Recap of Concepts covered:

1. Equity is a source of funds for the Corporates and is also known as Owners Funds.

2. Investments in Equity Shares are fraught with high risk. However selection of the proper share/stock will give investor high returns. Shares are therefore High Risk High Return Investments.

3. Shareholders' Funds in the Corporate can be identified by looking at Net worth in Balance Sheet.

4. Net worth of the Corporate is Issued Capital plus Reserves & Surplus.

5. Dividends, Rights and Bonus are types of corporate benefits given to shareholders.

6. Dividends are part of profits distributed to shareholders.

7. Bonus is essentially a book entry. In case of blue chip firms it increases wealth of shareholders.

This week, queries of readers are being addressed on other facets of Equity Shares.

Recently a colleague was quite upset when she reviewed her portfolio. The share price of one of her investments " South Indian Bank" had fallen from the investment price of Rs. 200/-to a value of Rs. 25/-. Pretty upset she posed me a query at this significant fall in price. My analysis however revealed that at current prices she had actually made money. This was due to the corporate action of Stock Split.

Q1) What is Stock Split?

Ans. As the term indicates, Stock split is splitting the Face value of the stock. Face Value (F.V.) is the value on the face of the instrument. Let us consider a case of splitting of F.V. of 1 share of Rs.10/- into 10 shares of F.V. 1/- each. The balance sheet representation of this stock split will be as follows:

As can be seen, though the figures are the same the key difference is w.r.t. to two factors

1) Number of shares and

2) Face Value of each share.

Stock split may have a number of significant advantages.

Q2) What are the advantages of Stock Split?

Ans. Stock split increases the shareholders wealth. Let me explain this with the same example of South Indian Bank discussed above. The initial investment was in 1 Share at a price of Rs.200/-. After Stock split of 10: 1 i.e. (reduction of F.V. of Rs. 10/- each to Rs.1/-), the investment stood increased to 10 shares. with each Share being valued at Rs. 25/-. Shareholder wealth pre & post Stock split is represented:

Thus in the above case my colleague had actually gained by 40% due to the Stock Split by South Indian Bank. This was because theoretically the share price was expected to fall to Rs. 20/-. However the share price had actually increased to Rs. 25/-

Q3) What was the reason for this increase in Share prices?

Ans. Stock split improves the number of shares in the market. For example a reduction of Face Value from Rs.10/- to Rs.1/- increases the no of shares issued by 10 times. This increased number of shares encourages bigger institutional investors who buy in large quantities. They find it beneficial as the share price is less prone to fluctuations post the stock split, due to the increased supply of shares. At the same time, even smaller retail investors are also attracted to the share due to this increased affordability. For example they have to now pay only about Rs. 20/- per share as compared to Rs. 200/- per share. This perceived cheapness attracts the retail investors too. This increased demand generally causes a rise in share prices post Stock Split. Investors are advised to check up for either Stock Split or Bonus Issue, in case of significant reduction in price per share. In such cases even though the price per share would have fallen, their total wealth would have increased due to an increase in the number of shares.

Another reader was curious to know how one can identify Companies which pay high dividends.

Q4) How does one indentify high dividend paying Companies?

Ans. In the Indian context one can logically identify 3 types of Companies, which are expected to pay high dividends.

1. Companies with High Promoter Shareholding.

As can be recalled dividends is profits distributed to the shareholders. In this case, a significant percentage of the dividends go to the promoters. Also the fact that this is tax free income in the hands of the shareholders makes it an icing on the cake. Thus we can expect high dividends from firms like Wipro, Reliance etc.

1. Profit Making Muti- national Companies ( MNCs)

In case of MNCs, a foreign Company owns a significant percentage of shareholding, by virtue of their investments in Equity. Dividend is one of the ways of earning a profit on their investment. Thus it is seen in case of profit making MNCs like Colgate etc.; one can expect high dividends as this is a way of repatriating profits to the foreign parent.

1. Profit Making Public Sector Units and Banks ( PSUs and PSBs)

In case of PSUs and PSBs, the Government of India (GOI) is the major shareholder. The Govt of India has been running a budgetary deficit, due to its expenditure overshooting income. One way of bridging this deficit is by getting dividends from PSUs and PSBs. It is often seen that profit making PSUs and PSBs not only pay a final dividend. They often pay interim dividend even before the end of the year. Also some times PSUs and PSBs also pay special dividends to commemorate so called "special occasions". ONGC, SBI, etc are examples of the same.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it

Snapshot of concepts covered in the previous two articles:

1. Equity is a source of funds for the Corporates and is known as Owners Funds.

2. Investments in Equity Shares are fraught with high risk. However selection of the proper share will give investor high returns. Shares are therefore High Risk High Return Investments.

