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THE INVESTOR VOLUME 5 ISSUE 6 June 2012

poor companies - rich multiples, Pg. 18

how do you do infosyspg. 16

FINANCIAL WOES OF

INDIAS RISING SUN


2/24Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bearsno responsibility whatsoever.

F R O M E D I T O R S D E S K

NiveshakVolume V ISSUE VI

June 2012

Faculty MentorProf. N. Sivasankaran

Editorial Team Akanksha Behl Akhil Tandon

Chandan GuptaHarshali Damle

Kailash V. MadanNilkesh Patra

Rakesh Agarwal

Creative Team Anuroop Bhanu

Venkata Abhiram M.

All images, design and artworkare copyright of

IIM Shillong Finance Club

Finance ClubIndian Institute of Management

Shillong

www.iims-niveshak.com

THE TEAM

Dear Niveshaks,

The month of June has wit essed some major nancial events that areshape the f t re of economic development globally. The fear of a dramatic kept the world on edge has nally subsided for some time a er Greece electThe emergence of pro-Europe par ies in the Greeces election should relax count will leave the euro for the rst time and unleash global nancial t rever, the slim majorit won by pro-bailout par ies in Greece elections and wthe Spains scal and banking problems kept tensions high.

Another major event this month has been the meeting of the G20 memLas Cabos, Mexico. The dangers that Europes escalating debt crisis would global economy back into recession for the second time in less than four ye nated the summit of G20 leaders of indust ialized and developing nations, wresent over 80 per cent of world out ut. European count ies showed at the20 summit that they were considering major steps to integ ate their bankingas to break the cycle of highly indebted count ies and rescue their banks, w pushes gover ments ever deeper into debt.

This years meeting of United Nations Conference on Sustainable Devdubbed Rio+20 aimed at se ing an agenda for policy akers to act in the cocades, and promote cuts in fossil-f el subsidies, suppor for the use of reneerg and measures to protect oceans. However, as any ag eement will have nt eat , the Rio +20 ended with a whimper rather than a bang compared to thits predecessor, the 1992 Rio Ear h Summit, which led to major conventionchange and biodiversit .

In India, RBI kept policy rates unchanged in its mid-quar er monetarreview because of high headline in ation. The market indices reacted negati news. In spite of a shar er than ex ected rate cut of 50 basis points in April,in activit , par icularly in invest ent, showed that the role of interest rates ismall and a f r her rate cut could exacerbate in ationar pressures rather t g owth. The RBI stance had another adverse impact causing r pee to dep 55.83/84 to a dollar on the day of the review and to its all-time low of 57.12dollar days later.

In another major development, Standard & Poors war ed that India ccome the rst BRIC economy to lose its invest ent-g ade credit rating. In move, Fitch added f r her insult to injur by revising Indias outlook o negative at BBB-.

This issue brings to you some more interesting and insightf l reads. Tstor this month focuses on nancial woes of solar power in India. The issut res ar icles on reg lations in Insider Trading in India, company valuation plications of reg lating propriet t ading of nancial instit tions. The Clas month ex lains the nuances of Leveraged Buyout.

We would also like to thank our readers for their constant suppor throuderf l ar icles and appreciation. It is your endless encouragement and enthat keeps us going.

Kindly send in your suggestions and feedback to niveshak.iims@g ail.

as always,Stay invested.

Team Niveshak


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C O N T E N T

Niveshak Times04 The Month That Was

Article of the month08 Is India Ready to FightInsider Trading ?

Cover Story

11 Financial Woes of IndiasRising Sun

Perspective

16 How Do You Do Infosys?

FinGyaan

18 Sir Volcker vs. Prop Trading

Finsight18 Poor Companies - RichMultiples

CLASSROOM21 Leveraged Buyout (LBO)


4/24 M ay 2012

May WPI inches up to 7.55% and CPI risesto 10.36%Countrys benchmark inflation rate rose to 7.55%in May as a result of elevated food and fuel pric-es. A jump of 0.22% in WPI matched the expec-tations in Reuters Poll. Core inflation, which ex-cludes volatile food and fuel prices, was around5% in May. Finance Minister talking to reporterson Thursday said core inflation falling is a silverlining. He said good monsoon will help easepressure on inflation and was confident that in-flation will be in the range of 6.5% to 7.5% inFY13.At the same time Consumer Price Inflation stoodat 10.36% up from 10.26% in April, as a resultof high vegetable, egg, meat, fish, oil and fatprices. In the urban areas annual inflation basedon the CPI stood at 11.52% while in rural areasit remained in single digit at 9.57%. In April in-

flation based on the CPI in rural areas stood at9.67% while in urban areas it was at 11.10%.Europe crisis: Spanish short-term debtcosts reach record levelsSpain, the eurozones fourth larg-est economy, hadto pay 5.07 percentto sell 12-monthTreasury bills and

5.11 percent to sell18-month paper on June 19 - an increase ofabout 200 basis points on the last auction forthe same maturities a month ago. Spain inchedcloser to becoming the largest euro zone coun-try to be shut out of credit markets when it hadto pay a record price to sell its short-term bor-rowing instruments. The soaring short term bor-rowing yields showed that Europes troubles aremuch bigger and deeper than just Greece and aconsiderable action is now needed to tame two-

and-a-half year old European debt crisis. Span-ish Economy Minister Luis de Guindos, attendingG20 summit, told reporters that Madrids poli-cies were not to blame for the loss of investorconfidence. We think ... that the way markets

are penalising Spain today does not reflect theefforts we have made or the growth potential ofthe economy, he said. Spain is a solvent coun-try and a country which has a capacity to grow.IIP in April was worse than anticipatedReduction in capital goods and shrinkage in man-ufacturing output in April has resulted in a IIP at0.1% versus -3.5% in March. This is worse than

what was expected. The slowdown in growth offactory output was expected to force RBI to cutinterest rates but RBI kept the rates unchangedin their quarterly mid-term review on June 18.The unexpected lower IIP and unchanged inter-est rates are expected to put more pressure onIndian Economy which is already suffering fromtwin problems of lower GDP growth rate andhigher inflation.Indian economy is in stag ation: Moodys

