Chapter 1 - Project Identification and Feasibility

What is a project?
A project is a specific, finite task to be accomplished in order to generate cash flows. It is a proposal for

capital investment to develop facilities to provide goods and services. The proposal may be for setting up a

new unit, for expansion or improvement of existing facilities. The project however has to be amenable for

analysis and evaluation as an independent unit.

The stages of project selection

The identification of project ideas is followed by a preliminary selection stage on the basis of their technical,
economic and financial soundness. The objective at this stage is to decide whether a project idea should be
studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a
prefeasibility study or opportunity study. For the purpose of screening and priority fixation, project ideas are
developed into prefeasibility studies. Prefeasibility studies give output of plant of economic size, raw
material requirement, sales realisation, total cost of production, capital input/ output ratio, labour
requirement, power and other infrastructure facilities.

Feasibility Study
After ensuring that a project idea is suitable for implementation, a detailed feasibility study
giving additional information on financing, breakdown of cost of capital and cash flow is
prepared. The feasibility study should contain all technical and economic data that are
essential for the evaluation of the project.

1. Before dealing with any specific aspect, feasibility study should public policy with respect to the
industry. For example, to evaluate the prospects for investing in the telecom market, a firm should
consider the following aspects of the New Telecom Policy:
• Cable networks will be allowed to provide data and voice services subject to licensing. Inter
connectivity between cable and basic service provider allowed.
• Domestic monopoly of DoT for long distance calls will end by January 1, 2000.
• For giving the licenses, almost 72 % weightage will be given to license fees, 15 % for rural
development, 10% for network rollout and 3% for indigenisation.

2. It should specify output and alternative techniques of production in terms of process choice and ecology
friendliness, choice of raw material and choice of plant size.
3. The feasibility study, after listing and describing alternative locations, should specify a site after
necessary investigation.
4. The study should include a layout plan along with a list of buildings, structures and yard facilities by
type, size and cost.
5. Major and auxiliary equipment by type, size and cost along with specification of sources of supply for
equipment and process know-how has to be listed.
6. The study has to identify supply sources and present estimates, costs for transportation, services, water
supply and power. The quality and dependence of raw materials and their source of supply have to be
investigated and presented in the feasibility study.
7. The feasibility study should include financial data. It should cover preliminary estimates of sales
revenue, capital costs and operating costs for different alternatives along with their profitability.
Feasibility study should present estimates of working capital requirement to operate the unit at a viable
level.
8. An essential part of the feasibility study is the schedule of implementation and estimates of expenditure
during construction.

The feasibility study is followed by project report firming up all the technical aspects such as location,
factory lay-out specifications and process techniques design. In a way, project report is a detailed plan of
follow-up of project through various stages of implementation.
Chapter 2 - Market Appraisal

Introduction
Analysis of demand for the product proposed to be manufactured requires collection of data and preparation of estimates. Market
appraisal involves:

• Preparing a description of the product, its major uses, scope of the market, possible competition from
substitutes, special features of the product proposed to be manufactured in regard to quality and price which
would result in consumer preference for the product in relation to competitive products
• Estimating existing and future demand and supply of the products proposed to be manufactured
• Assessing likely competition in future and special features of the product which may enable it to meet
competition.
Identifying export possibilities and compiling comparative data on manufacturing costs.
The CIF and FOB prices and landed cost of the proposed product have to stated.
It is also necessary to identify principal customers and state particulars of any firm arrangements entered into
with them. Selling arrangements contemplated in terms of direct sales or through distributors or dealers have
to be classified.
After collection of the data, the existing position has to be assessed to ascertain whether unsatisfied demand
exists. Since cash projections are to be made, possible future changes in the volume and pattern of supply and
demand have to be estimated. This would help in assessing the long term prospects of the unit.
Estimation of demand requires the determination of the total demand for a product and the share that can be
captured by the unit through appropriate marketing strategies.

Methods of demand forecasting

The commonly used methods of demand forecasting are trend, regression and end-use method.
Trend Method
The trend method assumes that the behaviour of the variable would continue in the same direction and magnitude as in the past. In this
method, it is useful first to draw a graph to ascertain whether a linear or an exponential trend is appropriate for projection. The
assumption under linear trend is that the variable would increase by a constant amount, whereas in exponential it will change by a
constant percentage amount. Graphing the data will help to decide which period to choose and what type of form be used for forecasting.
Only after analysis of past data the trend line should be fitted.

Regression Approach

In regression approach the factors influencing the variables that are to be forecast have to be identified. In
this method we have the dependent variable and the explanatory or independent variable. The dependent
variable is the one subject to forecasting. The explanatory variables are those which cause changes in the
dependent variable. If rate of inflation is to be forecast, the independent variables may be money supply, per
capita availability of food grains and rate of monetisation of the economy. Specification or identification of
factors is crucial in forecasting by regression approach. In multiple regression we have more than one
explanatory variable.
The regression coefficients should have the right sign arid be statistically significant. The actual value of
dependent variable and the estimated value should be close to each other for the sample period. This is
2
reflected in the value of R , the square of the multiple correlation coefficient

Limitations and Advantages of Trend and Regression Methods

The trend is a catch all approach. It takes into account the impact of all variables influencing the dependent
variable. In trend method the need for independently forecasting the explanatory variable does not arise, as
the values of 't' at a future period are known. In the case of regression the explanatory variables have to be
forecast independently.

The main advantage of regression method is that it enables the estimation of turning points, whereas the trend
method cannot predict the turning points. Regression method is more accurate than the trend method because
it takes into account causal factors. In actual practice forecasts by both methods may be attempted.

End-Use Method
In this method the users of the product proposed to be manufactured, are identified. An intensive study of the
past and present situation and a thorough assessment of the future prospects of the various end user industries
is made to determine the expected levels of production for the various end user industries. A study of the
consumption norms for each end user industry in respect of the product for which forecasts are needed is also
made. However, provision should be made for changes in the norms as a result of technological change or
emergence of substitute products.
The end use approach enables customer industry-wise demand forecasts and it is easy to evaluate any
discrepancy in the forecasts with the actual value. The method is appropriate for intermediate industrial
products such as steel and caustic soda.
Demand projections and estimates are made by agencies of government as well as industry associations.
Among the government agencies, the Directorate General of Technical Development and the Planning
Commission may be mentioned. Several associations of manufacturers make estimates. In regard to small
scale sector, the Development Commissioner for Small Scale Industries, the National Small Industries
Corporation and the Small Industries Services Institute provide valuable market information about projects
and products.
Several private consultants undertake market surveys for a fee.
Chapter 3 - Technical Appraisal

Objectives of technical appraisal

Technical appraisal is primarily concerned with the project concept covering technology, design, scope and
content of the plant as well as inputs and infrastructure facilities envisaged for the project. Evaluation of
industrial projects is undertaken to compare and evaluate alternative variants of technology, of raw materials
to be used, of production capacity, of location and of local production versus import.
Basically, the project should be able to deliver marketable product from the resources deployed, at a cost
which would leave a margin adequate to service the investment and plough-back a reasonable amount to
enable the enterprise to consolidate its position. Technical appraisal has a bearing on the financial viability of
the project as reflected by its ability to earn satisfactory return on the investment made and to service equity
and debt.

Project Concept - Project concept comprises various important aspects such as

plant capacity, degree of integration, facilities for by-product recovery
and flexibility of the plant. Accurate assessment of plant capacity on a
sustained basis is of crucial importance.
Capacity of Plant - Capacity of a plant depends on several factors such as product specification, product mix
and raw material composition. It is indeed difficult to assess capacity. For instance paper plant capacity
varies with grammage. In a textile mill, capacity varies with the composition of yarn of different counts. The
daily production in a sugar mill depends on sugar content of the cane; and annual production on the length of
the crushing season. The extent and degree of integration and facilities for by-product recovery also affect
size of project investment and profitability. An integrated textile mill with cotton as a starting material would
require larger investment and is more profitable than an un-integrated mill of the same capacity producing
fabric from grey cloth.
Sometimes additional investment would improve the profitability enormously. In a caustic soda plant,
recovery of chlorine and hydrogen no doubt requires additional investment but improves profitability as
compared to a plant producing just caustic soda.
Evaluation of Technology - Outstanding features of technology process, engineering design and plant and
machinery are established facts and can be checked from published information on the process or from
prospective collaborators/ consultants and on the basis of similar plants in operation elsewhere. However,
considerable skill is required in evaluating the claims of emergent technology, products and equipment
design.
The design and layout of the plant in technical appraisal should ensure ease of operation and convenience of
maintenance and uncomplicated expansion of the stream capacity, should the need arise.
Above all, in technical appraisal one should be alert and apply trained and informed skills. For example, the
availability of soft water is essential for a textile processing plant. It is on record that a public sector textile
process plant was set up without checking the quality of water. The result was a large additional investrnent
to cure water.
Inputs - In technical appraisal, inputs are scrutinised for availability and quality dependability. If there are
seasonal variations, especially, in the case of agricultural inputs, variations in price have to be checked.
Similarly power quality has to be checked in terms of variation in supply voltage and in-line current
frequency and duration of blackouts. Finally, the quality and availability of water which shows seasonal
trends especially in case of a project requiring water as an input should be checked.

Location - While it is easy to enumerate desirable factors to be taken into account while determining
location, in practice various constraints dictate location away from the ideal one. The ideal factors are, of
course, proximity to the market and inputs, preferably where well developed infrastructure exists. In some
industries effluent disposal facility is necessary. Pollution control restricts the use of steam boilers while
power scarcity restricts the installation of induction furnaces, which are environment friendly. Antipollution
regulations may also force the choice of large size plants to curtail noise pollution or to install anti- vibration
equipment with adverse impact on costs.
Interdependence or the Parameters or Project - Finally, the technical appraisal of the individual project
may be supplemented by a supplementary review of the project in terms of interdependence of the basic
parameters of the project which are, plant size, location and technology. A small integrated paper plant using
bagasse, paddy husk or straw without need to recover process chemicals may be more viable than large
integrated paper mill requiring forest based raw material, water and effluent disposal system. Sometimes
undependable supply of basic inputs could spell disaster. Several mini steel plants set up in a big way in '7Os
were out of business as a result of lack of steel scrap from imports, which was due to foreign exchange crisis.
The implementation of the project has cost and time over-run implications. The scheduling of construction
and the identification of potential causes of delay form an important part of the technical aspects of the
project appraisal. The schedule of construction depends mainly on the speed of civil construction works,
delivery period of equipment, as well as the efficiency of the management to tie up various ends in a
coordinated and speedy manner. Since an overrun In the pre-commissioning time invariably leads to overrun
in cost and consequential problems, it is important that timing of construction is realistically planned. For all
main physical elements of the projects, from project concept, obtaining Government approvals, tying- up
financial arrangements, engineering design, land acquisition, building construction, procurement of
equipment, its erection and testing to final commissioning, there must be realistic time schedules and a
coherent arrangement, which leads to the completion of the project on most economical basis. Use of
scheduling techniques like PERT and CPM and proper adherence to them is an essential aspect to be insisted
upon in technical appraisal.
Project Charts and Layouts - Project charts and layouts have to be prepared to define the scope of the
project and provide the basis for detailed project engineering. These are general functional layout, material
flow diagram, production line diagram, utility layout and plant layout.
General functional layout should facilitate smooth and economical movement of raw materials, work-in-
process and finished goods. Material flow diagram presents flow of materials, utilities, intermediate products,
final products, scrap and emissions. Production line diagram establishes the progress of production from one
machine to another with description, location, space required, need for power and utilities and distance from
the next section. Utility layout shows the principal consumption points of power, water and compressed air,
which helps in the installation of utility supply. Finally, plant layout identifies the exact location of each
piece of equipment determined by proper utilisation of space leaving scope for expansion, smooth flow of
goods to minimise production cost and safety of workers.
Cost of Production - Estimates of production costs and projection of profitability is the concluding part of
the technical appraisal. Cost of production is worked out taking into account the build up of capacity
utilisation, consumption norms for various inputs and yields and recovery of by- products. In estimating
production, a general build-up starting with 40 percent and reaching a normal level of 80 percent in three to
four year’s time is provided. In practice capacity utilisation may fall short of estimated levels on account of
defective plant and machinery, inadequate operating skills, inadequacy of raw materials, shortage of power
and lack of demand. The cost of production and profitability estimates take into account the level of
production in different years and product-mix (which are dependent on market potential, prices, marketing
strategy, technical constraints relating to process and plant facilities, and operators' efficiency), norms of raw
material consumption (including provision for wastage), power and fuel requirement, their costs, salaries and
wages, repairs and maintenance, administrative overheads, selling expenses (including product promotion)
and interest on borrowings. Adequate provision is made for higher expenses in the initial years for technical
troubles, higher wastages and lower yields, lower operating efficiency and higher selling costs. Here, too,
comparison with similar projects is useful. The profitability estimates should be on a realistic selling price. In
a competitive market, penetration price for a new producer will have to be lower than the current price of an
established manufacturer.
Chapter 4 - Financial Appraisal
Introduction
Financial appraisal is concerned with assessing the feasibility of a new proposal for investment for setting up
a new project or expansion of existing productive facilities. This involves an assessment of funds required to
implement the project and the sources of the same. The other aspect of financial appraisal relates to
estimation of operating costs and revenues, prospective liquidity and financial returns in the operating phase.
In appraising a project, the project's direct benefits and costs are estimated at the prevailing market prices.
This analysis is used to appraise the viability of a project as well as to rank projects on the basis of their
profitability. It may be noted that financial appraisal is concerned with the measurement of profitability of
resources invested in the project without reference to their source.
For the purpose of appraisal it is necessary to make estimates relating to working results in case of existing
concerns, cost of the project and means of financing. Financial projections for a ten-year period have also to
be made.

Working Results of Existing Units

In the case of an existing unit, it is desirable to make an assessment of its latest financial position. For this
purpose, its latest audited balance sheet and profit and loss statement as well as the balance sheets for the last
five years have to be analysed. In case an audited balance sheet as on a fairly recent date is not available, a
proforma balance sheet and profit and loss statement certified by the management may be examined.
The latest balance sheet and profit and loss account may be analysed with a view to ascertaining, whether the
concern is under/over capitalised, whether the borrowings raised are not out of proportion to its paid up
capital and reserves, how the current liabilities stand in relation to current assets, whether the gross block has
been properly depreciated and has not been shown at an inflated value, whether there is any inter-locking of
funds with associate companies and whether the concern has been ploughing back profits into the business
and building up reserves.
Cost of the Project
The capital cost of the project whether it pertains to expansion or a new project should be shown under,
a) Land and site developments,
b) Buildings,
c) Plant and machinery,
d) Technical know-how fees,
e) Expenses on foreign technicians and training of Indian technicians abroad,
f) Miscellaneous fixed assets,
g) Preliminary and pre-operative expenses,
h) Provision for contingencies and
i) Margin money for working capital.
It has to be ensured that all these items are covered in the cost and the expenditure under each item is
reasonable. As a part of the process of an appraisal of the capital cost of the project, it is desirable to compare
the cost of the project with the cost of a similar project or by the information about cost that may be gathered
in respect of other units in the same industry with comparable installed capacity and other common technical
features.

