself.
11.1.2 Capital Market

Capital market is the place where the medium-term and long-term financial
needs of business and other sectors of the economy are met by financial
institutions which supply medium and long-term funds to borrowers. The capital
market is composed of primary market and secondary market (also known as
stock market).
While the primary market provides a mechanism through which the resources
of the investing public are mobilized, the secondary market provides mechanism
to facilitate an investor to buy and sell securities through dispensation of
benefits of easy liquidity, transferability and continuous price formation of
securities. Thus, both the primary market and secondary market play an
important role in raising maximum resources for capital formation and balanced
and diversified industrial growth in the country. However, metamorphic
environmental developments in and outside the country following the policy of
liberalization, privatization and globalization with the walls cocooning the
economy being torn and unprecedented technological advancements have led to
geographical and functional integration of international financial markets and
intensification of competition among various players both in banking and nonbanking sectors, blurring of boundaries between money and capital markets and
culminating in the emergence of more diversified multipurpose financial
institutions and financial innovations of unprecendented dimensions.
11.2
METHODS OF PROCURING FINANCE
A company can raise funds through capital market by issuing the financial
securities. A financial security is a legal document that represents a claim on
the issuer. The corporates securities are broadly classified into ownership
securities and creditorships securities. There are also securities known as hybrid
securities having the mix of the features of ownership securites as well as
creditorship securities. Further, company can also raise the funds through public
deposits and borrowings from banking sector. Each method of financing has got
its distinctive features in terms of risk, return, control, repayment requirements,
and security. Depending upon the market conditions and financing strategies, the
issuers adopt different methods.
11.2.1 Equity Shares
According to the companies Act 1956, a share is a part of unit by which the
share capital of a company is divided. The Act makes a provision for only two
classes of shares capital, Viz., equity share capital and preference share capital,
Equity share capital refers to the share capital, which is not preference share
capital. Equity share capital is also defined as the amount of the value of
property over and above the total liens and charges. In other words, equity
share capital is what ever remains in the way of assets after all the debts and
other charges have been paid or provided for. Thus equity share capital is also
appropriately referred to as residual capital.
Equity shares represent the owners equity. Its holders are residual owners who
have unrestricted claim on income and assets and who enjoy all the voting
power in the company and thus can control the affairs of the company.
Equity share capital is also known as risk capital as the equity shareholders are
exposed to greater amounts of risk, but at the same time they have greater
opportunities for getting higher returns. The equity shareholders also enjoy
getting higher returns.
Financing Through
Capital Markets
(Domestic Sources)
Another redeeming feature of equity shares is that its holders have pre-emptive
right, right to purchase additional issues of equity shares before the same is
placed in the market for public subscription. As a result, equity shareholders
have the power their proportionate interest in the assets, earnings and control of
the company.
The following are the advantages and disadvantages of raising capital by issuing
equity shares.
Advantages:
1)
The equity shares are not repayable to the shareholders. So it is a

permanent capital for the company, unless the company opts to return it
through buying its own shares.
2)
The debt capacity of a company depends on its equity including reserves.

Raising capital through equity enhances the companys debt capacity.
3)
The company has no legal obligation to service the equity by paying a

certain rate of dividend, unlike the debt for which interest is payable. So,
the firm can conserve the cash when it faces the shortages, and pay when
its earnings are adequate to do so.
Disadvantages:
1)
Among the alternative sources of capital the equity capitals cost is high,
because of various reasons like higher risk, flotation costs, non-deductibility
of dividend for tax purposes, etc;
2)
Investors perceive the equity shares as highly risky due to last claim on
assets, uncertainty of dividend and capital gains. Therefore, the companies
should offer higher return to attract equity capital.
3)
Addition to equity capital may not raise profits immediately, but will dilute
the earnings per shares, adversely affecting the value of the company.
4)
Raising of capital by offering equity shares will reduce the controlling

power of promoters, unless they contribute proportionately, or opt for nonvoting shares which are costlier than ordinary equity shares.
Companies can raise funds by issuing equity shares in five ways, Viz., through
public issue, rights issue, private placement, convertible debentures, and
warrants, while the first three are discussed here. The other two are explained
in the later part.
Public Issue:
To approach the public with a public issue to raise capital, the company should
follow various regulations and guidelines of the Companies Act, and Securities
and exchanges Board of India (SEBI).
The important activities to public issue are:
1)
Prepare a detailed project report, for which funds are intended.
2)
Preparation of prospectus, and filing the same with SEBI.
3)
Arrangements for listing the equity share in the stock exchanges.

3
Financing Decisions
4)
Underwriting agreement with merchant bankers, brokers, etc.
5)
Bridge loan arrangements to complete the project before equity share

capital is raised.
6)
Finalization of quotas to promoters, NRIs employees, and firm allotments,

and public.
7)
If the public issue is not subscribed to the extent of atleast 90 percent of

the equity issue, the money so colleted should be returned to the public
within 120 days of the last subscription date. In case of over subscription,
proportional allotment has to be made as per SEBI guidelines.
11.2.2 Rights Issues

Under section 81 of the Companies Act, exiting shareholders of a company
have a right to subscribe for news equity shares. If the company intends to
raise additional equity capital in proportion to their share holding, these shares
are called rights shares. Instead of acquiring the rights shares the shareholders
can transfer the rights to others or can simply forego them. Those shares not
subscribed will be allotted to the other shareholders applying for more,
proportionately.
If shares are left out even after giving additional allotment to the existing
shareholders, those shares can be issued to the public. When rights are offered
in proportion to the existing shares of the shareholders, the rights pricing will
not influence the value of the company, when adjusted for the capital collected
towards rights shares.
The right issue offers three main advantages. First the existing shareholding
pattern will remain constant. Therefore, the controlling power of the
shareholders including promoter will not be disturbed the promoters may
enhance their controlling power, by allotting themselves additional shares to the
extent of rights un-utilised by other share holders. Second, raising of capital
through rights issue instead of public issue leads to lower flotation, commission,
and can reduce the publicity costs.
Even the over subscription will be limited, leading to lower costs of returning
the excess capital received. Third, the response to the rights issue is easy to
guage, especially when the rights share price is set much below the prevailing
price of the share.
The wealth and controlling power of the shareholder will be reduced if he fails
to subscrible to the rights issue. In India the financial institutions acquired large
number of shares by using the loan conversion clause policy. The loan extended
can be converted into equity shares at a pre-determined conversion price at the
option of the financial institution. In some profitable companies their share
holdings become more than that of the promoters making their controlling
power valuable. In such cases the promoters prefer public issue to rights issue.
11.2.3 Private Placement
In this method of raising capital, shares will be issued in bulk to issuing houses
through financial intermediaries, investment companies, or other companies. As
per SEBI norms a company cannot issue shares to more than 99 persons under
private placement. Often these institutions buy the shares through private
placement, with an intention to make profit by selling them to the investors in
the secondary market through clients. The sale can take place in short-term or
long-term. While issuing bankers and brokers normally resell the shares
acquired through private placement in the short-term. This method has the
advantages of negligible floatations costs (if any) and better price for the
shares.
11.2.4 Non-Voting Shares
The government came out with the proposal of non-voting shares to safeguard
the promoters from hostile takeovers. As per the Government proposal the nonvoting share is similar to ordinary equity shares in all respects except in case of
voting rights and dividend payment. The owners of non voting shares do not
possess voting right, and as a compensation for loosing the voting rights, they
will be paid a few percentage points of higher dividend than that was paid to
ordinary equity holders. If a company fails to pay dividend for more than a
stipulated period, the non-voting shares will automatically stand converted into
ordinary equity shares with voting rights.
Financing Through
Capital Markets
(Domestic Sources)
11.2.5 Preference Share

Preference shares are those which carry certain preferential rights as compared
to other securities. The preference shareholders have the right to get dividend
at a fixed rate prior to any other class of shareholders. Similarly, the preference
shareholders get repayment of capital before any other class of shareholders
get it when the company is liquidated. In other words, preference shares have
prior claims over equity shares on earnings and assets in the event of
liquidation, but rank below creditors. But unlike interest on bonds, dividend
declaration by the company is not obligatory and may not be paid in a year
when profits are not enough. In other words, the preference shareholders
cannot take legal action against the company for not declaring dividends.
However, the preference shareholders have got the protection that no dividend
can be declared on the ordinary shares, unless dividend on preference shares is
declared and paid. Further, if the preference shares are cumulative type,
dividends not paid in any year will accumulate and must be paid at a later date,
before paying dividend on ordinarily shares.
Preference shares are also of different kinds like redeemable preference
shares, cumulative preference shares and convertible preference shares.
Redeemable preference shares are those which will be redeemed in course of
time as per the terms and conditions as stated in the offer document.
Cumulative preference shares carry accumulated unpaid dividends year to year
till the company is in a position to pay all the dividends including the arrears at
a stated rate. While the convertible preference shares get converted into equity
shares as per the terms and conditions as stated into offer document, the
investors who seek security and assured returns than in found in equity shares
generally subscribe preference shares. Companies generally issue preference
shares in order to maintain the status quo in the control of the equity stock and
also to reduce the cost of capital as the preferred stock carries lower rates of
dividends as compared to other debt securities like debentures which usually
carry higher rates of interest. At time, the preference shareholders may have a
right to share the surplus profits by way of additional dividend and the right to
share in the surplus assets in the event of winding up after all kinds of capital
have been repaid.
11.2.6 Cumulative Convertible Preference Shares (CCP)

Cumulative Convertible Preference (CCP) shares were introduced by the
government in 1985.
The features of CCP are:
1)
The CCPs can be issued by any public limited company to raise funds for
new projects, expansion and diversification etc.
2)
The amount of funds raised can be to the extent of the equity shares to
the public for subscription.
3)
The dividend payable is 10 per cent.

5
Financing Decisions
4)
The entire amount of CCP would be convertible into equity shares between
three and five years.
This instrument is yet to become popular. Companies did not prefer it because
the dividend on CCPs is not tax deductible as in case of interest on debt. At
the same time dividend of 10 percent is also not attractive to the invester.
However dividends become tax free in the hands of shareholders from the
fiscal 1998-99 and therefore CCPs may become popular.
11.2.7 Warrants
Warrants is similar to call options. It is a right to buy a share of a company
which issues them at a certain price during a specified period of time. When a
warrant is exercised, the number of shares of the company increases, at the
same time resulting in cash flow for the company. Warrants may be issued in
the following circumstances.
i)
Warrants may be attached to the sale of new equity shares as

sweetener.
ii)
Through exchange as a result of reorganisation.
iii)
Through separate sale, as issued to promoters of some Indian companies

to strengthen their controlling power. This is not a common practice.
Price of Shares Issued Through Warrants

The company will receive the consideration for shares issued through warrants
in three parts of (a) Cash received on sale of the warrants, (b) Cash received
on exercise of warrants, and sale of the warrants, and (c) the consideration for
the earlier financing supplied to the company. The fair value of shares issued
on the exercise of warrants is the most reasonably determinable measure of
the total consideration for the shares issued through warrants. The difference
betwen the total consideration for the cash received represents the cost of
corporate financing. The following are the benefits to the company and investor,
when warrants are issued.
Benefits to the Company

By issuing warrants the company will receive funds for its investment needs.
However, it has no obligation to service those funds raised, in terms of paying
interest, and principal amount. The price of this privilege is the obligation to
deliver the share wherever the warrant holder desires so during the
prespecified time period. Normally, the exercise price will be more than the
current price of the share.
Benefits to the Investor

The investors seeking warrants advance funds to a company bearing the risk of
expecting return based on future share price of that company. The investors do
not get any interest, or dividends on their investment unless the warrants are
converted into shares. The possible gains to the investor are :
i)
Instead of investing in the equity shares of a company at current price,

the investor can opt for warrants with a right to buy the same number
of shares at a specified price in future paying a small amount for the
warrants. The funds, thus, saved can be used for other investment
avenues.
ii)
The warrants are usually traded on the stock exchanges offering

liquidity. The Investor can book profits,or can en-cash the warrants, if
necessary.
11.2.8 Debentures
Debentures are one of the principal sources of funds to meet long-term
financial needs of companies. Though there is no specific definition of
debenture, according to the Companies Act 1956, the word debenture includes
debenture stock, bonds and any other securities of a company. Thus, a
debenture is widely understood as a document issued by a company as
evidence of debt to the holder, usually arising out of loan and mostly secured
by charge. The major differences between shares and debentures are as
follows;
i)
The equity shareholders have proprietary interest in the company whereas

the debenture holders are only creditors of the company.
ii)
The equity shareholders have voting rights whereas debenture holders do

not enjoy such a right.
iii)
Debenture holders are entitled to interest at a fixed rate whereas the

equity Shareholders are entitled to dividends at varying rates.
iv)
Debenture are usually redeemable and therefore have maturity period

whereas the equity shares are not redeemable.
v)
Debenture holders have priority over shareholders in the distribution of

assets on liquidation of the company.
Financing Through
Capital Markets
(Domestic Sources)
Debenture holders can initiate legal proceedings against a company, if it defaults

on its interest payment or principal repayment when these become due. The
company using debentures usually offers some sort of a security which is called
charge. The charge may be fixed charge or floating charge.
Debenture are of various forms like: (i) secured and unsecured debentures,
(ii) Fully convertible, partly convertible and non-convetible debentures,
(iii) Redeemable and irredeemable debentures.
Of all the various kinds of debentures, convertible debentures, of late, have
become more appealing to the investors. The investors may also have the
option of retaining the debentures without exercising the conversion option. The
partly convertible debentures with buy back facility are also issued, wherein one
part of the debenture is converted into equity and non convertible part may
have the facility of buy back either by the company or its associates. The
convertible debentures can be exchanged for equity shares of the same
company on the terms and conditions stipulated at the time of issue of the
debentures. Till conversion, these debentures are treated as debt instruments
and enjoy the same priority in claims as those of ordinary debenture holders, on
the assets of the company. For the company, there is scope for reducing the
cost of capital, since investors would be content with a lower return than that
on ordinary debentures, if there is a high likelihood of capital appreciation of the
companys shares in later years.
There are many advantages of debenture issues for the company. More
particularly, the debenture holders cannot interfere with the operation of the
company as they do not have voting rights. The cost of debentures is usually
low, as the interest payments on debentures are tax deductible expenses.
11.2.9 Bonds
A bond is a creditorship security whereby a company obtains money from the
lenders for a promise to pay the stipulated rate of interest at specified intervals
and to repay the principal on maturity, and they get the principal sum on
maturity, which is also mentioned in the agreement. Bond holders have a prior
claim on the receipt of the interest and repayment of the principal over other
creditors of the company.
Financing Decisions
Bonds are of different types like secured and unsecured bonds, bearer bonds,
perpetual bonds, sinking funds bonds, zero coupon bonds, convertible bonds,
floating rate bonds, etc.
Zero coupon bonds have become very popular in recent years with the
investing public. The zero coupon bondholders are not entitled to any interest
and they get the principal sum on maturity. The zero coupon bonds are usually
sold at a hefty discount and the difference between the face value of the
certificate and the acquisition cost is the gain to the investors. There are
certain advantages to both the investors and issuers. As far as investors are
concerned, they need not bother about reinvestment of interest as there is no
periodical interest payment. Further, the difference between the acquisition cost
and maturity value of the bond is considered as capital gain and therefore, it
attracts lower rate of tax as compared to the tax rates applicable to interest
incomes. For the issuer, since there is no periodical payment of interest, the
company may not have the cash flow problem in the initial years of the
projects whereafter the payment to the bondholders can be synchronized with
cash flow pattern of the project.
Floating Rate Bonds (FRB) have also become popular in recent years. The
first floating rate bond in the Indian capital market was issued by the State
Bank of India adopting a reference rate of one-year bank deposit rate plus
300 basic points (BP). The bank also had the call option after 5 years to
redeem the bonds earlier than the maturity period of 10 years at certain
premium. Later many corporate and development finance institutions came out
with floating rate bonds of different maturity periods. But most of them used
364-days Treasury bill rate as the bench mark plus certain basis Points, which
again varied from issue to issue. For example, ICICI issued floating rate Bonds
adopting 364-days T-bill rate : 180 BP but Anvind Mills launched floating rate
Bonds adopting 364 days T Bill rate : 325 BP. Thus, the floating rate bonds
provide varying rates of return with a minimum assured return to the investors.
The issuers may also have the benefits of making interest payments according
to the current market.
11.2.10 Secured Premium Notes (SPN)

The Tata Iron and Steel company was the first corporate to issue SPN on
rights basis. The main features of SPN, as issued by TISCO are as follows:
The face value of a SPN was Rs 300 and no interest will become due or
accrue during the first three years after allotment. Therefore, each SPN will be
repaid in four equal annual instalments of Rs. 75 from the end of the fourth
year together with an equal amount of Rs. 75 with each installment, which will
consist of a mix of interest and premium on redemption. Further, each SPN will
have a warrant attached to it which will give the holder the right to apply for
or seek allotment of one equity share for cash payment of Rs. 80 per share.
Such rights are exercisable between first year and one and a half year after
allotment.
Thus, SPN can serve as long-term securities and given more flexibility to the
companies as well as investors.
11.2.11 Public Deposits
According to the companies Act, 1956, all types of money received by a

company except the contribution to capital would fall in the category of
deposits. Fixed deposits which are also known as public deposits have become
attractive for companies as well as investors. For the companies, public
deposits are easy form of fund mobilization without mortgaging assets. For the
investors, public deposits provide a simple avenue for investment in good and
popular companies at a better rate of interest without many formalities as
involved in the case of shares and debentures. However, the public deposits
being unsecured, the repayment of deposits and regular payment of interest are
subject to a lot of uncertainty. That is, by presenting false information some
companies manage to collect large deposits from the gullible public and fail to
honour commitments on payments, inspite of many regulatory provisions, as
contained in the Companies Act and Companies (Acceptance of Deposits)
Rules, 1975.
Financing Through
Capital Markets
(Domestic Sources)
11.2.12 Bank Credit

Banks including the development finance institutions have become chief source
of funds to the corporate sector. In other words, the industrial credit is a major
revenue earner to the banking sector as other types of credit like agricultural
credit are subject to many restrictive conditions and regulations of RBI and
therefore, the margins on such credits are very thin. Banks extend credit to
industries and commercial establishments at varying rates of interest depending
upon the credit worthiness of the borrower as well as period of loan. The
proportion of bank credit in the total funds of the companies is very high in
many a case. The major advantage for the companies in that the bank credit is
a flexible source of financing and it is relatively easy to mobilize funds through
this source.

Governments around the world have been actively encouraging small and
medium business, especially feasible projects. The usual sources of capital
generally do not suit those promoters who are not in a position to put in enough
contribution to satisfy the other investors and lending institutions. Even if other
investors are willing to chip in despite negligible promoter contributions, the
promoter cannot retain the control of the business after establishing and
stabilizing in a profitable path, if the other investors chose to vote them out.
The objective of the venture capital is to encourage those desiring
entrepreneurs by providing long-term capital without the risk of losing control.
By 1980s, the U.S.A. had a well developed venture capital market. In India
venture capital market is emerging as a new source of funds.
Features:
It is defined as (similar to) equity investment in growth oriented small or
medium business to enable the investors to accomplish corporate objectives, in
return for minority shareholding in the business or the irrevocable right to
acquire it. Further, venture capital organization provides value addition in the
form of management advice and contribution of overall strategy. The relatively
high risk will normally be compensated by the possibility of high return in the
form of capital gains in the medium term. Venture capital is also called as
private equity. The following are main features that distinguish the venture
capital from other sources of capital market.
i)
Venture capital is a form of equity capital for relatively new companies,

which find it too premature to approach the capital market to raise funds.
It can also be in the form of loan or convertible debt. However, the
basic objective of a venture capital fund is to earn capital gain, which
usually will be higher than interest at the time of exit.
ii)
It is long-term investment. The transfer of existing shares from other

shareholders cannot be considered as venture capital investment. The
funding should be for new project or for rapid growth of the business,
with cash transferring from the fund to the company.
iii)
The venture capital organization will actively participate with the top
management of the firm.
Financing Decisions
iv)
All the projects financed by the venture capitalists will not be successful.
However, some of the ventures yield very high return to more than
compensate for heavy losses on others.
Selection for Investment

The appraisal procedure for investment is similar to feasibility studies of the
development finance institutions for grant of term loans and other financial
assistance. In addition, the venture capital organization may persue track record
of enterpreneurs, threats from technological obsolescence and preliminary views
on preferred exits. The stages of financing and the mode of financing will also
be finalized at this stage.
Stage of Financing: Generally, the stages of financing are (a) early stage and
(b) later stage.
Early stage Financing: This stage is essentially an applied research phase
where the concepts and ideas of the promoters are discussed and tested
leading to a prototype. If the prototype is satisfactory, this stage moves towards
the development phase leading to product testing and commercialization.
Normally promoters complete this phase with their own resources, because
very few venture capital funds finance this stage.
Start-up : This refers to the stage when commercial production is ready to
begin. At this stage product will be commercialized in association with the
venture capital organization. In this stage some indication of the potential
market for the new product will be available. The risk perception is still high.
The involvement of the venture capital organization at this stage also is
relatively less. Due to the unwillingness of the promoters to dilute their
controlling stake, or too small amounts involved, or even unclear risk
perceptions.
Later stage Financing : At this stage the investor firms require funds but
cannot approach markets. This stage includes development capital, expansion,
buy-outs and turn around.
Development Capital : It is for financing of established firms which have
overcome the high risk stage with a profit record for a few years, but can not
raise funds in the capital market. The reasons for venture capital funds at this
stage are for purchase of new equipment/plant, expansion, improving marketing
facilities, refinancing of existing debt etc. In this stage the risk perception is
medium and venture capital funds involve actively.
Expansion and Buy-outs : In this stage the firms try to expand their
productive assets and marketing facilities considerably either by procuring assets
or by acquiring controlling power of other similar firms through controlling
stakes or other options.
Turn Around : This is an important segment of venture capitalists business.
They require not only money but also management skills. Once the venture
capitalists identify the firms with good management skill, they come forward to
provide money. As the risk perception is high, skill is a focus area for many
venture capital funds.
Thus, the venture capital firms fund both early and later stage of requirements
of investor firms, balancing between risk and prifitability. This is an ideal source
of capital for promotes having very good technical and management skills, with
limited financial resources.
10
11.3
SUMMARY
Financing Through
Capital Markets
(Domestic Sources)
Capital market plays a very important role in the mobilization of funds for
Investment. Capital market can be classified as primary market and secondary
market which are complimentary to each other. The capital market has
experienced metamorphic changes over the last few years. The competition in
the market has become so intense necessitating the introduction of several kinds
of securities. The corporates in India mostly raise their funds through capital
market by issuing equity shares, preference shares, debentures, bonds and
secured premium notes. They also raise their funds through public deposits and
borrowings from banks. Technocrats and entrepreneurs with feasible project but
having limited financial resources can approach venture capital organization.
Each method has got its own distinctive features and depending upon the
market conditions and financing strategies the issuers adopt different methods.
11.4
SELF ASSESSMENT QUESTIONS
1.
What are the characteristics of capital market? How is it different from

money market.
2.
Explain the relationship between primary market and secondary market?
3.
Assess utility of equity shares as source of corporate financing.
4.
Preference shares are known as hybrid securities. Comment.
5.
What is creditorship security? How is it different from ownership security?
6.
Examine potentiality bonds as source of corporate financing.
11.5
FURTHER READINGS
Jaimes C. Vanhorne, Financial Management and Policy, Prentice Hall of

India, New Delhi.
S.L.N. Sinha, D. Hemalatha and S. Balakrishan, Investment Management,
IFMR, Chennai.
RM Srivastava, R. Divya Nigam, Management of Indian Financing
Institutions, Himalaya Publishing House, Mumbai, 2001.
I.M. Pandey, Financial Mangement, Vikas Publishing House, Bombay.
M.Y. Khan, Indian Financial system, Vikas Publishing House, Bombay.
11
UNIT 12 GLOBALISATION OF FINANCIAL
SYSTEMS AND SOURCES OF
FINANCING
Objectives
explain the concept of globalisation,
throw light on globalisation of world Financial systems,
scan the Indian Scenario of globalisation,
study the various global sources of financing.
Structure
12.1
Introduction
12.2
Deregulation in Financial Markets
12.3
Developments in the Banking Sector
12.4
Developments in the Foreign Exchange Markets
12.5
Special Financial Institutions
12.6
Indian Scenario
12.7
Global Sources of Financing
12.8
Summary
12.9
12.10
Further Readings
12.1
INTRODUCTION
In financial circles in recent years, the word globalisation is often heard, most
commonly with reference to the heightened internationalisation of financial
transactions. This catch word sums up the Phenomenon in which financial
transactions increasingly transcend the geographical and time limitations of local
financial markets, giving rise to a single, uniform global market. While the
Phrase internationalisation refers to cross border transactions among national
markets, globalisation goes beyond national frontier to create a borderless
market in which national borders gradually disappear.
The international financial system is characterised by the following types of
institutions:
a)
Financial markets;
b)
The banking sector;
c)
Foreign exchange markets; and
d)
Special financial institutions, such as the World Bank, IMF, etc.
Since the early eighties, there has been a virtual transformation of these
markets. Not only has there been a complete integration of these markets in
any given country or economy, but the ties have been strengthened as to result
in a unified financial system on a world-wide scale. Not surprisingly, we hear
of tendencies towards common transaction methods and common settlement
periods across the globe. A complete integration of the markets world-wide, no
doubt, requires swift communication between countries. The developments in
technology whereby information can be had within a matter of seconds from
1
Financing
anyDecisions
part of
the globe have made the process of globalisation much easier and
profitable. Financial managers across the world are concerned with identifying
profitable opportunities with associated minimum risk. The financial integration
of markets whereby funds can be easily transferred from one place to another
has certainly influenced the financing and investment decisions financial
managers make on a day-to-day basis.
12.2
DEREGULATION IN FINANCIAL MARKETS
Many factors have helped the globalisation process in which no market,

howsoever remote, remains isolated and insulated from developments taking
place world-wide. The October 1987 crash is much too recent to be forgotten
and a telling evidence of the extent to which markets have been integrated.
Popularly too, of American and Japanese markets, it is said that when America
catches a cold, Japan sneezes. There have also been a number of studies on
the integration of European markets with the American market. In general, the
share prices move in tandem with each other.
The introduction of the floating exchange rate regime in 1973, interest rate
deregulation and securitisation since the 1970s have been among the major
factors behind the steady progress of financial globalisation. The OPEC
phenomenon of the 1970s and the debt crisis triggered by the developing
countries in the 1980s also significantly influenced the volume of international
capital flows and the restructuring of the financial system as a whole.
Innovative financing techniques are constantly being designed to turn the
financing game, instead of the zero-sum game that was witnessed in the 1980s.
The innovativeness in finacing techniques and tools have also been accompanied
by the growing deregulation of the national financial markets, characterised by
relaxation of barriers separating the activities of different types of institutions,
relaxation of interest rate ceiling, extension of the geographical domain of
existing institutions, and reduction in barriers to entry into the domestic financial
system by both foreign and non-banking institutions. The abolition or relaxation
of exchange controls, elimination of quantitative credit ceilings, removal or
reduction of withholding tax on interest earnings of non-residents and changes
in regulations governing access of foreigners to domestic markets, and access
of residents to international markets has tremendously helped the national
markets to forge a global financial market. The increasing competition among
banks themselves on the one hand and between banks and non-banks on the
other, for providing finance and financial services compelled banks to look into
hitherto uncharted territories.
The deregulation of the London Stock Exchange that took effect from October
27,1986, ecstatically referred to as the Big Bang, has been the most
memorable one in the far-reaching changes that were introduced in the
financing of the London financial market. The liberalisation, though initially
intended to be limited to the abolition of the fixed commission on broking
business and the separation of the functions of brokers and jobbers, now
encompasses a wide range of related aspects for facilitating competition and
internationalisation of the London Stock Exchange. The traditional distinction
between brokers (who buy and sell on behalf of investors) and jobbers (who
make the markets on the floor of the Stock Exchange) has been given a body
blow in other financial centres also. The permitting of institutional membership
into the stock market has meant the injection of new capital into the UK. Not
to be left behind is the Bombay Stock Exchange in India, which besides
permitting institutional membership has also taken up computerization on a mass
scale.
2
Globalisation of
Financial Systems
and Sources of
Financing
The prominence of the Swiss market to its present status has been largely due
to its deregulated functioning. A significant portion of the Euro-deposits came
to be parked in the Swiss market because of the virtual absence of
Governmental control as well as tax-free income from securities. The
emerging role of Tokyo as an important financial center has also been because
of the easy access it provides to both domestic and overseas investors and
financial intermediaries to a growing variety of instruments issued by or for
Japanese entities. Foreign banks can now engage in trust business (although
on a selected basis) and can join in the government bond underwriting
syndicate. Foreign securities houses can lead-manage Euro-yen bonds and can
be members of the Tokyo Stock Exchange. Amongst the great variety of debt
instruments and financial packages available in Japan are also the multicurrency bonds and the leasing bonds, where-in by providing funds to leasing
companies to purchase high-valued items such as aircraft, cross-border financial
leasing is facilitated.
The need for financial innovation to make large amounts of funds easily
accessible has also been felt because of the growing trend towards privatisation
of nationalised industries and increase in flexibility of operations leading to mass
restructuring and consolidation of business entities. Competitive pressures
have led to a growing awakening towards maximising both economies of scale
and scope. The mass restructuring and consolidation of business entities have
resulted in more frequent breakups and dispositions, leveraged buyouts (LBOs)
and management buyouts of units of companies that do not fit into coherent
strategic alliances, often with significant equity stakes, have also been entered
into as alternatives to full mergers or acquisitions. Resources for financing
merger transactions have also been provided with bridge loans, mezzanine
financing synthetic securities, junk bonds, and other related techniques. While
mezzanine financing refers to the issue of equity-related bonds, e.g., bonds
with warrants, the term synthetic securities refers to a package of securities
such as a Eurobond and a currency swap arrangement that converts an original
security into a security with different currency or other characteristics. Junk
bonds are simply bonds rated below investment grade (BBB) by rating agencies
but are popular because of the extremely high yields they promise. The junk
bond market flourished initially by financing large volumes of LBO transactions.
12.3
DEVELOPMENTS IN THE BANKING SECTOR
The banking sector too, has gone through revolutionary changes. At least three
trends characterise the future of banking the world over:
i)
The banks role as funding intermediaries is diminishing and instead banks

are taking on the role of broker and/or underwriter for credit
transactions;
ii)
Banks formerly protected turf is being invaded by investment banks,

thrifts, insurance companies, and even retail firms. In response, banks are
expanding their activities into the domain of investment banks and
insurance companies; and finally
iii)
Banks are expanding geographically as they compete in inter-state and

even international markets.
However, although the role banks play as funding intermediaries is diminishing,

it will not disappear entirely. Banks ability to fund loans will continue to be
important in, at least, two ways.
First, banks will continue to make and hold loans that are not readily
securitised. To make loan-backed securities marketable, securitisation requires
the standardisation of loan terms and conditions. Similarly, it requires that
Financing
Decisions
investors
be
able to evaluate the credit risk of the underlying pool of loans at

relatively little cost. Loans that require special knowledge of the expertise in
local markets, therefore, are not easily standardised. To compensate lenders
for the higher costs associated with making these non-standardised loans, their
yields will rise relative to the yields on debt obligations that can be securitised.
Consequently, banks will have incentives to continue to make and hold nonsecuritised loans. A second way in which banks will remain important
intermediaries is as backup sources of liquidity when borrowers find it difficult
and/or costly to raise funds in capital markets. For this reason, even the
borrowers that have ready access to commercial paper and other direct
securities markets still pay banks substantial fees to maintain lines of credit and
loan commitments. Likewise in international capital markets, borrowers have
been attracted to the note issuance facilities offered by banks. These facilities
ensure access to funds, should the borrowers be unable to sell their notes
directly to investors.
The volume of newly arranged underwritten facilities reached their peak in
1985 - about 18 per cent of total international financing. In 1986, they
accounted for only 8 per cent of total international financing, due to the
imposition of capital rations on banks off balance-sheet activities (OBSAs)
since 1984. Nevertheless, bankers will continue to engage in these activities, as
historical experience indicates that losses on such activities have been small.
Other fee-generating activities include issuing stand-by letters of credit,
commercial letters of credit, loan commitments and indulging in foreignexchange obligations and interest rate swaps. Such business for major palyers
run into billions of dollars. Some idea of the globalization of banking can be
had from the following table:
Table 12.1: The Growth of Bank Off Balance-Sheet Activities 1981-1987
Activity
$ Billions
1980
1986
Compound
Annual growth
$ Billions
1980-1986
Annual
growth
from
1986
Letters of Credit
47
170
23.9%
168
-1.6%
Stand-by Commercial
Loan
20
28
5.8
30
9.6%
Commitments
432
572
9.8%
595
5.4%
Foreign-exchange
transactions
177
893
31.0%
1558
110.0%
Interest-rate swaps
186
367
97.3%
602
93.9%
Band Capital
108
183
9.2%
180
-2.2%
Source: Joseph F. Sinkey, Jr., Commercial Bank Financial Management in the

Financial Service Industry, Macmillan Publishing Co., 1989, p.578.
The table clearly shows that foreign exchange transactions and interest rate
swaps are now the most important sources of revenues from OBSAs. Profits
in foreign-exchange trading come from two main sources:
i)
trading profits generated by the bank trading for its own accounts; and
ii)
fees generated by trading in currencies for its customers.
Multinational banks are very active in Euro-currency markets wherein they

gather deposits and make loans, usually in Eurodollars. Interest-arbitrage
transactions are frequently entered into, i.e., borrowing funds in one foreign
currency and country and making loans in another currency and country, due to
Globalisation of
Financial Systems
and Sources of
Financing
substantially different interest rates across countries. The objective of these
arbitrage transactions is to maximise the interest-rate spreads, given the banks
risk preferences.
12.4
DEVELOPMENTS IN THE FOREIGNEXCHANGE MARKETS
Foreign-exchange markets exist because of trade between countries with

different currencies. That is, exporters prefer not to hold foreign currencies;
they want to be paid in their national currency. Foreign exchange transactions
have, thus, become an integral, even essential, part of international trade and
finance. In the immediate aftermath of World War II, foreign exchange
trading was relatively limited, as most major currencies were subject to
extensive exchange controls, and the opportunities for the movement of funds
across national boundaries were severely limited. The subsequent recovery and
growth of the world economy brought a gradual relaxation of these controls
and as a result foreign exchange trading became more and more active. The
really explosive growth of the exchange markets began, however, with the
advent of floating exchange rates following the collapse of the Bretton Woods
system in the early 1970s. Since then, not only has world trade continued to
expand very rapidly, but international financial transactions have grown
exponentially and with them, the foreign exchange markets. Moreover, not only
has the volume grown, but the markets have become increasingly volatile, and
that, in itself, has drawn in additional players to the market, both, for defensive
and aggressive trading.
The foreign exchange market is dominated by giant commercial banks. To
provide foreign exchange services to customers, these banks take a position
(i.e., hold inventories) in the major currencies of the world. Some banks do
this by keeping deposits with foreign banks. In addition to providing for
customers foreign currency needs in either the spot or the forward markets,
banks also trade on their own account in the foreign exchange market. The
importance of foreign-exchange income to the major US banks is reflected by
the fact that it accounts for anywhere from 10 per cent to 60 per cent of the
overseas operating income of these banks.
This increased internationalisation has, nevertheless, meant increased
vulnerability of the players in these markets. Amongst the various risk-reduction
methods that have come to be employed, swaps, futures and options are the
most conspicuous. These facilities enable banks and corporations to hedge their
exposure to financial risks arising from interest rate and exchange rate
changes. In the international markets, currency options are more predominant
than interest rate options. In currency options, standard period options (3
months, 6 months, etc.) for major currencies against US dollars are being
increasingly traded. In the options market, banks may act as agents for other
parties or as principals. Financial futures have registered significant expansion
in recent years with the expansion of the business of existing futures markets
and also with the setting up of futures markets in other centres particularly
London, Singapore and Amsterdam. Interest and currency futures not only
offer actual hedging facilities but also speculative innovative techniques, which,
though useful to transfer risks to counterparties has also called for appropriate
management control and monitoring systems. Capital adequacy norms for the
banking sector was one such step in the regulatory system. The need for
regulation is heightened with fiascoes of massive proportions, such as the
failure of BCCI.
5
Financing Decisions
12.5
SPECIAL FINANCIAL INSTITUTIONS
The World Banks role as a catalyst in attracting development finance for highpriority programmes in the developing countries through co-financing has
increased significantly in recent years. Co-financing has been a feature in about
37 per cent of Bank/IDA operations and the volume of funds mobilised from
other sources external to borrowing countries has been equivalent to more than
36 per cent of the total volume of banks group lending. Although historically,
the major source of co-financing has been official bilateral and multilateral aid
agencies, projects with private co-financing especially in the industrial and
power sectors are becoming more and more popular.
The Special Drawing Rights (SDRs) mechanism operated by the International
Monetary Fund whereby member countries bail each other out in times of
foreign exchange crisis has provided a fair measure of stability to the
international development agencies such as the export-import banks in various
countries providing loans to domestic borrowers for export, import and
overseas projects, as well as technical service credits in such projects as the
construction of factories, dams, etc., and direct loans to foreign governments,
banks and corporations.
12.6
INDIAN SCENARIO
The Indian capital market had been insulated from changes in the international
economy till 1991. It was due to high insulation of the Indian capital market
that during the Gulf War when global capital markets were declining, the Indian
capital market was actually having a bullish run. However, since 1991 Indian
capital market has globalised so much so that now changes in any major capital
market or economy are reflected in the sensex. The Indian capital market has
now become a major investment avenue for foreign investors. Foreign
Institutional Investors (FIIS) have invested over US $ 6 billion directly, while
Indian companies have raised over US $ 4 billion from the international market
through the global depository receipts route.
The last one and a half decades witnessed dramatic change in the pattern of
financing of corporate sector, with its increasing reliance on capital market. Till
1980, funds raised from the capital market were less than Rs.200 crores and, in
fact, less than Rs.100 crores in several preceding years. Industry had to
depend largely on financial institutions and its own surplus generation for
meeting long-term investment needs and on banks for working capital
requirements. Capital market emerged as a major source of funds to industry
in 1980s. The equity culture which was lacking in its thrust earlier developed
fast during this period.
Within a period of 10 years, the amount of capital raised from the market rose
33 times from Rs.195.9 crores in 1980 to Rs.6473.1 crores in 1989-90. The
buoyancy in the capital market gained further momentum right from the
beginning of 1990s with significant boost in the activities in the new issues
market. The amount raised from the capital market was of the order of
Rs.22,480 crores in 1993-94 (11.4 per cent of the gross domestic savings) and
Rs.25,000 crores in 1994-95, however, in 1996-97 it slowed down.
The number of stock exchanges increased from 9 in the beginning of 1980s to
23 now. Around 8000 companies are currently listed on the stock exchanges
against only 2265 in 1980. The market capitalisation rose sharply from Rs.50
billion to about Rs.4330 billion during this period. The number of shareholders
and investors in mutual funds increased from about 2 million in 1980 to over 40
6
Globalisation of
Financial Systems
and Sources of
Financing
million now. As a result, India ranks second in terms of investor population in
the world, next only to the U.S.
At the end of 1993, the International Finance Corporation ranked India 22nd in
terms of market capitalisation and 24th in terms of total value traded among 40
countries with developed as well as developing markets. India is second only
to the United States, at the end of 1993, in terms of the number of listed
Domestic Companies with 8000 companies listed on Domestic Stock
Exchanges. India has become today an important market in the emerging
markets of the world, next only to Malaysia, South Africa, Mexico, Taiwan,
Brazil, Korea and Thailand in terms of Market Capitalisation. With the
expected new offerings pouring in at the rate of about 10 per cent of the
market capitalisation, disinvestment of public sector undertakings taking place at
the rate of about 5 per cent of the market capitalisation and prices registering
all appreciation of about 20 per cent, market capitalisation of Indian Stock
Markets can be estimated to rise by one-third every year which would mean
doubling up the market capitalisation every two and a half years. In terms of
average company size (market capitalisation/listed domestic companies), India,
however, did not figure in top 40 markets.
The market has been brought to a focal point by policy reforms initiated by
government since 1991. Pricing of equity is free and the Office of the
Controller of Capital Issues (CCI) is abolished. Capital market has been
opened to foreign institutional investors and Indian companies have been
allowed to raise funds from abroad through Euro Issues. Private sector has
been permitted to set up mutual funds. Today it is possible to raise capital at
lower cost, although there definitely continues to be a time lag between the
going to the Securities and Exchange Board of India (SEBI), taking permission
with regard to fixation of premia and clearance of prospectus and coming to
the market with their issues.
12.7
GLOBAL SOURCES OF FINANCING
Some of the major global sources of financing are;

