Q1) What is an IPO?

Ans. IPO stands for Initial Public offer. It is a process by which the existing shareholders of a Company offer their shares for sale. After an IPO the Company gets listed on a Stock Exchange to offer liquidity to the investors. In case of CIL, the Govt of India was off loading 10% of their stake in the Company.

Q2) Why did the Govt Of India (GOI) offer their stake?

Ans. The Offer is a part of a disinvestment program planned by GOI, which aims to raise a total of Rs. 40,000 crores by offering for sale its stakes in Public Sector Banks (PSBs) and Public sector Companies (PSUs). The disinvestment program would enable the GOI to raise funds and bring down the budgetary deficit.

Q3) What is budgetary deficit?

Ans. Deficit refers to the shortfall in Income over Expenses of the Govt. The Govt makes up the deficit by borrowings. A high fiscal deficit is therefore alarming as it shows that Govt finances are spinning out of control. In case of GOI the budgetary deficit last year was at a 16 year high of 6.9%.

Q4) Why did the GOI have such a high deficit?

Ans. This was primarily due to the stimulus package adopted by GOI to counter the global meltdown following the US subprime crisis. GOI, in order to stimulate consumption reduced taxes in order to lower prices of goods and to leave more money in the hands of the consumers. In addition, GOI increased its spending adopting the Keynesian approach (Lord Keynes was a famous economist who proposed that in tough times the Govt have to increase their spending). Now that normalcy is returning the GOI is striving to reduce its deficit and has set a target of deficit to 5.5% of GDP.

The success of the Coal India offer has increased the chances of GOI in reaching its target.

Q5) What are the highlights of the success of the offer of CIL?

Ans. The Coal India offer alone has raised 15000 crores for GOI, i.e. about 37% of the total target. This becomes even more striking considering the fact that GOI has been able to raise only 5.2% from two earlier offers. The issue was oversubscribed over 15 times, against the offer of 15000 crores. Thus the issue mobilised Rs. 2.36 lakh crores. This amount of Rs. 2.36 lakh crores is 25% of the entire Indian Union budget of this year, more than the Indian defence budget of Rs. 1.76 lakh crores, and ten times the Indian Union health budget of Rs. 25,154 crores. It is more than the GDP of Shri Lanka, Nepal and 140 other countries. The offer also set other records even in category wise subscription.

Q6) What other records have been set?

Ans. Of the total, 50% shares were earmarked for Qualified Institutional Bidders (QIBs) totaling $1.57 billion. This was oversubscribed 25 times bringing in $ 38 billion. Thanks to this Offer a number of new Foreign Institutional Investors (FIIs) have invested in the Indian markets for the first time. Also of the 15% reserved for High Net Worth Individuals (Individuals investing more than Rs. 1 lakh), there was an oversubscription of 25 times.

Q7) What was the interest of retail investors (Individuals investing less than Rs. 1 lakh) in the offer?

Ans. The retail portion received bids for 44.6 crores against the 20 crores shares offered to them, Thus retail portion was oversubscribed 2.23 times. Though this number looks small compared to the other categories of QIBs and HNIs it is significant. The IPO received over 17 lakh retail applications, the highest ever in a public sector IPO overtaking the 13 lakh retail applications for NHPC. This goes to prove that if correctly priced, retail investors would show interest in the primary markets. Also the average retail application was about Rs. 70,000 higher than the normal Rs. 40,000.

Q8) What were the reasons for this resounding success?

Ans. Apart from the largest reserves of coal, CIL has a good track record. It is a very profitable Company due to this low cost of production. It is a zero debt Company with more than $ 8 billion of cash reserves. Also as India is a power starved nation, the demand for coal is expected to go up by 11% This portends a good future for CIL. It has reported Rs. 15.60 per Share and expects profits to rise by 25% in the current year. These factors were highlighted very well in the road shows conducted for marketing. However there are certain negative factors which marred the offer to a small extent.

Q9) What were these negative factors & what lessons do they offer?

Ans. CIL had reserved 10% of the offer for its employees. This portion was undersubscribed indicating that employees of CIL have not taken advantage of a good opportunity. As on March 312, CIL had a total of 3, 97,138 employees the breakup being as follows: 15,092 executives, 38,475 supervisors and 343,571 workmen. A majority of workmen have not subscribed to the Offer, clearly showing that the equity cult has still not percolated down in the Indian capital markets.

Q10) What are the expectations of the Capital markets when CIL gets listed?

Ans. The markets are eagerly awaiting the listing of CIL on the stock exchanges on Nov 4^th. They expect CIL to list at a minimum price of Rs. 300/-. At this price CIL will have a market cap of Rs. 1.89 lakh crores. Markets are therefore expecting CIL to be debut among the Top 10 stocks in Market Cap post listing. Note: Market cap is No Of shares multiplied by the Market price.

Q10) What does this success portend for the future?

Ans. GOI is now more confident of meeting its target of disinvestment. This IPO is a game changer as it signals a shift in investor interest towards Asia from US. Asia which accounted for only 12% of IPOs in 1999 has seen a six fold increase since. On the other hand, US which traditionally dominated the Capital markets has seen its share decline by 75%. This shift is clearly evident considering that this year, the collections of all US IPOs has been equaled by collections from only 2 Asian Issues i.e. from Hong Kong's AIA issue and the CIL Issue.

However an analysis reveals a different picture. Neither is RBI in a hurry to issue fresh licenses. nor are many NBFCs are keen to get into commercial banking The reasons are as outlined below:

Restricted Freedom Due To Banking Regulations:

RBI rules are stringent for commercial banks as they are the visible face of the Indian Financial system. Another reason is the fact that commercial banks are primarily custodians of public money.

RBI places restrictions on commercial banks in their lending operations. Out of Rs.100 taken in as deposits approximately Rs.30 has to be set apart as statutory requirements towards Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR). This leaves the Banks Rs.70/- to lend. Out of this Rs.70/- forty percent has to be statutorily lent towards priority sector as defined by RBI.That essentially leaves banks with Rs. 42/- to lend as per their own discretion. Many NBFCs would definitely find this as restrictive to say the least.

As per guidelines of 2001, NBFCs seeking a banking license should have a minimum paid up capital of Rs.200 crores which was to be increased to Rs.300 crores within 3 years of conversion into a bank. (These requirements are further expected to be revised upwards to Rs.500 crores). Further Banks have to invest large funds in fixed assets and information technology primarily to facilitate financial inclusion, risk management anti money laundering, etc. These huge capital expenditures increase the payback period for the investments made. Also banking as a business model is far more people, process and product driven than a simple NBFC model. For example in order to adopt Universal banking the staff needs to be multi skilled in banking functions. Thus the operating expenses would be substantially higher , which in turn would reduce the profitability of operations. Also there are restrictions on ownership and voting rights. Current stipulations cap voting rights at 10% unless with specific approval of RBI.

Thus in light of all these restrictions, it is clear that commercial banking is a far more regulated and complicated business model. This explains the lukewarm response of many NBFCs . At the same time it is clear that RBI is in no hurry to issue new licenses. In a media interaction after outlining the latest April 20^th credit policy, Mr. Subbarao refused to give a time frame. "I am unable and unwilling to put a time frame on this (issue of new bank licenses). It will take several months because there are some significant issues that we have to consider. .We gave the last license in 2004 when Dr. Jalan was the Governor. Since then, India has changed a lot, the world has changed a lot and the world view on Banks has changed a lot. We will have to take into account all that "

It is true that RBI has not issued a new license in the last six years. The reasons are clear when one goes by past experience. In 1994, RBI had issued licenses to nine players. Post 2001, RBI further gave banking licenses to Kotak Mahindra and Yes bank Of these four do not survive today. GTB has been merged with OBC ,Times Bank was merged withHDFC, Bank Of Punjab with Centurion Bank which itself has been merged with HDFC Bank.. Thus out of eleven new banks only seven survive today (a failure ratio of above 35%).