3. Shareholders of a firm, as on specified record date are entitled to receive Corporate benefits.

4. Dividends and Rights are examples of corporate benefits given to the eligible shareholders.

5. Dividends are essentially portion of the profits that is distributed to the shareholders.

6. Rights is an offer of shares to the existing shareholders in proportion of shares held by them.

7. Shareholders can renounce their additional rights shares, in part or full to others by charging a Rights renunciation premium.

This week we shall logically understand one more corporate benefit i.e. a Bonus Share. Let us start by reviewing the all important concept of net-worth.

Q1) What is net worth ?

Ans. Net worth essentially is the shareholders i.e. owners funds in the business. It is essentially the summation of the Issued Capital plus Reserves & Surplus. Issued Capital is the product of Face value and the number of shares issued by the Capital. For example if the firm has issued 100 lakh shares of Face value Rs. 10 /- at a price of Rs. 50/-, then the Issued capital of the firm is : 100 X 10 = Rs. 1000 lakhs. Since the firm has charged an premium of Rs. 40/- (50-10) over the Face Value, there would be a premium reserves of 40 X 100 = Rs. 4000 lakhs. Assuming that the firm made a net profit of Rs. 700 lakhs of which it distributes Rs. 200 lakhs as dividends, a surplus of Rs. 500 lakhs ( 700- 200) will accrue to the firm. The representation of the above in the balance sheet is as under :

Net – worth is also called as Net Owned Funds. The corporate benefits of Bonus and stock split can now be simplified.

Q2) What are Bonus Shares ?

Ans. Bonus shares like Rights, are shares given to existing shareholders, as on the specified record date. Just like rights ratio we have the concept of bonus ratio. For example a bonus ratio of 1: 1 indicates that the shareholder is entitled to receive 1 Bonus Share for every share that he has. There is however a critical difference between rights and bonus in that Bonus shares are given free of cost. It is this aspect that excites shareholders. Often retail shareholders rush to buy shares on anticipation of a bonus issue. They feel that it is some sort of sale like 1 Free Shirt for every 1 that is purchased. However this is a fallacy. Investors should not invest in a firm only because it is considering a bonus issue.

Q3) Why should investors not invest in the shares of a firm just because it is considering a bonus issue ?

Ans. Bonus is essentially Capitilisation of reserves i.e. the reserves of the firm is converted into capital. For example if the firm mentioned in the above table announces a bonus of 1: 1, an additional 100 lakh shares of face value Rs.10/- will be issued to the existing 100 lakh shares of face value Rs.10/-. Thus the Issued capital will go up to Rs. 2000 lakhs, as there are now 200 lakh shares of Face Value of Rs. 10/-. However this increase will also lead to a corresponding reduction of Reserves by the same amount. Thus the Reserves & Surplus will be Rs. 4500 minus Rs. 1000 i.e. Rs. 3500 lakhs. The same is represented as:

It is to be noted that the net- worth of the firm is the same pre and post bonus. Simply put bonus is only a book entry. Thus investors should not get irrational and give undue importance to a bonus issue. However a bonus issue may have certain advantages too which the investors should carefully look for.

Q4) When can a Bonus Issue be beneficial to the investors ?

Ans. It can be beneficial in 3 ways as is explained below :

1) Signal of Increased Future Profitability :

Bonus issue technically increases the issued capital of the firm. The firm is indicating its readiness to service a larger investor base if it maintains the same dividend rate (on Face Value) post bonus. For e.g. assuming in the above case that the firm has paid dividends at the rate of 30% i.e Rs. 3 per share (30% of Face value of Rs.10/), in the past and is expected to retain it in the future post the bonus issue.

Dividend payments pre-bonus is Rs. 300 lakhs (i.e. Rs. 3/- per share on 100 lakh shares).

Dividend payments post bonus will increase to Rs. 600 lakhs as shareholder base is now 200 lakh shares.

Normally blue chip firms maintain dividend rate. Therefore as the firm is now committing itself to a larger dividend payout, analysts interpret a bonus issue as a signal of enhanced future profitability.

2) Increased Number of Shares (Float)

If the number of shares of a firm available for trading is small, then the share price is prone to wide price fluctuations. As the number of shares increases post bonus, a firm may be viewed favorably by institutional investors who trade in huge numbers. It is often seen that post bonus blue chip firms attract the attention of big investors. Finally,

3) Increase in demand from retail investors.

Post bonus the share price of the firm falls. For e.g. after a bonus of 1 : 1, the market price falls from say Rs. 300/- to about Rs. 150/- . This reduced price attracts investors due to its affordability and perceived cheapness.

Due to all the above reasons, it is seen that the share prices of blue chip firms go up after the bonus issue.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it

Recap of Concepts covered last week:

1. Equity is a source of funds for the Corporates and is also known as Owners Funds.

2. Investments in Equity Shares are fraught with high risk. However selection of the proper share/stock will give investor high returns. Shares are therefore High Risk High Return Investments.