1.
Global Depository Receipts (GDR).
2.
Euro Convertible Bonds (ECB).
3.
Foreign Direct Investment (FDI).
4.
Portfolio Funds (FII).
5.
International Financial Institutions like World Bank, IMF, etc.
The Euro Currency Market:

The Euro Currency Market is outside the legal purview of the country in
whose currency the finances are raised. The term Euro is affixed to an offshore currency transaction. Capital raised in the Euro Currency Market can be
classified temporarily as under:
Eurocurrency Finance:
Short term
(upto 365 days)
Medium term
(2 to 10 years)
(a) Euroloans from

banks
(b) Eurocommercial
paper (ECP)
(c) Syndicated
Loans
(d) Revolving
Underwriting
Facilities
(RUFs)
Long term
(10 Yrs and above)
(e) Eurobonds
(f) Euroequities
Financing
Decisions
Euro-loans
are essentially short term accommodations provided by bankers to

their clients. The interest charged is a mark up on the London Interbank Offered
Rate (LIBOR), which varies according to the credit worthiness of the borrowing
company.
Euro-commercial Papers are short term promissory (bearer) eurocurrency

notes. These are typically issued at a discount of their face value which
represent the yield to the investors.
Syndicated (Euro-currency) loans are given by syndicates of banks to
borrowers at a variable rate of interest (e.g. Libor + 0.25%).
Revolving Underwriting Facility (RUF) involves sale of bearer notes to
investors on a revolving basis. The investors under RUF undertake to make
certain amount of funds available to the borrower upto a certain date during
which the borrower is free to draw down, repay and redraw the funds after
giving due notice.
Eurobonds are long term unsecured debt securities usually fixed rate
instruments, with bullet repayments. These are targeted at high net worth
individual and institutions and are listed on stock exchanges such as
Luxembourg or London to provide liquidity.
Euroequities are company shares which could either be directly offered listing
on the foreign stock exchanges or take the form of global depository receipts
with shares underlying such receipts.
Core Strategies for a successful Euro-Issue:

Careful selection of a lead manager
Company Fundamentals
Timings of Issue
Careful Pricing
Good Marketing
Innovative options in terms of financial instruments offered
Euro Issues ($ Million):
The Finance Ministry permitted Indian Companies to make Euro Issues of
GDRs and Euro convertible bonds in the Union Budget speech of 1991-92.
Since May92 when the first Euro Issue was made till December96, Indian
companies have raised $ 6.7 million through Euro Issues. ECB approval as on
December 2002 were US $ 2788.94 million.
Table 12.2: Resources Raised
Year
(Amount Rs)
1992-93
240
1993-94
2,493
1994-95
2,152
1995-96
627
1996-97
1,189
(Apr-Dec)
Total
8,701
Of the total inflows through Euro issues, $5.43 billion (or 81 per cent) have
come in the form of GDRs and the remaining $1.27 billion have been in the
form of ECBS. The issuance of ECBs was discouraged by the government
during 1994-95 and 1995-96, since convertible bonds add to the external debt of
the country till the time of conversion.
Globalisation of
Financial Systems
and Sources of
Financing
GDR Issues:
Inflow through the issuance of global depositor receipts (GDR) declined
sharply during 1995-96. During this year, Indian companies raised
$0.63 billion as compared to $2.05 raised during 1994-95. During 1994-95,
there were 29 GDR issues. This crowding of issues resulted in a clear
oversupply of Indian paper in international markets, with the result prospective
companies either deferred or shelved their plans of making GDR issues,
fearing the possibility of having to price their issue at a steep discount
over the domestic price.
Table 12.3: GDRs/ADRs Issues ($ Million)

Year
94-95
95-96
96-97
97-98
98-99
99-00
00-01
01-02
Amount
2082
683
1366
645
270
768
831
477
Size of Indian GDR Issues:

GDR issues of Indian companies have, by and large, been small; in the region
of $50 million to $ 100 million. Out of the total 62 GDR issues made till
October 1996, the sizes of 22 issues were in this range.
Table 12.4: Size of Indian GDR Issues
Range ($ Million)
No. of Issue
Below 50
17
50-100
22
100-150
16
150-200
Above 250
Total
62
Pricing of Indian GDRs:

Indian GDRs have generally been priced at a discount over the prevailing
domestic market price. Of the 62 GDR issues made, 34 were priced at a
discount over the domestic price at the time of pricing.
Euro Convertible Bonds:
Resources raised through Euro convertible bonds have been much lower
than those raised through GDRS. This has been in view of the government
guidelines issued in October 1994 which banned the issuance of
convertible bonds. No ECB issue was floated during 1995-96.
During 1994-95, $ 102 million were raised in the form of ECBs as
compared with $ 896 million raised in 1993-94. The coupon rates offered on
these bonds ranged from 2.5 per cent to 5.5 per cent for funds raised in dollar
terms. Till the end of 1995-96, two companies issued ECBs designated in
Swiss Bangs and one of these, Bharat Forge, placed convertible bonds with a
coupon rate of just 1 per cent. The Finance Ministry permitted Indian
companies to issue Euro convertible bonds during 1996-97. Till December 1996,
three companies issued Euro convertible bonds for an aggregate amount of $273
million.
9
Financing Decisions
Globalisation of
Financial Systems
and Sources of
Financing
Table 12.5: ECB Issues ($ Million)

Year
Amount
1992-93
1993-94
1994-95
1995-96
1996-97
(Apr-Dec)
Total
0
896
102
0
273
1,271
Although Indian corporates have raised resources through convertibles bonds at

low interest rates, they are now facing redemption pressure. Almost all the
bond issues have a put option which enables the bondholder to convert or
redeem the bond before the bond matures.
Foreign Direct Investment:

Foreign direct investment is very necesssary for any developing country as it
brings not only badly needed financial resources but new technology as well.
Since 1991 India has made hectic efforts to attract FDI but the actual flow has
been much lower than the desired level. If we expect the Indian economy to
grow at a rate of 7 per cent per annum, then we would need $ 10 billion of FDI
annually. However, since 1991, we have not been able to cross the actual FDI
level of $4 billion mark per annum, which is really peanuts in comparison to countries
like china which is attracting anywhere between $30 to $50 billion per annum.
Although most of the FDI has come in the area of infrastructure but the actual
flow is only 25 per cent of the proposed FDI (Table 12.7) Although, scope is
unlimited but somehow, 1 per cent of the total world foreign direct investment.
Table 12.6: Foreign Investment Inflows (US $ Million) in India
Year
1993-94 94-95
95-96
96-97
97-98
98-99
99-00
00-01 01-02
Direct
Investment
586
1314
2144
2821
3557
2462
2155
2339 3904
Portfolio
Investment
3567
3824
2748
3312
1828
-61
3026
2760 2021
Direct
Investment
as percentage
of total
investment
14.11
25.57
43.82
45.99
66.05
102.54 41.59
45.87 65.89
Table 12.7: Foreign Investment (US $ Millions)

Approvals
Actuals
1991
207.63
141.12
1992
1315.41
242.28
1993
2822.23
568.79
1994
4519.00
946.37
1995 (Jan-April)
1783.58
709.41
1067.85
2607.97
Total
Actual Investment as a percentage of approved investment is 24.49 per cent.

Portfolio Funds:
10
Portfolio funds are basically brought in by foreign institutional investors. It is

largely through pension funds, mutual funds, investment trust, asset management
companies, institutional Portfolio managers or their power of attorney holders in
securities traded in the primary and secondary capital markets. Currently about
400 FIIs are registered with SEBI and about 100 are active players. FIIs
investment in Indian capital markets has been hovering around $2 to $3 billion
annually over the years (Table-12.6).
International Financial Institutions:
India has been financing its Public Sector as well as private sector industrial,
social and economic projects from the funds available from international
financial institutions like World Bank, IMF, Asian Development Bank, etc.,
right from the inception of these institutions. India has figured amongst the
top ten borrowing nations of the world. Currently, about over $ 100 billion
worth of funds are being made available by various international financial
institutions.
The new financing instruments possess great potential to fund the requirements
of the Indian industry. Their imaginative use can provide finance in abundance
at a lower cost, making Indian industry competitive and enabling it to globalise
its operations. The current intensity of the Indian financial market reveals that
there is a tremendous scope to deploy new financial instruments connected to
equity, debentures/bonds, add-on products and derivatives. This may require
appropriate changes in certain legislations and the will on the part of the Indian
corporate enterprises to take risks and tune their decision making to the
investors psychology and market preference.
The alternate sources of finance have to be increasingly tapped. This would
necessitate efforts on the part of the industry as well as necessary relaxations
in policy guidelines. In the new economic environment which stresses on
opening and globalising the Indian economy, Indian industry will have to play a
major role to keep the economy on a high growth curve. Finance is a vital
input for accelerating the pace of industrial progress. To ensure the timely
availability of sufficient funds at reasonable cost, it would be important to
strengthen the existing sources of finance and simultaneously initiate measures
to tap alternate sources and new financial instruments.
12.8
SUMMARY
Globalisation has lead to increased degree of trade between various countries

and as a consequence of that the domestic financial systems are alligning
themselves to international financial systems. In this process the basic building
blocks of financial system viz. the banking system, the foreign exchange
markets and the capital markets are becoming more and more integrated with
world financial systems.
Recent years have witnessed a change of roles of the financial institutions i.e.
banks moving into insurance and activities of non banking financial companies.
During the last decade the forex market has also witnessed quite a change,
now forex rate are market determined with little or no intervention from the
government.
One of the major impact of globalisation on Indian companies is that now they
can raise low cost funds from abroad by ADRs, GDRs, ECBs etc. Apart from
this due to the increased FIIs activities the shares of Indian companies are
being quoted at fair value and there is less of information asymetry in the
capital markets.
11
Financing Decisions

1.
What do you mean by globalisation? Comment on the level of globalisation

of Indian capital market.
2.
What are euro issues? Discuss some important instruments of euro currency.
3.
Discuss some of the major types of institutions that constitute the

international financial system.
4.
What are the major global sources of financing? How far have Indian
Corporates tapped these global sources?

Kim S.H. and S.H. Kim, Global Corporate Finance - Text and Cases
Blackwell, Oxford, U.K.,1996.
Neelamegham S., Competing Globally - Challenges and opportunities,
Allied Publishers, New Delhi, 1994.
Shapiro A.C., Multinational Financial Management, Prentice-Hall, New
Delhi, 1995.
Economic Survey, Government of India, New Delhi.
Management of Indian Financial Institutions, Himalaya Publishing House,
Mumbai, 2001.
12
Globalisation of
Financial Systems
and Sources of
Financing
UNIT 13 FINANCING THROUGH FIs
Objectives
trace out the historical setting with respect to the role of FIs in financing
industrial units,
analyse the trends in financing extended by FIs to different sectors,
industries, etc.
discuss the norms on the basis of which finance is extended,
survey the reforms initiated by the government together with the action
taken and the future agenda.
Structure
13.1
Historical Setting
13.2
Financing by All FIs
13.3
Role of Banks in Term Finance
13.4
Financing Norms
13.5
Share of FIs in the Company Financing
13.6
Reforms in the DFIs Sector
13.7
Summary
13.8
13.9
Further Readings
13.1
HISTORICAL SETTING
Financial Institutions (FIs) popularly known as Development Banks have started

engaging the attention of the people in the industry as early as in 1822, when
the Societe Generale de Belgique was founded in Belguim. This was followed
by the establishment of the French Credit Mobilier in 1852. By the turn of the
century, there was great interest generated in this exercise and almost every
country followed suit. In 1902, Japan founded the Industrial Bank of Japan.
England started its effort with the setting up of Carterhouse Industrial
Development Company in 1934 and Industrial and Commercial Finance
Corporation and Finance Corporation for Industry in 1945. Germany set up its
first development bank in 1949 for the purpose of supplying long term loans to
the industry. Encouraged by the success of Credit Mobilier, countries like
Austria, Netherlands, Italy, Switzerland and Spain have also floated financial
institutions of the French kind. A review of the experiences of the various
countries reveals the fact that almost all the countries realised the need for
creating a separate machinery for financing industrial development. As a matter
of fact, though there were attempts at founding a congenial agency for
financing industrial development, the real impetus for the development of FIs
took place only after the Second World War. The economies in the west
shattered by the war followed by the Depression found it a necessity to
innovate on the industrial front including the financing of it. This even led to the
founding of the International Bank for Reconstruction and Development
[IBRD]. Though there is lot of diversity in the structure, objectives and
methods of financing across the globe, the core activity financing industrial
units - however remained common to all FIs.
Developing economies, which happen to be the colonies of the West, always
looked to their rulers for innovation in forstering development. India, being no
Financing
Decisionsto
exception
this kind of a tendency, also emulated the experiments of the West

and founded its first financial institution - Industrial Finance Corporation of India
[IFCI] in 1948 to cater to the medium and long-term credit needs of industrial
units. The constitution of IFCI was changed in 1993 from a statutory
corporation to a company under the Companies Act, 1956 to ensure greater
flexibility in the operations and to cope up with the changing financial system of
the country. IFCI provides financial assistance by way of both rupee and
foreign currency loans, underwriting, direct subscription to shares, debentures,
guarantees, suppliers credit and equipment leasing. It provides a variety of
merchant banking services which include project counselling, issue management,
loan syndication, financial restructuring, mergers, acquisitions and debenture
trusteeship. The IFCI has now been merged with Punjab National Bank.The
IFCI followed by the setting up of the Industrial Credit and Investment
Corporation of India [ICICI] Limited in 1955 as a public limited company. The
primary objective of establishing ICICI was to promote industries in the private
sector and to meet their foreign currency requirements.
The next agency that was set up in this network for the provision of industrial
finance was the Refinance Corporation for Industry Limited (RCI) in 1958.
This institution was promoted jointly by the RBI, LIC and some leading
commercial banks. The RCI was intended primarily to provide refinance
facilities to commercial banks in respect of their medium term lending to
medium sized borrowers in the private sector. However, The RCI was merged
with the Industrial Development Bank of India (IDBI) in September 1964.
During the same time, several state governments have floated a variety of
Financial Corporations and Industrial Development Corporations. Thus, the
SFCs and SIDCs came into existence during 1950s. Further, in 1955 the
Government of India set up an exclusive agency for the development of small
industry in the name of National Small Industries Corporation Limited (NSIC).
Financing through FIs, however, took a sharp turn with the establishment of the
IDBI in July, 1964 under an Act of Parliament as a principal financial institution
to provide credit and other facilities for the development of industry in the
country. The main objective of IDBI was to provide term finance and financial
service for the establishment of new projects as well as for expansion,
diversification, modernisation and technology upgradation of existing industrial
projects. As a premier organisation, IDBI was also vested with the
responsibility of coordinating the activities of the other financial institutions
engaged in the promotion and development of the industry.
The activity of establishing some more specialised agencies for taking care of
financial and non-financial needs of the industries is continuing till now. As at
present, the structure of Financial Institutions catering to the needs of Indian
Industry comprises of 6 All-India level FIs, 4 specialised financial institutions, 3
investment, 18 SFCs, 28 SIDCs, besides NABARD, Export Import Bank and
many other technical consultancy organisations.
13.2
FINANCING BY ALL FIs
Overall Position of Sanctions and Disbursements:
As indicated earlier, Financial institutions have been instrumental in providing

term finance to industry. Responding to the emerging needs of the industry,
these institutions have developed and introduced a variety of products and
diversified into newer areas. Starting with the operations of IFCI, the Financial
Institutions today have been advancing finance in sizeable amounts. In
retrospect, the sanctions and disbursements of IFCI during 1949-50 stood at
only Rs. 2.90 and Rs. 2.08 crore respectively. The network has spread now to
Financing Through FIs
13 institutions at the national level and 46 at the state level. All these
institutions could sanction and disburse an amount of Rs. 6181747 crore and
Rs. 4354065 crore respectively registering an annual growth rate of over 40
per cent by the end of March 2000 (See Table 13.1). One particular problem
with the financial assistance sanctioned by these FIs is that it lacks consistency.
This would be evident from the growth rates of sanctions and disbursements.
These rates varied from the lowest of 2.6 per cent to the highest of 18.3 per
cent in case of sanctions and between 4.9 and 43.0 per cent in case of
sanctions during 1980-96. The individual record of the FIs during the same
period presents diversity of a still higher magnitude. In case of some of the FIs
there is even negative growth in the finance extended by them to the industrial
units.
Institution-wise Assistance:
Among the FIs, highest amounts were sanctioned by IDBI. It sanctioned an
amount of Rs. 1,73,978 crore and disbursed Rs. 1,17,687 crores by the end of
March 2000. This was followed by the IFCI and UTI (See Table 13.2).
Though IFCI was the first to be set up, it could not excel in sanctions for want
of limited funds available at its disposal, compared to the fund base of IDBI.
While IDBI had Rs. 69849 crores at its disposal by the end of March 2000,
IFCI had only Rs. 22,974 crore at its command. The differences that could be
noticed in the figures (Table 13.2) mainly account for this reason.
Sector-wise Assistance:
To whom assistance should be sanctioned is always a matter of concern. Some
FIs concentrated in financing the public sector projects; while others were
engaged in the task of promoting the private sector. Similarly, the size and
nature of activities also varied depending upon the peculiar conditions under
which FIs were constituted and operated. As a matter of fact, development
banks established in the underdeveloped countries in the initial years were
required to execute government investment projects. Some were even
authorised to formulate plans for economic development.
But the objective of setting up FIs in India was stated to be the financing of
private sector enterprisese. While piloting the bill for the setting up of IFCI, the
then Finance Minister was reported to have observed that the IFCI was not
intended to meet the financial requirements of nationalised industries; but only
to provide finance for the needs of private industry. However, these restrictions
are not followed now and by following the rules and regulations any industrial
enterprise can get sanction from the FIs; although private sector is the major
receipient of their assistance. Of the cumulative sanctions made so far by all
the FIs in India, 84.2 per cent went to private sector, 9.4 per cent to public
sector and 6.4 per cent to joint sector.
Forms of Assistance:
These FIs are mainly set up to finance long-term operations of the industrial
units. This may be in the form of equity, loans and guarantees. To a great
extent, they sanction assistance in the form of loans at specified rates of
interest. Their participation into the equity was once very limited. It is only
after the constitution of IDBI in 1964, FIs started providing direct finance in
the form of subscription to shares and debentures of industrial concerns.
Altogether a new dimension is added after the establishment of UTI in 1964,
since the very objective of this Trust was to channel household sector savings
for investment in risk bearing industrial securities. Above all, underwriting of
new issues of companies has been the continuous activity of FIs since their
inception. The intention of these institutions in extending underwriting support
was not merely to ensure that the financing of the project was fully tied up,
Financing
butDecisions
also to
indicate that the project was support-worthy and that investors could
take the risk of investing in such securities.
Further, the form in which assistance in sanctioned by the FIs is also dependent
on the specific provisions incorporated in their legislations, besides the financial
standing of the promoter, financing pattern, and the agreements already entered
into by the promoter. For instance, under section 23 of the IFC Act, the
Corporation was authorised to carry on and transact the following kinds of
business:
i)
guaranteeing loans raised by industrial concerns;
ii)
underwriting the issue of stock, shares, bonds or debentures by industrial

concerns;
iii)
granting loans or advances to or subscribing to debentures of industrial

concerns;
iv)
acting as agent for the central government and/or with its approval, for
the IBRD in respect of loans sanctioned by them to industrial concerns;
and
v)
extending guarantee in respect of diferred payments by importes who are

able to make such arrangements with foreign manufactures.
The powers given under section 23 of the Act were widened in 1960 through
an amendment to the Act to enable the Corporation to guarantee: (i) loans
raised by industrial concerns from scheduled banks or state co-operative banks;
(ii) deferred payments in connection with the purchase of capital goods
manufactured in India; and (iii) with the prior approval of the central
government, loans raised from or credit arrangement made by industrial
concerns with any bank or financial institution outside India in foreign currency.
The Corporation was also empowered to subscribe directly to the stock or
shares of any industrial concern.
In much the the same way, the SFCs were authorised to provide financial
assistance of the following types to small scale and medium sized industries:
i)
granting loans or advances or subscribing to debentures of industrial

concerns;
ii)
guaranteeing loans raised by industrial concerns on such terms and

conditions as may be mutually agreed upon; and
iii)
underwriting the stock, shares, bonds and debentures.
These restrictions on the form of assistance have started losing their

significance after the setting up of IDBI in 1976 with a considerable measure
of operational flexibility. The Bank has been empowered to finance all types of
industrial concerns in whatever form it prefers to.
There are no restrictions as regards nature and type of security that may be
accepted from the industrial concerns. The financial sector liberalisation initiated
in early nineties has also led to a structural transformation in the business of
FIs. They are now expected to respond to the challenges imposed by the new
competitive and deregulated financial environment. The FIs are now diversifying
into both project and non-project lending and fee-based services.
Table 13.3 provides the details regarding the different forms of assistance
sanctioned by diverse FIs by the end of March 2000. It is evident from the
table that loans forming part of the direct assistance are occupying the prime
place. Their significance seems to be more pronounced in case of SIDCs. As
indicated earlier, underwriting and direct subscription to the securities of
industrial units is also a preferred activity of the FIs. Nearly, one-fifth of their
money is earmarked for this purpose.
Certain Special Schemes of FIs:

Yet another glaring feature of the assistance of FIs is that they have launched
diverse schemes to cater to the special needs of the industrial units. As a
matter of fact, the list of such schemes is quite exhaustive; however specific
mention may be made of the following:
Development Assistance Fund of IDBI:

This fund was set up by the IDBI in 1965 with its own resources and from
the resources of the central government. The fund is intended to provide
assistance to those industries which, for various reasons like heavy investment
involved or low anticipated rate of return, may not be able to obtain funds in
the normal course. Assistance from the fund requires prior approval of the
central government. The government, in turn, is to be satisfied that the
proposed project is necessary in the interests of industrial development of the
country. The IDBI is supposed to maintain separate accounts for this fund and
also to submit a report on the operations of the fund to the Central
Government.
Risk Capital Foundation Scheme of IFCI:

This scheme was started by IFCI in June 1976 with an initial money of Rs. 1
crore. The objective of this scheme was to meet the seed capital requirements
of entrepreneurs who have other abilities but no finance to launch a project.
This was meant to enable the new entrepreneurs to contribute their share of
promoters equity. The loans from the foundation were granted on liberal term
such as no interest, limited service charge and repayment in 15 years. These
loans were to be repaid by the promoters out of their own income. This
scheme was similar to the Seed Capital Scheme of IDBI. This scheme was
merged with the Risk Capital and Technology Finance Corporation (RCTFC)
from January 1988. The RCTFC Ltd., extended the operation of this scheme to
include innovative technologies, products, processes, control of environmental
pollution, energy conservation and other venture capital schemes.
Soft Loan Scheme of IDBI:

This scheme is meant to finance traditional industries such as cotton, juste,
textiles, cement, sugar and some engineering industries towards modernisation,
replacement, renovation of their old and obsolete plant and machinery. Though
this scheme was originally introduced by IDBI in November 1976, the same is
now operated jointly by IDBI, IFCI and ICICI. The scheme is named as such
because of a number of concessions offered by the FIs to industrial units such
as low interest rates, less promoters contribution, high debt equity ratios, long
repayment periods, etc. Further, a liberal view is taken in respect of imposing
margins and security.
Seed Capital Assistance Scheme of IDBI:

In order ot encourage new enterpreneurs having technical and other skills,
IDBI has introduced this scheme in 1976. Under this scheme, entrepreneurs
are provided with necessary finance upto Rs. 3 crore as seed money. This
money is granted free of charge. This scheme is intendedto induce and
encourage the setting up of small and medium industrial units. The assistance is
also extended for the projects which have been appraised by the IDBI or any
other all India FI. The scheme is operated through the SFCs and SIDCs.
These state level FIs are expected to make a thorough evaluation of the
entrepreneur as to his capability to set up and run the project successfully;
Financing
Decisions
establish
on
the basis of appraisal, the technical, financial, economic and

feasibilities of the project and continously monitor the progress of the unit at
various stages. This scheme has been liberalised to make it more worthwhile
and effective. Now that not only technically qualified persons, but also any one
who has a worthy project can approach IDBI for this assistance. Similarly, the
scheme is no longer restricted to projects in backward regions or priority
sectors.
Suppliers Line of Credit Scheme of ICICI:

This scheme was introduced by ICICI to help indigenous machinery
manufacturers to offer deferred payment facilities to the buyers so as to
increase the sales. Under this scheme, payment is made by ICICI directly to
the supplier of equipment without involving banks. The facility under this
scheme is available only to actual users of equipment. The supplier will get
around 80-90 per cent of the invoice value much early. The purchaser is
provided with a deferment period varying between 5 and 7 years.
Industry-wise Assistance:
Though there are some restrictions at least in the initial years, regarding the
grant of assistance to different sectors, and in different forms, the FIs are
relatively free to choose the industry of their choice. Perhaps, they are obliged
to look into the priorities indicated in the Five-Year Plans regarding the
encouragement to be given to a particular type of industry. As one can observe
from the operations of the FIs, there is a general preference towards the
funding of projects promoted by new entrepreneurs and technologists, those
located in backward areas, those having foreign exchange earning potential,
those based on indigenous technoloy and those that are designed to fulfill the
increased demand for mass consumption goods like medicines, textiles, sugar
and other food products and those engaged in the creation of necessary
infrastructure for the development of Indian industry.
Table 13.4 provides the relevant statistics pertaining to the allocation of FIs
assistance to different industrial sectors. It is clear from the table that the
industries such as textiles, chemicals, electricity generation and services have
got major share of the assistance from FIs. Each of them have got around 10
per cent of the total assistance. Compared to over fifty categories of industries
considered by them for assistance, the above industries certainly had a better
preference.
13.3 ROLE OF BANKS IN TERM FINANCE
Though the nexus between banks and industry is evident from the beginning of
the growth of commercial banking during 19th century in India, banks have
mainly concentrated on the financing of trade and commerce. Though they
have opened their doors for industrial units, their financing is based on the
British tradition with rule that banks provide only the working capital
requirements of the industries. This was also because of the fact that the
Central Banking Enquiry Committee in 1931 and the A.D. Shroff Committee in
1954 advised against the banks entry into the term finance. Further, with the
growth of various merchant banking activities, banks realised the potentiality of
the corporate sector in their exercises for deposit mobilisation. They felt that
they could improve their deposits only with closer contact with the industrial
units. It is for this reason that banks have in recent years started exploring
various possibilities and are participating in the Consortia for meeting the term
needs of the industrial units. More so, banks had the facility now to get
refinancing facility from IDBI and NABARD for the term loans extended by
them. Thus term lending by commercial banks is of a recent phenomenon.
Initially, it was felt that the commercial banks could not afford to lock up large
funds in long-term assets because it would affect their liquidity and would make
it difficult for them to meet the working capital needs of trade and industry.
However, since 1958, when Refinance Corporation was established by Reserve
Bank of India (RBI), the latter was eager to recommend a change in the
attitude of commercial banks towards term lending because, on the one hand, it
could boost the profits of the lending banks and on the other hand, enable the
borrowing units to enjoy certainty of having funds for a specified period
irrespective of any change in the monetary policy. As a result of this the,
commercial banks started evincing interest in term-lending but on a very
nominal scale. In may 1975, the RBI urged the commercial banks to step up
their term-lending particularly in the following areas:
a)
Deferred export payments.
b)
Industries where a significant portion of the output is meant for exports.
c)
Industries having short gestation period particularly in the core sector and
especially those producing mass consumption goods.
d)
Agricultural sector.
e)
Industries in the industrially backward areas.
f)
Small scale industries involving investment and exceeding Rs. 25,000.
g)
Capital good industries.
Quantitatively speaking, the share of term loans in total advances of scheduled

commercial banks grew from one-tenth in seventies to about one-fifth now.
Further, commercial banks also take part in a limited way and subscribe directly
to theshares and debentures of the joint stock companies. Their holdings of
these securities may be sometimes out of their underwriting commitments.
Unfortunately, comprehensive data on investments in shares and debentures by
Commercial Banks is not available. Available data reveal that the holdings of
banks of shares and debentures aggregated to Rs. 12.7 crores; comprising of
8.7 crores of shares and 4.0 crore of debentures by the end of 1951. This has
gone upto Rs. 92.7 crore by the end of March 1976; comprising of shares of
27.3 crores and debentures of 65.4 crore. A remarkable feature of the banks
investment in these securities is that their investment in debentures vis-a-vis
shares is increasing over time. Moreover, the holdings of banks of these
securities (both shares and debentures) constitutes only around 2 per cent of
the aggregate investments of banks.
Activity 1
a)
Establish the need for founding specialised financial institutions for financing
industrial units.
...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
Refer to the Memorandum of Association of any FI and list out the

objectives for which it is set up.
...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
Explain different Forms of Assistance.

...................................................................................................................
...................................................................................................................
...................................................................................................................
Financing
d) Decisions
Collect
the Annual Report of any FI and write a note on its operations.
...................................................................................................................
...................................................................................................................
...................................................................................................................
13.4 FINANCING NORMS

There are certain aspects which need to be known to fully appreciate the
issues involved in financing through FIs. They include the following:
1.
Project appraisal
2.
Security of loans granted
3.
Interest rate
4.
Repayment schedule
5.
Disbursal procedures
6.
Conversion option
7.
Post sanction monitoring
Project Appraisal:
While granting financial assistance to industrial units, FIs appraise the projects
of the latter from various feasibility points of view including economic, technical,
financial and marketing. The economic feasibility may include the verification of
the projects suitability in terms of plan priorities, use of resources and import
substitution, export promotion. If satisfied,then the FI may conduct other
feasibility studies and satisfy itself about the worthiness of the project.
Under the technical feasibility, the FI may go into the aspects such as:
i)
Location of the project,
ii)
Appropriateness of the technology,
iii)
Scale of operation,
iv)
Suitability of plant and equipment
v)
Collaboration Agreements
vi)
Project implementation schedule.
Financial feasibility relates to the aspects like cost of the project, mode of
financing, capital structure, cash flow projections, rates of return and finally the
viability of the project. Though FIs are often termed as Development Banks,
they are more inclined to appraise the projects from the Commercial point of
view rather than development point of view. This is really a paradox. Perhaps
this is for this reason the word Development has outlived its existence now.
Security of Loans Granted:
Security happens to be the basic tenet of lending. As many of us are aware, till
nationalisation in 1969, commercial banks followed only security-based lending
instead of need-based lending. Same is true in case of FIs also. Security is
considered a necessary adjunct to financial appraisal. This is considered all the
more important due to non-availability of accurate information to probe into the
credit worthiness of the applicant in terms of his character. FIs accept many
things as security including the assets of the business, personal guarantees of
the Directors and promoters. FIs also try to ensure security for their loans by
incorporating certain conditions in the loan agreements; which may be of the
nature of : priority for repayment, restrictions on the payment of dividends,
commission, maintenance of minimum working capital, etc.
Interest Rates:
What should be the rate of interest charged to industrial units on the finance
extended by FIs is a matter of great concern. For, FIs should not charge too
low a rate to make loans to be a gift, nor they should put it high to drive away
the business units. There is lot of focus on the interest rate policy of FIs.
Apart from making available the needed finance, they should look into equity
and their own cost of funds. No institution can lend at the rates lower than its
own cost of capital. Then, they must add some spread to continue in the
business.
The issue that engages the attention of many as for as interest rate policy of
FIs is concerned is that whether they should charge market rate or a lower
rate; since the FIs may secure funds from Government, Central Bank whose
cost of funds is lower. Sometimes, FIs also receive grants from the
Government having no interest element. When such is the case, whether FIs
should necessarily extend the same benefit to business units in the form of
lower interest rates. This argument is not accepted by many. The reason being
that FIs also undertake various kinds of financial and non-financial services
involving financial commitment. As such, in majority of the cases, the FIs used
to charge a composite rate taking all its expenses into account.
In India, we have an administered interest rate system controlled by the
Reserve Bank. This has little to do with the rates determined by the market
forces. This is done as a matter of policy to maintain monetary stability in the
economy. The RBI used to announce the changes in the interest rates (both for
deposits and loans) from time to time keeping in view of the money supply and
demand for credit. However, some relaxation is provided in this regime now.
This process began in 1990 when the plethora of lending rates for different
slabs of borrowing were rationalised into six. A minimum lending rate
prescription for large borrowers was introduced in 1988. After the recent
changes, there are only two rates of interest prescribed on the lending side and
on the deposit side, there is only the prescription of a maximum rate. As far as
FIs are concerned prime lending rate is decided and FIs can lend at varying
rates subject to this. Consequent upon the recent policy changes (October
1997), there existed two prime lending rates, viz; one for the long-term loans
and the other for the short-term and medium-term lending. As applicable
from October 1997, the prime lending rate of IDBI, IFCI and ICICI is pegged
at 13.5 per cent; whereas SBI could fix it at 12:75 per cent for long term
loans.
Repayment Schedule:
In case of the financing through FIs, repayment is an important matter to be
decided. Usually, the repayment period is decided taking into account the
gestation period, life of the project and cash flow generation. The repayment
period is also sometimes governed by the provisions in the respective
legislations of the FIs. For example, under the provisions, IFCI is permitted to
extend loans having a maximum of repayment period of 25 years. Similarly, the
refinance facility extended by IDBI is subject to a specific maturity period.
However, FIs are using their discretion subject to these limitations and the loans
advanced by FIs are usually repayable in annual or semi-annual installments
spread over a period of 10 to 15 years.
Disbursal Procedures:
As can be seen from the data contained in Table 13.1, there is lot of gap
between sanctions and disbursements. Sometimes, disbursements are just little
over half of the sanctions. As it is said in law that Justice delayed is law
justice denied; we can say that Disbursal delayed is assistance denied. There
Financing
Decisions
is enormous
delay in the disbursal of assistance. Perhaps, this is caused due to

cumbersome loan procedures adopted by the FIs. The FIs may take appropriate
measures to cut short these delays. On the other hand, borrowers also should
help the FIs in completing their responsibilities in terms of providing their
contribution to the project, submitting the relevant information and other
necessary documents.
Conversion Option:
Convertability option refers to a provision in the loan agreement, whereby the
lender will have an option to convert his loan into equity at his discretion. This
clause came into the picture in the industrial financing on the recommendations
of the A.D. Shroff Committee. The objective of this provision was to check the
use of public money for private gain and to curb concentration of economic
power. The reasoning was that through convention, FIs would be able to
participate in the management and control of industrial concerns and also in the
profits made by them. FIs have started invoking this clause almost from 1970 in
their loan agreements. Not only the stipulation, but the actual exercise of the
option by FIs is also significant.
Because of the above, there was lot of opposition from the industrial units
regarding the convertibility clause. Realising this, the FIs have related this to
the magnitude of assistance. To start with convertibility clause was not
introduced into the agreements if the amount of loan is below Rs. 25 lakh. It
may be introduced at the discretion of the institution, if the assistance is
between Rs. 25 to 50 lakh; and the clause is compulsorily introduced, if the
assistance is more than Rs. 50 lakh. Usually, the institutions are expected to
exercise the option only after two or three years of the implementation of the
project. The government has relaxed these norms in June 1980. Thereafter,
convertibility clause is introduced in the case of loans exceeding Rs.1 crore.
Further, the FIs are forbidden to acquire more than 40 per cent of the total
share capital of a company through loan conversions, excepting in the cases
of persistent default by the company. In which case, the FIs can acquire upto
51 per cent of the total share capital. In addition, conversion option is not
now applicable in case of loans sanctioned for the purpose of modernisation
and rehabilitation.
Post-sanction Monitoring:
In view of the large stakes involved in the assistance sanctioned to different
industrial units, there is a need to monitor the working of the assisted units
closely, not only to ensure safety of the funds invested; but also to ensure
effective utilisation of the funds and timely completion of the projects. In this
regard, FIs have to call for periodical reports about the operations of the
projects in terms of production, sales, cash flows, profitability, cost structure,
etc. Depending on the necessity, FIs may hold discussions, consultations and
conferences with the others interested in the project like bankers, stock
brokers and fellow FIs. It is also important for the company to ensure that
the assisted units recruit qualified and experienced technical and managerial
personnel.
10
In this regard, FIs like IFCI, ICICI and IDBI have adopted a rigorous followup procedure and have made a practice of carrying out regular inspection of
the projects financed by them. As a matter of fact, ICICI is publishing a
report entitled Financial Performance of Companies: ICICI Portfolio almost
from the year 1971-72. This is a sample study of its assisted units (417)
covering about 55 per cent of the paid-up capital of the non-government
public limited companies at work in India by March 1981. Later, the coverage
has been increased to 675 companies with almost the same percentage in
paid-up capital. In addition, ICICI has also initiated exclusive studies on the
topics like export performance and capacity utilisation. Similar to this exercise,
IDBI has also started compiling and publishing data on the performance of its
assisted units.
Further, there is also the practice of nominating directors to the Boards of the
assisted units. Where the assistence is large or where the project is complex,
there is the practice of appointing nominee directors by the FIs. Nevertheless,
there is lot of criticism on the role and function of these nominee directors. It
should be constructive rather than destructive. Nominee directors are largely
criticised for their inaction and overaction. Instead of using their own discretion,
they are guided by the dictates of the employer. This is naturally denounced. It
is felt that the role of the nominee directors should be an unmixed blessing
rather than suspicious hindrance.
13.5
SHARE OF FIS IN THE COMPANY FINANCING
The foregoing analysis on the financing by FIs in terms of sanctions and

disbursements clearly reveals the fact that FIs played a useful role in
supporting the rapid industrialisation of the country. It is no matter of
exxaggeration that these institutions have now assumed a position that without
their support, hardly any large project in the corporate sector can materialise.
The discussion on the Financing through FIs cannot be considered complete,
unless we also account for the share of FIs in the total company financing. For
this purpose, we have compiled data from the finances of Public Limited
Companies published by RBI. The data of RBI covers a sample of 1720 nongovernment, non-financial public limited companies, accounting for 32.6 per cent
of such companies in terms of paid-up capital. The relevant data is presented
in Table 13.5.
It is evident from the table that FIs could provide about one-fifth of the total
external sources and around one-sixth in terms of the total sources in 1991-92.
However, in the subsequent years, the relative contribution of FIs has
significantly declined mainly due to entry of commercial banks in term financing
business and growing financial disintermeditation resulting in greater reliance of
the corporates on stock market.
Activity 2
a)
Note down the salient features of Seed Capital Assistance Scheme of

IDBI.
...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
Comment on the Role of Banks in Term Finance.

...................................................................................................................
...................................................................................................................
...................................................................................................................
c)
Elucidate the project appraisal procedure of any FI.

...................................................................................................................
...................................................................................................................
...................................................................................................................
11
Financing
d) Decisions
Write a
note on the Interest Rates in India.
...................................................................................................................
...................................................................................................................
...................................................................................................................
e)
Examine the link between sanctions and disbursements.

...................................................................................................................
...................................................................................................................
...................................................................................................................
f)
Role of External sources in Company Financing.

