Term Loan Appraisal

A new manufacturing unit

wants a term loan – will the
bank appraise it ?
 What to look at ?
Credit Worthiness

Cash Flows

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 Credit Worthiness
Repayment
Personality of capacity of the
the borrower borrower

Results of
Willingness to Management economic
repay talents activities

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3 stages of any new business

Project
Gestation Period Earning Profits
Implementation

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3 stages of any new business

This is the period when no

cash is generated from the
operations. During this
period the movement of
money is only from bank to
Project
the borrower.
Implementation

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 3 stages of any new business
Gestation Period
The unit comes into
operation and starts
generating cash but
takes time to reach the
Interest is accrued
break-even point.
during this period to
include it into the
cost of product.
No money movement takes place between the
borrower and the bank.
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 3 stages of any new business
This is the stage when enough
cash flows are expected to be
generated from the business to
meet the instalments (including
interest and principle).

The cash-flows should be at least

1.5 times the instalments amount.
Earning Profits
The movement of money is from
borrower to bank now.
Purpose for having more cash-flows than the instalment is two-fold:
1) The borrower must also get the part of earnings (else he might not work if all proceeds go
to bank).
2) The cash flows are not actual but estimated, this provides the security to margin of error.
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 Evaluation of a Business
Economic Evaluation Management Evaluation

Technical Evaluation

Financial Evaluation

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 Economic Evaluation
The demand of the product is evaluated.
There should be a demand-supply
gap, price advantage, timing and other
such benefits.
The prime attention is that the project
should survive the three stages of the
business (implementation, gestation
and operations).

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 Economic Evaluation
Thus the bank prefers loans where there is a large gap between the
supply and current demand.
E.g.:
Where a manufacturer of tables needs a loan:
1) Demand = 10000 Units
The market already
Supply = 12000 Units has enough supply
New Project = 2000 Units (prices might also fall).

2) Demand = 10000 Units

Current Supply = 8000 Units Not enough demand
New Project = 2000 Units supply gap.

3) Demand = 10000 Units

Large gap, thus the
Current Supply = 2000 Units
product has a wide
New Project = 2000 Units market.

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 Economic Evaluation
Case Study #1:
A company specialising in plastic engineered goods
wants to setup a plant for manufacturing large
computer keyboards (back in 90’s) seeing the large
market demand.

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 Economic Evaluation
Case Study #1:
A company specialising in plastic engineered goods
wants to setup a plant for manufacturing large
computer keyboards (back in 90’s) seeing the large
market demand.

Banks rejects it as it was found that the new types of

keyboard were soon to be introduced with new
additional features.
The survival of the project throughout the loan period
was doubtful.

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 Economic Evaluation
Case Study #2:
A person wants to set up a mini cement plant in the
local area. However UltraTech, Ambuja etc rule the
current market.

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 Economic Evaluation
Case Study #2:
A person wants to set up a mini cement plant in the
local area. However UltraTech, Ambuja etc rule the
current market.

Cement plants are basically of three sizes, Ultra – Mega

and Mini Cement Plant. The Ultra Projects have
lower fixed costs but higher transportation costs.
The mini plants though higher on fixed costs have the
benefit of low transport costs, thus if there is
potential of cement market (good book orders) within
100 kilometres, then the project is economically
viable.
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 Economic Evaluation
Case Study #3:
A Power Project in Himachal or in New Delhi ?

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 Economic Evaluation
Case Study #3:
A Small Power Project in Himachal or in New Delhi ?

The electricity produced is supplied to the national

grid (at a fixed price). The areas such as Himachal
have very low stealing of electricity while there is
always a power crisis in Delhi due to high stealing
of electricity.

Thus a small power project in New Delhi is preferred

as the demand – supply gap increases. This is one
of those “harsh realities.”
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 Management Evaluation
Case Study #1:
A “Lalaji” from Bihar (with enough land there), seeing
the rise in IT Industry, too wants to start a new IT
Company.

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 Management Evaluation
Case Study #1:
A “Lalaji” from Bihar (with enough land there), seeing
the rise in IT Industry, too wants to start a new IT
Company.

Bank might rate him good with the entrepreneur

skills but rate him very low for the lack of
experience in the business.

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 Management Evaluation
Case Study #1:
A “Lalaji” from Bihar (with enough land there), seeing
the rise in IT Industry, too wants to start a new IT
Company.

“Lalaji” still enthusiastic

about the business hires 2
genius (one from Infosys and
another from Wipro).

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 Management Evaluation
Case Study #1:
A “Lalaji” from Bihar (with enough land there), seeing
the rise in IT Industry, too wants to start a new IT
Company.

“Lalaji” still enthusiastic about the business hires 2

genius (one from Infosys and another from Wipro).

Bank still rates low. Like “Lalaji” took them from

Infosys and Wipro, someone else might take them
away from him someday too.
Bank needs to have safety and surety of survival
throughout the three periods.
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 Management Evaluation
Thus the “promoters” MUST be in
the core of the business.
Good Collaterals are often taken as enough security
to skip any other evaluation.
However a term loan is a loan where the instalments
are to be paid by earning from the assets (not from
selling the assets – though bank can always do so).

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 Technical Evaluation
Technical Evaluation is closely linked to the
Economic and Managerial Evaluation. The
technical competencies of the Management and
technicalities are evaluated in economic
specifications.

These ensure the technical feasibility of a project as

to whether a particular capacity machine is
available in market or not and all other such
technical evaluations.

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 Financial Evaluation
This is the ultimate part of the evaluation process
where all the things are summed up in the terms of
money.

The cash flows are estimated, the instalments periods

are fixed, the interest rate is computed and the
project is made bankable.