A key lesson of the recent financial crisis is that each time a bank fails it erodes the faith in the system which might eventually lead to a systemic collapse. This explains RBIs reluctance in handing over licenses liberally. In particular the comment on the current world view of the Banks is telling. To say the least private Banks in particular are viewed with suspicion due to their ownership. The last thing that RBI would want is banking failures which would undermine the stability of our financial system.

It is thus clear those only serious NBFCs with deep pockets and who have a differential operating model would seek banking licenses. Also RBI would be in no hurry to issue these licenses. The Governors famous words which he used to explain his credit policy would be worth reiterating "baby steps are far better than giant leaps". The same can be expected of RBI in the issue of new banking licenses.. Action on this front in the immediate future can be effectively ruled out as it is better for RBI to prepare & prevent than repair and repent.

Q1) What is the role of financial statements ?

Ans. Financial Statements play an important role as they give a picture of the state of the business. There are fundamentally 3 main statements. They are :

Profit & Loss Statement.

Cash Flow Statement.

Balance Sheet.

The study and analysis of each of these statements reveals important dimensions of the business.

Q2) Which are the important dimensions of the firm that these statements indicate ?

Ans. The fundamental purpose of any business is to make profits. It is the Consolidated Profit & Loss statement ( P & L) which indicates the profitability of the business. The Cash Flow statement is equally important as it indicates Liquidity. Finally the Balance Sheet indicates the Solvency.

Q3) Why is the word consolidated attached with the P & L statement ?

Ans. The word consolidated means the total of all business of the firm. The business of a firm can be broken up into a number of products or region wise etc. These are called as business segments. A consolidated P & L statement shows the total performance of all the business segments. Since it gives an aggregate picture, managers should always ask for the break up segment wise. This will give them the true picture of the profitability of each business segment. The managers can further analyse and improve the performance of each sector thus improving the business as a whole.

Q4) Why is the cash flow important?

Ans. As indicated the cash flow statement indicates liquidity of the firm. Liquidity of a firm is vital for its survival. Let us take an example to understand this : say a firm XYZ takes goods from its customer at RS. 100/ - for which it has to make upfront payment and sells it to its customer for Rs. 110/, the proceeds of which will be realized only after 6 months . Now the firm is profitable as it earns Rs. 10/- for every unit sold. However it will need cash for financing its purchases till it receives cash from its customers. It will be short of funds for some time and will need funds top continue its business normally. This rolling over of cash in business is called Working Capital Management.

Q5) What is the structure of the Balance Sheet & why is it so called?

Ans. Balance Sheet is a statement of Assets and Liabilities. The Balance Sheet can be simplified and understood in a logical manner if one remembers these 3 principles.

1. Assume the corporate to be an artificial person.

2. Liabilities are sources of Funds to the artificial person.

3. Assets are application of these Funds by the artificial person.

The statement is called Balance Sheet as finally the liabilities (sources) and Assets (application) will equalise and balance each other.

Q6) What are the various liabilities of a firm?

Ans. This is best understood by considering a simple example of a person buying a house. His two main sources of funds will be his own funds and borrowed loans. Similarly a Corporate will have two main sources : Equity which is essentially owners funds and Debt which is borrowed funds. The two main liabilities of a firm are Equity and Debt.

Q7) What are the various assets of a firm?

Ans. Assets as explained above are the applications of funds by the firm. The various assets possessed by the firm are listed below in a logical manner. They are Fixed Assets, Current Assets, Intangible Assets and Investments.

Q8 ) What are fixed assets ?

Ans. The firm would first buy land, erect a building, install plant & machinery (for running the production process) and also purchase furniture & fixtures to support the operations. Thus at the outset the firm would invest in Long term Fixed assets part of its capital expenditure. The various fixed assets of a firm as explained above therefore are Land, Building, Plant & Machinery and Furniture & Fixtures.

Q9) What are current assets?

Ans. Current assets are assets in which the firm applies money for a short period of time. The firm would need these assets for its daily operations. Let us look at a typical working capital cycle. The firm would invest funds in raw materials, convert into Work in Progress (WIP) which is finally processed into Finished Goods Inventory. These Finished goods would then be sold. Though the firm would prefer to sell these goods on cash, a part of them may be sold on credit basis due to business compulsions. Thus the firm would have receivables from where money is due. Finally the form would use these funds to procure raw material and the cycle would continue.

It is pertinent to note here that the firm may purchase some raw materials on credit. Thus it may have some payables on its books. These payables are essentially liabilities as they are sources of funds to the firm. Thus the various current assets are raw materials, work in progress, finished goods inventory, cash & cash equivalents and receivables. On the other hand payables/ creditors are current liabilities are

Q10) What are investments assets?

Ans. Just like a person purchases shares and may have deposits in banks, a firm too may invest its funds. These investments may be in shares of group companies, investments in other financial instruments etc. These investments may be for the long term or short term depending on the firm's investment strategy.

Q11) What are intangible assets ?

Ans. Intangible assets have no physical shape or size. Intangible assets possessed by a form can be patents, goodwill, brand, intellectual property rights (IPRs) etc. In the current globalised scenario intangible assets are as important as tangible assets(fixed assets, working capital assets & investments).

Q1) What is the subprime crisis?

Ans.  The word "Sub prime" can be divided into two words, i.e.

"Sub" meaning below.

"Prime" meaning quality.

Sub prime, thus, refers to those borrowers who were not eligible of getting loans, but were given the same by US banks. In case of such loans, the rate of interest is higher. It is this higher margin which attracted many commercial banks in US to go in for sub prime lending. The default by the borrowers set off a chain of events leading to the present crisis.

Q2) What is the origin of this crisis?

Ans. The soft interest policy adopted by Mr. Allan Greenspan the erstwhile Chairman of the US Federal Reserve (the Central Bank of US responsible for monetary policy) initiated the crisis. In fact he was famous for his "Greenspan Put" effect which referred to his tendency to drop interest rates. Interest rates in the economy were reduced to as low as 1 per cent over a period of time.

Q3) What was the strategy behind the Greenspan Put effect?

Ans. The strategy was to convert US from a savings economy to a consumption led economy. With easy availability of credit, Americans borrowed and spent more. They started buying various assets including houses. The ensuing boom in the real estate sector led to positive effects on the overall economy. However this expansion of debt led to US economy getting increasingly leveraged.

Q4) Why are the effects of the sub prime crisis serious & how did it spread to other economies?

Ans. The crisis originated in the Unites States which accounts for about 25% of the world wealth. Also it affected the banking sector which is the heart of an economy. The subsequent credit crunch hurt all the other economic sectors. Further the loans given by US Banks were sold to investors globally vide a process known as securitisation.

Q5) What is the securitisation process?

Ans. Once loans are given, funds are normally blocked till their maturity. However, through the process of securitisation, these loans is converted into Mortgage Backed Securities (MBS) and sold to investors.  This helped US banks get immediate liquidity apart from a good spread on the loans originated by them. For e.g. If the interest rate on the loans was 5%, the US banks would retain say 0.25% and pass on the balance 4.75% to the investors. The investors would pay upfront to the US Banks the value of the loan advanced.

Q6) What is a MBS and why did investors globally invest in MBS?

Ans. MBS essentially are derivatives. A derivative is an instrument which has no original value of its own; and derives its value lies from an underlying asset. In this case MBS derived their value from the underlying real estate loans. The MBS were securitised on two ways: with and without recourse.

Q7) What is with and without recourse type of securitisation?

Ans. With Recourse Securitisation: This means in case of default by the borrower, the investor could always go back to the bank which originally gave the loan (the originator bank). The risk of the bad loan therefore lies with the originator bank.

Without Recourse Securitisation: It is the reverse of the above. Here the investor will have to bear the risk of default and cannot turn back to the originator bank. This technically meant that risk of default by the borrower was transferred to the investors from the originator bank.

Many global investors invested on a without recourse basis. This was because the returns paid to the investor were higher. (Obviously due to the higher risk involved).

Also these MBS in general had a good rating.

Q8) How did these securities enjoy a good rating?

