UNIT I INVESTING DECISIONS

Project Investment Management Vs Project Management – Introduction to profitable projects –

evaluation of Investment opportunities – Investment decisions under conditions of uncertainty – Risk
analysis in Investment decision – Types of investments and disinvestments.

INTRODUCTION TO PROFITABLE PROJECT

1.1 MEANING OF PROJECT
The very foundation of an enterprise is the project. Hence, the success or failure of an enterprise largely
depends upon the project. In simple words, a project is an idea or plan that is intended to be carried out. The
dictionary meaning of a project is that it is a scheme, design, a proposal of something intended or devised to be
achieved.
According to Newman “a project typically has a distinct mission that it is designed to achieve and a clear
termination point, the achievement of the mission”.
Gillinger defines project “as the whole complex of activities involved in using resources to gain benefits”.
According to Encyclopaedia of Management “a project is an organised unit dedicated to the attainment of a
goal, the successful completion of a development project on time.
Now, a project can be defined as a scientifically evolved work plan devised to achieve a specific objective
within a specified period of time. Here, it is also important to mention that while projects can differ in their
size, nature, objectives, time duration and complexity, yet they partake of the following three basic attributes:
(i) A course of action (ii) Specific objectives, and (iii) Definite time perspective. Every project has a starting
point, an end point with specific objectives.

1.2 PROJECT CLASSIFICATION

Project classification is a natural corollary to the study of project idea. Different authorities have classified
projects differently. Following are the major classifications of projects:
1.2.1 Quantifiable and Non-Quantifiable Projects
Projects for which a plausible quantitative assessment of benefits can be made are called ‘quantifiable projects/
projects concerned with industrial development, power generation, and mineral development fall in this
category. On the contrary, non-quantifiable projects are those in which a plausible quantitative assessment
cannot be made. Projects involving health education and defence are the examples of non-quantifiable projects.
1.2.2 Sectoral Projects
According to this classification, a project may fall in any one of the following sectors: (i) Agriculture and
Allied Sector (ii) Irrigation and Power Sector iii) Industry and Mining Sector (iv) Transport and
Communication Sector (v) Social Services Sector (vi) Miscellaneous Sector The project classification based on
economic sectors is found useful in resource allocation more especially at macro levels.
1.2.3 Techno-Economic Projects
Projects classification based on techno-economic characteristics fall in this category. This type of classification
includes factors in intensity oriented classification, causation oriented classification and magnitude-oriented
classification. These are discussed as follows:
a. Factor Intensity-Oriented Classification: Based on factor intensity classification, projects may be
classified as capital intensive or labour intensive. If large investment is made in plant and machinery, the
projects will be termed as ‘capital intensive’. On the contrary, projects involving large number of human
resources will be termed as ‘labour intensive’.
b. Causation-Oriented Classification: Where causation is used as a basis of classification, projects may be
classified as demand based or raw material based projects. The very existence of demand for certain goods or
services makes the project demand-based and the availability of certain raw materials, skills or other inputs
makes the project raw material-based.
c. Magnitude-Oriented Classification: In case of magnitude-oriented classification, based on the size of
investment involved in the projects, the projects are classified into large scale, medium-scale or small-scale
projects. Project classification based on techno-economic characteristics is found useful in facilitating the
process of feasibility appraisal of the project
1.2.4 Project identification and Selection
The fact remains that in spite of increasing literature on entrepreneurship development, comparatively little is
known about how an entrepreneur identifies and selects a project Hence, it is somewhat difficult to state in any
categorical manner as to how an intending entrepreneur should proceed to select his/her project.
As a matter of fact, project selection is not a nebulous idea. It is a well outlined game plan. There is a definite
procedure of selecting a project. Basically, project selection consists of two main steps:
a. Project Identification b. Project Selection
1.2.4.1 Project Identification
A project is a proposal for capital investment to develop facilities to provide goods and services. The
investment proposal may be for setting up a new unit, expansion or improvement of existing facilities. The
project, however, has to be amenable for analysis and evaluation as an independent unit.
A project is a specific, finite task to be accomplished in order lo generates cash flows. The projects undertaken
after liberalisation are large and getting larger. They have increased in size and complexity. Projects for
tomorrow are not geared to the mass production of simpler goods but customised ones produced by flexible
manufacturing systems. Project idea can be conceived either from input or output side. The former are material
based while the latter, demand oriented. Input based projects are identified on the basis of information about
agricultural raw materials, forest products, animal husbandry, fishing products, mineral resources, human skills
and new technical process evolved in the country or elsewhere Output based projects are identified on the basis
of needs of population as revealed by family budget studies or industrial units as found by market studies and
statistics relating to imports and exports. Desk research surveying existing information is economical and
wherever necessary market surveys assessing demand for the output of project could help not only in
identification but in assessing viability of the project. Project identification is however, a continual process.
With the opening up of the economy, demand for sophisticated inputs is continuously rising. The quest for new
combinations of factors for optimising output and improving productivity to strengthen the competitive position
of Indian industry in the international market place is an ongoing process. Further- the growing demand for
complex, sophisticated, customised goods and services in international markets has added a new dimension to
project concept.
1.2.4.2 The stages of Project Selection
The identification of project ideas is followed by a preliminary selection stage on the basis of their technical,
economic and financial soundness. The objective at this stage is to decide whether a project idea should be
studied in detail and to determine the scope of further studies. The findings at this stage are embodied in a pre-
feasibility study or opportunity study. For the purpose of screening and priority fixation, project ideas are
developed into pre-feasibility studies. Pre-feasibility studies give output of plant of economic size, raw material
requirement, sales realisation, total cost of production, capital input/output ratio, labour requirement, power and
other infrastructure facilities. The project selection exercise should also ensure that it conforms to overall
economic policy of the government.

1.3 FEASIBILITY STUDY

After ensuring that a project idea is suitable for implementation, a detailed feasibility study giving additional
information on financing, breakdown of cost of capital and cash flow is prepared. Feasibility study is the final
document in the formulation of a project proposal. Feasibility studies can be prepared either by the entrepreneur
or consultants or experts. The cost of feasibility study can be debited to project cost and can be counted as
part of promoter’s contribution. The feasibility study should contain all technical and economic data that are
essential for the evaluation of the project. Before dealing with any specific aspect, feasibility study should
examine public policy with respect to the industry. After that, it should specify output and alternative
techniques of production in terms of process choice and ecology friendliness, choice of raw material and choice
of plant size. The feasibility study after listing and describing alternative locations should specify a site after
necessary investigation. The study should include a lay-out plan along with a list of buildings, structures and
yard facilities by type, size and cost. Major and auxiliary equipment by type, size and cost along with
specification of sources of supply for equipment and process know-how has to be listed. The study has to
identify supply sources and present estimates, costs for transportation, services, water supply and power. The
quality and dependence of raw materials and their source of supply have to be investigated and presented in the
feasibility study. Before presentation of the financial data, market analysis has to be covered to help in
establishing and determining economic levels of output and plant size. Financial data should cover preliminary
estimates of sales revenue, capital costs and operating costs for different alternatives along with their
profitability. Feasibility study should present estimates of working capital requirement to operate the unit at a
viable level. An essential part of the feasibility study is the schedule of implementation and estimates of
expenditure during construction.
1.4 PROJECT REPORT
The feasibility study is followed by a project report firming up all the technical aspects such as location, factory
lay-out specifications and process techniques design.
In a way, project report is a detailed plan of follow-up of project through various stages of implementation.
A project report should contain an examination of public policy with respect to the industry, listing of
equipment by type, size and cost and specification of sources of supply for equipment, broad specification of
outputs and alternative techniques of production in terms of choice of process, plant size and raw material,
listing and description of alternative location, capital costs, estimates of sales revenue and operating costs for
different alternatives, estimation of demand for product, sources of raw material supply, listing of buildings and
structures by type, size and cost, specification of supply sources and costs for transportation services, water
supply and power, preparation of layout, labour requirement and cost, working capital requirement, plan for
execution of project and expenditure during construction, analysis of profitability, pollution control method and
experience of promoters in execution of projects in the past.

1.5 PROFITABLE PROJECT COSTING TIPS

Profit is the key to success. Therefore, the firm should ensure that every project undertaken is profitable.
A useful project costing process can be the determining factor in business longevity. It’s not enough to just
track the company’s general information; the management also needs to manage the details. Here are some
guidelines for maintaining an effective process:
 Separate direct and indirect costs so that one can assess both gross and net profits. Direct costs include direct
materials and labour that relate to the product or service the firm provide. Indirect costs encapsulate all
operating expenses, such as administrative labour, rent, marketing, office supplies, utilities and rent.
 Track the customers and projects so as to easily review income and expenses tied to each project. The
accounting system should have this capability. The income and expenses to each job should be tied up
appropriately. This enables to monitor profitability as the job progresses.
 Record employee time to projects and spread out payroll expenses to each project. While the firm may not be
able to easily associate all payroll costs, associate as many as possible to get the firm close to accurate project
costing. If the accounting system uses timesheets to populate payroll data, on the payroll date, the firm should
see the costs spread out for gross payroll by hours associated to the projects.
 Associate all subcontractor labour and material payments to each project when entering the bills from the
vendors. The firm should do this regardless of how the bill its clients. The goal is to get a full costing of the
project.
 Compare the estimated costs and revenues compared to the actual numbers in the accounting system. This
will allow the firm to assess its project management strengths and weaknesses to help manage projects
profitability.
 Knowledge is power and having a good project costing system will help to manage projects wisely. The firm
should use reports within its accounting system to ensure that it operates with profitable projects. While it takes
more time to track this information, the value it receives can make the difference between profit and loss.

1.6 PROFITABLE PROJECT MANAGEMENT

With responsibilities in more than one initiative, the firm has multiple deadlines and milestones to meet. The
firm has more clients, more vendors, more requirements, more costs to track, more information to share and
more documents to file. Single project tools and techniques usually lack the overall work view and other
features the firm need to see and manage priorities and progress. To avoid getting dragged down by multiple-
project chaos, it need to know and see more. Systems engineered for multiple-project management and
collaboration can help. Still, methodology and culture, not software and technology, are the keys to success
when the firm regularly participate in more than one internal or client project. Seven steps are essential to
success in organizations that simultaneously manage multiple initiatives. Effectiveness begins with good pre-
project planning plus an understanding of what a project is and what can be at stake. Managing it almost always
involves:
 Applying technical knowledge, people, communications skills, and management talent.
 Attempting to meet contract requirements and customer commitments on time and within budget.
 Trying meeting customer expectations.
Skilfully balancing time, resources and scope is often not enough. To stay ahead, teams and companies
frequently must beat schedules, improve costs and exceed expectations.
1.7 BENEFITS OF GOOD PROJECTS MANAGEMENT
Collaboration right can be seen in staff morale and customer satisfaction. It also shows up in financials:
According to a study conducted by Pitney Bowes, Inc., and published in Automation World, good project
management practices saves 25 to 35 percent in time to complete a project.
Given today’s salaries and related expenses, that adds up to a lot of money. Companies or teams that cannot
manage multiple projects are unable to grow past a certain point, usually about 15 people and $1 million in
revenues. If the firm consistently miss deadlines, blow budgets and fail to deliver complete solutions, others
will not want to give any new work or referrals. Standard project management tools might not help. They tend
to be rigid where the work is fluid, resource rather than task oriented and lacking in communication and
collaboration functions.

Every project is an opportunity to produce something new, to make a real difference. The firm can introduce
change, increase productivity, enhance its capabilities or of a client or build new relationships. What commonly
goes wrong? No communication tools, unclear or poorly communicated goals, no agreed milestones, inaccurate
staffing, missing deadlines, surprises, inconsistency from project to project. Consistently following these seven
key steps can directly improve the operations, profitability and sanity.

1.8 ESSENTIALS OF PROFITABLE PROJECT MANAGEMENT

1.8.1 Define scope, deadlines and goals
The firm should clearly define each project before bringing in the full team. If the firm is unsure of the
objectives, scope and deadlines, the effort will begin in confusion. Responsibilities and even resources can be
worked out at the first meeting, but not without a firm grasp of what is to be achieved, when and for how much.
The internal kickoff meeting is an opportunity to energize and unite the team to work for a successful project
outcome. It serves notice to all team members that the project has begun. Have an agenda that includes a clear
exchange between sales and the project team. Communicate the project requirements. Ensure everyone
understands the work to be done and their part in the effort. Nodding heads do not mean message received! Ask
each member to state their responsibilities in their own words before adjourning. No one should be guessing at
what the client and management want.
1.8.2 Communicate, Communicate and Collaborate
Lack of communication derails even the most brilliant teams and shining projects. Ensuring key messages are
received and understood as a matter of routine is the single most important factor in a project’s success. There
cannot be enough communication among team members and with the client. The management must talk, chat,
discuss and exchange ideas.
Communication should not just float off into space or rely on individual recollection. Every organization can
benefit from a tool that enables to capture all material information. E-mail is unreliable, particularly when
unacknowledged or lost in the spam. Investigate a projects library and collaboration system. A systematic
approach to communication can be a boost to individuals or groups reluctant to interact, like engineers and
software programmers. An automated, accessible and mandated communication and collaboration tool can be a
wise investment.

1.8.3 Meet deadlines even if the firm must reduce scope

“Time is becoming the new corporate metric,” says management consultant Peter Drucker. In an ideal world,
the firm would completely finish every project on time. When forced to choose, the best bet is usually to get
something demons ratably done by deadline. Today, time is as important as cost and quality. Time to market is
critical. Time to respond to a client request is critical. Time to incorporate change is critical. And time to install
a finished system is critical. In addition, work expands to fill the time available for completion. When under a
tight schedule, which the firm should be, keep in mind that clients remember meeting schedule commitment,
not reduced scope. Communication matters here too. Involve the entire team in establishing and maintaining
schedules. Keep your milestones to ones that matter. It is better to have a few the firm meet than many
milestones it doesn’t.
1.8.4 Run every project the same way
When it comes to projects, consistency is quality. It builds efficiencies, reduces costs and improves quality.
Consistency is the most cost-effective, least capital-intensive route to profitability. The firm should have a
common methodology to follow for every project, regardless of the project content. Invest in technology that
supports standards and methodology, as this will reduce ongoing costs. With or without a project application
system, the project methodology should include:
a) A known location for communication, updates, documents and changes.
b) An acknowledgment system for important communications like change orders.

1.8.5 Chose proven projects technology, deploy it properly

Technology for projects management and collaboration should be field-proven. This sounds obvious. Teams
with few projects of experience often overemphasize technology. Seeing some application as a primary driver
of their solution, they lose focus of the primary purpose of the technology: improving project delivery and
completion. Selecting projects management tools by technological parameters instead of functionality is a
mistake. Remember that advanced features are seldom used. The firm wants stable technology that improves,
not hinders, its work. The firm needs sufficient training and implementation services at start-up. Typically the
biggest investment in application deployment is staff time. Good installation and proper training accelerate the
learning curve.

1.8.6 Monitor real-time costs

Many project managers are flying blind on project costs. Perhaps they don’t see it as part of the job. Perhaps the
accounting system doesn’t produce reports until month- or project-end when it is too late to make adjustments.
Perhaps they have a latent desire to change careers. The firm should put in place a project management system
that lets to see individual project costs at any time. Move cost-tracking responsibility into project team rather
than leaving it up to accounting. This is easily done with the right system and speeds up overall project
execution. Let all project members see and understand project costs to help the firm work within budget. A
system that allows the firm and the team to track project costs in real-time keeps more projects on track.

1.8.7 Manage the client as much as the project

The good news is that the client wants the firm to take a leadership position. The bad news is that the client
wants the firm to take responsibility when the project goes awry. The client’s perspective can include:
a) The project team can figure out what needs to be done.
b) Anything that needs to get done was part of the implied scope.
c) 27
d) “My project is the most important,’
e) “If I change my mind, the project team MUST accommodate the change in my time frame”
f) “If the project is running over budget, I expect my partner to share the cost.”
g) The client never remembers the voyage; just the destination.
h) Perception always wins over reality and good intentions.

1.9 PROJECT MANAGEMENT AND PROJECT INVESTMENT MANAGEMENT

1) Project investment management is about investment and financing analysis of project, whereas, project
management is wholesome process which involves identification project, finding out feasibility and execution
of project.
2) In the feasibility analysis itself there are several feasibility studies are involved. Project management requires
all kinds’ feasibility analysis such as market feasibility, technical feasibility, financial feasibility and
operational feasibility. The project investment management requires only the financial feasibility.
3) Project management requires technical, marketing and financial skill, whereas project investment
management requires only financial knowledge.

2 EVALUATION OF INVESTMENT OPPORTUNITIES

Simply speaking, project appraisal means the assessment of a project. Project appraisal is a costs and benefits
analysis of different aspects of proposed project with an objective to adjudge its viability. An entrepreneur
needs to appraise various alternative projects before allocating the scarce resources for the best project. Thus,
project appraisal help to select the best project among available alternative projects. For appraising a project, its
economic, financial, technical, market, managerial and social aspects are analysed. There are numerous capital
budgeting techniques are available to evaluate worthiness of projects. This chapter is devoted to explain basic
capital budgeting techniques and next chapter will explain risk adjusted capital budgeting techniques.

2.1. IMPORTANCE OF CAPITAL BUDGETING

‘Capital budgeting’ is the most vital activity which can ‘make or mar’ a future financial health. The following
are the reasons for its importance.
(1) Huge amount of investment: Capital expenditure decisions can commit the firm for huge investment over
a period of time. A wrong decision can result in heavy loss.

(2) Permanent and Irreversible Commitment of funds: Capital expenditure decisions result in commitment of
funds on long term basis. Once a project is taken up and investment is made, it is not usually possible to reverse
the decision. The reversal will be at the cost of heavy loss.
(3) Long-term impact on profitability: The Capital expenditure decisions will shape the future revenue streams
and the profitability of operations.
(4) Growth and Expansion: Business firms grow, expand diversity and acquire stature in the industry through
their capital budgeting activities. The success of mobilization and deployment of funds determines the future of
a firm.
(5) Cost over runs: If not meticulously implemented, delay in completion of projects will automatically result
in excess costs and heavy losses.
(6) Alternatives: Limited funds at the disposal of a firm have to be deployed in the most profitable of the
alternative projects. The elimination process is a difficult one.
(7) Multiplicity of variables: Large number of factors affects the decisions on capital expenditure. The make
the ‘capital expenditure decisions’ the most difficult to make.
(8) Top Management Activity: The metamorphic impact of capital expenditure decisions automatically thrusts
them on the top management. Only senior managerial personnel can take these decisions and bear responsibility
for them.

2.2. FACTORS INFLUENCING CAPITAL EXPENDITURE DECISIONS

There are many factors, both financial and non-financial, which influence the capital expenditure decisions. The
following are some of the important factors.
(1) Availability of funds: This is the crucial factor affecting all capital expenditure decisions. However
attractive some projects may be, they cannot be taken up if they are too big for a firm to mobilize the needed
funds.
(2) Future Earnings: Every project has to result in cash inflows in future. The extent of the revenues
anticipated is the most significant factor which affects the choice of a project.
(3) Legal compulsions: When statutory compulsion arises, cost and profit considerations have to be secondary.
For example, waste disposal plants have to be installed to satisfy environmental laws in most of the countries in
the world, particularly in industries like leather and chemicals.
(4) Degree of uncertainty or risk: The level of risk involved in a project is vital for deciding its desirability.
(5) Urgency: Projects which are to be immediately taken up for a firm’s survival have to be treated differently
from optional projects.
(6) Research and Development projects: Projects, which may result in invention of new products or methods,
etc., are a sort of ‘investment with hope’. They may prove successful or not. But ‘R & D’ is a must in most of
the industries, particularly in technology based industries.
(7) Obsolescence: If obsolete machinery and plant exist in a firm, their replacement becomes a compulsion.
(8) Competitor’s Activities: When competitors perform certain activities, they may compel a firm to undertake
similar activities to withstand competition.
(9) Intangible Factors: Firm’s prestige, worker’s safety, social welfare, etc., influence capital expenditure
which may be deemed as emotional factors.

2.3. TYPES OF CAPITAL EXPENDITURE

Capital expenditure can be divided into two categories, depending on the benefit expected from the
expenditure.
(1) Capital Expenditure which increases revenue: It is the expenditure which fetches additional income in
future. It may be by taking up production of new products or expanding the existing production facilities to
increase production. In both cases purchase of fixed assets becomes necessary.
(2) Capital expenditure which reduces costs: Expenditure which reduces the cost of present products or
processes or operations can increase the profitability of existing operations. It may be done by purchase of
improved machines and equipment or tools. In the former case the risk is higher because the firm has to enter
into new activities or produce new products. The later is less risky because the firm is already in the line and
cost reduction is more feasible because of the known operations.
2.4 CLASSIFICATION OF CAPITAL EXPENDITURE PROPOSALS
Investment proposals which are usually considered by firms can be classified into the following three types.
(a) Independent Proposals: These are proposals which are not interconnected. The acceptance or rejection of a
proposal has no effect on the acceptance or rejection of any other proposal.
Such proposals can be evaluated on the basis of the return expected and the return required by the firm’s norms
of return. Proposals which satisfy the firm’s return standards can be taken up irrespective of other proposals.
(b) Dependent proposals or contingent proposals: When a proposal depends on the acceptance of some other
proposal, it is called a dependent proposal. For example, purchasing a specific kind of computer printer depends
on the proposal to acquire a computer. In such cases it is preferable to consider both the proposals
simultaneously.
(c) Mutually exclusive proposals: If acceptance of one proposal results in the automatic rejection of the other
proposal or proposals, they can be termed as mutually exclusive proposals. For example two different kinds of
machines may be considered for a particular task. If one of them is selected, the other machine is
automatically rejected.

2.5 SOME IMPORTANT ASPECTS OF CAPITAL EXPENDITURE DECISIONS

The following are some of the important aspects of investment proposals which need careful consideration
irrespective of the methods employed for project selection.
(1) Cash out flow needed for a proposal
The Amount of investment needed may be completely initial investment or it may be needed in stages. The
amount of cash out flow needed should be ascertained and if the amount is within the firms reach, it becomes a
possible project which may have to complete with other similar projects on the basis of return and risk for final
approval. The following are taken into account while computing the cash out flow of a proposal.
(a) Cash cost of the new project or machine or equipment;
(b) Cost of Installation;
(c) Working capital needed to operate the machine or to implement the projects;
(d) Cash inflows from sale of old asset in case of replacement of assets;
(e) Tax effects of implementing the proposal: Excess cash out flows on account of tax or savings in tax due to a
proposal are to be adjusted in the calculation of overall cash out flow.
The total net cash out flow on account of a proposal is deemed as the investment in that proposal.
(2) Required return on investments
Every firm has to raise funds from different sources. The return demanded by sources of funds is called ‘Cost of
Capital’. So, funds invested in the investment proposals must result in satisfactory return to cover the cost of
capital and fetch reasonable profit to the firm. It is customary to develop ‘norms’ or ‘cut-off rates of return’ to
assess investment proposals. The norms or cut-off rates are ‘specific percentage returns’ which must be earned
from investment proposals. So, all proposals with lower returns are rejected straight away. Those proposals
which are estimated to result in returns above the ‘cut-off rate’ or ‘norm’ may be accepted, depending on the
availability of funds and the return from other similar proposals.
(3) Measurement of returns from Investment proposals
The returns from investment proposals may be measured in terms ‘Profit’ or ‘cash inflows’, “Profit” in the
accounting sense is after deducting all routine expenses including depreciation and tax. It is termed as
‘Accounting Profit’, ‘Cash inflows’ are the funds recovered from a project. They ignore depreciation and any
other ‘amortisation expenditure’ relating to fixed Assets because they do not result in case out flows. Modern
capital budgeting has recognized the superiority of the cash flow concept of measurement of returns over the
traditional accounting concept of profit. However the cash flows are ‘discounted’ to ascertain their ‘Present
Value’.
(4) Ranking of Investment Proposals
Most firms have limited funds at their disposal. The investments opportunities are unlimited. So, it is necessary
to ‘Rank’ all the available investment proposals in the order of their Profitability, combined with relative risk
involved. Each method in capital budgeting has its own mode of Ranking Projects.
(5) Assessment of ‘Risk’ or ‘Uncertainty’ involved in Projects
All investment proposals are subject to uncertainty because they have to be implemented in future. However the
extent of risk may differ from project to project. Higher risk may result in higher returns. The risk ‘Perception’
and the methods of dealing with risk is the most crucial factor in successful capital expenditure decisions.
To conclude, determining the amount of investment needed, required return, measurement of the return,
comparative assessment of proposals by ranking and risk perception of the projects are all common for various
methods of capital Budgeting.

2.6 METHODS OF CAPITAL BUDGETING (OR) “METHODS OF EVALUATIONS OF

INVESTMENT PROPOSALS”
At any given time, large number of investment proposals can be there and the funds available or funds which
can be raised are always limited. So, it is not possible take up all the proposals of Investment. It is essential to
select from amongst the competing proposals those, which give the highest benefits. The essence of capital
Budgeting is the ‘Balancing Act’ of matching the available resources with the acceptable projects. There are a
large number of methods in practice all over the world in the sphere of capital expenditure decisions.
Whichever method is selected, it should:
(1) Provide a basis for distinguishing between acceptable and non-acceptable projects.
(2) Rank different proposals in order of priority.
(3) Have suitable approach to choose from among the alternatives available;
(4) Adopt ‘Criterion’ which can assess any kind of project;
(5) Be logical by recognising the time value of money and the importance of returns.
The following is the popular classification of various methods of capital budgeting.
(A) Traditional methods:
(1) Pay –back period method
(2) Improvement in traditional approach to pay-back period method.
(3) Accounting rate of return or average rate of return method.
(B) Non Traditional Methods (or) Discounted cash flow methods (D.C.F. Methods)
(4) Net Present Value (N.P.V) method
(5) Profitability Index (or) Excess present Value Index Method (P.I. Method)
(6) Internal rate of return (I.R.R.) method. Each of the above methods is explained below:
2.6.1 Traditional Methods
These methods generally ignore ‘Time Value of money’ and treat incomes estimated for different future periods
alike. These methods have been traditionally used in business units.
2.6.1.1 Pay-Back Period Method
Pay-back period’ is also called ‘pay-out period’ or pay-off-period. Pay-back period’ is the time span in which a
project ‘pays for itself’ through surplus cash flows. It is the period within which investment in fixed assets or
projects can be recovered. It is the time required for the ‘Savings in costs’ or ‘net cash inflows’ from a project
to equal the investment made therein. Thus, pay-back period is the period of time for the cost of a project to be
recovered from the additional earnings of the project itself
2.6.2 Investment decisions, based on pay-back period
(a) Accept or Reject criterion: Management of a firm may establish a ‘Norm’ or ‘Standard’ for acceptable
pay-back period, usually based on cost of capital. It is called ‘cut-off’ point. All projects whose pay-back period
is higher than the norm or standard may be rejected outright. The projects within the norm or standard pay-back
period may be short listed for further consideration. They are acceptable projects.
(b) Ranking of Projects: Pay-back period can be used as the ‘criterion’ to rank different investment proposals,
those with lower pay-back period being ranked higher and vice versa. This method is very useful in case of
‘Mutually exclusive projects, Ranking can help in choosing projects in situations of limited funds being
available.
(c) When pay-back period of two or more projects is equal, the project with higher initial cash inflows is
preferred over the projects with lower initial cash inflows.
Advantages of pay-back period method (1) It is simple to understand and easy to calculate.
(2) Inherently, the method provides for uncertainty. Dealing with risk is a ‘Built-in’ feature of this method. Its
focus on recovery of investment takes care of uncertainty and risk to a great extent.
(3) Loss through obsolescence is minimized because short-term projects are preferred through lower pay-back
criterion.
(4) Profit is recognised only after the pay-back period. So, it acts as a guideline for dividend policy in the case
of new firms.
(5) The importance given to liquidity through the emphasis on early returns from projects will enable a firm to
manage with lower funds.
2.6.3 Disadvantages
(1) It ignores post-pay-back period returns. Thus many highly profitable projects may be ignored.
(2) It is not concerned with the length of a project’s lifetime. Particularly after payback period. All projects
which have longer gestation periods but very long periods of profitable operation are ignored by this method.
(3) It completely ignores ‘Time value’ of money. It treats the cash inflows in the first year and the last year
alike. Thus, the interest aspect and the risk aspect which make cash inflows in the distant future less desirable
than the immediate cash inflows are not recognised in this method.
(4) It does not make use of cost of capital which is highly relevant for investment analysis in the sense it
represents the cost of funds to be invested.
(5) Standard payback period or ‘Norm’ for pay back is difficult to determine because it is a subjective decision.
(6) The method treats each project in isolation where as in practice investment in different assets is interrelated.
(7) Pay-back period method does not measure profitability of projects at all because it is concerned with a short
period of a project’s life time.
Conclusion: In spite several demerits or shortcomings, pay-back period is the most frequently used criterion for
project analysis. It is particularly used by multinational companies to assess projects in developing countries.
The following are the reasons for its popularity.
(1) Most of the growing business units which take up new investment proposals are usually not well endowed
with funds. The built in liquidity preference of pay-back period method attracts such firms.
(2) Its focus on ‘recovery of investment’ is more suitable for the dynamic markets and uncertain investment
climate.
(3) The ‘speed’ or ‘haste’ which is the characteristic of the modern business world prefers short term ventures
which are the preferred projects under pay – back period method.

2.6.4 Improvements in traditional approach to pay –back period method

The popularity of pay – back period methods has promoted efforts to eliminate some of its major draw backs.
The following are some of the more popular improvements to traditional payback period concept.
(a) Post Pay – back profitability method: A serious limitation of pay – back period is that it ignores the post
pay-back returns of projects. To rectify the defect, post pay – back profitability is computed by ascertaining the
amount of net cash inflows estimated in each of the years, after the pay-back period. They are shown as a
percentage of the investments in the project. Projects with higher index are preferable when two or more
projects have more or less similar pay-back period.
(b) Post pay-back period method: Here the length of the post pay-back period with positive cash inflows is the
criterion. It is also called ‘surplus life over pay-back’ method. Projects with longer post pay –back periods with
significant even cash flows are preferred.
(c) Pay-back Reciprocal method (or) ‘Unadjusted rate of return method: Pay-back reciprocal method is
employed to estimate the rate of return of income generated by a project. Such rate of return can be used as a
criterion to rank different projects and choose the ones with the highest rate of return. Pay-back reciprocal. This
method can be employed only when the following two conditions are fulfilled:
(a) Annual Cash flows are uniform throughout a project’s life time.
(b) The project under consideration has a long life, preferably at least twice the payback period.
(d) Discounted Pay-back method: The most serious limitation of pay-back period method is that it ignores time
value of money by treating cash inflows in different future years alike. To circumvent the limitation and to
make pay-back period method more effective, the discounting concept is ‘infused’ into the traditional pay-back
period method. In this method, the estimated future net cash –inflows are discounted at an appropriate rate
(usually cost of capital rate) to find their present values. The discounted cash flows are used to ascertain pay-
back period. The discounted pay-back concept has radically changed the pay-back concept because it is now far
superior to other D.C.F methods. The discounted payback period method retains all the traditional advantages
and eliminates the glaring drawback of pay-back concept.

2.6.4.1 Accounting Rate of Return Method (Or) Average Rate of Return Method (A.R.R)
This method takes into account the total earnings expected from an investment proposal over its full life time.
The method is called Accounting rate of return method because it uses the accounting concept of profit i.e.,
income after depreciation and tax as the criterion for calculation of return. It should be noted that pay-back
period method and also the discounted cash flow methods make use of ‘cash inflows’ of projects, whereas
A.R.R. method is based on ‘profit’.
2.6.4.1.1 Steps in the use of A.R.R. method
(a) Accounting rate of return is calculated separately for each of the projects under consideration (Method of
computing is explained later).
(b) Different projects are ranked in the order of rate of earnings.
(c) If there is no cut-off rate, projects with higher A.R.R. are accepted over those with lower rates. The
availability of investible funds may limit the acceptable rate of return.
(d) A cut-off rate may be determined and all the projects with a lesser rate of return than the cut-off rate are
rejected outright. The cut-off rate is usually based on the cost of capital of the firm i.e., the rate at which funds
can be raised.
(e) Projects with higher rate of return than the cut-off rate are acceptable projects. Based on the availability of
funds, projects with the highest rates of return are taken up first and then the others in order of their respective
rates of return.

2.6.4.1.2 Computation of Accounting or Average Rate of Return There are three variations of the accounting
rate of return
(a). Total income method (or) Return per unit of investment methods Here, the total income, after
depreciation and tax, over the life time of a project is shown as a percentage of net investment in the project
(Original cost – scrap value)
Alternative (iv) above is more logical and popular method of ascertaining average investment, for the following
reasons.
(1) Assuming straight line method of depreciation, average investment for the entire life of the asset is 50% of
its original cost, less scrap value.
(2) The working capital needed to operate the asset will always be tied up during the full life time of the asset.
(3) The scrap value is reduced initially to ascertain depreciation rate. But the scrap value is realized only at the
end, tying up the amount of scrap value through the life time of the asset.
It should be noted that computation of accounting rate of return is a difficult process due to the alternative
methods available. Whichever method is adopted, by a firm, the same method should be consistently used so
that all the investment proposals are assessed on a uniform basis.

2.6.4.1.3 Advantages of Accounting Rate of Return method

(1) When the method of calculating is decided, it is easy to understand and operate.
(2) This method uses the entire earnings of an investment proposal, unlike the payback period method.
(3) It gives a clear picture of the profitability of a project.
(4) As the basis for the method is accounting concept of profit, it can be readily calculated from the data
available in the firm’s accounting records.
(5) This method is based on ‘Net earning’s i.e. earnings after depreciation and tax, unlike other methods. It
provides a more comprehensive comparative assessment
of projects.

2.6.4.1.4 Disadvantages
(1) Like pay-back period method, this method also ignores the time value of money and treats all incomes
received, whether in the first year or last year, alike.
(2) Reliability of A.R.R. method is affected due to the various concepts of investment. Different rates can be
obtained, using different interpretations of the meaning of ‘investment’.
(3) By considering profit as the criterion, ‘cash flow’ aspect of projects is not properly assessed.
(4) It is not useful to assess projects where investment is made in two or more instalments, at different times.
Due to the complications in calculating ‘Investment’ and other shortcomings, accounting or average rate of
return method is not very popular in modern capital budgeting.

2.6.5 Non Traditional Methods (or) Modern Methods (or) Discounted Cash Flow Methods (D.C.F.)
These methods, together, are called ‘Present Value Methods’ or ‘Time Adjusted methods’. They are based upon
the technique of ‘Discounted Cash Flow (D.C.F.)’. They recognize the importance of ‘Time Value of money’.
2.6.5.1 Time Value of Money
This is an important concept which demarcates D.C.F. methods of Capital Budgeting from the traditional
methods. The essence of the concept is that money received earlier is more valuable than that received later.
The estimated future cash inflows and outflows of a project should not be treated at their face value ignoring
their ‘Timing’. Income expected at the end of the first year of a project is definitely more valuable than the
income which may be earned in the 8th year of a project. There are two reasons for assigning higher value to
earlier incomes. These reasons are like foundations for the concept of ‘Time Value of Money’.
(a) Interest Aspect: - Cash inflows received earlier can be invested elsewhere or even in banks and further
income can be earned on them. Thus, the ‘Compounding benefit’ makes earlier cash inflows more valuable.
(b) Uncertainty Aspect: - Cash inflows expected in earlier years may be deemed more probable to materialize
than those of the later years. The more distant in the future an income is the more uncertain and hazy or
nebulous it becomes.
In general, ‘D.C.F.’ Technique provides quantitative, systematic and reliable shape to the concept of ‘Time
Value of Money’. The basic defect of traditional methods, from the point of view of investment analysis is that
they neglect the ‘Time Value of Money’. The discounted cash flow technique rectifies the defect of traditional
methods by bringing all the future cash flows to the common parameter of ‘present value’. The present value
methods are increasingly becoming popular in capital expenditure decisions due to their scientific basis and
accuracy.

2.6.5.1.1 Main features of present value methods.

(1) The basic feature of all the present value methods is that they are based on discounted cash flows. Both cash
inflows and cash out flows are discounted to ascertain their present value.
(2) They use cash flows and not the accounting concept of profit. Thus, cash inflows after tax before
depreciation are taken as the revenues.
(3) They take into account the interest factor by recognizing the value of earlier cash flows compared to later
cash flows.
(4) They consider the entire cash flows of an investment proposal throughout its economic life.

2.6.5.1.2 Major steps in discounted cash flow methods:

The following are the major steps in all the present value method.
(a) Estimated cash inflows and outflows, after tax, but before depreciation, relating to the project under
consideration should be ascertained. They must be for the full economic life of the project concerned.
(b) Both the cash inflows and outflows should be discounted at a predetermined discounting rate. Usually, the
discounting rate is the cost of capital rate of the firm. But it can be any other rate also. Discounting factors can
be obtained from present value tables.

2.6.5.2 Net Present Value (NPV) Method

Net present value method is one of the discounted cash flow methods of capital budgeting. It recognizes the
time value of money and that cash flows arising at different periods of time differ in value and are not
comparable unless their equivalent present values are found. The net present value of all inflows and outflows
of cash occurring during the entire life of a project is determined by discounting these flows by the firm’s cost
of capital or some other pre-determined rate. The following are the steps in the net present value method:
(a) Appropriate discounting rate has to be determined. It is the minimum required rate of return and is called
‘cut-off rate’ or ‘discount rate’. The rate is generally based on cost of capital which is suitably adjusted for the
risk and uncertainty involved in the project. Such addition to cost of capital is called ‘Risk return’.
(b) Present value of cash out flows should be found with the help of the discounting rate. If the entire
investment is made initially, there is no need to discount it. The amount of investment itself is the present value
of cash out flows. However any investments to be made at some future points of time are to be discounted to
find their present value. It should be remembered that any working capital should be taken as cash outflow in
the year in which commercial production actually starts on the project.
(c) Present value of estimated cash inflows should also be computed. The cash flows should be the net cash
flows after tax, before depreciation. The scrap value of the project has to be taken as a cash inflow in the last
year. Similarly working capital locked up in the project has to be assumed as ‘unlocked’ at the end of final year,
thus showing it as a cash inflow in the last year of the project.
(d) Net present value (NPV) is the difference between the present value of cash inflows and the present value of
cash out flows. NPV = P.V. of cash inflows – P.V. of cash out flows.
(e) Equation for calculation N.P.V. is as follows:
(i) When cash flows are conventional i.e. out flows are entirely initial and inflows are in the future.
(f) Accept or Reject Criterion: N.P.V. is a clear cut ‘accept/Reject’ criterion. If the N.P.V. is positive, project is
acceptable. If N.P.V. is negative, project should be rejected. Accept when NPV > zero Reject when NPV >
Zero
(g) To select between mutually exclusive projects, the projects can be ranked, on the basis of the amount of
N.P.V. since the amount of investment is almost same. The project with the highest ranking, representing the
maximum NPV is to be accepted. The other mutually exclusive projects stand rejected automatically.

2.6.5.2.1 Merits of N.P.V. Method

(1) It recognizes the time value of money and thus better than the traditional methods.
(2) It considers the earnings over the entire life of the project which makes a true assessment of profitability of
a project possible.
(3) It tries to maximize the profits by favouring more profitable projects.