...................................................................................................................
...................................................................................................................
...................................................................................................................
g)
Conversion option.
...................................................................................................................
...................................................................................................................
...................................................................................................................
13.6 REFORMS IN THE DFIS SECTOR

Consequent upon the poor performance of the economy, Government has
embarked upon initiating reforms from the beginning of nineties of the last
century. The sweep of the reform process extends logically to the FIs sector
also. In an attempt to making a systematic effort in the direction of reforms,
Government constituted a committee in 1991 under the chairmanship of M.
Narasimham to suggest reforms in the financial sector.
Recommendations of Narasimham Committee Relating to DFIs:
The following are some of the important recommendations of the Narasimham
Committee in respect of Development Financial Institutions.
12
1.
In view of increasing competition in the financial sector, pressure on the

availability of concessional finance and progressive deregulation of interest
rates, DFIs are required to become more and more competitive, efficient
and profitable. They are also required to ensure operational flexibility and
adequate internal autonomy in the matters of loan sanctioning and internal
administration.
2.
The present system of consortium lending is operating like a cartel. As

such, the consortium lending should be disposed with. In its place, a system
of syndication or participation in lending at the instance of lenders and
borrowers should be introduced.
3.
The present system of cross holding of equity and cross representation on

the boards of DFIs should be done away with.
4.
As a measure of enhancing competition and ensuring a level playing field,

the IDBI should retain only its apex and refinancing role and that its direct
lending function be transferred to a separate institution which could be
incorporated as a company.
5.
It is necessary to distance state level institutions from their respective state

Governments to ensure that they function on business principles.
6.
DFIs should seek to obtain their resources from the market on competitive
terms and their privileged access to concessional finance through SLR and
other arrangements should gradually be phased out over a period of three
years.
7.
The operations of the DFIs in respect of loan sanctions should be the sole
responsibility of the institutions themselves based on a professional
appraisal of the technical and economic aspects of the project, and
evaluation of the promoters competence and integrity and the financing
and other aspects of the proposal. There should be no room for behest
lending of any kind.
8.
DFIs should also be covered by the operations of the Asset Reconstruction

Fund (ARF), so that the contaminated portion of their portfolio is taken off
the books.
9.
While the entry of commercial banks into the provision of term finance is
the first of necessary steps, it is also necessary to permit DFIs to enter
the area of working capital finance.
10. In respect of corporate take overs, DFIs should lend support to existing
management who have a record of conducting the affairs of the company
in a manner beneficial to all concerned including the shareholders, unless in
their opinion the prospective new management is likely to promote the
interest of the company better. In doing so, the FIs are expected to
exercise their individual professional judgement, free of any extraneous
pressures.
Action taken by the Government:
Based on the recommendations of the Committee, the Government has taken
the following measures:
1.
IDBI, IFCI, ICICI, IRBI and Exim Bank were advised to achieve a capital
adequacy norm of 4 per cent by March 31, 1994. And those FIs having
dealings with agencies abroad were required to achieve a norm of 8 per
cent by March 31, 1995; while the rest were required to attain 8 per cent
norm by March 31, 1996.
2.
The Board for Financial Supervision (BFS) started supervising the DFIs
w.e.f. April 1995.
3.
Additional amounts have been sanctioned towards capitals of Certain DFIs.

Further, they were permitted to approach capital market. During the last
two years alone viz., 1995-96 and 1996-97, the six All India Financial
Institutions (Companies of IDBI, IFCI, ICICI, SIDBS, IRBI and SCICI)
raised an amount of Rs. 19,579 crore from the capital market. It is logical
to assume that when the FIs raise such large amounts of funds from the
market, they also insist on the borrowers the same market discipline.
4.
The prudential and capital adequacy norms, hitherto applied to the

commercial banks, are now made applicable to the FIs also. As per these
regulations, FIs are also required to maintain stipulated standards in respect
of capital adequacy, income recognition, asset classification and provisioning
requirements.
5.
There is reorganisation in some of the FIs intending to face emerging

challenges in the liberalized environment. SCICI Ltd. was merged with ICICI
Ltd., on April 15, 1997 and similarly the IRBI was converted into a company
and was renamed as Industrial Investment Bank of India (IIBI) Ltd.
The Unfinished Agenda:

As it appears, there is lot of ground yet to be covered by the government
towards implementing the recommendations of Narasimham Committee to
ensure competition, operational flexibility and superior performance. The
recommendations of the committee regarding the creation of asset
reconstruction fund, consortium lending, ensuring a level playing field, distancing
DFIs from their sponsors are all to be implemented.
13
Financing
In Decisions
a lecture
arranged by the A.D. Shroff Memorial Trust, Bombay, Narasimham

remarked as follows (after two years of the submission of committees report
on Financial Sector Reforms):
Since the submission of the report, the authorities have taken several steps on
different aspects of the recommendations. But essentially, the approach has
been somewhat ad hoc, piecemeal and at times even hesitant. The approach is
suggestive of incrementalism rather than a sequencing of reform as part of an
integrated programme. It is pertinent to suggest that the committees various
recommendations should be compared with a Jig-saw puzzle where the picture
becomes complete only when all the pieces are in place and until such time a
piecemeal approach to the problem would not help us to obtain the full benefits
of the exercise.
Even after a lapse of 5 years, the agenda is still unfinished, calling for a still
greater attention by the Government.
Activity 3
a)
Mention important Recommendations of Narasimham committee.

...................................................................................................................
...................................................................................................................
...................................................................................................................
b)
What is the unfinished Agenda.

...................................................................................................................
...................................................................................................................
...................................................................................................................
13.7 SUMMARY
Attempt has been made in this unit to highlight the significance of financing
extended to industrial units by Financial institutions. The discussion in this unit
began with tracing out the historical setting leading to the founding of various
FIs in the country. The discussion underlined for financing its industrial
development programmes. This was followed by the assessment of overall
position of sanctions and disbursements by the FIs as also according to sector,
institution, form and industry. It was noted that the FIs in India tailored its
process of industrial finance to the needs of the corporate sector.
14
With the entry of commercial banks into the term finance area, the latter
ceased to be the prerogative of term-lending institutions. The increasing
presence of commercial banks in this area has further radicalised the scene of
industrial finance. Aspects pertaining to the lending norms such as project
appraisal, security, interest rate, repayment schedule, disbursal procedures,
conversion option and post sanction monitoring are also discussed in this unit.
As a matter of fact, FIs are criticised by industrial units mainly because of
these norms and the cumbersome procedures they are following in disbursing
the loan applications. Financing by FIs has also assumed significance in the
total financing position of companies. Nearly one-fifth of the external resource
requirements are being met now by the FIs. However, its importance has
diminished remarkably in recent years. Nevertheless, there is lot ground yet to
be covered by our FIs. In view of increasing competition in the financial sector,
pressure on the availability of concessional finance and progressive deregulation
of interest rates, FIs are required to become more and more competitive,
efficient, profitable and operationally flexible. The implementation of the
recommendations of Narasimham Committee would go a long way in this regard.
1.
Bring out the significance of term lending organisations in the financing of industries.
2.
What are the recent trends in the financing of industrial units? Are they
going in healthy direction?
3.
Briefly highlight the procedures and norms followed by the FIs in extending
credit. Can you suggest any modifications to the existing procedure?
4.
What is post sanction monitoring? How is monitoring exercised by FIs in India?
5.
Bring out the role of nominee-directors in the industrial units. Should we

continue this practice?
6.
Convertibility clause is a drag on the Financing facility provided by Indian

Financial Institutions. Comment.
7.
Highlight the important recommendations of Narasimham Committee

relating to DFI sector. Are you satisfied with the way government is
implementing them?
8.
In the present day scenario, should there be restrictions on the form and
type of assistance sanctioned by FIs in the country?
9.
Briefly discuss the soft loan scheme of IDBI.

Table 13.1: Assistance Sanctioned and Disbursed by All FIs
(Rs. in crore)
Year
Sanctions
Growth
rate %
Disbursements
Growth
rate %
1964 - 65
118.1
90.5
1970 - 75
1916.7
1296.7
1975 - 80
7102.4
4623.4
1980 - 81
2934.0
1847.9
1981 - 82
3281.0
11.8
2352.0
27.3
1982 - 83
3366.9
2.6
2468.4
4.9
1983 - 84
4195.1
24.6
3138.4
27.1
1984 - 85
5578.7
33.0
3618.0
15.3
1985 - 86
6548.2
17.4
4937.7
36.5
1986 - 87
8138.9
24.3
5708.9
15.6
1987 - 88
9576.0
17.7
7061.3
23.7
1988 - 89
11386.6
18.9
7713.0
9.2
1989 - 90
14429.1
26.7
9640.4
25.0
1990 - 91
19254.7
33.4
12810.1
32.9
1991 - 92
22443.7
16.6
16259.9
26.9
1992 - 93
33282.0
48.3
23258.7
43.0
1993 - 94
41010.8
23.2
26629.3
14.5
1994 - 95
59663.1
45.5
33528.7
25.9
1995 - 96
67618.0
13.3
38442.6
14.7
1999 - 2000
1043407.6
15.5
684804.2
63.5
Cumulative
upto endMarch 2000
6181747.2
4354065.1
Source : Report on Development Banking in India, 1999-2000 Mumbai, IDBI.
15
Financing Table
Decisions
13.2:
Institution-Wise Assistance Sanctioned and Disbursed by All FIs

(Rs. in crore)
Institution
Cumulative
sanctions
upto March 2000
All-India Development Banks

IDBI
IFCI
ICICI
SIDBI
IIBI
Sub-Total
Cumulative
Disbursements
upto March 2000
1988112.9
430141.9
1914572.6
554084.9
100898.1
4969637.3
1348938.1
390042.0
1141987.3
399505.1
72525.6
1546.6
4710.2
19435.4
25692.2
1474.3
4080.3
11561.6
17116.2
Investment Institutions
LIC
UTI
GIC
Sub-Total
330345.1
623900.1
109361.6
1063606.8
297323.3
476699.2
86695.4
860787.9
State-level Institutions
SFCs
SIDCs
Sub-Total
Grant-Total
323282.1
207940.1
531222.2
6181747.2
265950.7
167998.2
433948.9
4354065.1
Specialised Financial Institutions

IVCF
ICICI Venture
TFCI
Sub-Total
* Including assistance to small scale sector upto end-March 1990.

Source: Report on Development Banking in India, 1999-2000. Mumbai, IDBI.
Table 13.3: Form-Wise Assistance (Cumulative) Sanctioned by FIs

By the end of March 2000
(Rs. in crore)
Form of Assistance
Rupee Loans
Foreignency Loans
All-India Dev. Banks

3531949.8
(71.1)
Total
Investment
Institutions
5046498
(95.0)
307723.5
(38.9)
616149.2
(12.4)
Underwriting and direct

subscription
Guarantees
State-Level
23309.3
(4.4)
506914.1
(10.2)
58746
(18.4)
755883.3
(61.1)
314384.2
(6.3)
14339
(4.5)
3263.1
(0.6)
4969637.3
(100.0)
531222.2
(100.0)
1063506.8
(100.0)
* Figures in the brackets indicate percentages to total assistance.

Source: Report on Development Banking in India, 1999-2000 Mumbai, IDBI.
16
Table 13.4: Industry-wise Cumulative Assistance Sanctioned by
All Financial Institutions by March end 2000
Industry
Rs. in Crore
Textiles
Chemicals
Chemical Products
Fertilizers
Refineries or Oil Exploration
Basic Metals
Electrical & Electronic Equipment
Infrastructure
Services
541631.1
676552.0
196127.6
279291.1
524411.2
299285.7
944851.9
715894.4
Total (Including Others)
5938759.8
Table 13.5: Share of 71s (Excluding Banks and Foreign 71s)

in the company financing
Year
Net Borrowings
from 71s
(Rs. Crore)
As % of
External
Services
As % of
Total
Services
1991-92
3594
19.8
14.3
1993-94
3689
18.6
13.8
1994-95
1584
4.8
3.4
1998-99
4115
2.6
1.1
1999-00
4322
2.6
1.1
2000-01
4642
2.7
1.0
Source: RBI Bulletins, January and October, 1997 and September, 2002
11.9
FURTHER READINGS
Sethuraman T.V., Institutional Financing of Economic Development in India,

Delhi, Vikas Publications, 1970.
Basu, S.K., Theory and Practice of development Banking: A Study in the
Asian Context, Bombay, Asia Publishing House, 1965.
Simha, S.L.N., Development Banking in India, Madras, Institute for Financial
Management and Research, 1976.
Report on Development Banking in India, Mumbai, IDBI, 1997.
Vinod Batra, Development Banking in India, Jaipur, Printwell Publishers,
1986.
Report on Trend and Progress of Banking in India, 1996-97, Mumbai, RBI,
December 1997.
Prasad, G., Corporation Finance in India, Guntur, Sai Publications, 1987.
Report on Currency and Finance, 1995-96, Mumbai, Reserve Bank of India,
1996.
Rao, K.V. and Venkataramaiah, B., Bank Finance to Industries, Jaipur,
Printwell, 1991.
Report of the Narasimham Committee on The Financial System, 1991.
R.M. Srivastava, Management of Indian Financial Institutions, Himalaya
Publishing House, Mumbai, 2001.
17
UNIT 14 OTHER MODES OF FINANCING
Objectives
provide an understanding of non-traditional sources of long-term financing,
focus on non-traditional sources of short-term financing.
Structure
14.1
Introduction
14.2
Non Traditional of Sources Long-term Financing

14.2.1
Leasing and Hire-Purchase
14.2.2
Suppliers Credit
14.2.3
Asset Securitization
14.2.4
Venture Capital
14.3
Non Traditional Services of Short-term Financing
14.4
Summary
14.5
14.6
Further Readings
14.1
INTRODUCTION
Raising funds is an important activity of finance managers. Business units

require funds for two reasons - to acquire fixed assets and to run the
operations of the units. Several factors influence the need for funds and
typically a growing firm needs more funds year after year. In the previous
units, we discussed how a firm can raise money from capital market and
institutions. In this unit, we will look into other alternative sources of funds.
Before we discuss these sources, let us quickly review the financing options
available before a firm and what is the need for additional non-conventional
sources of finance.
It was noted earlier that firms typically raise money in the form of equity or
debt. Equity is risk capital and brought by owners, who want to take risk while
investing money. Debt holders are typically risk-averse investors, and hence
want safety but willing to provide funds at a lower rate of return. Debt
holders are less interested on the future prospects of the company but they are
interested to know whether the company would be liquid enough to pay interest
and principal on the due date. In between the equity and debt, firms also raise
money through preference capital and convertible debt instruments. Also, firms
retain substantial part of the profit to meet their requirement. Fixing a broad
mix and then choosing different sources of capital is an important job of
financial managers. You would by now know why financial managers spend lot
of time on this issue particularly, when we also say finance mix is irrelevant in
valuation of firm (Modigliani and Miller Theory).
While equity capital is raised not so frequently, firms take additional debt from
institutions and other sources regularly. In fact, debt is found to be important
source of capital next to retained earnings. While retained earning provide
convenience (easy to tap), debt is often believed cost effective particularly for
tax reasons. In terms of convenience also, debt scores over fresh equity issue
since banks and financial institutions are easily approachable than approaching
1
Financing Decisions
capital market for equity issue. Equity issue involves considerable amount of
legal and other formalities and also there is no assurance that investors will be
interested in putting their money in the company. Finance managers choose a
particular source of capital after considering the following issues:
a)
Whether the duration for funds required and funds available match?
b)
What is the size of funds requirement?
c)
What is the risk involved in the investments for which funds are
demanded?
d)
Whether the funds are required urgently?
e)
What is the current and future financial markets scenario?
Finance managers look for constantly alternative sources of funding and

depending on the demand and nature of funds, a particular source of funds is
tapped. Often, the finance managers tap non-conventional source of funds. We
will discuss some of the non-conventional source of funds in this unit.
14.2
NON-TRADITIONAL SOURCES OF LONGTERM FINANCING
Long-term finance is raised when the need for funds is for more than one
year. Typically, long-term finance is required for acquisition of fixed assets
having a life more than one year or investments, which have long-term impact
on the earnings of the company. For instance, if a firm wants to buy a patent
or brand, which in turn contributes to the sales of the firm for a long-term, it
requires long-term funds for such acquisition. While equity and debt are
conventional source of finance, such source of finance is not available for
many investments. Some time, the investment needs may not be large enough
for the financial managers to approach banks or financial institutions. They
look for alternative source of finance under these circumstances. In the
following sections, we will discuss four such sources of alternative long-term
finance available for the firms. They are (a) Leasing and Hire-purchase (b)
Suppliers Credit (c) Asset Securitization and (d) Venture capital.
14.2.1 Leasing and Hire-Purchase

Firms need finance to acquire assets. Instead of borrowing and acquiring
assets, it is possible for firms to acquire the assets on lease. There are two
types of leasing - operational lease and financial lease. Operational lease is
used when the assets are used for temporary period and the asset is returned
at the end of the short period. Suppose a firm gets an extra order for which it
requires some additional equipment. Such additional equipment can be taken on
lease for few days, say three weeks and at the end of the three weeks, the
equipment is returned to the owner. Some of the assets that are normally
acquired under operational lease arrangement are computers, vehicles,
generators, small movable equipment, etc. While operational lease is not
considered a source of finance, financial lease is used when the assets are
required permanently or for a long period. Normally, the assets are ultimately
purchased by the firm from the lessor at a nominal value. During the period of
lease, the firm which acquired the assets on lease (called lessee) can use the
assets but it is not the owner of the asset. The ownership rests with the
company which provided the assets on lease. During the period of lease, the
lessee has to pay lease rent to the lessor. Lessee is not entitled for any
depreciation whereas lessor can claim depreciation for the assets for tax
purpose. Hire-purchase is similar to financial lease. A hire-purchase transaction
2
is usually defined as one where the hirer (user) has, at the end of the fixed
term of hire, an option to buy the asset at a token value. In other words,
financial leases with an option to buy the asset at the end of the lease term
can be called a hire-purchase transaction.
Other Modes of
Financing
So the basic question is why firms acquire assets on financial lease and why
someone wants to buy an asset and then lease the same to another firm. There
are several reasons given below:
a) Easy Procedure: Acquiring an asset through a lease transaction is much
simpler than borrowing money from a bank or financial institution for
acquiring the same asset. Leasing companies have developed fairly simple
procedure to process lease application. The level of legal documentation is
also fairly simple. In other words, you can acquire the asset in a very short
period of time through lease transaction. Suppose, a firm wants to buy 10
lorries, it can be done with in two or three days through lease transaction.
Acquisition of computers and other such electronics items like Air-conditioning
can be done within a day. Since the ownership of the asset rests with the
lessor, the leasing companies are willing to take additional risk while
processing the lease application. If the assets leased are special type assets,
whose re-sale value is low, leasing companies will take longer time to process
such lease application since the risk involved in funding such assets is fairly
high. Typically, in borrowing the end use of the funds will not differentiate the
loan application processing. Hence, firms use lease for acquiring certain type
of assets.
b) Size of Loan: Many banks and financial institutions fix certain minimum
loan amount. If the need of firm is much lower, it doesnt make sense to
borrow more and keep the cash idle. Leasing company funds assets of any
value. If the requirement of funds is large, a consortium of leasing companies
funds such acquisition.
c) Cost: It is difficult to say whether lease cost will be lower than borrowing
cost but it is possible in certain cases due to tax impact. When a firm borrows
money and then acquires the assets, it pays interest and also claims
depreciation. Both interest and depreciation can be claimed as deduction under
income tax. The net outflow will be thus much lower. On the other hand, when
a firm acquires an asset on lease, it pays lease rent, which qualifies for income
tax deduction but there is no depreciation benefit. However, depreciation benefit
is claimed by the lessor and in all probability, the lessor will pass on the impact
of the tax shield to the lessee by fixing lower lease rent. In other words, it is
possible to fix a lease rental such that it is equal to borrowing to both lessor
(borrower) and lessee (lender). The following example explains the issue
further.
Illustration: Suppose a firm requires an asset worth of Rs. 1,00,000 and it can
raise the funds at 10% for five years from a bank. The bank requires the firm
to repay the loan with interest in 60 equated monthly installment (EMI) at the
rate of Rs. 2124.70. Present value of annuity of Rs. 2174.20 at an interest
rate of 0.83% per month for 60 months is equal to Rs. 1,00,000. It means
by paying Rs. 2174.20 every month for the next 60 months, you can wind up
Rs. 1 lakh loan you have taken today with an interest rate of 10%.
Since each installment consists of interest as well as principal, the interest
and principal paid over the five years are to be separated. While interest is
eligible for tax deduction, the amount paid towards principal will not qualify
for income tax deduction.
3
Financing Decisions
The values of interest and principal are as follows:

Year
Interest
Principal
Total
9269.644
16226.76
25496.40
7570.491
17925.91
25496.40
5693.414
19802.99
25496.40
3619.782
21876.62
25496.40
1329.015
24167.39
25496.40
Total
27482.35
99999.65
127482.00
If the life of the asset is also 5 years and the asset qualifies a depreciation
rate of 25%, the depreciation schedule is as follows:
Year
Opening Balance Depreciation Closing Balance
100000
20000
80000
80000
16000
64000
64000
12800
51200
51200
10240
40960
40960
8192
32768
Let us assume that the asset is sold at the end of 5 years at Rs. 32768. If
the firm pays income tax at the rate of 35%, the after tax cost of the asset is
as follows:
Year
Interest
Depreciation
Total
Tax Shield
@ 35%
Cost net of
Tax Shield
9269.644
20000
29269.64
10244.38
19025.27
7570.491
16000
23570.49
8249.672
15320.82
5693.414
12800
18493.41
6472.695
12020.72
3619.782
10240
13859.78
4850.924
9008.859
1329.015
8192
9521.01
3332.355
6188.66
The present value of cost net of tax shield at a discount rate of 10% is equal
to Rs. 48985. Suppose a leasing company is willing to provide the asset on
lease at a lease rental of Rs. 7561 per month for five years and at the end is
willing to transfer the asset to you at a nominal cost of Re. 1, the present
value of lease rent net of tax is as follows:
Year
Lease Rent
Tax Shield
Lease Rent
Net of Tax
Present value of
Lease Rent
90732
31756.2
58975.8
33486.91
90732
31756.2
58975.8
10669.96
90732
31756.2
58975.8
3399.77
90732
31756.2
58975.8
1083.27
90732
31756.2
58975.8
345.16
Total
453660
158781.0
294879.0
48985.09
In other words, both lease and borrowing leads to same effect. However, the
actual lease rent may be higher or lower depending on the cost of funds to the
lessor and tax shield the lessor get on leasing the asset. Further, if the lessee
firm is not tax paying entity, then there is no actual tax benefit from
4
depreciation and in that process, the cost of owning the asset will go up. Thus,
in a situation where the tax rates of lessor and lessee are different and the
cost of funds to lessor and lessee are different, then lease may be cost
effective. Since lease transactions also attract some additional taxes like sales
tax, one has to consider such additional costs in evaluating lease vs. borrow
decision. Students desiring to know more on this may refer some specialized
book on Lease Finance (Vinod Kothari, Lease Financing and Hire Purchase,
Wadhwa and Company, Nagpur).
Other Modes of
Financing
Though leasing is not a major source of finance, Indian companies today

acquire assets through lease finance. The following table shows the value of
leased assets and lease rent (including operating lease rent) paid by BSE-100
index companies during the last five years.
The table values show an increasing trend in the value of leased assets over
the years and also more than three time increase in the value of lease rent.
Some of the prominent companies that use leasing extensively are ONGC,
Shipping Corporation of India, IPCL, Larsen & Toubro, Reliance Industries, etc.
Companies like ONGC hire most of the drilling equipment on lease and hence
the lease amount is significant. Transport companies like shipping companies,
air-lines also acquire their assets through lease transactions. Companies that
prominently use leased assets, whose percentage on total assets is significant
are Reliance Capital, Asian Paints, IPCL, Siemens, and BHEL. Today, there
are several types of leasing. There are also mega international lease
transactions called cross-broader leasing. Lease finance is likely to grow in the
future due to its flexibility and convenience.
Table 14.1: Value of Lease Rent and Leased Assets of BSE-100 Index Companies
(Rupees in Crores)
Year
Lease Rent
Value of Leased Assets
1998-99
1999-00
2000-01
2001-02
2002-03
593.52
778.72
798.31
1433.00
1950.99
5428.86
4819.34
5428.57
6940.09
7300.52
Activity 1
Leasing is nothing but borrowing and acquiring the asset - Do you agree with
this statement?
...........................................................................................................................
...........................................................................................................................
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...........................................................................................................................
Activity 2
Collect the details of lease/hire-purchase instalment per Rs. 1 lakh from a
local leasing company. Evaluate whether it is cheaper than borrowing Rs. 1
lakh at an interest rate of 10% and buying the asset. Summarise your findings
below:
...........................................................................................................................
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5
Financing Decisions
14.2.2 Suppliers Credit

The concept of supplier credit is fairly simple and in existence for a long time.
Under this, the equipment suppliers provide long-term credit and accept the
payment for the supply of equipment over a longer period of time say 5 to 8
years. In that process, the company which acquires the assets neither take
bank loan nor approach has leasing company for credit but directly takes the
credit from the supplier of the equipment. In other words, the supplier of
equipment acts as a lender or lessor. The question is how it is superior to
other forms of acquiring the assets. First of all, the buyer need not approach
any other agency for credit. Normally, suppliers provide short period of credit,
and in this special case, the suppliers provide long-term credit. Since there is no
intermediary to fund the acquisition between the seller and buyer, it reduces the
cost. In addition, it is possible that the supplier may be a cash rich company or
may get funds at a much lower rate than the buyer. For instance, the credit
rating of the supplier is far above than the credit rating of buyer or seller may
be in another country where the interest rates are low. There are specialised
government agencies to provide funds to the suppliers in order to improve the
export sales or to help a particular sector. Though suppliers provide long-term
credit to the buyers, there is no need for the suppliers to stuck with such huge
long-term receivables because they can get finance under certain specific
scheme against such receivables. They can also sell such receivables through
securitization.
14.2.3 Asset Securitization

Securitization is fairly a simple concept. It is the process through which an
asset (fixed or current) is converted into financial claim. It other words, it
brings liquidity to an illiquid asset. The concept is very popular in housing
finance. Let us explain the concept with a simple example. Suppose a housing
finance company has Rs. 100 cr. During the first six months, it accepts the
loan proposals and lent Rs. 100 cr. at an average interest rate of 10% and the
duration of the loan is 15 years. Suppose the housing finance company gets
some more loan applications say for Rs. 20 cr. in seventh month. The
company has to look for new source of finance to fund the new loan proposals
since it has already invested the entire capital and converted them into illiquid
long-term 15 years receivables. The growth of the housing finance company is
thus restricted to its ability to raise additional funds. Securitization assumes
importance in this context. Suppose a group of pension companies is willing to
buy Rs. 100 cr. 15-years receivables from the housing finance company
discounting the receivables at say 9%. With this new cash flow, the housing
finance company can finance new loans without making any fresh borrowing.
In other words, the housing finance company has sold its 15-year illiquid
receivables and raised money against it. The process of selling makes the
concept slightly different from simple bill discounting concept. Under
securitization, an intermediary agency is created, which initially buys the illiquid
asset and against that it issues securities, which are tradeable in the market
through listing. Thus, it is also called asset-backed securities or mortgagedbacked securities. The value of the securities is improved by taking credit
rating and often through insurance cover.
Securitization improves operating cycle of the capital in the sense the housing
finance company can recycle the capital several times and finance more houses
without borrowing on its book. Every time when the cycle is completed, the
firm receives profit. You might wonder why pension funds or other companies
prefer to buy housing loans instead of investing or lending to housing finance
company. The logic is fairly simple. For instance, if the pension funds give loan
to housing finance company, there is no guarantee that housing finance
6
company will lend money to quality loan proposals. The lender has no control
on the business of borrower. On the other hand, in buying the existing loan, the
pension company can ask a credit rating agency to assess the quality of loans.
In this process, the risk is reduced considerably. In addition, lending will block
the funds of pension funds for a long-term whereas an investment in securitized
asset brings liquidity for the funds invested. So it is a rare case of win-win
situation for both the housing finance company and pension fund investors. Like
pension fund, there are many investors who are looking for such investments,
which essentially creates liquidity for these kinds of securities. Though this
concept is yet to become popular in India, already several securitization deals
have taken place.
Other Modes of
Financing
While securitization as a concept was developed to help finance companies to

covert their loans into liquid assets, it is now extensively used in several other
business situations. It is possible for manufacturing or service firms to raise
long-term funds through securitization. For example, many electricity boards,
whose balance sheet is very weak and no financial institutions would be willing
to lend money to such companies, have raised long-term funds at a cheaper
interest rate by securitizing future receivables of some good clients. By
securitizing, the company actually sells the receivables to the intermediary
agency (called Special Purpose Vehicle or SPV), which collects the money and
distributes to the holders of such securities. Figure 14.1 shows the structure of
future flow securitization. There are several variation of this model but the
essential principle is to protect the interest of investors. It is possible for
companies producing commodities, where the demand is predictable, raise longterm resources by securitizing their future receivables. Companies like Reliance
Petroleum have done such securitization. The amount thus raised can be used
to strengthen long-term or permanent working capital needs of the firms or
invest in fixed assets to expand the capacity.
Structure of a typical future flow securitization
Designated Customers
(obligors)
Future
receivables
Product
payment
Trust (collection
account/fiscal agent)
Excess
collections
Future
product
Special Purpose
Vehicle
Principal and
interest
Investor
Securitized
Notes
Proceeds
Right to
collect future
receivables
Offshore
Borrower in developing
country (originator)
Figure 14.1: Structure of Future Flow Securitization
Source: Suhas Ketkar and Dilip Ratha, Securitization of Future Flow Receivables: A
Useful Tool for Developing Countries, Finance & Development, March 2001
Financing Decisions
Activity 3
Briefly discuss any one Securitization deal completed in India. You can get the
details from business magazines and economic dailies which periodically report
such details.
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Activity 4
Why securitization is not popular in India? Find the details from some of your
friends working for financial services company or bank.
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...........................................................................................................................

While leasing/hire-finance, suppliers credit or securitization are debt financing,
venture capital is a equity finance. Venture capital is investment in early-stage,
high-growth projects, which are high-risk with the potential to give
extraordinarily high returns over a period ranging from three to seven years.
The risk factor being high, the probability of failure is also high. The returns to
the venture capitalist are from the handful of the projects, which succeed.
Venture capital investment is generally in equity or quasi-equity instruments in
unlisted companies, often set up to commercialise a novel idea. The venture
capitalist will, in the normal course of business, like to have a 20% to 50%
stake in the company invested in. The returns to the venture capitalist are at
the time of disinvestment from the venture backed unit. This could be in
several ways, such as buy-back of the stake of the venture capitalist by the
promoters, disinvestment of the investment at time of an IPO, or during a
merger or acquisition transaction. Venture capital investment is hands-on
investment, where the investor mentors and advises the promoters of the
business in which the investment has been made. The venture capitalist is an
investor who guides the project through its different stages of growth by
identifying avoidable pitfalls and directs the business along possible avenues of
growth. The venture capitalist is, therefore, a partner who brings much more
than money to the project.
Venture capitalists receive several proposals for investment. Many projects,
which find it difficult to raise funds from banks and other financial institutions,
approach venture capitalists for assistance. Venture capitalists conduct a
preliminary project appraisal. This includes verification of whether the project is
in the area of their investment and a review of the promoters of the business.
If the venture capitalists are interested in the project they offer a term sheet to
the promoters. The term sheet is a summary of the proposed principal terms
and conditions of a venture capital investment. It sets out the broad terms and
conditions of investment and is signed by both the venture capitalist and the
proposed venture capital investee. Signing of a term sheet by both parties is a
statement of good faith and is not an obligation until an agreement is signed by
the parties. It is normally subject to satisfactory completion of due diligence
review and signing of legal documents such as an equity subscription
agreement.
8
A venture capitalist will look for a project that has potential for great returns.
The project should be feasible and though it may be risky, there must be a
definite chance that it can be successful. The venture capitalist would like to
maximize the upside potential in any project, and would like to exit from a
project at a time when he can get a maximum return on his investment in the
project. The venture capitalist will look at different aspects of the projects.
Some of these aspects are the integrity and ability of the promoters and key
management, the details of the project, the market potential and strategy for
sale. A professional venture capitalist would validate all the data included in
business plans. A venture capitalist is most concerned about the ability of the
entrepreneurs to adapt to different circumstances, good and bad. The promoters
must be committed and have a passion for their project. They must believe that
they can do something different or differently. They must believe that they can
succeed. The venture capitalist backs the promoter first and then the project. In
fact sometimes, the project may be excellent, but if the venture capitalist feels
that the promoters lack the required skills, the project may get rejected. This is
not very surprising as venture investment is akin to a partnership, particularly in
the initial stages of the project. If the partners in the project are not in
agreement or have different ways of functioning, the entire project can be in
jeopardy, despite having phenomenal potential.
Other Modes of
Financing
A venture capitalist will also scan the project in great depth. The project must
have the potential to be commercially viable. Ultimately the investor wants a
financial return, so it is important that the investment makes commercial
sense. It must have the potential for commercial success. The project must
be feasible, it must be marketable, ie it must meet an existing requirement or
fill a gap in the market or it must have the potential to create a market.
Further, the venture capitalist would like to have higher than normal returns
as compared to other financial investors in a project. This is not surprising,
since the venture capitalist does not expect all investments to do well, he
would like the few that do well to give above average returns. Professional
venture capitalists mentor projects they invest in. They are closely involved in
the operations of the investee. This does not stop at appointing a member to
the Board of Directors of the company and attending Board meetings
regularly. The venture capitalist often visits the project frequently. Some
venture capitalists visit the projects every week, even spending half-a-day in
each visit. This is one of the reasons why most venture capitalists do not
invest in many projects at a time.
A venture capitalist does not take any collateral or guarantee (there have been
cases of risk financiers who have asked for personal guarantees of the
promoters, but that is not typical of venture capital financing). If the project
does well, the venture capitalist would get good returns, if it fails, the entire
investment would be written off. A venture capitalist looks for very great
returns in say five years time. In many cases cash inflows in initial years are
ploughed back into the business.
Activity 5
Collect the details of any one projects funded by venture capital company,
which run successfully today?
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Financing Decisions
Activity 6
Do you have any idea that fits venture capital funding? If yes, briefly discuss
the idea here. Later on you can prepare a detailed business plan.
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14.3
NON-TRADITIONAL SERVICES OF SHORTTERM FINANCING
As in the case of long-term finance, firms can raise short-term finance from
banks and other investors. However, in recent time, new methods of financing
are also be used to raise funds for working capital. We will review briefly
some of these new methods in this section.
a) Commercial Paper:
Companies with good credit rating can raise money directly from the market
for working capital purpose by issuing commercial papers. Commercial papers
are unsecured notes but negotiable and hence liquid. Why firms issue
commercial paper and other invest in commercial paper? As discussed earlier,
loan typically binds both lender and borrower for a period. The option for exit
is difficult to exercise whereas instruments like commercial papers enable both
lenders and borrowers to move out of the relationship in a short period of time.
Since lender and borrower meet directly, the cost of commercial paper
borrowing will be lesser than working capital loan. Many banks and cash rich
companies participate in commercial papers, which are issued by high-quality
companies. Since they are liquid, even banks are willing to invest money in
commercial papers.
b) Factoring Service:
10
Factoring is essentially a management (financial) service designed to help firms

better manage their receivables; it is, in fact, a way of off-loading a firms
receivables and credit management on to some one else - in this case, the
factoring agency or the factor. Factoring involves an outright sale of the
receivables of a firm by another firm specialising in the management of trade
credit, called the factor. Under a typical factoring arrangement a factor collects
the accounts on the due dates, effects payments to its client firm on these days
(irrespective of whether or not it has received payment or not) and also
assumes the credit risks associated with the collection of the accounts. For
rendering these services, the factor charges a fee which is usually expressed
as a percentage of the total value of the receivables factored. Factoring is,
thus, an alternative to in-house management of receivables. The complete
package of factoring services includes (1) sales ledger administration; (2)
finance; and (3) risks control. Depending upon the inherent requirements of the
clients, the terms of factoring contract vary, but broadly speaking, factoring
service can be classified as (a) Non-recourse factoring; and (b) recourse
factoring. In non recourse factoring, the factor assumes the risk of the debts
going bad. The factor cannot call upon its client-firm whose debts it has
purchased to make good the loss in case of default in payment due to financial
distress. However, the factor can insist on payment from its client if a part of
the receivables turns bad for any reason other than financial insolvency. In
recourse factoring, the factoring firm can insist upon the firm whose
receivables were purchased to make good any of the receivables that prove to
be bad and unrealisable. However, the risk of bad debt is not transferred to the
factor. Canbank Factor and SBI Factor, the two factoring companies, have
done an annual turnover of nearly Rs. 2000 cr. and they are growing at an
attractive rate. Many foreign and private banks have also started providing the
factoring services.
Other Modes of
Financing
Activity 7
Visit the branch office of Canbank Factor or SBI Factor in your city or their
web site. Collect the details of factoring service schemes they provide for
different types of companies.
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14.4 SUMMARY
Apart from traditional sources of finance like debt and equity from institutions
and others, finance managers today look into several non-traditional sources of
finance. The reasons for raising finance from such non-traditional sources are
cost advantage and flexibility. In this unit, we discussed three such sources of
long-term finance namely leasing/hire-purchase, asset securitization, and venture
capital. Leasing definitely scores over others in terms of flexibility and in
special cases, it may also be cheaper. Asset Securitization is suitable when a
firm wants to raise funds against future receivables or against some existing
illiquid assets. Venture capital is most suitable for high risk venture where
venture capitalist is willing to put equity capital and assumes risk provided the
project has a scope for high return. Commercial paper and factoring are two
prominent sources through which firms can raise short-term funds in addition to
traditional source of short-term finance like bank loan. While traditional source
of finance contribute significant part of capital, these additional sources of
finance are often used to leverage cost advantage and in some cases to gain
flexibility. Finance managers have to bring innovative financial products that
satisfy different segments of investors. The job is as challenging as selling
products to consumers.
14.5 SELF-ASSESSMENT QUESTIONS

1.
How is lease finance different from that of equity or debt finance?
2.
In evaluating funding options, when do you chose lease finance?
3.
Is lease finance cheaper than other sources of finance? If so, under what
conditions will it be cheaper than other sources of finance?
4.
Explain how Securitization is considered as a source of finance? Who are

the typical investors for such papers?:
5.
Suppose you are working for a venture capital company. What are the
things you will look into a proposal that comes to you for venture capital
funding?
6.
Is it possible to get funds from venture capitalist for all kinds of projects?
Explain.
7.
How is factoring different from that of traditional bill discounting scheme?