Ans. This is where the credit rating agencies resorted to a kind of 'financial engineering' and played a dubious role. They designed Collateralized Debt Obligations (CDO), which was essentially a package of prime and subprime loans. They worked backwards and adjusted the proportion of various loans such that on an overall basis the CDO enjoyed a good rating.

Q9) What is a Home Equity loan?

Ans. Due to the increased demand for real estate assets, its prices started rising. Banks further gave top up loans against the same asset. Such loans are called Home Equity Loans. In short Americans started using their Homes as ATMs and treating Debt as a part of income. This vicious cycle led to an asset bubble. Note: An Asset Bubble is created when the prices of assets go up irrationally. The bursting of bubble leads to disastrous economic consequences.

Q10) What led to the precipitation of this crisis?

Ans. It was primarily to prevent an asset bubble burst that Ben Bernanke the current Chairman of the Federal Reserve reversed the lower interest rate policy and started increasing interest rates. However this led to a series of unprecedented defaults. Thanks to securitisation, the crisis which originated in the US quickly spread to other global economies. In fact no economy was spared.

Factoid:

1. As per a report by the National Bureau of Economic Research, the United States economy slipped into recession due to the subprime crisis which lasted 18 months.

2. 230 banks have collapsed due to the subprime crisis.

3. Lehman Brothers a 160 year old global investment Bank and Bear Sterns were some of the high profile bankruptcies.

4. The US Govt. had to resort to bailouts of many firms using tax payers' money. Total bailout package in pledges has touched an unprecedented $9.7 trillion. This amount would be enough to send a $1,430 check to every man, woman and child alive in the world.

5. The bailout packages have considerably weakened the budgetary position of the Federal Government especially during the last two years. The budget deficit now averages 9-1/2 percent of national income during that time. For comparison, the deficit averaged 2 percent of national income for the fiscal years 2005 to 2007, prior to the onset of the recession and financial crisis.

6. The recent deterioration was largely the result of a sharp decline in tax revenues brought about by the recession and the subsequent slow recovery, as well as by increases in federal spending needed to alleviate the recession and stabilize the financial system. As a result of these deficits, the accumulated federal debt measured relative to national income has increased to a level not seen since the aftermath of World War II.

7. The Outstanding Public Debt as of 16 Oct 2010 is:

8. The estimated population of the United States is 309,304,190
   so each citizen's share of this debt is $44,015.17.

9. The National Debt has continued to increase an average of
   $4.14 billion per day since September 28, 2007!

10. The effect of the subprime crisis is still lingering. Even as of Sept 2010 the unemployment rate in US is very high at 9.6%

Dr.Anil R Menon ( anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it ) interacts with the participants of the Family Managed Business Program at the S.P. Jain Institute Of Management & Research in the area of Finance.

Q1) What is Inflation?

Ans. In a simplified manner "Inflation can be defined as Lot of Money chasing Too Few Goods". This consequently leads to a rise in prices.

Q 2) What is supply side Inflation?

Ans. This essentially attributes the rise in prices to supply side constraints. For example global oil prices have often shown a rise due to the cuts in supply imposed by the oil producing countries (OPEC).

Q3) What is demand side Inflation?

Ans. This theory espouses that the rise in prices is caused by an increase in demand. For example the rise in global food grain prices was attributed to the increased demand from Chinese and Indian consumers by the erstwhile US president George Bush (much to our chagrin).

Q 4) What is the effect of Inflation?

Ans. Inflation affects the purchasing power of consumers as they can now buy only a lower number of goods with the same amount of money. This effect is more pronounced for those with a fixed income. In short the essence of inflation is that it devalues everything by its touch.

Q5) What is hyperinflation?

Ans. Hyperinflation refers to a runaway increase in prices. This phenomenon has been recently witnessed in Zimbabwe where prices changed by the hour. A sack full of Zimbabwean dollars was needed to buy small lots of goods. In fact Inflation rose to an unprecedented five digit figure. Hyperinflation occurs due to indiscriminate printing of currency leading to its debasement.

It is said that the rise of Adolf Hitler and his Nazism was primarily due to the hyperinflation conditions prevailing in Germany after World War 1.

Q5) How can inflation be controlled?

Ans. It can be controlled by increasing supply and/or reducing demand. Increasing supply of goods is normally falls within the purview of the Government while reduction is demand is achieved by monetary actions of the Central Bank of the country (RBI in our case).

Q6) What is monetary action by the Central Bank?

Ans. The Central bank of a country controls inflation by increasing interest rates prevailing in the economy. An increase in interest rates is expected to reduce demand for discretionary items. For example in case the Central Bank believes that the Real Estate prices have moved up substantially (a real estate bubble) it may raise interest rates. This increase in interest rates may reduce the demand for real estate, especially when it is purchased by taking loans.

Q7) What are the constraints under which a Central bank operates?

Ans. An increase in interest rates may control inflation. However an excessive increase in interest rates may lead to consumers cutting down consumption significantly. This also could lead to Corporates cutting down their production and shelving their expansion plans. Thus increases in interest rates could slowdown and even derail the growth of the economy, having serious repercussions on employment rate etc. The problem therefore is in identifying the interest rate (the so called sweet spot) at which inflation can be controlled without affecting growth significantly. Central banks world over have to perform this difficult fine balancing act.

Q8) What does the slowing down of Inflation rate indicate?

Ans. Slowing down of inflation rate indicates that prices are rising at a slower rate than earlier. It is pertinent to note here that prices are rising; only the rate of increase has slowed down.

Q9) Is Inflation always harmful?

Ans. This is the paradox. Some amount of inflation is necessary as the opposite of inflation is deflation. Deflation refers to a fall in prices. Though prima facie deflation looks good, it has very serious consequences. Consumers may postpone their discretionary purchases anticipating a further fall in prices (called the bottoming out effect). This will cause demand to shrink, causing prices to fall further ultimately leading to a deflationary spiral. Thus Central banks world over resort to inflation targeting, i.e. have some acceptable level of Inflation.

Q10) How is Inflation measured?

Ans. Inflation for a particular period can be measured on a year on year (YOY) basis w.r.t a base year. As with any Index, the sample of items considered and their weight ages is of prime importance. Also the base year selected is important and should be representative.

Also Inflation can be measured both at the wholesale level called the Wholesale Price Index (W.P.I.) and at the consumer level called Consumer Price Index (C.P.I.)

Let us now track now some recent events concerning Inflation w.r.t the Indian context.

Globally most countries use CPI to guide policy making unlike India which uses W.P.I. Also nearly 7 years after setting up of a committee chaired by Abhijit Sen, member Planning Commission W.P.I. measurement in India has been revised. It has been made more broad based with 676 items being covered instead of the existing 435. The base year has been revised from 1993-94 to a more recent 2004-05. Also the weight age given to manufactured items has been increased from the earlier 63.7% to 64.9% and that of primary articles (which includes the volatile food items) has been lowered from the earlier 22.02% to 20.11%. These changes, according to many have made W.P.I. more comprehensive and reflective of the structural changes in the economy. The YOY inflation estimate for August using the new series is 8.5% compared to the 9.5% under the old series. However unlike WPI which is measured monthly, food inflation which measures the rise in food prices is calculated on a more periodic basis.

Food inflation has risen at an alarming 16.44% during the week ended Sept 18 from 15.46% in the previous week. Last year the continual spurt in food inflation was attributed by many to the rise in food prices due to the then prevailing drought conditions, which restricted supply (food inflation). However the current continual spurt in food prices in spite of a good monsoon is alarming. What is worrying RBI and the Govt. further is that this inflation may now spread to other non food items (the core Inflation). This will then prompt RBI to raise interest rates further. In short an increase in Interest rates may be round the corner. Picture Ab Baki Hai Doston!!!

Logical Points to Ponder:

1. Inflation is the invisible tax we all pay.

2. Keep an eye on Inflation Rates.

3. A continual increase in Inflation may trigger a rise in Interest Rates.

Q1) What are the various ways a Corporate can achieve growth?