Sources of Finance
The usual sources of finance for a project are:
Equity capital, term loan, deferred payment, unsecured loans from promoters and internal accruals in the case
of an existing unit.
A balance has to be struck between debt and equity. A debt equity ratio of 1:1 is
considered ideal but it is relaxed upto 2:1 in suitable cases. Further relaxation in debt
equity is made in the case of capital intensive projects. All long-term loans/deferred
credit are treated as debt while equity includes free reserves. Equity is arrived after
deducting carried forward losses in the case of an existing unit.
It is important that no gap is left in financing patterns. Otherwise it will result in delays in implementation of
the project. A condition is stipulated by financial institutions that the promoters shall arrange for funds to
meet any over run in the cost of the project. While the emphasis of financial institution is on the viability of
the project they generally stipulate by way of security, a first legal charge on fixed assets of the company
ranking pari passu with the charge if any, in favour of other financing institutions.

Financial projections
For the purpose of determining the profitability of the project and the ability of the company to service its loans and give a reasonable
return on the equity capital, estimates of cost of the project, profitability, cash flow and projected balance sheets have to be prepared in
the proforma given in Annexure 1 for ten years. These are inter related and are prepared on the basis of the estimated cost of the project,
sources of finance envisaged and various assumptions regarding capacity utilisation, availability of inputs and their price trends and
selling price. The important assumption that should be scrutinised carefully before making estimates are capacity build up, raw material
cost, estimate of wages and salaries, cost of utilities, estimate of administrative expense, selling price assumed and provisions made for
depreciation and statutory taxes. Verification of profitability is the core of proper appraisal of the project. The entrepreneur may be
naturally tempted to present a bright picture but it is the task of financial appraisal to verify the estimates. It is to be ensured that the
profits projected are realistic. In case of new units, any sharp build up of capacity within a year or two will be unwarranted especially if
the product is new. The quantum of raw materials and utilities estimated to be consumed to obtain a particular quality/quantum of end
product is the core of cost of manufacture estimates and should tally with the performance guarantees furnished by the
collaborators/machinery suppliers. In case of multiproduct firms, the product mix is decided on the basis of contribution of each product,
utilisation of plant capacity as well as market. Annual increases in wages and salaries should be about five percent.

Repairs and maintenance will have to be provided keeping in view the type of industry and the number of
shifts to be worked. Depreciation of fixed assets should be provided as per income tax rules. The selling price
should be fixed keeping in view the present domestic price of the product. The profitability projections are
closely linked to the schedule of implementation. On the basis of profitability projections, cash flow and
projected balance
Evaluation of Cash Flow and Profitability

Financial appraisal uses two popular methods and two discounted cash flow techniques to evaluate the cash
flows and profitability of investment. The methods should have three properties to lead to consistently
correct decisions. First, it should consider all cash flows over the entire life of a project; secondly, it should
take into account the time value of money and finally it should help to choose a project from among mutually
exclusive projects, which maximise the value of the firm’s stock.
The two popular methods are the simple rate of return and pay back period. They employ annual data at their
nominal value. They do not take into account the life span of the project but rely on one year.
The discounted cash flow techniques take into consideration the project's entire life and the time factor by
discounting the future inflows and outflows to their present value.

Simple Rate or Return Method

Simple rate of return is the ratio of net profit in a normal year to the initial investment in terms of fixed and working capital. If one is
interested in equity alone the profitability of equity can be calculated. The simple rate of return could be presented as,

R = (F + Y)/ I

= Re =F/Q

where

R = Simple rate of return on total investment

Re = Simple rate of return on equity capital

F = Net profit in a normal year after depreciation, interest and taxes

Y = Annual interest charges
I = Total investment comprising of equity and debt; and Q = Equity capital invested.

Normal year is a representative year in which capacity utilisation is at technically maximum feasible level
and debt repayment is still under way.
The simple rate of return helps in making a quick assessment of profitability, particularly of projects with short life. Its shortcoming is
that it leaves out the magnitude and timing of cash flows for the rest of the years of a project's life. For evaluation, accurate data is
required. In its absence simple rate of return may be incorrect Simple rate of return method is more suitable for financial analysis of
existing units. It is not suitable for optimising investment

Pay-Back Period

Pay-back period for a project, measures the number of years required to recover a project's total investment
from the cash flows it generates. It is the expected number of years required to recover the original
investment If we consider a project with an investment of Rs. 5,00,000 and an expected cash flow of Rs.
1,00,000 per year for 10 years, the pay-back period is given by,
Payback Period = Initial Investment Outlay / Annual Cash Flow
 = 5,00,000/1,00,000
= 5 years

The pay-back period shows that the project's initial investment is recovered in five years. Even if cash flows are not uniform, the pay-
back period can be calculated easily by adding together cash flows until the investment is recovered. The method is easy to calculate and
emphasises the liquidity aspect of investment. The shorter the pay-back period the quicker is the recovery of initial investment But it
leaves out the time pattern of the cash flows within the pay-back period. It leaves out the cash flows after the pay back period. Actually,
it is biased against project which yield higher returns in later years. The payback period method is not suitable for evaluation of
alternatives and to make systematic comparison.

DCF Techniques
The discounted cash flow (DCF) methods provide a more objective basis for evaluating investment
proposals. They take into account both the magnitude and timing of expected cash flows in each period of a
project's life. The two methods are the internal rate of return and the present value method. They take into
account time value of money and a rupee today is more valuable than a rupee tomorrow.

Internal Rate of Return (IRR)

IRR for an investment proposal is the discount rate that equates the present value of future cash inflows to the
initial cost of the project. In the IRR method the discount rate is unknown. By definition, IRR is the rate of
discount that reduces net present value of a project to zero. The IRR method finds the specific discount rate
that equates the present value of the expected cash flows to the initial cost of the project. There is a value of
IRR, which will cause the sum of discounted cash flows to equal the initial cost of the project making the
NPV equal to zero. This value is defined as IRR.
IRR is represented by that rate, r, such that

n
∑ [At/ (1 + r)t]
T= 0
= 0

where
At is the cash flow for period t (net inflow or outflow) and n is the last period in which cash flow is expected.
If investment occurs at time 0, the above equation can be expressed as

The future cash flows Al through An are discounted by r to equal the initial investment at time 0, A0.
If initial investment is Rs. 18 lakhs, annual cash flows are Rs. 5.7 lakhs, for five years; the problem can be expressed as:

2 n
A0 = A1/ (1+r) + A2/ (1+r) + … An/ (1+r)

2 3 4 5
18,00,000 = 5,70,000/ (1+r) + 5,70,000/ (1+r) + 5,70,000/ (1+r) + 5,70,000/ (1+r) + 5,70,000/ (1+r)
The internal rate of return, r is 17.57 percent. When IRR is employed, the selection of a project is decided by
comparing it with a required rate of return or cut-off or hurdle rate. The project is accepted only if it exceeds
the required rate of return, leaving a surplus after paying for the capital. This surplus will accrue to the firms
shareholders by increasing the value of the company's stock. If IRR is less than the cost of capital, the project
will impose a cost and results in reduction of the value of the stock.

Net Present Value (NPV) Method

This is the present value of future cash flows, discounted at the appropriate cost of capital,
minus the cost of investment. All future cash flows from the project are discounted to
present value using the required rate of return. To calculate the net present value find the
present value of expected net cash flows of an investment discounted at an appropriate
interest rate, and subtract from it the initial cost of the project. The net present value (NPV)
of an investment proposal is, n

NPV = ∑
T= 0 At/ (1 + k)
t

where k is the required rate of return. An investment proposal is accepted if the sum of discounted cash flows
is zero or more. If not, it is rejected. The present value of cash inflows should exceed the present value of
cash outflows.
If we use the IRR example, the net present value with an assumed required rate of return of 12 per cent
would be,
2 3 4
NPV = -18,00,000 + 5,70,000/ (1.12) + 5,70,000/ (1.12) + 5,70,000/ (1.12) + 5,70,000/ (1.12) +
5
5,70,000/ (1.12)

= -18,00,000 + 20,54,700

= 2,54,700

When the NPV is zero, the project would cover all required operating and financial costs
but it has no excess returns. When the firm chooses a zero NPV project, the firm
becomes larger but its value does not change. If a project's NPV is zero or positive the
project is acceptable and if the NPV is negative, the project is unacceptable.
The two DCF techniques, the IRR and NPV lead to the same acceptance or rejection decisions. IRR method
is similar to the NPV method. Instead of a minimum acceptable rate of return being defined as an input, a
rate of return is calculated which balances the cash inflows over time with the cash outflows overtime. IRR is
estimated by an iterative process. If IRR is greater than the minimum acceptable rate of return, the project is
deemed to be profitable.

Estimating Cost of Capital with Capital Asset Pricing Model

In the analysis so far, the company's cost of capital was used to discount the forecasted cash flows of the new
project. Many companies estimate the rate of return required by investors in their securities. Towards this
purpose the company's cost of capital is used to discount cash flows in all new projects. This is not an
accurate method since the risk of existing assets of a company may differ from the risk of new project assets.
Since investors require a higher rate of return from a very risky company, such a company will have a higher
cost of capital and will set a higher discount rate for its new investment opportunities. The cost of capital or
required rate of return on the project would be the same as the one on company's existing assets if the risk is
the same. The company's cost of capital is the correct discount rate for projects that have the same risk as the
company's existing business. If the project risk differs from the risk on existing assets, the project has to be
evaluated at its own opportunity cost of capital. The true cost of capital depends on the use to which it is put.
The capital asset pricing model can be used for estimating the company's cost of capital. Each project should
be evaluated at its own opportunity cost of capital. Capital asset pricing theory tells us to invest in any project
offering a return that more than compensates for the project's beta which measures the amount that investors
expect the stock price to change for each one percent additional change in the market risk. The discount rate
increases as project beta increases. However, firms require different rates of return from different categories
of investment. The higher the beta risk associated with an investment the higher the expected rate of return
must be to compensate investors for assuming risk. The CAPM provides a framework for analysing the
relationship between risk and return. The CAPM holds that there is a minimum required rate of return even if
there are no risks, plus a premium for all non-diversifiable risks associated with investment Projects should
be evaluated as portfolios and there is a reduction of risk when they are so combined.
To calculate the company's cost of capital the beta of its assets has to be ascertained. But the beta cannot be
plugged into the capital asset pricing model to find the company's cost of capital because the stock's beta
reflects both business and financial risk. The beta has to be adjusted to remove the effect of financial risk
since borrowing increases the beta (and expected return) of its stock. A more reliable estimate is an average
of estimated betas for a group of companies in the same industry.
While estimating project betas, fudge factors to discount rates to offset bad outcomes of a project should be avoided. In cases where
project beta cannot be calculated directly, identification of the characteristics of high and low beta assets (for instance cyclical
investments are high beta investment) would help to figure out effect on cash flows. Finally, operating leverage should be assessed since
high fixed production charges are like fixed financial charges resulting in an increase in beta.

The expected rate of return calculated from the capital asset pricing model

r = rf + β (rm - rf)

(Where r is discount rate, rf interest rate on risk free asset like treasury bill, r m expected return) can be
plugged into standard discounted cash flow formula).

n n
PVT= 0∑ C t/ (1 + r)
t
= T=∑
0
Ct/ [1 + rf + β ( rm - rf )]t
The capital asset pricing model values only the cash flow for the first period C 1. Projects, however, yield cash
flows for several years. If the risk adjusted rate r is used to discount the cash flow, we assume that
cumulative risk increases at a constant rate. The assumption will hold when the project's beta is constant or
risk per period is constant.

Financial Analysis
An integral aspect of financial appraisal is financial analysis, which takes into account the financial features
of a project, especially source of finance. Financial analysis helps to determine smooth operation of the
project over its entire life cycle. The two major aspects of financial analysis are liquidity analysis and capital
structure analysis. For this purpose ratios are employed which reveal existing strengths and weaknesses of
the project

Liquidity Ratios

Liquidity ratios or solvency ratios measure a project's ability to meet its short-term obligations. Two ratios
are calculated to measure liquidity, the current ratio and quick ratio.
Current Ratio: The current ratio is defined as current assets [cash, bank balances, investment in securities,
accounts receivable (sundry debtors) and inventories] divided by current liabilities [accounts payable (sundry
creditors), short term loans from banks, creditors and advances from customers]. It is computed by,

Current ratio = Current Assets/ Current Liabilities

The current ratio measures the assets closest to being cash over those liabilities closest to being payable. It is an indicator of the extent to
which short term creditors are covered by assets that are expected to be converted to cash in a period corresponding to the maturity of
claims.

A current ratio 1.5 to 1.0 is considered acceptable.

Acid Test or Quick Ratio: Since inventories among current assets are not quite
liquid, the quick ratio excludes it. The quick ratio includes only assets
which can be readily converted into cash and constitutes a better test of
liquidity.
Quick Ratio = (Current Assets - Inventories)/ Current Liabilities
A quick ratio of 1:1 is considered good from the viewpoint of liquidity.

Capital Structure Analysis

Long-term solvency ratios measure the project's ability to meet long term commitments to creditors.
'Creditors' claims on a firm's income arise from contractual obligations, which must be honoured. The larger
the amount of these claims the higher the chances of their not being met. Legal action may be initiated to
enforce the fulfilment of the claims. The two long-term solvency ratios are debt utilisation ratio and coverage
ratio.
Debt Utilisation Ratio:
Debt utilisation ratio measures a firm's degree of indebtedness, which measures the proportion of the firm's
assets financed by debt relative to the proportion financed by equity. Debt includes current liabilities and
long term debt. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against
creditor's losses in the event of liquidation. The owners prefer higher levels either to magnify earnings or to
retain control.

Debt Ratio = Total Debt/ Total Assets

Debt Equity Ratio:

Debt equity ratio is the value of total debt divided by the book value of equity. In calculation of debt, short-term obligations of less than
one-year duration are excluded.

Debt Equity Ratio = Long Term Liabilities/ Shareholders Equity

Sometimes debt equity ratio is referred to as debt capitalisation ratio.

Fixed Assets Coverage Ratio:

Two other ratios relating to long term stability used by development finance institutions (DFIs) in appraisal of projects are fixed assets
coverage ratio and debt coverage ratio. The fixed assets coverage ratio shows the number of times fixed assets cover loan.