2.6.5.2.2 Demerits
(1) Compared to traditional methods it is complicated to understand and operate.
(2) Comparison of projects with unequal life times may be misleading because the amount of N.P.V. alone is
considered in these methods without any weightage for the time span.
(3) Comparing different projects with different amounts of investments becomes difficult in this method.
Generally, N.P.V. method is highly preferable to decide about a particular project whether to accept or reject.

2.6.5.2.3 Computation of NPV in case of Replacement of Machine or Equipment

Proposals to replace existing machines or equipment or plant with new ones require specific attention. The old
machine may be useful for some more years and it may be possible to replace it with a new machine which may
result in cost savings or additional revenues. The following are the points to be considered.
(a) Additional Investment: The difference between the purchase price and installation expenditure of new
machine and the current sale value of old equipment is the additional investment required.
(b) Net operating savings of profit: The savings resulting from the installation of new machine compared to the
continuation of the old machine are to be computed. The net savings is the income before depreciation and tax.
(c) Additional tax: From the net savings, difference in depreciation between new and old machines should be
reduced. On the balance, tax should be computed. This is the additional tax to be paid because of the savings
accruing due to the new machine.
If NPV is positive, replacement is advisable. The basic point to remember is that the old machine also can be
used instead of replacing it. So, the incremental cash flows alone should be considered for computation of
N.P.V.

2.6.5.3 Profitability Index (P.I.) (or) Excess Present value Index Method:
The profitability index is also called ‘Benefits cost Ratio’ Though this is treated as a separate method due to the
importance of results obtained by its usages, it is only a refinement of the N.P.V. method. It shows the
relationship between P.V. of cash inflows and P.V. of cash outflows.
Formula: Profitability Index (P.I.) (or) Benefit cost ratio (B/C) = Present value of future cash inflows/ Present
value of future cash outflows

2.6.5.3.1 Accept or reject criterion:

If the P.I. or B/C is more than ‘1’ project is acceptable. Projects with P.I. of less than ‘1’ are to be rejected
outright. Accept when P.I. > 1 Reject when P.I < 1
The profitability index method is especially suitable to rank a large amount of investment proposals
simultaneously. Based on the P.I., projects can be ranked, just like students are given ranks based on the marks
obtained in an exam.
2.6.5.3.2 Merits and Demerits
P.I. Method possesses all the merits and demerits of N.P.V. method because P.I. is a refinement of N.P.V.
method. However it is more useful in ranking two or more projects. Thus, P.I. is more suitable for comparative
assessment of projects whereas N.P.V. is appropriate to decide about a particular project.

2.6.5.4 Internal Rate of Return (IRR) Method

Internal rate of return is ‘that rate of return at which the present values of cash inflows and cash outflows are
equal’. Thus, at I.R.R. the total of discounted cash inflows equals the total of discounted cash out flows.
I.R.R. discounts the total cash flows to the level of zero. At I.R.R.  Cash Inflows/ Cash Outflows = 1
I.R.R. is also known as Trial and Error yield method. Unlike N.P.V. and P.I. methods where the cash flows are
discounted at predetermined cut-off rate, there is no specific discounting rate under I.R.R. method. Here, the
cash flows of a project are discounted at a suitable rate arrived at by ‘Trial and Error’. The rate equates the net
present value to Zero. Since the discounting rate is determined internally through Trial and error process, it is
called Internal rate of return method.
I.R.R. is also known as Trial and Error yield method. Unlike N.P.V. and P.I. methods where the cash flows are
discounted at predetermined cut-off rate, there is no specific discounting rate under I.R.R. method. Here, the
cash flows of a project are discounted at a suitable rate arrived at by ‘Trial and Error’. The rate equates the net
present value to Zero. Since the discounting rate is determined internally through Trial and error process, it is
called Internal rate of return method. It is customary to use the present value tables and ascertain I.R.R. with the
help of tabular values.
2.6.5.4.1 Accept or Reject criterion under I.R.R. Method
I.R.R. is the return that can be expected from the project which is under consideration. The project is acceptable
if ‘cut-off rate’ or cost of capital is less than the I.R.R. and vice versa.
Accept when IRR > Cut-off rate; Reject when IRR < Cut-off rate

2.6.5.4.2 Method of locating Tabular values for I.R.R

(1) When cash inflows are uniform (2) When cash inflows are not uniform:

2.6.5.4.3 Merits of I.R.R. Method

1. Like all the other D.C.F. based methods, I.R.R. also takes into account the time value of money and can be
applied where the cash inflows are even or unequal.
2. It also considers the profitability of a project over its entire economic life and thus the true profitability of a
project can be assessed.
3. Cost of capital or pre-determined cut-off rate is not a pre-requisite for applying I.R.R. method. Hence it is
better than the N.P.V. and P.I. methods in all those situations where determining cost of capital is difficult.
4. I.R.R. provides for ranking of various proposals because it is a percentage return.
5. It provides for maximizing profitability.

2.6.5.4.4 Demerits
1. It is complicated method and may lead to cumbersome calculations.
2. The underlying assumption of I.R.R. that the earnings are reinvested at I.R.R. for the remaining life of the
project is not a justifiable assumption. From this point of view, N.P.V. and P.I. which assume reinvestment at
cost of capital rate are better.
3. The results obtained through NPV or PI methods may differ from that obtained through I.R.R. depending on
the size, life and timings of the cash flows.

2.6.5.4.5 Comparison of I.R.R. with N.P.V. and P.I. Methods Differences

1. Cost of capital or cut-off rate is determined in advance in NPV and PI. In I.R.R., the discounting rate is the
‘unknown factor’.
2. NPV and PI strive to ascertain the amount which can be invested in a project which can earn the required rate
of return. I.R.R. ascertains the maximum interest that can be paid out of returns from the project.
3. The underlying assumption of the D.C.F. methods is that the cash inflows can be reinvested. However NPV
and PI assume the reinvestment at cost of capital rate or the cut-off rate. I.R.R. assumes re-investment at the
I.R.R. rate. The former is more practical and justifiable than ‘the later. Generally, NPV and PI are considered to
be more reliable for comparative analysis of projects than the I.R.R. method.

3 RISK ANALYSIS IN INVESTMENT DECISION

In discussing the capital budgeting techniques, we have so far assumed that the proposed investment projects do
not involve any risk. This assumption was made simply to facilitate the understanding of the capital budgeting
techniques. In real world situation, however, the firm in general and its investment projects in particular are
exposed to different degrees of risk. What is risk? How can risk be measured and analysed in the investment
decisions?
3.1 NATURE OF RISK
Risk exists because of the inability of the decision-maker to make perfect forecasts. Forecasts cannot be made
with perfection or certainty since the future events on which they depend are uncertain. An investment is not
risky if, we can specify a unique sequence of cash flows for it. But the whole trouble is that cash flows cannot
be forecasted accurately, and alternative sequences of cash flows can occur depending on the future events.
Thus, risk arises in investment evaluation because we cannot anticipate the occurrence of the possible future
events with certainty and consequently, cannot make any correct prediction about the cash flow, sequence. To
illustrate, let us suppose that a firm is considering a proposal to commit its funds in a machine, which will help
to produce a new product. The demand for this product may be very sensitive to the general economic
conditions. It may be very high under favourable economic conditions and very low under unfavourable
economic conditions. Thus, the investment would .be profitable in the former situation and unprofitable in the
latter case. But, it is quite difficult to predict the future state of economic conditions. Because of the uncertainty
of the economic conditions, uncertainty about the cash flows associated with the investment derives. A large
number of events influence forecasts. These events can be grouped in different ways. However, no particular
grouping of events will be useful for all purposes. We may, for example, consider three broad categories of the
events influencing the investment forecasts:
 General economic conditions: This category includes events which influence the general level of business
activity. The level of business activity might be affected by such events as internal and external economic and
political situations, monetary and fiscal policies, social conditions etc.
 Industry factors This category of events may affect all companies in an industry. For example, companies in
an industry would be affected by the industrial relations in the industry, by innovations, by change in material
cost etc.
 Company factors This category of events may affect only a company. The change in management, strike in
the company, a natural disaster such as flood or fire may affect directly a particular company. In formal terms,
the risk associated with an investment may be defined as the variability that is likely to occur in the future
returns from the investment. For example, if a person invests, say Rs 20,000 in short-term government bonds,
which are expected to yield 9 per cent return, he can accurately estimate the return on the investment. Such an
investment is relatively risk-free. The reason for this belief is that government will not fail and will pay interest
regularly and repay the amount invested. It is for this reason that the rate of interest paid on government
securities, such as short-term treasury bills, is the risk-free rate of interest. Instead of investing Rs 20,000 in
government securities, if the investor purchases the shares of a company, then it is not possible to estimate
future return accurately. The return could be negative, zero or some extremely large figure. Because of the high
degree of the variability associated with the future returns, this investment would be considered risky. Risk is
associated with the variability of future returns of a project. The greater the variability of the expected returns,
the riskier is the project. Risk can, however, be measured more precisely. The most common measures of risk
are standard deviation and coefficient of variations.

3.2 STATISTICAL TECHNIQUES FOR RISK ANALYSIS

Statistical techniques are analytical tools for handling risky investments. These techniques, drawing from the
fields of mathematics, logic, economics and psychology, enable the decision-maker to make decisions under
risk or uncertainty. The concept of probability is fundamental to the use of the risk analysis techniques. How is
probability defined? How are probabilities estimated? How are they used in the risk analysis techniques? How
do statistical techniques help in resolving the complex problem of analysing risk in capital budgeting? We
attempt to answer these questions in this section.

3.2.1 Probability Defined

The most crucial information for the capital budgeting decision is a forecast of future cash flows. A typical
forecast is single figure for a period. This is referred to as “best estimate” or “most likely” forecast. But the
questions are: To what extent can one rely on this single figure? How is this figure arrived at? Does it reflect
risk? In fact, the decision analysis is limited in two ways by this single figure forecast. Firstly, we do not know
the chances of this figure actually occurring, i.e., the uncertainty surrounding this figure. In other words, we do
not know the range of the forecast and the chance or the probability estimates associated with figures within
this range. Secondly, the meaning of best estimates or most likely is not very clear. It is not known whether it is
mean, median or mode. For these reasons, a forecaster should not give just one estimate, but a range of
associated probability—a probability distribution. Probability may be described as a measure of someone’s
opinion about the likelihood that an event will occur.
If an event is certain to occur, we say that it has a probability of one. If an event is certain not to occur, we say
that its probability of occurring is zero. Thus, probability of all events to occur lies between zero and one. A
probability distribution may consist of a number of estimates. But in the simple form it may consist of only a
few estimates. One commonly used form employs only the high, low and best guess estimates, or the
optimistic, most likely and pessimistic estimates.

3.2.2 Assigning probability

The classical probability theory assumes that no statement whatsoever can be made about the probability of any
single event. In fact, the classical view holds that one can talk about probability in a very long run sense, given
that the occurrence or non-occurrence of the event can be repeatedly observed over a very large number of
times under independent identical situations. Thus, the probability estimate, which is based on a very large
number of observations, is known as an objective probability. The classical concept of objective probability is
of little use in analysing investment decisions because these decisions are non-repetitive and hardly made under
independent identical conditions over time. As a result, some people opine that it is not very useful to express
the forecaster’s estimates in terms of probability. However, in recent years another view of probability has
revived, that is, the personalistic view, which holds that it makes a great deal of sense to talk about the
probability of a single event, without reference to the repeatability, long run frequency concept. It is perfectly
valid, therefore, to talk about the probability of rain tomorrow, the probability of sales reaching a certain level
next year, or the probability that earnings per share will exceed Rs 2.50 next year, or five years hence. Such
probability assignments that reflect the state of belief of a person rather than the objective evidence of a large
number of trials are called personal or subjective probabilities.
3.3 RISK AND UNCERTAINTY
Risk is sometimes distinguished from uncertainty. Risk is referred to a situation where the probability
distribution of the cash flow of an investment proposal is known. On the other hand, if no information is
available to formulate a probability distribution of the cash flows the situation is known as uncertainty. Most
financial authors do not recognise this distinction and use the two terms interchangeably. We too follow this
approach.
3.3.1 Expected Net Present Value
Once the probability assignments have been made to the future cash flows, the next step is to find out the
expected net present value. The expected net present value can be found out by multiplying the monetary values
of the possible events (cash flows) by their probabilities.
3.4 VARIANCE OR STANDARD DEVIATION: ABSOLUTE MEASURE OF RISK
Although, through the calculation of the expected net present value, risk is explicitly incorporated into the
capital budgeting analysis, yet a better insight into the risk analysis will be obtained if we find out the
dispersion of cash flows, i.e., the difference between the possible cash flows that can occur and their expected
value. The dispersion of cash flow indicates the degree of risk. A commonly used measure of risk is the
standard deviation or variance. Simply stated, variance measures the deviation about expected cash flow of
each of the possible cash flows. Standard deviation is the square root of variance.
3.4.1 Coefficient of Variation: Relative Measure of Risk
A relative measure of risk is the coefficient of variation. It is defined as the standard deviation of the probability
distribution divided by its expected value: The coefficient of variation is a useful measure of risk when we are
comparing the projects which have (i) same standard deviations but different expected values, or (ii) different
standard deviations but same expected values, or (iii) different standard deviations and different expected
values.
3.5 CONVENTIONAL TECHNIQUES OF RISK ANALYSIS
A number of techniques to handle risk are used by managers in practice (see Exhibit 3.1). They range from
simple rules of thumb to sophisticated statistical techniques. The following are the popular, non-conventional
techniques of handling risk in capital budgeting:  Payback
 Risk-adjusted discount rate
 Certainty equivalent These methods, as discussed below, are simple, familiar and partially defensible on
theoretical grounds. However, they are based on highly simplified and at times, unrealistic assumptions. They
fail to take account of the whole range of the effect of risky factors on the investment decision-making.
3.5.1 Payback
Payback is one of the oldest and commonly used methods for explicitly recognising risk associated with an
investment project. This method, as applied in practice, is more an attempt to allow for risk in capital budgeting
decision rather than a method to measure profitability.
Business firms using this method usually prefer short payback to longer ones, and often establish guidelines
that a firm should accept investments with some maximum payback period, say three or five years.
The merit of payback is its simplicity. Also, payback makes an allowance for risk by (i) focusing attention on
the near term future and thereby emphasising the liquidity of the firm through recovery of capital, and (ii) by
favouring short term projects over what may be riskier, longer term projects. It should be realised, however,
that the payback period, as a method of risk analysis, is useful only in allowing for a special type of risk — the
risk that a project will go exactly as planned for a certain period and will then suddenly cease altogether and be
worth nothing. It is essentially suited to the assessment of risks of time nature. Once a payback period has been
calculated, the decision-maker would compare it with his own assessment of the projects likely, and if the latter
exceeds the former, he would accept the project. This is a useful procedure, economic only if the forecasts of
cash flows associated with the project are likely to be unimpaired for a certain period. The risk that a project
will suddenly cease altogether after a certain period may arise due to reasons such as civil war in a country,
closure of the business due to an indefinite strike by the workers, introduction of a new product by a competitor
which captures the whole market and natural disasters such as flood or fire. Such risks undoubtedly exist but
they, by no means, constitute a large proportion of the commonly encountered business risks. The usual risk in
business is not that a project will go as forecast for a period and then collapse altogether; rather the normal
business risk is that the forecasts of cash flows will go wrong due to lower sales, higher cost etc. Further, even
as a method for allowing risks of time nature, it ignores the time value of cash flows. For example, two projects
with, say a four-year payback period are at very different risks if in one case the capital is recovered evenly
over the four years, while in the other it is recovered in the last year. Obviously, the second project is more
risky. If both cease after three years, the first project would have recovered three-fourths of its capital, while all
capital would be lost in the case of second project. Given the uncertainty element, it may well be that a four-
year payback period, based on fairly certain estimates might be preferred to a three-year payback period,
calculated with very uncertain estimates.
3.5.2 Risk-Adjusted Discount Rate
For a long time, economic theorists have assumed that, to allow for risk, the businessman required a premium
over and above an alternative, which was risk-free. Accordingly, the more uncertain the returns in the future,
the greater the risk and the greater the premium required. Based on this reasoning, it is proposed that the risk
premium be incorporated into the capital budgeting analysis through the discount rate. That is, if the time
preference for money is to be recognised by discounting estimated future cash flows, at some risk-free rate, to
their present value, then, to allow for the riskiness, of those future cash flows a risk premium rate may be added
to risk-free discount rate. Such a composite discount rate, called the risk-adjusted discount rate, will allow for
both time preference and risk preference and will be a sum of the risk-free rate and the risk-premium rate
reflecting the investor’s attitude towards risk.
3.5.2.1 Evaluation of risk-adjusted discount rate
The following are the advantages of risk-adjusted discount rate method:
 It is simple and can be easily understood.
 It has a great deal of intuitive appeal for risk-averse businessman.
 It incorporates an attitude (risk-aversion) towards uncertainty.
This approach, however, suffers from the following limitations:
 There is no easy way of deriving a risk-adjusted discount rate. As discussed earlier,
CAPM provides for a basis of calculating the risk-adjusted discount rate. Its use has yet to pick up in practice.
 It does not make any risk adjustment in the numerator for the cash flows that are forecast over the future
years.
 It is based on the assumption that investors are risk-averse. Though it is generally true, there exists a category
of risk seekers who do not demand premium for assuming risks; they are willing to pay a premium to take risks.
Accordingly, the composite discount rate would be reduced, not increased, as the level of risk increases.
3.5.3 Certainty Equivalent
Yet another common procedure for dealing with risk in capital budgeting is to reduce the forecasts of cash
flows to some conservative levels.
3.5.3.2 Evaluation of certainty equivalent
The certainty-equivalent approach explicitly recognises risk, but the procedure for reducing the forecasts of
cash flows is implicit and is likely to be inconsistent from one investment to another. Further, this method
suffers from many dangers in a large enterprise. First, the forecaster, expecting the reduction that will be made
in his forecasts, may inflate them in anticipation. This will no longer give forecasts according to ‘best estimate.’
Second, if forecasts have to pass through several layers of management, the effect may be to greatly exaggerate
the original forecast or to make it ultra conservative. Third, by focusing explicit attention only on the gloomy
outcomes, chances are increased for passing by some good investments.
3.5.3.3 Risk-Adjusted Discount Rate vs. Certainty-Equivalent
The certainty-equivalent approach recognises risk in capital budgeting analysis by adjusting estimated cash
flows and employs risk-free rate to discount the adjusted cash flows. On the other hand, the risk-adjusted
discount rate adjusts for risk by adjusting the discount rate. It has been suggested that the certainty equivalent
approach is theoretically a superior technique over the risk-adjusted discount approach because it can measure
risk more accurately. The risk-adjusted discount rate approach will yield the same result as the certainty
equivalent approach if the risk-free rate is constant and the risk-adjusted discount rate is the same for all future
periods.
Risk over time: It can be observed that  t will be a decreasing function of time with a constant k. This implies
that risk is an increasing function of time. This assumption may or may not be true in the actual investment
under consideration. We can think of an investment, which may be more risky during the gestation period, and
once established, the risk may reduce. In such a situation, the use of a constant risk-adjusted discount rate is not
valid. But the increased or decreased risks over a period of time can easily be accounted for by changing tt
factors when the certainty-equivalent approach is used. Therefore, the certainty-equivalent approach is
considered superior to the risk-adjusted discount rate. Even if the assumption that risk increases with time is
valid, the problem with the risk adjusted discount rate is to select the value of k, which properly measures the
degree of increasing risk. It is difficult to specify such a rate. With the certainty-equivalent approach, the 
factors in each period will specify, the different degree of risk.
3.6 SENSITIVITY ANALYSIS
In the evaluation of an investment project, we work with the forecasts of cash flows. Forecasted cash flows
depend on the expected revenue and costs. Further, expected revenue is a function of sales volume and unit
selling price. Similarly, sales volume will depend on the market size and the firm’s market share. Costs include
variable costs, which depend on sales volume, and unit variable cost and fixed costs. The net present value or
the internal rate of return of a project is determined by analysing the after-tax cash flows” arrived at by
combining forecasts of various variables. It is difficult to arrive at an accurate and unbiased forecast of each
variable. We can’t be certain about the outcome of any of these variables. The reliability of the NPV or IRR of
the project will depend on the reliability of the forecasts of variables underlying the estimates of net cash flows.
To determine the reliability of the project’s NPV or IRR, we can work out how much difference it makes if
any of these forecasts goes wrong. We can change each of the forecasts, one at a time, to at least three values:
pessimistic, expected, and optimistic. The NPV of the project is recalculated under these different assumptions.
This method of recalculating NPV or IRR by changing each forecast is called sensitivity analysis.
Sensitivity analysis is a way of analysing change in the project’s NPV (or IRR) for a given change in one of
the variables. It indicates how sensitive a project’s NPV (or IRR) is to changes in particular variables. The more
sensitive the NPV, the more critical is the variable. The following three steps are involved in the use of
sensitivity analysis:
 Identification of all those variables, which have an influence on the project’s NPV (or IRR).
 Definition of the underlying (mathematical) relationship between the variables.
 Analysis of the impact of the change in each of the variables on the project’s NPV.
The decision-maker, while performing sensitivity analysis, computes the projects NPV (or IRR) for each
forecast under three assumptions: (a) pessimistic, (b) expected, and (c) optimistic. It allows him to ask what if
questions. For example, what (is the NPV) if volume increase or decreases? What (is the NPV) if variable cost
or fixed cost increases or decreases? What (is the NPV) if the selling price increases or decreases? What (is the
NPV) if the project is delayed or outlay escalates or the project’s life is more or less than anticipated? A whole
range of questions can be answered with the help of sensitivity analysis. It examines the sensitivity of the
variables underlying the computation of NPV or IRR, rather than attempting to quantify risk. It can be applied
to any variable, which is an input for the after-tax cash flows.
3.7 DCF BREAK-EVEN ANALYSIS
Sensitivity analysis is a variation of the break-even, analysis. What you are asking is: what shall be the
consequences if volume or price or cost changes? You can ask this question differently: How much lower can
the sales volume become before the project becomes unprofitable? What you are asking for is the breakeven
point.
Pros and Cons of Sensitivity Analysis Sensitivity analysis has the following advantages
 It compels the decision maker to identify the variables, which affect the cash flow forecasts.
This helps him in understanding the investment project in totality.
 It indicates the critical variables for which additional information may be obtained. The decision maker can
consider actions, which may help in strengthening the ‘weak spots’ in the project. It helps to expose
inappropriate forecasts, and thus guides the decision-maker to concentrate on relevant variables. Let us
emphasise that sensitivity analysis is not a panacea for a project’s all uncertainties. It helps a decision-maker to
understand the project better. It has the following limitations:
 It does not provide clear-cut results. The terms ‘optimistic’ and ‘pessimistic’ could mean different things to
different persons in an organisation. Thus, the range of values suggested may be inconsistent.
 It fails to focus on the interrelationship between variables. For example, sale volume may be related to price
and cost. A price cut may lead to high sales and low operating cost.
3.8. SCENARIO ANALYSIS
The simple sensitivity analysis assumes that variables are independent of each other. In practice, the variables
will be interrelated and they may change in combination. One way to examine the risk of investment is to
analyse the impact of alternative combinations of variables, called scenarios, on the project’s NPV (or IRR).
The decision-maker can develop some plausible scenarios for this purpose.
3.9 SIMULATION ANALYSIS
We have explained in the previous sections that sensitivity and scenario analyses are quite useful to understand
the uncertainty of the investment projects. But both approaches suffer from certain weaknesses. As we have
discussed, they do not consider the interactions between variables and also, they do not reflect on the
probability of the change in variables.
The Monte Carlo simulation or simply the simulation analysis considers the interactions among variables and
probabilities of the change in variables.1 It does not give the project’s NPV as a single number rather it
computes the probability distribution of NPV. The simulation analysis is an extension of scenario analysis. In
simulation analysis a computer generates a very large number of scenarios according to the probability
distributions of the variables. The simulation analysis involves the following steps:
 First, you should identify variables that influence cash inflows and outflows. For example, when a firm
introduces a new product in the market these variables are initial investment, market size, market growth,
market share, price, variable costs, fixed costs, product life cycle, and terminal value.
 Second, specify the formulae that relate variables. For example, revenue depends on by sales volume and
price; sales volume is given by market size, market share, and market growth. Similarly, operating expenses
depend on production, sales and variable and fixed costs.
 Third, indicate the probability distribution for each variable. Some variables will have more uncertainty than
others. For example, it is quite difficult to predict price or market growth with confidence.
 Fourth, develop a computer programme that randomly selects one value from the probability distribution of
each variable and uses these values to calculate the project’s NPV. The computer generates a large number of
such scenarios, calculates NPVs and stores them. The stored values are printed as a probability distribution of
the project’s NPVs along with the expected NPV and its standard deviation. The risk-free rate should be used as
the discount rate to compute the project’s NPV. Since simulation is performed to account for the risk of the
project’s cash flows, the discount rate should reflect only the time value of money. Simulation analysis is a very
useful technique for risk analysis. Unfortunately, its practical use is limited because of a number of
shortcomings. First, the model becomes quite complex to use because the variables are interrelated with each
other, and each variable depends on its values in the previous periods as well. Identifying all possible
relationships and estimating probability distribution is a- difficult task; its time consuming as well as expensive.
Second, the model helps in generating a probability distribution of the project’s NPVs. But it does not indicate
whether or not the project should be accepted. Third, simulation analysis, like sensitivity or scenario analysis,
considers the risk of any project in isolation of other projects. We know that if we consider the portfolio of
projects, the unsystematic risk can be diversified.
A risky project may have a negative correlation with the firm’s other projects, and therefore, accepting the
project may reduce the overall risk of the firm.
3.10 DECISION TREES FOR SEQUENTIAL INVESTMENT DECISIONS
We have so far discussed simple accept-or-reject decisions, which view current investments in isolation of
subsequent decisions. . But in practice, the present investment decisions may have implications for future
investment decisions, and may affect future events and decisions. Such complex investment decisions involve a
sequence of decisions over time. It is argued that ‘since present choices modify future alternatives, industrial
activity cannot be reduced to a single decision and must be viewed as a sequence of decisions extending from
the present time into the future.
If this notion of industrial activity as a sequence of decisions is accepted, we must view investment
expenditures not as isolated period commitments, but as links in a chain of present and future commitments.2
An analytical technique to handle the sequential decisions is to employ decision trees.3 In this section, we shall
illustrate the use of decision trees in analysing and evaluating the sequential investments.
3.10.1 Steps in Decision Tree Approach
A present decision depends upon future events, and the alternatives of a whole sequence of decisions in future
are affected by the present decision as well as future events. Thus, the consequence of each decision is
influenced by the outcome of a chance event. At the time of taking decisions, the outcome of the chance event
is not known, but a probability distribution can be assigned to it. A decision tree is a graphic display of the
relationship between a present decision and future events, future decisions and their consequences. The
sequence of events is mapped out over time in a format similar to the branches of a tree. While constructing and
using a decision tree, some important steps should be considered:
 Define investment The investment proposal should be defined. Marketing, production or any other department
may sponsor the proposal. It may be either to enter a new market or to produce a new product.
 Identify decision alternatives The decision alternatives should be clearly identified. For example, if a
company is thinking of building a plant to produce a new product, it may construct a large plant, a medium-
sized plant, or a small plant initially- and expand it later on or construct no plant. Each alternative will have
different consequences.
 Draw a decision tree The decision tree should be graphed indicating the decision points, chance events and
other data. The relevant data such as the projected cash flows, probability distributions, the expected present
value etc., should be located on the decision tree branches.
 Analyse data -The results should be analysed and the best alternative should be selected.
3.10.2 Usefulness of Decision Tree Approach
The decision tree approach is extremely useful in handling the sequential investments. Working backwards—
from future to present—we are able to eliminate unprofitable branches and determine optimum decision at
various decision points. The merits of the decision tree approach are:’
 Clarity It clearly brings out the implicit assumptions and calculations for all to see, question and revise.
 Graphic visualisation it allows a decision maker to visualise assumptions and alternatives in graphic form,
which is usually much easier to understand than the more abstract, analytical form. However, the decision tree
diagrams can become more and more complicated as the decision-maker decides to include more alternatives
and more variables and to look farther and farther in time. It is complicated even further if the analysis is
extended to include interdependent alternatives and variables that are dependent upon one another; for example,
sales volume depends on market share which depends on promotion expenses, etc. The diagram itself quickly
becomes cumbersome and calculations become very time consuming or almost impossible.
EXHIBIT 3.1: RISK ANALYSIS IN PRACTICE
 Most companies in India account for risk while evaluating their capital expenditure decisions. The following
factors are considered to influence the riskiness of investment projects:
price of raw material and other inputs; price of product; product demand; government policies; technological
changes project life inflation
 Out of these factors, four factors thought to be contributing most to the project riskiness are: selling price,
product demand, technical changes and government policies.
 The most commonly used methods of risk analysis in practice are: sensitivity analysis conservative forecasts
 Sensitivity analysis allows to see the impact of the change in the behaviour of critical variables on the project
profitability. Conservative forecasts include using short payback or higher discount rate for discounting cash
flows.
 Except a very few companies, most companies do not use the statistical and other sophisticated techniques for
analysing risk in investment decisions.
3.11 UTILITYTHEORYAND CAPITALBUDGETING
We have earlier discussed the use of the concepts of expected value and standard deviation for analysing risk in
capital budgeting. On the basis of figures of the expected values and standard deviations, it is difficult to say
whether a decision-maker should choose a project with a high expected value and a high standard deviation or a
project with a comparatively low expected value and a low standard deviation. The decision-makers choice
would depend upon his risk preference. Individuals and firms differ in their attitudes towards risk. In contrast to
the approaches for handling risk discussed so far, utility theory aims at incorporation of decision-makers risk
preference explicitly into the decision procedure.2 In fact, a rational decision-maker would maximise his utility.
Thus, he would accept the investment project, which yields maximum utility to him.
3.11.1 Risk Attitude
As regards the attitude of individual investors towards risk, they can be classified in three categories:
 Risk-averse investors attach lower utility to increasing wealth. For them the value of the potential increase in
wealth is less than the possible loss from the decrease in wealth. In other words, for a given wealth (or return),
they prefer less risk to more risk.
 Risk-neutral investors attach same utility to increasing or decreasing wealth. They are indifferent to less or
more risk for a given wealth (or return).
 Risk-seeking investors attach more utility to the potential of additional wealth to the loss from the possible
loss from the decrease in wealth. For earning a given wealth (or return), they are prepared to assume higher
risk. It is well established by many empirical studies that individuals are generally risk averters and demonstrate
a decreasing marginal utility for money function. The utility function for a risk-averse individual may
resemble Figure 3.3 in which, the horizontal line represents the potential gain or loss in rupees and the vertical
line represents the attitudes of the individual towards such gains and losses, as defined by his utility functions.
The utility ‘values’, measured on relative basis, are called ‘utiles’ and are measured on an arbitrary scale. The
curve in Figure 3.3, which is upward sloping and convex to the origin, indicates that an investor always prefers
a higher return to a lower return, and that each successive identical increment of money is worth less to him
than the preceding one. In other words, the marginal utility of money is declining, although it is positive.
3.11.2 Benefits and Limitations of Utility Theory
The utility approach to risk analysis in capital budgeting has certain advantages. First, the risk preferences of
the decision-maker are directly incorporated in the capital budgeting analysis. Second, it facilitates the process
of delegating the authority for decision. If it is possible to specify the utility function of the superior—the
decision maker, the subordinates can be asked to take risks consistent with the risk preferences of the superior.
The use of utility theory in capital budgeting is not common. It suffers from a few limitations. First, in practice,
difficulties are encountered in specifying a utility function. Whose utility function should be used as a guide in
making decisions? For small firms, the utility function of the owner or one dominant shareholder may be used
to guide the decision making process of the firm. Second, even if the owner’s or a dominant shareholder’s
utility function be used as a guide, the derived utility function at a point of time is valid only for that one point
of time. Third, it is quite difficult to specify the utility function if the decision is taken by a group of persons.
Individuals differ in their risk preferences. As a result, it is very difficult to derive a consistent utility function
for the group.
4 TYPES OF INVESTMENTS AND DISINVESTMENTS
4.1. TYPES OF INVESTMENT DECISIONS
There are many ways to classify investments. One Classification is as follows:
4.1.1 Expansion and Diversification
A company may add capacity to its existing product lines to expand existing operations. For example, the
Gujarat State Fertiliser (GSFC) may increase its plant capacity to manufacture more urea. It is an example of
related diversification. A firm may expand its activities in a new business. Expansion of a new business
requires investment in new products and a new kind of production activity within the firm.
If a packing manufacturing company invests in a new plant and machinery to produce ball bearings, which the
firm has not manufactured before, this represents expansion of new business or unrelated diversification.
Sometimes a company acquires existing firms to expand its business. In either case, the firm makes investment
in the expectation of additional revenue. Investments in existing or new products may also be called as revenue-
expansion investments.
4.1.2 Replacement and Modernisation
The main objective of modernisation and replacement is to improve operating efficiency and reduce costs. Cost
savings will reflect in the increased profits, but the firm’s revenue may remain unchanged. Assets become
outdated and obsolete with technological changes.
The firm must decide to replace those assets with new assets that operate more economically. If a cement
company changes from semi-automatic drying equipment to fully automatic drying equipment, it is an example
of modernisation and replacement. Replacement decisions
help to introduce more efficient and economical assets and therefore are also called cost reduction investments.
However, replacement decisions that involve substantial modernisation and technological improvements
expand revenues as well as reduce costs. Yet another useful way to classify investments is as follows:
 Expansion of existing business  Expansion of new business  Replacement and modernisation  Mutually
exclusive investments  Independent investments  Contingent investments
4.1.4 Mutually Exclusive Investments
Mutually exclusive investments serve the same purpose and compete with each other. If one investment is
undertaken, others will have to be excluded. A company may, for example, either use a labour-intensive, semi-
automatic machine, or employ a more capital intensive, highly automatic machine for production. Choosing the
semi-automatic machine precludes the acceptance of the lightly automatic machine.
4.1.5 Independent Investments
Independent investments serve different purposes and do not compete with each other. For example, a heavy
engineering company may be considering expansion of its plant capacity to manufacture additional excavators
and addition of new production facilities to manufacture a new product – light commercial vehicles. Depending
on their profitability and availability of funds, the company can undertake both investments.
4.1.6 Contingent Investments
Contingent investments are dependent projects; the choice of one investment necessitates undertaking one or
more other investments. For example, if a company decides to build a factory on a remote, backward area, it
may have to invest in houses, roads, hospitals, schools etc. for employees to attract the work force. Thus,
building of factory also requires investment in facilities for employees. The total expenditure will be treated as
one single investment.
4.2 DIFFERENT AVENUES FOR DIVESTMENT
Self Off: A sell off is the sale of an asset, factory, division, product line or subsidiary by one entity to another
for a purchase consideration payable in cash or securities of the buyer. It is simply a reverse merger from the
point of view of the divesting firm. The reasons for sell off could be that a product line or subsidiary may not fit
in the core line of operations of the seller. During 1994-95, Glaxo Ltd. sold away its production facilities, brand
value, research and development relating to baby food and glucose business to Heinz Ltd. The purchase
consideration was received in cash, a major portion of which was distributed by Glaxo Ltd. as special dividend
among its shareholders. Lakme Ltd. (a Tata group company) sold its entire production facilities to Lever Lakme
Ltd. (a subsidiary of Hindustan Lever Ltd.)
Spin Off: In case of spin off, a part of the business is separated and instituted as a separate firm. The existing
shareholders of the firm get proportionate ownership (in terms of number of shares). So, there is no change in
ownership and the shareholders directly own the spin-off part instead of owning through being the shareholders
of the original firm. The management of the original firm gives up operating control of the separated business/
asset but the shareholders retain the same percentage ownership in both firms. In fact the original shareholders
of the firm become the shareholder of two firms, i.e. the existing as well as that of the new firm. The reasons for
spin off may be: i. The firm wants to give the separate identity to part / division.
ii. To avoid the take – over attempt on the whole firm. If a predator is looking to take over the control of the
firm, the valuable division of the firm may be spun-off, so that it is assessed separately by the market. This
may make the separated division un-attracted to the predator.
iii. To separate out the regulated and unregulated lines of business.
Carve –Outs: It is a variant of spin off. In carve-out, the shares of the new company are not given to the
existing shareholders, rather are sold for cash in the market by making a public offer. So, in carve out, the
existing company, may sell either the majority stake or a minority stake, depending upon whether the existing
management wants to continue to control or not the separated division.
Buy – Outs: It is also known as Management Buy – Out (MBO) In this case, the management of the company
buys a particular part of the business from the firm and then incorporate the business as a separate entity. In
certain cases, the management may buy – out the entire firm. In case, the existing management is short of funds
to pay for buy-out, then it can arrange debt funds from investors, banks or financial institutions. In such cases,
the buy- out is known as Leveraged Buy-Out (LBO). The LBO involves participation by third party (lenders)
and the management no longer needs to deal with a diverse group of shareholders, but instead with the lender or
lenders only. However, in LBO, there is a dramatic increase in the debt ratio. Still, the LBO may be acceptable
because of tax deductibility of interest payment on the debt.
To sum up, mergers, acquisitions, demergers and divestments provide different means to streamline the
operations of business firm. In merger, the activity base of the firm expands while in case of demergers, the
base contracts. In both cases, however, proper evaluation of different factors, financial as well as others is
required. There need not be haste in any such situation.
 UNIT II CRITICAL ANALYSIS OF APPRAISAL TECHNIQUES
Significance of Information and data bank in project selections – Investment decisions under capital
constraints – capital rationing, Portfolio – Portfolio risk and diversified projects.