Ans. There are essentially two ways a Corporate can achieve growth. They are:

Organic Route: In such a strategy, the Corporate undertakes projects and builds capacities by itself. Such a strategy is time consuming as the projects will have high gestation periods.

Inorganic Route: M & A fall under this strategy. In such a case the Corporate takes over another existing firm.

The key benefit in this case is the reduction in gestation period. In these cases if the Corporates would have gone by the organic route, it would have been a couple of months, even years to add capacity. The same objective can be achieved in a significantly shorter time by a properly executed inorganic route. There are other significant benefits also.

Q2) What are the other significant benefits of M&A?

Ans. The other significant benefits of M & A are:

A. Economics Of Scale And Economics Of Scope: - Reducing Fixed Cost/Unit.

Economies of scale:-

In this case, the company increases its production capacity to such an extent that the fixed cost/unit decreases.

Example:

In such a case, by reducing the fixed cost/unit, the co. will be able to price its products better. This is the advantage of global capacities.

Note: China has been using this technique and practicing dumping.

Economics of scope:

Is aiming to reduce marketing expenses. In such a case, we find that the co. is looking at reducing its marketing expenses.

For e.g.: if a pharma co. XYZ has 100 salesman and other ABC has 50, then by taking over ABC and removing the 50 salesmen, the two units after merging can bring down its overall marketing costs.

Both Economies of Scope and Economies of Scale will result in synergy (Synchronised energy). This essentially indicates that the whole unit formed after M &A is greater than sum of the merging units. In short 2 plus 2 equals 5.

b. Acquisition of Intangibles:

Often M & As are for acquisition of Intangibles like brands, patents, goodwill etc. In such cases the intangible assets are acquired at a hefty premium.

c. Diversification.

In this case the firms involved can offer better variety of products. Often firms resort to M & A as they can get access to new markets a prime example is that of Tata Steel with Corus.

d. Technology / Skilled man power.

Often Corporates go in for M & A to get access to new technology. All the M & As happening in the technology space are prime examples of the same. Also they may go in for M & A to get access to skilled management and manpower as seen in financial services investment banking firms.

These are all examples of value creation. Apart from that, there could be the added advantage of value capture.

Q 3) What is value capture?

Ans. Value capture essentially refers to the tax benefits that a Corporate will get when they go for M&A.

Often loss making firms are acquired by Corporates for getting tax benefits. In such a case, the taxable profit of the firm comes down. For e.g. Co.XYZ with 100 cr profit and with a taxation rate of 20% will have to pay taxes of 20 crores.

However, if it acquires a company ABC with losses of 30crores, its taxable profit will come down to 100- 30 =70 crores. The taxes in this case would be 14 crores. Thus, the co. is saving 20 – 14 = 6 crores.

This is known as Value Capture. In this case the value is captured from the Govt as less tax is paid. The Govt is in favor of the same as M & A in case of sick Corporates generate employment. In fact the Govt allows carry forward of losses in case the losses are so huge that they cannot be absorbed by the healthy units current year's profits.

Q4) What are the various ways in which M & A can be classified?

Ans. M & A can be further classified as:

Inbound Deals: Foreign companies acquiring Indian corporates are examples of the same for e.g. Daichi of Japan taking over Ranbaxy.

Outbound Deals: Indian Corporates acquiring foreign Corporates or brands are examples of the same. Hindalco of the Aditya Birla Group acquiring Novellis is an example of the same.

Domestic Deals: These refer to the deals between Indian Companies. For e.g. the merger of Global Trust Bank with Oriental Bank of Commerce.

It is significant to note that the outbound deals are increasing significantly showing increasing risk appetite of Indian Corporates.

Also though used interchangeably, there are significant differences between the terms Mergers and Acquisitions.

Q 5) What are the significant differences between Mergers and Acquisitions?

Ans. In Acquisitions, all the Corporates involved retain their original identity and survive.

In case of Mergers however at least one entity loses its existence. There are various types of mergers.

Q6) What are the various types of mergers?

Ans. Merger is defined as a financial restructuring strategy wherein two or more firms combine and at least one unit loses its legal entity.

In case of a straight merger, the bigger entity survives.

In case of reverse merger, the smaller entity survives.

Reverse Merger happens rarely as the smaller entity survives. In India, the classic example of reverse merger is that of ICICI Bank (the smaller entity) with ICICI (the bigger entity). In this case ICICI Bank survived as the management was of the view that the future belonged to universal banking. ("UNIVERSAL BANKING":- Refers to offering all financial products under one banking roof)

Another example would be that of conglomerate.

In this an all together new entity Z is formed and both the firms X & Y lose their Corporate identities.

Q1) What is a currency war?

Ans. This refers to the manipulation by countries of their respective currencies. Countries are now actively seeking to influence the value of its currency. This intervention is at different levels. Some are seeking to prevent a rapid appreciation of their currency by levying taxes on foreign exchange inflows and outflows. Many are seeking to undervalue their currency as it would help them boost their exports and compete better in global trade.

Q2) How will an undervalued currency boost exports?

Ans. An undervalued currency or depreciation in the local currency will always help exporters fetch more for the same FX value of exports. For e.g. Indian exporters would be happy when the rupee is at Rs. 50 to a dollar, as they would earn Rs. 50000 for every 1000 $ worth of exports. However in case the rupee appreciates to Rs. 40 to a dollar, then they would earn only Rs. 40000/- (20% lower) than earlier. Thus Indian exporters will always prefer the rupee (India's local currency) to depreciate or be undervalued. This principle applies for exporters all around the world.

Q3) What is the origin of the current crisis?

Ans. The origin can be attributed to the Chinese policy of fixed peg i.e. holding the value of its local currency Yuan fixed against the US dollar. The fixed peg policy has helped China boost their exports and become the No 2 economy of the world. They have maintained a peg of 6.83 Yuan per dollar from July 2008 to June 2010. In June 2010, China promised to let the Yuan respond more freely to market forces. However it is worth noting that its value has risen only 2% against the US dollar. Thus the fixed peg has in fact been China's stated policy and has been practiced by it for a long time. It is only now that many countries have been voicing their disapproval of the same.

Q4) What is the reason for the increasing vocal disapproval of the Chinese policy?

Ans. The global economy is very weak and is still reeling from the after effects of the global meltdown. Countries are fighting for a share of a shrunk market and lower demand from developed economies. Many countries especially export oriented countries like Germany; Japan etc are finding it difficult to compete with cheaper Chinese goods. This unfair advantage enjoyed by China is highlighted by the fact that their foreign exchange reserves rose by a high $194 billion in 3^rd quarter of 2010 primarily due to their exports.

China in its defense says that that it has always followed the fixed peg policy and that it is actually the US dollar which has fallen on value. It blames the easy monetary policy adopted by US and other developed countries US for the current global problems.

Q5) What is the easy monetary policy adopted by many developed countries?

Ans. Developed countries including US, UK and rest of Europe are currently faced with lower economic growth and anemic demand. In order to spur economic growth they are maintaining a low interest rate regime. In fact US have cut interest rates to historic lows to and is pumping money into the system in order to kick start growth. However this has led to the problem of carry trade.

Q6) What is carry trade?

Ans. As explained above many developed economies including US have kept their interest rates at historic lows. This has encouraged many institutional investors (FIIs etc) to borrow from these economies and invest in developing economies like BRIC (Brazil, Russia, India, China). The carry trade was a normal phenomenon when investors used to borrow in Japan and invest elsewhere. However the financial markets are witnessing the mother of all carry trades where many FIIs are borrowing in the US markets and investing in emerging economies. This has led to appreciation of the currencies of many countries making their exports non competitive.

Q7) Why are investors investing in BRIC economies?

Ans. The investors are encouraged to invest in BRIC as they are comparatively less affected by the global meltdown. Also a substantial part of future global growth (about 60% of the total global growth) is expected from these economies. Investors are hoping to make a good return on their investments in these economies. This coupled with the low interest costs has encouraged a lot of foreign exchange flows into various economies.

Q8) How have currencies of major economies been affected and what has been the response of the affected countries?