11
Financing Decisions

Bygrave, Willam et. al. (Ed), Venture Capital Handbook, Financial Times/
Pitman, London
Felix, Richard, Commercial Paper, Euromoney, London
Gupta, Naresh Kumar, Lease Financing: Concepts and Practice, Deep and
Deep Publication, New Delhi
Lerner, Josh, Venture Capital and Private Equity, John Wiley & Sons, New
York
Sengupta A K and Kaveri V S, International Factoring in India: Issues,
Problems and Prospects, Macmillan India, New Delhi
Sriram K, Handbook of Leasing, Hire Purchase and Factoring, ICFAI,
Hyderabad.
Vinod Kothari, Lease Financing and Hire Purchase, Wadhwa and Company,
Nagpur.
Vinod Kothari, Securitisation: The Financial Instrument of the New Millennium,
Academy of Financial Services, Calcutta.
R M Srivastava, Financial Management and Policy, Himalaya Publishing
12
UNIT 15 MANAGEMENT OF EARNINGS
Objectives
Objectives of this Unit are to:
discuss the dividend theories, their assumptions and criticism.
throw light on practical issues of dividend policy.
Structure
15.1
Introduction
15.2
Dividend Theories
15.3
Walters Model
15.4
Gordons Model
15.5
Modigliani-Miller Hypothesis
15.6
Procedure of Paying Dividends
15.7
Types of Dividends
15.8
Factors Influencing the Dividend Policy
15.9
Dividend Stability
15.10
Deciding the Dividend Payout Ratio
15.11
Summary
15.12
15.13
Further Readings
15.1
INTRODUCTION
Success of an enterprise rests not only on optimal utilization of funds but also
on efficient management of income produced by business operations.
Distribution of fair amount of dividend to shareholders, provision for sufficient
reserves to finance future expansion programmes of the enterprise and to
absorb the shock of business vicissitudes and provision of sufficient resources
for retiring old bonds and redeeming other debts call for effective management
of income. Efficacious management of income strengthens the financial position
of the enterprise and enables the firm to withstand seasonal fluctuation and
business oscillations, helps in enlisting the support of the shareholders in future
and finally facilitates in procuring resources from different avenues of capital
market.
As such dividend policy is the most important single area of decision making by
the management for a finance manager. Action taking in this area affects
growth rate of a firm and so also its value, nevertheless opinions of the
financial wizards, as evidenced from their theories, are not unanimous in this
regard.
15.2
DIVIDEND THEORIES
Dividend theories can broadly be classified into two groups:

a)
theories which consider divided policy as of no relevance, and
b)
which consider divided policy as a relevant variable to enhance

shareholders wealth. They are briefly discussed below.
1
Strategic Financing Decisions
15.3
WALTERS MODEL
Professor James E. Walter emphasizes that dividend policy is a critical factor

affecting the firms value. According to him, dividend policy hinges on firms
internal rate of return (r) and the cost of capital (k). His model is based on
the following assumptions:
1. The firm finances new investments through retained earnings, without opting
for new debt or equity.
2. The firms internal rate of return, and cost of capital, are constant.
3. 100 per cent of earnings are either distributed as dividends or reinvested
internally.
4. Initial earnings and dividends remain constant forever. The values of
earnings per share (EPS) and dividends per share (D) may be changed to
determine results, but any given values of EPS, and the D assumed to
remain constant forever in determining a given value.
5. The firm has a very long infinite life.
The following is the Walters formula to determine the market price (P) per
share:
D (EPS D) r
K
K
The above formula can also be written as:
(EPS D) r/K
D

K
K
The above equation gives the sum of the present value of future stream of
dividends (D/K), and capital gains resulted by reinvestment of retained earnings
(EPS-D) at the firms internal rate of return (r). The discount value is equal
to the firms cost of capital (K) The effect of dividend policy on the firms
share value is explained in the following illustration 1 using Walters model.
The basic data and computations are given in table 15.1 based on Walters
formula:
Table 15.1: Dividend Policy and the Value of Share
BASIC DATA
Growth Firm
(r > k)
Normal Firm
(r = k)
Declining Firm
(r < k)
R = 16%
R = 10%
R = 8%
K = 10%
K = 10%
K = 10%
EPS = Rs. 10
EPS = Rs. 10
EPS = Rs. 10
D = Rs. 0
D = Rs. 0
0 + (10/.10) (10.0)
.10
0 + (.08/.10) (10.0)
.10
= Rs. 100
= Rs. 80
When pay out ratio = 0%

D = Rs. 0
P =
0 + (.16/.10) (10.0)
.10
= Rs. 160
2
Management of Earnings

D = Rs. 3
P =
3 + (.16/.10) (10 - 3)
.10
= Rs. 142
D = Rs. 3
D = Rs. 3
3 + (10/.10) (10 - 3)
.10
3 + (.08/.10) (10 - 3)
.10
= Rs. 100
= Rs. 86
D = Rs. 5
D = Rs. 5
5 + (10/.10) (10 - 5)
.10
5 + (.08/.10) (10 - 5)
.10
= Rs. 100
= Rs. 90
D = Rs. 8
D = Rs. 8
8 + (10/.10) (10 - 8)
.10
8 + (.08/.10) (10 - 8)
.10
= Rs. 100
= Rs. 96
D = Rs. 10
D = Rs. 10
10 + (10/.10) (10 - 10)

.10
10 + (rs/.10) (10 - 10)

.10
= Rs. 100
= Rs. 100

D = Rs. 5
5 + (.16/.10) (10 - 5)
.10
P =
= Rs. 130

D = Rs. 8
P =
8 + (.16/.10) (10 - 8)
.10
= Rs. 112

D = Rs. 10
P =
10 + (.16/.10) (10 - 10)

.10
= Rs. 100
Thus, Walters model brings out that dividend policy does help maximize
shareholders value, if used properly depending on its internal rate of return,
and cost of capital. So the dividend policy differs depending on whether the
firm falls into the category of growth firm, normal firm, or declining firm. The
optimum dividend policy for these firms is as follows.
Growth Firms: Growth firms have very good investment opportunities with
returns greater than their respective cost of capital. It can be observed from
the table 15.1 that firms value will be maximized when then firms reinvest 100
percent of earnings, choosing a zero dividend policy 1, to maximize the share
value.
Normal Firms: Over a period of time firms may not find unlimited investment
opportunities with returns higher than their cost of capital. They may have
investments with returns equal to cost of capital. As a result, it can be note
from Table 15.1 that the share value remains constant, despite varying pay out
ratios. These firms can be indifferent to any dividend payout ratio, as there is
no optimum policy.
3
Declining Firms: These firms may not have investment alternatives giving
returns atleast equal to the cost of capital. Such firms can at best declare 100
dividend payout to enhance shareholders value, because they can reinvest them
at a higher rate than the return available to the firm. The data in Table 15.1
too supports this proposition.
Criticism of Walters Model: Though Walters model has been successful in
highlighting the role of firms return and cost of capital in determining the
dividend policy, the model has been critisised for its following un-realistic
assumptions.
No External Financing: Walters model is mixing both dividend policy and
investment policy by assuming that investment opportunities will be financed only
with retained earnings, without resorting to either debt or new equity. With these
restrictions the firms dividend policy, and investment policy will be sub optimal.
Constant Rate of Return: Walters Model assumes a constant rate of return,
which is real life may not hold good. Because, firms choose from among the
most profitable to less profitable projects, as long as their respective rate of
return is more than or equal to the firms cost of capital.
Constant Opportunity Cost of Capital: Another assumption of Walters
model, which may not hold good is constant opportunity cost of capital.
However the firms cost of capital changes with its risk, the Macro Economic
Changes in the economy. Further, the present value of the firms income
changes inversely with its cost of capital. By assuming the discount rate as
constant, Walters modal ignores the effect of risk on the firms value.
15.4
GORDONS MODEL
Myron Gordon developed a popular Model relating dividend policy and the
firms value, based on the following assumptions:
The firm has only equity capital, and no debt.
Only retained earnings will be used for financing expansion. This
assumption mixes dividend and investment policy, similar to Walters model.
Firms internal rate of return is constant, which is not correct in practice.
Firms discount rate is constant. Even this assumption is also incorrect, as
is the case with Walters model.
The firm and its stream of earnings are perpetual.
The corporate taxes are nil.
The retention ratio, once decided, remains constant, leading to a constant
growth rate of earnings.
The discount rate is higher than growth rate.
According to the Gordons model, the market value of a firms share will
be equal to the present value of future stream of dividends payable for that
share. Accordingly, the value of share can be obtained by the following
equation:
Po
D1
K -g
The above equation can also be expressed as:

4
Po =
EPS (I b)
K - br
The second equation highlights the relationship of earnings, dividends policy,
internal rate of return, and the firm cost of equity (which is also cost of capital
in the absence of debt) in deciding the value of the share.
The influence of dividend policy on the value of share and therefore on the
firms value can be understood by observing the following illustration, in which
the implication of dividend policy for growth, normal, and declining firms, is
explained. The results in the illustration can be explained as: (a) If the firms
internal rate of returnis less than its discount rate, retaining earnings is not
useful for the shareholders value maximization. Because, by retaining earnings
in the firm to invest at a lower rate of return, the shareholders are denied the
opportunity to invest at higher or at least at rates equal to the discount rate. In
such situation, the 100 percent pay out will maximize the share holders wealth.
The promoters can even think of partial or full dis-investment, if the firms
discount rate is less then to the prevailing rate of return in the market, to boost
the shareholders wealth. It can be seen that for normal firms whose discount
rate is equal to their internal rates of return, the dividend policy is of no
significance, as each firms value remains the same irrespective of any pay out
ratio adopted. The growth firms do well by retaining maximum portion of their
earnings to increase the shareholders value, because the opportunities available
to the shareholders are less attractive when compared to those available to the
growth firms.
The conclusions drawn by Gordons Model are akin to those of Walters Model,
essentially due to the similar asumptions made by both of then. However,
Gordon adds that uncertainty increases with futurity. When dividend policy is
considered in this context, the discount rate cannot be assumed to be constant.
Due to uncertainty, the investors may be willing to pay higher price for the
share that pays higher early dividends, other things remaining constant.
Therefore, Gordon concludes that dividend policy does effect the firms value.
Then even those firms having the rate of return equal to their respective
discount rates cannot be indifferent to the divident policy. The investors prefer
dividend to capital gains because dividends are easier to predict, less risky, and
do not involve timing decisions.
Illustration: In the following 15.2 the implications of dividend policy are shown
under Gordons Model for Growth, normal, and declining firms.
Table 15.2: Dividend Policy and the Value of Share
Growth Firm
(r > k)
Normal Firm
(r = k)
Deaclining Firm
(r < k)
r = .16
r = .12
r = .09
k = .12
k = .12
k = .12
EPS = Rs.12
EPS = Rs.12
EPS = Rs.12
Pay-out ratio (1-b) = 30%, Retention Ratio, b=70%

G=br=(.7)(.16)=.112
Po =
12 (1 .7)
.12 .112
= Rs. 450
G=br=(.7)(.12)=.084
Po =
12 (1 .7)
.12 .084
= Rs. 100
G=br=(.7)(.09)=.063
Po =
12 (1 .7)
.12 .063
= Rs. 63
5
Pay-out ratio = 60%, and Retention Ratio = 40%

G=br=(.4)(.16)=.064
Po =
G=br=(.4)(.12)=.012
12 (1 .4)
.12 .046
Po =
= Rs. 129
12 (1 .4)
.12 .048
= Rs. 100
G=br=(.4)(.12)=.036
Po =
12 (1 .4)
.12 .036
= Rs. 86
Pay-out ratio = 90%, and Retention Ratio = 10%

G=br=(.1)(.16)=.016
Po =
G=br=(.1)(.12)=.012
12 (1 .1)
.12 .016
Po =
= Rs. 104
15.5
12 (1 .1)
.12 .012
= 10.8 = Rs. 100
G=br=(.1)(.09)=.009
Po =
12 (1 .1)
.12 .009
= 10.8 = Rs. 97
MODIGLIANI MILLER HYPOTHESIS
Modigliani and Miller (MM) proposed an interesting model which concludes

that dividend policy does not affect the firms value. The firms value,
according to them, hinges only on its earnings which result from its investment
policy. Given the investment policy, decision of retention and pay-out, they hold,
will not affect the firms value M-Ms model is based on the following
assumption:
The capital markets are perfect, investors behave rationally, information is
available freely, and transaction and floatation costs do not exist.
Either taxes do not exist, or they are same on both dividend income and
capital gains so that investors do not prefer one over other.
The firm has a fixed investment policy.
The risk, will not increase with futurity. The investors can forecast future
prices and dividends with certainty, and one discount rate is appropriate for
all securities and all time periods.
When the above assumptions operate in capital market, the rate of return will
be equal to the discount rate which are same for all shares in the long term.
Consequently, the price of each share must adjust so that the rate of return,
based on dividends and capital gains, on each share will be equal to its discount
rate, which have to be identical for all shares. M-M believed that the equality
would take place through the process of switching from low yield shares to
high yield shares. According to this model, the rate of return for one period can
be computed as follows:
R =
D1 + (P1 Po)
Po
Similarly, the value of share can be calculated as:

Po =
D1 + P1
1+ R
D1 + P1
1+ K
The value of the firm can be obtained by multiplying both sides of the above
equation with number of shares outstanding:
V = Npo =
n (D1 + P1)
(1 + k)
MM model does not make a restrictive assumption of financing new

investments only with retained earnings like Walters and Gordons models for
the issuance of new shares. Firms can pay dividends and raise funds by issuing
new shares to take up investments, allowing the flexibility of financing new
investments with retained earnings, or new equity capital, or both. Using the
following equation MM show that the value of the firm will be unaffected by
its dividend policy:
Npo =
n D1 + (n + m) P1 (I1- X1 + nD1)
1+ k
=
Where:
N =
M =
I1 =
X1 =
n D1 + (n + m) P1 mP1
1+ k
(n + m) (P1 I1 + X2)
1+ k
Number of shares outstanding

Number of new shares to be sold by the firm at time 1 at price P1
Total amount of investment during time period 1.
Total net profit of the firm during time period 1.
The MM hypothesis is explained in the following illustration. It can be

observed that the firm has the flexibility of paying dividend and raising funds by
isuing new equity shares. When the firm is paying dividend its share value will
be adjusted by the market to the extent of dividend amount, and the firm has to
issue more number of shares to finance its investments. However the value of
the firm remains same irrespective of the dividend policy.
Illustration 3: Vikas WSP LTD has 10 lakh outstanding shares, with the
market price of Rs. 50 each. The firm is planning to pay Rs. 4 or dividend per
share. The discount rate is 12 percent. What will be the price of its share at
the end of the year if(a) dividend is not paid and (b) dividend is paid as above?
Vikas is expecting to earn a net profit Rs. 60,00,000 in the current year, and
has investment opportunities of Rs. 1,50,00,000 during the period. Decide how
many new shares should be issued. Also find out the value of the firm. Answer
the above question using MM model.
Price of the share at the end of the current year can be determined with
following equation:
Po =
D1 + P1
1+ k
P1 = Po (1+K) D1
The value of Vikas share when dividend is not paid.
= P1 = 50 (1+.12) 0 = Rs.56
7
Vikas share value when dividend is paid:

= P1 = 50 (1+.12) 4 = Rs. 52.
Number of new shares to be issued to finance new investments:
When dividend is not paid:
MP1 = I (XNd1)
Rs. 56 m = Rs. 1,50,000 (60,00,000-00)
Rs. 56 m = Rs. 90,00,000
M = 1,60,714
When dividend is paid:
Rs. 52 m = I (XnD1)
Rs. 52 m = Rs. 1,50,00,000 (60,00,000 40,00,000)
Rs. 52 m = Rs. 1,30,00,000
M = 2,50,000
Value of the firm:
Npo =
0 + (10,00,000 + 16074) 56 (56x160714)

1 + .12
5,60,000
= Rs. 5,00,00,000
1.12
When dividend is paid:

=
5,60,00,000
1.12
= Rs. 5,00,00,000
MM further state that the firm need not have only equity capital to hold
their model true. They conclude that their hypothesis of dividend
irrelevance holds good even if the firm raises debt capital instead of equity
capital. For this, they put forth their indifference hypothesis with reference
to leverage.
The above conclusions are based on several restrictive assumptions of
M.M. model. The divided policy may effect the value of a share if those
assumptions are relaxed and the market imperfections are considered, as
discussed below:
Tax Differential: MM made a simplistic assumption of no taxes or same rate
on both dividends and capital gains but the reality is far from the assumption.
In most of the countries both of them are taxed albeit at different rates.
Normally dividends are clubbed with ordinary income for tax purpose which is
taxed at a higher rate when compared to the capital gains. However, in India
the dividend income is tax free in the hands of investors from the financial
year 1998-1999. The companies pay a special tax of 10 percent of the profits
distributed which is similar to tax deduction at source. The current long-term
capital gains tax rate is 20 percent. From the tax point of view the
shareholders prefer the dividends. Therefore investors may prefer shares with
high dividend pay out, to maximize their wealth.
8
Floatation Costs: MM assume that the cost of retained earnings and
external financing are same. But in reality, the process of raising fresh capital
from the capital market involves significant expenses in terms of floatation costs
which may be in the range of 6 to 10 percent of capital raised. Thus, the
higher cost of external financing, makes the retention of earnings a favourable
option. However, companies tend to maintain dividend payments, despite
changing earnings, as a policy, unless the earnings change by a significant
proportion.
Transaction and Monitoring Costs: MM model assume that transaction

costs do not exist. They also assume that the shareholders can sell a small
portion of their shares in lieu of dividend, when they are indifferent between
dividend and capital gains. But reality is for from that assumption. The
shareholders have to pay brokerage and often incidental costs to sell their
shares. As a percentage, the transaction costs vary inversely with the sale
value of shares i.e., higher the value of shares sold lower the percentage of
transaction costs and vice versa.
Existence of Perfect Capital Market: MM assume that there exists a
perfect capital market where information is freely available and future share
prices are known with certainty. In practice, companies do not share complete
information with shareholders. The process of monitoring the company and the
managers performance involves significant costs and also leads to uncertainty
in future share prices. Therefore, timing of selling the share to encash the
capital gains in lieu of dividend income becomes difficult. As a result,
shareholders may prefer dividend income to capital gains.
To disseminate information to the share holders about the future earnings a
company can make statements to create a favourable impression. These
statements attract greater attention if they are accompanied by dividend
announcement. For example, if a firms earnings are expected to grow in
the future and if the firm does not announce increase in the dividend
payment, shareholders may not attach enough importance to such views of
growth in future earnings. Therefore, the share value may not reach realistic
value.
Uncertainty And Preference for Dividend: MM profess that the dividend
policy continues to be irrelevant even under the conditions of uncertainly,
because the share value of two firms with identical investment policies,
business risk and future earrings cannot be different. These views are not
convincing to many researchers. According to them, investors try to reduce
uncertainly to some extent through dividends. Their views are akin to the birdin-hand argument of Gordon who argues that the discount rate increases with
uncertainty, suggesting the preference of shareholders for higher dividend
payment. The preference for a steady stream of income in the form of
dividends by a section of investors also strengthen this argument.
Diversification: Even under the conditions of certainty, the argument of same
discount rate for all firms may not hold good because of investors preference
for a diversified portfolio of securities. To fulfil their desire share holders like
the firm to distribute the earnings to invest in other firms. As such, the
investors may use higher discount rate for firms with high retention ratios
compared to firms which pay high dividends by accessing external financing to
meet their requirements. Therefore, the value of the firm may increase if it
pays higher dividends instead of retaining them.
15.6
PROCEDURE OF PAYING DIVIDENDS
The dividends can be declared only by the board of directors, which is

subject to the ratification by the shareholders in the annual general meeting.
Once declared the dividends become a current liability of the firm. They can
be paid only out of profits (after providing depreciation) of the current or past
years. The dividends are payable to those investors whose names appear in
the shareholders list of the firm, on a particular date announced in advance
for that purpose, which is normally called record date. The buyers can get
the shares transferred in their name before the record date. Buyers get the
dividend from the seller if the shares are bought cum dividends. If the
shares are bought on ex dividend basis, the buyers should return the
dividend, if they receive.
15.7
TYPES OF DIVIDENDS
Several types of dividends exist in practice. Companies usually pay Regular

cash dividends. These may be paid once a year or more times in a year
spllitting the amount. In some western countries, it is common to pay dividends
quarterly which is rare in India. Here the word regular does not convey any
legal obligation of the company to compulsorily pay dividends. It only connotes
that the companies can maintain similar payments in future also. For that
purpose, dividends are set at such a level that a firm can pay even during the
years of poor performance. In a particular year, if a company pays a higher
dividend and it believes that such payment is not possible in future, it will
declare the extra dividend as special dividend indicating that they are not liable
to be repeated.
For example, Lakme Ltd., and Max India Ltd are distributing around
1000 percent as special dividends out of profits made by selling part of
their businesses. Investors naturally, will not expect similar pay outs in
future.
Companies may also choose stock dividends instead of cash dividend. It is
not uncommon in West to popular the payment of regular stock dividends of
around 5 percent. Such practice is not in India so far, though occasional
stock dividends of higher percentage in the name of bonus shares are
popular in India. Stock dividends are very similar to stock splits. They
increase the number of shares, but will not bring fresh funds to the firm,
and will reduce values per share. But a stock dividend leads to
capitalization of reserves equal to the sum of new shares at par value. In
case of a stock split the face value (par value) will be reduced to increase
the number of shares. So, there will not be transfer of funds even in the
books of accounts.
There are some other non cash dividends, corporate gifts, and discounts fall in
this category. For example, Reliance Industries Ltd., has been offering discounts
on its products, to the shareholders. In some countries companies encourages
shareholders to reinvest their dividends continuously, by allowing some discount,
on prevailing market price. By offering reinvestment opportunity to the
shareholders, the company can fulfil both payment of dividends and issuing of
new share for additional capital simultaneously. In the process the company can
also save the floatation costs of issuing new shares.
10
15.8
FACTORS INFLUENCING THE DIVIDEND

POLICY
A firm choosing a dividend policy will have to decide about the portion of
earning to be distributed as dividends, and the portion to be retained either for
liquidity needs or for investments. Various factors should be considered while
finalizing the dividend policy. They are firms expected rate of return on new
investment opportunities, tax rates on dividends, and capital gains legal
considerations, liquidity and debt servicing, control of management, shareholders
expectations, access to the capital market, and the implications of following a
particular dividend policy.
New Investments: If new investments are not available to the firm with
attractive rates of return and it is not willing to retire the debt, firm may use
the earnings to distribute as dividends. In a growing economy, if the firm finds
good investment opportunities, it may use major portion or all earnings to
finance the new projects. This can be found in case of new and fast growing
companies with profitable ventures. They may do so after considering the
relative costs and benefits of internal and external financing. At times, firms
may retain earnings in liquid assets, even if profitable investments are not
available currently, with the hope of investing in future. In real life, companies
neither follow 100 percent retention nor 100 percent distribution of their
earnings, whether projects with good returns are available or not.
Expectations of Shareholders: No doubt dividend decision is the prerogative
of the company directors. However, they only represent the shareholders, who
are the owners of the company, and they appoint the directors. Thus due
importance will be given to the share holders expectations with regard to
dividends. Shareholders preference for dividend or capital gains hinges on their
economic status and tax rates applicable to dividends and capital gains. Share
holders having sources of other regular income may not attach much weightage
to regular dividend, compared to those who depdn on dividens as regular
income. Similarly, institutional investors who buy large blocks of stocks prefer
regular dividen to meet their own dividend obligations.
In case of closely-held companies, it is easy to ascertain the expectations of
the shareholders to adopt a dividend policy of their choice. But, in case of
companies with large number of shareholders distributed across the country, it is
hardly possible to gather their views on expected dividend policy. Under the
circumstances, the directors may tend to meet the expectations of the
dominant groups of the shareholders. The minority groups may switch over
to other companies which meet their expectations. So, at times companies
should formulate its dividend policies keeping the target groups of shareholders
in mind.
Taxes: As explained in the dividend theories, the capital gains and dividend
income are not treated as same for tax purpose in most countries. In many
countries capital gains are treated favourable with a lower tax rate when
compared to dividends. However the situation is reverse in India, since
dividends are tax-free to the shareholders from 1998-99. Instead of the
shareholders, the companies pay 10 percent tax on the distributed earnings,
which is similar to uniform tax rate irrespective of the individual shareholders
tax slab. The current long-term capital gains tax rate is 20 percent. Therefore,
investors may prefer shares with high dividend pay-out. Institutional investors
are exempt from both capital gains tax, and tax on dividends.
11
Legal Restrictions on Paying Dividends: The companies have to follow

certain legal norms while deciding the dividend payments. Some of the
restrictions are: (a) The companies Act provides that dividend shall be paid only
out of the current profits or past profits after providing for depreciation. But,
the Central Government is empowered to allow any company to pay dividend
for any financial year out of the profits of the company without providing for
depreciation; (b) Lenders may put restrictions on dividend payment to protect
their interests when the firm is experiencing liquidity or profitability problems.
Control: The existing management group normally tries to continue their
control on the company. When a company pays dividend and raises new equity
capital, the shareholding of the management group may come down as a
percentage, unless they increase their share holding proportionately. If they are
unwilling to increase their shareholding they may retain more earnings to
finance the projects. Thus, the control aspiration will affect the dividend policy.
Access to Capital Market: In spite of policy to distribute high dividends and
raise new capital to finance the new investments, companies may fail to do so,
when the capital markets are in a highly depressed state. The firms may prune
the dividend rate in such periods until they are able to access the capital
market as per their expectations.
15.9
DIVIDEND STABILITY
Companies normally dislike to change their dividend policies too often. Even the
share holders value stable dividends higher than fluctuating one. There are
three forms of stable dividends. They are:
Stable dividend per share or rate
Stable dividend pay-out ratio, and
Stable dividend per share plus extra dividend.
Stable Dividend per Share: Most companies prefer to pay a fixed amount
per share as dividend per share, regardless of fluctuations in the earnings. The
dividends follow a very slow but steady up ward or downward trend over a
period of time. Relationship between earnings per share and dividend per share
is noticable in figure 15.1.
EPS
Rs.
DPS
Year
12
Figure 15.1: Relationship between EPS & DPS
It is easy to follow this policy when the earnings are stable. If they change
wildly, companies find it difficult to maintain stable dividends. To smoothen the
dividend payments companies dig into their reserves to pay the constant
dividend in years of low earnings. Research indicates that companies paying
stable dividends will be preferred by the investors.
Stable Pay Out: Some companies may follow the policy of paying a fixed
portion of earnings as dividends. Then the dividends entirely depend on the
current year earnings, and therefore dividend per share varies accordingly. In
this policy internal financing is automatic and it removes the trouble of over or
under payment of dividends. As a result the share values may change wildly.
Companies seldom follow this policy.
Stable Dividend per Share plus extra Dividend: In this method the
company pays a stable regular dividend, and also pays an extra dividend in
years of high profits. Very few companies follow this method as policy.
Residual Dividend Policy: Comapnies can finance their investments through
funds from debt market, retained earnings, and equity capital. Once the
company finalizes the investment and the target debt equity ratio, it will secure
the debt funds accordingly. The equity component will comprise of retained
earnings and new equity shares. In that components the management will
decide on how much to meet from retained earnings and capital market by
selling new shares. The earnings left over in the process with be distributed as
dividends.
15.10 DICIDING THE DIVIDEND PAY OUT RATIO

Based on a survey of corporate managers John Linter emphasized the following
points with reference to dividend policies:
Firms pursue long-term target dividend pay out ratios.
Managers do not attach much significance to dividend declarations, if they
do not represent any change from the current dividend policy of the
respective firms.
Dividend changes indicate significant changes in the long-term earnings.
However, dividends will be smoothened over a period of time. Temporary
shifts in earning will not reflect in dividend payments.
Managers dislike to reduce the dividends. So they tend to be overcautious
in recommending dividend hikes.
Considering the above facts, Linter developed a simple model to explain the
dividend payments. According to the model, if a firm decides on a target pay
out ratio, the dividend in the next fiscal will be equal to a constant proportion of
earnings per share (EPS).
D1 = target dividend
= target ratio x EPS1
then, the change in dividend will be equal to
= D1Do = target change
= target ratio X EPS1 Do
Any firm following a constant pay out ratio will be paying different amounts of
dividends whenever earnings change. According to Linter, managers dislike
13
changing dividends, preferring, smooth progression instead. Therefore, dividend

change as per Linter may conform to the following model:
(D1Do = adjustment rate) (target change)
= adjustment rate (target ratio X EPS1 Do)
Through this model firms can slowly move towards their respective target pay
outs instead of repeatedly changing dividends. This model suggests that dividend
hinges on both current earnings and dividend of the previous year. Some of
Indian studies also confirm the Linets hypothesis.
15.11 SUMMARY
The annual earnings of firm can be paid as dividend or retained for investments
increase the firms value. The Walters model suggests to take the dividend
decision based on firms rate of return and its discount factor, with several
restrictive assumptions. Gordon expresses similar moves, but indicates that risk
increases with futurity, therefore giving more importance to dividends. MM
hypothesis indicates the irrelevance of dividend policy to enhance the firms
value.
In practice, firms have been found pursuing are stable dividend policy and they
consider several factors before deciding on dividend payout rate.

What are the factors which influence managements decision to pay
dividend of a certain amount?
Discuss the implications of making dividends tax free.
If it is all very well saying that I can sell shares to cover cash needs, but
that may mean selling at the bottom of the market. If the company pays a
regular dividend, investors can avoid that risk discuss.
Risky companies tend to have lower target pay out ratios and more
gradual adjustment rates do you agree? Give reasons.
What are the different pay out methods? How do shareholders react to
these methods?
Distinguish between bonus shares and share split. What is their impact on
earnings per share, dividends, and market price?
Between 1971 and 1995 one could explain about two thirds of the variation
in TEP Ltds dividend changes by the following equation:
DT Dt2 = 0.90 + .54 (34 EPStDt1), Discuss.
Do you agree with Walters dividend model ? Discuss its relevance and
limitations.
Examine the M.Ms irrelevance hypothesis. Critically evaluate its
assumptions.
What is the informational content of dividends? Discuss its its influence on
share value.
14
Van Hore, James W. Financial Management and Policy, Printice Hall Inc,
New Jersey. Schall, L.D., and Halley C.W., Financial Management. Mc Graw
Hill Inc. New York.
Pandey I. M Financial Management. 7 ed, Vikas, New Delhi
Brealy R.A., and Stewart C. Myers. Principles of Corporate Finance, 4 ed,
Tata Mc Graw Hill Ltd., New Delhi.
R M Srivastava, Financial Management and Policy, Himalaya Publishing
15
UNIT 16 FINANCIAL ENGINEERING
Objectives
provide an overview of financial engineering and the process involved
therein
focus on newly emerging fixed income products
focus on newly emerging equity products
explain derivative products developed by financial engineering
Structure
16.1
Introduction
16.2
Factors Contributing to Financial Engineering
16.3
Financial Engineering Process
16.4
Financial Engineering in Fixed Income Securities
16.5
Financial Engineering in Equity Products
16.6
Financial Engineering in Derivatives
16.7
Summary
16.8
16.9
Further Readings
16.1
INTRODUCTION
In general, engineering is the process through which some value is added to the
raw material or semi-finished product so as to make it useful to the users or
consumers. Applying this general meaning of engineering, we can say financial
engineering is the process through which finance managers or intermediary
institutions in financial markets add value to existing plain vanilla products that
satisfy the users need. John Finnerty (1988) offers a comprehensive and lucid
definition of financial engineering as follows: "Financial engineering involves the
design, the development, and the implementation of innovative financial
instruments and processes, and the formulation of creative solutions to problems
in finance". The users of financially engineered products include investors
including institutional investors like pension funds, banks and financial institutions,
corporates, suppliers, consumers, employees and government.
We provide you a quick and intuitive understanding of financial engineering
concept. The meaning and characteristics of debt and equity instruments are
well known. If you place these two instruments along risk-reward line, they
can be placed at two extreme points. Debt carries low risk and hence low
return. Equity carries high risk and hence high expected return. These two are
plain vanilla products. Many financially engineered products are in between
these two products or decomposing the risk and return or changing them to the
level users want. We can say preference shares is one of the earliest
financially engineered product since it has higher risk compared to debt but also
carries higher return. Compared to equity, it carries lower risk but also lower
return. So, an investor, who need moderate risk and return can choose
'preference shares'. Is there any alternative to this financially engineered
product? Yes, it is possible that one can buy both equity and debt (or
debenture) of the same firm and synthetically create a product somewhat equal
to preference shares. But it is something like mixing individual chemicals in
Strategicyour
Financing
home Decisions
to prepare
cough syrup instead of buying formulated product. In

other words, preference share is equal to formulated product and ready for use
whereas buying both equity and debt in certain proportion to get the same
effect is something similar to mixing chemicals by yourself to get the same
formulation.
Convertible debenture is another financially engineered product that is in
existence for a long time. Convertible debentures, which are optionally
convertible, provide an opportunity to share the reward if the equity price goes
up without risking your capital when the company is not doing well. In other
words, here is a product, which decomposes the risk and return of the equity
and passes on the return only to the investor. Of course, the convertible
debenture holder can't expect such product without incurring any cost and
interest rate for convertible debt will be lower than non-convertible debt. While
convertible debentures or bonds are financially engineered product by the
company, the market has created similar product called option (call and put
option). It again decomposes risk and return and hand over return to one set of
investors and risk to another set of investors. The investors, who get return,
agree to compensate the investors who take risk by paying premium. Options
are again financially engineered product.
We can extend the concept to an extreme situation such that corporate form of
business with limited liability itself is a financial engineered product in which
equity holders hold a call option on the value of the assets of the company.
The plain vanilla product is sole proprietorship or partnership with unlimited
liability. Since the plain vanilla structure put a limitation on the growth of the
company, we need a structure in which many investors can participate but
management is vested only with few. Since there is no guarantee that
managers will manage the business well, there is a need to restrict the liability
of investors. Equity with a limited liability is financially engineered product.
Though Finnerty definition requires 'innovation' as an essential characteristic of
financial engineering, not all engineered products are innovative. They are to be
different and add value to users. A financially engineered product may be
innovative today but it may eventually become a common product in the future.
16.2
FACTORS CONTRIBUTING TO FINANCIAL

ENGINEERING
As stated above financial, engineering produces products or in some cases

solutions that add value to the users. Why users of financial products or
solutions want some value-added products? An understanding of such needs will
be useful to appreciate the role of financial engineering and the products and
solutions that come out of financial engineering. John Finnerty (1988) identified
eleven factors that are primarily responsible for financial innovation. These
factors are briefly discussed below:
(1)
Tax Advantage: If there is a way to save tax or defer tax, every one
will exploit the opportunity. Often financial engineering helps to develop
such products. For instance, if you buy a zero coupon bond in the
secondary market, the difference between the redemption value and the
purchase price is treated as capital gains whereas interest received from
interest paying bonds are treated as regular income. Since the tax rate
for capital gains is substantially lower (it is 10% now for long-term capital
gains) than marginal tax rate of high net worth investors (it is 30% for
individuals and 35% for corporate entities), it make sense for companies
to issue zero-coupon bonds. Small investors wanting to show the income
as regular income will buy the same in primary market whereas high net
Financial Engineering
worth investors will buy from secondary market. Mutual funds is also
tax-efficient medium through which you can change the character of the
income from one to another. For instance, if you invest in bond market
fund, which in turn invest the money in bonds and receive interest
income, you can still show the income as capital gain by choosing certain
schemes. You can convert capital gains into dividend and vice versa.
Thus, mutual fund is a financially engineered structure to get tax
advantage and of course, it is also a vehicle through which investors can
achieve diversification at low investment. There are several other
examples. While operating leasing is a plain vanilla product, financial
leasing is an engineered product, which often used to gain certain tax
advantage. Some years back, many companies have done 'sale and lease
back' transactions to exploit loopholes in tax laws, which was plugged
subsequently. Similarly, a non-tax paying company and tax paying
investors can save tax by investing in preference shares. It is possible for
a company to issue 'convertible preference shares' such that the preference
shares can be converted into non-convertible debenture on default of
dividend. Of course, many of the financially engineered product to exploit
tax law loopholes are effectively killed by the government by amending
the tax laws and sometime with retrospective effect. The life of
such products or solutions is generally short but opportunities come
regularly.
(2)
Reduced Transaction Cost: Financial products and solutions come with

high transaction cost. For instance, if a firm issues debenture for 7-year
period, it has to repay at the end of seventh year but invariably it has to
approach the market again with another bond issue in the near future
since growth demands fresh funds. An alternative is issue of fairly a
long-term bond, say 99-years with call and put options and in that process
tremendous transaction cost is reduced. Add more features to take care
of various concern like changes in credit rating, etc. and you will get
truly financially engineered product to handle transaction cost. Mutual
funds and several products of derivative markets are aimed to reduce
either transaction cost or at least recurring transaction cost to a large
extent.
(3)
Reduced Agency Cost: Agency relationship between promoter/managers

and other shareholders/stakeholders creates certain cost, which latter
bear. Employee Stock Option (ESOP) is a financial innovative product,
which swaps part of salary for equity such that the value of equity
increases only if mangers perform well. Leveraged Buyout (LBO)
through issue of junk bonds is a financial process through which
inefficient management is replaced with efficient one and productivity of
the assets is improved. Compare this with a situation where banks and
financial institutions were not able to take action against defaulting
companies except initiating time consuming court action and in meanwhile
productivity of assets are deteriorate further.
(4)
Risk Reallocation: Financial engineering plays a major role in this

respect too. We briefly discussed this point in introduction. Through
financial engineering, it is possible to reallocate the risk to different
parties and of course such reallocation comes with a price. For instance,
fixed interest rate bond is plain instrument in which both investors and
issuer are exposed to interest rate risk. A floating rate bond takes away
the risk. However floating rate brings new problem and issuers are
exposed to higher cost of borrowing. A swap transaction can shift such
risk from company to counter party. Like this, you can create an
environment in which you can trade 'risk'!! We will see more examples in
subsequent sections.
3
Strategic(5)
Financing
Decisions
Increased
Liquidity:
Liquidity reduces the cost and improves efficiency

of pricing. Liquidity is affected due to rigidity and inability to assess the
risk level. For instance, real assets in general are less liquid compared to
financial assets. Land is not as liquid as bonds issued by a company
dealing in buying and selling of land. Equity and bonds of leasing
companies are more liquid than assets funded by leasing companies. Loan
portfolio is less liquid if some banks want to sell the loan portfolio
compared to stocks and bonds of the bank. Through securitization,
financial engineering can improve the liquidity. Another example, is openend mutual funds, which give option to enter and exit at anytime and of
course with certain cost (entry and exit load).
(6)
Regulatory or Legislative Factors: Regulation or deregulation, both

make life complex. A regular public issue in the US market is highly
costly for an Indian company since the regulations are very high and the
cost of compliance of such regulations is high. ADR and GDR are
financially engineered products, which allow companies to issue shares in
US and other markets without attracting such high level of regulations.
Depository and electronic-trading are positive side of regulations, which
reduces level of risk and also transaction cost. Mutual funds are
introducing several new products within regulation to attract investors and
tap new sources of funds. Insurance is another highly regulated industry
but you can witness so many products offered by them. If regulation
puts certain restrictions, you have to be more innovative to keep the
interests of investors. If regulation removes certain restrictions and allows
competition, you have to be equally innovative to compete and retain your
investors. For instance, RBI puts lot of restrictions on companies raising
deposits from public.
(7)
Level and Volatility of Interest Rates: Interest rate influences the

price of almost all products of the economy and of course interest rate in
turn is influenced by several factors. Volatility in interest rate creates
problem for several players in the market but there are people who like
volatility of interest rates and hence want to assume additional risk.
Financial engineering can help these two parties to swap their risk
appetite on interest rate volatility. All interest rate derivatives are outcome
of such volatile behaviour of interest rates.
(8)
Level and Volatility of Prices: Producers and users of products (real

as well as financial) and services are exposed to high level of price risk.
Bonds linked to commodity prices shift such price risk from those riskaverse players to those who are willing to take up such risk.
(9)
Academic Work: Sometime new and value added products are

developed as a matter of academic exercise and subsequently someone
finds it useful.
(10) Accounting Benefits: Accounting regulation requires certain items to be

treated in a particular way. Earlier when there were no regulation on
treatment of stock option, many companies have reduced salary by
converting a part of salary into stock option (ESOP) but not recognized
as expense. In that process, profit and profitability increase. Zerocoupon convertible bonds are beneficial if there is no regulation on how
to treat the discount in stock price that is going to be offered in the
future;
(11) Technological Developments and other Factors: A complex exotic
derivative structure was neither in demand nor life was as complicated as
today requiring such products. Technological development in computational
finance today makes it possible to develop such products and allow users
to trade risk and return.
4
Activity 1
Visit the web site of few large Indian and US companies and see their annual
report. Examine whether they have issued any security other than plain equity
and bonds.
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16.3
FINANCIAL ENGINEERING PROCESS
Financial engineering process is no different from the process that any firm
follows in developing new value added products or services. The process starts
with identification or realization of some needs. Sometime such needs are
known but many times, you have to identify the needs of the market and bring
out products or services or solution to the users without expecting them to
formally communicate such needs. Like car manufacturers, mutual funds
managers have to constantly look for ways to innovate new products that are
appealing to investors and at the same time achieves certain additional
objectives. It is quiet possible that you may add one more feature to the
existing products, which increase its value to users. For example, an open-end
fund gives liquidity compared to close-end funds but still investors have to fulfil
so many formalities to get the money. Cheque book facility to mutual funds
holder takes away so many formalities relating to redemption and provide
instance liquidity. Corporate finance managers have to look for ways to reduce
cost of capital or reduce the risk arising out of operating activities. Treasury
managers of banks while talking to clients can get ideas for new product or
solutions. Once the need is identified, an initial sketch of the product is
developed. At this stage, depending on the product requirement, complex model
building exercise is used. For instance, a structured derivative product requires
high level of mathematical modeling. The next stage is testing of the product so
check whether the desired result is achieved. Sometime it involves simple
verification with the users or some senior managers' assessment. Sometime,
you may have to run some simulation exercise to verify how the product will
produce results under various simulated future scenario. Once the product is
perfected, the next stage is pricing of the product. At the stage of pricing, it is
quiet possible that the price paid by the customer may be more than the benefit
derived out of the product. So, the product may be restructured again so as to
make it attractive to the users. Finally, the product is launched or solutions are
provided either directly or after some test marketing.
Activity 2
Suppose you are in a large bank specialising consumer loans. You are asked to
develop a new product to achieve 20% growth in consumer loans. Examine the
existing products available and then develop a new product. List down the
process you have applied in developing new product.
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5
16.4
FINANCIAL ENGINEERING IN FIXED INCOME

