Project_finance_425_v1.pdf

PROJECT FINANCE Sub Code 425

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Developed by Prof. Dipal Rokadia On behalf of Prin. L.N. Welingkar Institute of Management Development & Research

Advisory Board Chairman Prof. Dr. V.S. Prasad Former Director (NAAC) Former Vice-Chancellor (Dr. B.R. Ambedkar Open University)

Board Members 1. Prof. Dr. Uday Salunkhe
 Group Director
 Welingkar Institute of Management

2. Dr. B.P. Sabale
 Chancellor, D.Y. Patil University, Navi Mumbai
 Ex Vice-Chancellor (YCMOU)

3. Prof. Dr. Vijay Khole
 Former Vice-Chancellor
 (Mumbai University)

4. Prof. Anuradha Deshmukh
 Former Director
 (YCMOU)

Program Design and Advisory Team Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. Manish Pitke Faculty – Travel and Tourism Management Consultant

Prof. Kanu Doshi Dean – Finance Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Dr. V.H. Iyer Dean – Management Development Programs Welingkar Institute of Management, Mumbai

Mr. Smitesh Bhosale Faculty – Media and Advertising Founder of EVALUENZ

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Prof. Vineel Bhurke Faculty – Rural Management Welingkar Institute of Management, Mumbai

Prof. Venkat lyer Director – Intraspect Development

Dr. Pravin Kumar Agrawal Faculty – Healthcare Management Manager Medical – Air India Ltd.

Prof. Dr. Pradeep Pendse Dean – IT/Business Design Welingkar Institute of Management, Mumbai

Mrs. Margaret Vas Faculty – Hospitality Former Manager-Catering Services – Air India Ltd.

Prof. Sandeep Kelkar Faculty – IT Welingkar Institute of Management, Mumbai

Mr. Anuj Pandey Publisher Management Books Publishing, Mumbai

Prof. Dr. Swapna Pradhan Faculty – Retail Welingkar Institute of Management, Mumbai

Course Editor

Prof. Bijoy B. Bhattacharyya Dean – Banking Welingkar Institute of Management, Mumbai

Prof. B.N. Chatterjee Dean – Marketing Welingkar Institute of Management, Mumbai

Mr. P.M. Bendre Faculty – Operations Former Quality Chief – Bosch Ltd.

Course Coordinators

Mr. Ajay Prabhu Faculty – International Business Corporate Consultant

Ms. Kirti Sampat Assistant Manager – PGDM (HB) Welingkar Institute of Management, Mumbai

Mr. A.S. Pillai Faculty – Services Excellence Ex Senior V.P. (Sify)

Mr. Kishor Tamhankar Manager (Diploma Division) Welingkar Institute of Management, Mumbai

Prof. Dr. P.S. Rao Dean – Quality Systems Welingkar Institute of Management, Mumbai

Prof. Dr. Rajesh Aparnath Head – PGDM (HB) Welingkar Institute of Management, Mumbai

COPYRIGHT © by Prin. L.N. Welingkar Institute of Management Development & Research. Printed and Published on behalf of Prin. L.N. Welingkar Institute of Management Development & Research, L.N. Road, Matunga (CR), Mumbai - 400 019. 
 ALL RIGHTS RESERVED. No part of this work covered by the copyright here on may be reproduced or used in any form or by any means – graphic, electronic or mechanical, including photocopying, recording, taping, web distribution or information storage and retrieval systems – without the written permission of the publisher. NOT FOR SALE. FOR PRIVATE CIRCULATION ONLY.

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1st Edition (May-2015)

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CONTENTS

Contents Chapter No.

Chapter Name

Page No.

SECTION 1: THE PROJECT AND APPRAISALS

3

1

The Project

4-31

2

Project Appraisal

32-41

3

Technical Appraisal

42-68

4

Economic Appraisal

69-78

5

Market Appraisal

79-92

6

Financial Appraisal

93-128

7

Capital Structure

129-149

SECTION 2: FINANCING OF PROJECTS

150

8

Presentation of your Project for Financier

151-193

9

Term Loans

194-247

10

Working Capital Finance

248-276

11

Private Equity

277-313

12

Public Listing of Securities

314-333

13

International Capital

334-357

14

Crowd Funding

358-372

SECTION 3: PROJECT IMPLEMENTATION AND REVIEW

373

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Project Planning, Risks and Management

374-387

16

Project Quality Assurance and Audit

388-396

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SECTION - I - THE PROJECT AND APPRAISALS

SECTION - I THE PROJECT AND APPRAISALS


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THE PROJECT

Chapter 1 THE PROJECT Objectives After studying this chapter, you should be able to: • • • • • • •

Get a brief overview about Projects. Provide conceptual understanding on Capital Expenditure and Revenue Expenditure. Understand the differences between Capital Expenditure v/s Revenue Expenditure. Explain the steps to formulate a Project. Explain on steps to finance a Project. Learn on steps to implement a Project. Learn about Post Implementation Work.

Structure: 1.1

Introduction

1.2

Steps on Formulating a Project

1.3

Steps on Financing the Project

1.4

Steps on Implementation of the Project

1.5

Post Implementation Work

1.6

Total Project Life Cycle

1.7

Sample Form for Undertaking New Project

1.8

Summary

1.9

Self Assessment Questions

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THE PROJECT

1.1 Introduction The Indian Government is considering interlinking the various rivers; Mahindra Motors is taking over an international motor company; Reliance Retail is planning to expand their stores throughout the country; A steel plant wants to set-up new arc furnace; Meghna, a dentist is planning to start her own clinic; Raj is planning to buy a motorbike; All these situations involve are Projects and involve a Capital Expenditure Decision. Often, Capital Expenditure Decisions represent the most important decisions taken by a firm. The consequences are Long-term, Irreversible and involve substantial outlays. Not only are they extremely important but also pose difficulties due to measurement, uncertainty and have a temporal spread. Images of Certain Projects

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THE PROJECT

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! As a financial manager, the investment decisions that you will make today will be critical to the future of your firm. A wise investment decision will create wealth and make the owners or shareholders of the company richer by exploiting an opportunity to increase the value of the firm. Alternatively, a poor investment decision will decrease the value of your company and destroy shareholder wealth. Throughout this subject, we shall assume that maximizing shareholder wealth is the goal of the owners of the firm, the shareholders. We also assume that managers, acting in the interest of the owners of the firm, use shareholder wealth maximization as their ultimate decision criterion. However, in reality, there are many conflicts of interest between the shareholders and the managers. Revenue expenditure if made on day-to-day operations of the organization is for a relatively short period and has short-term impact. Comparison between Capital Expenditure and Revenue Expenditure is enlisted in table below:


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Capital Expenditure

Revenue Expenditure

Expenditure is incurred and benefits are available on recurring basis.

Expenditure is made from one-time benefit/ utility. To avail benefit second time, the expenditure will have to be incurred again.

Expenditure generally creates a Capital Expenditure is to use and maintain the Asset. assets so created. Expenditure is charged to the P&L A/c in form of depreciation charges spread over the useful life period of the assets.

Expenditure is charged to the P&L A/c in the same year in which it is incurred.

Expenditure is subject to completion report of the scheme or asset.

Expenditure is subject to budgetary control only.

Expenditure precedes benefit/utility.

Expenditure follows benefit/utility.

Expenditure requires administrative approval from competent authority.

Expenditure requires only annual budgetary approval.

A smart finance manager keeps controls on Revenue Expenditure to reduce the overheads of the organization and make it more efficient. However, he deploys Project Finance to take his organization to the next level. Let us just have a look at the revenue expenditure of M/s Predict Projects Pvt. Ltd. (your assumed company):

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Sr. No.

Monthly Expense Sheet for M/s Predict Projects Pvt. Ltd. Amount Ideas to Reduce Expenditure Type % (Rs.) Expenses

1

Factory

a

Raw Materials Consumed

Variable

Ferrous Materials

Variable 12,42,142

18.56%

Fluxes – lime, alloying agent

Variable 7,41,245

11.08%

Refractories

Variable 4,24,125

6.34%

Fuels – coke, coal, gas

Variable 12,04,050

17.99%

b

Salaries – Factory

Fixed

2,01,504

3.01%

c

Electricity Expenses – Factory

Variable 3,12,421

4.67%

d

Miscellaneous

Variable 1,24,125

1.85%

e

Telephone Expenses

Variable 10,125

0.15%

f

Rent

Fixed

6.54%

g

Repairs and Maintenance

Variable 9,353

Sub-total

4,37,547

Can we use up all old stock first before buying fresh material?

Old material 6 months is still not used. 30% material spoilt. Purchase less quantity and improve storage.

We might have to increase as less staff is causing reduced output.

Can we re-negotiate?

0.14%

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47,06,637 70.33%

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THE PROJECT

2

a

b c d e

Head Office

Business Promotion Electricity Expenses – Office Salaries – Head Office Telephone Expenses Repairs and Maintenance

Variable 4,14,959

6.20%

Variable 14,540

0.22%

Fixed

9.66%

6,46,367

Variable 21,754

0.33%

Variable 24,214

0.36%

f

Bank Interest

Variable 1,24,124

1.85%

g

Bank Charges

Variable 5,436

0.08%

h

Commission and Variable 4,00,000 Brokerage

5.98%

i

Conveyance

Variable 22,756

0.34%

Variable 95,050

1.42%

Variable 12,000

0.18%

Variable 5,000

0.07% 1.12%

j k l

Interest on Payments Printing and Stationery Professional Charges

m

Rent

Fixed

75,000

n

Miscellaneous

Variable 1,24,124

Can do a sales audit? Which newspapers, advertisements and hoardings are not giving inquiries?

Can reduce nonperforming staff?

Can we re-negotiate?

1.85%

Sub-total

19,85,324 29.67%

GRAND TOTAL

66,91,961 100.00%

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1.2 STEPS ON FORMULATING A PROJECT Generally, Project involving Capital Expenditure is formulated in following stages:

! After it is concluded that a project is feasible and doable, the promoters and finance managers work on getting the resources to complete the project. He will look at the various sources available to his disposal and cost of each source. He will arrive at an optimum level of debt and equity to arrive at an optimum Weighted Average Cost of Funds and evaluate the Return on the Investment in the project. A project is a proposal for capital investment to develop facilities to provide goods and services. It is implemented in order to generate cash flows. The investment proposal may be for setting up a new unit, expansion or improvement of existing facilities. The project, however, has to be amenable for analysis and evaluation as an independent unit. The projects have increased in size and complexity. Projects for tomorrow are not geared to the mass production of simpler goods but customized ones produced by flexible manufacturing systems. Project identification is, however, a continual process. With the opening up of the economy, demand for sophisticated inputs is continuously rising. The

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quest for new combinations of factors for optimizing output and improving productivity to strengthen the competitive position of Indian industry in the international marketplace is an ongoing process. Further, the growing demand for complex, sophisticated, customized goods and services in international markets has added a new dimension to project concept. (a) Generation and Screening of Ideas Project idea can be conceived either from input or output side. The former are material based while the latter demand oriented. Input based projects are identified on the basis of information about agricultural raw materials, forest products, animal husbandry, fishing products, mineral resources, human skills and new technical process evolved in the country or elsewhere. Output based projects are identified on the basis of needs of population as revealed by family budget studies or industrial units as found by market studies and statistics relating to imports and exports. Desk research surveying existing information in economical and wherever necessary market surveys assessing demand for the output of project could help not only in identification but in assessing viability of the project. Good ideas are the key to success for any project. They can be generated using various methods such as: 1. 2. 3. 4. 5. 6.

SWOT Analysis Cost reduction Productivity improvement Increase in capacity utilization Improvement in contribution margin Expansion into promising fields

You can generate good ideas by following methodologies: • • • • • • • •

Analyze the performance of existing industries Examine the inputs and outputs of various industries Review import and exports Study Plan Outlays and Governmental Guidelines Look at suggestions of Financial Institutions and Developmental Agencies Investigate local materials and resources Analyze economic and social trends Study new technological developments

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THE PROJECT • • • • • •

Draw clues from consumption need Explore the possibility of reviving sick units Identify unfulfilled psychological needs Attend trade fairs Simulate creativity for generating new product ideas Hope that the chance factor will favor you

Preliminary Screening can be taken up looking at following aspects: • • • • • •

Compatibility with the promoter Consistency with governmental priorities Availability of inputs Adequacy of market Reasonableness of cost Acceptability of risk level

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 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 realization, total cost of production, capital input/output ratio, labor requirement, power and other infrastructure facilities. The project selection exercise should also ensure that it conforms to overall economic policy of the government. (b) Data Collection Data collection is an important step towards formulation of the project. It forms the backbone on making a good robust project. It has to be credible. Data is both primary and secondary.

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THE PROJECT

Primary Information Primary Information represents the information that is collected for the first time to meet the specific purpose on hand. Following are some of the various methods to obtain Secondary Information: •

Observation

•

In-depth Techniques

•

Experiments

•

Market Survey

Data can be of various kinds – cost of raw materials, technical specifications of raw materials, buyers’ market for finished products, price points to effectively enter the market, geographical areas, excise duties on raw materials and finished products, transportation costs, competition analysis, etc. Good amount of data is available through a number of sources – market dealers, CMIE, the internet, Credit Agencies, Analysts, Trade Journals, etc. For specialized or exclusive projects, Market Survey companies and Technical Consultants can be contacted. Nothing can be worse than a skewed Project Report based on inaccurate, unreal data. It can cause great repercussion on the fate of the Project.


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! Secondary Information Secondary Information is the information that has to be gathered in some other context and is already available. Following are some of the various methods to obtain Secondary Information: • • • • • • • • • • •

Census of India National Sample Survey Reports Plan Reports Statistical Abstract of India India Year Book Statistical Year Book Economic Survey Guidelines to Industries Annual Survey of Industries Stock Exchange Directory Trade Publications

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(c) Documentation All the data collected and assimilated has to be documented and presented in formats understandable to the Project Team, and Top Decision Makers. It can be presented in various formats – Tables, Graphically – Pie Charts, Bar Graphs, Line Graphs, etc. (d) Project Appraisal After ascertaining that a project idea is suitable for implementation, a detailed Project Appraisal is carried out under the following heads: 1. Technical: To assess whether that project is technically sound with respect to various parameters such as technology, plant capacity, raw material availability, location, manpower availability, etc. 2. Economic: To look into the economic benefits to the society and to the nation. 3. Market: To understand the potential market for the products and at the marketing strategy. To review competence of the marketing team. 4. Financial: To assess the financial feasibility of project – cost of project, cost of capital, revenues, cash flows and return on capital employed. Project Appraisal is the final document in the formulation of a project proposal. Project Appraisal is prepared either by the financial institution or consultants or experts. The cost of project Appraisal can be debited to project cost and can be counted as part of promoter’s contribution. The Project Appraisal should contain all technical and economic data that are essential for the evaluation of the project. Before dealing with any specific aspect, Project Appraisal should examine public policy w.r.t. the industry. After that, 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. The Project Appraisal after listing and describing alternative locations should specify a site after necessary investigation. The study should include a layout plan along with a list of buildings, structures and yard facilities by size, type and cost. An essential part of the feasibility study is the schedule of implementation and estimates of expenditure during construction. Major and auxiliary

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THE PROJECT

equipment by type, size and cost along with specification of sources of supply for equipment and process know-how has to be listed. 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. Before presentation of the financial data, market analysis has to be covered to help in establishing and determining economic levels of output and plant size. Financial data should cover preliminary estimates of sale revenue, capital costs and operating costs for different alternatives along with their profitability. Project Appraisal should present estimates of working capital requirement to operate the unit at a viable level. Additional information on financing, breakdown of cost of capital and cash flow is prepared. (e) Conclusion Once all the data is put on the paper, the Project Team and the Top management decision makers are to decide the priority of the project visà-vis alternate proposals. They are prepared as to the profitability or revenue decides whether the project has to be implemented or it is to be shelved. The decision makers will decide based on various criteria on how the particular project will benefit the organization. A particular project may be very sound financially may get shelved as it is less beneficial vis-à-vis alternative project. Similarly, a project may not be financially viable but may be considered as it has many indirect benefits such as improvement of the quality or product or improved services to its customers.

1.3 STEPS ON FINANCING THE PROJECT a. Investment in the Project Once a project is desired to be taken up for implementation, the project team along with the finance team will work on the finance required for the above project. Heads such as Plant, Machinery, Equipment, Manpower, Contingencies, Power Costs, Raw Materials, Working Capital requirements, etc.

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THE PROJECT

b. Sources of Funds There are two main sources of funds: Debt and Equity. A company can raise equity and debt capital from both public and private sources. Capital raised from public sources is in the form of securities offered to public. These securities can be traded on public secondary markets like Bombay Stock Exchange or National Stock Exchange, which are recognized stock exchanges that facilitate trading of public securities. Promoters usually go for Projects that creates value for the owners or shareholders of the firm. Maximum value for shareholders is created if project generates maximum ROI and Cost of Source of Funds is kept as low as possible. If the Cost of Source of Funds is not higher than ROI by at least 2% or the Net Present Value (NPV) of the project is negative, it is not worthwhile doing the project. Private capital comes either in the form of loan given by banks, financial institutions, NBFCs, Private Lenders in form of Term Loans, Working Capital, etc. Public capital comes either in the form of issuing shares, preference, warrants, debentures, bonds to public, institutions, investors, PE companies, etc.

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THE PROJECT

c. Cost of Each Source The different sources of funds have varying costs. Debt and preference stock entail more or less fixed payments, estimating cost of debt and preference is relatively easy. Preference capital carries a fixed rate of dividend and is redeemable in nature. Cost of Equity is difficult to estimate. The difficulty stems from the fact that equity shareholders have a residual claim on the earnings of the company. This means that they will receive a return when all other claimants (lenders, preference shareholders) have been paid. Generally, equity is costlier than debt as these investors expect higher rate of return compared to debt. d. Weighted Average Cost of Capital Invested in the Project A company’s cost of capital is the weighted average cost of various sources of finance used by it, viz., equity, preference and debt. Suppose a company uses 30% equity @ 24%, 20% preference @ 12% and 40% debt @13%, and then the Weighted average cost of capital of the company is WACC

= (Proportion of equity) × (Cost of equity) + (Proportion of preference) × (Cost of preference) + (Proportion of debt) × (Cost of debt) Rp × P Re × E Rd × D + + =! D+E+P D+E+P D+E+P = ! WeR e + WpR p + WdR d = (0.30) × (24) + (0.20) × (12) + (0.40) × (13) =14.8 %

Company cost of capital is the rate of return expected by existing capital providers. It reflects the business risk of existing assets and the capital structure currently employed. Project cost of capital is the rate of return expected by existing capital providers for a new project or investment the company proposed to

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THE PROJECT

undertake. It depends on the business risk and the debt capacity of the new project. e. Return from Investment from the Project Suppose, the company invests Rs. 10 crores on a project which earns a rate of return of 25% and uses equity, preference and debt in above proportions, then WACC

= 14.8%

Total Return on Project

= 10 × 25%

= 2.50 crores

WACC

= 10 × 14.8%

= 1.48 crores

Return to Shareholders

= 2.50 – 1.48

= 1.02 crores

1.02

ROI

=!

10.00

= 10.20%

1.4 STEPS ON IMPLEMENTATION OF THE PROJECT a. Engagement of Consultants For all projects, Consultants are very much required. Consultants may be either in-house consultant or outside consultant or foreign consultant. Sometimes, the projects are executed on turnkey contract basis or on EPC contract basis. When the contractor is given full responsibility including the design, engineering, consultancy as well as monitoring and supervision of the project, in that case, there may not be requirement of a consultant. But still, consultant may be required for the basic engineering and design supervision and approval. b. Financial Closure Before the contracts are finalized or even before approval of the Government is obtained for the projects involving foreign direct investment (FDI), finalization of the financing of the projects has to be completed. Financing of projects may be from external commercial borrowings, foreign direct investment, financial institutions, and enquiry participation through joint venture or issue of shares to the public. Completion of all these

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THE PROJECT

arrangements for financing modes of the project is called ‘Financial Closure’. c. Contracts Finalization Contracts may be Turnkey, Non-turnkey, Engineering Procurement Construction (EPC), Build Operate Transfer (BOT), Build Own Operate Transfer (BOOT), Build Own Operate Lease (BOOL), Build Own Operate Sale (BOOS), etc. Under this stage, mode of execution of project on the basis of any one of the above mode of contract is decided. d. Execution of Contracts/Project After the contract/contracts have been finalized, the next stage for execution of the contract and the project starts. This includes meetings with contractors, follow-up of the progress by the contractors, site activities, etc. e. Monitoring and Control Monitoring and control involves monitoring and control of physical progress, financial progress, quality control, performance guarantee parameters, etc. so as to ensure the successful execution and completion of the project. f. Completion of Construction This includes physical completion of project in all respects, so that the project may be finally commissioned for commercial production. g. Commissioning After the project has been physically completed, i.e., the work on all activities such as civil engineering work, structural fabrication, supply and installation of equipment have been completed, the next stage comes for the commissioning of the project, so as to make the commercial utilization of the project. Commercial utilization may be commercial production as envisaged in the approved project. h. Performance Guarantee Test After the project has been commissioned and commercial production started, the next stage would be to do the performance guarantee test as per the parameters envisaged in the contract.

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i. Handing over to Operation After the performance guarantee tests have been conducted and plant and equipments have stabilized, the commissioned plant is handed over to Operation Department. In some organizations, the handing over of the plant and equipment is done by executing the handing over and taking over act. Authorities from both the departments, i.e., Project and Organization sign this Act. This is a statement signed jointly by the authorities of project and operation department. j. Closure of Contract After the project has been completed, commissioned, performance guarantee test completed and handed over to Operations, all the contracts are finalized and closed.

1.5 POST IMPLEMENTATION WORK a. Completion Cost and Capitalization The last but one activity in the project’s life cycle is to work out the completion cost and capitalize the cost of completed project in the books of accounts. b. Post Project Evaluation and Report The last stage in the project life cycle is the post project evaluation and post completion audit report. In this stage, after the completion of the project, the actual results, completion cost, profitability, etc. are compared with the provisions made in the approved project. The variations are scrutinized for the adverse results for correction in the future projects.


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! Every Project starts with an idea. Once the financiers are satisfied about its feasibility, they finance it and they get their income from revenue streams generated from the Project.

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1.6 Total Project Life Cycle

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1.7 Sample Form for undertaking New Project PROJECT Project Type/Idea Project Name/s Generated by Department

Key Person

Brief Summary on the project and its benefit to the organization Data Collected SWOT Analysis

Strengths

Opportunities

Weaknesses

Threats

1. 2. 3. 4. 1. 2. 3. 4. 1. 2. 3. 4. 1. 2. 3. 4.

Appraisals/Findings

Technical

1. 2. 3. 4.

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THE PROJECT

1. 2. 3. 4. 1. 2. 3. 4. 1. 2. 3. 4.

Economic

Market

Financial Additional Revenue Generated/Costs Saved

1. 2. 3.

Conclusions

Potential Revenue Potential Amounts Saved Investments

Particulars

Amount (Rs.)

Particula rs

(a)

(e)

(b)

(f)

(c)

(g)

(d)

(h)

Amou nt (Rs.)

Total Project Cost (Rs.)

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THE PROJECT

Sources of Funds

Particu lars

Amount (Rs.)

Cost p.a (%)

Cost per annu m (Rs.)

Weighted Average Capital Cost (WACC) (%)

Own Contrib ution Preferre d Stock Internal Accrual s Term Loan/s Debent ures/ Warrant s Bonds Other Sources Total Return on Project Recommende d by

Name

Designation

Signature

Designation

Signature

(A) Approved/ Rejected by

Name (A) (B) (C)

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THE PROJECT

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! Government of India has launched the “MAKE IN INDIA” campaign to promote the domestic industrial production. 


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1.8 Summary •

Essentially, a capital project represents a scheme for investing resources that can be analyzed and appraised reasonably independently.

•

Capital Expenditure is different from Revenue Expenditure.

•

Capital Expenditure decisions often represent the most important decisions taken by a firm. Their importance stems from three interrelated reasons: long-term effects, irreversibility and substantial outlays.

•

Shareholder Wealth Maximization is the goal of the financial manager.

•

A smart financial manager will try to save running costs by reducing expenses. He will increase expenses if more value is created by spending more.

•

Formulation of a Project involves various stages such as: Generation and Screening of Ideas, Data Collection, Documentation, Project Appraisal and Conclusion.

•

Financing of a Project involves detailed study on various aspects such as: Investment in the Project, Sources of Funds, Cost of Each Source, Weighted Average Cost of Funds invested and Return on Investment from the Project.

•

Implementation of a Project involves Engagement of Consultants, Financial Closure, Contracts Finalization, Execution of Contracts/Project, Monitoring and Control, Completion of Construction, Commissioning, Performance Guarantee Test, Handing over to Operations and Closure of Contract.

•

Post Implementation Work includes Analyzing Completion Cost and Capitalization and Post Project Evaluation and Report.

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Activities 1. What capital project do you have in mind? Is it a new factory/new machinery for new products/etc.? Is land acquired for said purpose? Do a rough guesstimate of the capital project you have in mind? What would be the approximate capital investment required? Remember that banks will expect promoters to chip in some contribution (from 20% to 50%) for capital expenditure projects. You can expect assistance of balance funds from the bank. What security can you offer to avail the said loan? Usually, banks expect additional security to the extent of loan amount. a. If land is acquired or it is a running factory, copies of Conveyance Deeds/ Agreements/title copies of the land. b. Start collecting catalogues and price lists of various machineries required for the unit. Catalogues and Prices from three different vendors are desired. c. Copies of Conveyance Deeds/Agreements/title copies of the collateral security. (In case, you are not able to provide documents as required for questions (a) and (b), you may make a summary project report which you would like to take up if you were provided the necessary resources). 2. Approach any nationalized bank or co-operative bank and take the forms for Term Loans and Working Capital Loans. Study the data requirements by the bankers to finance a Project Loan. 3. Make a excel sheet of monthly company’s Revenue Expenditure. Include important heads such as Raw Materials, Business Promotion, Bank Interest, Electricity, Salaries, Staff Welfare, Maintenance/Rent, Electricity, Professional Charges, etc. Compare it vis-à-vis your company’s monthly income. Or

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Make a excel sheet of monthly household expenses (Revenue Expenditure). Include important heads such as Food, Education, Maintenance/Rent, Electricity, Travel, Salaries, etc. Compare it vis-à-vis your household’s monthly income. 4. Use net resources and find out and write in detail out the ‘Make in India’ campaign.

1.9 Self Assessment Questions 1. What is a Project? 2. Write down three major differences between Capital Expenditure v/s Revenue Expenditure. 3. What can a company do to stimulate the flow of project ideas? 4. Draw the flowchart for different stages of a Project Formulation. 5. What are the different stages of Project implementation? 6. What is the Post Implementation Work carried out? 7. Draw the complete flowchart for entire life cycle of the Project.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Video Lecture

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PROJECT APPRAISAL

Chapter 2 PROJECT APPRAISAL Objectives After studying this chapter, you should be able to: •

Provide conceptual understanding about Project Appraisals.

•

Outline the importance of Project Appraisals.

•

Bring out the various aspects of Project Appraisals.

•

Enlist the various documents required by financial institution.

Structure: 2.1

Introduction to Project Appraisals

2.2

Importance for Appraisals

2.3

Aspects of Project Appraisals

2.4

Supporting Documents Required by Financial Institution to Appraise a Project

2.5

Summary

2.6

Self Assessment Questions

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2.1 Introduction to Project Appraisals Project appraisal is the structured process of assessing the viability of a project or proposal. It involves calculating the feasibility of a project before resources are committed. It is an essential tool for effective action in starting a project. Project Appraisal is also a tool used to review the projects completed by the organization. When a project is at the conceptualization stage, the owners and managers have a rough idea of what they are going to produce, what price they might sell it, and how many units will be sold. Many a times, project conceptualization takes place on the basis of an idea or market gap perceived by the Top Management or Project Manager.

! Project Appraisal may be carried out by the various stakeholders or interested parties such as: •

Owner of the project

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Banks, that do the financing

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Financial institutions, that do the financing

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Government appraising agencies. !

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The Project Appraisal gives a clear and unbiased view from an outsider’s point of view. It is a means which can give a better picture of partnerships can choose the best projects to help them achieve what they want for the organization. It is defined as taking a second look critically and carefully at a project by a person who is in no way involved or connected with its preparation. He is able to take independent, dispassionate and objective view of the project in totality, along with its various components Any project’s success or failure depends on the pre-planning work carried out by the project’s team and the promoters. A project’s success or failure depends 80% on thorough planning and appraisals and 20% on execution and other parameters. The earlier the project appraisal starts the better it is for the organization. The company is in a better position to decide how much capital to deploy for the project to decide to scrap an unviable project. Various types of examinations forming part of the Project Appraisal are: 1. 2. 3. 4.

Technical Appraisal Economic Appraisal Market Appraisal Financial Appraisal

Project appraisal is a requirement before funding of project is done. But tackling problems is about more than getting the systems right on paper. Experience in projects emphasizes the importance of developing an ‘appraisal culture’ which involves developing the right system for local circumstances and ensuring that everyone involved recognizes the value of project appraisal and has the knowledge and skills necessary to play their part in it. Project appraisal helps project managers to: •

Be consistent and objective in choosing projects

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Make sure their program benefits the organisation

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Provide documentation to meet financial and audit requirements and to explain decisions to all the stakeholders and auditors.

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The terms evaluation, appraisal and assessment are used interchangeably. They are used in analyzing the soundness of an investment project. The analysis is based on projections in terms of cash flows. The analysis is carried out by the entrepreneurs or promoters of the project, the merchant banker who, is going to be involved in the management and underwriting of public issue and public financial institutions who may lend money. Project evaluation is indispensable because resources are limited and alternative opportunities in terms of projects exist for commitment of resources. A Project should only be selected if it is superior to others in terms of profitability (net financial benefits accruing to owners of project) or on national profitability (net overall importance of the project) to the nation as a whole. The purpose of the project appraisal is to ensure that the project is technically sound, provides reasonable financial return and conforms to the overall economic policy of the country. In view of the importance of the competitive status of unit, performance measures have to be applied to assess the ability of a unit to meet competition in the modern business environment.

2.2 Importance for Appraisals Appraisals are very important before dedicating resources towards a project. Some of the important reasons for appraising a project are: 1. Appraisal justifies spending money on a project Appraisal asks fundamental questions about whether funding is required and whether a project will create value for the organization. It can give confidence that the money is being put to good use, and help identify other funding to support a project. Getting it right may help an organization garner further resources to meet the project objectives. 2. Appraisal is an important decision making tool Appraisal involves the comprehensive analysis of a wide range of data, judgments and assumptions, all of which need adequate evidence. This helps ensure that projects selected for funding: • • • •

Will help the organisation achieve its objectives Are deliverable Are sustainable Have sensible ways of managing risk.

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3. Appraisal lays the foundations for delivery Appraisal helps ensure that projects will be properly managed, by ensuring appropriate financial and monitoring systems are in place, that there are contingency plans to deal with risks and setting milestones against which progress can be judged. 4. Getting the system right The process of project development, appraisal and delivery is complex and should be suitable to the organization. Good appraisal systems should ensure that: •

Project application, appraisal and approval functions are separate

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All the necessary information is gathered for appraisal, often as part of project development in which projects will need support.

2.3 Aspects of Project Appraisals Brief write-up on various types of appraisals namely: 1. Technical Appraisal Technical Appraisal is the technical review to ascertain that the project is technically sound in all respects with respect to various parameters such as technology, plant capacity, raw material availability, location, manpower availability, etc. The technical review is done by qualified and experienced personnel available in institutions and/or outside experts (particularly where large and technologically sophisticated projects are involved). 2. Economic Appraisal Economic appraisal is the economic review carried out by financial institutions that looks into the economic benefits to the society and to the nation. They also look at various parameters such as resource cost and effective rate of protection. Admittedly, the economic appraisal done by financial institutions is not very rigorous and sophisticated. Also, the emphasis placed on this appraisal is rather limited. 3. Market Appraisal Market Appraisal is carried out to understand the potential market for the products and at the marketing strategy. A review of the market survey and

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competence of the marketing team. Also, whether the unit can sell its products at the desired/estimated price points. 4. Financial Appraisal Financial appraisal is concerned with assessing the financial feasibility of a new capital investment proposal 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.

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! A 3D visual of the proposed project provide a vision to the project team.

2.4 Supporting Documents required by Financial Institution to Appraise a Project 1. Completed Input Form in their format 2. Company Profile, Promoters Profile 3. Past audited accounts for three years of the company and associated entities 4. Copies of J.V./Technical Collaboration, if any 5. Organization Chart

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6. Profile of Key Staff Members 7. List of machineries procured/to be procured 8. Contracts/Arrangement to procure various raw materials 9. Market Survey Report from reputed Consultants/Surveyors 10.Marketing material prepared, catalogues 11.Financial Projections, Cash flows, Fund flows, Break-even Point Analysis 12.Licenses, Clearances for the project 13.Title deeds of land, Approvals to start construction 14.In-principle arrangement for Working Capital Facility from Banks, etc.

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2.5 Summary •

Project Appraisal is a structured process of assessing the viability of a project.

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Project Appraisal is important as it: ❖ ❖ ❖ ❖

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Project Appraisal is broadly divided into following four aspects: ❖ ❖ ❖ ❖

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justifies spending money on a project is an important decision making tool lays the foundations for delivery Ensure getting the system right.

Technical Economic Market Financial.

Financial Institutions require an exhaustive list of documents to carry out Project Appraisal.

Activities 1. Your friend wants to start a company selling groceries online. He has approached you for financial loan of Rs. 5 lakhs being part of the project cost. What assessment (what questions would you ask) would you carry out to decide whether you’ll assist your friend or not? 2. Find out suitable companies/consultants carrying out Project Appraisal in and around your location.

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2.6 Self Assessment Questions 1. What is meant by Project Appraisal? 2. What is the importance of Project Appraisal? 3. What are the various aspects of Project Appraisal? Write a brief note on each. 4. Enlist the major documents will help a financial institution to appraise the Project.


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Video Lecture


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Chapter 3 TECHNICAL APPRAISAL Objectives After studying this chapter, you should be able to: •

Provide conceptual understanding to Technical Appraisal.

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Inform the various aspects of Technical Appraisal.

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Get an introduction to Plant Flexibility and Flexible Manufacturing Systems.

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Know about Project Charts and Layouts.

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Assess Competitive Status of a Project/Unit.

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Learn a few methods to improve quality and productivity.

Structure: 3.1 3.2 3.3 3.4 3.5 3.6 3.7 3.8 3.9 3.10 3.11

Introduction Aspects of Technical Appraisal Flexibility of Plant and Flexible Manufacturing Systems Interdependence of the Parameters of Project Project Charts and Layouts Cost of Production Assessing Competitive Status of a Project/Unit Methods to Improve Quality and Productivity Review of the Project Summary Self Assessment Questions

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3.1 Introduction Technical Appraisal is the technical review carried out by financial institutions to ascertain that the project is technically sound with respect to various parameters such as technology, plant capacity, raw material availability, location, manpower availability, etc. Is the project in a position to deliver marketable products from the resources deployed? Is the Return on Investment sufficient to service the cost of loan/equity and leave a reasonable amount for the enterprise to carry out sustainable operations? Technical appraisal is important as: 1. It ensures that the project is technically feasible – all the inputs required to set up the project are available. 2. It facilitates the optimal project formulations in terms of capacity, technology, location, technology, size, etc. Usually, technical appraisal is carried out by independent agencies carrying out technical studies or by the institution by their in-house technical experts. The financial analyst participating in the project appraisal exercise should be able to raise basic issues relating to technical analysis using common sense and economic logic. 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.

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! A Petrochemical Plant is a highly technical and complex project

! A Marina bay though looks simple is very technically challenging project

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3.2 Aspects of Technical Appraisal The technical review done by the financial institutions focuses mainly on the following aspects: • • • • • • • • •

Manufacturing Process/Technology Technical Arrangements Material Inputs and Utilities Product Mix Plant Capacity Location and Site Machineries and Equipments Structures and Civil Works Environmental Aspects

3.2.1 Manufacturing Process/Technology For a manufacturing product/service, often two or more alternative technologies are available. For example, •

Cement can be made either by dry process or the wet process.

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Vinyl chloride can be manufactured by using one of the following reactions: acetylene on hydrochloric acid or ethylene on chlorine.

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Steel can be made either from Bessemer process or open hearth process.

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Soda can be made by the electrolysis method or the chemical method.

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Paper, using bagasse as the raw material can be manufactured by the Kraft process or the soda process or the Simon Cusi process.

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Soap can be manufactured by semi-bottled process or fully boiled process.

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! 1. Production of Molten Steel

! 2. Production of iron and rough steel products

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! 3. Production of Cement by the Dry Process


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! 4. Production of Vinyl Chloride

3.2.2 Choice of Technology The choice of technology is influenced by a variety of considerations such as: •

Availability of raw materials/inputs: Raw materials should be easily available for unhampered production cycle. Sometimes, quality of some raw materials affects the process/technology used. For example, the quality of limestone determines dry or wet process should be used for a cement plant.

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Availability of manpower and transport: The plant should not be located where skilled labor for that industry is not available. For example, a footwear company that required skilled stitching labor would not be advisable to be set up where the laborers would be hesitant to travel/ stay.

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Plant Capacity: To meet a certain plant capacity requirement, only a certain production technology may be viable.

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Investment outlay and production cost: The cost of technology/ process should not be so high that the unit itself is uncompetitive and cannot sustain over a period of time.

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Use by other Units: The technology adopted should be proven successful by other units, preferably in India.

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Product mix: Usually, a number of products/variants/models are manufactured using the same process. Therefore, the technology/process used must be able to produce all the products in the product mix.

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Latest developments: Technology adopted should be based on latest developments so that technological obsolescence in near future is avoided.

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Ease of absorption: An advanced technology may be available but may have to be shelved due to inadequate trained manpower to handle that technology.

3.2.3 Technical Arrangements It is important for a unit to have a good technical collaborator or a good consultant to guide it in relation to the manufacturing process. Major technical inputs include: a. Selection of the process or technology. Design, purchase, procurement and installation of the plant and training of the manpower. b. Process and performance guarantees in terms of plant capacity, product quality and consumption of raw materials and utilities. c. Periodic Royalty fees or one-time licensing fees. d. Period of collaboration agreement. 3.2.4 Material Inputs and Utilities An important aspect of technical analysis is concerned with defining the materials and utilities required. Material Inputs and Utilities may be classified into four broad categories:

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a. b. c. d.

raw materials processed industrial material and components auxiliary materials and factory supplies utilities.

3.2.5 Product Mix A company offering a wider choice to its consumers can cater to a wider segment of customers or offer better consumer satisfaction. While planning production facilities for a firm, flexibility with respect to product mix enables company to alter its product mix to survive in changing market conditions. For example, a garment manufacturer can offer wide range in terms of size and quality to different consumers. Biscuit and Fast food snack manufacturers can have smaller pouches at low cost for one-time users and larger economical sizes for monthly family consumption. 3.2.6 Plant Capacity Plant Capacity refers to the number of units or volume that can be produced during a given period. In traditional manufacturing system, capacity is defined as the maximum output available. However, operating conditions like power or raw material or labor shortages can influence capacity. Sometimes, seasonal availability of raw materials (such as sugarcane for sugar plants) can hamper plant capacity. 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 unintegrated mill of the same capacity producing fabric grey cloth. Sometimes additional investment would improve the profitability enormously. In a caustic soda plant, recovery of chlorine and hydrogen no doubt require additional investment but improve profitability as compared to a plant producing just caustic soda.

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3.2.7 Location and Site Location refers to a fairly broader area such as city or town or industrial zone where the plant is likely to be set up. Site refers to the actual piece of plot where the plant is going to be set up. Usually, location is selected such that it is close to supply of raw materials and/or to the markets where the final products shall be consumed. Further, availability of infrastructure such as roads, power and water availability are critical. By power, we broadly mean power supply that is cost-effective, uninterrupted and stable. Transportation of raw materials to the plant and finished goods to the markets is also possible in cost-effective and available easily. Polluting units should be set up away from residential areas, in approved industrial zones and where permission from Pollution Control Board is easily available. Usually, polluting units are set up where the Effluent Treatment Plants (ETPs) are already available to neutralize the output waste. 3.2.8 Machineries and Equipments The machinery and equipments for a particular project are dependent on the production technology and plant capacity. In selecting the machineries and equipments, the various stages should be matched well. If technical expertise is insufficient, external consultants must be employed to ensure smooth flow of production over long periods of time. 3.2.9 Structures and Civil Works Structures and civil works comprise of: a. site preparation and development b. buildings and structures c. outdoor works. Structures and civil works are the domain of the technical team, equipment suppliers, architects, structural consultants and the administration team. Various technical design parameters are taken into consideration such as load requirements for machinery foundation, height of machinery/ceiling, ventilation, heat generated in the production areas, cleanrooms, administrative staff requirements, loading/unloading areas, secure zones, handling of effluents and wastages, etc.

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3.2.10 Environmental Aspects A project may cause environmental pollution in the form of emissions, effluent discharge, noise, heat and vibrations. Environmental aspects of the project have to be properly examined. Polluting units should be set up away from residential areas, in approved industrial zones and where permission from Pollution Control Board is easily available. Usually, polluting units are set up where the Effluent Treatment Plants (ETPs) are already available to neutralize the output waste. In technical appraisal, inputs are scrutinized 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.

3.3 Flexibility of Plant and Flexible Manufacturing Systems The consumer demands are at an all-time high – choice of colors, taste, packaging, sizes and at the desired prices. At the same time, the production being sustainable for the organization. Today is the age of mass customization. Flexibility is desired at the production level so that more customization is possible to suit the wide variety of users. Flexible manufacturing system is the emerging system to manufacture what the customer wants. These systems help in production of a large variety of products in small batch sizes. The days of assembly line manufacturing emphasizing economies of scale are over. Even otherwise flexibility imparts strength to the project to withstand market fluctuations and variations in the quality of inputs.

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3.4 Interdependence of the Parameters of Project Undependable supply of basic inputs could result in closure of the project or bankruptcy of the organization. If coal, the main ingredient for a power plant is not available in sufficient quantity, it can throw all project calculations in disarray. It will affect not just the organization but also millions of consumers, production facilities and the national economy. If iron ore is not available for a steel unit, it can disturb steel production while will have a cascading effect on important infrastructure projects. It is better to have as much interdependence of parameters so that shortfall in one can have disorder in the entire project. For example, a small integrated paper plant using bagasse, paddy husk or straw without need to recover process chemicals is considered more viable than large integrated paper mill requiring forest based raw material, water and effluent disposal system.

3.5 Project Charts and Layouts Project charts and layouts are the tools 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 plan layout. The various different kinds of technical drawings are: 1. General functional layout should facilitate smooth and economical movements of raw materials, work-in-progress and finished goods. 2. Material flow diagram presents flow of materials, utilities, intermediate products, final products scrap and emissions. 3. 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. 4. Utility layouts show the principal consumption points of power, water and compressed air which helps in the installation of utility supply.

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5. Plant layout identifies the exact location of each piece of equipment determined by proper utilization of space leaving scope for expansion, smooth flow of goods to minimize production cost and safety of workers.

! General Functional Layout/Plant Layout

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! Material Flow Diagram

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! Production Line Diagram

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Utility Layout

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Plant Layout

3.6 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 utilization, consumption norms for various inputs and yields and recovery of by-products. In estimating production, a general build-up starting with 40% and reaching a normal level of 80% in three to four years time is provided. In practice, capacity utilization 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,

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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.

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3.7 Assessing Competitive Status of a Project/Unit Just delve over the technological developments over the past few years; Do we use the VCR nowadays, Audio Players, CD Players, Fax machines, Telex, Wire Connected Landline phones? Globalization of world economies and availability of new technologies expose any product or project to the severe global competition. It is necessary to ensure that the project/unit is strong and can face competition. The competitive status of a manufacturing unit is evaluated by eight performance measures some of which form part of technical appraisal. • • • • • • •

Manufacturing Lead Time (MLT) Work-in-process (WIP) Throughput Capacity Flexibility Performability Quality

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1. MLT: The manufacturing lead time (MLT) is the total time required to process the product through the manufacturing plant. MLT should ideally be equal to actual machining and assembly time. The ratio of MLT to the sum of processing time is a good indicator of the time a part is unnecessarily lying on the factory floor. Real value is added to a product during a product’s passage through the production system. Other times such as move time, queue time and setup time should be reduced. 2. WIP: Work-in-process (WIP) is the quantity of semi-finished product currently lying on the factory floor. WIP constitutes an investment and many companies incur large WIP costs. Recent trend is to consider inventory as avoidable since required items only are produced. WIP can be measured by multiplying the rate at which parts flow through the factory with the length of time parts spend in the factory which is MLT. The number of parts currently being processed should be equal to the number of busy machines which in turn equals the total number of machines multiplied by the utilization factor. Ideally, there should be as many parts waiting as are being processed. WIP should be low. 3. Machine utilization: Machine utilization should not be decided with a view to amortize the cost of machinery faster by higher utilization. Such a view turns a machine asset into an inventory asset. Idle inventory may be perishable or may not be in demand resulting in tying up cash in raw materials. If the choice is between idle machinery and building up inventory, let the machine be idle. Machine should be run to manufacture exactly the right quality of exactly right things at exactly the right time. 4. Throughput: Throughput is the hourly or daily production rate which is the reciprocal of production time per unit of the product. 5. Capacity: Capacity is defined in terms of possible output the plant is able to produce over some specified duration. In the case of continuous plant, the duration is 24 hours a day, 7 days a week whereas in others it is defined over a shift period. Capacity is measured as tons in the case of a steel mill, seat miles in the case of airlines, rooms in the case of hotels and total available beds in the case of hospital. Available machine hours are used to measure capacity when output is non-homogenous or the plant produces a variety of products.

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6. Flexibility: Flexibility is the ability of the system to respond effectively to change. High degree of flexibility requires higher levels of automation and large investment. Flexibility is fundamental to achieve competitiveness. Further it provides a strategic advantage to handle risk associated with uncertain markets. Transfer lines which produce identical parts do not have flexibility and cannot tolerate design modifications or part mix changes or machine failure. On the other hand, job shops are highly flexible and are used for manufacture of oneof-a-kind products. Their trait is large MLT and high WIP. 7. Performability: Performability is influenced by the unscheduled downtime of the equipment. In a manufacturing system, the two constituents are the workpiece and the manufacturing in equipment. Workpiece can cause faults resulting in line stops; and equipment can fail because of wearing down. Production is then a function of repair time due to failures and fault. Reliability and availability measure the percentage of down time and repair time. Reliability of a manufacturing system is defined as the probability that it will perform well enough to produce quality products. Availability is the instantaneous availability of a system at an operational time. 8. Quality: Maintenance of high quality depends on the integrity of the materials and integrity of manufacturing process. Together, they help the supply of products that are made right the first time. Quality is an important constituent in attaining competitiveness. Total Quality Control (TQC) involves control of quality at source. Errors should be corrected at the source where work is performed. This is defect prevention where workers and supervisors have the primary responsibility for quality and any problems with process are corrected immediately. Quality control at source provides fast feedback on defects. This is unlike the sampling method employed after the lot has already been produced. The benefits of total quality control are fewer rework labor hours and less material waste. Good quality increases productivity. The basic requirements of total quality control are process control, easy to see quality, insistence on compliance and 100% inspection.

