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April 2014

banking S Ec to r

new banking license

FROM EDITOR’S DESK Dear Niveshaks,

Niveshak Volume VII ISSUE IV April 2014 Faculty Chairman

Prof. P. Saravanan

THE TEAM Akanksha Gupta Apoorva Sharma Gaurav Bhardwaj Jatin Sethi Kocherlakota Tarun Mohit Gupta Mohnish Khiani Priyadarshi Agarwal S C Chakravarthi V All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

While the whole country is gripped in the poll fever, we bring to you a fresh new edition of Niveshak. The month of April started with The Reserve Bank of India (RBI) granting two preliminary licenses to IDFC Ltd and Bandhan Financial Services to set up new banks in a country where only one household in two has access to formal banking services. RBI Governor Raghuram Rajan said that banking licenses will be an on-tap facility, meaning the central bank will keep issuing new licenses to applicants it deems fit as and when required. Another major event was Sun Pharma’s acquisition of Ranbaxy Laboratories, in a landmark $4-billion transaction, which marks the coming together of two major Indian pharmaceutical companies to create the world’s fifth-largest generic drug maker by sales. The all-share deal, the biggest in the pharmaceutical sector in the Asia Pacific region this year, is seen as a rare purchase of a local rival by a leading Indian company. The erstwhile ‘king of good times’, Vijay Mallya, may now lose his Kingfisher brand. Lenders have started the process of selling brands associated with the grounded Kingfisher Airlines (KFA). And the ones up for grab include ‘Kingfisher’, ‘fly the good times’ and ‘flying models’. On the international front, Vic Gundotra, the high-profile Indian executive who headed the Google+ team at Google, is leaving the company. Apart from being the man behind Google+, Gundotra was instrumental in making Google I/O, company’s annual conference for developers a success. But, the biggest happening in the country right now is going on in regards to the 16th Lok Sabha Elections, the world’s largest election. Every major party is busy doing campaigning for elections and all the citizens are busy contemplating whom to give the hot seat for the next 5 years!! As we move ahead with our initiative of Niveshak Investment Fund (NIF), the portfolio has shown a favorable growth trend, outperforming the market. A detailed report inside summarizes the overall performance of the fund for this month. The Article of the Month this time is “2016: A bubble waiting to burst?” which intends to address the recessions that occurred in the US economy and their global impact and then identify a pattern followed by business cycles. Our Cover Story for this month “Banking Licenses” analyses the various aspects related to the new banking license and what effects it will have on the Indian banking sector. FinGyan section of this edition elaborates on “Behavioral Approach To Understand US 2008 Crisis”. FinSight article “CAPM- Telecom” shows computation of cost of equity for different valuations in the Telecom sector derived by different values over different spans of time. The FinPact article “The Vodafone – Hutchison Essar Deal” tells about one of the biggest telecom M&A deal for India. Not only was this one of India’s largest foreign takeovers, this deal also attracted an unprecedented array of blue-chip legal teams from India and abroad. This time, the FinView section has the excerpts from our interaction with Mr. Jaydip Mukhopadhyay, ERS Manager at Deloitte & Touche LLP. He gave us many useful insights into the risk management sector. The Classroom section this time throws light on the famous term of “Chinese Wall”. We would like to thank our readers for their immense support and encouragement. You remain our prime motivation factor that keeps our spirits high and gives us the vigor and vitality to keep working hard. Thank you. Stay invested !

Team Niveshak

Disclaimer: The views presented are the opinion/work of the individual author and The Finance Club of IIM Shillong bears no responsibility whatsoever.

CONTENTS Cover Story Niveshak Times

04 The Month That Was

Article of the month


New Banking Licenses: A 10 2016: A bubble waiting to Post Mortem burst?

FinGyaan 18

A behavioural approach to understand the US 2008 crisis


26 CAPM- Telecom


24 The

Vodafone – Hutchison Essar Deal


29 Chinese Wall FINVIEW

30 Jaydip Mukhopadhyay,

Phd, ERS Manager, Deloitte & Touche LLP

The Month That Was



The Niveshak Times Team NIVESHAK

IIM Shillong Russia’s Credit Rating Downgraded to ‘BBB-‘ The global credit ratings agency Standard & Poor’s downgraded Russia’s credit rating from ‘BBB’ to ‘BBB-‘, which is just one notch above “junk” status. This move comes in the wake of foreign investors continue to pull out money from the country amid tensions over the Ukraine situation and new sanctions imposed by Western Economies including USA. In the first three months of this foreign investors have withdrawn USD 63.7 billion from Russia, and economic growth has slowed significantly. Russia’s central bank has again raised its key interest rate form 7% to 7.5% as it sought to defend the value of the roble Amazon in India Inc., the world’s largest online retailer, started selling apparel on its India website—entering a fast-growing and higher margin category in e-commerce. Amazon will sell ethnic women wear from more than 90 brands and also offer sunglasses for men, women and children. The company’s entry into apparel and accessories will increase competition for the likes of Myntra and Jabong, the top firms in the category. The US-based firm launched its marketplace platform in India last June by selling books and video content. Since then it has expanded

