advanced financial management as per syllabus

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PAPER III -5.ADVANCED FINANCIAL MANAGEMENT

Unit – 1

An overview of Corporate Financing Patterns of Corporate Financing in

India.

Overview of Pattern of Corporate Financing in India

The pattern of corporate financing in India has been different throughout its economic history.The outline of corporate financing in India has been determined by the economic rules andregulations that operate at different points of time.

Pattern of Corporate Financing in India from 1960 to 1990

During the 30-year period in Indian economy ranging from 1960 to 1990 the stress of Indianeconomy was on public finance. There were a lot of rules and regulations regarding variouseconomic issues like rates of interest and many more.

During the middle part of the decade of 80s there was some change in the Indian economicscenario.The performance of the capital markets in India improved.

Pattern of Corporate Financing in India from 1990 onwards

After 1992 a lot of reforms have been made in the capital markets of India. The performance of the stock markets of India was remarkable in the 1990s. This was keeping with the healthy state

of the Indian economy in and around that time.

All this altered the trend of corporate financing in India. The dependency on banks for loans or other financial assistance reduced to a significant extent. The equity capital that was gained fromthe capital markets came up as a suitable alternative for them.

The Gross Domestic Product of India rose steadily in this period. The Gross Domestic Productwent up by about 4.3% in 1992-93. The Gross Domestic Product of India again increased byalmost 2% in the year 1995-96. The growth rate of the Gross Domestic Product of India has beenimpressive in the recent years.

Role of Banking Sector in Pattern of Corporate Financing in India

The banking sector of India has played an important role in the context of the development of Indian economy. The banks of India have been doing well with the distribution of funds andmonetary resources for the purpose of the development of India's economy.



Equity versus Debt –

Debt vs. equity financing is one of the most important decisions facing managers who needcapital to fund their business operations. Debt and equity are the two main sources of capitalavailable to businesses, and each offers both advantages and disadvantages. "Absolutely nothing

is more important to a new business than raising capital," Steve Jefferson wrote in Pacific Business News (Jefferson, 2001). "But the way that money is raised can have an enormousimpact on the success of a business."

DEBT FINANCING

Debt financing takes the form of loans that must be repaid over time, usually with interest.Businesses can borrow money over the short term (less than one year) or long term (more thanone year). The main sources of debt financing are banks and government agencies, such as theSmall Business Administration (SBA). Debt financing offers businesses a tax advantage, becausethe interest paid on loans is generally deductible. Borrowing also limits the business's future

obligation of repayment of the loan, because the lender does not receive an ownership share inthe business.

However, debt financing also has its disadvantages. New businesses sometimes find it difficult tomake regular loan payments when they have irregular cash flow. In this way, debt financing canleave businesses vulnerable to economic downturns or interest rate hikes. Carrying too muchdebt is a problem because it increases the perceived risk associated with businesses, makingthem unattractive to investors and thus reducing their ability to raise additional capital in thefuture.

EQUITY FINANCING

Equity financing takes the form of money obtained from investors in exchange for an ownershipshare in the business. Such funds may come from friends and family members of the businessowner, wealthy "angel" investors, or venture capital firms. The main advantage to equityfinancing is that the business is not obligated to repay the money. Instead, the investors hope toreclaim their investment out of future profits. The involvement of high-profile investors may alsohelp increase the credibility of a new business.

The main disadvantage to equity financing is that the investors become part-owners of the business, and thus gain a say in business decisions. "Equity investors are looking for a partner aswell as an investment, or else they would be lenders," venture capitalist Bill Richardsonexplained in Pacific Business News (Jefferson, 2001). As ownership interests become diluted,managers face a possible loss of autonomy or control. In addition, an excessive reliance onequity financing may indicate that a business is not using its capital in the most productivemanner.

Both debt and equity financing are important ways for businesses to obtain capital to fund their operations. Deciding which to use or emphasize, depends on the long-term goals of the business



and the amount of control managers wish to maintain. Ideally, experts suggest that businessesuse both debt and equity financing in a commercially acceptable ratio. This ratio, known as thedebt-to-equity ratio, is a key factor analysts use to determine whether managers are running a business in a sensible manner. Although debt-to-equity ratios vary greatly by industry andcompany, a general rule of thumb holds that a reasonable ratio should fall between 1:1 and 1:2.

Some experts recommend that companies rely more heavily on equity financing during the earlystages of their existence, because such businesses may find it difficult to service debt until theyachieve reliable cash flow. But start-up companies may have trouble attracting venture capitaluntil they demonstrate strong profit potential. In any case, all businesses require sufficient capitalin order to succeed. The most prudent course of action is to obtain capital from a variety of sources, using both debt and equity, and hire professional accountants and attorneys to assistwith financial decisions.

Factors influencing Capital Structure –

Meaning of Capital Structure

Capital Structure is referred to as the ratio of different kinds of securities raised by a firm aslong-term finance. The capital structure involves two decisions-

a. Type of securities to be issued are equity shares, preference shares and longterm borrowings( Debentures).

b. Relative ratio of securities can be determined by process of capital gearing.On this basis, the companies are divided into two-

i. Highly geared companies- Those companies whose proportion of

equity capitalization is small.

ii. Low geared companies- Those companies whose equity capitaldominates total capitalization.

For instance - There are two companies A and B. Total capitalization amounts to be Rs.20 lakh in each case. The ratio of equity capital to total capitalization in company A isRs. 5 lakh, while in company B, ratio of equity capital is Rs. 15 lakh to totalcapitalization, i.e, in Company A, proportion is 25% and in company B, proportion is75%. In such cases, company A is considered to be a highly geared company andcompany B is low geared company.

Factors Determining Capital Structure

1. Trading on Equity- The word “equity” denotes the ownership of thecompany. Trading on equity means taking advantage of equity share capitalto borrowed funds on reasonable basis. It refers to additional profits thatequity shareholders earn because of issuance of debentures and preferenceshares. It is based on the thought that if the rate of dividend on preferencecapital and the rate of interest on borrowed capital is lower than the general



rate of company’s earnings, equity shareholders are at advantage whichmeans a company should go for a judicious blend of preference shares,equity shares as well as debentures. Trading on equity becomes moreimportant when expectations of shareholders are high.

2. Degree of control- In a company, it is the directors who are so calledelected representatives of equity shareholders. These members have got

maximum voting rights in a concern as compared to the preferenceshareholders and debenture holders. Preference shareholders havereasonably less voting rights while debenture holders have no voting rights. If the company’s management policies are such that they want to retain theirvoting rights in their hands, the capital structure consists of debentureholders and loans rather than equity shares.

3. Flexibility of financial plan- In an enterprise, the capital structure shouldbe such that there is both contractions as well as relaxation in plans.Debentures and loans can be refunded back as the time requires. Whileequity capital cannot be refunded at any point which provides rigidity toplans. Therefore, in order to make the capital structure possible, the

company should go for issue of debentures and other loans.

4. Choice of investors- The company’s policy generally is to have differentcategories of investors for securities. Therefore, a capital structure shouldgive enough choice to all kind of investors to invest. Bold and adventurousinvestors generally go for equity shares and loans and debentures aregenerally raised keeping into mind conscious investors.

5. Capital market condition- In the lifetime of the company, the market priceof the shares has got an important influence. During the depression period,the company’s capital structure generally consists of debentures and loans.While in period of boons and inflation, the company’s capital should consist of

share capital generally equity shares.

6. Period of financing- When company wants to raise finance for short period,it goes for loans from banks and other institutions; while for long period itgoes for issue of shares and debentures.

7. Cost of financing- In a capital structure, the company has to look to thefactor of cost when securities are raised. It is seen that debentures at thetime of profit earning of company prove to be a cheaper source of finance ascompared to equity shares where equity shareholders demand an extra sharein profits.

8. Stability of sales- An established business which has a growing market and

high sales turnover, the company is in position to meet fixed commitments.Interest on debentures has to be paid regardless of profit. Therefore, whensales are high, thereby the profits are high and company is in better positionto meet such fixed commitments like interest on debentures and dividendson preference shares. If company is having unstable sales, then the companyis not in position to meet fixed obligations. So, equity capital proves to besafe in such cases.



9. Sizes of a company- Small size business firms capital structure generallyconsists of loans from banks and retained profits. While on the other hand,big companies having goodwill, stability and an established profit can easilygo for issuance of shares and debentures as well as loans and borrowingsfrom financial institutions. The bigger the size, the wider is totalcapitalization.

Importance of Capital Structure – Capital Structure Planning :

Capital structure planning is very important to survive the business in long run. After simple

watching the balance sheet of company, you see two sides of balance sheet. One side is liability

side and other side is asset side. Liability side is the mixture of finance of company which

company has collected from internal and external sources and it has been used or will be used for development of company.

Liability side of balance sheet is made under perfect capital structure planning. Finance

manager and other promoters decides which source of fund or funds should be selected after

monitoring the factors affecting capital structures. So, capital structure planning makes

strong balance sheet. The right capital structure planning also increases the power of company to

face the losses and changes in financial markets. Following points shows the importance of

capital structure and its planning.

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1. To reduce the overall risk of company

When we make capital structure before actual getting money from money supplier, we can do

many adjustments for reducing our overall risk. Suppose, we have made capital structure inwhich we add three sources of fund, one is equity share, and other is debenture and last is pref.shares. Because we know that we have to pay debt at its maturity at any cost and its interest atfixed rate. So, we try to get minimum debt in new business because in new business our rate of return will be less than rate of interest and for getting more loan means taking high risk of returnmore amount of interest even there is no profit.

But, if our business will be succeeded, at that time, we can increase estimated amount of debt by just changing the value of debt in capital structure (written just for planning) in excel sheet. Wecan easily pay the interest because our ROI is very high. At that, time company can enjoy thetrading on equity. But finance manager should also careful watch whether shareholders are

more expected regarding dividend or not. Because high expectation will also against thedevelopment of our company.

2. To do adjustment according to Business Environment

Company also adjusts different sources expected amount according to business environment.Suppose in future, if government of India cuts off his relation with China, from where our company is getting fund, it will definitely tough for us to get more money from China. But proper planning of capital structure of future sources will be helpful for us to enlarge our area for getting money. In finance, it is called maneuverability. It means to create mobility of sources of fund by including maximum alternatives in planned capital structure. Suppose, if RBI increasesthe interest rate, it means your cost for getting debt will be high, at that time, you can choose anyother cheap source of fund.

3. Idea generation of new source of fund

Good planning of capital structure will make versatile to finance manager for getting moneyfrom new sources. If you have studied Wikipedia’s page of venture capital or private equity sources, you would precisely understand that how finance managers of company are generatingnew and new idea for getting money from public at low risk . Promoters or managers do 10minutes meeting with investors and motivate them by showing the special event which they havemade in PPT

Theories of Capital Structure – 1st Theory of Capital Structure

Name of Theory = Net Income Theory of Capital Structure

This theory gives the idea for increasing market value of firm and decreasing overallcost of capital. A firm can choose a degree of capital structure in which debt is morethan equity share capital. It will be helpful to increase the market value of firm and

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decrease the value of overall cost of capital. Debt is cheap source of financebecause its interest is deductible from net profit before taxes. After deduction of interest company has to pay less tax and thus, it will decrease the weightedaverage cost of capital.

For example if you have equity debt mix is 50:50 but if you increase it as 20: 80, it

will increase the market value of firm and its positive effect on the value of pershare.

High debt content mixture of equity debt mix ratio is also called financial leverage.Increasing of financial leverage will be helpful to for maximize the firm's value.

2nd Theory of Capital Structure

Name of Theory = Net Operating income Theory of Capital Structure

Net operating income theory or approach does not accept the idea of increasing the

financial leverage under NI approach. It means to change the capital structure doesnot affect overall cost of capital and market value of firm. At each and every level of capital structure, market value of firm will be same.

3rd Theory of Capital Structure

Name of Theory = Traditional Theory of Capital Structure

This theory or approach of capital structure is mix of net income approach and netoperating income approach of capital structure. It has three stages which youshould understand:

Ist Stage

In the first stage which is also initial stage, company should increase debt contentsin its equity debt mix for increasing the market value of firm.

2nd Stage

In second stage, after increasing debt in equity debt mix, company gets the positionof optimum capital structure, where weighted cost of capital is minimum andmarket value of firm is maximum. So, no need to further increase in debt in capitalstructure.

3rd Stage

Company can gets loss in its market value because increasing the amount of debt incapital structure after its optimum level will definitely increase the cost of debt andoverall cost of capital.

4th Theory of Capital Structure

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Name of theory = Modigliani and Miller

MM theory or approach is fully opposite of traditional approach. This approach saysthat there is not any relationship between capital structure and cost of capital.

There will not effect of increasing debt on cost of capital.

Value of firm and cost of capital is fully affected from investor's expectations.Investors' expectations may be further affected by large numbers of other factorswhich have been ignored by traditional theorem of capital structure.

Role of EBIT-

Definition of 'Earnings Before Interest & Tax - EBIT'

An indicator of a company's profitability, calculated as revenue minus expenses,

excluding tax and interest. EBIT is also referred to as "operating earnings","operating profit" and "operating income", as you can re-arrange the formula to be

calculated as follows:

EBIT

=

Revenue - Operating

Expenses

Also known as Profit Before Interest & Taxes (PBIT), and equals Net Income with

interest and taxes added back to it.