Global financial services firm Moodys, on June14, said that Indian economy is facing stagfla-tion. Indias economy is in stagflation, with no-tably weaker growth but inflation still stubborn-ly high, said Glenn Levine, Senior Economist,Moodys Analytics. As per Moody, the recentplunge in the rupee is pushing up the price, es-pecially imported goods and commodities pricedin US dollar and combined with slower GDPgrowth, this has led to the situation of stagfla-tion for Indian economy. It further said with the

rupee, sitting 15 per cent below its peak of late-February, will ensure that WPI inflation remainsin the 7 per cent to 8 per cent range for anothersix months. Indeed, with the growth side of theeconomy slowing, the risks have shifted sharplytowards growth and they (the RBI and other pol-icy makers) should just grin and bear the higherinflation numbers, it addedRBI Governor announces Mid Term re-view, disappoints industry with no ratecuts The Reserve Bank of India (RBI) announced itsmid-term credit policy review here on June 18,and against the industry expectations, kept theshort term lending rate and the Cash Reserve

The Niveshak Times


IIM, Shillong

Team NIVESHAK

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Ratio (CRR) unchanged at 8 and 4.75 percent re-spectively. Industry expected RBI to bring downthe repo rate by at least 0.25-percentage pointto 7.75 percent, and the Cash Reserve Ratio(CRR) up by 1 percentage point. Our assess-ment of the current growth-inflation dynamic isthat there are several factors responsible for theslowdown in activity, particularly in investment,with the role of interest rates being relativelysmall. Consequently, further reduction in thepolicy interest rate at this juncture, rather thansupporting growth, could exacerbate inflationarypressures, the RBI said in a statement. RBI, tar-geting GOI, also said that government has failedto follow the path of fiscal consolidation whileit is trying its best to link monetary policy withfiscal policy. Finance Minister Pranab Mukherjeesaid high inflation weighed on RBIs mind butCommerce and Industry Minister Anand Sharmaexpressed his anguish over RBI choosing a sta-tus quo when the industrial growth was down.Stock market reacted strongly to the announce-ment and tanked, suffering a loss of 244 pointsat closing.Indias stand on infrastructure invest-ment sanctioned by G20

The G20 meeting held re-cently in Mexico concludedwith an approval of In-dias stand on investmentin infrastructure by theleaders that included USPresident Barack Obama,German Vice Chancellor

Angela Morkel, Chinese Prime Minister Wen Jia-bao and Russian President Vladimir Putin. TheG20 comprises of the worlds prominent and de-veloping economies. India was of the viewpointthat investment in infrastructure is critical forcontinued growth, worldwide economic retriev-al, poverty reduction and job creation. India re-quires a minimum of $1 trillion in infrastructurein the coming five years. Manmohan Singh an-nounced that the much needed investment ininfrastructure in emerging economies can playa crucial role in firming expansion and stimulat-ing the process of recovery world-wide. A clear

communication was given that growth cannot beoverlooked and while austerity is important forcountries facing too much debt, surplus nationsmust counter it with expansion. The affirmationalso had other observations which were in linewith what was being pushed for by Indian debat-ers at G20 Summits and other forums.

Indian money has risen after ve years inSwiss Banks

At the end of 2011, the amount of money held byIndians in Swiss banks totalled 2.18 billion Swissfrancs. This figure has risen for the first time inthe last five years. The latest data by the SwissNational Bank has revealed that the total fund isinclusive of 2.025 billion Swiss francs held direct-ly by the Indian individuals and 158 million heldthrough fiduciaries or wealth managers. This fig-ure does not indicate the much-debated allegedblack money held by Indians in safe tax havensof Switzerland. Also, the figure is exclusive ofmoney held by Indians in the names of others.The quantum of funds by Indians in Swiss bankshas last increased in 2006 by over 1 billion Swissfrancs but fell to less than one third by the endof year 2010.SBI does not agree to RBIs move to pre-vent Rupee from falling RBI has directed the oil companies to purchasehalf of their dollar requirementsdirectly from a selected

group of PSU banks as theybelieve that this movewould prevent the Rupeefrom falling. It maintainsthat this would help checkvolatility and seize the free-fallof the rupee. However, State Bank of India statedthat it doesnt think that such a move wouldincrease the overall availability of dollar or en-hance the rupee-dollar prices and considers themove to be a step by the RBI to keep away the

criticism that RBI is not doing enough.

The Niveshak Times

www.iims-niveshak.com 5NIVESHAK

T h eM on t h T h a t W a s

FINANCE CLUB, INDIAN INSTITUTE OF MANAGEMENT SHILLONG


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MARKET CAP (IN RS. CR)BSE Mkt. Cap 60,08,120Index Full Mkt. Cap 28,54,377Index Free Float Mkt. Cap 14,37,177

CURRENCY RATESINR / 1 USD 56.99INR / 1 Euro 71.57INR / 100 Jap. YEN 70.88INR / 1 Pound Sterling 88.97

POLICY RATESBank Rate 9.00%Repo rate 8.00%Reverse Repo rate 7.00%

Market Snapshot


RESERVE RATIOSCRR 4.75%SLR 24%

LENDING / DEPOSIT RATESBase rate 10%-10.75%Deposit rate 8.5% - 9.25%

Source: www.bseindia.comwww.nseindia.com

Source: www.bseindia.com

Source: www.bseindia.com23rd May to 22nd June 2012

Data as on 22 nd June 2012

M a r k e t

S n a p s h o t

CURRENCY MOVEMENTS


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M ar k e t S n a p s h o t

BSEIndex Open Close % ChangeSensex 15995.14 16972.51 6.11%

MIDCAP 5845.02 6010.21 2.83%Smallcap 6275.06 6407.50 2.11%AUTO 9140.47 9202.50 0.68%BANKEX 10620.53 11561.05 8.86%CD 6376.56 6175.39 -3.15%CG 8724.07 9737.67 11.62%FMCG 4587.90 4875.32 6.26%Healthcare 6595.40 6709.57 1.73%IT 5504.10 5663.69 2.90%METAL 9876.02 10344.99 4.75%OIL&GAS 7455.43 7895.03 5.90%POWER 1766.58 1893.62 7.19%PSU 6617.44 7089.80 7.14%REALTY 1562.39 1630.87 4.38%TECK 3190.29 3293.54 3.24%