Fixed Assets Coverage Ratio = Net Fixed Assets/ Term Loan

Debt Coverage Ratio:

The debt coverage ratio measures the degree to which fixed payments are covered by operating profits. The
ratio emphasis the ability of the project to generate adequate cash flow to service its financial charges, (non-
operating expenses). Debt coverage ratio measures the number of times earnings cover the payment of
interest and repayment of principal. A debt coverage ratio of 2 is considered good.
DSCR = (PAT + Depreciation + other non-cash charges + interest on term loan )/ (Interest on term loan +
repayment of term loan).
The above formula takes into account the effect of taxes on the profits expected. Hence it gives a realistic picture of the ability to meet
obligations.

Interest Coverage Ratio:

The interest coverage ratio measures the number of times interest expenses are earned or covered by profits.
Interest Coverage Ratio = (Net Profit before taxes + interest)/ Interest

Market Value Ratios:

Market value ratios relate the company's share price to its earnings and book value per share. These ratios are
a performance index of the company and indicate the investor’s perception of the company's performance
and future prospects.

Price Earnings Ratio:

P/E ratio relates the per share earnings to price of the share.
P I E Ratio = Market Price Per Share /Earning Per Share
P/E ratios are computed for firms as well as for the market. P/E ratios are higher for companies with high
growth prospects and lower for riskier companies.
Market/Book Value Ratio:
The ratio of market price of the share of the company to its book value per share gives an indication of how
investors regard the company. Generally if the returns on assets are high, these shares sell at higher multiples
of book value than those with low return. Book value per share is the sum of net worth (paid up capital plus
reserves) divided by number of shares outstanding.
Book value per share = Total Net Worth/ No. of shares outstanding
Market/Book Ratio (M/B Ratio):
If the market price per share is divided by book value, we get the market book (M/B) ratio.
Break Even Point (BEP):
An essential aspect of financial appraisal is the determination of BEP. Unless it is determined, other
measures make no sense. To calculate and project cash flows it is important to assess the BEP . Break-even is
that level of production and sales at which total revenues are exactly equal to operating costs. BEP occurs at
that production level at which net operating income (sales-operating cost) is zero. It indicates the volume
necessary for profitable operation of the project. With the help of break-even analysis the quantity required to
be produced at a given sales price per unit to cover total fixed cost and variable cost can be found. If BEP is
too high, the price assumed for the output may have to be reviewed. In summary, the viability of a project
can be assessed with the help of break-even analysis.
For the purpose of break even analysis, the conventional income statement has to be classified into fixed and
variable costs. An example of conventional income statement is presented in Table 2, which is classified into
fixed and variable expenses.
Table 2: Illustrative Conventional Income Statement

Net Sales Rs. 6,00,000

Less: Cost of goods sold:

Materials Rs. 1,80,000
Labour 60,000
Manufacturing exp. 1,95,000 4,35,000

1,65,000

Less: Operating expenses 36,000

Selling expenses 54,000 90,000
75,000
Less: Miscellaneous expenses 3,000
Profit 72,000

Table 3:1 Derivation of BEP from Income Statement

For deriving BEP , it is necessary to recast the income statement in Table3:1 into fixed and variable costs.

Items of cost Fixed Variable Total

Materials ----------- 1,80,000 1,80,000
Labour 60,000 60,000
Manufacturing expenses 1,00,000 95,000 1,95,000
Selling expenses 20,,000 16,000 36,000
Administrative expenses 46,000 8,000 54,000
Miscellaneous expenses 2,000 1,000 3,000
1,68,000 3,60,000 5,28,000
Net profit 72,000
Total Sales 6,00,000

It may be seen from the above statement that for a sale of Rs. 6,00,000 the variable cost is Rs. 3,60,000 i.e.,
60 per cent of sales. It means that on every rupee of sales, 60 paisa is spent on variable costs and the balance
of 40 paisa (40% ) is left to meet the fixed cost. To find the total sales required to meet the fixed cost of Rs,
1,68,000 tile total fixed cost is divided by 40 per cent.

Sales required to meet fixed cost = (1,68,000 * 100)/ 40

= Rs. 4,20,000
The volume of Rs, 4,20,000 is known as the break-even sales volume which must be achieved if loss is to be
avoided. The profit status at this level is,
Sales Rs.4,20,000
Less: Variable costs(60% on sales) 2,52,000
Margin available for fixed expenses 1,68,000
Profit Nil
The computation of break-even sales volume can be summarised as,

Break -even sales volume = Total Fixed Cost/ (1 – Total Variable Cost/
Total Sales Volume)
BEP = F/ (1 – V/S)

where
F is fixed cost
V is variable cost S is sales volume.
Substituting the figures mentioned above,

Breakeven Sales Volume = 1,68,000/ (3,60,000/ 6,00,000)

= 1,68,000/(1 - .60)
= 1,68,000/ .4
= Rs. 4,20,000

If Rs. 6,00,000 sales can be regarded as normal for a month, (standard sales volume) capacity utilisation rate
at which the project must operate in order to 'break-even' can be calculated. This will be
Breakeven Sales Volume * 100/ Standard Sales Volume
= 4,20,000 *100/ 6,20,000 = 70%
At capacities lower than 70 percent, project is bound to incur losses. On the other hand, it will make profits at
levels above the 70 per capacity utilisation. The 'break- even' capacity represents the capacity utilisation rate
to be achieved to make the project viable. The normal rate for capacity utilisation is about 50 percent.
Chapter 5 - 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.

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,

t
ZTe = JOT / I

where

ZTe = total employment effect

JOT = total number of new job opportunities

t
I = total investment (direct and indirect)

Net foreign exchange effect

A project may be export oriented or reduce reliance on imports. In such cases an analysis of the effects of
the project on balance of payments and import substitution is necessary. The assessment of project on the
country's foreign exchange is done in two stages; first, balance of payments effects of the project and second,
import substitution effect of a project. For this purpose, net foreign exchange flows are calculated as per the
proforma in Annexure 2. The proforma enables the analysis of liquidity of a project in terms of foreign
exchange. The annual net flows as well as the net impact over the economic life of the project have to be
found.

The import substitution effect of a project measures the estimated savings in foreign exchange owing to the
curtailment of imports of the items of production of which has been taken up by the project. CIF values are
used in calculation of import substitution effect.
Net foreign exchange effect of the project includes the net foreign exchange flow in Statement 3 and the
import substitution effect.
The analysis of net foreign exchange effect may be done for the entire life of the project or on the basis of a
normal year. If two or more projects are compared on the basis of their net foreign exchange effect, the
annual figure should be discounted to their present value.

Social cost benefit analysis

Another aspect of economic appraisal is social cost benefit analysis. Cost benefit analysis is concerned with
the examination of a project from the view point of maximisation of net social benefit. While cost benefit
analysis originated to evaluate public investment, it is also used in project appraisal.
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 1osses be valued in a common
unit. The unit should reflect society's strength of preference for each outcome. The economist uses as a
measure of this preference, the consumer’s willingness to pay (WTP) for a good. This will be partly reflected
in the price he pays for the goods.
In many cases the prices are not observable or are distorted. In these circumstances cost benefit analysis must
seek surrogate prices or shadow prices to measure what the society will be willing to pay if there is a market.
Net social benefits are found by deducting from WTP the compensation required (the cost). Maximisation of
net benefit should be finally equivalent to the maximisation of social utility or social welfare.
Chapter 6 - Choice of Securities

Introduction
To meet 1ong-term requirements for funds, securities are issued to public (issue of capital) by firms in the
corporate sector and public sector. Securities represent claims on a stream of income and/or particular assets.
Debentures are debt securities and there is a wide range of them. Equity shares in corporate sector or
privatised public sector undertakings are ownership securities. Preference share is a hybrid security that
entails a mixture of both ownership and creditorship privileges.
Issue of capital which was regulated by the Capital Issues (Control) Act, 1947 was repealed on May 29,1992.
The issue of capital and pricing of issue have become free of prior approval.

Debentures
Definition and Nature
The issue of debentures by public limited companies is regulated by Companies Act 1956. Debenture is a
document, which either creates a debt or acknowledges it. Debentures are issued through a prospectus. A
debenture is issued by a company and is usually in the form of a certificate, which is an acknowledgement of
indebtedness. They are issued under the company's seal. Debentures are one of a series issued to a number of
lenders. The date of repayment is invariably specified in the debenture. Generally debentures are issued
against a charge on the assets of the company. Debentures may, however, be issued without any such charge.
Debenture holders have no right to vote in the meetings of the company.

Kinds of Debentures
Bearer Debentures:
They are registered and are payable to its bearer. They are negotiable instruments and are transferable by delivery.

Registered Debentures:
They are payable to the registered holder whose name appears both on debenture and in the register of
debenture holders maintained by the company. Registered debentures can be transferred but have to be
registered again. Registered debentures are not negotiable instruments. A registered debenture contains a
commitment to pay the principal sum and interest. It also has a description of the charge and a statement that
it is issued subject to the conditions endorsed therein.

Secured Debentures
Debentures, which create a charge on the assets of the company, which may be fixed or floating, are known
as secured debentures.

Unsecured or Naked Debentures

Debentures, which are issued without any charge on assets, are unsecured or naked debentures. The holders
are like unsecured creditors and may sue the company for recovery of debt.

Redeemable Debentures
Normally debentures are issued on the condition that they shall be redeemed after a certain period. They can,
however, be reissued after redemption under Section 121 of Companies Act 1956.

Perpetual Debentures
When debentures are irredeemable they are called perpetual.

Convertible Debentures
If an option is given to convert debentures into equity shares at stated rate of
exchange after a specified period, they are called convertible debentures.
In our country the convertible debentures are very popular. On
conversion, the holders cease to be lenders and become owners.
Debentures are usually issued in a series with a pari passu (at the same rate) clause which entitles them to be
discharged rateably though issued at different times. New series of debentures cannot rank pari passu with
old series unless the old series provides so.

New debt instruments issued by public limited companies are participating debentures, convertible
debentures with options, third party convertible debentures, convertible debentures redeemable at premium,
debt equity swaps and zero coupon convertible notes.

Participating Debentures
They are unsecured corporate debt securities, which participate in the profits of a company. They might find
investors if issued by existing dividend paying companies.

Convertible Debentures with Options

They are a derivative of convertible debentures with an embedded option, providing flexibility to the issuer
as well as the investor to exit from the terms of the issue. The coupon rate is specified at the time of issue.

Third Party Convertible Debentures

They are debt with a warrant allowing the investor to subscribe to the equity of a third firm at a preferential
price vis-a-vis the market price. Interest rate on third party convertible debentures is lower than pure debt on
account of the conversion option.

Convertible Debentures Redeemable at a Premium

Convertible debentures are issued at face value with a put op entitling investors to later sell the bond to the
issuer at a premium. They are basically similar to convertible debentures but embody less risk.

Debt-equity Swaps
Debt-equity swaps are an offer from an issuer of debt to swap it for equity. The instrument is quite risky for
the investor because the anticipated capital appreciation may not materialise.

Deep Discount Bonds

They are designed to meet the long term funds requirement of the issuer and investors who are not looking
for immediate return and can be sold with a long maturity of 25-30 years at a deep discount of the face value
of debentures. IDBI deep discount bonds for Rs. 1 lakh repayable after 25 years were sold at a discount price
of Rs. 2,700/-.

Zero Coupon Convertible Note

A zero coupon convertible note can be converted into shares. If choice is exercised investors forego all accrued and unpaid interest. The
zero coupon convertible notes are quite sensitive to changes in interest rates.

Secured Premium Notes (SPN) with Detachable Warrants

SPN, which is issued along with a detachable warrant, is redeemable after a notified period, say four to seven
years. The warrants attached to it ensure the holder the right to apply and get allotted equity shares, provided
SPN is fully paid.
There is a lock-in period for SPN during which no interest will be paid for the invested amount The SPN
holder has an option to sell back he SPN to the company at par value after the lock-in period. If the holder
exercises this option, no interest/premium will be paid on redemption. In case the SPN holder holds it further,
the holder will be repaid the principal amount along with additional amount of interest/ premium on
redemption in instalments, as decided by the company. The conversion of detachable warrant into equity
shares will have to be done within the time limit notified by the company.
Floating Rate Bonds
The yield on the floating rate bond is linked to a benchmark interest rate like the prime rate in USA or LIBOR in Eurocurrency market.
The State Bank of India's floating rate bond issue was linked to maximum interest on term deposits, which was 10 percent. Floating rate
is quoted in terms of a margin above or below the benchmark rate. The floor rate in SBI case was 12 percent. Interest rates linked to the
benchmark ensure that neither the borrower nor the lender suffers from the changes in interest rates. When rates are fixed, they are likely
to be inequitable to the borrower when interest rates fall subsequently, and the same bonds are likely to be inequitable to the lender when
interest rates rise subsequently.

Warrants
A warrant is a security issued by a company granting the holder of the warrant the right to purchase a
specified number of shares at a specified price any time prior to an expirable date. Warrants may be issued
with debentures or equity shares. The specific rights are set out in the warrant. The main features of a warrant
are number of shares entitled, expiration date, and stated price/exercise price. The exercise price is 10 to 30
percent above the prevailing market price. Warrants have a secondary market. The minimum value of a
warrant represents the exchange value between current price of the share and the shares purchased at the
exercise price. Warrants have no floatation costs and when they are exercised the firm receives additional
funds at a price lower than the current market, yet above those prevailing at issue time. New or growing firms
and venture capitalists issue warrants. They are also issued in mergers and acquisitions. Debentures issued
with warrants, like convertible debentures carry lower coupon rates.

Interest and Yield on Debentures

No matter what happens, interest payments and repayment of principal at maturity have to be made to debenture holders. But they would
be irrational if they ignore alternative investments that bring in a higher return. If the investor knows the price of a debenture and its
characteristics, be can infer a rate of return called Yield to Maturity (YTM). Yield means the return on investment at current market
price. It is expressed as

(Rate of return * Face value)/ Current Market Price

= Yield percent
The yield works out more than the rate of interest if market price is below par value; and less than the rate of
interest when the market price is higher than par value. Risky debentures have to pay higher yields to
maturity to attract investors. Yield to maturity is more significant than the coupon rate to debenture investors.
If the debenture is selling at a discount, its market price is below its face value. Its yield to maturity exceeds
coupon rate. If it is selling at a premium, the market price is above its face value and the coupon rate is
higher than yield to maturity. Yield to maturity and average rate of return compounded annually to maturity
refer to effective rate of return if held to maturity.

Advantages of debentures
From the company point of view:

1. The cost of debentures is lower than that of equity or preference capital because the interest on
debentures is tax deductible. Hence the effective post tax cost of debentures is lower.

2. Debenture financing does not lead to dilution of control since debentures do not carry voting rights.

Irrespective of the price level, debentures carry a fixed financial burden. This
would be attractive to a company which expects its income level to go up
substantially in the future.
From the investor’s point of view:

1. They earn a stable rate of return

2. They enjoy priority in the event of liquidation
3. They generally enjoy a fixed maturity period

Disadvantages of debentures
From the company’s point of view

1. The debenture interest and capital repayment are obligatory payments.

2. Debenture financing increases the financial risk associated with the firm. This may increase the cost of
equity t the company.