Investopedia explains 'Earnings Before Interest & Tax -EBIT'

In other words, EBIT is all profits before taking into account interest payments andincome taxes. An important factor contributing to the widespread use of EBIT is theway in which it nulls the effects of the different capital structures and tax rates usedby different companies. By excluding both taxes and interest expenses, the figurehones in on the company's ability to profit and thus makes for easier cross-companycomparisons.

EBIT was the precursor to the EBITDA calculation, which takes the process furtherby removing two non-cash items from the equation (depreciation and amortization).

EPS Analysis –

Definition of 'Earnings Per Share - EPS'

The portion of a company's profit allocated to each outstanding share of common stock. Earnings per share serves as an indicator of a company's profitability.



Calculated as:

When calculating, it is more accurate to use a weighted average number of shares

outstanding over the reporting term, because the number of shares outstanding can

change over time. However, data sources sometimes simplify the calculation by

using the number of shares outstanding at the end of the period.

Diluted EPS expands on basic EPS by including the shares of convertibles or

warrants outstanding in the outstanding shares number.

Investopedia explains 'Earnings Per Share - EPS'Earnings per share is generally considered to be the single most important variable

in determining a share's price. It is also a major component used to calculate the

price-to-earnings valuation ratio.

For example, assume that a company has a net income of $25 million. If the

company pays out $1 million in preferred dividends and has 10 million shares

for half of the year and 15 million shares for the other half, the EPS would be $1.92

(24/12.5). First, the $1 million is deducted from the net income to get $24 million,

then a weighted average is taken to find the number of shares outstanding (0.5 x

10M+ 0.5 x 15M = 12.5M).

An important aspect of EPS that's often ignored is the capital that is required to

generate the earnings (net income) in the calculation. Two companies could

generate the same EPS number, but one could do so with less equity (investment) -

that company would be more efficient at using its capital to generate income and,

all other things being equal, would be a "better" company. Investors also need to be

aware of earnings manipulation that will affect the quality of the earnings number.

It is important not to rely on any one financial measure, but to use it in conjunction

with statement analysis and other measures.

Cost of Capital –

Capital is the term used by firms for funds needed for investment

purposes, i.e., capital equipment

(not for day to day operating needs)



This capital carries a cost because each source of capital funding costs

money to raise (i.e., issuing stock costs a lot of money)

Definition of 'Cost Of Capital'

The required return necessary to make a capital budgeting project, such as buildinga new factory, worthwhile. Cost of capital includes the cost of debt and the cost of

equity.

The cost of capital determines how a company can raise money (through a stock

issue, borrowing, or a mix of the two). This is the rate of return that a firm would

receive if it invested in a different vehicle with similar risk.

Sources of Capital

Borrowing: issue Bonds, bank loans,

Issuing Preferred stock

Issuing Common stock

Net Income (earnings)

Each of these sources carries a different cost based on the required rate of

return of each provider (source) of these funds

Computation of Cost of Capital for each source of Finance -

Learning Goals

Determining the value of K, the required rate of return for an investor

Sources of capital funding (Debt, Equity)

Cost of each type of funding

Calculation of the weighted average cost of capital funding (WACC) = K

Construction and use of the marginal cost of capital schedule (MCC) fordecision making

Weighted Average cost of capital.

Definition of 'Weighted Average Cost Of Capital - WACC'

A calculation of a firm's cost of capital in which each category of capital is

proportionately weighted. All capital sources - common stock, preferred stock,

bonds and any other long-term debt - are included in a WACC calculation. All else

equal, the WACC of a firm increases as the beta and rate of return on equity

increases, as an increase in WACC notes a decrease in valuation and a higher risk.



The WACC equation is the cost of each capital component multiplied by its

proportional weight and then summing:

Where:

Re = cost of equity

Rd = cost of debt

E = market value of the firm's equity

D = market value of the firm's debt

V = E + D

E/V = percentage of financing that is equity

D/V = percentage of financing that is debt

Tc = corporate tax rate

Businesses often discount cash flows at WACC to determine the Net Present Value

(NPV) of a project, using the formula:

NPV = Present Value (PV) of the Cash Flows discounted at WACC.

Investopedia explains 'Weighted Average Cost Of Capital -

WACC'

Broadly speaking, a company’s assets are financed by either debt or equity. WACC

is the average of the costs of these sources of financing, each of which is weighted

by its respective use in the given situation. By taking a weighted average, we can

see how much interest the company has to pay for every dollar it finances.

A firm's WACC is the overall required return on the firm as a whole and, as such, it is

often used internally by company directors to determine the economic feasibility of

expansionary opportunities and mergers. It is the appropriate discount rate to use

for cash flows with risk that is similar to that of the overall firm.

Tricks of the Trade

• To accurately calculate WACC, you need to know the specific rates of return required for

each source of capital. For example, different sources of finance may attract differentlevels of taxation, or interest, which should be accounted for. A true WACC calculationcould therefore be much more complex than the example provided here.

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• Critics of WACC argue that financial analysts rely on it too heavily, and that the

algorithm should not be used to assess risky projects, where the cost of capital willnecessarily be higher to reflect the higher risk.

• Investors use WACC to help decide whether a company represents a good investment

opportunity. To some extent, WACC represents the rate at which a company producesvalue for investors—if a company produces a return of 20% and has a WACC of 11%,then the company creates 9% additional value for investors. If the return is lower than theWACC, the business is unlikely to secure investment.

• Although the WACC formula seems simple, different analysts will often come up with

different WACC calculations for the same company depending on how they interpret thecompany’s debt, market value, and interest rates.

Unit - 2

Valuation of Bonds and Shares :

Basic Valuation Model –

Valuation of Bonds -

Valuation of Equity Shares: Parameters in the Dividend Discount Model -

Dividend

Growth Model and the NPVGO Model - P/E Ratio Approach – Book Value

Approach.

Unit - 3

Components of Working Capital Working Capital –

What is working capital?

Working capital is the money needed to fund the normal, day to day operations of your business. It ensures you have enough cash to pay your debts and expenses asthey fall due, particularly during your start-up period.Very few new businesses are profitable as soon as they open their doors. It takes

time to reach your breakeven point and start making a profit. The working capital cycle

The working capital cycle measures the time between paying for goods supplied toyou and the final receipt of cash to you from their sale. It is desirable to keep thecycle as short as possible as it increases the effectiveness of working capital.The working capital cycle is made up of four core components:

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Cash (funds available)Creditors (accounts payable)Inventory (stock on hand)Debtors (accounts payable)

Diagram of the working capital cycle The key to successful cash management is to be in control of each step in thecycle. If you can quickly convert your trading operations into available cash, youwill be increasing the liquidity in your business and will be less reliant on cashfrom customers, extended terms from suppliers, overdrafts, and loans. What's the right level of working capital?

The right level of working capital depends on the industry and the particular circumstances of the business.For example: Businesses that only sell services, and do not need to pay cash for inventory need a lower level of working capital. Businesses that take asubstantial amount of time to make of sell a product will need a higher level of working capital.It is important you work out the right level of working capital you will need. If theworking capital is too:

high - your business has surplus funds which are not earning a return; andlow - may indicate that your business is facing financial difficulties.

The formula used to calculate working capital for your business is:(NOTE: You will need figures from your most recent balance sheet)

working capital ($ value) = current assets - current liabilities

This calculation will not give you a sense of whether your working capital safety

margin is wide enough. The working capital ratio (current ratio/liquidity ratio) willgive you a better measure of liquidity. Working capital as a percentage of salesMost business owners have a clear idea of their weekly, monthly, or quarterlysales levels, so you may prefer to calculate how much working capital you need asa percentage of sales.



The formula used to calculate an estimate of working capital as a percentage of sales for your business is: (NOTE: You will need figures from your most recent

balance sheet and profit and loss statement)

Working capital = (Inventory + accounts receivable - accounts payable)as a % of sales Sales x 100

and:

Working capital ($ value) = sales x (working capital as a % of sales)

For example: Working capital as a percentage of sales of 35% means that you need$35 for every $100 of sales to fund the sale to allow for the time delay in theworking capital cycle.

This method is useful for businesses going through a period of growth andexpansion to work out how much extra working capital you need if turnover increased by a certain amount.

Policies Liquidity –

Profitability

Linkages –

Factors determining Working Capital –

FACTORS DETERMINING WORKING CAPITAL

REQUIREMENT

The working capital needs of a firm are determined and influenced by variousfactors. A wide variety of considerations may affect the quantum of working capitalrequired and these considerations may vary from time to time. The working capitalneeded at one point of time may not be good enough for some other situation. Thedetermination of working capital requirement is a continuous process and must beundertaken on a regular basis in the light of the changing situations. Following aresome of the factors which are relevant in determining the working capital needs of

the firm:

1. Basic Nature of Business: The working capital requirement is closely relatedto the nature of the business of the firm. In case of a retail shop or a trading firm,the amount of working capital required is small enough. Most of the transactionsare undertaken in cash and the length of the operating cycle is generally small. Thetrading concerns usually have smaller needs of working capital, however, in certaincases, large inventories of goods may be required and consequently the working



capital may be large. In case of financial concerns (engaged in financial business)there may not be stock of goods but these firms do have to maintain sufficientliquidity all the times.

In case of manufacturing concerns, different types of production processes areperformed. One unit of raw material introduced in the production schedule may

take a long period before it is available as finished goods for sale. Funds areblocked not only in raw materials but also in labor expenses and overheads at everystage of production. The operating cycle is usually a longer one and sales are madegenerally on credit terms. So, in case of manufacturing concerns, there is arequirement of substantial working capital.

2. Business Cycle Fluctuations: Different phases of business cycle i.e., boom,recession, recovery etc. also affect the working capital requirement. In case of boom conditions, inflationary pressure appears and business activities expand. As aresult, the overall need for cash, inventories etc. increases resulting in more andmore funds blocked in these current assets. In case of recession period however,there is usually a dullness in business activities and there will be an opposite effect

on the level of working capital requirement. There will be a fall in inventories andcash requirement etc.

3. Seasonal Operations: If a firm is operating in goods and services havingseasonal fluctuations in demand, then the working capital requirement will alsofluctuate with every change. In a cold drink factory, the demand will certainly behigher during summer season and therefore, more working capital is required tomaintain higher production, in the form of larger inventories and biggerreceivables. On the other hand, if the operations are smooth and even through outthe year then the working capital requirement will be constant and will not beaffected by the seasonal factors.

4. Market Competitiveness: The market competitiveness has an importantbearing on the working capital needs of a firm. In view of the competitiveconditions prevailing in the market, the firm may have to offer liberal credit termsto the customers resulting in higher debtors. Even larger inventories may bemaintained to serve an order as and when received; otherwise the customer may goto some other supplier. Thus, the working capital tends to be high as a result of greater investment in inventories and receivable. On the other hand, amonopolistic firm may not require larger working capital. It may ask the customersto pay in advance or to wait for some time after placing the order.

5. Credit Policy: The credit policy means the totality of terms and conditions onwhich goods are sold and purchased. A firm has to interact with two types of creditpolicies at a time. One, the credit policy of the supplier of raw materials, goods etc.,and two, the credit policy relating to credit which it extends to its customers. Inboth the cases, however, the firm while deciding its credit policy, has to take care of the credit policy of the market. For example, a firm might be purchasing goods andservices on credit terms but selling goods only for cash. The working capitalrequirement of this firm will be lower than that of a firm which is purchasing cashbut has to sell on credit basis.



6. Supply Conditions: The time taken by a supplier of raw materials, goods etc.after placing an order, also determines the working capital requirement. If goodsare received as soon as or in a short period after placing an order, then thepurchaser will not like to maintain a high level of inventory of that good. Otherwise,larger inventories should be kept e.g., in case of imported goods. It is often seenthat the shopkeepers may not be keeping stock of all items, but whenever there is a

demand, they procure from the wholesaler/producer and supply it to theircustomers.

Thus, the working capital requirement of a firm is determined by a host of factors.Every consideration is to be weighted relatively to determine the working capitalrequirement. Further, the determination of working capital requirement is not oncea while exercise, rather a continuous review must be made in order to assess theworking capital requirement in the changing situation. There are various reasonswhich may require the review of the working capital requirement e.g., change incredit policy, change in sales volume etc.

sources of Working Capital Finance

Short Term Sources of Working Capital Finance

Factoring Instalment Credit Invoice Discounting

Factoring is a traditional

source of short term

funding. Factoring facility

arrangements tend to be

restrictive and entering

into a whole-turnoverfactoring facility can lead

to aggressive chasing of

outstanding invoices from

clients, and a loss of

control of a company’s

credit function.

Instalment credit is a form

of finance to pay for

goods or services over a

period through the

payment of principal and

interest in regular

payments.

Invoice Discounting is a form

of asset based finance which

enables a business to

release cash tied up in aninvoice and unlike factoring

enables a client to retain

control of the administration

of its debtors.

Income received in

advance

Advances received

from customersBank Overdraft

Income received in

advance is seen as a

liability because it is

money that does not

correlate to that specific

accounting or business

A liability account used to

record an amount

received from a customer

before a service has been

provided or before goods

have been shipped.

A bank overdraft is when

someone is able to spend

more than what is actually

in their bank account. The

overdraft will be limited. A

bank overdraft is also a type

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year but rather for one that

is still to come. The income

account will then be

credited to the income

received in advance

account and the income

received in advance will be

debited to the income

account such as rent.

of loan as the money is

technically borrowed.

Commercial Papers Trade Finance Letter of Credit

A commercial paper is an

unsecured promissory

note. Commercial paper isa money-market security

issued by large

corporations to get money

to meet short term debt

obligations e.g.payroll, and

is only backed by an

issuing bank or

corporation’s promise to

pay the face amount on

the maturity date specifiedon the note. Since it is not

backed by collateral, only

firms with excellent credit

ratings will be able to sell

their commercial paper at

a reasonable price.