Market Snapshot

% CHANGE


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All of us, as investors seek the best avenues toinvest our hard earned money. As a prerequisiteto this, we expect the equity markets we investin to be free of any manipulation or bias. How-ever, there have been an increasing number ofcases where board members or top executivesof companies have manipulated the marketspurely on the basis of certain information privyto them. Such acts of insider trading are growing

in number and if not acted upon swiftly coulddeprive regular investors of a clean and an ef-ficient market.Insider trading is the buying, selling or dealingin the securities of a listed company by a di-rector, member of the management, employeeof the company, or by any other person suchas internal auditor, advisor, consultant, analystetc., who has material and non-public informa-tion. One of the most common indications ofinsider trading is the spike in stock prices aheadof some important corporate announcement,especially mergers and acquisitions.To put the entire scenario in perspective, we canconsider the case of the United States.The Indian born Managing Director of McKinsey& Co, Rajat Gupta, was recently found guilty onthree cases of securities fraud and one case of

conspiracy. He, along with his business partnerAnil Kumar and close friend Raj Rajaratnam, theSri Lankan born head of the Galleon group arebelieved to have indulged in insider trading andare now held guilty by the law. Mr. Gupta couldface up to 20 years in prison, proving that nocorporate honcho is above the law in the US.As much as its against the law for company ex-ecutives to profit from inside information, these

laws seldom apply to the Congress.They call their Congress members representa-tives, but they are far wealthier and live fardifferent lives than those they are supposed torepresent. Election to the House or Senate putsmembers in esteemed company, replete withrespect and perks most of their constituents canbarely imagine. And since wealth accompaniespower, that means they are often surrounded bywealthy people, who invite them to restaurants,

golf clubs and resorts frequented by the veryrich.The wealth gap and disparity between Congressmembers and their constituents appears tobe growing. A recent New York Times analysisof public records found that nearly half of themembers of the House and Senate are now mil-lionaires. And while many Americans have lost

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IIM ShIllongKailash V. Madan

Is India

ready to fight Insider

Trading ?

One of the most common indications of insider trading is the spike in stock prices ahead of some important corporate announcement, especially mergers and acquisitions.



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ground in the last few years, Congress membershave gotten wealthier.There have been several cases where speakersand other politicians have been invited on theground floor when private companies went pub-lic through their IPOs. It is not a rare sight tosee politicians and bureaucrats make millionsfrom stock market killings.If the goal is to root out corruption and ensurean information-efficient market, and raise thepublics low opinion of the Congress, the Houseshould ensure that the Senate Bill is applied foreveryone in the same effect.Closer home, in India, any broker, dealer, ana-lyst, securities lawyer or even someone in the

stock market will accept that insider trading isnot only rampant on Dalal Street, but also inter-linked with stock trading.Insider trading was branded as illegal only abouttwo decades ago after the regulator SEBI (Securi-ties and Exchange Board of India) enacted theProhibition of Insider Trading Regulations, 1992.Earlier, phone calls, emails and internet chatswere the preferred mode of communicationfor sharing information. Nowadays, messagesthrough Blackberry, which make tracking at thesource and recipient after deletion impossiblein India, has emerged as the preferred mediumamong market players.Because of such loopholes, there have been

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Company Year Problem

Hindustan Lever Limited Mar-98

The case involved HLL pur-chasing a sizeable chunk ofBrooke Bond Lipton sharesfrom UTI, prior to its public

announcement related to themerger of the two outfits

ABS Industries Jun-01

ABS' MD purchased his owncompany's shares from the

market prior to the takeoverdeal between ABS and Bayer

Alliance Capital Mutual Fund Apr-04

Their Asia-Pacific head wascharged with indulging in un-fair trade practices for dispos-ing off a considerable quantity

of shares held by the fundunder his management whichresulted in a sharp decline in

the valuation of Alliance

Wockhardt Nov-06

The CFO of Wockhardt, alongwith his immediate family

members, was alleged to havetraded in the pharma com-

pany's shares on the basis ofunpublished price-sensitive

informationTable 1: Instances of insider trading in India

If the goal is to root out corruption and ensure an information-ef cient market, and raise the publics low opinion of the Congress, the House should ensure that the Senate Bill is applied for everyone in the same

effect.


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sive bids, it is a no brainer to assume solar powerto be a solution the panacea to Indias Carbon-ized power sector.Though solar power seems to be a lucrative option,a question worth pondering upon is why solar pow-er fuels only 0.48% of Indias electricity demand?One of the major reasons behind this is the Bank-ability of solar power plants. As these projectsrequire a heavy upfront capital investment, the de-velopers rely on banks for funding. However, the

bankers are apprehensive about the same, whichleaves the cash crunched developers in a difficultsituation. Even the successful bidders under JNNSMhave faced problems to achieve financial closurewithin the stipulated time. The particular risks thatmake solar power project financing a concern forbanks are as follows: TechnologyGiven the fact that solar technologies are relativelya new concept in India, there exists numerous riskswith respect to execution of the projects. Crystal-line cells and modules are comparatively easier toexecute and come with a guarantee of more than20 years, rendering them to be less risky both fordevelopers as well as banks. However, in the lastcouple of years, novel technologies like thin-filmmodules have emerged which involve a lower up-front investment, but are unproven and thereforeconsidered more risky. Power Purchase AgreementsThe current draft of the JNNSM provides for a Trader

PPA with Nation Vidyut Vyapar Nigam Ltd. (NVVN),under which the developers will receive the pre-defined tariff for supplying solar power to the stateutilities. This may appear a sure shot money mak-ing project on paper, but the financial health of the

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TeaM n IveShak Akhil Tandon

IntroductionIndia is located in the equatorial sun belt of theearth, thereby receiving abundant radiant energyfrom the sun. As per the data published by The In-dia Meteorological Department (IMD), in most partsof India, clear sunny weather is experienced 300 to330 days a year. The annual global radiation variesfrom 1600 to 2200 kWh/sq. m. which is comparablewith radiation received in the tropical and sub-tropical regions. The equivalent energy potential is

about 6,000 million GWh of energy per year, whichqualifies solar to be one of the most lucrative op-tions for fuelling Indias power requirement in thenear future.In an effort to provide impetus to the adoption ofsolar power, the government has taken numer-ous initiatives, notably setting up of Ministry ofnew and renewable energy(MNRE), introductionof Renewable Purchase Obligations(RPOs) and Re-newable energy certificates(RECs). However, themost significant effort has been the launch of the