5 FINANCIAL INFORMATION SYSTEM

Financial information systems encompass all of the applications of the computer in finance functions, that is,
acquisition and management of funds, management control, supported by accounting and financial; intelligence
system. Thus like other information systems, a financing information system has input, output, and database
Input subsystems use financial data from both internal and external sources. Accounting subsystem captures
transaction data and processes these to prepare various account books. Financial intelligence subsystem gathers
relevant data from external sources, such as shareholders, financial illustrations, government etc. All these data
go to database. Output subsystems of a financial information system consist of funds management subsystem
and control subsystem. Funds management subsystem tracks information flow related to acquisition,
distribution, and administration of funds. Control subsystem helps in exercising control related to financial
aspects of organisational operations.
5.1 ACCOUNTING SYSTEM
Every organisation, whether small or large, maintains an accounting system that maintains and analyses book
keeping records. It also prepares financial statements profit and loss account and balance sheet which measure
the impact of financial transactions and other events pertaining to the business. Generally, a large business
organisation has numerous transactions every day. Unless these transactions are recorded and analysed
individually, it is not possible to determine the impact of each transaction in the financial statements. However,
since the spectrum of business transactions is so wide, it is not feasible to analyse each transaction individually
to measure its effect on financial statements. The basic purpose of accounting is to ascertain the cumulative
effect of the transactions in the form of financial statements.
In order to ensure that accounting system maintains proper records, large organisations install internal audit
system. Internal audit is a review of various operations of an organisation and of its records by staff specially
appointed for this purpose. Internal audit may’ be undertaken on periodic basis or continuous basis. Internal
audit was formerly restricted to financial transactions and financial records only. In large organisations, internal
audit now extends to such matters which are not directly of financial or accounting nature; it is used as a control
device. The functions of internal audit are not the authorisation and recording of transactions, but its functions
start after the functions related to authorisation and recording of transactions are over. Internal audit is
concerned with the examination of these records and finding out the validity of these transactions.
5.2 FINANCIAL INTELLIGENCE SYSTEM
Since the finance functions control the money flow throughout an organisation, information is needed to
expedite this flow. The basic objective of the finance functions is to raise funds at the lowest possible cost and
to investment these funds to maximise returns from them. In order to achieve this objective, financial
intelligence system gathers information about the most desirable sources of funds and investment opportunities
for surplus funds. Financial intelligence system gathers relevant information from financial environment
comprising specialised financial institutions, common banks, investing public, stock exchanges, etc. for raising
funds. It also monitors the monetary policy of the central bank of the country (Reserve Bank of India in the case
of India) as this policy has direct impact on interest rates and availability of funds. For investing surplus funds
that may be available with the organisation, financial intelligence system tries to gather information about the
investment opportunities that may be available. Information may be collected from stock exchanges, mutual
funds and other financial market intermediaries.
5.3 FINANCIAL SOFTWARE PACKAGES
More prewritten software has been developed in finance area as compared to any other business functional area.
The most probable reason for this is the pattern of computer usage in business. The computer was first used in
business to process accounting data like payroll, accounts receivable payable, etc. Subsequently, computer use
spread in other areas. Financial software packages may be classified into four major categories accounting data
processing, personal productivity software, decision model packages, and financial database service.
Accounting Data Processing: Prewritten accounting data processing packages perform a number of activities
ranging from transaction recording and processing to preparation of final financial statements in the forms of
profit and loss account and balance sheet. Various types of accounts that can be prepared with these packages
include accounts payable, account receivable, general ledger, job accounting, job costing, payroll processing,
tax accounting, etc.
Most commonly used accounting package in India is Tally, developed by Bangalore-based Tally Solutions
(formerly Peutronics). Tally is able to perform most of the accounting functions.
Personal Productivity Software: Personal productivity software has the capability to be used in different
business functions. For example, electronic spreadsheet can be used in many areas including finance. When
spreadsheet is used in finance area, it shows various financial data such as cost of production with detailed
break-up in rows and various periods, such as monthly, quarterly, yearly, etc. are shown in columns. Thus,
spreadsheet can be used to make comparative analysis of a financial phenomenon over a period of time.
Decision Model Packages: There are number of packages that produce different models which can be used for
financial decision making. Areas which are covered include profit planning, evaluation of economic feasibility
of a project, forecasting funds requirement, deciding optimum financing mix, financial ratio analysis, etc. Some
of the packages that are available include Minitab, IDA SAS, SPSS, etc.
Financial Database Service: Financial database service is provided by different organisations in different
forms. First, financial database is provided in the form of CD ROM which can be used by the buying
organisation, Such a CD-ROM includes industry analysis, financial performance of various companies in the
industry, etc. Second, financial database created by service providers can be accessed through local/wide area
network or Internet after paying certain prescribed fee. In India, many organisations provide financial database
services which are relevant mostly for investment purposes. For example, Cyberboltz provides financial
information of companies listed on stock exchanges that includes profit and loss accounts and balance sheet of
each company for the last five years, financial ratios, share price movements, charts, news headlines, etc. for an
annual subscription fee of Rs. 30,000 annually (as on September 30, 2001).
5.4 MANAGERIAL USE OF FINANCIAL INFORMATION SYSTEMS
In most of the organisations, financial information systems are used more as compared to other functional areas
as everyone in the organisation is related to finance either directly or indirectly. Along with the finance
department, all the departments of the organisation, whether major like production, marketing, and human
resources, or minor like legal and secretarial, estate management, and other service departments use some part
of the financial information systems.
Financial information systems are used by corporate-level management which has overall responsibility of
maintaining financial health of the organisation. Financial information systems at this level are used to provide
guidelines to conduct finance functions as well as to make final decisions on certain financial matters like
financing mix and management of earnings on the basis of recommendation of finance department. While
finance director uses all subsystems of financial information systems in varying proportion, managers
concerned with different aspects of finance use subsystems relevant to them. All other departments use control
subsystem of financial information systems along with relevant additional subsystems. For example, a
production director is also interested in how funds are used in fixed assets and working capital relevant to
production like inventory. Other departments use financial information that is relevant to them.
5.5 INFORMATION AND PROJECT SELECTION
The project is selected after conducting feasibility study. Feasibility analysis warrants a detailed analysis of
technical, financial and other aspects. Feasibility analysis includes various evaluations such technical,
commercial, financial, social, environmental, managerial, etc. It is needless to say that each of these dimensions
is important and be analysed carefully. For this purpose, detailed information and data are collected, analysed
and interpreted. If more than on projects are identified, then analysis is required for all such projects. To carry
out these analyses different kinds of information are required. For example market analysis requires following
information 1) What is the total size of the market (demand)?
2) What is the existing level of capacity installed by competitors?
3) What is the growth pattern of the demand?
4) What is the expected market share to be captured by the project under way
To answer the above questions require in depth study of various factors like consumption pattern, elasticity of
demand, nature of competition, government policies. This information may be gathered from
1) Situational analysis by way of informal talks to customers, retailers, wholesalers and other participants of
market.
2) Secondary sources such as economic surveys, industry reports, newspapers, periodicals, National Sample
surveys, Annual Reports of companies, RBI reports, Publications of advertising agencies etc.
3) Primary sources, i.e. preparing a questionnaire, and getting necessary information from the potential
customers and other parties. Sometimes, the secondary information is to be supplemented with the information
collected from primary sources.
The technical analysis is concerned with the details regarding input; production technology, location, site and
capacity of the plant; civil work; plant charts and layout. The financial analysis requires information about cost
of project, estimation of revenues and costs, projected earnings, projected balance sheet, projected cash flow
statement, Break even analysis. To make all the above analysis, the firm requires lot of information. The
information should be adequate and correct. If there is no information then decision cannot made, and if the
information is not correct then decision will not be right one, which will end up in project failure. Some of the
information may be available within the company database and some have to be collected from outside sources.

5.6 INFORMATION ASYMMETRY AND CAPITAL BUDGETING

The conventional approach to capital budgeting is accept projects which have positive NPV. It does not make
any difference whether the investment decision making is centralized or decentralized; it is irrelevant whether
the existing firm implements it or a newly set up firm executes it; it does not matter what mix of financing is
employed.
The behaviour of firms, however, is not always in conformity with what has been said above. In the real world;
 Firms often ration capital and do not invest in all projects that have positive NPVs.
 A lot of attention is paid to the extent to which capital budgeting decisions are centralized.
 The mix of financing is considered to be very important.
Why dose a discrepancy exist between what the conventional model says and how the real world firms behave?
Information asymmetries of various sorts seem to create such a hiatus. Informational asymmetry exists if the
transacting parties have unequal information, ex ante or ex post.
We may classify informational asymmetry into three broad types:
1) Informational asymmetry between shareholders and bondholders.
2) Informational asymmetry between current shareholders and prospective shareholders.
3) Informational asymmetry between managers and shareholders.

5.6.1 Informational Asymmetry between Shareholders and Bond Holders

Informational asymmetry between shareholders and bondholders has two possible distorting consequences.
have an incentive to avoid investing in new projects that have a positive NPV, because they would not like the
cash flows of new projects to be diverted for servicing existing risky debt.

5.6.2 Informational Asymmetry between Current Shareholders and Prospective Shareholders

When there is informational asymmetry between current shareholders and prospective shareholders, the latter
will not fully appreciate the future payoffs of various resource commitments. As the firms’ stock price may not
fully reflect the benefits of such resource commitments, the new share holders will not fully share the cost of
resource commitments even though they partake in the benefits arising from them. If the firm is interested in
Asset substitution moral hazard: Shareholders may ask the management to Substitute riskier assets for safer
assets, At the expense of bondholders.
Underinvestment moral hazard: In firms with risky debt, shareholders have an incentive to avoid investing in
new projects that have a positive NPV, because they would not like the cash flows of new projects to be
diverted for servicing existing risky debt.
5.6.2 Informational Asymmetry between Current Shareholders and Prospective Shareholders
When there is informational asymmetry between current shareholders and prospective shareholders, the latter
will not fully appreciate the future payoffs of various resource commitments. As the firms’ stock price may not
fully reflect the benefits of such resource commitments, the new share holders will not fully share the cost of
resource commitments even though they partake in the benefits arising from them. If the firm is interested in
maximizing the wealth of present shareholders, it may choose projects that are likely to be different from those
that would be chosen in a symmetric information setting. The common distortions resulting from such
informational asymmetry are:
 Preference for projects with shorter payback period. A greater degree of capital rationing. Centralization
of capital budgeting.Accumulation of liquidity despite the existence of positive NPV projects.

5.6.3 Informational Asymmetry between Managers and Shareholders

Managers are interested in maintaining and building their reputation. Since, as compared to shareholders, they
are typically better informed about the payoffs of projects they can trade on the relative ignorance of the latter.
This gives them latitude to choose investments aimed at building their reputation rather than enhancing the
wealth of shareholders.
 As David Hirshleifer has suggested, the concern for managerial reputation may lead to three kinds of
distortions in investment decisions, namely:
Visibility Bias: Managers seek to improve short-term indicators of performance.
Resolution preference: Managers attempt to advance the arrival of good news and delay the announcement of
bad news.
Mimicry and Avoidance: Managers try to imitate the actions of superior managers and avoid the actions of
inferior managers.
These incentives may lead to the following investment biases:
 Squeezing of an investment to improve short-term cash flows.
 Premature liquidation of assets to show that they are worth a lot.
 Adoption of projects with earlier payoffs.
 Avoidance of worthwhile projects that carry risk of early failure to protect short term reputation.
 Escalation of inferior projects to avoid admission of failure.
 Undertaking projects which are supposed to have benefits in the distant future to protect short-term
reputation.
 Conformity with other managers to avoid the ‘odd manager’ label.
 Deviation from other managers to avoid seeming mediocre.

6 INVESTMENT DECISIONS UNDER CAPITAL RATIONING

For capital budgeting decisions, the term capital rationing may be defined as a situation where the firm has
limited funds available for fresh investments. Many Profitable and financially viable proposals may be
available but cannot be undertaken in view of the limited funds. A situation of capital rationing may occur
when a firm is either unable or unwilling to obtain additional funds in order to undertake financially viable
capital budgeting proposals. Thus a firm by choice or under compulsions sets absolute ceiling on its capital
spending in a period at a level that will cause it to reject or avoid some of the profitable projects. A firm should
accept all investment projects with positive NPV in order to maximize the wealth of shareholders. The NPV
rule tells us to spend funds in the projects until the NPV of the last (marginal) project is zero.
If a firm has different proposals with positive NPV but the initial funds required for the implementation of all
these proposals are not available or cannot be procured from the capital market for one reason or the other, the
firm is said to be operating under condition of capital rationing. The capital rationing may be of two types.
1) Internal Capital Rationing. It is a situation where the firm has imposed limit on the funds allocated for
fresh investment though (i) the funds might otherwise be available within the firm, or (ii) additional funds can
be procured by the firm from the capital market. Some firms may follow a policy of using only internally
generated funds (by ploughing back of profits) for new investments. Some firms avoid debt capital because of
the associated financial risk and avoid external equity because of a desire not to lose control. This type of
capital rationing implies that the firm is not willing to grow further.
2) External Capital Rationing. It is a situation when the firm is willing to undertake the financially viable
proposals but is unable to do so because either it is not having sufficient funds available at its disposal or the
capital market conditions are not conducive enough to let the firm raise the required funds from the market. The
external capital rationing may occur because of several reasons.
a) The Lack of Credibility. The capacity of the firm to raise funds and avoid a capital rationing depends largely
on the firm’s credibility with the capital market. Obviously, a firm with good standing in the capital market is
less likely to face capital rationing constraints than a firm with credibility problems.
b) High Flotation cost. The larger the cost of issuing securities in the capital market, the greater the chances
that a firm will face the capital rationing. The size of the flotation cost tends to vary inversely with the size of
the issue, i.e., larger issues tend to have proportionately lower flotation cost. Smaller firms are more likely to
face capital rationing constraints than the larger firms because the former have higher flotation cost. Further, the
firms that are primarily dependent on equity financing are more likely to face capital rationing.
c) Higher Marginal cost of Capital. A Firm faces a capital rationing because the additional funds can be raised
only at a higher cost than that the cost of existing funds, and hence the firm faces an increasing marginal cost of
funds. Capital funds in such a case are assumed to be available at the market rate of interest up to a certain limit
only and thereafter for additional funds, the cost of funds will also increase. At this stage, it is also necessary to
classify different projects into 2 classes, i.e., divisible projects and indivisible projects.
1) Divisible Projects : There are certain projects, which can either be taken in full or can be taken in parts. For
example, a building (having 5 floors) can be constructed at a cost of Rs. 5 Crores.
However, if the funds are not sufficiently available then only a part of the building, say only 2 floors, can be
constructed for the time being. But all the proposals may not be divisible.
2) Indivisible Projects: There are certain proposals which are indivisible. These proposals have a feature that
either the proposal, as a whole, be taken in its totality or not taken at all for example; a proposal to buy a
helicopter cannot be taken parts. Similarly, a multi-stage plant can only be installed fully but not in parts. There
can be many instances of indivisible projects. A firm may have capital rationing in single period only or over
number of years (known a multi period capital rationing). The capital budgeting decisions in case of single
period and multi-period capital rationing can be analysed as follows:

6.1 SINGLE PERIOD CAPITAL RATIONING

This is simple types of capital rationing and occurs when a firm faces shortage of funds in a particular year only
and thereafter the funds may be available easily. Impliedly, these limited capital funds can finance fewer than
other wise available feasible proposals. This necessitates restructuring the decision process to a certain extent.
The simple way out can be to rank the various proposals in descending order of attractiveness and then go
on accepting the proposals top down until the available funds are exhausted. But how to rank the proposals?
Which technique may be used to rank the proposals? Following are some of the methods and procedures to deal
with single period capital rationing.

6.1.1 Aggregation of projects or Feasible set approach.

Under this approach, the NPV of various proposals are put in different possible combinations and then that
combination is selected which has the maximum total NPV. The following two points are worth noting;
i. That total outlay of the combination is within the limits of capital rationing, and
ii. The total NPV of the combination is the highest among all the combinations.
The Feasible Set approach, thus can be summarized as follows:
a) Find out all the feasible combinations of different proposals in the light of the capital funds constraints and
proposal’s independence.
b) Find out the total NPV of each of these combinations and arrange these combinations in order of decreasing
NPVs.
c) Select the combinations with the highest NPV.
The above process of feasibility set approach can be easily applied if the number of available projects is limited
to, say, 5 or 6. However, if the number of available proposals is more, then help of mathematical techniques
may be taken. Thus, the above feasibility set approach (based on the NPV technique) helps selecting those
proposals which will result in maximum contribution to the wealth of the shareholders.

6.1.2 Cumulative Outlay Analysis based on IRR.

In this method, the IRRs of different proposals are calculated. These proposals are then ranked in order of
decreasing IRR. The proposals whose IRR is less than the hurdle rate are rejected out rightly. Out of other
projects, the firm can select the proposals in the descending IRR order so longer the funds are available.

6.1.3 Profitability Index

The PI has been defined as the ratio of PV of cash inflows to PV of cash outflows of a proposal. Under this
method, the PI of different proposals may be calculated and placed in decreasing order. The firm may start from
the top and go on accepting the proposals subject to that (i) funds are available, and (ii) the PI is more than 1.
(a) When the projects are indivisible. The indivisible projects are those which can be taken up in totality and
the part acceptance is not possible. The firm will select the proposals in order of decreasing PI so long as the
funds are available. At any stage, if the funds are not sufficient for the next proposal, then it can be skipped and
the firm can move onto the next highest PI proposal.
(b) When the projects are divisible. In this case, the firm would be able to take up the projects in descending
PI order. If at any stage, the funds are not sufficient to take up the entire next project, then it would be taken up
in part. In case of divisible projects, it is implied that the relationship between the capital outlay and the NPV is
linear.
The capital budgeting procedure under the simple situation of capital rationing may be summarized as follows:
The NPV rule should be modified while choosing among projects under capital constraint. The objective should
be to maximize NPV per rupee of capital rather than to maximize NPV Projects should be ranked by their
profitability index, and top-ranked projects should be undertaken until funds are exhausted.
6.2 USE OF PROFITABILITY INDEX IN CAPITAL RATIONING
Under capital rationing, we need a method of selecting that portfolio of projects which yields highest possible
NPV within - the available funds.
6.2.1 Limitations of Profitability Index
The capital budgeting procedure described above does not always work. It fails in two situations:
 Multi-period capital constraints  Project indivisibility
A serious limitation in using the PI rule is caused by the multi-period constraints.

6.3 MULTI-CONSTRAINTS CAPITAL RATIONING

A Capital budgeting situation may have multi-constraints i.e. there may be different limitations all of which are
to be incorporated in the decision. These limitations may be in terms of institutional constraints or expenditure
constraints.
6.4 MULTI – PERIOD CAPITAL RATIONING
When a firm faces limitations of funds in more than one period, then the above techniques may not be of much
help. In such a case, the firm may have to resort to some sort of mathematical programming in order to identify
the optimum selection of proposals.

6.5 PROGRAMMING APPROACH TO CAPITAL RATIONING

The limitations of the profitability index method make it necessary to have a better method for investment
decisions under capital rationing. Let us develop a general procedure for solving the capital rationing problem.
6.5.1 Linear Programming (LP)
It may be realized that the above situation is a linear programming (LP) problem. It can be easily solved with
the help of a computer. (You can use Solver in Excel to solve linear programming problems.)
6.5.2 Integer Programming (IP)
It may be noted in this example that the LP solution requires us to accept a fraction of Project O. Perhaps some
projects can be divided. If Project O is divisible, it may be Appropriate to undertake a part of it and assume that
cash flows will be reduced proportionately. However, a large number of projects in practice are indivisible.
When projects are not divisible, we can use integer programming (IP) by limiting the X’s to be integers of
either 0 to 1.
Integer programmers are difficult to solve. It may take unwieldy number of iterations for generated funds or the
reluctance to raise capital from outside.
Most companies do not use mathematical approach to select projects under capital the model to converge on
a solution. Also, other restrictions may prove to be redundant on account of integer restriction.

6.5.3 Dual Variable

One important advantage in using the programming models for solving the capital-rationed capital budgeting
decisions is the information about ‘dual variables.’’ Dual variables for the budget constraints may be
interpreted as ‘opportunity costs’ or ‘shadow prices.’

6.5.4 Extensions of Programming Approach

The use of LP or IP models can be extended to cope with other constraints. A firm may like to provide for the
carryover of unspent cash from one period to another. Let C denote funds carried from period 0 to period 1 and
let them earn interest at the rate i

6.5.5 Limits to the Use of Programming Approach

LP or IP models seem to be best suited for making investment decisions under limited resources. However,
these models are not in common use. There are at least two important reasons for the unpopularity of these
models. First, they are costly to use when large, indivisible projects are involved. Second, these models assume
that future investment opportunities are known. The discovery of investment opportunities in practice is an
unfolding process.’

6.6 CAPITAL RATIONING IN PRACTICE

How serious is the problem of capital rationing in practice? Do companies reject projects due to shortage of
funds? How do they select projects under capital rationing? Capital rationing does not seem to be a serious
problem in practice.
It may arise due to the internal constraint or the management’s reluctance to raise external funds. When
companies face the problem of shortage of funds, they use simple rules of choosing projects rather than the
complicated mathematical models

EXHIBIT 6.1: DO COMPANIES FACE CAPITAL RATIONING PROBLEM IN PRACTICE?

In a study of Indian companies, it is revealed that most companies do not reject projects on account of capital
shortage. They face the problem of shortage of funds due to the management’s desire to limit capital
expenditures to internally following. The bases to choose projects under capital rationing are:
profitability
priorities set by management
experience
Some companies satisfy the criteria of profitability and strategic considerations for allocating limited funds.
Generally companies do not reject profitable projects under capital rationing; they postpone them till funds
become available in future.

6.7 CAPITAL RATIONING V/S PORTFOLIO

Capital rationing is allocation of available fund to list most profitable projects. In capital rationing projects are
listed according to profitability then available funds are allotted to the projects to ensure maximum profitability.
There may be lot of profitable projects but only few projects are selected according availability of funds. In the
portfolio all the funds are not invested in one projects rather invested in few projects mainly to diversify the
risk. In the portfolio selection minimizing the risk is more important whereas in capital rationing maximizing
the profit is the main objective. In capital rationing capital constraint and other constraints are analysed in
detail. In portfolio both systematic risk and unsystematic risk are considered.

7 PORTFOLIO AND RISK MANAGEMENT THROUGH DIVERSIFICATION

7.1 PORTFOLIO
In finance, a portfolio is an appropriate mix of or collection of investments held by an institution or a private
individual. Holding a portfolio is part of an investment and risk-limiting strategy called diversification. By
owning several assets, certain types of risk (in particular specific risk) can be reduced. The assets in the
portfolio could include stocks, bonds, options, warrants, gold certificates, real estate, futures contracts,
production facilities, or any other item that is expected to retain its value. In building up an investment portfolio
a financial institution will typically conduct its own investment analysis, whilst a private individual may make
use of the services of a financial advisor or a financial institution which offers portfolio management services

7.2 PORTFOLIO MANAGEMENT

Portfolio management involves deciding what assets to include in the portfolio, given the goals of the portfolio
owner and changing economic conditions. Selection involves deciding what assets to purchase, how many to
purchase, when to purchase them, and what assets to divest. These decisions always involve some sort of
performance measurement, most typically expected return on the portfolio, and the risk associated with this
return (i.e. the standard deviation of the return). Typically the expected return from portfolios of different
asset bundles is compared. The unique goals and circumstances of the investor must also be considered. Some
investors are more risk averse than others. Mutual funds have developed particular techniques to optimize their
portfolio holdings. See fund management for details.

7.3 RETURNS
There are many different methods for calculating portfolio returns. A traditional method has been using
quarterly or monthly money-weighted returns. A money-weighted return calculated over a period such as a
month or a quarter assumes that the rate of return over that period is constant. As portfolio returns actually
fluctuate daily, money-weighted returns may only provide an approximation to a portfolio’s actual return.
These errors happen because of cash flows during the measurement period. The size of the errors depends on
three variables: the size of the cash flows, the timing of the cash flows within the measurement period, and the
volatility of the portfolio. A more accurate method for calculating portfolio returns is to use the true time-
weighted method. This entails revaluing the portfolio on every date where a cash flow takes place (perhaps
even every day), and then compounding together the daily returns.
7.4 ATTRIBUTION
Performance Attribution explains the active performance (i.e. the benchmark-relative performance) of a
portfolio. For example, a particular portfolio might be benchmarked against the S&P 500 index. If the
benchmark return over some period was 5%, and the portfolio return was 8%, this would leave an active return
of 3% to be explained. This 3% active return represents the component of the portfolio’s return that was
generated by the investment manager (rather than by the benchmark). There are different models for
performance attribution, corresponding to different investment processes. For example, one simple model
explains the active return in “bottom up” terms, as the result of stock selection only. On the other hand, sector
attribution explains the active return in terms of both sector bets (for example, an overweight position in
Materials, and an underweight position in Financials), and also stock selection within each sector (for example,
choosing to hold more of the portfolio in one bank than another.

7.5 MODERN PORTFOLIO THEORY: AN OVERVIEW

If you were to craft the perfect investment, you would probably want its attributes to include high returns
coupled with little risk. The reality, of course, is that this kind of investment is next to impossible to find. Not
surprisingly, people spend a lot of time developing methods and strategies that come close to the “perfect
investment”. But none is as popular, or as compelling, as modern portfolio theory (MPT). It is one of the most
important and influential economic theories dealing with finance and investment, MPT was developed by Harry
Markowitz and published under the title “Portfolio Selection” in the 1952 Journal of Finance. MPT says that it
is not enough to look at the expected risk and return of one particular stock. By investing in more than one
stock, an investor can reap the benefits of diversification - chief among them, a reduction in the riskiness of the
portfolio. MPT quantifies the benefits of diversification, also known as not putting all of your eggs in one
basket. For most investors, the risk they take when they buy a stock is that the return will be lower than
expected. In other words, it is the deviation from the average return. Each stock has its own standard deviation
from the mean, which MPT calls “risk”. The risk in a portfolio of diverse individual stocks will be less than the
risk inherent in holding any single individual stocks (provided the risks of the various stocks are not directly
related). Consider a portfolio that holds two risky stocks: one that pays off when it rains and another that pays
off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains
or shines. Adding one risky asset to another can reduce the overall risk of an all-weather portfolio. In other
words, Markowitz showed that investment is not just about picking stocks, but about choosing the right
combination of stocks among which to distribute one’s nest eggs
7.6. TWO KINDS OF RISK
Modern portfolio theory states that the risk for individual stock returns has two components:
Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are
examples of systematic risks.
Unsystematic Risk - Also known as “specific risk”, this risk is specific to individual stocks and can be
diversified away as you increase the number of stocks in your portfolio. It represents the component of a
stock’s return that is not correlated with general market moves. For a well-diversified portfolio, the risk - or
average deviation from the mean – of each stock contributes little to portfolio risk. Instead, it is the difference -
or covariance - between individual stocks’ levels of risk that determines overall portfolio risk. As a result,
investors benefit from holding diversified portfolios instead of individual stocks. The Efficient Frontier Now
that we understand the benefits of diversification, the question of how to identify the best level of
diversification arises. Enter the efficient frontier. For every level of return, there is one portfolio that offers the
lowest possible risk, and for every level of risk, there is a portfolio that offers the highest return. These
combinations can be plotted on a graph, and the resulting line is the efficient frontier. Figure 2 shows the
efficient frontier for just two stocks - a high risk/high return technology stock (Google) and a low risk/low
return consumer products stock (Coca Cola). Any portfolio that lies on the upper part of the curve is efficient: it
gives the maximum expected return for a given level of risk. A rational investor will only ever hold a portfolio
that lies somewhere on the efficient frontier. The maximum level of risk that the investor will take on
determines the position of the portfolio on the line.
Modern portfolio theory takes this idea even further. It suggests that combining a stock portfolio that sits on the
efficient frontier with a risk-free asset, the purchase of which is funded by borrowing, can actually increase
returns beyond the efficient frontier. In other words, if you were to borrow to acquire a risk-free stock, then the
remaining stock portfolio could have a riskier profile and, therefore, a higher return than you might otherwise
choose. The theory demonstrates that portfolio diversification can reduce investment risk. In fact, modern
money managers routinely follow its precepts.
MPT has some shortcomings in the real world. For starters, it often requires investors to rethink notions of risk.
Sometimes it demands that the investor take on a perceived risky investment (futures, for example) in order to
reduce overall risk. That can be a tough sell to an investor not familiar with the benefits of sophisticated
portfolio management techniques. Furthermore, MPT assumes that it is possible to select stocks whose
individual performance is independent of other investments in the portfolio. But market historians have shown
that there are no such instruments; in times of market stress, seemingly independent investments do, in fact, act
as though they are related. Likewise, it is logical to borrow to hold a risk-free asset and increase investor
portfolio returns, but finding a truly risk-free asset is another matter. Government-backed bonds are presumed
to be risk free, but, in reality, they are not. Securities such as gilts and U.S. Treasury bonds are free of default
risk, but expectations of higher inflation and interest rate changes can both affect their value. Then there is the
question of the number of stocks required for diversification. How many is enough? Mutual funds can contain
dozens and dozens of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to
diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book “Modern
Portfolio Theory and Investment Analysis” (1981), conclude that investor would come very close to achieving
optimal diversity after adding the twentieth stock. The gist of MPT is that the market is hard to beat and that the
people who beat the market are those who take above-average risk. It is also implied that these risk takers will
get their comeuppance when markets turn down. Then again, investors such as Warren Buffett remind us that
portfolio theory is just that - theory. At the end of the day, a portfolio’s success rests on the investor’s skills and
the time he or she devotes to it. Sometimes it is better to pick a small number of out-of favour investments and
wait for the market to turn in your favour than to rely on market averages alone.

7.7. RISK AND RETURN

The model assumes that investors are risk averse, meaning that given two assets that offer the same expected
return, investors will prefer the less risky one. Thus, an investor will take on increased risk only if compensated
by higher expected returns. Conversely, an investor who wants higher returns must accept more risk. The exact
trade-off will differ by investor based on individual risk aversion characteristics. The implication is that a
rational investor will not invest in a portfolio if a second portfolio exists with a more favourable risk return
profile – i.e., if for that level of risk an alternative portfolio exists which has better expected returns.

7.8. MEAN AND VARIANCE

It is further assumed that investor’s risk / reward preference can be described via a quadratic utility function.
The effect of this assumption is that only the expected return and the volatility (i.e., mean return and standard
deviation) matter to the investor. The investor is indifferent to other characteristics of the distribution of returns,
such as its skew (measures the level of asymmetry in the distribution) or kurtosis (measure of the thickness or
so called “fat tail”). Note that the theory uses a parameter, volatility, as a proxy for risk, while return is an
expectation on the future. This is in line with the efficient market hypothesis and most of the classical findings
in finance such as Black and Scholes European Option Pricing (martingale measure: shortly speaking means
that the best forecast for tomorrow is the price of today). Recent innovations in portfolio theory, particularly
under the rubric of Post-Modern Portfolio Theory (PMPT), have exposed several flaws in this reliance on
variance as the investor’s risk proxy.
7.9. DIVERSIFICATION
An investor can reduce portfolio risk simply by holding instruments which are not perfectly correlated. In other
words, investors can reduce their exposure to individual asset risk by holding a diversified portfolio of assets.
Diversification will allow for the same portfolio return with reduced risk. If all the assets of a portfolio have a
correlation of 1, i.e., perfect correlation, the portfolio volatility (standard deviation) will be equal to the
weighted sum of the individual asset volatilities. Hence the portfolio variance will be equal to the square of the
total weighted sum of the individual asset volatilities. If all the assets have a correlation of 0, i.e., perfectly
uncorrelated, the portfolio variance is the sum of the individual asset weights squared times the individual asset
variance (and volatility is the square root of this sum). If correlation is less than zero, i.e., the assets are
inversely correlated, the portfolio variance and hence volatility will be less than if the correlation is 0.

7.10 SYSTEMATIC RISK AND SPECIFIC RISK

Specific risk is the risk associated with individual assets - within a portfolio these risks can be reduced through
diversification (specific risks “cancel out”). Specific risk is also called diversifiable, unique, unsystematic, or
idiosyncratic risk.
Systematic risk (a.k.a. portfolio risk or market risk refers to the risk common to all securities - except for selling
short as noted below, systematic risk cannot be diversified away (within one market). Within the market
portfolio, asset specific risk will be diversified away to the extent possible. Systematic risk is therefore equated
with the risk (standard deviation of the market portfolio. Since a security will be purchased only if it improves
the risk / return characteristics of the market portfolio, the risk of a security will be the risk it adds to the market
portfolio. In this context, the volatility of the asset, and its correlation with the market portfolio, is historically
observed and is therefore a given (there are several approaches to asset pricing that attempt to price assets by
modeling the stochastic properties of the moments of assets’ returns - these are broadly referred to as
conditional asset pricing models. The maximum price paid for any particular asset (and hence the return it will
generate should also be determined based on its relationship with the market portfolio. Systematic risks within
one market can be managed through a strategy of using both long and short positions within one portfolio,
creating a “market neutral” portfolio.

7.11. APPLICATIONS OF MODERN PORTFOLIO THEORY IN OTHER DISCIPLINES

In the 1970s, concepts from Modern Portfolio Theory found their way into the field of regional science. In a
series of seminal works, Michael Conroy modelled the labour force in the economy using portfolio-theoretic
methods to examine growth and variability in the labour force. This was followed by a long literature on the
relationship between economic growth and volatility.
More recently, modern portfolio theory has been used to model the self-concept in social psychology. When the
self attributes comprising the self-concept constitute a well diversified portfolio, then psychological outcomes
at the level of the individual such as mood and self-esteem should be more stable than when the self-concept is
undiversified. This prediction has been confirmed in studies involving human subjects.

7.12. COMPARISON WITH ARBITRAGE PRICING THEORY

The SML and CAPM are often contrasted with the arbitrage pricing theory (APT), which holds that the
expected return of a financial asset can be modelled as a linear function of various macro-economic factors,
where sensitivity to changes in each factor is represented by a factor specific beta coefficient. The APT is less
restrictive in its assumptions: it allows for an explanatory (as opposed to statistical) model of asset returns, and
assumes that each investor will hold a unique portfolio with its own particular array of betas, as opposed to the
identical “market portfolio”. Unlike the CAPM, the APT, however, does not itself reveal the identity of its
priced factors - the number and nature of these factors is likely to change over time and between economies.

7.13. DIVERSIFICATION
Diversification in finance is a risk management technique, related to hedging, that mixes a wide variety of
investments within a portfolio. Because the fluctuations of a single security have less impact on a diverse
portfolio, diversification minimizes the risk from any one investment. A simple example of diversification is
the following: On a particular island the entire economy consists of two companies: one that sells umbrellas and
another that sells sunscreen. If a portfolio is completely invested in the company that sells umbrellas, it will
have strong performance during the rainy season, but poor performance when the weather is sunny. The reverse
occurs if the portfolio is only invested in the sunscreen company, the alternative investment: the portfolio will
be high performance when the sun is out, but will tank when clouds roll in. To minimize the weather-dependent
risk in the example portfolio, the investment should be split between the companies. With this diversified
portfolio, returns are decent no matter the weather, rather than alternating between excellent and terrible.
There are three primary strategies used in improving diversification: Spread the portfolio among multiple
investment vehicles, such as stocks, mutual funds, bonds, and cash. Vary the risk in the securities. A portfolio
can also be diversified into different mutual fund investment strategies, including growth funds, balanced funds,
index funds, small cap, and large cap funds. When a portfolio includes investments with varied risk levels, large
losses in one area are offset by other areas. The investor should vary his securities by industry, or by geography.
This will minimize the impact of industry- or location-specific risks. The example portfolio above was
diversified by investing in both umbrellas and sunscreen. Another practical application of this kind of
diversification is mixing investments between domestic and international funds. By choosing funds in many
countries, events within any one country’s economy have less effect on the overall portfolio. Diversification
reduces the risk of a portfolio, and consequently it can reduce the returns. However, since diversification
reduces the risk of an entire portfolio being diminished by single investment’s loss, it is referred to as “the only
free lunch in finance
7.13.1. Horizontal Diversification
Horizontal diversification is when a portfolio is diversified between same-type investments. It can be a broad
diversification (like investing in several NASDAQ companies) or more narrowed (investing in several stocks of
the same branch or sector). In the example above, the move to invest in both umbrellas and sunscreen is an
example of horizontal diversification. As usual, the broader the diversification the lower the risk from any one
investment.

7.13.2. Vertical Diversification

Vertical diversification is investment between different types of securities. Again, it can be a very broad
diversification, like diversifying between bonds and stocks, or a more narrowed diversification, like
diversifying between stocks of different branches. Continuing the example from the introduction, a vertical
diversification would be taking some money from umbrella and sunscreen stock and investing it instead in
bonds issued the government of the island. While horizontal diversification lessens the risk of investing entirely
in one security, vertical diversification goes beyond that and protects against market and/or economical
changes.

7.14. RETURN EXPECTATIONS WHILE DIVERSIFYING

The average of all the returns in a diverse portfolio can never exceed that of the top performing investment, and
will almost always be lower than the highest return. This is unavoidable, and is the cost of the risk insurance
that diversification provides. However, strategies exist that allow the portfolio’s manager to maximize returns
while still keeping risk as low as possible.

7.15. THE DIFFERENT TYPES OF DIVERSIFICATION STRATEGIES

The strategies of diversification can include internal development of new products or markets, acquisition of a
firm, alliance with a complementary company, licensing of new technologies, and distributing or importing a
products line manufactured by another firm. Generally, the final strategy involves a combination of these
options. This combination is determined in function of available opportunities and consistency with the
objectives and the resources of the company. There are three types of diversification: concentric, horizontal and
conglomerate:
7.15.1 Concentric Diversification
This means that there is a technological similarity between the industries, which means that the firm is able to
leverage its technical know-how to gain some advantage. For example, a company that manufactures industrial
adhesives might decide to diversify into adhesives to be sold via retailers. The technology would be the same
but the marketing effort would need to change. It also seems to increase its market share to launch a new
product which helps the particular company to earn profit.
7.15.2 Horizontal Diversification
The Company adds new products or services that are technologically or commercially unrelated (but not
always) to current products, but which may appeal to current customers. In a competitive environment, this
form of diversification is desirable if the present customers are loyal to the current products and if the new
products have a good quality and are well promoted and priced. Moreover, the new products are marketed to
the same economic environment as the existing products, which may lead to rigidity and instability. In other
words, this strategy tends to increase the firm’s dependence on certain market segments. For example company
was making note books earlier now they are also entering into pen market through its new product. Horizontal
integration occurs when a firm enters a new business (either related or unrelated) at the same stage of
production as its current operations. For example, Avon’s move to market jewellery through its door-to-door
sales force involved marketing new products through existing channels of distribution. An alternative form of
that Avon has also undertaken is selling its products by mail order (e.g., clothing, plastic products) and through
retail stores (e.g., Tiffany’s). In both cases, Avon is still at the retail stage of the production process.
7.15.3 Conglomerate Diversification (or lateral diversification)
The company markets new products or services that have no technological or commercial synergies with
current products, but which may appeal to new groups of customers. The conglomerate diversification has very
little relationship with the firm’s current business. Therefore, the main reasons of adopting such a strategy are
first to improve the profitability and the flexibility of the company, and second to get a better reception in
capital markets as the company gets bigger. Even if this strategy is very risky, it could also, if successful,
provide increased growth and profitability.
7.16 RATIONALE OF DIVERSIFICATION
According to Calori and Harvatopoulos (1988), there are two dimensions of rationale for diversification. The
first one relates to the nature of the strategic objective: diversification may be defensive or offensive. Defensive
reasons may be spreading the risk of market contraction, or being forced to diversify when current product or
current market orientation seems to provide no further opportunities for growth. Offensive reasons may be
conquering new positions, taking opportunities that promise greater profitability than expansion opportunities,
or using retained cash that exceeds total expansion needs. The second dimension involves the expected
outcomes of diversification: management may expect great economic value (growth, profitability) or first and
foremost great coherence and complementarities with their current activities (exploitation of know-how, more
efficient use of available resources and capacities). In addition, companies may also explore diversification just
to get a valuable comparison between this strategy and expansion.