An exporter requires an

importer to prepay for

goods shipped. Theimporter naturally wants

to reduce risk by asking

the exporter to document

that the goods have been

shipped. The importer’s

bank assists by providing

a letter of credit to the

exporter (or the exporter’s

bank) providing for

payment uponpresentation of certain

documents, such as a bill

of lading. The exporter’s

bank may make a loan to

the exporter on the basis

of the export contract.

A letter of credit is a

document that a financial

institution issues to a seller

of goods or services whichsays that the issuer will pay

the seller for goods/services

the seller delivers to a third-

party buyer. The issuer then

seeks reimbursement from

the buyer or from the

buyer’s bank. The document

is essentially a guarantee to

the seller that it will be paid

by the issuer of the letter of credit regardless of whether

the buyer ultimately fails to

pay. In this way, the risk

that the buyer will fail to pay

is transferred from the seller

to the letter of credit’s

issuer.

Long Term Sources of Working Capital Finance

Shares Capital

Shares capital refers to the portion of a company’s equity that has been obtained (or will beobtained) by trading stock to a shareholder for cash or an equivalent item of capital value. Sharecapital comprises the nominal values of all shares issued (that is, the sum of their “par values”).

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Share capital can simply be defined as the sum of capital (cash or other assets) the company hasreceived from investors for its shares.

Debenture

A debenture is a document that either creates a debt or acknowledges it, and it is a debt withoutcollateral. In corporate finance, the term is used for a medium- to long-term debt instrument used by large companies to borrow money. A debenture is like a certificate of loan evidencing the factthat the company is liable to pay a specified amount with interest and although the money raised by the debentures becomes a part of the company’s capital structure, it does not become sharecapital. Debentures are generally freely transferable by the debenture holder.

Loan from financial institution

A loan is a type of debt which it entails the redistribution of financial assets over time, betweenthe lender and the borrower. In a loan, the borrower initially receives or borrows an amount of

money from the lender, and is obligated to pay back or repay an equal amount of money to thelender at a later time. Typically, the money is paid back in regular installments, or partialrepayments; in an annuity, each installment is the same amount. Acting as a provider of loans isone of the principal tasks for financial institutions like banks. A secured loan is a loan in whichthe borrower pledges some asset (e.g. a car or property) as collateral. Unsecured loans aremonetary loans that are not secured against the borrower’s assets.

-Inventory Management –

Defining Inventory

Inventory is an idle stock of physical goods that contain economic value, and are held in variousforms by an organization in its custody awaiting packing, processing, transformation, use or salein a future point of time.

Any organization which is into production, trading, sale and service of a product will necessarilyhold stock of various physical resources to aid in future consumption and sale. While inventoryis a necessary evil of any such business, it may be noted that the organizations hold inventoriesfor various reasons, which include speculative purposes, functional purposes, physicalnecessities etc.

From the above definition the following points stand out with reference to inventory:

All organizations engaged in production or sale of products hold inventory inone form or other.

Inventory can be in complete state or incomplete state.

Inventory is held to facilitate future consumption, sale or furtherprocessing/value addition.



All inventoried resources have economic value and can be considered asassets of the organization.

Different Types of Inventory

Inventory of materials occurs at various stages and departments of an organization. Amanufacturing organization holds inventory of raw materials and consumables required for production. It also holds inventory of semi-finished goods at various stages in the plant withvarious departments. Finished goods inventory is held at plant, FG Stores, distribution centersetc. Further both raw materials and finished goods those that are in transit at various locationsalso form a part of inventory depending upon who owns the inventory at the particular juncture.Finished goods inventory is held by the organization at various stocking points or with dealersand stockiest until it reaches the market and end customers.

Besides Raw materials and finished goods, organizations also hold inventories of spare parts toservice the products. Defective products, defective parts and scrap also forms a part of inventory

as long as these items are inventoried in the books of the company and have economic value.

Types of Inventory by Function

INPUT PROCESS OUTPUT

Raw Materials Work In Process Finished Goods

Consumables required

for processing. Eg : Fuel,

Stationary, Bolts & Nuts

etc. required in

manufacturing

Semi Finished Production in various

stages, lying with various

departments like Production, WIP

Stores, QC, Final Assembly, Paint

Shop, Packing, Outbound Store etc.

Finished Goods at

Distribution Centers

through out Supply

Chain

Maintenance

Items/Consumables

Production Waste and Scrap Finished Goods in

transit

Packing Materials Rejections and Defectives Finished Goods with

Stockiest and Dealers

Local purchased Items

required for production

Spare Parts Stocks &

Bought Out items

Defectives, Rejects



and Sales Returns

Repaired Stock and

Parts

Sales Promotion &

Sample Stocks

Receivables Management –

Receivables Management

Managing and collecting commercial receivables (unpaid receivables between companies or organisations) is linked to the credit insurance business and the information business.

Coface has succeeded in considerably reducing its claims expenses by setting up efficientreceivables management processes, developing excellent knowledge of local payment andcollection regulations and practices, accurately predicting the commercial and financial behaviour of buyers throughout the world and closely monitoring changes in their behaviour.

Coface RBI (Recovery Business Intelligence) provides a tailor-made service for the recovery of large trade debts in all countries. In the field of debt collection, Coface RBI responds to theneeds of credit managers and financial groups with regard to atypical or complex transactions.

Collecting debts is a full time job that requires experienced, fully trained and efficient resources.Coface allows you to take advantage of its negotiating skills and legal expertise to collect cashon your behalf, either in our name or yours, on a confidential basis.

You can benefit from our experience and recognition in this field:

- Better manage your amount of outstandings,- Maintain your trading relationship with a valued customer either on domestic or internationallevel- Be fully informed of progress,- Get liquidity and cash flow- Increase own company financial attractiveness- Save personal resources



Money Market Instruments.



Money Market Instruments provide the tools by which one can

operate in the money market.

Types Of Money Market Instruments

Treasury Bills: The Treasury bills are short-term money market

instrument that mature in a year or less than that. The

purchase price is less than the face value. At maturity the

government pays the Treasury Bill holder the full face

value.The Treasury Bills are marketable, affordable and risk

free. The security attached to the treasury bills comes at the

cost of very low returns.

Certificate of Deposit: The certificates of deposit are basically

time deposits that are issued by the commercial banks with

maturity periods ranging from 3 months to five years. The

return on the certificate of deposit is higher than the Treasury

Bills because it assumes a higher level of risk.

Advantages of Certificate of Deposit as a money market

instrument 1. Since one can know the returns from before, the

certificates of deposits are considered much safe.

2. One can earn more as compared to depositing money in

savings account.

3. The Federal Insurance Corporation guarantees the

investments in the certificate of deposit.

Disadvantages of Certificate of deposit as a money market

instrument:

1. As compared to other investments the returns is less.

2. The money is tied along with the long maturity period of

the Certificate of Deposit. Huge penalties are paid if one gets

out of it before maturity.



Commercial Paper: Commercial Paper is short-term loan that

is issued by a corporation use for financing accounts

receivable and inventories. Commercial Papers have higher

denominations as compared to the Treasury Bills and the

Certificate of Deposit. The maturity period of CommercialPapers are a maximum of 9 months. They are very safe since

the financial situation of the corporation can be anticipated

over a few months.

Banker's Acceptance: It is a short-term credit investment. It is

guaranteed by a bank to make payments. The Banker's

Acceptance is traded in the Secondary market. The banker's

acceptance is mostly used to finance exports, imports andother transactions in goods. The banker's acceptance need

not be held till the maturity date but the holder has the

option to sell it off in the secondary market whenever he finds

it suitable.

Euro Dollars: The Eurodollars are basically dollar- denominated

deposits that are held in banks outside the United States.

Since the Eurodollar market is free from any stringent regulations, the banks can operate at narrower margins as

compared to the banks in U.S. The Eurodollars are traded at

very high denominations and mature before six months. The

Eurodollar market is within the reach of large institutions only

and individual investors can access it only through money

market funds.

Repos: The Repo or the repurchase agreement is used by the

government security holder when he sells the security to a

lender and promises to repurchase from him overnight.

Hence the Repos have terms raging from 1 night to 30 days.

They are very safe due government backing.



Unit - 4

Mergers and Acquisitions :

An entrepreneur may grow its business either by internal expansion or by external expansion. In

the case of internal expansion, a firm grows gradually over time in the normal course of the business, through acquisition of new assets, replacement of the technologically obsoleteequipments and the establishment of new lines of products. But in external expansion, a firmacquires a running business and grows overnight through corporate combinations. Thesecombinations are in the form of mergers, acquisitions, amalgamations and takeovers and havenow become important features of corporate restructuring. They have been playing an importantrole in the external growth of a number of leading companies the world over. They have become popular because of the enhanced competition, breaking of trade barriers, free flow of capitalacross countries and globalisation of businesses. In the wake of economic reforms, Indianindustries have also started restructuring their operations around their core business activitiesthrough acquisition and takeovers because of their increasing exposure to competition both

domestically and internationally.

Mergers and acquisitions are strategic decisions taken for maximisation of a company's growth by enhancing its production and marketing operations. They are being used in a wide array of fields such as information technology, telecommunications, and business process outsourcing aswell as in traditional businesses in order to gain strength, expand the customer base, cutcompetition or enter into a new market or product segment.

Mergers or Amalgamations

A merger is a combination of two or more businesses into one business. Laws in India use the

term 'amalgamation' for merger. The Income Tax Act,1961 [Section 2(1A)] definesamalgamation as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of theamalgamating companies become assets and liabilities of the amalgamated company andshareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated company.

Thus, mergers or amalgamations may take two forms:-

Merger through Absorption:- An absorption is a combination of two or morecompanies into an 'existing company'. All companies except one lose their identity in

such a merger. For example, absorption of Tata Fertilisers Ltd (TFL) by Tata ChemicalsLtd. (TCL). TCL, an acquiring company (a buyer), survived after merger while TFL, anacquired company (a seller), ceased to exist. TFL transferred its assets, liabilities andshares to TCL.

Merger through Consolidation:- A consolidation is a combination of two or morecompanies into a 'new company'. In this form of merger, all companies are legallydissolved and a new entity is created. Here, the acquired company transfers its assets,liabilities and shares to the acquiring company for cash or exchange of shares. For

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example, merger of Hindustan Computers Ltd, Hindustan Instruments Ltd, IndianSoftware Company Ltd and Indian Reprographics Ltd into an entirely new companycalled HCL Ltd.

A fundamental characteristic of merger (either through absorption or consolidation) is that the

acquiring company (existing or new) takes over the ownership of other companies and combinestheir operations with its own operations.

Besides, there are three major types of mergers:-

Horizontal merger:- is a combination of two or more firms in the same area of business.For example, combining of two book publishers or two luggage manufacturingcompanies to gain dominant market share.

Vertical merger:- is a combination of two or more firms involved in different stages of production or distribution of the same product. For example, joining of a TVmanufacturing(assembling) company and a TV marketing company or joining of a

spinning company and a weaving company. Vertical merger may take the form of forward or backward merger. When a company combines with the supplier of material, itis called backward merger and when it combines with the customer, it is known asforward merger.

Conglomerate merger:- is a combination of firms engaged in unrelated lines of businessactivity. For example, merging of different businesses like manufacturing of cement products, fertilizer products, electronic products, insurance investment and advertisingagencies. L&T and Voltas Ltd are examples of such mergers.

Acquisitions and Takeovers

An acquisition may be defined as an act of acquiring effective control by one company over assets or management of another company without any combination of companies. Thus, in anacquisition two or more companies may remain independent, separate legal entities, but theremay be a change in control of the companies. When an acquisition is 'forced' or 'unwilling', it iscalled a takeover. In an unwilling acquisition, the management of 'target' company would opposea move of being taken over. But, when managements of acquiring and target companies mutuallyand willingly agree for the takeover, it is called acquisition or friendly takeover.

Under the Monopolies and Restrictive Practices Act, takeover meant acquisition of not less than25 percent of the voting power in a company. While in the Companies Act (Section 372), acompany's investment in the shares of another company in excess of 10 percent of the subscribed

capital can result in takeovers. An acquisition or takeover does not necessarily entail full legalcontrol. A company can also have effective control over another company by holding a minorityownership.

Advantages of Mergers & Acquisitions

The most common motives and advantages of mergers and acquisitions are:-

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Accelerating a company's growth, particularly when its internal growth is constrained dueto paucity of resources. Internal growth requires that a company should develop itsoperating facilities- manufacturing, research, marketing, etc. But, lack or inadequacy of resources and time needed for internal development may constrain a company's pace of growth. Hence, a company can acquire production facilities as well as other resources

from outside through mergers and acquisitions. Specially, for entering in new products/markets, the company may lack technical skills and may require specialmarketing skills and a wide distribution network to access different segments of markets.The company can acquire existing company or companies with requisite infrastructureand skills and grow quickly.

Enhancing profitability because a combination of two or more companies may result inmore than average profitability due to cost reduction and efficient utilization of resources.This may happen because of:-

• Economies of scale:- arise when increase in the volume of production leads to a

reduction in the cost of production per unit. This is because, with merger, fixedcosts are distributed over a large volume of production causing the unit cost of production to decline. Economies of scale may also arise from other indivisibilities such as production facilities, management functions andmanagement resources and systems. This is because a given function, facility or resource is utilized for a large scale of operations by the combined firm.