Jawaharlal Nehru National Solar Mission (JNNSM)in 2010. Under JNNSM, the government adopted aunique mechanism of inviting bids from develop-ers at which they were to supply solar power tothe state utilities. The tariff was to last a period of25 years.Till date, two round of bidding have successfullytaken place, which saw the participation from bothnational and international behemoths. The tworounds of bidding saw the average bids to declinefrom Rs 12.16 per Kwh to Rs 8.77 per kWh. Solaire

Direct SA, a French company, surprised the entireglobe by offering an ultra-low bid of Rs 7.49 perkWh, which was more than 50% lower than thebenchmark tariff quoted by the Central ElectricityRegulatory Commission (CERC). With such aggres-

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There exist primarily two routes by which developerscan raise finance: Balance-sheet based financing This option can be effectively tapped by large con-glomerates having a healthy balance sheet, whichwould interest the bankers. The companies can usetheir liaison with their banks to provide debt at acheaper rate. Also, the large asset base of these com-panies provides them with the necessary armour tosupport large projects, which helps in lowering thecost of operations and operating efficiently. Howeverthis would put the company balance sheets at riskand the entire burden of the project failing or under-performing falls on the developers. In India, com-panies like GAIL, IOCL, Punj Lloyd have successfullyavailed of this option to fund their projects. Non-recourse project financing Non-recourse financing refers to a loan where thelending bank is only entitled to repayment from theprofits of the project the loan is funding, not fromother assets of the borrower. This is the preferredfinancing structure where the lending financial insti-tution funds a special purpose vehicle (SPV) set-upespecially for the project or for a group of projects. Insuch a framework, the financial institution has a lienon the projects cash-flows. However as this structuredoes not provide recourse to the developers balancesheet, lending institutions require rock-solid agree-ments for revenues from the projects. Given the un-certainty of cash flows, the spread for non-recoursefinancing is typically higher than what banks are will-ing to accept for balance sheet financing. In India,many conglomerates such as Mahindra & Mahindra,Reliance Industries, Jindal Group, etc. have under-taken this route to fund their projects.While entering into a negotiation with the banks, thedevelopers also need to ensure that the following arein place to make the lending institutions comfort-able:1. Performance The viability of a solar power plantis contingent on the Capacity Utilization factor (CUF)

state utilities puts a question mark on the assumedto be assured return. Many state discoms are no-torious about delaying and even defaulting on pay-ments which results in financial institutions refusing

to consider these PPAs bankable. Estimation of Solar Radiation The output of a solar power plant is contingent uponthe Direct Normal Irradiance (DNI) at the plant site.High quality solar radiation data is a pre-requisite fordetermining the viability of a plant. Given the sensi-tivity of the generation capacity to the solar radiationreceived, solar radiation assessment is deemed tobe a very important activity and typically requiresseveral months for ground measurement of solar ra-diations. Any error in solar resource estimation addsan uncertainty to expected future returns. As of now,on-ground solar radiation data is sketchy and thesimulation models are at a preliminary stage. Evacuation InfrastructureIn India, the interiors of states of Rajasthan, Gujarat,Maharashtra and Tamil Nadu are considered to be thebest sites for installing solar power plants. Evacua-tion of the electricity generated from power plantslocated in these isolated areas is a challenging task.Extending the grid to these sites requires develop-

ment of new transmission lines which are often con-troversial, both because of their expense and the po-tential of damage to property and environment.Given the above factors, it is highly unlikely for thebanks to consider Solar Projects as bankable in thenear future, which makes recourse based lending adistant dream.In wake of such circumstances, let us examine thepossible options which can help reviving Indias Set-ting Sun.Options for debt nancing

Solar power is at a nascent stage in India. However,nations like Germany, Italy and France have beensuccessful in arranging for finance for solar projects.This provides a ray of hope for Indian developers.

Fig. 1: Cuurent capacity in India



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lier this month, Azure power announced long-termfinancing of $70.35 million by Export Import Bank ofthe United States for its solar power plant at Nagaurin Rajasthan. Indian behemoths like Reliance Power

have also availed of these concessional loans. Foreign fundingLarge project developers can tap international banks

to get lower rates of finance. Financing of Solar proj-ects is not a new prospect for banks abroad, whichmakes the spread relatively lower than that offeredby their Indian counterparts. However, hedging canput a substantial dent in the rate differential andonly someone ready to take the currency risk shouldresort to this option. Given the current macro-eco-nomic scenario, it will be a bold move to discountcurrency fluctuations while taking a call on foreignfunding. Joint VenturesMany companies have also entered into JVs withforeign companies for technical as well as financialassistance. Companies like Tata group have taken alead here, and have tied up with BP Solar to set upTata BP Solar Ltd. Green Energy fundsThere are many green energy funds currently in the

market and these can provide equity, quasi-equityand mezzanine financing.ConclusionIn view of the policy support and the abundant solarradiation available in India, solar projects are an at-tractive investment option and can provide equity re-turns in the 15%-20% range. However until the banksget comfortable with the proposed solar PPA, devel-opers rely on non-conventional sources of financing;and support from the government, in terms of final-izing the PPA,REC and RPO structures, can go a longway in getting the projects financed in a nonrecoursemanner.