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3.8 Methods to Improve Quality and Productivity India ranks at a dismal low vis-à-vis Global benchmarks in terms of launch of innovative products, productivity and safety records. There is an urgent need to improve the quality and productivity to strengthen the competitiveness of Indian industry. Among the methods used to Myron productivity and strengthen competitiveness are expert systems and enterprise resource planning (ERP) which spread the use of lean techniques and lean thinking. The adoption of these methods has to be insisted upon while making appraisal to help improve the competitiveness of the unit. 1. Expert Systems (ES): Expert Systems (ES) are being used in manufacturing environments to improve productivity and flexibility. They are used along with capacity planning to ensure that parts are manufactured to meet due dates and optimize use of production equipment. When used in conjunction with conventional methods, ES can handle unforeseen circumstances allowing for easy extension and modifications to revised schedules. They are also used for simulation of the scheduling system and to assist with machine learning of scheduling procedures. An ES is a computer program that performs a task normally done by an expert and which in doing so, uses captured, heuristic knowledge. It can make the best expertise available to a decision maker at the very moment the decision must be made. Its primary function has been in diagnostics, decision making, system debugging and problem solving. Of late, its use in the field of manufacturing has grown considerably, and now many systems are being used in the areas of production scheduling, process planning, quality control and inventory management. Expert system has two components, knowledge base and an inference engine. Inference engines are of two types, backward chaining which is goal driven and forward chaining which is data driven. They can be used to search knowledge and find a suitable solution to the problem one has. For metal industry, researchers in the US have developed an ES to produce rolling mill schedules (procedures) that yield specified values for

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metallurgical properties such as grain size and internal stress. The results were used to help consolidate and downsize the overall operations. Expert systems are a way to convert corporate knowledge into corporate assets. An ES enables the distribution of knowledge of experts present in one place and to accumulate in one place; the knowledge of several widely separated experts. Usually, ES is faster and more accurate as it uses the same logic normally used by the expert. Resort to ES is attributable to the need to cut the lead time required to carry a product from conception to a finished state. To remain competitive in the global context, manufacturing has to do better and more, using fewer resources. Lean manufacturing uses less of each input: less labor, less machinery, less space, and less time in designing products. In lean production, each act in the factory, as it were done on demand.

! Expert Systems

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2. Enterprise Resource Planning (ERP): Lean techniques apply the idea of lean production thinking to the whole company. The supply chain connects the factory to its suppliers upstream and its customers downstream. Various parts of the company need to share the flow of the same information. The new software program let the companies integrate their financial data with payrolls, manufacturing and inventory records and purchasing. Enterprise Resource Planning (ERP) is the toolkit that spreads lean thinking throughout the company. A company using ERP can know, how efficiently its various resources, people, money, machines are being used to satisfy its customers. The integration of all aspects of company data into the same software helps to keep manufacturing operations in balance and to keep work flowing smoothly through the factory. Bottlenecks and imbalances show up quickly and can be set right.

! Enterprise Resource Planning

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3.9 Review of the 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. The implementation of the project has Cost and Time overrun implications. The scheduling of construction, delivery and installation of machinery and other 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 the 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 Gantt Charts, PERT, CPM and GERT and proper adherence to them is an essential aspect to be insisted upon in technical appraisal.

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3.10 Summary •

Technical Appraisal is the technical review to ascertain that the project is sound with respect to various parameters such as technology, plant capacity, raw material availability, location, manpower availability, etc.

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For manufacturing a product/service, often two or more alternative technologies are available. The choice of technology is influenced by a variety of considerations: plant capacity, principal units, investment outlay, production cost, use by other up product mix, latest developments, and ease of absorption.

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Satisfactory arrangements have to be made to obtain the technical knowhow needed for the proposed manufacturing process

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Material Inputs and Utilities forms is an important aspect of technical analysis. Materials may be classified into four broad categories: (i) raw materials, (ii) processed industrial materials and components, (iii) auxiliary mated and factory supplies, and (iv) utilities.

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Appropriate technology refers to those methods of production which are suitable local economic, social, and cultural conditions.

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Several factors have a bearing on the plant capacity decision: power, raw material availability, technology requirements, etc.

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The choice of location is influenced by a variety of considerations: proximity for materials and markets, availability of infrastructure facilities, and other factors. Once a broad location is chosen, the attention needs to be focused on the selection of site-specific piece of land where the project would be set up.

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The requirement of machinery and equipment is dependent on product technology and plant capacity. Further, it is influenced by the type of product.

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A project may cause environmental pollution in various ways. Hence, environmental aspects have to be properly examined.

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The important Project charts and layout drawings are: (1) general functional layout, (ii) material flow diagrams, (iii) production line diagram, (iv) transport layout, (v) utility consumption layout, (vi) communication layout, (vii) organizational layout, and (viii) plant layout.

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Estimates of the Cost of Production takes into account the costs such as raw materials, power and fuel, product R&D, administrative overheads, interest on borrowings, etc.

•

Competitive Status of a project is assessed to ensure that the project is strong and can face competition.

•

Quality and Productivity can be improved by implementing Expert Systems (ES) and Enterprise Resource Planning (ERP).

Activities 1. Find out names and contact numbers of a Technical consultants. Use internet resources to read their profile and work carried out by them. 2. The promoter you are working for is looking out for starting a new engineering/assembly unit. Use local newspapers (advertisements in classified sections) and net resources to locate suitable industrial zones in your state and neighboring states. You may go to sites of various State Industrial Development Corporations and/or search for private industrial plots in various zones. Find out the minimum/maximum plot sizes and approximate capital investment required for land purchase. 3. Which are the popular ERP packages available in the market? Do a comparative study on them?

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3.11 Self Assessment Questions 1. What is Technical Appraisal? 2. What are the different aspects of Technical Appraisal? Explain each in brief. 3. Explain the different types of charts and layouts. What are the differences between each? 4. What do you understand by Flexible Management System? Justify its need. 5. State the criteria to evaluate the competitiveness of the unit. 6. Discuss the methods to improve productivity and competitiveness.


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ Video Lecture - Part 1 Video Lecture - Part 2


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ECONOMIC APPRAISAL

Chapter 4 ECONOMIC APPRAISAL Objectives After studying this chapter, you should be able to: •

Provide conceptual understanding on Economic Appraisals.

•

Know the different aspects of Economic Appraisals.

•

Learn about Social Cost Benefit Analysis.

•

Know how the SCBA is followed by Financial Institutions.

Structure: 4.1

Introduction

4.2

Aspects of Economic Appraisal

4.3

Social Cost Benefit Analysis

4.4

SCBA by Financial Institutions

4.5

Summary

4.6

Self Assessment Questions

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4.1 Introduction Let us study the names of some of the financial institutions that fund projects: a. b. c. d.

IDBI – Industrial Development Bank of India SICOM – Small Industries Corporation of Maharashtra IFCI – Industrial Financial Corporation of India TFCI – Tourism Finance Corporation of India

We see that these institutions are formed for some specialized purpose. One’s objective is to promote Industrial Development, someone if for small industries, someone else for promoting tourism. The goal is not simply to earn profit. This indicates that these institutions are formed for a greater purpose rather than just earning profit. Earning money is important for creating sustainable institutions, but while earning profit, they also do a good to the society and the vast majority of population.

4.2 Aspects of Economic Appraisal Economic Appraisal of a project deals with the impact of the project on economic aggregates. The study of the potential impact of the project to the nation and the society. We may classify these under two broad categories: They are: 1. Employment generation – effect of the project on net social benefits or welfare 2. Foreign Exchange savings – effect of the project on foreign exchange The economic appraisal looks at the project from the larger point of view. Economic Appraisal analyzes if the benefits will justify the project cost/ investment done. A successful project gives following benefits:

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ECONOMIC APPRAISAL • • • • • • • •

Increased output Enhanced services Increased employment Larger government revenue Higher earnings Higher standard of living Increased national income Improved income distribution

The economic appraisal done by financial institutions is not very meticulous and precise. Also, the emphasis placed on this appraisal is rather limited. 4.2.1 Employment Generation While assessing the impact of a project on employment, the impact on unskilled and skilled labor 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 should be counted. 4.2.2 Foreign Exchange Savings A project may produce goods that have to be imported from foreign countries currently. By producing them in our country, the country might save a lot of foreign exchange. Or a project could be Export Oriented that might get a lot of foreign exchange within our country. In such cases, an analysis of the effects of the project on balance of payments and import substitution is necessary. Special formats are prepared by the institutions to study this impact. 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.

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! SMEs provide a good source of employment for the Nation

4.3 Social Cost Benefit Analysis Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment projects from the social point of view. Social Cost Benefit Analysis is concerned with the examination of a project from the view point of maximization of net social benefit. SCBA has received a lot of emphasis in the last few decades as it is believed that not just government but also private projects carry some responsibility in imparting social benefits to the nation. In SCBA, the focus is on the social costs and benefits of the project. These often tend to differ from monetary costs and benefits of the project. The principal sources of discrepancy are: a. b. c. d. e. f.

Market imperfections Externalities Taxes and subsidies Concern for savings Concern for redistribution Merit wants

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a. Market Imperfections Perfect market competition conditions are very rare. Market imperfections create inaccurate prices of products and services. When imperfections exist, market prices do not reflect social values. The common imperfections found in developing countries are: i) rationing, ii) prescription of minimum wage rate, and iii) foreign exchange regulation. Consumers pay less for a commodity under rationing than they would in a competitive market. When minimum wages are prescribed by law, laborers are paid more than what they would be paid in perfect market conditions. Similarly, foreign exchange rates in a regulated developing economy are less than what would prevail in absence of exchange regulations. b. Externalities A project may have beneficial external effects. A road created for its new project may benefit neighboring areas. These benefits are considered in SCBA although they do not receive any monetary compensation from the external beneficiaries. Similarly, a project may have harmful external effect like environmental pollution. In SCBA, the cost of environmental pollution is relevant although the project sponsors do not incur monetary costs. c. Taxes and Subsidies Taxes are definitely monetary costs and subsidies are monetary gains. For SCBA, they are irrelevant as they are just considered as transfer payments. d. Concern for Savings For SCBA, the division of benefits between consumption and savings is relevant especially in developing countries. However, for project sponsors this may be irrelevant.

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e. Concern for Redistribution: A private company is not bothered as to how project benefits are distributed amongst different groups in society. The society however, is concerned about the distribution of benefits across different groups. f. Merit Wants: There are differences of goals amongst the marketplace and the policymakers. For example, a blood donation camp or balanced nutrition program for school going children is not sought by consumers in the marketplace. However, from SCBA point of view, it is very relevant.

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! A Power Plant Generate a Lot of Social Benefits, Despite itself Creating Substantial Pollution

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4.4 SCBA by Financial Institutions While financial institutions approach project proposals primarily from finance point of view, they also evaluate projects from larger social point of view. Though there a minor variations amongst various institutions, they essentially follow a similar approach which is a simplified version of the Little-Mirrlees approach. Various financial institutions in India carry out Economic Appraisals considering the following three aspects: a. Economic Rate of Return b. Effective Rate of Production c. Domestic Resource Cost

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4.5 Summary •

Financial Institutions are not just to fund promoters to fund their projects. They would also like to evaluate how the projects benefit the society.

•

Economic Appraisal looks at Employment generation and Foreign Exchange savings.

•

Social Cost Benefit Analysis (SCBA) is a methodology for evaluating investment projects from the social point of view.

Activities 1. Study the balance sheet of any five large Indian corporates. Find out how the organizations have indirectly benefited the nation. What are the CSR activities carried out by them? 2. Specifically, find out about five large projects. List out how their projects stand as per SCBA.

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4.6 Self Assessment Questions 1. What is Economic Appraisal? What are its aspects? 2. What do you understand by social cost benefit analysis? 3. What are the causes of discrepancies in SCBA? 4. Is distribution of project’s benefits irrelevant in Project Appraisal? Give your views on the same.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Video Lecture


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MARKET APPRAISAL

Chapter 5 MARKET APPRAISAL Objectives After studying this chapter, you should be able to: • • • • • • • • • •

Provide a conceptual understanding on Market Appraisal. List the importance of Market Appraisal. Provide familiarization on Aspects of Market Appraisal. Understand Demand Analysis. Explain the various methods of Demand Forecasting. Understand Market Analysis. Shed light on Market Segmentation. Provide insight on Product Positioning and Pricing. Provide insight on Distribution and Promotional Strategies. Explain on Managerial Appraisal.

Structure: 5.1 5.2 5.3 5.4 5.5 5.6 5.7 5.8 5.9 5.10 5.11 5.12 5.13 5.14

Introduction Importance of Market Appraisal Sales and Marketing – Birth of a Project Aspects of Market Appraisal Demand Analysis Methods of Demand Forecasting Market Analysis Market Segmentation Product Positioning and Pricing Distribution and Promotional Strategies Competitive Analysis Managerial Appraisal Summary Self Assessment Questions

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5.1 Introduction Market Appraisal is the review carried out by financial institutions to ascertain that the products manufactured by the project can be sold and its value realized. It ascertains whether the company has competent sales force and distribution network to sell the products manufactured. It is also necessary to establish how the project is going to capture its share of the feasible market. Whether the unit can sell its products at the desired price points? It ascertains the size of the potential market and whether the organization has a suitable marketing strategy. Is the project in a position to deliver marketable products from the resources deployed? Is the Return on Investment sufficient to service the cost of loan/equity and leave a reasonable amount for the enterprise to carry out sustainable operations?

5.2 Importance of Market Appraisal Market appraisal is important as: 1. It ensures that the project has the competent sales force and distribution network to sell the products manufactured. 2. It can sell the products at the price points such that it can service the interest on loans taken. Even after servicing the loan, there is sufficient surplus for the unit to carry out sustainable operations. 3. It ensures that there is a potential market which can be met by the production capacity of the unit. 4. There is a well thought-out sales and marketing strategy favorable for long-term operations.

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5.3 Sales and Marketing – Birth of a Project While launching a new product/model, a promoter or CEO or Project Incharge will delve on the following questions: How many units can be sold in first year, its expected selling price, its cost? Also, sales in further few years down the line. Then he will estimate the costs and profits generated. An example is depicted in the chart as shown: Sr. No.

Particulars

Year 1

1

No of Units Sold

2

Sales Rate per piece (Rs.)

3

Sales (Rs.)

4

Cost Price per piece (Rs.)

5

Cost Price (Rs.)

6

Profit (Rs.)

Year 2

Year 3

50,000

55,000

60,000

250

250

250

1,25,00,000

1,37,50,000

1,50,00,000

175

175

175

87,50,000

96,25,000

1,05,00,000

37,50,000

41,25,000

45,00,000

Next he will ask what are the indirect costs such as the Cost of Capital, interest costs, sales costs, salaries, etc. associated with the project. The other costs will have to be lower than the profit generated per year. Else, he will have to go to scratch and work out the numbers again. Usually, corporations go about on a new project in a systematic and welldefined manner. There is a detailed study on the market, demand for the product, technical aspects of the project, financial estimates, ways to raise the funds, etc.

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5.4 Aspects of Market Appraisal The Market Appraisal done by the financial institutions focuses mainly on the following aspects: • •

Demand Analysis Market Analysis

The first step in project analysis is to estimate the potential size of the market for the product proposed to be manufactured (or service planned to be offered) and get an idea about the market share that is likely to be captured. Two broad issues are covered by Market and Demand Analysis: • •

What is likely aggregate demand for the product/service? What share of the market will the proposed project enjoy?

These are very important, yet difficult questions in project analysis. Intelligent and meaningful answers to them call for an in-depth study and assessment of various factors like patterns of consumption growth, income and price elasticity of demand, composition of market, nature of competition, availability of substitutes, reach of distribution channels, so on and so forth. It is not only essential to estimate the demand for the product but also define the target customer to position the business in order to garner the unit’s share of sales. Further, it is necessary to establish how the unit is going to capture its share of the feasible market. Suppose a company wants to launch a new brand of high quality kitchenware in the domestic market. Important questions that should be asked to get a correct Market and Demand Analysis will be: •

Who are the buyers of the kitchenware?

•

What is the total current demand for this new kitchenware?

•

How is the demand distributed temporarily (pattern of sales over the year geographically)?

•

What is the break-up of demand of kitchenware of different types?

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What price will the customers be willing to pay for the improved range of kitchenware?

•

How can potential customers be convinced about the superiority of the new kitchenware?

•

What price and warranty will ensure its acceptance?

•

What channels of distribution are most suited for the kitchenware? What trade margins will induce distributors to carry it?

•

What are the prospects of immediate sales?

5.5 Demand Analysis Demand Analysis for the product proposed to be manufactured requires collection of data and preparation of estimates. Market appraisal requires description of the product, applications, market scope, market competition from similar products/substitutes, areas of competitive advantage, pricing, etc. In a highly competitive environment, customized products with short lifespan are vital. Customer needs are foremost to be kept in the manufacturer’s mind. Functionality, costs, delivery, service, physical appearance, etc. are some of the key parameters to be attended to. Physical distribution and manufacturing are a part of the supply chain. Reasonable estimates have to be made regarding existing and future demand of the product. After gathering the information, the existing position has to be assessed to ascertain whether unsatisfied demand exists. Since cash flow 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.

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5.6 Methods of Demand Forecasting A wide range of forecasting methods are available to the market analyst. It can be classified into three broad categories as under: Trend, Regression and End-use Method. 5.6.1 Trend Method The Trend Projection Method assumes that the demand in the number of units/sales increases by the same proportion as earlier. The behavior follows a linear equation or an exponential trend as in the past few years. In a linear trend, it would increase by a constant amount whereas in an exponential trend, it would increase by a constant percentage. Graphing the data will help to decide which period to choose and what type of form to be used for forecasting. Only after analysis of past data the trend line should be fitted. 5.6.2 Regression Method The Regression Method follows a concept of various dependent and independent factors or variables. The dependent variable is the one subject to forecasting. The independent variable is the ones that 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 foodgrains and rate of monetization of the economy. Specification of identification of factors is crucial in forecasting by regression approach. In multiple regressions, we have more than one independent variable. 5.6.3 End-use Method The method is appropriate for predicting demand of intermediate industrial products such as steel and caustic soda. The industries using these materials are identified. An intensive study of the past and thorough assessment of the future prospects of the various end-user industries is made. An expected production level of the various end-user industries is made and based on that the product use forecasts are made. Provisions have to be made for competition from substitute products and changes due to technological changes. Hence, the end-use method should be used judiciously. The end-use approach enable preparation of industry-wise customer demand forecasts and it is easy to evaluate any discrepancy in the forecasts with the actual value.

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Comparison of Trend, Regression and End-use Methods The Trend Method simply assumes that the demand follows the pattern as it has done so in the past. It 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. The End-use Method has limitations as it may be difficult to estimate the projected output levels of consuming industries. More important, the consumption coefficients may vary from one period to another in the wake of technological changes and improvements in the methods of manufacturing.

5.7 Market Analysis Market analysis deals with the study of the segmented market, product positioning, product promotion and distribution strategies and analysis of the competition. Market analysis defines the target customer, the resultant market in terms of size, structure, growth prospects, trends and sales potential. Various private companies also carry out market surveys for a fee. Further, good information relating to the market is available from various manufacturer/trade associations, trade journals and related Government Organizations.

5.8 Market Segmentation Market Segmentation narrows the total market which is segmented by factors such as geographic (where they live), demographic (who they are – age, sex, income), psychographic (why they buy – lifestyle factors) and synchrographic (when they buy). After the target market is defined, the feasible market has to be defined by identifying the various produce gaps. The unit’s share in the total feasible market is tied to the structure of industry, the impact of competition, strategies for market penetration and continued growth and advertisement budget.

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Market share depends on industry growth which will increase the total number of users of the product and conversion of users from the total feasible market during a sales cycle. A sales cycle has four distinct stages – early pioneer users, early majority users, late majority users and late users.

! Market Segmentation

! Distribution Channels

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5.9 Product Positioning and Pricing Product Positioning will help place the product as a differential identity in the eyes of the potential buyer. The strategy used for product positioning is usually the result of an analysis of customers and competition. Product Pricing decision is very important because it has a direct effect on marketing and financial success of the business. The basic rules of pricing are that they must cover costs and should be reduced only through lower costs. Prices may be determined on a cost plus basis as practiced by manufacturers to recover all costs, both fixed and variable and realize a desired profit percentage. Mark-up pricing is used by all retailers which are calculated by adding desired profit to the cost of the product. Finally, competitive pricing as in the case of markets where there is an established price and the product is more or less homogeneous.

! Product Positioning

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! Product Positioning for Chocolate Brands

5.10 Distribution and Promotional Strategies Choice of distribution channel to move the product from the factory to the end-user depends on channels being used by competitors and the strategic advantage it would confer. The company may choose direct sales, OEM (original equipment manufacturer) sales, manufacturer’s representative, wholesale distributors, brokers, retail distributors or direct mail. Apart from channels being used by competitors, choice of distribution strategy is based on factors such as pricing method and internal resources. A promotion plan consisting of controlled distribution to sell the product has to be formulated after the distribution strategy is formulated. It encompasses every marketing tool utilized in communication efforts. These are advertising, packaging, public relations, sales promotion and personal sales.

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Once the market has been researched and analyzed in terms of defining it, positioning the product and pricing, distribution and promotional strategies – financial projections can be made for three or five years.

5.11 Competitive Analysis The purpose of competitive analysis is to determine the strengths and weaknesses of competitors. Strategies that will confer a distinct advantage, barriers that can be raised in order to prevent competition from entering the market and any weaknesses that can be exploited within the product development cycle. The criteria employed to judge what constitutes a key asset or skill within an industry or market segment may be identified from any analysis of reasons behind successful as well as unsuccessful companies, prime customer motivators, major component costs and barriers to mobility. Through the competitor analysis, a marketing strategy that will generate a unique asset or skill to provide a distinct and enduring competitive advantage has to be framed. The results of market research which have helped in defining the distinct competitive advantage have to be communicated in a strategic form that will attract market share as well as defend it. Competitive strategies usually fall into product, distribution, pricing, promotion and advertising. The competitive advantage has to be clearly established. So, the appraiser of the project understands not only how the goals will be achieved but why the company’s strategy will work.

5.12 Managerial Appraisal In order to judge the managerial capability of the promoters, the following questions are raised: • • •

How resourceful are the promoters? How sound is the understanding of the project by the promoters? How committed are the promoters?

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5.13 Summary •

Market Appraisal is the review carried out to ascertain that the products manufactured by the project can be sold and its value realized.

•

Market Appraisal is important to determine whether the unit has a competent sales force and distribution network, the products can be sold at the estimated price points, there is a potential market for the products and there is a comprehensive sales and marketing strategy for long-term operations.

•

Market Appraisal comprises of Demand Analysis and Market Analysis.

•

Demand Analysis analyzes the aggregate demand of the product/services and what will be the potential market share of the unit.

•

Market Analysis studies the market segmentation, product positioning, product promotion and distribution strategies, competition, etc.

•

Financial Institution carry out Managerial Appraisal of the promoters as part of its appraisal.

Activities 1. Use internet resources to find out suitable Market Survey companies in and around your location. 2. Do a comparative analysis of the products of your company vis-à-vis competition. Please collect competitor’s catalogues and price lists. Make under heads such as technical specifications, quality, price, etc.

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5.14 Self Assessment Questions 1. What is Market Appraisal? State its importance. 2. What are the various aspects of Market Appraisal? Describe each in detail. 3. How do you estimate the demand for a product which you choose to manufacture? 4. What is Market Analysis? Describe each aspect in detail. 5. What is Managerial Appraisal?


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

!

Video Lecture


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FINANCIAL APPRAISAL

Chapter 6 FINANCIAL APPRAISAL Objectives After studying this chapter, you should be able to: • • • • • • • • • • •

Provide a conceptual understanding on Financial Appraisal and its importance. Shed light on working results of existing units. Provide familiarization on Cost of the Project. Provide familiarization on Sources of Finance. Provide understanding on Financial Projections. Explain Evaluation of Cash Flow and Profitability. Explain the popular methods of FA and Discounted Cash Flow Techniques. Explain estimation of Cost of Capital with CAPM. Shed light on Financial Analysis. Provide insight on Break-even Point. Appraisal of Advanced Manufacturing Systems.

Structure: 6.1 6.2 6.3 6.4 6.5 6.6 6.7 6.8 6.9 6.10 6.11 6.12 6.13 6.14

Introduction Importance of Financial Appraisal Working Results of Existing Units Cost of the Project Sources of Finance Financial Projections Evaluation of Cash Flows and Profitability Discounted Cash Flow Techniques Estimating Cost of Capital with Capital Asset Pricing Model (CAPM) Financial Analysis Break-even Point (BEP) Appraisal of Advanced Manufacturing Systems Summary Self Assessment Questions

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6.1 Introduction Financial Appraisal is the review carried out by financial institutions to ascertain whether the project to be financed is financial viable. The project could be a new project or expansion of existing production facilities. Any project appraisal exercise involves asking the three basic questions: Can we produce the goods or services? Can we sell the goods or services? Can we earn a satisfactory return on the investment made in the project? While first two questions are answered can be answered reasonably well through the technical and market appraisal. The most important question of earning sufficient return is answered through the Financial Appraisal. On aspect of Financial Appraisal is the assessment of funds required to implement the project and sources of the same. The other aspect relates to estimation of operating costs and revenues, prospective liquidity and financial returns in the operating phase. The project’s direct benefits are estimated at the prevailing market prices. Financial appraisal is concerned with the measurement of profitability of resources without reference to their source.

6.2 Importance of Financial Appraisal Financial Appraisal is important as: 1. It ensures that the project is able to get a reasonable return on the investment made to carry on sustainable operations. 2. It estimates the cash flows and reasonable level of profit that the unit can make from the operations. 3. It estimates the Cost of the Project and the Sources of Finance, their respective costs and the Cost of Capital of the unit to complete the project. 4. It deals with various liquidity and Capital Structure ratios.

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5. It determines the Break-even Point to find the exact level of sales and production when the unit can break-even.

6.3 Working Results of Existing Units For existing units, the banker and other stakeholders need to understand of the past performance of the company. Although the financial projections may project a very rosy picture about the future, they would like to assess what has been your performance in the past. The company’s last three audited balance sheets and profit and loss statements as well as the latest unaudited provisional accounts certified by the management/CA have to be analyzed. The latest balance sheet and profit and loss account may be analyzed with a view to ascertain, whether the concern is under/overcapitalized, 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 interlocking of funds with associate companies and whether the concern has been ploughing back profits into the business and building up reserves. They also assess the changes in balance sheets of the company over a period of time with respect to sales, profitability, fixed assets, etc.

6.4 Cost of the Project The capital cost of the project whether it refers to expansion or a new project should be shown under: i. ii. iii. iv. v.

Land and site development, Buildings, Plant and machinery, Technical know-how fees, Expenses on foreign technicians and training of Indian technicians abroad, vi. Miscellaneous fixed assets, vii.Preliminary and pre-operative expenses, viii.Provision for contingencies, and ix. Margin money for working capital. !

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It has to be ascertained that all these items are covered in the cost and the expenditure under each item is reasonable. It will help 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.

!

6.5 Sources of Finance The usual sources of finance for a project are: • • • • • • •

Share capital Term loans Debenture capital Deferred payments Miscellaneous sources Unsecured loans from promoters Internal accruals in the case of an existing unit.

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How should a promoter or project manager plan out the Project Capital Structure? He will rationalize the capital structure with the current legal and banking norms. a. Share Capital: Share Capital is the long-term contribution to the project by the promoters. Any financial institution/banker would expect the promoter to contribute around 20-30% of the total project. This promoter contribution increases with the increase in the size of the project. For large projects, bankers expect promoters to contribute almost 50% of the total project cost. The promoter contribution will be in the form of unsecured loans which the financial institution will insist to convert to Paid-up Equity Capital. Thus, the promoter contribution becomes locked in the project. Some portion of the Share Capital can also be in the form of Preference Capital by the preference shareholders who get generally paid a fixed dividend but who are not allowed to withdraw the sum invested. Preliminary expenses incurred by the promoter are included in promoter’s contribution. Modern finance in the form of Private Equity is available for startups and other companies that provide such companies with much needed equity capital to develop but comes at a higher cost are available nowadays. b. Term Loans: 70-80% of the Project Cost is usually funded by the institution. It goes down to 50% for very large projects. Depending on the project repaying capacity, the balance amount shall be funded by the financial institution for the usual tenure as per their norms. This is in form is a reducing balance Term Loan, where there is a principal repayment and interest on the outstanding loan balance. As the promoter repays and the outstanding loan balance is reduced, the interest repayment also reduces. There are some concessions by the government for technical entrepreneurs and female entrepreneurs. Usually, technical entrepreneurs have flexibility of lower promoter contribution and female entrepreneurs get some discount in the rate of lending.

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Terms loans are available in variety of forms such as Rupee Term Loans, Foreign Currency Term Loans, Working Capital Term Loans, etc. c. Debenture Capital: Debentures are debt instruments to raise capital from the public. Maturity period is of 5 to 9 years. There are convertible debentures and non-convertible debentures. Non-convertible debentures are straight debt instruments. Convertible debentures are convertible partially or wholly into equity shares – conversion period, price are determined in advance. d. Deferred Payments: Suppliers of capital goods offer a deferred credit facility under which the payments can be made over a period of time. e. Miscellaneous Sources: A small portion of the project finance can come from miscellaneous sources like public deposits, unsecured loans, hire purchase and lease facilities, etc. f. Unsecured loans from promoters: Promoters also do provide unsecured loans to bridge the gap between the promoter’s contribution and the equity capital required. g. Internal accruals in the case of an existing unit: Internal accruals from existing operations can fund marginally gap between the capital needs for the project. It is important that no gap is left in financing patterns. Otherwise it will result in cost overruns and time overruns in the implementation of the project. Financial institutions stipulate a condition that any kind of cost overrun or time overrun shall be funded by the promoters. 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 favor of other financing institutions.

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6.6 Financial Projections Projected Profit and Loss Statements, Balance Sheets and Cash Flow Statements over a long period – say 5 to 10 years will give us the realistic picture of the finances of the project. What is the profit generated over a period of time? What are the interest costs? What is the Return on Capital Employed? etc. These projected financial statements are interrelated and are prepared on the basis of various assumptions regarding capacity utilization, availability of inputs, their price trends and their selling prices, various indirect costs, statutory taxes, etc. These assumptions should be scrutinized carefully before making estimates. A proforma is annexed hereto. New units should not go for any sharp build-up of capacity within a year or two 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 companies, the product mix is decided on the basis of contribution of each product, utilization of plant capacity as well as market. There should also be reasonable annual increases in indirect costs such as wages and salaries, electricity, etc. Financial Appraisal’s main goal is to ascertain the profitability of the project. The promoter might present a very rosy picture to the financial institution due to his own conviction on the project but it is the task of analyst to verify the estimates. It is to be ensured that the profits projected are realistic and achievable. 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. Repairs and maintenance will have to be provided keeping in view the type of industry and the number of shifts to be worked. The profitability projections are closely linked to the schedule of implementation. On the basis of profitability projections, cash flow and projected balance sheets are prepared for a period of five to ten years.

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Project Cost Financing and Cash Flow Proforma for Appraisal (‘ lakhs) Particulars 0

Year 1 2 3 4 5

…

10

I. Cost of Project 1. Land and Building 2. Plant and Machinery 3. Working Capital Total Outlay II. Sources of Finance 1. Term Loans (1) 2. Equity Capital (2) (DE Ratio 1 : 2) Total III. Cash Flow Projections 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

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6.7 Evaluation of Cash Flows and Profitability There are various methods and two discounted cash flow techniques for financial appraisal to evaluate the cash flows and profitability of investment. The methods should have three properties to lead to consistently correct decisions. 1. It should consider all cash flows over the entire life of a project; 2. It should take into account the time value of money; 3. It should help to choose a project from among mutually exclusive projects which maximize the value of the companies’ stock. The two popular methods for Financial Appraisal are the: 1. Simple Rate of Return; and 2. Payback 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 two Discounted Cash Flow techniques for Financial Appraisal are the: 1. Net Present value Method (NPV) 2. Internal Rate of Return (IRR). They take into consideration the project’s entire life and the time factor by discounting the future inflows and outflows to their present value. 6.7.1 Simple Rate of 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

F+Y I

!

Re = Q

!

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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 utilization 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 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 suitable for financial analysis of existing units. It is not suitable for optimizing investment. 6.7.2 Payback Period Method Payback 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. 20 crores and an expected cash flow of Rs. 2 crores per year for 10 years, the payback period is given by, ! Payback period =

Initial investment outlay 20,00,00,000 = = 10 years Annual cash flow 2,00,00,000

The Payback period shows that the project’s initial investment is recovered in ten years. Even if cash flows are not uniform, the payback period can be calculated easily by adding together cash flows until the investment is recovered. The payback method is calculated simple and lays importance to recovering the original investment as fast as possible. The shorter the

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payback period, the quicker is the recovery of initial investment. But it leaves out the time pattern of the cash flows within the payback period and the cash flows after the payback period. Actually, it is biased against projects which yield higher returns in later years. The payback period method is not suitable for evaluation of alternatives and to make systematic comparison.

6.8 Discounted Cash Flow Techniques When appraising capital projects, basic techniques such as ROCE and Payback could be used. Alternatively, companies could use discounted cash flow techniques discussed on this page, such as Net Present Value (NPV) and Internal Rate of Return (IRR). Cash Flows and Relevant Costs Money received today is worth more than the same sum received in the future, i.e., it has a time value. This occurs for three reasons: 1. potential for earning interest/cost of finance 2. impact of inflation 3. effect of risk. Compounding A sum invested today will earn interest. Compounding calculates the future or terminal value of a given sum invested today for a number of years. To compound a sum, the figure is increased by the amount of interest it would earn over the period. Example of compounding: An investment of Rs. 1,00,000/- is to be made today. What is the value of the investment after two years if the interest rate is 10%? Solution: Value after 1 year 1,00,000 × 1.1 = 1,10,000 Value after 2 years 1,10,000 × 1.1 = 1,21,000

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The Rs. 1,00,000 will be worth Rs. 1,21,000/- in two years at an interest rate of 10%. Formula for compounding: To speed up the compounding calculation, we can use a formula to calculate the future value of a sum invested now. The formula is:

where,

F F P R N

= = = = =

P(1 + r)n Future value after n periods Present or Initial value Rate of interest per period Number of periods.

Discounting In a potential investment project, cash flows will arise at many different points in time. To make a useful comparison of the different flows, they must all be converted to a common point in time, usually the present day, i.e., the cash flows are discounted.

! The present value (PV) is the cash equivalent now of money receivable/ payable at some future date. Formula for Discounting: The PV of a future sum can be calculated using the formula:

F = R × (1+ r)n n (1+ r)

!P =

This is just a rearrangement of the formula used for compounding. !

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(1 + r)–n is called the discount factor (DF). Example of Discounting: What is the PV of Rs. 1,15,000 receivable in nine years time if r = 6%? Solution: !

P=

F (1+ r)

n

1,15,000

=

(1+ 0.06)

= 68,068

9

The cost of capital In discounted cash flow techniques, the rate of interest is required. There are a number of alternative terms used to refer to the rate of interest: • • •

cost of capital discount rate required return.

Discounted cash flow (DCF) techniques take account of this time value of money when appraising project investments. The Discounted Cash Flow (DCF) methods are more objective than earlier methods. They take into account both the magnitude and timing of expected cash flows in each period of a project’s life. They take into account time value of money – a rupee today is has more value than a rupee at a later date. The two methods are the: 1. Net Present Value (NPV) method 2. Internal Rate of Return (IRR).

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6.8.1 Net Present Value (NPV) Method To appraise the overall impact of a project using DCF techniques involves discounting all the relevant cash flows associated with the project back to their PV (present value). If we treat outflows of the project as negative and inflows as positive, the NPV of the project is the sum of the PVs of all flows that arise as a result of doing the project. Decision rule: The NPV represents the surplus funds (after funding the investment) earned on the project, therefore: • • • •

if the NPV is positive – the project is financially viable if the NPV is zero – the project breaks even if the NPV is negative – the project is not financially viable if the company has two or more mutually exclusive projects under consideration, it should choose the one with the highest NPV.

Assumptions in Calculating the Net Present Value The following assumptions are made about cash flows when calculating the net present value: • • •

all cash flows occur at the start or end of a year initial investments occur (T0) other cash flows start one year after that (T1).

Also interest payments are never included within an NPV calculation as these are taken account of by the cost of capital. Example using NPV An organisation is considering a capital investment in new equipment. The estimated cash flows are as follows: Year

Cash Flow (Rs.) –240,000 80,000 1,20,000 70,000 40,000 20,000

0 1 2 3 4 5

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The company’s cost of capital is 9%. Calculate the NPV of the project to assess whether it should be undertaken. Solution: Year

Cash Flow (Rs.)

DF

PV (Rs.)

0

–240,000

1.000

–240,000

1 2 3 4 5

80,000 1,20,000 70,000 40,000 20,000

0.917 0.842 0.772 0.708 0.650

73,360 1,01,040 54,040 28,320 13,000

PV

+29,760

The PV of cash inflows exceeds the PV of cash outflows by Rs. 29,760, which means that the project will earn a DCF return in excess of 9%, i.e., it will earn a surplus of Rs. 29,760 after paying the cost of financing. It should, therefore, be undertaken. Advantages and Disadvantages of Using NPV Advantages Theoretically, the NPV method of investment appraisal is superior to all others. This is because: • • • • •

It It It It It

considers the time value of money is an absolute measure of return is based on cash flows not profits considers the whole life of the project should lead to maximization of shareholder wealth.

Disadvantages • It is difficult to explain to managers. • It requires knowledge of the cost of capital. • It is relatively complex.

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6.8.2 Internal Rate of Return (IRR) The IRR is another project appraisal method using DCF techniques. The IRR represents the discount rate at which the NPV of an investment is zero. As such, it represents a break-even cost of capital. Calculating the IRR using Linear Interpolation The steps in linear interpolation are: 1. Calculate two NPVs for the project at two different costs of capital 2. Use the following formula to find the IRR:

⎛ NL ⎞ IRR = L + × (H − L) ⎜ ⎟ ! ⎝ NL − NH ⎠ where, L = Lower rate of interest H

= Higher rate of interest

NL

= NPV at lower rate of interest

NH

= NPV at higher rate of interest.

The diagram below shows the IRR as estimated by the formula.

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! In all practical situation, NH < NL

Decision Rule: •

Projects should be accepted if their IRR is greater than the cost of capital.

Example using IRR A potential project’s predicted cash flows give a Novo Rs. 50,000 at a discount rate of 10% and an NPV of Rs. 10,000 at a rate of 15%. Calculate the IRR. Solution: ! IRR = 10% +

50,000 × (15% − 10%)

= 14.17%

50,000 − (−10,000)

The IRR = 14.17%

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Advantages and Disadvantages of IRR Advantages The IRR has a number of benefits, e.g.: • It considers the time value of money. • It is a percentage and therefore easily understood. • It uses cash flows not profits. • It considers the whole life of the project. • It means a firm selecting projects where the IRR exceeds the cost of capital should increase shareholders’ wealth. Disadvantages • It is not a measure of absolute profitability. • Interpolation only provides an estimate and an accurate estimate requires the use of a spreadsheet programme. • It is fairly complicated to calculate. • Non-conventional cash flows may give rise to multiple IRRs which means the interpolation method can’t be used. Difficulties with the IRR Approach Interpolation only provides an estimate (and an accurate estimate requires the use of a spreadsheet program). The cost of capital calculation itself is also only an estimate and if the margin between required return and the IRR is small, this lack of accuracy could actually mean the wrong decision is taken. Another drawback of IRR is that non-conventional cash flows may give rise to no IRR or multiple IRRs. For example, a project with an outflow at T0 and T2 but income at T1 could, depending on the size of the cash flows, have a number of different profiles on a graph (see below). Even where the project does have one IRR, it can be seen from the graph that the decision rule would lead to the wrong result as the project does not earn a positive NPV at any cost of capital.

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! NPV versus IRR Both NPV and IRR are investment appraisal techniques which discount cash flows and are superior to the basic techniques such as ROCE or payback. However, only NPV can be used to distinguish between two mutually exclusive projects, as the diagram below demonstrates:

!

!

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The profile of Project A is such that it has a lower IRR and applying the IRR rule would prefer Project B. However, in absolute terms, Project A has the higher NPV at the company’s cost of capital and should, therefore, be preferred. NPV is, therefore, the better technique for choosing between projects. The advantage of NPV is that it tells us the absolute increase in shareholder wealth as a result of accepting the project, at the current cost of capital. The IRR simply tells us how far the cost of capital could increase before the project would not be worth accepting. The modified internal rate of return (MIRR) solves many of these problems with the conventional IRR.

6.9 Estimating Cost of Capital with Capital Asset Pricing Model (CAPM) 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 sane. 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 (CAPM) 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 per cent additional change in the market risk. The !

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discount rate increases as project beta increases. However, companies 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 analyzing 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. 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 Financial Appraisal 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 + B (rm – rf) where r is discount rate, rf is interest rate on risk-free asset like treasury bill and rm expected return can be plugged into standard discounted cash flow formula: T

T Ct Ct = ∑ ! PV = ∑ t t t=1 (1+ r) t=1 [1+ rf + B(rm − rf )]

The Capital Asset Pricing Model values only the cash flow for the first period (C1). 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.

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6.10 FINANCIAL ANALYSIS An integral aspect of Financial Appraisal is Financial Analysis which takes into account the financial features of a project, especially sources 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. 6.10.1 Liquidity Analysis 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. a. 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, short-term 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. b. 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.

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6.10.2 Capital Structure Analysis Long-term solvency ratios measure the project’s ability to meet long-term commitments to creditors. Creditors’ claims on a company’s income arise from contractual obligations which must be honored. The larger the amount of these claims, the higher the chances of their not being met, legal action may be initiated to enforce the fulfillment of the claims. The two long-term solvency ratios are: debt utilization ratio and coverage ratio. a. Debt utilization ratio: Debt utilization ratio measures a company’s degree of indebtedness which measures the proportion of the company’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 total debt. Debit Ratio=

Total Debit Total Asset

b. Debt-Equity Ratio: Debt-Equity Ratio is the value of the total debt divided by the book value of equity. In calculation of debt, short-term obligations of less than one year duration are excluded. Long-term Liabilities (Debit)

Debit-Equity Ratio =

Shareholders’ Equity

c. 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. The fixed assets coverage ratio shows the number of times fixed assets cover loan. d. Debt Coverage Ratio: The debt coverage ratio measures the degree to which fixed payments are covered by operating profits. The ratio emphasizes 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.

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e. Interest Coverage Ratio: The interest coverage ratio measures the number of times interest expenses are earned or covered by profits. Net Profit before Taxes + Interest

Interest Coverage Ration =

Interest

f. Market Value Ratio: Market value ratios relate to 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. g. Price Earnings Ratio: P/E Ratio relates the per share earnings to price of the share. Market price per share

P/E Ratio =

Earning per share

P/E Ratios are computed for companies as well as for the market. P/E ratios are higher for companies with high growth prospects and lower for riskier companies. h. 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

i. Market/Book Value Ratio (M/B ratio): If the market price per share is divided by book value, we get the market book (M/B) ratio.

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6.11 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.

! Break-even Point

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 6.1 which is classified into fixed and variable expenses.

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Table 6.1: Illustrative Conventional Income Statement Total Cost Particulars Cost (Rs.) (Rs.) Net Sales

6,00,000

Less: Cost of Goods Sold: Materials Labor Manufacturing Expenses

1,80,000 60,000 1,95,000

Less: Operating Expenses

36,000

Selling Expenses

54,000

4,35,000 1,65,000

90,000 75,000

Less: Miscellaneous Expenses

3,000

Profit

72,000

Derivation of BEP from Income Statement For deriving BEP, it is necessary to recast the income statement in Table 6.1 into fixed and variable costs. Items of Cost

Fixed

Materials

Less: Operating Expenses Selling Expenses Miscellaneous Expenses Total Net Profit

Total

1,80,000

1,80,000

60,000

60,000

1,00,000

95,000

1,95,000

20,000

16,000

36,000

46,000

8,000

54,000

2,000

1,000

3,000

1,68,000

3,60,000

5,28,000

Labour Manufacturing Expenses

Variable

Total Sales

72,000

!

6,00,000

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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% of sales. It means that on every rupee of sales, 60 paisa (60%) 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, the total fixed cost is divided by 40%.

1,68,000 × 100

! Sales required to meet fixed cost =

= 4,20,000 40 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, Items of Cost

Amount 4,20,000

Sales Less: Variable Cost (60% of sales)

2,52,000 1,68,000 1,68,000

Margin Available for Fixed Expenses Profit

Nil

The computation of break-even sales volume can be summarized as, Break - Even Sales Volume =

Total Fixed Cost

! BEP =

1- (Total Variable Cost/Total Sales Volume

F 1− (V / S)

where,

F V S

is fixed cost is variable cost is sales volume.

Substituting the figures mentioned above, ! Break - Even Sales Volume =

1,68,000 1− (3,60,000 / 1,68,000)

!

=

1,68,000 1− 0.6

=

1,68,000

= 4,20,000

0.4

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If Rs. 6,00,000 sales can be regarded as normal for a month (standard sales volume), capacity utilization rate at which the project must operate in order to ‘break-even’ can be calculated. This will be: !

Break-even sales volume 4,20,000 ×100 ×100 = = 70% Standard sales volume 6,00,000

At capacities lower than 70%, the project is bound to incur losses. On the other hand, it will make profits at levels above the 70% capacity utilization. The ‘break-even’ capacity represents the capacity utilization rate to be achieved to make the project viable. The normal rate for capacity utilization is about 50%.