3. Shareholders' Funds in the Corporate can be identified by looking at Net worth in Balance Sheet.

4. Net worth of the Corporate is Issued Capital plus Reserves & Surplus.

5. Dividends are a form of corporate benefits given to shareholders.

This week we shall logically understand the other Corporate benefits.

Q1) What are Corporate benefits?

Ans. Corporate benefits, as the term indicates, are benefits given by Corporates to their investors. All Corporate benefits are given to investors who hold the equity shares as on a specified date known as the Record Date. The record date is also known as book closure date as trading of shares is stopped on that particular date. The record date is announced well in advance by Corporates. It is important for investors to note the record/book closure as the Corporate benefits accrue only to those investors whose name appears in the books of the company. An investor can also make out whether he is eligible for the corporate benefits, by looking at the trading status of the share, in case he is contemplating investment in stock exchange listed shares.

Q2) How does an investor identify his eligibility for Corporate benefits by looking at trading status?

Ans. Before the record date, a share will be trading on Cum basis. This indicates that an investor who purchases the share on Cum basis is entitled to the corporate benefit. The share trades on Ex basis, after the record date. This indicates that the shareholder who purchases the share on Ex basis is not entitled to the corporate benefit. Thus the terms C-D will appear by the side of the share price for a share which is trading on Cum dividend basis. Similarly the term X-D will appear when the share is trading on Ex- dividend basis.

Q3) Is the traded price of the share same on Cum and Ex basis?

Ans. The traded prices of the share will not be the same on Ex and cum basis. This is because the share prices will temporarily adjust itself for the payment of the corporate benefit. For example if the cum dividend price of a share is Rs. 100/- (CD), then after a payment of dividend of say Rs.10/-, the share price will temporarily fall to Rs.90/- (XD). The similar effect is seen in other corporate benefits like rights etc.

Q4) What is a Rights Issue?

Ans. Rights Issue is an Issue of Shares to the existing shareholders. As per the law of Companies Act, whenever a Company issues new Shares they have to first offer it to the existing shareholders. This is the right of the existing shareholders (hence the term Rights). The rights shares are always offered on basis of the existing shareholding of the shareholder, known as the Rights ratio.

Q5) What is a Rights ratio?

Ans. Rights ratio determines the eligibility of the existing shareholder to subscribe to fresh shares. For example, Rights ratio of 1: 1 indicates that the shareholder will be offered 1 Rights Share for every 1 share that he has in the Company. It needs to be remembered that the second number is the original holding. Thus a ratio of 1: 2 should be read as one share for every two shares held.

Thus a Rights ratio of 1: 2 indicates that the shareholder will be offered 1 share for every 2 shares that he holds. Thus if a shareholder has invested 100 shares, he is entitled to subscribe to an additional 50 Rights shares at a price known as the Rights Price.

Q6) What is Rights Price?

Ans. Rights Price is the price at which the existing shareholder can subscribe to further Rights shares. The Rights price is normally at a discount to the price at which the shares are traded in the stock markets. For example if the shares of a Company is traded at Rs.100/- in the stock market, the Rights shares will be offered normally to shareholders at a discounted price of less than Rs. 100/-. This discounted offer is taken as a good sign, as it indicates a sign of corporate friendliness to the existing shareholders.

Q7) Is it compulsory for an investor to subscribe to the Rights Shares?

Ans. No. It is not compulsory for an investor to invest in the Rights Shares. A rights Issue is essentially an offer of shares by the Company to the existing shareholders. He can also renounce his right to others.

Q8) What is Rights renunciation?

Ans. Rights renunciation essentially means passing on one's right to others. Thus an existing shareholder may offer his entitlement of Rights to others partially or completely. For example if a share-holder (Mr.A) is entitled to 100 shares, he can renounce either the entire 100 shares or a lower number to any other person( Mr.X) This beneficiary person (Mr.X) can even be an outsider and need not necessarily be an existing shareholder of the Company. The best part is that Mr. X can now apply to the Rights issue at the lower Rights Price.

Foot note: Mr. S. Tanwani, a senior reader, has pointed out a small typing error in calculation of Dividend Yield last week article on Understanding Equity Part 1. The case was when a firm had announced a Dividend Rate of 400% on Shares of Face Value of Rs.10/-. Thus the dividends per share works out to Rs.40/- (400/100 X 10). Assuming an investment price of Rs.800/- (this figure was inadvertently missed out in the article), the dividend yield works out to 5% (40/800 X 100). Sincere thanks for the feedback.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it

A new class of investors is making their mark in the Indian capital markets. These are Private Equity firms and Venture Capitalists. The emergence of these investors is a very good sign as it is expected to promote entrepreneurship and give a fillip to the Indian economy. This article seeks to simplify their role and logically explain the various strategies adopted by these investors.