of the equipment, which is a measure of the abil-ity of the equipment to convert solar radiations intoelectricity. Contractual guarantees from technologyproviders for the long-term performance of the plant

is one possible way out which can assure the bank-ers that the plant will be able to sustain the prom-ised performance.2. Revenues As discussed above, the PPAs provideassured revenues only on paper. With the currentstructure of the JNNSM, PPA may not be bankable dueto the credibility of many states. There has been abuzz around that government has been contemplat-ing a tri-partite agreement between the developer,state discom and the Reserve Bank of India to ensurethe PPAs bankability, however this is not confirmedyet. Another source of revenue for the projects canbe the Renewable Energy Certificate (REC). The devel-opers can forego the preferential tariff and trade theRECs on the energy exchange. In India, the trading ofRECs has started in two exchanges Indian EnergyExchange (IEX) and Power Exchange India Limited(PXIL). However, the market is in its nascent stageand depends on the states renewable purchase ob-ligations.3. Project viability In addition to the above, develop-ers must be able to take the lenders into confidencethat projects are viable and have the capability ofrepaying debt without outside assistance. This couldmean that the project has to fund a Debt-Service-Reserve-Account in addition to having healthy DebtService Coverage Ratios.Other options for nancing

Other non-conventional options for obtaining fundingthat can be considered by developers are: EXIM financingThe United States export-import bank provides fund-

ing for projects which import a significant chunk oftheir equipment from the United States. This is agood option in case the main technology provider isfrom the US and has relations with the EXIM bank.US EXIM bank has committed $7 billion to India. Ear-

Fig. 2: Grid parity projections(Source: Internal Analysis)


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Taking the example of two energy firms ApacheCorp (APA) and Anadarko Petroleum (APC), each

with an EV/EBITDA multiple of just over 5 in theyear 2010, the average EV/EBITDA multiple in theirpeer group being just under 7. This seems to in-dicate APA and APC were relatively undervalued.However, looking at these companies strictly on aP/E basis, one would wonder why shares in thesecompanies hold any appeal when they are tradingat P/E multiple of nearly 30x.

There are more detailed valuation models availablein the market that incorporates not only the pastperformance but also forecast future ones. However,these models are complex for the general investingpublic and they seldom make the headline. This isgenerally a cause of concern for senior executivesas their claim that their company has great growthprospects and many investments projects in handare not properly valued in their companys stock

price. Actually, they are not necessarily wrong. Evenfinancial theories suggest that companies whichhave higher growth prospects should have higherearnings ratios and hence better market value.But the problem with the P/E ratio is that its aretroactive metric. It pits a companys current mar-ket cap against its trailing-12-month (TTM) profit.But when you buy shares of a company, you are

A premium earning multiple is hard to come to acompany and even harder to maintain.In recent times when everybody seems to be in ahurry, investors too have discovered a quick shorthand for their investment P/E ratio.Countless investors, individuals and professionalsalike, spend their time seeking out cheap stockswith very low P/E ratios. Sometimes the stocks arecheap for negative reasons like uncomplimentary

industries or poor fundamentals hidden within.And as a result, the stock prices stay stagnant...sometimes for years. But sometimes investors donot pay attention to this fact and companies takeundue advantage and modify the P/E ratio by var-ious means the most common being inclusionsof debt in the capital structure.When companies are financially leveraged thenthe company with higher debt in the capital struc-ture has lower P/E ratio and is more preferableamong its peers.

Company withdebt

Company withonly equity

Earnings (EBITA) 50 50

Interest -20 0

Net Income 30 50

Enterprise Value(EV)

1,000 1,000

Debt -500 0

Market Capitaliza-tion

500 1000

EV/EBITA 20.0x 20.0x

Debt/Interest 25.0x N/A

P/E Ratio 16.7x 20.0x

Table 1: Leverage distorts the P/E ratio (Hypothetical case)

Table 1 clearly shows that though both the com-pany has same EV value, their P/E ratios havechanged substantially due to inclusion of debt.

Poor Companies - Rich Multiples

W elIngkar InSTITuTe of M anageMenTPreetam Mittal

Countless investors, individuals and professionals alike, spend their time seeking out cheap

stocks with very low P/E ratios



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not purchasing its history you are purchas-ing its future cash flows. What matters is whatthe company is going to do and not what it hasdone.Another very common form of manipulationused by companies is called the big bath , andthis can make stocks seem undervalued to in-vestors. This happens when the company incursa big loss to their bottom line. In this methodthe company takes the complete loss in a singleaccounting period, instead of spreading theselosses over years. This will cause the earningsper share to drop significantly for the time pe-riod involved due to the large losses posted andmove earnings from the present to the future.The intention of the company is to foster theidea among investors that this charge is a onceonly deal, and that the stock will rise consider-ably after the loss has been absorbed. This willcause investors to see the stock as underval-ued and an attractive investment and thus willcause the demand and price for the stock to riseartificially.One must always keep in mind that using onlyP/E ratios on a relative basis means that theanalysis can be skewed by the benchmark be-ing used. After all, there are periods when in-dustries in entire market become overvalued. In

2000, an Internet stock with a P/E of 75 mighthave looked cheap when the rest of its peershad an average P/E of 200. In hindsight, neitherthe price of the stock nor the benchmark madesense. This shows that being less expensivethan a benchmark does not mean that the stockis cheap because the benchmark itself may bevastly overpriced.Also, these ratios are completely ineffective forcyclical firms that go through boom and bust cy-cles--semiconductor companies and auto manu-facturers are good examples and these requiresa bit more investigation. Although one wouldtypically think of a firm with a very low trailingP/E as cheap, for a cyclical industry it would bethe wrong time to buy because it means thatearnings have been very high in the recent pastand are likely to fall off soon.Other things that can distort the P/E ratio include

Even nancial theories suggest that companies which have higher growth prospects should

have higher earnings ratios and hence better market value

inclusion of gains from recently sold businessesto produce an artificially inflated earnings anda lower P/E as a result. The denominator of theratio can also be manipulated by changing therevenue recognition, depreciation and capital-izing cost. In late 2000, software-maker OracleORCLhad a very low P/E based on its prior fourquarters earnings giving the impression that itis a good investment opportunity until a deeperinvestigation into the numbers revealed that thecompany had booked a $7 billion gain by sellingits stake in Oracle Japan. Based on operatingearnings, the stock was not cheap at all.So whats the solution?The solution is to account for the growth rate ofthe company or expected growth rate if it canbe calculated. Thus, it gives birth to a new and

better ratio - PEG ratio computed as:PEG Ratio= Price-to-Earnings (P/E) Ratio / An-nual Earnings per Share GrowthA crude analysis suggests that companies withPEG values between 0 to 1 may provide higherreturns (the closer to 0 the more undervalued acompany).In fact, if one goes back a decade then one mayfind that Apples P/E ratio at the time was 297.So, anyone making investment on the basis ofP/E ratios would not have considered it a veryprofitable investment then based on its highP/E value. However investors who had boughtshares of the company then have made whoop-ing returns of 7,300% today.But if someone calculated the PEG ratio, it wouldbe something close to 1 indicating that PEG canbetter guide investors in their investments.Finally, as an investor, it is important to continu-ally sharpen your skills and put new tools inthe toolbox. It makes sense to go through and

calculate different multiples such as EV multiple(EV/EBITDA, EV/EBIT, EV/NPAT, EV/Invested Capi-tal etc.), PEG and Dividend yield ratio etc. for allcurrent holdings and for future investments toreduce the likelihood of making poor bets.