its product offering to electronics, toys, music and other consumer goods. Amazon operates an online marketplace in the country as India doesn’t allow foreign direct investment in e-commerce. Analysts say that apparel and accessories offer higher margins to online retailers compared with books and electronics, where there’s less or no room to set high prices. All the top four ecommerce firms— Flipkart, Snapdeal, Myntra and Jabong—have raised between $50 million and $360 million in the past year enabling them to gear up for excessive advertising. China Factory Activity Shrinks for 4th Month, but Pace of Decline Slows China’s factory activity shrank for the fourth straight month in April, signalling economic weakness into

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the second quarter. Initial signs of stabilisation in the economy is visible due to the government’s targeted measures to underpin growth, but believe more policy support may be needed as structural reforms put additional pressure on activity. Annual growth slowed to 7.4 percent in the first quarter from a year earlier, its slowest reading in 18 months, but the pace was just ahead of market expectations and seemed to soothe fears of a sharp downturn. Piramal buys 20% Stake in Shriram Group In what was a deal between a Marwari businessman and a conservative Sothern group, Piramal Enterprises Ltd., acquired 20% stake in Shriram Capital Ltd, an arm of Chennai based Shriram Group for a consideration of Rs. 2014 crore. This transaction has reinforced the presence of Piramal in financial services industry. Piramal Enterprises, which so far focused on corporate debt and equity financing would gain entry into retail financial businesses. This 20% stake gives Piramal a presence in vehicle financing, general and life insurance, consumer and gold loans, and brokerage and mutual funds and also a vast retail network of 9 million customers that Shriram group has built. Adding to that, a possibility of Shriram group getting a banking license in future will be an added advantage to Piramal Enterprises Ltd. Piramal sold its generic drug business to Abbott Laboratories in 2010 and 11% stake in Vodafone India Ltd a week before the transaction with Shriram Group and used this accumulated cash to fulfill its ambition of becoming a financial service powerhouse. Middle East: The Promising Land for E-Commerce Based Indian Start-Ups Indian startups eager to sell technology-enabled services and products in global markets are finding customers in a hitherto untapped region, the Middle East. These ventures in sectors ranging from healthcare to hospitality are finding that customers with high disposable incomes are quick to snap up their offerings. Padmaja Ruparel, president of the Indian Angel Network, said the Middle East is strategically the best located region for Indian startups to take their business further to Europe and Africa. For investors, the tax breaks and a liberal investment policy in the Middle East is a big draw to invest in the region. “The


downside however is the need for a local partner to enter these markets, which may dilute the startup product or service value,” she said. Apple Prepares another $17 Billion Bond to Finance Stock Buyback Apple Inc. is preparing a second US$17 billion bond offering to finance the company’s expanded stock buyback program. Apple is considering tapping European bond markets for the offering in order to diversify its investor base. Apple announced it was expanding its stock buyback

program from $60 billion to $90 billion on April 23rd. The company has to finance its buyback by issuing debt, even though it has some $150 billion in cash because most of that cash—roughly $130 billion—is overseas. For Apple to buy back shares of its stock, it must do so in the U.S., where those shares are traded. If the company were to bring money in from overseas, it would have to pay 35 percent in taxes on that money, something almost every major U.S. Corporation avoids whenever possible. This comes at a time when the US treasury rates are at low levels and therefore the source of financing is less