Q1) What are Private Equity (P.E.) and Venture Capital (V.C.) investors?

Ans. P.E. and V.C. are firms which typically invest in the equity shares of Companies. They, like all investors follow the strategy of investing at a low price and disinvesting at a higher price. They normally take up stake in firms which are not listed on a Stock Exchange, though sometimes they also buy shares of listed Companies. Though both P.E. and V.C. have a similar invest and disinvest strategy, there is a fundamental difference between the two.

Q2) What is the difference between Private Equity and Venture Capital investors?

Ans. Venture Capital (V.C.) firms invest in startups i.e. new ventures. Private Equity (P.E.) firms on the other hand invest in existing Companies which want to grow bigger. V.C. thus takes more risk than P.E. Consequently, return expected by V.C. is typically upwards of 35% to 40% per annum, while P.E. expects returns of 20% to 24% per annum. It is true that a significant number of investments made by V.C.s could be a failure, as they invest in firms at the idea stage. However they may also earn very high returns if the firms in which they invest, comes out with products which do well in the market place. Hotmail, Apple are examples of firms in which V.C.s made significant returns. Thus, V.C.s are playing the high risk - high return game. The success of a V.C. lies in identifying good ideas which when executed properly can lead to good products. Both V.C. and P.E. follow a stringent due diligence policy to ascertain the worthiness of their investment.

Q3) What is their due diligence policy for investment?

Ans. Due diligence is checking the investment worthiness. Normally all firms have their own checklist. Some of the salient points considered during due diligence are:

1. Promoter background.

2. Credit History of Promoters and Company.

3. Past Financial Performance. (not applicable for new ventures)

4. Expansion Details.

5. Financial Projections.

6. Govt policy towards the sector.

7. Performance of Group Companies.

8. Promoter's Contribution towards the project.

9. Details of other funding.

10. Any civil & criminal cases.

11. Details of key personnel like their qualifications, experience etc.

For V.C.s , the due diligence is more difficult as they have to predict the future performance of the firm which typically do not have a past track record. After due diligence, these investors may take a strategic stake less than 25% of the total shareholding. They may also take controlling stake.

Q4)What is a controlling stake?

Ans. Controlling stake is an investment greater than 25% of the total shareholding. The logic for controlling stake can be understood by remembering three simple rules:

1. Share holders control the Company by passing resolutions. There are basically two types of resolutions : Ordinary and Special Resolutions.

2. To pass an Ordinary Resolution we need to have a minimum 50% of shareholders present and voting in favor of the resolution.

3. To pass a Special Resolution we need to have a minimum 75% of shareholders present and voting in favor of the resolution.

Thus there are basically three controlling stakes.

Q5) What are the three controlling stakes?

Ans. i) When the shareholding crosses 25%, the shareholder gets the right to block special resolutions.

ii) When the shareholding crosses 50%, the shareholder can pass ordinary resolutions.

iii) When the shareholding crosses 75%, the shareholder can pass both ordinary and special resolutions.

Thus, when the shareholding crosses 75%, one is the deemed owner. In case of strategic investors, they normally pay an additional amount when they take controlling stake. This amount is called the control premium. In addition to investment criteria, they also consider the mode of disinvestment.

Q6) What is the mode of disinvestment normally adopted by these investors?

Ans. Disinvestment is the exit mode by which the investors sell their shares and earn their return. These exit strategies are clearly outlined in the disinvestment agreement. P.E./V.C may adopt any or a combination of the disinvestment modes as follows:

1. Buyback by the promoters : This clause is in the interest of the original promoters. They should be given the right to buy the shares first. Such a clause is called R.O.F.R. (Right of First Refusal). Such rights should be given as it is the promoters idea/firm originally. The price at which the purchase would be done would be such as to give the P.E. and V.C. investors the targeted return.

2. Sale to Other Strategic Investors : In case, the promoters do not wish to exercise the R.O.F.R either partially or completely, the initial investors can sell their stake to other investors. It is in the interest of the promoters, that their consent is taken before the sale. This is to ensure that the shares are not sold to parties who are hostile to the promoters. Normally, promoters insist that a No Objection Certificate ( N.O.C.) is taken before the sale.

3. Offer Of Sale to the Public : P.E. and V.C. may offer their shares either partially or completely to the public. In such a case, the Company generally needs to be listed on a stock exchange so that the public investors can freely trade the shares. Often during such offer, the promoters may also offload a part of their stake along with the P.E./V.C.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@simplifiedfinance.netThis e-mail address is being protected from spambots. You need JavaScript enabled to view it

Simplifying the Union Budget: Part 1

The Union Budget of India will be announced by the Honorable Finance Minister on Feb 28^th in the Budget Session of Parliament. It would not be wrong to say that everyone starting from India Inc, the common man and even the world will have an eye on this important event. This article seeks to simplify the various terms and issues associated with the budget as it is an important statement of fiscal policy.