6.12 APPRAISAL OF ADVANCED MANUFACTURING SYSTEMS Intangible and Tangible Benefits For evaluation of advanced manufacturing systems, conventional appraisal techniques may be unsuitable since there are a large number of hidden benefits in such systems. These benefits are of tangible and intangible natures which have to be quantified. A few such benefits of advanced manufacturing systems are listed here. Quantification of such benefits can be carried out by analytic hierarchy process and other processes. Intangible Benefits • Centralized database • Better quality control • Faster product introduction • Better competitive standing • Greater customer satisfaction • Improved employee participation • Consistently high product quality • Improved on-time product delivery • Redistribution of personnel skills • Better data quality for management • Consistent and tireless operation • Shortened design and manufacturing lead time • Ability to simulate the total factory operations • Wider variety of designs within a product family • Ability to attract and retain high-quality engineers

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Ability to handle increasingly complex product designs Flexibility in design, product mix, volumes and schedules Greater control, accuracy and repeatability of production process

Tangible Benefits • Lower inventory. • Reduced labor costs. • Less scrap and rework. • Higher throughput and yield. • Fewer engineering prototypes through the use of CAD. • Reduced changeover costs and time. • Improved and safer working conditions. • Increased design and drafting productivity. • Reduced and more predictable maintenance cost. • Eliminated data re-entry and duplicated data processing systems. Strategic Issues The strategic issues to be considered before taking a decision on acceptance or rejection of a proposal to set up an advanced manufacturing system as compared to other traditional manufacturing systems are: 1. The goal of the company in 7 to 10 years. 2. The advantage, the investment is going to provide over competitors. 3. Ability to capture a greater proportion of the market for the company’s products. 4. Ability to respond to market changes quickly. 5. Impact of improvements in quality and consistent output in obtaining competitive advantage. 6. Incremental sales resulting from the publicity gained from the company installing advanced manufacturing technology. An advanced system should be viewed as a long-term, strategic move, not a tactical adjustment in a strategy. The installation of such a system is comparable to other strategic moves like installing a new computing system or hiring a new dynamic, result-oriented, but a very highly paid

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CEO. The benefits of such moves cannot be immediately quantified. Their impact is felt in the long run. Shortcomings of Traditional Financial Analysis for Advanced Manufacturing Systems like FMS Traditional evaluation assumes: 1. Impact of investment is limited to immediate environment of equipment. 2. Capabilities and rates of new equipment are assumed to be well known and do not change, i.e., not increase but will decrease as machine ages. 3. Savings and benefits can be estimated with accuracy and ease. 4. The pros and cons of the project can be envisaged by the manager or specialist concerned with the project. 5. Evaluation should be done case by case. These assumptions are not applicable to FMS as it integrates the complete facilities of different stages of manufacturing. CNCs would just reduce labor costs, but FMS in addition to reducing labor costs can also help in controls and in-process inspection, work tracking, transportation, tool control, scheduling and production control. FMS would require a smaller and dedicated team, which is generally more motivated, loyal and sincere. It has generally been observed in FMS that the capabilities of the system tend to increase over passage of time because of increasing understanding of operations of the system and the accumulated experience, upgradability of the system, both software and hardware, to speed up operations and intrinsic flexibility of the system. FMS has the flexibility to process several part types simultaneously. In contrast, a transfer line requires full capital expenditure before production can start. On the other hand, changes in product type, or mix, or volume cannot be easily effected in transfer line since such changes result in underutilization of lines. Actual costs and benefits are difficult to evaluate in FMS. Many hidden costs like new skilled labor, training costs, costs due to adjustments or refining cannot be accurately estimated. Hidden/non-financial savings like simple and fast engineering change over, reduction of lead time are difficult to quantify to

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take into calculation in profit and loss account. Further, FMS operations and benefits cut across various functions. A broader team is required to evaluate FMS projects. Finally, capital costs cannot be appraised on a case by case basis. They have to be evaluated by senior management of the company on a long-term plan basis of say 5 to 10 years. Financial evaluation of FMS is feasible in the following cases: 1. Total FMS picture is taken into consideration by evaluating a. costs: direct and indirect of traditional systems and b. savings: direct and indirect/non-financial savings of FMS. 2. All intangible benefits are evaluated and a hypothetical value attached to every qualitative benefit. 3. Estimates of savings and costs cover 7 to 10 year period taking into consideration long-term impact of FMS. 4. Probability and sensitivity are taken into account. 5. Justification/appraisal results are seen in a broader/strategic perspective. Before rejecting an FMS investment proposal, the following factors may be considered: 1. What are the other options? 2. What happens if investment is not made in FMS? 3. What are the methods employed by competitor? 4. How can the benefits of FMS open up new markets and make the company more competitive?

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Conclusions 1. FMS should be an integral part of a well-defined strategy to meet the corporate goals. 2. While evaluating FMS, judicious designing should be done. FMS project may be unviable but technically feasible. 3. Traditional methods of analysis may lead us astray from real justification of the FMS project. 4. Conventional appraisal techniques should be used to compare different systems, as relevant facts of FMS will not be highlighted.

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6.13 Summary •

Financial Appraisal is the review carried out to ascertain if the project is financially viable. Whether a satisfactory return can be generated from the investment made?

•

Financial Appraisal is important as it determines whether a reasonable return can be made, the cash flows, the cost of the project and the sources of finance, various liquidity and capital structure ratios and the break-even point of the project.

•

For existing units, bankers need to understand the past performance of the company. so they scrutinize the last three years audited financials.

•

Cost of the Project is the total amount of all the various components of the project.

•

Sources of Finance refers to the total of from various sources such as equity capital, term loans, debentures, deferred payments, miscellaneous sources, etc.

•

Financial Projections based on realistic assumptions will give a true picture of finances of the company over a long period of time.

•

Two popular methods of Financial Appraisal are Simple Rate of Return and Payback period.

•

Two popular DCF techniques are Internal Rate of Return (IRR) and Net Present Value Method (NPV) methods of Financial Appraisal are Simple Rate of Return and Payback period.

•

CAPM is a tool to estimate the company’s cost of capital.

•

Financial Analysis takes into account the financial features of the project, especially sources of finance.

•

Break-even Point is that level of sales at which revenues exactly equal the operating costs.

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Advanced Manufacturing Systems have a number of tangible and intangible benefits which have to be quantified.

Activity 1. You have a project in your mind that you want to set up. Find out the cost of the project, sources of finance, appraisal through DCF methods and break-even point.

6.14 Self Assessment Questions 1. What is Financial Appraisal? What is its importance? 2. What are the various parameters under Cost of Project and Sources of Funds? 3. What the various methods and DCF Methods for Financial Appraisal? Compare each. 4. Define Payback period. What is the Payback period of a project which require Rs. 1,00,00,000 initial investment and has receipt of 37,00,000 for five years. What will be its payback if the receipts are 40,00,000 for two years? 5. What are the weaknesses of the payback method? 6. Describe the IRR Method. What are its advantages and disadvantages? 7. Describe the NPV Method. What are its advantages and disadvantages? 8. Assume Rs. 5,00,000 investment and the following cash flows for two alternatives: Year 1 2 3 4 5

Investment A (Rs.) 1,00,000 1,10,000 1,30,000 1,60,000 3,00,000

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Investment B (Rs.) 2,00,000 2,50,000 1,50,000 – –

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Which alternative would you select under the payback method? 9. The cost of a machine is Rs. 1,17,780 and you receive a cash inflow of Rs. 20,000 per year for 10 years. What is the Internal Rate of Return? 10.If the cost of a new machine is Rs. 1,38,690, annual cash flow Rs. 30,000 for six years and cost of capital 12%, evaluate the project using Internal Rate of Return method and indicate whether it should be undertaken. 11.A project estimated to require an investment of Rs. 16,00,000 and a cost of capital of ?% will produce the following cash flows. Using Net Present Value method, state whether the project should be undertaken. Year

Cash Flow (Rs.)

1

5,40,000

2

6,60,000

3

- 600,000

4

5,70,000

5

12,00,000

12.Explain the estimation of cost of capital with CAPM.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ Video Lecture - Part 1 Video Lecture - Part 2


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Chapter 7 CAPITAL STRUCTURE Objectives After studying this chapter, you should be able to: • • • • • •

Get an introduction and brief overview on Capital Structure. Provide conceptual understanding on Modigliani and Miller Proposition I and II and its application in real-life situations. Understand the Pecking order theory and Agency Cost. Learn about Structural Corporate Finance and Gearing ratios. Learn about the Debt Tax Shield and Debt Capacity. Provide conceptual understanding on Weighted Average Cost of Capital.

Structure: 7.1 7.2 7.3 7.4 7.5 7.6 7.7 7.8 7.9 7.10 7.11 7.12 7.13 7.14 7.15 7.16

Introduction Capital Structure Decision – Theory and Practice Capital Structure – An Overview Modigliani and Miller Proposition I and II Trade-off Theory Pecking Order Theory Agency Cost Structural Corporate Finance The Debt Tax Shield Debt Capacity Weighted Average Cost of Capital (WACC) Focus on WACC WACC under Changing Debt Conditions Financial Closure Summary Self Assessment Questions

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7.1 Introduction Project financing structure refers to the way a company finances its assets through some combination of equity, debt, or hybrid securities. A company’s capital structure is then the composition or ‘structure’ of its liabilities. For example, a company that sells Rs. 20 crores in equity and Rs. 80 crores in debt is said to be 20% equity-financed and 80% debtfinanced. The company’s ratio of debt to total financing, 80% in this example is referred to as the company’s leverage. In reality, capital structure may be highly complex and include dozens of sources. Gearing Ratio is the proportion of the capital employed of the company which come from outside of the business finance, e.g., by taking a short-term loan etc. This topic starts with a theory that shows capital structure is irrelevant in a world with no taxes and no other market imperfections. It will also show that when you increase the level of debt in a company, you increase the required rate of return on equity because increasing leverage increases the risk of equity.

7.2 Capital Structure Decision – Theory and Practice The financing choices manager affect the liabilities and stockholder’s equity side of the balance sheet. Capital budgeting decisions, on the other hand, affect the asset side of the balance sheet. Managers have choices of debt and equity. The key question is what mix of these securities will maximize the value of the shareholders. Debt service requires interest payments that are tax deductible, but equity service requires dividends, which are paid from after tax income. However, increases in the use of debt increase the risk of default on debt service and can lead to bankruptcy. Managers must also make choices about whether to use fixed-rate or floating-rate debt, and how to mix longterm and short-term debt. These issues affect the cost of debt.

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7.3 Capital Structure – an Overview Companies raise capital for their investment projects with a mix of debt and equity instruments. The combination of all of these instruments is known as the company’s capital structure. For the purposes of our discussion, let us look at some key differences between debt and equity. Key differences are: Sr. No.

Equity

Debt

Equity is a residual claim to the cash flows of a company. Because the claim to equity is residual, equity holders are entitled only to the operating cash flows that remain after debt holders have been paid.

1

Debt is a contractual claim to the cash flows of a company that has a fixed life and does not depend on the company’s operating performance.

2

Unlike debt holders, equity holders Debt holders do not have the right have the right to vote and thus can to vote so cannot affect the overall affect the overall management of management of the company. the company.

3

Interest payments on bonds are tax deductible to the issuing corporation.

Dividends paid to stockholders are not tax deductible. This benefits lowers the company’s cost of issuing debt, if the company is paying taxes.

4

Debt is not a residual claim.

Equity is a residual claim.

5

The company must make scheduled interest payments.

The company can announce dividends on its own will.

6

The company must repay the principal.

The company does not have to buy back the share.

7

The repayment is not optional.

The payment of dividends is the company’s prerogative.

It is important that a company consider its appropriate mix of debt and equity. For a given level of sales, higher use of debt in proportion to equity makes the company more risky, because the proportion of operating income needed to cover debt service increases with increasing debt.

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Therefore, the probability rises that if sales decline due to changes in market conditions, the company will not be able to service the debt. Clearly, debt and equity present different opportunities to investors. You might ask why companies use both debt and equity financing. By issuing debt, a company’s owners can keep a greater amount of equity for themselves. Assuming a company’s investments are profitable, the owners can finance their projects and also reap the benefit of these investments. Some companies, however, might not be able to make the annual interest payments on debt – or they might desire the flexibility to use their cash flow for other investments – and will tend to issue equity instead. Furthermore, there is a key difference between the way debt and equity holders are paid. Companies pay interest to debt holders and dividends to equity holders. Interest expenses are tax deductible, but dividend payments are not. As a result, companies receive a tax benefit from issuing debt. Most companies usually use a mix of debt and equity financing – despite the tax advantages of debt – to suit their strategic and competitive interests.

7.4 Modigliani and Miller Proposition I and II A company’s capital structure is a mix of the various debt and equity instruments used to finance the company. To assess the value of a company, your first need to determine the appropriate discount rate use. Should you use the rate that is appropriate for a company financed with 100% equity? Or should you use a company’s cost of debt as the rate at which to discount its cash flows? Or a mix of both? Modigliani-Miller The Modigliani-Miller theorem, proposed by Franco Modigliani and Merton Miller, forms the basis for modern thinking on capital structure, though it is generally viewed as a purely theoretical result since it disregards many important factors in the capital structure process factors like fluctuations and uncertain situations that may occur in the course of financing a company.

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The theorem states that, in a perfect market, how a company is financed is irrelevant to its value. This result provides the base with which to examine real-world reasons why capital structure is relevant, that is, a company’s value is affected by the capital structure it employs. Some other reasons include bankruptcy costs, agency costs, taxes, and information asymmetry. This analysis can then be extended to look at whether there is in fact an optimal capital structure: the one which maximizes the value of the company. In 1958, Franco Modigliani and Merton Miller (referred to as MM) published an article that discussed whether companies could vary their capital structures to obtain better returns – that is, whether companies could manipulate the amounts of debt and equity financing in their capital structures to yield a higher overall return. MM showed the conditions under which the value of a project is invariant to how it is financed. MM also demonstrated that when a company finances a project using more debt than equity, the residual equity becomes riskier, because it is supporting more debt claims. So even though the debt will require a lower rate because financing with debt rather than equity is cheaper, the equity will in turn require a higher discount rate as it takes on more risk. However, the overall rate, or the weighted average cost of capital (WACC), will not be affected as the ratio of debt to equity in a company’s capital structure changes. These claims are based on specific assumptions. It was MM’s intention to define this ‘constant value’ condition as a benchmark, much like the frictionless state or perfect vacuum in physics, or the concept of perfect competition in economics. These conditions may not exist in the ‘realworld’, but they provide useful anchors for thought, or benchmarks against which real conditions can be measured. MM’s propositions offer a basis for understanding why a company’s decisions about capital structure may, in fact, matter. Capital structure in a Perfect Market: Consider a perfect capital market (no transaction or bankruptcy costs; perfect information); companies and individuals can borrow at the same interest rate; no taxes; and investment returns are not affected by financial uncertainty. Modigliani and Miller made two findings under these conditions. Their first ‘proposition’ was that the value of a company is independent of its capital structure. Their second

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‘proposition’ stated that the cost of equity for a leveraged company is equal to the cost of equity for an unleveraged company, plus an added premium for financial risk. That is, as leverage increases, while the burden of individual risks is shifted between different investor classes, total risk is conserved and hence no extra value created. Their analysis was extended to include the effect of taxes and risky debt. Under a classical tax system, the tax deductibility of interest makes debt financing valuable; that is, the cost of capital decreases as the proportion of debt in the capital structure increases. The optimal structure then would be to have virtually no equity at all, i.e., a capital structure consisting of 99.99% debt. Capital structure in the real world: If capital structure is irrelevant in a perfect market, then imperfections which exist in the real world must be the cause of its relevance. The theories below try to address some of these imperfections, by relaxing assumptions made in the M&M model. MM Proposition I According to MM Proposition I, the total value of the securities issued by a company does not depend on the company’s choice of capital structure. In other words, the value of the company is determined by its real assets and growth opportunities and not by the types of securities (debt or equity) it issues. Under particular conditions, the company’s value turns out to be constant regardless of its capital structure. MM Proposition I applies in a world under the following assumptions: Capital structure does not affect investment policy. Cash flows paid out to different securities are taxed at the same rate. No costs of bankruptcy exist. Managers’ goal is to maximise shareholder wealth. Everyone has immediate and equal access to all relevant information about the company. 6. No transaction costs exist. 1. 2. 3. 4. 5.

If these conditions hold, the company is said to operate in a perfect market (comparable to perfect vacuum in physics).

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MM Proposition I is based on the idea that investors can, on their own, replicate any capital structure designed by a company. Companies cannot change value by altering the composition of their financing. If one capital structure has a greater value than another, then investors could sell the capital structure of greater value and buy the one of lesser value. To understand Modigliani and Miller’s argument, consider two companies, U and L, which are identical in all respects except for the capital structure. Both companies are expected to generate earnings equal to Rs. 1,00,000 per annum in perpetuity, and the cash flows have the same risk. MM Proposition II The following formula states that the company’s weighted average cost of capital is a weighted average of its cost of debt (rd) and its cost of equity (re): D × rd D × re + ! ra = (D + E) (D + E) In this formula, D and E are the market values of debt and equity, respectively, and equity, and ra, rd, and re are the expected returns on assets, debt and equity respectively. Note that there is no tax in the equation above, as MM’s world has no tax assumption. We have just seen that in a perfect market, a company’s value is unaffected by its capital structure (MM Proposition I). We also know that a company’s capital structure has no impact on the cash flows the company is expected to generate. If the value and the future cash flows generated by a company are not affected by its capital structure, then it must be true that the company’s weighted average cost of capital is unaffected by a company’s capital structure. What about the cost of equity? How does the capital structure choice impact the cost of equity? Rearranging the equation above, you find that the return on equity is equal to: ! re = ra +

D E(ra − rd )

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If we assume that at low levels of debt rd is constant and equal to the riskfree rate, the cost of equity increases linearly with leverage. At higher levels of debt, debt becomes risky, which means that debt holders can no longer be certain that the company is able to meet its commitments to pay interest and repay the principal. When debt becomes risky, rd starts to increase as leverage goes up. In this case, more of the company’s risk is borne by the debt holders and re still increases as leverage increases, but at a decreasing rate. Since leveraged equity has greater risk, it should have greater return as compensation. MM Proposition II states that the expected return on equity is positively related to leverage. As shown in the graph, MM Proposition II states that increasing a company’s debt ratio does not affect the riskiness of its assets (ra is not dependent on the leverage ratio), but it does increase the riskiness of its equity. Also note that for any company, the return on debt will always be less than the return on equity. This is because interest payments to debt holders have higher priority than dividend payments to equity holders, and thus debt carries less risk. However, the weighted average sum of the return on debt and the return on equity is always constant and is equal to the return on assets. MM Proposition I and II point to the conclusion that companies cannot change in value simply by repackaging their securities from equity to debt, or vice versa. As equity is replaced by debt, a company’s overall value and its cost of capital cannot be reduced, because the riskiness of the equity increases as the amount of debt increases. This increase in risk of the equity offsets the reduction in risk that results from issuing debt. In other words, while the fraction of low-cost debt increases, equity demands a return high enough to compensate for the extra risk it is bearing. Thus, using the asset beta to calculate the cost of capital is appropriate in a world based on MM’s assumptions where debt, but no tax, exists. Application in the Real World Every company has a limit to the amount of debt it can support. If a company goes beyond this debt capacity level, it risks bankruptcy. Debt does matter in the real world! Consider what happens when MM’s assumption that there is no tax differential between debt and equity is relaxed. In the real world, corporations are taxed on operating cash flow

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after interest payments have been made. Cash paid to shareholders as dividends is taxed first to the corporation, but interest payments are not. Therefore, two companies that have equivalent earnings before interest but different capital structures – perhaps one with all stock and the other with bond interest payments – will be worth different amounts. In a world with taxes, companies with identical assets, cash flows, and risk will be worth different amounts as capital structures differ. This concept will become clearer as you learn more about the benefits of the debt tax shield.

7.5 Trade-Off Theory Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefits of debt) and that there is a cost of financing with debt (the bankruptcy costs and the financial distress costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a company that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn’t explain differences within the same industry.

! After a certain level of Debt, the Firm’s Value reduces instead of increasing

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7.6 Pecking Order Theory Pecking Order Theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means “of last resort”. Hence, internal financing is used first; when that is depleted, then debt is issued; and when it is no longer sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required (equity would mean issuing shares which meant ‘bringing external ownership’ into the company). Thus, the form of debt a company chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers (1984) when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the company than investors) issue new equity, investors believe that managers think that the company is overvalued and managers are taking advantage of this overvaluation. As a result, investors will place a lower value to the new equity issuance.

7.7 Agency Cost There are three types of agency costs which can help explain the relevance of capital structure. 1. Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, shareholders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of company value decreasing and a wealth transfer from debt holders to shareholders. 2. Underinvestment problem (or Debt overhang problem): If debt is risky (e.g., in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase company value.

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3. Free cash flow: Unless free cash flow is given back to investors, management has an incentive to destroy company value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

7.8 Structural Corporate Finance An active area of research in finance is that which tries to translate the models above as well as others into a structured theoretical setup that is time-consistent and that has a dynamic setup similar to one that can be observed in the real world. Managerial contracts, debt contracts, equity contracts, investment returns, all have long lived, multi-period implications. Therefore, it is hard to think through what the implications of the basic models above are for the real world if they are not embedded in a dynamic structure that approximates reality. A similar type of research is performed under the guise of credit risk research in which the modelling of the likelihood of default and its pricing is undertaken under different assumptions about investors and about the incentives of management, shareholders and debt holders. Examples of research in this area are Goldstein, Ju, Leland (1998) and Hennessy and Whited (2004). Other The neutral mutation hypothesis—companies fall into various habits of financing, which do not impact on value. •

Market timing hypothesis—capital structure is the outcome of the historical cumulative timing of the market by managers.

•

Accelerated investment effect—even in absence of agency costs, leveraged companies invest faster because of the existence of default risk.

•

Capital structure substitution theory—managements of public companies manipulate capital structure such that earnings per share are maximized.

•

In transition economies, there have been evidences reported unveiling significant impact of capital structure on company performance, especially short-term debt such as the case of Vietnamese emerging market economy. !

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Capital Gearing Ratio ! Capital gearing ratio =

Capital Bearing Risk Capital not Bearing Risk

•

Capital bearing risk includes debentures (risk is to pay interest) and preference capital (risk to pay dividend at fixed rate).

•

Capital not bearing risk includes equity share capital.

Therefore, we can also say, ! Capital gearing ratio =

Debentures + Preference share capital Shareholders' fund

Arbitrage Similar questions are also the concern of a variety of speculator known as a capital structure arbitrageur, see arbitrage. A capital structure arbitrageur seeks opportunities created by differential pricing of various instruments issued by one corporation. Consider, for example, traditional bonds and convertible bonds. The latter are bonds that are under contracted – for conditions, convertible into shares of equity. The stock option component of a convertible bond has a calculable value in itself. The value of the whole instrument should be the value of the traditional bonds plus the extra value of the option feature. If the spread (the difference between the convertible and the non-convertible bonds) grows excessively, then the capital structure arbitrageur will bet that it will converge.

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7.9 The Debt Tax Shield One of the key assumptions made in the analysis above is that there are no taxes. In fact, governments claim some of the cash flows in the form of taxes. Although tax laws differ from country to country, in most countries, interest costs can be deducted as an expense. This discussion assumes that the tax code allows deduction of interest costs as a business expense before computing taxes. Equity holders and debt holders are not the only claimants to the cash flows of a company – the government is an additional claimant. The government exercises its claim by taxing the company’s earnings. Payments to debt holders and equity holders are taxed differently; interest payments to debt holders are tax-deductible, reducing a company’s taxable income by the amount of the interest expense. Therefore, the amount of debt (and the corresponding interest payments due) in a company’s capital structure reduces the government’s share of the company’s cash flows and increases what is left for equity and debt holders.

7.10 Debt Capacity In a market that is perfect, except for the existence of corporate taxes, the greatest value to a company would result from a capital structure with 100% debt. In practice, however, companies do not hold 100% debt, or anywhere near that percentage for the following reasons: Why Companies Do Not Hold 100% Debt? Possible Bankruptcy First, if a company goes bankrupt, it will no longer be able to utilize its tax shield from debt. As leverage increases, the probability of financial distress increases, moderating the company’s incentives to add more debt. Additional Costs There are additional costs of financial distress that also reduce a company’s incentive to increase leverage. For example, when the company is in financial distress, it will incur various legal, accounting and administrative expenses.

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Negative Action Various concerned parties will also react negatively. •

Creditors:More importantly, creditors will raise their required interest rate to compensate for the higher risk of bankruptcy.

•

Stakeholders: Other stakeholders in the company will also become increasingly worried as leverage increases, and take actions that are likely to worsen the company’s situation.

•

Employees: For example, employees might start looking for other jobs because they do not want to work for a company that might go bankrupt in the near future. Note that it is likely that the best employees are the ones to find new jobs first.

•

Customers: Customers might also be worried about the survival of the company and its commitment to supply spare parts in the future and the value of product warranties. These customers might decide to switch to another supplier.

•

Suppliers: Finally, suppliers will be increasingly reluctant to trade on favorable credit terms as the probability of financial distress increases.

Impact on Cash Flows This discussion reflects another departure from the perfect market assumption of MM. Here, we see that in reality, adding more debt to the capital structure of a company that is close to financial distress will negatively impact the company’s future cash flows. Thus, in reality’ capital structure and future cash flows are not independent (in contrast to the assumptions made by MM). Flexibility Another reason not to have a capital structure with 100% debt is the desire for flexibility that comes from having cash on hand. Issuing new bonds or new shares is expensive. If a company is financially constrained, it might be hard to obtain additional financing when a good investment opportunity arises, thereby limiting its growth potential. This ‘opportunity cost’ must be considered as the company takes on additional amounts of debt.

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Covenants Finally, a company might be limited in the amount of debt it can take on based on covenants (promises) in existing debt contracts that prohibit companies from issuing debt beyond a certain level. The trade-off between the tax advantage of debt financing and the disadvantage of financial distress costs results in a different optimal debt level for each company. This Optimal debt level is often referred to as a company’s debt capacity. A company’s debt capacity reflects the owner’s subjective willingness to bear risk; other owners may have the desire or ability to take on more debt. In fact, according to some, this issue is the motivation behind some mergers and acquisitions. If a company’s owners choose not to take on debt because they do not want to bear the default risk, other potential owners or investors may see an arbitrage opportunity to buy the company and increase its debt capacity.

7.11 Weighted Average Cost of Capital (WACC) The WACC method allows analysts to value a company at any capital structure – that is, at any amount of debt and equity – to determine a blended discount rate that reflects the relative shares of debt and equity in the company. This blended discount rate is the WACC, and it is used to value the company’s expected future cash flows. The WACC method can be used to value a company under either its current capital structure or under a proposed or different structure. If you want to value a company at its current capital structure, the basic WACC method is appropriate. However, you will often want to know if a greater valuation can be achieved by increasing the debt ratio. In these cases, you must extend your analysis to consider WACC under changing debt conditions. WACC declines as the per cent of debt in the capital structure increases because of the debt tax shield. Also note that the return on assets is defined as the required rate of return on the company’s assets if the company is 100% equity financed.

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7.12 Focus on WACC Let us consider the components of the equation in greater detail in the section below. Components of the WACC Formula Return on Debt (Rd) Return on debt (rd) is the expected return required by debt holders as compensation for the risk associated with their debt claims. If you are evaluating a new investment project, the return on debt to use in the WACC calculation is the cost of debt to the company if the company was to raise capital in the debt markets today. You should not use the interest rate for debt that is already on the balance sheet. All other things equal, the higher the percentage of debt on a company’s balance sheet, the greater the interest rate the company will have to pay to debt holders. This is so because greater amounts of debt increase the default risk of the company. In the figure, this is illustrated by a flat rd line for low and medium levels of debt, and an upward sloping line for higher levels of debt. Return on Equity (Re) Return on equity (re) is the expected return required by equity holders as compensation for the risk associated with their equity claims. The expected return on equity can be determined by using the Capital Asset Pricing Model (CAPM) formula or any other asset pricing relationship such as the Arbitrage Pricing Theory. Specifically, the CAPM measures risk of the equity (through equity beta) and converts this risk measure into an expected return on equity, as shown in the following formula. ! re

= rr + β e(rm − rf )

Note that the equity beta will, other things held constant, be higher as the debt ratio increases because of the increased risk of holding equity. This higher equity beta will yield an increased return on equity because of the increased proportion of debt, a concept illustrated in the graph shown above. Also note that at high debt levels, the slope of re as a function of the debt level is decreasing. The reason for this is that part of the increased risk resulting from the increased debt level is borne by debt holders.

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Equity (E) Equity (E) is the market value of the equity. This amount can easily be determined by multiplying the number of shares issued and outstanding by the current stock price. Debt (D) Debt (D) is the market value of the debt. In practice, we often assume that the market value of the debt is the same as the book value. Sometimes, we can calculate the value of long-term debt by multiplying the number of bonds outstanding by the market price. Short-term debt is determined by using the amount shown on the balance sheet because it is due within one year. Companies often list the value of debt in the notes to their financial statements. Remember, a company will generally issue debt up to its perceived debt capacity. Thus, it is assumed in this course that the company is always operating at its current debt capacity. Debt + Equity (D + E) Debt + Equity (D + E) is equal to the market value of the company. Recall that D and E are the market values of debt and equity, respectively. E is also referred to as the ‘equity value’ of the company. Marginal Corporate Tax Rate The marginal corporate tax rate (Tc) is used in determining WACC. In doing this, make sure that you count all taxes that a company bears. For example, in the US, companies have a marginal federal tax rate of 35%; they also have to bear state taxes. When considering state taxes, analysts often use a total marginal tax rate of 40%. The marginal tax rate should be used instead of the average tax rate, because the tax deduction of interest payments will take effect at the marginal rate (i.e., the rate at which the last dollar is taxed).

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7.13 WACC under Changing Debt Conditions As you have learned, the WACC method can be used to value a company at its debt capacity. WACC is a dynamic tool, however, and can also be used to value a company at any capital structure different from its current one. Use of WACC under changing debt conditions differs from basic WACC in that it requires you to estimate the cost of capital for a company or asset at an all-equity capital structure and then re-estimate your calculations assuming a revised capital structure. In practice, using WACC under changing debt conditions involves recalculating a company’s beta in a twostep process. First, you must recalculate beta so that it reflects an allequity capital structure. This is known as unleveraging beta. Second, you must recalculate beta at the new capital structure, which is known as releveraging beta.

7.14 Financial Closure Financial closure means that all the sources of funds required for the project have been tied up / have been arranged. A key milestone in project implementation, financial closure may take a long time particularly for infrastructure projects, because several things have to be sorted out to the project structure fundable. For example, it took about three years to hammer out a in power purchase agreement to be signed by the independent power producers with respective state electricity boards. In general, financial closure is achieved soon when: •

Suitable credit enhancement is done to the satisfaction of lenders.

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Adequate underwriting arrangements are made for market-related offerings.

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The resourcefulness of the promoters is well established.

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The process is started early and concurrent appraisal is initiated if several lend agencies are involved.

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7.15 Summary •

Project financing refers to the way a company finances its assets through some combination of equity, debt or hybrid securities.

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There a number of differences between Debt and Equity. Company should consider an appropriate mix of debt and equity.

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Modigliani and Miller theorem states that in a perfect market, how a company is financed is irrelevant to its value. It ignored costs such as bankruptcy costs, agency costs, taxes and information asymmetry.

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Trade-off theory states that allows bankruptcy costs to exist.

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Pecking order theory states that companies prioritize their sources of financing according to the law of the least effort.

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Three types of agency costs exist.

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Structural corporate finance aims to translate models discussed above into real-world ones.

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The Government is also a claimant on share of the profits generated by the company. Debt in a capital structure reduces the government’s share and increases what is left for equity and debt holders.

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Weighted Average Cost of Capital method allows to value a company at any capital structure.

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Financial Closure means that all sources of funds required for the project have been set up.

Activities 1. Use internet resources to find out about the Capital Structure of large Indian companies. Preferably use companies from different sectors. 2. Use internet resources to find out about the Capital Structure of large multinational companies.

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3. Your sister wants to start her first venture - own fashion dress store. She discusses with you about the capital required. Since, personal funds at disposal are not sufficient, she will have to borrow money from external sources (at cost). Work out a hypothetical model to ensure optimum capital structure.

7.16 Self Assessment Questions 1.

What is the meant by optimal Capital Structure? Comment.

2.

Explain Modigliani-Miller Proposition I and II.

3.

Can a company hold 100% debt and 0% equity? Why?

4.

What is the Pecking Order Theory?

5.

What is meant by Tax Debt Shield?

6.

What is meant by Weighted Average Cost of Capital?

7.

What is meant by Financial Closure?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ Video Lecture - Part 1 Video Lecture - Part 2


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SECTION - II - FINANCING OF PROJECTS

SECTION - II FINANCING OF PROJECTS


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Chapter 8 PRESENTATION OF YOUR PROJECT FOR FINANCIER Objectives After studying this chapter, you should be able to: •

Get a brief overview on Project Presentation.

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Understand the importance of Project Presentation.

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List of Support Documents required to complete the file.

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Learn on the importance of a Business Plan.

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Typical Format of a Business Plan.

Structure: 8.1

Introduction

8.2

Importance of Project Presentation

8.3

Support Documents in the Project Presentation

8.4

Preparing a Business Plan

8.5

Format of a Business Plan

8.6

Summary

8.7

Self Assessment Questions

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8.1 Introduction Preparation and proper presentation of your project/files is very important aspect of Project Finance. A proper, neat file submission will greatly improve the chances of you getting the loan/equity. A well and thoughtfully prepared file will help the bankers get their appraisals done faster, more accurately and with minimum queries. This might improve the comfort of the bankers. They will get the impression that they are working with professional people. Remember that every financial institution has exhaustive appraisal procedures before lending to you. They have many professional and technical people working with them. Many times, they take help of professional consultants for appraisals. Further, once detailed reports are prepared and recommendations put in, they are put before the Screening Committees. If they are not fully satisfied with any of the appraisal reports, they refer back to the appraisal team with their comments. If a file is not presented completely, then there are high chances of delays/ rejection. Delayed funds or lack of funds can change the entire course of the project. Even your loan application fees, if any can get forfeited, Professional consultants are available who help you prepare your file and who represent your company/group to the institution in a befitting manner and get the work done.

8.2 Importance of Project Presentation •

It will improve the chances of you availing the loan/equity.

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Bankers will be more comfortable to sanction loan if almost all requirements are submitted by the applicant.

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A well prepared file will make the project manager/promoter better prepared with the project.

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Bankers will believe that they are dealing with professional people.


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8.3 Support Documents in the Project Presentation 1. Duly Filled Application Form 2. Audited Financial Statements for last three years 3. Audited Financial Statements for last three years of associate concerns 4. Memorandum and Articles of Association/Certificate of Incorporation/ Certificate of Commencement of Business/Partnership Deed/Trust Deed/ Bye-laws/Registration Certificate from Registrar of Companies/Societies, as the case may be 5. IT/Wealth Tax assessment orders/returns/certificates for the last 3 years in the respect of the applicant unit (if in existence) and the promoters 6. Sales Tax Returns and assessment orders for the last three years (if in existence) 7. Ration card/Passport/Voter ID card of all the promoters/directors/ guarantors 8. Photograph of all the promoters/directors/guarantors with signatures duly certified by their bankers 9. Biodata and Net worth statements of the promoters/directors/ guarantors duly signed by the concerned individual and certified by a CA firm !

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10. SSI registration certificate/CA certificate for applicability of clubbing provisions 11. Project feasibility report, if any 12. Collaboration agreement and related details including copy approval from RBI/Government, if required 13. Agreement with Technical consultants (if any) and related details including copy approval from RBI/Government, if required 14. Title Documents such as Sale/lease deed/agreement for the land and buildings on which the project is to be operated/set up and of collateral securities, if any 15. Government order/permission converting the land into industrial land, if required 16. Location/site map of the land showing contour lines, the internal roads, power receiving station, railway siding, tubewells, etc. and blueprints of the building plan duly approved by the concerned government/corporation/municipality/Panchayat authorities 17. Details of charges/encumbrances created/to be created on the existing assets 18. Agreement with the electricity board for sanction of requisite power load/Electricity Bill for last three months 19. No objection certificate/consent to operate/establish obtained from the pollution control board (if applicable) 20. Orders/enquiries in hand for the output of the proposed project 21. Invoices/quotations from at least three suppliers for each item of plant and machinery and miscellaneous fixed assets proposed to be purchased under the project along with a write up on the technical specifications, advantages, etc. of the machinery

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22. Justification for choosing a particular supplier of plant and machinery with details of its credentials 23. Detailed estimates for civil construction with bio-data of the builder/ architect 24. Detailed assumptions underlying the projected profitability statements 25. Please attach worksheet for calculation of cost of various inputs and break-even point 26. In-principle letter of sanction for working capital assistance to the applicant unit given by a Bank 27. In case some portion of the expenditure has already been incurred, please furnish necessary proofs (cash receipts) along with a CA certificate with regard to sources of finance, items of expenditure, etc. 28. In case a Company has promoted the applicant unit, please furnish Memorandum and Articles of Association and Audited Balance Sheet and Trading and Profit and Loss A/cs for the past three years of the promoter company 29. License/Permissions/Approvals by Regulatory Authority, where applicable 30. Plan showing layout of machinery and organizational chart

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8.4 Preparing a Business Plan The promoter must prepare a Business Plan/Presentation stating the longterm and short-term objectives of his business. It is a important tool for availing means of funding such as Private Equity, Institutional investors, etc. What is a Business Plan? If you’ve ever jotted down a business idea on a napkin with a few tasks you need to accomplish, you’ve written a business plan, or at least the very basic components of one. At its heart, a business plan is just a plan for how your business is going to work, and how you’re going to make it succeed. Typically, a business plan is longer than a list on a napkin (although, as you’ll see below, it is possible – and sometimes ideal – to write your entire business plan on one page). For me in practice, and for most real businesses, it can be as simple as a few bullet points to focus strategy, milestones to track tasks and responsibilities, and the basic financial projections you need to plan cash flow budget expenses. Business plans should only become printed documents on select occasions, when needed to share information with outsiders or team members. Otherwise, they should be dynamic documents that you maintain on your computer. The plan goes on forever, so the printed version is like a snapshot of what the plan was on the day that it was printed. If you do need a formal business plan document, then that includes an executive summary, a company overview, some information about your products and/or services, your marketing plan, a list of major company milestones, some information about each member of the management team and their role in the company, and details of your company’s financial plan. These are often called the “sections” or “chapters” of the business plan, and I’ll go into much greater depth about each of them below. In all cases, the most important section of the business plan is the review schedule. That’s as simple as “the third Thursday of every month” to cite one obvious example. That’s the part of the plan that acknowledges that it is part of a planning process, in which results and metrics will be reviewed and revised regularly. A real business plan is always wrong — hence the

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regular review and revisions — and never done — because the process of review and revise is vital. Unfortunately, many people think of business plans only for starting a new business or applying for business loans. But business plans are also vital for running a business, whether or not it needs new loans or new investments. Existing businesses should have business plans that they maintain and update as market conditions change and as new opportunities arise. Every business has long-term and short-term goals, sales targets, and expense budgets—a business plan encompasses all of those things, and is as useful to a start-up trying to raise funds as it is to a 10-year-old business that’s looking to grow. Who Needs a Business Plan? If you’re just planning on picking up some freelance work to supplement your income, you can skip the business plan. But, if you’re embarking on a more significant endeavour that’s likely to consume a significant amount of time, money, and resources, then you need a business plan. If you’re serious about business, taking planning seriously is critical to your success. Start-up Businesses The most classic business planning scenario is for a start-up, for which the plan helps the founders break uncertainty down into meaningful pieces, like the sales projection, expense budget, milestones and tasks. The need becomes obvious as soon as you recognize that you don’t know how much money you need, and when you need it, without laying out projected sales, costs, expenses, and timing of payments. And that’s for all start-ups, whether or not they need to convince investors, banks, or friends and family to part with their money and fund the new venture. In this case, the business plan is focused on explaining what the new company is going to do, how it is going to accomplish its goals, and—most importantly—why the founders are the right people to do the job. A start-up business plan also details the amount of money needed to get the business off the ground, and through the initial growth phases that will lead (hopefully!) to profitability.

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Existing Businesses Not all business plans are for start-ups that are launching the next big thing. Existing businesses use business plans to manage and steer the business, not just to address changes in their markets and to take advantage of new opportunities. They use a plan to reinforce strategy, establish metrics, manage responsibilities and goals, track results, and manage and plan resources including critical cash flow. And of course, they use a plan to sets the schedule for regular review and revision. Business plans can be a critical driver of growth for existing businesses. Did you know that businesses that write plans and use them to manage their business grow 30% faster than businesses that take a “seat of the pants” approach? A recent study by Professor Andrew Burke, the founding Director of the Bettany Centre for Entrepreneurial Performance and Economics at Cranfield School of Management, discovered exactly this. For existing businesses, a robust business planning process can be a competitive advantage that drives faster growth and greater innovation. Instead of a static document, business plans in existing businesses become dynamic tools that are used to track growth and spot potential problems before they derail the business. Choosing the right kind of business plan for your business Considering that business plans serve many different purposes, it’s no surprise that they come in many different forms. Before you even start writing your business plan, you need to think about whom the audience is and what the goals of your plan are. While there are common components that are found in almost every business plan, such as sales forecasts and marketing strategy, business plan formats can be very different depending on the audience and the type of business. For example, if you’re building a plan for a biotech firm, your plan will go into details about government approval processes. If you are writing a plan for a restaurant, details about location and renovations might be critical factors. And, the language you’d use in the biotech firm’s business plan would be much more technical than the language you’d use in the plan for the restaurant.

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Plans can also differ greatly in length, detail, and presentation. Plans that never leave the office and are used exclusively for internal strategic planning and management might use more casual language and might not have much visual polish. On the other end of the spectrum, a plan that is destined for the desk of a top venture capitalist will have a high degree of polish and will focus on the high-growth aspects of the business and the experienced team that is going to deliver stunning results. Here is a quick overview of three common types of plans: One-page Business plan A one-page business plan is exactly what it sounds like: a quick summary of your business delivered on a single page. No, this doesn’t mean a very small font size and cramming tons of information onto a single page—it means that the business is described in very concise language that is direct and to-the-point. A one-page business plan can serve two purposes. First, it can be a great tool to introduce the business to outsiders, such as potential investors. Since investors have very little time to read detailed business plans, a simple one-page plan is often a better approach to get that first meeting. Later, in the process, a more detailed plan will be needed, but the onepage plan is great for getting in the door. This simple plan format is also great for early-stage companies that just want to sketch out their idea in broad strokes. Think of the one-page business plan as an expanded version of jotting your idea down on a napkin. Keeping the business idea on one page makes it easy to see the entire concept at a glance and quickly refine concepts as new ideas come up. The Internal Business Plan The internal business plan dispenses with the formalities that are needed when presenting a plan externally and focuses almost exclusively on business strategy, milestones, metrics, budgets, and forecasts. And of course, it also includes the review schedule for monthly review and revision. These internal business plans skip details about company history and management team since everyone in the company almost certainly knows this information.

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Internal business plans are management tools used to guide the growth of both start-ups and existing businesses. They help business owners think through strategic decisions and measure progress towards goals. External Business Plan (a.k.a. The Standard Business Plan Document) External business plans, the formal business plan documents, are designed to be read by outsiders to provide information about a business. The most common use is to convince investors to fund a business, and the second most common is to support a loan application. Occasionally, this type of business plan is also used to recruit or train or absorb key employees, but that is much less common. A formal business plan document is an extension of the internal business plan. It’s mostly a snapshot of the internal plan as it existed at a certain time. But while the internal plan is short on polish and formality, a formal business plan document should be very well-presented, with more attention to detail in the language and format. In addition, an external plan details how potential funds are going to be used. Investors don’t just hand over cash with no strings attached—they want to understand how their funds will be used and what the expected return on their investment is. Finally, external plans put a strong emphasis on the team that is building the company. Investors invest in people rather than ideas, so it’s critical to include biographies of key team members and how their background and experience is going to help grow the company. What to Include in Your Business Plan? While we just discussed several different types of business plans, there are key elements that appear in virtually all business plans. These include the review schedule, strategy summary, milestones, responsibilities, metrics (numerical goals that can be tracked), and basic projections. The projections include sales, costs, expenses, and cash flow. These core elements grow organically as needed by the business for actual business purpose.

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And for the formal business plan document, to be read by outsiders for business purposes such as backing a loan application or seeking investment, the following summarizes those special case business plans. Here’s what they normally include: ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Executive Summary Just like the old adage that you never get a second chance to make a first impression, the executive summary is your business’s calling card. It needs to be succinct and hit the key highlights of the plan. Many potential investors will never make it beyond the executive summary, so it needs to be compelling and intriguing. The executive summary should provide a quick overview of the problem your business solves, your solution to the problem, the business’s target market, key financial highlights, and a summary of who does what on the management team. While it’s difficult to convey everything you might want to convey in the executive summary, keeping it short is critical. If you hook your reader, they’ll find more detail in the body of the plan as they continue reading. You could even consider using your one-page business plan as your executive summary. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Company Overview For external plans, the company overview is a brief summary of the company’s legal structure, ownership, history, and location. It’s common to include a mission statement in the company overview, but that’s certainly not a critical component of all business plans. The company overview is often omitted from internal plans. ………………………………………………………………………………………………………………………… …………………………………………………………………………………………………………………………

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Products and Services The products and services chapter of your business plan delves into the core of what you are trying to achieve. In this section, you will detail the problem you are solving, how you are solving it, the competitive landscape, and your business’s competitive edge. Depending on the type of company you are starting, this section may also detail the technologies you are using, intellectual property that you own, and other key factors about the products that you are building now and plan on building in the future. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Target Market As critical as it is that your company is solving a real-world problem that people or other businesses have, it’s equally important to detail who you are selling to. Understanding your target market is key to building marketing campaigns and sales processes that work. And, beyond marketing, your target market will define how your company grows. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Marketing and Sales Plan The marketing and sales plan details the strategies that you will use to reach your target market. This portion of your business plan provides an overview of how you will position your company in the market, how you will price your products and services, how you will promote your offerings, and any sales processes you need to have in place. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Milestones and Metrics Plans are nothing without solid implementation. The milestones and metrics chapter of your business plan lays out concrete tasks that you plan to accomplish complete with due dates and the names of the people to be held responsible. This chapter should also detail the key metrics that you plan to use to track the growth of your business. This could include the number of sales leads

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generated, the number of page views to your website, or any other critical metric that helps determine the health of your business. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Management Team The management team chapter of a business plan is critical for entrepreneurs seeking investment, but can be omitted for virtually any other type of plan. The management team section should include relevant team bios that explain why your management personnel are the right people for their jobs. After all, good ideas are a dime a dozen—it’s a talented entrepreneur who can take those ideas and turn them into thriving businesses. Business plans should help identify not only strengths of a business, but areas that need improvement and gaps that need to be filled. Identifying gaps in the management team shows knowledge and foresight, not a lack of ability to build the business. ………………………………………………………………………………………………………………………… ………………………………………………………………………………………………………………………… Financial Plan The financial plan is a critical component of nearly all business plans. Running a successful business means paying close attention to how much money you are bringing in, and how much money you are spending. A good financial plan goes a long way to help determine when to hire new employees or buy a new piece of equipment. If you are a start-up and/or are seeking funding, a solid financial plan helps you figure out how much capital your business needs to get started or to grow, so you know how much money to ask for from the bank or from investors. A typical financial plan includes: • • • • •

Sales Forecast Personnel Plan Profit and Loss Statement Cash Flow Statement Balance Sheet

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For more details on what to include in your business plan, check out our detailed business plan outline, download a business plan template in Word format, or read through our library of sample business plans so you can see how other businesses have structured their plans and how they describe their business strategy. Using Your Business Plan to Get Ahead I mentioned earlier in this article that businesses that write business plans grow 30% faster than businesses that don’t plan. Taking the simple step forward to do any planning at all will certainly put your business at a significant advantage over businesses that just drive forward with no specific plans. But just writing a business plan does not guarantee your success. The best way to extract value from your business plan is to use it as an ongoing management tool. To do this, your business plan must be constantly revisited and revised to reflect current conditions and the new information that you’ve collected as you run your business. When you’re running a business, you are learning new things every day: what your customers like, what they don’t like, which marketing tactics work, which ones don’t. Your business plan should be a reflection of those learnings to guide your future strategy. This all sounds like a lot of work, but it doesn’t have to be. Here are some tips to extract the most value from your plan in the least amount of time: 1. Use your one-page business plan to quickly outline your strategy. Use this document to periodically review your high-level strategy. Are you still solving the same problem for your customers? Has your target market changed? 2. Use an internal plan to document processes that work. Share this document with new employees to give them a clear picture of your overall strategy. 3. Set milestones for what you plan to accomplish in the next 30 days. Assign these tasks to team members, set dates, and allocate part of your budget, if necessary.