7.17 FIRM-PORTFOLIO APPROACH

In the chapter 3 we measured risk for a single, stand-alone investment proposal. When multiple investment
projects are involved, we may want to study their combined risk. In that case, we need to use a measurement
procedure that differs from that for a single project. The approach we take corresponds to the portfolio approach
in security analysis. Now, however, we apply that approach to capital investment projects. Our purpose here is
only to show how to measure risk for combination of risky investments, assuming that such a measure is
desired. If a firm adds a project whose future cash flows are likely to be highly correlate with those of existing
assets, the total risk of the firm will increase more than that the project which has a low degree of correlation
with existing assets. Given the reality, a firm might wish to seek out projects that could be combined to reduce
firm risk.
Expectation and Measurement of Portfolio Risk The expected value of the net present value for a
combination (portfolio) of involvement projects, NPV , is simply the sum of the separate expected values of net
present value, where discounting takes place at the risk-free rate. The standard deviation of the probability
distribution of the portfolio’s net present values (σ p); however it is merely the summation of the standard
deviations of the individual projects making up the portfolio. Where r j,k is the expected correlation coefficient
between possible net present values for projects j and k, σj, is the standard deviation for project j and σ,k is the
standard deviation for project k. The Standard deviations of the probability distributions of possible net present
values for projects j and k are determined by the methods taken up in the previous section. When j = k, the
correlation coefficient is 1, and σj, σ,k becomes σj,2 (that is, the covariance of project j ‘s net present value with
itself is its variance). By accepting projects with relatively low degrees of correlation with existing projects, a
firm diversifies and, in so doing, may be able to lower its overall risk. Note, the lower the degree of positive
correlation between possible net present values for projects, the lower the standard deviation of possible net
present values, all other things being equal. Whether the coefficient of variation declines when an investment
project is added also depends on the expected value of net present value for the project.
Correlation between Projects The correlation between possible net present values for pairs of projects proves
to be the key ingredients in analyzing risk in a firm-portfolio context. When prospective projects are similar to
projects with which the company has had experience, it may be feasible to compute the correlation coefficients
using historical data. For other investments, estimates of the correlation coefficients must be based solely on an
assessment of the future. Management might have reason to expect only slight correlation between investment
projects involving research and development for an electronic tester and a new food product. On the other hand,
it might expect high positive correlation between investments in a milling machine and a turret lathe if both
machines were used in the production of industrial lift trucks. The profit from a machine to be used in a
production line will be highly, if not perfectly, correlated with the profit for the production line itself. The
correlation between expected net present values of various investments may be positive, negative, or 0,
depending on the nature of the association. A correlation of 1 indicates that the net present values of two
investments vary directly in the same proportional manner. A correlation coefficient of – 1 indicates that they
vary inversely in exactly the same proportional manner. And, a correlation of 0 indicates that they are
independent or unrelated. For most pairs of investments, the correlation coefficient lies between 0 and 1. The
reason for the lack of negatively correlated investment projects is that most investments are correlated
positively with the economy and, thus, with each other. Estimates of the correlation coefficients must be as
objective as possible if the total standard deviation obtained is to be realistic. It is not unreasonable to expect
management to make fairly accurate estimates of these coefficients. When actual correlation differs from
expected correlation, the situation can be learning process, and estimates on other projects can be revised.
 UNIT III STRATEGIC ANALYSIS OF SELECTED INVESTMENT DECISIONS
Lease financing – Lease Vs Buy decision – Hire Purchase and instalment decision – Hire Purchase Vs
Lease Decision – Mergers and acquisition – Cash Vs Equity for mergers.

8 LEASING AND HIRE PURCHASE

The traditional financing is related to the liability side of the balance sheet. The firm issues long-term debt or
equity to meet its financing needs, and in the process expands its capitalisation. The dangers of traditional
financing are that equity becomes an expensive method of financing because of decreasing corporate earning
and low price-earnings ratios. The high rate of inflation causes long-term debt to be an expensive source of
financing as interest rates rise. The corporate finance managers, therefore, are developing financing alternatives
related to the asset side of the balance sheet. These alternatives may lower the cost and redistribute the risk.
Asset-based financing uses assets as direct security. There are many possibilities. We shall discuss two most
popular asset-based financing: (i) lease, and (ii) hire purchase.

8.1. LEASE FINANCING

Leasing is widely used in western countries to finance investments. In USA, which has the largest leasing
industry in the world, lease financing contributes approximately one third of total business investments. In the
changing economic and financial environment of India, it has assumed an important role. what is lease
financing? What are its advantages and disadvantages? How can a lease be evaluated?

8.1.1 Lease Defined

Lease is a contract between a lessor, the owner of the asset and a lessee, the user of the asset. Under the
contract, the owner gives the right to use the asset to the user over an agreed period of time for a consideration
called the lease rental. The lessee pays the rental to the lessor as regular fixed payments over a period of time at
the beginning or at the end of a month, quarter, half-year or year. Although generally fixed, the amount and
timing of payment of lease rentals can be tailored to the lessee’s profits or cash flows. In up-fronted leases,
more rentals are charged in the initial years and less in the latter years of the contract. The opposite happens in
back-ended leases. At the end of the lease contract, the asset reverts to the lessor, who is the legal owner. It is
the lessor not lessee, who is entitled to claim depreciation on the leased asset. In long-term lease contracts, the
lessee is generally given an option to buy or renew the lease. Sometimes, the lease contract is divided into
two parts – primary lease and secondary lease for the purposes of lease rentals. Primary lease provides for the
recovery of the cost of the asset and profit through lease rentals during a period of about four or five years. A
perpetual, secondary lease may follow it on nominal lease rentals. Various other combinations are possible.
Although the lessor is the legal owner of a leased asset, the lessee bears the risk and enjoys the returns. The
lessee benefits if the leased assets operates profitably, and suffers if the asset fails to perform. Leasing separates
ownership and use as two economic activities, and facilitates asset use without ownership. A lessee can be
individual or a firm interested in the use of an asset without owning. Lessor may be equipment manufacturers
or leasing companies who bring together the manufacturers and the users. In USA, equipment manufacturers
are the largest group of lessor followed by banks. In India, independent leasing companies from the major
group in number in the leasing industry. Banks together with financial institutions are the largest group in terms
of the volume of business.

8.1.2 Types of Leases

Two types of leases can be distinguished: Operating lease Financial lease Sale-and-lease-back
Operating lease short-term cancellable lease agreements are called operating leases. Convenience and instant
services are the hallmarks of operating leases. Examples are: a tourist renting a car, lease contracts for
computers or office equipment, an operating lease may run for 3 to 5 years. The lessor is generally responsible
for maintenance and insurance. He may also provide other services. A single operating lease contract may not
fully amortise the original cost of the asset; it covers a period considerably shorter than the useful life of the
asset. Because of the short duration and the lessee’s option to cancel the lease, the risk of obsolescence remains
with the lessor. Naturally, the shorter the lease period and/or higher the risk of obsolescence, the higher will be
the lease rentals.
Financial lease Long term, non-cancellable lease contracts are known as financial leases. Examples are plant,
machinery, land, buildings, ships, and aircraft. In India, financial leases are very popular with high-cost and
high technology equipment.
Financial leases amortise the cost of the asset over the term of lease; they are, therefore, also called capital or
full pay out leases. Most financial leases are direct leases. The lessor buys the asset identified by the lessee
from the manufacturer and signs a contract to lease it out to the lessee.
Sale-and-lease back Sale-and-lease-back is a special financial lease arrangement. Sometimes, a user may sell
an (existing) asset owned by him. Such sale-and-lease back arrangements may provide substantial tax benefits.
For example, in April 1989, Shipping Credit and Investment Corporation of India (SCICI) purchased Great
Eastern Shipping Company’s bulk carrier, Jag Lata, for Rs.12.5 Crore and then leased it back to Great Eastern
on a five-year lease, the rentals being Rs.28.13 lakh per month. The ship’s written down book value was Rs.2.5
Crore.
In financial lease, the maintenance and insurance are normally the responsibility of the lessee. The lessee also
bears the risk of obsolescence. A financial lease agreement may provide for renewal of contract or purchase of
the asset by the lessee after the contact expires. The option of purchasing the leased asset by the lessee is not
incorporated in the lease contract in India, because if such an option is provided the lease is legally construed
to be a hire purchase agreement.
8.1.3 Cash Flow Consequences of a Financial Lease
A financial lease has cash flow consequences. It is a way of normal financing for a company. Suppose a
company has found it financially worthwhile to acquire an equipment costing Rs.800 lakh. The equipment is
estimated to last eight years. Instead of buying, the company can lease the equipment for eight years at an
annual (end-of-the period) lease rental of Rs.160 lakh from the manufacturer. Suppose that the company will
have to provide for the maintenance, insurance and other operating expenses associated with the use of the
asset in both alternatives leasing or buying. Assume a straight-line depreciation for tax purposes, a borrowing
rate of 14 percent, and a marginal tax rate of 35 percent for the company.
Exhibit 8.1: Commonly used lease Terminology
Two basic types of leases are i) financial lease and ii) operating lease.
Financial lease is further divided into i) leveraged lease, ii) sale-and-lease-back iii) Cross-border lease.
Leveraged lease Leveraged lease involves lessor, lessee and financier. Lessor (leasing company) provides
equity equal to about 25 percent of the asset’s cost while the remaining amount is provided by the financier (a
bank or a financial institution), mainly as loan. Leveraged lease is a popular method of financing expensive
assets.
Sales-and-lease-back As discussed to the main text, the lessee first sells asset owned by him to the lessor
and then leases it back from the lessor. This provides liquidity as well as possible tax gains to the lessee.
Cross-border lease In case of cross-border or international lease, the lessor and the lessee are situated in two
different countries. Because the lease transaction takes place between two parties of two or more countries, it is
called cross border lease. It involves relationships and tax implications more complex than the domestic lease.
When the lease transaction takes place between three parties’ manufacturer / vendor, lessor and lessee in three
different countries, it is called foreign-to-foreign lease.
There are many other terms used by the leasing industry. Some of them are defined below:
Closed and open ended lease In the close ended lease, the asset gets transferred to the lessor at the end, and
the risk of obsolescence, residual value etc. remain with the lessor being the legal owner of the asset. In the
open ended lease, the lessee has the option of purchasing the asset at the end of lease.
Direct lease It is a mix of operating and finance lease on a full payout basis and provides for the purchase
option to the lessee.
Master lease Master lease provides for a longer than the asset’s life and holds the lessor responsible for
providing equipment in good operating condition during the lease period.
Percentage lease Percentage lease provides for a fixed rent plus some percent of the previous year’s gross
revenue to be paid to the lessor. This ensures protection against the inflation.
Wet and dry lease In the aircraft industry, when the lease involves financing as well as servicing and fuel, it
is called wet lease. Dry lease provides only for financing.
Net net net lease In the triple net (net net net) lease, the lessee is obliged to take care of maintenance, taxes
and insurance of the equipment.
Update lease Update lease is intended to protect the lessee against the risk of obsolescence. The lessor
agrees to replace obsolete asset with new one at specified rent.
8.1.4 Myths About Leasing We can now examine the truth about some myths on leasing. Leasing provides
100 percent financing. One misconception about leasing is that it provides 100 percent financing for the asset
as the lessee can avoid payment for acquiring the asset.
The lessee it is assumed can preserve his liquid resources for other purposes. When a firm borrows to buy an
asset, cash increases with borrowing and decreases by the same amount with the purchase of the asset.
It has the asset to use but a liability to repay the loan and interest. In leasing also, the firm acquires the asset and
incurs the liability to make fixed payments in future. In practice, therefore, leasing like borrowing, commits the
company for a stream of payments in future.
Leasing provides off-the-balance-sheet financing: As the lessee may not be obliged to disclose his lease
liability on the balance sheet, it is believed that leasing does not affect the debt-equity ratio while borrowing
increases his debt-equity ratio. The myth goes, therefore, that leasing provides off-the-balance-sheet financing
leaving the firm’s debt raising ability intact. This is a fallacious argument. First, a debt-equity norm puts a limit
on the firm’s total borrowings. In debt capacity depends on its debt servicing ability rather than the balance
sheet ratios. Contractual obligations of any form through a lease or loan reduce debt servicing ability and add to
financial risk. Lenders recognise the lessee’s cash flow burden arising from lease payments. As a lease use the
firm’s debt capacity, it displaces debt. Leasing can certainly help companies which have enough debt servicing
ability but cannot borrow from banks or financial institutions on account of institutional norms or debt-equity or
regulations. Under no circumstances can a lease enhance the firm’s debt capacity.
Leasing improves performance Another myth is that the return on investment (profits divided by investment)
will increase since a lease does not appear as an investment on the books or the balance sheet. Besides, back-
ended leases enable showing higher profits in the initial years of the lease. Such performance ratios are illusory.
A firm’s value is affected by the value of its assets and liabilities rather than book profits created through
accounting adjustments. A lease will create value to the firm only if the benefits from it are more than its costs.
Leasing avoids control of capital spending: Another misconception is that leasing does not need capital
expenditure screening as no investments are involved. Since a long-term lease involves long-term financial
commitments, it ought to be screened accordingly in any good capital expenditure planning and control system.
If leasing is not screened and is used to circumvent capital expenditure screening and approval, it may add to
the firm’s risk, made it vulnerable to business fluctuations, and endanger its survival.
8.1.5 Advantages of Leasing
If all these myths are exploded, why then should a company lease instead of following the straightforward
alternative of a secured loan and purchase of the asset? The primary consideration is the cost of the lease vs.
cost of buying. They can be different. For, if a firm is incurring losses or making low profits, it cannot take full
advantage of the depreciation tax shield on purchase of assets. It is, therefore, sensible for it to let the leasing
company (lessor) own the assets, take full advantage of tax benefits and expect that the lessor passes on at least
some part of the benefits in the form of reduced lease rentals. Both the lessor and the lessee may stand to gain
financially. Apart from these tangible financial implications, there are other real advantages to leasing.
Convenience and flexibility If an asset is needed for a short period, leasing makes sense. Buying an asset and
arranging to resell it after use is time consuming, inconvenient and costly. Long-term financial leases also offer
flexibility to the user. In India, borrowing from banks and financial institutions involve long, complicated
procedures. Institutions often put restrictions on borrowers, stipulate conversion of loan into equity and appoint
nominee directors on the board. Financial leases are less restrictive and can be negotiated faster, especially if
the leasing industry is well developed. Yet another advantage of a lease is the flexibility it provides to tailor
lease payments to the lessee’s cash flows. Such tailored payment schedules are helpful to lessee who has
fluctuating cash flows. New or small companies in non-priority sectors such as confectioneries, bottlers and
distilleries find it difficult to raise funds from banks and financial institutions in India.
Shifting of risk of obsolescence: When the technology embedded in assets, as in a computer, is subject to rapid
and unpredictable changes, a lessee can, through a short term cancellable lease, shift the risk of obsolescence to
the lessor. A manufacturer-lessor, or a specialised leasing company, is usually in a better position than the user
to assume the risk of obsolescence and manage the fast advancing technology. Specialised leasing companies
are emerging in India. In fact, in such situations, the lessee is buying an insurance against obsolescence paying
a premium in terms of higher lease rentals.
Maintenance and specialised services with a full-service lease, a lessee can look for advantages in
maintenance and specialised services. For example, computer manufacturers who lease out computers are better
equipped than the user to provide effective maintenance and specialised services. Their cost too may be less
than what the lessee would have to incur if he were to maintain the leased asset. The lessor is able to provide
maintenance and other services cheaply because of his larger volume and specialisation. He may pass on a part
of that advantage to the lessee. What do not yet have in India many integrated specialised leasing companies. In
the face of such myths and realities, how does one evaluate a lease?
8.1.6 Evaluating a Financial Lease
Leasing is a two-step decision for the lessee firm. First, it has to evaluate the economic viability of the asset as
an investment. If the asset has a positive net present value, the company should proceed to acquire the asset.
Once it has decided to do so, the firm can compare the costs of financing the asset through leasing with that of
normal sources of financing. When the firm finances the asset by normal financing, it takes the following two
steps.
Purchase the asset for the cash, for say, X.
Purchases the necessary cash by selling package of financing instruments (debt and / equity) taking into
account its long-term target capital structure, for say, Y. When the asset is leased the following two transactions
takes place simultaneously:
Purchase of the asset for cash, for say, A.
Purchase of necessary cash, say B, by
(i) giving up the asset’s depreciation tax shield, and salvage value and
(ii) by agreeing to make a stream of cash payments as lease rentals to the lessor.
It is to the firm’s advantage to finance the asset by leasing if there is a positive difference, in net present value
terms, of B over Y. Thus, in evaluating a lease, a firm should be concerned about how the value of the firm is
affected if the lease is used as a ‘substitute’ for normal finance. The net present value of an asset (investment
project) is found by discounting the cash flows associated with the use of the asset by the firm’s cost of capital,
given its target debt-equity structure.

8.1.7 Leasing and Operating Risk

Anything which requires fixed commitment leads to operating risk. Lease rent is fixed in nature, whether there
is a production or not lease rental is to be paid. If it is purchase equipment then wear and tear will be less when
there is no production. Hence operating risk is less in purchase decision. At the same time this fixed cost can be
used as leverage. The lease rental will be fixed when there is a increase in production. This will increase the
earning available to the equity shareholders. Ultimately wealth maximization can be achieved. Hence the lease
decision will be riskier when there is a fluctuation in the demand and production schedule. It is also to be noted
that lease decision eliminates the risk of obsolescence. The leasing decision will not increase the liability side of
balance sheet, because it is a asset side financing. The debt and equity ratio which is one of the important
solvency ratios will not get affected by lease financing.

8.1.8 Leveraged Lease

Under a leveraged lease, four parties are involved: the manufacturer of the asset, the lessor, the lender from
whom the lessor borrows a substantial portion of the asset’s purchase price, and the lessee. In a direct lease, the
lessor buys the asset and becomes the owner by making the full payment of the asset. In a leveraged lease, the
lessor makes substantial borrowing, even up to 80 percent of the asset’s purchase price. He provides the
remaining amount – about 20 percent or so – as equity to become the owner (Figure 8.1). The lessor claims all
tax benefits related to the ownership of the asset. Lenders, generally the large financial institutions, provide
loans on a non-recourse basis to the lessor. Their debt is serviced exclusively out of the lease proceeds. To
secure the loan provided by the lenders, the lessor also agrees to give them a mortgage on the asset. Thus,
lenders have the first claim on the lease payments together with the collateral on the asset. Lenders will take
charge of the asset if the lessee is unable to make lease payments. Leveraged lease are called so because the
high non-recourse debt creates a high degree of leverage. The effect is to amplify the return of the equity-holder
(that is, the lessor). But the risk is also quite high if the lease payments are not received. Leveraged lease is
quite useful for large capital equipment with long economic life, say, 20 years or more. It is one of the popular
means of financing large infrastructure projects.

8.2. HIRE PURCHASE FINANCING

Hire purchase financing is a popular financing mechanism especially in certain sectors of Indian business such
as the automobile sector. In hire purchase financing, there are three parties: the manufacturer, the hiree and the
hirer. The hiree may be a manufacturer or a finance company. The manufacturer sells asset to the hirer who
sells it to the hirer exchange for the payment to be made over a specified period of time. A hire purchase
agreement between the hirer and the hiree involves the following three conditions:
The owner of the asset (the hirer or the manufacturer) gives the possession of the asset to the hirer with an
understanding that the hirer will pay agreed instalments over a specified period of time.
The ownership of the asset will transfer to the hirer on the payment of all instalments.
 The hirer will have the option of terminating the agreement any time before the transfer of ownership of the
asset.
Thus, for the hirer, the hire purchase agreement is like a cancellable lease with a right to buy the asset. The hirer
is required to show the hired assed on his balance sheet and is entitled to claim depreciation, although he does
not own the asset until full payment has been made. The payment made by the hirer is divided two parts:
interest charges and repayment of principal. The hirer, thus, gets tax relief on interest paid and not the entire
payment.

8.2.1 Hire Purchase Financings v/s Lease Financing.

Both hire purchase financing and lease financing are a form of secured loan. Both displace the debt capacity of
the firm since they involve fixed payments. However, they differ in terms of the ownership of the asset. The
hirer becomes the owner of the assets as soon as he pays the last instalment. In case of lease, the asset reverts
back to the lessor at the end of lease period. In practice, the lessee may be able to keep the asset after the expiry
of the primary lease period for nominal lease rentals. The following are the differences between hire purchase
financing and lease financing:

8.2.2 Instalment Sale

In contrast to the acquisition of an asset on the hire purchase basis, a customer can buy and own it out rightly on
instalment basis. Instalment scale is a credit scale and the legal ownership of the asset passes immediately to the
buyer as soon as the agreement is made between the buyer and the seller. The outstanding instalments are
treated as secured loan. As the owner of the asset, the buyer is entitled to depreciation and interest as deductible
expenses and claim salvage on the sale of the asset. Except for the timing of the transfer of ownership,
instalment sale and hire purchase are similar in nature.

8.3. LEASING V/S PURCHASING

Finance lease effectively transfers the risks and rewards associated with the ownership of equipment from the
lessor to the lessee. A lease can be evaluated either as an investment decision or as a financing alternative.
Given that an investment decision has already been made, a firm (lessee) has to evaluate whether it will
purchase the asset/equipment or acquire it on lease basis. Since lease rental payments are similar to payments of
interest on debt, leasing in essence is an alternative to borrowing. The lease evaluation from the lessee’s point
of view, thus, essentially involves a choice between debts financing versus lease financing. It is in this context
that an evaluation of lease financing from the view point of lessee is presented in this Section. The decision-
criterion used is the Net Present Value of Leasing [NPV (L)]/Net Advantage of Leasing (NAL). The discount
rate used is the marginal cost of capital for all cash flows other than lease payments and the tax cost of debt for
lease payments. The value of the interest tax shield is included as a foregone cash flow in the computation of
NPV (L)/NAL.
If the NAL/NPV (L) is positive, the leasing alternative should be used, otherwise the borrowing alternative
would be preferable. An alternative approach is to determine the present values of the cash outflows after taxes
under the leasing and the borrowing alternatives. The decision-criterion is to select the alternative with the
lower present value of cash outflows.
8.3.1 Break-Even Lease Rental
The break - even lease rental (BELR) is the rental at which the lessee is indifferent between lease financing and
borrowing and buying. Alternatively, BELR has NAL as Zero. If reflects the maximum level of rental which
the lesser would be willing to pay. If the BELR exceeds the actual lease rental, the lease proposal would be
accepted, otherwise rejected.

9 MERGER AND ACQUISITION

Corporate restructuring includes mergers and acquisitions (M&A), amalgamation, takes-over, spin-offs,
leveraged buy-outs, buy-back of shares, capital reorganisation, sale of business units and assets etc. M&A are
the most popular means of corporate restructuring or business combinations. They have played an important
role in the external growth of a number of leading companies in the world over. In the United States, the first
merger wave occurred between 1890 and 1904 and the second began at the end of the World War I and
continued through the 1920s. The third merger wave commenced in the latter part of World War II and
continues to the present day. About two-thirds of the large public corporations in the USA have merger or
amalgamation in their history. In India, about 1180 proposals for amalgamation of corporate bodies involving
about 2,400 companies were filed with the High Courts during 1976-86.
These formed 6 percent of the 40,600 companies at work at the beginning of 1976. In the year 2003-04, 834
mergers and acquisitions deals involved Rs.35,980 Crore. Mergers and acquisitions, the way in which they are
understood in the Western countries, have started taking place in India in the recent years. A number of mega
mergers and hostile takeovers could be witnessed in India now. There are several aspects relating to mergers
and acquisitions that are worthy of study. Some important questions are:
1. What are the basic economic forces that led to mergers and acquisitions? How do these interact with one
another?
2. What are the manager’s true motives for mergers and acquisitions?
3. Why do mergers and acquisitions occur more frequently at sometimes than another times? Which are the
segments of the economy that stand to gain or lose?
4. How could merger and acquisition decisions be evaluated?
5. What managerial process is involved in merger and acquisition decisions?
6. What process is followed in integrating merging and merged firms post-merger?

9.1. CORPORATE RESTRUCTURING

Corporate Restructuring refers to the changes in ownership, business mix, assets mix and alliances with a view
to enhance the shareholder value. Hence, corporate restructuring may involve ownership restructuring, business
restructuring and assets restructuring. A company can affect ownership restructuring through mergers and
acquisitions, leveraged buy-outs, buyback of shares, spin-offs, joint ventures and strategic alliances. Business
restructuring involves the reorganization of business units or divisions. It includes diversification into new
businesses, out-sourcing, divestment, brand acquisitions etc. Asset restructuring involves the acquisition or sale
of asset and their ownership structure. The examples of asset restructuring are sale and lease back of assets,
securitization of debt, receivable factoring, etc.
The basic purpose of corporate restructuring is to enhance the shareholder value. A company should
continuously evaluate its portfolio of businesses, capital mix and ownership and assets arrangements to find
opportunities for increasing the share-holder value. It should focus on assets utilization and profitable
investment opportunities, and recognize or divest less profitable or loss making business/products. The
company can also enhance value through capital restructuring; it can design innovative securities that help to
reduce cost of capital.
Our focus here is no mergers and acquisitions, leveraged buy-outs and divestment. We have discussed many
other aspects of restructuring like buyback of shares, capital structuring etc. earlier in this book.

9.2. TYPE OF BUSINESS COMBINATION

There is a great deal of confusion and disagreement regarding the precise meaning of terms relating to the
business combination viz. merger, acquisition, takeover, amalgamation and consolidation. Sometimes, these
terms are used in broad sense, encompassing most dimensions of business combination, while sometimes they
are defined in a restricted legal sense. We shall define these terms keeping in mind the relevant legal framework
in India.

9.3. MERGER OR AMALGAMATION

A merger is said to occur when two or more companies combine into one company. One or more companies
may merge with an existing company or they may merge to form a new company. In merger, there is complete
amalgamation of the assets and liabilities as well as shareholders’ interests and businesses of the merging
companies. There is yet another mode of merger. Here one company may purchase another company without
giving proportionate ownership to the shareholders’ of the acquired company. Laws in India use the term
amalgamation for merger. For example, Section 21(A) of the Income Tax Act, 1961 defines amalgamation as
the merger of one or more companies (called amalgamating company or companies) with another company
(called amalgamated company) or the merger of two or more companies to form a new company in such a way
that all assets and liabilities of the amalgamating company or companies become shareholders of the
amalgamated company. We shall use the terms merger and amalgamation interchangeably. Merger or
amalgamation may take two forms: Merger through absorption Merger through consolidation

Absorption
Absorption is a combination of two or more companies into an existing company. All companies except one
lose their identity in a merger through absorption.
An example of this type of merger is the absorption of Tata Fertilisers Ltd. (TFL) by Tata Chemicals Ltd.
(TCL), an acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller),
ceased to exist. TFL transferred its assets, liabilities and shares to TCL. Under the scheme of merger, TFL
shareholders were offered 17 shares of TCL (market value per share being Rs.114) for every 100 shares of TFL
held by them.

Consolidation
Consolidation is a combination of two or more companies into new company. In this form of merger, all
companies are legally dissolved and a new entity is created. In a consolidation, the acquired company transfers
its assets, liabilities and shares to the new company for cash or exchange of shares. In a narrow sense, the terms
amalgamation and consolidation are sometime used interchangeably. An example of consolidation is the merger
or amalgamation of Hindustan Computers Ltd., Hindustan Instruments Ltd., Indian Software Company Ltd.,
and Indian Reprographics Ltd. in 1986 to an entirely new company called HCL Ltd.

Acquisition
A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring or
amalgamated company (existing or new) takes over the ownership of other company and combines its
operations with its own operations. Acquisition may be defined as an act of acquiring effective control over
assets or management of a company by another company without any combination of businesses or
companies.

A substantial acquisition occurs when an acquiring firm acquires substantial quantity of shares or voting
rights of the target company. Thus, in an acquisition, two or more companies may remain independent, separate
legal entity, but there may be change in control of companies. An acquirer may be a company or persons acting
in concert that act together for the purpose of substantial acquisition of shares or voting rights or gaining control
over the target company.

Takeover: Generally speaking take over means acquisition. A takeover occurs when the acquiring firm takes
over the control of the target firm. An acquisition or take-over does not necessarily entail full, legal control. A
company can have effective control over another company by holding minority ownership. Under the
Monopolies and Restrictive Trade Practices Act, take over means acquisition of not less than 25 percent of the
voting power in a company. Section 372 of the Companies Act defines the limit of a company’s investment in
the shares of another company. If a company wants to invest in more than 10 percent of the subscribed capital
of another company, it has to be approved in the shareholders general meeting and also by the central
government. The investment in shares of other companies in excess of 10 percent of the subscribed capital can
result into their takeovers.
Takeover vs. acquisition Sometimes, a distinction between takeover and acquisition is made. The term
takeover is understood to connote hostility. When an acquisition is a ‘forced’ or ‘unwilling’ acquisition, it is
called a takeover. In an unwilling acquisition, the management of “target” company would oppose a move of
being taken over. When managements of acquiring and target companies mutually and willingly agree for the
takeover, it is called acquisition or friendly takeover. An example of acquisition is the acquisition of controlling
interest (45 percent shares) of Universal Luggage Manufacturing Company Ltd. by Blow Plast Ltd. Similarly,
Mahindra and Mahindra Ltd., a leading manufacturer of jeeps and tractors acquired a 26 percent equity stake in
Allwyn Nissan Ltd. Yet another example is the acquisition of 28 percent equity of International Data
Management (IDM) by HCL Ltd. In recent years, due to the liberalisation of financial sector as well as opening
up of the economy for foreign investors, a number of hostile take-overs could be witnessed in India. Examples
include takeover of Shaw Wallace, Dunlop, Mather and Platt and Hindustan Dorr Oliver by Chhabrias, Ashok
Leyland by Hindujas and ICICM, Harrison Malayalam and Spencers by Goenkas. Both Hindujas and Chhabrias
are non-resident Indian (NRIs).
Holding Company A company can obtain the status of a holding company by acquiring shares of other
companies. A holding company is a company that holds more than half of the nominal value of the equity
capital of another company, called a subsidiary company, or controls the composition of its Board of Directors.
Both holding and subsidiary companies retain their separate legal entities and maintain their separate books of
accounts. Unlike some countries like USA or UK, India it is not legally required to consolidate accounts of
holding and subsidiary companies.
9.4. FORMS OF MERGER There are three major types of mergers:
Horizontal merger: This is a combination of two or more firms in similar type of production, distribution or
area of business. Examples would be combining of two book publishers or two luggage manufacturing
companies to gain dominant market share.
Vertical merger: This is a combination of two or more firms involved in different stages of production or
distribution. For example, joining of a TV manufacturing (assembling) company and a TV marketing company
or the joining of a spinning company and a weaving company. Vertical merger may take the form of forward or
backward merger. When a company combines with the supplier of material, it is called backward merger and
when it combines with the customer, it is known as forward merger.
Conglomerate merger: This is a combination of firms engaged in unrelated lines of business activity. A
typical example is merging of different businesses like manufacturing of cement products, fertilizers products,
electronic products, insurance investment and advertising agencies. Voltas Ltd. is an example of a
conglomerate company.

9.5. MERGERS AND ACQUISITION TRENDS IN INDIA

Economic reforms and deregulation of the Indian economy has brought in more domestic as well as
international players in Indian industries. This has caused increased competitive pressure leading to structural
changes of Indian industries. M&A is a part of the restructuring strategy of Indian Industries. The first M&A
wave in India took place towards the end of 1990s. The data presented in the Table 9.1 reveal that substantial
growth in the M&A activities in India occurred in 2000-01. The total number of M&A deals in 2000-01 was
estimated at 1,177 which is 54 percent higher than the total number of deals in the previous year. The amount
involved in deals has shown variation; after falling to Rs.23106 Crore in 2002-03 the amount increased to
Rs.35,980 Crore in 2003-04.
The total number of mergers in 2003-04 was 284 down from 381 mergers in the previous period. From data in
Table 9.2, it appears that mergers account for around one third of total M&A deals in India. It implies that
takeovers or acquisitions are the dominant feature of M&A activity in India, similar to the trend in most of the
developed countries. Along with the rise in M&A, there has also an increase in the number of open offers,
albeit at a lower place. The number of open offers rose to 109 in 2002-03 from 58 in 1998-99. In 2003-04, 72
open offers involved Rs.1,122 crore – much less than as compared to the previous year.

9.6. MOTIVES AND BENEFITS OF MERGERS AND ACQUISITIONS

Why do mergers take place? It is believed that mergers and acquisitions are strategic decisions leading to
maximisation of a company’s growth by enhancing its production and marketing operations. They have become
popular in the recent times because of the enhanced competition, breaking of trade barriers, free flow of capital
across countries are being deregulated and integrated with other economies. A number of reasons are attributed
for the occurrence of mergers and acquisitions. For example, it is suggested that mergers and acquisition are
intended to:
Limit competition
Utilise under-utilised market power
Overcome the problem of slow growth and profitability in one’s own industry.
Achieve diversification
Gain economies of scale and increase income with proportionately less investment.
Establish a transnational bridgehead without excessive start-up costs to gain access to a foreign market.
Utilise under-utilised resources-human and physical and managerial skills
Displace existing management
Circumvent government regulations
Reap speculative gains attendant upon new security issue or change in P/E ratio.
Create an image of aggressiveness and strategic opportunism, empire building and to amass vast economic
power of the company.
Are there are real benefits merger? A number of benefits of mergers are claimed. All of them are not real
benefits. Based on the empirical evidence and the experiences of certain companies, the most common motives
and advantages of mergers and acquisitions are explained below:
Maintaining or accelerating a company’s growth, particularly when the internal growth is constrained due to
paucity of resources;
Enhancing profitability, through cost reduction resulting from economies of scale, operating efficiency and
synergy;
 Diversifying the risk of the company, particularly when it acquires those businesses whose income streams
are not correlated.
Reducing tax liability because of the provision of setting-off accumulated losses and unabsorbed depreciation
of one company against the profits of another;
Limiting the severity of competition by increasing the company’s market power.

9.7. FINANCING A MERGER

Cash or exchange of shares or a combination of cash, shares and debt can finance a merger or an acquisition.
This means of financing may change the debt-equity mix of the combined or the acquiring firm after the
merger. When a large merger takes place, the desired capital structure is difficult to be maintained, and it makes
the calculation of the cost of capital a formidable task. Thus, the choice of the means of financing a merger may
be influenced by its impact on the acquiring firm’s capital structure. The other important factors are the
financial condition and liquidity position of the acquiring firm, the capital market conditions, the availability of
long-term debt etc.

9.7.1 Cash Offer

A cash offer is a straightforward means of financing a merger. It does not cause any dilution in the earnings per
share and the ownership of the existing shareholders of the acquiring company. It is also unlikely to cause wide
fluctuations in the share prices of the merging companies. The shareholders of the target company get cash for
selling their shares to the acquiring company. This may involve tax liability for them. The management of
sangam fertilizers company (SFC) is concerned about the fluctuating sales and earnings. The variability of the
company’s earnings has caused its P/E at about 22 to be much lower than the industry average of about 45.
Currently SFC’s share is selling for Rs.57.60 in the market. To boost its sales and bring stability to its earnings,
SFC’s management has identified Excel Chemical Company as a possible target for acquisition. Excel is known
for its quality of products and national-wide markets. The company has not been performing well in the recent
past due to poor management. Its sales have grown at 4 percent per year. The current price of Excel’s share is
Rs. 24.90. Let us assume that SFC decided to offer a price of Rs.42.40 per share to acquire Excel’s shares. If
SFC wants to pay cash for the shares, it would need Rs.1,060 crore in cash. It can borrow funds as well as use
its tradable (temporary) investment and surplus cash for acquiring Excel. SFC’s current debt is Rs.2,170 crore,
which is 50 percent of its book value equity. After merger, the combined firm’s debt would be Rs.2,465 crore
(Rs.2,170 crore of SFC and Rs.295 Crore of Excel). The debt capacity of the combined firm would depend on
its target debt-equity ratio. Assuming that it is 1:1, then it can have a total debt of Rs.4,330 crore (i.e. equal to
the combined firm’s equity, which is pre merger equity of SFC). Thus, unutilised debt capacity is Rs.1,865
Crore (i.e. Rs.4330 Crore minus the combined debt of SFC and Excel, Rs.2465 crore). Further, both companies
have marketable investments of Rs.52 crore, which may also be available for acquisition. Given SFC has
unutilised debt capacity (Rs.1865 crore), it can borrow Rs.1060 crore to acquire excel.

9.7.2 Share Exchange

A share exchange offer will result into the sharing of ownership of the acquiring company between its existing
shareholders and new shareholders (that is, shareholders of the acquired company). The earnings and benefits
would also be shared between these two groups of shareholders. The precise extent of net benefits that accrue to
each group depends on the exchange ratio in terms of the market prices of the shares, the receiving shareholders
would not pay capital gains tax when they sell their shares after holding them for the required period. SFC,
instead of paying cash, could acquire Excel through the exchange of shares. For simplicity, let us assume that
SFC’s share price is fairly valued in the market. If the company feels that its shares are either under-valued or
over-valued in the market, it can follow a similar procedure as in the case of Excel to calculate the value of its
shares. SFC’s current price per share is Rs.57.80 and it has 157.50 crore outstanding shares. At its current share
price, the company must exchange: Rs.1,060 crore / Rs.57.80 = 18.34 crore shares to pay Rs.1060 crore to
excel. After acquisition, SFC would hold about 10.4 percent of shares (i.e. 18.34/175.84). Excel’s shares are
valued at Rs.1060 crore and the value of SFC’s shares at the current market price is Rs.9104 crore (157.5 crore
x 57.80). Thus, the post-merger value of the combined firm is Rs.10,164 crore and per share value is
Rs.10,164/175.84 = Rs.57.80. Thus there is no loss, no gain to SFC’s shareholders. SFC would be offering
18.34 shares for 25 crore outstanding shares of Excel, which means 0.734 shares of SFC for one share of Excel
or a swap ratio of 0.734:1. The book value of SFC’s share in 2004 is Rs.27.49 while that of Excel is Rs.29.20.
Thus, SFC alternatively could offer 0.94 shares for each outstanding share of Excel without diluting its
present book value. Since it is exchanging only 0.734 shares, its book value of equity should increase.
Impact on Earnings per share Would SFC’s EPS be diluted if it exchanged 18.34 crore shares to Excel? Or,
what is the maximum number of shares, which SFC could exchange without diluting it EPS? Let us assume the
earnings of both firms at 2004 level. We can calculate the maximum number of SFC’s shares to be exchanged
for Excel’s shares without diluting the former company’s EPS after merger as shown in Table 9.3. We can also
directly calculate the maximum number of shares as follows:
Maximum number of share to be exchanged without EPS dilution = Acquiring firm’s post-merger earnings -
Acquiring firm’s Acquiring firm’s pre-merger shares Pre-merger EPS

9.8. TENDER OFFER AND HOSTILE TAKE OVER

A tender offer is a formal offer to purchase a given number of a company’s shares at a specific price. The
acquiring company asks the shareholders of the target company to “tender” their shares in exchange for a
specific price. The price is generally quoted at a premium in order to induce the shareholders too tender their
shares. Tender offer can be used in two situations. First, the acquiring company may directly approach the
shareholders by means of a tender offer. Second, the tender offer may be used without any negotiations, and it
may be tantamount to a hostile takeover. The shareholders are generally approached through announcement in
the financial press or through direct communication individually. They may or may not react to a tender offer.
Their reaction exclusively depends upon their attitude and sentiment and the difference between the market
price and the offered price. The tender offer may or may not be acceptable to the management of the target
company. In USA, the tender offers have been used for a number of years. In India, one may see only one or
two instances of tender offer in the recent years. In September 1989, Tata Tea Ltd. (TTL), the largest integrated
tea company in India, made an open offer for controlling interest to the shareholders of the Consolidated Coffee
Ltd. (CCL). TTL’s Chairman, Darbari Seth, offered one share in TTL and Rs.100 in cash (which is equivalent
to Rs.140) for a CCL share that was then quoting at Rs.88 on the Madras Stock Exchange. TTL’s decision is
not only novel in the India corporate sector but also a trendsetter. TTL had notified in the financial press about
its intention to buyout some tea estates and solicited offers from the shareholders concerned. The management
of the target company generally do not approve of tender offers. The major reason is the fear of being replaced.
The acquiring company’s plans may not be compatible with the best interests of the shareholders of the target
company. The management of the target company can try to convince its shareholders that they should not
tender their shares since the offer value is not enough in the light of the real value of shares, i.e., the offer is too
low comparative to its real value. The management may use techniques to dissuade its shareholders from
accepting tender offer. For example, it may lure them by announcing higher dividends. If this helps to raise the
share price due to psychological impact or information content, then the shareholders may not consider the
offer price tempting enough. The company may issue bonus shares and/or rights shares and make it difficult for
the acquirer to acquire controlling shares.
The target company may also launch a counter-publicity programme by informing that the tender is not in the
interest of the shareholders. If the shareholders are convinced, then the tender offer may fail. The target
company can follow delay tactics and try to get help from the regulatory authorities such as the Securities and
Exchange Board of India (SEBI), or the Stock Exchanges of India.