SECURITIES
Fixed income securities have seen large-scale innovation and new products. As
was mentioned in the introduction of the Unit, zero-coupon bond and convertible
bonds are some of the early part of new products. A zero-coupon bond enables
the borrowers to defer interest payment whereas it gives an option for the
investors to show the appreciation either income or capital gain depending on
tax preference. An optionally convertible bond reduces interest cost to
borrowers whereas investors get an option for converting the same into equity
depending on the performance of the company, which may not be assessable at
the time of investment. Another major innovation in bonds was floating rate
bond, which takes away the interest rate risk. A number of subsequent
innovations on floating rate bond aim to deal with different types of risk. A
typical floating rate bond contains a float part and fixed part. For example, it
can be bank rate or LIBOR + fixed premium say 4% or 2%. When the
interest rate moves upward in the market, the bank rate or LIBOR also moves
up and hence investors get higher interest rate. When the rate declines,
borrowers are not stuck with higher interest liability. Thus, float part effectively
handles the interest rate risk. Here interest rate risk means additional interest
liability on account of fixed interest commitment that the borrower has to bear
when the interest rates are moving down in the market. Similarly, when the
interest rate moving upward, the investors of fixed interest rate bonds loose
money as the prices of bonds decline. In other words, the market prices of
bonds move up and down based on changes in the market interest rates.
Instead of fixing the float to Bank Rate or LIBOR, if the issuer and investor
fix the float to some other value, they can tackle different types of risk. For
instance, a commodity producer or oil company is exposed to considerable
amount of commodity or oil price risk. Prices of commodities, oil, metal, etc.,
are highly volatile and producers of these products are exposed to high level of
risk. In other words, in a balance sheet context, the asset side risk (also called
business or operating risk) is very high. Naturally, for these companies, a pure
fixed interest paying debt will add more problems. For some reasons, if the
prices of the products crash, it may hurt the business considerably. While debt
creates such adverse effect in a falling prices, it creates value when price
moves upward. The issue before the finance managers of these companies is
how to resolve the negative effect of the debt in a falling market price while
retaining profit opportunity when the prices move up. It is resolved by linking
floating rate with the commodity price index. That is, the investors will get
higher interest rate when the market price of the commodity moves up and
gets lower return when the prices fall. For instance, if the interest rate of
such floating bond is 4%+changes in oil price or price index, the bond holders
will get a return of 4% only if the price remains same. If the price increases
by 3%, then bond holders will get 7%. Normally, there will be a floor rate and
cap rate for such issues. In the above case if the floor is 4% and cap is 10%,
the interest rate will be minimum of 4% (even in cases when the oil price
declines by 10%) and maximum of 10% (even when the oil price increases by
20%). So, the instrument, by and large, retains, the characteristics of debt but
it brings some equity flavour into the instrument.
What about the users of such commodities, metals and oils? They are also
exposed to price risk. When the prices of input moves up, it may not be
always possible for the company to adjust the end product price. This will hurt
the profitability of the company particularly cause distress if the company also
has fixed interest rate debt. Inverse floating rate bonds, where interest is linked
to commodity price changes but in a inverse direction. That is, interest liability
will be lower when the price of input moves upward. Similarly, when the price
of input moves downward, then interest liability will be more. The borrower
would be happy to share part of the profit caused by lower input price with the
lender provided the lender agrees to share the loss when the input price
increases. You may be wondering why no one bothers to develop such
instruments for consumers, who are ultimately affected by the prices. They can
invest in the bonds and shares of those companies until financial engineers
come out with a product.
As was discussed earlier, financial engineering developed several innovative
products in debt instrument. We mentioned earlier that zero-coupon bond is one
of the earliest innovations. But the problem is, investors who are looking for
regular investments that will avoid such instrument. To overcome this and also
to create some additional liquidity, issuers of such zero-coupon bonds have
started issuing baby bonds, which are also zero-coupon bonds. Those who are
looking for regular income can sell the baby bonds while retaining the mother
bond. Of course, tax treatment for such baby bonds was also one of the
reasons for such innovations.
Can you create Zero-coupon bond (ZCB) from an interest-paying bond? There
is nothing impossible before financial engineer. It works like this. If you
carefully look into interest-paying bond, it is a structure in which you invest
today some amount and borrower will pay you regularly interest at the end of
every period (say six months) and principal on maturity (say 10 years). Thus
you will be getting 20 cash inflows. Investment bankers issued 20 different
series securities backed by investments in such interest paying securities and
the 20 such securities are zero coupon bonds with different maturity. That is,
series 1 will mature at the end of 6 months and the face value of the same is
equal to first interest payment. Series 2 will mature at the end of 12 months
and the face value is equal to second interest payment. Such that series 20 will
mature at the end of 10 years and the face value is equal to principal and last
instalment interest. All these zero-coupon bonds are discounted and issued today
such that investment banker collects the face value of the interest paying bond
plus a small commission. Those investors, who have surplus for 6 months, will
invest in series 1, those who have surplus for 12 months will invest in series 2,
etc. Interestingly, all investors of ZCB get benefit more than what they would
get otherwise for investing money for such term.
Innovation in debt instruments in general (a) aims to remove interest rate risk
(b) bring a bit of equity flavour into the instrument and (c) improve tax
efficiency of the product. Suppose a firm borrows money in dollar but does not
want to take the risk of foreign exchange rate fluctuations. It is possible to
issue a bond in one currency, pay interest in another currency and repay in a
different currency. Alternatively, you can peg the interest rate to the changes in
foreign exchange rate fluctuations. In essence, foreign exchange risk is
transferred from the company to others. In other words, any risk can be
handled, restructured and transferred from a person who is not willing to take
such risk to a person who is willing to assume such risk.
Activity 3
Reliance Industries has successfully leveraged convertible debentures for
expansion. Examine convertible debentures issues of Reliance and figure out
how it helped them to achieve high growth without diluting their stake. Also,
figure out why other companies like Essar Oil failed to replicate such innovation.
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7
16.5
FINANCIAL ENGINEERING IN EQUITY

PRODUCTS
Equity product witnessed limited innovations since by definition, these products

are designed to carry high risk. Nevertheless, a few attempts have been made
to reduce the risk or share the risk and change some of the basic
characteristics of the instruments. One of the basic characteristics of common
stock is voting rights that it gets for the holders. Unlike co-operative form of
organization in which each shareholder gets only one vote irrespective of share
that the shareholder contributes, common stocks holders' votes equal to number
of shares that the shareholder possess. For instance if you have 1000 shares
and your friend has 100 shares, you get 1000 votes and your friend gets 100
shares. Voting rights give the shareholders to participate in key decisions to the
extent of their stake in the company. Such voting right has a value. This basic
characteristic of the equity has been changed and voting rights value is
swapped for additional dividend by issuing different classes of shares. For
instance, under Indian law, it is now possible for the public limited company in
India to issue non-voting shares. Subscribers of such shares have no voting
rights and in this process it is almost like preference shares but without any
right on even dividend. However, when companies issue such non-voting shares,
a suitable compensation either in the form of discount in offer price or
additional dividend is offered to the subscribers. Though so far no company has
issued such shares, some companies may issue such shares in the future. The
benefits that non-voting shares offer are (a) it enables key promoters to retain
their voting rights while issuing additional shares and (b) many small investors
and mutual funds are not interested in voting rights of good companies and they
are happy with additional dividend to exchange the voting rights. Empirical
studies have shown that there is no significant difference in market price
between the shares of different classes except in period of takeover contest
where voting rights assume importance.
A more common form of this kind of shares is 'differential voting rights' shares
in which all classes of shares have voting rights but in a disproportionate form.
For instance, Class A shares will have voting right of one vote for one share
whereas Class B shares will have a voting right of 100 votes for one share.
Sometime, the arrangement will be such that Class B shareholder will not get
any dividend from the company or get only one-tenth of dividend of Class A
shareholders. Typically, promoters would subscribe Class B shares whereas
most small investors would prefer Class A shares. Initially, companies will issue
Class A shares to all investors and subsequently will announce for exchanging
Class A shares with Class B shares on certain terms (eg. For every 10 shares
of Class A surrendered, the shareholder will get one Class B shares, which has
100 voting rights per share and no dividend). Naturally, those who are
interested in control stake would go for exchange. Sometime, companies may
issue non-voting or low-voting shares for ESOP. While the uses of such
instruments could be many, it is generally considered that non-voting or lowvoting shares increase the agency cost since promoters are trying to retain their
control without investing an equal amount.
Some companies in the US and West have issued puttable common shares in
which the holders of the equity shares have right to surrender the equity shares
at a pre-determined price on a pre-determined date. If you closely observe the
basic characteristics of the instruments, it is somewhat equal to buyback of
shares or selling puts. In other words, the risk associated with equity shares is
considerably reduced by issuing such shares. You might wonder that why Indian
regulators have not insisted such instruments from companies since many Indian
companies during the period of 1994-96 and recently in 2000-01 have been
8
promoted by fly-by-night operators. Good companies gain by charging more
premium for such shares because of less risk associated with such shares.
There is no loss to the company since the shareholders will not exercise their
right if the company performs well. Companies like Intel have issued 'put
option' instead of puttable common shares.
Yet another innovation from mutual funds and investment bankers is splitting the
total return of equity into two components and trade them separately. For
example, SBI Mutual fund could invest 100000 shares in Infosys and create
100000 Class A and 100000 Class B stripes against the investment in Infosys.
SBI defines that those who purchase Class A shares will get only dividend (or
dividend plus 20% capital appreciation) and Class B shares will get no dividend
but entire capital appreciation (or 80% capital appreciation). The Class A is
called PRIME and Class B is called SCORE. While small investors prefer
Class A or PRIME, speculators will prefer Class B or SCORE component.
16.6
FINANCIAL ENGINEERING IN DERIVATIVES
The contribution of financial engineering on derivatives is substantial. In fact,

every derivative instrument is the outcome of financial engineering. To
appreciate the contribution of financial engineering on managing risk through
derivatives, let us go back to the origin of such developments. Market is a
place where goods, products or services are exchanged. Normally, such
exchanges take place when the parties transact and such trades are called
cash market trades. However, cash market transaction creates certain
problems. For example, a food processing company may not be in a position to
buy its entire one-year requirement of wheat and wheat producer may not be
in a position to supply entire quantity of wheat. Both parties are exposed to
price risk if they decide to transact periodically, say once in a month - that is,
producer will supply one month wheat every month based on the price
prevailing in the market. To manage the price risk, producers and consumers
have started transacting in forward market. Forward is an agreement between
the two parties entered today with all terms of contracts agreed today but
settled at a future period. Forward is a plain vanilla instrument that gives birth
to derivatives through financial engineering. Forward performs almost all
requirements of both parties of transactions but there are certain limitations. For
instance, if one of the parties wants to get out of the contract before the
settlement date, both parties have to negotiate for the reversal of the contract,
which often will be expensive. In other words, there is no easy way for getting
in and getting out of the forward contract. However, futures (both commodity
and financial futures), which are a derivative instrument, offer this facility.
Future is a standardized forward contract entered between two parties and
traded in the exchange. Because of standardization, it is possible to trade in
organized exchanges and because it is traded in exchanges, it is easy to get in
and get out of the contract. Today, futures are highly liquid and available on
large number of financial products like stocks, bonds, currencies and
commodities like coffee, cotton, plantation, etc. They are also available on
metals and energy products.
While futures resolve basic problem of liquidity while allowing parties to 'lockin' the price today so that there is no price risk, the parties forgo the
opportunity to exploit the price advantage. For instance, the buyer will continue
to pay higher price even the current market price is much lower. Of course,
the producers gain in such situation. On the hand, if the prices move up, the
producers continue to sell at lower price while buyers' gain in such a situation.
Hence when the prices move up or down, one of the parties gain and other
incur loss. Financial engineers designed options contract which allows buyer of
Strategicthe
Financing
Decisions
option to
retain
the benefit of price movement while avoiding loss.

Consumers buy call option, which gives them a right to buy at a predetermined
price. They exercise the right only when the price is more than the
predetermined price. Producers buy put option, which gives them a right to sell
at a predetermined price and producers exercise their right when the price
moves downward. Option contracts split the risk into positive and negative and
allow parties to take whatever they like. Buyers of option, who take positive
side of the risk, are expected to pay a price or premium to sellers of option,
who take negative side of the risk.
Swaps are similar to futures but the difference is it is a series of futures.
Swaps are normally entered into exchange fixed rate borrowing/lending with
floating rate borrowing/lending or to exchange one currency borrowing/lending
with another currency borrowing/lending. Suppose your company has borrowed
money in the US but your exports are primarily to Europe. It is possible that
you can swap dollar loan with Euro currency loan so that your foreign
exchange risk is reduced. Swaption is another variation of swaps contract and
it brings option element into swaps. Financial engineers have developed several
such variations and you will have an opportunity to learn them in derivative
courses.
Activity 4
Visit internet and find out the details of some exotic derivatives like weather
derivative and write a brief report on the same.
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16.7
SUMMARY
Financial engineering like any other engineering has brought several new
products and solutions to the market. It has completely changed the financial
market today. Its main contribution is to split the risk and return into several
components and allow investors of financial markets to decide the combination
that is most suitable to them. Such innovations are seen in bonds, equity,
derivatives, and also in other fields like merger, acquisition and corporate
restructuring. It also provides mechanism to price such combinations by
developing various pricing models for futures and options. Some of the models
are cost-of-carry model, binominal model, Black-Scholes Option Pricing Model,
etc. Today, it is possible to quantify risk and return of any new products and
also price them with the help of these models. Financial engineering is an
exciting field, which attracts some of the best human resources. The profession
is also highly rewarding.
10
16.8
SELF-ASSESSMENT QUESTIONS
1. What is financial engineering? Do you feel financial engineers play an

economic role in the society?
2. Briefly discuss the financial engineering process that you will follow while
developing new products or solutions.
3. List down with examples any five variables that contribute new products
development.
4. Explain how fixed income securities are used to manage product price risk.
5. Discuss innovation that took place in equity products and explain what they
achieved.
6. What is non-voting share? How is it useful to the company and investors?
7. What is the use of derivatives? Is it an instrument designed for speculators
or useful to others too?
8. Explain any two derivative products and show the value addition in them.
16.9
FURTHER READINGS
Finnerty, J. D., Financial Engineering in Corporate Finance: An Overview,

Financial Management, Winter 1988, Pp. 14-33.
Marshall, John.F and Bansal, Vipul K, Financial Engineering: A Complete
Guide to Financial Innovoation, Printice-Hall of India,New Delhi, 1996.
Mason, S P., Merton, R.C., Perold A. F., and Tufano P., Cases in Financial
Engineering: Applied Studies of Financial Innovation, Prentice Hall, Englewood
Cliffs, New Jersey, 1995.
Miller, M H. Finanical Innovation: The Last Twenty Years and the Next,
Journal of Financial and Quantitative Analysis, December 1986, Pp. 459-71.
11
UNIT 17 INVESTORS RELATIONS
Objectives
explain the corporate form of business organization and the need for
maintaining investor relations
highlight the importance of investor relationship for the corporate form of
business organization.
pinpoint the different forces that demand for information from the
companies and varying purposes for which it is demanded by the
stakeholders
bring out the rationale for corporate governance in building by good investor
relations
explain the advantages achieved from being a good governance company
Structure
17.1
Introduction
17.2
Corporate form of Business Organization
17.3
Demand for Information
17.4
Transparency and Disclosure
17.5
Corporate Governance
17.6
Investor Service
17.7
Summary
17.8
17.9
Further Readings
Appendix : Corporate Governance Report of Infosys Technologies Ltd.
17.1
INTRODUCTION
Savings and investment determine the growth, be it the economy or the

company. Business units require funds for acquiring assets for manufacturing
and investing in good projects and thereby achieving economies of scale. The
company form of business organization facilitates the creation of such large
firms with large capital base. This is made possible by collecting money from
millions of investors. Investors provide capital at the time of starting the
venture as well as for the growth of the firm. While the funds provided by the
equity holders make them the owners of the company, the funds provided by
the debt holders make them the lenders.
Hence, the company form of business mostly has a financial structure with a
mix of debt and equity. Generally the equity holders are the promoters, the
directors and their relatives, Government, sometimes the institutional investors,
the banks and the general public (or small investors) and they all jointly own
the company. The debt holders are basically financial institutions, banks and
general public who lend money against a mortgage or by getting bonds or debentures
issued from the company. In some cases, the debt holders are issued convertible
bonds, as per which they can submit their bonds and get them converted to
equity at later stage. So in this case they become owners from lenders.
Table 17.1 furnishes the details of the equity share capital and the number of
equity shares held by the investors of large Indian companies forming part of
NSE 50 index. The table shows that the paid up share capital of these firms
range from Rs. 30 crores to 4000 crores. The number of equity shares issued
run into millions and in some cases in billions. To get better understanding of
who actually controls the company, we need to look into the shareholding
pattern data of these companies. Table 17.2 presents the percentage of equity
holding by different categories of equity shareholders of these nifty companies.
The promoters holding represent the equity holding of those who had promoted
the company and they basically control the management. The foreign
promoters' holding arises if there is joint venture between an Indian company
and a foreign company. Such investment can also arise if the foreign firm sets
up its own company in India, which are often called as multinationals. Hence
promoters could comprise of either Indian or foreign based on how they
originated. The institutional investors' holding represents the equity holding of
the financial institutions, the banks and mutual funds. The other private
corporate body equity holding implies the holdings of other companies. For
instance if Britannia industries invests in the shares of the ABB Ltd, it would
be classified into other company holdings. Companies at times do this form of
investing, when excess cash is available and it lies idle in the company. The
others equity shareholding represent the holdings of small investors, who are
also owners of the company. But these small investors mostly invest for the
sake of investment or speculation. They sell their shares if they feel that the
company's share is performing badly in the capital market.
These two tables thus highlight the fact that number of investors are large
typically in large companies and also the categories of the investors are of
different kinds. While the average promoters' holding of these companies is
around 43%, non-promoters contribution is 57%. In such a scenario a formal
investor relationship arrangement assumes importance. Many companies today
have a full fledged investor relations department headed by an investor
relationship officer. The present unit is dedicated to discuss why the
companies need to have a good relationship with investors and what exactly
should the companies do to maintain such good relationships.
17.2
CORPORATE FORM OF BUSINESS

ORGANIZATION
The company form of organization is governed by the Companies Act. In India,

the Companies Act was passed during 1956. The Companies Act of most
countries allow a group of people to start a company and approach public to
raise large capital in the form of debt or equity. Generally, the small investors
buy the shares and become the owners of the company. Institutional investors,
as explained earlier, not only buy the shares, they also lend money to these
companies against bonds or mortgage. Hence it can be found that the owners
of a company could be any number of small investors. The investor range
increases with the size of the company. So the ownership is spread across the
world or countries. Figure 17.1 provides an overview of the links between the
company, the shareholders, the institutions and the market.
While ownership is widely spread, the control is retained by a few. In the

sense that the management of the company is handed over to few Board of
Directors elected by the shareholders. This is because not all owners can
manage the company with a very small stake. This separation of ownership
and control leads to agency problem. Since agents behave with self-interest, it
might harm other investors who are not directly involved in management of the
company. For instance, managers may invest the capital in not so good projects,
and the result being the shareholders bear the loss of such bad investment. The
managers may also use the shareholders money in different possible ways to
serve their own interest.
Table 17.1: Equity shares and capital of NSE 50 companies
Company Name
Eq. Capital (Rs. Crores)
No. of Shares
A B B Ltd.
42.38
42381675
Associated Cement Cos. Ltd.
171.13
170929944
B S E S Ltd.
137.83
137725666
Bajaj Auto Ltd.
101.19
101183510
Bharat Heavy Electricals Ltd.
244.76
244760000
Bharat Petroleum Corpn. Ltd.
300
300000000
Britannia Industries Ltd.
25.9
25904276
Cipla Ltd.
59.97
59972349
Colgate-Palmolive (India) Ltd.
135.99
135992817
Dabur India Ltd.
28.58
285749934
Digital Globalsoft Ltd.
32.98
32980532
Dr. Reddy'S Laboratories Ltd.
38.26
76515948
G A I L (India) Ltd.
845.65
845651600
Glaxosmithkline Con.Healthcare Ltd.
45.38
45380621
Glaxosmithkline Pharmaceuticals Ltd.
74.48
74475000
Grasim Industries Ltd.
91.69
91669685
Gujarat Ambuja Cements Ltd.
155.27
155189921
H C L Technologies Ltd.
57.58
287884290
H D F C Bank Ltd.
282.05
282045713
Hero Honda Motors Ltd.
39.94
199687500
Hindalco Industries Ltd.
92.46
92481325
Hindustan Lever Ltd.
220.12
2201243793
Hindustan Petroleum Corpn. Ltd.
338.83
339330000
HDFC
244.41
244414492
I C I C I Bank Ltd.
612.66
613034404
I T C Ltd.
247.51
247511886
Indian Hotels Co. Ltd.
45.12
45114695
Indian Petrochemicals Corpn. Ltd.
249.05
248225622
Infosys Technologies Ltd.
33.12
66243078
Larsen & Toubro Ltd.
248.67
248668756
630
630000000
116.01
116008599
Mahanagar Telephone Nigam Ltd.

Mahindra & Mahindra Ltd.
N I I T Ltd.
38.65
38649279
National Aluminium Co. Ltd.
644.31
644309628
Oriental Bank Of Commerce
192.54
192539700
Ranbaxy Laboratories Ltd.
196.72
185452098
Reliance Industries Ltd.
1395.92
1396377536
Satyam Computer Services Ltd.
62.91
314542800
Shipping Corpn. Of India Ltd.
282.3
282302420
State Bank Of India
526.3
526298878
Steel Authority Of India Ltd.
4130.4
4130400545
Sun Pharmaceutical Inds. Ltd.
46.52
93048478
Tata Chemicals Ltd.
180.7
180638651
Tata Iron & Steel Co. Ltd.
369.18
367771901
Tata Motors Ltd.
319.83
319784387
Tata Power Co. Ltd.
197.91
197897864
Tata Tea Ltd.
56.22
56219857
285
285000000
Videsh Sanchar Nigam Ltd.
Investors Relations
Wipro Ltd.
46.51
232563992
Zee Telefilms Ltd.
41.25
412505012
Table 17.2: Shareholding pattern of Nifty companies (in %), March 2003
Company Name
Promoters
Institutions
Cor. Bodies
Others
ABB
52.11
ACC
0.00
30.47
1.10
17.42
45.48
18.26
BSES
58.22
54.52
28.13
0.48
13.65
Bajaj Auto
BHEL
29.17
21.07
13.52
49.76
67.72
29.83
0.52
2.44
BPCL
66.20
27.72
1.39
6.08
Britannia Industries
47.00
28.37
1.98
24.63
Cipla
39.94
24.85
2.22
35.21
Colgate-Palmolive (India)
51.00
11.93
1.01
37.07
Dabur India
78.34
11.61
1.09
10.04
Digital Globalsoft
50.61
33.85
1.37
15.54
Dr. Reddy'S Laboratories
26.02
35.20
1.90
38.77
G A I L (India)
67.34
9.42
0.36
23.23
Glaxosmithkline Con. Health
40.00
34.19
3.54
25.81
Glaxosmithkline Pharma
48.83
26.56
1.50
24.61
Grasim Industries
20.42
38.23
5.80
41.36
Gujarat Ambuja Cements
27.51
38.45
3.55
34.04
H C L Technologies
77.04
10.55
4.12
12.41
H D F C Bank
24.41
30.49
1.16
45.09
Hero Honda Motors
52.00
31.05
2.01
16.95
Hindalco Industries
24.37
38.15
3.19
37.48
Hindustan Lever
51.56
26.03
0.84
22.42
HPCL
51.01
37.01
3.14
11.98
HDFC
0.00
59.70
2.37
40.30
I C I C I Bank
0.00
59.74
4.93
40.26
I T C
0.00
48.00
0.85
52.00
Indian Hotels Co.
37.38
27.24
2.33
35.37
Indian Petrochemicals Corpn.
79.98
8.38
2.11
11.64
Infosys Technologies
28.42
48.44
1.01
23.14
Larsen & Toubro
0.00
44.09
20.04
55.91
Mahanagar Telephone Nigam
56.25
31.29
0.74
12.46
Mahindra & Mahindra
26.26
43.79
5.61
29.94
N I I T
31.25
41.97
7.42
26.78
National Aluminium Co.
87.15
7.47
3.59
5.38
Oriental Bank Of Commerce
66.48
16.67
1.71
16.85
Ranbaxy Laboratories
32.05
35.85
1.00
32.10
Reliance Industries
46.52
27.76
1.67
25.72
Satyam Computer Services
20.74
56.27
2.34
22.99
Shipping Corpn. Of India
80.12
11.17
2.90
8.71
State Bank Of India
0.00
82.40
1.79
17.60
Steel Authority Of India
85.82
9.73
0.69
4.45
Sun Pharmaceutical Inds.
71.75
17.37
2.69
10.88
Tata Chemicals
30.56
26.39
5.03
43.05
Tata Iron & Steel Co.
26.41
34.34
6.78
39.25
Tata Motors
32.21
35.03
9.87
32.76
Tata Power Co.
32.54
33.95
2.35
33.51
Tata Tea
29.48
34.03
3.21
36.49
Videsh Sanchar Nigam
71.12
9.36
2.80
19.52
Wipro
83.90
4.40
1.78
11.70
Zee Telefilms
51.77
33.53
3.28
14.70
Investors Relations
Corporate
Capital
Market
Institu
Primary / Secondary
Functional
Managers
Finance
Function
Managers
Figure 17.1: The Functioning of Corporate Form of Business
These managers may also get involved with creative accounting, with the help
of the auditors. We have seen many instances of scams of this nature. In all
these cases, every stakeholder is affected. The equity holders, on learning
such frauds, start selling the shares and this pulls down the prices of the stock
in the market. Not only will the small investors do such act, this could happen
with the institutional investors as well. The matter is even worse with the
institutional investors. This is because the institutional investors are both lenders
as well owners in many companies. They not only cause damage by selling
the shares, they will avoid lending to these companies in future. So the growth
of the firm gets affected and finally the company might get liquidated.
There are several ways in which the management or promoters can assure the
managers manage the firm efficiently. Investor relationship in a broader sense
includes all such efforts taken by the agents to ensure that investors are not
affected by the agency problem. Investors expect management to run the firm
efficiently in a most transparent manner and take all decisions that maximize
the investors return. The next section would explain in detail the expectations of
the investors from the management of the company. If these expectations are
not met, then the company would be heading towards serious trouble.
17.3
DEMAND FOR INFORMATION
Basically, the demand for corporate information comes from the shareholders
and investors, managers, employees, customers, lenders and other suppliers,
security analysts, policy makers, regulators and government. Purpose of
soliciting information by different stakeholders of the organization varies to a
great extent. For instance, the Government seeks financial information of the
company mainly to check if it pays the right amount of taxes as also to check
if it does not violate licenses granted, export-import policies etc.
The suppliers would be demanding the financial information basically to ensure
that the company would be in business for sufficiently long period of time and
it would be worth while to have business with them. They would like to know
if the company would be able to pay their dues. Likewise, the lenders would
use information to verify the creatibility of the company.
The managers call upon information of various types for planning and control
purposes. Of course, the information supplied to the managers within the firm
may be much more in detail and confidential compared to the information
provided to the outsiders. The customers, particularly the consumers of durable
goods or vehicles or IT products, would be interested in knowing whether the
company would exist in near future to provide them the service for the product
they purchased. So they would be constantly watching the companys
performance for the same. The employees would be interested in the company
information because they would want to know if they would get better wages
or salaries for the coming years. Because if the firm is not doing well, the
chances are that they might lose their jobs and also lose wages. So they keep
a watch on the performance of the company.
The analyst demand information to publish reports on the performance of the
company and to rate its debt payment capacity. He continuously tracks the
company for information and analyzes the company accordingly and informs the
public on buy and hold strategies. On the other hand, the demand for
information by small and retail investors differs from that of the experienced
analysts. The small investors simply do not have the time to keep track of the
companies latest information. This is because small investors invest in a number
of companies and it is difficult for them to keep track of the information of all
these companies. Moreover they would not be able to analyze the information
as usefully as the experienced analysts do. Hence, they require much more
detailed information and mainly in a processed format so that they can evaluate
the risk and return characteristic of the company. This is for the fact that the
risk and return of a firm are dependent on the following:
(i)
the social, political and macroeconomic factors which are common to

belonging to differents all companies industries, such as social harmony,
relations with other countries, political stability, growth rate of gross
domestic product (GDP), inflation rate, money supply, and policies of the
government;
(ii)
the industry factors which are common to all companies in a particular

industry, such as labour conditions in the industry, policies of government
which have influence on the industry, and demand and supply factors and;
(iii)
company-specific factors which are important to any company, such as

financial performance, changes in the top management, decisions relating
to financing, investment and dividend. With the knowledge of these
factors, investors would be able to calculate the expected returns of
securities of different firms, the risk associated with their returns and
accordingly take their investment or portfolio decision.
Once the investment decision is made, shareholders and investors demand

information for the purpose of safeguarding their interest in the corporate firm.
This involves control of managerial behaviour so as to guide managerial
activities towards the maximisation of shareholders' wealth. Thus, shareholders
and potential investors require information so as to help them to make the
investment decision, as also to design contracts and mechanisms for controlling
the behaviour of managers, and orient the managerial behaviour towards
realising the objectives of a firm. Accordingly, they demand all information that
is non-proprietary, i.e. information whose disclosure does not affect the firm's
future cash flows.
We know that the objective of existing shareholders is to maximise their

expected utility or wealth, even if it is at the expense of other parties involved
in the activities of a concern. First, they wish to safeguard their interest and
want to limit the possibilities for expropriation by all other parties. Second, they
will try to achieve the goal of maximisation of the wealth of the firm or
alternatively the expected utility or wealth of shareholders by expropriating the
other parties involved. Towards this end, they would like the management to
take decisions which would increase their wealth either through achieving
higher sales, higher incomes and higher profits or through transfer of wealth
from other parties involved in the corporate activity such as creditors, managers,
employees, customers and government. They also demand the management of
the company to disclose information that maximises the value of the firm.
Investors Relations
However, we should also note that the demand for disclosure of corporate
information of prospective shareholders differs from that of existing investors.
Whereas the former wants the firm to reveal both value enhancing as well as
value diminishing information, the latter, expects the firm to reveal only the
value enhancing information and not to reveal the value diminishing information.
Such conflicts can be seen as amount existing groups of promoters, institutional
shareholders and public shareholders.
There are several agencies engaged in protecting the interest of small investors
and other stakeholders. The requirement that the company form of organization
has to be registered under the companies Act, 1956 is the first protection to
investors and others. The Registrar of companies makes sure that the company
that is formed is genuine and has been formed for the purpose of being in the
business. The investors' interests are protected by the Securities Exchange and
Board of India (SEBI). SEBI had laid down some listing requirements for the
companies seeking to raise money from the small investors or public. Once the
company accepts the listing agreements, the company's shares get listed in the
stock exchange. SEBI has also brought several regulations and guidelines for
market participants and intermediaries to protect the interest of investors. The
Institute of Chartered Accountants of India lays down the necessary accounting
standards based on which the companies need to prepare the financial
statements and get it audited by the chartered accountants. This is done to
ensure that the financial statements represent true and fair view of the financial
position of the company.
Basically the investor demands can be classified into three basic categories.
1) Transparency and Disclosure
2) Good corporate governance
3) Investors Service
Each of these are discussed in detail in the following sections.
Activity 1
Check with some of your friends who invest in stocks on the information that
they require/use while selecting the stocks for investments. Identify whether
companies disclose such information in the annual report.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
Activity 2
Check with your friend whether he/she is happy with the information supplied
by the company in disclosing such information. Also, find out whether they are
satisfied with the role of SEBI and Stock Exchanges in improving disclosure
standards.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
7
17.4
TRANSPARENCY AND DISCLOSURE
Companies typically do not make available information on a day to day basis

because of strategic reasons, and huge costs involved in collection and
dissemination of such information to all the users. At the same time, the
companies disclose summary of information periodically for various purposes.
Corporate disclosure of information is determined by the market forces, costs
associated with corporate disclosures and the regulatory forces (Refer Figure 17.2)
Market forces which influence the decision of corporate firms may relate to
the capital, labour and corporate control market. Corporate firms compete with
each other in the capital market for resources. They may issue different
instruments which meet the requirements of investors. The various forms of
raising finance have been discussed in the earlier sections. Under these
circumstances, capital market forces exert pressure on firms to provide
information relating to the instruments offered, terms of instruments, the
distribution of expected returns and importantly, on the projects for which the
capital is being raised. This is necessary because the investors have no
foresight about returns and the quality of the product. And firms may be
apprehensive, that in the absence of the authentic information, they may be
perceived by investors as 'lemon'. In the instance of non-disclosure by
corporate firms, the investors may not be able to assess the risk and returns on
the projects undertaken by the firms, as they would have no idea as to which
firm's projects are good or bad. Investors, under such circumstances, require
on average a high return. This higher required return may force the issuers of
capital to withdraw from the market as the net present value of the project
would be negative, if the projects are implemented with resources mobilised at
a higher cost. When 'good' issues are withdrawn from the market, investors
revise their required return upwards, which force some firms to withdraw from
the market. In this process, the capital market ends up in a situation where
there are only high risk offers, and there would be no investors ready to supply
the resources. Given the uncertainty about the product quality, success of the
projects and the cost of being perceived as a 'lemon', corporate firms have an
incentive to supply the information that they believe will enable them to raise
capital on the best available terms.
Some firms may make overly optimistic forecasts about the future cash flows
associated with a project. However, checks such as (i) reputation of the firm,
(ii) reputation of the management, (iii) third-party assessment and clarification,
and (iv) legal penalties, act as deterrents for firms to make these overly
optimistic forecasts.
The labour market forces also exert pressure on the management to disclose
information to the public. This can be due to either external or internal forces.
For example, reputation of a management plays a vital role in determining the
managers' prospects of promotion and other incentives structure within the firm
as well as outside the firm. Hence, managers would not be willing to take
steps that damage their reputation of competence. Further, professional
managers are governed by a set of standards of behaviour or a code of
conduct which are determined by professional bodies, and non-adherence to
standards may lead to disciplinary action against them by the professional
bodies. Thus, forces in the labour market prompt the managers to disclose
information which improves their prospects, as well as their reputation.
The corporate control market forces also influence the firms' decision of
disclosure, and the timing of information release to the public. The efficient
working of a concern depends on the soundness of the policies determined by
the board of directors, and their effective implementation by the managing
director and his team of managers. If investors perceive that a company is not
Investors Relations
Decision by Firms
Market Forces
Information Available
to External Parties
Regulatory Forces
Decision by non firm Information

Sources, for example, brokerage
houses, and industry trade associations
Fig. 17.2: Factors Influencing the Information Set Available to External Parties
Source: Foster, George, Financial Statement Information, p.24, Prentice-Hall International,
Englewoodcliffs, New Jersey, 1986.
run efficiently and identify ways in which its functioning can be improved, they
may attempt to take over the controlling stake of the company. This perception
of non-controlling stakeholders is influenced by their private information. Such
private information gives them an advantage, as they can acquire the stocks of
the company at the existing prices. Under such circumstances, managers are
forced to improve not only their working but also the level of information
disclosure. At times, even when the investors do not have information about its
good future prospects, the prices of a company's securities may be under
priced. However, the corporate predators and raiders, under such
circumstances, make attempts to take over the company by actively buying the
securities of the company in the secondary market. This forces the managers
to reveal the information about the prospects of the company to the outsiders.
Thus, the market forces influence the supply of information in two ways: first
by prompting the existing management of firms to disclose information to the
public and secondly, through the threat of actions of corporate predators and
raiders, who continuously explore the opportunities for takeovers.
The costs associated with corporate disclosures also influence the time and
extent of disclosure of information. These costs include: (i) collection and
processing costs, (ii) litigation costs, (iii) political costs, (iv) competitive
disadvantage costs, and (v) additional constraints on management decisions.
Collection and processing costs include the costs borne by both the suppliers
and users of financial information. Corporate firms as well as users of
information incur the costs of collection of information. The corporate
management has to make decisions on what information is to be collected and
at what frequency. It is not possible for firms to collect all the information on a
continuous basis, as it involves unlimited resources, both human and financial.
The decision on information collection is often based on the assessment of
costs and benefits associated with such information. Firms, while computing
the costs of collecting and processing information, have to bear in mind the
costs incurred by the firm as well as the costs borne by investors in performing
such task. Similarly, while computing the benefits of information production and
processing, firms have to take into view the benefits that accrue to all the
users of corporate information who have a stake in the corporate firm.
Litigation costs arise when the corporate has to face a dispute in a legal forum.
The prompt public release of information as well as corrective information, if
any, can reduce the potential losses to shareholders and the potential exposure
of the firm and its management in subsequent litigations.
Political costs arise in situations where the perception of government and

policies of government are influenced by the disclosure of corporate information
which influences the government to take actions which transfer resources from
the corporate to the other constituents of society through fiscal and other
measures. In these circumstances, firms may choose accounting methods that
they perceive will reduce the likelihood of large profit increase being reported
in any one year.
Competitive disadvantage costs arise when firms choose to reveal a portion of
proprietary information. Typically, firms choose to keep strategic information
such as information on research and development, new products, advertising
expenditure, break down of major customers and forecasts of gross margin,
income or sales by individual lines of business, when they perceive that they
have an advantage over competitors in these areas. However, they face a
difficult situation when they want to raise new capital. In such a situation,
irrespective of whether the firms disclose the information or not, the firm
stands to experience a reduction in its value. For instance, unless firms provide
some information pertaining to their research and development activities or new
products, the capital market is not likely to support a new share offering, and
yet, if they do provide detailed information, they may reduce the lead time with
which competitors learn about developments within the company.
Disclosure of certain types of information by managers imposes constraints on
their behaviour and may lead to a conflict between their efficiency and
reputation. For example, earnings forecasts and their disclosure to the public
put pressure on managers to implement policies that result in the actual
earnings converging towards the forecast values.
Regulatory forces also influence the disclosure and timing of release of
information by firms. A number of regulatory agencies govern the functioning
of corporate and regulate their information disclosure. Such agencies can be
broadly discussed under four levels: (i) level one consists of the executive,
legislative, and judicial branches of the government. The legislative makes laws
which are enforced by the executive. The legislative and executive define the
manner in which the corporate has to disclose information. The judiciary
exerts influence on the disclosure practices by its rulings; (ii) level two includes
government regulatory bodies. As discussed briefly in the earlier sections, in
India, this level includes the Securities and Exchange Board of India (SEBI),
the Company Law Board, and the Department of Company Affairs under the
Ministry of Finance. These agencies are often delegated with the authority of
overseeing the adherence of rules and procedures by corporate firms; (iii) level
three includes private sector regulatory bodies such as Accounting Standard
Board, the Institute of Chartered Accountants of India, and Stock Exchanges.
Professional bodies, through conducting seminars and publication of discussion
papers and in-depth analysis, from time to time, recommend standard practices
to be followed in the preparation of balance sheets, cash flow statements and
profit and loss accounts; (iv) level four includes lobbying groups that attempt to
influence the decisions made by the parties in the above three levels. These
professional bodies include industrial and trade associations, investor associations
and other interest groups.
The market forces and regulatory forces, described above, influence the
decisions of both the corporate firms and non-firm information sources such as
brokerage houses, and industry and trade associations as to what to disclose
and when to disclose. The decisions of corporate firms and decisions of
sources other than corporate firms influence each other.
10
However, not all information disclosed by the companies are mandated by

regulation. Companies also choose to disclose voluntarily information like the
social services performed by them, the company philosophy, objective, business
they are operating, the market share of the business, etc. However, as sated
earlier, companies would be hesitating to provide information, which would
reveal their competitive advantage to the competitors. For instance, the ICAI
introduced a new accounting standard on Segment Reporting (AS-17) with
effect from 2001. However, most companies still do not provide this information
despite being made mandatory by claiming that they are single segment
company. This is because as per this standard, companies are supposed to
disclose their financial information based on the different segments. Prior to
2001, investors did not know whether companies were performing good in all
the segments in which they were operating. For instance, prior to 2001 investors
did not know whether L&T was performing well in their cement or construction
segment. Only the performance of L&T was made known to the companies.
Investors Relations
There has been tremendous improvement in the last few years in the disclosure
level of the Indian companies. This is mainly due to the new accounting
standards introduced by the ICAI like consolidation of accounts, segment
reporting, revealing the related party transactions, revealing the intangible asset
valuation etc. Apart from this the listing requirement had also been tightened.
And listing requirements demanded more information from the companies. One
such latest requirement is the introduction of the Clause 49 on corporate
governance code. Accordingly, every company wanting to get listed in the stock
exchange will have to disclose the corporate governance systems and
procedures existing within the company. Detailed aspect discussion on this made
had been made in the next section.
Activity 3
Compare for any one company, the annual reports of the year ending March
2000 and March 2003. Identify major changes that you have seen on the items
disclosed by the company.
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17.5
CORPORATE GOVERNANCE
Corporate governance plays an important role in building a good relationship

with the investors. This is because when companies are able to keep their
investor well informed about the way the business is done in a transparent
manner, this would definitely present a positive image. No investor would want
to do away his investment from such a company. McKinney in one of their
surveys (2000) reported that investors are willing to pay more for companies
with good governance. And the premium the investors would be willing to pay
for well-governed companies, they reported, differed by country. As reported,
the investors were willing to pay 18 percent more for the shares of a wellgoverned UK or US company, for example, than for the shares of a company
with similar financial performance but poorer governance practices. But they
would be willing to pay a 22 percent premium for a well-governed Italian
company and a 27 percent premium for a well-governed company in Indonesia.
A well governed company is defined as having a majority of outside directors
on board with no management ties; holding formal evaluation of directors; and
being responsive to investor's requests for information on governance issues. In
addition, directors hold significant stockholdings in the company, and a large
proportion of director's pay in the form of stock options. (Monks, 2001).
11
However, the existence of corporate governance by itself does not become a

sufficient condition for the better performance of a firm. It can, however,
become a necessary condition in the highly competitive world, particularly when
the market has become global. But why does it become a necessary condition?
Corporate governance can do a lot of things for the better performance of the
company:
1. Good corporate governance helps the company to evaluate the better
investment decisions.
2. It would help resolve the agency cost of debt and equity.
3. It can help retain the existing investors.
4. It can attract more and more investors, implying raising capital would be easier.
5. Suppliers would be willing to deal with such companies.
6. Lenders would not be hesitating to lend to such companies, as the systems
are transparent and the performance of the company is well revealed.
Companies like Infosys could be shown as a good example for maintaining
good corporate governance. The corporate governance report of the Infosys
Technologies Ltd., for the year 2003 as required under clause 49 is given in
Appendix to this Unit.
Activity 4
Find and write a brief report on events that lead to appointment of Cadbury
Committee on Corporate Governance in the UK.
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Activity 5
Find from your stock market investor friend whether he or she is happy with
the corporate governance set up of Indian companies.
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17.6
INVESTOR SERVICE
In the earlier sections we had discussed about the importance of companies

maintaining a good relation with the investors. We had seen that companies
gain a substantial advantage by transparent policies and disclosure practices.
However, in order to sustain the good relationship earned, the companies need
to provide the right information at the right time at the right place. Further they
must also attend to the queries of the investors promptly and provide them a
better service.
12
Though most of the information discussed above is filed with the stock
exchanges, information in the annual report are sent to the shareholders by
post. Some information are sent to the interested parties on demand. The better
practice has been that companies these days provide almost all information in
their websites. In fact, this is also mandatory by regulation. The quarterly
returns filed with the stock exchange have to be made available in their
website as well.
Some good governance companies provide a lot of these information in a
systematic manner in their websites; for instance the website of Infosys
technologies covers almost all information filed with the regulatory agencies.
Investors Relations
As part of the annual reports, companies furnish the following details which are
useful to investors.
1. Financial calendar specifying the dates of holding the annual general meeting
2. Dates on which the quarterly returns are to be released
3. Dates of book closure for different purposes like share transfer and
dividend payment
4. The addresses of the companies and the head office
5. Listing in stock exchanges
6. Information on dividend payment
7. Details about the investor grievances committee
8. Method of voting by proxy
9. Shareholding pattern of the company
10. The number of shareholders present in the company supplying the different
range of shares held.
11. Market price data of the shares traded in the listed stock exchanges and a
comparison of the share performance with the indices are also given.
12. Share transfer procedures. Though all the share trading is performed these
days in the demat mode, the details of the same are also given.
13. Plant locations
Investors are comfortable dealing with companies that furnish the maximum
information for the shareholders and also provide them good service.
Activity 6
List down the procedure to be followed when a shareholder has grievance
against the company. What are the alternative avenues available to investors
and what is the role of SEBI in handling investors grievances?
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
Activity 7
Visit SEBI's web site (www.sebi.gov.in) and visit EDIFAR link and write a
brief note on EDIFAR and its usefulness to investors.
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
...........................................................................................................................
13
17.7
SUMMARY
Mr. Narayanamurthy of Infosys stated that "The primary purpose of corporate

leadership is to create wealth legally and ethically. This translates to bringing a
high level of satisfaction to five constituencies -- customers, employees,
investors, vendors and the society-at-large. The raison d'tre of every corporate
body is to ensure predictability, sustainability and profitability of revenues year
after year." Some companies not only state their philosophies in just letter but
they act on it as well. Having a mission statement, underlying principles for
achieving the mission and delivering value to the owners and the other
stakeholders enables the companies to have a long-term good relationship with
its investors. If the companies do not sustain such long-term good relationship,
we have seen that most companies get liquidated in the process of cheating the
investors. Hence, maintaining a good relationship with the investors and
performing the operations in the most transparent manner helps the companies
in the long term.
17.8
SELF-ASSESSMENT QUESTIONS
1. Who are the stakeholders of a company?