From the investor’s point of view

1. The interest on debentures is taxable
2. Debentures do not carry voting rights

Equity Shares
Equity shares represent proportionate ownership of a company. This right is expressed in the form of
participating in the profits of a going company and sharing the assets of a wound up company. Equity shares
have the lowest priority claim on earnings and assets of all securities issued. A company may pay dividend if
if it generates earnings and has no pressing internal needs for them. The firm has no fixed obligation to pay
periodic dividends. Shares have unlimited potential for dividend payments and share appreciation. They also
provide cushion against losses from the pointof view iof the creditors. To the extent the equity is higher the
credit worthiness of the firm is higher. This should have a favourable effect on the rating of its debentures,
lower its cost of debt and increase its future ability to raise debt. Maintaininig a reserve borrowing capacity is
essential to overcome operating problems. In contrast, owners of debentures and preference shares enjoy an
assured return in the form of interest and dividend. As a result of this risk, investors are unwilling to invest
in equity shares unless they offer a rate of return sufficiently high to induce investors to assume the possible
loss.

Voting rights
The Companies’ Act deals with the voting rights of a shareowner. An equity shareowner has a right to vote
on every resolution placed before the company. The voting rights are proportional to the share owners share
of paid-up capital of the company. All shares carry proportionate rights. No Company can issue shares that
carry voting rights disproportionate to the rights attached to the holders of other issues. Voting rights cannot,
however, be exercised in respect of shares on which a call or any other sum due to the company has not been
paid.
It may be noted that the word 'capital' in share capital is used to mean nominal, authorised or issued or paid-
up capital.
Nominal or Authorised Capital is the maximum capital the Memorandum envisages for the company unless
it is changed. The Memorandum also specifies the division of authorised capital into shares of fixed amount.
Issued capital is the nominal value of shares offered for public subscription. In case all shares offered for
public subscription are not taken up. The portion subscribed, is subscribed capital that is less than issued
capital.
Paid-up Capital is the share capital paid-up by shareowners or which is credited as paid-up on the shares.
Par Value is the face value of a share. It does not tell anything about the value of shares.
Book Value is determined by deducting total liabilities including preference shares from total assets and the
difference, which is equal to shareholder equity with the number of equity shares outstanding.

Equity Shares with Detachable Warrants

Detachable warrants are issued along with fully paid equity shares, which will entitle the warrant holder to apply for a specified number
of shares at a determined price. Detachable warrants are separately listed with the stock exchanges and traded separately. The terms and
conditions relating to issue of equity shares against warrants are determined by the company.

Cash Dividends
A stable cash dividend payment was believed to be the basis for the increase in company's share prices. A
growth-oriented firm retains as much capital as possible for internal financing. Capital appreciation rather
than dividends is what an investor has to look for in their case. Old established firms tend to pay out large
proportion of their earnings as dividend.
Bonus Shares (or stock dividends)
Bonus shares are dividends paid on shares instead of cash. Bonus shares are issued by capitalising reserves. While net worth remains the
same in the balance sheet its distribution between shares and surplus is altered.

Alteration or Share Capital

If the Articles of Association authorise limited company can (I) increase share capital by issue of new shares,
(2) consolidate and divide all or any part of its share capital into shares of larger amount, (3) convert fully
paid-up shares into stock or vice versa, (4) subdivide shares into shares of smaller amount and (5) cancel
shares which have not been subscribed (does not constitute reduction of share capital). Under Section 95,
notice of alteration of capital should be sent to Registrar of Companies (ROC) within 30 days.

Increase in Subscribed Capital

Increase in the subscribed capital of a company may occur by allotment of further shares and by conversion
of debentures or loans into shares. Increase in subscribed capital by issue of new shares should be offered in
proportion to existing shares held by shareholders.

Composite Issues
Composite issues consist of rights and public issues. The SEBI guidelines provide for issues to public by
existing companies being tI priced differentially as compared to rights share holders.

Advantages of equity
From the company’s point of view
1. It represents permanent capital. There is no obligation for repayment.
2. There is no fixed obligation for payment of dividends.
3. It increases the creditworthiness of the company. In general, the larger the equity base of the company,
the higher is the ability to obtain credit.

From the investor’s point of view

1. Equity usually earns a higher rate of interest than other instruments.
2. Income from equity is exempt from tax.
3. Equity shareholders have voting rights that enable them to have controlling power in the company.

Disadvantages of equity
From the company’s point of view
1. The cost of equity capital is usually the highest.
2. Equity dividends are not tax deductible
3. The cost of issuing equity is higher than the cost of issuing other types of securities due to expenses like
brokerage, underwriting commission, advertisement, etc.
4. It results in dilution of control over the company.

From the investor’s point of view

1. Though the equity shareholders have voting power, the real control exercised by them is often weak
because they are disorganised.
2. Equity shareholders cannot insist on the payment dividend.
3. They enjoy the lowest priority in the payment of dividend and the repayment of capital.
4. Equity prices fluctuate wildly, making equity investment risky.

Preference shares
Nature
Preference shares carry preferential rights in comparison with ordinary shares. As a rule, preference
shareholders enjoy a preferential right to dividend. As regards capital, it carries on the winding up of a
company a preferential right to be repaid the amount of capital paid- up on such shares.
Cumulative and Non-cumulative
Preference shares are of two types, cumulative and non- cumulative. In the case of cumulative preference
share, if there is no profit in any year, the arrears of dividend are carried forward and paid in the following
years out of profits, before any dividend is paid on ordinary shares. No such carry forward provision exists
for non- cumulative preference shares.

Participating Preference Shares

If the articles of association provide that a preference share holder will also have the right to participate in
surplus profits or surplus assets on the liquidation of a company or in both, such preference share holders
would be called participating preference shareholders.

Redeemable preference shares

Redeemable preference shares are paid back to the shareholder out of the profits or out of the proceeds of
new issue of shares. But in the case of irredeemable preference shares the amount that is fully paid is never
returned. The shares have to state clearly that they are redeemable. It should be noted that redeemable
preference shares are not shares in the strict sense of the term. Since they are repayable, they are similar to
debentures. Only fully paid shares are redeemed. Where redemption is made out of profits, a Capital
Redemption Reserve Account is opened to which a sum equal to the nominal amount of the shares redeemed
is transferred. It is treated as paid-up share capital of the company.

Fully Convertible Cumulative Preference Share (Equipref)

Equipref is a very recent introduction (1993) into the market It consists of two parts, A and B. Part A is
convertible into equity shares automatically and compulsorily on the date of allotment. Part B will be
redeemed at par/converted into equity shares after a lock-in period at the option of the investors.
Conversion into equity shares after the lock-in period will take place at a price which would be 30 percent lower than the average market
price calculated on the basis of monthly high and low price of the share in the preceding six months including the month of conversion.

The dividend on fully convertible cumulative preference share is fixed and paid on the Part B of the share.
Upon conversion of each part of the equipref shares, the face value of it will stand reduced proportionately
and the equipref shares are deemed to have been redeemed to the extent of each part on the respective dates
of conversion.
Preference Shares with Warrants Attached
Each preference share carries a certain number of warrants entitling the holder to apply for equity shares for cash at 'premium' at any
time in one or more stages between the third and fifth year from the date of allotment. If the warrant holder fails to exercise his option,
the unsubscribed portion will lapse. The holders of warrants will be entitled to all rights/bonus shares that may be issued by the
company. From the date of allotment, the preference shares with warrants attached would not be transferred/sold for a period of three
years.

Transfer of Shares
A transfer of shares is complete as soon as the name of the transferee is substituted in place of transferor in
the register of members. The procedure on transfer of share or debenture has been laid down in Sections 108,
110 and 111 of the Companies Act.
There are two kinds of transfer: (a) a transfer under a proper instrument of transfer duly stamped and
executed by the transferor and transferee and (b) transmission by operation of law. Transfer means a
transaction by the act of the parties whereas transmission means a transaction by operation of law.
Transmission occurs on death or bankruptcy of owner.
Another form of transfer of shares is blank transfer. It must be made in prescribed form and delivered to the
company for registration within the prescribed time.

Advantages of preference shares

From the company’s point of view
1. There is no obligation to pay preference dividend.
2. There is no redemption liability in case of perpetual preference shares.
3. Preference capital is generally regarded as a [art of net worth. Hence it increases the creditworthiness of
the firm.
4. They do not usually carry voting rights. Hence they do not lead to dilution of control from the promoters.

From the investor’s point of view

1. It earns a stable dividend rate.
2. Preference dividend has been exempted from income tax.

Disadvantages of Preference Capital

From the company’s point of view
1. As compared to debt capital, it is more expensive, because the dividend paid to preference shareholders
is not tax deductible.
2. Though it is not obligatory to pay preference dividends, skipping them may seriously affect the image of
the firm.

From the investor’s point of view

1. They cannot enforce the right to dividend.
2. The rate on preference dividend is usually not very high.
Chapter 7 - Term Loans

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

Sources of term loans: Development Finance Institutions

Industrial Development Bank of India (IDBI)
The Industrial Development Bank of India (IDBI) which was established in 1964 under an Act of Parliament,
is the principal financial institution for providing credit and other facilities for development of industry .It
also promotes or develops industrial units, co-ordinates working of institutions engaged in financing, and
assisting development of such institutions. IDBI has been providing direct financial assistance to large and
medium industrial units and also helping small and medium industrial concerns through banks and state level
financial institutions.
Industrial Credit and Investment Corporation of India (ICICI)
Industrial Credit and Investment Corporation of India (ICICI) was established in 1955 as a public limited
company to encourage and assist industrial units in the country .It provides term loans in Indian and foreign
currencies, underwrites issues of shares and debentures, makes direct subscription to the issues and
guarantees payment for credit made by others.
Industrial Finance Corporation of India (IFCI)
The Industrial Finance Corporation of India (IFCI) was set up under a statute in 1948 but has been converted
into a public limited company to give flexibility to its operations. IFCI provides to industrial units, project
finance, financial services and promotional services. Under its project finance, financial assistance is
available to units in the corporate and cooperative sectors for new units, expansion, diversification and
modernisation programme in the form of rupee loans and foreign currency loans, underwriting and direct
subscription to shares, debentures, guarantees for deferred payments and foreign currency loans.
State Finance Corporations (SFCs)
At the state level, State Financial Corporations have been set-up under State Financial Corporations Act
1951. Along with the all India financial institutions, they form an integral part of the development financing
institutions in the country. There are 18 SFCs in the country. They provide financial assistance to small and
medium enterprises by term loan, direct subscription to equity/debentures, discounting of bills of exchange
and guarantees. SFCs also provide equity type assistance under the special capital and seed capital schemes
to entrepreneurs having viable projects but lacking adequate funds of their own.
Small Industries Development Bank or India (SIDBI)
Small Industries Development Bank of India has been established in 1989 to function as an apex bank for
tiny and small scale industries. It functions as the principal financial institution for promotion, financing and
development of industrial concerns in small scale sector and also coordinates functions of institutions
engaged in promotion, financing and developing industrial concerns in small scale sector. From 1993 SIDBI
is extending direct assistance to small-scale units. Such assistance of above Rs. 50 lakhs is given on a
selective basis. SIDBI will also participate with selected commercial banks in financing small-scale projects
so that working capital will be fully tied up in the case of jointly financed projects. Equipment finance
targeted at well run existing units will be extended to take up modernisation and technology upgradation.
Tourism Finance Corporation of India Ltd (TFCI)
TFCI was sponsored by IFCI which commenced operations in 1989 to sanction project loans, lease assistance and direct subscription to
shares. Apart from the conventional tourism projects in the hospitality segments, assistance sanctioned by TFCI has enabled non
conventional tourism projects like amusement parks, car rental services and air taxi passenger facilities.

Investment Institutions
Institutions like UTI, LIC and GIC and its subsidiaries also provide term loans.

Commercial Banks
Apart from these financial institutions, commercial banks also can sanction term loans.

Borrowing From Financial Institutions

Term loans can be raised from financial institutions. The decision as to which financial institution should be approached depends on
industry, location of the unit and size of project cost. For example, for projects in tourism, TFCI has to be approached.

Foreign Currency Loans from Financial Institutions

Wherever imported machinery and equipment is necessary, the financial institutions provide the necessary
foreign exchange loan after assessing the viability of the project The foreign currency loans are part of
various lines of credit for financing projects based on imported plant and equipment. The loan covers CIF
value of the capital goods and the know-how fees. Interest rate depends on the rate applicable to the foreign
currency funds utilised by the financial institution. IFCI, IDBI and ICICI grant foreign currency loans.
The promoters or merchant bankers retained by them should make an appraisal of the project to satisfy that it
is viable. Techniques described in the earlier chapters have to be applied. The next step would be design of
capital structure. The choice of debt and equity has to be made on the basis of the cost of capital and the
ability of the unit to yield a required rate of return. Before weighing how much of debt and equity, promoters'
contribution has to be taken into account.

Capital Incentives
They are part of equity. The viability of the project should however, be judged
independent of the quantum and availability of capital incentives.
Application for Term Loans
Having determined the promoters' contribution, the approximate amount of term loan has to be determined. Assume that the project cost
is Rs. 1 crore and promoters contribution is at 22.5 percent The debt equity ratio, of let us say, 2:1 is to be applied That would give debt
of Rs. 66 lakhs and equity of 33 lakhs. Out of equity of Rs. 33 lakhs, promoters' contribution of 22.5 percent of project cost or Rs. 22.5
lakhs should be deducted. That would leave equity to be raised at Rs. 10.5 lakhs and loan to be raised at Rs. 66 lakhs.

The merchant banker has also to ensure that the project adheres to the guidelines for financing of industrial
projects.
After verification that the project would be eligible for term loan, a preliminary meeting should be fixed with the financial institution. If
the DFI agrees to consider the proposal, the application for term loan along with the check list of information to be supplied, has to be
obtained.

The loan application requires details of promoters, background, technical skills, relevant experience and
financial soundness. The market research study for the project has to establish the contribution of the project
to existing and estimated demand. Aspects on technical, financial and economic appraisal are covered. Cash
flow statement for a seven to ten year period is required. The land for the project, plans for building and
quotations for the machinery from two manufacturers have to be obtained. The actual production process has
to be depicted. Finally, working capital requirements have to be estimated and a commercial bank should be
approached. Some preliminary understanding with the bank would be necessary before going ahead with the
application for term loan.
The, merchant banker's involvement would also enable him to state that he has exercised due diligence in the
exercise of his obligation under various regulations. Along with the loan application, memorandum, articles
of association, certificate of incorporation, latest annual report and statement of accounts if any, have to be
filed.
Similarly, documents are to be enclosed for the guarantor company if the loan is guaranteed.
The final structure of financing emerges after taking into account debt-equity ratio, debt service coverage
ratio and security margin. The debt equity ratio is 3: 1 for Small industrial units and 2: 1 for medium and
large units. While computing debt equity ratio, unsecured loans from friends and relatives and capital
incentives are considered a part of equity. Debt equity ratio by and large constitutes an upper limit. The
financial institution determines the proportion of debt in capital structure on the basis of the nature of the
project (capital intensive or otherwise), the ability of the project to service debt in reasonable time and the
priority of the industry in government policy into which the project falls.
Debt Service Coverage Ratio (DSCR)
The payment of interest and repayment of principal within the stipulated time is measured by DSCR. Gross
cash accruals are related to project liability in respect of interest and payment of installment towards
principal. The gross cash accruals should normally be 1.6 to 2 times to assure that the project has inherent
strength and potential to service debt.
Security Margin
The term loan is sanctioned against the security of fixed assets. Security margin represents the excess value of fixed assets over the term
loan. Normally, the term loan is 75 percent of the value of fixed assets. The security margin is 25 percent.