9.9. DEFENSIVE TACTICS

A target company in practice adopts a number of tactics to defend itself from hostile takeover through a tender
offer. These tactics include a divestiture or spin-off, poison pill, greenmail, white knight, crown jewels, golden
parachutes, etc.
Divestiture In a divestiture the target company divests or spins off some of its businesses in the form of an
independent, subsidiary company. Thus, it reduces the attractiveness of the existing business to the acquirer.
Crown jewels: When a target company uses the tactic of divestiture it is said to sell the crown jewels. In
some countries such as UK, such tactic is not allowed once the deal becomes known and is unavoidable.
Poison Pill An acquiring company itself could become a target when it is bidding for another company. The
tactics used by the acquiring company to make itself unattractive to a potential bidder is called poison pills. For
example, the acquiring company may issue substantial amount of convertible debentures to its existing
shareholders to be converted at a future date when it faces a takeover threat. The task of the bidder would
become difficult since the number of shares to have voting control of the company will increase substantially.
Greenmail: Greenmail refers to an incentive offered by management of the target company to the potential
bidder for not pursuing the takeover. The management of the target company may offer the acquirer for its
shares a price higher than the market price.
 White knight: A target company is said to use a white knight when its management offers to be acquired by
a friendly company to escape from a hostile takeover. The possible motive for the management of the target
company to do so is not to lose the management of the company. The hostile acquirer may replace the
management.
Golden parachutes: When a company offers hefty compensations to its mergers if they get ousted due to
takeover, the company is said to offer golden purchases. This reduces their resistance to takeover.

9.10. CORPORATE STRATEGY AND ACQUISITIONS

In our earlier discussion, we made distinctions between merger and acquisition or takeover. However, they
generally involve similar analyses and evaluations. A merger or acquisition might be considered successful if it
increases the shareholder value. Though it is quite difficult to say how the firm would have performed without
merger or acquisition, but the post-merger poor performance would be attributed as a failure of merger or
acquisition.
What are the chances that mergers or acquisitions would succeed? Empirical evidence shows that there is more
than fifty percent chance that they would succeed. There are several reasons responsible for the failure of a
merger or acquisition. They include:
Excessive premium An acquirer may pay high premium for acquiring its target company. The value paid
may far exceed the benefits. This happens when acquirer becomes too eager to acquire the target for prestige or
increasing the size of its empire.
Faulty evaluation At times acquirers do not carry out the detailed diligence of the target company. They
make a wrong assessment of the benefits from the acquisition and land up paying a higher price.
Lack of research Acquisition requires gathering a lot of data and information and analyzing it. It requires
extensive research. A shoddily carried out research about the acquisition causes the destruction of the acquirer’s
wealth.
Failure to manage post-merger integration Many times acquirers are unable to integrate the acquired
companies in their businesses. They overlook the organisational and cultural issues. They do not have adequate
understanding of the culture of the acquired companies which creates problem of integration and synergy.
To avoid these problems the acquiring company needs to have an acquisition and merger strategy. All
acquisitions must be seen as strategic. The acquisition should be well planned; target companies should be
carefully selected after adequate screening. The acquiring company must understand the organisational climate
and culture of the target company while performing the due diligence. There are four important steps involved
in a decision regarding merger or acquisition Planning Search and Screening Financial evaluation
Integration

9.11.1 Planning
A merger or acquisition should be seen in the over-all strategic perspective of the acquiring company. It should
fit with the strategy and must contribute in the growth of the company and in creating value for shareholders
and other stakeholders. The acquiring company must assess its strengths and weaknesses and likely
opportunities arising from the acquisitions in order to identify the target companies. The acquiring firm should
review its objective of acquisition in the context of its strengths and weaknesses, and corporate goals. This will
help in indicating the product-market strategies that are appropriate for the company. It will also force the firm
to identify business units that should be dropped and those that should be added or strengthened. The following
two steps are involved in the planning process:
Acquisition strategy: The Company should have a well articulated acquisition strategy. It should be growth-
oriented. It should spell out the objectives of acquisition and other growth options. The acquisition strategy
should be formulated after an assessment of the company’s own strengths and weaknesses.
Assessment approaches and criteria: The Company should spell out its approach to acquisitions and the
criteria to be applied to acquisitions. The planning of acquisition will require the analysis of industry-specific
and the firm specific information. The acquiring firm will need industry data on market growth, nature of
competition, ease of entry, capital and labour intensity, degree of regulation etc. About the target firm the
information needed will include the quality of management, market share, size, capital structure, profitability,
production and marketing capabilities etc.

9.11.2. Search and Screening

Search focuses on how and where to look for suitable candidates for acquisition. Screening process shortlists a
few candidates from many available.
Detailed information about each of these candidates is obtained. Merger objectives would be the basis for
search and screening. The objectives may include the attaining faster growth, improving profitability,
improving managerial effectiveness, gaining market power and leadership, achieving cost reduction etc. These
objectives can be achieved in various ways rather than through mergers alone. The alternatives to merger
include joint ventures, strategic alliances, elimination of inefficient operations, cost reduction and productivity
improvement, hiring capable managers etc. If merger is considered as the best alternative, the acquiring firm
must satisfy itself that it is the best available option in terms of its own screening criteria and economically
most attractive.
9.11.3 Financial Evaluation
Financial evaluation is the most important part of due diligence. Due diligence would also include evaluation of
the target company’s organisational climate and culture, competencies and skills of employees etc. Financial
evaluation of a merger is needed to determine the earnings and cash flows, areas of risk, the maximum price
payable to the target company and the best way to finance the merger. The acquiring firm must pay a fair
consideration to the target firm for acquiring its business. In a competitive market situation with capital market
efficiency, the current market value is the correct and fair value of the share of the target firm. The target firm
will not accept any offer below the current market value of its share. The target firm may, in fact, expect the
offer price to be more than the current market value of its share since it may expect that merger benefits will
accrue to the acquiring firm. A merger is said to be at a premium when the offer price is higher than the target
firm’s pre-merger market value. The acquiring firm may pay the premium if it thinks that it can increase the
target firm’s profits after merger by improving its operations and due to synergy. It may have to pay premium
as an incentive to the target firm’s shareholders to induce them to sell their shares so that the acquiring firm is
enabled to obtain the control of the target firm.
9.11.4 Integration
The most difficult part of the merger or acquisition is the integration of the acquired company into the acquiring
company. In the case of a hostile takeover, the acquiring company may get disappointed to find the inferior
quality of the acquired firm’s assets and employees. The difficulty of integration also depends on the degree of
control desired by the acquirer. The acquirer may simply desire financial consolidation leaving the entire
management to the existing managers. On the other hand, if the intention is total integration of manufacturing,
marketing, finance, personnel etc. integration becomes quite complex. A horizontal merger or acquisition
requires a detailed planning for integration.
Integration plan After the merger or acquisition, the acquiring company should prepare a detailed strategic
plan for integration based on its own and the acquired company’s strengths and weaknesses. The plan should
highlight the objectives and the process of integration.
Communication The integration plan should be communicated to all employees. The management should
also inform the employees about their involvement in making the integration smooth and easy and remove any
ambiguity and fears in the minds of the staff.
Authority and responsibility The first step that the acquiring company should take is to take all employees
into confidence and decide the authority and responsibility relationships. The detailed organisational structure
can be decided upon later on. This is essential to avoid any confusion and indecisiveness.
Cultural integration People management is the most critical step in integration. A number of mergers and
acquisitions fail because of the failure of management to integrate people from two different organisations.
Management should focus the culture integration of the employees. A proper understanding the cultures of two
organisations, clear communication and training can help to bridge the cultural gaps.
Skill and Competencies up-gradation If there is difference in the skills and competencies of employees of
the merging companies, management should prepare a plan for skill and competencies up-gradation through
training and implement it immediately. To make an assessment of the gaps in the skills and competencies, the
acquiring company can conduct a survey of employees.
Structural adjustments After receiving the cultural integration and skills up gradation, management may
design the new organization structure and redefine the roles, authorities and responsibilities. Management
should be prepared to make adjustments to accommodate the aspirations of the employees of the acquired
company.
Control systems Management must ensure that it is in control of all resources and activities of the merged
firms. It must put proper financial control in place so that resources are optimally utilized and wastage is
avoided.
Peter Drucker provides the following five rules for the integration process:
Ensure that the acquired firm has a “common core of unity” with the parent. They should have overlapping
characteristics like shared technology or markets to exploit synergies.
The acquirer should think through what potential skill contribution it can make the acquiree.
The acquirer must respect the products, markets and customers of the acquired firm.
The acquirer should provide appropriately skilled top management for the acquiree within a year.
The acquirer should make several cross-company promotions within a year.
Post-merger Integration: Integrating VSNL with Tata Group
Tata Group acquired VSNL in February 2002. Tata Group is the most respected group of companies in private
sector. VSNL is a public sector company. These two companies belonged to two different environments,
systems and culture. Both had committed people but with capabilities and expectations. Hence the task of
integration was quite difficult and demanding. Tata Group’s primary focus to protect its ‘market position in the
ILD business, get the national long-distance business launched as soon as possible, and work on making the
operations of the company more market/customer focussed and efficient’. The integration process involved the
following steps:
The Tata Group constituted multiple task forces for the purpose of prioritising tasks and achieving the
objectives.
The Group simultaneously focused on the integration of operations, processes and technology and people.
The people issue was considered as important as the integration of operations, processes and technology.
A special programme called ‘Confluence’ was conducted for the senior management team from VSNL. They
were informed about Tata Group’s the mission, value systems and practices. Similar programmes were
organised for more than 500 employees.
A people driven organisational restructuring was undertaken at headquarters simultaneously as the
employees were being trained. Employees from different backgrounds, disciplines and levels discussed about
the organisational roles, structure and responsibility relationship. After the headquarters, the focus was to the
regional and branch offices for the similar initiatives.
Several new functions were created. Weak were strengthened and supplemented by sales and marketing
people brought in from other Tata Group Companies. These areas included carrier relations to work with
domestic and international telecom carriers, OSP or outside plant to implement the countrywide fibre optic
backbone for NLD, and customer services.
The employees were trained to take up the new roles and challenges, and to strengthen their marketing skills
to focus on customer. Training programmes were organised on functional areas.
A management development programme was conducting focusing on critical commercial skills like business
management, people and performance management, negotiating skills, and planning and budgeting skills. A
key part of this exercise was that Tata Group executives, who are operating managers, were invited to share
their experiences as managers with the VSNL teams.
Information about initiatives or changes was communicated through new processes. The house magazine
Patrika was supplemented with a monthly wallpaper called VSNL Buzz, which shared information about
important developments within the company – new customer wins, major milestones achieved, new technical
and product developments etc. – to make the employee feel proud to be part of the VSNL and Tata family.
Periodic briefing sessions, at which members of the management spoke on the recent performance and
achievements in the company, were also started.
The existing processes could not give the company the competitive edge in the marketplace. Hence, VSNL is
restructuring a few of internal processes, ranging from product development to service delivery. It has also
begun leveraging the experience and processes available in the Tata Group telecom companies in marketing,
customer acquisition and customer services. Many of these are applicable to VSNL, though with fine-tuning to
meet specific requirements.
The first areas to be re-engineered will be those that impact the customer. A structure is planned that is
aligned with the industry best practices in customer care.
Customer service is being broken down into four functions. The first is the customer access point, the call
centre or the public office. The second is the backend that handles the issues, queries or complaints received by
the front office. The third function is credit and collection; the fourth is that of order management. Mr. Srinath,
Director (Operations), VSNL says: “We realise that our most valuable asset, across all our businesses, is
people.
They are the respiratory of business experience and culture and the outward face of the company to the client.
This combination of structures skills and processes, supported by the right tools, should provide our employees
a healthy work environment to enable them to reach their full potential, while facilitating the company’s
drive to achieve all its objectives in the marketplace”.
9.12. ACCOUNTING FOR MERGERS AND ACQUISITIONS
Mergers and acquisitions involve complex accounting treatment. A merger, defined as amalgamation in India,
involves the absorption of the target company by the acquiring company, which results in the uniting of the
interests of the two companies. The merger should be structured as pooling of interest. In the case of
acquisition, where the acquiring company purchases the shares of the target company, the acquisition should be
structured as a purchase.
9.12.1 Pooling of Interests Method
In the pooling of interests method of accounting, the balance sheet items and the profit and loss items of the
merged firms are combined without recording the effects of merger. This implies that asset, liabilities and other
items of the acquiring and the acquired firms are simply added at the book values without making any
adjustments. Thus, there is no revaluation of assets or creation of goodwill. Thus, there is no revaluation of
assets or creation of goodwill.
9.12.2 Purchase Method
Under the purchase method, the assets and liabilities of the acquiring firm after the acquisition of the target may
be updated at their exiting carrying amounts or at the amounts adjusted for the purchase price paid to the target
company. The assets and liabilities after merger are generally revalued under the purchase method. If the
acquirer pays a price greater than the fair market value of assets and liabilities, the excess amount is shown as
goodwill in the acquiring company’s books. On the contrary, if the fair value of assets and liabilities is less than
the purchase price paid, then this difference is recorded as capital reserve.
9.12.3 Leveraged Buy-Outs
A leveraged buy-out (LBO) is an acquisition of a company in which the acquisition is substantially financed
through debt. When the managers buy their company from its owners employing debt, the leveraged buy-out is
called management buy-out (MBO). Debt typically forms 90-70 percent of the purchase price and it may have a
low credit rating. In USA, the LBO shares are not bought and sold in the stock market and the equity is
concentrated in the hands of a few investors. Debt is obtained on the basis of the company’s future earnings
potential. LBOs generally involve payment by cash to the seller. LBOs are very popular in USA. It has been
found there that in LBOs, the sellers require very high premium, ranging from 50 to 100 percent. The main
motivation in LBOs is to increase wealth rapidly in a short span of time. A buyer would typically go public
after four or five years, and make substantial capital gains.
9.12.3.1 LBO Targets
Which companies are targets for the leveraged buy-outs? The following firms are generally the target for LBOs:
High growth, high market share firms
High profit potential firms
High liquidity and high debt capacity firms
Low operating risk firms
In LBOs, a buyer generally looks for a company that is operating in a high growth market with a high market
share. It should have a potential to grow fast, and be capable to earning superior profits. The demand for the
company’s product should be known so that its earnings can be easily forecasted. A typical company for a
leveraged buy-out would be one that has high profit potential, high liquidity and low or no debt. Low operating
risk of such companies allows the acquiring firm or the management team to assume a high degree of financial
leverage and risk.
9.12.3.2 Risk and Rewards
Why is a lender prepared to assume high risk in a leveraged buy-out? A lender provides high leverage in a
leveraged buy-out because he may have full confidence in the abilities of the managers-buyers to fully utilise
the potential of the business and convert it into enormous value. His perceived risk is low because of the
soundness of the company and its assumed, predictable performance.
He would also guard himself against loss by taking ownership position in the future and retaining the right to
change the ownership of the buyers if they fail to manage the company. The lender also expects a high return
on his investment in a leveraged buy-out since the risk is high. He may, therefore, stipulate that the acquired
company will go public after four or five years. A major portion of his return comes from capital gains. MBOs /
LBOs can create a conflict between the (acquiring) manages and shareholders of the firm. The shareholders’
benefits will reduce if the deal is very attractive for the managers. This gives rise to agency costs. It is the
responsibility of the board to protect the interests of the shareholders, and ensure that the deal offers a fair value
of their shares. Another problem of LBOs could be the fall in the price of the LBO target company’s debt
instruments (bonds/debentures). This implies a transfer of wealth from debenture holders to share holders since
their claim gets diluted. Debenture holders may, thus, demand a protection in the event of a LBO / MBO.
They may insist for the redemption of their claims at par if the ownership/control of the firm changes.
9.13. DIVESTMENT
A divestment involves the sale of a company’s assets, or product lines, or divisions or brand to the outsiders. It
is reverse of acquisition. Companies use divestment as a means of restructuring and consolidating their
businesses for creating more value for shareholders. It sells the part of business for a higher price than its
current worth. The remaining business might also find it true value. Thus divestment creates reverse synergy.
The following are some of the common motives for divestment:
Strategic change Due to the economic and competitive changes, a company may change its product-market
strategy. It might like to concentrate its energy to certain types of businesses where it has competencies and
competitive advantage. Hence it may sell businesses that more fit with the new strategy.
Selling cash rows Some of the company’s businesses might have reached saturation. The company might
sell these businesses which are now ‘cash cows’. It might realise high cash flows that it can invest in ‘stars’ that
have high growth potential in future.
Disposal of unprofitable businesses Unprofitable businesses are a drain on the company’s resources. The
company would be better of discarding such businesses.
Consolidation A company might have become highly diversified due to unplanned acquisitions in the past.
It might sell its unrelated businesses, and consolidate its remaining businesses as a balanced portfolio.
Unlocking value Sometimes stock market is not able to value a diversified company properly since it does
not have full disclosure of information for the businesses separately. Once the businesses are separated, the
stock market correct values the businesses.
Sell-off There are two types of divestment: sell-off and spin-off. When a company sells part of its business to a
third party, it is called sell-off. It is a usual practice of a large number of companies to sell-off is to divest
unprofitable or less profitable businesses to avoid further drain on its resources. Sometimes the company might
sell its profitable, but non-core businesses to ease its liquidity problems.
Spin-offs
When a company creates a new from the existing single entity, it is called spin-off. The spin-off company
would usually be created as a subsidiary. Hence, there is no change in ownership. After the spin-off,
shareholders hold shares in two different companies. Spin-off may have the following advantages:
1. When the businesses are legally and physically separated, shareholders would have information about
separate businesses. They would be able to value separate businesses more easily. Management would now
know which business is a poor performing business. Quick managerial action could be initiated to improve the
performance.
2. There may be improvement in the operating efficiency of the separate businesses as they would receive
concentrated attention of the respective managements.
3. Spin-offs could reduce the attractiveness for acquisition when the new company is clearly and under
performer. As a part of a single entry, it might be obvious that the business unit is an under-performer.
4. Spin-off (and sell-off as well) makes it possible for companies to allocate their resources to growth
opportunities that have the potential of creating high values for shareholders in the future.
9.14. REGULATIONS OF MERGERS AND TAKEOVERS IN INDIA
Mergers and acquisitions may degenerate into the exploitation of shareholders, particularly minority
shareholders. They may also stifle competition and encourage monopoly and monopolistic corporate behaviour.
Therefore, most countries have legal framework to regulate the merger and acquisition activities. In India,
mergers and acquisitions are regulated through the provision of the Companies Act, 1956, the Monopolies and
Restrictive Trade Practice (MRTP) Act, 1969, the Foreign Exchange Regulation Act (FERA), 1973, the
Income Tax Act, 1961, and the Securities and Controls (Regulations) Act, 1956. The Securities and Exchange
Board of India (SEBI) has issued guidelines to regulate mergers, acquisitions and takeovers.
9.14.1 Legal Measures against Takeovers
The companies act restricts an individual or a company or a group of individuals from acquiring shares together
with the shares held earlier, in a public company to 25 percent of the total paid-up capital. Also, the Central
Government needs to be intimated whenever such holding exceeds 10 percent of the subscribed capital. The
companies act also provides for the approval of shareholders and the Central Government when a company, by
itself or in association of an individual or individuals purchases shares of another company in excess of its
specified limit. The approval of the Central Government is necessary if such investment exceeds 10 percent of
the subscribed capital of another company. These are precautionary measures against the takeover of the public
limited companies.
9.14.2 Refusal to Register the Transfer of Shares
In order to defuse situation of hostile takeover attempts, companies have been given power to refuse to register
the transfer of shares. If this is done, a company must inform the transferee and the transferor within 60 days. A
refusal to register transfer is permitted if:
a legal requirement relating to the transfer of shares have not be complied with or
the transfer is in contravention of the law; or
the transfer is prohibited by a court order or
The transfer is not in the interests of the company and the public.
9.14.3 Protection of Minority Shareholders’ Interests
In a takeover bid, the interests of all shareholders should be protected without a prejudice to genuine takeovers.
It would be unfair if the same high price is not offered to all the shareholders of prospective acquired company.
The large shareholders (including financial institutions, banks and individuals) may get most of the benefits
because of their accessibility to the brokers and the takeover dealmakers. Before the small shareholders know
about the proposal, it may too late for them. The Companies Act provides that a purchaser can force the
minority shareholder to sell their shares if:
the offer has been made to the shareholders of the company;
the offer has been approved by at least 90 percent of the shareholders of the company whose transfer is
involved, within 4 months of making the offer; and
the minority shareholders have been intimated within 2 months from the expiry of 4 months referred above.
If the purchaser is already in possession of more than 90 percent of the aggregate value of all the shares of the
company, the transfer of the shares of minority shareholders is possible if:
the purchaser offers the same terms to all shareholders and
The tenders who approve the transfer, besides holding at least 90 percent of the value of shares, should also
form at least 75 percent of the total holders of shares.
9.15. SEBI GUIDELINES OF TAKEOVERS
The salient features of some of the important guidelines as follows:
Disclosure of share acquisition / holding Any person who acquires 5% or 10% or 14% shares or voting rights
of the target company should disclose of his holdings at every stage to the target company and the stock
exchanges within 2 days of acquisition or receipt of intimation of allotment of shares. Any person who holds
more than 15% but less than 75% shares or voting rights of target company, and who purchases or sells shares
aggregating to 2% or more shall within 2 days disclose such purchase or sale along with the aggregate of his
shareholding to the target company and the stock exchanges. Any person who holds more than 15% shares or
voting rights of target company and a promoter and person having control over the target company, shall within
21 days from the financial year ending March 31 as well as the record date fixed for the purpose of dividend
declaration, disclose every year his aggregate shareholding to the target company.
Public announcement and open offer An acquirer who intends to acquire shares which along with his existing
shareholding would entitle him to exercise 15% or more voting rights, can acquire such additional shares only
after making a public announcement to acquire atleast additional 20% of the voting capital of target company
from the shareholders through an open offer.
An acquirer who holds 15% or more but less than 75% of shares or voting rights of a target company, can
acquire such additional shares as would entitle him to exercise more than 5% of the voting rights in any
financial year ending March 31 only after making a public announcement to acquire at least additional 20%
shares of target company from the shareholders through an open offer.
An acquirer, who holds 75% shares or voting rights of a target company, can acquire further shares or voting
rights only after making a public announcement to acquire atleast additional 20% shares of a target company
from the shareholders through an open offer.
Offer price The acquirer is required to ensure that all the relevant parameters are taken into consideration while
determining the offer price and that justification for the same is disclosed in the letter of offer. The relevant
parameters are: Negotiated price under the agreement which triggered the open offer.
price paid by the acquirer for acquisition, if any, including by way of allotment in a public or rights or
preferential issue during the twenty six week period prior to the date of public announcement, whichever is
higher; the average of the weekly high and low of the closing prices of the shares of the target company as
quoted on the stock exchange where the shares of the company are most frequently traded during the twenty six
weeks or the average of the daily high and low prices of the shares as quoted on the stock exchange where the
shares of the company are most frequently traded during the two weeks preceding the date of public
announcement, whichever is higher.
In case the shares of Target Company are not frequently traded then parameters based on the fundamentals of
the company such as return of net worth of the company, book value per share, EPS etc. are required to be
considered and disclosed.
Disclosure The offer should disclose the detailed terms of the offer, identity of the offerer, details of the offer’s
existing holdings in the offeree company etc. and the information should be available to all shareholders at the
same time and in the same manner.
Offer document The offer document should contain the offer’s financial information, its intention to continue
the offeree company’s business and to make major change and long term commercial justification for the offer.
The objectives of the Companies Act and the guidelines for takeover are to ensure full disclosure about the
mergers and takeovers and to protect the interests of the shareholders, particularly the small shareholders. The
main thrust is that public authorities should be notified within two days. In a nutshell, an individual or company
can continue to purchase the shares without making an offer to other shareholders until the shareholding
exceeds 10 percent. Once the offer is made to other shareholders, the offer price should not be less than the
weekly average price in the past 6 months or the negotiated price.
9.16. LEGAL PROCEDURES
The following is the summary of legal procedures for merger or acquisition laid down in the companies act,
1956.
Permission for merger Two or more companies can amalgamate only when amalgamation is permitted
under their memorandum of association. Also, the acquiring company should have the permission in its object
clause to carry on the business of the acquired company. In the absence of these provisions in the memorandum
of association, it is necessary to seek the permission of the shareholders, board of directors and the Company
Law Board before affecting the merger.
Information to the stock exchange The acquiring and the acquired companies should inform the stock
exchanges where they are listed about the merger.
Approval of board of directors The boards of directors of the individual companies should approve the
draft proposal for amalgamation and authorize the managements of companies to further pursue the proposal.
Application in the High Court An application for approving the draft amalgamation proposal duly
approved by the boards of directors of the individual companies should be made to the High Court. The High
Court would convene a meeting of the shareholders and Creditors to approve the amalgamation proposal. The
notice of meeting should be sent to them atleast 21 days in advance.
Shareholders’ and creditors’ meetings The individual companies should hold separate meetings of their
shareholders and creditors for approving the amalgamation scheme. Atleast 75 percent of share holders and
creditors in separate meeting, voting in person or by proxy, must accord their approval to the scheme.
Sanction by the High Court After the approval of shareholders and creditors, on the petitions of the
companies, the High Court will pass order sanctioning the amalgamation scheme after it is satisfied that the
scheme is fair and reasonable. If it deems so, it can modify the scheme. The date of the court’s hearing will be
published in two newspapers, and also, the Regional Director of the company Law Board will be intimated.
Filing of the court order After the court order, it is certified true copies will be filed with the Registrar of
Companies.
Transfer of assets and liabilities The assets and liabilities of the acquired company will be transferred to the
acquiring company in accordance with the approved scheme, with effect from the specified date.
Payment by cash or securities As per the proposal, the acquiring company will exchange shares and
debentures and/or pay cash for the shares and debentures of the acquired company. These securities will be
listed on the stock exchange.
9.17. ACQUISITION AS A CAPITAL BUDGETING DECISION
In case of a merger situation, it is implied that the acquirer firm is ready to pay the price (in cash or in terms of
shares because it is expecting inflows in terms of sale of assets or in terms of operating cash flows for a number
of years. These inflows and outflows (all in PV terms) can be compared to find out the NPV of the proposal.
 UNIT IV FINANCING DECISIONS

Capital Structure – Capital structure theories – Capital structure planning in Practice.

10 CAPITAL STRUCTURE THEORIES

Given the objective of the firm to maximise the value of the equity shares, the firm should select a financing-
mix/capital structure/financial leverage which will help in achieving the objective of financial management. As
a corollary, the capital structure should be examined from the viewpoint of its impact on the value of the firm. It
can be ultimately expected that if the capital structure decision affects the total value of the firm, a firm should
select such a shareholder’s financing-mix as will maximise the shareholders’ wealth. Such a capital structure is
referred to as the optimum capital structure. The optimum capital structure may be defined as the capital
structure or combination of debt and equity that leads to the maximum value of the firm. The importance of an
appropriate capital structure is, thus, obvious. There is a viewpoint that strongly supports the close relationship
between leverage and value of a firm. There is an equally strong body of opinion which believes that financing
mix or the combination of debt and equity has no impact on the shareholders’ wealth and the decision on
financial structure is irrelevant. In other words, there is nothing such as optimum capital structure.
In theory, capital structure can affect the value of a company by affecting either its expected earnings or the
cost of capital, or both. While it is true that financing-mix cannot affect the total operating earnings of a firm, as
they are determined by the investment decisions, it can affect the share of earnings belonging to the ordinary
shareholders. The capital structure decision can influence the value of the firm through the earnings available
to the shareholders. But the leverage can largely influence the value of the firm through the cost of capital. In
exploring the relationship between leverage and value of a firm in this chapter we are concerned with the
relationship between leverage and cost of capital from the standpoint of valuation. While section one deals with
the assumptions, definition and symbols relating to capital structure theories, the next four Sections of the this
chapter explain the major capital structure theories, namely: (i) Net Income Approach, (ii) Net Operating
Income Approach, (iii) Modigliani-Miller (MM) Approach, and (iv) Traditional Approach. The last Section
summarises the main points.

10.1. CAPITAL STRUCTURE THEORIES

Assumptions
1. There are only two sources of funds used by a firm: perpetual riskless debt and ordinary shares.
2. There are no corporate taxes. This assumption is removed later.
3. The dividend-payout ratio is 100. That is, the total earnings are paid out as dividend to the shareholders and
there are no retained earnings.
4. The total assets are given and do not change. The investment decisions are, in other words, assumed to be
constant.
5. The total financing remains constant. The firm can change its degree of leverage (capital structure) either by
selling shares and use the proceeds to retire debentures or by raising more debt and reduce the equity capital.
6. The operating profits (EBIT) are not expected to grow.
7. All investors are assumed to have the same subjective probability distribution of the future expected EBIT
for a given firm.
8. Business risk is constant over time and is assumed to be independent of its capital structure and financial
risk.
9. Perpetual life of the firm.
Definitions and Symbols
In addition to the above assumptions, we shall make use of some symbols in our
analysis of capital structure theories:
S = total market value of equity
B = total market value of debt
I = total interest payments
V = total market value of the firm (V = S + B)
NI = net income available to equity holders.
10.1.1 Net Income Approach
According to the Net Income (NI) Approach, suggested by the Durand, the capital structure decision is relevant
to the valuation of the firm. In other words, a changing the financial leverage will lead to a corresponding
change in the cost of capital as well as the total value of the firm.
If, therefore, the degree of financial leverage as measured by the ratio of debt to equity is increased, the
weighted average cost of capital will decline, while the value of firm as well as the market price of ordinary
shares will increase. Conversely, decrease in the leverage will cause an increase in the overall cost of capital
and a decline both in the value of the firm as well as the market price of equity shares. The NI Approach to
valuation is based on three assumptions: first, there are no’ taxes; second, that the cost of debt is less than the
equity capitalisation rate or the cost of equity; third, that the use of debt does not ‘change the risk perception of
investors. That the financial risk perception of the investors does not change with the introduction of debt or
change in leverage implies that due to change in leverage, there is no change in either the cost of debt or the
cost of equity. The implication of the three assumptions underlying the NI Approach is that as the degree of
leverage increases, the proportion of a cheaper source of funds, that is, debt in the capital structure increases. As
a result, the weighted average of capital tends to decline, leading to an increase in the total value of the firm.
Thus, with the cost of debt and cost of equity being constant, the increased use of debt (increase in leverage),
will magnify the shareholder’s earnings and, thereby, the market value of the ordinary shares.
The financial leverage is, according to the NI Approach, an important variable to the capital structure of a firm.
With a judicious mixture of debt and equity, a firm can evolve an optimum capital structure which will be the
one at which value of the firm is the highest and the over a cost of capital the lowest. At that structure, the
market price per share would be maximum. If the firm uses no debt or if the financial leverage is zero, the
overall cost of capital will be equal to the equity-capitalisation rate. The weighted average cost of capital will
decline and will approach the cost of debt as the degree of average reaches one.
10.1.2 Net Operating Income (Noi) Approach
Another theory of capital structure, suggested by Durand, is the Net Operating Income (NOI) Approach. This
Approach is diametrically opposite to the NI Approach. The essence of this Approach is that the capital
structure decision of a firm is irrelevant. Any change in leverage will not lead to any-change in the total value
of the firm and the market price of shares as well as the overall cost of capital is independent of the degree of
leverage. The NOI Approach is based on the following propositions.
10.1.2.1 Overall Cost of Capital/Capitalisation Rate (k0) is Constant
The NOI Approach to valuation argues that the overall capitalisation rate of the firm remains constant, for all
degrees of leverage. The value of the firm, given the level of EBIT, is V = EBIT/Ko
10.1.2.2. Residual Value of Equity
The value of equity is a residual value which is determined by deducting the total value of debt (S) from the
total value of the firm (V). Symbolically, Total market value of equity capital (S) = V - B.
10.1.2.3 Changes in Cost of Equity Capital
The equity capitalisation rate cost of equity capital (ke), increases with the degree of leverage. The increase in
the proportion of debt in the capital structure relative to equity shares would lead to an increase in the financial
risk to the ordinary shareholders. To compensate for the increased risk, the shareholders would expect a higher
rate to return on their investments. The increase in the equity capitalisation rate (or the lowering of the price-
earnings ratio, that is, P/E ratio) would match in the increase in the debt equity ratio.
10.1.2.3.4 Cost of Debt
The cost of debt (Ki) has two parts: (a) Explicit cost which is represented by the rate of interest. Irrespective of
the degree of leverage, the firm is assumed to be able to borrow at a given rate of interest. This implies that the
increasing proportion of debt in the financial structure does not affect the financial risk of the lenders and they
do not penalise the firm by charging higher interest; (b) Implicit or ‘hidden’ cost. As shown in the assumption
relating to the changes in ke, increase in the degree of leverage or the proportion of debt to equity causes an
increase in the cost of equity capital. This increase in Ke, being attributable to the increase in debt, is the
implicit part of Ki. Thus, the advantage associated with the use of debt, supposed to be a ‘cheaper’ source of
funds in terms of the explicit cost, is exactly neutralised by the implicit cost represented by the increase in Ke;
As a result, the real cost of debt and the real cost of equity, according to the NOI Approach, are the same and
equal Ko.
Optimum Capital Structure
The total value of the firm is unaffected by its capital structure. No matter what the degree of leverage is, the
total value of the firm will remain constant. The market price of shares will also not change with the change in
the debt-equity ratio. There is nothing such as an optimum capital structure. Any capital structure is optimum
according to the NOI Approach.
10.1.3 Modigliani-Miller (Mm) Approach
The Modigliani-Miller Thesis relating to the relationship between the capital structure, cost of capital and
valuation is akin to the NOI Approach.
The NOI Approach, as explained above, is definitional or conceptual and lacks behavioural significance. The
NOI. Approach, in other words, does not provide operational justification for the irrelevance of the capital
structure. The MM proposition supports the NOI Approach relating to the independence of the cost of capital
and the degree of leverage at any level of debt-equity ratio. The significance of their hypothesis lies in the fact
that it provides behavioural justification for constant overall cost of capital and, therefore, total value of the
firm. In other words, the MM Approach maintains that the weighted average (overall) cost of capital does not
change, with a change in the proportion of debt to equity in the capital structure (or degree of leverage). They
offer operational justification for this and are not content with merely stating the proposition.
10.1.3.1 Basic Propositions
There are three basic propositions of the MM Approach:
I The overall cost of capital (k0) and the value of the firm (V) are independent of its capital structure. The kQ
and V are constant for all degrees of leverage. The total value is given by capitalising the expected stream of
operating earnings at a discount rate appropriate for its risk class.
II The second proposition of the MM Approach is that the ke is equal to the capitalisation rate of a pure equity
stream plus a premium for financial risk equal to the difference between the pure equity-capitalisation rate (Ke)
and Ki times the ratio of debt to equity. In other words, ke increases in a manner to offset exactly the use of a
less expensive source of funds represented by debt.
III The cut-off rate for investment purposes is completely independent of the way in which an investment is
financed. We are interested mainly in exploring the relationship between leverage and valuation. Our focus,
therefore, is on proposition (I).
10.1.3.2 Assumptions
The proposition that the weighted average cost of capital is constant irrespective of the type of capital structure
is based on the following assumptions:
a) Perfect capital markets: The implication of a perfect capital market is that (i) securities are infinitely
divisible; (ii) investors are free to buy/sell securities; (iii) investors can borrow without restrictions on the same
terms and conditions as firms can T(iv) There are no transaction costs; (v) information is perfect, that is, each
investor has the same information which is readily available to him without cost; and (vi) investors are rational
and behave accordingly.
b) Given the assumption of perfect information and rationality, all investors have the same expectation of firm’s
net operating income (EBIT) with which to evaluate the value of a firm.
c) Business risk is equal among all firms within similar operating environment. That means, all firms can be
divided into ‘equivalent risk class’ or ‘homogeneous risk class’. The term equivalent homogeneous risk class
means that the expected earnings have identical risk characteristics. Firms within an industry are assumed to
have the same risk characteristics. The categorisation of firms into equivalent risk class is on the basis of the
industry group to which the firm belongs.
(a) The dividend pay out ratio is 100 per cent.
(b) There are no taxes. This assumption is removed later.
Proposition I The basic premise of the MM Approach (proposition I) is that, given the above assumptions, the
total value of a firm must be constant irrespective of the degree of leverage (debt-equity ratio). Similarly, the
cost of capital as well as the market price of shares must be the same regardless of the financing-mix. The
operational justification for the MM hypothesis is the arbitrage process. The term ‘arbitrage’ refers to an act of
buying an asset/security in one market (at lower prices) and selling it in another (at higher price). As a result,
equilibrium is restored in the market price of a security in different in markets. The essence of the arbitrage
process is the purchase of securities assets whose prices are lower (undervalued securities) and, sale of
securities whose prices are higher, in related markets which are temporarily out of equilibrium. The arbitrage
process is essentially a balancing operation. It implies that a security cannot sell at different prices. The MM
Approach illustrates the arbitrage process with reference to valuation in terms of two firms which are exactly
similar in all respects except leverage so that one of them has debt in its capital structure while the other does
not. Such homogeneous firms are, according to Modigliani and Miller, perfect substitutes. The total value of the
homogeneous firms which differ only in respect of leverage cannot be different because of the operation of
arbitrage. The investors of the firm whose value is higher will sell their shares and instead buy the shares-of-the
firm whose value is lower. Investors will be able to earn the same return at lower outlay with the same
perceived risk or lower risk. They would, therefore, be better off. The behaviour of the investors will have the
effect of (i) increasing the share prices (value) of the firm whose shares are being purchased; and (ii) lowering
the share prices (value) of the firm whose shares are being sold. This will continue till the market prices of the
two identical firms become identical.
Thus, the switching operation (arbitrage) drives the total value of two homogeneous firms in all respects, except
the debt-equity ratio, together. The arbitrage process, as already indicated, ensures to the investor the same
return at lower outlay as he was getting by investing in the firm whose total value was higher and yet, his risk is
not increased. This is so because the investors would borrow in the proportion of the degree of leverage present
in the firm. The use of debt by the investor for arbitrage is called as ‘home-made’ or ‘personal’ leverage. The
essence of the arbitrage argument of Modigliani and Miller is that the investors (arbitragers) are able to
substitute personal leverage or home-made leverage for corporate leverage, that is, the use of debt by the firm
itself. Thus, the total market value of the firm which employs debt in the capital structure (L) is more than that
of the unlevered firm (U). According to the MM hypothesis, this situation cannot continue as the-arbitrage
process, based on the substitutability of personal leverage for corporate leverage will operate and the values of
the two firms will be brought to an identical level.