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4. Keep your sales forecast and expense budget current. As you learn more about customer buying patterns, revise your forecast. 5. Compare your planned budgets and forecasts with your actual results at least monthly. Make adjustments to your plan based on the results. The final, most important aspect of leveraging your business plan as a growth engine is to schedule a monthly review. The review doesn’t have to take longer than an hour, but it needs to be a regular recurring meeting on your calendar. In your monthly review, go over your key numbers compared to your plan, review the milestones you planned to accomplish, set new milestones, and do a quick review of your overall strategy. It’s easier than it sounds, and can put you in that “30% growth” club faster than you think. A format of a business plan covering almost all points required by various stakeholders is annexed hereto. Importance of a Business Plan Why do you want a business plan? You already know the obvious reasons, but there are so many other good reasons to create a business plan that many business owners don’t know about. So, just for a change, let’s take a look at the less obvious reasons first and finish with the ones you probably already know about. Think of this as a late-show top 10, with us building up to the most important reasons you need a business plan. 1. Set specific objectives for managers. Good management requires setting specific objectives and then tracking and following up. I’m surprised how many existing businesses manage without a plan. How do they establish what’s supposed to happen? In truth, you’re really just taking a short-cut and planning in your head—and good for you if you can do it, but as your business grows you want to organize and plan better, and communicate the priorities better. Be strategic. Develop a plan; don’t just wing it. 2. Share your strategy, priorities and specific action points with your spouse, partner or significant other. Your business life goes by so quickly: a rush of answering phone calls, putting out fires, etc. Don’t

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the other people in your business life need to know what’s supposed to be happening? Don’t you want them to know? 3. Deal with displacement. Displacement is probably by far the most important practical business concept you’ve never heard of. It goes like this: “Whatever you do is something else you don’t do.” Displacement lives at the heart of all small business strategy. At least most people have never heard of it. 4. Decide whether or not to rent new space. Rent is a new obligation, usually a fixed cost. Do your growth prospects and plans justify taking on this increased fixed cost? Shouldn’t that be in your business plan? 5. Hire new people. This is another new obligation (a fixed cost) that increases your risk. How will new people help your business grow and prosper? What exactly are they supposed to be doing? The rationale for hiring should be in your business plan. 6. Decide whether you need new assets, how many, and whether to buy or lease them. Use your business plan to help decide what’s going to happen in the long term, which should be an important input to the classic make vs. buy. How long will this important purchase last in your plan? 7. Share and explain business objectives with your management team, employees and new hires. Make selected portions of your business plan part of your new employee training. 8. Develop new business alliances. Use your plan to set targets for new alliances, and selected portions of your plan to communicate with those alliances. 9. Deal with professionals. Share selected highlights or your plans with your attorneys and accountants, and, if this is relevant to you, consultants. 10.Sell your business. Usually, the business plan is a very important part of selling the business. Help buyers understand what you have, what it’s worth and why they want it.

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11.Valuation of the business for formal transactions related to divorce, inheritance, estate planning and tax issues. Valuation is the term for establishing how much your business is worth. Usually that takes a business plan, as well as a professional with experience. The plan tells the valuation expert what your business is doing, when, why and how much that will cost and how much it will produce. 12.Create a new business. Use a plan to establish the right steps to starting a new business, including what you need to do, what resources will be required, and what you expect to happen. 13.Seek investment for a business, whether it’s a start-up or not. Investors need to see a business plan before they decide whether or not to invest. They’ll expect the plan to cover all the main points. 14.Back up a business loan application. Like investors, lenders want to see the plan and will expect the plan to cover the main points. 15.Grow your existing business. Establish strategy and allocate resources according to strategic priority. Business Plan for a Start-up Business The business plan consists of a narrative and several financial worksheets. The narrative template is the body of the business plan. It contains more than 150 questions divided into several sections. Work through the sections in any order that you want, except for the Executive Summary, which should be done last. Skip any questions that do not apply to your type of business. When you are finished writing your first draft, you’ll have a collection of small essays on the various topics of the business plan. Then you’ll want to edit them into a smooth-flowing narrative. The real value of creating a business plan is not in having the finished product in hand; rather, the value lies in the process of researching and thinking about your business in a systematic way. The act of planning helps you to think things through thoroughly, study and research if you are not sure of the facts, and look at your ideas critically. It takes time now, but avoids costly, perhaps disastrous, mistakes later. This business plan is a generic model suitable for all types of businesses. However, you should modify it to suit your particular circumstances. Before

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you begin, review the section titled Refining the Plan, found at the end. It suggests emphasizing certain areas depending upon your type of business (manufacturing, retail, service, etc.). It also has tips for fine-tuning your plan to make an effective presentation to investors or bankers. If this is why you’re creating your plan, pay particular attention to your writing style. You will be judged by the quality and appearance of your work as well as by your ideas. It typically takes several weeks to complete a good plan. Most of that time is spent in research and rethinking your ideas and assumptions. But then, that’s the value of the process. So, make time to do the job properly. Those who do never regret the effort. And finally, be sure to keep detailed notes on your sources of information and on the assumptions underlying your financial data.

8.5 Format of a Business Plan A sample format for preparing a Business Plan is as under: Business Plan OWNERS Your Business Name Street Address Address 2 City, ST ZIP Code Telephone Fax E-mail ………………………………………………………………………………………………………………………… I. Table of Contents I. Table of Contents II. Executive Summary III. General Company Description IV. Products and Services V. Marketing Plan VI. Operational Plan VII. Management and Organization VIII. Personal Financial Statements

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IX. Start-up Expenses and Capitalization X. Financial Plan XI. Appendices XII. Refining the Plan ………………………………………………………………………………………………………………………… II. Executive Summary Write this section last. We suggest that you make it two pages or fewer. Include everything that you would cover in a five-minute interview. Explain the fundamentals of the proposed business: What will your product be? Who will your customers be? Who are the owners? What do you think the future holds for your business and your industry? Make it enthusiastic, professional, complete, and concise. If applying for a loan, state clearly how much you want, precisely how you are going to use it, and how the money will make your business more profitable, thereby ensuring repayment. ………………………………………………………………………………………………………………………… III. General Company Description What business will you be in? What will you do? Mission Statement: Many companies have a brief mission statement, usually in 30 words or fewer, explaining their reason for being and their guiding principles. If you want to draft a mission statement, this is a good place to put it in the plan, followed by: Company Goals and Objectives: Goals are destinations—where you want your business to be. Objectives are progress markers along the way to goal achievement. For example, a goal might be to have a healthy, successful company that is a leader in customer service and that has a loyal customer following. Objectives might be annual sales targets and some specific measures of customer satisfaction.

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Business Philosophy: What is important to you in business? To whom will you market your products? (State it briefly here—you will do a more thorough explanation in the Marketing Plan section). Describe your industry. Is it a growth industry? What changes do you foresee in the industry, short term and long term? How will your company be poised to take advantage of them? Describe your most important company strengths and core competencies. What factors will make the company succeed? What do you think your major competitive strengths will be? What background experience, skills, and strengths do you personally bring to this new venture? Legal Form of Ownership: Sole proprietor, Partnership, Corporation, Limited Liability Corporation (LLC)? Why have you selected this form? ………………………………………………………………………………………………………………………… IV. Products and Services Describe in depth your products or services (technical specifications, drawings, photos, sales brochures, and other bulky items belong in Appendices). What factors will give you competitive advantages or disadvantages? Examples include level of quality or unique or proprietary features. What are the pricing, fee, or leasing structures of your products or services? ………………………………………………………………………………………………………………………… V. Marketing Plan Market Research – Why? No matter how good your product and your service, the venture cannot succeed without effective marketing. And this begins with careful, systematic research. It is very dangerous to assume that you already know about your intended market. You need to do market research to make sure you’re on track. Use the business planning process as your opportunity to uncover data and to question your marketing efforts. Your time will be well spent.

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Market Research – How? There are two kinds of market research: primary and secondary. Secondary research means using published information such as industry profiles, trade journals, newspapers, magazines, census data, and demographic profiles. This type of information is available in public libraries, industry associations, chambers of commerce, from vendors who sell to your industry, and from government agencies. Start with your local library. Most librarians are pleased to guide you through their business data collection. You will be amazed at what is there. There are more online sources than you could possibly use. Your chamber of commerce has good information on the local area. Trade associations and trade publications often have excellent industry-specific data. Primary research means gathering your own data. For example, you could do your own traffic count at a proposed location, use the yellow pages to identify competitors, and do surveys or focus group interviews to learn about consumer preferences. Professional market research can be very costly, but there are many books that show small business owners how to do effective research themselves. In your marketing plan, be as specific as possible; give statistics, numbers, and sources. The marketing plan will be the basis, later on, of the allimportant sales projection. Economics Facts about your industry: • • • • • •

What is the total size of your market? What per cent share of the market will you have? (This is important only if you think you will be a major factor in the market.) Current demand in target market. Trends in target market—growth trends, trends in consumer preferences, and trends in product development. Growth potential and opportunity for a business of your size. What barriers to entry do you face in entering this market with your new company? Some typical barriers are:

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○ ○ ○ ○ ○ ○ ○ ○ ○

High capital costs High production costs High marketing costs Consumer acceptance and brand recognition Training and skills Unique technology and patents Unions Shipping costs Tariff barriers and quotas

•

And of course, how will you overcome the barriers?

•

How could the following affect your company? ○ ○ ○ ○

Change Change Change Change

in in in in

technology government regulations the economy your industry

Product In the Products and Services section, you described your products and services as you see them. Now describe them from your customers’ point of view. Features and Benefits List all of your major products or services. For each product or service: •

Describe the most important features. What is special about it?

•

Describe the benefits. That is, what will the product do for the customer?

Note the difference between features and benefits, and think about them. For example, a house that gives shelter and lasts a long time is made with certain materials and to a certain design; those are its features. Its benefits include pride of ownership, financial security, providing for the

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family, and inclusion in a neighborhood. You build features into your product so that you can sell the benefits. What after-sale services will you give? Some examples are delivery, warranty, service contracts, support, follow-up, and refund policy. Customers Identify your targeted customers, their characteristics, and their geographic locations, otherwise known as their demographics. The description will be completely different depending on whether you plan to sell to other businesses or directly to consumers. If you sell a consumer product, but sell it through a channel of distributors, wholesalers, and retailers, you must carefully analyze both the end consumer and the middleman businesses to which you sell. You may have more than one customer group. Identify the most important groups. Then, for each customer group, construct what is called a demographic profile: • • • • • • •

Age Gender Location Income level Social class and occupation Education Other (specific to your industry)

For business customers, the demographic factors might be: • • • • •

Industry (or portion of an industry) Location Size of company Quality, technology, and price preferences Other (specific to your industry)

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Competition What products and companies will compete with you? List your major competitors: (Names and addresses) Will they compete with you across the board, or just for certain products, certain customers, or in certain locations? Will you have important indirect competitors? (For example, video rental stores compete with theaters, although they are different types of businesses.) How will your products or services compare with the competition? Use the Competitive Analysis table below to compare your company with your two most important competitors. In the first column are key competitive factors. Since these vary from one industry to another, you may want to customize the list of factors. In the column labeled Me, state how you honestly think you will stack up in customers’ minds. Then check whether you think this factor will be a strength or a weakness for you. Sometimes, it is hard to analyze our own weaknesses. Try to be very honest here. Better yet, get some disinterested strangers to assess you. This can be a real eye-opener. And remember that you cannot be all things to all people. In fact, trying to be causes many business failures because efforts become scattered and diluted. You want an honest assessment of your company’s strong and weak points. Now, analyze each major competitor. In a few words, state how you think they compare. In the final column, estimate the importance of each competitive factor to the customer. 1 = critical; 5 = not very important.

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Table 1: Competitive Analysis Factor

Me Strength

Weakness

Competitor A

Competitor B

Importance to Customer

Products Price Quality Selection Service Reliability Stability Expertise Company Reputation Location Appearance Sales Method Credit Policies Advertising Image

Now, write a short paragraph stating your competitive advantages and disadvantages. Niche Now that you have systematically analyzed your industry, your product, your customers, and the competition, you should have a clear picture of where your company fits into the world. In one short paragraph, define your niche, your unique corner of the market. Strategy Now outline a marketing strategy that is consistent with your niche.

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Promotion How will you get the word out to customers? Advertising What media, why, and how often? Why this mix and not some other? Have you identified low-cost methods to get the most out of your promotional budget? Will you use methods other than paid advertising, such as trade shows, catalogs, dealer incentives, word-of-mouth (how will you stimulate it?), and network of friends or professionals? What image do you want to project? How do you want customers to see you? In addition to advertising, what plans do you have for graphic image support? This includes things like logo design, cards and letterhead, brochures, signage, and interior design (if customers come to your place of business). Should you have a system to identify repeat customers and then systematically contact them? Promotional Budget How much will you spend on the items listed above? Before start-up? (These numbers will go into your startup budget.) Ongoing? (These numbers will go into your operating plan budget.) Pricing Explain your method or methods of setting prices. For most small businesses, having the lowest price is not a good policy. It robs you of needed profit margin; customers may not care as much about price as you think; and large competitors can underprice you anyway. Usually, you will do better to have average prices and compete on quality and service.

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Does your pricing strategy fit with what was revealed in your competitive analysis? Compare your prices with those of the competition. Are they higher, lower, the same? Why? How important is price as a competitive factor? Do your intended customers really make their purchase decisions mostly on price? What will be your customer service and credit policies? Proposed Location Probably, you do not have a precise location picked out yet. This is the time to think about what you want and need in a location. Many start-ups run successfully from home for a while. You will describe your physical needs later, in the Operational Plan section. Here, analyze your location criteria as they will affect your customers. Is your location important to your customers? If yes, how? If customers come to your place of business: Is it convenient? Parking? Interior spaces? Not out of the way? Is it consistent with your image? Is it what customers want and expect? Where is the competition located? Is it better for you to be near them (like car dealers or fast-food restaurants) or distant (like convenience food stores)? Distribution Channels How do you sell your products or services? Retail Direct (mail order, Web, catalog)

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Wholesale Your own sales force Agents Independent representatives Bid on contracts Sales Forecast Now that you have described your products, services, customers, markets, and marketing plans in detail, it’s time to attach some numbers to your plan. Use a sales forecast spreadsheet to prepare a month-by-month projection. The forecast should be based on your historical sales, the marketing strategies that you have just described, your market research, and industry data, if available. You may want to do two forecasts: (1) a “best guess”, which is what you really expect, and (2) a “worst case” low estimate that you are confident you can reach no matter what happens. Remember to keep notes on your research and your assumptions as you build this sales forecast and all subsequent spreadsheets in the plan. This is critical if you are going to present it to funding sources. ………………………………………………………………………………………………………………………… VI. Operational Plan Explain the daily operation of the business, its location, equipment, people, processes, and surrounding environment. Production How and where are your products or services produced? Explain your methods of: • Production techniques and costs • Quality control • Customer service • Inventory control • Product development

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Location What qualities do you need in a location? Describe the type of location you’ll have. Physical requirements: • • • •

Amount of space Type of building Zoning Power and other utilities

Access: Is it important that your location be convenient to transportation or to suppliers? Do you need easy walk-in access? What are your requirements for parking and proximity to freeway, airports, railroads, and shipping centers? Include a drawing or layout of your proposed facility if it is important, as it might be for a manufacturer. Construction: Most new companies should not sink capital into construction, but if you are planning to build, costs and specifications will be a big part of your plan. Cost: Estimate your occupation expenses, including rent, but also including maintenance, utilities, insurance, and initial remodeling costs to make the space suit your needs. These numbers will become part of your financial plan. What will be your business hours?

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Legal Environment Describe the following: • Licensing and bonding requirements • Permits • Health, workplace, or environmental regulations • Special regulations covering your industry or profession • Zoning or building code requirements • Insurance coverage • Trademarks, copyrights, or patents (pending, existing, or purchased) Personnel • • • • • • • • • •

Number of employees Type of labor (skilled, unskilled, and professional) Where and how will you find the right employees? Quality of existing staff Pay structure Training methods and requirements Who does which tasks? Do you have schedules and written procedures prepared? Have you drafted job descriptions for employees? If not, take time to write some. They really help internal communications with employees. For certain functions, will you use contract workers in addition to employees?

Inventory • • • • •

What kind of inventory will you keep: raw materials, supplies, finished goods? Average value in stock (i.e., what is your inventory investment)? Rate of turnover and how this compares to the industry averages? Seasonal buildups? Lead time for ordering?

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Suppliers Identify key suppliers: • Names and addresses • Type and amount of inventory furnished • Credit and delivery policies • History and reliability Should you have more than one supplier for critical items (as a backup)? Do you expect shortages or short-term delivery problems? Are supply costs steady or fluctuating? If fluctuating, how would you deal with changing costs? Credit Policies • • • • • • •

Do you plan to sell on credit? Do you really need to sell on credit? Is it customary in your industry and expected by your clientele? If yes, what policies will you have about who gets credit and how much? How will you check the creditworthiness of new applicants? What terms will you offer your customers; that is, how much credit and when is payment due? Will you offer prompt payment discounts? (Hint: Do this only if it is usual and customary in your industry.) Do you know what it will cost you to extend credit? Have you built the costs into your prices?

Managing Your Accounts Receivable If you do extend credit, you should do an aging at least monthly to track how much of your money is tied up in credit given to customers and to alert you to slow payment problems. A receivables aging looks like the following table:

Total Current

30 days

60 days

90 days

Over 90 days

Accounts Receivable Aging

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You will need a policy for dealing with slow paying customers: • • •

When do you make a phone call? When do you send a letter? When do you get your attorney to threaten?

Managing Your Accounts Payable You should also age your accounts payable, what you owe to your suppliers. This helps you plan whom to pay and when. Paying too early depletes your cash, but paying late can cost you valuable discounts and can damage your credit. (Hint: If you know you will be late making a payment, call the creditor before the due date.) Do your proposed vendors offer prompt payment discounts? A payables aging looks like the following table.

Total Current

30 days

60 days

90 days

Over 90 days

Accounts Receivable Aging

………………………………………………………………………………………………………………………… VII. Management and Organization Who will manage the business on a day-to-day basis? What experience does that person bring to the business? What special or distinctive competencies? Is there a plan for continuation of the business if this person is lost or incapacitated? If you’ll have more than 10 employees, create an organizational chart showing the management hierarchy and who is responsible for key functions. Include position descriptions for key employees. If you are seeking loans or investors, include resumes of owners and key employees.

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Professional and Advisory Support List the following: • Board of directors • Management advisory board • Attorney • Accountant • Insurance agent • Banker • Consultant/s • Mentor and Key Advisors ………………………………………………………………………………………………………………………… VIII. Personal Financial Statement Include personal financial statements for each owner and major stockholder, showing assets and liabilities held outside the business and personal net worth. Owners will often have to draw on personal assets to finance the business, and these statements will show what is available. Bankers and investors usually want this information as well. ………………………………………………………………………………………………………………………… IX. Start-up Expenses and Capitalization You will have many expenses before you even begin operating your business. It’s important to estimate these expenses accurately and then to plan where you will get sufficient capital. This is a research project, and the more thorough your research efforts, the less chance that you will leave out important expenses or underestimate them. Even with the best of research, however, opening a new business has a way of costing more than you anticipate. There are two ways to make allowances for surprise expenses. The first is to add a little “padding” to each item in the budget. The problem with that approach, however, is that it destroys the accuracy of your carefully wrought plan. The second approach is to add a separate line item, called contingencies, to account for the unforeseeable. This is the approach we recommend. Talk to others who have started similar businesses to get a good idea of how much to allow for contingencies. If you cannot get good information, we recommend a rule of thumb that contingencies should equal at least 20% of the total of all other start-up expenses.

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Explain your research and how you arrived at your forecasts of expenses. Give sources, amounts, and terms of proposed loans. Also explain in detail how much will be contributed by each investor and what per cent ownership each will have. ………………………………………………………………………………………………………………………… X. Financial Plan The financial plan consists of a 12-month profit and loss projection, a fouryear profit and loss projection (optional), a cash flow projection, a projected balance sheet, and a break-even calculation. Together they constitute a reasonable estimate of your company’s financial future. More important, the process of thinking through the financial plan will improve your insight into the inner financial workings of your company. 12-Month Profit and Loss Projection Many business owners think of the 12-month profit and loss projection as the centerpiece of their plan. This is where you put it all together in numbers and get an idea of what it will take to make a profit and be successful. Your sales projections will come from a sales forecast in which you forecast sales, cost of goods sold, expenses, and profit month-by-month for one year. Profit projections should be accompanied by a narrative explaining the major assumptions used to estimate company income and expenses. Research Notes: Keep careful notes on your research and assumptions, so that you can explain them later if necessary, and also so that you can go back to your sources when it’s time to revise your plan. Four-year Profit Projection (Optional) The 12-month projection is the heart of your financial plan. This section is for those who want to carry their forecasts beyond the first year. Of course, keep notes of your key assumptions, especially about things that you expect will change dramatically after the first year.

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Projected Cash Flow If the profit projection is the heart of your business plan, cash flow is the blood. Businesses fail because they cannot pay their bills. Every part of your business plan is important, but none of it means a thing if you run out of cash. The point of this worksheet is to plan how much you need before start-up, for preliminary expenses, operating expenses, and reserves. You should keep updating it and using it afterward. It will enable you to foresee shortages in time to do something about them—perhaps cut expenses, or perhaps negotiate a loan. But foremost, you shouldn’t be taken by surprise. There is no great trick to preparing it: The cash flow projection is just a forward look at your checking account. For each item, determine when you actually expect to receive cash (for sales) or when you will actually have to write a check (for expense items). You should track essential operating data, which is not necessarily part of cash flow but allows you to track items that have a heavy impact on cash flow, such as sales and inventory purchases. You should also track cash outlays prior to opening in a pre-start-up column. You should have already researched those for your start-up expenses plan. Your cash flow will show you whether your working capital is adequate. Clearly, if your projected cash balance ever goes negative, you will need more start-up capital. This plan will also predict just when and how much you will need to borrow. Explain your major assumptions, especially those that make the cash flow differ from the Profit and Loss Projection. For example, if you make a sale in month one, when do you actually collect the cash? When you buy inventory or materials, do you pay in advance, upon delivery, or much later? How will this affect cash flow?

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Are some expenses payable in advance? When? Are there irregular expenses, such as quarterly tax payments, maintenance and repairs, or seasonal inventory buildup, that should be budgeted? Loan payments, equipment purchases, and owner's draws usually do not show on profit and loss statements but definitely do take cash out. Be sure to include them. And of course, depreciation does not appear in the cash flow at all because you never write a check for it. Opening Day Balance Sheet A balance sheet is one of the fundamental financial reports that any business needs for reporting and financial management. A balance sheet shows what items of value are held by the company (assets), and what its debts are (liabilities). When liabilities are subtracted from assets, the remainder is owners’ equity. Use a start-up expenses and capitalization spreadsheet as a guide to preparing a balance sheet as of opening day. Then detail how you calculated the account balances on your opening day balance sheet. Optional: Some people want to add a projected balance sheet showing the estimated financial position of the company at the end of the first year. This is especially useful when selling your proposal to investors. Break-Even Analysis A break-even analysis predicts the sales volume, at a given price, required to recover total costs. In other words, it’s the sales level that is the dividing line between operating at a loss and operating at a profit. Expressed as a formula, break-even is: Fixed Costs

Break-even Sales =

1- Variable Costs

(where, fixed costs are expressed in dollars, but variable costs are expressed as a per cent of total sales.)

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Include all assumptions upon which your break-even calculation is based. ………………………………………………………………………………………………………………………… XI. Appendices Include details and studies used in your business plan; for example: Brochures and advertising materials • Industry studies • Blueprints and plans • Maps and photos of location • Magazine or other articles • Detailed lists of equipment owned or to be purchased • Copies of leases and contracts • Letters of support from future customers • Any other materials needed to support the assumptions in this plan • Market research studies • List of assets available as collateral for a loan ………………………………………………………………………………………………………………………… •

XII. Refining the Plan The generic business plan presented above should be modified to suit your specific type of business and the audience for which the plan is written. For Raising Capital For Bankers •

Bankers want assurance of orderly repayment. If you intend using this plan to present to lenders, include: ๏ ๏ ๏ ๏

๏

Amount of loan How the funds will be used What this will accomplish—how will it make the business stronger? Requested repayment terms (number of years to repay). You will probably not have much negotiating room on interest rate but may be able to negotiate a longer repayment term, which will help cash flow. Collateral offered, and a list of all existing liens against collateral.

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For Investors •

Investors have a different perspective. They are looking for dramatic growth, and they expect to share in the rewards: ๏ ๏ ๏

๏ ๏ ๏ ๏ ๏ ๏

Funds needed short-term Funds needed in two to five years How the company will use the funds, and what this will accomplish for growth Estimated return on investment Exit strategy for investors (buyback, sale, or IPO) Percent of ownership that you will give up to investors Milestones or conditions that you will accept Financial reporting to be provided Involvement of investors on the board or in management

For Type of Business Manufacturing • • • • • • • •

Planned production levels Anticipated levels of direct production costs and indirect (overhead) costs —how do these compare to industry averages (if available)? Prices per product line Gross profit margin, overall and for each product line Production/capacity limits of planned physical plant Production/capacity limits of equipment Purchasing and inventory management procedures New products under development or anticipated to come online after start-up

Service Businesses •

• • • •

Service businesses sell intangible products. They are usually more flexible than other types of businesses, but they also have higher labor costs and generally very little in fixed assets What are the key competitive factors in this industry? Your prices Methods used to set prices System of production management

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PRESENTATION OF YOUR PROJECT FOR FINANCIER • • • • •

Quality control procedures. Standard or accepted industry quality standards How will you measure labor productivity? Per cent of work subcontracted to other companies. Will you make a profit on subcontracting? Credit, payment, and collections policies and procedures Strategy for keeping client base

High Technology Companies • • • •

•

Economic outlook for the industry Will the company have information systems in place to manage rapidly changing prices, costs, and markets? Will you be on the cutting edge with your products and services? What is the status of research and development? And what is required to: ○ Bring product/service to market? ○ Keep the company competitive? How does the company: ○ ○ ○ ○

Protect intellectual property? Avoid technological obsolescence? Supply necessary capital? Retain key personnel?

High-tech companies sometimes have to operate for a long time without profits and sometimes even without sales. If this fits your situation, a banker probably will not want to lend to you. Venture capitalists may invest, but your story must be very good. You must do longer-term financial forecasts to show when profit take-off is expected to occur. And your assumptions must be well documented and well argued. Retail Business • •

Company image Pricing: ○ Explain mark-up policies. ○ Prices should be profitable, competitive, and in accordance with company image.

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PRESENTATION OF YOUR PROJECT FOR FINANCIER • •

• • •

•

Inventory: ○ Selection and price should be consistent with company image. Inventory level: Find industry average numbers for annual inventory turnover rate (available in RMA book). Multiply your initial inventory investment by the average turnover rate. The result should be at least equal to your projected first year’s cost of goods sold. If it is not, you may not have enough budgeted for start-up inventory. Customer service policies: These should be competitive and in accord with company image. Location: Does it give the exposure that you need? Is it convenient for customers? Is it consistent with company image? Promotion: Methods used, cost. Does it project a consistent company image? Credit: Do you extend credit to customers? If yes, do you really need to, and do you factor the cost into prices?

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8.6 Summary •

Presentation of your project/file is a very important aspect of Project Finance. It improves the chances of you availing the loan, creates a greater comfort towards your bankers, creates a good impression.

•

There is an exhaustive list of documents required to scrutinize your loan application.

•

Business Plan presents the long-term and short-term plan of the organization. It is an important tool for availing funding.

Activities 1. During the progress of this book, students should enable themselves to prepare themselves to submit a Capital Project proposal. Students may start gathering all support documents to submit a project proposal for institution/bank. Please keep a separate project file and start preparing and putting following documents in the file. Use very good spring/box file and good clear xerox copies. Use separators/cardboard leafs to segregate different papers. Remember that success depends on presentation. A company with long-term vision with need for funding over longer tenure will always keeps its presentation and financials in immaculate order. a. Prepare Company Profile (following heads must – Name, Addresses, Contact Details, Name of Directors, Project/Business Activity, Management Structure, Competitor Details b. Catalogues/Brochures of products c. Profile of Promoters/Directors/Partners – Name, Address, Contact Details, Education Qualifications, Skills, Experience, Responsibilities in the unit d. Prepare an Organization Chart e. Prepare a Employee Chart with details of Key Employees – Name, Designation, Qualification, Experience, Any special achievements, Functional duties at the unit

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f. Shareholding Pattern of the Company g. Copy of Memorandum and Articles of Association/Partnership Deed h. Copies of audited Balance Sheets and Profit and Loss Statements for past three years i. Copies of IT returns – company and directors for past three years j. Copies of VAT Returns for past three years IT returns (if applicable) k. Copies of personal balance sheets of directors for past 2 years l. Copies of Bank Statements for past 12 months – company and directors m. Copies of registration with various departments such as SSI, Pollution Control Board, Electricity Board, etc. (if applicable) n. Copies of identity and address proofs of the company and directors 2. Prepare a business plan for a business/project in which you are working in/you desire to create.

8.7 Self Assessment Questions 1. What is the importance of a properly presented file to your bankers? 2. What is a Business Plan? What is its importance?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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TERM LOANS

Chapter 9 TERM LOANS Objectives After studying this chapter, you should be able to: • • • • • • •

Provide a brief overview about Term Loans. Learn about the advantages/disadvantages of Term Loans. Provide conceptual understanding on features of Term Loans. Learn about procedure to avail Term Loan. Learn about Syndicated Loans and Foreign Currency Loans. Learn the relevance of DSCR Ratio. Have a look at the Application Form for Term Loan from Financial institution.

Structure: 9.1 9.2 9.3 9.4 9.5 9.6 9.7 9.8 9.9

Introduction Advantages/Disadvantages of Term Loans Aspects of Term Loans Term Loan Procedure Syndicated Loans Foreign Currency Loans from Financial Institutions Debt Service Coverage Ratio (DSCR) Summary Self Assessment Questions

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9.1 Introduction Development financial institutions (DFIs) or development banks provide long-term credit for projects. The rapid industrialization of continental Europe in the 19th century has been facilitated with the emergence of DFIs. Many of these institutions were sponsored by national governments and international organizations. Netherlands set up an institution in 1822; and in France institutions such as Credit Froncier and Credit Mobilizer were created dining 1848-1852. In Asia, the Industrial Bank of Japan founded in 1902 assisted not only in the development of the domestic capital markets, but also obtained equity for the industrial companies in Japan. To resolve the dearth of long-term funds and the perceived socially unjustified risk aversion of creditors specialized financial institutions were set up in India: Industrial Finance Corporation in 1948 followed by the setting up of State Finance Corporations (SFCs) at the state level under the State Finance Corporation Act, 1951; Industrial Credit and Investment Corporation (ICICI) in 1955; and Industrial Development Bank of India (ICICI) as the apex bank in 1964. There are investment institutions which mobilize resources and provide medium- to long-term investment. These are Unit Trust of India (1964) and LIC and GIC and its subsidiaries; and specialized institutions like the Technology Development and Information Company of India Ltd. (TDICI), Tourism Finance Corporation of India (TFCI) and Small Industries Development Bank of India (SIDBI) to serve in their specified areas. Of the total disbursements of Rs. 51,885 crores in 1997-98 by the all-India financial institutions, the three major all-India financial institutions IDBI (29.2%), IFCI (10.9%) and ICICI (30.5%) account for 70.6%. These institutions played an important role in acquiring and disseminating skills necessary to assess investment projects and borrowers creditworthiness. Companies in India obtain long-term debt mainly by raising term loans or issuing debentures. Term loans given by banks and financial institutions have been the primary source of long-term debt for private companies and most public companies. Term loans, also referred to as term finance, represent a source of debt finance which is generally repayable in less than 10 years. They are self-liquidating in nature. For western and European market, issuing bonds is also a part of raising loan term debt. However, the Indian Bond market is nascent and not very developed.

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TERM LOANS

In India, term loans are typically provided by Commercial Banks, Financial Institutions like Industrial Development Bank of India (IDBI), Industrial Finance Corporation of India (IFCI), IL&FS, IDFC, IMF/World Bank, State Financial Corporations (SFCs), Industrial Credit and Investment Corporation of India (ICICI), Power Finance Corporation, HUDCO, Insurance Companies (LIC and GIC), Small Industries Development Bank of India (SIDBI) and investment companies. Term Loans typically are those having maturity between 7 to 10 years. Term loans make take the form of an ordinary loan or a revolving credit. In an ordinary term loan, the funds are arranged for a period of one year upto 10 years as per the loan agreement. Line of Credit, is a commitment by the lender to lend a certain amount of money to a company for a certain specified period of time. Usually, Term Loans are self-liquidating in nature. Lenders do ask for audited annual reports every year till the loan is liquidated. They undertake inspections during the development stage and at least once in a year. Valuation reports are taken prior to each disbursement. However, there is no monthly Stock and Book Debts statements to be submitted as in case of Working Capital facilities.

9.2 Advantages/Disadvantages of Term Loans A term loan is the most traditional (and generic) type of loan for businesses and consumers. Term loans have a specific duration, payment frequency and carry fixed interest rates. Some advantages of term loans include the following: 1. Payment w i l l be the s ame every month – budgeti ng i s straightforward. 2. Rate does not change – not at mercy of the interest rate markets. 3. Accounting entries for term loan transactions are clear and easy. 4. Helpful for improving a credit report – steady but sure wins the race.

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Debt is least costly source of long-term financing. It is the least costly because: 1. Interest on debt is tax-deductible, 2. Bondholders or creditors consider debt as a relatively less risky investment and require lower return. 3. Debt financing provides sufficient flexibility in the financial/capital structure of the company. Flexibility in capital structure of the company can be increased by inserting call provision in the bond indenture. In case of overcapitalization, the company can redeem the debt to balance its capitalization. 4. Bondholders are creditors and have no interference in business operations because they are not entitled to vote. 5. The company can enjoy tax saving on interest on debt.

Some Disadvantages of term loans include the following: 1. Interest on debt is permanent burden to the company. Company has to pay the interest to bondholders or creditors at fixed rate whether it earns profit or not. It is legally liable to pay interest on debt. 2. Debt usually has a fixed maturity date. Therefore, the financial officer must make provision for repayment of debt. 3. Debt is the most risky source of long-term financing. Company must pay interest and principal at specified time. Non-payment of interest and principal on time take the company into bankruptcy. 4. Debenture indentures may contain restrictive covenants which may limit the company’s operating flexibility in future. 5. Only large scale, creditworthy firm, whose assets are good for collateral can raise capitalfrom long-term debt. 6. Any change in need requires a new/additional loan. 7. If interest rates go down, interest expense payments are higher relative to the market rate.

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8. Many term loans have prepayment penalties.

9.3 Aspects of Term Loans The following features of term loans are discussed below: • • • • • • • • • •

Currency Purpose Interest and Principal Payment Period of Repayment, Moratorium Period Security Cost Flexibility Guarantee/s Pre-disbursement and Special Conditions Protective Covenants

9.4 Term Loan Procedure The procedure associated with a term loan involves the following steps: 9.4.1 Submission of Loan Application The borrower submits an application form which seeks comprehensive information about the project. The application form covers the following aspects: • • •

• • • • • •

Promoters’ background Particulars of the industrial concern Particulars of the project (capacity, process, technical arrangements, management, location, land and buildings, plant and machinery, raw materials, effluents, labor, housing, and schedule of implementation) Cost of the project Means of financing Marketing and selling arrangements Profitability and cash flow Economic considerations Government consents

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9.4.2 Initial Processing of Loan Application When the application is received, an officer of the financial institution reviews it to ascertain whether it is complete for processing. If it is incomplete, the borrower is asked to provide the required additional information. When the application is considered complete, the financial institution prepares a ‘Flash Report’ which is essentially a summarization of the loan application. On the basis of the ‘Flash Report’, it is decided whether the project justifies a detailed appraisal or not. 9.4.3 Appraisal of the Proposed Project The detailed appraisal of the project covers the marketing, technical, financial, managerial, and economic aspects. The appraisal memorandum is normally prepared within two months after site inspection. Based on that, a decision is taken whether the project will be accepted or not. 9.4.4 Issue of the Letter of Sanction If the project is accepted, a financial letter of sanction is issued to the borrower. This communicates to the borrower the assistance sanctioned and the terms and conditions relating thereto. 9.4.5 Acceptance of the Terms and Conditions by the Borrowing Unit On receiving the letter of sanction from the financial institution, the borrowing unit convenes its board meeting at which the terms and conditions associated with the letter of sanction are accepted and an appropriate resolution is passed to that effect. The acceptance of the terms and conditions has to be conveyed to the financial institution within a stipulated period. 9.4.6 Execution of Loan Agreement The financial institution, after receiving the letter of acceptance from the borrower, sends the draft of the agreement to the borrower to be executed by authorized persons and properly stamped as per the Indian Stamp Act, 1899. The agreement, properly executed and stamped, along with other documents as required by the financial institution must be returned to it. Once the financial institution also signs the agreement, it becomes effective.

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9.4.7 Creation of Security The term loans (both rupee and foreign currency) and the deferred payment guarantee assistance provided by the financial institutions are secured through the first mortgage, by way of deposit of title deeds, of immovable properties and hypothecation of movable properties. As the creation of mortgage, particularly in the case of land, tends to be a timeconsuming process, the institutions permit interim disbursements. The mortgage, however, has to be created within a year from the date of the first disbursement. Otherwise, the borrower has to pay an additional charge of 1% interest. 9.4.8 Disbursement of Loans Periodically, the borrower is required to submit information on the physical progress of the projects, financial status of the project, arrangements made for financing the project, contribution made by the promoters, projected funds flow statement, compliance with various statutory requirements, and fulfillment of the pre-disbursement conditions. Based on the information provided by the borrower, the financial institution will determine the amount of term loan to be disbursed from time to time. Before the entire term loan is disbursed, the borrower must fully comply with all terms and conditions of the loan agreement. 9.4.9 Monitoring Monitoring of the project is done at the implementation stage as well as at the operational stage. During the implementation stage, the project is monitored through: i. Regular reports, furnished by the company, which provide information about placement of orders, construction of buildings, procurement of plant, installation of plant and machinery trial production, etc., ii. Periodic site visits, iii. Discussion with promoters, bankers, suppliers, creditors, and others connected with the project, iv. Progress reports submitted by the nominee directors, and v. Audited accounts of the company. During the operational stage, the project is monitored with the help of: i. quarterly performance reports on the project, ii. site inspection,

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iii. reports of nominee directors, and iv. comparison of performance with promise. The most important aspect of monitoring, of course, is the timely recovery of due represented by interest and principal repayment.

9.5 Syndicated Loans Syndication is an arrangement wherein several banks participate in single loan. The corporate seeking a syndicated loan chooses a lead bank to manage the same. The lead bank prepares an information memorandum which is sent to other banks potentially interested in participating in the syndicated loan. Based on the interest evinced by the participating banks, the lead bank works out the sharing arrangement. While bilateral loans are preferred for small ticket loans, syndicated loans are becoming popular for large ticket loan. For example, IDBI Bank lead managed a Rs. 6,000 crore syndicated loan for HINDALCO in 2005. The loan has a tenor of 10 years with a reset after five years. Thirty banks participated in this loan which was priced at five-year G-Sec yield plus 65 basis points. How is loan syndication different from consortium financing which was popular earlier? Consortium financing involved a presentation to be given by the company to a group of bankers and was more rule-based. Further, under a consortium arrangement, participating banks offered other services like letter of credit, working capital credit, guarantees and so and interacted regularly with the company.

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9.6 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. Some of the lines of credit are Eurodollar loans, export credit from UK, Japanese yen loans, Deutsche Mark Revolving Funds and KFW, Germany. 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 utilized by the financial institution. IFCI, IDBI and ICICI grant foreign currency loans. All India financial institutions (IDBI, IFCI and ICICI) operate Exchange Rate Administration Scheme (ERAS) to cover the risk of foreign exchange rate fluctuations. The institutions carry the risk themselves and charge a composite rate to the borrower. The composite rate is announced from time to time for ERAS loans to be sanctioned during the period as a band of interest rates.

9.7 Debt Service Coverage Ratio (DSCR) Debt Service Coverage Ratio (DSCR) essentially calculates the repayment capacity of a borrower. DSCR less than 1 suggests inability of firm’s profits to serve its debts whereas a DSCR greater than 1 means not only serving the debt obligations but also the ability to pay the dividends. Debt Service Coverage Ratio (DSCR), one of the leverage/coverage ratios, is calculated in order to know the cash profit availability to repay the debt including interest. Essentially, DSCR is calculated when a company/firm takes loan from bank/financial institution/any other loan provider. This ratio suggests the capability of cash profits to meet the repayment of the financial loan. DSCR is very important from the viewpoint of the financing authority as it indicates repaying capability of the entity taking loan. Just a year’s analysis of DSCR does not lead to any concrete conclusion about the debt servicing capability. DSCR is relevant only when it is seen for the entire remaining period of loan.

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How to Calculate Debt Service Coverage Ratio? Calculation of DSCR is very simple. To calculate this ratio, following items from the financial statement are required: • • • • •

Profit after tax (PAT) Non-cash expenses (e.g., Depreciation, Miscellaneous expenses written off etc.) Interest for the current year Instalment for the current year Lease Rental for the current year.

Sometimes, these figures are readily available but at times, they are to be determined using the financial statements of the company/firm. Formula for DSCR is stated as follows:

DSCR =

PAT + Interest + Lease rental + Non-cash expenses Instalment (Interest + Principal repayment) + Lease Rental

•

Profit After Tax (PAT): PAT is generally available readily on the face of the Profit and Loss account. It is the balance of the profit and loss account which is transferred to the reserve and surplus fund of the business. Sometimes, in absence of the profit and loss statement, we can also find it from the balance sheet by subtracting the current year P&L account from the previous year’s balance, which is readily available under the head of reserve and surplus.

•

Interest: The amount which is paid or payable for the financial year under concern on the loan taken.

•

Non-Cash Expenses: Non-cash expenses are those expenses which are charged to the profit and loss account for which payment has already been done in the past years. Following are the non cash expenses: -

-

Writing off of preliminary expenses, pre-operative expenses, etc. Depreciation on the fixed assets Amortization of the intangible assets like goodwill, trademark, patent, copyright, etc. Provisions for doubtful debts

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Deferment of expenses like advertisement, promotion, etc.

•

Instalment Amount: The amount which is paid or payable for the financial year under review for the loan taken. It includes the payment towards principal and interest for the financial year.

•

Lease Rental: The amount of lease rent paid or payable for the financial year.

Interpretation of Debt Service Coverage Ratio Just calculating a ratio does not serve the purpose till it is not interpreted in the correct sense. The result of a debt service coverage ratio is an absolute figure. Higher this figure better is the debt serving capacity. If the ratio is less than 1, it is considered bad because it simply indicates that the profits of the firm are not sufficient to service its debt obligations. Acceptable industry norm for a debt service coverage ratio is between 1.5 to 2. The ratio is of utmost use to lenders of money such as banks, financial institutions etc. There are two objectives of any financial institution behind giving loan to a business, viz., earning interest and not letting the account go bad. Let’s take an example where the DSCR is coming to be less than 1, which directly indicate negative views about the repayment capacity of the firm. Does this mean that the bank should not extend loan? No, absolutely not. It is because the bank will analyze the profit generating capacity and business idea as a whole and if the business is strong in both of them; the DSCR can be improved by increasing the term of loan. Increasing the term of loan will reduce the denominator of the ratio and thereby enlarge the ratio to greater than 1.

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! Term Loans remain a favorite avenue of raising funds for setting up new projects

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9.8 Summary •

Term Loans is a long-term debt having maturity period from 7 to 10 years.

•

There are various advantages of Term Loans such as simple repayment, rate is fixed, less cost, interest cost is tax-deductible, relatively less risk.

•

There are various disadvantages of Term Loans such as being permanent burden on company, having fixed maturity date, most risky of long-term financing, less operating flexibility, only large creditworthy companies can avail, prepayment penalties, etc.

•

Term Loan has many aspects such as Currency, Interest and Principal Repayment, Period of Repayment, Security, Guarantee, Pre-disbursement and Special Conditions, Protective Covenants, etc.

•

Term Loan procedure comprises of submission of loan application file, initial processing, appraisal, issue of letter of sanction, acceptance of terms of sanction, execution of loan agreement, creation of security, disbursement of loans and monitoring.

•

Syndicated Loans are used when the requirement is larger with participation from multiple banks.

•

Foreign Currency Loans are used when imported machinery and equipment is necessary for the project.

•

Debt Service Coverage Ratio (DSCR) essentially calculates the repayment capacity of a borrower.

Activity 1. Have a look at Application Form for Credit Facilities from a financial institution. Make a soft copy in MS Excel and try filling in all the details as per your project/industry.

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9.9 Self Assessment Questions 1. Define a term loan. Discuss some of the characteristics of a typical term loan. 2. State the sources of term loans. 3. What are the advantages/disadvantages of Term Loans? 4. What are the aspects of Term Loans? 5. What is procedure to avail Term Loan? 6. How do you negotiate effective Term Loan Arrangements? 7. What is relevance of DSCR Ratio? Explain in detail.

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TYPICAL FORM FOR APPLICATION FORM FOR CREDIT FACILITIES Kindly study the data and documentation requirements of the institution. Students already working on projects can copy the requirements in Word format and start filling in the details. SMALL-SCALE INDUSTRIES (SSI) APPLICATION FORM FOR CREDIT FACILITIES (Term Loan plus Working Capital)* (To be submitted in duplicate)

(*For Working Capital application to be submitted to a Commercial Bank separately)

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LOAN APPLICATION – CHECKLIST Please enclose Certified Xerox Copy of: Sr. No.

List of Documents to be Furnished/
 Enclosures to be Completed

1

Audited Financial statements for the last three years of the applicant unit (if in existence).

2

Audited Financial statements for the last three years of all the associate concerns of the applicant unit.

3

Memorandum and Articles of Association/ Certificate of Incorporation/Certificate of Commencement of business/ Partnership Deed/ Trust Deed/Bye-laws/Registration Certificate from Registrar of companies/Societies, as the case may be.

4

IT/Wealth Tax assessment orders/returns/ certificates for the last 3 years in the respect of the applicant unit (if in existence) and the promoters.

5

Sales Tax Returns and assessment orders for the last three years (if in existence).

6

Ration card/Passport/Voter ID card of all the promoters/ directors/guarantors.

7

Photograph of all the promoters/directors/ guarantors with signatures duly certified by their bankers.

8

Bio-data and Net worth statements of the promoters/directors/ guarantors duly signed by the concerned individual and certified by a CA firm.

9

SSI registration certificate/CA certificate for applicability of clubbing provisions.

10

Enclosure Furnished No. (Yes/No)

Project feasibility report, if any.

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11

Collaboration agreement and related details including copy approval from RBI/Government, if required.

12

Agreement with Technical consultants (if any) and related details including copy approval from RBI/Government, if required.

13

Title Documents such as Sale/lease deed/ agreement for the land and buildings on which the project is to be operated/set up and of collateral securities, if any.

14

Government order/permission converting the land into industrial land, if required.

15

Location/site map of the land showing contour lines, the internal roads, power receiving station, railway siding, tubewells, etc. and blueprints of the building plan duly approved by the concerned government/corporation/ municipality/Panchayat authorities.

16

Details of charges/encumbrances created/to be created on the existing assets.

17

Agreement with the electricity board for sanction of requisite power load/Electricity Bill for last three months.

18

No objection certificate/consent to operate/ establish obtained from the pollution control board (if applicable).

19

Orders/enquiries in hand for the output of the proposed project.

20

Invoices/quotations from at least three suppliers for each item of plant and machinery and miscellaneous fixed assets proposed to be purchased under the project along with a writeup on the technical specifications, advantages, etc. of the machinery.

21

Justification for choosing a particular supplier of plant and machinery with details of its credentials.