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 Cash Flow Structure
Cash from Operations:
Profit generated by the production & sales of goods and services
+/- Adjustments for the expansion and tightening of working assets
+/- Adjustments for non-cash income and expense items

Cash from Investments:

Cash generated by changing the asset base

Cash from Financing:

Cash associated with borrowings, dividends paid and
private withdrawals

+ Consideration of opening cash balance

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 Analysis of Cash Flows
The most commonly used indicators for
doing this are:
• Debt Service Coverage Ratio
(DSCR); and
• net cash flow after loan repayment
or “free net cash flow.”

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Debt Service Coverage Ratio (DSCR);

Cumulative Net Cash Flow over Loan Period

Total Loan Repayment plus Interest

> 1.5

This indicator is calculated by adding up all the

monthly/quarterly balances during the envisaged
loan term and comparing this figure to the total
amount to be repaid (including both principal and
interest). Since the cumulative net cash flow needs
to be higher than the total repayment obligation
which the applicant would have towards the lender,
this indicator must be above 1 (recommended at
1.5). Dalaal-Street.com
 Case Study
The new manufacturing which wants a four year term loan has
following projected cash flows:

All amounts in Rs. crores

Loan Application Net Cash Flow before Loan repayment

Loan amount 200 First Year 50

Equal annual Second Year 100
instalments @ Third Year 175
15% per annum 69.93 Fourth Year 300
TOTAL 279.72 TOTAL 625

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 Case Study
The new manufacturing which wants a four year term loan has
following projected cash flows:

All amounts in Rs. crores

Loan Application Net Cash Flow before Loan repayment

Loan amount 200 First Year 50

Equal annual Second Year 100
instalments @ Third Year 175
15% per annum 69.93 Fourth Year 300
TOTAL for 4 years 279.72 TOTAL 625

Accumulated Repayment Capacity = 625 / 279.72 = 2.23

However, it does not show whether the applicant will be able to

cover every individual repayment instalment (as in first year).
Thus comes the “free net cash flow” method.
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 Free net cash flow method
Net Cash Flow after Repayment

Loan Repayment Instalments

> 0.5

This indicator is ratio of the net cash flow after

repayment and the loan repayment instalments. A
“free net cash flow” indicator must be positive
(recommended at 0.5).

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 Case Study
The new manufacturing which wants a four year term loan has
following projected cash flows:

All amounts in Rs. crores

Loan Application Net Cash Flow before Loan repayment Free Net Cash Flow

Loan amount 200 First Year 50 -0.28

Equal annual Second Year 100 0.43
instalments @ Third Year 175 1.50
15% per annum 69.93 Fourth Year 300 3.29
TOTAL 279.72 TOTAL 625

Accumulated Repayment Capacity = 625 / 279.72 = 2.23

The free Net Cash Flow is negative in the first year and too low
in the second year. Thus, it is recommended to reschedule the
loan and provide necessary moratorium period.
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 Financial Evaluation
The interest rates are fixed based on the degree of
risk. This risk is computed based on the concepts
of probability and margin of safety.

Margin of Safety- is how much output or sales level

can fall before a business reaches its breakeven
point.

Thus where the margin of safety is riskier, the

interest premium applied is also higher (above the
PLR – Prime Lending Rate)

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 RISK

“The only man who sticks closer to

you in adversity than a friend is a
creditor.”
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 RISK

Webster’s Dictionary- “exposing to danger or hazard.”

Chinese Symbol- “The first symbol is the symbol for ‘danger’, while
the second is the symbol for ‘opportunity’, making risk a mix of
danger and opportunity.”

Financial Terms- Risk, as we see it, refers to the likelihood that we

will receive a return on an investment that is different from the
return we expected to make. Thus, risk includes not only the bad
outcomes, i.e. returns that are lower than expected, but also good
outcomes, i.e., returns that are higher than expected. In fact, we
can refer to the former as downside risk and the latter is upside
risk; but we consider both when measuring risk.
Dalaal-Street.com - From “Damodaran on Valuation” by Aswath Damodaran
 RISK
There are 3 types of business decisions:
1)Certainty: These are those decisions
relating to events which are bound to
happen. Thus these are risk free.

The good companies (often with a very high credit

rating) even bargain for loans at below the PLR
(Prime Lending Rate). The reason being, they take
their borrowings as almost risk free.

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 RISK
The second is not “Uncertainty” but “Risk”
2)Risk: These are those decisions relating
to events which are risky and might not
happen as expected.

These are the decisions where the profits are made. The
banks give the loans on evaluation of risk and thus
charge a higher interest.
This is based on the same principle as the principle of
insurance business.

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 RISK
In insurance business the loss of few people is
distributed among a large group (via
premiums).

Similarly the bank operates, based on the probability. Say

that out off every 100 borrowers – 4 make a default. Thus
the bank charges around 4% higher interest (i.e. above
PLR) from each of the borrower. Thus these “risky” lending
are more generous.

Also, if the bank is able to recover from those 4% who default,

then the are the even higher super profits resulting from
risks.
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 RISK
The third is “Uncertainty”
3)Uncertainty: The decisions relating to
events which can not be predicted.
These are baseless.

A gambling is an example of “Uncertainty” as the

results cannot be predicted but only hoped for. The
result of such is mostly LOSS.

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 Common Practices
One of the common practices in the market is that
once a person gets a loan, he floats it in the market
at even higher rates.

Thus a person may get a loan @ 15% and he might

float it in the market at 25% as there are many
who are unable to get the loans sanctioned from
the banks.

Thus the evaluation in all the four areas needs to be

careful and well evaluated.

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 A Good Bank ?

Overall, a good bank is not the one that

rejects “not-so-good” loans, but the
one that makes every loan appraisal
bankable.
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