Arbitrage Process The modus operandi of the arbitrage process is as follows:

Suppose an investor, Mr X, holds 10 per cent of the outstanding shares of the levered firm (L). His holdings
amount to Rs 31,250 (i.e. 0.10 x Rs 3,12,500) and his share in the earnings that belong to the equity
shareholders would be Rs 5,000 (0.10 x Rs 50,000). He will sell his holdings in firm L and invest in the
unlevered firm (U). Since firm U has no debt in its capital structure the financial risk to would be less than in
firm L. To reach the level of financial risk of firm L, he will borrow additional funds equal to his proportionate
share in the levered firm’s debt on his personal account. That is, he will substitute personal leverage (or home-
made leverage) for corporate leverage. In other words, instead of the firm using debt, Mr X will borrow money.
The effect, in essence, of this is that he is able to introduce leverage in the capital structure of the unlevered
firm by borrowing on his personal account. Mr X in our example will borrow Rs 50,000 at 10 per cent rate of
interest. His proportionate holding (10 per cent) in the unlevered firm will amount to Rs 80,000 on which he
will receive a dividend income of Rs 10,000. Out of the income of Rs 10,000 from the unlevered firm (U), Mr
X will pay Rs 5,000 as interest on his personal borrowings. He will be left with Rs 5,000 that is, the same
amount as he was getting from the levered firm (L). But his investment outlay in firm U is less (Rs 30,000) as
compared with that in firm L (Rs 31,250). At the same time, his risk is identical in both the situations.
It is, thus, clear that Mr X will be better off by selling his securities in the levered firm and buying the shares of
the unlevered firm. With identical risk characteristics of the two firms, he gets the same income with lower
investment outlay in the unlevered firm. He will obviously prefer switching from the levered to the unlevered
firm. Other investors will also, given the assumption of rational investors, enter into the arbitrage process. The
consequent increasing demand for the securities of the levered firm will lead to an increase in the market price
of its shares. At the same time, the price of the shares of the levered firm will decline. This will continue till it is
possible to reduce the investment outlays and get the same return. Beyond this point, switching from firm L to
firm U or arbitrage will not be identical is the point of equilibrium. At this point, the total value of the two firms
would be identical. The cost of capital of the two firms would also be the same. Thus, it is unimportant
what the capital structure of firm L is. The weighted cost of capital(kQ) after the investors exercise their home-
made leverage is constant because investors exactly offset the firm’s leverage with their own.
10.1.3.3 Arbitrage Process: Reverse Direction
According to the MM hypothesis, since debt financing has no advantage, it has no disadvantage .either. In other
words, just as the total value of a levered firm cannot be more than that of an unlevered firm, the value of an
unlevered firm cannot be greater than the value of a levered firm. This is because the arbitrage process will set
in and depress the value of the unlevered firm and increase the market price and, thereby, the total value of the
levered firm. The arbitrage would, thus, operate in the opposite direction. Here, the investors will dispose of
their holdings in the unlevered firm and obtain the same return by acquiring proportionate share in the equity
capital and the debt of the levered firm at a lower outlay without any increase in the risk.
10.1.3.4 Limitations
Does the MM hypothesis provide a valid framework to explain the relationship between capital structure, cost
of capital and total value of a firm? The most crucial element in the MM Approach is the arbitrage process
which forms the behavioural foundation of, and provides operational justification to, the MM hypothesis. The
arbitrage process, in turn, is based on the crucial assumption of perfect substitutability of personal/home-made
leverage with corporate leverage. The validity of the MM hypothesis depends on whether the arbitrage process
is effective in the sense that personal leverage is a perfect substitute for corporate leverage. The arbitrage
process is, however, not realistic and the exercise based upon it is purely theoretical and has no practical
relevance.
10.1.3.5.1 Risk Perception
In the first place, the risk perceptions of personal and corporate leverage are different. If home-made and
corporate leverages are perfect substitutes, as the MM Approach assumes, the risk of which an investor is
exposed, must be identical irrespective of whether the firm has borrowed - (corporate leverage) or the investor
himself borrows proportionate to his share in the firm debt. If not, they cannot be perfect substitutes and
consequently the arbitrage process will not be effective. This risk exposure to the investor is greater with
personal leverage than with corporate leverage. The liability of an investor is limited in corporate enterprises in
the sense that he is liable to the extent of his proportionate shareholdings in case the company is forced to go
into liquidation. The risk to which he is exposed, therefore, is limited to his relative holding. The liability of an
individual borrower is, on the other hand, unlimited as even his personal property is liable to be used for
payment to the creditors. The risk to the investor with personal borrowing is higher.
10.1.3.5.2 Convenience
Apart from higher risk exposure, the investors would find the personal leverage inconvenient. This is so
because with corporate leverage the formalities and procedures involved in borrowing are to be observed by the
firms while these will be the responsibility of the investor-borrower in case of personal leverage. That corporate
borrowing is more convenient to the investor means, in other words, that investors would prefer them rather
than to do the job themselves. The perfect substitutability of the two types of leverage is, thus, open to question.
10.1.3.5.3 Cost
Another constraint on the perfect substitutability of personal and corporate leverage and, hence, the
effectiveness of the arbitrage process is the relatively high cost of borrowing with personal leverage. If the two
types of leverage are to be perfect substitutes, the cost of borrowing ought to be identical for both: borrowing
by the firm and borrowing by the investor-borrower. If the borrowing costs vary so that they are higher/lower
depending on whether the borrowing is done by a firm or an individual, the borrowing arrangement with lower
cost will be preferred by the investors. That lending costs are not uniform for all categories of borrowers is, as
an economic proposition, well recognised. As a general rule, large borrowers with high credit-standing can
borrow at a lower rate of interest compared to borrowers who are small and do not enjoy high credit-standing.
For this reason, it is reasonable to assume that a firm can obtain a loan at a cost lower than what the individual
investor would have to pay. As a result of higher interest charges, the advantage of personal leverage would
largely disappear and the MM assumption of personal and corporate leverages being perfect substitutes would
be of doubtful validity. In fact, borrowing by a firm has definite superiority over a personal loan from the
viewpoint of the cost of borrowing. Investors can be expected to definitely prefer corporate borrowing as they
would not be in the same position by borrowing on personal account.
10.1.3.5.4 Institutional Restrictions
Yet another problem with the MM hypothesis is that institutional restrictions stand in the way of a smooth
operation of the arbitrage process. Several institutional investors such as Life Insurance Corporation of India,
Unit Trust of India, commercial banks and so on are not allowed to engage in personal leverage. Thus,
switching the option from the unlevered to the levered firm may not apply to all investors and, to that extent,
personal leverage is an imperfect substitute for corporate leverage.
10.1.3.5.5 Double Leverage
A related dimension is that in certain situations, the arbitrage process (substituting corporate leverage by
personal leverage) may not actually work. For instance, when an investor has already borrowed funds while
investing in shares of an unlevered firm. If the value of the firm is more than that of the levered firm, the
arbitrage process would require selling the securities of the overvalued (unlevered) firm and purchasing the
securities of the levered firm. Thus, an investor would have double leverage both in the personal portfolio as
well as in the firm’s portfolio. The MM assumption would not hold true in such a Institution.
10.1.3.5.6 Transaction Costs
Transaction costs would affect the arbitrage process. The effect of transaction/ flotation cost is that the investor
would receive net proceeds from the sale of securities which will be lower than his investment holding in the
levered/unlevered firm, to the extent of the brokerage fee and other costs. He would, therefore, have to invest a
larger amount in the shares of the unlevered/ levered firm, than his present investment, to earn the same return.
Personal leverage and corporate leverage are, therefore, not perfect substitutes. This implies that the arbitrage
process will be hampered and will not be effective. To put it differently, the basic postulate of the MM
Approach is not valid. Therefore, a firm may increase its ‘total value and lower its weighted cost of capital with
an appropriate degree of leverage. Thus, the capital structure of the firm is not irrelevant to its valuation and the
overall cost of capital. In brief, imperfections in the capital market retard perfect
Functioning of the arbitrage: As a consequence, the MM Approach does not appear to provide a valid
framework for the theoretical relationship between capital structure, cost of capital and valuation of a firm.
10.1.3.5.7 Taxes
Finally, if corporate taxes are taken into account, the MM Approach will fail to explain the relationship
between financing decision and value of the firm. Modigliani and Miller themselves, as shown below, are
aware of it and have, in fact, recognised it.
10.1.3.5.8 Corporate Taxes
As already mentioned, MM agree that the value of the firm will increase and cost of capital will decline with
leverage, if corporate taxes are introduced in the exercise. Since interest on debt is tax-deductible, the effective
cost of borrowing is less than the contractual rate of interest. Debt, thus, provides a benefit to the firm because
of the tax-deductibility of interest payments. Therefore, a levered firm would have greater market value than an
unlevered firm. Specifically, MM state that the value of the levered firm would exceed that of the unlevered
firm by an amount equal to the levered firm’s debt multiplied by the tax rate. The implication of MM analysis
in, this case is that the value of the firm is maximised when its capital structure contains only debt. In other
words, a firm can lower its cost of capital continually with increased leverage. However, the extensive use of
debt financing would expose business to high probabilities of default; it would find it difficult to meet the
promised payments of interest and principal. Moreover, the firm is likely to incur costs and suffer penalties if it
fails to make payments of interest and principal when they become due. Legal expenses, disruption of
operations, and loss of potentially profitable investment opportunities may result. As the amount of debt in the
capital structure increases, so does the probability of incurring these costs. Consequently, there are
disadvantages of debt; and excessive use of debt may cause a rise in the cost of capital owing to the increased
financial risk and may reduce the value of the firm. Again, we find that MM’s proposition is unjustified when
leverage is extreme, that is, when the firm uses 100 per cent debt and no equity. Clearly, the optimal capital
structure is not one which has the maximum amount of debt, but, one which has the desired amount of debt,
determined at a point and/or range where the overall cost of capital is minimum. Modigliani and Miller also
recognise that extreme leverage increases Financial risk as also the cost of capital. They suggest that firms
should adopt ‘’target debt ratio” so as not to violate limits of leverage imposed by the creditors. This
suggestion indirectly admits that there is a safe limit for the use of debt and firms should not use debt beyond
that limit/point. It implies that the cost of capital rises beyond a certain level on the use of debt. There is,
therefore, an optimal capital structure.
10.1.4 Traditional Approach
The preceding discussions clearly show that the Net Income Approach (NI) as well as Net Operating Income
Approach (NOI) represent two extremes as regards the theoretical relationship between financing decisions as
determined by the capital structure, the weighted average cost of capital and total value of the firm. While the
NI Approach takes the position that the use of debt in the capital structure will always affect the overall cost of
capital and the total valuation, the NOI Approach argues that capital structure is totally irrelevant. The MM
Approach supports the NOI Approach. But the assumptions of MM hypothesis are of doubtful validity. The
Traditional Approach is midway between the NI and NOI Approaches. It partakes of some features of both
these Approaches. It is also known as the intermediate Approach. It resembles the NI Approach in arguing that
cost of capital firm are not independent of the capital structure. But it does not subscribe to the view (of NI
Approach) that value of a firm will necessarily increase of average. In one respect it shares a feature with the
NOI Approach that beyond a certain degree of leverage, the overall cost increases leading to a decrease in the
total value of the firm. But it differs from the NOI Approach in that it does not argue that the weighted average
cost of capital is constant for all degrees of leverage. In one respect it shares a feature with the NOI approach
that beyond a certain degree of leverage, the overall cost increases leading to a decrease in the total value of the
firm. But it differs from the NOI approach in that it does not argue that the weighted average cost of capital is
constant for all degrees of leverage. The crux of the traditional view relating to leverage and valuation is the
through judicious use of debt equity proposition, a firm can increase its total value and thereby reduced its
overall cost of capital. The rational behind this view is that debt is relatively cheaper source of funds as
compared to ordinary shares. With a change the leverage, that is, using more debt in place of equity, a relatively
cheaper source of funds replaces a source of funds which involves a relatively higher cost. This obviously
causes a decline in the overall cost of capital. If the debt-equity ratio is raised further, the firm would become
financially more risky to the investors who would penalise the firm by demanding a higher equity –
capitalisation rate (ke). But the increase in ke may not be so high as to neutralise the benefit of using cheaper
debt. In other words, the advantages arising out of the use of debt is so large that, even after allowing for higher
ke the benefit of use of the cheaper source of funds is still available.
If, however, the amount of debt is increased further, two things are likely to happen: (i) owing to increased
financial risk, ke will record a substantial rise; (ii) the firm would become very risky to the creditors who also
would like to the compensated by a higher return such that ki will rise. The use of debt beyond the certain point
will, therefore, have the effect of raising the weighted average cost of capital and conversely the total value of
the firm. Thus, up to a point/degree of leverage, the use of debt will favourably affect the value of a firm;
beyond the point, use of debt will adversely affect it. At the level of debt-equity ratio, the capital structure is an
optimal capital structure. Optimum capital structure, the marginal real cost of debt, define to include both
implicit and explicit, will be equal to the real cost of equity. For a debt; equity ratio before that level the
marginal real cost of debt would be less than that of equity capital, while beyond that level leverage, the
marginal real cost of debt would exceed that of equity. There are, of course, variations to the traditional
approach. According to one of these, the equity capitalisation rate (ke) rises only after a certain level of
leverage and not before, so that the use of debt does not necessarily increase the ke. This happens only after a
certain degree of leverage. The implication is that a firm can reduce its cost of capital significantly with the
initial use of leverage. Another of the variant of the Traditional Approach suggests that there is no one single
capital structure, but, there is a range of capital structures in which the cost of capital (k0) is the minimum and
the value of the firm is the maximum. In this range, changes in leverage have very little effect on the value of
the firm.