expensive for Apple. India Displaces Japan to Become Third-Largest World Economy in Terms of PPP: World Bank Infrastructure India has displaced Japan to become the world’s third biggest economy in terms of purchasing power parity (PPP), according to a World Bank report released on Tuesday. The 2011 round of the bank’s International Comparison Program (ICP) ranked India after the US and China. The last survey in 2005 had placed the country on 10th place. PPP is used to compare economies and incomes of people by adjusting for differences in prices in different countries to make a meaningful comparison. India’s share in World GDP in terms of PPP was 6.4% in 2011 compared with China’s 14.9% and the US’ 17.1%, the latest ICP showed. The survey covered 199 economies. Despite high inflation in India in recent years, prices in the country are still well below those in advanced economies, explaining the higher raking for India on the PPP measure. But according to the International Monetary Fund (IMF), India’s economy is 12th largest and only about a third of Japan’s in terms of absolute unadjusted dollars. In the latest ranking, India’s economy was 37.1% of the US economy compared with 18.9% in 2005. Twitter Sees $132 Million Loss; Revenue, Users Grow Twitter on Tuesday reported a $132 million loss in the first quarter, while revenues rose sharply and the popular messaging platform boosted its user base. The company said revenues grew 119 per cent from a year ago to $250 million, and its monthly active users rose to 255 million. Twitter made a splash last year on Wall Street with a surge on its market debut, but its shares have struggled since then amid doubts on its pace of growth and progress toward profitability. Using a popular Wall Street measure excluding special items, Twitter essentially broke even on a per-share basis, according to its quarterly report. But investors were unimpressed, and Twitter’s shares sank more than eight per cent in after-hours electronic trades to $39.12. Twitter said the number of monthly active users was up 25 per cent from a year ago at 255 million, and 198 million were on mobile devices. Advertising revenue hit $226 million, an increase of 125 per cent over the past year, with mobile accounting for roughly 80 per cent of the total.


The Month That Was

The Niveshak Times




Article ofSnapshot the Month Market Cover Story

Market Snapshot



75,95,397.17 Source:

CURRENCY RATES INR / 1 USD INR / 1 Euro INR / 100 Jap. YEN INR / 1 Pound Sterling INR/ 1 SGD

61.1163 84.522 59.73 102.7059 48.26


LENDING / DEPOSIT RATES Base rate Deposit rate

10.00%-10.25% 8.00% - 9.25%


4.00% 23%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: 28th March 2014 to 26th April 2014 Data as on 26th April 2014

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% change

22339.97 7010.29 6999.06 13142.84 14585.16 6359.59 12068.53 7015.94 10072.73 8774.41 9684.27 9455.85 1743.99 6363.83 1427.96 4897.52

22688.07 7373.64 7597.34 13615.96 14910.3 6633.02 12589.52 6837.11 10619.78 8786.98 10432.38 9605.77 1741.18 6561.7 1472.17 4929.63

1.56% 5.18% 8.55% 3.60% 2.23% 4.30% 4.32% -2.55% 5.43% 0.14% 7.73% 1.59% -0.16% 3.11% 3.10% 0.66%



Article Market of Snapshot the Month Cover Story

Market Snapshot



Article of the Month Cover Story


2016: A bubble waiting to burst?

Vinita J. and Vishak E.B.

Modern economies experience significant swings in economic activity. In some years most of the industries are booming and the rate of unemployment is low; while, in other years, it is an entirely opposite trend. Period of positive growth is called booms; period of negative growth is called recessions. The combination of expansions and recessions is called the Business Cycle. Many economists have tried to explain occurrence of business cycles, of which two have been used to explain and predict the next recession time – Innovation theory of J. Schumpeter and Overinvestment theory of Gottfried von Haberler. This article intends to address the recessions that occurred in the US economy and their global impact and then identify a pattern followed by business cycles. Innovation Theory In ‘Theory of Economic Development’ (1934), Schumpeter states that the economy which follows a circular flow is in equilibrium. However, the entrepreneur, by introducing his innovations disrupts this equilibrium, and causes business cycles to occur. Booms happen due to

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XIME, Bangalore

innovations in industry and commerce, which involve changes in methods of production, or in industrial organisation, or in the production of a new article, or in the opening up of new markets. When these innovations turn out to be non-revenue generating activities, they lead to capital blockage, resulting in reduction in output, employment and ends in the birth of a recessionary period. Overinvestment theory Gottfried von Haberler, in his work ‘Prosperity and Depression’ (1937), classifies over-investments into three groups: Over-investment due to a) Monetary and Credit changes; b)Non-monetary influences such as inventions, discoveries, and the opening of new markets; c)Changes in the demand for consumer goods—which reacts slowly but more violently on the capital goods industry. This theory explains that there is a disparity in development, as one sector is on high growth while the other is lagging behind due to overinvestment. This growth during the boom phase is corrected by a slump, in the hope of bringing the balance in the economy.