Ans. The Japanese Yen has risen to a 15 year high of 82.87 yen against the US dollar in mid Sept and has hovered around that rate since. The Euro too has touched an eight month high. Brazil's currency has risen more than 30% against the dollar since last year. Many countries have seen an appreciation in their currencies prompting them to respond.

Japan sold the yen for the first time in six years. The effort was to primarily weaken the yen so as to boost their exports. Switzerland has been intervening to prevent the appreciation of the Swiss franc for close to 6 months now. Brazil has doubled taxes on foreign inflows and South Korea has also indicated curbs on currency trades. Asian economies like Singapore, Malaysia, Taiwan, and Thailand and Latin American countries like Columbia & Peru have intervened to tap down their currencies. In case of India too, RBI has also finally intervened due to the strengthening of the Indian rupee to 44 levels.

Q10) What is the solution to this problem?

Ans. The rule to be remembered in these times of weak global recovery is that "When you are in a hole stop digging." Therefore countries should give up their beggar thy neighbor strategies of competitive devaluation. This strategy would be of nobody's gain and the world trade would be a loser at large. They should instead adopt a coordinated action to put the global economy on track. The real structural cause is that there are some countries like China, Germany, and Japan etc which have based their growth on exports. These economies should slowly reorient and try to increase domestic consumption. Countries like US which have been a net consumer should also reorient towards lower consumption, more savings and exports. This alone in the long run can set right the global imbalances. However this is easier said than done as good economics need not necessarily be good politics and vice versa.

Points To Ponder

1. Many countries are seeking to lower the value of their respective currencies (currency devaluation).

2. This is being done to boost exports and the growth of their economy.

3. Many analysts believe that the Chinese currency Yuan is grossly undervalued.

This gives China an unfair advantage in world trade.

1. China on the other hand says that the lower interest rates set by the developed economies especially US is fuelling capital flows into other economies.

2. This has led to a war between many countries of devaluing their currency.

3. If not controlled, this may lead to an all out trade protectionism. IMF, G 20 etc should act to prevent an all out currency war.

Microfinancing Institutions (MFIs) in India have of late been in the limelight for all wrong reasons. The sector is currently passing through a very critical phase. The article seeks to simplify in a logical way the present issues facing the sector and outline its future.

Q1) When did microfinance originate and what is its underlying philosophy?

Ans. Micro financing activity is recorded as early as 1720 when Mr. Jonathan swift (author of the famous Gulliver's Travels) started the Irish Loan fund. The industry globally came into prominence in 2006 when Mr. Muhammad Yunus was awarded the Nobel Prize for his Grammen bank initiative in Bangladesh. In India, the sector came into prominence thanks to the SKS promoted by Mr. Vikram Akula. The underlying philosophy of MFIs is to lend to the poor at the bottom strata of society, who are otherwise deprived of formal sources of lending. However often the interest rates charged by MFIs are high.

Q2) What is the interest rate charged by MFIs?

Ans. MFIs charge typically an interest rate between 36% to 40%. MFIs attribute this high interest rate to the high cost of administering and collecting the loans. Also the rates look high on an annualised basis as is explained below. Say Rs. 1/- is charged per day to a borrower who borrows Rs. 100. On annualised basis the interest rate will be a choking 365%. However if the borrower say buys vegetables for Rs. 100. and is able to sell it for Rs. 125/- he can easily pay that Rs. 1/- as interest. In fact he can keep the balance Rs. 24 as profits. Thus it is important that apart from the interest rates, the end use of the loans need to be actively monitored. It is critical that the loans are given for productive activities. Though the underlying philosophy is same, the business models adopted are as different as chalk and cheese.

Q3) How are the business models different from each other?

Ans. The two prominent business models of MFIs are different in their motives and ownership pattern. One is the model practiced by Grammen Bank promoted and managed by Muhammad Yunus. This aims at poverty removal by lending to the poorest of the poor for income generating activities. A notable highlight is that borrowers themselves are owners and profit remains in the system.

In contrast the other model adopted by MFIs like SKS is a "for profit" model. These MFIs only strive to give the poor access to capital at high interest rates. The key highlight here is that poverty removal is secondary and wealth created is shared by private investors. Many Indian MFIs have adopted the second model due to high profit potential. It has even attracted investments from many international private equity (PE) players like Sequoia Capital (which invested in Google at the start up stage), Quantum Hedge Fund, and Unitus etc. However the purely for profit model is facing problems today.

Q4) What are the current problems of the sector?

Ans. The current problems facing the sector are suicides by borrowers, increasing defaults etc. As the for profit MFIs had loan lending targets to meet, they went into an overdrive giving multiple loans to already penetrated markets. In many cases, the borrower took loans much more than needed and utilized them for unproductive activities. They started taking fresh loans to repay the earlier loans. This bubble had to burst somewhere. Ultimately when these borrowers were unable to service the loans they started defaulting. This prompted some MFIs to adopt harsh recovery mechanisms causing the present crisis. It is thus clear that over-lending is the root cause of these problems. Another problem is over concentration. MFI industry is concentrated in South India. As of Sept 2010, MFIs have lent to over 30 million customers a total amount of over Rs. 30, 000 crores. Of this Rs. 9000 crores have been lent in AP making it the hub of MFI activities (data source: MFIN). The AP Govt has moved to regulate the sector leading to willful defaults. This increasing defaults could lead to serious systemic problems.

Q5) Why will the failure of MFIs lead to a more serious systemic failure?

Ans. Since MFIs do not have access to funds, they have borrowed from banks to lend further to clients. Banks lend to these MFIs as it helps them to comply with mandatory RBI norms on priority sector lending. Currently around 85% of the loans given to borrowers by MFIs, come from banks. Default of the borrowers will lead to losses to MFI. It is feared that this in turn will cause the MFIs to default to banks, causing a bigger crisis. This is the reason many analysts are scared that it can lead to a bigger systemic failure. It is therefore increasingly felt that the MFI sector needs to be regulated properly.

Q6) What are the current regulations for MFIs?

Ans. At present there are no uniform nationwide norms separately for MFIs. Some MFIs are Non Banking Financial Institutions (NBFCs) and are therefore regulated by RBI. Others are regulated by sectoral norms which fall in state regulations. Recently on Oct 15, due to the increasing number of suicides allegedly due to harassment by MFI recovery agents, Govt of AP issued an ordinance to control MFIs. It has mandated that interest be capped at 24% and be collected on a minimum monthly basis.

Q7) What is the future for MFIs?

Ans. MFIs have been identified as important for financial inclusion and their role in delivering credit to the last mile has been well appreciated. Indian MFIs will definitely survive but will be subject to tighter regulations. RBI is awaiting the Malegam committee report by Jan end to decide the future course of action. Uniform regulatory norms are the need of the hour to dissuade fly by night operators who indulge in profiteering rather than profiting at the expense of the poor.

Basic purpose of a business firm is to earn profits. P&L statement is important as it indicates the profitability of the unit. The present article seeks to simplify P&L and explain it in a logical manner.

Q1) What does the P & L statement broadly indicate?

Ans. P & L broadly indicates the income earned and expenses incurred by the business entity over a period of the time. It captures all business activities during the specified period. The period could be calendar year (Jan-Dec) as in case of MNCs or fiscal year (April-March) as in case of Indian companies.

Q2) What is the starting point of P & L statement?

Ans. Revenue or Income generated is the starting point of P& L. The revenue earned is therefore called as Top-line. A firm can earn revenue either through its core activities or by way of other income. A good blue chip firm shows consistent growth in core income, which essentially is its value driver.

Q3) What is core income of a firm?

Ans. Firm's core Income is income from activities, for which firm was formed, as defined in its financial charter. In India, financial charter is known as Memorandum of Association (MOA) and Articles of Association (AOA). Core activities can also be easily identified as income from these is recurring in nature. Other Income is normally non recurring and is one time. A classic example of other Income is that received by a manufacturing firm on sale of real estate. However sale of real estate would be core income for a real estate company. From Income, expenses incurred are deducted.