Term loans are granted subject to the following terms and conditions.
1. Clean title to land as security.
2. Insurance of assets, building and machinery separately.
3. Scrutiny of Articles of Association to ensure that it does not contain any restrictive clause against
covenants of the financial institutions.
4. Lien on all fixed assets.
5. Personal and corporate guarantees of major shareholders and associates concerns.
6. Undertaking from promoters to finance shortfalls in funds/cost over-run.
7. Approval of appointment of managerial personnel by DFI.
8. Further capital expenditure only on the approval of DFI.
9. Payment of dividend and issue of bonus shares subject to the approval of financial institution.
10. Undertaking for non-disposal of promoters' shareholding for a period of 3 years.
After the loan is sanctioned the requirements to be met are,
1. Acceptance of terms and conditions of loans
2. Deposit of legal charges
3. Details of plot of land for project
4. Search report and title deeds for the land
5. General body resolutions for creation of charge over assets; 6. pollution clearance
7. Legal documents to create a charge on proposed assets
8. Personal guarantees and undertakings along with income tax and wealth tax clearance of the prompters
and directors
9. Architect and auditor's certificate for civil construction.

Before the loan is disbursed, documents have to be executed and submitted. Stamp duty and registration fees
have to be paid, subscribed and paid-up capital to be brought in by the promoters as required by the DFI and
creation and registration of charge on the present and future assets of the company.
After these requirements are complied with, disbursements are made on the basis of assets created at site.
There has to be a security matching every disbursement starting with land and buildings. Balance after
security margin is paid by the DFI. As machines arrive term loan is disbursed at 75 percent of their value, the
cheque being made in the name of the supplier. In the case of large projects, disbursements are need-based.
In such cases, promoters have to bring in their entire contribution first.
In some cases after the term loan is sanctioned, a bridge loan is granted against a bank guarantee. The bank,
in turn, disburses the loan in parts ensuring that machines or assets are on site. This is done in special cases
where it is physically not possible to inspect each machine as it arrives because of locational factors or to
overcome procedural problems such as establishing clean title, pollution clearance, which require time.
Advantages of Term Loans
From the Company point of view:
1. In post tax terms, the cost of term loans is less than that of equity or preference capital.
2. Term loans do not lead to dilution of control, as the lenders do not have voting rights.
From the lender’s point of view:

1. Term loans carry fixed rate of interest and have a definite maturity period.
2. Term loans represent secured lending
3. Term loans carry several restrictive covenants to protect the interest of the lender.

Disadvantages of Term Loans

From the company point of view:
1. The interest and principal repayment are obligatory. Their non payment may threaten the existence of the
firm.
2. Term loan contracts carry restrictive covenants that restrict the managerial freedom. Further, they entitle
the lenders to put their nominees on the board of the borrowing company.
3. Term loans increase the financial risk of the firm. This in turn raises the cost of equity to the company.
From the lender’s point of view:
1. Term loans do not carry voting rights.
Term loans are not represented by negotiable securities. (They need to be securitised, to overcome this
limitation.)
Chapter 8 - Issue of ADRs and GDRs
American Depository Receipts
Definition: An ADR is a certificate issued by an American bank, which represents a foreign stock share, held
on deposit. Since the bank holds the stock, it is equivalent to trading the foreign stock.
Origin and Nature:
Introduced to the financial markets in 1927, an American Depository Receipt (ADR) is a stock, which trades
in the United States but represents a specified number of shares in a foreign corporation. ADRs are bought
and sold on American markets a just like regular stocks, and are issued/sponsored in the US by a bank or
brokerage.
ADRs were introduced as a result of the difficulty buying shares in other countries, which trade at different
prices and currency values. For this reason US banks simply purchase a large lot of shares from the company,
bundles the shares into groups and reissues them on the NYSE, AMEX, or NASDAQ. The depository bank
sets the ratio of US ADRs per home country share. This ratio can be anything less than or greater than 1. The
reason they do this is because they wish to price the ADR at a value that can be easily purchased by
individual investors yet convey substantial value to the stock. A majority of ADRs range between $10 and
$100 per share. If, in the home country, the shares are worth considerably less, then each ADR would
represent several real shares.

Why do companies use ADRs?

1. Companies may have capital demands that outstrip the availability of financing at home. It gives more
US exposure and allows them to tap into the rich North American equity markets.
2. Increasing the size of the market for its shares that may increase or stabilise the share price.
3. They also enhance the image of the company's products or services.
4. For those companies who are truly global, it allows buyers of the company's products and services to
also invest in the company.
The following are a few Indian companies whose ADRs are being traded on the American Exchanges.

Bajaj Auto Limited

Dr. Reddy's Laboratories Ltd
Finolex Cables Limited
Great Eastern Shipping Co. Ltd.
Tata Engineering and Locomotive Co. Ltd.
Videsh Sanchar Nigam Ltd (VSNL)
Types of ADRs
1. Unsponsored: These are issued by one or more depositories in response to market demand but without a
formal agreement with the foreign issuer. These are becoming less common.
2. Sponsored: These ADRs are issued by a depository appointed by the foreign issuer under a Deposit
Agreement. There are three levels of sponsored ADRs:
a. Level I: They trade on the U.S. OTC market but cannot be used to raise capital. The foreign issuer does
not have to comply with SEC disclosure.
b. Level II and III: These are for foreign issuers who want a listing on a recognised exchange and the ability
to raise capital in the U.S.
c. Private Placement Depository Receipt: These allow foreign companies to have easy access to the U.S.
private placement market with Qualified Institutional Buyers.

Benefits of ADRs to investors:

- Abundant Selection
- Easier than buying foreign shares
- Entitled to the same information disclosure as holders of the underlying security
- All notices and reports are issued in English
- All issuers must report by U.S. standards
- Simplicity
- Safety
- Denominated in U.S. dollars
- Liquidity
- U.S. research is available
Global Depository Receipts
Nature and Definition: Global depository receipts (GDRs) are essentially instruments created by overseas
depository banks which are authorised by issuing companies in India to issue outside the country. GDRs are
issued to non-resident investors against the shares of the issuing companies held with the nominated domestic
custodian banks. They are negotiable certificates that usually represent a company's publicly traded equity
and are denominated in US dollars. They are listed on a European Stock Exchange-often Luxembourg, but
London is also used. Each depository receipt represents a multiple number or fraction of the underlying share
or alternatively the shares correspond to the GDR in a fixed ratio say of 1 GDR = 10 shares.
The price of GDRs reflects the price performance of the underlying shares.
GDRs can be redeemed at the price of the corresponding shares of the issuing company ruling on the date of
redemption. For all good purposes, GDRs can be treated as direct investment in the issuing companies. There
are however, ceilings on foreign equity participation. GDRs simplify cross-border trading and settlement,
enhance liquidity, minimise transaction costs, accommodate legal restrictions or direct ownership of shares,
realise tax advantages and broaden investor base.
Permission for Issue: An applicant company seeking Government's approval in this regard should have
consistent track record for good performance (financial or otherwise) for a minimum period of 3 years. This
condition would be relaxed for infrastructure projects such as power generation, telecommunication,
petroleum exploration and refining, ports, airports and roads.

Clearance Requirements
a.) "In Principle Approval" by DEA for issue of GDR/FCCB.
b.) Approval by FIPB in the case of Industries/activity that is outside the purview of Annex
III items or cases involving foreign equity beyond 51% foreign equity after the proposed
GDR issue.
c.) Approval from Department of Company Affairs under the provisions of Companies
Act, if necessary.
d.) Any other mandatory approval under Government Laws, if any, like IMC approval for
joint venture, Cabinet approval etc.
e.) "Final Approval" by DEA for issue parameters where other mandatory approvals are involved, DEA's
final approval will be granted only after other approvals are obtained by the GDR issuing company.

Use of GDRs
The proceeds of the GDRs can be used for financing capital goods imports, capital expenditure including
domestic purchase/installation of plant, equipment and building and investment in software development,
prepayment or scheduled repayment of earlier external borrowings, and equity investment in JVs in India.

Restrictions
However, investment in stock markets and real estate will not be permitted. Companies may retain the
proceeds abroad or may remit funds into India in anticipation of the use of funds for approved end uses. Any
investment from a foreign firm into India requires the prior approval of the Government of India.
Advantages of GDR for the Issuer: The share price of the company may stabilise because of the widening
of the market. The image of the issuer is also enhanced in the global market. Euro issues cost less than
domestic rights issue. Companies making Euro issues may have understanding with depository bank
resulting in certain voting pattern. The Indian Company does not bear any foreign exchange risk since the
securities are denominated in rupees. On the other hand, it receives the proceeds of Euro-issue in foreign
currency. Euro-issues are easier to administer since dealings are with a single shareholder, the custodian
depository bank.
Advantages to the Investor: In regard to the investors, they enjoy the benefits of international
diversification while avoiding long delays in settlement and transfer of shares, confusing trade and tax
practices. GDRs are quoted in dollars and dividends are paid in dollar, free of foreign exchange risk. They
enable the foreign investor to avoid restriction on purchase and holding of individual company's shares.
GDRs are quite as liquid as the underlying shares and they can be exchanged for shares. GDR transactions do
not involve the foreign investor in SEBI approval as a foreign investor. Finally, GDRs are attractive to
foreign investors because the returns are large.
Chapter 9 - Lease Finance
Introduction
Lease finance has emerged as a source of financing project cost over the last few years. Lease finance is a
cheap and flexible means of financing as compared to term loans from financial institutions. While the
investor or lender in conventional financing looks to the cash flow from the issuers' overall business to
provide the return on investment or loan, in lease finance, the investor or lender looks principally to the cash
flow from the specific assets or collection of assets in which their funds are invested, for these returns.

Definition and Nature

Lease is a rental agreement that extends for a year or more and involves a series of fixed payments.
Generally, firms own fixed assets and report them in their balance sheet. For carrying on economic activity or
organising production, the access or use of equipment and building is important than their ownership.
Leasing achieves the
separation of ownership from economic use. Traditionally, firms obtained use of assets by buying them.
However, an alternative is to lease equipment. Actually, anything can be had on lease and in advanced
countries 25 percent of all new capital equipment acquired by business is at lease.
There are two parties to a lease. The user of the asset is the lessee who makes periodic payments to the owner
of the asset who is called the lessor. Lease agreements contain an option to the lessee to purchase the asset at
fair market value at the end of the lease period. The burden of costs the lessee or lessor have to bear differ
according to the type of lease. The lessor is responsible for maintenance, insurance and payment of property
taxes in the case of a full service lease. The lessee is responsible for these costs under a net lease.
The terms of the lease as well as the rights of the lessee vary from lease to lease. For instance, operating
leases are short-term leases and can be terminated at the lessee's option prior to the end of the contract period.
Among long term leases are financial or capital leases which extend over the estimated useful economic life
of the asset and cannot be cancelled by the lessee before the expiry of the lease. Where they are cancellable,
the lessee has to reimburse the lessor for any losses occasioned by the cancellation.

Leasing industry consists mainly of finance and leasing companies who are lessors. Several banks have
added leasing activity to their business. Finance companies undertake leasing as one of their activities.

Types of Leases
There are four kinds of leases:
Sale and Lease Back
Under this lease a firm that owns the asset (building, land and equipment) sells the asset and simultaneously

executes an agreement to lease the asset back for a specified period on specific terms. The sale and lease

back instrument is an alternative to mortgage. The firn which sells the assets is the lessee. It receives the

purchase price put by the buyer or the lessor. The seller-lessee retains the use of the assets. The lease
payments under sale and lease back are set so as to return the full purchase price to the investor-lessor while

providing a specified rate of return on the lessor's outstanding investment.

Operating Lease
They are also called service leases and provide for the lessor to maintain and service the leased asset and the
cost of such maintenance is built into the lease payment. Operating leases are frequently not fully amortised.
The lessor expects to recover the full investment costs through subsequent rental payments, leases or sale of
leased equipment. Operating leases frequently contain a cancellation clause which gives the lessee the right
to cancel the lease.
Structuring of the Operating Lease
The equipment leased under an operational lease has an established use or an active second hand market. The
equipment is leased for relatively short periods of around six months to a year or two years. Longer duration
is adopted for ships and aircraft. In view of these factors, the cost of equipment is not sought to be fully
recovered by the lessor through rental from a single lessee. The equipment may be given on lease to a
succession of lessors over the economic life of the equipment The lessor may also sell the equipment in
second hand market. Finally, in cases where the lessor activities are restricted to a given range of equipment,
he may be able to offer attractive lease terms reflecting his purchase discounts, lower maintenance cost and
expertise in the range of equipment he specialises.
Financial or Capital Lease
Financial or capital lease involves a long term commitment between lessor and lessee. The lease duration is
generally equal to half of the expected life of the asset. But financial lease differs from operating lease in
three respects:
• They do not provide for maintenance service
• They can not be cancelled
• They are fully amortised.
The equipment is selected by the firm that uses it (lessee) and negotiates the price and delivery terms with the manufacturer. The user
firm negotiates with the leasing unit to buy the equipment from the manufacturer or distributor and after purchase the lease agreement is
executed by the user.

The lease payment is a fixed obligation of the lessee and apart from amortising the cost of asset, leaves a
return to the lessor.

Financial Lease
A financial lease is a long term agreement, generally extending over the estimated economic life of the asset.
Under the agreement, the lessor agrees to finance the use of the equipment by the lessee over a time period
and is generally not subject to cancellation by the lessee before the end of the base lease period. Financial
lease is a source of finance for the acquisition of the equipment. Signing a financial lease contract is like
borrowing money. Financial leases are also called full payout leases as they enable a lessor to recover his
investment in the lease and make a profit.