Q1) What is fiscal policy?

Ans. Fiscal policy deals with the income and expenditure of the Govt. It lays out among other items the taxation policy of the Govt. The Finance Ministry, headed by the Finance Minister is responsible for framing and implementing the fiscal policy. In order to have a sound economy, it is important to have a co-ordination between Fiscal Policy and Monetary Policy. Monetary Policy is the responsibility of the Reserve Bank of India, which outlines it in the Credit Policy. The Budget is thus a fiscal statement.

Q2) What does the word Budget mean? What does it indicate?

Ans. The word budget is derived from the French word 'Budgette' which means a bag, wallet or a briefcase. (Remember the photograph with a smiling Finance Minister holding up the briefcase containing the Budget papers). It outlines the Govt's plan on how it seeks to earn its revenue and where it plans to deploy the resources. A Budget also highlights the performance in the past financial year. It needs to be noted here that the Budget is preceded by the Economic Survey which lays out the current state of the economy. Any Budget should be analysed in light of the current context of the economy.

Q3) What is the current context of the Indian Union Budget?

Ans. The last two budgets were outlined when globally economies were suffering the disastrous effects of the global meltdown. They aimed at stimulating the Indian economy by offering tax cuts & promoting Govt expenditure. The primary aim then was to insulate the Indian economy & keep it growing at a steady rate. These purposes have now been more or less achieved. Unfortunately this has led to a significant increase in the fiscal deficit.

Q4) What is fiscal deficit?

Ans.  A deficit means a shortfall. Fiscal deficit therefore means that the Govt expenditure has exceeded its income. It is normally expressed as a % of Gross Domestic Product (G.D.P. is the value of the goods and services produced by an economy in a year) .The Indian fiscal deficit had risen alarmingly to above 6% of G.D.P., due to a drop in Govt income and increase in Govt expenditure.

Q5) Why is a high fiscal deficit generally alarming?

Ans. Logically a high deficit, whether at personal level or at Corporate level, is alarming as it indicates that one is spending beyond their means. In case of fiscal deficit the same logic applies. It essentially indicates that the Govt is spending beyond what it is earning. The Govt bridges this deficit by taking loans from either domestic or foreign lenders. Many economists believe that both these forms of borrowings by the Govt are detrimental to the economy. This is because in case of domestic loans the Govt competes with the private sector in attracting the savings. In case of very high borrowing they may even crowd out the private sector also causing interest rates to increase. In case of foreign currency loans too, they are considered equally bad if not worse, as the country is indebted to a foreign party .A very high debt position may eventually lead to a crisis due to the consequent inability to meet loan obligations. However there are situations when a high fiscal deficit is considered necessary and useful.

Q6) When is a high fiscal deficit useful?

Ans. A high fiscal deficit is considered necessary especially during recessionary times. As the famous economist John Maynard Keynes advocated in tough economic times, it is the Govt responsibility to increase spending and cut taxes in order to stimulate the economy. He in fact went on to exaggerate that if the Govt has nothing useful to spend on, they may as well recruit and pay people to dig up holes and fill then up later. According to him, this spending by the Govt will increase employment and will leave enough money in the hands of the consumers who would then restart their consumption of goods and services. In the process the overall economy will thus recover. It is in this context that one should appreciate the high fiscal deficit of the Indian Govt., due to the implementation of the stimulus package. However with the tough conditions now behind us, the Finance Minister (FM) has started rewinding the stimulus package and reducing the fiscal deficit beginning with the last Budget.

Q7) What are the targets of reduction of fiscal deficit?

Ans.  As per the Fiscal Responsibility and the Budget Management (FRBM) Act operationalised in 2004-05, the Govt was to reduce its fiscal deficit to 3% of G.D.P. by 2008-09. These targets have been missed due to the stimulus package and the reasons outlined above. However the FM resumed the task of reduction of fiscal deficit and consolidation from the last budget. In the last Union Budget, the FM had sought to bring down the fiscal deficit to 5.5%, which many believe he will more or less achieve. He is expected to continue with this process and aim for a fiscal deficit lower than 5% in this Budget.

It is interesting to note that the FM could achieve his target of fiscal deficit reduction last year due to a significant one time receipt of nearly Rs. 1,00,000 crores due to the 3 G auction. The composition of the Budget is therefore of immense significance. We shall examine the same in the next part of the article.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@gmail.comThis e-mail address is being protected from spambots. You need JavaScript enabled to view it

SERIES ON ORGANIC GROWTH THROUGH PROJECTS:

Costing Of a Project: Part 3

Let us start by re-looking the total Project Cost.