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22

Detailed estimates for civil construction with biodata of the builder/architect.

23

Detailed assumptions underlying the projected profitability statements as per Annexure XI.

24

Please attach worksheet for calculation of cost of various inputs and break-even point.

25

In-principle letter of sanction for working capital assistance to the applicant unit given by a Bank.

26

In case some portion of the expenditure has already been incurred, please furnish necessary proofs (cash receipts) along with a CA certificate with regard to sources of finance, items of expenditure, etc.

27

In case a Company has promoted the applicant unit, please furnish Memorandum and Articles of Association and Audited Balance Sheet and Trading and Profit and Loss A/cs for the past three years of the promoter company.

28

License/Permissions/Approvals by Regulatory Authority, where applicable.

29

Plan showing layout of machinery and organizational chart.

Note: All the required information should be duly typed in the application form. The comments like “As per the project report”, “As per the Annexure” will not be accepted. A soft copy should also be submitted in a floppy along with the signed hard copy of the Application form.

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APPLICATION FORM 
 FOR CREDIT FACILITIES (Term Loan plus Working Capital*) (To be submitted in duplicate) 1

DETAILS OF APPLICANT UNIT

1.1

Name of the Unit

1.2

Addresses with Telephone/Telex/Fax No. (a) Registered Office (b) Administrative office (c) Factory – Existing – Proposed

1.3

Constitution (please strike out which are not applicable)

1.4

Date of Incorporation

1.5

(As given by the District Industries Center/Directorate of Industries)

1.6

Exporters’ Code Number

1.7

Name of the business house/group to which the unit belongs

2

PROJECT (In case of existing units, please furnish detailed information as per Annexure I)

3

MANAGEMENT

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Brief particulars of the Promoters/Directors (Furnish Bio-data and net worth statement for each person in Annexure II and III respectively) S. No .

Name, Area of Desig- responsination bility in the Unit

Age Qualifi(in cations yrs.)

Relation ship with the chief promot er/s

Experie nce in propose d line of activity (in years)

Other Experience (in years)

Whether income tax Payee

Net worth (Rs. lakh) as on ____

1 2

In case the promoters are a limited company, please furnish a write-up on the activities and past performance. 3.2 Shareholding 3.2.1 - Please provide a list of existing and proposed equity and preference shareholders owning or controlling 5% or more of equity shares, indicating the amount owned and business relationship, if any, with the Company. Name

Existing Shareholding No. of equity shares (in lakhs)

Face value

Amount (Rs. lakhs)

Proposed Shareholding %

No. of Face equity value shares

Amount (Rs. lakhs)

%

Total Others Total

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3.3 - Details of the associate concern(s), if any (Please furnish detailed information for each associate concern in Annexure IV) S. No.

Name of the concern

In operation, since

Activity

3.4 - Particulars of key technical and executive staff (Please furnish data for existing as well as proposed staff) Name

Designation Qualification

Experience

Any special achievement (Inventions/
 Research etc.)

Functio-nal duties at the Unit

(Please enclose Organizational Chart) 4 - TECHNICALLY FEASIBILITY (Please enclose the feasibility/project report, if available/considered necessary) 4.1 - Name of the Products (including by-products) and its (their) uses 4.2 - Capacity (No. of Units/Quantify in Kg./Volume in Liters)

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Existing Capacity for Each Product

Licensed/ Installed

Proposed Licensed/Installed

No. of working days in a month:

Operating

No. of shifts in a day:

No. of hours per shift:

4.3 - Manufacturing process (Indicate technical details including type of process, material flow, etc.) 4.4 - Arrangement proposed for technology transfer/know-how 4.4.1 - Through technical collaboration (If yes, please furnish relevant information in Annexure V). 4.4.2 - Through technical consultants (If yes, please furnish relevant information in Annexure V). 4.4.3 - In-house – Yes/No. If yes, briefly explain how this will be done. 4.5 - Location advantages of existing and proposed premises with reference to absence of civic restrictions; proximity to the source of raw materials; market for the product; availability of power, water, labor, transport; and whether backward area and benefits available. 4.6 - Type of soil and load bearing capacity (enclose test report) 4.7 - Raw Materials and components (enclose copies of Proforma Invoices in respect of each item)

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Raw Material/Component Imported/Indigenous Quantity Required per unit of Product Sources of Supply Minimum Purchase Quantity/unit cost Availability (Easy/Restricted/Seasonal, etc.) Arrangement for transportation in case of bulky Raw Materials/Components

4.8 - Employment Present

Proposed

– Executives/Supervisors/Engineers – Administrative/Office Staff – Skilled Labor – Unskilled Labor – Others (specify)

4.9 - Utilities (Give comments on requirements, availability/adequacy, etc.)

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4.9.1 - Power (a)

Sources of Power and Supply Voltage

(b)

Maximum Demand

(c)

Contracted Load

(d)

Connected Load

(e)

Energy consumption per year

(f)

Power tariff (Rs./Unit)

(g)

Cost of Power per annum at maximum capacity utilization

h)

DG Set Capacity

(i)

Power cost per unit using DG set

(j)

Alternate arrangement for Power

4.9.2 - Water 4.9.2.1 - Indicate the requirements and suitability of water 4.9.2.2 - Describe water treatment arrangements 4.9.2.3 - Sources for supply of water, arrangement proposed and water charges payable 4.9.3 - Steam/Compressed Air: a. Requirement b. Arrangements proposed 4.9.4 - Fuel: a. Requirement of fuel (Type, Amount and Rate) b. Arrangements proposed for supply No requirements for fuels 4.10 - Effluent Treatment: Please furnish full details of the nature of atmosphere, soil, and water pollution likely to be created by the project

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and the measures proposed for control of pollution. Indicate whether necessary permission for the disposal of effluent has been obtained from the concerned authority; if yes, a copy of the certificate should be furnished. 4.11 - Quality control a. Details of arrangement made for quality control b. Particulars of R&D activity proposed, if any 4.12 - Schedule of implementation Please indicate the progress made so far in the implementation of project and furnish the schedule of implementation as follows: Date of Expected Date Commencement of Completion Acquisition of Land Development of Land Civil Works for – Factory building – Machinery foundation – Administrative Building Placement of Order for Plant and Machinery and MFA – Imported – Indigenous Arrangement for power Arrangement for water Erection of equipment Commissioning Initial Procurement of Raw Material Trial Runs Commercial Production

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4.13 - Government Consents Please indicate whether the various licenses/consents/approvals required for the project have been obtained from the respective authorities. (Indicative list Consent from Pollution Control Board, Non-agricultural (NA) Land Order, Approval for commencement of building construction approved building plan, Food and Drug, Storage of explosive material, MMPO etc.) 4.13.1 - Specify any special condition attached to the licenses/consents/ approvals and the undertaking given by The Company in connection herewith. 5 - ECONOMIC FEASIBILITY 5.1 - Market (Please enclose a Market Survey Report) The Products and Marketing Strategy: 5.1.1 - Industry/Sector Profile and its performance, Demand Supply Gap 5.1.2 - Names/Type of the Major Customers 5.1.3 - Region/Area where the product is being/will be sold 5.1.4 - Extent of competition, number and names of units engaged in similar line in the area, their capacity utilization/performance 5.1.5 - How do the unit/meet propose to meet the competition (comment on the competitive advantages enjoyed by the unit?) 5.1.6 - In price and quality, how does the unit's product compare with those of its competitors? 5.2 - Selling Arrangements 5.2.1 - Is the unit selling directly to its customers? If so please furnish details like sales force, showrooms, depots, etc. 5.2.2 - If a selling/distribution agency has been appointed, its name, period of contract, commission payable, period by which the bills will be paid by it etc. (enclose copies of agreement, wherever applicable)

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5.2.3 - Nature and volume of orders/enquiries on hand, if any (Xerox copies to be furnished) 6 - COST OF PROJECT (Please furnish estimates of cost of project under the following heads. Indicate the basis for arriving at the cost of project) Project at a glance (1st stage) Cost of Project

Means of Finance

Land

Capital

Land Development and Other Infrastructures

Unsecured Loans without Interest

Preliminary Expenses

Internal Accruals

Margin on Working Capital

Term Loan from Bank

…

…

…

…

TOTAL

TOTAL

6.1 - Land 1. Location 2. Area (in sq. mt./sq. ft.) 3. Whether Freehold land or Leasehold 4. Purchase Price of Land, if owned 5. Name of the person(s) from whom land has been/is being purchased (Please indicate relationship, if any with the applicant unit or the promoters/director 6. Terms of lease (such as rent, period, mortgage clause etc.)

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6.2 - Details of Site Development expenses 6.3 - Building 1. Location 2. Whether Owned or Leased 3. Purchase price of Building, if owned 4. Rents in Case of Leased/Rented Premises 5. Terms of lease 6. Estimated Cost of construction 7. Particulars of building (Furnish details in Annexure VI). 6.4 - Particulars of Plant and Machinery and Misc. Fixed Assets (Furnish details in Annexure VI) 6.5 - Arrangements made for erection and commissioning of the plant 6.6 - Break-up/Details of Preliminary and pre-operative expenses; Refer project report

Establishment Expenses Company Formation Deposit with SEB Traveling Expenses Pre-operative Expenses Interest During Construction Upfront Fee Other (Specify) Total

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6.7 - Margin Money Requirements for Working Capital (As per Annexure X). 7 - MEANS OF FINANCING (Please furnish details of sources of finance for meeting the cost under the following heads) (Rs. lakhs) S. No.

Amount Already Raised as on______

Particulars

(A)

Share Capital

(B)

Internal Accruals

(C)

Term Loans (give full particulars)

(D)

Unsecured Loans and Deposits (indicate sources, rate of interest, repayment period, etc.)

(E)

Other sources (specify)

(F)

Total

Amount Proposed to be Raised

Total

* Please note that the Subsidy from State/Central Government if any may be utilized for reducing the term liability of the unit 7.1 - Indicate sources from which expenditure already incurred has been financed (Please indicate CA certificate for the same along with copies of Bills/Invoices) 7.2 - Indicate the sources from which the share capital is proposed to be raised 7.3 - In case internal accruals are taken as source of finance explain the basis for estimation of internal accruals by means of a statement 7.4 - Promoter's contribution to the project as % of the total cost @ 25%

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7.5 - Financial Assistance required: 7.5.1 - Rupee Loan 7.5.2 - Foreign currency Loan 7.5.3 - Working Capital Term Loan 7.5.4 - Other forms of assistance (e.g., LCs guarantees, etc.) 7.6 - Repayment period required years and Moratorium Period (if required) 8 - FUTURE PROJECTIONS Please furnish: 8.1 - Projected profitability as per Annexure VII 8.2 - Project cash flow statement as per Annexure VIII 8.3 - Projected Balance Sheet as per Annexure IX 8.4 - Working Capital Requirements as per Annexure X 9 - DETAILS OF SECURITIES OFFERED FOR THE PROPOSED ASSISTANCE 9.1 - Primary: 9.2 - Collateral [Give full details like nature (residential/industrial/ commercial) and address of the property, area, name of the owner, cost/ market value, freehold/leasehold, whether charged to any other bank, tenancy, etc.] 9.3 - Details of guarantor(s). Please furnish Net worth Statements in the format enclosed at Annexure III separately for each guarantor. 9.3.1 - Name(s) 9.3.2 - Residential Address(es)

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9.3.3 - Occupation(s) (If in service, name and address of his/her employer) 9.3.4 - Details of any similar guarantee, if any, given to other institutions 10 - OTHER DETAILS 10.1 - Whether any Government enquiry, proceedings or prosecution has been instituted against the unit or its proprietor/partners/ promoters/ directors for any offences? If so, please give details 10.2 - Details of pending litigation, if any, against and by the concern 10.3.1 - Please indicate whether any of the promoters or directors has at any time declared themselves as insolvent

I/We certify that all information furnished by me/us is true; that I/We have no borrowing arrangement for the unit with any Bank except as indicated in the application; that there is no overdues/statutory dues against me/us/ promoters except as indicated in the application; that no legal action has been/is being taken against me/us/promoters that I/We shall furnish all other information that may be required by you in connection with my/our application; that this may also be exchanged by you with any agency you may deem fit; and you, your representatives, representatives of the Reserve Bank of India or any other agency as authorized by you, may, at any time, inspect/verify my/our assets, books of accounts, etc. in our factory/business premises as given above.

Signature of the Borrower Name and Designation Date: Place: 


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Annexure – I Details of Existing Unit (To be filled up in case of existing units only) 1. Nature of activity, Product and their uses 2. Capacity (No. of Units/Quantity in Kg./Volume in Liters) NOT APPLICABLE Capacity for each product

No. of working days in a month:

Licensed

Installed

No. of shifts in a day:

Operating

No. of hours per shift:

3.1 Details of Existing Fixed Assets (a)

1. 2. 3. 4. 5. 6.

Location Area (in sq. ft./sq. mt.) Whether Freehold land or Leasehold Purchase Price of Land, if owned Rent in case of leased Land Terms of Lease

(b)

Building 1. Whether Owned or Leased 2. Purchase price of Building, if owned 3. Rent in Case of Leased/Rented Premises 4. Terms of lease 5. Building details

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Own Building

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Structure

Type of construction

Area (in sq.m)

Actual Cost Date of Erection (in Rs. lakh)

(c) Particulars of Machinery (including those taken on lease/hire-purchase) S.No. Name of Machinery and Specification

Second Name of Hand/ manufacturer/ New fabricator (place of Country and Origin, if imported

Date of acquisition

Purchase cost including taxes, excise duty, etc.

Indigenous

Imported

(d) In case the assets have been revalued or written up at any time during the existence of the unit, furnish full details of such revaluation together with the reason therefore 3.2 Whether existing assets fully insured? 4 Past Performance Particulars

Last Year

Last but One Year

Last but Two Year

Capacity utilization (%) Turnover – Domestic – Exports Net Profit Net Worth (Please enclose audited balance sheet for last three years)

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4.1 Monthly turnover for last twelve months 5 Financial Arrangement: Sole Banking/Consortium/Multiple Banking Sole Banking 5.1 Details of Existing Credit Facilities (Please enclose copies of sanction letters) (Rs. in lakhs) Name and address of Bank/ FI

Nature Amt of sanctioned facility (date of sanction)

Rate of Interest

Amount Amount Security O/S as Overdue (including on , if any collateral, ____ if any)

5.2 Arrears in Statutory Payments (if any) NO Arrears in Statutory Payments a. b. c. d. e.

Income Tax Sales Tax Provident Fund Employees State Insurance Corporation Others (Specify)

5.3 - Contingent liabilities (if any) (including Bank Guarantee/Corporate Guarantees, if any, etc.) 6 - If the unit is an ancillary unit, the undertaking to which it is catering and its address 7- Necessity and purpose for the proposed investment/addition to factory premises/machinery (in case where such investment is intended) and details of benefits that would accrue to the unit by way of reduction in unit cost of production, quality improvement etc. after implementation of the scheme 8 - In case of switch over from another bank/FI, give reasons thereof

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Bio-Data Form

Annexure - II

Details of Proprietor/Partners/Managing Partner/Promoters/Directors/Managing Director
 (Please indicate interrelationship, if any, among the partners/directors/promoter)
 (Please use separate sheet for each person) 1. Full Name 2. Name of the Father/Husband 3. Age 4. Sex 5. Whether belongs to Scheduled Castes/Scheduled Tribes/Minority Community Yes/No 6. Are you an Ex-Servicemen Yes/No 7. Ration Card No. and name of the Issuing Office 8. Passport No. 9. Address Office Tel. No. Permanent Residence 10.Academic Qualification 11.Experience Year

Employer

Designation

Last Salary Drawn

12. Functional responsibilities in the unit 13. Capital/Loan contribution at the Beginning at Present in the unit 14. Reasons for joining/ establishing the unit (Please mention about the motivating factors)

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15. If associated as proprietor/partner/director/shareholder with concerns other than the applicant unit, please furnish following details separately for each concerns by way of enclosure 16. Name and address of the branch/associates/identical concern Activity of the concern Functional responsibility in that concern Capital/ Loan contribution Name of the associate concern’s banker and their address Aggregate credit facilities enjoyed by the concern Security offered by the concern for its borrowing Working results of the units for the past three years 17.Personal Assets and Liabilities: 18.Immovable property details like land/buildings, location, area, date of acquisition, cost, present value, basis of valuation etc. 19.Other Assets 20. Personal Liabilities, if any (indicating guarantees/acceptances given) 21. Any other relevant information Place: Date:

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Signature

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Net Worth Statement Form Annexure-III Net Worth of Details of Proprietor/Partners/Managing Partner/Promoters/ Directors/
 Managing Director/Guarantors (Please use separate sheet for each person) Net Worth Statement of _______________ A. Investment in immovable property (including construction/investment activity yet to be completed): S. No.

Details of location of property (As per revenue and municipal records, postal address)

Type of Proper ty (*)

If in joint ownership with others (indicate names)

Date of acquis ition

Built-up area (in sq.ft./ sq.mt.) @

Cost Market (Rs. Value Lakh) @ (Rs. Lakh) @

1 TOTAL

7.60

*Indicate type as Residential/Industrial/Agricultural/Gala/ others (Please specify) @ if jointly owned with others, only relevant share to be taken for value

B. Investment in shares/debentures/capital/securities/bonds/mutual funds etc.

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S. No

Name of the Company/ Concern

Invest ment Type

No. of Units

Cost (Rs. Lakh)

Market Value (Rs. Lakh)

Associate/Sister/Group Concern 1 2 3 Sub-total Other s 4 5 Sub-total

C. Loans and Advances/Investment in S No.

Name of the Company/ Concern

Investmen t type

Long term/ Short term

Amount (Rs. Lakh)

Associate/Sister/Group Concern 1 2 3 Sub-total Other s 4 5 Sub-total

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TOTA L

D. Other Assets S. No.

Details

Amount (Rs. Lakh)

Long term/Short term

TOTAL

E. Secured/Unsecured Borrowings from S. No.

Name of the Lender

Nature Purpose of Borro wing (long term/ short term)

Amou nt outst andin g
 (Rs. Lakh)

Amount Natu overdue, if any 
 re of (Rs. Lakh) Secu rity offer ed

Banks/Financial Institutions/Finance Companies -

Sub-total Associate/Sister/Group Concern -

Sub-total Others Sub-total

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TOTA L

F. Any Other Liability S. No Details

Amoun t (Rs. Lakh)

Long term/Short term

-

TOTA L G. Networth [A + B + C + D – E – F]: I, _______________, Son of _______________, certify that the contents of this statement are true and correct to the best of my knowledge and belief. Place: Date:

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Signature


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Annexure – IV Details of Associate/Sister/Group Concerns (Please use separate sheet for each Concern) 1. Name of the Concern: 2. Address: 3. Name(s) of Proprietor/Partners/ Promoters/Directors: 4. Past Performance (please enclose copies of audited balance sheet for last three years) (Rs. Lakh) Particulars

Last Year

Last But One Year

Last But Two Year

Turnover – Domestic – Exports Net Profit Net Worth 5. Existing credit facilities (Please enclose copies of sanction letters) [Rs. Lakh] Name and address of Bank/FI

Nature of facility

Amt Rate of sanctioned 
 Interest (date of sanction)

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Amount O/S as|
 on _______

Amount Overdue, 
 if any

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Annexure – V Arrangement Proposed for Technical Know-How for the Project 1. Technical Collaboration: Please furnish a brief write-up on the period of collaboration agreement, the name of the collaborator company, indicating the activities, size, turnover, particulars of the existing plants, and other projects in India and abroad set up with same collaboration, fees/royalties payable and the manner in which payable, etc. 2. Technical Consultants: Please furnish full details of arrangement proposed to be made for obtaining technical advice and services needed for the implementation of the project, Particulars of the Consultants like name and address of the consultants, fees payable and the manner in which payable, scope of work assigned to them, organizational set-up, bio data of senior personnel, names of directors/partners, particulars of work done in the past and work on hand. 3. Whether any of partners/promoters/directors has any interest in consultant/collaboration firm. If so, details to be furnished.

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Annexure – VI Details of Building, Plant and Machinery and Miscellaneous Fixed Assets Proposed in the Project 1 Particulars of building proposed to be constructed Sr. Description Type of No of each construc building -tion

Built-up area (in meters)

Total floor area in sq. m.

Rate of construction per sq. m. 
 (in Rs.)

Length

Breadth

Height

Estimated cost of each bldg (Rs. Lakh)

Lump sum amount (in case not calculated) (Rs. lakh)

Architect’s fees Others (specify)

2. Please furnish the following particulars of Architect(s) (a) Name and address of the architect(s) firm (b) Scope of work (c) Fee payable and manner in which payable (d) Past experience of the architect(s) in similar work 3. Particulars of Plant and Machinery and Miscellaneous Fixed Assets


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Name of Machinery and Specificati on

Second Hand/ New

Name of manufactur er/supplier fabricator (place of Country and Origin, if imported

Date of Expected acquisition date of /Date of Delivery placement of order (actual/ expected

Invoice Price including taxes for Indigenous machinery/ CIF for Imported Machinery

Estimated expenses o/a of insurance, freight, installation , import duty

Total cost

PLANT and MACHINERY – Indigenous

– Imported

Total Cost of Plant and Machinery MISCELLANEOUS FIXED ASSETS – Indigenous

– Imported Total cost of Miscellaneous Fixed Assets

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3. Particulars of Plant and Machinery and Miscellaneous Fixed Assets 3.1. Competitive Quotations/Catalogues/Invoices from at least three suppliers and other details like technical specifications, advantages and justification for choosing a particular supplier along with the credentials of the suppliers in respect of each machine is to be furnished. 3.2. In case of second hand machinery, valuation report regarding age, performance and value from competent valuer to be submitted. Also please indicate reasons for going in for second hand machinery and its depreciated value Prior approval necessary 3.3 In case of imported machinery, please indicate mode of payment and price of the machinery in foreign currency also.

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Projections of Performance, Profitability and Repayment Annexure – VII Break-even point % of installed capacity (Rs. In lakhs) 1st year A

Production during the year (Quantity)

B

Sales 1

Break-even quantity Break-even Value 2nd year

3rd year

4th year

5th year

6th year

7th year

(a) Domestic Sales (b) Export Sales

2

Less: Excise

3

Net Sales

4

Other income (give details), if any Total Income

C

Cost of Production 1

Cost of construction

2

Administrative Expenses

3

Office Expenditure

4

Selling and Marketing Expenses

5

Preliminary and Preoperative Expenses

6

Contingencies

Total operating Expenses D

Gross Profit (B – D) (EBIDTA)

E

Interest on 1

Term Loans

2

Working Capital

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3

Other Loans, if any Depreciation

F

Profit before Taxation ( E – F + G)

G

Other Non-operating Expenses

H

Provision for Taxes

I

Net Profit (H – I)

J

Depreciation added back

K

Net Cash Accruals (J + K)

L

Repayment obligations

357.29

1

Towards term loan

2

Towards other loans, if any Total Repayment

M

Debt Service Ratio (K + E1 + E3) : (L + E1 + E3)

Average DSCR


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Projected Cash Flow Statement (Rs. in lakhs) Year 1

Particulars A.

Year 2

Year 3

Year 4

Annexure - VIII Year 5

Year 6

Year 6

Sources of funds 1

Cash accruals (viz. profit before Taxation + interest)

2

Increase in share capital: Equity/ Preference

3

Depreciation

4

Increase in long-term loans/ debentures

5

Increase in deferred payment facilities

6

Decrease in current assets

6

Increase in unsecured loans and deposits

7

Increase in bank borrowing for working capital

8

Sales of fixed assets/ investments

9

Decrease in intangible assets

10

Others (specify) – increase in current liabilities

TOTAL SOURCE (A) B

Disposition of Funds 1

Preliminary and preoperative expenses

2

Increase in capital expenditure

3

Decrease in current liability

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4

Increase in current assets

5

Decrease in long-term loans/ debentures

6

Decrease in deferred payment facilities

7

Decrease in unsecured loans/ deposits

8

Increase in investment

9

Interest

10

Taxation

11

Dividend (amount and rate)

12

Other expenses (specify)

Total Disposition (B) C

Opening Balance

D

Net Surplus (A – B)

E

Closing Balance

Tally Cash Balance with Balance Sheet

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Annexure – IX PROJECTED BALANCE SHEET [Rs. lakh] 1st Year A.

2nd Year

3rd Year

4th 5th Year Year

6th 7th Year Year

LIABILITIES 1

Equity Share Capital

2

Reserve and Surplus Net Worth

3

Unsecured Loans

4

Term Loans

5

Current Liabilities Total Liabilities

B.

ASSETS 1

Net Block

2

Investment (ONCA)

3

Intangible Assets

4

Current Assets

a

Inventories

b

Sundry Debtors

c

Cash and Bank Balance

d

Other Current Assets Total Assets

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Assessment of Working Capital Requirements 1st Year I.

2nd Year

3rd Year

Annexure – X

4th 5th Year Year

6th Year

6th Year

Current Assets 1 1.1

Raw materials including stores Imported (Month’s consumption)

1.2

Indigenous (Month’s consumption)

2

Other consumables spares

3

Stock-in-process (Month’s cost of production)

4

Finished goods (Month’s cost of sales)

5

Receivables other than export and deferred receivables (including bills purchased/ discounted by banks ) (Month’s domestic sales excluding deferred payment sales)

6

Export receivables (including bills) purchased/discounted by banks) (Month’s export sales)

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7

Advances to suppliers of raw materials and stores/spares/ consumables

8

Other current assets including cash and bank balances and deferred receivables due within one year (furnish individual details of major items)

Total Current Assets (I) II

Current Liabilities 1

Creditors for purchases of raw materials and stores/ spares/ consumables (Month’s purchases)

2

Advances from customers

3

Accrued expenses

4

Statutory liabilities

5

Other current liabilities (furnish individual details of major items)

Total Current Liabilities (II) III. Working Capital Gap (I – II) IV.

Margin Money for Working Capital

V.

Bank Borrowings

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Annexure - XI Major Assumptions underlying Projected Profitability Statements Indicative Format: NOT APPLICABLE Particulars

Previous Year (Actual)

Current Year (Estimate)

Projections I
 II III IV V Year Year Year Year Year

Installed capacity* % Capacity Utilization Product-wise Sale Price per unit (Rs.) Other Income* Excise Duty (%) Raw material cost/Sales (%) Consumables/Sales (%) Labour cost Other manufacturing expenses Selling and marketing expenses Administrative expenses Other major expenses, if any Depreciation rate

* Detailed calculation may be indicated.

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Video Lecture


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WORKING CAPITAL FINANCE

Chapter 10 WORKING CAPITAL FINANCE Objectives After studying this chapter, you should be able to: •

Provide a brief overview about Working Capital Finance.

•

Learn about the Definition of Working Capital.

•

Learn about Working Capital Techniques to find the optional level of Working Capital.

•

Learn about the Methods of Analysis of Working Capital.

•

Provide conceptual understanding about find Flow Charge Analysis.

Structure: 10.1 Introduction 10.2 Definition of Working Capital 10.3 Different Types of Working Capital Facilities 10.4 Working Capital Management Techniques for Finding Optimal Level of Working Capital 10.5 Methods of Analysis of Working Capital 10.6 Funds Flow Analysis 10.7 Summary 10.8 Self Assessment Questions

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WORKING CAPITAL FINANCE

10.1 Introduction Working capital financing is done by various modes such as trade credit, cash credit/bank overdraft, working capital loan, purchase of bills/discount of bills, bank guarantee, letter of credit, factoring, commercial paper, intercorporate deposits, etc. Arrangement of working capital financing forms a major part of the day-today activities of a finance manager. It is a very crucial activity and requires continuous attention because working capital is the money which keeps the day-to-day business operations smooth. Without appropriate and sufficient working capital financing, a firm may get into troubles. Insufficient working capital may result into non-payment of certain dues on time. Inappropriate mode of financing would result in loss of interest which directly hits the profits of the firm.

10.2 Definition of Working Capital Working capital refers to Current Assets and Current liabilities. Strictly, it is not a part of project finance which deals with financing fixed assets. But working capital has to be dealt with under project finance for two reasons: 1. The margin money for working capital has to be financed by long-term sources. 2. The record of industrial sickness establishes that many a unit flounders on the quagmire of inadequate working capital. Industrial sickness ties up national resources and renders waste the project loan as well as the equity of the promoter. Promoters have to make sure that adequate working capital to reach break-even point and step up capacity utilization is available. It is essential that such estimates are available and resources are tied up to meet the working capital requirements of the project. Net working capital is the difference between current assets and current liabilities and is a measure of the company’s liquidity. A survey of large companies shows that almost 50% of total net assets of all companies are devoted to current assets; and current liabilities constitute 59.1% of total liabilities. !

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WORKING CAPITAL FINANCE •

In the case of smaller companies, almost 63% of total net assets were devoted to current assets.

•

In the case of medium companies, 55% of total assets were devoted to current assets.

•

In the case of large companies, 40% of total assets were devoted to current assets, and current liabilities constituted almost 40% of total liabilities.

10.3 Different Types of Working Capital Facilities 10.3.1 Trade Credit Trade Credit is simply the credit period extended by the creditor of the business. Trade credit is extended based on the creditworthiness of the firm which is reflected by its earning records, liquidity position and records of payment. Just like other sources of working capital financing, trade credit also comes with a cost after the free credit period. Normally, it is a costly source as a means of financing business working capital. 10.3.2 Cash Credit/Bank Overdraft Cash Credit or Bank Overdraft is the most useful and appropriate type of working capital financing extensively used by all small and big businesses. It is a facility offered by commercial banks whereby the borrower is sanctioned a particular amount which can be utilized for making his business payments. The borrower has to make sure that he does not cross the sanctioned limit. Best part is that the interest is charged to the extent the money is used and not on the sanctioned amount which motivates him to keep depositing the amount as soon as possible to save on interest cost. Without a doubt, this is a cost-effective working capital financing. 10.3.3 Working Capital Loans Working capital loans are as good as term loan for a short period. These loans may be repaid in instalments or a lump sum at the end. The borrower should take such loans for financing permanent working capital needs. The cost of interest would not allow using such loans for temporary working capital.

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WORKING CAPITAL FINANCE

10.3.4 Purchase/Discount of Bills For a business, it is another good service provided by commercial banks for working capital financing. Every firm generates bills in the normal course of business while selling goods to debtors. Ultimately, that bill acts as a document to receive payment from the debtor. The seller who requires money will approach bank with that bill and bank will apply discount on the total amount of the bill based on the prevailing interest rates and pay the remaining amount to the seller. On the date of maturity of that bill, the bank will approach the debtor and collect the money from him. 10.3.5 Bank Guarantee It is primarily known as non-fund based working capital financing. Bank guarantee is acquired by a buyer or seller to reduce the risk of loss to the opposite party due to non-performance of agreed task which may be repaying of money or providing of some services etc. A buyer ‘B1’ is buying some products from seller ‘S1’. In this case, ‘B1’ may acquire bank guarantee from bank and give it to ‘S1’ to save him from the risk of nonpayment. Similarly, if ‘S1’ may acquire bank guarantee and hand it over to ‘B1’ to save him from the risk of getting lower quality goods or late delivery of goods etc. In essence, a bank guarantee is revoked by the holder only in case of non-performance by the other party. Bank charges some commission for same and may also ask for security. 10.3.6 Letter of Credit It is also known as non-fund based working capital financing. Letter of credit and bank guarantee has a very thin line of difference. Bank guarantee is revoked and bank makes payment to the holder in case of non-performance of the opposite party whereas in case of letter of credit, the bank will pay the opposite party as soon as the party performs as per agreed terms. So, a buyer would buy a letter of credit and send it to the seller. Once the seller sends the goods as per agreement, the bank would pay the seller and collect that money from buyer. 10.3.7 Factoring Factoring is an arrangement whereby a business sells all or selected accounts payables to a third party at a price lower than the realizable value of those accounts. The third party here is known as the ‘factor’ who provides factoring services to business. The factor would not only provide financing by purchasing the accounts but also collects the amount from the debtors. Factoring is of two types – with recourse and without recourse.

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WORKING CAPITAL FINANCE

The credit risk of non-payment by the debtor is borne by the business in case of with recourse and it is borne by the factor in case of without recourse. Some other sources of working capital financing used are inter-corporate deposits, commercial paper, public deposits etc.

10.4 Working Capital Management Techniques for Finding Optimal Level of Working Capital Working capital management techniques such as intersection of carrying cost and shortage cost, working capital financing policy, cash budgeting, EOQ and JIT are applied to manage different components of working capital like cash, inventories, debtors, financing of working capital etc. These effective techniques mainly manage different components of current assets. Working capital management techniques are very effective tools in managing the working capital efficiently and effectively. Working capital is the difference between current assets and current liabilities of a business. Major focus is on current assets because current liabilities arise due to current assets only. Therefore, controlling the current assets can automatically control the current liabilities. Now, current assets include Inventories, Sundry Debtors or Receivables, Loans and Advances, Cash and Bank Balance. All working capital management techniques attempt to find optimum level of working capital because both excess and shortage of working capital involves cost to the business. Excess working capital carries the ‘carrying cost’ or ‘interest cost’ on the capital lying unutilized. Shortage of working capital carries ‘shortage cost’ which include disturbance in production plan, loss in revenue etc. Finding the optimum level of working capital is the main goal or winning situation for any business manager. There are certain techniques used for finding the optimum level of working capital or management of different items of working capital.

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WORKING CAPITAL FINANCE

10.4.1 Intersection of Carrying Cost and Shortage Cost One of the important methods of finding the optimum level of working capital is the point of intersection of carrying cost and shortage cost in a graphical representation. The total of carrying and shortage cost is minimum at this point.

! Intersection of Carrying Cost and Shortage Cost

Here, the levels of current assets are optimum at the point where the shortage and carrying costs are meeting or intersecting. At this point, the total cost, as we can see, is minimum and this is why that level of current assets is considered to be optimal. 10.4.2 Working Capital Financing Policy Working capital can be divided into two, viz., Permanent and Temporary. Permanent working capital is the level of working capital which is always required and maintained. Temporary working capital is the part of working capital which keeps on fluctuating. It is high in good seasons and low in bad seasons. There are two types of financing available. They are longterm financing and short-term financing. Three strategies are possible with respect to financing of working capital. Efficient financing of working capital reduces carrying cost of capital:

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WORKING CAPITAL FINANCE

1. Long-term financing is used for both permanent and temporary WC. 2. Long-term financing is used for permanent and some part of temporary WC. Remaining part of temporary WC is financed through short-term financing as and when required. 3. Long-term financing is used for permanent and short-term financing for temporary WC. These strategies should be chosen so as to match the maturity of source of finance with the maturity of the asset. 10.4.3 Cash Budgeting Cash budgeting is another important technique for working capital management which helps keeping optimum level of cash in the business. Cash budgeting involves estimating the requirements of cash by estimating all the forthcoming receipts and payments. For effective management, a balance is needed between both excess and shortage of cash. It is because both ends are costly. Speeding up of collection and getting relaxed credit terms from the creditors can reduce the cash requirements. 10.4.4 Inventory Management Inventory is an important component of working capital or current assets. Optimum level of inventory can save on costs heavily. 1. EOQ: Economic Order Quantity (EOQ) model is a famous model for managing the inventories. It helps the inventory manager know how to find the right quantity that should be ordered considering other factors like cost of ordering, carrying costs, purchase price and annual sales. The formula used for finding EOQ is as follows: EOQ

= √[(2 × A × O)/(P × C)]

where, A O P C

– – – –

Annual Sales Cost per Order Purchase price per unit Carrying Cost


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WORKING CAPITAL FINANCE

2. Just-in-time: Just-in-time is another very important technique which brought about paradigm shift in the management of inventories. It did not reduce cost of inventory but it abolished it completely. Just-in-time means acquiring raw material or manufacturing product at the time when it is required by the customer. This strategy is very difficult to implement but if implemented can bring down inventory cost to minimum levels. These are some important techniques discussed here. They are very effective in managing working capital. Managing working capital means managing current assets. Current assets like cash can be managed using cash budgeting; inventory can be managed using inventory techniques like EOQ and JIT. Debtors and financing of working capital can be managed using appropriate sources of finance.

10.5 Methods of Analysis of Working Capital Analysis of working capital is significant for both management and shortterm creditors. Management can assess the efficiency of the working capital employed in the business. Such an analysis helps management to detect trends and initiate corrective measures. It helps the shareholders and creditors to determine prospects of payment of dividend and interest. The analysis of working capital helps in determining the ability of the company to repay its current debts promptly, assess the effectiveness of management of working capital, adequacy of working capital and to undertake credit rating. Analysis of working capital relates to an examination of circulation, liquidity, level and structural aspects of working capital. In the analysis of working capital, the tools used are ratio analysis and funds flow analysis of the company. 10.5.1 Ratio Analysis To analyze the current financial position of a company, ratios computed on the basis of figures appearing in the balance sheet are covered with the norms set for the ratios. Depending upon the purpose, various ratios are used. The ratios discussed here relate to liquidity, circulation level and structure of working capital.

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10.5.2 Liquidity Ratios a. Net working capital to total assets: It was noted earlier that current assets are those assets which the company expects to turn into cash in the near future and current liabilities are those which it expects to meet in the near future. Net working capital is the difference between current assets and current liabilities. Net working capital toughly measures the company’s potential reserve of cash. Net working capital is expressed as a proportion of total assets.

Net working capital !

Total assets

b. Current Ratio: Current ratio serves a similar purpose and is frequently used. It is also called working capital ratio. It is considered as an index of solvency of a company. It indicates the ability of the company to meet its current obligations. Changes in current ratio can, however, be misleading. If a company raises money through commercial paper and invests the amount in marketable securities, net working capital is unaffected but the current ratio changes. Current ratio is computed by dividing the total current assets by current liabilities. The result shows the number of times the current assets pay off the current liabilities. Current ratio =

Current assets Current liabilities

A current ratio of 2 : 1 is generally considered satisfactory for a manufacturing company. It constitutes a rule of thumb for measuring liquidity. A demand for 100% margin of current assets over current liabilities is a precaution based on the practical knowledge of the possible shrinkage that may occur in the value of current assets. The current ratio cannot, however, be applied as a norm for all companies because the quality and character of current assets varies according to the type of activity. c. Quick (or Acid test) ratio: Another ratio which measures immediate solvency is the current ratio. It includes assets which can be quickly or immediately converted to cash. Such assets include only cash, marketable securities and bills customers have not yet paid

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(receivables). Inventories are excluded because they cannot be sold at any thing above fire-sale prices. The liquidity arises because finished goods cannot be sold for more than production cost. Quick ratio is computed as:

QR =

Cash + Marketable securities + Receivables

=

Current liabilities

=

Current assets – Current liabilities Current liabilities

Liquid assets Current liabilities

d. Interval Measure: Sometimes, it may be useful to compare current assets to regular cash outgoings of a company. The interval measure is calculated by:

Cash + Marketable securities + Receivables !

Average daily expenditure from operations The interval expressed in number of days measures the ability of the company to finance its daily expenditure with the current assets in its position even if it receives no further cash. 10.5.3 Inventory Turnover Ratios The inventory turnover ratios show the extent of use of work in different types of inventory. These ratios include:

1. Turnover of raw materials: This ratio shows the number of times the raw materials were replaced during a year. It is obtained by dividing raw materials issued to the factory by raw materials in ending inventory. The raw materials inventory of a manufacturing enterprise may be reduced to a number of months in a year by the turnover of raw materials inventory. A low turnover ratio of raw materials inventory indicates that excessive raw materials have been procured and the opposite is the condition with a high turnover of raw materials inventory.

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WORKING CAPITAL FINANCE

2. Turnover of stores and spares: This ratio shows utilization of funds in stores and spares inventory. This ratio is obtained by dividing stores and spares consumed in a fiscal year by the value of stock and spares at the end of the fiscal year. The stores and spares inventory may be reduced to number of months stores and spares inventory by dividing number of months in a year by the turnover of stores and spares inventory. A higher turnover of stores and spares inventory is an indication of management’s efforts to reduce investment in this component. On the other hand, a falling turnover of stores and spares inventory may be taken to mean that excessive working funds have been deployed in this component. 3. Turnover of goods-in-process: This ratio is obtained by dividing the value of goods produced in a year by the value of goods-in-process at the end of a fiscal year. This ratio establishes relationship between the value of goods produced and the value of goods-in-process of production. A high turnover indicates less accumulation of inventory and less working finance tied up in this component. 4. Turnover of finished goods: This ratio is computed by dividing the net sales by finished goods inventory. The finished goods inventory may be reduced to number of months’ finished goods inventory by dividing number of months in a year by turnover of finished goods inventory. A higher turnover of finished goods inventory indicates that a higher level of sales has been attained with less investment in the finished goods inventory. A falling turnover indicates that the investment in finished goods is increasing in relation to sales. 5. Turnover of aggregate inventory: This ratio is obtained by dividing the net sales in a year by the value of aggregate inventory at the end of the year. The aggregate inventory of a business enterprise may be reduced to a number of months’ inventory by dividing the number of months in the year by ratio of turnover of aggregate inventory. 10.5.4 Work-in-process Work-in-process represents investment by firm. It is the amount of semifinished products currently lying on the factory floor. In the traditional view, inventories including WIP are considered as assets and inventory build-up is seen as value added. They are also considered as a buffer

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WORKING CAPITAL FINANCE

against uncertainties arising out of delayed supplies, machine breakdowns, absenteeism and uncertain customer orders. The desire to improve utilization of expensive equipment also contributed to building up WIP. In recent times, inventory is considered evil and evidence of poor design, poor forecasting, poor coordination and poor operation of the manufacturing system. The current trend is to produce times as required. WIP should be equal to the sum obtained by multiplying the rate at which parts flow through the factory with the length of time parts spent in the factory. The higher turnover of inventory quickens the flow of funds from inventory. A low turnover ratio indicates an over-investment in inventory in relation to sales. 10.5.5 Receivables Turnover Ratio The receivables turnover ratio is computed by dividing annual credit sales by total customer receivables. When the number of days in a year is divided by the turnover of receivables, the ratio gives average collection period. The turnover of receivables indicates the rate at which sales are converted into cash and the average collection period shows the number of days of sales that are represented by the account receivables. A declining turnover of account receivables indicates an over-investment of funds in receivables which may raise the requirement of working capital of a firm. a. Cash turnover ratio: This ratio shows the relationship between cash balance plus other liquid assets and operating costs and expenses. It shows the adequacy of liquid assets to meet current operating needs. A high turnover of cash indicates an insufficiency of cash to provide for emergencies. A low turnover of cash shows that an excess cash balance is lying with the enterprise. b. Current assets turnover ratio: This ratio measures the turnover of total current assets used in business operations. The ratio is obtained by dividing the cost of goods sold by total current assets. This ratio may be linked with the profitability of an enterprise. For this purpose, two other computations are done. First, net income is divided into current assets which gives the rate of profit on average current assets. Second, the rate of profit of current assets is divided by the turnover of current assets which gives the rate of profit per turnover of current assets.

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WORKING CAPITAL FINANCE

The lower turnover and profitability of current assets indicate utilization of working capital and reverse is the case with a higher turnover and profitability. c. Working capital turnover ratio: This ratio is obtained by dividing net sales by working capital. This ratio indicates the efficiency with which the working capital has been used in the company. The higher turnover of working capital represents lower investment in it and greater profitability. But a very high turnover of working capital may also indicate the efficient utilization of working capital in the enterprise. 10.5.6 Efficiency or Profitability Ratios These ratios are employed to judge how efficiently a company is using its assets. It should, however, be noted that there is quite a bit of ambiguity about these ratios. a. Sales to Total Assets: The ratio shows how hard the company’s assets are being to put to use. The ratio is represented by:

Sales Average total assets !

This reveals how close a company is operating to capacity. A high ratio would imply that sales cannot be stepped up without an increase in capital invested in the company. b. Sales to Net Working Capital: The ratio would help focus on how efficient working capital is being used. The ratio is represented by: !

Sales Average net working capital

c. Net Profit Margin (NPM): The ratio helps in establishing the proportion of sales that finds its way into profits. It is computed by: !

NPM =

Earnings before interest and taxes (pa) – Tax Sales

d. Inventory turnover: The ratio which tells about the rate at which companies turnover their inventories is obtained by:

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! Inventory Turnover =

Cost of goods Average inventory

A high inventory ratio could mean efficiency or hand-to-mouth existence. e. Return on Total Assets: The ratio of income (earnings before interest and after taxes) to total assets (original cost – depreciation) is used to measure the performance of a company.

!

Return on Total Assets =

EBIT – Tax Average total assets (average of assets at the beginning and end of the year)

f. Payout ratio: The ratio measures the earnings paid out as dividends. !

Payout ratio =

Dividend per share Earning per share

Companies follow a low average payout ratio if earnings are not stable. Earnings not paid out are retained in business. Retained earnings = 1 – Payout ratio !=

Earnings – Dividend Earnings

The impact of retained earnings in the growth of shareholders’ investment can be measured by multiplying retained earnings by the return on equity (earnings/equity). ! Growth in Equity =

Earnings – Dividends Earnings × Earnings Equity

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WORKING CAPITAL FINANCE

10.5.7 Market Value Ratios There are four ratios that combine accounting and stock market data which are useful in assessing the company’s position. a. Price earning ratio (P/E ratio): It is a common measure of the investors’ estimate of the company. It is obtained by: ! P/E ratio =

Stock price Earnings per share

The stock price is arrived at by assuming that dividends are at steady rate. ! Po =

DIV1 r–g

Where, DIV1 measures the expected dividend next year, r is the required rate of return and g is the expected rate of dividend growth. To find the P/E ratio, divide current stock price formula with expected earnings per share:

Po DIV1 1 = × EPS1 EPS1 r – g !

Normally, P/E ratios are in mid-teens. In the Indian stock market, PE ratios are quite high. High P/E ratios normally indicate that: •

Investors expect high dividend growth (g);

•

The share has low risk and therefore investors accept a low prospective return (r);

•

The company is expected to achieve average growth while paying out a high proportion of earnings (DIV1/EPS). But in the Indian context, high PE ratios are a demand phenomenon. Excess demand for shares has driven up prices and high P/E ratios have been registered.

b. Dividend yield: Dividend yield measures dividends as a proportion of the share price. ! Dividend yield =

Dividend yield per share Share price

In the case of a company with a steady expected growth in dividends,

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WORKING CAPITAL FINANCE

! Dividend yield =

DIV1 =r–g Po

High yield is indicative of investors’ expectation of low dividend growth or requirement of a high return. c. Market to book ratio: The ratio of market price per share to book value per share reveals the market worth of the company as compared to what past and present shareholders have put into it. Book value per share is net worth (paid-up capital ÷ free reserves) divided by the number of shares outstanding. ! Market to Book Ratio =

Stock price Book value per share

Market value (assets, debt and equity) to replacement cost or Tobin’s q. The ratio q is obtained by: ! q=

Market value of assets Estimated replacement cost

Assets in the ratio include all assets, debt and equity; and replacement cost is current cost estimated after adjusting historic cost for inflation. When capital equipment is worth more than it costs to replace, q is greater than one and companies have an incentive to invest; and when equipment is worth less than its replacement cost, q is less than one, companies will stop investing. The merger route is preferred for acquisition of assets than purchase new assets when q is less than 1. High market values may exist even when existing assets are worth much more than their cost because investors believe that the company has good opportunities. 10.5.8 Level of Working Capital The analysis of level of working capital throws light on the size of working capital. It shows whether the size of working capital of an enterprise is excessive or adequate or inadequate to its needs. The most important ratio tests in this regard are the amount of working capital in terms of months’ cost of production or months’ average sales turnover. The results of these ratio tests when compared with the norms

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WORKING CAPITAL FINANCE

for the industry indicates whether the size of working capital maintained by the enterprise is excessive or adequate or inadequate to its requirements. A comparison of working capital with other variables such as output and sales over a period of time may also indicate the trend in the growth of working capital.