• Operating economies:- arise because, a combination of two or more firms may

result in cost reduction due to operating economies. In other words, a combinedfirm may avoid or reduce over-lapping functions and consolidate its managementfunctions such as manufacturing, marketing, R&D and thus reduce operatingcosts. For example, a combined firm may eliminate duplicate channels of distribution, or crate a centralized training center, or introduce an integrated planning and control system.

• Synergy:- implies a situation where the combined firm is more valuable than the

sum of the individual combining firms. It refers to benefits other than thoserelated to economies of scale. Operating economies are one form of synergy benefits. But apart from operating economies, synergy may also arise fromenhanced managerial capabilities, creativity, innovativeness, R&D and marketcoverage capacity due to the complementarity of resources and skills and awidened horizon of opportunities.

Diversifying the risks of the company, particularly when it acquires those businesseswhose income streams are not correlated. Diversification implies growth through thecombination of firms in unrelated businesses. It results in reduction of total risks throughsubstantial reduction of cyclicality of operations. The combination of management andother systems strengthen the capacity of the combined firm to withstand the severity of the unforeseen economic factors which could otherwise endanger the survival of theindividual companies.



A merger may result in financial synergy and benefits for the firm in many ways:-

• By eliminating financial constraints

•

By enhancing debt capacity. This is because a merger of two companies can bringstability of cash flows which in turn reduces the risk of insolvency and enhancesthe capacity of the new entity to service a larger amount of debt

• By lowering the financial costs. This is because due to financial stability, the

merged firm is able to borrow at a lower rate of interest.

Limiting the severity of competition by increasing the company's market power. Amerger can increase the market share of the merged firm. This improves the profitabilityof the firm due to economies of scale. The bargaining power of the firm vis-à-vis labour,suppliers and buyers is also enhanced. The merged firm can exploit technological

breakthroughs against obsolescence and price wars.

Procedure for evaluating the decision for mergers and acquisitions

The three important steps involved in the analysis of mergers and acquisitions are:-

Planning:- of acquisition will require the analysis of industry-specific and firm-specificinformation. The acquiring firm should review its objective of acquisition in the contextof its strengths and weaknesses and corporate goals. It will need industry data on marketgrowth, nature of competition, ease of entry, capital and labour intensity, degree of regulation, etc. This will help in indicating the product-market strategies that are

appropriate for the company. It will also help the firm in identifying the business unitsthat should be dropped or added. On the other hand, the target firm will need informationabout quality of management, market share and size, capital structure, profitability, production and marketing capabilities, etc.

Search and Screening:- Search focuses on how and where to look for suitablecandidates for acquisition. Screening process short-lists a few candidates from manyavailable and obtains detailed information about each of them.

Financial Evaluation:- of a merger is needed to determine the earnings and cash flows,areas of risk, the maximum price payable to the target company and the best way tofinance the merger. In a competitive market situation, the current market value is the

correct and fair value of the share of the target firm. The target firm will not accept anyoffer below the current market value of its share. The target firm may, in fact, expect theoffer price to be more than the current market value of its share since it may expect thatmerger benefits will accrue to the acquiring firm.

A merger is said to be at a premium when the offer price is higher than the target firm's pre-merger market value. The acquiring firm may have to pay premium as an incentive to



target firm's shareholders to induce them to sell their shares so that it (acquiring firm) isable to obtain the control of the target firm.

Regulations for Mergers & Acquisitions

Mergers and acquisitions are regulated under various laws in India. The objective of the laws isto make these deals transparent and protect the interest of all shareholders. They are regulatedthrough the provisions of :-

The Companies Act, 1956

The Act lays down the legal procedures for mergers or acquisitions :-

• Permission for merger:- Two or more companies can amalgamate only when the

amalgamation is permitted under their memorandum of association. Also, theacquiring company should have the permission in its object clause to carry on the

business of the acquired company. In the absence of these provisions in thememorandum of association, it is necessary to seek the permission of theshareholders, board of directors and the Company Law Board before affecting themerger.

• Information to the stock exchange:- The acquiring and the acquired companies

should inform the stock exchanges (where they are listed) about the merger.

• Approval of board of directors:- The board of directors of the individual

companies should approve the draft proposal for amalgamation and authorise themanagements of the companies to further pursue the proposal.

• Application in the High Court:- An application for approving the draft

amalgamation proposal duly approved by the board of directors of the individualcompanies should be made to the High Court.

• Shareholders' and creators' meetings:- The individual companies should hold

separate meetings of their shareholders and creditors for approving theamalgamation scheme. At least, 75 percent of shareholders and creditors inseparate meeting, voting in person or by proxy, must accord their approval to thescheme.

• Sanction by the High Court:- After the approval of the shareholders andcreditors, on the petitions of the companies, the High Court will pass an order,

sanctioning the amalgamation scheme after it is satisfied that the scheme is fair and reasonable. The date of the court's hearing will be published in twonewspapers, and also, the regional director of the Company Law Board will beintimated.

• Filing of the Court order:- After the Court order, its certified true copies will be

filed with the Registrar of Companies.





• Transfer of assets and liabilities:- The assets and liabilities of the acquired

company will be transferred to the acquiring company in accordance with theapproved scheme, with effect from the specified date.

• Payment by cash or securities:- As per the proposal, the acquiring company will

exchange shares and debentures and/or cash for the shares and debentures of theacquired company. These securities will be listed on the stock exchange.

NPV of a Merger –

osts and Benefits of Merger

When a company ‘A’ acquires another company say ‘B’, then it is a capital investment decisionfor company ‘A’ and it is a capital disinvestment decision for company ‘B”. Thus, both the

companies need to calculate the Net Present Value (NPV) of their decisions.

To calculate the NPV to company ‘A’ there is a need to calculate the benefit and cost of themerger. The benefit of the merger is equal to the difference between the value of the combinedidentity (PV AB) and the sum of the value of both firms as a separate entity. It can be expressed asBenefit = (PV AB) – (PV A+ PVB)

Assuming that compensation to firm B is paid in cash, the cost of the merger from the point of view of firm A can be calculated as

Cost= Cash - PVB

Thus NPV for A = Benefit –Cost= (PV AB – (PV A + PVB)) – (Cash – PVB)

the net present value of the merger from the point of view of firm B is the same as the cost of themerger for ‘A’. Hence, NPV to B = (Cash - PVB)

NPV of A and B in case the compensation is in stock

In the above scenario we assumed that compensation is paid in cash, however in real life

compensation is paid in terms of stock. In that case, cost of the merger needs to be calculatedcaarefully. It is explained with the help of an illustration – Firm A plans to acquire firm B. Following are the statistics of firms before the merger –

A B

Market price per share Rs.50 Rs.20

Number of Shares 500,000 250,000

Market value of the firm Rs.25 Rs.5



million million

The merger is expected to bring gains, which have a PV of Rs.5 million. Firm A offers 125,000shares in exchange for 250,000 shares to the shareholders of firm B.

The cost in this case is defined as –

Cost = αPV AB - PVB

Where a represents the fraction of the combined entity received by shareholders of B.In the above example, the share of B in the combined entity is – α = 125,000 / (500,000 + 125,000) = 0.2

assuming that the market value of the combined entity will be equal to the sum of present valueof the separate entities and the benefit of merger. Then,

PV AB = PV A+ PVB+ Benefit = 25 + 5 + 5 = Rs.35 million

Cost = αPV AB - PVB = 0.2 x 35 – 5= Rs.2 million

thus

NPV to A =Benefit – Cost= 5 –2 = Rs.3 million NPV to B = Cost to A = Rs 2 million

Defensive Strategies to prevent take over attempts –

Other Takeover DefensesPoison pill

is someti mes used more broadly to descr ibe othe r types of ta keove r defenses that involve thetarget taking some action. Although the broad category of ta k e o v e r de fe n s e s (mo re c o mmo n l ykno wn as "s ha rk re pel len ts" ) i nc lud es the t radit ional shareholder r ights plan poisonpill. Other anti-takeover protectionsinclude:•Classified boards with staggered terms.

•Limitations on the ability to call special meetings or ta ke action by written consent.•Supermajority vote requirements to approve mergers.•Supermajority vote requirements to remove directors.•T h e t a r g e t a d d s t o i t s c h a r t e r a p r o v i s i o n w h i c h g i v e s t h ec u r r e n t shareholders the right to sell their shares to the acquirer at an increased price(usuall y100% above rece nt average share price ), if the acquire r's share of the company reaches a



critical limit (usually one third). This kind of poison p i l l ca n no t s t o p a d e te r m i n e d a c qu i r e r ,but ensu res a h igh pr i c e for the company.•The target takes on largedebtsin an effort to make the debt load too high to be attractive—the acquirer would eventually have to pay the debts.•T h e c o m p a n y b u y s a n u m b e r o f s m a l l e r c o m p a n i e s u s i n g a stock swap,diluting thevalue of the target's stock.•The target grants its employeesstock optionsthat immediately vest if thecompany is takenover. This is intended to give emp loyees an incent ive to continue working for the target companyat least until a merger is completedins te ad of lo ok in g fo r a ne w jo b as so on as ta ke ov er d i s c u s s i o n s b e g i nH o w e v e r , w i t h t h e r e l e a s e o f t h e " golden handcuffs", many discontentedemployees mayquit immediately after they've cashed in their stock options.This poison pill may create an exodus of talented employees. In many high-tech businesses, attrition of talentedhuman resourcesoften means anemptyshell is left behind for the new owner.•Peoplesoftguaranteed its customers in June 2003 that if it were acquiredwithin two years,presumably by its rivalOracle Corporation, and productsuppo r t we re r edu ced w i th in f our

y e ar s , i t s c u st o me r s w o ul d r e ce i ve a r e f u n d o f b e t w e e n t w o a n d f i v e t i m e st h e f e e s t h e y h a d p a i d f o r t h e i r Peoplesoft software licenses. The hypothetical cost toOracle was valued atas mu ch as US$1.5 billion. Peoplesoft a llowed the guarantee to expirei nApr i l 2004 . I f Peo p l eSo f t had no t p repared i t se l f by a dop t i ng e f f ec t i ve takeover defenses, it is unclear if Oracle would have significantly raised itsoriginal bid of $16 per share. Theincreased bid provided an additional $4.1 billion for PeopleSoft's shareholders.•The practice of having staggered elections for the board of directors. Fo r example, if acompany had nine directors, then three directors would be upfo r r e -e l e c t i o n ea c h ye a r , w i t h ath ree -ye ar ter m. Thi s wou ld pre se nt a potent ia l acqui rer with the posi tion of having ahostile board for at least ayear a fter the first election. In some companies, ce rtainpercentages of the board (33%) may be enough to block key decisions (such as a fullmerger agreement or major asset sale), so an acquirer may not be able to close

an acquisition for years after having purchased a majority of the target's stock.As of December 31, 2008,47.05% of the companies in the S&P Super 1500had a classified boardRecent DevelopmentsShareholder Input on Poison PillsMor e co mp a ni es ar e gi vi ng sh ar e ho ld er s a sa y onp oi so n p i l ls . A cc or di ng t o F a c t S e t S h a r k R e p e l l e n t d a t a , s o f a r t h i s y e a r 2 1 c o m p a n i e s t h a t a d o p t e d o r extended a poison pill have publicly disclosed they plan toput the poison pill to ashareholder vote within a year. That's already more than 2008's full year total of 18and in fact is the most in any year since the first poison pill was adopted in the early1980s.

Leveraged Buy outs Spin-offs and Restructurings –

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Spin-Offs and Split-Offs

Spin-Offs

In a spin-off, the parent company (ParentCo) distributes to its existing shareholders new sharesin a subsidiary, thereby creating a separate legal entity with its own management team and boardof directors. The distribution is conducted pro-rata, such that each existing shareholder receivesstock of the subsidiary in proportion to the amount of parent company stock already held. Nocash changes hands, and the shareholders of the original parent company become theshareholders of the newly spun company (SpinCo).

Strategic Rationale

Divesting a subsidiary can achieve a variety of strategic objectives, such as:

• Unlocking hidden value – Establish a public market valuation for undervalued

assets and create a pure-play entity that is transparent and easier to value• Undiversification – Divest non-core businesses and sharpen strategic focus

when direct sale to a strategic or financial buyer is either not compelling ornot possible

• Institutional sponsorship – Promote equity research coverage and ownershipby sophisticated institutional investors, either of which tend to validateSpinCo as a standalone business

• Public currency – Create a public currency for acquisitions and stock-basedcompensation programs

• Motivating management – Improve performance by better aligning

management incentives with SpinCo's performance (using SpinCo, ratherthan ParentCo, stock-based awards), creating direct accountability to publicshareholders, and increasing transparency into management performance

• Eliminating dissynergies – Reduce bureaucracy and give SpinCo managementcomplete autonomy

• Anti-trust – Break up a business in response to anti-trust concerns



• Corporate defense – Divest "crown jewel" assets to make a hostile takeoverof ParentCo less attractive

Transaction Structure

In general, there are four ways to execute a spin-off:

• Regular spin-off – Completed all at once in a 100% distribution toshareholders

• Majority spin-off – Parent retains a minority interest (< 20%) in SpinCo anddistributes the majority of the SpinCo stock to shareholders

• Equity carve out (IPO) / spin-off – Implemented as a second step following anearlier equity carve-out of less than 20% of the voting control of thesubsidiary

• Reverse Morris Trust – Implemented as a first step immediately preceding a

Reverse Morris Trust transaction

ParentCo's existing credit agreements may impose restrictions on divestitures that are material innature. It is important to determine if any credit terms will be violated if ParentCo spins off asubsidiary that materially contributes to its business.