Q1) What are the various costs involved in a project?

Ans. The various costs in a project are:

1)      Land.

2)      Buildings.

3)      Plant & Machinery.

4)      Furniture & Fixtures.

5)      Preliminary Expenses.

6)      Pre-operative Expenses.

7)      Margin For Working Capital

8)      Contingencies

9)      Miscellaneous Costs.

Q2) What is pre-operative expenses?

Ans. As the term implies, pre-operative expenses are all the expenses incurred by the firm before commencement of operations of the firm. As per accounting norms, a firm can prepare its Profit & Loss (P&L) statement only after it starts commercial productions. Thus pre-operative expenses will include all the operating expenses incurred before start of commercial production. This includes the commissioning costs, trial run expenses, etc. The Interest during construction (IDC) is a major component in case the firm has taken a loan. This is because banks and financial institutions start charging interest immediately on disbursement whether the firm has started commercial production or not. In case of infrastructure projects with a long gestation period like ports, road construction etc, IDC will thus be significant and may even account for as much as 60% to 70% of the total pre-operative expenses. After the commencement of commercial production, these expenses are accounted as revenue expenses in the Profit & Loss (P&L) statement.

Q3) What is the accounting treatment for pre-operative expenses?

Ans. As per accounting norms. the pre-operative expenses are capitalised. In simplified terms, the term capitalised means added to total project capital cost. The logic here is that the pre-operative expenses should be added to the individual fixed assets constituting the project like land, Plant & Machinery (P&M) etc. Normally these costs are added to the cost of the P&M so as to get maximum depreciation shield. For example, if the original cost of P&M is 10 crores and the loan paid in the construction period is 1 crore, after Capitilisation, the total cost of P&M in the balance sheet is taken as 10 crores plus 1 crore. This will be beneficial to the firm as they can now claim depreciation on a higher base of 11 crores as against the original 10 crores. This will give them a higher tax shield. (As the term implies, tax shield means saving on taxes).

Q4) What is Working Capital?

Ans. Working Capital essentially means capital needed for the day to day working of the firm. It is estimated as Net Current Assets i.e. Current Assets less Current Liabilities. 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. The firm would use funds to procure raw material and cycle continues.

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.

Q5) What is margin on Working Capital?

Ans. Normally firms take bank loans to fund working capital. However banks insist that a part of the same be funded through own sources. This amount is called Margin and the normal figure is 20% of the total Working Capital. The logic here is that in case the working capital requirements are Rs. 100; the bank will fund only Rs. 80. This will ensure that in case of bankruptcy, the banks will be able to recover the amount due by selling the current assets. It is obvious that for volatile and depreciable assets with a high threat of obsolescence, the margin insisted by the banks will be higher.

Q6) What is Contingencies?

Ans. This is a very important element as it takes care of cost escalations. Often projects face time delays and cost over-runs which affect their financial viability. It is to account for this that we have contingencies. As the term implies, contingencies means unexpected situations. The first step towards estimating contingencies is to classify all the costs as firm and non firm costs.

Q7) What are firm and non firm costs?

Ans. Firm costs are costs which are firmed up or fixed up and therefore are not prone to escalation. On the other hand, non-firm costs can escalate. For example, estimating cost of P&M by way of quotations is a non firm cost, while estimating the same via confirmed orders gives us firm cost.

Q8) How is the total cost towards contingencies estimated?

Ans. Once the classification is done, a percentage of Non firm costs are accounted for as Cost towards Contingencies. Normally 10% is taken as a thumb rule. The logic here is that the non firm costs can increase by up to 10% and therefore needs to be provided for. It is to be noted here that this figure is just a thumb rule. We can take a higher or lower rate depending on case to case basis. For in case of projects with a long gestation period a higher figure can be taken. Past trends are also considered. For example, in case of imported machinery payable in foreign currency, the figure can be estimated based on the movement of the foreign currency in the near past. These contingencies costs are provided for after considering situations which are expected. We do not account for unexpected events like earth-quake etc. Normally projects are insured so that it is not affected due to such unforeseen events. (Insurance is accounted for as preliminary expense.)

SERIES ON ORGANIC GROWTH THROUGH PROJECTS:

Part 1: Costing Of a Project

Corporates often take up projects in order to grow or diversify their business. The decision to grow organically is a critical decision as its success has a definite bearing on the firm. This series of articles will examine the entire gamut of costing and financing of projects. The first part of the series looks at the various cost elements in a project and seeks to simplify the various practical issues associated with it.

Q1) What are the various costs involved in a project?

Ans. The various costs in a project typically are:

1)      Land.

2)      Buildings.

3)      Plant & Machinery.