10.2 INCREASED VALUATION AND DECREASED OVERALLCOST OF CAPITAL

During the first phase, increasing leverage increases the total valuation of the firm and lowers the overall cost
of capital. As the proportion of debt in the capital structure increases, the cost of equity (Ke) begins to rise as a
reflection of the increased financial risk. But it does not rise fast enough to offset the advantage of using the
cheaper source of debt capital. Likewise, for most of the range of this phase, the cost of debt (Ki.) either
remains constant or rises to a very small extent because the proportion of debt by the lender is considered to be
within safe limits. Therefore, they are prepared to lend to the firm at almost the same rate of interest. Since debt
is typically a cheaper source of capital than equity, the combined effect is that the overall cost of capital begins
to fall with the increasing use of debt. Example 10.7 has shown that an increase in leverage (B/S) from 0.53 to
1.08 has had the effect of increasing the total market value from Rs 2,87,500 to Rs 2,88,235 and decreasing the
overall capitalisation rate from 13.9 to 13.8 per cent.
10.3 CONSTANT VALUATION AND CONSTANT OVERALLCOST OF CAPITAL
After a certain degree of leverage is reached, further moderate increases in leverage have little or no effect on
total market value. During the middle range, the changes brought in equity-capitalisation rate and debt-
capitalisation rate balance each other. As a result, the values of (V) and (k0) remain almost constant.
10.4 DECREASED VALUATIONAND INCREASED OVERALLCOST OF CAPITAL
Beyond a certain critical point, further increases in debt proportions are not considered desirable. They increase
financial risks so much that both ke and K i start rising rapidly causing (kQ) to rise and (V) to fall.
11 DETERMINANTS OF OPTIMUM CAPITAL STRUCTURE
Some companies do not plan their capital structures; it develops as a result of the financial decisions taken by
the financial manager without any formal policy and planning. Financing decisions are reactive and they evolve
in response to the operating decisions. These companies may prosper in the short-run, but ultimately they may
face considerable difficulties in raising funds to finance their activities. With unplanned capital structure, these
companies may also fail to economise the use of their funds. Consequently, it is being increasingly realised that
a company should plan its capital structure to maximise the use of the funds and to be able to adapt more easily
to the changing conditions. Theoretically, the financial manager should plan an optimum capital structure for
his company. The optimum capital structure is one that maximises the market value of the firm. What we have
discussed in the last chapter has been theoretical. In practice, the determination of an optimum capital structure
is a formidable task, and one has to go beyond the theory. There are significant variations among industries and
among companies within an industry in terms of capital structure. Since a number of factors influence the
capital structure decision of a company, the judgment of the person making the capital structure decision plays
a crucial part. Two similar companies may have different capital structures if the decision-makers differ in their
judgment of the significance of various factors. A totally theoretical model perhaps cannot adequately handle
all those factors, which affect the capital structure decision in practice. These factors are highly psychological,
complex and qualitative and do not always follow accepted theory, since capital markets are not perfect and the
decision has to be taken under imperfect knowledge and risk. The board of directors or the chief financial
officer (CFO) of a company should develop an appropriate or target capital structure, which is most
advantageous to the company.
This can be done only when all those factors, which are relevant to the company’s capital structure decision, are
properly analysed and balanced. The capital structure should be planned generally keeping in view the interests
of the equity shareholders and the financial requirements of a company. The equity shareholders, being the
owners of the company and the providers of risk capital (equity), would be concerned about the ways of
financing a company’s operations. However, the interests of other groups, such as employees, customers,
creditors, society and government, should also be given reasonable consideration. When the company lays
down its objective in terms of the shareholder wealth maximisation (SWM), it is generally compatible with the
interests of other groups. Thus, while developing an appropriate capital structure for its company, the financial
manager should inter alia aim at maximising the long-term market price per share. Theoretically, there may be
a precise point or range within which the market value per share is maximum. In practice, for most companies
within an industry there may be a range of an appropriate
capital structure within which there would not be great differences in the market value per share. One way to
get an idea of this range is to observe the capital structure patterns of companies’ vis-à-vis their market prices
of shares. It may be found empirically that there are not significant differences in the share values within a
given range. The management of a company may fix its capital structure near the top of this range in order to
make maximum use of favourable leverage, subject to other requirements such as flexibility, solvency, control
and norms set by the financial institutions, the Security Exchange Board of India (SEBI) and stock exchanges.
11.1 ELEMENTS OFCAPITALSTRUCTURE
A company formulating its long-term financial policy should, first of all, analyse its current financial structure.
The following are the important elements of the company’s financial structure that need proper scrutiny and
analysis.
11.1.1 Capital Mix
Firms have to decide about the mix of debt and equity capital. Debt capital can be mobilised from a variety of
sources. How heavily does the company depend on debt? What is the mix of debt instruments? Given the
company’s risks, is the reliance on the level and instruments of debt reasonable? Does the firm’s debt policy
allow it flexibility to undertake strategic investments in adverse financial conditions? The firms and analysts
use debt ratios, debt-service coverage ratios, and the funds flow statement to analyse the capital mix.
11.1.2 Maturity and Priority
The maturity of securities used in the capital mix may differ. Equity is the most permanent capital. Within debt,
commercial paper has the shortest maturity and public debt longest. Similarly, the priorities of securities also
differ. Capitalised debt like lease or hire purchase finance is quite safe from the lender’s point of view and the
value of assets backing the debt provides the protection to the lender. Collateralised or secured debts are
relatively safe and have priority over unsecured debt in the event of insolvency. Do maturities of the firm’s
assets and liabilities match? If not, what trade-off is the firm making? A firm may obtain a risk-neutral position
by matching the maturity of assets and liabilities; that is, it may use current liabilities to finance current assets
and short-medium and long-term debt for financing the fixed assets in that order of maturities. In practice, firms
do not perfectly match the sources and uses of funds. They may show preference for retained earnings. Within
debt, they may use long-term funds to finance current assets and assets with shorter life. Some firms are more
aggressive, and they use short-term funds to finance long-term assets.
11.1.3 Terms and Conditions
Firms have choices with regard to the basis of interest payments. They may obtain loans either at fixed or
floating rates of interest. In case of equity, the firm may like to return income either in the form of large
dividends or large capital gains. What is the firm’s preference with regard to the basis of payments of interest
and dividend? How do the firm’s interest and dividend payments match with its earnings and operating cash
flows? The firm’s choice of the basis of payments indicates the management’s assessment about the future
interest rates and the firm’s earnings. Does the firm have protection against interest rates fluctuations? The
financial manager can protect the firm against interest rates fluctuations through the interest rates derivatives.
There are other important terms and conditions that the firm should consider. Most loan agreements include
what the firm can do and what it can’t do. They may also state the schemes of payments, pre-payments,
renegotiations etc. What are the lending criteria used by the suppliers of capital? How do negative and positive
conditions affect the operations of the firm? Do they constraint and compromise the firm’s operating strategy?
Do they limit or enhance the firm’s competitive position? Is the company level to comply with the terms and
conditions in good time and bad time?
11.1.4 Currency
Firms in a number of countries have the choice of raising funds from the overseas markets. Overseas financial
markets provide opportunities to raise large amounts of funds.
Accessing capital internationally also helps company to globalise its operations fast. Because international
financial markets may not be perfect and may not be fully integrated, firms may be able to issue capital
overseas at lower costs than in the domestic markets. The exchange rates fluctuations can create risk for the
firm in servicing it foreign debt and equity. The financial manager will have to ensure a system of risk hedging.
Does the firm borrow from the overseas markets? At what terms and conditions? How has firm benefited -
operationally and or financially in raising funds overseas? Is there a consistency between the firm’s foreign
currency obligations and operating inflows?
11.1.5 Financial innovations
Firms may raise capital either through the issues of simple securities or through the issues innovative securities.
Financial innovations are intended to make the security issue attractive to investors and reduce cost of capital.
For example, a company may issue convertible debentures at a lower interest rate rather than non-convertible
debentures at a relatively higher interest rate. A further innovation could be that the company may offer higher
simple interest rate on debentures and offer to convert interest amount into equity. The company will be able to
conserve cash outflows. A firm can issue varieties of option linked securities; it can also issue tailor-made
securities to large suppliers of capital. The financial manager will have to continuously design innovative
securities to be able to reduce the cost. An innovation introduced once does not attract investors any more.
What is the firm’s history in terms of issuing innovative securities? What were the motivations in issuing
innovative securities and did the company achieve intended benefits?
11.1.6 Financial market segments
There are several segments of financial markets from where the firm can tap capital. For example, a firm can
tap the private or the public debt market for raising long-term debt. The firm can raise short-term debt either
from banks or by issuing commercial papers or certificate deposits in the money market. The firm also has the
alternative of raising short-term funds by public deposits. What segments of financial markets have the firm
tapped for raising funds and why? How did the firm tap and approach these segments?
11.2 FRAMEWORK FOR CAPITAL STRUCTURE: THE FRICT ANALYSIS
A financial structure may be evaluated from various perspectives. From the owners’ point of view return, risk
and value are important considerations. From the strategic point of view, flexibility is an important concern.
Issues of control, flexibility and feasibility assume great significance. A sound capital structure will be achieved
by balancing all these considerations:
Flexibility The capital structure should be determined within the debt capacity of the company, and this
capacity should not be exceeded. The debt capacity of a company depends on its ability to generate future cash
flows. It should have enough cash to pay creditors’ fixed charges and principal sum and leave some excess
cash to meet future contingency. The capital structure should be flexible. It should be possible for a company to
adapt its capital structure with a minimum cost and delay if warranted by a changed situation. It should also be
possible for the company to provide funds whenever needed to finance its profitable activities.
Risk The risk depends on the variability in the firm’s operations. It may be caused by the macroeconomic
factors and industry and firm specific factors. The excessive use of debt magnifies the variability of
shareholders’ earnings, and threatens the solvency of the company.
Income The capital structure of the company should be most advantageous to the owners (shareholders) of
the firm. It should create value; subject to other considerations, it should generate maximum returns to the
shareholders with minimum additional cost.
Control The capital structure should involve minimum risk of loss of control of the company. The owners of
closely held companies are particularly concerned about dilution of control.
Timing The capital structure should be feasible to implement given the current and future conditions of the
capital market. The sequencing of sources of financing is important. The current decision influences the future
options of raising capital. The FRICT (flexibility, risk, income, control and timing) analysis provides the
general framework for evaluating a firm’s capital structure. The particular characteristics of a company may
reflect some additional specific features. Further, the emphasis given to each of these features will differ from
company to company. For example, a company may give more importance to flexibility than control, while
another company may be more concerned about solvency than any other requirement. Furthermore, the relative
importance of these requirements may change with shifting conditions. The company’s capital structure should,
therefore, be easily adaptable.
11.3 APPROACHES TO ESTABLISH TARGET CAPITAL STRUCTURE
The capital structure will be planned initially when a company is incorporated. The initial capital structure
should be designed very carefully. The management of the company should set a target capital structure and
the subsequent financing decisions should be made with a view to achieve the target capital structure.
The financial manager has also to deal with an existing capital structure. The company needs funds to finance
its activities continuously. Every time when funds have to be procured, the financial manager weighs the pros
and cons of various sources of finance and selects the most advantageous sources keeping in view the target
capital structure. Thus, the capital structure decision is a continuous one and has to be taken whenever a firm
needs additional finances. The following are the three most common approaches to decide about a firm’s capital
structure:
EBIT-EPS approach for analysing the impact of debt on shareholders’ return and risk.
Valuation approach for determining the impact of debt on the shareholders’ value.
Cash flow approach for analysing the firm’s ability to service debt and avoid financial distress.
11.3.1 EBIT-EPS Analysis
The EBIT-EPS analysis is an important tool to analyse the impact of alternative financial plans on the
shareholders’ income and its variability. The firm should consider the possible fluctuations in EBIT and
examine their impact on EPS (or ROE) under different financial plans. If the probability of the rate of return on
the firm’s assets falling below the cost of debt is low, the firm can employ high debt to increase EPS. Other
things remaining the same, this may also have a favourable effect on the market value the firm’s share. On the
other hand, if the probability of the rate of return on the firm’s assets falling below the cost of debt is very high,
the firm should refrain from employing too much debt capital. Thus, the greater the level of EBIT and lower the
probability of downward fluctuations, the more beneficial it is to employ debt. However, it should be realised
that the EBIT-EPS analysis is a first step in deciding about a firm’s capital structure. It suffers from certain
limitations and does not provide unambiguous - guide in determining the level of debt in practice. EPS is one of
the most widely used measures of a company’s performance in practice. Hence, in choosing between debt and
equity, sometimes too much attention is paid on EPS, which, however, has serious limitations as a financing-
decision criterion. The major shortcomings of the EPS as a financing-decision criterion are:
It is based on arbitrary accounting assumptions and does not reflect the economic profits.
It does not consider the time value of money.
It ignores the variability about the expected value of EPS, and hence, ignores risk.
The belief that investors would be just concerned with the expected EPS is not well founded. Investors in
valuing the shares of the company consider both expected value and risk (variability).
11.3.1.1 EPS variability and financial risk
We know that the EPS variability, resulting from the use of leverage, causes financial risk. The extreme
variability in earnings can threaten the firm’s solvency. A firm can avoid financial risk altogether if it does not
employ any debt. But then the shareholders will be deprived of the benefit of the expected increases in EPS.
Therefore, a company may employ debt to take advantage of the increase in earnings provided shareholders do
not perceive the financial risk exceeding the benefit of increased EPS. As we have discussed earlier in this
chapter, as a firm increases the use of debt, the expected EPS may continue to increase, but the value of the
company may fall because of the greater exposure of shareholders to financial risk in the form of financial
distress. Shareholders expect higher compensation for taking the additional financial risk. The EPS criterion
does not consider the long-term perspectives of financing decisions. It fails to deal with the risk-return trade-
off. A long-term view of the effects of financing decisions will lead one to a criterion of wealth maximisation
rather than EPS maximisation. The EPS criterion is an important performance measure but not a decision
criterion. Given its limitations, should the EPS criterion be ignored in making financing decisions? Remember
that it is an important index of the firm’s performance and that investors rely heavily on it for their investment
decisions. Investors also do not have information on the projected earnings and cash flows and they base their
evaluation on historical data. In choosing between alternative financial plans, management should start with the
evaluation of the impact of each alternative on near-term EPS. But the best interests of shareholders should
guide management’s ultimate decision making. Therefore, a long-term view of the effect of the alternative
financial plans on the value of the shares should be taken. If management opts for a financial plan, which will
maximise value in the long run but has an adverse impact on near-term EPS, the reasons must be communicated
to investors. A careful communication to market will be helpful in reducing the misunderstanding between
management and investors.
11.3.1.2 Operating conditions and business risk
The level and variability of EPS depends is the growth and stability of sales. EPS will fluctuate with
fluctuations in sales. The magnitude of the EPS variability with sales will depend on the degrees of operating
and financial leverages employed by the company. A firm with stable sales and favourable cost and price
structure and well-focused operating strategy will have stable earnings and cash flows and thus, it can employ a
high degree of financial leverage; it will not face difficulty in meeting the fixed charges commitments of
debt. The likely fluctuations in sales increase the business risk. A small change in sales can lead to a dramatic
change in the earnings of a company when its fixed costs are high. The fixed interest charges shift the break-
even point upward. Hence, shareholders perceive a high degree of financial risk if companies with high
operating leverage employ high amount of debt. A company will get into a debt trap if operating conditions
become unfavourable and if it lacks a well articulated, focused strategy (see Exhibit 11.1 for an example of a
company in a debt trap). Sales of the consumer goods industries show wide fluctuations; therefore, they do not
employ a large amount of debt. On the other hand, the sales of public utilities are quite stable and predictable.
Public utilities, therefore, employ a large amount of debt to finance their assets. The expected growth in sales
also affects the degree of leverage. The greater the expectation of growth, the greater the amount of external
financing needed since it may not be possible for the firm to cope up with growth through internally generated
funds. A number of managers consider debt to be cheaper and easy to raise. The growth firms, therefore, may
usually employ a high degree of leverage. Companies with declining sales should not employ debt, as they
would find difficulty in meeting their fixed obligations. Non-payment of fixed charges can force a company
into liquidation. It may be noted that sales growth and stability is just one factor in the leverage decision; many
other factors would dictate the final decision. There are instances of a large number of high growth firms
employing no or small amount of debt.
EXHIBIT 11.1: DEBT TRAP: CASE OF HINDUSTAN SHIPYARD
The fluctuating raw materials and component prices cause ups and downs in the revenues and profits of a
ship-building company. With the right operating strategy and appropriate prudent financing, a company can
manage to sail safely. Hindustan Shipyard Limited (HSL), however, found it quite difficult to come out of the
troubled waters due to huge borrowings. In 1990, it had total outstanding debt of Rs 554 crore: working capital
loan Rs 138 crore, development loan for modernisation Rs 69 crore, and outstanding interest on these loans Rs
160 crore; cash credit Rs 62 crore, outstanding interest on cash credit Rs 65 crore and penal interest Rs 60
crore. How did this happen?
HSL’s trouble began when, between 1981 and 1982, Japanese and South Korean shipbuilders started offering
“heavily subsidised rates” against the rates fixed by the Indian government, based on international parity price.
In effect, building ships turned out to be unviable for the yard. Further, HSL’s overtime wages bill soared
up, being a highly overstaffed company. It had 11,000 workers in 1990. A lack of strategy paved way for
unchecked downfall. Orders continued declining, and became almost nil by 1988 and 1989. To tide over this,
company borrowed funds, and since operating performance did not improve, the company fell deeper and
deeper into debt trap.
HSL was technically insolvent. The capital restructuring plans helped to put the company back on its feet.
11.3.2 Valuation Approach
We have discussed that shareholders assume a high degree of risk than debt-holders. Hence debt is a cheaper
source of funds than equity. But debt causes financial risk, which increases the cost of equity. Higher debt
increases the costs of financial distress and the agency costs also increase. The tax deductibility of interest
charges, however, adds value to shareholders. Thus, there is a trade-off between the tax benefits and the costs of
financial distress and agency problems. The firm should employ debt to the point where the marginal benefits
and costs are equal. This will be the point of maximum value of the firm and minimum weighted average cost
of capital.
The difficulty with the valuation framework is that managers find it difficult to put into practice. It is not
possible for them to quantify the effect of debt on the value of the firm. Also, the operations of the financial
markets are so complicated that it is not easy for the financial managers to understand them. But the analysis of
the impact of debt on the value is crucial and it must be carried out. A financial manager should think and act
like investors. He or she must determine the contribution of alternative financial policies in creating value for
shareholders. The most desirable capital structure is the one that creates the maximum value.
11.3.3 Cash Flow Analysis
One practical method of assessing the firm’s ability to carry debt without getting into serious financial distress
is to carry out a comprehensive cash flow analysis over a long period of time. A sound capital structure is
expected to be conservative. Conservatism does not mean employing no debt or small amount of debt.
Conservatism is related to the firm’s ability to-generate cash to meet the fixed charges created by the use of
debt in the capital structure under adverse conditions. Hence, in practice, the question of the optimum debt-
equity mix boils down to the firm’s ability to service debt without any threat of insolvency and operating
inflexibility. A firm is considered prudently financed if it is able to service its fixed charges under any
reasonably predictable adverse conditions.
The fixed charges of a company include payment of interest and principal, and they depend on both the amount
of loan, interest rates and the terms of payment. The amount of fixed charges may be high if the company
employs a large amount of debt with short-term maturity. Whenever a company thinks of raising additional
debt, it should analyse its expected future cash flows to meet the fixed charges. It is mandatory to pay interest
and repay the principal amount of debt. If a company is not able to generate enough cash to meet its fixed
obligation, it may face financial distress leading to insolvency. The companies expecting larger and stable cash
inflows in the future can employ a large amount of debt in their capital structure. It is quite risky to employ high
amount of debt by those companies whose cash inflows are unstable and unpredictable. It is possible for a high
growth, profitable company to suffer from cash shortage if its liquidity (working capital) management is poor.
We have examples of Indian companies like BHEL and NTPC, whose debtors are very sticky and they
continuously face liquidity problem in spite of being profitable and high growth companies. Servicing debt
proves burdensome for these companies.
11.3.3.1 Debt-servicing coverage ratio
One-important ratio, which should be examined at the time of planning the capital structure, is the ratio of
expected net operating cash flows to fixed charges or the debt servicing coverage ratio. This ratio indicates the
number of times the fixed financial obligations are covered by the net operating cash flows generated by the
company. The greater is the expected coverage ratio, the greater is the amount of debt a company could use.
However, a company with a small coverage can also employ high amount of debt if there are not significant
yearly variations in its operating cash flows and if there is a low probability of these cash flows being
considerably less to meet fixed charges in a given period. Thus, it is not the average cash flows but the yearly
cash flows, which are important to determine the debt capacity of a company. Fixed financial obligations must
be met when due, not on an average or in most years, but always. This requires a full cash flow analysis
showing the impact of different capital structures under different economic conditions.
11.3.3.2 Debt capacity
The technique of cash flow analysis is helpful in determining a firm’s debt capacity. Debt capacity is the
amount, which a firm can service easily even under adverse conditions; it is the amount that the firm should
employ. There may be lenders who are prepared to lend to the firm at higher interest rates. But the firm should
borrow only if it can service debt without any problem. A firm can avoid the risk of financial distress if it can
maintain its ability to meet contractual obligation of interest and principal payments. Debt capacity, therefore,
should be thought in terms of the operating cash flows servicing debt rather than debt ratios. A high debt ratio is
not necessarily bad. If a firm can service high amount of debt without much financial risk, it will increase
shareholders’ wealth. On the other hand, a low debt ratio can prove to be burdensome for a firm, which has
liquidity problem. A firm faces financial distress (or even insolvency) when it has cash flow problem. It is
dangerous to finance a capital-intensive project out of borrowings, which has built in uncertainty about the
earnings and cash flows. National Aluminium Company is an example of a wrong initial choice of capital
structure, which was inconsistent with its operating conditions (see Exhibit 11.2). Some companies define their
target capital structure or debt capacity in terms of the debt rating they desire. They choose the debt-equity ratio
consistent with the debt rating. They work out the financial consequences of this choice and adjust their
operations and other sources of finance ensuring the feasibility of the chosen capital structure.
11.3.3.3 Components of cash flows
The cash flows should be analysed over a long period of time, which can cover the various adverse phases, for
determining the firm’s debt policy. The cash flow analysis involves preparing Proforma cash flow statements
showing the firm’s financial conditions under adverse conditions such as a recession. The expected cash flows
can be categorised into three groups: Operating cash flows Non-operating cash flows Financial flows
EXHIBIT 11.2: DEBT BURDEN UNDER CASH CRUNCH SITUATION CASE OF NALCO
National Aluminium Company (NALCO), started in 1981, is the largest integrated aluminium complex in Asia
of total investment of Rs 2,408 crore, borrowings ‘from a consortium of European banks financed to the extent
of $ 830 million or Rs. 1,119 crore (46.5 percent). The loan was repayable by 1995. Aluminium is an
electricity-intensive business; each tonne of aluminium needs over 15,000 kw of electricity. Since its
commissioning inl988, Nalco has exported substantial portion of its production since the domestic demand has
been very low than what the company had projected at its inception. The falling international prices in last few
years have eroded the company’s profitability. The net profit of Rs 172 crore in 1989 dropped to Rs 14 crore in
1991-92. The Rs 1,119 crore Eurodollar loan has appreciated to Rs 2,667 crore inspite of having repaid Rs 644
crore. Due to profitability and liquidity problem and hit by the depreciating rupee and the liberalised exchange
mechanism, the company is forced to reschedule repayments of its debt by the year 2003 instead of 1995.
Nalco’s debt-equity ratio has increased from 1:1 to 2.7:1.
 The reasons for Nalco’s plight are its decision to go for the production of aluminium which consumes heavy
electricity in addition to alumina. The problem of power shortage led to the setting up of power plant, which is
proving very costly to the company. The overcapacities of aluminium production worldwide and highly
competitive prices have added to Nalco’s woes. Nalco is trying to get out of its problems by attempting to
diversify into value-added products.
Nalco’s fate can change if the domestic demand for aluminium picks up and international prices rise. The
mounting debt of the company poses a question: Should you use heavy dose of debt (since it is available from
certain sources) to finance investments in a business like aluminium which has worldwide overcapacity,
fluctuating international prices and expensive and short supply of electricity in the country in which it is set up?
Debt would accentuate the financial crises when a company has built-in operating uncertainties.
Operating cash flows relate to the operations of the firm and can be determined from the projected profit and
loss statements. The behaviour of sales volume, output price and input price over the period of analysis should
be examined and predicted
Non-operating cash flows generally include capital expenditures and working capital changes. During a
recessionary period, the firm may have to specially spend on advertising etc. for the promotion of the product.
Such expenditures should be included in the non operating cash flows. Certain types of capital expenditures
cannot be avoided even during most adverse conditions. They are necessary to maintain the minimum operating
efficiency of the firm’s resources. Such irreducible, minimum capital expenditures should be clearly identified.
Financial flows include interest, dividends, lease rentals, repayment of debt etc. They are further divided into:
contractual obligations and policy obligations. Contractual obligations include those financial obligations, like
interest, lease rentals and principal payments that are matters of contract, and should not be defaulted.
Policy obligations consist of those financial obligations, like dividends, that are at the discretion of the board of
directors. Policy obligations are also called discretionary obligations.
The cash flow analysis may indicate that a decline in sales, resulting in profit decline or losses, may not
necessarily cause cash inadequacy. This may be so because cash may be realised from permanent inventory and
receivable. Also, some of the permanent current liabilities may decline with fall in sales and profits. On the
other hand, when sales and profits are growing, the firm may face cash inadequacy, as large amount of cash is
needed to finance growing inventory and receivable. If the profits decline due to increase in expenses or falling
output prices, instead of the decline in the number of units sold, the firm may face cash inadequacy because its
funds in inventory and receivable will not be released. The point to be emphasised is that a firm should carry
out cash flow analysis to get a clear picture of its ability to service debt obligations even under the adverse
conditions, and thus, decide about the proper amount of debt. The firm must examine the impact of alternative
debt policies on the firm’s cash flow ability. The firm should then choose the debt policy, which it can
implement.
11.3.3.4 Utility of cash flow analysis
Is cash flow analysis superior to EBIT-EPS analysis? How does it incorporate the insights of the finance
theory? The cash flow analysis has the following advantages
It focuses on the liquidity and solvency of the firm over a long period of time, even encompassing adverse
circumstances. Thus, it evaluates the firm’s ability to meet fixed obligations.
It is more comprehensive and goes beyond the analysis of profit and loss statement and also considers
changes in the balance sheet items.
It identifies discretionary cash flows. The firm can thus prepare an action plan to face adverse situations.
It provides a list of potential financial flows, which can be utilised under emergency
It is a long-term dynamic analysis and does not remain confined to a single period analysis. The most
significant advantage of the cash flow analysis is that it provides a practical way of incorporating the insights of
the finance theory. As per the theory, debt financing has tax advantage. But it also involves risk of financial
distress. Therefore, the optimum amount of debt depends on the trade-off between tax advantage of debt and
risk of financial distress. Financial distress occurs when the firm is not in a position to meet its contractual
obligations. The cash flow analysis indicates when the firm will find it difficult to service its debt. Therefore, it
is useful in providing good insights to determine the debt capacity, which helps to maximise the market value
of me firm.
11.3.3.5 Cash flow analysis versus debt-equity ratio
The cash flow analysis might reveal that a higher debt-equity ratio is not risky if the company has the ability of
generating substantial cash inflows in the future to meet its fixed financial obligations. Financial risk in this
sense is indicated by the company’s cash-flow ability, not by the debt-equity ratio.
To quote Van Horne the analysis of debt-to-equity ratios alone can be deceiving, and analysis of the magnitude
and stability of cash-flows relative to fixed charges is extremely important in determining the appropriate
capital structure for the firm. To the extent that creditors and investors analyse a firm’s cash-flow ability to
service debt, and management’s risk preferences correspond to those of investors, capital structure decisions
made in this basis should tend to maximise share price. The cash-flow analysis does have its limitations. It is
difficult to predict all possible factors, which may influence the firm’s cash flows. Therefore, it is not a
foolproof technique to determine the firm’s debt policy
11.4 PRACTICALCONSIDERATIONS IN DETERMINING CAPITAL STRUCTURE
The determination of capital structure in practice involves additional considerations in addition to the concerns
about EPS, value and cash flow. A firm may have enough debt servicing ability but it may not have assets to
offer as collateral. Attitudes of firms with regard to financing decisions may also be quite often influenced by
their desire of not losing control, maintaining operating flexibility and have convenient timing and cheaper
means of raising funds. Some of the most important considerations are discussed below.
11.4.1 Assets
The forms of assets held by a company are important determinants of its capital structure. Tangible fixed assets
serve as collateral to debt. In the event of financial distress, the lenders can access these assets and liquidate
them to realise funds lent by them. Companies with higher tangible fixed assets will have less expected costs of
financial distress and hence, higher debt ratios. On the other hand, those companies, whose primary assets
are intangible assets, will not have much to offer by way of collateral and will have higher costs of financial
distress. Companies have intangible assets in the form of human capital, relations with stakeholders, brands,
reputation etc., and their values start eroding as the firm faces financial difficulties and its financial risk
increases.
11.4.2 Growth Opportunities
The nature of growth opportunities has an important influence on a firm’s financial leverage. Firms with high
market-to-book value ratios have high growth opportunities. A substantial part of the value for these companies
comes from organisational or intangible assets. These firms have a lot of investment opportunities. There is also
higher threat of bankruptcy and high costs of financial distress associated with high growth firms once they
start facing financial problems. These firms employ lower debt ratios to avoid the problem of under-investment
and costs of financial distress. But bankruptcy is not the only time when debt-financed high-growth firms let go
of the valuable investment opportunities. When faced with the possibility of interest default, managers tend to
be risk averse and either put off major capital projects or cut down on R&D expenses or both. Therefore, firms
with growth opportunities will probably find debt financing quite expensive in terms of high interest to be paid
due to lack of good collateral and investment opportunities to be lost. High growth firms would prefer to take
debts with lower maturities to keep interest rates down and to retain the financial flexibility since their
performance can change unexpectedly any time. They would also prefer unsecured debt to have operating
flexibility. Mature firms with low market-to-book value ratio and limited growth opportunities face the risk of
managers spending free cash flow either in unprofitable maturing business or diversifying into risky businesses.
Both these decisions are undesirable. This behaviour of managers can be controlled by high leverage that makes
them more careful in utilising surplus cash. Mature firms have tangible assets and stable profits. They have low
costs of financial distress. Hence these firms would raise debt with longer maturities as the interest rates will
not be high for them and they have a lesser need of financial flexibility since their fortunes are not expected to
shift suddenly. They can avail high interest tax shields by having high leverage ratios.
11.4.3 Debt- and Non-debt Tax Shields
We know that debt, due to interest deductibility, reduces the tax liability and increases the firm’s after-tax free
cash flows. In the absence of personal taxes, the interest tax shields increase the value of the firm. Generally,
investors pay taxes on interest income but not on equity income. Hence, personal taxes reduce the tax
advantage of debt over equity. The tax advantage of debt implies that firms will employ more debt to reduce tax
liabilities and increase value. In practice, this is not always true as is evidenced from many empirical studies.
Firms also have non-debt tax shields available to them. For example, firms can use depreciation; carry forward
losses etc. to shield taxes. This implies that those firms that have larger non-debt tax shields would employ low
debt, as they may not have sufficient taxable profit available to have the benefit of interest deductibility.
However, there is a link between the non-debt tax shields and the debt tax shields since companies with higher
depreciation would tend to have higher fixed assets, which serve as collateral against debt.
11.4.4 Financial Flexibility and Operating Strategy
A cash flow analysis might indicate that a firm could carry high level of debt without much threat of
insolvency. But in practice, the firm may still make conservative use of debt since the future is uncertain and it
is difficult to be able to consider all possible scenarios of adversity.
It is, therefore, prudent to maintain financial flexibility that enables the firm to adjust to any change in the
future events or forecasting error. As discussed earlier, financial flexibility is a serious consideration in setting
up the capital structure policy. Financial flexibility means a company’s ability to adapt its capital structure to
the needs of the changing conditions. The company should be able to raise funds, without undue delay and cost,
whenever needed, to finance the profitable investments. It should also be in a position to redeem its debt
whenever warranted by the future conditions. The financial plan of the company should be flexible enough to
change the composition of the capital structure as warranted by the company’s operating strategy and needs. It
should also be able to substitute one form of financing for another to economise the use of funds. Flexibility
depends on loan covenants, option to early retirement of loans and the financial slack, viz., excess resources at
the command of the firm.
11.4.5 Loan Covenants
Restrictive covenants are commonly included in the long-term loan agreements and debentures. These
restrictions curtail the company’s freedom in dealing with the financial matters and put it in an inflexible
position. Covenants in loan agreements may include restrictions to distribute cash dividends, to incur capital
expenditure, to raise additional external finances or to maintain working capital at a particular level. The types
of covenants restricting the firm’s investment, financing and dividend policies vary depending on the source of
debt. While private debt contains both affirmative and negative covenants, public debt has a lot of negative
covenants and commercial paper does not entail much restrictions. Loan covenants may look quite reasonable
from the lenders’ point of view as they are meant to protect their interests, but they reduce the flexibility of the
borrowing company to operate freely and it may become burdensome if conditions change. Growth firms prefer
to take private rather than public debt since it is much easier to renegotiate terms in time of crisis with few
private lenders than several debenture-holders. Generally, a company while issuing debentures or accepting
other forms of debt should ensure to have minimum of restrictive clauses that circumscribe its financial actions
in the future in debt agreements. This is a tough task for the financial manager. A highly levered firm is subject
to many constraints under debt covenants that restrict its choice of decisions, policies and programmes.
Violation of covenants can have serious adverse consequences. The firm’s ability to respond quickly to
changing conditions also reduces. The operating inflexibility could prove to be very costly for the firms that are
operating in unstable environment. These companies are likely to have low debt ratios and maintain high
financial flexibility to remain competitive and not allow compromising their competitive posture. Thus,
financial flexibility is essential to maintain the operating flexibility and face unanticipated contingencies.
11.4.6 Financial Slack
The financial flexibility of a firm depends on the financial slack it maintains. The financial slack includes
unused debt capacity, excess liquid assets, unutilised lines of credit and access to various untapped sources of
funds. The financial flexibility depends a lot on the company’s debt capacity and unused debt capacity. The
higher is the debt capacity of a firm and the higher is the unused debt capacity; the higher will be the degree of
flexibility enjoyed by the firm. If a company borrows to the limit of its debt capacity, it will not be in a position
to borrow additional funds to finance unforeseen and unpredictable demands except at restrictive and
unfavourable terms. Therefore, a company should not borrow to the limit of its capacity, but keep available
some unused capacity to raise funds in the future to meet some sudden demand for finances.
11.4.7 Early repayment
A considerable degree of flexibility will be introduced if a company has the discretion of early repaying its
debt. This will enable management to retire or replace cheaper source of finance for the expensive one
whenever warranted by the circumstances. When a company has excess cash and does not have profitable
investment opportunities, it becomes desirable to retire debt. Similarly, a company can take advantage of
declining rates of interest if it has a right to repay debt at its option. Suppose that funds are available at 12 per
cent rate of interest presently. The company has outstanding debt at 16 per cent rate o f interest. It can save in
terms of interest cost if it can retire the ‘old’ debt and replace it by the ‘new’ debt.
11.4.8 Limits of financial flexibility
Financial flexibility is useful, but the firm must understand its limit. It can help a profitable firm to seize
opportunities, and it can provide temporary help in adverse situation, but it cannot save a firm, which is
basically unhealthy. No doubt that financial flexibility is desirable, but the firm should have basic financial
strength.
 Also, it is achieved at a cost. A company trying to obtain loans on easy terms will have to pay interest at a
higher rate. Also, to obtain the right of refunding, it may have to compensate lenders by paying a higher interest
or may have to allow them to participate in the equity. Therefore, the company should compare the benefits and
costs of attaining the desired degree of flexibility and balance them properly.
11.4.9 Sustainability and Feasibility
The financing policy of a firm should be sustainable and feasible in the long run. Most firms want to maintain
the sustainability of their financing policy over a long period of time. The sustainable growth model helps to
analyse the sustainability and the feasibility of the long-term financial plans in achieving growth. This model is
based on the assumption that the firm uses the internal financing and debt, consistent with the target debt-equity
ratio and payout ratio and does not issue shares during the planning horizon. Given the firm’s financing and
payout policies and operating efficiency, this model implies that its assets and sales will grow in tandem with
growth in equity (internal). Thus, the sustainable growth depends on return on equity (ROE) and retention ratio:
Alternatively, ROE depends on the firm’s before-tax return on capital employed (ROCE), the financial leverage
premium and the tax rate: ROE = [ROCE + (ROCE - Kd) D/E] (1 - T) (3)
The sustainable growth model indicates the growth rate that the firm should target. Any other growth rate will
not be consistent with the financial policies set by the management.
Sustainable growth = ROE x (1 - payout) (1)
ROE depends on assets turnover, net margin, and financial leverage:
ROE = asset turnover x net margin x leverage
ROE = assets/sales x net profit/sales x assets/equity (2)
If the firm intends to achieve a different growth rate than that implied by the sustainable growth model, it will
have to change its financial policy, either the debt-equity ratio, or the payout ratio or both. In fact, the model
also indicates the trade-offs between the financing and operating policies. Instead of changing its financial
policies for achieving higher growth, the firm can examine its operating policies vis-à-vis price, cost, assets
utilisation etc. The firm must realise that growth does not ensure value creation. If the firm does not account for
the investment duration and the cost of capital, growth may destroy value. The firm should also examine the
impact of alternative financial policy on the value of the firm.
11.4.10 Control
In designing the capital structure, sometimes the existing management is governed by its desire to continue
control over the company. This is particularly so in the case of the firms promoted by entrepreneurs. The
existing management team not only wants control and ownership but also to manage the company, without any
outside interference.
11.4.11 Widely held companies
The ordinary shareholders elect the directors of the company. If the company issues new shares, there is risk of
dilution of control. The company can issue rights shares to avoid dilution of ownership. But the existing
shareholders may not be willing to fully subscribe to the issue. Dilution is not a very important consideration in
the case of widely held companies. Most shareholders are not interested in taking active part in a company’s
management. Nor do they have time and money to attend the meetings. They are interested in dividends and
capital gains. If they are not satisfied, they will sell their shares. Thus, the best way to ensure control and to
have the confidence of the shareholders is to manage the company most efficiently and compensate
shareholders in the form of dividends and capital gains. The risk of loss of control can be reduced by
distribution of shares widely and in small lots.
11.4.12 Closely held companies
The consideration of maintaining control may be significant in case of closely held and small companies. A
shareholder or a group of shareholders can purchase all or most of the new shares of a small or closely held
company and control it. Even if the owner-managers hold the majority shares, their freedom to manage the
company will be curtailed when they go for initial public offerings (IPOs). Fear of sharing control and being
interfered by others often delays the decision of the closely held small companies to go public. To avoid the risk
of loss of control, small companies may slow their rate of growth or issue preference shares or raise debt
capital. If the closely held companies can ensure a wide distribution of shares, they need not worry about the
loss of control so much. The holders of debt do not have voting rights. Therefore, it is suggested that a company
should use debt to avoid the loss of control. However, when a company uses large amount of debt, a lot of
restrictions are put by the debt-holders, specifically the financial institutions in India, since they are the major
providers of loan capital to the companies. These restrictions curtail the freedom of the management to run the
business. A very excessive amount of debt can also cause serious liquidity problem and ultimately render the
company sick, which means a complete loss of control.
11.4.13 Marketability and Timing
Marketability means the readiness of investors to purchase a security in a given period of time and to demand
reasonable return. Marketability does not influence the initial capital structure, but it is an important
consideration to decide about the appropriate timing of security issues. The capital markets are changing
continuously. At one time, the market favours debenture issues, and, at another time, it may readily accept share
issues. Due to the changing market sentiments, the company has to decide whether to raise funds with an
equity issue or a debt issue. The alternative methods of financing should, therefore, be evaluated in the light of
general market conditions and the internal ‘conditions of the company.
11.4.14 Capital market conditions
If the capital market is depressed, a company will not issue equity shares, but it may issue debt and wait to issue
equity shares till the share market revives. During boom period in the share market, it may be advantageous for
the company to issue shares at high premium. This will help to keep its debt capacity unutilised. The internal
conditions of a company may also dictate the marketability of securities. For example, a highly levered
company may find it difficult to raise additional debt. Similarly, when restrictive covenants in existing debt-
agreements preclude payment of dividends on equity shares, convertible debt may be the only source to raise
additional funds. A small company may find difficulty in issuing any security in the market merely because of
its small size. The heavy indebtedness, low payout, small size, low profitability, high degree of competition etc.
cause low rating of the company, which would make it difficult for the company to raise external finance at
favourable terms.
11.4.15 Issue Costs
Issue or flotation costs are incurred when the funds are externally raised. Generally, the cost of floating a debt is
less than the cost of floating an equity issue. This may encourage companies to use debt than issue equity
shares. Retained earnings do not involve flotation costs. The source of debt also influences the issue costs with
fixed costs being much higher for issue of commercial paper and public debt (debenture) than the private debt.
This also means that economies of scale are high for the debt instruments having high fixed costs. Hence these
instruments should be used when large amounts of funds are needed. Issue costs as a percentage of funds raised
will decline with larger amount of funds. Large firms require large amounts of funds, and they may plan large
issues of securities to economise on the issue costs. These firms are more likely than others to resort to
commercial paper or public debt for raising capital. A large issue of securities can, however, curtail a
company’s financial flexibility. The company should raise only that much of funds, which it can employ
profitably. Many other more important factors have to be considered when deciding about the methods of
financing and the size of a security issue.
11.4.16 Capacity of Raising Funds
The size of a company may influence its capital and availability of funds from different sources. A small
company finds great difficulties in raising long-term loans. If it is able to obtain some long-term loan, it will be
available at a higher rate of interest and inconvenient terms. The highly restrictive covenants in loan agreements
in case of small companies make their capital structures very inflexible and management cannot run business
freely without interference. Small companies, therefore, depend on share capital and retained earnings for their
long-term funds requirements. It is quite difficult for small companies to raise share capital in the capital
markets. Also, the capital base of most small companies is so small that they cannot be listed on the stock
exchanges. For those small companies, which are able to approach the capital markets, the cost of issuing
shares is generally more than the large ones. Further, resorting frequently to ordinary share issues to raise long-
term funds carries a greater risk of the possible loss of control for a small company. The shares of small
companies are not widely scattered and the dissident group of shareholders can be easily organised to get
control of the company. The small companies, therefore, sometimes limit the growth of their business to what
can easily be financed by retaining the earnings.
A large company has relative flexibility in designing its capital structure. It can obtain loans on easy terms and
sell ordinary shares, preference shares and debentures to the public. Because of the large size of issues, its cost
of distributing a security is less than that for a small company. A large issue of ordinary shares can be widely
distributed and thus, making the loss of control difficult. The size of the firm has an influence on the amount
and the cost of funds, but it does not necessarily determine the pattern of financing. In practice, the debt-equity
ratios of the firms do not have a definite relationship with their size.
EXHIBIT 11.3 DO MANAGERS PREFER BORROWING?
A number of companies in practice prefer to borrow for the following reasons:
Tax deducibility of interest
Higher return to shareholders due to gearing
 Complicated procedure for raising equity capital
No dilution of ownership and control
Equity results in a permanent commitment than debt.
There are, however, managers whose choice of financing depends on internal and external factors. The
internal factors include: purpose of financing, company’ earning capacity, existing capital structure, cash flow
ability, investment plans etc. The external factors are: capital and money market conditions, debt-equity
stipulations followed by financiers, restrictions imposed etc. A company, for example, feels:
“There can be no specific preference towards borrowings as a source of finance. The company’s financial
requirement will vary from time to time depending on factors such as its existing capital structure, investment
plans vis-à-vis expansion, modernisation and replacement as also its margin money requirement for incremental
working capital. In addition, the cost of share issue, existing money market and banking conditions and the
impact of statutory regulations would influence the mix of finance required by a company.”
In practice, it may not be possible for a company to borrow whenever it wants. Lenders may analyse a
number of characteristics of the borrower before they decide to lend. What factors do borrowers think are
considered by lenders? Borrowing firms’ managers perceive the following factors in order of importance being
considered by lenders: (i) profitability, (ii) quality of management, (iii)security, (iv) liquidity, (v) existing debt-
equity ratio, (vi) sales growth, (yii) net worth, (viii) reserve position, and (ix) fluctuations in profits.
11.4.17 MANAGER’S ATTITUDE TOWARDS DEBT
We know now the factors, which are theoretically important in determining the capital structure policy of a
company. They are interest tax shield (adjusted for personal taxes) and costs of financial distress. We also know
the additional factors in practice such as sales growth and stability, cash flow, market conditions, transaction
costs etc. which may have influence on the choice of capital structure. How do managers really view the
question of borrowing? There seems to be a mixed feeling. Some would prefer borrowing while others would
like to decide after considering a variety of factors. They also feel that they can borrow only when lenders are
prepared to lend. They think that lenders evaluate a number of factors before deciding to lend, and these factors
go beyond the theoretical considerations of risk, return and value.
12 INTERNATIONAL CAPITAL STRUCTURE
In the two previous sections, we examined various motivations for using particular types of financing.
However, while knowledge of the costs and benefits of each individual source of funds is helpful, it is not
sufficient to establish an optimal global financial plan. This plan requires consideration not only of the
component costs of capital, but also of how the use of one source affects the cost and availability of other
sources. A firm that uses too much debt might find the cost of equity (and new-debt) financing prohibitive. The
capital structure problem for the multinational enterprise, therefore, is to determine the mix of debt and equity
for the parent entity and for all consolidated and unconsolidated subsidiaries that maximizes shareholder
wealth. The focus is on the consolidated, worldwide financial structure because suppliers of capital to a
multinational firm are assumed to associate the risk of default with the MNC’s worldwide debt ratio. This
association stems from the view that bankruptcy or other forms of financial distress in an overseas subsidiary
can seriously impair the parent company’s ability to operate domestically. Any deviations from the MNC’s
target capital structure will cause adjustments in the mix of debt and equity used to finance future investments.
Another factor that may be relevant in establishing a worldwide debt ratio is the empirical evidence that
earnings variability appears to be a decreasing function of foreign source earnings. Because the risk of
bankruptcy for a firm is dependent on its total earnings variability, th earnings diversification provided by its
foreign operations may enable the multinational - firm to leverage itself more highly than can a purely domestic
corporation, without increasing its default risk.
12.1 FOREIGN SUBSIDIARY CAPITAL STRUCTURE
Once a decision has been made regarding the appropriate mix of debt and equity for the entire corporation,
questions about individual operations can be raised. How should MNCs arrange the capital structures of their
foreign affiliates? And what factors are relevant in making this decision? Specifically, the problem is whether
foreign subsidiary capital structures should
 Conform to the capital structure of the parent company
 Reflect the capitalization norms in each foreign county
 Vary to take advantage of opportunities to minimize the MNC’s cost of capital
Disregarding public and government relations and legal requirements for the moment, the parent company
could finance its foreign affiliates by raising funds in its own country and investing these funds as equity. The
overseas operations would then have a zero debt ratio (debt/total assets).
Alternatively, the parent could hold only one dollar of share capital in each affiliate and require all to borrow on
their own, with or without guarantees; in this case, affiliate debt ratios would approach 100%. Or the parent can
itself borrow and relend the monies as intra-corporate advances. Here again, the affiliates’ debt ratios would be
close to 100%, In all these cases, the total amount of borrowing and the debt/equity mix of the consolidated
corporation are identical. Thus, the question of an optimal capital structure for a foreign affiliate is completely
distinct from the corporation’s overall debt / equity ratio.
Moreover, any accounting rendition of a separate capital structure for the subsidiary is wholly illusory unless
the parent is willing to allow its affiliate to default on its debt. As long as the rest of the MNC group has a legal
or moral obligation or sound business reasons for preventing the affiliate from defaulting, the individual unit
has no independent capital structure Rather, its true debt/equity ratio is equal to that of the consolidated group.
The irrelevance of subsidiary financial structures seems to be recognized by multinationals. In a 1979 survey by
Business International of eight U.S. based MNCs, most of the firms expressed little concern with the debt/
equity mixes of their foreign affiliates (Admittedly, for most of the firms interviewed, the debt ratios of
affiliates had not significantly raised the MNCs’ consolidated indebtedness.) Their primary focus was on the
worldwide, rather than individual, capital structure. The third option of varying affiliate financial structures to
take advantage of local financing opportunities appears to be the appropriate choice. Thus, within the
constraints set by foreign statutory or minimum equity requirements, the need to appear to be a responsible and,
good guest, and the requirements of a worldwide financial structure, a multinational corporation should finance
its affiliates to minimize its incremental average cost of capital. A subsidiary with a capital structure similar to
its parent may forgo profitable opportunities to lower its cost of funds. For example, rigid adherence to a fixed
debt/ equity ratio may not allow a subsidiary to take advantage of government-subsidized debt or low-cost loans
from international agencies. Furthermore, it may be worthwhile to raise funds locally if the country is
politically risky. In the event the affiliate is expropriated, for instance, it would default on all loans from local
financial institutions. Similarly, borrowing funds locally will decrease the company’s vulnerability to exchange
controls. Local currency (LC) profits can be used to service its LC debt. On the other hand, forcing a subsidiary
to borrow funds locally to meet parent norms may be quite expensive in a country with a high-cost, capital
market or if the subsidiary is in a tax-loss-carry forward position. In the latter case, since the subsidiary can’t
realize the tax benefits of the interest write-off, the parent should make an equity injection financed by
borrowed funds. In this way, the interest deduction need not be sacrificed.
Leverage and the Tax Reform Act of 1986. The choice of where to borrow to finance foreign operations has
become more complicated with passage of the Tax Reform Act of 1986 because the distribution of debt
between U.S. parents and their foreign subsidiaries affects the use of foreign tax credits. Tax Reform Act has
put many U.S,-based MNCs in a position of excess foreign tax credits. One way to use up these FTCs is to push
expenses overseas—and thus lower overseas profits—by increasing the leverage of foreign subsidiaries. In the
aforementioned example, the U.S. parent may have one of its taxpaying foreign units borrow funds and use
them to pay a dividend to the parent. The parent can then turn around and invest these funds as equity in the
non-tax paying subsidiary, In this way, the worldwide corporation can reduce its taxes without being subject to
the constraints imposed by the Tax Reform Act.
Leasing and the Tax Reform Act of 1986. As an alternative to increasing the debt of foreign subsidiaries, U.S.
multinationals could expand their use of leasing in the United States. Although leasing an asset is economically
equivalent to using borrowed funds to purchase the asset, the international tax consequences differ. Prior to
1986, U.S. multinationals counted virtually all their interest expense as a fully deductible U.S. expense. Under
the new law, firms must allocate interest expense on general borrowings to match the location of their assets,
even if all the interest is paid in the United States. This allocation has the effect of reducing the amount of
interest expense that can be written off against U.S. income. Rental expense, on the other hand, can be allocated
to the location of the leased property. Lease payments on equipment located in the United States, therefore,
can be fully deducted. At the same time, leasing equipment to be used in the United States, instead of
borrowing to finance it, increases reported foreign income (since there is less interest expense to allocate
against foreign income). The effect of leasing, therefore, is to increase the allowable foreign tax credit to offset
U.S. taxes owed on foreign source income, thereby providing another tax advantage of leasing for firms that
Owe U.S. tax on their foreign source income.
Cost Minimizing Approach to Global Capital Structure: The cost-minimizing approach to determining
foreign affiliate capital structures would be to allow subsidiaries with access to low-cost capital markets to
exceed the parent company capitalization norm, while subsidiaries in higher-capital-cost nations would have
lower target debt ratios. These costs must be figured on an after-tax basis, taking into account the company’s
worldwide tax position.
A counterargument is that a subsidiary’s financial structure should conform to local norms. Then because
German and Japanese firms are more highly leveraged than, say, companies in the United States and France, the
Japanese and German subsidiaries of a U.S. firm should have much higher debt/equity ratios than the U.S.
parent or a French subsidiary.
The problem with this argument, though, is that it ignores the strong linkage between U.S-based multinationals
and the U.S. capital market. Because most of their stock is owned and traded in the United States, it follows that
the firms’ target debt/equity ratios are dependent on U.S. shareholders’ risk perceptions. Similar arguments
hold for multinationals not based in the United States. Furthermore, the level of foreign debt/equity ratios is
usually determined by institutional factors that have no bearing on foreign-based multinationals, For example.
Japanese and German banks own much of the equity as well as the debt issues of local corporations. Combining
the functions of stockholder and lender may reduce the perceived risk of default on loans to captive
corporations and increase the desirability of substantial leverage. These institutional considerations would not
apply to a wholly owned subsidiary. However, a joint venture with a corporation tied to the local banking
system may enable an MNC to lower its local cost of capital by leveraging itself— without a proportional
increase in risk - to a degree that would be impossible otherwise. The basic hypothesis proposed in this section
is that a subsidiary’s capital structure is relevant only insofar as it affects the parent’s consolidated worldwide
debt ratio. Nonetheless, some companies have a general policy of “every tub on its own bottom.” Foreign units
are expected to be financially independent following the parent’s initial investment. The rationale for this policy
is to “avoid giving management a crutch”. By forcing foreign affiliates to stand on their own feet, affiliate
managers will presumably be working harder to improve local operations, thereby generating the internal cash
flow that will help replace parent financing. Moreover, the local financial institutions will have a greater
incentive to monitor the local subsidiary’s performance because they can no longer look to the parent company
to bail them out if their loans go sour. But companies that expect their subsidiaries to borrow locally had better
be prepared to provide enough initial equity capital or subordinated loans. In addition, local suppliers and
customers are likely to shy away from a new subsidiary operating on a shoestring if that subsidiary is not
receiving financial backing from its parent. The foreign subsidiary may have to show its balance sheet to local
trade creditors, distributors, and other stakeholders. Having a balance sheet that shows more equity
demonstrates that the unit has greater staying power. It also takes more staff time to manage a highly leveraged
subsidiary in counties like Brazil and Mexico where government controls and high inflation make local funds
scarce. One treasury manager complained. “We spend 75%—8O% of management’s time trying to figure out
how to finance the company. Running around chasing our tails instead of attending to our basic business—
getting production costs lower, sales up, and making the product better.”
12.2 PARENT COMPANY GUARANTEES AND CONSOLIDATION
Multinational firms are sometimes reluctant to guarantee explicitly the debt of their subsidiaries, even when a
more advantageous interest rate can be negotiated for several reasons.
1. Some companies argue that their affiliates should be able to stand alone. In the case of a joint venture when
the other partner is unable or unwilling to provide a valuable counter guarantee, a penalty rate of interest may
be accepted to avoid over-financing other shareholders. A cost is incurred to maintain a principle and avoid a
dangerous precedent.
2. The protection against expropriation provided by an affiliate’s borrowing may be lost if the parent guarantees
those debts.
3. Many firms believe lenders should be reasonable, requesting a guarantee when the affiliate is operating at a
loss or with a debt-heavy capital structure and lending without one when the borrower itself is creditworthy.
4. Providing explicit support for one operation can lead to lenders’ demands in other cases.
5. Many firms assume that non-guaranteed debt would not be included in the parent company’s worldwide debt
ratio, whereas guaranteed debt as a contingent liability would affect the parent’s debt-raising capacity. The
issue of whether or not to issue guarantees may be more important in theory than in fact. It is likely that a
parent company would keep lenders whole if a subsidiary defaulted, even if it had no legal obligation to do so.
in a 1985 survey by Business International, most treasurers said that they would always assume the debt of a
failed overseas subsidiary even if the parent had not guaranteed it. This attitude reflects pragmatic business
reasons, not benevolence or a sense of morality. A multinational firm relies on financial institutions in many
countries. In a real sense, it could rarely, if ever, function without them. Any action, such as allowing an
affiliate to become bankrupt, that jeopardizes these relations has an extremely high cost. Multinational firms
also may distinguish between international and local banks. The former could be kept whole and the latter
directed to their own government for repayment if an affiliate were expropriated and were unable to pay its
debts.
If an explicit guarantee will reduce a subsidiary’s borrowing costs, it will usually be in the parent’s best interest
to give this support, provided there is an actual commitment to satisfy the subsidiary’s obligations. It is likely
that the market has already incorporated this practical commitment in its estimate of the parent’s worldwide
debt capacity. An overseas creditor, on the other hand, may not be as certain regarding the firm’s intentions.
The fact that the parent doesn’t guarantee its subsidiaries’ debt may then convey some information
(i.e., commitment to subsidiary debt is not that strong). In at least two cases, Raytheon in Sicily (1968) and
Freeport Sulphur in Cuba (1960), firms did allow their foreign affiliates to go bankrupt. However, the publicity
surrounding these events makes it clear how unusual they were. Moreover, a parent that once walks away from
the debt of an affiliate will be unable to again borrow overseas unless it either guarantees its affiliates’ debts or
pays a higher interest rate to compensate lenders for the possibility of default.
The U.S. Internal Revenue Service argues that by guaranteeing foreign affiliates’ debts, a U.S. corporation is
providing a valuable service for which it should be compensated. The IRS, therefore, imputes income to the
guarantor and levies a tax. This additional tax cost should be incorporated in the determination of whether the
parent should guarantee a foreign subsidiary’s borrowing. Another factor may also influence corporate policy
regarding parent guarantees. When a firm provides an affiliate with a loan guarantee, “you lose the bank as your
partner in controls.” Since it will be repaid regardless of the affiliate’s profitability, the bank will have
less incentive to monitor the affiliate’s activities. On the other hand, in the absence of a guarantee, the local
bank will probably insist on inserting various restrictive covenants in its loan agreement with the subsidiary.
The parent can prevent these restrictive covenants and the resulting loss in operational and financial flexibility
by supplying loan guarantees. The relative magnitudes of these two costs will help determine whether the
parent guarantees its affiliates’ debts. Related to the issue of parent-guaranteed debt is the belief among some
firms that do not consolidate their foreign affiliates that unconsolidated (and non-guaranteed) overseas debt
need not affect the MNC’s debt ratio. But unless investors and analysts can be fooled permanently,
unconsolidated overseas leveraging will not allow a firm to lower its cost of capital below the cost of capital for
an identical firm that consolidates its foreign affiliates. Any overseas debt offering that is large enough to
materially affect an MNC’s degree of leverage would quickly come to the attention of financial analysts. Some
evidence of this form of market efficiency was provided by bond raters at Moody’s and at Standard and Poor’s.
Individuals from both agencies said that they would closely examine situations where non-guaranteed debt
issued by unconsolidated foreign affiliates would noticeably affect a firm’s worldwide debt: equity ratio. In
addition, parent company-guaranteed debt is included in bond rater analyses of a firm’s contingent liabilities,
whether this debt is consolidated or not. Thus, it appears that the growing financial sophistication of MNCs has
been paralleled by increased sophistication among rating agencies and investors.
12.3 JOINT VENTURES
Because many MNCs participate in joint ventures, either by choice or necessity, establishing an appropriate
financing mix for this form of investment is an important consideration. The previous assumption that affiliate
debt is equivalent to parent debt in terms of its impact on perceived default risk may no longer be valid. In
countries such as Japan and Germany, increased leverage will not necessarily lead to increased financial risks,
due to the close relationship between the local banks and corporations. Thus, debt raised by a joint venture in
Japan, for example, may not be equivalent to parent-raised debt in terms of its impact on default risk. The
assessment of the effects of leverage in a joint venture requires a qualitative analysis of the partner’s ties with
the local financial community, particularly with the local banks. Unless the joint venture can be isolated from
its partners’ operations, there are likely to be some significant conflicts associated with this form of ownership.
Transfer pricing, setting royalty and licensing fees, and allocating production and markets among plants are just
some of the areas in which each owner has an incentive to engage in activities that will harm its partners. These
conflicts explain why bringing in outside equity investors is generally such an unstable form of external
financing. Because of their lack of complete control over a joint venture’s decisions and its profits, most MNCs
will, at most, guarantee joint venture loans in proportion to their share of ownership. But where the MNC is
substantially stronger financially than its partner, the MNC may wind up implicitly guaranteeing its weaker
partner’s share of any joint-venture borrowings, as well as its own. In this case, it makes sense to push for as
large an equity base as possible; the weaker partner’s share of the borrowings is then supported by its larger
equity investment,
 UNIT V FINANCIAL DISTRESS
Consequences, Issues, Bankruptcy, Settlements, reorganization and Liquidation in bankruptcy.