Leveraged lease
A leveraged lease is arranged when the equipment is very costly. Leveraged leases are financial leases in
which the lessor borrows a part of the purchase price of the leased asset, using lease contract as the security
of the loan. In the leveraged lease, the cost of the leased asset is financed by issuing debt and equity claims
against the asset and the future lease payments. The leveraged lease has a longer maturity owing to its high
value.
Generally, there are three parties in the leveraged lease, which include the lessor, the lessee and the lender of
funds. The lessor provides equity funds and is generally termed as equity participant and the lender is called
the debt participant. While the lessee pays rentals without much difference of the nature of the lease, the
lessor receives leveraged lease rentals after debt service, taxes and other expenses. The lessor obtains
maximum tax shelter under the leveraged lease such as complete tax benefits of depreciation as owner of the
equipment despite limited equity participation.
The funds borrowed to finance the cost of the assets are of nonrecourse nature i.e. the debt is secured by a
first charge on the equipment or lien on lease rentals beyond which the lessor is not liable for the debt
obligation. The agreement may, however, create a lien on other assets for realisation of debt from the lessor.
The cost of the lease depends upon the weighted cost of the capital.
Requirements for a leveraged lease are,
a) The existence of a large value equipment providing for substantial depreciation,
b) The inability of either the lessee or a single lessor to utilise depreciation in good time,
c) The availability of a lender willing to extend funds to the user on the strength of user's credit rating
d) The existence of equity investors (lessors) with potentially large tax outflow.
Advantages of Leasing:
Short Term: Operating leases are short term which constitute a convenient means of obtaining the use of an
asset for a relatively short period of time. They also relieve the lessee of product obsolescence.
Full Funding: Leasing provides 100 percent of equipment finance.
Simplicity: A leasing agreement is simple to negotiate and administer. The documentation is quicker as
compared to 'security tied' credits such as term loans. The procedure for lease financing is much simpler than
any other form of asset-backed financing.
Reduced cost of borrowing: Lease finance is highly cost effective source of funds for smaller companies. A
large leasing company may be able to borrow more cheaply than a smaller operating company. Transaction
costs are also lower for lessors of readily saleable assets.
Swapping Tax Shields: In situations where the lessor is in tax paying position vis-a-vis the lessee, the lessor
can pass on a part of the benefit to the lessee through a lowering of the lease rental.
New Source or Funds: Lease financing may permit a lessee to tap a new source of funds such as finance
companies.
Lease Rentals: Lease rental can be structured to accommodate the operational cash-flow pattern of the lessee
and aid tax planning of the lease rental. As a result, lease funding may work out cheaper than a term loan.
Restrictive Covenants: Lease agreements are free of restrictive covenants and conditionalities as compared
to term-loan agreements. Lease financing is more comprehensive.
Expenses: Most of the expenses associated with the leased equipment can be built into the lease and
amortised over the lease period. These expenses include delivery charges, interest on advance payments,
taxes and installment payments. These expenses are generally not financed under a term loan. Leasing can
also be used in project financing with the rentals structured so as to defer lessee's payment obligation till the
asset is in commercial operation. Further, lease rentals can be structured to get maximum tax benefit. In view
of the accelerated amortisation of equipment, the risk of obsolescence is minimised under a lease.
Dilution of Equity: Dilution of equity by the issuance of equity or convertible term finance can be avoided
in lease financing.

Disadvantages or Leasing
The principal disadvantages are lessee's forfeiture of the tax benefits of ownership and loss of residual value.
In opting for a lease, the lessee may have to accept some restrictions. The lessee also assumes a higher
financial obligation in the event of equipment being found operationally unsuitable or if lessee opts for an
early termination of the lease agreement Incentives and grants available to owners of assets who are also end
users are lost in the case of a lease by both lessor and lessee. Finally, in several states of the Indian Union,
sales tax is applicable on lease rentals rendering lease finance, cost ineffective.
Chapter 10 - Working Capital Financing
Introduction
Working capital refers to current assets and liabilities. Strictly, it is not a part of Project Finance, which deals with financing of fixed
assets. But working capital has to be dealt with under project finance for two reasons: first, the margin money for working capital has to
be financed by long term sources and, secondly, it is seen that many a unit flounders because of inadequate working capital. Promoters
have to ensure adequate working capital to reach breakeven point and step up capacity utilisation, if available. It is essential that such
estimates are available and resources are tied up to meet the working capital requirements of the project.

Concepts of working capital

Working capital is the capital you require for the working i.e. functioning of your business in the short run.

Gross working capital refers to the firm’s investment in the current assets and includes cash, short term
securities, debtors, bills receivables and stock (inventories).
It is necessary that the investment in the current assets should be neither excessive nor inadequate.
WC requirement of a firm keeps changing with the change in the business activity and hence the firm must
be in a position to strike a balance between them. The financial manager should know where to source the
funds from, in case the need arises and whereto invest in case of excess funds.

Net working capital refers to the difference between the current assets and the current liabilities. Current
liabilities are those claims of outsiders, which are expected to mature for payment within an accounting year
and include creditors, bills payable, bank overdraft and outstanding expenses.
When current assets exceed current liabilities it is called Positive WC and when current liabilities exceed
current assets it is called Negative WC.

The Net WC being the difference between the current assets and current liabilities is a qualitative concept. It
indicates:
 The liquidity position of the firm
 Suggests the extent to which the WC needs maybe financed by permanent sources of funds

Operating Cycle and Cash Cycle

All business firms aim at maximising the wealth of the shareholder for which they need to earn sufficient
return on their operations. To earn sufficient profits they need to do enough sales, which further necessitates
investment in current assets like raw materiel etc. There is always an operating cycle involved in the
conversion of sales into cash.
The time required to complete the following sequences of events in case of a manufacturing firm is
called the operating cycle.
1. Conversion of cash into raw material
2. Conversion of raw material into WIP
 3. Conversion of WIP into FG
4. Conversion of FG into debtors and bills receivable through sales
5. Conversion of debtors and bills receivable into cash

Each component of working capital (namely inventory, receivables and payables)

has two dimensions -time and money. When it comes to managing working capital, Time Is
Money. Therefore, if cash is tight, one should consider other ways of financing capital
investment - loans, equity, leasing etc. Similarly, if you pay dividends or increase
drawings, these are cash outflows remove liquidity from the business.

If you ....... Then ......

• Collect receivables (debtors) faster You release cash from the cycle
• Collect receivables (debtors) slower Your receivables soak up cash
• Get better credit (in terms of duration or You increase your cash resources
amount) from suppliers

• Shift inventory (stocks) faster You free up cash

• Move inventory (stocks) slower You consume more cash

Operating Cycle Of Non Manufacturing Firms / Operating Cycle Of

CASH
Service And Financial Firms

DEBTORS

CASH DEBTORS

STOCK OF
FINISHED GOODS

Operating cycle of non-manufacturing firm like the wholesaler and retail includes conversion of cash into
stock of finished goods, stock of finished goods into debtors and debtors into cash. Also the operating cycle
of financial and service firms involves conversion of cash into debtors and debtors into cash.
Thus we can say that the time that elapses between the purchase of raw material and collection of cash for
sales is called operating cycle whereas time length between the payment for raw material purchases and the
collection of cash for sales is referred to as cash cycle.
The operating cycle is the sum of the inventory period and the accounts receivables period, whereas the cash

cycle is equal to the operating cycle less the accounts payable period.
 CASH RECD.
ORDER PLACED STOCK ARRIVES STOCK GOES

INV. PERIOD A/C’S REC. PERIOD

A/C’S Pay. Period

FIRM REC. INVOICE CASH PAID FOR

MATERIALS

OPERATING CYCLE

CASH CYCLE
Operating Cycle and Cash Cycle
Factors influencing the working capital requirement

All firms do not have the same WC needs .The following are the factors that affect the WC
needs:
1. Nature and size of business: The WC requirement of a firm is closely related to the
nature of the business. We can say that trading and financial firms have very less
investment in fixed assets but require a large sum of money to be invested in WC. On
the other hand Retail stores, for example, have to carry large stock of variety of goods
little investment in the fixed assets.
Also a firm with a large scale of operations will obviously require more WC than the smaller firm.

The following table shows the relative proportion of investment in current assets and fixed assets for certain
industries:
Current assets Fixed assets Industries
(%) (%)
10-20 80-90 Hotel and restaurants
20-30 70-80 Electricity generation and Distribution
30-40 60-70 Aluminum, Shipping
40-50 50-60 Iron and Steel, basic industrial chemical
50-60 40-30 Tea plantation
60-70 30-40 Cotton textiles and Sugar
70-80 20-30 Edible oils, Tobacco
80-90 10-20 Trading, Construction

2. Manufacturing cycle: It starts with the purchase and use of raw materials and completes with the
production of finished goods. Longer the manufacturing cycle larger will be the WC requirement, this is
seen mostly in the industrial products.
3. Business fluctuation: When there is an upward swing in the economy, sales will increase also the firm’s
investment in inventories and book debts will also increase, thus it will increase the WC requirement of
the firm and vice-versa.
4. Production policy: To maintain an efficient level of production the firm’s may resort to normal
production even during the slack season. This will lead to excess production and hence the funds will be
blocked in form of inventories for a long time, hence provisions should be made accordingly. Since the
cost and risk of maintaining a constant production is high during the slack season some firm’s may resort
to producing various products to solve their capital problems. If they do not, then they require high WC.
5. Firm’s Credit Policy: If the firm has a liberal credit policy its funds will remain blocked for a long time
in form of debtors and vice-versa. Normally industrial goods manufacturing will have a liberal credit
policy, whereas dealers of consumer goods will a tight credit policy.
6. Availability of Credit: If the firm gets credit on liberal terms it will require less WC since it can always
pay its creditors later and vice-versa.
7. Growth and Expansion Activities: It is difficult precisely to determine the relationship between
volume of sales and need for WC. The need for WC does not follow the growth but precedes it. Hence,
if the firm is planning to increase its business activities, it needs to plan its WC requirements during the
growth period.
8. Conditions of Supply of Raw Material: If the supply of RM is scarce the firm may need to stock it in
advance and hence need more WC and vice-versa.
9. Profit Margin and Profit Appropriation: A high net profit margin contributes towards the WC pool.
Also, tax liability is unavoidable and hence provision for its payment must be made in the WC plan,
otherwise it may impose a strain on the WC.
Also if the firm’s policy is to retain the profits it will increase their WC, and if they decide to pay their
dividends it will weaken their WC position, as the cash will flow out. However this can be avoided by
declaring bonus shares out of past profits. This will help the firm to maintain a good image and also not part
with the money immediately, thus not affecting the WC position.
Depreciation policy of the firm, through its effect on tax liability and retained earning, has an influence on
the WC. The firm may charge a high rate of depreciation, which will reduce the tax payable and also retain
more cash, as the cash does not flow out. If the dividend policy is linked with net profits, the firm can pay
fewer dividends by providing more depreciation. Thus depreciation is an indirect way of retaining profits and
preserving the firms WC position.

Financing Working Capital

Sources
Working capital may be obtained from different sources such as raising from funds from capital market through issue of shares and
debentures, borrowing from banks, directors, and shareholders and trade credit. Internal sources such as retained earnings and
depreciation may be good for an established unit. In the case of a new unit, a portion of working capital, margin, may be financed by
equity.

Core current assets

To maintain the operating cycle, current assets are required which vary over time. But a minimum level is required to ensure continuous
production, which is known as fixed or permanent working capital or core current assets. The core current assets represent the absolute
minimum stock of raw materials, goods in process and finished goods and stores, which are in pipeline to ensure continuity of
production.

Usually, banks insist that the permanent portion of the working capital requirement be brought by the promoters from long term sources
– either equity or debt.

Variable working capital

On the other hand, excess balance of current assets is required to support varying levels of production and sales caused by seasonal
factors. While fixed and variable components are required to facilitate production and sale through operating cycle, variable working
capital is required to meet the liquidity, which is temporary. The choice of sources for financing working capital has to be made on the
basis of their suitability for fixed and variable components.

Sources of Working Capital

A combination of short and long term finances is used to finance to WC requirements. Current assets are
normally financed by the short-term sources, which include the following:
1. Accruals: This includes what the firm owes to the employees. Its main components are wages and taxes.
Since they are payable at a future date, they have been accrued but not shown as paid in the balance
sheet. Till that time they serve as source of finance. They are a source of spontaneous financing. Since
the firm pays no interest, they are regarded as a ‘free’ source of finance.
2. Trade Credit: It is a spontaneous source of financing, which constitutes 25 to 50 % of short term
financing. Obtaining trade credit depends on:
a) Earnings record over a period of time
b) Liquidity position of a firm over a period of time
c) Record of payment.
d) The confidence of the suppliers
3. Forms Of Bank Finance: Banks are the most important source of Working Capital Finance. They give
working capital advances in the following ways:
 Cash Credits / Overdrafts: Under this arrangement the borrower can borrow upto a fixed limit and repay
it as and when he desires. Interest is charged only on the running balance and not on the sanctioned
amount. A minimal chare is payable for availing this facility.
 Loans: They are either credited to the current account of the borrower or given to him in cash. A fixed
rate of interest is charged and the loan amount is repayable on demand or in periodical installments.
 Purchase/Discount of Bills: A bill may be discounted with the bank and when it matures on a future date
the bank collects the amount from the party who had accepted the bill. When a bank is short of funds it
can sell or rediscount the bill on the other hand the bank with surplus funds would invest in bills.
However, with discount rates at 13-14 per cent for 90-day paper, bill discounting is an expensive source
of short-term funds.
 Letter Of Credit: When an L/C is opened by the bank in favour of the customer it takes the responsibility
of honoring the obligation in case the customer fails to do so. In this case though the customer provides
the credit the risk is borne by the bank.
4. Public Deposits:
There are certain provisions under the Companies Act, 1956 (the Act) under which a company may accept
fixed deposits from public/shareholders to meet its short term requirements.
Section 58A of the Act deals with the acceptance of deposits.

Pursuant to the provisions of the Act, the company cannot invite, or allow any other person to invite or cause
to be invited on its behalf, any deposit unless –
 It is in accordance with the prescribed rules.
 An advertisement is issued showing the financial position of the company and
 The company is not in default in the repayment of any deposit or interest.
In case of non banking and non financial companies, the Central Government has issued `Companies (Acceptance of Deposits) Rules,
1975’ and in case of non banking financial companies, the Reserve Bank of India has issued `Non Banking Financial Companies
Acceptance of Public Deposits (Reserve Bank) Directions, 1998’ which have to be complied with along with the provisions of Section
58A of the Act.
For its short term requirements, companies normally prefers to accept fixed deposits instead of taking loans from banks as the rate of
interest for deposits is generally less as compared to interest charged by banks. Normally, listed companies come out with the schemes
of fixed deposits. Response to such listed companies from public is better as compared to unlisted companies.

Limits for accepting deposits

A Company can borrow deposits upto the extent given below:
 upto 25% of the paid-up capital and free reserves of the company from the public and
 Upto 10% of its paid-up capital and free reserves from its shareholders.
Therefore, maximum deposit a company can accept from public/shareholders is 35% of its paid up capital
and free reserves as mentioned above.
If the company is a `Government Company’, then it can accept or renew deposits from public upto 35% of its

paid up capital and free reserves.

