Financial Leverage: the Balance Sheet Polluter

-B.V.Raghunandan

Department of Commerce,Poornaprajna College,

UdupiSeptember 8, 2015

Leverage• Leverage: Having debt in the

capital structure of a company• In 1950s and 60s, it was

considered to be a magical act through comparison of leveraged company and a non-leveraged company

• Effect was considered for profitable companies and non-profitable companies were ignored

Rationale for Acceptance

• High corporate taxes caused reduced tax incidence as interest on debt was a business expense

• Promoters’ Control was not diluted as debt did not carry voting rights

• Equity form of finance like venture capital emerged later• The concept of risk management also emerged later

Reality Check• During a long gestation period of heavy industries and

infrastructure projects, it becomes toxic• For the industry having a huge capital cost and huge running

expenses like civil aviation, it is devastating• When unexpected risks exist, the tables will turn very quickly• Prolonged trade cycles like mining and metal industries

Warning

• Sharia held debt to be a sin• Shakespeare maintained, "never a lender nor a borrower be” and also

depicted the cruelest aspect through the character of Shylock in Merchant of Venice

• Financial Management considered both equity and debt to be the components of capital structure

• Never considered the repayment programme, cautions, warning signals etc as an important exercise

A Carefree World• Corporates did not learn the

lesson leading to the development of art and science of bankruptcy

• Individuals and families were encouraged to over-borrow like housing finance, consumer finance, finance for hospital bills, student loans

• Questionable methods employed for recovery including foreclosure

• Credit card booms• Empty houses and homeless

population

Banks: the uninnovative bureaucrats

• Since 2003, after the reverse merger of ICICI into ICICI Bank, commercial banks started development finance also

• However, it was in the form of Long Term Loans rather than in the form of subscribing to equity shares

• Eventually, the loans get converted into equity as a part of Strategic Corporate Debt Restructuring

• Loan targets are given to bank managers forcing them to find borrowers

Revival of Equity Culture

• A more mature and developed primary market and stock market• Reduced corporate tax rates• Emergence of venture capital and private equity fund• Contribution of HNI and Angel Investors• A Systematic Risk Management and Popularity of debt-free capital structure• Basel Norms for Banks

Rationale for Equity Shares• No need to pay dividend in the absence of profit• Even in the presence of profit, a growth oriented

company does not declare dividend• No need to pay dividend during gestation period• Large body of investors to share the losses• Equity shares are the cheapest source of finance• Shareholder Loyalty for other projects and group

companies• Huge funds can be raised through IPOs and FPOs• Share Premium as another cheap source of finance• Listed companies having access to cheaper foreign funds

The Fallen Empire-DLF Limited• 1946-Chaudhry Ragvendra

Singh promoted• Developer of residential

and other complexes in Delhi until 1957

• 1957-Delhi Development Authority banned private developers

• It went out to Gurgaon in Haryana to develop a city

IPO Details of DLF Ltd.

• 2007-IPO made• 17.5 crore shares of Rs.2 through book-building• Cut-off Price Rs.525• Face Value of Shares: Rs.35 crore• Share Premium: Rs.9,152.5 crore• Share Price went upto Rs.1000 in 2008

Falling Down from Grace

• Forays into Capital Intensive expansion

• Hospitality Industry• Wind and other power

business• Extensive Borrowings• Debt: Rs.19000 crores• Questionable Trade Practices

Correlation between Interest and Profit of DLF Ltd.(Figures in Rs.Crore)

Year Sales Interest Profit

2007-08 14433 310 7,847

2008-09 10,035 555 4,497

2009-10 7,423 1,110 1,709

2010-11 9,560 1,706 1,638

2011-12 9,629 2,246 1,169

2012-13 7,773 2,314 663

2013-14 8,298 2,463 582

Alternative

• FPO at the cut-off price of IPO could have brought in a huge amount of cost-free funds

• It would have saved the interest• More meaningful diversification• Taking care of quality of building in Gurgaon

and maintaining the customer relation

THANK YOU