Tax Implications

A spin-off is usually tax-free under Internal Revenue Code (IRC) Section 355, meaning that notaxable gain is recognized by either the parent entity or the parent's existing shareholders. Toqualify for favorable tax treatment, the spin-off must meet the requirements of Section 355:

• The parent and subsidiary must both have been engaged in an "active tradeor business" the entire 5 years preceding the spin-off, and neither entity mayhave been acquired during that period in a taxable transaction.

• ParentCo and SpinCo must continue in an active trade or business followingseparation.

• ParentCo must have tax control before the spin-off, defined as ownership of at least 80% of the vote and value of all classes of subsidiary stock.

• ParentCo must relinquish tax control as a result of the spin-off (< 80% voteand value).

• The spin-off must have a valid business purpose, and cannot be used as a"device" to distribute earnings (dividends).

• The parent's shareholders, collectively, must retain continuity of interest inboth parent and subsidiary for a 4-year period beginning 2 years before thespin-off by maintaining 50% equity ownership interest in both companies (achange in control of either ParentCo or SpinCo during this period could triggera tax liability for the ParentCo). This is the anti-Morris Trust rule.

http://macabacus.com/restructuring/equity-carve-outs

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http://macabacus.com/restructuring/morris-trusts



If the unusual event that a spin-off does not qualify for tax-free treatment, there are two levels of tax:

• Ordinary income at the shareholder level equal to the FMV of subsidiary stockreceived (similar to a dividend) and

• Capital gain on the sale of stock at the parent entity level equal to the FMV of subsidiary stock distributed less the parent's inside basis in that stock.

Any cash received by shareholders in lieu of fractional shares of SpinCo is generally taxable toshareholders.

Accounting for Spin-Offs

From the announcement of the spin-off until the date it is completed, the parent accounts for thedisposition of its subsidiary in a single line item on its balance sheet called Net Assets of Discontinued Operations, or similar. The parent also segregates the net income attributable to the

subsidiary on its income statement in an account called Income from Discontinued Operations,or similar.

The spin-off is recorded at book value on the transaction date as follows:

Parent's Journal Entry

dr. Retained Earnings$$

$

cr. Net Assets of Discontinued

Operations

$$

$

Subsidiary's Journal Entry

dr. Assets$$

$

cr. Liabilities$$

$

cr. Equity$$

$

Monetization Techniques

The parent company will often extract value from the subsidiary before spinning it off bylevering up SpinCo and siphoning the cash proceeds as a special tax-free dividend (courtesy of the 100% DRD) or pushing down debt to SpinCo. The special dividend and amount of debt pushdown are both limited in size to ParentCo's inside basis in the subsidiary's assets. If either

http://macabacus.com/taxes/drd

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exceeds the inside basis, the spin-off is taxable to the extent of the excess. The amount of debtParentCo can push down to SpinCo is also limited by SpinCo's ability to service the debt.

Exhibit 4.1 – Monetization of Verizon's Spin-Off of Idearc

The following is excerpted from an Idearc 8-K filing detailing its spin-off from Verizon, andoutlines how Verizon monetized the spin-off:

On November 17, 2006, Verizon Communications Inc. ("Verizon") spun off the companies thatcomprised its domestic print and Internet yellow pages directories publishing operations. Inconnection with the spin-off, Verizon transferred to Idearc Inc. ("Idearc") all of its ownershipinterest in Idearc Information Services LLC and other assets, liabilities, businesses andemployees primarily related to Verizon's domestic print and Internet yellow pages directories publishing operations (the "Contribution"). The spin-off was completed by making a pro ratadistribution to Verizon's shareholders of all of the outstanding shares of common stock of Idearc.

In connection with the spin-off, on November 17, 2006, and in consideration for theContribution, Idearc (1) issued to Verizon additional shares of Idearc common stock, (2) issuedto Verizon $2.85 billion aggregate principal amount of Idearc's 8% senior notes due 2016 and$4.3 billion aggregate principal amount of loans under Idearc's tranche B term loan facility(collectively, the "Idearc Debt Obligations") and (3) transferred to Verizon approximately $2.4 billion in cash from cash on hand, from the proceeds of loans under Idearc's tranche A term loanfacility and from the proceeds of the remaining portion of the loans under Idearc's tranche B termloan facility.

Creative monetization techniques such as debt-for-debt and debt-for-equity swaps, or exchanges,allow ParentCo to extract value in excess of its basis in SpinCo's stock without affecting the tax-

free nature of the spin-off.

Debt-for-Debt Swaps

In a debt-for-debt swap, the parent company (ParentCo) uses an investment bank as anintermediary to retire debt in connection with a spin-off. Generally speaking, a debt-for-debtswap is executed as follows:

1. ParentCo contributes assets to SpinCo in exchange for all of SpinCo'scommon stock and SpinCo notes

2. An investment bank purchases previously-issued ParentCo debt securities in

the market3. ParentCo swaps with the investment bank its SpinCo notes for a like amount

of its own debt securities, which it then retires

4. The investment bank sells the SpinCo notes



A debt-for-equity swap is mechanically similar to a debt-for-debt swap, except that ParentCoswaps its SpinCo notes for ParentCo stock . Thus, the debt-for-equity swap resembles a stock repurchase rather than debt retirement.

Capital Markets Implications of Spin-Offs

The separate business entities created in a spin-off sometimes differ in many ways from theconsolidated company, and may no longer be suitable investments for some originalshareholders. Spun-off companies are often much smaller than their original parents, and arefrequently characterized by higher growth. Institutional investors committed to specificinvestment styles (e.g. value, growth, large-cap, etc.) or subject to certain fiduciary restrictionsmay need to realign their holdings with their investment objectives following a spin-off by oneof their portfolio companies. For example, index funds would be forced to indiscriminately sellSpinCo stock if SpinCo is not included in the particular index.

As institutional investors "rotate out" of, or sell, their parent and/or new subsidiary stock, the

stocks may face short-term downward pricing pressure lasting weeks or even months until theshareholder bases reach new equilibriums. Shareholder churn and the corresponding potential for short-term pricing pressure can affect timing of a spin-off when CEOs are sensitive to stock price performance.

On the other hand, spin-offs are commonly executed in response to shareholder pressure todivest a subsidiary, perhaps because the hypothetical sum-of-the-parts valuation exceeds thecurrent value of the consolidated enterprise. In these cases, the parent and/or new subsidiarystock may experience upward pricing pressure following a spin-off that mitigates downward pressure due to shareholder rotation. In the long run, stocks of the individual companies shouldtheoretically trade higher in aggregate than stock of the consolidated company when the spin-off

is well-received by investors.

Also, when SpinCo is highly levered as a result of debt pushdown or loans incurred prior to spin-off, shareholder returns receive a boost when SpinCo generates returns in excess of its cost of capital. The effect is identical to how the use of leverage in LBO transactions magnifies returnsto financial buyers.

Sponsored Spin-Offs

In a sponsored spin-off, a financial sponsor (e.g. private equity fund) generally makes a pre-arranged "anchor" investment in a newly spun company (SpinCo). Participation by a

sophisticated investor is viewed favorably by the market because it validates SpinCo as astandalone business and serves as an endorsement of SpinCo's management team. The mechanicsof a sponsored spin-off are similar to those in Morris Trust transactions.

To qualify for tax-free treatment, the transaction must meet the conditions of Section 355described above. Additionally, Section 355(e), known as the anti-Morris Trust rule, limits thesponsor's investment to less than 50% of the vote and value of SpinCo's outstanding stock whenthe investment is made in connection with the spin-off. In general, if the sponsor's participation



is arranged prior to or within 6 months after the spin-off, the sponsor can acquire no more than aminority interest in SpinCo without compromising the tax-free nature of the transaction.

As a result of the Section 355(e) restriction, the sponsor will not have legal control over SpinCofollowing the investment. Also, unlike traditional privately held portfolio companies, SpinCo

will be a public company subject to SEC reporting requirements whose share price will fluctuatein market.

The sponsor has several exit options. If the sponsor's equity stake appreciates in value, it canreadily sell the appreciated SpinCo shares in the market. If the shares decline in value and thesponsor continues to view SpinCo as a good investment, the sponsor may acquire additionalshares at a low price and gain control of SpinCo following the 2-year waiting period, possiblyeven taking SpinCo private.

The sponsored spin-off may be alternatively structured as an investment in ParentCo, rather thanSpinCo. In this case, ParentCo would spin off assets not wanted by the sponsor prior to the

sponsor's investment in ParentCo. Since any subsequent event compromising tax-free treatmentof the original transaction would create a tax liability for ParentCo, the sponsor would be sure toinclude a tax indemnification clause in the transaction agreement.

You can learn more about sponsored spin-offs in articles posted on TheDeal.com andAltAssets.com.

Split-Offs

In a split-off, the parent company offers its shareholders the opportunity to exchange their ParentCo shares for new shares of a subsidiary (SplitCo). This tender offer often includes a

premium to encourage existing ParentCo shareholders to accept the offer. For example, ParentComight offer its shareholders $11.00 worth of SplitCo stock in exchange for $10.00 of ParentCostock (a 10% premium).

If the tender offer is oversubscribed, meaning that more ParentCo shares are tendered thanSplitCo shares are offered, the exchange is conducted on a pro-rata basis. If the tender offer isundersubscribed, meaning that too few ParentCo shareholders accept the tender offer, ParentCowill usually distribute the remaining unsubscribed SplitCo shares pro-rata via a spin-off.

A split-off is viewed as a sale for accounting purposes with a recognized gain or loss equal to thedifference between the market price of the new SplitCo stock issued and ParentCo's inside basis

in SplitCo's assets. Because the split-off is tax-free, provided that it meets the requirements setforth by Section 355, there is no corresponding gain or loss recognized for tax purposes.

The split-off is a tax-efficient way for ParentCo to redeem its shares. However, since split-offsrequire shareholders to tender their ParentCo shares to receive new shares of the subsidiary, theysuffer from lower certainty of execution and are mechanically more complex relative to spin-offs. Another notable disadvantage of split-offs is the potential for shareholder lawsuits if theexchange ratio (premium) offered by ParentCo is deemed unfair by activist shareholders. On the

http://www.thedeal.com/corporatedealmaker/2007/10/whats_a_reverse_sponsored_spin.php


http://www.altassets.com/private-equity-knowledge-bank/article/nz2903.html






other hand, shareholder churn may be lower for a split-off than for a spin-off because thesubscription feature of a split-off better aligns shareholders' preferences with their equityholdings than does a pro rata spin-off.

An equity carve-out is typically executed ahead of a split-off to establish a public market

valuation for SubCo's stock. Although the split-off can be conducted without a preceding carve-out, execution is more challenging given the difficulty in measuring the appropriate premiumwithout an established market value for SubCo. The preceding carve-out therefore all buteliminates the possibility of shareholder lawsuits related to the premium.

Fraudulent Conveyance

When SpinCo incurs a loan and dividends the proceeds to the ParentCo, as described above,creditor claims of fraudulent conveyance may arise if SpinCo later declares bankruptcy becauseit is unable to service its debt. Similar creditor claims may also arise if the spin-off leaves ParentCo insolvent. Therefore, it is necessary to ensure that both SpinCo and ParentCo are

adequately capitalized following the spin-off.

Financial Distress –

Definition

Tight cash situation in which a business, household, or individual cannot pay the

owed amounts on the due date. If prolonged, this situation can force the owing

entity into bankruptcy or forced liquidation. It is compounded by the fact that banks

and other financial institutions refuse to lend to those in serious distress. When a

firm is under financial distress, the situation frequently sharply reduces its marketvalue, suppliers of goods and services usually insist on COD terms, and large

customer may cancel their orders in anticipation of not getting deliveries on time.

Reorganization of Firms.

By Shefali Anand and Nikita Garia

Are you worried about what will happen to you, now that your company is being reorganized?

If you won’t be happy in the new role post-reorganization, then it might be time to explore lifeoutside your company.

Whether your company is undergoing a strategic restructuring, a cost-cutting exercise or has just been acquired by another company, a large-scale change can be a source of much stress for employees.


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More In Career Journal

• Career Journal: Beware of This Crippling Condition

• Career Journal: Do Fancy Job Titles Matter?

•

Career Journal: Four Horrible Bosses• Career Journal: How to Deal With Mr. Know-It-All

• Career Journal: A Job-Seeker's Guide In a Slow Market

“Will I lose my job? How will the work environment change? Will I have a new boss? Couldthere be changes to my pay and benefits?” are common questions that plague employees, saysLen Gray, Asia Pacific leader for mergers-and-acquisition consulting at Mercer.

These could be questions facing employees of securities firm MF Global Sify Securities IndiaPvt. right now, as their U.S. parent MF Global Holdings Ltd. recently went bankrupt. MF Global

Sify’s head has said the India unit is not affected, but it’s likely to find itself in the hands of newowners in the near future.

While employees don’t have much say in times of reorganization, it helps to brace yourself for what may lie ahead. Here are some tips to survive your company’s reorganization:

Get the facts straight: Instead of fretting about the unknown, try to get answers to the questionabout your future. A good starting point is to understand the management’s vision after therestructuring or acquisition.

“You’ve got to listen very carefully about what the company is saying,” says Dony Kuriakose,

director of Edge Executive Search Pvt., a Delhi-based search firm.

For instance, if your company has been acquired because of its special expertise or its presencein a certain geographical area where the acquiring company isn’t present, your unit is relativelysecure. “If it’s a pure growth play, you’re not likely to lose your job,” says Mr. Gray of Mercer.