Q4) What are the various expenses incurred by the firm?

Ans. The expenses incurred by the firm can be broadly classified as :

Production Expenses.

Administration Expenses.

Selling & Distribution Expenses.( S&D )

Research & Development Expenses. ( R&D)

Miscellanous Expenses.

It is important to analyse each expense in detail as it helps one understand the cost drivers of the firm.

Q5) What are the cost drivers?

Ans. It is often found that ,in general, 20% of expenses in number, constitute 80% of total costs in value, of the firm. These expenses are called as Cost Drivers. For example in IT firms, expenses on salaries and wages is significant. On the other hand, in Ferro Alloy manufacturing units, expenses on power will be significant due to melting process involved. Indian firms are increasing their spend on S&D and R&D, due to the belief that future belongs to firms with good intangible assets like brands and patents. The identification of cost drivers helps in Strategic Cost Management.

Q6) What is Strategic Cost Management (SCM)?

Ans. SCM aims at improving the competitive ability of the firm by reducing costs significantly without affecting the quality. For example, ferro- alloy manufacturing firms will be benefitted more by reduction in power costs. On the other hand, IT firms may benefit more if manpower costs are reduced. SCM is important as it shows the path towards effective cost management and control.

When these expenses are subtracted from Income we get a measure known as Earnings Before Interest Tax Depreciation & Amortisation abbreviated as EBITDA. EBITDA is critical for business analysis.

Q7) How can EBITDA be analysed ?

Ans. If EBITDA of a firm is negative, it shows that it is earning an income which is not sufficient to cover even its basic expenses. An apt example will be that of the new Indian telecom companies which recently acquired licenses. Such a precarious financial condition cannot last for long and if the situation persists, eventually the firm will end up in bankruptcy. Basic requirement for any business unit therefore is to be positive at EBITDA level, as there are other operating expenses remaining to be covered.

Q8) What are these other operating expenses?

Ans. Depreciation and Amortisation (D & A) account for these expenses. Depreciation accounts for this loss of value of assets such as machinery due to wear & tear and passage of time. Charging depreciation expenses every year also helps us to set aside funds for future replacement of assets. It is important to note that that unlike other expenses, D & A is a non cash expense, as it is not paid out by the firm. When D & A is subtracted from EBITDA, we arrive at Earnings Before Interest (EBIT). EBIT is also called as Operating Income from which financial expenses are subtracted.

Q9) What are these financial expenses?

Ans. Financial expenses are primarily interest charges. Interest is the servicing costs on loans taken by the company. This is primarily influenced by the financing policy adopted by the firm. It needs to be noted here that some firms reduce the interest they receive on their investments, from the interest they pay on their loans. The figure thus arrived at is called net interest. Apart from the net interest, financial charges also include commission, processing fees etc. When these financial charges are subtracted from EBIT we arrive at Earnings Before Tax (EBT), from which statutory expenses are deducted.

Q10) What are these statutory expenses?

Ans. Taxes are the main statutory expenses. These are basically direct corporate taxes to be paid by the firm. If a firm plans its tax policy well, it can substantially reduce its tax burden. In India we find that though the taxation rate is about 30%, many companies have an effective tax which is far lower due to tax planning. When these taxes are subtracted from EBT we arrive at Earnings after Tax (EAT) or simply earnings. Earnings is commonly known as Profit after Tax (PAT) which is a significant measure.

Q11 ) Why is PAT significant ?

Ans. PAT is final bottom line of a firm. It is significant as it represents profits earned by the firm, which belongs exclusively to the owners i.e. shareholders. The firm can either distribute it as dividends (hence called as distributed profits) or plough it back into the business as internal accruals. Firms normally follow a mixed dividend policy. They distribute part of the profits to shareholders as dividends and retain the balance earnings to plough back into the firm for future growth.

1. What is the Sensex?

Ans : The BSE Sensex( Sensex as it is popularly known) is a Sensitive Index which tracks price movements of 30 stocks on the Bombay Stock Exchange (BSE).

1. How are these stocks selected?

Ans : Top 30 companies with highest Free Market Capitalisation are selected as the sample size. Free market capitalisation considers only the free float i.e. shares available for trading. It excludes the locked in shares (those issued to promoters and other strategic investors which cannot be traded), from the total no of shares issued by the Company.

Free Market Capitalization = Total shares available for trading X Current Market Price

As can be seen from the formula, it is dynamic due to change in market price every minute.

1. Who formulates/updates the SENSEX?

Ans : BSE reviews the list of stocks periodically . This essentially means that some stocks are moved out of the SENSEX calculation and some are brought into the list of 30 after every review. The sample of stocks included thus reflects the current Top 30 stocks in terms of Free Market Capitilisation.

1. Is each of these 30 stocks given equal weightage?

Ans : No. Each individual stock is given a weightage as per its market capitalisation.

1. What does the SENSEX level of 20000 signify ?

Ans : The base value of the SENSEX is 100 as on April 1, 1979. The level of the SENSEX at any point of time thus reflects the collective free float value of the 30 component stocks, relative to the base period. For example a SENSEX level of 20000 indicates that the Capitilisation of the current Top 30 stocks is 200 times the Capitilisation of the Top 30 stocks as of the base year.

It needs to be noted that the SENSEX is the most tracked & talked about but the least understood. Some analysis is given below debunking some prominent myths.

Myth 1: SENSEX mirrors the performance of all the sectors in the Economy.

SENSEX does not have any sectoral allocations and therefore is not a representative of all the sectors in the Indian economy. In fact it is heavily biased towards three sectors Oil & Gas, Financial Services and Information Technology which have a combined weight of more than 50% in the Index. Also some sectors are not tracked by the SENSEX for e.g. Aviation, Aquaculture, Diamond & Gems Processing etc.

Myth 2: SENSEX is a true indicator of the Indian Economy's Growth.

Often the rise or fall in the SENSEX is taken as a macro economic indicator. This is not correct as the SENSEX only tracks the listed Companies listed on the Bombay Stock Exchange.

Many of the Indian firms are proprietary, partnerships or micro units which are not eligible for listing on a Stock Exchange. Also many bigger Indian Companies prefer not get listed. Of the 2,70,000 odd firms in India, hardy 3500 are listed on the BSE. Thus only a small proportion of the Indian firms are listed. SENSEX therefore does not mirror entire Indian economy as a whole.

Myth 3: SENSEX tracks the performance of all Companies listed on the BSE.

This also is false as the SENSEX tracks only a small sample of 30 listed Companies with the highest Market Capitalisation, compared to the approximately 3500 companies listed on BSE. SENSEX thus tracks only a small representative of the entire population of listed stocks and therefore does not reflect the market movement as a whole.

Often even though SENSEX registers an increase in value, many listed individual stocks may have lost value. In fact on Sept 21, the day SENSEX touched 20000, 2123 out of a total 3113 Companies (i.e. roughly 70%) declined in value over the previous day at the end of trade.

Myth 4: SENSEX captures the stock price movement of all these selected 30 Companies.

This again is not true as the 30 SENSEX stocks are not given equal weights but are given individual weights based on their Free Market Capitilisation. On an individual basis Reliance Industries Ltd., which currently has a weight of 12% to 13% would influence the SENSEX more than ACC which has a weight of only 0.6 to 0.7 % .

The top 10 stocks have a combined weight age of more than 65% in the SENSEX. The rise and fall of these 10 stocks thus influence the SENSEX considerably more than the bottom 20 Stocks. Often SENSEX rises in value due to a rise in market prices of the stocks with large weights irrespective of the price movements of the other low weighted stocks.

Again on Sept 21, 14 out of the total 30 stocks in SENSEX actually lost value during days trade (a significant 47%).

Myth 5: Investment decisions of Institutional Investors are based only on SENSEX .

Wrong again. Only if an investor has invested in stocks comprising the SENSEX and in exactly the same proportion then it makes sense to track it. However this is rare and happens only in case of Index Mutual Funds, Exchange Traded Funds etc.