index exploded from 600 to 5,000 points. “Dotcom” companies were going public and raising millions of dollars as capital. Many of these companies lacked clear business plans and even more had no earnings whatsoever to speak of. By early 2000, investors realized that the dot-com dream had developed into a classic speculative bubble. Within months, the NASDAQ stock index crashed to 2,000 as shown in the graph. Thousands of technology professionals lost their jobs and, if they had invested in tech stocks, lost a significant portion of their life savings. The prime reason for entrepreneurs to start tech companies was to explore new markets by innovating in the field of IT. This created imbalances in the economy due to overinvestment in IT stocks and subsequently caused a recession. 2008 Ironically, the end of the 2000-tech bubble was sort of a beginning for the 2008-real estate bubble. The resulting losses of the dot-com bubble had affected the broader American economy in general. To revive growth and increase consumption, the then Fed chief economist Alan

Booms happen due to innovations in industry and commerce, which involve changes in methods of production, or in industrial organisation, or in the production of a new article, or in the opening up of new markets. © FINANCE CLUB, INDIAN INSTITUTE Of MANAGEMENT SHILLONG

Article of the Month Cover Story

The article focuses on over-investment arising from non-monetary influences such as patents and inventions in the field of technology. Rapid innovations in Communication and IT Systems are taking place globally. Social media has boomed and Applets are the talk of the town. Even the field of Finance hasn’t been spared, such as the rise of the New Derivatives Market. Let’s start by evaluating the impact of these theories on the last two recessions experienced by US. Recessions: 2000 and 2008 2000 The Dot-com Bubble was a speculative bubble in the share prices of early internet companies called “Dot-coms.” During the mid-1990s, the internet had evolved as a way for people to communicate. Almost immediately, businesses such as AOL and Yahoo saw the internet as a significant profit opportunity. As the internet became increasingly commercialized, many online businesses and their founders grew fantastically wealthy. Technology stocks soared and created a very strong incentive for more technology companies to become publicly traded. From 1996 to 2000, the NASDAQ stock



Article of the Month Cover Story


Greenspan lowered interest rates, flooding the market with liquidity. Unfortunately, the lower interest rates did not lead to more investment in plant and machinery. With the availability of cheap credit, Mortgage companies had pushed exotic mortgages on to millions of people, many of whom did not know what they were getting into, but were reeled in with the promise of a steady stream of income and increased returns. This crisis saw the birth of a new type of innovation – the ‘financial innovation’ as Stiglitz calls it in his book Free Fall (2009). These financial products were so complex that they increased risk and eventually brought down the entire US financial system. Also, the banks got directly involved in these products – that is, they weren’t just acting as middlemen for the risky assets that they were creating, but they actually invested in them. When the day of reckoning came, it turned out that the entire financial system was caught off-guard as seen in the exhibit. Citizen investors had resisted investments in innovations that would have helped people and countries manage important risks, in favour of investments in collateraliseddebt instruments. Thus, America’s financial markets had failed to perform their function of managing risk, allocating capital and mobilizing savings. Instead they had created risk, misallocated capital and most importantly, encouraged excessive indebtedness among laymen. Relating Overinvestment and Innovation Theories to significant deals in Tech Companies Google–Motorola Deal

In May 2012, Google acquired Motorola Mobility,

at a whopping $12.5 billion! In 2014, Google divested from this venture by selling it to Lenovo for just $2.9 billion. Sure, Motorola had $3 billion of cash on its balance sheet when it was acquired and Google later sold a set-top box division for $2.4 billion. But that still doesn’t explain why Google got only $3 billion for the remaining net investment of $7 billion. As Larry Page, the CEO of Google replies, “Patents”. Google made the hasty deal only to get control of Motorola’s pool of about 17,000 patents. At that time, Apple and Microsoft appeared to be waging an intellectual property (IP) war to break the Android challenge. However, many of those battles continue and IP attorneys are split over whether the Motorola patents have helped Google at all. Besides the book loss of $4 billion that Google suffered on the sale, its Motorola operations were far from successful. Google reported operating losses for Motorola as its owner, including $800 million in 2013 and $1.1 billion in 2012. Overinvestment theory says that non-monetary influences such as inventions, discoveries and new markets have an impact on trade cycles. Google’s justification for acquiring Motorola was its patents (inventions) and entry into new markets (smartphones). But as is obvious, the deal didn’t bring success to Google. Are such overinvestment propositions building up bubbles? Facebook-WhatsApp Deal On 20th Feb 2014, Mark Zuckerberg announced that Facebook would acquire WhatsApp for $19

billion, one of the biggest deals the world has ever seen. WhatsApp has around 450 million users worldwide and an interesting revenue model - it charges a one-time fee of $0.99/iPhone

The end of the 2000-tech bubble was sort of a beginning for the 2008-real estate bubble. The resulting losses of the dotcom bubble had affected the broader American economy in general. APRIL 2014


It may be a matter of time before the market does a reality check. Going by the trend of overinvestment deals in innovation-driven technology companies and correlating it to the 8 year recession cycles that we have observed, one can surely question - is 2016 a year to look out for and is enough being done?