2. Why is that the investor relationship gains more importance in corporate
form of business organization rather than the other forms of business
structures. Does it really matter or apply for other forms of business
organizations? If so, how?
3. What are the forces that drive for information from the company?
4. What type of information is demanded by the different type of stakeholders
including the shareholders?
5. Do you think corporate governance matter in investor relationship?
6. Find out about 5 companies who have been rated as 'Good Corporate
Governance' company and examine their investor relationship. Are the
information provided by these companies to the investors differ to a great
extent? If so, list down in what aspects they differ.
7. What are the regulatory agencies that govern the disclosure of information
by companies. List them and their roles.
8. How does the information demanded by the inside shareholders differ from
the retail or external investors?
17.9
FURTHER READINGS
Bhabatosh Banerjee and Arun Kumar Basu (2001), Corporate Financial

Reporting (Eds.), University of Calcutta, Calcutta.
Bhabatosh Banerjee (2002), Regulation of Corporate Accounting and
Reporting in India, World Press, Calcutta.
Birgul Caramanolis-coteli, Lucien Gardiol, Rajna Gibson Asner Nils S.
Tuchschmid (1999), "Are Investors Sensitive to the Quality and the
Disclosure of Financial Statements?" European Financial Review 3, 131159.Monks, Robert A. G. (2001), "Redesigning Corporate Governance
Structures and Systems for the Twenty First Century" Corporate Governance
Journal 9(3), July: pp. 142-147.
John E. Core (2001), "A review of the empirical disclosure literature:
discussion" Journal of Accounting and Economics 31, 441-456.
Paul Coombes and Mark Watson (2000), "Three Surveys on Corporate
Governance" Mckinsey Quarterly, No. 4.
14
Paul M. Healy, Krishna G. Palepu (2001), "Information asymmetry, corporate
disclosure, and the capital markets: A review of the empirical disclosure
literature" Journal of Accounting and Economics 31, 405-440.
Investors Relations
Stenberg, Elaine, (1999), "The Stakeholder Concept: A Mistaken Doctrine"

Working Paper, Centre for Business and Professional Ethics, University of
Leeds.
Ubha D.S. (2002), Corporate Disclosure Practices, Deep & Deep Publications.
15
Appendix: Corporate Governance Report of Infosys Technologies Ltd.

Infosys Technologies Limited
Corporate Governance report for the year ending March 2003
'1 hope to challenge corporate America to Look beyond rules, regulations
and laws, and Look to the principles upon which sound business is
based."
William H. Donaldson, Chairman, Securities and Exchange Commission, USA
(Remarks at the practicing law institute - SEC speaks)
Corporate governance is about commitment to values and about ethical business
conduct. It is about how an organization is managed. This includes its corporate
and other structures, its culture, its policies and the manner in which it deals
with various stakeholders. Accordingly, timely and accurate disclosure of
information regarding the financial situation, performance, ownership and
governance of the company is an important part of corporate governance. This
improves pubic understanding of the structure, activities and policies of the
organization. Consequently, the organization is able to attract investors, and to
enhance the trust and confidence of the stakeholders.
Corporate governance guidelines and best practices have evolved over a period
of time. The Cadbury Report on the financial aspects of corporate governance,
published in the UK in 1992, was a landmark. This led to the publication of the
Vi Report in France in 1995. This report boldly advocated the removal of
cross-shareholdings that had formed the bedrock of French capitalism for
decades. Further, The General Motors Board of Directors Guidelines in the US
and the Dey Report in Canada proved to be influential in the evolution of other
guidelines and codes, across the world. Dyer the past decade, various countries
have issued recommendations for corporate governance. Compliance with these
is generally not mandated by law, although codes that are linked to stock
exchanges sometimes have a mandatory content.
The Sarbanes-Oxley Act, which was signed by the US President George W
Bush into law last July has brought about sweeping changes in financial
reporting. This is perceived to be the most significant change to the federal
securities law since the 1930s. Besides directors and auditors, it has also laid
down new accountability standards for security analysts and legal counsels.
The Higgs report on non-executive directors and the Smith report on audit
committees, both published in January 2003, form part of the systematic review
of corporate governance being undertaken in UK and Europe. This is in light of
recent corporate failures. The recommendations of these two reports are aimed
at strengthening the existing framework for corporate governance in the UK.
Enhancing the effectiveness of the non-executive directors and switching the
key audit relationship from executive directors to an independent audit
committee are part of this. These recommendations are intended to take effect
as revisions to the Combined Code on Corporate Governance.
In India, the Confederation of Indian Industry (CII) took the lead in framing a
desirable code of corporate governance in April 1998. This was followed by the
recommendations of the Kumar Mangalam Birla Committee on Corporate
Governance. This committee was appointed by the Securities and Exchange
Board of India (SEBI). The recommendations were accepted by SEBI in
December 1999, and are now enshrined in Clause 49 of the Listing Agreement
of every Indian stock exchange. Infosys' compliance with these requirements is
presented in this chapter. Your company fully complies with, and indeed goes
beyond all these recommendations on corporate governance.
16
In addition, the Department of Company Affairs, Government of India,
constituted a nine-member committee under the chairmanship of Naresh Chandra,
former Indian ambassador to the US, to examine various corporate governance
issues. The committee has submitted its report to the government. The
government has not made it mandatory yet for Indian companies. Your company's
compliance with these recommendations is listed in the course of this chapter
Investors Relations
We believe that sound corporate governance is critical to enhance and retain

investor trust. Accordingly we always seek to attain our performance rules with
integrity The Board extends its fiduciary responsibilities in the widest sense of
the term. Our disclosures always seek to attain the best practices in
international corporate governance. We also endeavour to enhance long term
shareholder value and respect minority rights in all our business decisions.
Our corporate governance philosophy is based on the following principles:
1. Satisfy the spirit of the law and not just the letter of the law. Corporate
governance standards should go beyond the law.
2. Be transparent and maintain high degree of disclosure levels. When in
doubt, disclose.
3. Make a clear distinction between personal conveniences and corporate resources.
4. Communicate externally in a truthful manner, about how we run our
company internally
5. Comply with the laws in all the countries in which we operate.
6. Have a simple and transparent corporate structure driven solely by the
business needs.
7. Management is the trustee of the shareholders' capital and not the owner.
At the core of our corporate governance practice is the board, which overseas
how the management serves and protects the long-term interests of all the
stakeholders of the company We believe that an active, well-informed and
independent board is necessary to ensure the highest standards of corporate
governance. Majority of our board - 8 out of 15 - are independent members.
Further, we have a compensation, a nomination and an audit committee, which
are fully comprised of independent directors.
As a part of Infosys' commitment to follow global best practices, we comply
with the Euro shareholders Corporate Governance Guidelines 2000, and the
recommendations of the Conference Board Commission on Public Trusts and
Private Enterprises in the US. Your company also adheres to the UN Global
Compact Programme. Further, a note on Infosys' compliance with the corporate
governance guidelines of six countries - in their national languages - is
presented in the chapter entitled Financial statements prepared in substantial
compliance with GAAP requirements of Australia, Canada, Prance, Germany,
Japan and the United Kingdom, and reports of compliance with the respective
corporate governance standards.
Corporate Governance Guidelines
Over the course of many years, the board has developed corporate governance
guidelines to help fulfill its corporate responsibility to various stakeholders. This
ensures that the board will have the necessary authority and practices in place
to review and evaluate the company operations as and when needed. Further, it
allows the hoard to make decisions that are independent of the company
management. These guidelines are intended to align the interests of the
directors and the management with those of the company shareholders.
These guidelines may be changed from time to time by the board in order to
effectively achieve its stated objectives.
17
A) BOARD COMPOSITION
1. Size and Composition of the Board
The current policy is to have an appropriate mix of executive and independent
directors to maintain the independence of the board, and to separate the board
functions of governance and management. The board consists of fifteen
members, seven of whom are executive or whole-time directors, and eight are
independent directors. Five of the executive directors are founders of the
company The board believes that the current size is appropriate based on the
company present circumstances. The board periodically evaluates the need for
increasing or decreasing its size.
Table 1 gives the composition of Infosys' board, and the number of outside
directorships held by each of the directors.
Table 1: Composition of the board, and external directorships held during FY 2003
2. Responsibilities of the Chairman, CEO and the COO

The current policy of the company is to have a chairman and chief Mentor Mr. N. R. Narayana Murthy; a chief Executive Officer (CEO), President and
Managing Director - Mr. Nandan M. Nilekani; and a Chief Operating Officer
(COO) and Deputy Managing Director - Mr. S. Gopalakrishnan. There are
clear demarcations of responsibility and authority between the three.
The Chairman and Chief Mentor is responsible for mentoring Infosys' core
management team in transforming the company into a world-class, nextgeneration organization that provides state-of-the-art technology-leveraged
business solutions to corporations across the world. He also interacts with
global thought-leaders to enhance the leadership position of Infosys. In
addition, he continues to interact with various institutions to highlight and to
help bring about the benefits of IT to every section of society As chairman
of the board, he is also responsible for all board matters.
18
The CEO, President and Managing Director is responsible for corporate

strategy, brand equity, planning, external contacts and other management
matters. He is also responsible for achieving the annual business plan.
The COO and Deputy Managing Director is responsible for all customer
service operations. He is also responsible for technology; new initiatives,
acquisitions and investments.
Investors Relations
The Chairman, CEO, COO, the other executive directors and the senior
management make periodic presentations to the board on their responsibilities,
performance and targets.
3. Broad Definition of Independent Directors
According to Clause 49 of the Listing Agreement with Indian stock exchanges,
an independent director means a person other than an officer or employee of
the company or its subsidiaries or any other individual having a material
pecuniary relationship or transactions with the company which, in the opinion of
the company's board of directors, would interfere with the exercise of
independent judgment in carrying Out the responsibilities of a director.
Infosys adopted a much stricter definition of independence as required by the
NASDAQ listing rules and the Sarbanes-Oxley Act, US. The same is provided
in the Audit charter section of this Annual Report.
4. Board Membership Criteria
The nominations committee works with the entire board to determine the
appropriate characteristics, skills and experience for the board as a whole as
well as its individual members. Board members are expected to possess the
expertise, skills and experience required to manage and guide a high-growth, hitech, software company deriving revenue primarily from G-7 countless.
Expertise in strategy, technology, finance, quality and human resources is
essential. Generally, they will be between 40 and 60 years of age. They will
not be relatives of an executive director or of an independent director. They
are generally not expected to serve in any executive or independent position in
any company that is in direct competition with Infosys. Board members are
expected to rigorously prepare for, attend, and participate in all board and
applicable committee meetings. Each board member is expected to ensure that
their other current and planned future commitments do not materially interfere
with the member responsibility as a director of Infosys.
5. Selection of New Directors
The board is responsible for the selection of any new director. The board
delegates the screening and selection process involved in selecting the new
directors to the nominations committee, which consists exclusively of
independent directors. The nominations committee makes recommendations to
the board on the induction of any new member.
6. Membership Term
The board constantly evaluates the contribution of its members, and
recommends to shareholders their re-appointment periodically as per statute.
The current law in India mandates the retirement of one-third of the board
members (who are liable to retire by rotation) every year, and qualifies the
retiring members for re-appointment. Executive directors are appointed by the
shareholders for a maximum period of five years at a time, but are eligible for
re-appointment upon completion of their term. Non-executive directors do not
have a specified term, but retire by rotation as per law. The nominations
committee of the board recommends such appointments and / or reappointments. However, the membership term is limited by the retirement age
for the members.
19
7. Retirement Policy
Under this policy, the maximum age of retirement of all executive directors is
60 years, which is the age of superannuation for the employees of the
company. Their continuation as members of the board upon superannuation /
retirement is determined by the nominations committee. The age limit for
serving on the board is 65 years.
8. Succession Planning
The nominations committee constantly works with the board to evolve
succession planning for the positions of the Chairman, CEO and COO, as well
as to develop plans for interim succession for any of them, in case of an
unexpected occurrence. The board, as required, may more frequently review
succession planning.
9. Board Compensation Review
The compensation committee determines and recommends to the board the
compensation payable to the directors. All board-level compensation is approved
by shareholders, and separately disclosed in the financial statements.
Remuneration of the executive directors consists of a fixed component and a
performance incentive. The compensation committee makes a quarterly
appraisal of the performance of the executive directors based on a detailed
performance-related matrix. The annual compensation of the executive directors
is approved by the compensation committee, within the parameters set by the
shareholders at the shareholders meetings.
Compensation payable to each of the independent directors is limited to a fixed
amount per year as determined and approved by the board - the sum of which
is within the limit of 0.5% of the net profits of the company for the year,
calculated as per the provisions of the Companies Act, 1956. The compensation
payable to independent directors and the method of calculation are disclosed
separately in the financial statements.
Those executive directors who are founders of the company have voluntarily
excluded themselves from the 1994 Stock Offer Plan, the 1998 Stock Option
Plan and the 1999 Stock Option Plan. Independent directors are also not eligible
for stock options under these plans, except for the latest 1999 Stock Option
Plan. Table 2a gives the compensation of each director; and Table 2b gives the
grant of stock options to directors.
10. Memberships of other Boards
Executive directors are excluded from serving on the board of any other entity,
unless these are corporate or government bodies whose interests are germane
to the future of the software business, or are key economic institutions of the
nation, or whose prime objective is that of benefiting society Independent
directors are not expected to serve on the boards of competing companies.
Other than this, there are no limitations on them save those imposed by law
and good corporate governance practices. The number of outside directorships
held by each director of Infosys is given in Table 1 above.
20
Investors Relations
Table 2a: Cash compensation to the directors for FY 2003
in Rs. crore
Name of directors
Salary
N.R. Narayana Murthy

Nandan M. Nilekani
S. Gopalakrishnan
Deepak M. Satwalekar
Prof. Marti G. Subrahmanyam
Philip Yeo
Prof. Jitendra Vir Singh **
Dr. Omkar Goswami
Sen. Larry Pressler
Rama Bijapurkar
Claude Smadja
K. Dinesh
S. D. Shibulal
T. V. Mohandas Pai
Phaneesh Murthy
Srinath Batni
Performance
incentive/bonus
Commission
payable
Sitting fees
(in months)
Total
Notice period
(in months)
0.12
0.12
0.12
0.28
0.12
0.12
0.12
0.12
0.01
0.01
NA
0.01
0.01
0.01
0.01
0.01
0.19
0.19
0.19
0.13
0.13
0.12
0.30
0.13
0.13
0.13
0.13
0.19
1.25
0.18
3.73
0.17
6
6
6
NA
NA
NA
NA
NA
NA
NA
NA
6
6
6
NA
6
0.19
0.19
0.19
0.19
1.25
0.18
3.73
0.17
* Resigned on July 23, 2002

** Resigned effective April 12, 2003
None of the above is eligible for any severance pay.
Table 2b: Grant of stock options to directors during FY 2003

Name of director
Claude Smadja
Number of options
(1999 ESOP)
Grant price
(in Indian Rs.)
Expiry date
2,000
3,333.65
July 09, 2012
The above options were issued at fair market value. The options granted will vest over a period of four years
from the date of grant.
21
B) BOARD MEETINGS
1. Scheduling and Selection of Agenda Items for Board Meetings
Dates for the board meetings in the ensuing year are decided in advance and
published as part of the Annual Report. Most board meetings are held at the
company registered office at Electronics City, Bangalore, India. The Chairman
of the board and the company secretary draft the agenda for each meeting,
along with explanatory notes, and distribute these in advance to the directors.
Every board member is free to suggest the inclusion of items on the agenda.
The board meets at least once a quarter to review the quarterly results and
other items on the agenda, and also on the occasion of the annual shareholders'
meeting. When necessary, additional meetings are held. Independent directors
are expected to attend at least four board meetings in a year. Committees of
the board usually meet the day before the formal board meeting, or when
required for transacting business.
There were six board meetings held during the year ended March 31, 2002.
These were on April 10, 2002, June 8, 2002 (coinciding with last year Annual
General Meeting of the shareholders), July 10, 2002, October 10, 2002,
December 8, 2002 and January 10, 2003.
2. Availability of Information to the Members of the Board
The board has unfettered and complete access to any information within the
company, and to any employee of the company. At meetings of the board, it
welcomes the presence of managers who can provide additional insights into
the items being discussed.
The information regularly supplied to the board includes:
annual operating plans and budgets, capital budgets, updates;
quarterly results of the company and its operating divisions or business
segments;
minutes of meetings of audit, compensation, nomination, investors grievance and
investment committees, as well as abstracts of circular resolutions passed;
general notices of interest;
declaration of dividend;
Table 3: Number of board meetings and the attendance of directors during FY 2003
Name of directors
Number of board
meetings held
Number of board
meetings attended
Whether attended
last AGM
6
6
6
6
6
6
6
6
6
6
6
6
6
6
3
6
6
6
6
6
5
3
5
5
5
5
4
6
5
6
3
5
Yes
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
No
Yes
Yes
Yes
Yes
Yes
N. R. Nasrayana Murthy
Nandan M. Nilekani
S. Gopalakrishnan
Philip Yeo
Prof. Jitendra Vir Singh **
Dr. Omkar Goswami
Sen. Larry Pressler
Rama Bijapurkar
Claude Smadja
K. Dinesh
S. D. Shibulal
T. V. Mohandas Pai
Phaneesh Murthy *
Srinath Batni
* Resigned on July 23, 2002
** Resigned effective April 12, 2003
22
information on recruitment and remuneration of senior officers just below
the board level including appointment or removal of CFO and company
secretary;
Investors Relations
materially important litigations, show cause, demand, prosecution and penalty

notices;
fatal or serious accidents or dangerous occurrences, any material effluent or
pollution problems;
any materially relevant default in financial obligations to and by the
company or substantial non-payment for goods sold by the company;
any issue which involves possible public or product liability claims of a
substantial nature;
details of any joint venture or collaboration agreement;
transactions that involve substantial payment towards goodwill, brand equity
or intellectual property;
significant development on the human resources front;
sale of material nature, of investments, subsidiaries, assets, which is not in
the normal course of business;
details of foreign exchange exposure and the steps taken by management to
limit the risks of adverse exchange rate movement; and
non-compliance of any regulatory statutory nature or listing requirements as
well as shareholder services such as non-payment of dividend and delays in
share transfer.
3. Independent Directors' Discussion
The board's policy is to regularly have separate meetings with independent
directors to update them on all business-related issues and new initiatives. In
such meetings, the executive directors and other senior management personnel
make presentations on relevant issues.
In addition, the independent directors of the company will meet periodically in
executive session i.e. without the chairman, any of the executive directors or
the management being present.
4. Materially Significant Related Party Transactions
There have been no materially significant related party transactions, pecuniary
transactions or relationships between Infosys and its directors, management,
subsidiary or relatives except for those disclosed in the financial statements for
the year ended March 31, 2003.
23
C) BOARD COMMITTEES
Currently, the board has six committees - the audit committee, the
compensation committee, the nominations committee, the investors grievance
committee, the investment committee and the share transfer committee. The
first three consist entirely of independent directors. The investors grievance
committee is composed of an independent, non-executive chairman and some
executive and non-executive directors. The investment committee and the share
transfer committee consist of all executive directors.
The board is responsible for the constituting, assigning, co-opting and fixing of
terms of service for committee members to various committees, and it
delegates these powers to the nominations committee.
The chairman of the board, in consultation with the company secretary of the
company and the committee chairman, determines the frequency and duration
of the committee meetings. Normally all the committees meet four times a year
except the investment committee and the share transfer committee, which meet
as and when the need arises. Typically the meetings of the audit, compensation
and nominations committees last for the better part of a working day
Recommendations of the committee are submitted to the full board for
approval.
The quorum for meetings is either two members or one-third of the members
of the committees, whichever is higher.
1. Audit Committee
In India, Infosys is listed on the stock Exchange, Mumbai (or the BSE), the
National Stock Exchange (N5E) and the Bangalore Stock Exchange (BgSE). In
the US, it is listed on the NASDAQ. In India, Clause 49 of the Listing
Agreement makes it mandatory for listed companies to adopt an appropriate
audit committee charter. The Blue Ribbon Committee set up by the US
Securities and Exchange Commission (SEC) recommended that every listed
company adopt an audit committee charter, which has been adopted by
NA5DAQ.
In its meeting on May 27, 2000, Infosys' audit committee adopted a charter
which meets the requirements of Clause 49 of the Listing Agreement with
Indian stock exchanges and the SEC. It is given below.
The audit committee of Infosys comprises six independent directors. They are:
Mr. Deepak M. Satwalekar, Choirmon
Ms. Rams Bijapurkar
Dr. Omkar Goswami
Sen. Larry Pressler
Mr. Claude Smadja
Prof. Marti G. Subrahmanysm
24
1.1 Audit Committee Charter
Investors Relations
1. Primary Objectives of the Audit Committee

The primary objective of the audit committee (the "committee") of Infosys
Technologies Limited (the "Company") is to monitor and provide effective
supervision of the management's financial reporting process with a view to
ensure accurate, timely and proper disclosures and the transparency integrity
and quality of financial reporting.
The committee oversees the work carried out in the financial reporting process
- by the management, including the internal auditors and the independent auditor
- and notes the processes and safeguards employed by each.
2. Responsibilities of the Audit Committee
2.1
Provide an open avenue of communication between the independent

auditor, internal auditor, and the board of directors
2.2
Meet four times every year or more frequently as circumstances require.

The audit committee may ask members of the management or others to
attend meetings and provide pertinent information as necessary
2.3
Confirm and assure the independence of the external auditor and

objectivity of the internal auditor.
2.4
Appoint, compensate and oversee the work of the independent auditor

(including resolving disagreements between management and the
independent auditors regarding financial reporting) for the purpose of
preparing or issuing an audit report or related work.
2.5
Review and pre-approve all related party transactions in the Company for
this purpose, the committee may designate one member who shall be
responsible for pre-approving related party transactions.
2.6
Review with the independent auditor the co-ordination of audit efforts to

assure completeness of coverage, reduction of redundant efforts, and the
effective use of all audit resources.
2.7
Consider and review with the independent auditor and the management:
(a) The adequacy of internal controls including computerized information
system controls and security; and
(b) Related findings and recommendations of the independent auditor and
internal auditor together with the management's responses.
2.8
Consider and if deemed fit, pre-approve all non-auditing services to be

provided by the independent auditor to the Company For the purpose of
this clause, "non-auditing services" shall mean any professional services
provided to the Company by the independent auditor, other than those
provided to the company in connection with an audit or a review of the
financial statements of the Company and includes (but is not limited to):
Bookkeeping or other services related to the accounting records of

financial statements of the Company;
Financial information system design and implementation;
Appraisal or valuation services, fairness opinions, or contribution-inkind reports;
Actuarial services;
Internal audit outsourcing services;
Management functions or human resources;
Broker or dealer, investment advisor, or investment banking services;
Legal services and expert services unrelated to the audit; and
Any other service that the BoD determines is impermissible.
25
2.9
Review and discuss with the management and the independent auditors,
the annual audited financial statements and quarterly unaudited financial
statements, including the Company's disclosures under "Management
Discussion and Analysis of Financial Condition and Results of Operations"
prior to filing the Company Annual Report on Form 20-F and Quarterly
Results on Form 6-K, respectively with the SEC.
2.10 Direct the Company independent auditors to review before filing with the
SEC the Company interim financial statements included in Quarterly
Reports on Form 6-K, using professional standards and procedures for
conducting such reviews.
2.11 Conduct a post-audit review of the financial statements and audit findings,
including any significant suggestions for improvements provided to
management by the independent auditors.
2.12 Review before release, the unedited quarterly operating results in the
Company quarterly earnings release.
2.13 Oversee compliance with the requirements of the SEC and SEBI, as the
case maybe, for disclosure of auditor's services and audit committee
members, member qualifications and activities.
2.14 Review, approve and monitor the code of ethics that the Company plans
for its senior financial officers.
2.15 Review management monitoring of compliance with the Company
standards of business conduct and with the Foreign Corrupt Practices Act.
2.16 Review, in conjunction with counsel, any legal matters that could have a
significant impact on the Company financial statements.
2.17 Provide oversight and review at least annually of the Company risk
management policies, including its investment policies.
2.18 Review the Company compliance with employee benefit plans.
2.19 Oversee and review the Company policies regarding information
technology and management information systems.
2.20 If necessary, institute special investigations with full access to all books,
records, faculties and personnel of the Company
2.21 As appropriate, obtain advice and assistance from outside legal,
accounting or other advisors.
2.22 Review its own charter, structure, processes and membership requirements.
2.23 Provide a report in the Company proxy statement in accordance with the
rules and regulations of the SEC.
2.24 Establish procedures for receiving, retaining and treating complaints
received by the Company regarding accounting, internal accounting
controls or auditing matters and procedures for the confidential,
anonymous submission by employees of concerns regarding questionable
accounting or auditing matters.
2.25 Consider and review with the management, internal auditor and the
independent auditor:
(a) Significant findings during the year, including the status of previous
audit recommendations;
(b) Any difficulties encountered in the course of audit work including any
restrictions on the scope of activities or access to required
information;
(c) Any changes required in the planned scope of the internal audit plan.
2.26 Report periodically to the BoD on significant results of the foregoing
activities.
26
3. Composition of the Audit Committee
Investors Relations
3.1 The committee shall consist solely of 'independent' directors (as defined in
(i) NASOAQ Rule 4200 and (ii) the rules of the Securities and Exchange
Commission) of the Company and shall be comprised of a minimum of three
directors. Each member will be able to read and understand fundamental
financial statements, in accordance with the NASOAQ National Market Audit
Committee requirements. They should be diligent, knowledgeable, dedicated,
interested in the job and willing to devote a substantial amount of time and
energy to the responsibilities of the committee, in addition to BoD
responsibilities. At least one of the members shall be a "Financial Expert" as
defined in Section 407 of the Sarbanes-Oxley Act. The members of the
committee shall be elected by the BoD and shall continue until their successors
are duly elected. The duties and responsibilities of a member are in addition to
those applicable to a member of the BoD. In recognition of the time burden
associated with the service and, with a view to bringing in fresh insight, the
committee may consider limiting the term of the audit committee service, by
automatic rotation or by other means. One of the members shall be elected as
the chairman, either by the full BoD or by the members themselves, by
majority vote.
4. Relationship with Independent and Internal Auditors
4.1 The committee has the ultimate authority and responsibility to select,
evaluate, and, where appropriate, replace the independent auditors in
accordance with law. All possible measures must be taken by the committee to
ensure the objectivity and independence of the independent auditors. These
include:
reviewing the independent auditors' proposed audit scope, approach and

independence;
obtaining from the independent auditors periodic formal written statements

delineating all relationships between the auditors and the company consistent
with applicable regulatory requirements and presenting this statement to the BoD;
actively engaging in dialogues with the auditors with respect to any

disclosed relationships or services that may impact their objectivity and
independence and I or recommend that the full BoD take appropriate action
to ensure their independence;
encouraging the independent auditors to open and frank discussions on their

judgments shout the quality, not just the acceptability of the company
accounting principles as applied in its financial reporting. This includes such
issues as the clarity of the company's financial disclosures, and degree of
aggressiveness or conservatism of the company accounting principles and
underlying estimates, and other significant decisions made by the
management in preparing the financial disclosure and audited by them;
carrying out the attest function in conformity with US GAAS, to perform

an interim financial review as required under Statement of Auditing
Standards 71 of the American Institute of Certified Public Accountants and
also discuss with the committee or its chairman, and an appropriate
representative of Financial Management and Accounting, in person or by
telephone conference call, the matters described in SAS 61,
Communications with the Committee, as amended by SAS 90 Audit
Committee Communication prior to the company filing of its Form 6-K (and
preferably prior to any public announcement of financial results), including
significant adjustments, management judgment and accounting estimates,
significant new accounting policies, and disagreements with management; and
reviewing reports submitted to the audit committee by the independent

auditors in accordance with the applicable SEC requirements.
27
4.2 The internal auditors of the company are in the best position to evaluate
and report on the adequacy and effectiveness of the internal controls. Keeping
in view the need for the internal auditors' independence from management in
order to remain objective, a formal mechanism should be created to facilitate
confidential exchanges between the internal auditors and the committee,
regardless of irregularities or problems. The work carried out by each of these
auditors needs to be assessed and reviewed with the independent auditors and
appropriate recommendations made to the BoD.
5. Disclosure Requirements
5.1 The committee charter should be published in the annual report once every
three years and also whenever any significant amendment is made to the
charter.
5.2 The committee shall disclose in the company Annual Report whether or not,
with respect to the concerned fiscal year:
the management has reviewed the audited financial statements with the
committee, including a discussion of the quality of the accounting
principles as applied and significant judgments affecting the company
financial statements;
the independent auditors have discussed with the committee their

judgments of the quality of those principles as applied and judgments
referred to the above under the circumstances;
the members of the committee have discussed among themselves,

without the management or the independent auditors being present, the
information disclosed to the committee as described above;
with the committee, in reliance on the review and discussions conducted

with management and the independent auditors pursuant to the
requirements above, believes that the company's financial statements
are fairly presented in conformity with Generally Accepted Accounting
Principles ("GAAP") in all material respects; and
the committee has satisfied its responsibilities in compliance with its charter
5.3 The committee shall secure compliance that the BoD has affirmed to the
NASD / Amex Stock Exchange on the following matters, as required in
terms of the relevant NASD I Amex rules:
Composition of the committee and independence of committee members;
Disclosures relating to non-independent members;
Financial literacy and financial expertise of members; and
Review of the committee charter.
5.4 The committee shall report to shareholders as required by the relevant rules
of the Securities and Exchange Commission ("SEC") of the United States.
6. Meetings and Reports
6.1 The Committee shall meet at least four rimes a year
6.2 The Committee will meet separately with the CEO and separately with the
CEO of the Company at such times as are appropriate to review the
financial affairs of the Company The audit committee will meet separately
with the independent auditors and internal auditors of the Company at such
times as it deems appropriate (but not less than quarterly) to fulfill the
responsibilities of the Audit Committee under this Charter
28
6.3 In addition to preparing the report in the Company proxy statement in

accordance with the rules and regulations of the SEC, the committee will
summarize its examinations and recommendations to the Board of Directors
as may be appropriate, consistent with the committee's charter.
Investors Relations
7. Delegation of Authority
7.1 The committee may delegate to one or more designated members of the
committee the authority to pre-approve audit and permissible non-audit
services, provided such pre-approval decision is presented to the full audit
committee at its scheduled meetings.
8. Definitions
8.1 Independent Member
In order to be 'independent', members should have no relationship with the
company that may interfere with the exercise of their independence from the
management and the company The following persons are not considered
independent:
a director who is employed by the company or any of its affiliates for the
current year or any of the past five years;
a director who has been a former partner or employee of the independent

auditor who worked on the company audit engagement in the current year
or any of the past five years;
a director who accepts any compensation from the company or any of its
affiliates in excess of $60,000 during the previous fiscal year, other than
compensation for board service, benefits under a tax-qualified retirement
plan, or non-discretionary compensation in the current year or any of the
past five years;
a director who is a member of the immediate family of an individual who

is, or has been, in any of the past three years, employed by the corporation
or any of its affiliates as an executive officer. "Immediate family" includes
a person's spouse, parents, children, siblings, mother-in-law; father-in-law,
brother-in-law, sister-in-law, son-in-law, daughter-in-law, and anyone who
resides in such person home;
a director who is a partner in, or a controlling shareholder or an executive

officer of, any for-profit business organization to which the company
made, or from which the company received, payments (other than those
arising solely from investments in the company securities) that exceed
5% of the company or business organization's consolidated gross
revenues for that year, or $200,000, whichever is more, in any of the past
five years;
a director who is employed as an executive of another entity where any of

the company's executives serve on that entity compensation committee for
the current year or any of the past five years; and
a shareholder owning or controlling 20% or more of the company voting

securities.
8.2 Financial Expert

'Financial Expert' means one, who has through education and experience as a
public accountant or auditor or a principal financial officer, comptroller or
1.2 Table 4: Audit Committee Attendance during FY 2003
Name of audit committee member
Dr. Omkar Goswami
Sen. Larry Pressler
Rama Bijapurkar
Claude Smadja
No. of meetings held
No. of meetings attended
4
4
4
4
4
4
4
4
4
4
4
4
Four audit committee meetings were held during the year. These were held on April 9, 2002, July 9,
2002, October 9, 2002 and January 9, 2003.
29
principal accounting officer of a company (or from a position involving similar

functions), an understanding of generally accepted accounting principles and
financial statements, experience in preparing or auditing financial statement of
comparable companies and in applying generally accepted accounting principles
in connection with the accounting for estimates, accruals and reserves,
experience with internal accounting controls, and an understanding of audit
committee functions.
1.3 Audit Committee Report for the year ended March 31, 2003
Each member of the committee is an independent director, according to the
definition laid down in the audit committee charter given above, and Clause 49
of the Listing Agreement with the relevant Indian stock exchanges.
Management is responsible for the company internal controls and the financial
reporting process. The independent auditors are responsible for performing an
independent audit of the company financial statements in accordance with the
generally accepted auditing standards, and for issuing a report thereon. The
committee's responsibility is to monitor these processes. The committee is also
responsible to oversee the processes related to the financial reporting and
information dissemination, in order to ensure that the financial statements are
true, correct, sufficient and credible. In addition, the committee recommends to
the board the appointment of the company internal and statutory auditors.
In this context, the committee discussed with the company auditors the overall
scope and plans for the independent audit. Management represented to the
committee that the company financial statements were prepared in accordance
with Generally Accepted Accounting Principles. The committee discussed with
the auditors, in the absence of the management (whenever necessary), the
company's audited financial statements including the auditor's judgments about
the quality, not just the applicability, of the accounting principles, the
reasonableness of significant judgments and the clarity of disclosures in the
financial statements.
The committee also discussed with the auditors other matters required by the
Statement on Auditing Standards No.6 1 (SAS 61)- Communication with audit
committees, as amended by SAS 90 - Audit committee communication.
Relying on the review and discussions conducted with the management and the
independent auditors, the audit committee believes that the company financial
statements are fairly presented in conformity with Generally Accepted
Accounting Principles in all material aspects.
The committee also reviewed the internal controls put in place to ensure that
the accounts of the company are properly maintained and that the accounting
transactions are in accordance with prevailing laws and regulations. In
conducting such reviews, the committee found no material discrepancy or
weakness in the internal control systems of the company
The committee also reviewed the financial and risk management policies of the
company and expressed its satisfaction with the same.
The company auditors provided to the committee the written disclosures
required by Independence Standards Board Standard No. 1 - 'Independence
discussions with audit committees', based on which the committee discussed the
auditors' independence with both the management and the auditors. After
review, the committee expressed its satisfaction on the independence of both
the internal and the statutory auditors.
30
Moreover, the committee considered whether any non-audit consulting services
provided by the auditor's firm could impair the auditor's independence, and
concluded that there was no such materially significant service provided.
Investors Relations
The committee secured compliance that the board of directors has affirmed to
the NASOAQ stock exchange, under the relevant rules of the exchange on
composition of the committee and independence of the committee members,
disclosures relating to non-independent members, financial literacy and financial
expertise of members, and a review of the audit charter.
Based on the committee discussion with management and the auditors and the
committee's review of the representations of management and the report of the
auditors to the committee, the committee has recommended to the board of
directors that:
1. The audited financial statements prepared as per Indian GAAP for the year
ended March 31, 2003 be accepted by the board as a true and fair
statement of the financial health of the company; and
2. The audited financial statements prepared as per US GAAP and to be
included in the company Annual Report on Form-20F for the fiscal year
ended March 31, 2003 be filed with the Securities and Exchange
Commission.
The committee has recommended to the board the appointment of Bharat S.
Raut & Co., Chartered Accountants, as the statutory and independent auditors
of the company for the fiscal year ending March 31, 2004, and that that the
necessary resolutions for appointing them as auditors be placed before the
shareholders. The committee has also recommended to the board the
appointment of KPMG as independent auditors of the company for the US
GAAP financial statements, for the financial year ending March 31, 2004.
The committee recommended the appointment of internal auditors to review
various operations of the company, and determined and approved the fees
payable to them.
The committee has also issued a letter in line with recommendation No. 9 of
the Blue Ribbon Committee on audit committee effectiveness, which has been
provided in the Financial statements prepared in accordance with US GAAF
section of this Annual Report.
In conclusion, the committee is sufficiently satisfied that it has complied with its
responsibilities as outlined in the Audit committee charter.
Sd/Bangalore
April 9, 2003
Chairman, Audit committee
2. Compensation Committee
The compensation committee of Infosys consists entirely of non-executive,
independent directors:
Prof. Marti C. Subrahmanyam, Chairman
Dr. Omkar Goswami
Mr. Deepak M. Satwalekar
Prof. Jitendra Vir Singh (resigned effective April 12, 2003)
Mr. Philip Yea
31
2.1 Compensation Committee Charter