But if the purchasing company is not saying anything, or is giving a vague message, it’s potentially worrisome. If one company is acquiring another that is in the same business, there’s ahigher chance of layoffs.

Look at the acquiring company’s organization structure. “If there are overlaps, those areas may

be more at risk than others,” says Mr. Gray.

The Spiel: You can look for a company’s message either in internal communications from your senior management or HR personnel, or in external communications, such as press releases,investor presentations, and interviews top management gives to the media.

Sometimes company communication “may not be specific or the individual may not be able tomake a very robust deduction about their career,” says Jayesh Pandey, India head for talent and

http://blogs.wsj.com/indiarealtime/2011/11/04/career-journal-how-to-survive-your-companys-reorganization/

http://blogs.wsj.com/indiarealtime/2012/10/19/career-journal-beware-of-this-crippling-condition/

http://blogs.wsj.com/indiarealtime/2012/10/12/career-journal-do-fancy-job-titles-matter/

http://blogs.wsj.com/indiarealtime/2012/10/05/career-journal-four-horrible-bosses/

http://blogs.wsj.com/indiarealtime/2012/09/21/career-journal-how-to-deal-with-mr-know-it-all/

http://blogs.wsj.com/indiarealtime/2012/09/14/career-journal-a-job-seekers-guide-in-a-slow-market/

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http://blogs.wsj.com/indiarealtime/2011/11/04/career-journal-how-to-survive-your-companys-reorganization/

http://blogs.wsj.com/indiarealtime/2012/10/19/career-journal-beware-of-this-crippling-condition/

http://blogs.wsj.com/indiarealtime/2012/10/12/career-journal-do-fancy-job-titles-matter/

http://blogs.wsj.com/indiarealtime/2012/10/05/career-journal-four-horrible-bosses/

http://blogs.wsj.com/indiarealtime/2012/09/21/career-journal-how-to-deal-with-mr-know-it-all/

http://blogs.wsj.com/indiarealtime/2012/09/14/career-journal-a-job-seekers-guide-in-a-slow-market/

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organization performance at consulting firm Accenture. He says it’s best to ask your bossdirectly about what you can expect.

Self-Assessment: It’s possible that your supervisor is unsure of all the upcoming changes, or specifically how your position will be impacted. In that case, do your own assessment of how

vulnerable you are to potential job cuts.

A stellar performance record and being in the good books of the managers makes you relativelysafe.

If you have some unique skills, “it is that much more difficult for the company to get rid of you,”says Mr. Kuriakose. On the other hand, if your skills are not up-to-date with the latest technologyand knowledge in your industry, that’s bad news.

Some types of jobs are more susceptible to job losses than others. In a cost-cutting exercise, so-called “cost overheads” such as jobs of administration or finance are more likely to be cut versus

jobs which bring revenue, such as sales directors.

Suppose your division is poor-performing and is being shut down – in this case the chances of survival are lower. For stellar performers, the company might provide an alternative career path,says Mr. Pandey.

Sometimes companies cut staff based on the date of employment: newer employees are let gofirst.

In mergers and acquisitions, management-level staff is at higher risk of losing jobs. “There could be two people with equal capability but now the company has space only for one,” says Subeer

Bakshi, director of talent and rewards practice at consulting firm Towers Watson.

While none of these are fool-proof ways of knowing your future, they can give you some idea of where you stand.

Your options: If you are confident about being retained and happy with the new look of thecompany, great.

But if you are not so sure about your job, or if you won’t be happy in the new role post-reorganization, then it might be time to explore life outside your company.

If your self-assessment showed that your skills are not on track with what the job market needs,then consider a “skill inventory build-up,” says Mr. Pandey. This could involve taking up atraining course, or joining a management program, or potentially moving to another functionwithin your organization to add to your skills.

If skills are not an issue, it’s time to look for a job.



Recruiters say that the stigma associated with being fired is slowly going away in corporate India because cost-cutting is happening in almost all industries. “It’s reasonable to say – I lost my jobin a restructuring,” says Mr. Kuriakose of Edge. To separate the wheat from the chaff though, hisrecruitment firm usually asks for references from the candidate’s previous employer.

Update your profile on LinkedIn, and go to as many networking events as possible. “Most of thegood people are already in touch with prospective employers,” says Mr. Pandey.

For the in-betweeners: If you are not sure whether you’ll be retained but not ready to move outif you can avoid it, your best bet is to stay focused on your job. If possible, with renewedenthusiasm.

Employees who add value “tend to survive better than those who complain or are too doubtful,”says Mr. Bakshi of Towers Watson.

Be open to change, and think of your company’s reorganization as an opportunity to grow your

career. “If you are unwilling to change your own behavior…you will face a kind of career slowdown,” says Mr. Pandey.

Finally, network, network, network – especially within your own company.

If you aren’t already known by the managers and top leaders, make yourself more visible. If thecompany is still deciding on where the cuts will come, you still have a chance.

“Between the Johnny that you know and the Johnny that you don’t know, you’ll likely keep theJohnny that you know,” says Mr. Kuriakose.

Unit - 5

Financial Planning Model –

Financial Planning Model – Your Gateway to Financial Happiness!

We hope that you are taking good care of your finances with manageME7. Most of the time we continue adhering to money

management without realizing our future financial needs. Also, we do not emphasize much on various ways to achieve the

financial goals and evaluate the planning criteria from time-to-time. Therefore, for making a sound proof plan, we had come

up with a financial model in this particular edition, which would help you plan your expenses and provide you an optimum

way to achieve your financial goals.

With the help of financial planning model, you will be able to determine your financial troubles, look for the best strategies to

achieve your financial goals and monitor the implemented strategy at frequent intervals. You may refer the following steps to

achieve your financial goals which works as your financial planning model:

1. Identify your financial goals & objectives: The first step in the financial planning model is realization of your financialgoals. To make it more simple for you, categorize your financial objectives into short term and long term goals. For example- saving money for buying a house can be a long term goal and a short term goal is can be your planning for a trip in theyear end. If you have set clear financial objectives in front of you, it becomes easier for you to achieve them.

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2. Identify the hurdles in achieving the financial goals: The next step in the model is to identify the hurdles you face inachieving your financial goals. For example, a sudden increase in the rate of interest may compel you to pay more onmonthly EMIs. You need to consider every factor that acts as a boulder in achieving your financial goals.

3. Look for all possible alternatives: The third step is to look for various remedies which can help you achieve your financial goals with minimum effort in less time. For instance - for buying a home, you may stick to the monthly saving rule or can choose one among a number of credit giving companies for the application of home loan. Accordingly, you can look for various other alternatives that can help you in achieving your financial goals.4. Choose the best alternative: Based upon the assessment of previous steps, you need to choose one optimumalternative. This step is very crucial because it is the final strategy which will be helping you in accomplishing your financialgoals. We should dig all pros and cons of every alternative we have been provided before actually finalizing the bestsolution, as this would help us to achieve our financial goals more effectively.5. Implement the selected alternative: In this step, simply you need to implement the best remedy to achieve your financial goals and adhere to it on regular basis.



6. Monitor and Evaluate the results: This is the last and final step that should never be ignored by you. You need todecide the time lines for evaluating the performance of the alternatives you have implemented so far . This would help you toknow whether you are following the right path or moving towards the wrong direction. If the performance is good and youhave achieved your goal, you can plan for your next financial goals wherein you will need to follow the same steps again,right from the beginning of the financial planning model. Or else, if you have not achieved the desired result by implementingthe best solutions, then you need to look for the loopholes. When you come to know that you can not reap the benefits fromthe implemented alternatives, you need to follow step 3 again and look for other alternatives which can help you in achievingyour financial goals.

Percent of Sales Method –

Percentage of Sales Method

The Percentage of Sales Method is a Financial Forecasting approach which is based on the premise that most Balance Sheet and Income Statement Accounts vary with sales. Therefore, thekey driver of this method is the Sales Forecast and based upon this, Pro-Forma FinancialStatements (i.e., forecasted) can be constructed and the firms needs for external financing can be

identified. The calculations illustrated on this page will refer to the Balance Sheet and IncomeStatement which follow. The forecasted Sales growth rate in this example is 25%

Balance Sheet ($ in Millions)

Assets 1999 Liabilities and

Owners' Equity

1999

Current Assets Current Liabilities

Cash 200 Accounts Payable 400

AccountsReceivable

400 Notes Payable 400

Inventory 600 Total Current

Liabilities

800

Total Current Assets1200 Long-Term

Liabilities

Long-Term Debt 500

Fixed Assets Total Long-Term

Liabilities

500

Net Fixed Assests 800 Owners' Equity

Common Stock ($1

Par)

300

Retained Earnings 400

Income Statement ($ in

Millions)

199

9

Sales120

0

Cost of Goods Sold 900

Taxable Income 300

Taxes 90

Net Income 210

Dividends 70

Addition to Retained

Earnings140



Total Owners'

Equity

700

Total Assets 2000 Total Liab. and

Owners' Equity

2000

Percentages of Sales

The first step is to express the Balance Sheet and Income Statement accounts which vary directlywith Sales as percentages of Sales. This is done by dividing the balance for these accounts for thecurrent year (1999) by sales revenue for the current year.

The Balance Sheet accounts which generally vary closely with Sales are Cash, AccountsReceivable, Inventory, and Accounts Payable. Fixed Assets are also often tied closely to Sales,unless there is excess capacity. (The issue of excess capacity will be addressed in External

Financing Needed section.) For this example, we will assume that Fixed Assets are currently atfull capacity and, thus, will vary directly will sales.

Retained Earnings on the Balance Sheet represent the cumulative total of the firm's earningswhich have been reinvested in the firm. Thus, the change in this account is linked to Sales;however, the link comes from relationship betwen Sales growth and Earnings

The Notes Payable, Long-Term Debt, and Common Stock accounts do not vary automaticallywith Sales. The changes in these accounts depend upon how the firm chooses to raise the fundsneeded to support the forecasted growth in Sales.

On the Income Statement, Costs are expressed as a percentage of Sales. Since we are assumingthat all costs remain at a fixed percentage of Sales, Net Income can be expressed as a percentageof Sales. This indicates the Profit Margin.

Taxes are expressed as a percentage of Taxable Income (to determine the tax rate). Dividendsand Addition to Retained Earnings are expressed as a percentage of Net Income to determine thePayout and Retention Ratios respectively.

Determinants of growth –

The Fundamental Determinants of Growth

With both historical and analyst estimates, growth is an exogenous variable that affects value but

is divorced from the operating details of the firm. The soundest way of incorporating growth into

value is to make it endogenous, i.e., to make it a function of how much a firm reinvests for future

http://www.zenwealth.com/BusinessFinanceOnline/FF/EFN.html






growth and the quality of its reinvestment. We will begin by considering the relationship

between fundamentals and growth in equity income, and then move on to look at the

determinants of growth in operating income.

Growth In Equity Earnings

When estimating cash flows to equity, we usually begin with estimates of net

income, if we are valuing equity in the aggregate, or earnings per share, if we are

valuing equity per share. In this section, we will begin by presenting the

fundamentals that determine expected growth in earnings per share and then move

on to consider a more expanded version of the model that looks at growth in net

income.

Growth in Earnings Per Share

The simplest relationship determining growth is one based upon the retention

ratio (percentage of earnings retained in the firm) and the return on equity on its

projects. Firms that have higher retention ratios and earn higher returns on equity

should have much higher growth rates in earnings per share than firms that do not

share these characteristics. To establish this, note that

where,

gt = Growth Rate in Net Income

NIt = Net Income in year t

Given the definition of return on equity, the net income in year t-1 can be written

as:

where,



ROEt-1 = Return on equity in year t-1

The net income in year t can be written as:

Assuming that the return on equity is unchanged, i.e., ROEt = ROEt-1 =ROE,

where b is the retention ratio. Note that the firm is not being allowed to raise equityby issuing new shares. Consequently, the growth rate in net income and the growth

rate in earnings per share are the same in this formulation.

Illustration 11.5: Growth in Earnings Per Share

In this illustration, we will consider the expected growth rate in earnings

based upon the retention ratio and return on equity for three firms � Consolidated

Edison, a regulated utility that provides power to New York City and its environs,

Procter & Gamble, a leading brand-name consumer product firm and Reliance

Industries, a large Indian manufacturing firm. In Table 11.5, we summarize the

returns on equity, retention ratios and expected growth rates in earnings for the

three firms.

Table 11.5: Fundamental Growth Rates in Earnings per Share

Return on

Equity

Retention

Ratio

Expected Growth

Rate

Consolidated Edison 11.63% 29.96% 3.49%

Procter & Gamble 29.37% 49.29% 14.48%

Reliance Industries 19.43% 82.57% 16.04%

Reliance has the highest expected growth rate in earnings per share, assuming that it can

maintain its current return on equity and retention ratio. Procter & Gamble also can be expected



to post a healthy growth rate, notwithstanding the fact that it pays out more than 50% of its

earnings as dividends, because of its high return on equity. Co Ed, on the other hand, has a very

low expected growth rate because its return on equity and retention ratio are anemic.

Growth in Net Income

If we relax the assumption that the only source of equity is retained earnings,

the growth in net income can be different from the growth in earnings per share.

Intuitively, note that a firm can grow net income significantly by issuing new equity

to fund new projects while earnings per share stagnates. To derive the relationship

between net income growth and fundamentals, we need a measure of how

investment that goes beyond retained earnings. One way to obtain such a measure

is to estimate directly how much equity the firm reinvests back into its businesses

in the form of net capital expenditures and investments in working capital.