4)      Furniture & Fixtures.

5)      Preliminary Expenses.

6)      Pre-operative Expenses.

7)      Margin For W. Capital

8)      Miscellaneous Costs.

9)      Contingencies.

Let us look at each of these cost elements one by one starting with location & land costs:

Q2) What are the various issues to be considered while deciding location of the project?

Ans. Location of the project is a very significant decision. Some industries like cement, sugar etc have to be located near  raw material sources, while some like assembling plants have to be located near the customers. Units like auto ancillaries are located near the automobile manufacturer in order to ensure timely supplies. Infrastructure available also is a critical factor. Often corporates do not prefer setting up units in certain areas due to the poor infrastructure and connectivity. The Govt therefore gives various financial incentives in order to promote these industrially backward regions & employment in general. These financial incentives often encourage corporates to set up units in specified industrially backward areas and Special Economic Zones (SEZ).The financial incentives can be classifies as tax and non tax ones.

Q3) What are the various tax incentives given by the Govt of India?

Ans. The various tax incentives given by the Govt are tax holidays and tax deferrals. Tax holidays essentially mean that the Corporate has to pay no tax on the profits earned by them. Tax deferral on the other hand is only a postponement of tax liabilities. (Obviously corporates would prefer tax holidays to tax deferrals). Currently Govt of India gives tax holidays ranging from 5 years to 10 years for units located in specified areas. These tax incentives are with respect to both direct taxes like corporate taxes as well as indirect taxes like excise duties, sales tax etc.

Q4) What are the various non tax incentives given by the Govt of India?

Ans.  The various non tax financial incentives given by the Govt are subsidies, grants etc. Subsidies could be in the form of interest subsidies. In such a case the corporates are given soft loans at substantially lower rates of interest than the market rates. Moratoriums are also given for the repayment of the loan, where Corporate enjoys a freeze on payments for a specified period. Moratoriums are of two types:

i)                    Capital Moratorium where there Corporate has to pay only the interest for a specified period and no repayment towards the capital is to be made.

ii)                   Total Moratorium where the Corporate enjoys a total freeze on payments. In this case absolutely no payments are to be made towards the loan for the specified period.

Q5) Does the Govt also directly invest in the project?

Ans. Yes. In specified cases, Govt also directly invests and contributes towards the project. However there is a practical difficulty here. The amount towards the Govt's contribution is released only after the complete setting up of the project and the commencement of commercial production. This condition is imposed as the Govt wants to ensure that the amount is fruitfully used only for the projects. (In the past it has been seen that promoters have taken this amount but not implemented their projects). This leads to difficulty as the Corporates need the amount to set up the project itself. This is where financing sources such as a bridge loan helps.

Q6) What is a bridge loan?

Ans. Bridge loan as the name indicates is a short term loan. In order to tide over the above practical difficulty the Corporate can approach a financial institution or a bank and avail bridge financing. The lenders will lend for a short term period to cover the financing gap. The bridge loan is to be repaid when the Govt's contribution is received. In order to ensure the same the lenders will also specify repayment conditions like provision of an escrow account.

Q7) What is an escrow account?

Ans. An escrow account is a specific purpose account. Once the escrow account is opened then the amount deposited in the same can be used for specified purposes. It cannot be used for any other purposes. Thus an escrow account ensures that there is no diversion of funds. Let us consider the above case of escrow account as specified by the banks. It will ensure that once the Govt proceeds are deposited in the escrow account they can be used only to repay the bridge loan.

Q8) What are the various costs associated with the land?

Ans. Land costs include both costs incurred towards purchase of land as well as development of land. Here it is to be mentioned that in India certain areas and zones are clearly demarcated as for only agricultural use. Thus specific costs have to be incurred for converting such land from agricultural to non agriculture use. Also often the land acquired has to be suitably developed and modified for industrial use. Such costs are clubbed under development costs. Land costs also obviously involve the consideration paid for acquiring the land. It is to be noted here that lenders are fine with funding land requirements in excess of the current requirements. In fact many lenders are willing to fund land requirements in excess of as much as 50% of current requirements. This is to ensure that the unit does not face problems in future expansions as land is a scarce asset.

Prof anil menon interacts with students of Family Managed Business in SP Jain Institute of Management Studies. His previous articles and lecture videos are available at www.simplifiedfinance.net. He can be contacted at anilrmenon1@gmail.comThis e-mail address is being protected from spambots. You need JavaScript enabled to view it .

SERIES ON ORGANIC GROWTH THROUGH PROJECTS:

Financing a Project: Part 1

The next step after estimation of the project cost is planning the funding pattern. A number of funding options are available today. However the selection of a particular source of funding is very subjective and a number of factors are considered while taking this crucial decision. This series of articles looks at various options available for financing. It then proceeds to examine the various issues pertaining to the same. Let us start by listing the same.