Though institutional investors consider the level of SENSEX before investing, there are various other factors too. Most of them follow the EIC (Economy, Industry, and Company) approach. They are primarily concerned about the macroeconomic fundamentals, the stage of the Life Cycle of the Industry and the individual Company's prospects. Also they track the prices of individual investments rather than the SENSEX levels on real time basis, to gauge the performance of their portfolio.

Conclusion :Summarising, SENSEX is not an unbiased true indicator of the 30 Index stocks let alone the entire Stock market and Indian economy.

Investors should not rush into investing in the stock markets and should look at other fundamentals before investing. Those who have invested in stocks which are not in the list of 30 SENSEX stocks, should concentrate on the stock price movements of the portfolio. They are advised not to get unduly influenced just because the SENSEX is on an upward move (the so called Bull Run). Many Investors have lost their shirts, and incumbent Governments have lost elections due to this misleading illusionary "Shining" effect.

Simplified Finance Tools : Ask the following logical questions for any INDEX :

Q1) What does it seek to measure ? (details of population)

Q2) What does the sample comprise of ? (details of the sample size and weights)

Q3) What is compared with ? (details of base year and period of comparison)

Dr.Anil R Menon interacts with students of Family Managed Business of S.P. Jain in the area of Finance and can be contacted at anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it .

In this article, we shall conclude our discussion on debt, by defining spread, role of guarantors, credit rating agencies, etc. In the previous articles we had looked at various terms used in debt and specifically examined various types of interest rates. One of the types was a floating interest rate wherein the interest rate varied with a benchmark. The benchmark used is typically base rate or PLR in domestic loans while it could be LIBOR in foreign currency loans. A spread over and above the benchmark rate is charged as per the risk perceived by the lender.

Q1) What is spread? Why is it charged?

Ans. Spread is the percentage charged over and above the benchmark. For e.g. the spread is 1% in case a Indian domestic loan is priced at PLR +1%. Spread is a function of risk perceived by the borrower. The cardinal rule in finance is Risk v/s Return. The borrower would be comfortable with a lower spread if he perceives a lower risk. Thus the aim of the borrower should always be to portray a lower risk during negotiations and thereby lower the spread charged. A basis point reduction in spread can lead to huge savings.

Q2) What is basis points?

Ans. 1% = 100 basis points. Basis points (b.p.s.) is a terminology often used in debt, instead of percentage. Borrowers quote the interest rates in basis points as the quotes given by lenders may vary by as little as 1 basis point or a fraction thereof. In the case of finer quotes, it is considerably easier to denote in b.p.s. than in percentage terms. (For example 1 b.p.s is easier to denote than 0.01%). It needs to be noted that even if the borrower saves 1 b.p.s, it would be a significant saving , especially if the amount involved is huge. For example, a saving of 1 b.p.s on a loan amount of $1,00,000 million is a significant saving of $10 million in value terms. Conversely, a borrower will charge a higher spread if he perceives a higher risk. It is here that the credit rating agencies and credit score play an important role.

Q3) What are credit rating agencies?

Ans. Credit rating agencies are firms which specialize in assessing risk of corporates. They assess both external and internal risks faced by the firm. External risks are risks which affect all firms example being Govt policy etc. Internal risks are risks specific to the firm like management, factory location etc. The credit rating firms examine the past track record of the firm and assign ratings. In general, there are three main ratings: High Safety, Medium Safety and Low Safety. The interest rate charged by the lenders is higher for low safety borrowers and vice versa. Similarly, in case of persons, a credit score is assigned to individual borrowers.

Q4) What is credit score?

Ans. Credit score is the score assigned to each individual borrower. In USA, the FIECO score is very popular whereas currently in India, score of Credit Information Bureau India Ltd (CIBIL) is popular. Many banks in India share the credit history of their borrowers with CIBIL. CIBIL therefore has a good database of individuals who have taken loans in the past. It essentially helps track the past credit record of individuals and clearly identifies any past defaults by the borrower. It needs to be noted here that a person who has taken a credit card or a loan can apply to CIBIL and get their credit score by paying a nominal fee. A good CIBIL score is always in favor of the borrowers. As a mandatory practice, many Indian banks ascertain the borrower's CIBIL score before the loan disbursement. In many cases, the banks may decline the loan in case of a poor credit score or may ask for additional collateral.

Q5) What is a collateral?

Ans. Collateral is a security to the loan. For e.g. in case of a housing loan, the house is the collateral. In case of a default, the bank will seize the house and sell it to recover their dues. Collateral in general is also known as charge, hypothecation, mortgage etc. Also as per current legal environment, banks can seize the collateral after giving a notice of 60 days to the defaulting borrower. In such cases the amount realised on selling the collateral will go first in meeting the claims of the bankers. This has given banks enough incentive to recover their bad loans and reduce their Non Performing Assets (NPA). Bankers may ask for additional collateral to safeguard their position. They may also request for guarantors.

Q6) Who is a guarantor?

Ans : A guarantor is a person who essentially stands surety for a loan. He is agreeing to the condition that in case the borrower defaults, he will repay the defaulted amount. Banks may ask for guarantors to safeguard their position especially if they are not convinced about the financial position of the principal borrower. Readers are advised to avoid being a guarantor for loans, as they may end up paying the balance defaulted loan amount.

Note: 1) A senior reader has asked for the formula by which the EMI is calculated. The same is as reproduced under:

The formula for calculation of EMI given the loan, term and interest rate is:

EMI = (p*r) (1+r)^n

(1+r)^n - 1

p = principal (amount of loan),

r = rate of interest per installment period ,

i.e., if interest is 12% per annum. r = 1%

n = no. of installments in the tenure, ^ denotes whole to the power.

Alternatively, the reader can use 'pmt' function in EXCEL spread sheet.

Note 2) Another colleague has pointed out there are certain loans where the principal is repaid in equal installments and the interest is calculated on the outstanding loan. In this case we will not have a fixed EMI as the payment amount keeps on varying.

Dr.Anil R Menon interacts with students of Family Managed Business (FMB) in S.P. Jain Institute Of Management Studies and Research. He can be contacted at anilrmenon1@gmail.comThis e-mail address is being protected from spambots. You need JavaScript enabled to view it .For his previous articles & lecture videos visit www.simplifiedfinance.net.

Interest rates are of primarily two types pure fixed and pure floating. However a variety of combinations can be arrived at to create hybrids. Hybrids would combine property of both fixed as well as floating rates. The present article seeks to simplify the various types of interest rates, the current controversy of teaser loans etc. It especially seeks to highlight the care that needs to be taken by the borrower's w.r.t. interest rates while going for a loan.

Q1) What is a fixed interest rate loan?

Ans. A fixed interest rate does not vary and is constant throughout loan tenure. The borrower knows the applicable interest rate at the beginning of the loan and is not exposed to interest rate fluctuations. Borrower would not be affected by an increase in interest rate. However he would not get any benefit of any future interest rate decreases. Here, the lender carries the interest rate risk and therefore normally do not prefer giving out loans on pure fixed interest rate basis. The lender would always price a pure fixed interest rate loan higher than a floating interest rate loan as they cannot pass on any interest rate increases to the borrower. Fixed interest rate therefore would always be higher than a comparable floating interest rate. For e.g. if a floating rate offered by the lender is at 6%, a pure fixed loan would be at a higher rate say 7%. Due to this higher initial rate, a borrower is likely to get discouraged from taking a fixed interest rate loan. However a borrower should go for fixed interest rate loans if he perceives that the floating interest rates would rise higher than the fixed interest rate offered by the lender during the tenure of the loan. For example in the above case, if the borrower is of the opinion that the floating interest rates in the future will be higher than 7% (the fixed rate offered) for substantial periods of the tenure he should lock into the fixed rate. It is worth noting that a number of Indian borrowers took housing loans at a fixed rate of 7% in 2004-05. These borrowers are a happy lot as they are immune to interest rate rise unlike the borrowers who took loans at floating rates.

Q2) What is a floating interest rate loan?