Equity reinvested in business = (Capital Expenditures � Depreciation + Change in

Working Capital � (New Debt Issued � Debt Repaid))

Dividing this number by the net income gives us a much broader measure of the

equity reinvestment rate:

Equity Reinvestment Rate =

Unlike the retention ratio, this number can be well in excess of 100% because firms

can raise new equity. The expected growth in net income can then be written as:

Expected Growth in Net Income =

Illustration 11.6: Growth in Net Income

To estimate growth in operating income based upon fundamentals, we look at three firms

� Coca Cola, Nestle and Sony. In Table 11.6, we first estimate the components of equity

reinvestment and use it to estimate the reinvestment rate for each of the firms. We also present

the return on equity and the expected growth rate in net income at each of these firms.



Table 11.6: Expected Growth in Net Income

Net

Income

Net Cap

Ex

Change in

Working

Capital

Net Debt

Issued

(paid)

Equity

Reinvestm

ent Rate ROE

Expected

Growth

RateCoca

Cola

$ 2177

m 468 852 -$104.00 65.41%

23.12

% 15.12%

Nestle

SFr

5763m 2470 368 272 44.53%

21.20

% 9.44%

Sony

JY

30.24b 26.29 -4.1 3.96 60.28% 1.80% 1.09%

The pluses and minuses of this approach are visible in the table above. The approach much more

accurately captures the true reinvestment in the firm by focusing not on what was retained but onwhat was reinvested. The limitation of the approach is that the ingredients that go into the

reinvestment � capital expenditures, working capital change and net debt issued � are all volatile

numbers. Note that Coca Cola paid off debt last year, while reinvesting back into the business

and Sony�s working capital dropped. In fact, it would probably be much more realistic to look at

the average reinvestment rate over three or five years, rather than just the current year. We will

return to examine this question in more depth when we look at growth in operating income.

Determinants of Return on Equity

Both earnings per share and net income growth are affected by the return on

equity of a firm. The return on equity is affected by the leverage decisions of the

firm. In the broadest terms, increasing leverage will lead to a higher return on

equity if the pre-interest, after-tax return on capital exceeds the after-tax interest

rate paid on debt. This is captured in the following formulation of return on equity:

where,



t = Tax rate on ordinary income

The derivation is simple1[1]. Using this expanded version of ROE, the growth

rate can be written as:

The advantage of this formulation is that it allows explicitly for changes in leverage

and the consequent effects on growth.

Illustration 11.7: Breaking down Return on Equity

To consider the components of return on equity, we look, in Table 11.7, at

Con Ed, Procter & Gamble and Reliance Industries, three firms whose returns on

equity we looked at in Illustration 11.5.

Table 11.7: Components of Return on Equity

ROC

Book

D/E

Book Interest

rate

Tax

Rate ROE

Consolidated

Edison 8.76% 75.72% 7.76% 35.91% 11.63%

Procter &

Gamble 17.77% 77.80% 5.95% 36.02% 28.63%Reliance 10.24% 94.24% 8.65% 2.37% 11.94%

Comparing these numbers to those reported in Illustration 11.5, you will note that the return on

equity is identical for Con Ed but significantly lower here for the other two firms. This is because

1



both Procter & Gamble and Reliance posted significant non-operating profits. We have chosen to

consider only operating income in the return on capital computation. To the extent that firms

routinely report non-operating income, you could modify the return on capital.

The decomposition of return on equity for Reliance suggests a couple of areas of concern.

One is that the high return on equity in Illustration 11.5 reported by the firm is driven by three

factors � high leverage, a significant non-operating profit and a low tax rate. If the firm loses its

tax breaks and the sources of non-operating income dry up, the firm could very easily find itself

with a return on capital that is lower than its book interest rate. If this occurs, leverage could

bring down the return on equity of the firm.

Average and Marginal Returns

The return on equity is conventionally measured by dividing the net income

in the most recent year by the book value of equity at the end of the previous year.

Consequently, the return on equity measures both the quality of both older projects

that have been on the books for a substantial period and new projects from more

recent periods. Since older investments represent a significant portion of the

earnings, the average returns may not shift substantially for larger firms that are

facing a decline in returns on new investments, either because of market saturation

or competition. In other words, poor returns on new projects will have a lagged

effect on the measured returns. In valuation, it is the returns that firms are making

on their newer investments that convey the most information about a quality of a

firm�s projects. To measure these returns, we could compute a marginal return on

equity by dividing the change in net income in the most recent year by the change

in book value of equity in the prior year:

Marginal Return on Equity =

For example, Reliance Industries reported net income of Rs 24033 million in 2000

on book value of equity of Rs 123693 million in 1999, resulting in an average

return on equity of 19.43%:

Average Return on Equity = 24033/123693 = 19.43%



The marginal return on equity is computed below:

Change in net income from 1999 to 2000 = 24033- 17037 = Rs 6996 million

Change in Book value of equity from 1998 to 1999 = 123693 � 104006 = Rs 19,687

million

Marginal Return on Equity = 6996/19687 = 35.54%

The Effects of Changing Return on Equity

So far in this section, we have operated on the assumption that the return on

equity remains unchanged over time. If we relax this assumption, we introduce a

new component to growth � the effect of changing return on equity on existing

investment over time. Consider, for instance, a firm that has a book value of equity

of $100 million and a return on equity of 10%. If this firm improves its return on

equity to 11%, it will post an earnings growth rate of 10% even if it does not

reinvest any money. This additional growth can be written as a function of the

change in the return on equity.

Addition to Expected Growth Rate =

where ROEt is the return on equity in period t. This will be in addition to the

fundamental growth rate computed as the product of the return on equity in period

t and the retention ratio.

Total Expected Growth Rate =

While increasing return on equity will generate a spurt in the growth rate in

the period of the improvement, a decline in the return on equity will create a more

than proportional drop in the growth rate in the period of the decline.

It is worth differentiating at this point between returns on equity on new

investments and returns on equity on existing investments. The additional growth



that we are estimating above comes not from improving returns on new

investments but by changing the return on existing investments. For lack of a better

term, you could consider it �efficiency generated growth�.

Illustration 11.8: Effects of Changing Return on Equity: Con Ed

In Illustration 11.5, we looked at Con Ed�s expected growth rate based upon its return on

equity of 11.63% and its retention ratio of 29.96%. Assume that the firm will be able to improve

its overall return on equity (on both new and existing investments) to 13% next year and that the

retention ratio remains at 29.96%. The expected growth rate in earnings per share next year can

then be written as:

Expected Growth rate in EPS =

After next year, the growth rate will subside to a more sustainable 3.89% (0.13*0.2996).

How would the answer be different if the improvement in return on equity were only on

new investments but not on existing assets? The expected growth rate in earnings per share can

then be written as:

Expected Growth rate in EPS = ROEt* Retention Ratio= 0.13* 0.2996 = 0.0389

Thus, there is no additional growth created in this case. What if the improvement had been only

on existing assets and not on new investments? Then, the expected growth rate in earnings per

share can be written as:

Expected Growth rate in EPS =



Growth in Operating Income

Just as equity income growth is determined by the equity reinvested back into the business and

the return made on that equity investment, you can relate growth in operating income to total

reinvestment made into the firm and the return earned on capital invested.

When a firm has a stable return on capital, its expected growth in operating

income is a product of the reinvestment rate, i.e., the proportion of the after-tax

operating income that is invested in net capital expenditures and non-cash working

capital, and the quality of these reinvestments, measured as the return on the

capital invested.

Expected GrowthEBIT = Reinvestment Rate * Return on Capital

where,

Return on Capital =

In making these estimates, you use the adjusted operating income and

reinvestment values that you computed in Chapter 4. Both measures should be

forward looking and the return on capital should represent the expected return on

capital on future investments. In the rest of this section, you consider how best to

estimate the reinvestment rate and the return on capital.

Reinvestment Rate

The reinvestment rate measures how much a firm is plowing back togenerate future growth. The reinvestment rate is often measured using the most

recent financial statements for the firm. Although this is a good place to start, it is

not necessarily the best estimate of the future reinvestment rate. A firm�s

reinvestment rate can ebb and flow, especially in firms that invest in relatively few,

large projects or acquisitions. For these firms, looking at an average reinvestment



rate over time may be a better measure of the future. In addition, as firms grow and

mature, their reinvestment needs (and rates) tend to decrease. For firms that have

expanded significantly over the last few years, the historical reinvestment rate is

likely to be higher than the expected future reinvestment rate. For these firms,

industry averages for reinvestment rates may provide a better indication of the

future than using numbers from the past. Finally, it is important that you continue

treating R&D expenses and operating lease expenses consistently. The R&D

expenses, in particular, need to be categorized as part of capital expenditures for

purposes of measuring the reinvestment rate.

Return on Capital

The return on capital is often based upon the firm's return on existinginvestments, where the book value of capital is assumed to measure the capital

invested in these investments. Implicitly, you assume that the current accounting

return on capital is a good measure of the true returns earned on existing

investments and that this return is a good proxy for returns that will be made on

future investments. This assumption, of course, is open to question for the following

reasons.

�

The book value of capital might not be a good measure of the capital invested inexisting investments, since it reflects the historical cost of these assets and

accounting decisions on depreciation. When the book value understates the

capital invested, the return on capital will be overstated; when book value

overstates the capital invested, the return on capital will be understated. This

problem is exacerbated if the book value of capital is not adjusted to reflect the

value of the research asset or the capital value of operating leases.

� The operating income, like the book value of capital, is an accounting measure of

the earnings made by a firm during a period. All the problems in using

unadjusted operating income described in Chapter 4 continue to apply.

� Even if the operating income and book value of capital are measured correctly,

the return on capital on existing investments may not be equal to the marginal



return on capital that the firm expects to make on new investments, especially

as you go further into the future.

Given these concerns, you should consider not only a firm�s current return on

capital, but any trends in this return as well as the industry average return oncapital. If the current return on capital for a firm is significantly higher than the

industry average, the forecasted return on capital should be set lower than the

current return to reflect the erosion that is likely to occur as competition responds.

Finally, any firm that earns a return on capital greater than its cost of capital

is earning an excess return. The excess returns are the result of a firm�s

competitive advantages or barriers to entry into the industry. High excess returns

locked in for very long periods imply that this firm has a permanent competitive

advantage.

Illustration 11.9: Measuring the Reinvestment Rate, Return on Capital and

Expected Growth Rate � Embraer and Amgen

In this Illustration, we will estimate the reinvestment rate, return on capital

and expected growth rate for Embraer, the Brazilian aerospace firm, and Amgen.

We begin by presenting the inputs for the return on capital computation in Table

11.8.

Table 11.8: Return on Capital

EBIT EBIT (1-t) BV of Debt

BV of

Equity

Return on

Capital

Embraer 945 716.54 1321.00 697.00 35.51%

Amgen $1,996 $1,500 $323 $5,933 23.98%

We use the effective tax rate for computing after-tax operating income and

the book value of debt and equity from the end of the prior year. For Amgen, we use

the operating income and book value of equity, adjusted for the capitalization of the

research asset, as described in Illustration 9.2. The after-tax returns on capital are

computed in the last column.



We follow up by estimating capital expenditures, depreciation and the change in non-cash

working capital from the most recent year in Table 11.9.

Table 11.9: Reinvestment Rate

EBIT(1-t)

Capital

expenditur

es

Depreciatio

n

Change in

Working

Capital

Reinvestm

ent

Reinvestme

nt Rate

Embraer 716.54 182.10 150.16 -173.00 -141.06 -19.69%

Amgen $1,500.32 $1,283.00 $610.00 $121.00 $794.00 52.92%

Here again, we treat R&D as a capital expenditure and the amortization of

the research asset as part of depreciation for computing the values for Amgen. In

the last column, we compute the reinvestment rate by dividing the total

reinvestment (cap ex � depreciation + Change in working capital) by the after-tax

operating income. Note that Embraer�s reinvestment rate is negative because of

non-cash working capital dropped by 173 million in the most recent year.

Finally, we compute the expected growth rate by multiplying the after-tax

return on capital by the reinvestment rate in Table 11.10

Table 11.10: Expected Growth Rate in Operating Income

Reinvestment

Rate

Return on

Capital

Expected Growth

Rate

Embra

er -19.69% 35.51% -6.99%

Amgen 52.92% 23.98% 12.69%

If Amgen can maintain the return on capital and reinvestment rate that they had last year, it

would be able to grow at 12.69% a year. Embraer �s growth rate is negative because its

reinvestment rate is negative. In the Illustration that follows, we will look at the reinvestment

rate in more detail.



Caveats of Financial Planning Models.

Smaller startups are often less concerned with long-term planning than getting off the ground andsurviving. While many businesses may benefit from long-term financial planning, the more

established businesses tend to have the resources and stability to analyze the long-term.

Why do companies bother with financial planning? Because financial planning establishesguidelines for the firm. Additionally, a company's growth rate and financial policy are linked.The goal of financial planning is to:

Identify the firm's financial goals

Analyze the difference between goals and current financial status

State actions needed for the firm to achieve its financial goals.

All these points are taken care of by the experts providing Finance homework

help and assignment help at Transtutors.com.

Of course, financial plans are only as accurate as the assumptions that go into the plan. TheGIGO principle applies – garbage in, garbage out.

There are other concerns about financial planning models.

Financial models don't uncover which financial policies are best.

Financial planning models are too simple. In reality, their assumptions don't always hold.