Means of Finance

1)      Equity

2)      Debt

3)      Hybrids

4)      Leasing /Hire Purchase

5)      Deferred Credit

6)      Subsidy

7)      Miscellaneous Sources

Q1) What is equity?

Ans. Equity is owner's funds or owners capital. It refers to the funds brought in by the equity shareholders. Equity contribution can be brought in by the promoters as well as the non promoter shareholders. The non promoter shareholders can be institutional investors as well as individual public shareholders. This contribution towards equity capital can be brought in as common share capital or preference share capital.

Q2) What is preference share capital? Why is it so called?

Ans. The word preference means priority. Preference shareholders get priority (preference) over common shareholders in payment of dividends. (Dividend refers to the profits distributed among the shareholders). Similarly when a firm is liquidated, the preference share-holders get priority (preference) over ordinary shareholders. Thus the term preference indicates that preference shareholders are preferred over ordinary shareholders.

Q3) Why will investors prefer to invest in preference shares?

Ans.  Preference shares normally are instruments which carry a fixed dividend. A profit making firm is obligated to pay the dividend promised to the preference share investors, when it issues preference shares.

Thus any investor who wishes to get a fixed return in the form of dividends will invest in preference shares. The icing on the cake is that unlike interest income, dividend income is tax free in the hands of the investors. Though preference shares share characteristics with debt instruments, it needs to be noted that the firm has to compulsorily pay interest on the amount borrowed whether it makes a profit or not. On the other hand if the firm makes losses or insufficient profits, it may skip paying preference dividend. Therefore many times investors insist on a cumulative option when they invest in preference shares.

Q4) What is cumulative option in case of preference shares?

Ans. As the term signifies, cumulative means addition. For example, let us consider case of a firm which has issued preference shares promising to pay dividends at the rate of 15%. In case in any particular year it is unable to pay the contracted 15%, then next year it has to pay dividends at the rate 30%   (15% for current year plus 15% for last year). It is obvious that investors will always prefer the cumulative option. Sometimes the preference shares are irredeemable.

Q5) What are irredeemable preference shares?

Ans. In simplified terms, redemption means maturing of instruments and payback of proceeds. Thus irredeemable preference shares are instruments which do not mature. They are also called perpetual instruments as they form a permanent source of capital for firms. Irredeemable instruments are rare. Redeemable preference shares are more commonly issued. Often these redeemable instruments have a convertible option.

Q6) What are convertible preference shares?

Ans. Convertible preference shares are preference share which are subsequently converted into common equity shares. For example, these instruments carry a fixed dividend rate during the initial period. After the pre-determined period these are converted into common shares. It may be noted that common shares do not have a fixed dividend rate. However, unlike preference share-holders, common share-holders have voting rights. The preference shareholders generally do not have voting rights. (It may be noted here that preference shareholders do have voting rights regards matters concerning them. For example, preference shareholders are eligible to vote on any decision to reduce the preference dividend rate).Of all the sources, common shareholder's equity is high risk capital.

Q7) Why is common share- holder's equity called high risk capital?

Ans. Common share-holder's equity is called high risk capital as on liquidation of the firm, the equity shareholders are last in the queue to recoup their investments. Thus, they often lose their investments if a firm is liquidated on bankruptcy. Often nothing remains after meeting the claims of other stakeholders like bankers. (Note: As against popular perception, it is the employees who currently have first claim on the assets of the liquidated firm and not the bankers).

Q8) Which entities are called promoters?

Ans. Explained in simplified terms, promoters are entities who promote (start) the firm. In a legal sense, promoters are essentially entities or persons who are signatories to the Memorandum of Association (MOA) and Articles of Association (AOA). Thus the promoters are original shareholders of the firm. Often the promoters may decide to reduce their stake and bring in other non promoter entities as shareholders in the firm.

Q9) Who are non promoter shareholder entities?

Ans. Non promoter shareholders include private equity or venture capital firms. These are basically strategic institutional shareholders which specialise in investing in non listed firms. In case, the firm decides to go public and get listed on a stock exchange, the non-promoter shareholders will include the general public as well. In such instances, there are stipulations with respect to the minimum contribution to be brought in by promoter entities, listing norms, lock in period etc. (For further details on the same please refer to the articles on Strategic Shareholders and Going Public).

Q10) What are hybrid instruments?

Ans. As the term indicates, these are financial instruments which include the features of both debt and equity instruments. Often they are also called quasi equity or quasi debt (the term quasi means like). These are also called convertible instruments. Currently there are three types of hybrid instruments in vogue.

a)      Fully Convertible Debentures. (FCDs)

b)      Partly or Partially Convertible Debentures. (PCDs)

c)       Non Convertible Debentures ( NCDs)