"Free Reserves" mean the balance in the share premium account, capital and debenture redemption reserves
and any other reserves shown in the balance-sheet of the company and created by appropriation out of the
profits of the company, but does not include (i) the balance in any reserve created for repayment of any
future liability or for depreciation in assets or for bad debts; and (ii) by the revaluation of any assets of the
company.
Period of accepting deposits
A Company can invite/accept deposits for a period not less than 6 months and not more than 36 months from
the date of acceptance of such deposits or from the date of its renewal.
Therefore, a company can accept/invite deposits for a period between 6-36 months.
However, a company may accept deposits upto 10% of its paid up capital and free reserves which are

repayable after three months, from the date of such deposits or renewal thereof to meet any of its short term

requirements.

Advantages of Public Deposits from the Company’s point of view:

 Simple procedure for obtaining deposits
 No restrictive covenants are involved
 No security needs to be offered
 The post tax cost is fairly simple
Disadvantages of Public Deposits from the Company’s point of view:
 Only limited amount of funds can be raised
 The maturity period being short, the funds have to repaid faster
Advantages of Public Deposits from the investor point of view:
 Higher rate of interest
 Short period of maturity, normally 1 to 3 years
Disadvantages of Public Deposits from the investor point of view:
No security offered by the company
 The interest on public deposits is not exempt from tax
5. Inter-Corporate Deposits:
They are defined as deposits made by one Company in another company for a period upto 6 months. They
are divided into the following types:
 Call deposits: They are withdrawable by the lender after giving a day’s notice, however in real life it
takes about three days. The interest on such deposits is around 16 % p. a
 Three-months deposit: they are taken to overcome the shortage resulting out of disruption in production,
excessive imports of raw material, tax payment, delay in collection, etc. The interest in this case is
normally around 18 % p.a.
 Six-months deposits: They are normally made with good borrowers and the interest rate in this case is
around 20 % p.a.

Important characteristics of the inters-corporate deposits market include:

 Lack of regulation: It has helped to make inter-corporate deposits hassles free and hence very convenient
 Secrecy: The brokers do not reveal the names of their borrowers and lenders, which would other wise
lead to unwanted competition and underwriting of rates
 Importance of personal contacts: The lending decisions in these markets are often based on personal
contacts rather than reliable market information
Although deposits can be of varying maturity structures, they work best as short-term bridging instruments and not as a regular funding
source.

6. Short-Term Loans From Financial Institutions: The LIC, GIC and UTI provide short-term loans to
manufacturing companies that have a good track record. The following are the eligibility conditions if
obtaining the loans:
 Declared an annual dividend of 6 % for the past 5 years, in some cases it is 10 % over last 3 years
 The debt equity ratio should not exceed 2:1
 The current ratio should be at least 1:1
 The average of the interest cover ratios for the past three years should be at least 2:1

The important features of the short-term loans provided by the financial institutions include:
 They are unsecured and given on the basis of a demand promissory note
 The loan is given for a period of 1 year and can be renewed for two consecutive years if the eligibility
conditions are satisfied
 The company has to wait for at least 6 months after its repayment in order to avail of a fresh loan

7. Rights Debentures For Working Capital: In order to get long term resources for working capital, the
public limited companies can issue ‘rights’ debentures to their shareholders. The key guidelines to be
followed include:
 The amount of debenture issue should not exceed 20 % of the gross current assets, loans and advances
minus the long term loans presently available for financing working capital OR 20 % of paid up share
capital, including preference capital and free reserves, whichever is the lower of the two
 The debt - equity ratio including the proposed dividend issue should not exceed 1:1
 They shall be first offered to Indian resident shareholders of the company on a pro rata basis
8. Commercial Paper: Large firms who are financially strong issue commercial paper .It represents a short-
term unsecured promissory note issued by firms of high credit rating. Its important feature include:
 Maturity ranges from 60-180 days
 It is sold at a discount from its face value and redeemed at its face value. Thus the implicit interest rate is
a function of size of the discount and the period of maturity
 Either directly placed with investors or sold through dealers
 Usually bought by investors who keep it till the maturity and hence no well developed secondary market

Who can issue CP?

Highly rated Corporate Bodies, primary dealers, satellite dealers and All-India financial institutions have
been permitted to raise short-term resources.
Eligibility of issuing CP
 Minimum tangible net worth as per the latest audited balance sheet is Rs. 4 crore.
 Company has been sanctioned working capital limit by bank(s) or all-India financial Institution(s) and
 Borrowal account of the company is classified as a Standard Asset by the financing
bank(s)/institution(s).
 Minimum Credit Rating required from recognised credit rating agencies.
Minimum credit rating required to issue CP
Specified credit rating of P2 is obtained from Credit Rating Information Services of India Ltd. (CRISIL), A2
in the case of Investment Information and Credit Rating Agency of India Limited (ICRA) and PR2 in the
case of Credit Analysis and Research Limited (CARE),
Maturity period of CP
The CP can be issued for maturities between 15 days to 1 year from the date of its issue.
Minimum amount of investment and denomination of CP
The minimum amount required to be invested by a single investor is atleast Rs. 5 lakhs. It can be issued in
denominations of Rs. 5 lakh or multiples thereof.
Who can act as Issuing and Paying Agent (IPA)?
Only a scheduled bank can act as an IPA for issuance of CP.
Who can invest in CP?
CP may be issued, to and, held by individuals, banking companies, other corporate bodies registered or
incorporated in India and unincorporated bodies, Non-Resident Indians (NRIs) and Foreign Institutional
Investors (FIIs). However, investment by FIIs would be within the limits set for their investments by
Securities and Exchange Board of India (SEBI).
Mode of issuance of CP
CP can be issued either in the form of a promissory note or in a dematerialised form through any of the depositories approved by and
registered with SEBI. As regards the existing stock of CP, the same can continue to be held either in physical form or can be
dematerialised, if both the issuer and the investor agree for the same.

Procedure of issuing CP
Every issuer must appoint an IPA for issuance of CP. The issuer should disclose to the potential investors its
financial position as per the standard market practice. After the exchange of deal confirmation between the
investor and the issuer, issuing company shall issue physical certificates to the investor or arrange for
crediting the CP to the investor’s account with a depository. Investors shall be given a copy of IPA certificate
to the effect that the issuer has a valid agreement with the IPA and documents are in order
9. Factoring:
A factor is a financial institution set up to provide services related to management and financing of debt

arising from credit sales.

The important features of factoring services include:

 The factors selects the account of the clients, and establishes credit limits applicable to the selected
accounts
 It takes the responsibility for collecting the debt of accounts handled by it. For each account the factor
pays to the client at the end of the credit period or when the account is collected, whichever comes
earlier
 The factor advances the money to the client against not yet collected and not yet due debts. Normally the
amount received is 70-80 % of the face value of the debt and carries an interest rate which is equal or a
little higher than the lending rate of the commercial banks
The credit risk could be borne by the client or the factor. In India it is mostly on the recourse basis, i.e. the

risk is borne by the client.

The factor charges a commission which may be 1-2 % of the face value of the debt factored.
Advantages of factoring:
 Ensures definite pattern of cash inflows from credit sales
 Continuous factoring may virtually eliminate the need for the credit and the collection department
Disadvantages of Factoring
 Comparatively an expensive form of financing
 The factoring debt may be perceived as a sign of financial weakness

10. Loan Syndication

Borrowing for working capital from a single commercial bank or a consortium has restricted fund flows to
corporates. Loan syndication, a method used in Euro-dollar market is an alternative to consortium lending.
The major benefits reaped by corporates, in syndication, are amount, tenor and price. The syndication method
reverses the current practice where the corporate borrower faces rigid terms in a take it or leave it situation.
The cost of syndication is likely to vary with credit risk. Borrowers of high credit standing are likely to get
best terms. Syndications make for efficient pricing and are administratively easier.
In loan syndication, the borrower approaches several banks, which might be willing to syndicate a loan,
specifying the amount and tenor for which the loan is to be syndicated. The syndicated loans are being
discussed as an alternative for consortium loans for working capital. But they can be used for project
financing, as is the practice in the Euro- dollar market. On receiving a query, the syndicator or the lead bank
scouts for banks that may be willing to participate in the syndicate. The lead bank/syndicator assembles a
management group of other banks to underwrite the loan and to market shares in it to other participating
banks.
The lead bank or syndicator can underscore his willingness to syndicate the loan on a firm commitment basis
or on a best efforts basis. The former is akin to underwriting and will attract capital adequacy norms reducing
the bank's flexibility. Once the syndicator/ lead bank receives the mandate from the borrower, a placement
memorandum is prepared by the lead bank and the loan is marketed to other banks who may be interested in
taking up shares. The placement memorandum helps the banks to understand the transaction and provides
information about the borrower. On the basis of data in the placement memorandum, banks make a
reasonable appraisal of the credit before deciding about the participation in the loan. Once the bank decides
to become a member of the syndicate, it indicates the amount and the price it is likely to charge on the loan.
Based on the information received from all participating banks, the lead bank/syndicator prepares a common
document to be signed by all the members of the syndicate and the borrowing company. The document
usually lists out details of the agreement with regard to tenor, interest, loan pre-payment, security, warranties
and agency. While the borrower signs only one document, he shares separate contractual relationship with
each syndicate member. The agent to the loan who is normally the lead bank/ syndicator attends to all
administrative work such as collection of interest and amortisation of the loan. Agent's fees is a yearly
charge.
A syndicated loan would have a funded component or core component on which interest will be charged on
the loan being sanctioned and a standby line of credit which would meet the adhoc increases in credit needs
of borrower. Interest on the standby portion will be charged only on the amount withdrawn. However, a
commitment fee is charged on unutilised portion.
The total syndicated loan could take care of the requirement for project finance and working capital. The loan
could dispense with the restrictions or norms of the working capital assessment. The interest charge can
either be floating or fixed. Actually working capital requirements for, say, a five-year period, may be on a
floating rate basis pegged to minimum lending rate.
Case Study 1 - Konkan Railway Corporation (KRC)

Methodology: Interview with Mr. RK Sinha, Director, Finance, Konkan Railway

Corporation.

Findings:

The project:
The Konkan Railway is the missing link between India's commercial capital, Mumbai and Mangalore. The
760 Km. line now connects Maharashtra, Goa and Karnataka - a region of criss-crossing rivers, plunging
valleys and mountains that soar into the clouds.
With a total number of 2,000 bridges and 92 tunnels to be built through this mountainous terrain containing
many rivers, the project is the biggest and perhaps most difficult railway undertaking during this century, at
least in this part of the world. The various problems, had been carried out efficiently and in a very short time.
The largest railway project in this part of the world in the last five decades threw up a whole range of
difficulties technical, financial, emotional and psychological. The rocky Sahyadris had to be bored through,
1,500 rivers had to be forded, a railway line had to be built out of nowhere. And sometimes, poisonous
snakes and tigers had to be faced.

Objective of the project

The project intended to provide alternate, permanent and shorter transport facilities to this part of the country.
It aimed at improving access to the fertile areas of Konkan and thus ensure economic development of the
region.

The Appraisal
Before the project was handed over to the KRC, it was being handled by the Southern Railway.
A two level appraisal was followed:

1. A rough estimate of the returns from the project was made. The project was expected to generate an
internal rate of return (IRR)of 14 percent.
2. A Detailed Project Report was prepared. This report consisted of two parts:

• Detailed Engineering Survey

• Detailed Traffic survey

The Engineering Survey aimed at studying the land terrain to arrive at the optimum alignment between the
starting and the end points of the rail network. For this, the following two factors were kept in mind:

1) The land acquisition had to be minimum. That is, not too many inhabited areas were to be affected by
the project. Hence, emphasis was laid on laying the track from around the inhabited areas.
2) Arriving at the optimum path to minimise the cost of levelling the land. To level the land for laying the
track, three things could be done:
- Building bridges
- Boring tunnels through the mountain
- Earthwork, i.e., either ‘cutting’ the land or ‘filling’ the land
The Traffic Survey consisted of Origin-Destination Study (OD). The OD consisted of studying the industries
in the catchment area, through the questionnaire method. It is essentially the ‘end use’ method of demand
forecasting. It aimed at finding out the movement of raw materials and finished goods into and through the
project area. Estimates were also made regarding future bulk traffic on account of the establishment of Essar
Steel in Ratnagiri, Usha Ispat, etc. Similarly, cement plants were expected to be established at Saurashtra and
hence increase the flow of traffic.

Estimated cost of the project:

The project, as estimated by the Southern Railway Corporation in 1989-90, was expected to cost Rs.861
Crore.
However, the government did not have the funds to meet the cost of the project. Hence the need was felt to
separate the project from the government. This would enable access to the capital market. however that
would essentially mean the privatisation of railways, which was not acceptable to the government. Hence the
idea of Konkan railway bonds took birth. The debt equity ratio for the project was fixed at 3:1.

The project had not taken off for two years. In 1991, the KRC took the project over from the Southern
Railway. This was on a BOT basis. Providing for the inflation for two years @10%, the project cost went up
to Rs. 1043 crore from Rs. 861 crore earlier.
The equity was fixed at Rs. 250 crore and the debt (only bonds) at Rs. 750 crore. The central government
roped in four state governments to subscribe to the equity. Accordingly, the ownership pattern of the KRC
was now as follows:
Ministry of Railways : 51%
Maharashtra: 22%
Karnataka: 15%
Goa: 6%
Kerala: 6%

The interest rate on the bonds, which were tax free, was fixed at 9%. This was raised to 10.5% by the
Ministry of Finance in 1992. The interest was payable even during the construction period. Thus the cost of
the project rose to Rs 1600 crore.

There was a need for further funds, but the securities scam of 1992 depressed the primary market for bonds
too. Hence, KRC resorted to External Commercial Borrowings of $115 million (Rs. 409 crores).
Sale and Lease Back was another source of finance that KRC resorted to. It sold off the already constructed
railway tracks to Infrastructure Leasing and Financial Services (IL & FS) and raised Rs. 100 crore.
Time and Cost overruns
Two important factors led to time and thus cost overruns for the project:
1) Objection from environmental groups in Goa: The Prime Minister ordered stoppage of work till the
enquiry by the Justice Ojha Committee was completed. This delayed the project by 7 to 8 months.
2) Unexpected terrain: The soil structure turned out to be much more difficult than expected. Instead of the
laterite soil that was expected, it turned out to be fractured rock. This delayed the project by two years.
This led to major expenses by way of interest.

By now the estimated project cost had gone up to Rs. 2520 crore. This was over and above the interest
burden of Rs. 1030 crore. Thus the total cost of the project worked out to Rs. 3550 crore.