Purpose
The purpose of the compensation committee of the board of directors (the
"Board") of Infosys Technologies Limited (the "Company") shall be to discharge
the Board responsibilities relating to compensation of the Company executive
directors and senior management. The committee has overall responsibility for
approving and evaluating the executive directors and senior management
compensation plans, policies and programs of the Company
The compensation committee is also responsible for producing an annual
report on executive compensation for inclusion in the Company proxy
statement.
Committee membership and organization
The compensation committee will be appointed by and will serve at the
discretion of the Board. The compensation committee shall consist of no fewer
than three members. The members of the compensation committee shall meet
the (i) independence requirements of the listing standards of the NASDAQ, (ii)
non-employee director definition of Rule 16b-3 promulgated under Section 16 of
the Securities Exchange Act of 1934, as amended, and (iii) the outside director
definition of Section 162(m) of the Internal Revenue Code of 19B6, as
amended.
The members of the compensation committee will be appointed by the Board
on the recommendation of the nomination committee. Compensation committee
members will serve at the discretion of the Board.
Committee responsibilities and authority
The compensation committee shall annually review and approve for the CEO
and the executive directors and senior management of the Company (a) the
annual base salary, (b) the annual incentive bonus, including the specific goals
and amount, (c) equity compensation, (d) employment agreements, severance
arrangements, and change in control agreements I provisions, and (e) any other
benefits, compensation or arrangements.
The compensation committee in consultation with the CEO, shall review the
performance of all the executive directors each quarter basis on the basis of
detailed performance parameters set for each of the executive directors at the
beginning of the year. The compensation committee may, from time to time,
also evaluate the usefulness of such performance parameters, and make
necessary amendments.
The compensation committee is responsible far administering the Company
stock option plans, including the review and grant of eligible employees under
the plans.
The compensation committee may also make recommendations to the board
with respect to incentive compensation plans. The compensation committee may
form subcommittees and delegate authority to when appropriate.
The compensation committee shall make regular reports to the Board.
The compensation committee shall review and reassess the adequacy of this
charter annually and recommend any proposed changes to the Board for
approval.
32
The compensation committee shall annually review its own performance.
Investors Relations
2.2 Table 5: Compensation committee attendance during FY 2003

Name of audit committee member
No. of meetings held
No. of meetings attended
4
4
4
4
4
4
4
3
4
4

Philip Yeo
Prof. Jitendra Vir Singh
Dr. Omkar Goswami
Four compensation committee meetings were held during the year ended March 31, 2003: on April
9, 2002, July 9, 2002, October 9, 2002 and January 9, 2003.
The compensation committee shall have the sole authority to retain and
terminate any compensation consultant to be used by the Company to assist in
the evaluation of CEO, executive directors or senior management compensation
and shall have the sole authority to approve the consultant's fees and other
retention terms. The compensation committee shall also have the authority to
obtain advice and assistance from internal or external legal, accounting or other
advisors.
2.3 Compensation Committee Report for the year ended March 31, 2003
The committee reviewed the performance of all executive directors and
approved the compensation payable to them for fiscal 2004, within the overall
limits approved by the shareholders. The committee also reviewed and approved
the compensation proposed for all the management council members for fiscal
2004. The committee also reviewed the grant of stock options on a sign-on and
regular basis to various employees of the company during the year.
The committee believes that the proposed compensation and benefits, along with
stock options, are adequate to motivate and retain the senior officers of the
company
The committee took on record the compensation committee charter in its
meeting held on October 9, 2002.
Save as disclosed, none of the directors had a material beneficial interest in any
contract of significance to which the company or any of its subsidiary
undertakings was a party, during the financial year.
Sd/
Bangalore
April 9, 2003
Prof. Math G. Subrahmanyam

Chairman, compensation committee
3. Nominations Committee
The nominations committee of the board consists exclusively of the following
non-executive, independent directors:
Mr. Claude Smadja, Chairman
Sen. Larry Pressler
Prof. Jitendra Vir Singh (resigned effective April 12, 2003)
Mr. Philip Yeo
3.1 Nominations Committee Charter Purpose
The purpose of the nominations committee is to ensure that the board of
directors is properly constituted to meet its fiduciary obligations to shareholders
and the Company To carry Out this purpose, the nominations committee shall:
(1) assist the board by identifying prospective director nominees and to select /
recommend to the board the director nominees for the next annual meeting of
shareholders; (2) oversee the evaluation of the board and management; and (3)
recommend to the board, director nominees for each committee.
33
Committee Membership and Organization

The nominations committee shall be comprised of no fewer than two (2)
members.
The members of the nominations committee shall meet the independence
requirements of the NASDAQ.
The members of the nominations committee shall be appointed and replaced
by the board.
Committee Responsibilities and Authority
Evaluate the current composition, organization and governance of the board
and its committees as well as determine future requirements and make
recommendations to the board for approval.
Determine on an annual basis, desired board qualifications, expertise and
characteristics. and conduct searches for potential board members with
corresponding attributes. Evaluate and propose nominees for election to the
board. In performing these tasks, the Committee shall have the sole
authority to retain and terminate any search firm to be used to identify
director candidates.
Oversee the board performance evaluation process including conducting
surveys of director observations, suggestions and preferences.
Form and delegate authority to subcommittees when appropriate.
Evaluate and make recommendations to the board concerning the
appointment of directors to board committees, the selection of board
committee chairs, and proposal of the board slate for election.
Evaluate and recommend termination of membership of individual directors
in accordance with the board governance principles, for cause or for other
appropriate reasons.
Conduct an annual review on succession planning, report its findings and
recommendations to the board, and work with the board in evaluating
potential successors to executive management positions.
Coordinate and approve board and committee meeting schedules.
Make regular reports to the board.
Review and re-examine this charter annually and make recommendations to
the board for any proposed changes.
Annually review and evaluate its own performance.
In performing its responsibilities, the Committee shall have the authority to
obtain advice, reports or opinions from internal or external counsel and
expert advisors.
3.2 Table 6: Nominations committee attendance during FY 2003
Name of compensation committee
members
Claude Smadja
Philip Yeo
Prof. Jitendra Vir Singh
Sen. Larry Pressler
Number of meetings
held
Number of meetings
attended
4
4
4
4
4
3
4
4
Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002,
October 9, 2002 and January 9, 2003.
34
3.3 Nominations Committee Report for the year ended March 31, 2003
Investors Relations
During the year, Mr. Phaneesh Murthy resigned from the directorship of the
company and the same was taken on record. Also the comittee took on record
the resignation of Prof. Jitendra Vir Singh effective April 12, 2003.
The committee approved the induction of Mr. Sridar Iyengar as an additional
director of the company and also recommended his induction into audit committee.
The committee discussed the issue of the retirement of members of the board
as per statutory requirements. As a third of the members have to retire every
year based on their date of appointment, Messrs. Srinath Batni, Sen. Larry
Pressler, Omkar Goswami and Rama Bijapurkar will retire in the ensuing
Annual General Meeting. The committee has recommended the resolution for
re-appointment of the retiring directors by the shareholders.
Sd/Bangalore
April 9, 2003
Claude Smadja
Chairman, nominations committee
4. Investors Grievance Committee

The investors grievance committee is headed by an independent director, and
consists of the following directors:
Mr. Philip leo, Chairman
Ms. Rama Bijapurkar
Mr. K. Dinesh
Mr. Nandan M. Nilekani
Mr. S. 0. Shibulal
4.1 Table 7: Investors grievance committee attendance during FY 2003
Name of compensation committee
members
Philip Yeo
Rama Bijapurkar
Nandan M. Nilekani
K. Dinesh
S. D. Shibulal
Number of meetings
held
Number of meetings
attended
4
4
4
4
4
3
3
4
4
4
Four nominations committee meetings were held during the year on April 9, 2002, July 9, 2002,
October 9, 2002 and January 9, 2003.
4.2 Investors Grievance Committee Report for the year ended March
31, 2003
The committee expresses satisfaction with the company performance in dealing
with investors grievance and its share transfer system. It has also noted the
shareholding in dematerialised mode as on March 31, 2003 as being 99.18%.
Sd/Bangalore
April 9, 2003
Rama Bijapurkar
Member, investors grievance committee
35
5. Investment Committee
The investment committee consists exclusively of executive directors:
Mr. N. R. Narayana Murthy, Chairman
Mr. Nandan M. Nilekani
Mr. S. Gopalakrishnan
Mr. K. Dinesh
Mr. S. D. Shibulal
Mr. T. V Mohandas Pai
Mr. Phaneesh Murthy (resigned on July 23, 2002)
Mr. Srinath Batni
Investment Committee Report for the year ended March 31, 2003
The committee has the mandate to approve investments in various corporate
bodies within statutory limits and the powers delegated by the hoard. During
the year, the committee approved an investment of USS 2.5 million (Rs. 12.25
crore) in Progeon Limited, majority owned subsidiary of Infosys.
Sd/Bangalore
April 9, 2003
N. R. Narayana Murthy
Chairman, investment committee
6. Share Transfer Committee

The share transfer committee consists exclusively of executive directors:
Mr. Nandan M. Nilekani, Chairman
Mr. K. Dinesh
Mr. S. 0. Shibulal
Share transfer committee report for the year ended March 31, 2003
The committee has the mandate to approve all share transfers. During the year,
the committee approved transposition with respect to 200 shares and
transmissions with respect to 4,800 shares.
Sd/Bangalore
April 9, 2003
36
Nandan M. Nilekani
Chairman, share transfer committee
D) MANAGEMENT REVIEW AND RESPONSIBILITY
Investors Relations
1. Formal Evaluation of Officers

The compensation committee of the board approves the compensation and
benefits for all executive board members, as well as members of the
management council. Another committee headed by the CEO reviews, evaluates
and decides the annual compensation for officers of the company from the
level of associate vice president, but excluding members of the management
council. The compensation committee of the board administers the 1998 and the
1999 Stock Option Plans.
2. Board interaction with Clients, Employees, Institutional Investors,
the Government and the Press
The chairman, the CEO and the COO, in consultation with the CPO, handle all
interactions with investors, media, and various governments. The CEO and the
COO manage all interaction with clients and employees.
3. Risk Management
The company has an integrated approach to managing the risks inherent in
various aspects of its business. As part of this approach, the board of directors
is responsible for monitoring risk levels according to various parameters, and the
management council is responsible for ensuring implementation of mitigation
measures, if required. The audit committee provides the overall direction on the
risk management policies.
4. Managements Discussion and Analysis
This is given as separate chapters in this Annual Report, according to Indian
GAAP and US GAAP financials, respectively
37
E) SHAREHOLDERS
1. Disclosures Regarding Appointment or Re-appointment of Directors
According to the Articles of Association, one-third of the directors retire by
Rotarian and, if eligible, offer themselves for re-election at the Annual General
Meeting of shareholders. As per Article 122 of the Articles of Association,
Messrs. Srinath Batni, Sen. Larry Pressler, Omkar Goswami and Rama
Bijapurkar will retire in the ensuing Annual General Meeting. The board has
recommended the re-election of all the retiring directors.
In addition, Mr. Sridar Iyengar, who was appointed as an additional director
with effect from April 10, 2003, is eligible and is offering himself for
appointment as independent director of the company
The detailed resumes of all these directors are provided in the notice to the
Annual General Meeting.
2. Communication to Shareholders
Since June 1997, Infosys has been sending to each shareholder, quarterly
reports which contain audited financial statements under Indian GAAP and
unaudited financial statements under US GAAP, along with additional
information. Moreover, the quarterly and annual results are generally published
in The Economic Times, The Times of India, Business Standard, Business Line,
Financial Express and the Udayavani (a regional body of Bangalore). Quarterly
and annual financial statements, along with segmental information, are pasted on
the company website (w Earnings calls with analysts and investors are
broadcast live on the website, and their transcripts are pasted an the website
soon thereafter. Any specific presentations made to analysts and others are also
posted an the company website.
The proceedings of the Annual General Meeting is web-cast live an the
Internet to enable shareholders across the world to view the proceedings. The
archives of the video are also available an the company home page far future
reference to all the shareholders.
3. Investors Grievances and Share Transfer
As mentioned earlier, the company has a board-level investors grievance
committee to examine and redress shareholders' and investors' complaints. The
status an complaints and share transfers is reported to the full board. The
details of shares transferred and nature of complaints are provided in the
following chapter an Additional information to shareholders.
For matters regarding shares transferred in physical form, share certificates,
dividends, change of address, etc. shareholders should communicate with Karvy
Consultants Limited, the company's registrar and share transfer agent. Their
address is given in the section on Shareholder information.
4. Details of Non-compliance
There has been no non-compliance of any legal requirements by the company
nor has there been any strictures imposed by any stock exchange, SEBI or
SEC, on any matters relating to the capital market over the last three years.
5. General Body Meetings
Details of the last three Annual General Meetings are given in Table 8.
38
Table 8: Date, time and venue of the last three AGMs
Financial year (ended)
Date
Time
Venue
March 31, 2000
May 27, 2000
1500 hrs
Taj Residency Hotel, 41/3 M.G.

Road, Bangalore, India
March 31, 2001
June 2, 2001
1500 hrs
J. N. Tata Auditorium, National

Science Seminar Complex, Indian
Institute of Science, Bangalore,
India
March 31, 2002
June 8, 2002
1500 hrs
J. N. Tata Auditorium, National

Science Seminar Complex, Indian
Institute of Science, Bangalore,
India
Investors Relations
Date, time and venue of the last EGM

Date
Time
Venue
February 22, 2003
1500 hrs
Taj Residency Hotel, 41/3 M.G. Goad,

Bangalore, India
6. Postal Ballots
For the year ended March 31, 2003, there have been no ordinary or special
resolutions passed by the company's shareholders that require a postal ballot.
However, the company has voluntarily decided to comply with the provisions of
postal ballot for all the resolutions placed before the shareholders in the AGM
to be held on June 14, 2003. The detailed instructions are provided in the notice
to the Annual General Meeting.
7. Auditors Certificate on Corporate Governance
As required by Clause 49 of the Listing Agreement, the auditor's certificate is
given as an annexure to the Directors' report.
39
F) COMPLIANCE WITH THE RECOMMENDATIONS OF THE

REPORT OF THE COMMITTEE ON CORPORATE AUDIT AND
GOVERNANCE (NARESH CHANDRA COMMITTEE)
The Government of India by an order dated the 21st August 2002 constituted a
high level committee under the Chairmanship of Mr. Naresh Chandra to
examine the auditor-company relationship. The committee had since submitted
its report to the government. The Government of India has not yet made it
mandatory for the Indian companies.
The report contains five chapters. Chapters 2, 3 and 4 which deal with auditorcompany relationship, auditing the auditors and independent directors - role,
remuneration and training is relevant to your company The chapter one is an
introductory section and chapter 5 relates to regulatory changes. Your company
has substantially complied with most of these recommendations.
The auditor-company relationship
Recommendation 2.1 Disqualifications for audit assignments In line with the
international best practices, the committee recommends an abbreviated list of
disqualifications for auditing assignments which includes:
Prohibition
Prohibition
Prohibition
Prohibition
Prohibition
Prohibition
of any direct financial interest in the audit client

of receiving any loans and I or guarantees
of any business relationship
of personal relationships
of service or cooling off period
of undue dependence on an audit client
Complied with.
Complied with.
Complied with.
complied with.
Complied with.
Not applicable
Recommendation 2.2 List of prohibited non-audit services
Complied with.
Recommendation 2.3 Independence standards for consulting and

other entities are affiliated to audit firms
Complied with.
Recommendation 2.4 Compulsory audit partner rotation
Complied with.
Recommendation 2.5 Auditors disclosure of contingent liabilities
Complied with.
Recommendation 2.6 Auditors disclosure of qualifications and

consequent action
Complied with.
Recommendation 2.7 Managements certification in the event of

auditors replacement
Complied with.
Not applicable, as we do not have any proposal to replace the auditors. The
Companys Act is yet to be amended by the government to seek special resolution of
the shareholders in case of a replacement of an auditor. The audit committee consisting
fully of independent directors recommends the appointment of replacement of auditors.
Recommendation 2.8 Auditors annual certification of independence
The audit committee receives the certification of independence from both the internal
and statutory auditors every year.
Recommendation 2.9 Appointment of auditors
Complied with.
Recommendation 2.10 CEO and CFO certification of annual

audited accounts
Complied with.
Auditing the auditors

Recommendation 3.1 Setting-up of independence quality review
board
Not applicable
Recommendation 3.2 Proposed disciplinary mechanism for auditors Not applicable

Independent directors: Role, remuneration and training
40
Recommendation 4.1 Definition of an independent director
Complied with.
Recommendation 4.2 Percentage of independent directors
Complied with.
Recommendation 4.3 Minimum board size of listed companies
Recommendation 4.4 Disclosure on duration of board meetings /
committee meetings
Recommendation 4.5 Tele-conferencing and video conferencing
Complied with.
Investors Relations
Is being
complied with
from January
2003 meetings.
At present,
the law does
not permit
this.
Recommendation 4.6 Additional disclosure to directors

At present, we submit a summary of all the press releases issued during a quarter, to
all the external board members, during the board meetings. The presentations made at
various investors conferences are available on the web. Going forward, the company
would send a compy of all press releases as well as the investor presentations to all
the directors.
Recommendation 4.7 Independent directors on audit committee of
listed companies
Complied with.
Recommendation 4.8 Audit committee charter
Complied with.
Recommendation 4.9 Remuneration of non-executive director
Not applicable
Recommendation 4.10 Exempting non-executive directors from

certain liabilities
Not applicable
Recommendation 4.11 Training of independent directors
Not applicable
41
UNIT 18 FINANCIAL RESTRUCTURING
Objectives
provide an understanding of concept, motives and dimensions of corporate
restructuring;
explain concept, forms and motives of mergers;
assess merger as a source of value addition;
provide an understanding of criteria for determining exchanges rate;
explain process entailed in formulating merger and acquisition strategy;
throw light on divestiture and its financial assessment;
explain leveraged buyout, leveraged recapitalization, spin-offs, carve-outs,
reorganization of capital and financial reconstruction.
Structure
18.1
Introduction
18.2
Corporate Restructuring
18.3
Financial Restructuring
18.4
Assessing Merger as a Source of a Value Addition
18.5
Formulating Merger and Acquisition Strategy
18.6
Regulation of Mergers and Takeovers in India
18.7
Takeover Strategies Indian Experience
18.8
Divestitures
18.9
Characteristics of and Pre-requisities to Leveraged Buyout Success
18.10
Leveraged Recapitalization
18.11
Reorganization of Capital
18.12
Financial Reconstruction
18.13
Summary
18.14
Key Words
18.15
18.16
Further Readings
18.1
INTRODUCTION
The world has witnessed tectonic and tumultuous changes during the last two
decades in terms of unification of Germany, rising economic power of Japan
and NICs in the world market, dismantling of the erstwhile USSR, emergence
of new trade blocks, realignment of economic forces such as the unification of
the European Community, the North American Market, ASEAN, etc; formation
of WTO and far reaching changes in global trading regulations prescribed by it,
growing economic inter dependencies and globalization of markets, free flow of
capital and knowledge, following economic liberalization, greater interactions
among different financial systems of different countries, faster growth in world
trade, integration of world financial markets at unprecedented reforms across
the East European and South Asian Countries, and path breaking proliferation
and convergence of technologies. These changes along with fast changing
demographies of work force, cataclysmic change in personal, social, familial and
cultural values of people and rapidly moving customers tastes have not only
1
Strategicincreased
Financingbusiness
Decisions complexities
but also rendered global business scenario much

more volatile and fairly competitive. To cope with the incredible opportunities
and enhance share owners wealth, business enterprises across the globe
embarked on programmes of restructuring and alliance spree Global deal
volume during the historic mergers and alliance wave of 1995 to 2000 totalled
more than $12trillion.
To meet competitive challenges from the foray of multinationals following
liberalization, privatization and globalization and to ensure their survival Indian
corporate giants such as Tatas, A V Birlas, Reliance, HLL, SBI have, of late,
pursued, the strategy of restructuring their assets, products, technologies, market
and manpower resulting in spate of mergers and acquisitions in recent years
(Table 18.1). Indeed, 2003 has seen the biggest ever rush of Indian corporates
acquiring foreign firms. A V Birla group acquired four companies. Wipro
acquired Nerve Wire, Essar group acquired a 3 MT Steel Plant in Thailand,
Dabur India having acquired three comanies in the UAE and Bangladesh and
Mahindra & Mahindra is scouting for a tractor plant in Europe.
Table 18.1: Mergers & Acquisitions
18.2
Year
No.
1991
285
1992
842
1993
858
1994
872
1995
1208
1996
524
2000
447
2001
395
2002
290
CORPORATE RESTRUCTURING
A. Concept of Restructuring
Corporate Structuring is a process of redefining the basic line of business and
discovering a common thread for the firms existence and consolidation. Thus,
restructuring is a process by which a corporate enterprise seeks to alter what it
owes, refocus itself to specific tasks performance. This it does after making a
detailed analysis of itself at a point of time. At times restructuring would
radically alter a firms product market mix, capital structure, asset mix and
organization so as to enhance the value of the firm and attain competitive edge
on sustainable basis. While planning for restructuring, the management should
specify what type of business the firm can do most effectively. Those business/
market areas which offer little or no potential should be removed from the
basic business structure. Others having unsatisfactory earnings, poor competitive
position or management incapability should also be discontinued.
B. Motives for Restructuring
Corporate enterprises are motivated to restructure themselves in view of the
following forces:
The Government policy of liberalization, privatization and globalization
spurred many Indian organizations to restructure their product mix, market,
2
technologies etc. so as to meet the competitive challenges in terms of cost,
quality and delivery. Many organizations pursued the strategy of accessing
new market and customer segment. Convertibility of rupee has encouraged
many medium sized companies to operate in the global market.
Revolution in information technology facilitated companies to adopt new
changes in the field of communication for improving corporate performance.
Wrong diversification and divisionalization strategy has led many
organizations to revamp themselves. New business embraced by companies
in the past had to be dropped because of their irrelevance in the changed
environment. Product divisions which do not fit into companys care
business are being divested.
Improved productivity and cost reduction have necessitated downsizing of
the workforce.
Another plausible reason for restructuring is improved management. Some
companies are suffering because of inefficient management. Such
companies opted for change in top management.
At times, organizations are motivated to reorganize their financial structure
for improving the financial strength and improving operating performance.
C. Dimension of Restructuring
Corporate restructuring is a broad umbrella that covers the following:
Financial Restructuring: This involves decisions pertaining to acquisition,
mergers, divestitures, leveraged buyout, leveraged recapitalization,
reorganization of capital, etc.
Technological Restructuring: This involves decisions pertaining to
redesigning the business process through revamping existing technologies.
Market Restructuring: This involves decisions regarding product
market positioning to suit the changed situations.
Organizational Restructuring: During the post liberalization period many
Indian firms embarked on organizational restructuring programme through
regrouping the existing businesses into a few compact business units,
decentralization and delayering, downsizing, outsourcing non-value adding
activities and subcontracting.
You may please note that a good restructuring exercise consists of a mixture of
all these. These alterations have a significant impact on the firms balance
sheet or by exploiting unused financial capacity.
Activity 1
a) List out the five primary forces that forced Indian corporates to engage in
restructuring exercises.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
b) Name three top business groups in India which embarked on restructuring
programmes.
....................................................................................................................
....................................................................................................................
....................................................................................................................
....................................................................................................................
3
18.3
FINANCIAL RESTRUCTURING
A. Concept of Financial Restructuring

Financial restructuring is the process of reorganizing the company by affecting
major changes in ownership pattern, asset mix, operations which are outside the
ordinary course of business. Thus, financial restructuring covers many things
such as the mergers and takeovers, divestitures, leveraged, recapitalization, spinoffs, curve-outs, reorganization of capital and financial re-construction. Let us
dilate upon each of these aspects.
B. Mergers and Takeovers
Concept
A company intending to acquire another company may buy the assets or stock
or may combine with the latter. Thus, acquisition of an organization is
accomplished either through the process of merger or through the takeover
route.
Merger is combination of two or more companies into a single company where
one survives and the others lose their identity or a new company is formed.
The survivor acquires the assets as well as liabilities of the merged company.
As a result of a merger, if one company survives and others lose their
independent entity, it is a case of Absorption. But if a new company comes
into existence because of merger, it is a process of Amalgamation.
Takeover is the purchase by one company of a controlling interest in the share
capital of another existing company. In takeover, both the companies retain their
separate legal entity. A takeover is resorted to gain control over a company
while companies are amalgamated to derive advantage of scale of operations,
achieve rapid growth and expansion and build strong managerial and
technological competence so as to ensure higher value to shareowners. Indian
takeover kings are R P Goenka, Chabria, Khaitan, Kumar Mangalam Birla and
London based Swaraj Paul.
Forms
Horizontal Merger
A horizontal merger is one that takes place between two firms in the same line
of business. Merger of Hindustan Lever with TOMCO and Global Telecom
Services Ltd. with Atlas Telecom, GEC with EEC are examples of Horizontal
Merger.
Vertical Merger
Vertical Merger takes place when firms in successive stages of the same
industry are integrated. Vertical Merger may be backward, forward or both
ways. Backward merger refers moving closer to the source of raw materials in
their beginning form. Merger of Renusagar Power Supply and Hindalco is a
case in point. Forward merger refers to moving closer to the ultimate
customer. DU Pont acquired a chain of stores that sold chemical products at
the retail level for increased control and influence of its distribution.
Conglomerate Merger
Conglomerate Merger is a fusion in unrelated lines of business. The main
reason for this type of merger is to seek diversification for the surviving
company. A case in point is the merger of Brooke Bond Lipton with Hindustan
Lever. While the former was mostly into foods, the latter was into detergents
and personal care.
4
Reverse Merger
It occurs when firms want to take advantage of tax savings under the Income
Tax Act (Section 72A) so that a healthy and profitable company is allowed the
benefit of carry forward losses when merged with a sick company. Godrej
soaps, which merged with the loss-making Godrej Innovative Chemicals is an
example of reverse merger.
Reverse merger can also occur when regulatory requirements need one to
become one kind of company or another. For example, the reverse merger of
ICICI into ICICI Bank.
Motives for Mergers
To Avail Operating Economics
Firms are merged to derive operating economies in terms of elimination of
duplicate facilities, reduction of cost, increased efficiency, better utilization
of capacities and adoption of latest technology. Operating economies at the
staff level can be achieved through centralization or combination of such
departmental as personnel accounting, advertising and finance which are
common to both organizations. Merger of Reliance Petrochemicals with
Reliance Industries was aimed at enhancing shareholders value by realizing
significant synergies of both the companies. Similarly, amalgamation of Asea
Ltd with Asea Browns Bover (ABB) was intended to avail of the benefits
of rationalization and synergy effects.
To Achieve Accelerated Growth
Both horizontal and vertical combination take place to achieve growth at
higher rate than the one accomplished through its normal process of internal
expansion. In fact, mergers and takeovers have played pivotal role in the
growth of most of the leading corporations of the world. Nearly two-thirds
of the giant public corporations in the USA are the outcome of mergers
and acquisitions.
To Take Advantage of Complementary Resources
It is in the vital interest of two firms to merge if they have complementary
resources each has each other needs. The two firms are worth more
together than apart because each acquires something it does not have and
gets it cheaper than it would by acting on its own. Also the merger may
open up opportunities that neither firm would pursue otherwise.
To Speed Up Diversification
Many companies join together to reduce business risk through diversification
of their operations. By merging with relatively more stable enterprise, a
company prone to wide cyclical swings may be able to minimize the degree
of instability in its earnings and improve its performance. Similarly, a small
company may be hesitant to launch a new product with a high potential
market because of high risk exposure to the projects, the potential loss will
not be as significant to the surviving company as to the small one. Recent
alliances of Jenson and Nicholson India Ltd. with Carl Scheneek A G, and
J K Corporation with Mitel of Canada are examples of acquisition based on
diversification motive.
To Combat Competitive Threats
Majority of the recent mergers struck in India were motivated to thwart
competitive challenges both from domestic as well as multinational
comapnies and achieve competitive edge over the rivals. The fear of
increasing competitive resulting from the tie up between Procter and
Gamble and Godrej Soaps forced Hindustan Lever to merge with TOMCO.
Recent alliance between Max India and GISTBrocades has made to
covert potential competitor into a partner.
Strategic Financing
Decisions
To Access
to Latest
Technology
Many organizations have, of late, forged alliances with foreign firms so as

to gain access to latest product technology cheaply. Tata Telecom tie up
with AT&T, Maruti-Suzuki alliance, Caltex alliance with IBP were made
essentially to secure latest technology.
To Widen Market Base
In recent few years large number of firms forged alliances with specific
purpose of globalising the firms products. Tie-ups between HCL and HP
Ltd, Tata-IBM, Ranbaxy Laboratories and Eli Lilly, Parle and Coco-Cola,
Hindustan Motors and General Motors, DCM Data and Control Data of
USA, Tata Tea and Tetelay of USA and Onida and JVC have been made
to exploit tremendous market opportunities of foreign countries.
To Strengthen Financial Position
Another cogent motive for the merger may be to mitigate the financial
problem. A company embarking on the expansion programme may find its
difficult to satisfy its requirements owing to temporary imbalance in its cash
flows, capital structure or working capital position. By joining with a stable,
unlevered cash rich company a firm may present a consolidated picture of
the financial position that will be more appealing to potential investors.
Merger of Renu Sagar Power Supply and Hindal Co and ICICI with ICICI
Bank are cases in point.
To Avail Tax Shields
A firm with accumulated losses and/or unabsorbed depreciation would like
to merge with a profit making company to utilize tax advantages better for
a long time.
To Utilize Surplus Funds
At times, a firm in a mature industry having generated a substantial amount
of cash may not find adequate profitable investment opportunities.
Management of such firms may be tempted to acquire another company
shares. Such firms often turn to mergers financed by cash as a way of
redeploying their capital.
To Acquire Competent Management
When a firm finds that it is not a position to hire top quality management
and that it has none to come up through the ranks, it may seek merger
with a firm endowed with sapient and savvy management.
To Strengthen Controlling Power
Acquisition of profit making companies by Indian businessmen like Kumar
Mangalam Birla, Ratan Tata, Mukesh Ambani, R P Goenka, G P Goenka,
Piramals, Modis, Ruias, Khaitan, etc. took place to get hold of the
controlling interest through open offer of market prices.
18.4
ASSESSING MERGER AS A SOURCE OF

VALUE ADDITION
While taking decision whether to acquire a firm, finance manager of a firm

must ensure that this step would add value to the firm. For this purpose he
has to follow the procedure laid down below:
(i) Determine if there is an economic gain from the merger. There is an
economic gain only if the two firms are worth more together than
apart. Thus, economic gain of the merger is the difference between
the present value (PV) of the combined entity (Pvxy) and the present
value of the two entities if they remain separate (Pvx + pvy). Hence,
6
Gain = Pvxy (Pvx+Pvy)
(ii) Determine the cost of acquiring firm Y. If payment is made in cash,
the cost of acquiring Y is equal to the cash payment minus Ys value
as a separate entity. Thus,
Cost = Cash paid Pvy
(iii) Determine the net present value to X of a merger with Y. It is
measured by the difference between the gain and cost. Thus,
NPV = gain cost
= W Pvxy (CashPvy)
If the difference is positive, it would be advisable to go ahead with the merger.
Example 1
Firm X has a value of Rs. 400 crore, and Y has a value of Rs. 100 crore.
Merging the two would allow cost savings with a present value of Rs. 50
crore. This is the gain from the merger. Thus,
Pvx = Rs. 400 crore
Pvy = Rs. 100 crore
Gain = W Pvxy = Rs. 50 crore
Pvxy = Rs. 550 crore
Suppose that Firm Y is bought for cash, say for Rs. 130 crore. The cost of
merger is:
Cost = Cash paid Pvy
= Rs. 130 crore Rs. 100 crore = Rs. 30 crore
Note that the owners of firm Y are ahead by Rs. 30 crore. Ys gain will be
Xs cost. Y has captured Rs. 30 crore of Rs. 50 crore merger gain. Firm Xs
gain will, therefore, be:
NPV = Rs. 50 crore Rs. 30 crore = Rs. 20 crore
In other words, firms Xs worth in the beginning is Pv = Rs. 400 crore. Its
worth after the merger comes to Pv = Rs. 400 crore and then it has to pay
out Rs. 130 crore to Ys stockholders. Net gain of Xs owners is
NPV = Wealth with merger Wealth without merger
= (Pvxycash) Pvx
= (Rs. 550 crore Rs.30 crore) Rs. 400 crore = Rs. 20 crore
In the above procedure, the target firms market value (Pvy) is taken into
consideration along with the changes in cash flow that would result from the
merger. It should be noted that it would be incorrect to undertak emerger
analysis on the basis of forecast of the target firms furture cash flows in
terms of incremental revenue or cost reductions attributable to the merger and
then discount them back to the present and compare with the purchase price.
This is for the fact that there are chances of large errors in valuing a business.
The estimated net gain may come up positive not because the merger makes
sense but simply because the analysts cash flow forecasts are too optimistic.
Estimating Cost When the Merger is financed by Stock
In the preceding discussion our assumption was that the acquiring firm pays
cash compensation to the acquired firm. In real life, compensation is usually
paid in stock. In such a situation, cost depends on the value of the shares in
new company received by the shareholders of the selling company. If the
sellers receive N shares, each worth Pxy, the cost is:
Cost = NX Pxy Pvy
StrategicLet
Financing
Decisions
us consider
an
example:
Example 2
Firm X is planning to acquire firm Y, the relevant financial details of the two
firms prior to the merger announcement are:
X
Market Price per share
Rs. 100
Rs. 40
Number of shares
Rs. 50,000
Rs. 2,50,000
Market value of the firm
Rs. 50 lakh
Rs. 10 lakh
The merger deal is expected to bring gains which have a present value of Rs.
10 lakh. Firm X offers 125,000 shares in exchange for 250,000 shares to the
shareholders of firm Y.
The apparent cost of acquiring firm Y is:
125,000 X 100 10,000,000 = Rs. 25,00,000
However, the apparent cost may not be the true cost. X stock price in Rs.
100 before the merger announcement. At the announcement it ought to go up.
The true cost, when Ys shareholders get a fraction of the share capital of the
combined firm, is equal to:
Cost = aPvxy Pvy
In the above example, the share of Y in the combined entity will be:
a = 12,50,000/5,00,000 + 1,25,000 = 0.2
Terms of Merger
While designing the terms of merger management of both the firms would insist
on the exchange ratio that preserves the wealth of their shareholders. The
acquired firm (Firm X) would, therefore, like that the price per share of the
combined firm is atleast equal to the price per share of the firm X.
Pxy = Px ...................................... (1)
The market price per share of the combined firm (XY) is denoted as the
product of price earnings ratio and earnings per share:
Pxy = (PExy) (EPSxy) = Px ........ (2)
The earnings per share of the combined firm is denoted as:
EPSxy = Ex+Ey/Sx+Sy(Erx) ......... (3)
Here Erx represents the number of shares of firm X given in lieu of one share
of firm Y. Accordingly, Eq. 2 may be restated as:
Px = (Pexy)(Ex+Ey)/Sx+Sy(Erx) ... (4)
Solving Eq. 4 for Erx yields:
Erx = Sx/Sy + (Ex+Ey) (Pexy)/PxSy
Let us explain the process of determination of exchange rate with the help of
an example:
8
Example 3
X corporation is contemplating to acquire Y corporation. Financial information
about the firms are setout below:
X
Total current earnings, E
Rs. 10 lakh
Rs. 4 lakh
Number of outstanding shares, S
Rs. 5 lakh
Rs. 2 lakh
Market price per share, P
Rs. 6
Rs. 4
Determine the maximum exchange ratio acceptable to the shareholders of X

corporation if the P/E ratio of the combined entity is 3 and there is no synergy.
What is the minimum exchange ratio acceptable to the shareholders of Y
corporation if the P/E ratio of the combined entity is 2 and there is synergy
benefit of 5%?
Solution:
(a) Maximum exchange ratio from the Point of the shareholders of X corporation
ERx = Sx/Sy + PExy (Exy)/PxSy
= 5 lakh/2 lakh + 3X 14lakh/6X2lakh
= 1.0
(b) Minimum exchange ratio from the point of view of the Y shareholders:
ERy = PySx / (Pxy) Exy PySy
= 4X5lakh/2X (14lakhX1.05) 4X2lakh
= 20 lakh/14.70 lakh 8 lakh
= 0.3
Criteria for Determining Exchange Ratio
Commonly used criteria for establishing exchange ratio are earnings per share
(EPS), market price per share and book value per share.
Earnings per share reflect, the earning power of a firm. However, it does not
take into consideration the difference in the growth rate of earnings of the two
firms, gains stemming out of merger and the differential risks associated with
the earnings of the two firms. Further, EPS cannot be the basis if it is
negative.
Market price per share can also be the basis for determining exchange ratio.
This measure is very useful where the shares of the firms are actively traded.
Otherwise, market prices may not be very reliable. There is also possibility of
manipulation of market process by those having a vested interest.
As regards utility of book value per share as the basis for determining
exchange ratio, it may be noted that book values do not reflect changes in
purchasing power of money as also true economic values.
Takeovers
Financial restructuring via takeover generally implies the acquisition of a certain
block of equity share capital of a firm which enables the acquirer to exercise
control over the affairs of the company. It is not always necessary to buy
more than 50% of the equity share capital to enjoy control since effective
control can be exercised with a remaining portion is widely diffused among the
shareholders who are scattered and ill-organized.
StrategicSome
Financing
Decisions
of the
recent
major takeovers in the Indian Corporate world are:
HLL
Modern Foods
HINDALCO
INDAL
Sterlite Industries
Hindustan Zinc
Chhabrias
Shaw Wallace
Tatas
CMC
Hindujas
Ashok Leyland
Goenkas
Calcutta Electric Supply Company
Wipro
Ner Ve Wire
Satyam
India World
Gujarat Ambuja
DLF Cement
18.5
FORMULATING MERGER AND ACQUISITION