In practice, especially in large corporations, financial planning relies on a top-down approach.Senior managers determine a growth target, and financial planners tweak the plan with overlyoptimistic figures to match that target.



Short-Term & Long-Term Defined

The short-term is usually defined as the coming year. The long-term is usually defined as longer

than one year. Often, the long-term is defined as the coming two to five years.

What is Corporate Financial Planning?

A financial plan is a statement of what needs to be done in the future to achieve company goals.

Long-term financial planning is required to implement decisions that have long lead times. For

example, if a company wants to build a factory next year, contractors probably have to be linedup this year.

Financial plans are made up of the combined capital budgeting analyses of each the firms projects. So, the smaller investment proposals of each operational unit are added up and treatedas one big project.

Financial plans are meant to:

Make the link between different investment proposals and the financing choices available tothe firm.

Help the firm work through finding the best investment and/or financing option.

Help the firm avoid surprises by identifying what may happen in the future if certain eventstake place.

A financial plan can serve to provide guidelines but don't rely on the plan blindly.



Financial planning models do not always ask the right questions. A primary reason is that theytend to rely on accounting relationships and not financial relationships. In particular, the three basic elements of firm value tend to get left out, namely, cash flow size, risk, and timing.

Because of this, financial planning models sometimes do not produce output that gives the user many meaningful clues about what strategies will lead to increases in value. Instead, they divertthe user's attention to questions concerning the association of, say, the debt-equity ratio and firmgrowth.

The financial model we used for the Hoffman Company was simple—in fact, too simple. Our model, like many in use today, is really an accounting statement generator at heart. Such modelsare useful for pointing out inconsistencies and reminding us of financial needs, but they offer

very little guidance concerning what to do about these problems.

In closing our discussion, we should add that financial planning is an iterative process. Plans arecreated, examined, and modified over and over. The final plan will be a result negotiated between all the different parties to the process. In fact, long-term financial planning in mostcorporations relies on what might be called the Procrustes approach.1 Upper-level Finance has agoal in mind, and it is up to the planning staff to rework and to ultimately deliver a feasible planthat meets that goal.

Measures of Corporate Performance : RoI, RoE, EVA, MVA,

In today’s competitive world, value and value creation for shareholders are among the mostimportant goals of businesses. For the sake of achieving his goals, the investor needs someinstruments in order to evaluate the potential value of each opportunity of investment. It isclear that these instruments are not capable of predicting the exact future, they just providesome piece of information and advice that help the investor in the decisions he makes.Among these criteria, the most common types are Return on assets (ROA), Return on equity(ROE) and cash flow from operations (CFO). Despite the numerous applications of theseinstruments, theoretically, they are not related with shareholders’ value or creation wealth.In recent years, the modern evaluation methods based on economic profit such as Economicvalue added (EVA), Market value added (MVA), Refined economic value added (REVA),adjusted economic value added (AEVA), cash value added (CVA), shareholder value added(SVA) and created shareholder value (CSV) replace the accounting of accounting measuresand have widely drawn the attentions. These criteria follow the performance assessmentwith regard to the changes in the value and alongside maximizing the long-term shareholder



returns. Thus, in the financial literature, there has been an observed attempt to develop newfinancial performance measures (Ittner and Larcker, 1998).

Balanced Score Card –

Traditional financial reporting systems provide an indication of how a firm has performedin the past, but offer little information about how it might perform in the future. For example, a firm might reduce its level of customer service in order to boost currentearnings, but then future earnings might be negatively impacted due to reducedcustomer satisfaction.

To deal with this problem, Robert Kaplan and David Norton developed the BalancedScorecard, a performance measurement system that considers not only financialmeasures, but also customer, business process, and learning measures. The BalancedScorecard framework is depicted in the following diagram:

Diagram of the Balanced Scorecard

Financi

al

Custom

er

Strate

gy

Busines

s

Process

es

Learnin

g

&



Growth

The balanced scorecard translates the organization's strategy into four perspectives,with a balance between the following:

• between internal and external measures• between objective measures and subjective measures

• between performance results and the drivers of future results

Beyond the Financial Perspective

In the industrial age, most of the assets of a firm were in property, plant, and equipment,and the financial accounting system performed an adequate job of valuing those assets.In the information age, much of the value of the firm is embedded in innovativeprocesses, customer relationships, and human resources. The financial accountingsystem is not so good at valuing such assets.

The Balanced Scorecard goes beyond standard financial measures to include the

following additional perspectives: the customer perspective, the internal processperspective, and the learning and growth perspective.

• Financial perspective - includes measures such as operating income, return oncapital employed, and economic value added.

• Customer perspective - includes measures such as customer satisfaction,customer retention, and market share in target segments.

• Business process perspective - includes measures such as cost, throughput,and quality. These are for business processes such as procurement, production,and order fulfillment.

• Learning & growth perspective - includes measures such as employeesatisfaction, employee retention, skill sets, etc.

These four realms are not simply a collection of independent perspectives. Rather,there is a logical connection between them - learning and growth lead to better businessprocesses, which in turn lead to increased value to the customer, which finally leads toimproved financial performance.



Objectives, Measures, Targets, and Initiatives

Each perspective of the Balanced Scorecard includes objectives, measures of those

objectives, target values of those measures, and initiatives, defined as follows:

• Objectives - major objectives to be achieved, for example, profitable growth.• Measures - the observable parameters that will be used to measure progress

toward reaching the objective. For example, the objective of profitable growthmight be measured by growth in net margin.

• Targets - the specific target values for the measures, for example, +2% growth innet margin.

• Initiatives - action programs to be initiated in order to meet the objective.

These can be organized for each perspective in a table as shown below.

Objecti

ves

Measur

es

Targ

ets

Initiati

ves

Financi

al

Customer

Proces

s

Learni

ng

Balanced Scorecard as a Strategic Management System

The Balanced Scorecard originally was conceived as an improved performancemeasurement system. However, it soon became evident that it could be used as amanagement system to implement strategy at all levels of the organization by facilitatingthe following functions:



1. Clarifying strategy - the translation of strategic objectives into quantifiablemeasures clarifies the management team's understanding of the strategy andhelps to develop a coherent consensus.

2. Communicating strategic objectives - the Balanced Scorecard can serve totranslate high level objectives into operational objectives and communicate the

strategy effectively throughout the organization.

3. Planning, setting targets, and aligning strategic initiatives - ambitious butachievable targets are set for each perspective and initiatives are developed toalign efforts to reach the targets.

4. Strategic feedback and learning - executives receive feedback on whether thestrategy implementation is proceeding according to plan and on whether thestrategy itself is successful ("double-loop learning").

These functions have made the Balanced Scorecard an effective management system

for the implementation of strategy. The Balanced Scorecard has been appliedsuccessfully to private sector companies, non-profit organizations, and governmentagencies.

Practices of Indian Companies.

In order to be sustainable, businesses need to recognize and effectively address the complexrelationship of good corporate performance, social development, and environmental protection.Good corporate governance is now being recognized as a key risk management tool and a toolfor socio-economic development to enhance economic efficiency, growth, and stakeholder

confidence.

The paradigm shift in the global business environment has led to the Indian government promoting inclusive growth and CSR as a policy among corporates in India. However, a lot moreneeds to be done in this direction. Very limited India-centric studies and activities have beenundertaken on this subject.

TERI in association with National Foundation for Corporate Governance (NFCG) is jointlyworking towards adopting good governance practices and uptake of sustainability reporting.

Objectives of the initiative

• Understand the current status of Corporate Governance and Sustainability Reporting initiatives in India

• Assess the needs, challenges, and opportunities to adopt good governance practices and uptake of sustainability

reporting, and

• Identify best practices undertaken in the industry, if any

Expected Outcomes



• A report stating current status of Corporate Governance and Sustainability Reporting in India

• Inculcating latest thinking/global practices on Governance and Sustainability suited to the Indian context

• Increased uptake of quality reporting of Companies’ sustainability performance.

• Better understanding and appreciation of the concept of Business ethics and Sustainability Reporting among Corporates

in India.

Risk Management Tools –

Risk Management Tools

We offer five risk management tools, designed to protect CME Globex customers and clearingfirms:

• Cancel on Disconnect

• Credit Controls

• Risk Management Interface (RMI)

• Drop Copy

• FirmSoft

Use the drop-down below to learn more about these tools.

FirmSoft is a browser-based order management tool that provides real-time access to informationon working and filled CME Globex orders, across multiple firm IDs. FirmSoft providesimportant risk mitigation functionality during system failures.

With FirmSoft, customers can view and cancel orders for iLink and EOS Trader.

FirmSoft users can view:

• current order status

• fill information, including partial fills and fills from mass quotes

• cancel replace history

• CME Globex timestamps

If enabled to do so, FirmSoft users can cancel:



• an individual order

• a group of orders

• all working orders and mass quotes

FirmSoft

Launched in April 2009, FirmSoft leverages a completely redesigned order managementdatabase to optimize performance and reliability, and an updated interface for improvedusability. FirmSoft 6.0 makes accessing FirmSoft easier than ever:

• SMART Click registration and profile management platform

• Improved clearing firm administration tools

• Secure Socket Layer (SSL) Internet connectivity

• Microsoft® Internet Explorer® 6.0 & 7.0, and Mozilla® Firefox® 3

Clearing Firm Administrator Access to FirmSoft 6.0

To request access to the Clearing Firm Administration tools within FirmSoft, please

1. Create a SMART Click user ID and profile online2. Complete and submit the Schedule 9 to the CME Globex Connection Agreement

New FirmSoft 6.0 Users

To request access to FirmSoft , new users will need to:

• Create a SMART Click user ID and profile online

• Login to the SMART Click profile management tool and request a token

• Give your SMART Click user ID and token to your Clearing Firm FirmSoft

administrator.

o If you do not know who your Clearing Firm FirmSoft administrator is, please

contact your CME Globex Account Manager

• You will receive an e-mail confirmation once your FirmSoft access has been enabled

Hedging –

What is hedging?

Hedging is the process of managing the risk of price changes in physical material by offsettingthat risk in the futures market. Hedging can vary in complexity from a relatively simple activity,through to a highly complex strategies, including the use of options.

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http://www.cmegroup.com/globex/files/CMEGlobexSch9CMEFirmsoft.pdf


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The ability to hedge means that industry can decide on the amount of risk it is prepared to accept.It may wish to eliminate the risk entirely and can generally do so quickly and easily using theLME.

Managing price risk means achieving greater control of either the cost of inputs, or revenuesfrom sales, or both; planning for the future based on assured costs and revenues; and eliminatingconcerns that a sharply adverse move in the price of material could turn an otherwise flourishingand efficient business into a loss maker.

Hedging by trade and industry is the opposite of speculation and is undertaken in order toeliminate an existing physical price risk, by taking a compensating position in the futures market.Speculators come to the futures market with no initial risk. They assume risk by taking futures positions.

Hedgers reduce or eliminate the chance of further losses or profits, while the speculators risk

losses in order to make profits.

Before starting a hedging programme it is essential to assess the risk due to exposure to the priceof physical material. Once the hedger has an understanding of the tools available at the LME, itis relatively easy to select the appropriate action to manage this risk. It is important that thisaction is properly managed at all times and that the appropriate controls and approval proceduresare in place.

It is generally advisable to work with an LME broker so that expert advice can be taken indevising a hedging programme.

Options Futures and Swaps.

Definition

A swap is a derivative in which two parties agree to exchange a set of cash flows (or leg) for another set. A notional principal amount is used to calculate each cash flow; these are rarelyexchanged by the parties. A swap is usually used to hedge a risk, such as an interest-rate risk , or to speculate on a price change. It may also be used to access an underlying asset in order to earna profit or loss from any change in price while avoiding posting the notional amount in cash or

collateral.

An option is a financial instrument that gives the holder the right to engage in a futuretransaction on an underlying security or futures contract. The holder is under no obligation toexercise this right. There are two main types of option. A call option gives the holder the right to purchase a specified quantity of a security at a fixed price (the strike price) on or before thespecified expiration date. A put option gives the holder the right to sell. If the holder chooses to

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exercise the option, the party who sold, or wrote, the option is obliged to fulfil the terms of thecontract.

Futures are traded on a futures exchange and represent an obligation to buy or sell a specifiedunderlying instrument on a specified date (the delivery date or final settlement date) in the future

at a specified price (the futures price). The settlement price is the price of the underlying asset onthe delivery date. Both parties to a futures contract are legally bound to fulfil the contract on thedelivery date. If the holder of a futures position wishes to exit their obligation before the deliverydate, they must offset it either by selling a long position or buying back a short position. Such anaction effectively closes the futures position and its contractual obligations.

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Advantages

• The use of derivatives means that some financial risks can be transferred to other parties

who are more willing or better suited to take or manage those risks and can thus be auseful tool for risk management.

• Purchasing derivatives can be a safer choice if there is a possibility of a looming bear

market as they are hedged, unlike equities.

• Buying now at a future price can be cheaper than buying at market price in the future,

bearing in mind that the spot price could be less expensive.

• A long call option requires no obligation when it is due.

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Disadvantages

• If the market changes dramatically, it is possible to lose financially if the derivatives are

being used as a speculative instrument.• If you hold the put option on a derivative, you are obliged to adhere to it if the holder of

the call chooses to exercise their right to sell or buy.

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Dos and Don’ts

Do

• Take time to consider which derivative is most suitable for the transaction you have in

mind.

• Consult a financial intermediary or seek other expert guidance if you are unsure.

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Don’t

• Don’t enter into a contract that will lock you in if there’s the slightest possibility that you

may need to exit before its expiration date




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