The final financing structure stood as follows:

Equity: Rs. 800 crore
Debt: Rs. 2750 crore
The debt was made up of the following components:
Bonds: Rs. 2250 crores
ECB: Rs.409 crore
Sale and lease back: Rs. 100 crore

Breakeven Point
KRC expects to breakeven in the next 20 years. The reason for such a long gestation is the nature of the
demand for railways. The demand being derived demand, it is very sensitive to the state of the economy and
the rate of growth in basic industries. But the bulk traffic in the form of transport of coal, steel, cement, etc is
not coming as expected. Infact it has reduced due to an overall slowdown in the economy.
The cement units expected to start at Saurashtra did not start their operations. Infact, now the cement is
milled and packed at different locations. Hence the expected traffic did not materialise.

Analysis of the Konkan Project:

1. Highly unfavourable debt equity ratio: The debt equity ratio of KRC stood at about 5:1. This is highly
unfavourable, as the high cost bonds entail a permanent burden even during the construction period.
More equity should have been raised from the state governments as the centre did not have the funds.
2. The major item of expense, as seen in the P&L Account of 2000-01 is the financing charges, mostly the
interest on bonds. It stands at Rs. 325 crore, which is 60% of the total expenses incurred in the year.
3. The falling rupee market increased the value of the ECB from Rs. 409 crore to Rs. 520 crore (it was
swapped at this point). This increased the cost of finance as well as increased the principal substantially.
4. Time overruns due to opposition from the environment groups proved very costly, as it increased the
interest burden.
5. The fall in the bond markets due to the Harshad Mehta scam of 1992 forced KRC to avail itself of ECBs,
which proved very costly in a falling rupee scenario.
Steps that can be taken now:
1. Ensuring that the operating income is positive, i.e., though KRC is making losses, ensuring that it
recovers atleast its variable costs.
2. Augmenting income from other sources: This is necessary so that KRC can repay its debt early and
hence bring down its cost of finance.
3. KRC should use the expertise it has developed in commissioning such infrastructure projects to augment
its income. It should undertake more construction projects like the Skybus project it has undertaken for
Iraq.
4. Roping in a private company as a minority stakeholder should not be ruled out. A company that is
directly benefiting from the project can be approached to subscribe to the equity.
Observations and conclusions:
There are certain very important practical and unexpected problems that a project manager
may face. These problems need to be given due consideration when anyone is undertaking
any project.
1. Uncertainty of political environment:
The political environment and consequently the public policy with regard to sector or a
project may undergo serious and adverse change. This was amply evident in the recent
controversy involving Enron Corp with regard to the Dabhol Power Company.
The project managers thus have to ensure that a healthy relationship is maintained with the
policy makers and the ruling parties.
2. Background of the promoters:
This factor plays a very important role in the ability of a project to raise finance for its
project. This is applicable to term loans and more so to the capital markets. Thus, the
strong image of Reliance Industries as being excellent at project implementing and getting
it off the ground would help them get access to funds much more readily than to another
company.
3. Market Dynamics:
The ability of a firm and the ease with which it can raise funds depends on the market
sentiments. For example, the current recession in the global economy has made it difficult
for any company to come out with a public issue. In such an environment, an ongoing
project needing more funds will find it extremely tough to raise equity in the dried up
market. The Harshad Mehta scam in 1992 scared away investors from the market for some
time. Hence Konkan Railway Corporation had to resort to External Commercial
Borrowings at a high cost. The recent terrorist attacks on World Trade Center have
depressed market sentiments worldwide. A firm proposing to raise equity capital has to
trade off between time and cost overruns (of waiting for the markets to revive) and the
decision to raise finance from other sources.
4. Time and cost overruns:
This problem may be faced by any project manager. The failure to get the project off the
ground in time or delays due to external factors push the cost of a project upwards
significantly. Sometimes delays may make a project completely unviable to undertake. In
the Indian context, delays may occur primarily due to the failure to get the legal approvals
in time. The financial structure has to be adjusted suitably to minimise such costs. For
example, a two year delay in getting the project off the ground cost Konkan Railway Rs.
182 crores in terms of inflation. Similarly, its financial structure was such that it entailed a
high fixed interest burden on the project even during the construction period. Such
problems should be avoided by devising appropriate financial structures.
5. The entry of credit rating:
Credit rating has entered the Project Finance arena. Firms like Moody's help a project get a
rating based on its viability and expected profitability. A new project should make full use
of such ratings to convince the FIs, Banks and the retail investors of its viability and thus
make it easier to raise finance.
6. The Globalisation of Project Financing:
Project financing has become truly global. The issue of ADRs and GDRs makes it possible
for companies to access global markets for their funds requirement. This also means that
project appraisal and management techniques will have to be tuned to meet global
standards.
7. Development of innovative means of finance:
The market sentiment and legal requirements may force you to look beyond the traditional
means of finance. This calls for creative solutions to enable the project to get funds.
Companies should make full use of the leeway that is allowed to them by law in designing
financial instruments. For example, Tatas had issued Secured Premium Notes in 1992.
Similarly, the Japanese Leveraged Lease used by Air India to finance its aircraft purchases
is an excellent innovation.
Case Study 2 - Aircraft Financing At Air India
Methodology: Interview with Mrs. Pradnya Oraskar, Dy. General Manager, Projects Division, Air India
Findings:
1. Air India initiates the process of contracting foreign currency loans to finance the acquisition of the
aircraft after signing a purchase agreement with the aircraft manufacturer.
2. Air India has financed its aircraft acquisition programmes in the past through External Commercial
Borrowings instead of borrowings in the domestic market. The reasons for borrowing in foreign
currency are as follows:
(a) Air India earns a large proportion of its revenues in foreign currencies. It has therefore a natural hedge
against adverse currency fluctuations, which could otherwise offset the low cost of borrowing in the
international market. Air India’s low cost borrowings in the international market are protected in this
manner from the impact of the virtually continuous depreciation of the Indian Rupee;
(b) Air India can avail of export credit guarantees given by ‘Export Credit Agencies’ in the countries of
aircraft manufacture, thereby achieving a more competitive cost of financing as export credit guarantees
have even lower spreads than foreign currency commercial loans.
3. Before delivery of aircraft, Air India approaches the Ministry of Finance through the Ministry of Civil
Aviation for their approval in principle to invite bids and contract foreign currency loans for aircraft
purchase. The bids are invited from international banks / financial institutions for a suitable financing
package including any innovative financing proposals for acquisition of aircraft.
4. Air India then evaluates the underwritten offers received in order to determine the most economic
package. The term sheet submitted by the banks / financial institutions are scrutinised and detailed
discussions are held with the shortlisted banks/ financial institutions wherein clarifications on their term
sheets are sought. The parties are requested to resubmit their best possible offers.
5. The revised offers are again evaluated and the recommendations submitted to the Ministry of Finance
through the Ministry of Civil Aviation in order to obtain Government of India’s approval to arrange the
financing package. The mandate is then awarded to the bank / financial institution offering the cheapest
package as per the approval of the Ministry of Finance.
6. An aircraft-financing package can either be a conventional ‘Vanilla Loan’ or ‘ Structured Financing’.
7. A conventional ‘Vanilla Loan’ package for aircraft financing normally consist of two tranches:
8. An export credit agency guaranteed tranche upto 85% of the aircraft cost. This tranche normally carries
a lower spread over LIBOR (London Interbank Offered Rate) since this tranche is guaranteed by the
’Export Credit Agencies’ of the country of the aircraft manufacturer. The lending banks accept a lower
spread over LIBOR under this tranche since there is no risk exposure to either Air India or to the
Government of India defaulting in the transaction; and
9. A Commercial Loan tranche for the remaining 15% of the aircraft cost. In addition, this tranche is also
available for financing the cost of acquisition of spares, workshop equipment and ramp equipment
included in the aircraft project cost. The spread over LIBOR of this tranche is comparatively higher than
the export credit agencies guaranteed tranche at (a) above.
10. Both tranches together comprise the total aircraft financing package. The tenure of both the tranches is
normally for a period of 10/12 years and in any case not exceeding 12 years. The repayment of the loan
 principal is in semi-annual installments. In the past the entire financing package was guaranteed by the
Government of India. However, the Government has informed Air India that no guarantee can be given
for financing aircraft acquisitions in future from January 1995 even if the airline were prepared to pay a
guarantee as in the past.

Other Finance Structures

A. Japanese Leverage Lease (Jll)

Air India had also financed three aircraft (one B747-300 Combi in 1988 and two A310-300s in 1990) through
Japanese Leverage Lease (JLL). This mode of financing gained popularity in the mid 1980’s and early
1990’s and was a much favoured form of financing employed by various airlines for their aircraft purchases.
Under the JLL financing, the agent bank forms a Special Purpose Company (SPC) in Japan with an equity
participation from a group of Japanese investors. The Japanese equity investors are required to contribute
around 15% to 25% of the aircraft cost and the balance is arranged through loans. The SPC borrows money
from the lending banks and makes the payment to the aircraft manufacturer and thereby owns the aircraft.
The aircraft is then leased to the airline by a separate agreement for a maximum period of 12 years. The
airline makes regular lease payments comprising of principal and interest, which is passed on to the lending
banks through the SPC. Technically, the airline pays interest only on the loan amount and the equity
providers mainly get their returns by claiming the depreciation in their books in addition to a marginal return
from the airline.

Some additional features of a Japanese Leverage Lease are as follows:

(a) The equity subscribers to the SPC are mainly Japanese corporations desirous of taking advantage of the
Japanese tax laws which allow depreciation benefit on the aircraft under JLL
(b) A part of the tax benefit is passed on to the airline through the mechanism of lower lease rentals, thus
making the JLL very attractive as compared to traditional loans
(c) The Japanese equity providers require an indication of comfort that their contributions will be repaid and
hence the Airline has to keep a deposit (in Yen) in a bank in Japan to secure this obligation
(d) At the end of the lease term of 12 years, the ownership of the aircraft passes to the airline after the
payment of a Purchase Option of approximately 45% of the original aircraft cost. A part of this payment
is covered by an initial yen deposit placed with the bank structuring the deal
(e) The entire payment profile is structured to minimise the cost to the airline and thus make the structure
attractive
(f) This structure enables the airline to keep the debt (balance lease obligations) off its balance sheet thus
allowing it to show a better debt: equity position. However, recent accounting guidelines in India and
abroad make it mandatory to disclose JLLs in the Balance Sheet
(g) As the airline does not have to borrow 100% of the aircraft cost upfront to pay the aircraft manufacturer,
there is a substantial Net Present Value (NPV) benefit in such a structure. For example, in the case of
two A310-300s financed under JLL in 1990, Air India was required only to borrow 91% of the cost to
service the debt and the equity holders thus resulting in an upfront 9% NPV benefit.
Accounting Treatment for Japanese Leverage Lease (JLL)
The Japanese Leverage Leases are off Balance Sheet, i.e. neither the aircraft nor the balance lease obligations
of the Corporation are shown in the Balance Sheet. All payments against the lease are debited to Profit and
Loss Account and no depreciation is claimed on these aircraft. At the end of the lease period, the Company
has an option to purchase these aircraft at 45% of the original cost or terminate the lease as per the
agreement. The Company will capitalise these values at the end of lease period if the option to purchase is
exercised.

B. Asset Based Financing

1. Air India acquired two B747-400 aircraft in Oct/Nov 1996. The Government of India had at that time
categorically stated that no guarantee would be forthcoming for the financing package for these aircraft.
Air India, therefore, arranged asset based financing with a US Eximbank’s guarantee.
2. Normally the US Eximbank does not allow government owned airlines to undertake asset based
financing. However as the Government of India was firm in its decision of not providing a guarantee,
the US Eximbank agreed to do an asset based financing structured as a Finance Lease.
3. Under this structure a Special Purpose Company (SPC) was set up in a tax-free haven (Bermuda) to own
the aircraft and subsequently lease the aircraft to Air India. This enabled the US Eximbank to control
directly the SPC (i.e. the Lessor) as the shares of this SPC were pledged to US Eximbank.
4. As this structure was asset based, the aircraft acquired under this financing structure together with two
additional B747-400 aircraft acquired earlier were required to be mortgaged to the US Eximbank as
security for their guarantee.
5. Unlike a Japanese Leveraged Lease structure, there is no equity contribution from the lessor as owner of
the aircraft and therefore Air India could not derive any upfront benefit.
6. The US Exim guaranteed lenders provided the funds to the SPC to enable the SPC to purchase the
aircraft from the manufacturer. The outgo to Air India under this finance lease structure was exactly the
same as under a vanilla loan.
7. The interest rate on the US Exim tranche of this financing was very attractive (three-month LIBOR in
US dollars plus a spread of 0.08%).
8. The title to the aircraft will pass on to Air India on expiry of the lease term of 12 years without payment
of any purchase price.
9. The US Eximbank insisted on a Letter of “Comfort” from the Government of India. This letter was
provided after protracted negotiations with the Ministry of Finance, the Ministry of Civil Aviation and
the Ministry of Law.
10. In view of a 100% Government ownership, Air India had not faced any problem in getting guarantees
from the US Eximbank and the export credit agencies of the UK, France and Germany. This enabled Air
India to arrange loans at competitive rates.

Accounting Treatment for Asset Based Financing

Air India had structured the loan taken for acquisition of these aircraft as Finance Lease in order to give US
Exim Bank control over the mortgaged aircraft. Keeping with International Accounting Standards the two
aircraft acquired during the year 1996-97 have been brought into the books of accounts. The new aircraft
form a part of the Fixed Assets of the Company and the balance lease obligations are shown under Long
Term Debt. Only the interest charges of the lease rent is debited to Profit and Loss Account and the principal
amount of the lease rent is reduced from the balance lease obligation i.e. loan taken for lease financing. Air
India claims depreciation on these aircraft as per the standard depreciation policy adopted for all aircraft.
Annexure 1 Project Cost Financing and Cash Flow Proforma for Appraisal (Rs. Lakhs)

Outflows Year
0 1 2 3 4 5 ...10
1. Land and building
2. Plant and machinery
3. Working capital
Total outlay

Sources of finance 1. Term loans (1)

2. Equity capital (2)
(DE Ratio 1:2) Total
Cash flow projections (Rs. lakhs)
Projected figures Year
0 1 2 3 4 5 ...10
A. Sales Revenues
B. Less Operating Costs:
1. Raw materials
2. Salaries & wages
3. Manufacturing expenses
4. Administration expenses
5. Sales tax @ x%
Earnings before depreciation, interest and income tax(A-B)
Less: interest
Profit before depreciation and income tax
Less: depreciation
Profit before income tax
Less: Income tax
Net profit
Add: Depreciation
Working capital
Cash inflows
Less: Cash outflows
Net cash flow

Annexure 2: Proforma for Estimate of Foreign-Exchange Flows or a Project (In foreign exchange)
Item Year
0 1 2 3 4 5
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. Others

B. Indirect inflow
(For linked projects)
7. Capital
8. Term 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
(Payable in foreign currency)
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 (for linked projects)
23. Import of capital goods, equipment, and machinery
24. Import of raw materials, intermediates and replacements
25. Imported goods purchased on domestic market
26. Others
III Net foreign-exchange flow (I -II) (positive +; negative -)