10.6 Funds Flow Analysis Funds flow analysis shows the sources and uses of funds of a company. This technique helps to analyze changes in working capital components between two dates. A comparative analysis of current assets and liabilities, as shown in the balance sheet at the beginning and the end of a year, indicates changes in each type of current assets as well as the sources from which working capital has been obtained. However, the technique of funds flow analysis fails to clarify the significance of movements in the working capital structure. Predict Projects Pvt. Ltd. has just started trading operations of an engineering product in last year. It has applied to a Commercial Bank for Working Capital facility. A typical application for a Working Capital Facility of Rs. 70 lakhs by M/s Predict Projects Pvt. Ltd. is enclosed herewith. Kindly study it. 


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WORKING CAPITAL FINANCE

Predict Projects Pvt. Ltd.
 Assessment of Working Capital Requirements
 FORM II
 Operating Statement Audited Provisional Projected Latest 1

Gross Sales

(i)

Domestic Sales

(ii)

Other Revenue Income Total

1st Year

2nd Year

124.65

215.30

360.00

–

–

–

124.65

215.30

360.00

–

–

–

124.65

215.30

360.00

–

72.72

67.21

131.90

204.59

345.00

2

Less: Excise duty – Deduct other items

3

Net Sales (item 1– item 2)

4

% age rise (+) or fall (–) in net sales as compared to in net sales as compared to previous year (annualized)

5

Cost of Sales

(iii)

Raw materials

(iv)

Salary and Wages

–

–

–

(v)

Other manufacturing expenses

–

–

–

(vi)

Depreciation

0.80

1.26

0.80

(vii)

Sub-total (i to vi)

132.70

205.85

345.80

(viii)

Add: Opening Stocks-in-process and Raw MATERIALS

–

–

–

132.70

205.85

345.80

–

–

–

132.70

205.85

345.80

–

17.02

23.75

132.70

222.87

369.55

17.02

23.75

50.00

115.68

199.12

319.55

Sub-total (ix)

Deduct: Closing Stocks-in-process and Raw materials

(x)

Cost of Production

(xi)

Add: Opening stock of finished goods Sub-total

(xii)

Deduct: Closing stock of finished goods

(xiii)

Sub-total (Total cost of sales)

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WORKING CAPITAL FINANCE

6

Selling, general and administrative expenses

7

Sub-total (5 + 6)

8

Operating profit before interest (3 – 7)

9

Interest

10

Operating profit after interest (8 – 9)

11

Add: Other non-operating income

(a)

4.42

6.78

10.00

120.10

205.90

329.55

4.55

9.40

30.45

–

9.80

4.55

9.40

20.65

Interest received

–

–

–

(b)

Dividend Received

–

–

–

(c)

Facility Fee

–

–

–

(d)

Miscellaneous –

–

–

Sub-total (income) (ii)

Deduct: Other non-operating expenses

(a)

Preliminary Expenses

(b)

Deferred Revenue Expenses

–

–

–

Sub-total (expenses)

–

–

–

(iii)

Net of other non-operating income/ expenses

–

–

–

12

Profit before tax/loss [10 + 11(iii)]

4.55

9.40

20.65

13

Provision for taxes

1.00

2.00

4.00

14

Net Profit/Loss (12 – 13)

3.55

7.40

16.65

15

Drawing

0.48

0.48

1.00

16

Retained Profit (14– 15)

3.07

6.92

15.65

17

Retained Profit/NET profit (% age)

86.48

93.51

93.99

!

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WORKING CAPITAL FINANCE

FORM III Analysis of Balance Sheet Audited Provisional Projected Latest

1st Year

2nd Year

Current Liabilities 1

Short-term borrowings from banks (incl. bills purchased, discounted and excess borrowings placed on repayment basis)

(i)

From applicant bank

–

–

70.00

Sub-total (A)

-

–

70.00

2

Short-term borrowings from others

-

–

-

3

Sundry creditors (Trade)

16.65

27.73

2.00

4

Advance payments from customer/deposits from dealers

5

Provision for Taxation

1.00

2.00

4.00

6

Dividend payable

–

–

-

7

Other statutory liabilities

–

–

-

8

Deposits/Instalments of term loans/DPGs/ Debentures, etc. (due within one year)

–

–

-

9

Other current liabilities and provisions (due within one year)

0.32

0.36

0.50

Sub total (B)

17.97

30.09

6.50

10

Total Current Liabilities (total of 1 to 9 excl. 1(iii))

17.97

30.09

76.50

11

Term Loans from Promoters (not maturing within one year)

–

–

-

12

Preference shares (redeemable after one year)

-

–

-

13

Term loans (excl. instalments payable within one year)

-

–

-

14

Deferred Payment Credits (excluding instalments due within one year)

-

–

-

15

Security Deposits (repayable after one year)

-

–

-

16

Other Term Liabilities

-

–

-

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WORKING CAPITAL FINANCE

-

–

-

17.97

30.09

76.50

-

18.07

24.99

Add: Additions

15.00

–

-

Add: Net Profit

3.55

7.40

16.65

18.55

25.47

41.64

0.48

0.48

1.00

17

Total Term Liabilities

18

Total Outside Liabilities (Item 10 plus item 17)

19

Capital

20 21 22 23

Less: Drawing

24

Net Worth

18.07

24.99

40.64

25

Total Liabilities

36.04

55.08

117.14

1.36

1.66

2.53

-

-

-

-

-

-

16.77

28.51

60.00

–

–

–

–

–

–

–

–

–

17.02

23.75

50.00

–

–

Current Assets 26

Cash and bank balances

27

Investments (other than long-term investments)

(i)

Government and other Trustee Securities

(ii) Fixed deposits with banks – margin money 28 (i)

Receivables other than deferred and exports (incl. bills purchased and discounted by banks)

(ii) Exports receivables (incl. bills purchased and discounted by bank 29

Instalments of deferred receivables (due within one year)

30

Inventory:

(i)

Raw materials

(a)

Imported

(b)

Indigenous

(ii) Stocks-in-process (iii) Finished goods (iv) Other consumable spares (a)

Imported

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WORKING CAPITAL FINANCE

(b)

Indigenous

31

Advances to suppliers of raw materials and stores/ spares

–

–

32

Advance payment of taxes

–

–

33

Other current assets

–

–

34

Total Current Assets

35.15

53.92

116.78

4.25

(Total of 26 to 33) 35

Gross Block (land and building machinery, work-in-progress)

1.69

2.42

1.16

36

Depreciation to date

0.80

1.26

0.80

37

Net Block (35 – 36)

0.89

1.16

0.36

Other Non-current Assets 38

Investments/book debts/advances/deposits which are non-current assets

(i) (a)

Investments in subsidiary companies

–

–

–

(b)

Others

–

–

–

(ii) Advances to suppliers of capital goods and contractors

–

–

–

(iii) Deferred receivables (maturity exceeding one year)

–

–

–

(iv) Others – CWIP

–

–

–

39

Non-consumables stores and spares

–

–

–

40

Other non-current assets incldg dues from directors

–

–

–

41

Total Other Non-current Assets

–

–

–

42

Intangible assets (patents, goodwill, preliminary expenses not provided for, etc.) (Doubtful debts)

–

–

–

43

Total Assets (34 + 37 + 41 + 42)

36.04

55.08

117.14

44

Tangible Net Worth (24 – 42)

18.07

24.99

40.64

45

Net Working Capital [(17 + 24) – (37 + 41 + 42)]

17.18

23.83

40.28

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WORKING CAPITAL FINANCE

46

Current Ratio

1.96

1.79

1.53

47

Total Outside Liabilities/Tangible Net Worth

0.99

1.20

1.88

48

Total Term Liabilities/Tangible Net Worth

–

–

–

17.18

23.83

40.28

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WORKING CAPITAL FINANCE

Predict Projects Pvt. Ltd.
 FORM IV
 Comparative Statement of Current Assets and Current Liabilities Audited

Provisional

Projected

Latest

1st Year

2nd Year

(A) Current Assets 1

Raw materials (incl. stores and other items used in the process of manufacturing): Indigenous

–

–

–

Days’ consumption

–

–

–

Indigenous

–

–

–

Days’ consumption

–

–

–

3

Stocks-in-process

–

–

–

4

Finished goods: Amount

17.02

23.75

50.00

Days’ cost of sales

46.81

42.11

52.78

Purchased and discounted

16.77

28.51

60.00

Days’ domestic sales

49.11

48.33

60.83

2

5

Other consumable spares, excluding those included in (1) above:

Receivable other than export and deferred receivables (incl. bills purchased and discounted by banks):

6

Export receivable (incl. bills purchased and discounted)

–

–

–

7

Advances to suppliers of materials and stores/spares, consumables

–

–

–

8

Other current assets including cash and bank balances and defer receivables due within one year (specify major items)

1.36

1.66

2.53

9

Total Current Assets

35.15

53.92

112.53

35.15

53.92

116.78

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WORKING CAPITAL FINANCE

(B) Current Liabilities (Other than bank borrowings for working capital) 10

Creditors for purchase of raw materials, stores and consumable spares: Amount

16.65

27.73

2.00

Days’ purchase

46.07

49.47

2.12

–

–

–

1.00

2.00

4.00

11

Advances from customers

12

Statutory liabilities

13

Other current liabilities – specify major items

(a)

Short-term Borrowings – others

–

–

–

(b)

Dividend payable

–

–

–

(c)

Instalments of TL, DPG and public deposits

–

–

–

(d)

Other current liabilities and provisions

0.32

0.36

0.50

14

Total Current Liabilities

17.97

30.09

6.50

!

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WORKING CAPITAL FINANCE

Predict Projects Pvt. Ltd.
 FORM V
 Working of Maximum Permissible Bank Finance Audited

Provisional

Projected

Latest

1st Year

2nd Year

First Method of Lending 1

Total current assets

35.15

53.92

116.78

2

Total current liabilities (other than Bank Borrowings)

17.97

30.09

6.50

3

Working capital gap

17.18

23.83

110.28

4

Min stipulated Net working capital (25% of Total Current Assets)

8.79

13.48

29.20

5

Actual/Projected net working capital

17.18

23.83

40.28

6

Item 3 minus Item 4

8.39

10.35

81.09

7

Item 3 minus Item 5

–

–

70.00

8

Maximum permissible bank finance (lower of 6 or 7)

9

Excess borrowings representing shortfall in NWC

!

70.00 –

–

–

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WORKING CAPITAL FINANCE

10.7 Summary •

Working Capital is the money which keeps the day-to-day business operations smooth. It refers to Current Assets and Current Liabilities.

•

Working capital financing is done by various modes such as trade credit, cash credit/ bank overdraft, working capital loan, purchase of bills/ discount of bills, bank guarantee, letter of credit, factoring, commercial paper, inter-corporate deposits etc.

•

Working capital management techniques such as intersection of carrying cost and shortage cost, working capital financing policy, cash budgeting, EOQ and JIT are applied to manage different components of working capital like cash, inventories, debtors, financing of working capital etc. These effective techniques mainly manage different components of current assets.

•

Analysis of working capital is carried out by various ratio analysis such as: i. Liquidity ii. Inventory turnover iii. Receivable turnover iv. Efficiency/profitability ratios v. Market value ratios.

•

Funds flow analysis shows the sources and uses of funds of a company.

Activities 1. Study the application form for Predict Projects Pvt Ltd. Now, apply this in your company or a project in which you have interest. Amounts, assumptions may vary. They should be reasonable and achievable. Take all this charts in MS Excel and prepare one for your company. 2. Find out the general cost of Working Capital charged by various nationalized banks and cooperative banks in India.

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10.8 Self Assessment Questions 1. What is Working Capital? What is its importance? 2. What are the different kinds of Working Capital which a finance manager may tap into? 3. Discuss the various Working Capital Management Techniques for finding Optimal Level of Working Capital. 4. Explain the various liquidity ratios of Working Capital. What is each one’s relevance? 5. Explain the various inventory turnover ratios. What is each one’s relevance? 6. Explain the various receivable turnover ratios. What is each one’s relevance? 7. Explain the various efficiency or profitability ratios. What is each one’s relevance? 8. Explain the various market value ratios. What is each one’s relevance?


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ Video Lecture - Part 1 Video Lecture - Part 2


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PRIVATE EQUITY

Chapter 11 PRIVATE EQUITY Objectives After studying this chapter, you should be able to: •

Get a brief overview on the Private Equity Market, its history, performance and trends.

•

Get a list of top 10 private equity companies in India.

•

Understanding Venture Capital.

•

Shed light on the stages of Venture Capital Financing.

•

Learn about Venture Capital Process.

•

Learn about steps in Venture Capital Process.

•

Refer some sample Term Sheets.

Structure: 11.1 Introduction 11.2 Private Equity Market 11.3 Venture Capital 11.4 Stages of Venture Capital Financing 11.5 Venture Capital Process 11.6 Summary 11.7 Self Assessment Questions

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PRIVATE EQUITY

11.1 Introduction Many young companies are unable to raise capital in public equity markets because they are not large enough to attract investor’s interests. A company having a very promising product or service but not sufficient track record. This also holds true for companies that are in financial distress. Such companies can get funding from Private Equity investments. Venture represents financial investment in a risky proposition made in the hope of earning a high rate of return.

11.2 Private Equity Market The Private Equity Market is dominated by private equity companies that represent large institutional investors. The private equity market is crucial for both start-up companies and established publicly traded companies. For example, a public company in financial difficulty will generally not be able to raise public equity or public debt. Private equity companies invest private money in businesses they consider attractive. Private equity companies are usually structured as partnerships, with general partners (GP) presiding over limited partners. The partners tend to be high net-worth individuals, public and private pension funds, endowments, foundations and sovereign wealth funds. According to PEI Media’s 2008 ranking of the top 50 private equity companies worldwide, the top four were United States-based. These were The Carlyle Group, Goldman Sachs Principal Investment Area, TPG Capital, and Kohlberg Kravis Roberts. 11.2.1 History From obscure beginnings as boutique investment houses, through the junk bond leveraged buyout debacle of the 1980s, to the thousands in existence today, private equity companies have become an important source of capital. According to the trade industry association, Private Equity Growth Capital Council (PEGCC), in 2009, private equity companies raised close to $250 billion and made more than 900 transactions with a total value over $76 billion. 11.2.2 Facts Private equity companies typically manage funds on behalf of their investors. They look for businesses with higher-than-average growth !

!279

PRIVATE EQUITY

potential over the long term. They often provide senior management direction to the companies in which they invest. This is especially true in cases of majority control, because bigger returns mean bigger carried interest payouts for the GPs. Carried interest is the portion of the funds that remains with the company after paying the limited partners and other investors their paid-in capital plus a minimum rate of return, known as the hurdle rate, and transaction expenses. 11.2.3 Strategies In 2009, private equity companies invested mainly in five sectors: business services, consumer products, healthcare, industrial products and services, and information technology. The most common types of investment structures are leveraged buyouts, or LBOs; venture capital; growth capital and turnaround capital. LBOs use both equity and borrowed capital to invest in companies, hence the term “leveraged”. Venture capital funds focus on new companies, mainly in the technology, biotechnology and green energy sectors. Growth capital invests in mature companies deemed to be undervalued. Turnaround capital, also known as distressed capital or vulture funds, looks for financially-troubled companies to buy inexpensively; potentially restructured, often through layoffs and asset sales; and then sold for a healthy profit. 11.2.4 Performance It is difficult, from the outside, to judge the performance of a private equity firm. Unlike public companies that trade on the stock exchanges, subject to regulatory disclosure requirements, private equity companies do not typically disclose their financial statements. Private equity companies that trade publicly, like Kohlberg Kravis Roberts, do provide information on realized and unrealized profits from their investments. The realized profits are significant. According to PEGCC, through 2009, private equity companies have returned close to $400 billion in cumulative net profits to their investors. 11.2.5 Trends With consolidation, private equity companies are getting bigger, investing larger amounts all over the world, and employing multiple investment strategies. After the financial crisis of 2008, the lavish payouts and secretive nature of these companies were under the media and regulatory

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spotlight. Disclosure requirements and other regulations are under consideration in the US and Europe, with some already in place. 11.2.6 Top 10 Private Equity Companies in India Private equity funds—investment funding made without stock being issued —have raised over $17 billion since the year 2000, according to the research agency Preqin. The private equity sector in India declined about 60% in 2009 due to recession in overseas markets, but as of 2010, the Indian markets have stabilized despite volatility and uncertainty in global finances. When determining the top 10 private equity companies in India, one measure of success is the amount of funds raised. 1. ICICI Venture ICICI Venture Fund management, headquartered in Mumbai, has raised funds to the tune of $3 billion over the last decade. As one of the largest funds, it is a subsidiary of ICICI bank, the largest private sector bank in India. 2. Chrys Capital This New Delhi-based fund, launched in 1999, has raised $1.9 billion in private equity funds. It has made more than 45 investments since its inception, according its website. 3. Sequoia Capital Sequoia Capital India, formerly known as WestBridge Capital Partners, mainly invests in consumer, energy and financial services in India. Headquartered in Bangalore, it focuses on investment in the seed, early and growth stages of industry. 4. India Value Fund India Value Fund, a Mumbai-based fund, was established in 1999 and boasts more than $1.4 billion distributed across four funds. It was formerly known as GW Capital. 5. Kotak Private Equity Group This company stands as one of the early investors in Indian private equity, launched in 1997. Kotak pumped $1.4 billion into the Indian market mainly in the infrastructure and health care sectors. 6. Baring Private Equity Partners

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Established in 1998, Gurgaon-based BPEP has over $3 billion invested mainly in the American, Latin and Indian markets. It generally invests in manufacturing, pharmaceutical and information technology. 7. Ascent Capital Ascent Capital, as one of India largest private equity funds, has invested $600 million across three funds, helping more than 40 entrepreneurs access its funds. 8. CX Partners CX Partners promoted by former Citigroup Venture Capital Investment made “a final close of its debut fund in excess of $500 million,” according to a July 7, 2010, report from Reuters. 9. Everstone Capital Everstone Capital, the equity subsidiary of Future Holdings, raised its first fund in 2006, for $425 million, and set its sights on a $550-million fund in 2010, reports AltAssets.com. Everstone invested in engineering companies, a renowned children clothing producer and other industries. 10.Blackstone Group Blackstone, a US-based firm, remains an emerging player, announcing plans to invest as much as $1.5 billion in Indian infrastructure. In April 2010, it invested $50 million in a regional Indian newspaper, “Jagran Prakashan.”

11.3 Venture Capital Venture Capital is part of the private equity market. In return for the venture capital, companies have to offer a share in their ownership. Venture capital investments can be in different stages of business. However, it is usually made in the early stages because those investments are more likely to yield high returns. To compensate for some likely venture failures, high returns on some of these investments are required for venture capitalists to be willing to take on the risks associated with these high growth businesses.


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11.4 Stages of Venture Capital Financing Venture capitalists invest in different stages of the company’s life cycle. The various stages are: 1. 2. 3. 4. 5. 6.

Seed-money stage Start-up First-round funding Second-round funding Third-round funding Fourth-round funding

Let us discuss each stage in detail: 1. Seed-money Stage Seed money is the initial equity capital needed to start a new business. The initial capital money is used to develop a product or prove a concept. It is usually a small amount of financing and does not include marketing. 2. Start-up Financing for companies that were started within the past year. The funds usually include marketing and product development expenditures. 3. First-round Funding After the company has spent the start-up funds, additional capital is provided to begin sales and manufacturing. 4. Second-round Funding Funds provided for the working capital needs of a company whose product is selling but still losing money. 5. Third-round Funding Financing for a company that is at least breaking even and is considering expansion. This is also known as mezzanine funding. 6. Fourth-round Funding Funds provided to companies that are likely to go public within half a year. This is also called bridge financing.

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An IPO is the next stage after venture capital financing. As mentioned before, venture capital funds are significant players in the IPOs. It is the norm that venture capitalists do not sell their shares when one of their portfolio companies goes through an IPO. Instead, they usually sell out in subsequent public offerings. The maximum number of companies need seed capital. Then as they progressively move up the pyramid, number of companies requiring funding reduces. And they move up the pyramid, the investment size increases. An informal survey shows that most of the companies die off in the seed financing stage itself. Current trends indicate that only 27% of companies that are seed funded actually raise the required angel round. 16% of the companies shut down at the Seed stage.

11.5 Venture Capital Process Venture Capitalists invest in private businesses to make profit. They attract most of their financial resources from sophisticated institutional investors. Venture capitalists try to create value by monitoring the companies and making sound business decisions about follow-on (staged) investments. Venture capital financing can be thought of as a joint product of both investment capital and consulting services. The venture capital process can be analyzed in following five steps. Steps in Venture Capital Process Step 1: Getting the attention of private equity investors Many young businesses are interested in raising capital from the limited supply of private equity investors. These investors are interested in specific types of businesses that include biotechnology, internet and technology. In order for any of the companies to be able to attract these investors, their management must have a vision for converting their private company into a public company in the future. Step 2: Performing the valuation and rate of return Once the private equity investors are interested in a particular company, they will attempt to estimate its value. In addition to the conventional valuation methods, venture capitalists use another method to value private

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companies. In this method, the future earnings of the company, i.e., when it is expected to go public, are forecasted. With the use of price-earnings multiples for similar public traded companies, the value of this particular company is assessed at the time of the contemplated IPO. This value is called the exit, or terminal value because the IPO is an exit strategy for venture capitalists. Step 3: Structuring the deal In structuring the deal, private equity investors and the owners of the company negotiate through the ownership proportion. Private equity investors need to determine what proportion of the company they want in return for their investment. On the other hand, the company needs to determine the ownership proportion that they are willing to give up in return for the capital. Step 4: Post-deal management After the investment, it is usual for the private equity investors to have an active role in the investment of the company. Sometimes, they also seek out new business opportunities and try to raise more capital for the company. Step 5: Exit Private equity investors and venture capitalists invest in private businesses because they are interested in high return on their investment. There are different ways of realizing targeted returns such as an IPO which can be an exit strategy for venture capitalists. However, as mentioned before, these companies usually do not sell their shares at the IPO, but after the securities have traded for some time. Alternatively, investors may exit by selling the business to another company. Quite often, private equity investors prefer to liquidate a company, if it is not generating sufficiently high returns.

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Preparing a Business Plan for Venture Capitalist If you are approaching a venture capitalist to finance your project, how should you prepare your business plan? Here are some guidelines: 1. Use simple and clear language. Avoid bombastic presentation and technical language 2. Focus on four basic elements, viz., people, product, market, and competition. 3. Give projections for about two to five years with emphasis on cash flows. 4. Identify risks and develop a strategy to cope with the same. 5. Convince them that the management team is talented, experienced, committed and determined. THE TIMES OF INDIA Reeba Zachariah and Boby Kurian, TNN | May 30, 2014, 07.03AM IST JustDial’s private equity backers set to sell $600 million shares MUMBAI: Three private equity backers of India’s first voice-based search company JustDial — Sequoia Capital, Tiger Global and SAIF Partners — will at least part sell their shares worth $600 million as the capital markets regulatormandated lock-in period gets over this week. Investment bankers have held talks with the PE funds for a block trade on bourses, which would see them making one of the heftiest returns in Indian start-up investing. The JustDial share price ended at Rs. 1,428 on Thursday, boosting the company’s market value to $1.7 billion, or Rs. 10,000 crore. Thursday’s stock price was more than double the listing price of Rs. 530 a year ago.

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2014: Private Equity Players Seal Over $11 Billion Deals NEW DELHI: Led by the booming e-commerce sector, private equity investments in India surged over 17% with deals worth $11.49 billion and the outlook for next year also remains positive, says a PwC report. According to the report by the consultancy firm, PE investments in India this year till December 22 stood at $11,492 million (excluding real estate deals) across 459 deals. In 2013, PE investments stood at $9,781 million by way of 469 deals. The higher level of PE investments was largely driven by increased interest in ecommerce, which has so far seen investments of over $2,474 million in 48 deals as against $553 million last year (in 36 deals). Inclusive of e-commerce, the information technology and IT-enabled Services (IT/ITeS) sector attracted $4,827 million in PE investments, more than double the value it had attracted in 2013. A sector-wise analysis shows that financial service was another sector which saw a spate of deals, attracting $1,775 million of PE investments. It was followed by energy (mostly renewables). Engineering and construction together witnessed $1531 million of PE investments. Manufacturing and healthcare put in disappointing performances and saw decline of 62% and 33% respectively at $459 million and $868 million respectively, the report said. Going forward, “the outlook for PE in 2015 is positive. In part, this could be attributed to the anticipated higher levels of growth owing to the economic reforms on the anvil, it is in part also attributed to the exit activity from the funds of 2006-08 vintage”, PwC said. Anticipated higher growth rates and a lower interest rate regime are likely to create investment opportunities in the consumer sector, it added. Healthcare and Life Sciences are expected to continue to receive significant PE attention. Financial Services is also expected to continue to see significant interest on both book-based and fee-based businesses. E-commerce is expected to continue to generate interest, as would the IT sector; high growth levels in large developed markets like the US will help this trend, it said. “Private equity investors are also going to be watching the impact of key reforms such as the introduction of the Goods and Services Tax regime that said, there are some concerns about the ability of the Government to speed up reforms, and this would be key to the activity levels in 2015,” the PwC report said.

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Example: Let us explore a scenario where you need to raise capital for your business. You run a biotechnology start-up Predict Projects Pvt. Ltd. You are looking for venture capital funding. Let us perform the steps in the venture capital process to raise capital for your business. At every step, you need to make critical decisions that will determine whether you move to the next step. The companies, individuals and events referred to herein are fictional. Any similarity to actual companies, individuals and events is purely coincidental. The first step is getting the attention of the private equity investors. Your management team has narrowed down private equity investors, Vertical Ventures to present your company’s strategy. Vertical Ventures is a top venture capitalist in the biotechnology space. What must your team focus on in the presentation? 1. Convey your vision of converting Predict Projects Pvt. Ltd. into a public limited company in 3 years. 2. Focus on Vertical Venture’s key interest area, which is biotechnology. 3. Emphasize Predict Projects Pvt. Ltd.’s improved performance since it was formed two years ago. 4. Explain in detail how Predict Projects Pvt. Ltd. plans to spend the expected venture capital. Predict Projects Pvt. Ltd. into a public company in 3 years? You are right. To attract investors, the management team must have a vision of converting their private company into a public company in the future. This focus will get Ventura interested in your company. The second step is performing the valuation and rate of return. Vertical Ventures is convinced about Predict Projects Pvt. Ltd.’s plans to go public in 3 years. Now, Vertical venture needs to estimate the value of the

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company. Predict Projects Pvt. Ltd.’s net income in three years is expected to be US$ 6 million. The price to earnings ratio of similarly publicly traded companies is 20. The exit value is equal to price to earnings ratio multiplied by Net Income. This is equal to 120 and is calculated as 20 multiplied by 6. The exit value is estimated as US$ 120 million three years from now. This value is discounted back to the present at a rate called target rate of return. Given the risk that the venture capitalists are exposed to and assuming a return of 25%, what is the discounted exit value estimated by Vertical Ventures? Hint: The discounted exit value is computed as the estimated exit value divided by the summation of 1 and the target rate of return to the power of number of periods. 1. US$ 80000 2. US$ 32 million 3. US$ 6.144 million 4. US$ 120 million Having reviewed the options, did you think the correct answer is option 3, US$ 61.44 million. That is correct. Vertical Ventures needs to calculate the target rate of return, which is set at a much higher level than the cost of equity for the company. Assuming a 25% return, the discounted exit value is US$ 61.44 million. The third step is structuring the deal. Vertical Ventures has agreed to invest US$ 15 million. The ownership proportion of Vertical Ventures is estimated as 24.4% of the firm. Which one component needs to be considered while determining the ownership proportion? 1. The ownership proportion depends on the capital invested and the estimated value of the company. 2. To determine ownership proportion, estimate the company’s net income expected in three years. 3. Ownership proportion depends only upon the capital invested by the company.

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4. Ownership proportion depends upon the discretion of the company looking for funds. Did you identify the correct answer as option 1. The ownership proportion depends on the capital invested and the estimated value of the company? You are right again. Ownership proportion depends on the capital invested and the estimated value of the company. The ownership proportion is equal to capital invested by estimated value. The ownership proportion is equal to capital invested by estimate value. The ownership proportion of Vertical Ventures is equal to 15 divided by 61.44, which is equal to 24.4% of Predict Projects Pvt. Ltd. The fourth step is the post-deal management. Vertical Ventures places two people on the board to monitor the operations of Predict Projects Pvt. Ltd.

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Sample Term Sheets are enclosed herewith for your reference. Kindly study them. Find out the terms which are good and flexible and ones that can create difficulties in future.

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SAMPLE TERM SHEET 1 Date: THE TERMS SET FORTH BELOW ARE SOLELY FOR THE PURPOSE OF OUTLINING THOSE TERMS PURSUANT TO WHICH A DEFINITIVE AGREEMENT MAY BE ENTERED INTO AND DO NOT AT THIS TIME CONSTITUTE A BINDING CONTRACT, EXCEPT THAT BY ACCEPTING THESE TERMS THE COMPANY AGREES THAT FOR A PERIOD OF 30 DAYS FOLLOWING THE DATE OF SIGNATURE, PROVIDED THAT THE PARTIES CONTINUE TO NEGOTIATE TO CONCLUDE AN INVESTMENT, THEY WILL NOT NEGOTIATE OR ENTER INTO DISCUSSION WITH ANY OTHER INVESTORS OR GROUP OF INVESTORS REGARDING THIS “SERIES X” ROUND OF INVESTMENT. AN INVESTMENT IN THE COMPANY IS CONTINGENT UPON, AMONG OTHER THINGS, COMPLETION OF DUE DILIGENCE AND THE NEGOTIATION AND EXECUTION OF A SATISFACTORY STOCK PURCHASE AGREEMENT. Summary of Terms for Proposed Private Placement of Series X Preferred Stock I. Issuer: Predict Projects Pvt. Ltd. (Hereinafter referred to as the “Company”). II. Investor: Venture Capital Partners, LLC or its affiliates (“VC”) and other investors acceptable to the Company and VC (collectively the “Investors”) III. Security: Series X Preferred Stock (“Preferred”) IV. Amount of Investment: $[ ] V. Valuation: Pre-money valuation is $[ ] VI. Post Investment Ownership: The company would be capitalized such that post investment ownership at closing would be as follows: VC Founders, Management and Other Option Pool

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VII. Closing Date: Closing for the investment would be on or before __________, provided that all requirements for the closing have been met or expressly waived in writing by the investors. VIII. Board Representation: The Board of Directors will include a total of five (5) people. Holders of Series X Convertible Preferred Stock are entitled to two (2) representatives on the Company’s Board of Directors. Common Shareholders will have three (3) designees to the board, one of which must be the CEO of the Company. Board of Directors meetings would be scheduled on a monthly basis until such time as the Board of Directors votes to schedule them less frequently. VC’s representative would be appointed to all Board Committees (including the compensation committee), each of which would consist of three (3) members. The Company would reimburse each Director’s reasonable expenses incurred in attending the board meetings or any other activities (e.g., meetings, trade shows) which are required and/or requested and that involve expenses. IX. Proprietary Information and Inventions Agreement: Each officer, director, and employee of the Company shall have entered into a proprietary information and inventions agreement in a form reasonably acceptable to the Company and the Investors. Each Founder and other key technical employee shall have executed an assignment of inventions acceptable to the Company and Investors. Description of Series B Preferred X. Dividends: An [ ]% annual dividend would accrue as of the closing date to holders of the Series X Convertible Preferred. Accrued dividends would be payable: a. if, as and when determined by the Company’s Board of Directors, b. upon the liquidation or winding up of the company, or c. upon redemption of the Series X Preferred. Upon an automatic conversion, accrued but unpaid dividends would be forfeited. No dividends may be declared and/or paid on the Common Stock until all dividends have been paid in full on the Convertible Preferred Stock. The Convertible Preferred Stock would also participate pari passu in any

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dividends declared on Common Stock. Dividends will cease to accrue in the event that the investor converts its holdings to Common Stock. XI. Liquidation Preference: In the event of any liquidation or winding up of the Company, the Series X Preferred will be entitled to receive in preference to the holders of Common Stock an amount per share equal to their Original Purchase Price plus all accrued but unpaid dividends (if any). The Series X Preferred will be participating so that after payments of the Original Purchase Price and all accrued dividends to the Preferred, the remaining assets shall be distributed pro-rata to all shareholders on a common equivalent basis. A merger, acquisition or sale of substantially all of the assets of the Company in which the shareholders of the Company do not own a majority of the outstanding shares of the surviving corporation shall be deemed a liquidation of the Company. XII. Conversion: The Preferred will have the right to convert Preferred shares at the option of the holder, at any time, into shares of Common Stock at an initial conversion rate of 1-to-1. The conversion rate shall be subject from time to time to anti-dilution adjustments as described below. XIII. Automatic Conversion: The Series X Preferred would be automatically converted into Common Stock, at the then applicable conversion price, upon the sale of the Company’s Common Stock in an initial public offering (“Public Offering”) at a price equal to or exceeding [ ] times the Series X Preferred original purchase price in an offering which, after deduction for underwriter commissions and expenses related to the gross proceeds, is not less than [ ]. XIV. Antidilution Provisions: Proportional anti-dilution protection for stock splits, stock dividends, combinations, recapitalization, etc. The conversion price of the Preferred shall be subject to adjustment to prevent dilution, on a “weighted average” basis, in the event that the Company issues additional shares of Common or Common equivalents (other than reserved employee shares) at a purchase price less than the applicable conversion price.

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XV. Voting Rights: The Preferred will have a right to that number of votes equal to the number of shares of Common Stock issuable upon conversion of the Preferred. XVI. Restrictions and Limitations: Consent of the Series X Preferred, voting as a separate class would be required for any actions which: i) alter or change the rights, preferences or privileges of the Series X Preferred; ii) increase the authorized number of shares of Series X Preferred; iii) increase the authorized number of shares of any other class of Preferred Stock; iv) create any new class or series of stock, which has preference over or is on parity with the Series X Preferred; v) involve a merger, consolidation, reorganization, encumbrance, or sale of all or substantially all of the assets or sale or of more than 50% of the Company’s stock; vi) involve a repurchase or other acquisition of shares of the Company’s stock other than pursuant to redemption provisions described below under “Redemption”; or vii)amend the Company’s charter or bye-laws. XVII. Redemption: After five (5) years and at the request of the holders of the Series X Preferred, all or part of the Series X Preferred shares may be redeemed at 110% of the Series X purchase price plus all accrued but unpaid dividends. XVIII. Conditions precedent to Investor’s obligation to invest: i. Legal documentation satisfactory to the Investor and Investor’s counsel. ii. Satisfactory completion of due diligence. iii. If not already in place, the Company would obtain employment agreements with key employees, which would include satisfactory (to Investor) non-compete and non-disclosure language.

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XIX. Registration Rights: 1. If, at any time after the Issuer’s initial public offering (but not within 6 months of the effective date of a registration), Investors holding at least 51% of the Common issued or issuable upon conversion of the Preferred request that the Issuer file a Registration Statement covering at least 20% of the Common issued or issuable upon conversion of the Preferred (or any lesser percentage if the anticipated aggregate offering price would exceed $[ ]), the Issuer will be obligated to cause such share to be registered. The Issuer will not be obligated to effect more than two registrations (other than on Form S-3 under these demand right provisions. 2. Company Registration: The Preferred shall be entitled to “piggy-back” registration rights on registrations of the Company or on demand registrations of any later round investor subject to the right, however, of the Company and its underwriters to reduce the number of shares proposed to be registered pro rata in view of market conditions. No shareholder of the Company shall be granted piggyback registration rights superior to those of the Series X Preferred without the consent of the holders of at least 50% of the Series X (or Common Stock issued upon conversion of the Series X Preferred or a combination of such Common Stock and Preferred). 3. S-3 Rights: Preferred shall be entitled to an unlimited number of demand registrations on Form S-3 (if available to the Company) so long as such registration offerings are in excess of $500,000, provided, however, that the Company shall only be required to file two Form S-3 Registration Statements on demand of the Preferred every 12 months. 4. Expenses: The Company shall bear registration expenses (exclusive of underwriting discounts and commissions and special counsel of the selling shareholders) of all demands, piggybacks, and S-3 registrations. The expenses in excess of $15,000 of any special audit required in connection with a demand registration shall be borne pro rata by the selling shareholders. 5. Transfer of Rights: The registration rights may be transferred provided that the Company is given written notice thereof and provided that the transfer (a) is in connection with a transfer of at least 20% of

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the securities of the transferor, (b) involves a transfer of at least 100,000 shares, or (c) is to constituent partners of shareholders who agree to act through a single representative. 6. Other Provisions: Other provisions shall be contained in the Investor Rights Agreement with respect to registration rights as are reasonable, including cross-indemnification, the period of time in which the Registration Statement shall be kept effective, standard standoff provisions, underwriting arrangements and the ability of the Company to delay demand registrations for up to 90 days (S-3 Registrations for up to 60 days). XX. Right of First Offer: The Preferred shall have the right in the event the Company proposes an equity offering of any amount to any person or entity (other than for a strategic corporate partner, employee stock grant, equipment financing, acquisition of another company, shares offered to the public pursuant to an underwritten public offering, or other conventional exclusion) to purchase up to [ ]% of such shares. The Company has an obligation to notify the Preferred of any proposed equity offering of any amount. If the Preferred does not respond within 15 days of being notified of such an offering, or decline to purchase all of such securities, then that portion which is not purchased may be offered to other parties on terms no less favourable to the Company for a period of 120 days. Such right of first offer will terminate upon an underwritten public offering of shares of the Company. In addition, the Company will grant the Preferred any rights of first refusal or registration rights granted to subsequent purchasers of the Company’s equity securities to the extent that such subsequent rights are superior, in good faith judgment of the Board, to those granted in connection with this transaction. XXI. Right of Co-Sale: The Company, the Preferred and the Founders will enter into a co-sale agreement pursuant to which any Founder who proposes to sell all or a portion of his shares to a third party, will offer the Preferred the right to participate in such sale on a pro rata basis or to exercise a right of first refusal on the same basis (subject to customary

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exclusions for up to 15% of the stock, gifts, pledges, etc.). The agreement will terminate on the earlier of an IPO or fifteen (15) years from the close of this financing. XXII. Use of Proceeds: The proceeds from the sale of the Preferred will be used solely for general corporate purposes. XXIII. Reporting Covenants: The Company would furnish to the Investor the following: i. Monthly Reports: Within 20 days following the end of each month, an income statement, cash flow and balance sheet for the prior monthly period. Statements would include year-to-date figures compared to budgets, with variances delineated. ii. Annual Financial Statements: Within 90 days following the end of the fiscal year, an unqualified audit, together with a copy of the auditor’s letter to management, from a Big Five accounting company or equivalent, which company would be approved by the Investor. iii. Audit: In the event, the Company fails to provide monthly reports and/ or financial statements in accordance with the foregoing, Investor would have the authority, at the Company’s expense, to request an audit by an accounting company of its choice, such that statements are produced to the satisfaction of the Investor. iv. Annual Budget: At least 30 days before the end of each fiscal year, a budget, including projected income statement, cash flow and balance sheet, on a monthly basis for the ensuing fiscal year, together with underlying assumptions and a brief qualitative description of the company’s plan by the Chief Executive Officer in support of that budget. v. Non-compliance: Within 10 days after the discovery of any default in the terms of the stock purchase agreement, or of any other material adverse event, a statement outlining such default or event, and management’s proposed response. XXIV. Purchase Agreement: The purchase of the Company’s Series X Preferred Stock would be made pursuant to a Series X Convertible Preferred Stock Purchase Agreement drafted by counsel to the Investor,

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which would be mutually agreeable to the Company, and the Investor. This agreement would contain, among other things, appropriate representations and warranties of the Company, covenants of the Company reflecting the provisions set forth herein and other typical covenants, and appropriate conditions of closing, including among other things, qualification of the shares under applicable Blue Sky laws, the filing of a certificate of amendment to the Company’s charter to authorize the Series X Preferred, and an opinion of counsel. Until the Purchase Agreement is signed, there would not exist any binding obligation on the part of either party to consummate the transaction. This Summary of Terms does not constitute a contractual commitment of the Company or the Investor or an obligation of either party to negotiate with the other. XXV. Other: The Company would pay legal expenses incurred by the Investor at closing from the proceeds of the investment. The investor would make all reasonable efforts to see that this expense does not exceed $30,000. Once this term sheet is signed, the Company would accept responsibility for legal fees incurred by the Investor if the transaction does not close up to the amount set forth above. XXVI. Exclusivity: (i) Upon the acceptance hereof, the Company, its officers and shareholders agree not to discuss the sale of assets or any equity or equity type securities, provide any information to or close any such transaction with any other investor or prospective investor, except to named entities mutually acceptable to Management and Investor. (ii)The undersigned agree to proceed in good faith to execute and deliver definitive agreements incorporating the terms outlined above and such additional terms as are customary for transactions of the type described herein. This letter expresses the intent of the parties and is not legally binding on any of them unless and until such mutually satisfactory definitive agreements are executed and delivered by the undersigned. This letter of intent may be signed by the parties in counterparts. If this Summary of Terms is not signed and returned to VC by midnight (EST) [ ], it shall expire without any further action on the part of VC and shall be of no further force or effect.

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VENTURE CAPITAL PARTNERS, LLC Date ___________ By: _______________________ Terms agreed to and accepted by: PREDICT PROJECTS PVT. LTD. Date _______________ By:_________________________

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SAMPLE TERM SHEET 2 XYZ Company 
 SERIES A OPTIONALLY CONVERTIBLE FINANCING 
 TERM SHEET The intent of this document is to describe, for negotiation purposes only, some key terms of the proposed agreement between Venture Fund Investment Advisors Limited or one of its affiliates (“Venture Fund”) (referred as “Series A Preferred Investors” or “Investors”) and XYZ Company, (the “Company”). By signing this agreement, the Company agrees, undertakes and shall procure that henceforth (a) no directors, officers, employees, agents and representatives of it or of any of its direct or indirect subsidiaries or affiliates will initiate or participate in any discussion or negotiations with any person other than investors mutually agreed upon relating to the sale, issuance or grant of any equity interests in the Company (including any form of options, derivatives or arrangement relating thereto) (“Company Equity Interests”) and (b) no issuance, sale, or offer to sell will be made to any person other than investors mutually agreed upon in respect of any Company Equity. Notwithstanding anything to the contrary, any obligations of Venture Fund to complete or provide funding for any transaction, whether contemplated herein or otherwise, are subject to Venture Fund’s internal approvals, completion of due diligence to the satisfaction of Venture Fund in their sole and absolute discretion, all necessary corporate approvals having been obtained, and the parties having negotiated, approved, executed and delivered the appropriate definitive agreements. Notwithstanding anything to the contrary, any obligations of the Company to complete any transaction, whether contemplated herein or otherwise, are subject to the parties having negotiated, approved, executed and delivered the appropriate definitive agreements and such definitive agreements remaining in full force and effect. Until execution and delivery of such definitive agreements, Venture Fund and the Company shall have the absolute right to terminate all negotiations for any reason without liability therefore, but without prejudice to Clauses (a) and (b) in the foregoing paragraph. This term sheet shall remain valid until __________. If this term sheet remains unsigned after that time, Venture Fund at its option may immediately terminate discussions with the Company or change any or all pricing, terms and conditions contained herein.

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Confidentiality The terms and conditions described in this Term Sheet including its existence shall be confidential information and shall not be disclosed to any third party. If either party determines that it is required by law to disclose information regarding this Term Sheet or to file this Term Sheet with the Securities and Exchange Board of India (SEBI) or any equivalent regulatory body, it shall, a reasonable time before making any such disclosure or filing, consult with the other party regarding such disclosure or filing and seek confidential treatment for such portions of the disclosure or filing as may be requested by the other party. Legal Structure

Venture Fund will in XYZ Company

Amount of Financing (Investment Amount)

Up to Rs. Fifteen Crores

Type of Security

Series A Optionally Convertible Preferred Stock (“Series A Preferred”), convertible into (“Common Shares”), in part or full, at any time, at the option of Venture Fund, at the premoney valuation of the Company as described below.

Valuation

8 times Profit after tax or One time revenue (Inter-company revenue, revenue attributable to minority interests, and other income excluded) which ever is lower for the FY _____ of the consolidated holding company. The pre-money valuation is subject to a floor of _____ and cap of _____.

Definitions

“Qualified IPO” means closing of an underwritten public offering of shares of Common Stock of the Company with gross proceeds to the Company in excess of Rs. Fifty Crores Mn, at a minimum pre-IPO market capitalization of Rs. Two Hundred Crores. “Strategic sale” means sale of majority shareholding (>50%) of the Company for cash or listed securities as approved by Series A.

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Purchase Price

An amount per share (the “Purchase Price”) such that the Purchase Price multiplied by the number of shares outstanding on a fully diluted basis (taking into account, without limitations, all options, warrants, stock option plans or any other arrangements relating to the Company’s equity) prior to this Series A Preferred financing is equal to the premoney valuation as explained above. Fully diluted means the total of all classes and series of shares outstanding combined with all options (including both issued and unissued), warrants (including both issued and unissued) and convertible securities of all kinds and the effect of any anti-dilution protection regarding previous financings, all on an “as if converted” basis and in addition, taking into account a ___ per cent (___%) pool for issuance of employee options/equity.

Closing

Approximately __________

Conditions Precedent to Closing

Reasonable Closing conditions include: 1. Completion of Accounting, Business, Technical and Legal due diligence of the Company and all of its subsidiaries, to the satisfaction of Series A Preferred Investors. 2. Obtaining all regulatory permissions, approvals and consents required. 3. Creating an Employee Stock Option Pool of ___% shares to be granted over the next 4 years. 4. Execution of Definitive agreements. 5. Passing requisite resolutions by shareholders of Company for the issue of shares to Series A Preferred Investors. 6. Opinion from Company’s attorneys, in standard form, of Company’s good standing and that the issue of shares to Series A Preferred Investors has been duly authorized and does not conflict with contractual commitments of the company.

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7. Preparation of a pre-closing financial statements in accordance with Indian GAAP and evidence acceptable to investors that the Company is not subject to any present or potential liabilities, defaults, claims or proceedings which, if adversely decided or concluded, would materially affect the Company or its properties or assets or impair its ability to comply with its obligations under the Definitive Agreements. 8. Take all actions required under law to amend the Articles of Association of the Company, to reflect the terms and conditions of the Definitive Agreements. 9. Appointment of a reputable Accounting and a reputable Legal company to the satisfaction of the Series A Preferred Investors. 10.Incorporation of a legal corporate structure which is acceptable to Venture Fund. Rights and Preferences of Series Preferred Dividend Rights No dividend, whether in cash, in property or in shares of the Company or any of its subsidiaries, would be allowed to be paid on any other class or series of shares of the Company without a specific written approval of Series A Preferred Investors. On approval as mentioned above, the dividend will be paid only after dividend in like amount and other contractual payments were first paid in full on Series A Preferred.