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With Infosys witnessing steep falls in stock price,

with stagnant salaries to continue for one more yearand with attrition rates to blow up, the headwind ofsquatty guidances has hit the bellwether companybadly from all sides. In the wake of these develop-ments, this article is an analysis of a few aspects ofInfosys financials and policies. Using concepts ofleverage, cost of equity, human-resource accountingand balanced scorecard, the analysis tries to explorethe possibilities which the management, particularlyfinance department, might have partially or fullymissed to attend; overlooking which can be hazard-ous to Infys health.Why didnt CFO Mr. Balakrishnan deem it es-sential to burn up.?Any company would and should take pride in maxi-mizing profits through leverage. By leverage, I meanthat you step up your revenue by x%, but your netand operating profits jump by (x+ )% where >0.But this happens only when you incur a Fixed Costfor your operations.

In absence of fixed costs, revenue = profits. Itsbecause of fixed costs that a 50% rise in revenueresults in 80% rise in profits. Now, had the fixedcost been 4000 instead of 3000, the leveraging effectwould have been better. A 50% revenue could have

led to 100% profits, bringing leverage multiple to 2from 1.6.Thus, more the fixed cost, the better leverage yourfirm enjoys. In other words, to bring your companyin a better condition, so that it enjoys better lever-age, you need to expend some additional fixedcost. The moment I say fixed cost, it has abso-lutely no proportionate relation with revenues.One such fixed cost is Salaries. Coming to Infosys,where the mantra to be harped upon in FY 2012-13 is to maximize profits,with financial leveragealmost absent, to capitalize on operating leverage,why didnt CFO Mr. Balakrishnan deem it essential toburn up some money on salary increments and soincur the additional fixed cost?

With this decision not at all favoring a rise

in pro ts in any which way, what good hasbeen cited in slashing variable.?Lets try to understand the aspect of distribution ofcosts between fixed and variable on leverage effect.A higher leverage multiple also means a higher riskof losing profits substantially on a relatively smallerfall in revenues. So, if a company senses a slow-down in future, it ought to divert its spending un-der fixed costs to variable costs. As a manifestationof this idea, the company may decrease fixed salarycomponent and increase the performance-based in-

centives. On the other hand, if the company sensesa brighter market ahead, it diverts the salary com-ponents in the reverse manner to make the leveragemultiple higher.Surprisingly, what Infosys has done is that it hasmade steep cuts to variable pay of their employeeswith no diversion of the same to the fixed compo-nent of the salary. Oops..! This falls in neither of thetwo categories of decisionsCheck table 1 for a few numbers to get a clearerpicture.

The only difference between the three cases in table1 is of the variable cost. Relative to case1, the de-crease in variable costs in case 3 is more than that ofcase 2. Observe that lesser the variable costs, lesseris the increase in net profits for the same 50% risein the revenues of the company from Rs. 10000 toRs. 15000. Even though one may say that more thanthe percent increase in profits, the rise in absoluteprofits due to variable cost cut makes more sensefor a firm, what I wish to say is, this is possible onlywhen two things are ensured. One, if the variablecost cut is in salaries, it should not result in a fallin top-line (revenues), as a salary cut is enough tocause exodus of top talent. If revenues fall, profitsare destined to plummet. Second, to still maintaina fair result compared to case 1, the firm needs toat least ensure the same 50% rise in revenues forgrowth. Practically speaking; how is it possible forany company to enhance its sales by reducingvariable costs and by keeping the fixed costs thesame?With respect to Infosys, the departure of a few peo-ple from top management is already an event of re-cent past. The blow of this verdict has fallen harderon the 300 top executives whose variable salariesshall be cut by 70%, and the already existing lever-age has been substantially tarnished due to this.

SCMhrD,PuneVibhu Gangal

How do you do ?



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With this decision, not at all favoring a rise in profitsin any which way, what good has been sighted inslashing variable salaries heftily and giving a nullhike in fixed component of salaries by Infosys to itsemployees?Has Infosys also succumbed to the trap of?Any company aims to earn substantially more thanits cost of capital. Thus, if a firm has missed to learnits true cost of capital, the target set for earnings

and revenues is also virtual. This eventually leads todisappointing actual earnings and leaves the man-agement puzzled.Equity is often considered as a less expensivesource of capital.Lets give a second thought to this. Owners carrythe maximum risk, which gets accentuated by thefact that they have zero security of assetsto fall back in case the company drownstomorrow unlike the lenders which havethe first preference during liquidation

of company assets. More the risk moreshould be the returns. Following this, company isobliged to consider the true cost of equity muchmore than the rest of the sources. If the firm fal-ters here, it gets into the trap of setting false tar-gets and landing in trouble as mentioned above.Infosys has been the legacy for being a zero-debtcompany in its sector and functioning purelybased on stockholders money. So, the questionis, has Infosys also succumbed to the trap of under-estimating cost of equity, setting stumpy guidances,pursuing and achieving them and causing shares ul-timately to plummet? One may contest this with the stand that Infosyshas declared a massive 940% dividend per share thisyear and so has taken due care of its owners. Tothis, lets understand that that the activity of maxi-mizing shareholders interests is based on two legs:Paying considerable dividends and performing suchthat share price in secondary market keeps on rising.What Infy has chosen to do could strengthen the firstleg, but will badly knock and punch the second. Andthats what seems to be happening- the worst fall ofstock in the last 3 years.Without directly spending more, how canthis massive asset be churned to..?Say a firm targets to earn 25% based on its Cost of