Article of the Month Cover Story

user and $0.99/year on all other platforms (with the first year being free). It reported revenues of just $20 million in 2013 and has no plans of advertising or changing its revenue model. Although its expenses are low, there seems to be no clear way to objectively validate the $19-billion price for the messaging company. The only justifiable method of determining the fair price for WhatsApp is by predicting its future cash flows. Even if the company targets a 100% increase in its users YoY (which is possible with strong growth markets such as India, Mexico, Brazil, and entrenched presence in Western Europe and the US), the maximum revenue that it can generate is $900 million, but only by the end of 2015. At this rate, Facebook would take approximately 7 years to recover the price paid. Now, for a tech company to survive for 7 years and have an exponential growth of 100% in its user base YoY is questionable. Another way of valuing this deal is by predicting the profits per-user per-year. With the current user base of 450 million and the deal size of $19 billion, WhatsApp should generate $42 peruser per-year. With WhatsApp not intending to change its revenue model, how will it generate an additional $41 per-user per-year? Since the inner workings of Zuckerberg’s mind are unknown to us, we can only guess that Facebook is looking to reclaim markets of youth users, lost to IMs (Instant Messaging) such as WhatsApp. So, to win back the lost ground, Facebook has acquired WhatsApp, but clearly, $19 billion is an overinvestment. This may spark the rise of a bubble.


Cover Story



New Banking Licenses: A Post M o rtem

Mohit Gupta & SC Vellanki

IIM Shillong Introduction Recently, the Reserve Bank of India granted in-principle bank licenses to Infrastructure Development Finance Co and a microfinance lender Bandhan Financial Services Ltd., thus ending a four year process of issuing new bank licenses. This announcement came after a nod from Election Commission. This in-principle nod is valid for 18 months during which these two companies should try and meet the guidelines set by the RBI to secure permanent licenses. This article tries to bring out the implications of new banking licensing system and also the probable analysis that might have been done to arrive at these two names for offering bank licenses. Marking the end of first phase of issuing new bank licenses, RBI has announced a list of 26 applicants on July 1st, 2013. The guidelines were released by the central bank in February, 2013 and further clarifications were issued in the month of June. Since then, the Tatas and Mahindras withdrew their applications saying that they won’t be able to meet the stringent regulations set by RBI (i.e. holding company rule which says that all financial services entities in the group necessarily need to be owned by the NOFHC and no group company can have a direct shareholding in entities) and it would be better to continue with their existing NBFCs. Initially, the RBI had conducted a due diligence process which included collecting details from the regulators

such as SEBI and IRDA about the businesses of the applicants under their jurisdiction. The central bank had also contacted foreign regulators for collecting information related to the operations of the applicants that are related to other foreign businesses or overseas listings. After the completion of due diligence process, in the month of November, 2013, a panel headed by Bimal Jalan, former RBI Governor, was formed in order to carefully scrutinize the applicants for new banking licenses and to suggest the most eligible ones. Jalan panel had submitted its report in the month of February, 2014 and then RBI board took a final call on 02nd April, 2014 based on the recommendations given by the panel. Existing System (What is the need for new banking licenses?) After the nationalization of banks in 1960s and 1980s, the Reserve Bank of India issued banking licenses to 10 private sector banks that included the “Big Three� (ICICI Bank Ltd., HDFC Bank Ltd., and Axis Bank Ltd.) between 1993 and 1994. There were a few other banks which were given licenses during the same time, but they either got merged with some other bank or collapsed. After that, only two licenses were given in between 2003 and 2004 to Kotak Mahindra bank and Yes Bank. These banking licenses issued during 1993-1994 and 2003-2004 were most probably the outcome of economic liberalization by the then-government. Banking

Is it enough to ensure ethical usage of funds raised through IPO?