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Liquidation Preference

In the event of any liquidation, dissolution or winding up of the Company, the holders of the Series A Preferred would be entitled to receive, prior to any distribution to the holders of the Common Stock, an amount so as to return the Investment Amount and give them a 2 times return on the Investment Amount (plus all declared but unpaid dividends) from the date of investment thereon (the “Preference Amount”). A merger or consolidation of the Company in which its shareholders did not retain a majority of the voting power in the surviving corporation, or a sale of all or substantially all the Company’s assets, would each be deemed to be a liquidation, dissolution or winding up of the Company.

Conversion Rights

The holders of the Series A Preferred would have the right to convert the Series A Preferred into shares of Common Stock, in part or full, at any time. The Conversion rate for the Series A Preferred would be based on the valuation described above.

Drag Along Rights:

The company will provide an exit through a Qualified IPO/ Strategic sale before _____. In the event of the company not providing an exit route, Series A Preferred investors have the right to sell, merge or liquidate the Company at its own option and the founders shall be obliged to offer their shares in part or in full to facilitate an exit for Series A Preferred.

Automatic Conversion

The Series A Preferred would automatically be converted into Common Stock, at the then applicable conversion rate, upon a Qualified IPO/Strategic Sale.

Antidilution Provisions

The conversion price of the Series A Preferred would be subject to adjustment on a full ratchet basis, for issuances at a purchase price less than the then-effective conversion price with a carve-out for: (i) issuances of up to ___% option pool and any other equity issued to employees, officers or directors of the Company pursuant to stock purchase or stock option plans or agreements or other incentive stock arrangements approved by the Board. (ii) Issuances up to ___% of the company to strategic vendors and other strategic investors approved by the board and proportional anti-dilution protection for rights issue, stock splits, stock dividends, etc. This would be applicable till the execution of a Qualified IPO/Strategic sale.

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Approval of Business Plan

Detailed business plan shall be presented to the board of directors 30 days prior to the commencement of the new financial year. The business plan including financial statements will be made out on a monthly basis for the remainder of the first fiscal year following investment and on a quarterly basis thereafter. Such plan to be approved by the board of directors. Any business plan that has less than 10% growth on any of the “Key financial parameters” has to be specifically approved by the Series A Preferred. Key financial parameters are defined as: (a) Consolidated revenue from operations, (b) Consolidated net income from operations and (c) Net cash flow from operations.

Appointment of The senior management of the company will include (a) CEO, Senior (b) CTO, (c) Head of India operations, (d) Head of SBU, and Management (e) Head of sales and marketing. Any recruitment or change to the senior management will be done in consultation with the Series A Preferred. The investor has the option to change any individual in the senior management if there is significant non-performance by the team. Significant non-performance is defined as follows: Under achievement of key financial parameter on any financial year by more than 30% compared to the business plan as approved by the board of directors. Founders Earn Back

Founders have the option to earn back up to 15% of the company based on achievement of the following for CY Dec __: 1. Consolidated net income of _____ and above and operating cash flow of _____ and above for CY Dec ____,

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Protective Provisions

Consent of the holders of Series A Preferred would be required for (with regard to items (v) through (xvi) below, the term “Company” is expanded to include the Company and all of its subsidiaries): (i) Any amendment or change of the rights, preferences, privileges or powers of, or the restrictions provided for the benefit of, the Series A Preferred; (ii)Any action that authorized, created or issued shares including rights issue of any class or series of stock having preferences superior to or on a parity with the Series A Preferred; (iii)Any action that reclassified any outstanding shares into shares having preferences or priority as to dividends or assets senior to or on a parity with the preference of the Series A Preferred; (iv)Any transactions with related parties or companies; (v)Any amendment of the Company’s Memorandum and Articles of Association (the “M/A”); (vi)Any merger or consolidation of the Company; (vii) The sale of all or substantially all the Company’s assets; (viii) The liquidation or dissolution of the Company; (ix) Any dividend payout; (x)Incurrence of indebtedness either through loan or guaranteed future lease payment or capital commitment in excess of _____; (xi)An increase of more than 15% in the total compensation of any of the five (5) most highly compensated employees of the Company in a twelve (12) month period; (xii)The purchase or lease of any automobile with a purchase value greater than _____ and an aggregate value of _____. in a twelve (12) month period;

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(xiii)The purchase or lease of any real estate used in the ordinary course of business in excess of ______ per year (purchase or lease of any real estate to includes only office and R&D space); (xiv)The strategic purchase of equity securities with a purchase value greater than ______ (no purchase of securities, either private or publicly traded, for speculative or non-strategic investment purposes to be allowed, other than high grade money market securities. No purchases of the Company’s own securities from any party allowed); (xv)The extension of any loan to any party except loans to full time employees, up to _____ per employee, under the normal course of business (Advances to employees towards Lease deposits excluded and will be decided by the Compensation Committee); (and) (xvi)Any material changes in the Company’s business plan Terms of the Stock Purchase Agreement and Rights Agreement

The purchase of shares of Series A Preferred would be made pursuant to a Stock Purchase Agreement and a Rights Agreement reasonably acceptable to the Company and Series A Preferred Investors, which agreement would contain, among other things, customary representations and warranties of the Company, covenants of the Company reflecting the provisions set forth herein, and appropriate conditions of closing, including an opinion of counsel for the Company.

Board of Directors

The Company’s Memorandum and Articles of Association would provide for a Board of five (5) Directors. The number of directors could not be changed except by amendment. With respect to the election of the Board, so long as Venture Fund continues to hold at least 30% of its original investment, Venture Fund would be entitled to elect one (1) member of the Board of the Company and one (1) member of the Board of each of its subsidiaries.

Committees

The Company would constitute Audit and Compensation Committees and Venture Fund would be entitled to appoint a member to each of these committees.

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Use of Proceeds The Company would use the proceeds from the Series A Preferred Financing for acquisitions, capital expenditure and general working capital in its business. Right of First Offer

Each holder of Series A Preferred would have a right of first offer to purchase up to its pro rata share (based on its percentage of the Company’s outstanding common shares, calculated on a fully diluted as-converted basis at the Purchase price) of any equity securities offered by the Company on the same price and terms and conditions as the Company offers such securities to other potential investors (with a right of oversubscription if any holder of Series A Preferred elected not to purchase its pro rata share). This right would not apply to: (i) the issuance to employees and officers of the Company, pursuant to stock purchase or stock option plans approved by the Board, (ii) issuances up to ___% of the equity to strategic vendors and other strategic investors approved by the board and (iii) issuances in consideration for the acquisition of other businesses.

Right of First Refusal and Cosale and Restriction for Founders

The Company, each holder of Series A Preferred and the Founders would enter into a Co-sale Agreement which would give the holders of the Series A Preferred first refusal rights and co-sale rights providing that any Founder or major shareholder who proposed to sell all or a portion of his shares to a third party must permit the holders of the Series A Preferred hereunder at their option: (i) to purchase such stock on the same terms as the proposed transferee, or (ii) sell a proportionate part of their shares on the same terms offered by the proposed transferee. This right would terminate upon the closing of a Qualified IPO.

Founders Lockup Period and Employee Vesting

The Promoters agree that they will not pledge, hypothecate, sell, transfer, or otherwise dispose their shareholding following the closing of this financing, without the written consent of Series A Preferred holders. Stock issued to employees, directors and consultants under bona fide incentive stock option plans would be subject to vesting over four (4) years.

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Information Rights

So long as shares of Series A Preferred were outstanding, the Company would deliver to each holder of Series A Preferred: (i) audited consolidated annual financial statements within 90 days after the end of each fiscal year; (ii) unaudited consolidated monthly financial statements within 15 days of the end of each month; and (iii) an annual budget within 30 days prior to the end of each fiscal year. All financial statements to include a balance sheet, income statement and statement of cash flows prepared in accordance with Indian GAAP. All annual audited financial statements to be prepared by an international accounting company or an associate of an international accounting company of the Company’s choosing. For so long as shares of Series A Preferred were outstanding, such holders would have standard inspection rights. These information and inspection rights would terminate upon the Company’s initial public offering.

Confidentiality

The terms and conditions of the equity financing, including (prior to closing) its existence, would-be confidential information and would not be disclosed to any third party by the Company except as provided below. Both Venture Fund and the Company would be able to disclose the existence of the equity financing, but not its pricing or other terms and conditions. The pricing or other terms and conditions of Venture Fund’s investment in the Company could be disclosed solely to the Company’s lenders, investors, partners and advisors and to bona fide prospective lenders, investors, partners and advisors, in each case only where such persons or entities are under appropriate nondisclosure obligations. In the event of a disclosure required by law, and other regulatory bodies, the disclosing party would use all reasonable efforts (and cooperate with the other party’s efforts) to obtain confidential treatment of materials so disclosed.

Confidential Information and Invention Assignment Agreement

Each key officer and employee of the Company would have entered into an acceptable confidential information and invention assignment agreement. The Company would use its best efforts to have the remainder of the employees and officers sign such an agreement.

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Capitalization

The capitalization of the Company on a fully diluted as if converted basis will be listed out in the definitive Agreements.

Other Major Covenants Exclusivity

The Company will work exclusively with Venture Fund for 60 to 75 days from the date of signing of this term sheet. The Company shall not solicit, have discussions or provide any information to any other investors, without written approval from Venture Fund during this period.

Due Diligence Expenses

Venture Fund will perform detailed due diligence (DD) on the Company and all of its subsidiaries. Conditional upon closing, the cost of financial and legal due diligence including travel and stay for the team, and the other legal expenses of Venture Fund in connection with the financing will be borne entirely and directly by the Company up to a maximum of _____. The payment will be made directly by the company to the financial and legal firm. Any additional expenditure will be borne by the Series A Preferred Investors. The appointment, scope of the audit for financial and legal companies will be done by the Series A Preferred and the companies will be of international repute.

Other Expenses The Company shall bear all reasonable expenses incurred towards providing an exit through IPO/listing to Series A Preferred Investors. Investors will bear their own exit-related expenses for sale to private Investors. IN WITNESS whereof the parties hereto executed this Term Sheet the day and year first above written. Venture Fund -----------------------------------------------------------------------------------------XYZ Company

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! Real estate developers use Private Equity for selected projects where the area above a certain threshold as per Indian Government Norms.

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11.6 SUMMARY •

Private equity investments are not traded on exchanges and are generally available to companies that do not have access to public funding.

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Venture capital is part of the Private Equity market and can be defined as the capital provided to young and relatively risky businesses seeking rapid growth, in return for a share in the company’s ownership.

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Venture Capitalists invest in the different stages of the life cycle of private companies; the seed money stage, the start-up stage and additional rounds of funding until the IPO.

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The venture capital process starts when a private company approaches a venture capitalist who will estimate the value of the company. The owners of the company and the venture capitalists state their interests and negotiate the terms of the deal. After the deal is structured, the venture capitalists continue to support the company, often becoming actively involved in the management and business development of the company. The final step in a venture capital process is to implement the exit strategy. It can be an IPO, the selling off of the business or the liquidation of the company.

•

Activities 1. Use internet resources to find out how the e-retail web portals such as Snapdeal, Flipkart, various others are funded through Private Equity/ Venture Capital. 2. Use internet resources to find out how Facebook, Pinterest are funded. 3. Suppose you had a great idea or invention. But you did not have a strong balance sheet or past performance to tap the bank debt. Prepare a business plan to access venture capital for your great idea.

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11.7 Self Assessment Questions 1. What is Private Equity? Discuss its history and performance in past two decades. 2. Name the top 10 Private Equity companies in India. 3. What are the various stages of Venture Capital Financing? Describe each in brief. 4. What are the steps in venture Capital Process?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Chapter 12 PUBLIC LISTING OF SECURITIES Objectives After studying this chapter, you should be able to: •

Get a brief overview about listing a company.

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Provide conceptual understanding on various types of equity offerings.

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Explain listing a company, its pros and cons.

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Explain the methods of offerings.

Structure: 12.1 Introduction 12.2 Various Types of Equity 12.3 Listing a Company 12.4 Stock Exchanges 12.5 Methods of Offering 12.6 Summary 12.7 Self Assessment Questions

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12.1 Introduction At some point, a successful company may expand to that point that it is no longer feasible for a single investor or even a small group of investors, to provide all the capital that the company needs to keep growing. When that occurs, the company may choose to convert from private to public ownership. When a company makes the transition from private to public ownership, it may decide to list its stock on a recognized stock exchange. Popular Stock Exchanges in India are NSE and BSE. To list on an exchange, a company must comply with all listing requirements established by the exchange and a host of laws and regulations enforced by SEBI and ROC. An international company can list itself on following exchanges: US

New York Stock Exchange (NYSE) or NASDAQ

UK

London Stock Exchange

Japan

TSE or Tokyo Stock Exchange

Australia

ASX or Australian Stock Exchange

Malaysia

Bourse or ‘Bursa Malaysia’

Singapore

SGX or Singapore Stock Exchange

To list its stock on an international exchange, a company must comply with any listing requirements established by the exchange (such as minimum profit requirements) and a host of laws and regulations enforced by the government body that administers the company law and regulates equity markets. For example, in the US, this body is the Securities and Exchange Commission (SEC); in Australia, the Australian Securities and Investments Commission (ASIC); and in Malaysia, the Malaysian Securities Commission. 


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Benefits

Costs

Access to a larger pool of capital

Dilution

Respectability

Loss of flexibility

Lower cost of capital compared to private placement

Disclosures and accountability

Liquidity

Periodic costs

12.2 Various types of Equity There are a variety of types of stocks a company can offer in the form of equity. These are: 1. 2. 3. 4. 5. 6. 7. 8.

Common Stock Preferred Stock Rights Debentures Warrants Convertibles Sweat Equity ESOPs

12.2.1 Common Stock The most familiar form of equity is the common or ordinary stock. Holders of common stock are entitled to a proportionate share in any cash that is distributed to the company’s investors. They also enjoy the right to vote (typically one vote per share) at the company’s annual meeting. Collectively, a company’s shareholders elect the board of directors that oversees the actions of senior management, and they also vote on important matters such as mergers and acquisitions or changes to the corporate charter, the legal document that outlines how the company will be governed. In some countries, companies are allowed to issue more than one class of common stock. Often these dual-class companies issue a second class of stock with special voting rights (such as 10 votes per share rather than 1 or the exclusive right to elect a majority of the board of directors). Usually, senior managers or members of the founding family hold the second class of stock; this offers insiders a mechanism to exercise control of a majority of the company’s votes without having to invest a majority of the capital needed to finance the firm.

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12.2.2 Preferred Stock Some companies issue a hybrid security known as preferred stock, sometimes called as preference shares. Like debt, preferred stock promises to pay a fixed cash payment, usually one payment per quarter. Like debt, preferred stock has a higher priority claim than common stock, meaning that preferred shareholders must receive their dividends before dividends may be paid to common stockholders. Some preferred shares pay cumulative dividends, meaning if a financially troubled company misses a preferred payment, the payment must be made before any dividends can be paid on common stock. However, preferred stock has several features that more closely resemble traditional equity securities than debt. For example, when a company pays dividends to preferred shareholders, it cannot deduct them from taxes as it can on interest payment to bondholders. Likewise, when a company fails to make the promised payments on its preferred stock, the preferred shareholders have no legal right to force the company to make these payments. Bondholders can force the company into bankruptcy or liquidation if it does not make principal and interest payments on time. Therefore, preferred stock is a hybrid security offering neither a pure fixed claim like debt nor a residual claim like equity. Because it is somewhat riskier than debt, but not as risky as common equity, preferred stock generally offers investors a return that is a little higher than bonds, but somewhat lower than common stock. 12.2.3 Rights A rights issue involves selling securities in the primary market by issuing rights to the existing shareholders. When a company issues additional equity capital, it has to be offered; in the first instance to the existing shareholders on a pro rata basis. This is required under Section 81 of the Companies Act, 1956. The shareholders, however, may by a special resolution forfeit this right, partially or fully, to enable a company to issue additional capital to the public.

Procedure for Rights Issue: A company making a rights issue sends a letter of offer along with a composite application form consisting of four forms (A, B, C and D) to the

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shareholders. Form A is meant for the acceptance of the rights and application of additional shares. This form also shows the number of rights shares the shareholder is entitled to. It also has a column through which a request for additional shares may be made. Form B is to be used if the shareholder wants to renounce the rights in favour of someone else. Form C is meant for application by the renounced in whose favour the rights have been renounced, by the original allottee, through Form B. Form D is to be used to make a request for split forms. The composite application form must be mailed to the company within a specific period, which is usually 30 days. Rights Issue versus Public Issue: A rights issue offers several advantages over a public issue. The flotation costs of a rights issue are significantly lower than those of a public issue. Theoretically, the subscription price of a rights issue is irrelevant because the wealth of a shareholder who subscribes to the rights issue or sells the rights remains unchanged, irrespective of what the subscription price is. Hence, the problem of transfer of wealth from existing shareholders to new shareholders does not arise in a rights issue. Public Issue Rights Issue Private Placement Amount that can be raised

Large

Moderate

Moderate

Cost of Issue

High

Negligible

Negligible

Dilution of Control

Yes

No

Yes

Large

Irrelevant

Small

Negative

Neutral

Neutral

Degree of underpricing Market perception

12.2.4 Debentures Debenture is a debt instrument. A debenture is a written instrument signed by a company acknowledging its debt due to its holders. The instrument promises to pay its holders a specific amount of money at a fixed date in future together with periodic payment of interest. It is an unsecured instrument. If the company gets liquidated, its debenture holders will become general creditors. Debentures secured by specific asset of the company are termed as “Secured Debentures”.

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Important aspects of Debentures are that: a. They have a specific maturity date. b. Debenture holders have claim to income of the company. They have priority over stockholders. c. Debenture holders have priority in respect of claim on the assets of the company. They have priority over stockholders. d. Debenture holders do not have voting or controlling right on the company. Various kinds of Debentures are raised in Indian market: a. b. c. d. e. f. g.

Non-cumulative Debentures Cumulative Debentures Floating Rate Bonds Secured Premium Notes Zero Coupon Bonds Deep Discount Bonds (DDB) Convertible Bonds/Debentures

12.2.5 Warrants A warrant is an option to buy a stated number of shares of stock at a specified price. It gives the holder the right to buy common stock for cash. When the holder exercises the option, he surrenders the right. Warrants are a means for long-term financing. They have maturity dates of 5 years or more in the future. 12.2.6 Convertibles Convertible represent a bond or a share of preferred stock with embedded options issued by organizations. The holder has a right to exchange convertible bond for equity in the issuing company at certain times in the future. Convertible preference shares are preference shares with the right to convert to ordinary shares. 12.2.7 Sweat Equity, ESOPs Sweat equity shares are equity shares issued by a company to its employees or directors at a discount, or as a consideration for providing know-how or a similar value to the company. A company may issue sweat equity shares of a class of shares already issued if these conditions are met.

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The issue of sweat equity shares should be authorized by a special resolution passed by the company in a general meeting The resolution should specify the number of shares, current market price, consideration, if any, and the section of directors/employees to whom they are to be issued As on the date of issue, a year should have elapsed since the company was entitled to commence business. The sweat equity shares of a company whose equity shares are listed on a recognized stock exchange should be issued in accordance with the regulations made by the Securities and Exchange Board of India (SEBI). In the case of a company whose equity shares are not listed on any recognized stock exchange, sweat equity shares can be issued in accordance with such guidelines as may be prescribed. In the case of unlisted companies, sweat equity shares cannot be issued before one year of commencement of operations. Moreover, there is a cap of 15% on the number of sweat equity shares that can be issued without a specific central government approval. Sweat equity shares are no different from employee stock options with a one year vesting period. It is essential when a company is formed, to assure the financial investors that the know-how providers will stay on, or for a start-up with limited resources to attract highly qualified professionals to join the team as long-term stakeholders. These shares are given to a company’s employees on favourable terms, in recognition of their work. Sweat equity usually takes the form of giving options to employees to buy shares of the company, so they become part owners and participate in the profits, apart from earning salary. Section 79A of the Companies Act lays down conditions for the issue of sweat equity shares. For listed companies, there are regulations made by the SEBI. The SEBI also prescribes the accounting treatment of sweat equity shares. Thus, sweat equity is expensed, unless issued in consideration of a depreciable asset, in which case it is carried to the balance sheet. Sweat equity is a device that companies use to retain their best talent. Usually, it is given as part of a remuneration package. However, start-ups

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sometimes use sweat equity to retain talent. If the company fails, its employees may end up with worthless paper in the form of sweat equity shares. Unlisted companies cannot issue more than 15% of the paid-up capital in a year or shares with a value of more than Rs. 5 crores – whichever is higher – except with the prior approval of the central government. If the sweat equity is being issued for consideration other than cash, an independent valuer has to carry out an assessment and submit a valuation report. The company should also give ‘justification for the issue of sweat equity shares for consideration other than cash, which should form a part of the notice sent for the general meeting’. The board of directors’ decision to issue sweat equity has to be approved by passing a special resolution at a shareholders’ meeting later in the year. The special resolution must be passed by 75% of the members attending voting for it. An ESOP is a type of employee benefit plan which is intended to encourage employees to acquire stocks or ownership in the company. Definition: An employee stock ownership plan (ESOP) is a type of employee benefit plan which is intended to encourage employees to acquire stocks or ownership in the company. Description: Under these plans, the employer gives certain stocks of the company to the employee for negligible or less costs which remain in the ESOP trust fund, until the options vests and the employee exercises them or the employee leaves/retires from the company or institution. These plans are aimed at improving the performance of the company and increasing the value of the shares by involving stock holders, who are also the employees, in the working of the company. The ESOPs help in minimizing problems related to incentives.

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12.3 Listing a Company Converting from a private company to a public company is a complex and highly regulated process. Companies usually enlist the help of investment bankers or merchant bankers. Working in concert with the company’s management, investment bankers prepare a prospectus. The prospectus contains: • • • •

A description of how the company operates An outline of the risks that investors in the company will face The lists of names and backgrounds of senior managers Detailed financial information about the company

Following steps are followed while listing a company: 1. An investment banker distributes a company’s prospectus to potential investors to generate interest in the company and to solicit orders for shares in the soon to be public company. In return for these and other services that it provides, the investment bank charges the company a fee, usually about 7% of the total amount of money that the company raises in the offering. 2. When the investment bank is confident that the demand for shares will be more than sufficient to supply the company with the capital it needs, the bank will write the company a cheque in exchange for shares of stock. The bank than resells these shares to investors who want to buy them, a process known as underwriting. 3. When a company issues shares directly to investors (with help of an investment banker), it is selling shares on the primary market. 4. Once securities are listed on the Stock Exchange, investors may trade these securities in the secondary market. There are many costs of listing as a public company

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1. One of the biggest is that listed companies must comply with an array of securities regulations and disclosure requirements. 2. Listed companies must file quarterly and annual shareholding patterns, results and secretarial audits. 3. Executives who work for these companies face insider trading regulations limiting the circumstances in which they may buy or sell shares in the company. 4. If the company or its executives fail to comply with any of these regulations, they may face action from the Stock Exchange or the regulator. 12.3.1 Relationship between SEBI and the Stock Exchanges in India SEBI and the Stock Exchanges play very different roles in the securities market even though both impose certain requirements on companies that want to list. SEBI was created by the Government to enforce legislation passed in the Securities Act. SEBI is primarily charged with prevention of fraud in securities market. Consequently, SEBI devotes a substantial fraction of its resources to establish and enforce various disclosure requirements. Stock Exchanges, on the other hand, exist mainly to provide liquidity to investors. Exchanges act as intermediaries between buyers and sellers of securities of securities, lowering the costs of trading.

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12.3.2 Pros and Cons of Public Listing Advantages • A listed company can raise capital from a much wider pool of investors than can a company that does not list its shares. •

Once the company’s shares are publicly traded, the share price can serve as a useful barometer of how the business is performing. The market’s perception of the value of a listed company’s equity is reflected every day – indeed at every moment.

•

The company may use shares or stock options as part of the compensation package that it offers to recruit and retain talented employees. Companies also use stock and stock options as incentive devices. By including stock options in employee compensation packages, companies tie employee’s financial rewards directly to the overall financial success of the company. The financial linkage between employee success and overall company success reduces the need for constant monitoring.

•

Listing the company’s stock on the public market allows the original entrepreneurs and other investors with large stakes to sell a portion of their investment and diversify their portfolios if they choose.

•

Listing shares on any exchange may also provide companies with marketing benefits. The publicly and news coverage associated with listing securities may attract new customers as well as new investors.

Disadvantages • There are substantial costs of going public. Firstly, there are direct costs of an Initial Public Offering (IPO) such as underwriting fees. •

Public companies are also required to provide quarterly and annual reports, and are subject to greater public scrutiny.

•

Publicly listed companies have to provide more information to their shareholders than private companies. This information will also be available to their competitors and might put the company at a competitive disadvantage.

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12.4 Stock Exchanges 12.4.1 NSE – The National Stock Exchange (NSE) (www.nseindia.com) NSE is India’s leading stock exchange covering various cities and towns across the country. NSE was set up by leading institutions to provide a modern, fully automated screen-based trading system with national reach. The Exchange has brought about unparalleled transparency, speed and efficiency, safety and market integrity. It has set up facilities that serve as a model for the securities industry in terms of systems, practices and procedures. 12.4.2 BSE – The Bombay Stock Exchange (www.bseindia.com) BSE is the oldest stock exchange in India. It is very popular covering various cities and towns across the country. NSE was set up by leading institutions to provide a modern, fully automated screen-based trading system with national reach. The Exchange has brought about number of revolutionary steps for the safety and security of various members and retail investors. 12.4.3 BSESME – SME Stock Exchange (www.bsesme.com) This is a platform for SME companies to raise money from the public. SME companies form the backbone of any developing economy. This platform is a great avenue to raise equity capital for the growth and expansion of the SMEs.

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! BSE is a popular exchange for domestic companies

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12.5 METHODS OF OFFERING There are different ways in which a company may raise finances in the primary market public offering, rights issue, and private placement. 12.5.1 Public Offering A public offering or public issue involves sale of securities to the members of the public. The three types of public offering are: the initial public offering (IPO), the seasoned equity offering, and the bond offering. 12.5.2 Initial Public Offering The first public offering of equity shares of a company, which is followed by a listing of its shares on the stock market, is called the initial public offering (IPO).. Decision to Go Public The decision to go public (or more precisely the decision to make an IPO so that the securities of the company are listed on the stock market and are publicly traded) is a very important issue. It is a complex decision, which calls for carefully weighing the benefits against costs. Eligibility for IPOs An Indian company, excluding certain banks and infrastructure companies, can make an IPO if it satisfies the following conditions: •

The company has a certain track record of profitability and a certain minimum net worth.

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The securities are compulsorily listed on a recognized stock exchange, which means that a certain minimum per cent of each class of securities is offered to the public.

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The promoter group (promoters, friends, relatives, associates, etc.) is required to make a certain minimum contribution to the post-issue capital.

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The promoters’ contribution to the equity is subject to a certain lock-in period.

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The IPO Process: From the perspective of merchant banking, the IPO process consists of four major phases: (a) hiring the merchant bankers, (b) due diligence and prospectus preparation, (c) marketing, and (d) subscription and allotment. The company wishing to go public has to hire the merchant bankers to manage its offering. The selection of a merchant banker is usually referred to as a ‘beauty contest’. Typically, it involves meeting different merchant bankers, discussing the plans for going public, and getting a valuation estimate. Understandably, the choice of the merchant banker is guided mainly by the valuation estimate offered. Often, a company going for an IPO selects two or more merchant bankers to manage the issue. The primary manager is called the “lead manager” and the other managers are called “co-managers”. Once the managers are selected, due diligence and prospectus preparation begin. The merchant bankers understand the company’s business and plans, examine various documents and records, prepare the draft prospectus, file the same with the regulatory authorities, and arrange for its printing. Merchant bankers, lawyers, accountants, and company managers have to toil for countless hours to complete the legal formalities that finally culminate in the printing of the prospectus. Since book building is commonly used, the issue price is not fixed in advance, but a price band is given. The next phase of an IPO is the marketing phase. After all the regulatory approvals are in place, the company embarks on a road show to promote the issue. A road show involves presentation by the management of the company to potential investors (mostly institutional) in different locations. Concurrently, the issue is advertised in various media primarily targeted at retail investors. The final phase of the IPO involves receiving subscription and allotment of shares. The subscription is normally kept open for five to ten days. During this period, investors can submit their bid-cum-application forms. After the subscription is closed, the merchant bankers fix the final issue price,

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determine the pattern of allotment, complete the allotment of shares, and secure the listing on one or more recognized stock exchanges. Seasoned Equity Offering: For most companies, their IPO is seldom their last public issue. As companies need more finances, they are likely to make further trips to the capital with seasoned equity offerings, also called secondary offerings. While the process of a seasoned equity offering is similar to that of an IPO, it is much complicated. The company may employ the merchant bankers who handled the IPO. Further, with the availability of secondary market prices, there is no need for elaborate valuation. Finally, prospectus preparation and road shows can be completed with lesser effort and time than that required for the IPO. Bond Offering: The bond offering process is similar to the IPO process. There are, however, some differences: •

The prospectus for a bond offering typically emphasizes a company’s stable flows, whereas the prospectus for an equity offering highlights the company’s growth prospects.

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Pure debt securities are typically offered at a predetermined yield because the book building route is not considered appropriate for them.

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Debt securities are generally secured against the assets of the issuing company and that security should be created within six months of the close of the issue of debentures.

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A debt issue cannot be made unless credit rating from a credit rating agency is obtained and disclosed in the offer document.

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It is mandatory to create a debenture redemption reserve for every issue of debentures.

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It is necessary for a company to appoint one or more debenture trustees before a debenture issue.

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Private Placement A private placement is an issue of securities to a select group of persons not exceeding 49 (number increased in the new Companies Act, 2013). Private placement of shares and convertible debentures by a listed company can be of two types: Preferential Allotment: When a listed company issues shares or debentures to a select group of persons in terms of the provisions of Chapter XIII of SERI (DIP) Guidelines, it is referred to as a private placement. The issuer has to comply with various provisions, starting from pricing, disclosures, lock-in period and so on, apart from the requirements of the Companies Act. Qualified Institutional Placement (QIP): A QIP is an issue of equity shares or convertible securities to Qualified Institutional Buyers in terms of the provisions of Chapter XIIIA of SEBI (DIP) Guidelines. Private Placement of Bonds: From 1995 onwards, private placement of debentures thrived, minimal regulation. Corporates, financial institutions, infrastructure companies, depended considerably on privately placed debentures which were subscribed to mutual funds, banks, insurance organizations, and provident funds. Information and disclosures to be included in the Private Placement Memorandum were not defined, credit rating was not mandatory, listing was not compulsory, and banks and institutions could subscribe to these issues without too many constraints. The regulatory framework changed significantly in late 2003 when SEBI and RBI tightened their regulations over the issuance of privately placed debentures and the subscription of the same by banks and financial institutions. The key features of the new regulatory dispensation are: 


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The disclosure requirements for privately placed debentures are similar to those of publicly offered debentures.

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Debt securities shall carry a credit rating of not less than investment grade from a rating agency registered with SEBI.

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Debt securities shall be issued and traded in demat form.

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Debt securities shall be compulsorily listed.

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The trading in privately placed debt shall take place between QIBs and HNIs (High Net Worth individuals) in standard denomination of Rs. 10 lakh.

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Banks should not invest in non-SLR securities of original maturity of less than one other than commercial paper and certificates of deposits which are covered under guidelines.

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Banks should not invest in unrated non-SLR securities.

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12.6 Summary •

At some point in time, a company may expand to a point when it is no longer feasible for a group of investors to provide all the capital it needs. When that occurs, it may decide to convert from private to public ownership.

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To list on an exchange, a company must comply with all the listing requirements by the exchange and the securities regulator.

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Various types of equity are issued such as common stock, preferred stock, rights, debentures, warrants, convertibles, Sweat Equity and ESOPs.

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Converting a private company to a listed company is a complex and highly regulated process.

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There are various advantages of listing a company – can raise more capital from a wider pool of investors, share prices reflect its performance, company can use ESOPs to retain talented employees, Original entrepreneurs can sell a portion of their investment and diversify their portfolios and marketing benefits.

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There are disadvantages of listing a company – direct costs of an IPO, companies have to provide results quarterly and annually, disclosed information can be misused by the competitors.

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There are local popular stock exchanges – NSE, BSE for companies. New BSESME exchange for SMEs.

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There are various methods of offerings in the primary market.

Activities 1. You want to list your enterprise on a local exchange. What is the eligibility criteria for various exchange? What documents will your merchant banker require to complete this?

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2. Logon to www.nseindia.com, www.bseindia.com and www.bsesme.com. Find out the number of companies registered, annual turnover of the exchange and number of issues in current financial year.

12.7 Self Assessment Questions 1. When should a company decide to go public? 2. Which are the major international exchanges? 3. Which are the major Indian Exchanges? 4. What are the various kinds of equity stocks that can be listed? Describe each in brief. 5. What are the pros and cons of going public? 6. What is difference between Sweat Equity and ESOPs?


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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Chapter 13 INTERNATIONAL CAPITAL Objectives After studying this chapter, you should be able to: •

Understand the scenario in terms of Indian companies raising International Capital.

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Know the popular destinations where companies go for International Capital.

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Government and regulator laws relating to International Capital.

Structure: 13.1 Introduction 13.2 An Interesting Article on International Capital Raising Trends by Indian Companies 13.3 Summary 13.4 Self Assessment Questions

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13.1 Introduction Thanks to the globalization of capital markets, Indian companies can raise capital from Euromarkets or from the domestic markets of various countries or from Export Credit Agencies.

13.2 An Interesting Article on International Capital Raising by Indian Companies I am presenting a few notes from the City of London Corporation prepared by TRUSTED SOURCES and published in 2010. This will give students a perspective of how international financiers view India and how Indian companies are tapping international markets for capital. “Although Indian companies can now largely rely on their domestic capital market to fulfil even “jumbo” equity offerings, this was not always the case. The equity issuance market for Indian companies saw rapid growth from 2004 just as India’s economic growth rate started to accelerate. Previously, only a handful of Indian firms had tapped overseas capital markets in any size and usually by ADR/GDR issuances in New York and London, typically at around the US$100-200 million level. These offerings included ADRs listed on the NYSE by Wipro and Satyam in 2000 and HDFC and Dr. Reddy’s Laboratories in 2001; Infosys listed on NASDAQ in 2003. They tended to be carried out in conjunction with an offering on the BSE and/or the NSE, India’s two leading stock exchanges, for the purpose of augmenting the limited amount of funds capable of being raised domestically. The chart below shows the dramatic increase in overall equity issuance since 2004. This upward trend was temporarily dented during the global crisis in 2008 but resumed again in H2/09.

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! Public equity raised by Indian companies on domestic and foreign markets, 2000-10 year to date (US$ million).

NOTE: Does not include companies incorporated offshore. Source: Bloomberg, TS estimates. Most of the new issues in 2004 were in the domestic market as the government came forward with privatization offers for energy companies Oil and Natural Gas Corporation (ONGC) (US$ 2.3 billion) and, after the election that year, National Thermal Power Corporation (NTPC) (US$ 1.1 billion), while Tata Consultancy Services managed a US$ 1.2 billion offering. Such large offerings were made possible primarily by the recovery in global investor appetite as memories of the 2000-01 collapse of the technology bubble faded. In addition, investors were reassured when a Communist-supported coalition led by the Congress Party came to power in May 2004 and signalled broad policy continuity with its right-wing

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predecessor government; political risk was no longer seen as a major impediment to investment. This picture started to change in 2005 as the supply of listing candidates increased and was met by growing overseas demand. The most popular mode for Indian firms to raise capital during the first big equity rush of 2005/06 was GDR listings in Luxembourg, owing to the low compliance costs and relatively fast approval process. These were typically small deals in the range of US$ 30-100 million issued by mid-cap firms wishing to source quick, cheap capital for domestic operations. But these smaller issues were overshadowed by “jumbo” offerings in 2005 for Infosys (US$ 1.1 billion, listed both in Mumbai and on NASDAQ) and ICICI Bank (US $1.6 billion, listed both in Mumbai and on the NYSE). These companies were joined in 2007 by Sterlite with a US$ 2 billion NYSE-listed IPO as well as follow-on offerings from both ICICI and Infosys. Meanwhile, the capacity of the local markets was expanding, and Cairn India raised US$1.9 billion from a purely domestic IPO in 2006. This was followed by more “jumbo”-sized domestic offerings including large retail tranches for Reliance Power (US$ 2.6 billion) and the State Bank of India (US$ 4.2 billion) in 2007-08. Subsequently, several state-owned minerals and energy firms made “jumbo” offerings in 2009-10: National Mineral Development Corporation (NMDC) Ltd. (US$ 2.1 billion), NTPC Ltd. (US$ 1.8 billion) and National Hydroelectric Power Corporation (NHPC) Ltd. (US$ 1.2 billion); this trend towards privatization continues with imminent issuances from ONGC, Indian Oil and Coal India among others. Of the remainder, the bulk of those in the US$ 200 million to US$ 1 billion range came from banks/financials, infrastructure, energy/power generation and realty. These huge offerings demonstrated that the domestic market, helped by a vibrant retail segment, had come of age. Capital raising efforts in large part relocated to Indian exchanges following the introduction by the Securities and Exchange Board of India (SEBI) of a local qualified institutional placement (QIP) programme in May 2006. This coincided with the gradual easing of the foreign institutional investor (FII) scheme in India and subsequent growth in foreign institutional investors buying and trading shares in the domestic market, thereby enabling Indian firms to tap into a larger pool of institutional capital domestically.

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Foreign institutional investors were first allowed access to India’s equity markets in 1991 as part of the broader economic liberalisation process. Regulatory sector caps (on percentage of equity owned in a company) restricted FII investment until 2002 when they were lifted in most sectors. FIIs were also allowed into all derivative segments at this point, facilitating a much greater volume of FII trading. This was followed in 2007 by the streamlining of the process for granting FII licences. By March 2010, there were 1,713 FIIs registered (with 5,378 registered sub-accounts). This expansion helped portfolio flows into India soar from US$ 979 million in FY2003 to US$ 11.3 billion in FY2004. Except for a dip in FY2009 caused by the global credit crisis, inflows have stayed strong ever since, hitting a high of US$ 32.3 billion in FY2010. Flows remained strong in Q1/FY2011, at US$ 4.6 billion.

! Source: RBI, India; Portfolio flows, FY2003 – FY2010 (US$ billion)

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Accordingly, the volume of Indian issuances from Luxembourg dropped off sharply in 2007. There were only four listings that year compared to 26 in 2006. A Hong Kong based hedge fund told us, “Indian GDRs died as more investors got access to the domestic market via FII licences”. Luxembourg has still attracted a handful of Indian firms to list each year since 2006, but these tend to be small issues by mid-cap companies. The exceptions have been larger GDR issues (in the US$ 100-400 million range) by Suzlon, Tata Motors and Tata Power. Tata Steel chose to make a US$500 million GDR issue in London in July 2009 because of the need to raise its profile there following its 2007 acquisition of UK steel company Corus. (One attraction of GDRs for firms concerned about management control is that they can be issued in non-voting form; QIPs always involve the issuance of local voting stock). The majority of companies now use the QIP route in India. A total of 36 issuers raised Rs. 255 billion (US$ 5.5 billion) in QIPs domestically in FY2008, a figure that plummeted during the credit crisis to just two companies raising a total of Rs. 2 billion (US$ 43 million) in FY2009. This route to raising capital has, however, seen strong growth in FY2010: 62 QIP issues have raised Rs. 427 billion (US$ 9.2 billion).


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Where Have Companies Been Going? •

New York has attracted technology, banks and pharmaceuticals. The August 2010 NASDAQ listing of MakeMyTrip.com (online travel services) is the latest example of a technology firm sourcing capital in New York. Other examples include Satyam Computer Services (2005, NASDAQ), Rediff.com (2005, NASDAQ) and Infosys Technology (2005-06, NASDAQ), all of which focus on software and business process outsourcing. They have been able to tap into the large pools of capital available in the US for investment in the tech sector, and thereby raise their profile among current and potential US clients. As highlighted earlier, two Indian banks (ICICI and HDFC) and a pharmaceutical company (Dr. Reddy’s Laboratories) have also listed on the NYSE. Indian banks in particular are attracted to New York by the perception that tighter disclosure norms and greater ADR liquidity will strengthen investor confidence in those firms.

•

London has attracted metals, mining and energy companies. Back in 2003 the UK-registered holding company of Vedanta Resources raised US$ 1 billion in its London offering. A “jumbo” US$ 1.9 billion offering for the UK-registered holding company of Essar Energy as well as a modest US$ 500 million GDR placement by Tata Steel took place in 2009. Great Eastern Energy, specializing in coalbed methane, has recently been transferred from AIM to the LSE Main Market. The pattern on AIM is a little different. More than one-third of India related listings on AIM have come from real estate firms and funds. Other sectors have been clean energy, private equity, media and infrastructure; the most recent listings are in these sectors. Only one Indian-domiciled firm – the Noida Toll Bridge – is presently listed on AIM; most are either funds of companies domiciled in UK tax havens such as the Isle of Man and Guernsey.

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Singapore is targeting the Indian market. Singapore has so far not succeeded in attracting a large number of Indian listings. However, an officer of the Singapore Stock Exchange (SGX) announced that it was keen to win Indian business and could offer regional “clusters” in “marine, offshore and energy, real estate investment trusts (REITs) and property trusts, resources and commodities trading”. Recent press comment suggests that the much delayed launch of Indian REITs by DLF and Unitech on the SGX may be back in prospect, potentially the first such issuances since the Ascendas and Indiabulls REITs in 2007 and

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2008. If the REITs were launched, this would be a major achievement for Singapore. But, as a Hong Kong fund management source told us: “The Singapore listing of REITs and property companies has been a high profile disaster. SEBI has not pushed forward a 2008 proposal to facilitate domestic REITs, leaving Singapore as the only outlet for such a vehicle.” Singapore does hold some attraction in the form of geographical proximity to India, cheaper costs and lower taxes than London and New York. Indian firms in real estate, telecoms and financial services could be attracted to a good peer group listed in Singapore. However, most Indian firms remain focused on the advantages of a London or New York listing. Outlook for Capital Raising We expect several sectors to generate a large proportion of capital raising in the future: •

Infrastructure. There is huge demand among energy, construction, power generation and ports sectors for capital. These companies will continue to raise capital to finance their growth plans inside and outside India, both for parent firms and for project-specific entities also known as “special purpose vehicles”. Some of the big issues in the past have come from Adani Enterprises (US$ 850 million in July 2010), GMR Infrastructure (US$ 1 billion in 2007), Jaypee Infratech, JSW Energy and Videocon.

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Mining and energy companies. The successful flotations of Vedanta, Sterlite and Essar Energy may encourage other capital-hungry and acquisitive companies to come to London and NYSE.

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Banks and other financial services firms. Banks will need capital to finance their rapid expansion in India’s underpenetrated market. ICICI Bank, HDFC Bank and Axis Bank have already raised substantial quantities of capital internationally.

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Technology, internet and renewable energy companies. Typically, firms in these sectors can obtain better valuations overseas because dedicated investor pools exist in London and New York.

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Acquisitive multinationals. Indian multinationals are attracted to foreign listings to raise their profiles among host consumers, suppliers, financiers and investors. However, most have not sought to finance their acquisitions through foreign equity issuances and have relied instead on debt, internal resources and domestic rights issues.

•

REITs. SEBI has not permitted REITs in India, which leaves a Singapore listing as the only feasible option. Ascendas and Indiabulls listed Indiafocussed REITs in Singapore in 2007 and 2008. Other property firms are expected to follow suit. These include Fortis Healthcare (with a reported planned deal size of US$ 600-700 million), DLF (US$ 1.5 billion), Unitech (US$ 500 million) and Embassy Property Developments (US$ 300-500 million).

[From 2014, SEBI has permitted REITs to enter India] The Indian Exchanges Will Dominate New Listings The BSE and NSE in Mumbai will continue to be the primary venues for Indian firms to raise capital and we believe they will take further market share away from international exchanges such as London and New York. According to our sources, the domestic markets can already handle issuances of US$ 3-4 billion without the support of dual or follow-on GDR listings in New York or London, as the US$ 2.6 billion IPO of Reliance Power in January 2008 illustrated. Market participants are watching the upcoming US$ 3-4 billion Coal India IPO to test demand for the largest domestic listing to date. If successful, it will pave the way for more “jumbo” listings that no longer need to be accompanied by a GDR issuance in London or New York. Will Recent Government Programmes Affect This Position? Privatization In its current second term, the Congress-led coalition has managed to accelerate minority stake sales in state-owned firms, targeting revenues of around US$ 8-10 billion per year from issues in the domestic market. The volume of these issues has the potential to saturate the domestic markets and force some companies to go abroad in search of better valuations. In FY2010, for example, a high-volume stream of overpriced issues by state-owned firms dampened primary market sentiment. Six such

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issuances accounted for 54% of the total Rs. 576 billion (US$ 12.4 billion) raised on the domestic markets. Aggressive pricing deterred retail investors from subscribing, and state-owned financial institutions such as the Life Insurance Corporation of India and the State Bank of India were forced to step in and support the issuances. The government also missed its revenue targets because it was necessary to hold back further issuances. The outlook for successful issuances is better in FY2011 because the government appears to have decided to adopt more realistic pricing for its next privatization round to attract retail investors. The target for the year is Rs. 400 billion (US$ 8.6 billion), and stakes in good quality firms in energy and minerals are once again up for sale: Coal India, ONGC, Indian Oil, Manganese Ore India and MMTC Ltd. If these issuances prove successful, investment bankers expect private firms to get involved and take advantage of primary market momentum. The New 25% Rule The government introduced a new rule in June 2010 that required at least 25% of the equity of all listed firms to be made available to the public. Close to 5,000 firms are listed on the BSE, although only about one-third are actively traded. As of March 2010, 41% of the equity of all firms on the NSE was available to the public, but in practice, there are many firms in which family ownership groups known as “promoters” hold more than 75% of the equity. Promoters own approximately 49% of the share capital in the market today. The original implementation of this rule would have unleashed a flood of equity into the local market and possibly encouraged some firms to issue shares abroad that would not have done so in the absence of the rule. The government subsequently relaxed the programme following fears that the domestic market could not handle the supply. State-owned enterprises will now have to dilute only up to 10% of their equity until 2014. This means that whereas under the original requirement a projected Rs. 1,250 billion (US$ 27 billion) was to be issued by 35 state-owned firms, only 15 will now be required to issue Rs. 200 billion (US$ 4.3 billion) of equity. Private companies will still be required to dilute their equity to 25% over the next three years but they will be at liberty to decide both timing and strategy (the original order mandated an annual 5% dilution until the threshold was reached).

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The chart below highlights the dominance of international investors compared to domestic institutions.

! Shareholding of Major Institutions in BSE-listed Companies (Per Cent) FIIs have emerged as the biggest market movers in India and currently account for 32% of the free float market capitalization of the BSE. As the chart above illustrates, they also make up the largest institutional investor base, holding 55% of the total institutional shareholding on the BSE. FII interest in primary markets remains strong. SEBI data show that in the year to 27 August 2010 FIIs invested a net Rs. 201 billion (US$ 4.3 billion) in primary markets compared with Rs. 390 billion (US$ 8.4 billion) in secondary markets. According to the India Brand Equity Foundation, FIIs invested more in primary markets than in secondary markets in the AprilSeptember 2009 period. This is a very substantial commitment of funds to primary markets, demonstrating how foreign investors are increasingly willing to buy equity in local primary markets rather than wait for GDR or ADR issuances. !