capital calculations and has an asset size of 1000,which currently is earning 20%. To get this additional5%, the firm may increase the asset size, but be-fore that a wiser decision would be to check if thecapabilities of these assets have been exploited tomaximum. If yes, then the firm shall incur cost toacquire more assets. If not, the firm shall spend toaugment productivity of existing assets. In the lattercase, the firm shall prudently choose to spend mon-ey more on those assets which directly contribute tothe revenue rather than spending on ancillary activi-ties and non-performing assets which just facilitatethe performing assets to perform (like furniture andtransport).Lets understand that with the presence of NPAs,even if the asset size stands tall, the actual pres-sure on each unit of PA to earn 25% profit is much

more (its 50% if PAs are half of total assets)than it appears and so, firms responsibil-ity to keep these PAs pepped-up to per-form is indispensable. For this analysis,employees are considered as assets; withreference to concept of human resource

accounting.Coming to Infosys, where an employee-base of

1.5 lacs a huge performing asset, how canthis massive asset be churned to contributemore to earn revenue without directly

spending more on them? In other words, howcould a zero salary hike enable these PAs to bemore productive? Even though HR accounting is notfollowed commercially in India, has Infosys missed

to understand that employees are its significantPerforming Assets?Infosys was the one which kept its promise to ab-sorb recruited candidates when the industry wasgripped with job crunch in 2009, which paid salaryhikes of 10% even during recession, which rolled outESOPs in 2010, and which was uniquely efficient withexcellent cash management practices.With due credits and acknowledgement for all thisto you, CFO Mr. Balakrishnan, the present speaksof a totally different picture. I am really curious to

know whats going on in your mind. Looks like eitheryou have a big surprise to throw or youve falteredbadly.

Table 1: Three cases with different variable costs


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The Volcker Rule comingto effect from July 2012is an effort by the USto restrict the proprietytrading done by financialinstitutions. The articlealso reflects the tradingscenario in India. This isan important step in thelight of the recent trad-ing losses seen by JPMorgan. The regulationcurrently seeks to re-strict the trading and theFDI in the institutionscarrying on such trading.

nicipal, Treasury and federal agencysecurities. The rules provisions are

scheduled to be implemented as apart of DoddFrank Wall Street Reformand Consumer Protection Act on July21, 2012 and were publicly endorsedby President Obama on January 21,2010. (Refer Fig 1).There has been a constant tussle be-tween the Regional Bond Dealers As-sociation being supportive of the rulewhile the Securities Industry and Fi-nancial Markets Associations oppose

the provision. The Volcker rule re-mains highly problematic and is likelyto have the unintended consequenceof constricting market liquidity, asevidenced by the fact that Treasuries,agencies and munis are exempted, said Michael Decker, managing direc-tor and co-head of municipal securi-ties at SIFMA. Lets delve deeper intothe various provisions and technicali-ties of the rule and leave such deci-

sions to the avid readers.The financial industries started offwith the banking industry and invest-ment banking being at bipolar endsbut as time passed these were broughtunder a common umbrella holdingfor e.g. Citibank has retail bankingas well as an investment arm thoughthe line has blurred being under thesame cap. Let us rather use the terminvestment banks to generalize the

commonality between the bank andthe investment arm. The main motiveof such banks is to make a market forthemselves (market-maker) to sur-vive in terms of the services offered

Everybody Rest Assured Sir, Just wishus Luck says the big banker to his

customer. If the deal turns sweet, itsthe bankers to praise and if it doesntwell they are Too Big to fall. Thisvery stance of power and autonomyachieved by these institutions is whatPaul Volcker is adamant about endingbut then who is Paul Volcker and howis he planning to do so?Paul Volcker is an economist andformer head of the Federal Reservewho currently heads President Barack

Obamas Economic Recovery AdvisoryBoard and is credited with endingthe high periods of inflation duringthe 1970s and 1980s. But then he ismore famous among the biggies ofthe financial markets because of theVolcker rule established by him.

Wiki states the rule as a ban onproprietary trading by commercial

banks, whereby deposits are usedto trade on the banks personal ac-counts, although a number of excep-tions to this ban were included in theDodd-Frank law, such as the mu-

goa InSTITuTe of M anageMenTSavio Fernandes

Sir Vo l c k e r

Prop Trading

vs.



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y a an

(trading stocks, derivatives, currencies, loans incapital raising etc.). Say, a new trader decides

to sells his shares through private placement,since his repute is limited, there would be fewtakers but then suppose an investment banksay Citibank agrees to purchase the shares andthen sells the same at a marginal profit, it woulddefinitely lead to quick liquidity.

This is the basis of proprietary trading which hascome to the phase wherein banks employ trad-ers devoted to the sole cause of trading thoughnow with more focus on profits. These propri-etary desks usually have the highest value atrisk compared to other internal divisions. Manyfamous financial entities belonging to the 2007-08 crises have been known to garner a signifi-cant portion of their annual profits through themeans described. History speaks of traders suchas Brian Hunter who brought down the hedgefund Amaranth Advisors when his massive posi-tions in natural gas futures went bad.The Federal Deposit Insurance Corporation (FDIC)provides deposit insurance, which guaranteesthe safety of deposits in member banks, up to$250,000 per depositor per bank similar to the

DICGC guarantee of Rupees 1 lakh in India. Thusbanks were basically handed a silver platter for

proprietary trading knowing very well that anyloss would be stalled by the government, inshort a Win-Win situation.In contrast financial entities such as GoldmanSachs, speak of the huge reduction of liquidityin the US equity markets as well as internationalbond markets. Another issue lies in the opera-tion difficulty of distinguishing permitted ac-tivities such as underwriting, hedging, tradingof government securities etc. from the restrictedones. This entails additional spends on technol-ogy and infrastructures by banks to comply withthese rules thus claiming these as higher feesfor the corporate customers.Ponder on the following example. The samebanking entity as before, acting as a marketmaker, has purchased one of the several 40,000corporate bond issues in the U.S market andwants to resell the same though a match is notreadily found. During this holding period thebank can experience risks such as counterpartyrisk, price movement risk etc. But then whenthe bank is able to liquidate the same and it sohappens that at a profit, the question is Is it aform of proprietary trading? The repercussions have been felt on the Indiansoil too with the Reserve Bank of India becomingever more cautious towards such trading firmswho seldom divulge their contact information.Recently the finance ministry imposed a banon proprietary trading by finance arms or groupcompanies of foreign banks and a complete re-

striction on foreign direct investment (FDI) inIndian finance companies that only trade in fi-nancial assets on their own account. Sourcesalso speak of a rejection of about three to fourproposals regarding proprietary trading in India,