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entire economy of India. New Banking Licenses With the aim of creating a banking entity which is adequately capitalized, financially inclusive and has an independent governance and a competitive business model RBI has set the guidelines, providing several parameters related to eligible promoters, corporate structure, minimum capital requirement, ownership and governance, foreign shareholding, business model considerations, specific provisions for NBFCs, etc. RBI has set these guidelines with the objective to make an explicit policy on structure of the new private sector banks as well as to outline application and selection process to guide the applicants. By issuing new licenses for banks, RBI has opened the banking sector to new private and public sector players and has provided them a tremendous opportunity to participate in the banking sector which has been growing at a high rate of around 20% since the last decade. These new banks will encourage competition, which will result in lower interest rates and customized loan and deposit products for the consumer. Challenges Although, there are advantages of issuing new bank licenses, it is not the complete reality. To get a complete picture, one has to look into the challenges that are going to be faced by the companies that were granted banking licenses. Regulatory requirements: New banks will have to meet CRR (cash reserve ratio) and SLR (service level requirements) mandates from day one. They will have to raise enough low-cost deposits to park funds with RBI and also invest in government securities. Financial inclusion and priority sector lending: RBI’s two primary objectives in issuing new licenses could prove costly and difficult for most applicants. Taking banking services to unbanked areas and lending to priority sectors could significantly pressure

Fig 1: Market shares of leading players (based on total credit) and split between government, private and foreign banks in India


Cover Story

in India is moderately consolidated with the top 10 players approximately accounting for 60% of the market share. The Indian banking industry is mainly dominated by the Public Sector Banks. The following figure shows the split of public sector, private sector and foreign banks and also market shares of different banks. Figure 1 clearly indicates that the Indian banking industry is highly dominated by the Public Sector Banks. The conception of private sector banks during 1990s has led to considerable progress in the banking sector from the past two decades. In the past decade, the revenues of Indian banks have grown four-fold from $11.8 billion to $46.9 billion. This growth was primarily attributed to two factors: FDI of up to 74% with certain restrictions and the conservative policies adopted by the Reserve Bank of India (RBI), which were the main reasons for the banking industry to be stable even during the period of recession and global economic turmoil. Although the banking industry has witnessed some significant changes, there are still some challenges faced by the sector. Still, the main concern remains lower levels of financial inclusion. A large proportion of people are still financially excluded, with the number of branches per one lakh adults at a meagre value of 10.64 commercial branches (According to World Bank in 2011). In contrast, the same number in South Africa is 10.71, in China (Hongkong) is 23.81, in Russia is 37.09 and in US is 37.03. Also, the developments made in the last decade are limited to only a small part of the industry. In order to tackle the growing challenges, a revamped framework for banking is the need of the hour. The new banking licenses were issued to bring reforms into the financial sector, to upgrade the technology and to avoid placing the entire economic power in the hands of a few and to take India towards the goal of financial inclusion. This is a clear indication that the private sector banks and foreign banks have a considerable role in improving the banking sector and hence the


Cover Story



banks’ balance sheets. Capital investment: Following issuance of licenses, the new banks will need to set up an operational branch within 18 months. This will require investments in land, premises, IT and other infrastructure; recruitment and training of personnel; and advertising and publicity, for example. New banks will also need to bear the cost of setting up branches in rural areas without the possibility of immediate returns. Human resources: The new banks will need staff that is trained for work in a bank¬ing set-up. Apart from technical skills, staff will need to be proficient in “soft skills” as well, since banking today is also about rela¬tionship management. Additionally, banks will need to spend time and funds on training and recruitment. IT infrastructure: Applicants that are given licenses will need to considerably enhance their IT infrastructure. Tasks like core banking implementation and multi-channel banking are likely to pose major challenges for a new bank. Regulatory reporting and compliance auto¬mation: The regulatory reporting environ¬ment for a bank is very different from that of other financial entities. Apart from setting up a regulatory reporting process, new banks will also have to be ADF (automated data flow) compliant – automating regulatory reports per RBI guidelines. Customer loyalty: Not all customers are dissatisfied with their existing banks, and not all dissatisfied customers are likely to switch banks. New banks need to consider this when they start looking for customers. Now that we have looked into pros and cons of new banking licenses, let us see how similar schemes have been implemented in other developing countries. Implementation of Banking Systems in Other countries: To improve the access to financial institutions, developing nations relied on microfinance models that were pioneered in Bangladesh. Over the past two decades, as the incomes of the poor improved, the focus of the countries shifted to commercial finance by launching savings plans, new credit schemes and banking channels with varying success. Most of these schemes implemented in the developing countries were aimed at having financial inclusion. In 1999, Brazil’s central bank approved “Banking correspondents” who are rural retailers trained as tellers by the commercial banks. In 2004, South Africa introduced Mzansi, a bare-bones