13 FINANCIAL DISTRESS
Financial distress is defined as a condition where obligations are not met or are met with difficulty. It is a
situation where a firm’s operating cash flows are not sufficient to satisfy current obligations and the firm is
forced to take corrective action. Financial distress may lead a firm to default on a contract, and it may involve
financial restructuring between the firm, its creditors, and its equity investors. The three terms default,
bankruptcy and financial distress can be distinguished as follows
Default – Failure to meet an interest payment, or – Violation of debt agreement
Bankruptcy – Formal procedure for working out default – Does not automatically follow from default.
Financial Distress – Includes default and bankruptcy, but also – Threat of default or bankruptcy and its effect
on the company – Defined to capture the costs and benefits of using large amounts of debt finance A major
disadvantage for a firm taking on higher levels of debt is that it increases the risk of financial distress, and
ultimately liquidation. This may have detrimental effect on both the equity and debt holders.
13.1 TYPES OF BUSINESS FAILURE
A firm may fail because its returns are negative or low. A firm that consistently reports operating losses will
probably experience a decline in market value. If the firm fails to earn a return that is greater than its cost of
capital, it can be viewed as having failed. Negative or low returns, unless remedied, are likely to result
eventually in one of the following more serious types of failure.
A second type of failure, technical insolvency, occurs when a firm is unable to pay its liabilities as they come
due. When a firm is technically insolvent, its assets are still greater than its liabilities, but it is confronted with a
liquidity crisis. If some of its assets can be converted into cash within a reasonable period, the company may be
able to escape complete failure. If not, the result is the third and most serious type of failure, bankruptcy.
Bankruptcy occurs when a firm’s liabilities exceed the fair market value of its assets. A bankrupt firm has a
negative stockholders’ equity. This means that the claims of creditors cannot be satisfied unless the firm’s
assets can be liquidated for more than their book value. Although bankruptcy is an obvious form of failure, the
courts treat technical insolvency and bankruptcy in the same way. They are both considered to indicate the
financial failure of the firm.
13.2 MAJOR CAUSES OF BUSINESS FAILURE
The primary cause of business failure is mismanagement, which accounts for more than 50 percent of all cases.
Numerous specific managerial faults can cause the firm to fail. Overexpansion, poor financial actions, an
ineffective sales force, and high production costs can all singly or in combination cause failure. For example,
poor financial actions include bad capital budgeting decisions (based on unrealistic sales and cost forecasts,
failure to identify all relevant cash flows, or failure to assess risk properly), poor financial evaluation of the
firm’s strategic plans prior to making financial commitments, inadequate or nonexistent cash flow planning,
and failure to control receivables and inventories. Because all major corporate decisions are eventually
measured in terms of money value, the financial manager may play a key role in avoiding or causing a business
failure. It is his or her duty to monitor the firm’s financial pulse.
Economic activity – especially economic downturns – can contribute to the failure of a firm. If the economy
goes into a recession, sale may decrease abruptly, leaving the firm with high fixed costs and insufficient
revenues to cover them. In addition, rapid rises in interest rates just prior to a recession can further contribute to
cash flow problems and make it more difficult for the firm to obtain and maintain needed financing. During the
early 1990s, a number of major business failures such as those of Olympia and York (real estate) America,
West Airlines, and South mark Corporation (convenience stores) resulted from over expansion and the
recessionary economy. A final cause of business failure is corporate maturity. Firms, like individuals, do not
have infinite lives. Like a product, a firm goes through the stages of birth, growth, maturity, and eventual
decline. The firm’s management should attempt to prolong the growth stage through research, new products,
and mergers. Once the firm has matured and has begun to decline, it should seek to be acquired by another firm
or liquidate before it fails. Effective management planning should help the firm to postpone decline and
ultimate failure.
13.3 THE BUSINESS FAILURE RECORD
How widespread is business failure in the United States? In Table 13-2, we see that a fairly large number of
businesses fail each year, although the failures in any one year are not a large percentage of the total business
population.
It is interesting to note that the failure rate per 10,000 business population fluctuates with the state of the
economy, the average liability per failure has tended to increase over time, at least into the early 1990s.
This is due primarily to inflation, but it also reflects the fact that some very large firms have failed in recent
years. Although bankruptcy is more frequent among smaller firms, it is clear from Table 13- 3 that large firms
are not immune. However, some firms might be too big or too important to be allowed to fail. The mergers or
governmental intervention are often used as an alternative to outright failure and liquidation. The decision to
give federal aid to Chrysler (now a part of Daimler Chrysler AG) in the 1980s is an excellent illustration. Also,
in recent years federal regulators have arranged the absorption of many “problem” financial institutions by
financially sound institutions. In addition, several U.S. government agencies, principally the Defence
Department, were able to bail out Lockheed when it otherwise would have failed, and the “short gun marriage”
of Douglas Aircraft and Mc Donnel was designed to prevent Douglas’s failure. Another example of
intervention is that of Merrill Lynch taking over the brokerage firm Good body & company, which would
otherwise have gone bankrupt and would have frozen the accounts of its 225,000 customers while a
bankruptcy settlement was being worked out. Good body’s failure would have panicked investors across the
country, so New York Stock Exchange member firms put up $30 million as an inducement to get Merrill Lynch
to keep Good body from folding. Similar instances in other industries could also be cited. Why do government
and industry seek to avoid failure among larger firms? There are many reasons. In the case of banks, the main
reason is to prevent an erosion of confidence and a consequent run on the banks. With Lockheed and Douglas,
the Defence Department wanted not only to maintain viable suppliers but also to avoid disrupting local
communities. With Chrysler, the government wanted to preserve jobs as well as a competitor in the U.S. auto
industry. Even when the public interest is not at stake, the fact that bankruptcy is a very expensive process gives
private industry strong incentives to avoid outright bankruptcy. The costs and complexities of a formal
Bankruptcy are discussed in subsequent sections of this chapter, after we examine some less formal and less
expensive procedures.
13.4 CONSEQUENCES OF FINANCIAL DISTRESS
The risk of incurring the costs of financial distress has a negative effect on a firm’s value which offsets the
value of tax relief of increasing debt levels.
These costs become considerable with very high gearing. Even if a firm manages to avoid liquidation its
relationships with suppliers, customers, employees and creditors may be seriously damaged.
Suppliers providing goods and services on credit are likely to reduce the generosity of their terms, or even
stop supplying altogether, if they believe that there is an increased chance of the firm not being in existence in a
few months’ time.
Customers may develop close relationships with their suppliers, and plan their own production on the
assumption of a continuance of that relationship. If there is any doubt about the longevity of a firm it will not be
able to secure high-quality contracts. In the consumer markets customers often need assurance that firms are
sufficiently stable to deliver on promises. In a financial distress situation, employees may become demotivated
as they sense increased job insecurity and few prospects for advancement. The best staff will start to
move to posts in safer companies. Bankers and other lenders will tend to look upon a request for further finance
from a financially distressed company with a prejudiced eye – taking a safety-first approach – and this can
continue for many years after the crisis has passed. Management find that much of their time is spent “fire
fighting” – dealing with day-today liquidity problems – and focusing on short-term cash flow rather than long-
term shareholder wealth. The indirect costs associated with financial distress can be much more significant than
the more obvious direct costs such as paying for lawyers, accountants and for refinancing programs
13.5 SOME INDICATORS OF FINANCIAL DISTRESS
As the risk of financial distress rises with the gearing ratio, shareholders (and lenders) demand an increasing
return in compensation. The important issue is at what point does the probability of financial distress so
increase the cost of equity and debt that it outweighs the benefit of the tax relief on debt?
Financial Analysis may be used to view some of the indicators of the financial distress. Important ratios to be
considered include:
Liquidity ratios Debt management ratios Asset utilization ratios
13.6 BANKRUPTCY PREDICTION MODELS
Interest in insolvency prediction has long been confined to academics, with most of the published material
restricted to business and accounting journals specializing in esoteric and complicated subjects. A possible
reason why insolvency prediction models have not gained greater use in the business community is because it
has been difficult to calculate the results.
With the wide spread use of personal computers and the internet, the utilization of an insolvency prediction
model is now practical and available to all. Now may be the time when prediction models come into their own.
Four software programs are reviewed here using five different prediction models. All of the models reviewed
here, but one, were developed using the statistical technique, step wise multiple discriminate analysis. This
statistical technique gives weights to financial ratios used to best differentiate or discriminate between failed
and successful companies. For example, 22 financial ratios were tested in developing the Altman Model (1968).
66 companies were used - 33 failed and 33 successful. The first result was a formula with 22 functions. The
function that contributed the least to discriminating between the failed and successful companies was dropped
and the statistical software was run again. This was repeated over and over each time dropping the ratio which
least contributed to discriminating between the failed and successful companies. In the case of the Altman
model, five functions remained. The software we have reviewed here are easy to operate and give quick read
outs. We have not evaluated the models compared with each other because it is impossible to say, in this kind
of review, that one model is better or more accurate than another. One of the great problems in developing and
testing prediction models is that it is very difficult to gather data on matched sets of failed and successful
companies. Some Words of Caution! All developers of prediction models warn that the technique should be
considered as just another tool of the analyst and that it is not intended to replace experienced and informed
personal evaluation. Perhaps the best use of any of these models is as a “filter” to identify companies requiring
further review or to establish a trend for a company over a number of years. If, for example, the trend for a
company over a number of years is downward then that company has problems that if caught in time, could be
corrected to allow the company to survive.
13.6.1 Altman Model (U.S. - 1968)
Edward I. Altman (1968) is the dean of insolvency predictors. He was the first person to successfully use step-
wise multiple discriminate analysis to develop a prediction model with a high degree of accuracy. Using the
sample of 66 companies, 33 failed and 33 successful, Altman’s model achieved an accuracy rate of 95.0%.
Altman’s model takes the following form -:
Z = 1.2A + 1.4B + 3.3C + 0.6D + .999E
Z < 2.675; then the firm is classified as “failed”
C = Earnings before Interest and Taxes/Total Assets
D = Market Value of Equity/Book Value of Total Debt
E = Sales/Total Assets
13.6.2 Springate (Canadian - 1978)
This model was developed in 1978 at S.F.U. by Gordon L.V. Springate, following procedures developed by
Altman in the U.S. Springate used step-wise multiple discriminate analysis to select four out of 19 popular
financial ratios that best distinguished between sound business and those that actually failed. The Springate
model takes the following form -:
Z = 1.03A + 3.07B + 0.66C + 0.4D
Z < 0.862; then the firm is classified as “failed”
WHERE A = Working Capital/Total Assets
B = Net Profit before Interest and Taxes/Total Assets
C = Net Profit before Taxes/Current Liabilities
D = Sales/Total Assets
This model achieved an accuracy rate of 92.5% using the 40 companies tested by Springate. Botheras (1979)
tested the Springate Model on 50 companies with an average asset size of $2.5 million and found an 88.0%
accuracy rate. Sands (1980) tested the Springate Model on 24 companies with an average asset size of $63.4
million and found an accuracy rate of 83.3%.
13.6.3 Fulmer Model (U.S. - 1984)
Fulmer (1984) used step-wise multiple discriminate analysis to evaluate 40 financial ratios applied to a sample
of 60 companies -30 failed and 30 successful. The average asset size of these firms was $455,000.
WHERE A = Working Capital/Total Assets B = Retained Earnings/Total Assets
The model takes the following form -:
H = 5.528 (V1) + 0.212 (V2) + 0.073 (V3)
+ 1.270 (V4) - 0.120 (V5) + 2.335 (V6)
+ 0.575 (V7) + 1.083 (V8) + 0.894 (V9) - 6.075
H < 0; then the firm is classified as “failed”
V3 = EBT/Equity
V4 = Cash Flow/Total Debt
V5 = Debt/Total Assets
V6 = Current Liabilities/Total Assets
V7 = Log Tangible Total Assets
V8 = Working Capital/Total Debt
V9 = Log EBIT/Interest
Fulmer reported a 98% accuracy rate in classifying the test companies one year prior to failure and an 81%
accuracy rate more than one year prior to bankruptcy.
13.6.4 Blasztk System (Canadian 1984)
This is the only business failure prediction method outlined here that was not developed using multiple
discriminate analysis. This system was developed by William Blasztk in 1984. The essence of the system is that
the financial ratios for the company to be evaluated are calculated, weighted and then compared with ratios for
average companies in that same industry as given by Dunn & Bradstreet. One of this method’s strengths is that
it does compare the company being evaluated with companies in the same industry.
13.6.5 CA - Score (Canadian 1987)
This model is recommended by the Order des compatibles agrees des Quebec (Quebec CA’s) and according to
its developer is used by over 1,000 CA’s in Quebec. This model was developed under the direction of Jean
Legault of the University of Quebec at Montreal, using step-wise multiple discriminate analysis. Thirty
financial ratios were analyzed in a sample of 173 Quebec manufacturing businesses having annual sales ranging
between $1-20 million.
WHERE V1 = Retained Earning/Total Assets
V2 = Sales/Total Assets
The model takes the following form -:
CA-Score = 4.5913 (*shareholders’ investments(1)/total assets(1)) + 4.5080 (earnings before taxes and
extraordinary items + financial expenses(1)/total assets(1)) + 0.3936 (sales(2)/total assets(2)) 2.7616
CA-Score < - 0.3; then the firm is classified as “failed”
1) Figures from previous period
2) Figures from two previous periods
* Shareholders’ investments is calculated by adding to shareholders’ equity the net debt owing to directors.
This model, as reported in Bilanas (1987), has an average reliability rate of 83% and
is restricted to evaluating manufacturing companies.
13.7 ISSUES FACING A FIRM IN FINANCIAL DISTRESS
Financial distress begins when a firm is unable to meet scheduled payments or when cash flow projections
indicate that it will soon be unable to do so. As the situation develops, these central issues arise:
1. Is the firm’s inability to meet scheduled debt payments a temporary cash flow problem, or is it a permanent
problem caused by asset values having fallen below debt obligations?
2. If the problem is a temporary one, then an agreement with creditors that gives the firm time to recover and to
satisfy everyone may be worked out. However, if basic long-run asset values have truly declined, then
economic losses have occurred. In this event, who should bear losses, and who should get whatever value
remains?
3. Is the company “worth more dead than alive”? That is, would the business be more valuable if it were
maintained and continued in operation or if it were liquidated and sold off in pieces?
4. Should the firm file for protection under chapter 11 of the Bankruptcy Act, or should it try to use informal
procedure? (Both reorganization and liquidation can be accomplished either informally or under the direction of
a bankruptcy court)
5. Who should control the firm while it is being liquidated or rehabilitated? Should the existing management be
left in charge, or should a trustee be placed in charge of operations? In the remainder of the chapter, we discuss
these questions.
13.8 WHAT HAPPENS IN FINANCIAL DISTRESS?
Financial distress does not usually result in the firm’s death.
Firms deal with distress by
Selling major assets.
Merging with another firm.
Reducing capital spending and research and development.
Issuing new securities.
Negotiating with banks and other creditors.
 Exchanging debt for equity.
Filing for bankruptcy
13.9 RESPONSES TO FINANCIAL DISTRESS
Think of the two sides of the balance sheet.
Asset Restructuring:
– Selling major assets.
– Merging with another firm.
– Reducing capital spending and R&D spending.
Financial Restructuring:
– Issuing new securities.
– Negotiating with banks and other creditors.
– Exchanging debt for equity.
– Filing for bankruptcy
13.10 VOLUNTARY SETTLEMENT TO SUSTAIN THE FIRM
Normally, the rationale for sustaining a firm is that it is reasonable to believe that the firm’s recovery is
feasible. By sustaining the firm, the creditor can continue to receive business from it. A number of strategies are
commonly used. An extension is an arrangement whereby the firm’s creditors receive payment in full, although
not immediately. Normally, when creditors grant an extension, they require the firm to make cash payments for
purchases until all past debts have been paid. A second arrangement, called composition, is a pro rata cash
settlement of creditor claims. Instead of receiving full payment of their claims, creditors receive only a partial
payment. A uniform percentage of each dollar owed is paid in satisfaction of each creditor’s claim. A third
arrangement is creditor control. In this case, the creditor committee may decide that the only circumstance in
which maintaining the firm is feasible, if the operating management is replaced. The Committee may then take
control of the firm and operate it until all claims have been settled. Sometimes, a plan involving some
combination of extension, composition, and creditor control will result. An example of this would be a
settlement whereby the debtor agrees to pay a total of 75 cents on the dollar in three annual instalments of 25
cents on the dollar, and the creditors agree to sell additional merchandise to the firm on 30 day terms if the
existing management is replaced by new management that is acceptable to them.
13.10.1 Voluntary Settlement Resulting in Liquidation
After the situation of the firm has been investigated by the creditor committee, the only acceptable course of
action may be liquidation of the firm. Liquidation can be carried out in two ways – privately or through the
legal procedures provided by bankruptcy law. If the debtor firm is willing to accept liquidation, legal
procedures may not be required. Generally, the avoidance of litigation enables the creditors to obtain quicker
and higher settlements. However, all the creditors must agree to a private liquidation for it to be feasible. The
objective of the voluntary liquidation process is to recover as much per dollar owed as possible. Under
voluntary liquidation, common stockholders (the firm’s true owners) cannot receive any funds until the claims
of all other parties have been satisfied. A common procedure is to have a meeting of the creditors at which they
make an assignment by passing the power to liquidate the firm’s assets to an adjustment bureau, a trade
association, or a third party, which is designated the assignee. The assignee’s job is to liquidate the assets,
obtaining the best price possible. The assignee is sometimes referred to as the trustee, because it is entrusted
with the title to the company’s assets and the responsibility to liquidate them efficiently. Once the trustee has
liquidated the assets, it distributes the recovered funds to the creditors and owners (if any funds remain for the
owners). The final action in a private liquidation is for the creditors to sign a release attesting to the satisfactory
settlement of their claims.
13.11 INFORMAL REORGANIZATION
In the case of an economically sound company whose financial difficulties appear to be temporary, creditors are
generally willing to work with the company to help it recover and re establish itself on a sound financial basis.
Such voluntary plans, commonly called workouts, usually require a restructuring of the firm’s debt, because
current cash flows are insufficient to service the existing debt. Restructuring typically involves extension and /
or composition. In an extension, creditors postpone the dates of required interest or principal payments, or both.
In a composition, creditors voluntarily reduce their fixed claims on the debtor by accepting a lower principal
amount, by reducing the interest rate on the debt, by taking equity for debt, or by some combination of these
changes. A debt restructuring begins with a meeting between the failing firm’s managers and creditors. The
creditors appoint a committee consisting of four or five of the largest creditors, plus one or two of the smaller
ones. This meeting is often arranged and conducted by an adjustment bureau associated with and run by a local
credit manager’s association. The first step is to draw up a list of creditors, with amounts of debt owed.
There are typically different classes of debt, ranging from first – mortgage holders to unsecured creditors. Next,
the company develops information showing the value of the firm under different scenarios. Typically, one
scenario is going out of business, selling off the assets, and then distributing the proceeds to the various
creditors in accordance with the priority of their claims, with any surplus going to the common stockholders.
The company may hire an appraiser to get an appraisal for the value of the firm’s property to use as basis for
this scenario. Other scenarios include continued operations, frequently with some improvements in capital
equipment, marketing, and perhaps some management changes. This information is then shared with the firm’s
bankers and other creditors. Frequently, it can be demonstrated that the firm’s debts exceed its liquidating
value, and it can also be shown that legal fees and other costs associated with a formal liquidation under federal
bankruptcy procedures would materially lower the net proceeds available to creditors. Further, it generally takes
at least a year, and often several years, to resolve matters in a formal proceeding, so the present value of the
eventual proceeds will be lower still. This information, when presented in a credible manner, often convinces
creditors that they would be better off accepting something less than the full amount of their claims rather than
holding out for the full face amount. If management and the major creditors agree that the problems
can probably be resolved, then a more formal plan is drafted and presented to all the creditors, along with the
reasons creditors should be willing to compromise on their claims. In developing the reorganization plan,
creditors prefer an extension because it promises eventual payment in full. In some cases, creditors may agree
not only to postpone the date of payment but also to subordinate existing claims to vendors who are willing to
extend new credit during the extension, perhaps in exchange for a pledge of collateral. Because of the sacrifices
involved, the creditors must have faith that the debtor firm will be able to solve its problems. In a composition,
creditors agree to reduce their claims. Typically, creditors receive cash and / or new securities that have a
combined market value that is less than the amounts owned them. The cash and securities, which might have a
value of only 10 percent of the original claim, are taken as full settlement of the original debt. Bargaining will
take place between the debtor and the creditors over the savings that result from avoiding the costs of legal
bankruptcy: administrative costs, legal fees, investigative costs, and so on. In addition to escaping such costs,
the debtor gains in that the stigma of bankruptcy may be avoided. As a result, the debtor may be induced to part
with most of the savings from avoiding formal bankruptcy. Often, the bargaining process will result in a
restructuring that involves both extension and composition. For example, the settlement may provide for a cash
payment of 25 percent of the debt immediately, plus a new note promising six future instalments of 10 percent
each, for a total payment of 85 percent. Voluntary settlements are both informal and simple, and also relatively
inexpensive because legal and administrative expenses are held to a minimum. Thus, voluntary procedures
generally result in the largest return to creditors. Although creditors do not obtain immediate payment and may
even have to accept less than is owned them, they generally recover more money, and sooner, than if the firm
were to file for bankruptcy. In recent years, one factor that has motivated some creditors, especially banks and
insurance companies, to agree to voluntary restructurings is the fact that restructurings can sometimes help
creditors avoid showing a loss. Thus, a bank that is “in trouble” with its regulators over weak capital ratios may
agree to extend further loans that are used to pay the interest on earlier loans in order to keep the bank from
having to write down the value of its earlier loans. The particular type of restructuring depends on (1) the
willingness of the regulators to go along with the process, and (2) whether the bank is likely to recover more in
the end by restructuring the debt than by forcing the borrower into bankruptcy immediately. We should point
out that informal voluntary settlements are not reserved for small firms. International Harvester (now Navistar
International) avoided formal bankruptcy proceedings by getting its creditors to agree to restructure more than
$3.5 billion of debt. Likewise, Chrysler’s creditors accepted both an extension and a composition to help it
through its bad years. The biggest problem with informal reorganizations is getting all the parties to agree to the
voluntary plan. This problem, called the holdout problem, is discussed in a later section.
13.12 INFORMAL LIQUIDATION
When it is obvious that a firm is more valuable dead than alive, informal procedures can also be used to
liquidate the firm. Assignment is an informal procedure for liquidating a firm, and it usually yields creditors a
larger amount than they would get in formal bankruptcy liquidation. However, assignments are feasible only if
the firm is small and its affairs are not too complex. An assignment calls for title to the debtor’s assets to be
transferred to a third party, known as an assignee or trustee. The assignee is instructed to liquidate the assets
through a private sale or public auction and then to distribute the proceeds among the creditors on a pro rata
basis. The assignment does not automatically discharge the debtor’s obligations. However, the debtor may have
the assignee write on the check to each creditor the requisite legal language to make endorsement of the check
acknowledgement of full settlement of the claim. Assignment has some advantages over liquidation in federal
bankruptcy courts in terms of time, legal formality, and expense.
The assignee has more flexibility in disposing of property than does a federal bankruptcy trustee, so action can
be taken sooner, before inventory becomes obsolete or machinery rusts. Also, because the assignee is often
familiar with the debtor’s business, better results may be achieved. However, an assignment does not
automatically result in a full and legal discharge of all the debtor’s liabilities, nor does it protect the creditors
against fraud. Both of these problems can be reduced by formal liquidation in bankruptcy, which we discuss in
a later section.
13.13 REORGANIZATION IN BANKRUPTCY
It might appear that most reorganizations should be handled informally because informal reorganizations are
faster and less costly than formal bankruptcy. However, two problems often arise to stymie informal
reorganization and thus force debtors into Chapter 11 bankruptcy – the common pool problem and the holdout
problem. To illustrate these problems, consider a firm that is having financial difficulties. It is worth $9 million
as a going concern (this is the present value of its expected future free cash flows) but only $7 million if it is
liquidated. The firm’s debt totals $10 million at face value – ten creditors with equal priority each have a $1
million claim. Now suppose the firm’s liquidity deteriorates to the point where it defaults on one of its loans.
The holder of that loan has the contractual right to accelerate the claim, which means the creditor can
foreclose on the loan and demand payment of the entire balance. Further, since most debt agreements have
cross –default provisions, defaulting on one loan effectively places all loans in default. The firm’s market value
is less than the $10 million face value of debt, regardless of whether it remains in business or liquidates.
Therefore, it would be impossible to pay off all of the creditors in full. However, the creditors in total would be
better off if the firm I not shut down, because they can recover $9 million if the firm remains in business but
only $7 million if it is liquidated. The problem here, which is called the common pool problem, is that, in the
absence of protection under the bankruptcy Act, individual creditors would have an incentive to foreclose on
the firm even though it is worth more as an ongoing concern. An individual creditor would have the incentive to
foreclose because it could then force the firm to liquidate a portion of its assets to pay off that particular
creditor’s $I million claim in full. The payment to that creditor would probably require the liquidation of vital
assets, which might cause a shutdown of the firm and thus lead to liquidation. Therefore, the value of the
remaining creditor’s claims would decline. Of course, all the creditors would recognize the gains to be had from
this strategy, so they would storm the debtor with foreclosure notices. Even those creditors who understand the
merits of keeping the firm alive would be forced to foreclose, because the foreclosures of the other creditors
would reduce the payoff to those who do not. In our hypothetical example, if seven creditors foreclosed and
forced liquidation, they would be paid in full, and the remaining three creditors would receive nothing. With
many creditors, as soon as a firm defaults on one loan, there is the potential for a disruptive flood of
foreclosures that would make the creditors collectively worse off. In our example, the creditors would lose $9 -
$7 = $2 million in value if a flood of foreclosures were to force the firm to liquidate. If the firm had only one
creditor, say, a single bank loan, the common pool problem would not exist. If a bank has loaned the company
$10 million, it would not force liquidation to get $7 million when it could keep the firm alive and eventually
realize $9 million. Chapter 11 of the Bankruptcy Act provides a solution to the common pool problem through
its automatic stay provision. An automatic stay, which is forced on all creditors in a bankruptcy, limits the
ability of creditors of foreclose to collect their individual claims. However, the creditors can collectively
foreclose on the debtor and force liquidation. While bankruptcy gives the firm a chance to work out its
problems without the threat of creditor foreclosure, management does not have a completely free reign over the
firm’s assets. First, bankruptcy law requires the debtor firm to request permission from the court to take many
actions, and the law also gives creditors the right to petition the bankruptcy court to block almost any action the
firm might take while in bankruptcy. Second, fraudulent conveyance statutes, which are part of debtor-creditor
law, protect creditors from unjustified transfers of property by a firm in financial distress. To illustrate
fraudulent conveyance, suppose a holding company is contemplating bankruptcy protection for one of its
subsidiaries. The holding company might be tempted to sell some or all of the subsidiary’s assets to itself (the
parent company) for less than the true market value of its assets and the amount paid and the loss would be
borne primarily by the subsidiary’s creditors. Such a transaction would be voided by the courts as a fraudulent
conveyance. Note also that transactions that favour one creditor at the expense of another can be voided under
the same law. For example, a transaction in which an asset is sold and the proceeds are used to pay one creditor
in full at the expense of other creditors could be voided. Thus, fraudulent conveyance laws also protect
creditors from each other. The second problem that the bankruptcy law mitigates is the holdout problem. To
illustrate this problem, consider again our example with ten creditors owed $1 million each but with assets
worth only $9 million. The goal of the firm is to avoid Liquidation by remedying the default. In an informal
workout, this would require a reorganization plan that is agreed to by each of the ten creditors.
Suppose the firm offers each creditor new debt with a face value of $850,000 in exchange for the old
$1,000,000 face value debt. If each of the creditors accepted the offer, the firm could be successfully
reorganized. The reorganization would leave the equity holders with some value – the market value of the
equity would be $9,000,000 – 10($850,000) = $500,000. Further, the creditors would have claims worth $8.5
million, much more than the $7 million value of their claims in liquidation. Although such an exchange offer
seems to benefit all parties, it might not be accepted by the creditors. Here’s why: Suppose seven of the ten
creditors tender their bonds; thus seven creditors each now have claims with a face value of $850,000 each, or
$5,950,000 in total, while the three creditors that did not tender their bonds each still have a claim with a face
value of $1 million. The total face value of the debt at this pointy is $8,950,000 which is less than the $9
million value of the firm. In this situation, the three holdout creditors would receive the full face value of their
debt. However, this probably would not happen, because (1) all of the creditors would be sophisticated enough
to realize this could happen, and (2) each creditor would want to be one of the three holdouts that gets paid in
full. Thus, it is likely that none of the creditors would accept the offer. Thus, the holdout problem makes it
difficult to restructure the firm’s debts. Again, if the firm had a single creditor, there would be no holdout
problem. The holdout problem is mitigated in bankruptcy proceedings by the bankruptcy court’s ability to lump
creditors into classes. Each class is considered to have accepted a reorganization plan if two-thirds of the
amount of debt and one-half the number of claimants vote for the plan, and the plan will be approved by the
court if it is deemed to be “fair and equitable” to the dissenting parties. This procedure, in which the court
mandates a reorganization plan in spite of dissent, is called a cram down, because the court crams the plan
down the throats of the dissenters. The ability of the court to force acceptance of a reorganization plan greatly
reduces the incentive for creditors to hold out. Thus, in our example, if the reorganization plan offered each
creditor a new claim worth $850,000 in
face value, along with information that each creditor would probably receive only &700,000 under the
liquidation alternative, it would have a good chance of success. It is easier for a firm with few creditors to
informally reorganize than it is for a firm with many creditors. A study examined 169 publicly traded firms that
experienced severe financial distress from 1978 to 1987. About half of the firms reorganized without filing for
bankruptcy, while the other half were forced to reorganize in bankruptcy. The firms that reorganized without
filing for bankruptcy owed most of their debt to a few banks, and they had fewer creditors. Generally, bank debt
can be reorganized outside of bankruptcy, but a publicly traded bond issue held by thousands of individual
bondholders makes reorganization difficult. Filing for bankruptcy under Chapter 11 has several other features
that help the bankrupt firm:
1. Interest and principal payments, including interest on delayed payments, may be delayed without penalty
until a reorganization plan is approved, and the plan itself may call for even further delays. This permits cash
generated from operations to be used to sustain operations rather than be paid to creditors.
2. The firm is permitted to issue debtor-in-possession (DIP0 financing). DIP financing enhances the ability of
the firm to borrow funds for short-term liquidity purposes, because such as loans are, under the law, senior to
all previous unsecured debt.
3. The debtor firm’s managers are given the exclusive right for 120 days after filing for bankruptcy protection
to submit a reorganization plan, plus another 60 days to obtain agreement on the plan from the affected parties.
The court may also extend these dates. After management’s first right to submit a plan has expired, any party
to the proceedings may propose its own reorganization plan. Under the early bankruptcy laws, most formal
reorganization plans were guided by the absolute priority doctrine. This doctrine holds that creditors should
be compensated for their claims in a rigid hierarchical order, and that senior claims must be paid in full
before junior claims can receive even a dime. If there was any chance that a delay would lead to losses by
senior creditors, then the firm would be shut down and liquidated. However, an alternative position, the relative
priority doctrine, holds that more flexibility should be allowed in reorganization, and that a balanced
consideration should be given to all claimants. The current law represents a movement away from absolute
priority toward relative priority. The primary role of the bankruptcy court in reorganization is to determine the
fairness and the feasibility of the proposed plan of reorganization. The basis doctrine of fairness states that
claims must be recognized in the order of their legal and contractual priority. Feasibility means that there is a
reasonable chance that the reorganized company will be viable. Carrying out the concepts of fairness and
feasibility in reorganization involves the following steps:1. Future sales must be estimated.
2. Operating conditions must be analyzed so that future earnings and cash flows can be predicted.
3. The appropriate capitalization rate must be determined.
4. This capitalization rate must then be applied to the estimated cash flows to obtain an estimate of the
company’s value.
5. An appropriate capital structure for the company after it emerges from Chapter 11 must be determined.
6. The reorganized firm’s securities must be allocated to the various claimants in a fair and equitable manner.
The primary test of feasibility in reorganization is whether the fixed charges after reorganization will be
adequately covered by earnings. Adequate coverage generally requires an improvement in earnings, a reduction
of fixed charges, or both. Among the actions that must generally be taken are the following:
1. Debt maturities are usually lengthened, interest rates may be lowered, and some debt is usually converted
into equity.
2. When the quality of management has been substandard, a new team must be given control of the company.
3. If inventories have become obsolete or depleted, they must be replaced.
4. Sometimes the plant and equipment must be modernized before the firm can operate and compete
successfully.
5. Reorganization may also require an improvement in production, marketing, advertising, and other functions.
6. It is sometimes necessary to develop new products or markets to enable the firm to move from areas where
economic trends are poor into areas with more potential for growth.
These actions usually require at least some new money, so most reorganization plans include new investors
who are willing to put up new capital. It might appear that stockholders have very little to say in a bankruptcy
situation where the firm’s assets are worth less than the face value of its debt. Under the absolute priority rule,
stockholders in such a situation should get nothing of value under a reorganization plan. In fact, however,
stockholders may be able to extract some of the firm’s value. This occurs because (1) stockholders generally
continue to control the firm during the bankruptcy proceedings, (2) stockholders have the first right to file a
reorganization plan, and (3) for the creditors, developing a plan taking it through the courts would be expensive
and time consuming, Given this situation, creditors may support a plan under which they are not paid off in full
and where the old stockholders will control the reorganized company just because the creditors want to get the
problem behind them and to get some money in the near future.
13.14 PREPACKAGED BANKRUPTCIES
In recent years, a new type of reorganization that combines the advantages of both the informal workout and
formal chapter 11 reorganization has become popular. This new hybrid is called a pre-packaged bankruptcy, or
pre-pack. In an informal workout, debtor negotiates a restructuring with its creditors. Even though complex
workouts typically involve corporate officers, lenders, lawyers, and investment bankers, workouts are still less
expensive and less damaging to reputations than are chapter 11 reorganizations. In a prepackaged bankruptcy,
the debtor firm gets all, or most of, the creditors to agree to the reorganization plan prior to filing for
bankruptcy. Then, a reorganization plan is filed along with, or shortly after, the bankruptcy petition. If enough
creditors have signed on before the filing, a cram down can be used to bring reluctant creditors along. A logical
question arises: Why would a firm that can arrange an informal reorganization want to file for bankruptcy? The
three primary advantages of a prepackaged bankruptcy are (1) reduction of the holdout problem, (2) preserving
creditors’ claims, and (3) taxes. Perhaps the biggest benefit of a prepackaged bankruptcy is the reduction of the
holdout problem-a bankruptcy filing permits a cream down that would otherwise be impossible. By eliminating
holdouts, bankruptcy forces all creditors in each class to participate on a pro rata basis, which preserves the
relative value of all claimants. Also, filing for formal bankruptcy can at times have positive tax implications.
First, in an informal reorganization in which the debt holders trade debt for equity, if the original equity holders
end up with less than 50 percent ownership, the company loses its accumulated tax losses. If formal bankruptcy,
the firm may get to keep its loss carry forwards. Second, in a workout, when debt worth, say, $1,000, is
exchanged for debt worth, say, $500, the reduction in debt of $500 is considered to be taxable income to the
corporation. However, if this same situation occurs in a chapter 11 reorganization, the difference is not treated
as taxable income.
13.15 REORGANIZATION TIME AND EXPENSE
The time, expense, and headaches involved in reorganization are almost beyond comprehension. Even in $2 to
$3 million bankruptcies, many people and groups are involved: lawyers representing the company, the U.S.
Bankruptcy Trustee, each class of secured creditor, the general creditors as a group, tax authorities, and the
stockholders if they are upset with management. There are time limits within which things are supposed to be
done, but the process generally takes at least a year and probably much longer. The company must be given
time to file its plan, and creditor groups must be given time to study and seek clarifications to it and then file
counter plans to which the company must respond. Also, different creditor classes often disagree among
themselves as to how much each class should receive, and hearings must be held to resolve such conflicts.
Management may want to remain in business, while some well-secured creditors may want the company
liquidated as quickly as possible.
Often, some party’s plan will involve selling the business to another concern. Obviously, it can take months to
seek out and negotiate with potential merger candidates. The typical bankruptcy case takes about two years
from the time the company files for protection under chapter 11 until the final reorganization plan is approved
or rejected. While all of this is going on, the company’s business suffers. Sales certainly won’t be helped, key
employees may leave, and the remaining employees will be worrying about their jobs rather than concentrating
on their work. Further, management will be spending much of its time on the bankruptcy rather than running
the business, and it won’t be able to take any significant action without court approval, which requires filing a
formal petition with the court and giving all parties involved a chance to respond. Even if its operations do not
suffer, the company’s assets will surely be reduced by its own legal fees and the required court and trustee
costs. Good bankruptcy lawyers charge from $200 to $400 per hour, depending on the location, so those costs
are not trivial. The creditors will also be incurring legal costs. Indeed, the sound of all of those meters ticking at
$200 or so an hour in a slow-moving hearing can be deafening. Note that creditors also lose the time value of
their money. A creditor with a $100,000 claim and a 10 percent opportunity cost who ends up getting $50,000
after two years would have been better off settling for $41,500 initially. When the creditor’s legal fees,
executive time, and general aggravation are taken into account, it might make sense to settle for $20,000 or
$25,000. Both the troubled company and its creditors know the drawbacks of formal bankruptcy or their
lawyers will inform them. Armed with knowledge of how bankruptcy works, management may be in a strong
position to persuade creditors to accept a workout which on the surface appears to be unfair and unreasonable.
Or, if a Chapter 11 case has already begun, creditors may at some point agree to settle just to stop the bleeding.
One final point should be made before closing this section. In most reorganization plans, creditors with claims
of less than $1,000 are paid off in full. Paying off these “nuisance claims” does not cost much money, and it
saves time and gets votes to support the plan.
13.16 LIQUIDATION IN BANKRUPTCY
If a company “too far gone” to be recognized, then it must be liquidated. Liquidation should occur when the
business is worth more dead than alive, or when the possibility of resorting it to financial health is remote and
the creditors are exposed to a high risk of greater loss if operations are continued. Earlier we discussed
assignment, which is an informal liquidation procedure. Now we consider liquidation in bankruptcy, which is
carried out under the jurisdiction of a federal bankruptcy court. Chapter 7 of the federal Bankruptcy reform Act
deals with liquidation. It (10s provides safeguards against fraud by the debtor, (2) provides for an equitable
distribution of the debtors assets among the creditors (3) allows insolvent debtors to discharge all their
obligations and thus be able to start new business unhampered by the burdens of prior debt. However, formal
Liquidations is time consuming and costly, and it extinguishes the business. The distribution of assets in
liquidation under chapter 7 is governed by the following priority of claims:
1. Past – due property taxes.
2. Secured creditors, who are entitled to the proceeds of the sale of specific property pledged for a lien or a
mortgage. If the proceeds from the sale of the pledged property do not fully satisfy a secured creditors claim the
remaining balance is treated as a general creditor claim ( see Item 10 below) 12
3. Legal fees and other expenses to administer and operate the bankrupt firm. These costs include legal fees
incurred in trying to reorganize.
4. Expenses incurred after an involuntary case has begun but before a trustee is appointed.
5. Wages due workers if earned within three months prior to the filing of the petition in bankruptcy. The
amount of wages is limited to $2,000 per employee.
6. Claims for unpaid contributions to employee pension plans that should have been paid within six months
prior to filing. These claims, plus wages in Item 5, may not exceed the $2,000 per- wage-earner limit.
7. Unsecured claims for customer deposits. These claims are limited to a maximum of $900 per individual.
8. Taxes due to federal, state, country and other government agencies.
9. Unfunded pension plan liabilities. These liabilities have a claim above that of the general creditors for an
amount up to 30 percent of the common and preferred equity, and any remaining unfunded pension claims rank
with the general creditors.
10. General, or unsecured, creditors. Holders of trade credit, unsecured loans, the unsatisfied portion of
secured loans, and debenture bonds are classified as general creditors. Holders of subordinated debt also fall
into this category, but they must turn over required amounts to the senior debt.
11. Preferred stockholders. These stockholders can receive an amount up to the par value of their stock.
12. Common stockholders. These stockholders receive any remaining funds.
13.17 OTHER MOTIVATIONS FOR BANKRUPTCY
Normally, bankruptcy proceedings do not commence until a company has become so financially weak that it
cannot meet its current obligations. However, bankruptcy law also permits a company to file for bankruptcy if
its financial forecasts indicate that a continuation of current conditions would lead to insolvency. This provision
was used by Continental Airlines in 1993 to break its union contract and hence lower its labour costs.
Continental demonstrated to a bankruptcy court that operations under the then current union contract would
lead to insolvency in a matter of months. The company then filed a reorganization plan that included major
changes in all its contracts, including its union contract. Continental then reorganized as a non union carrier,
and that reorganization turned the company from a money loser into a money maker. Congress changed the law
after the Continental affair to make it more difficult for companies to use bankruptcy to break union contracts,
but this case did set the precedent for using bankruptcy to help head off financial problems as well as to help
solve existing ones. Bankruptcy law has also been used to hasten settlements in major product liability suits.
The Manville asbestos and A.H. Robins Dalkon Shield cases are examples. In both situations, the companies
were being bombarded by thousands of lawsuits, and the very existence of such huge contingent liabilities
made normal operations impossible. Further, in both cases it was relatively easy to prove (1) that if the
plaintiffs won, the companies would be unable to be the full amount of the claims, (2) that a larger amount of
funds would be available to the claimants if the companies continued to operate rather than liquidate, (3) that
continued operations were possible only if the suits were brought to a conclusion, and (4) that a timely
resolution of all the suits was impossible because of their vast number and variety. The bankruptcy statutes
were used to consolidate all the suits and to reach settlement under which the plaintiffs obtained more money
than they otherwise would have received, and the companies were able to stay in business. The stockholders did
poorly under these plans, because most of the companies’ future cash flows were assigned to the plaintiffs, but
even so, the stockholders probably fared better than they would have if the suits had been concluded through
the jury system.