STRATEGY
Mergers and acquisition should be planned carefully since they may not always
be helpful to the organizations seeking expansion and consolidation and
strengthening of financial position. Studies made by Mc Kinsey & Co. show
that during a given 10-year period, only 23 percent of the mergers ended up
recovering the costs incurred in the deal, much less shimmering synergistic
heights of glory. The American Management Association examined 54 big
mergers in the late 1980s and found that about half of them lead straight down
hill in productivity and profits or both.
Broadly speaking, acquisition strategy should be developed along the following
lines:
Laying down Objectives and Criteria
A firm embarking upon a strategy of expansion through acquisition must lay
down acquisition objectives and criteria. These criteria sum up the acquisition
requirements including the type of organization to be acquired and the type of
efforts required in the process. Laying down the corporate objectives and the
acquisition criteria ensures that resources are not dissipated on an acquisition
when these might more profitably be used to expand existing business activities.
Assessing Corporate Competence
A detailed and dispassionate study of the firms own capabilities should form an
integral part of acquisition planning. Such a study is done to make sure that the
firm possesses the necessary competence to carry out the acquisition
programme successfully. Once the corporate strengths have been formulated
the management should appoint an adhoc task force with a member of the top
management team to head this body and functional executives on its members
to carry out the pre-acquisition analysis, negotiate with the prospective firm and
integrate the firm, perform post-acquisition tasks and monitor acquisition results.
Locating Companies to Acquire
Before undertaking search process the central management should consider a
number of factors which have their significant bearing on the aquisition. Some
of these factors are listed below:
10
1. Choice of Company: A firm keen to takeover another company
should look for companies with high growth potential and shortlist firms
with large assets, low capital bases with fully depreciated assets or
with large tracts of real estate or securities.
2. Type of Diversification: Success of acquisition also depends on form
of diversification. Success has been reported mostly in horizontal
acquisitions, where the company purchased belonged to the same
product-market as the acquirer. Success rate in the case of vertical
integrations has been relatively lower. Further, marketing-inspired
diversifications appeared to offer the lowest risk, but acquisitions
motivated by the desire to take advantage of a common technology
had the highest failure rate of all. Pure conglomerate acquisitions, which
tend to be in low technology industries, had a lower overall failure rate
than all forms of acquisition except horizontal purchases.
3. Market Share: Another variable influencing acquisition success is the
market share. Higher the market share, greater the success of
acquisition move. Kitchings study reveals that acquisition with market
shares of less than 5 percent for diversification moves had failure rates
of over 50 percent.
4. Size of Purchase: The size of an acquired firm in relation to the
acquirer is an important determinant of acquisition success. The
possibility of success increases with increase in size of the
acquisitionbecause acquisition of a large firm is likely to bring about
material change in corporate performance. For large purchases,
management makes a determined effort to ensure that the new
acquisition achieves the results expected of it quickly.
5. Profitability of Acquisitions: Success of acquisition also depends
upon profitability of the firm being acquired. Acquiring a loss making
firm may not ensure success unless the acquiring firm is equipped with
a skilled management, capable of handling such situations. It may,
therefore, be in firms are not available for sale or require the payment
of such a premium as to make their acquisitions unattractive.
Acquisition of highly promising organizations may be resisted by the
host country governments. The firm may go for low profit organizations
if they are at the bottom of their business cycle or when the
unprofitable assets are broken up and disposed off to return more than
the purchase price or where there are tax shields of losses to be
carry forward or other similar financial advantages.
Keeping in view the above factors, the acquiring firm should ascertain
what the potential firm can be for the organization which it cannot do
on its own, what the organization can do for the potential firm, what it
cannot do itself, what direct and tangible benefits or improvements
results from acquiring the potential firm and what is the intangible
value of these saving to the organization. In the same way, legal
procedures involved in acquisition must begin through in detail.
An enormous amount of information pertaining to the above aspects
gathered over a period of time is indispensable to a firm with an active
continuous acquisition programme. Commercial data are not readily
available everywhere. Financial data in particular is not reliable in some
countries due to varying accounting conventions and standards, local
tax patterns and financial market requirements. However, this should
not deter management from going ahead with its plan of acquiring
overseas firms. The desired information can be gathered particularly
through information service organizations such as Business International
and Economic Intelligence Unit, non-competing firms and from various
international publications like International Yellow Pages, the Exporters 11
Strategic Financing
Decisions
Encyclopaedia
and Directories of manufacturers, importers and other

kinds of business in world markets.
Evaluating the Prospective Candidtates for Acquisition

After identifying firms according to the specification, the task force should
evaluate each of the prospective candidates to pick out the one that suits most
of the needs of the acquiring company. The following aspects should receive
attention of the evaluator:
General Background of the Potential Candidates
The background information of each of the identified companies about the
nature of business, past year business performance, product range, fixed assets,
sales policy, capital base, ownership, management structure, directors and
principal officers and the recent changes in regard to the above should be
collected and sifted in terms of the interests of the acquiring company.
It will also be useful to scan the current organizational structure and climate of
the perspective firms. The focus of the study should be on strength of labour,
their skills, labour unions and their relations with management. Departmentation
of the firms, extent of delegation of authority, communication channels, wage
and incentive structure, job evaluation etc.
Appraisal of Operation of the Potential Candidates
The task force should scan the location of the plants of the company, its
machines and equipments and their productivity, replacement needs, operating
capacity and actual capacity being used, critical bottlenecks, volume of
production by product line, production costs in relation to sale price, quality,
stage in life cycle, production control, inventory management policies, stores
procedures, and plant management competence. It may be helpful to appraise
research and development capability of managing production lines and
competence in distributing products.
It will also be useful to undertake detailed appraisal of the product purchasing
organization and its competence, major suppliers and materials supplied by them,
prices being charged and alternative sources. It should also be found out if
there have been instances of bad buying, overstocking, large stock write offs,
slow moving stock.
Evaluator should assess the operations of the firm from marketing point of
view. Thus, current policies of the firm pertaining to product, pricing, packaging,
promotion and distribution and recent changes therein, channels of distribution,
sales force and its composition, markets served in terms of the share held,
nature of consumers, consumer loyalty, geographical distribution of consumers
should be kept in view. Identification of major competitors and their market
share are source of the critical aspects the must receive attention of the
evaluator.
18.6
12
REGULATION OF MERGERS AND TAKE

OVERS IN INDIA
Mergers and acquisition may lead to exploitation of minority share holders, may
also stifle competition and encourage monopoly and monopolist corporate
behavior. Therefore, most of the countries have their own legal frame work to
regulate the merger and acquisition activities. In India, merger and acquisition
are regulated through the provision of companies Act 1956, the monopolies and
restrictive trade practices (MRTP) Act 1969, the Foreign exchange regulation
Act (FERA) 1973, the income tax Act 1961, and the securities and exchange
board of India (SEBI) also regulates mergers and acquisition (take over).
Legal Measures Against Takeover:
The companys act restricts an individual or a group of people or a company in
acquiring shares in public limited company to 25 percent (including the share
held earlier) of the total paid up capital. However, the control group needs to
be informed when ever such holding exceeds 10 percent. When ever the
company, or group of individuals or individuals acquires the share of another
company in excess of the limits should take the approval of the share holders
and the Government.
In case of a hostile takeover bid companies have been given power to refuse
to register the transfer of shares and the company should inform the transfere
and transfer within 60 days. Hostile take over is said to have taken place in
case if
legal requirements relating to the transfer of share have not be complied
with or
the transfer is in contravention of law or
the transfer is prohibited by Court order
the transfer is not in the interests of the company and the public Protection
of minority shareholders interests
The interest of all the shareholders should be protected by offering the same
high price that is offered to the large share holders. Financial Institutions, banks
and few individuals may get most of the benefits because of their accessibility
to the process of the take-over deal market. It may be too late for small
investor before he knows about the proposal. The company act provides that a
purchaser can force the minority shareholders to sell their shares if.
1. The offer has been made to the shareholders of the company.
2. The offer has been approved by at least 90 percent of the shareholders
when transfer is involved within four months of making the offer.
Guidelines for Takeovers:
A listing agreement of the stock exchange contains the guidelines of takeovers.
The salient features of the guildelines are:
1. Notification to the Stock Exchange: If an individual or a company
acquires 5 percent or more of the voting capital of a company the stock
exchange shall be notified within 2 days of such acquisition.
2. Limit to Share Acquisition: An individual or a company which continues
acquiring the shares of another company without making any offer to share
holders until the individual or the company acquires 10 percent of the voting
capital.
3. Public Offer: If this limit is exceeded a public offer to purchase a
minimum of 20 percent of the shares shall be made to the remaining
shareholders.
4. Offer Price: The offer price should not be less than the highest price paid
in the paid in the past 6 months or the negotiated price.
Disclosure: The offer should disclose the detailed terms of offer in details of
existing holding.
Offer Document: The offer document should contains the offer and financial
information. The companies act guidelines for take over are to ensure full
disclosure about the merger and take over and to protect the interests of the
share holders.
13
StrategicLegal
Financing
Decisions
Procedures:
The following in the legal procedure for merger or

acquisitions laid out in the Companies Act 1956.
Permission for Merger: Two or more companies can amalgamate only when
amalgamation is permitted under their memorandum of association. If the
memorandum of association does not contain this clause it is necessary to seek
the permission of the share holders board of directors and the company law
board before affecting the merger.
Information to the Stock Exchange: The acquiring and acquired companies

should inform the stock exchange where they are listed about the merger.
Approval of Board of Directors: The Board of Directors of the individual
companies should approve the draft proposal for merger and authorize the
management to further to pursue the proposal.
Application in the High Court: An application for approving the draft
amalgamation proposal duly approved by the board of directors of the individual
companies should be made to the high court. The high court would convene the
meeting of the shareholders and creditors to approve the amalgamation
proposal. The notice of meeting should be sent to them at least 21 days in
advance.
Shareholders and Creditors Meetings: The individual companies should hold
corporate meetings of their shareholders and creditors for approving the merger
scheme. A minimum of 75 percent of share holders and creditors in separate
meetings by voting in person or by proxy must accord approval to the scheme.
Sanction by the High Court: After the approval of shareholders and creditors
on the petitions of the companies the high court will pass order sanctioning the
amalgamation scheme after it is satisfied that the scheme is fair and
reasonable. It can modify the scheme if it deems fit so.
Filling of the Court Order: After the court order its certified true copies will
have to be filled with the Registrar of companies.
Transfer of Assets and Liabilities: The assets and liabilities of the acquired
company will exchange shares and debentures of the acquired company of
accordance with the approved scheme.
Payment by Cash or Securities: As per the proposal the acquiring company
will exchange shares and debentures and or pay cash for the shares and
debentures of the acquired company. These securities will be listed on the stock
exchange.
18.7
TAKE OVER STRATEGIES: INDIAN

EXPERIENCE
The take over strategies involve successful identification and takeover of

another corporation. However, it entails complex legal and financial action on
the part of the acquiring firm when a firms strategy is to seek external growth
through acquisition. This is generally done by the firms top management, legal
staff, bankers and even outside consultants who specialise in recommending
workable corporate unions.
14
As financial analyst, we must have a way to evaluate mergers and acquisitions.
The evaluator of acquisition should analyse the price paid for acquisition and its
impact on the share holders wealth. The shareholders wealth is interpreted by
different people in different ways. There are several methods of wealth
maximisation of share holders. The tools and techniques for the evaluation of
mergers are also used in support of the executive judgement and political
process in corporations.
When a company wants to acquire another company, its share holders have to
pay considerations to the shareholders of the company under acquisition. This
consideration is the value of the shares or assets of the company under
acquisition. The right kind of consideration to be paid its current market value
of the firm under acquisition. However, it is found in many of the acquisitions
that the current market value is minimum consideration to be offered, if the
consideration price to be paid is more than the current market price is at
premium. The premium may be paid because of the under valuation of the
shares or as an incentive to the share holders of the company under
acquisition. This would enable the acquiring company to have the controlling
right of the acquired company.
In 1932 the Lever Brothers (INDIA) began its manufacturing activity in India
(now Hindustan Lever Ltd) taking over North West South Co with a capacity
of 2,250 tones. Over the years and till the mid fifties Lever similarly acquired
sick factories at various other sites. The govt. got tough in 1969 with the
MRTP Legislation making takeover virtually impossible.
In the early eighties the Government accorded high priority to the revival of
sick units and enacted laws like the Industrial Reconstruction Bank of India Act
and other Sick Industrial Legislation.
Lever quickly saw an opportunity in taking over and reviving a sick company
viz. Stepehn Chemicals a Punjab based soaps and detergents firm. The
company was not in attractive shape, its outstanding debts stood at Rs. 6 crore
and its Rs. 3 crore capital had been wiped out by losses. But that did not deter
Lever from 10,000 tones of detergents and 7,200 tones of soaps that Stephen
had capacities for when lever started the lease. The Rs. 200 crore company
today rolls out more than 50,000 tonnes of soaps and detergents. The high point
of stephens success game four years ago is in the forefront of Lever war
against Nirma, Wheel washing power. Levers successful answer to Nirma
challenge was produced by Stephen.
The Stephen acquisition was followed by a chain of other sick units which
Lever snapped up and quickly revived.
Detergent Bar Manufacturer jon. Home products and Sunrise Chemicals, a
soap company in Rajakot. There is also a unique case of Shivalik cellulose a
Gujarat based paper plant which was set up in seventies, but turned sick
though it was a paper plant. Lever was interested. Taking Shivalik on a 24
years lease with an option to buy after five years; Lever turned the paper plant
into a 30,000 tones soap plant has kicked of production recently.
In the afternoon of 9th March 1993 Tata Oil Mill company Ltd (TOMCO)
informed the Bombay stock exchange about its intention to merge with the
Hindustan Lever Ltd. The Board of Directors of the two companies approved
the merger on 19th March, 1993, TOMCO is Rs. 4,460 million turn over (1992)
company and Levers Rs. 20,000 million.
Lever would control one-third of three million tonnes soaps and detergents
markets by this merger. Some competitors of Lever think that it will eliminate
15
Strategiccompetition.
Financing Decisions
The management
of Lever, however, felt that the merger would

result into a strategic fit in many areas such as brand positioning, manufacturing
locations, geographical reach and distribution network. Tomco has four
manufacturing plants and large distributive network covering 2,400 stockists and
nine million outlets. It is strong in South.
Merger would have many benefits for Tomco which is reported to have
incurred a loss of Rs. 66 million for the first six months of 1992-1993. It was
Levers nearest rival but lagged much beind in the eighties. A number of
attempts by management to revive Tomco through diversification did not
succeed. The acquisition of Tomco by the Lever to gain market leadership and
dominance is seen strategically important in view of the intensifying competition
following strategic alliance between Godrej soaps and the American
multinational, Procter and Gamble.
Already most of Tomcos brands Hamam, Moti, the 501 range of laundry soaps
range have been re-launched. Tomco take over has helped on capitalizing on
new brand like Tomco hair Oil, Nihar and Tomcos eau de cologne.
With the new take over code, the Indian corporates are experiencing the wave
of merger and acquisitions. The new legal frame work govering the merger and
take over opened the doors to hostile take over. The market for corporate
control has exploded, with merger and acquisitions being accepted as means of
corporate restructuring and redirecting capital towards efficient management.
The political uncertainty and the slow down of industrial production have
depressed the share prices to levels where acquisition have become viable. This
is an ideal opportunity to take over without the government intervention. Now
the financial institutions are also ready to sell their stock at good prices. They
are no more interested in protecting the existing promoters, in the recent half a
dozen mergers and acquisitions. The Rs. 8,342/- crore Hindustan Lever
resurfaced with the negotiated acquisition of the Rs. 59,11 crore LAKME from
the Rs. 35,000 crore TATA GROUP the Rs. 1,162 crore Indian Aluminum was
targeted by Rs. 1,146 Sterlite Industries by targeting 20 percent stock in the
former one. Imeediately alarmed by this, Indian Aluminum targeted the Rs. 162
crore Pennar Aluminum. In Pharmaceuticals, the Rs. 400 crore wockhard
targeted Rs. 200 crore Merind. The cement Industry saw a major restructuring
bid as the Rs. 832 crore India Cements managed to take over the Rs. 349
crore Raasi Cements.
Indian Cements Ltd.
The Chennai based cements major India Cements Ltd. (ICL) has pulled off a
quite coup in its bid to acquire Raasi Cement Ltd by winning over the fighting
main promoter and chairman Dr. B.V. Raju ICL originally held 9.75 percent
stake in RCL. Later it acquired 8.28 percent from Mr. M.K.P. Raju, 2.23
percent from APIDC and 1.14 percent from a Chennai based shar broking
Financials 1996-97 (Rs. Crores)
India Cements
16
Raasi Cements
Sales
632.50
410.19
Gross Profit
126.65
42.20
Net Profit
82.58
22.83
Equity
64.34
16.31
EPS (Rs)
12.83
13.99
firm. The promoters of RCL sold their 32 percent equity to ICL. ICL and its
associates on the verge of picking up 8 percent from a transport contractor
who is also an the board of Raasi. ICL now plan to go ahead with an open
offer to mop up 20 percent at the earlier offered price of Rs. 300. This will
increase the total Stake in Raasi to nearly 78 percent. Dr. B. v Raju, managing
Director of Raasi said the The present take over regulation do not give
protection to technocrat promoter who cannot have large stake in companies.
The regulations should be modified to protect the technocrat entrepreneurs and
the government should seriously consider of introducing the buy back of
shares.
While the merger and acquisition may become direction less and corporate
conglomerates may end up with unanticipated added costs instead of anticipated
economies of scale, the benefits of a successful acquisition are powerful,
offering dominant market share, the strength of sheer size and unique
competitive advantage. But how does the bidder for takeover know before
hand whether the acquisition he is targeting will be worth the price he has to
pay?
Corporate India is in the grip of a new wave of mergers. It is take over time
again if you read the pink papers. The take over bazaar is brimming over with
companies waiting to be picked up. The volume of mergers & acquisitions deal
in the country is no match for similar deals currently struck abroad. One
International Mega deal the recently aborted one is between Glaxo and
Smithkilne Beecham will dwarf the total value of deal (roughly estimated at Rs.
2000 crore by market source) struck here over past few months.
Activity 1
Bharat Chemicals Ltd. is planning to merge Modern Fertilizers Ltd. Bharat
Chemicals has approached you to advise in this regard. Putting yourself in the
position of a financial consultant:
a) What information would you like to collect from the firms?
b) How would you evaluate feasibility of the proposal?
c) What important criteria would you take into account to determine exchange
rate between the two firms?
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17
18.8
DIVESTITURES
While mergers and acquisitions lead to expansion of business in some way or

the other, divestiture move involves some sort of contraction of business.
Divestiture as form of corporate restructuring signifies the transfer of
ownership of a unit, division or a plant to someone else. Sale of its cement
division by Coromandel Fertilizers Ltd. to India Cements Ltd. is an example of
divestiture.
Divestiture strategy is pursued generally by highly diversified firms who have
had difficulty in managing broad diversification and have elected to divest
certain of their businesses to focus their total attention and resources on a
lesser number of core businesses. Divesting such businesses frees resources
that can be used to reduce debt, to support expansion of the remaining busines,
or to make acquisitions that materially strengthen the companys competitive
position in one or more of the remaining core business. For instance, A V Birla
group divested a publicly announced paper and chemicals project and a sea
water magnesia unit in Visakapatnam and MRPL a petrochemicals Joint
Venture with HPCL, so as to strengthen its core business.
Before taking a final decision, finance manager should assess if its is in the
interest of the firm to do so.
Financial Assessment of a Divestiture

Financial assessment of divestiture proposition involved the following steps:
Estimate the post-tax cash flow of the selling firm with and without
divestiture of the unit in question.
Establish the discount rate for the unit on the basis of cost of capital of
some firms engaged in the same line of business.
Compute the units present value, using the discount rate, as determined above.
Find the market value of the units specific liabilities in terms of present
value of the obligations arising from the liabilities of the unit.
Determine the value of the selling firms ownership position in the unit by
deducting market value of the units liabilities from the present value of its
cash flow.
Compare the value of ownership position (VOP) with the proceeds from
the divestiture (PD). PD represents compensation received by the selling
firm for giving up its ownership in the unit. Hence, the decision rule will be:
PD > VOP = Sell the unit
PD = VOP = Be indifferent
PD < VOP = Retain the unit
18.9
CHARACTERISTICS OF AND PRE-REQUISITIES

TO LEVERAGED BUYOUT SUCCESS
Leveraged buyout (LBO) is an important form of financial restructuring which

represents transfer of an ownership consummated heavily with debt. LBO
involves an acquisition of a division of a company or sometime other sub unit.
At times, it entails the acquisition of an entire company.
Characteristics of LBO
1. A large proposition of the purchase price in debt financed.
18
2. The debt is secured by the assets of the enterprise involved.
3. The debt is not intended to be permanent. It is designed to be paid down.
4. The sale is to the management of the division being sold.
5. Leveraged buyouts are cash purchases, as opposed to stock purchases.
6. The business unit involved invariably becomes a privately held company.
Pre-requisites to Success of LBO
1. The company must have a several year window of opportunity where
major expenditures can be deferred. Often it is a company having gone
through a heavy capital expenditure programme and whose plant is modern.
2. For the first several years, cash flows must be dedicated to debt service. If
the company has subsidiary assets that can be sold without adversely
impacting the core business, this may be attractive because sale of such
assets provides cash for debt service in the initial years.
3. The company must have stable, predictable operating cash flows.
4. The company should have adequate physical assets and/or brand names
which in times of need may lead to cash flows.
5. Highly competent and experienced management is critical to the success of LBO.
Example 5
Modern Manufacturing Ltd. (MML) has four divisions, viz; Chemical, Cement,
Fertilizers and Food. The Company desires to divest the Food Division. The
assets of this division have a book value of Rs. 240 lakh. The replacement
value of the assets is Rs. 340 lakh. If the division is liquidated, the assets
would fetch only Rs. 190 lakh. MML has decided to sell the division if it gets
Rs. 220 lakh in cash. The four top divisional executives are willing to acquire
the division through a leveraged buyout. They are able to come up with only
Rs. 6 lakh in personal capital among them. They approach a finance consultant
for financial assistance for the project.
The Finance Consultant prepares projections for the Food division on the
assumption that it will be run independently by the Four executives. The
consultant works out that cash flows of the division can support debt of Rs.
200 lakh it finds a finance company that is willing to lend Rs. 170 lakh for the
project. It has also located a private investor who is ready to invest Rs. 24
lakh in the equity if this project. Thus, the Food division of MML is acquired by
an independent company run by the four key executives, which is funded through
debt to the tune of Rs. 170 lakh and equity participation of Rs. 30 lakh.
In the above case, two forms of funds are employed:
Debt (Rs. 170 lakh) and equity (Rs. 30 lakh). Thus, LBO permits going private
with only moderate equity. The assets of the acquired division are used to
secure a large amount of debt. The equity holders are, of course, residual
owners. If things move as per plans and the debt is serviced according to
schedule, after 5 years they will own a healthy company with a moderate debt.
In any LBO, the first several years are key. If the company can repay debt
regularly, the interest burden declines resulting in improved operating earnings.
Two types of risks involved in LBO are: business risk arising out of
unsatisfactory performance of the company and the consequent failure to
service the debt and interest rate risk arising out of changing interest rates
which may, in case of sharp rise, involve increased financial burden.
Thus, the equity owners are playing a high-risk game and the principle of
leverage being a double-edged weapon becomes evident. Another potential
19
Strategicproblem
Financing
Decisions
with
the need
to service debt is the focus on short-run profitability.

This may have telling effect on the long-term survival and success of the
organization.
18.10 LEVERAGED RECAPITALIZATION

Another kind of financial restructuring is leveraged recapitalization (LR). LR is
a process of raising funds through increased leverage and using the cash so
raised to distribute to equity owners, often by means of dividedn. In this
transaction, management and other insiders do not participate in the payout but
take additional shares instead. As a result, their proportional ownership of the
company increases sharply.
LR is similar to LBO in as much as high degree of leverage is incorporated in
the company and the managers are given a greater stake in the business via
stock options or direct ownership of shares. However, LR allows company to
remain public unlike LBO which converts public traded company into private one.
As for the potentiality of LR as a means of value addition to the company, LR
has been found to have a salutary effect on management efficiency due to high
leverage and a greater equity stake. Under the discipline of debt, internal
organization changes may take place which may lead to improvements in
operating performance.
Spin-Offs
A spin-off, as a form of restructuring, involves creation of a new, independent
company by detaching part of a parent companys assets and operations. Shares
in the new company are distributed to the parent companys stockholders.
Spin-offs widen investors choices by allowing them to invest in just one part of
the business. More important, spin-offs can motivate managers to perform
better. By spinning-off those businesses which do not fit the companys core
competence, the management of the parent company can concentrate on its
main business. If the businesses are independent, it is easier to see the value
and performance of each and reward managers accordingly. Investors feel
relieved from the worry that funds will be siphoned from one business to
support unprofitable capital investment another.
Announcement of a spin-off is generally greeted as good news by investors
who reward the focus and penalize scope, scale and diversification. Spin-off is
considered as a way of protecting the Crown Jewel from a predator. In
increases the competence of core business and keeps away the unwanted
activities resulting in improved profitability of the parent company.
Carve-Outs
Carve-outs are similar to spin-off with one exception that shares in the new
company are sold in public instead of distributing them among existing equity
owners. Carve outs result in new cash flows.
Although carve-outs share many of the virtues of spin-offs, the same depends
on whether a majority stake is sold so that the new company operates
independently. Sale of a minority stake leaves the parent company is control
and may not reassure without the investors who worry about lack of focus or
poor fit.
20
But at times a minority carve-out can create a market for the subsidiary shares
and allows compensation schemes based on management ownership of shares
or stock options.
18.11 REORGANIZATION OF CAPITAL
Reorganization of Capital refers to the restructuring of company by affecting
change in the capital structure of the company with a view to improving its
financial strength. It is an adjustment of gearing i.e. debt-equity ratio of the
company so as to maximize the wealth of the share owners.
Despite careful financial planning, a firm may be constrained to bring about
certain adjustments in its capital structure because of changes in business climate,
fluctuation of interest rates need to avoid unwanted leverage or to eliminate a
bond issue carrying prohibitively restrictive features and similar other situations.
In reorganization of capital a firm attempts to reduce total debt by reducing
fixed charges through raising fresh equity share capital. But when the equity is
higher, the cost of serving also tends to be higher which can be reduced by
relying more on debt for financing further expansion programmes. Firm may,
therefore, think of reducing fixed burden of debt financing through voluntary
extinction of bonds, extinction through refunding, extinction through redemption
and extinction through conversion.
Extinction Through Refunding
Refunding means substituting old bonds by new bond issue. The management
uses this method to take advantage of cheaper sources of financing. When
interest rate in the market drops and the management believes that the firm
can sell new bonds at a lower rate of interest than that being paid on
outstanding debts. Sometimes, to avoid bonds carrying unfavourable terms, the
management may be tempted to substitute old bonds by new ones. Also, a firm
which borrowed funds in its initial years at higher cost because of its weak
financial position may find subsequently when it gains strength that it can
procure loans at cheaper cost and at convenient terms.
Accordingly, the firm may take recourse to refunding as a means of reducing
its cost of capital. The management may also use refunding to consolidate
several existing bond issues to simplify their management. Among these
reasons, however, refunding is generally resorted to reduce cost of servicing
debt and to improve earning per share of the firm.
Before refunding an outstanding bond the finance manager must determine
whether or not refunding is profitable. Accordingly he must, as in capital
budgeting decision, match the costs of refunding against receipts as a result of
the refunding operation. It is only when receipts exceed costs, the management
should proceed ahead with refunding operation otherwise the idea of refunding
must be dropped.
Extinction Through Redemption
Redemption is the actual paying of the debt. Through redemption, the firm
extinguishes the bonded debt absolutely. this is possible only when bond issues
contain call privilege giving the firm the option to buy back the bonds at a
stated price before their maturity. The bond indenture provides the prices which
the firm pay the bondholder for a bond called for redemption before their
maturity. Generally, this redemption price is greater than the par value of the
bond. The actual price is fixed taking into account par value of the bond plus a
reasonable premium. This bonus is provided to enable the bondholder whose
bond has been called for redemption to take time to find another profitable
investment for his money without suffering any loss of interest.
When bonds are redeemed, the firm needs cash to take them up. There are
two methods of providing the cash, viz; (i) voluntary setting aside of moneys
21
Strategicreceived
Financing
Decisions
from
earnings
in such amounts as make it possible to meet the bonds

when they are to be paid and (ii) putting aside of a sinking fund to pay off the
bonds. While the former is done by the management as a matter of business
and financial policy and not because of any agreement with bondholders, the
latter is made obligatory by the terms of the bond indenture.
Extinction Through Conversion
Management may sometimes convert bonds into stocks in order to simplify

capital structure and also to get rid of bonded indebtedness and the fixed
interest charges associated with it. When a firm converts its bonds, it does not
require cash to pay to the bondholders. When bonds are converted into stock,
bondholders become owner of the firm and bonded indebtedness is wiped out.
This is possible only when bond issue is convertible. The conversion privillege is
exercised almost without exception wholly at the option of the bondholders.
However, the company may force conversion at a time when it is more
profitable for the bondholders to convert rather than surrender the bonds and
receive cash. Before deciding about conversion finance manager must examine
the impact of the transaction on the market value of the stock as the decision
criterion. Rate of conversion is provided in debt indenture. For example, one
Rs. 1000 par value bond may be exchanged for 10 shares of the stock.
Sometimes the conversion basis is expressed by stating that the bonds are
convertible into stock at some specified figure, say Rs. 100 which means that
the stock is being valued for conversion purposes at Rs. 100 a share.
18.12 FINANCIAL RECONSTRUCTION

Financial reconstruction is the recasting of firms capital structure to reduce the
amount of fixed burden of leverage. Where firm has been suffering operating
losses for several years but has potential to recover in future and its economic
worth as an operating entity is greater than its liquidation value, management
may think of keeping the firm alive by changing its capital structure.
The major difference between reorganization of capital and financial
reconstruction is that the former is resorted to for further improving financial
health of the firm but the latter is taken up when the firm is continuously
suffering losses and is heading towards liquidation.
Formulation of reconstruction plan involves three steps:
22
(i)
Determine total valuation of the company by capitalization of prospective

earnings. For example, if future earnings of a company are expected to
be Rs. 4 lakh, and the overall capitalization rate of similar companies
average 10 percent, total value of Rs. 40 lakh would be set for the company.
(ii)
Determine new capital structure for the company to reduce fixed charges
so that there will be an adequate coverage margin. To reduce these fixed
charges, the total debt of the firm is reduced by shifting to income, bonds,
preferred stock and common stock. In addition, terms of the debt may be
changed. If it appears that the reconstructed company will need new
financing in the future, a more conservative ratio of debt to equity may
be thought of so as to provide for future financial flexibility.
(iii)
Valuation of the old securities and their exchange for new securities. In
general, all senior claims on assets must be settled in full before a junior
claim can be settled. In the exchange process, bondholders must receive
the par value of their bonds in another security before there can be any
distribution to preferred stockholders. The total valuation figure arrived at
in step 1 sets an upper limit on the amount of securities that can be issued.
The existing capital structure of a company undergoing reconstruction is given
as under:
Rs. in lakhs
Debentures
18
Subordinated debentures
6
Preferred stock
12
Common stock equity (book value)
20
Total
Rs. 56
If the total valuation of the company is to be Rs. 40 lakh, the following could
be the new capital structure:
Rs. in lakhs
Debentures
6
Income bonds
12
Preferred stock
6
Common stock
16
Total
Rs. 40
After deciding about the appropriate capital structure for the company, the
new securities have got to be allocated. Thus, the debentureholders exchange
their Rs. 18 lakh in debentures for Rs. 6 lakh in new debentures and Rs. 12
lakh in income bonds, that the subordinated debentureholders exchange their
Rs.6 lakh in securities for preferred stock, and that preferred stock holders
exchange their securities for Rs. 12 lakh of common stockholders would then
be entitled to Rs. 4 lakh in stock in the reconstructed company, or 25 percent
of the total common stock of the reconstructed company.
Thus, exchange claim is settled in full before a junior claim is settled. In a harsh
reconstruction, debt instruments may be exchanged for common stock in the
newly reconstructed company and the old common stock may be eliminated
completely. Much depends on negotiation between the management and claimholders.
18.13 SUMMARY
In recent years majority of the Corporate Organizations across the globe
including India engaged in restructuring exercises so as to cope with increased
business complexities and uncertainties and improve their competitive strength.
Corporate restructuring exercises were financial, technological and organizational
in nature.
Mergers, acquisitions, takeovers, divestitures, spin-offs, leveraged buyouts,
leveraged recapitalization and financial reconstruction, as significant forms of
financial restructuring, have become a major force in the economic and
financial milieu all over the world.
Mergers, which subsume both absorption and consolidation, may take the form
of horizontal, vertical, conglomerate and reverse. The principle economic rule
for a merger is that value of the combined entity should be greater than the
sum of the independent values of the merging entities. The most cogent
reasons for merger are economies of scale, higher growth, advantage of
complementary resources, speedy diversification, access to latest technology,
larger market base, strong financial position and so on. The net economic
benefit of a merger is the difference between the present value of the combined
unit and the present value of the combining entities if they remain independent.
A divestiture represents sale of division or plant or unit of one firm to another.
Divestiture decisions are driven by a variety of motives such as raising capital,
23
Strategiccurtailment
Financing Decisions
of losses,
strategic realignment and efficiency gain. Since

divestitures have become common, management should scan their financial
desirability systematically and rationally.
LBO as a form of restructuring represents transfer of an ownership
consummated heavily with debt. It is a cash purchase as opposed to stock
purchase. The firm going for LBO must have stable, predictable operating cash
flows and should have adequate physical assets and/or brand names.
LR is a process of raising funds through increased leverage and using the cash
so raised to distribute to equity owners. It is similar to LBO in as much as high
degree of leverage is incorporated in the company. However, LR allows the
company to remain public unlike LBO which converts public traded Company
into private one.
At times, a company suffering from operating losses and financial problem may
go for financial reconstruction to recast its capital structure to reduce the
amount of fixed burden of leverage. Financial reconstruction process involves
three main steps, viz; determination of total valuation of the company,
determination of new capital structure for the company to reduce fixed charges
and finally valuation of the old securities and their exchange for new structures.
18.14 KEY WORDS

Absorption: refers to a situation where a company survives and others lose
their identity.
Amalgamation: refers to a situation where a new company comes into
existence because of merger.
Take over: is the purchase by one company of a controlling interest in the
share capital of another existing company.
Divestiture: signifies the transfer of ownership of a unit, division or a plant to
some one else.
Leveraged buyout: represents transfer of an ownership consummated heavily
with debt.
Leveraged Recapitalization: is a process of raising funds through increased
leverage and using the cash so raised to distribute to equity owners.
Spin-offs: involve creation of a new, independent company by detaching part of
a parent companys assets and operations.
24
1.
What is corporate restructuring? What motivates an enterprise to engage

in restructuring exercise?
2.
Discuss various forms of mergers. What are the driving forces for
mergers & acquisitions?
3.
Discuss various steps involved in a merger.
4.
What are the regulatory provisions in India regarding mergers and acquisitions?
5.
How would you assess merger as a source of value addition?
6.
What is the cost of a merger from the point of the acquiring company?
7.
How would you determine the present value of a merger from the point
of view of the acquiring company?
8.
What are the important bases for determining the exchange ratio?
9.
What are the salient features of divestitures? How would you assess
divestiture programme of a company?
10.
What is leveraged buy out? How is it different from leveraged

recapitalization?
11.
Distinguish between spin-offs and carve-outs.
12.
Under what circumstances does a firm reorganize its capital? What are
the various techniques of reorganization of capital?
13.
Divya Sugar Mills plans to acquire Shubhra Sugar Mills. The relevant
financial information are:
Divya Sugar Mills
Shubhra Sugar Mills
Market Price per share
Rs. 140
Rs. 64
Number of outstanding shares
40 lakh
30 lakh
The merger is expected to generate gains which have a present value of Rs.
400 lakh. The exchange rate agreed to is 0.5.
Compute the true cost of the merger from the view point of Divya Sugar Mills.
14.
Dolly Electronics is contemplating to merge Smriti Electronics. The

following data are available:
Dolly Electronics
Smriti Electronics
Rs. 100 lakh
Rs. 40 lakh
Number of outstanding shares, S
40 lakh
20 lakh
Market Price per share, P
Rs. 30
Rs. 20
Total Current Earnings, E
(i) What is the maximum exchange ratio acceptable to the owners of Dolly
Electronics if the P/E ratio of the combined entity is 12 and there is no
synergy gain?
(ii) What is the minimum exchange ratio acceptable to the shareholders of
Smriti Electronics if the P/E of the combined entity is 11 and there is a
synergy benefit of 5 percent?

James C. Van Horne, Financial Management Policy, Prentice Hall of India
Pvt. Ltd., New Delhi, 2002
Richard A. Brealey and Stewart C. Myers, Principles of Corporate Finance,
Tata Mc Graw Hill Public Company Ltd., New Delhi, 2000
J.F. Weston, K.S. Chung and J.A. Siu, Takeovers, Restructuring and
Corporate Finance, Prentice-Hall, upper saddle River, N.J. 1998
John J. Hompton, Financial Decision Making, Prentice Hall Publishing
Company, Virginia, 1978
J. Fred Weston, Eugene F. Brigham, Managerial Fiannce, Dryden Press,
Hinsdace, Illinois, 1978
Prasanna Chandra, Financial Management, Tata Mc Graw Hill Public
Company Ltd., New Delhi, 2001
25

Capital Investment and Financial Decisions

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Nature of Financial Decisions

Wealth Maximisation Objective

Cardinal principles of Financial Decision

Time value of Money

Determination of Implied interest Rates, Implied Principal Amount and

Basic Factors Influencing Long term financial Decisions

1.10 Self Assessment Questions

1.2 NATURE OF FINANCIAL DECISIONS

1.2.1 Investment Decisions

1.2.2 Financing Decision

In Financing decision, finance manager has to decide about the optimal

Nature of Long Term

(i) Question of making financing decision arise as soon as decision regarding

1.2.3 Dividend Policy Decision

1.2.4 Inter-relationship Amongst these Decisions

Nature of Long Term

1.3 WEALTH MAXIMISATION AND MAXIMISATION

1.3.1 Value Maximisation is Wealth Maximisation

1.3.2 Objective of Maximization of Profit Pool:

1.3.3 Other Objectives and Value Maximisation Objective

Nature of Long Term

1.3.4 Net Present Value Rule

1.3.5 VMO and NPV Rule

Nature of Long Term

1.4 CARDINAL PRINCIPLES OF FINANCIAL

(i) Strategic Principle:

(ii) Optimization Principle:

(iii) Risk Return Principle

(iv) Marginal Principle:

(v) Suitability Principle:

(vi) Flexibility Principle:

(vii) Timing Principle:

1.5 TIME VALUE OF MONEY

Nature of Long Term

The process of finding the future value of a payment or receipt or series of

Amount after n period

1.5.2 Discounted Value

Future Cash to Present Cash

was the terminal value of

1.6 DETERMINATION OF IMPLIED INTEREST

1.6.1 Determination of Implied Interest Rates

1st year = Rs.

1.6.2 Determination of the Implied Principal Amount

Nature of Long Term

1.6.3 Determination of Annuities

1.7 BASIC FACTORS INFLUENCING LONG TERM

The objective of a firm is to maximize the wealth of its shareholders. The

Nature of Long Term

1.9 KEY WORDS

1.10 SELF-ASSESSMENT QUESTIONS

Why is Time Value of Money independent of inflation and risk?

What is Investment Decisions? How is it different from financing

Project a and B require equal amount of investment. Project a will yield

10) Mr. X is considering to invest Rs.1 lakh in a project which is expected to

Nature of Long Term

1.11 FURTHER READINGS

Concept of Cost of Capital

Components of Cost of Capital

Classification of Cost of Capital

Computing Cost of Capital of Individual Components

Cost of Long-term Debt

Cost of Preference Capital

Cost of Equity Capital