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bank account that allowed with-drawls at any ATM. Within 4 years, almost one fifth of the population signed for it and got benefitted. Similarly, M-Pesa, a private mobile banking platform, has enrolled two-thirds of adult population in Kenya. Emerging economies are slowly opening the doors to private and foreign players with a focus on privatization. There has been a clear cut evidence that privatization coupled with the entry of foreign banks had an overall positive impact on the banking systems and hence on the economies. This has helped in improving the overall efficiency of Public Sector banks by intensifying the competition and helped customers with better products and services. Central banks are playing a key role in encouraging the consolidation of the banking sector. According to a World Bank study, the foreign banks are controlling more than half of the banking system assets in Argentina, Chile, Czech Republic, Hungary, Poland and Mexico. The reason for the central banks to encourage consolidation is that this process can resolve the problems of financial distress. After seeing these successes of financial inclusion and privatization in other developing nations, it can be inferred that the move taken up RBI to issue new banking licenses to increase the financial inclusion and the presence of private sector in banking industry can play a significant role in improving the life style of the people and economy as a whole. Post-Mortem of Banking Licenses Issuance Process: As already pointed out, there were 26 applicants for new banking licenses. These included corporate houses and India Post. By applying for licenses, the applicants would like to leverage their advantages that are intrinsic to them. In this aspect, let us analyse a few of the applicants to understand their competency and fitness to obtain banking licenses. PSUs: India Post is one of the major applicants from PSU sector. The biggest advantages for India Post are government support and a huge network of 1.55 lakh post offices across the country of which majority (1.39 lakhs) of them are in rural areas. Thus, a PSU is better placed to fulfill the objectives of financial inclusion and rural banking as proposed by RBI. Despite all these advantages, India Post might not have found its place in the final list due to the inability of India Post to have last mile connectivity and lack of trained employees in the banking domain. India Post is possibly handicapped by the unworkable


of these companies may indulge in undue favours to their industrial owners. Given the fact that Kotak Mahindra was an NBFC, when it was offered a banking license in 2003, the RBI might have followed the same trend of granting licenses to NBFCs and microfinance institutions. To state a few facts about Bandhan Financial Services, Bandhan has a huge presence in the country with 2000 branches and 13000 employees and a significant presence in the eastern and other north-eastern states which are otherwise hugely unbanked areas. It has a huge borrower base of 52 lakhs and it was ranked second in the world by the Forbes magazine in 2007. With the current guidelines requiring new banks to set up at least 25 percent of their branches in unbanked areas and an already existing presence of Bandhan in unbanked eastern areas, this move of new banking licenses definitely helps to mitigate the problem of financial inclusion. Conclusion There are very less number of bank branches per a lakh of population in India. Most of the existing banks do not have a significant presence in the rural areas and hence there is very less credit penetration into rural circles of India and this can be substantiated by the fact that the number of deposit accounts in India is four times that of the number of credit accounts. Also, there is very less awareness among the majority of the population about Third Party Products such as mutual funds and insurance, and services such as portfolio management. Given the existing challenges and huge opportunities available in rural India, it is a well calculated decision by the RBI to issue banking licenses at this juncture with a key focus on financial inclusion. These entrants (IDFC and Bandhan) will find it difficult to set up and run a bank, considering the challenges they are going to face and the regulatory requirements in which they are going to operate, given the level of competition they have to deal with in order to stay profitable. On the other hand, the other applicants need not be dissatisfied since RBI hinted the new banking license aspirants to consider the possibility of on-tap as well as differentiated licenses. Going by the comments of the CEO of IDFC, it seems they are almost ready in meeting the regulatory requirements and they are very confident of running the bank successfully. Right now, everything is in air. One has to get into the sea to estimate its depth. Time can only tell the answers for these questions. So, the best thing to do is to wait for another 18 months!!!