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Where Will Firms Go to Carry Out International Listings? Despite the likely dominance of the BSE and NSE in attracting future Indian IPOs and SPOs, many Indian firms believe that the benefits from listing abroad outweigh the greater compliance costs and currency risks than are incurred in domestic listings. These benefits fall into the following categories: Higher valuations (and greater analyst coverage) in specialty stocks. The main international investor bases for several key sectors do not invest directly into India either because of restrictions on EM exposure or because they do not have the research bandwidth to cover local Indian companies. As a result, many Indian firms will continue to gravitate towards their natural investor base in order to achieve higher valuations. The main trends are: •

Technology stocks on the NYSE and NASDAQ. There is a history of Indian outsourcing and technology firms accessing capital on NASDAQ and the NYSE. This trend will continue. The recent IPO of MakeMyTrip.com on NASDAQ is the latest illustration of this trend.

•

Valuation arbitrage. Indian stock markets generally offer higher earnings multiples for stocks than international markets. However, in some sectors, Indian valuations are lower than global valuations, and there are opportunities to arbitrage this presumed mispricing. For instance, India’s largest paper company, Ballarpur Industries, is planning to list its Malaysian subsidiary Sabah Paper Industries in London or Singapore, partly because it hopes that better valuations there will help to improve its Indian stock price.

•

Mining, metals and renewable energy in London. Indian mining and energy private companies have traditionally listed in London. There is a good possibility that more energy firms will list there, and Indian firms that acquire foreign energy or commodity assets will likely list them separately in London. For instance, it is conceivable that the state-owned Bharat Petroleum will list its Australian shale gas assets in London or Singapore. An additional incentive for larger firms is to get representation in the FTSE 100 Index, which brings additional prestige and may bring better valuations from buying by index funds. However, there is no evidence that state-owned firms in these sectors will list in

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London; the recent spate of “jumbo” issuances has been exclusively domestic. Another sector in which foreign valuations tend to be higher than in India is renewable energy, and a foreign listing in London or elsewhere could make sense for a domestic renewables firm. Foreign capital for global expansion. Mergers and acquisitions will be the biggest driver favouring foreign listings by Indian companies. Indian firms invested Rs. 818 billion (US$ 17.5 billion) outside India in FY2009 and Rs. 570 billion (US$ 12 billion) in FY2010. This is a long-term process and is likely to gather force over time. The motivation for Indian companies expanding abroad to list in their target markets is to raise their profile and reputation among host consumers, suppliers, financiers and of course investors. A higher local profile can help to increase company sales if consumers gain confidence in the firm. This will also have a positive effect on suppliers. Debt costs will be more manageable if domestic financial institutions reward a higher local profile with better terms. The ability to tap the pool of investors that have traditionally had confidence in the acquired firm, such as British Steel and the Tata-acquired Corus, is useful because it also allows the Indian firm to access foreign currency financing without exposing itself to FX risk if the debt is in the same local currency as the acquired firm. Our interviews revealed that the sectors considered to have the greatest potential for foreign listings are banks and financial services, automobiles and components, metals, pharmaceuticals and energy. London has a natural advantage when it comes to metals and energy firms, but firms seeking a foothold in Europe will also gravitate towards a London listing. This dynamic works both ways: Standard Chartered and Cairns have made domestic offerings in India in order to raise their local profile and to tap into the local investor base. Stanchart’s IDR was a small percentage of its overall equity, but the Cairns issue was significant (US$ 1.9 billion) and involved a productive Indian asset. London’s prestigious premium listing. A full London listing offers access to most global investment groups. A senior banker at a Londonbased global investment bank told us:

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“A London listing allows access to an enormous pool of capital. If you are in the FTSE Index, tracker funds have got to own you and others will follow.” Both Vedanta Resources and Essar Energy are members of the FTSE 100. London’s reputation as a market with high standards of transparency and corporate governance is another draw for Indian companies. Both Vedanta and Essar have faced criticism on corporate governance grounds in India, and a foreign listing is seen as one way to signal to investors that the company does maintain high standards. For example, the marketing of Essar’s London listing prominently emphasized how doing so would highlight the company’s good corporate governance. At the same time, firms in sectors like infrastructure, mining, energy and property that sometimes face corporate governance issues may perceive that London’s governance regime is less onerous than that of the US under Sarbox. A further advantage of London may be better research coverage. The senior banker quoted above advised, “There is a global problem in equity research. The secondary equity market alone cannot produce sufficient research coverage. This is a big problem for US listed firms from the emerging markets where at US$ 3 billion you are only a mid-cap. You will be lucky to have a couple of analysts following you.” He pointed out that, at least for the present, companies of this size attract better coverage in London. This research coverage should of course be particularly strong in the mining and energy clusters described above. Finally, London’s track record as a successful and liquid home for companies from Russia, South Africa, Eastern Europe and India offers encouragement to Indian firms considering foreign listings. Opportunities for the City of London Capital raising business Although the volume of business in the immediate term has been hit by the success of QIPs in domestic Indian markets and the liberalization of FII access to them, investment bankers we spoke to said that there is strong interest among Indian firms for a London listing and that several offerings on LSE and AIM are in the pipeline.

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Although New York remains attractive for banks and technology and outsourcing firms, London will be a draw for Indian multinationals seeking to access European markets, as well as energy, mining and metals companies and, not least, firms that believe that a London listing will help them in strategic or valuation terms. Advisory work There is a level playing field in India for financial intermediaries like brokerages, underwriters and merchant banks. Foreign firms are permitted to establish wholly owned subsidiaries that can practise with a SEBI licence. Even state-owned issuances have involved both domestic and foreign-owned firms: book runners and lead managers for Coal India’s forthcoming domestic listing are Citi, Deutsche Bank, Morgan Stanley, Enam Financial, Kotak Mahindra and BofA Merrill Lynch. Foreign audit firms such as PwC, Ernst & Young and KPMG are also permitted to offer financial advisory services under the same regulatory umbrella (though their audit functions are more strictly regulated). Only Indian citizens licensed in India are permitted to practise Indian law. This means that any legal work related to domestic listings must be carried out by local lawyers and partnerships. Indian firms such as Amarchand & Mangaldas & Suresh A. Shroff & Co., AZB & Partners, Dua Associates, Luthra & Luthra, FoxMandal Little and Trilegal will continue to be the main players in the domestic market. However, foreign law firms are permitted to handle external work related to Indian issuances abroad. This has created an opportunity for firms like Linklaters, Freshfields Bruckhaus Deringer, Allen & Overy, Clifford Chance and Jones Day. In practice, foreign firms work closely with their Indian counterparts and in many cases have developed longstanding relationships. Larger firms like Linklaters have dozens of Indian lawyers on their staff in locations such as Hong Kong and London. There are less onerous restrictions on audit-related functions by accounting firms. Global audit firms are not permitted to use their own names while practising in India, and there is a cap of 20 on the number of partners a firm can have and on the number of audits per partner. However, there are no similar restrictions on the Big Four audit firms’ advisory functions such as underwriting and consultancy once they have secured SEBI registration.

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Conclusion Continued rapid growth in demand for capital The impressive growth over the past 10 years in the number of EM firms raising equity capital and the amount of capital raised will continue. Although the 2008 crisis sharply interrupted this trend, we have already witnessed a strong resumption in domestic and international capital raising activities by companies from the larger markets of India and Brazil, including several “jumbo” offerings (NHPC Ltd. [India] – 2009, Essar Energy [India] ─ 2010, VisaNet [Brazil] – 2009, Banco Santander Brasil – 2009). Capital market activity in Russia (which was the most severely affected by the crisis) and South Africa remains subdued. With the exception of two IPOs this year, Mexico’s new issue market remains sluggish as it comes out of a deep recession – although, it must be noted, the demand for equity capital by Mexican firms has historically lagged that of other EMs. Robust economic growth in Brazil, India and Russia over the next few years will propel demand for investment capital from local companies attempting to ramp up domestic operations and expand into new markets. This demand will be intensified by other drivers, including the high levels of investment capital needed for infrastructure development (Brazil and India), the privatization of state-owned enterprises (Russia and India), the rapid expansion of consumer sectors (Brazil and Russia) and foreign M&A (India). Capital raising in South Africa and Mexico, in contrast, faces constraints on growth. In particular, Mexico’s corporate environment, dominated by family-run companies, has a culture of preferring debt financing over equity. India, Brazil and South Africa: Demand will be met in large part by domestic markets, unless there are compelling reasons to go abroad. Brazil and India’s equity markets are now large and liquid following financial market reforms and rapid growth since 2003. They can and do handle the majority of new offerings by local firms without the support of dual or ADR/GDR listings in New York or London, as had been necessary in the late 1990s and early 2000s. At the top end of the scale, the Reliance Power IPO (US$2.6 billion in 2008) highlighted the capacity of the Indian market. The upcoming US$ 3-4 billion Coal India IPO will be a

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good test of post-crisis capacity. Brazil’s Novo Mercado has shown it can handle even larger amounts, with the Banco do Brasil IPO (US$ 5.4 billion in 2010) and the VisaNet IPO (US$ 4.2 billion in 2009) being completed without accompanying US listings. The super-”jumbo” Petrobras global offering, in spite of its ADR listing on the NYSE, challenged the local market due to its sheer size. It has drained liquidity from the system and will likely prevent many smaller offerings by mid-cap firms from taking place for several months. The depth and liquidity of the BOVESPA and BSE/NSE in India mean that Indian and Brazilian firms will carry out offerings domestically unless there are compelling reasons to go abroad. The most important of these is the goal of accessing a wider pool of investors, who increase demand and thus the pricing tension for large offerings while also providing greater institutional support in the after-market. “Jumbo” offerings of more than US$3-5 billion in these markets are not the only operations to benefit from twin-track issuance. Some specialty stocks benefit from deep knowledge of their sector in certain international centres. Access for large firms to major global indices, such as the FTSE 100 Index, has been another important driver of going abroad, as have raising foreign capital for global expansion and building profile and reputation among host consumers, particularly for Indian firms. Vedanta Resources, Essar Energy and Tata Steel have all followed this path. Nearly, all new offerings in South Africa will be carried out on the JSE, but for different reasons than in India and Brazil. Government controls prevent all but a handful of companies from going abroad and are unlikely to be relaxed in the near term.

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13.3 Summary This is an article prepared by International financiers and will give students an independent perspective on how Indian companies are tapping international markets for capital. 1. Although Indian companies largely rely on domestic capital market to fulfill jumbo equity offerings, they do approach International Capital Markets. 2. There is rapid growth from 2004 just as India’s economic growth rate started to accelerate. Again in 2008, growth was temporarily dented during the global crisis. 3. Previously, only a handful of Indian firms had tapped overseas capital markets in any size and usually by ADR/GDR issuances in New York and London, typically at around the US$ 100-200 million level. 4. There was increase in domestic Issues also after 2004. 5. Some examples are:


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Wipro

NYSE

2000

Satyam

NYSE

2000

HDFC

NYSE

Dr. Reddy’s Labs

NYSE

ONGC

Domestic

2004

US$2.3 billion

NTPC

Domestic

2004

US$1.1 billion

TCS

Domestic

2004

US$1.2 billion

Infosys

Mumbai + NASDAQ

2005

US$1.1 billion

Rediff.com

NYSE

2005

ICICI Bank

Mumbai + NYSE

2005

US$1.6 billion

Cairn India

Domestic

2006

US$1.9 billion

NYSE

2007

US$2.0 billion

Reliance Power

Domestic

2007

US$2.6 billion

SBI

Domestic

2007-08

US$4.2 billion

NMDC

Domestic

2009-10

US$2.1 billion

NTPC

Domestic

2009-10

US$2.1 billion

NHPC

Domestic

2009-10

US$1.2 billion

NYSE

2010

Sterlite

ONGC Indian Oil Coal India MakeMyTrip

6. By March 2010, there were 1,713 FIIs registered (with 5,378 registered sub-accounts). This expansion greatly helped portfolio flows into India soar from US$ 979 million in FY2003 to US$ 11.3 billion in FY2004 (except for a dip in FY2009). 7. Indian GDRs listed with Luxembourg died sharply after 2007 as more investors got access to the domestic market via FII licences.

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Suzlon

Luxembourg

Tata Motors

Luxembourg

Tata Power

Luxembourg

Tata Steel

London

2007

US$500 million

8. The majority of companies now use the QIP route in India. 9. New York has attracted technology, banks and pharmaceuticals. 10.London has attracted metals, mining and energy companies. 11.Singapore is targeting the Indian market. Singapore has so far not succeeded in attracting a large number of Indian listings. It was keen to win Indian business and could offer regional “clusters” in “marine, offshore and energy, real estate investment trusts (REITs) and property trusts, resources and commodities trading. 12.Outlook for capital raising: Several sectors are expected to generate a large proportion of capital raising in the future: •

Infrastructure. Adani Enterprises (US$ 850 million in July 2010), GMR Infrastructure (US$ 1 billion in 2007), Jaypee Infratech, JSW Energy and Videocon.

•

Mining and energy companies. Vedanta, Sterlite and Essar Energy may encourage other capital hungry and acquisitive companies to come to London and NYSE.

•

Banks and other financial services firms. ICICI Bank, HDFC Bank and Axis Bank have already raised substantial quantities of capital internationally.

•

Technology, internet and renewable energy companies. Typically, firms in these sectors can obtain better valuations overseas because dedicated investor pools exist in London and New York.

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Acquisitive multinationals.

•

REITs. Ascendas and Indiabulls listed India-focussed REITs in Singapore in 2007 and 2008. Other property firms are expected to follow suit. Fortis Healthcare (with a reported planned deal size of US$ 600-700 million), DLF (US$ 1.5 billion), Unitech (US$ 500 million) and Embassy Property Developments (US$ 300-500 million).

13.The Indian exchanges will dominate new listings. 14.The new 25% Rule – required at least 25% of the equity of all listed firms to be made available to the public. 15.Despite the likely dominance of the BSE and NSE in attracting future Indian IPOs and SPOs, many Indian firms believe that the benefits from listing abroad outweigh the greater compliance costs and currency risks than are incurred in domestic listings. •

Higher valuations (and greater analyst coverage) in specialty stocks.

•

Technology stocks on the NYSE and NASDAQ.

•

Valuation arbitrage.

•

Mining, metals and renewable energy in London.

•

Foreign capital for global expansion.

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13.4 Self Assessment Questions 1. How would your describe the current situation for capital raising in international markets for Indian companies? 2. Which are the most desirable markets for Indian companies – sectorwise? 3. Your view – Indian companies can get sufficient capital from India itself. They do not need to tap foreign shores. 


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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CROWD FUNDING

Chapter 14 CROWD FUNDING Objectives After studying this chapter, you should be able to: •

Get a brief overview on Crowd Funding.

•

Learn about different types of Crowd Funding.

•

Learn about various sites to generate Crowd Funding.

•

Get a list of top 50 projects funded by Crowd Funding.

Structure: 14.1 Introduction to Crowd Funding 14.2 Types of Crowd Funding 14.3 Various Sites to Generate Crowd Funding 14.4 List of Top 50 Projects Funded by Crowd Funding 14.5 Summary 14.6 Self Assessment Questions

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14.1 Introduction to Crowd Funding Crowd funding is solicitation of funds (small amount) from multiple investors through a web-based platform or social networking site for a specific project, business venture or social cause. Crowd sourced funding is a means of raising money for a creative project (for instance, music, film, book publication), a benevolent or public interest cause (for instance, a community based social or co-operative initiative) or a business venture, through small financial contributions from persons who may number in the hundreds or thousands. Those contributions are sought through an online crowd funding platform, while the offer may also be promoted through social media.

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14.2 Types of Crowd Funding As per IOSCO Staff Working Paper – Crowd-funding: An Infant Industry Growing Fast, 2014 (‘IOSCO Paper’), Crowd funding can be divided into four categories: donation crowd funding, reward crowd funding, peer-topeer lending and equity crowd funding. 1. Donation Crowd Funding Donation crowd funding denotes solicitation of funds for social, artistic, philanthropic or other purpose, and not in exchange for anything of tangible value. For example, in the US, Kickstarter, Indiegogo etc. are some of the platforms that support donation-based crowd funding.

! 2. Reward Crowd Funding Reward crowd funding refers to solicitation of funds, wherein investors receive some existing or future tangible reward (such as an existing or future consumer product or a membership rewards scheme) as consideration. Most of the websites which support donation crowd funding, also enable reward crowd funding, e.g., Kicktstarter, Rockethub etc. 3. Peer-to-peer lending In Peer-to-peer lending, an online platform matches lenders/investors with borrowers/ issuers in order to provide unsecured loans and the interest rate is set by the platform. Some Peer-to-peer platforms arrange loans between individuals, while other platforms pool funds which are then lent to small- and medium-sized businesses. Some of the leading examples from the US are Lending Club, Prosper etc. and from UK are Zopa, Funding Circle etc.

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A report by the Open Data Institute in July 2013 found that between October 2010 and May 2013, some 49,000 investors in the UK funded peer-to-peer loans worth more than £378 million.

14.3 Various Crowd Funding sites to generate Capital a. Kickstarter Kickstarter is a site where creative projects raise donation-based funding. These projects can range from new creative products, like an art installation, to a cool watch, to pre-selling a music album. It’s not for businesses, causes, charities, or personal financing needs. Kickstarter is one of the earlier platforms, and has experienced strong growth and many break out large campaigns in the last few years. b. Indiegogo While Kickstarter maintains a tighter focus and curates the creative projects approved on its site, Indiegogo approves donation-based fundraising campaigns for most anything — music, hobbyists, personal finance needs, charities and whatever else you could think of (except investment). They have had international growth because of their flexibility, broad approach and their early start in the industry. c. Crowd Funder Crowdfunder.com is the platform for raising investment (not rewards), and has a one of the largest and fastest growing network of investors. It was recently featured on Fox News as the new breed of crowd funding due to the story about a $ 2 billion exit of a crowd funded company. After getting rewards-based funding on Kickstarter or Indiegogo, companies are often giving the crowd the opportunity to invest at Crowd Funder to raise more formal Seed and Series A rounds. Crowd funder offers equity crowd funding currently only from individuals + angels + VCs, and was a leading participant in the JOBS Act legislation. d. RocketHub Rockethub powers donation-based funding for a wide variety of creative projects. What’s unique about RocketHub is their FuelPad and LaunchPad programs that help campaign owners and potential promotion and marketing partners connect and collaborate for the success of a campaign.

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e. Crowdrise Crowdrise is a place for donation-based funding for Causes and Charity. They’ve attracted a community of do-gooders and fund all kinds of inspiring causes and needs. A unique Points System on Crowdrise helps track and reveal how much charitable impact members and organizations are making. f. Somolend Somolend is a site for lending for small businesses in the US, providing debt-based investment funding to qualified businesses with existing operations and revenue. Somolend has partnered with banks to provide loans, as well as helping small business owners bring their friends and family into the effort. With their Midwest roots, a strong founder who was a leading participant in the JOBS Act legislation, and their focus and lead in the local small business market, Somolend has begun expanding into multiple cities and markets in the US. g. Appbackr If you want to build the next new mobile app and are seeking donationbased funding to get things off the ground or growing, then check out appbackr and their niche community for mobile app development. h. AngelList If you’re a tech start-up with a shiny lead investor already signed on, or looking for Silicon Valley momentum, then there are angels and institutions funding investments through AngelList. For a long while AngelList didn’t say that they did crowd funding, which makes sense as they have catered to the investment establishment of VCs in tech startups, but now they’re getting into the game. The accredited investors and institutions on AngelList have been funding a growing number of top tech start-up deals. i. Invested.in You might want to create your own crowd funding community to support donation-based fundraising for a specific group or niche in the market. Invested.in is a Venice, CA based company that is a top name “white label” software provider, giving you the tools to get started and grow your own.

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j. Quirky If you’re an inventor, maker, or tinkerer of some kind, then Quirky is a place to collaborate and crowd fund for donation-based funding with a community of other like-minded folks. Their site digs deeper into helping the process of bringing an invention or product to life, allowing community participation in the process. These 10 crowd funding sites cover most campaign types or funding goals you might have. Whether you’re looking to fundraise or not, go check out the sites here that grab your attention and get involved in this collaborative community. •

How Crowd funding is shaping a new economy.

•

Crowd funding has revitalized the Arts at a time when public programs that support it are steadily dying off.

•

Crowd funding is growing a market for impact investing in social enterprises, marrying the worlds of entrepreneurship and philanthropy, and helping a broader base of investors to back companies for both profits and purpose.

•

Crowd funding is accelerating angel investing and creating an entirely new market for investment crowd funding for businesses.

•

So get involved and join a crowd funding community today. You’ll make a difference for a project or business owner, and also help build a new and more collaborative economy.

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The Coolest Cooler
 – successfully funded by Kickstarter

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14.4 List of highest Crowd Funded Projects (Ref: Wikipedia) This is an incomplete list of the most well-funded crowd funding projects, either successful or not (23-Sep-2014).

Rank

Project

Category

Platform

Campaig n
 end date

1

Star Citizen

Video game

Kickstarter, Independent

Ongoing

2

Ethereum

Protocol & Platform

Bitcoin, Independent

3

Coolest Cooler

Product Design

Kickstarter

4

Ubuntu Edge

5

Campaign
 target

Amount
 raised

$2,000,000

$53,845,242

Sept 2, 2014

--

$18,441,318.4 6

Aug 29, 2014

$50,000

$13,285,226

Smartphone Indiegogo

Aug 21, 2013

$32,000,000

$12,814,196

Pebble (watch)

Smartwatch

Kickstarter

May 18, 2012

$100,000

$10,266,845

6

OUYA

Video game 
 console

Kickstarter

Aug 9, 2012

$950,000

$8,596,474

7

Elite: Video game Dangerous

8

Pono Music

9

Kickstarter, Independent

Ongoing

£ 12,50,000

£ 36,86,327

Digital music player

Kickstarter

Apr 15, 2014

$800,000

$6,225,354

Mayday PAC

Super PAC

Independent

Jul 4, 2014

$6,000,000

$6,132,554

10

WEISSEN HAUS

Real Estate

Companisto

Ongoing

€ 20,00,000

€ 43,00,000

11

Veronica Mars

Movie

Kickstarter

Apr 13, 2013

$2,000,000

$5,702,153

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12

Project Bring Back Reading Rainbow for Every Child, Everywher e

Television

Kickstarter

Jul 2, 2014

$1,000,000

$5,408,916

13

Torment: Tides of Numenera

Video game

Kickstarter, Independent

Apr 5, 2013

$900,000

$4,188,927

14

Mighty No. Video game 9

Kickstarter

Oct 1, 2013

$900,000

$4,046,579

15

Project Eternity

Video game

Kickstarter, Independent

Oct 16, 2012

$1,100,000

$3,986,929

16

Reaper Miniatures Bones

Gaming miniatures

Kickstarter

Aug 25, 2012

$30,000

$3,429,235

17

The Micro

3D Printer

Kickstarter

May 7, 2014

$50,000

$3,401,361

18

The Dash

Headphones Kickstarter

Mar 31, 2014

$260,000

$3,390,551

19

Double Fine Adventure

Video game

Kickstarter

Mar 13, 2012

$400,000

$3,336,371

20

Reaper Gaming Miniatures 
 miniatures Bones II

Kickstarter

Oct 26, 2013

$30,000

$3,169,610

21

Project CARS

Video game

World Of Mass Development

Nov 11, 2012

$3,108,600

$3,142,808

22

Wish I Was Here

Movie

Kickstarter

May 24, 2013

$2,000,000

$3,105,473

23

FORM 1

3D Printer

Kickstarter

Oct 26, 2012

$100,000

$2,945,885

24

Wasteland 2

Video game

Kickstarter

Apr 17, 2012

$900,000

$2,933,252

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SCiO: Your Spectromet Sixth er Sense

Kickstarter

Jun 15, 2014

$200,000

$2,762,571

26

Stone Groundbre aking Collaborati ons

Beer

Indiegogo

Aug 29, 2014

$1,000,000

$2,532,211

27

Homestuc k Adventure Game

Adventure game

Kickstarter

Oct 4, 2012

$700,000

$2,485,506

28

Lazer Team

Movie

Indiegogo

Jul 6, 2014

$650,000

$2,480,209

29

VR headOculus Rift mounted display

Kickstarter

Sep 1, 2012

$250,000

$2,437,429

30

3Doodler

3D printing pen

Kickstarter

Mar 25, 2013

$30,000

$2,344,134

31

Hex: Shards of Fate

Video game

Kickstarter

Jun 7, 2013

$300,000

$2,278,255

32

Gosnell Movie

Movie

Indiegogo

May 12, 2014

$2,100,000

$2,241,043

33

Camelot Unchained

Video game

Kickstarter

May 2, 2013

$2,000,000

$2,232,933

34

Planetary Annihilatio n

Video game

Kickstarter

Sep 14, 2012

$900,000

$2,229,344

35

Solar Roadways

Technology

Indiegogo

Jun 20, 2014

$1,000,000

$2,200,961

36

Shroud of the Avatar: Forsaken Virtues

Video game

Kickstarter, Independent

Apr 7, 2013

$1,000,000

$2,067,246

37

Canary Home Security

Home security

Indiegogo

Aug 26, 2013

$1,000,000

$1,961,464

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38

Blue Mountain State: The Movie

Movie

Kickstarter

May 15, 2014

$1,500,000

$1,911,827

39

Shadowru n Returns

Video game

Kickstarter

Apr 29, 2012

$400,000

$1,836,447

40

Scanadu Scout

Health scan ner

Indiegogo

Jul 20, 2013

$100,000

$1,664,375

41

Warmachi ne: Tactics

Video game

Kickstarter

Aug 10, 2013

$550,000

$1,578,950

42

Dreamfall Chapters: The Longest Journey

Video game

Kickstarter

Mar 10, 2013

$850,000

$1,538,425

43

ARKYD: A Space Telescope for Everyone

Space Telescope

Kickstarter

Jun 30, 2013

$1,000,000

$1,505,366

44

Kreyos

Smartwatch

Indiegogo

Aug 12, 2013

$100,000

$1,504,616

45

Elevation Dock

Design

Kickstarter

Feb 11, 2012

$75,000

$1,464,706

46

Road Hard

Movie

Fund Anything

Aug 2, 2013

$1,000,000

$1,445,889

47

The Buccaneer

3D Printer

Kickstarter

Jun 29, 2013

$100,000

$1,438,765

48

The Newest Hottest Spike Lee Joint

Movie

Kickstarter

Aug 21, 2013

$1,250,000

$1,418,910

49

Petzval Portrait Lens

Photograph y

Kickstarter

Aug 24, 2013

$100,000

$1,396,149

50

Tesla Museum

Museum

Indiegogo

Sep 29, 2012

$850,000

$1,370,461

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14.5 Summary •

Crowd funding is solicitation of funds (small amounts) from multiple investors through a web-based platform or social networking site for specific project, business venture or social cause.

•

There are four basic types of Crowd-funding – Donation, Reward, Peerto-peer and Equity.

•

Various sites to generate Crowd Funding are provided.

•

There is huge amounts of capital collected through crowd funding. Top 50 projects funded by crowd funding is enlisted.

Activities 1. Study the various crowd funding websites? If you were to set up a crowd funding site, what would you need? 2. Do you think that crowd funding is ethical or unethical? Your views? 3. Go to the website www.kickstarter.com and describe features of 3 project success of these projects. 4. Go to the website www.indiegogo.com and describe features of 3 project success of these projects.

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14.6 Self Assessment Questions 1. What is crowd funding? 2. What are various types of crowd funding? 3. Which are the popular crowd funding sites? 4. Study the list of the top 50 projects funded by crowd-funding. Which are the different types of projects funded by crowd funding?


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

Summary PPT MCQ

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SECTION - III - PROJECT IMPLEMENTATION AND REVIEW

SECTION - III PROJECT IMPLEMENTATION AND REVIEW


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PROJECT PLANNING, RISKS AND MANAGEMENT

Chapter 15 PROJECT PLANNING, RISKS AND MANAGEMENT Objectives After studying this chapter, you should be able to: •

Provide a conceptual understanding on Project Planning.

•

Provide a conceptual understanding on Project Risk Management.

•

Learn about Project Management through Work Breakdown Structure.

•

Learn about why some projects fail.

Structure: 15.1 Project Planning 15.2 Project Risk Management 15.3 Project Management through Work Breakdown Structure (WBS) 15.4 Why Projects Fail? 15.5 Summary 15.6 Self Assessment Questions

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15.1 Project Planning The key to a successful project is in the planning. The first thing to do while undertaking any kind of project is to create a Project Plan. Many times, project planning is ignored in favour of getting on with the work. However, many people fail to realize the value of a project plan in saving time, money and many problems. Step 1: Project Goals A project is successful when the needs of the stakeholders have been met. A stakeholder is anybody directly, or indirectly impacted by the project. As a first step, it is important to identify the stakeholders in your project. It is not always easy to identify the stakeholders of a project, particularly those impacted indirectly. Examples of stakeholders are: •

The project sponsor, financier

•

The customer, end-user, dealers, intermediaries

•

The project manager and project team.

Once you understand who the stakeholders are, the next step is to find out their needs. The best way to do this is by conducting stakeholder interviews. Take time during the interviews to draw out the true needs that create real benefits. Needs that aren’t relevant and don’t deliver benefits can be recorded and set as a low priority. The next step, once you have conducted all the interviews, and have a comprehensive list of needs is to prioritize them. From the prioritized list, create a set of goals that can be easily measured. This way it will be easy to know when a goal has been achieved. Once you have established a clear set of goals, they should be recorded in the project plan. It can be useful to also include the needs and expectations of your stakeholders. This is the most difficult part of the planning process completed. It’s time to move on and look at the project deliverables.

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Step 2: Project Deliverables Using the goals you have defined, create a list of things the project needs to deliver in order to meet those goals. Specify when and how each item must be delivered. Add the deliverables to the project plan with an estimated delivery date. More accurate delivery dates will be established during the scheduling phase, which is next. Step 3: Project Schedule Create a list of tasks that need to be carried out for each deliverable identified in Step 2. For each task, identify the following: •

The amount of effort (hours or days) required to complete the task.

•

The resource who will carryout the task.

Once you have established the amount of effort for each task, you can workout the effort required for each deliverable, and an accurate delivery date. Update your deliverables section with the more accurate delivery dates. At this point in the planning, you could choose to use a software package such as Primavera or Microsoft Project (Gantt Charts) to create your project schedule. Alternatively, use one of the many free templates available. Input all of the deliverables, tasks, durations and the resources who will complete each task. A common problem discovered at this point, is when a project has an imposed delivery deadline from the sponsor that is not realistic based on your estimates. If you discover this is the case, you must contact the sponsor immediately. The options you have in this situation are: • • •

Renegotiate the deadline (project delay). Employ additional resources (increased cost). Reduce the scope of the project (less delivered).

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Use the project schedule to justify pursuing one of these options.

! Microsoft Projects and Primavera are two effective software programs designed to implement complex projects.

Step 4: Supporting Plans This section deals with plans you should create as part of the planning process. These can be included directly in the plan. 15.1.1 Human Resource Plan Identify by name, the individuals and organizations with a leading role in the project. For each, describe their roles and responsibilities on the project. Next, describe the number and type of people needed to carryout the project. For each resource detail start dates, estimated duration and the method you will use for obtaining them.

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Create a single sheet containing this information. 15.1.2 Communications Plan Create a document showing who needs to be kept informed about the project and how they will receive the information. The most common mechanism is a weekly or monthly progress report, describing how the project is performing, milestones achieved and work planned for the next period. 15.1.3 Risk Management Plan Risk management is an important part of project management. Although often overlooked, it is important to identify as many risks to your project as possible, and be prepared if something bad happens. Here are some examples of common project risks: •

Time and cost estimates too optimistic.

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Customer review and feedback cycle too slow.

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Lack of resource commitment.

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Unexpected budget cuts.

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Unclear roles and responsibilities.

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Stakeholders input is not sought, or their needs are not properly understood.

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Stakeholders changing requirements after the project has started.

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Stakeholders adding new requirements after the project has started.

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Poor communication resulting in misunderstandings, quality problems and rework.

Risks can be tracked using a simple risk log. Add each risk you have identified to your risk log; write down what you will do in the event it occurs, and what you will do to prevent it from occurring. Review your risk

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log on a regular basis, adding new risks as they occur during the life of the project. Remember, when risks are ignored they don’t go away.

15.2 Project Risk Management Project Risk Management is an important aspect of project management. Project Risk Management is one areas in which a project manager must be competent. Project risk is ‘an uncertain event or condition that, if it occurs, has a positive or negative effect on a project’s objectives’. Good Project Risk Management depends on supporting organizational factors, clear roles and responsibilities, and technical analysis skills. Project risk management in its entirety, includes the following six process groups: 1. 2. 3. 4. 5. 6.

Planning risk management Risk identification Performing qualitative risk analysis Performing quantitative risk analysis Planning risk responses Monitoring and controlling risks.

Project Risk Management is the identification, assessment, and prioritization of risks followed by coordinated and economical application of resources to minimize, monitor, and control the probability and/or impact of unfortunate events or to maximize the realization of opportunities. It will reap great rewards for an organization. If uncertainties in a project are taken care of or removed, it will result in timely completion of projects in the estimated budgets. Also, all threats and firefighting will be removed.

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15.3 Project Management using Work Breakdown Structure (WBS) The Work Breakdown Structure, usually shortened to WBS, is a tool project managers use to break projects down into manageable pieces. It is the start of the planning process and is often called the ‘foundation’ of project planning. Most project professionals recognize the importance and benefits of a WBS in outperforming projects without one. What is a WBS? A WBS is a hierarchical decomposition of the deliverables needed to complete a project. It breaks the deliverables down into manageable work packages that can be scheduled, costed and have resources assigned to them. As a rule, the lowest level should be two-week work packages. Another rule commonly used when creating a WBS is the 8/80 rule. This says no single activity should be less than 8 hours, or greater than 80 hours. A WBS is deliverables based; meaning the product or service the customer will get when the project is finished. There is another tool called a Product Breakdown Structure (PBS), which comes before the WBS and breaks a project down into outputs (products) needed to complete the project. Why Create a WBS? These are some of the benefits of a WBS: • • • • • • •

Provides a solid foundation for planning and scheduling. Breaks down projects into manageable work packages. Provides a way to estimate project costs accurately. Makes sure no important deliverables are forgotten. Helps project managers with resource allocation. Provides a proven and repeatable approach to planning projects. Provides an ideal tool for team brainstorming and for promoting team cohesion.

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WBS Inputs There are three inputs to the WBS process: 1. Project Scope Statement: Detailed description of the project’s deliverables and work needed to create them. 2. Statement of Requirements: Document detailing the business need for the project and what will be delivered in detail. 3. Organizational Process Assets: The organization’s policies, procedures, guidelines, templates, plans, lessons learned, etc. These items give you and your team all the information needed to create the WBS. You’ll also need a WBS template. WBS Outputs There are four outputs from the WBS process: 1. W o r k B r e a k d o w n S t r u c t u r e ( W B S ) : D e l i v e ra b l e s b a s e d decomposition of the total project scope. 2. WBS Dictionary: Accompanying document describing each WBS element. 3. Scope Baseline: The Project Scope Statement, WBS and WBS Dictionary. 4. Project Documentation Updates: Changes and additions to project documentation.

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How to Create a WBS? A WBS is easy to create. Once the aims and objectives of the project are understood, a meeting can be arranged where the project team breaks down the deliverables needed to complete the project. Creation is best done as a team exercise. This helps engage your team and gives them an emotional stake in the project. It’s a good idea to involve your stakeholders at this point. There are two formats in which the WBS can be expressed, tabular form and graphical form. The tabular form can be created in a spreadsheet; numbering each level and sub-level. The graphical form can be created using drawing software, creating a tree style diagram. Either form starts with the project name as its first level. Then all the top-level deliverables are added. Remember, at the second level, you are looking to identify everything needed to complete the project. Break down each second level deliverable until you reach work packages of no less than two weeks. As a general rule, two-week work packages are manageable. You might also consider the 8/80 rule at this point. It is up to the team how each item is broken down; there are no rules that define this, and it will reflect the style of the team creating the WBS. It’s important to note that activities and tasks are not included in a WBS, these are planned out from the work packages later. Check no major areas or deliverables have been missed, and you’ve only included the work needed to complete your project successfully. Your WBS should contain the complete project scope, including the project management work packages. Conducting the WBS creation as a team exercise helps make sure nothing is forgotten. This level of decomposition makes it easy to cost each work package and arrive at an accurate cost for the project. Similarly, people can be assigned to the work packages; however, you may prefer to add the skills needed for the work packages and leave the people allocation until you create your schedule, when you can see the timeline. The next step is to transfer your WBS output into a project schedule, typically a Gantt chart. Expand the work packages with the activities and tasks needed to complete them. The Gantt chart is used to track progress across time of the work packages identified in your WBS.

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15.4 Why Projects Fail? In a perfect world, every project would be “on time and within budget.” But reality (especially the proven statistics) tells a very different story. It is not uncommon for projects to fail. Even if the budget and schedule are met, one must ask “did the project deliver the results and quality we expected?” True project success must be evaluated on all three components. Otherwise, a project could be considered a “failure.” Have you ever seen a situation where projects begin to show signs of disorganization, appear out of control, and have a sense of doom and failure? Have you witnessed settings where everyone works in a silo and no one seems to know what the other team member is doing? What about team members who live by the creed “I’ll do my part (as I see fit) and after that, it’s their problem.” Even worse is when team members resort to finger-pointing. Situations similar to these scenarios point to a sign that reads “danger.” And if you read the fine print under the word “danger” it reads, “your project needs to be brought under control or else it could fail.” When projects begin to show signs of stress and failure, everyone looks to the project manager for answers. It may seem unfair that the burden of doom falls upon a single individual. But this is the reason why you chose to manage projects for a living! You’ve been trained to recognize and deal with these types of situations. There are many reasons why projects (both simple and complex) fail; the number of reasons can be infinite. However, if we apply the 80/20 rule, the most common reasons for failure can be found in the following list:


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1. Undefined objectives and goals 2. Poorly managed 3. Lack of management commitment 4. Lack of a solid project plan 5. Lack of user input 6. Lack of organizational support 7. Centralized proactive management initiatives to combat project risk 8. Enterprise management of budget resources 9. Provides universal templates and documentation 10.Poorly defined roles and responsibilities 11.Inadequate or vague requirements 12.Stakeholder conflict 13.Team weaknesses 14.Unrealistic timeframes and tasks 15.Competing priorities 16.Poor communication 17.Insufficient resources (funding and personnel) 18.Business politics 19.Overruns of schedule and cost 20.Estimates for cost and schedule are erroneous 21.Lack of prioritization and project portfolio management 22.Scope creep 23.No change control process 24.Meeting end-user expectations 25.Ignoring project warning signs 26.Inadequate testing processes 27.Bad decisions Even with the best of intentions or solid plans, project can go awry if they are not managed properly. All too often, mishaps can occur. This is when the project manager must recognize a warning sign and take action. If you understand the difference between symptoms and problems and can spot warning signs of project failure, it will help you take steps to right the ship before it keels over. Yes, it’s the project manager’s responsibility to correct the listing no one else. In addition to applying the processes and principles taught in project management class, you can also use your personal work skills of communication, management, leadership, conflict resolution, and diplomacy to take corrective action.

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During the course of managing a project, the project manager must monitor activities (and distractions) from many sources and directions. Complacency can easily set in. When this happens, the process of “monitoring” breaks down. This is why the project manager must remain in control of a project and be aware of any activity which presents a risk of project failure.

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15.5 Summary •

Project Planning in the most important step in Project and if done properly done, can save time, money and many problems. The Plan should include Project Goals, Deliverables, Schedules and Supporting Plans.

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Project Risk Management involves steps such as Risk identification, Performing qualitative risk analysis, Performing quantitative risk analysis, Planning risk responses and Monitoring and controlling risks.

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The need for an emphasis on planning is what separates project management from general management. The WBS is the first step in producing a quality project plan and setting you and your team on the road to success. Neglecting this process in favour of getting on with the work has been the downfall of many projects. Improve your chances of success by always producing a WBS for your projects.

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Projects fail for a variety of reasons mainly being Undefined objectives and goals, Poor management, Lack of management commitment and Lack of a solid project plan.

15.6 Self Assessment Questions 1. What is Project Planning? What are the aspects of Project Planning? What is their importance? 2. What is Project Risk Management? What is their importance? 3. What is Work Breakdown Structure? What is its importance? 4. Why do Projects fail?

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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

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Chapter 16 PROJECT QUALITY ASSURANCE AND AUDIT Objectives. After studying this chapter, you should be able to: •

Get a brief overview on Project Quality Assurance.

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Learn about steps to Project Audit.

Structure: 16.1 Project Quality Assurance 16.2 Project Audit 16.3 Summary 16.4 Self Assessment Questions

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16.1 Project Quality Management The Quality Management Plan defines the acceptable level of quality, which is typically defined by the customer, and describes how the project will ensure this level of quality in its deliverables and work processes. Quality management activities ensure that: •

Products are built to meet agreed-upon standards and requirements.

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Work processes are performed efficiently and as documented.

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Non-conformances found are identified and appropriate corrective action is taken.

Quality Management plans apply to project deliverables and project work processes. Quality control activities monitor and verify that project deliverables meet defined quality standards. Quality assurance activities monitor and verify that the processes used to manage and create the deliverables are followed and are effective. 16.1.1 Quality Plan Components The Quality Management Plan describes the following quality management components: 1. Quality objectives 2. Key project deliverables and processes to be reviewed for satisfactory quality level 3. Quality standards 4. Quality control and assurance activities 5. Quality roles and responsibilities 6. Quality tools 7. Plan for reporting quality control and assurance problems 16.1.2 Rationale/Purpose The purpose of developing a quality plan is to elicit the customer’s expectations in terms of quality and prepare a proactive quality management plan to meet those expectations. The Quality Management Plan helps the project manager determine if deliverables are being produced to an acceptable quality level and if the

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project processes used to manage and create the deliverables are effective and properly applied. 16.1.3 Who is Involved? 1. Project Manager 2. Project Team 3. Customer 4. Project Sponsor

16.2 Project Audit A Project Audit involves comparing actual results with predicted results and explaining the differences, if any. The post-audit serves three purposes: 1. Improvement of forecasts 2. Improvement in operations 3. Identification of termination opportunities. It provides an opportunity to uncover issues, concerns and challenges encountered during the project life cycle. Conducted midway through the project, an audit affords the project manager, project sponsor and project team an interim view of what has gone well, as well as what needs to be improved to successfully complete the project. If done at the close of a project, the audit can be used to develop success criteria for future projects by providing a forensic review. This review identifies which elements of the project were successfully managed and which ones presented challenges. As a result, the review will help the organization identify what it needs to do to avoid repeating the same mistakes on future projects. Regardless of whether the project audit is conducted mid-term on a project or at its conclusion, the process is similar. It is generally recommended that an outside facilitator conduct the project audit. This ensures confidentiality, but also allows the team members and other stakeholders to be candid. They know that their input will be valued and the final report will not identify individual names, only facts. Often, individuals involved in a poorly managed project will find that speaking with an outside facilitator

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during a project audit allows them to openly express their emotions and feelings about their involvement in the project and/or the impact the project has had on them. This “venting” is an important part of the overall audit. A successful project audit consists of three phases: 1. Success Criteria, Questionnaire, and Audit Interview Development. 2. In-depth Research. 3. Report Development. Phase 1: Success Criteria, Questionnaire and Audit Interview Development 1. Success Criteria Development Interview the core project sponsor and project manager to determine their “success criteria” for the project audit and find out what they expect to gain from the audit. This ensures that their individual and collective needs are met. 2. Questionnaire Development Develop a questionnaire to be sent to each member of the core project team and to selected stakeholders. Often, individuals will complete the questionnaire in advance of an interview because it helps them to gather and focus their thoughts. The actual interview will give the facilitator the opportunity to gain deeper insights into the team member’s comments. The questionnaire simply serves as a catalyst for helping team members and stakeholders reflect on the project’s successes, failures, challenges and missed opportunities. 3. Audit Interview Questions There are many questions that can be asked in an audit interview. It is most effective, however, to develop open-ended questions, i.e., questions that cannot be answered with a simple “yes” or “no.” Develop interview questions that will help identify the major project successes; the major project issues, concerns and challenges; how the team worked together; how vendors were managed; how reporting and meetings were handled; how risk and change were managed, etc. Questionnaires can be used for team members and/or other stakeholders who are unable to attend an interview.

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Phase 2: In-depth Research 1. Conduct individual research interviews with the project sponsor, project manager and project team members to identify past, current and future issues, concerns, challenges and opportunities. 2. Conduct individual research interviews with stakeholders, including vendors, suppliers, contractors, other internal and external project resources and selected customers. 3. Assess the issues, challenges and concerns in more depth to discover the root causes of any problems. 4. Review all historical and current documentation related to the project, including team structure, scope statement, business requirements, project plan, milestone reports, meeting minutes, action items, risk logs, issue logs and change logs. 5. Review the project plan to determine how the vendor plan has been incorporated into the overall project plan. 6. Interview selected stakeholders to identify and determine their initial expectations for the project and determine to what extent their expectations have been met. 7. Review the project quality management and the product quality management to identify issues, concerns and challenges in the overall management of the project. Identify any opportunities that can be realized through improvements to the attention of project and product quality. 8. Identify any lessons learned that could improve the performance of future projects within the organization.

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Phase 3: Report Development 1. Compile the information collected from all of the interviews. 2. Compile the information collected from individuals who only completed the questionnaire. 3. Consolidate the findings from the project documentation review. 4. Identify the issues, concerns and challenges presented through the review of the project quality management and product quality management plans and isolate the opportunities you believe may be realized. 5. Identify all of the project’s issues, concerns and challenges. 6. Identify all of the project’s opportunities that can be realized through the report’s recommendations. 7. Identify the lessons learned that can improve the performance of future projects within the organization. 8. Finalize the creation of the report and recommendations based on the findings and present the detailed report and recommendations, including a road map to get future projects to the “next level” of performance.

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16.2.1 Conclusion The purpose of a project audit is to identify lessons learned that can help improve the performance of a project or improve the performance of future projects by undertaking a forensic review to uncover problems to be avoided. In this way, project audits are highly beneficial to the organization and provide the following outcomes: •

Development of lessons learned on the project that can be applied to both the organization and its vendors.

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Development of strategies which, if implemented within the organization, will increase the likelihood of future projects being managed successfully.

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Development of strategies which, if implemented within the organization, will increase the likelihood of change initiatives being managed successfully.

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Development of project success criteria which might include on-time, onbudget, meeting customer and other stakeholder requirements, transition to next phase successfully executed, etc.

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Recognition of risk management so that risk assessment and the development of associated contingency plans becomes commonplace within the organization.

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Development of change management success criteria which might include how staff are involved, how customers are impacted, how the organization is impacted, transition to next level of change to be initiated, etc.

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Development of criteria that will continue the improvement of relationships between the organization and its vendors, suppliers and contractors regarding the management of projects.

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Application of the lessons learned on the project to future projects within the organization.

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16.3 Summary •

Project Quality Management defines the acceptable level of quality, which is typically defined by the customer, and describes how the project will ensure this level of quality in its deliverables and work processes.

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A Project Audit involves comparing actual results with predicted results and explaining the differences, if any. It serves three purposes – Improvement of forecasts, Improvement in operations and Identification of termination opportunities.

16.4 Self Assessment Questions 1. What is Project Quality Management? Explain in detail. 2. What is meant by Project Audit? What is its relevance?


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REFERENCE MATERIAL Click on the links below to view additional reference material for this chapter

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