Figure 1: Timing of Volcker Rule implementation


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from firms such as Morgan Stanley India Com-pany Pvt Ltd and UBS Securities India Pvt Ltd.Domestic banks are not allowed proprietarytrading as a standalone activity but are allowedto do so through separate subsidiary or a jointventure though the maximum market exposure

cap stands at 40%. Cur-rently, FDI is regulatedthrough foreign invest-ment promotion board(FIPB) in India. However,in 18 NBFC activities, 100%FDI is permitted throughthe automatic route. Thishas been viewed by theRBI as a clear possibilityof regulatory arbitrage by

foreign investors for thencan directly pump in theirmoney into these firmswithout having themselves subject to the regu-lations of SEBI. This uniform amount of highercapital inflow can subsequently weaken the In-dian rupee thus harming the nation. Rough es-timates during the April-June 2010 period statethat nearly 24% of total trading on the stockmarket was a part of proprietary trading.On a different perspective, we are limiting a

huge chuck of the banks assets which couldbe used for the trading activities benefiting notonly the bank but also the customers throughlower transaction charges. True we alreadyhave Capital adequacy ratio based on the BASELnorms which restrict reserves in bank but a banon proprietary trading may actually increase thesystemic risk by accumulating assets into thebanking system thus only fuelling the too big tofail scenario. The new norms release by RBI forbanking licenses states that a minimum capital

of 500 crore needs to be held hence the bankswill lose a significant amount of returns whichcould be passed on to customers.Overall, calling for a sudden closure of suchtrades may lead to a huge increase in the banksadministrative costs such as costs of regulatorycompliance, which would be passed on to con-sumers thus making capital investments costsmuch higher in turn affecting the GDP negative-ly. Studies state this as an additional 6.6 millionwork hours coupled with 1.8 million hours per

year for enforcement. It would also entail an ad-ditional 3000 employees per bank along with acost increase of around $350 million.The effect may also make foreign interest rates

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attractive thus affecting trade and devaluationof the domestic currency. Small time firms andstart-ups would also be left devoid of funds dueto these high fees and interest rates.In conclusion it can be said that these regulationdont merely remove risk but simply transfer it.

Say a company thatwould be protectedby hedging strategiesused by a bank maynow undergo curren-cy risk, operationalrisks, currency risksetc. Of course theend customer seemsto be at a loss butthen frequent finan-

cial crisis such as thecollapse of MF GlobalHoldings Ltd, attrib-

uted to proprietary trading, left the authority noother option but to tighten the regulatory cordswhich come into effect post July 21, 2012.


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Sir, I recently read about LeveragedBuyout, what is a Leveraged Buyout?

In a leveraged buyout, the Investor /Private Equity fund acquires controlling in-terest in another company through substan-tial proportion of debt. Apart from very highproportion of debt, what distinguishes LBO

from a normal acquisition is that the assets of the ac-quired company are used as collateral for the debt,which is usually non-recourse to the investor. Also cashflows of the acquired company are used to make inter-est and principal payments.

Sir, it all looks very confusing. Canyou please explain the concept with thehelp of an example?

It is similar to buying a rental housethrough mortgage. As in a rental house,mortgage is secured by the house; in LBOthe assets of the target company are used

to secure the mortgage. Rental income generates cash

flows for servicing debt, while in a LBO target com-panys earnings are used for paying the mortgage. Nor-mally institutional investors and private equity fundsuse LBO to acquire large companies without contribut-ing much capital of their own.

But sir, as we have read in our fi-nance course, high debt also increases therisk. Isnt LBO a risky acquisition strategyconsidering the high degree of leverageinvolved?

Correct, high debt involves both highgain and high risk. A very high proportion ofdebt sometimes results in downfall of thecompany, if the cash flow projections of the

company do not go the predicted way. Company insuch cases, therefore, is unable to service high debtobligations and goes bankrupt.

Which companies are the likely tar-gets to be acquired through a LBO?

Some features like low debt, highassets (useful for collateral), stable cashflows, and synergies make a companyhighly attractive and more vulnerable to

takeovers. Also the acquiring firms look for compa-nies with viable exit options. LBO funds or investorstypically try to exit within three to five years throughan outright sale, IPO or recapitalisation i.e. replacingequity with more debt.

If suppose, the company manage-ment wants to avoid this takeover, whatshould they do?

A number of strategies are adoptedby companies to avoid hostile takeovers.A company may adopt Poison Pill strat-egy, i.e. making the company less attrac-tive to the investor by strategies like load-

ing the company with debt, selling its priced assetsetc. Another strategy used is White knight, wherethe company approaches another party for a friendlytakeover, to counter the hostile takeover.

When did the LBOs originate, andare they actually practiced?

LBOs started around the post-worldwar period and were hugely successfulduring the 1980s. However, its popular-ity has faded since due to stricter lend-ing norms and sceptical perception of the

companys management. Tatas acquisitions of Tet-ley, Corus and Jaguar, Hindalcos acquisition of Nov-elis, and Suzlons acquisition of Re-power are some

of the examples of LBOs.

Sir, thank you for explaining Lever-aged Buyout to us.

CLASSROOM

FinFunda of the Month

Leveraged Buyout (LBO)

NIVESHAK 21

Cl a s s r o om

IIM Shillong Shirish jain


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9. X is the financial regulator of the banks where India is reported to be the 55thbiggest client. Identify X.

10. X is a term in bond valuation which represents the value of a bond, exclusiveof any commissions or fees mostly used in European Markets. What is X?

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