Ans. A floating interest rate is not constant and varies as per a benchmark. The normal benchmarks used are Prime Lending Rate (PLR); Base Rate (B.R.) In case of foreign currency loans the benchmark often used is London Interbank Offer Rate (LIBOR). The lender normally charges a spread over the benchmark rate. This spread is based on the risks perceived by the lender. For e.g. a borrower may give a loan at P.L.R. + 2% (spread). In this case when the P.L.R. is 7%, the interest rate applicable will be 7%+ 2% =9%. When the P.L.R. drops to 6%, the interest rate applicable on the loan will be 8% (6%+2%). Similarly, when P.L.R is increased by the lender to 10%, the interest rate applicable will be 12% (10%+2%). Thus a borrower benefits when the interest rates decrease over the loan tenure. However he stands to lose if interest rate increases over the loan tenure. One should go for floating rate loan if one perceives that interest rates are going to decrease over tenure of the loan. With reference to floating rates, an obnoxious practice of Indian banks that has been revealed is that of sub PLR lending.

Q3) What is a sub PLR loan?

Ans. As explained above PLR stands for Prime Lending Rate. Reserve Bank Of India (RBI) has allowed each individual bank to decide their Prime lending Rate (PLR). The word prime stands for best and the term sub means below. Sub PLR rate therefore means a rate below PLR. Going by the name, a borrower believes that PLR is the minimum rate or the floor rate offered by the bank. Banks however often lend below the PLR, calling it a limited period offer. Such offers for new borrowers are often at the detriment of existing borrowers. For e.g. if an existing borrower is on PLR basis, then the bank may offer loans to new customers at PLR-1%. In this case, even though they are on floating interest rates, existing borrowers do not benefit as the PLR remains unchanged. It is to avoid such practices that RBI has now mandated that each bank should disclose their base rate and that for most loans, the base rate should be the minimum loan rate. Borrowers should therefore ascertain the base rate of their lenders to get a clear picture of the spread (the extra %) they are paying over the base rate.

Also the borrower needs to read the fine print and ensure that the loan is a pure fixed rate loan. Often they mistake a hybrid loan to a pure fixed loan.

Q 4) What is a hybrid loan?

Ans. Hybrid loan is a combination of pure fixed rate loans and floating rate loans. An example of the same is when interest rates are linked to inflation rates. For e.g. borrower may have to pay an increased rate if inflation moves up beyond that stated in the agreement. Another variant of the same is when the rate is fixed for a predetermined period subsequent to which it is on floating basis. Current housing loans offered by State Bank Of India (SBI) are an example. In this interest rate is fixed at 8% for the 1^st year and 9% for the next two years. After 3 years, rate applicable on housing loan is on floating basis and is based on the then applicable PLR. In other words the borrower is not sure of the exact interest rate from the 4^th year onwards. Borrowers should realise that the interest rate is on hybrid basis if they do not know the exact interest rate (in % terms) for any part of the period of tenure of loan. Incidentally RBI is worried about such housing loans and has been calling them as teaser loans.

Q5) What are teaser loans?

Ans. Teaser loans are loans with a lower initial interest rate for the initial tenure of the loan. Borrowers are attracted towards the loan due to the low rate, (hence the name teaser). They fail to realise that interest rates may rise significantly in the future. RBI is worried that the borrower may not be able to pay the future interest rates, and may therefore default .It is worth noting here that one of the reasons for the US subprime crisis was the teaser housing loans.

Next week we shall conclude by examining, role of guarantors credit rating agencies, etc.

Dr.Anil R Menon interacts with students of Family Managed Business (FMB) in S.P. Jain Institute Of Management Studies and Research. For his previous articles & lecture videos visit www.simplifiedfinance.net.

For e.g. a number of home loan borrowers who had taken loans at a fixed interest rate of 7.5%, in 200 are today happy as they do not have to worry about interest rate increases.

Debt as a source of funds is a double edged sword. If intelligently used, it will aid in wealth creation. If misused, it will lead to wealth destruction and even bankruptcy. A proper understanding of debt is of utmost importance for corporates and individuals alike. Also many borrowers do not understand the various terms & conditions associated with debt due to which they get misled. This article seeks to simplify the various terms associated with debt.

Q1) What is debt?

Ans. Debt is a source of funds for the borrower. and is another name for loans taken. It is essentially funding from outside sources, which has certain fixed obligations. These obligations are payment of interest and repayment of the principal over the pre-decided tenure of the loan. The borrower generally meets these obligations and services the loan by paying EMI.

Q2) What is EMI?

Ans. Though marketed as Easy Monthly Installments EMI stands for Equated Monthly Installments. EMI consists of two components. (i).Interest on the outstanding loan and (ii) Principal repayment component. The table below is EMI payment schedule of a 1 lakh loan over a period of 12 months at 9% interest rate, payable monthly.

Table 1: Amortisation Schedule

The loan is fully amortised at the end of the period of 12 months, as can be seen from the zero closing balance. The amortisation chart helps us to identify and analyse the tax shield.

Q3) What is a tax shield?

Ans. The borrower often gets tax rebates and shelters on the interest component of the EMI. In case of an individual, one can deduct interest paid up to Rs. 1.50 lakhs from ones taxable income for self occupied property. For example if a person has a taxable income of Rs, 10 lakhs, then on payment of interest of Rs. 1.50 lakhs the persons taxable income then stands reduced to Rs.8.5 lakhs (10-1.5). Thus interest is a good tax shield as it reduces the tax liability of the borrower. In case of corporates too, the interest paid on the loans can be claimed as business expenses and is fully tax deductible. The amortization schedule gives the breakup of the EMI into the interest component and the principal repayment component. This is important as one gets tax benefits only on the interest component and not on the entire EMI paid. Also the tax benefits or tax shield gets reduced over the tenure of the loan as the interest component of the EMI reduces. It is also called as reducing balance method.

Q 4) What is reducing balance method of interest calculation?

Ans. As can be seen from the table 1, each EMI paid reduces the outstanding loan amount. For example the loan outstanding at the beginning is Rs. 1 lakh which stands reduced to Rs. 42,758.87 at the end of the payment of the 7^th installment. Hence it is called reducing balance method of interest calculation. However one has to be careful about the terms of the repayment, even within the reducing method. For example the terms could be of the daily reducing type. Here, the outstanding principal is reduced on the day itself when the lender gets the funds. However various modifications are possible. One such modification is the monthly reducing type. Here, the outstanding is reduced only at the end of the month though the borrower may pay earlier. The lender benefits as he has interest free funds (float) at his disposal. However this is detrimental to the borrower. So a borrower has to take these precautions.

A) As far as possible, opt for daily reducing type of repayment.

B) Avoid loans which do not calculate interest payments on daily or monthly reducing methods.

C) In case of monthly reducing, note the cycle date. This is because cycle periods could be different for different banks. Also for different products from the same bank the cycle periods could be different. Time the payments as close to the cycle date as possible. For example if the cycle period is 27^th of every month, borrower should pay EMI only on the 27^th. Even if the borrower has access to funds and can pay the EMI on the 5^th, he should not do so. This is because he stands to lose interest for 22 (27-5) days. Even if the borrower retains the amount in a savings account, he would get interest at the rate of 3.5% per annum on daily basis for the 22 days. Returns would be higher if investment is made in liquid mutual funds.

Another trap he should not fall for is taking loans just because the flat rate is low.

Q5) What is flat rate of interest?

Ans. Flat rate is the simple interest rate. It is calculated by dividing the total interest paid by the product of the opening principal and the number of years. In other words

Flat Rate = Total Interest Amount / (No of yrs x Loan Amount)

In the case of Table 1 the flat rate works out to approx 4.9%. The flat rate is significantly lower than the reducing rate and is therefore used extensively for marketing of loans. The borrower should always remember that he is actually paying the reducing rate of interest. The approximate thumb rule is that: Multiply the Flat Rate by 2 to get the Reducing Rate

Next week we shall examine logically other terms associated with debt such as teaser loans, credit rating agencies, moratorium etc.