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contracts for the provider of hand-held devices that are going to be used by its postal staff. Many of the branches are not usable for banking and it will be a humungous task for its employees to convince rural people for opening bank accounts. Also, the urban people may not be encouraged to use the services of a bank promoted by the postal department. Tourism Finance Group, another PSU, does not have any experience in banking. Corporate Houses: Corporate houses benefit from prior financial experience (if any), availability of capital, updated IT and trained personnel. However, the norms of financial inclusion and priority sector lending may put pressure on their parent entity’s balance sheet. There has been a widespread opposition regarding the issuance of banking licenses to corporate houses. Many economists and institutions felt that the risks of giving bank licenses to corporate houses may outweigh the benefits. On previous two occasions, when the bank licenses were given (during 1993-94 and 2003-04), business houses were not considered for granting licenses. Hence, it might be a case that RBI again went by the word ‘caution’. The parliamentary panel felt that the management of private companies may indulge in undue favour to their industrial owners. Hence, it can be inferred that except in the cases where the core business is related to banking, the RBI might not have shown any interest in offering licenses to corporate houses (which include Aditya Birla Group, Reliance Capital and Bajaj Group). Microfinance Institutions and other NBFCs: The business model for microfinance institutions makes them ideal vehicle for achieving the RBI’s objective of financial inclusion. These entities are usually concentrated in rural areas and lend loans where banks are normally unwilling to do so. Their network and spread in unbanked areas help them to open branches in rural areas and hence fulfill the objective of RBI of financial inclusion. Of course, the obvious flipside is that these entities can be hampered by low profitability, but this is the same case for all other companies. Among these NBFCs and microfinance institutions, there are some applicants, whose group activities are subject to high asset price volatility. For e.g., gold loans in case of Muthoot Finance. RBI might not have been encouraged by these kind of businesses for offering licenses. Out of the other NBFCs that have applied for banking licenses, NBFCs such as Reliance Capital, L&T Finance and Bajaj Finserve might not have obtained licenses because of the fact that (already mentioned) the management






A behavioural approach to understand the US 2008

crisis & the key takeaways Vineet Jain & Girish Hemnani


The US sub-prime crisis in 2008 sent a shockwave across the world, leaving millions of people jobless, economies in downturn, crash in stock markets and financial distress. Also one of the foremost effects was the banking giants like Lehman Brothers going bankrupt and many others on the verge of bankruptcy. Till 1980s, the U.S. financial sector was highly regulated followed by deregulation for next few years. It led to the rise of 5 giant Investment banks namely Goldman Sachs, Lehman Brothers, Morgan Stanley, Merrill Lynch & Bear Stearns. Most of these banks were initially partnership firms, but after the deregulation they turned into public corporations and expanded vastly. The size of these banks was so huge that the bankruptcy of a few caused the global recession for almost 3 years and unemployment in US to go many folds.

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There were many reasons to explain the crisis caused due to the bursting of housing bubble but apart from the technicalities, the crisis could be looked upon from the behavioural angle as well with the help of behavioural finance. Behavioural finance deals with the psychology based theories to explain the phenomenon in financial decision making. The understanding of rational behind human behaviour, beliefs and preferences of investors are the focused areas in this field. There are some beliefs and preference based theories which could be used to analyse the crisis. On belief side, the type one theory explains the overvaluation of assets due to bubble formation when investors don’t agree about an asset’s future aspects. And under the presence of short-sale constraints, the price of the asset

would be reflected by the bullish behaviour of the investors while the role of bearish investors would be neglected. The type-2 theory explains the extrapolation of past trends and outcomes too far in future which leads to surge in assets pricing. The third type of theory explains the overestimation of forecasts due to overconfidence in the little of gathered information by investors to analyze the asset. In order to understand the rationale behind the US sub-prime crisis, the type 2 theory is of utmost importance. It tells that the initial surge in the prices of the real estate asset could be the result of extrapolation of past trends and outcomes too far into the future. The household prices were increasing over the years and the same was expected in future without undermining the risk involved due to their defaults. This led to the overvaluation of real estate assets. It was not

only the housing prices that were extrapolated but the outside financing too. The rating agencies gave AAA ratings to many CDOs which didn’t even deserve this rating. The ratings made these securities very attractive to the investors and the increasing demand pushed the prices further up. In order to purchase these costly homes with higher forecasted future values, people started taking huge loans from banks. Since the expectation was that the land prices will continuously rise as it has been in the past, the profits were assumed certain & the banks gave loans to people who could possibly never pay the mortgage in future. The oversupply of credits in the form of sub-prime loans caused the housing bubble to go so big that resulted in formation of the real estate bubble. In 2007, when the CDO market collapsed, the house prices started falling and banks were left with large holdings in sub-prime loans. The



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Fig 1: Prospect Theory & Sunk Costs

reasoning for the sharp fall in prices could be explained using the concept of psychological plification mechanism related to loss aversion and ambiguity aversion. The theory explains why after suffering losses, the investors become more averse to loss and ambiguity which leads to smaller holdings of riskier assets by them. Resulting from the initial losses, the feeling of incompetency in analyzing the assets by investors develops the confusing market sentiments and triggers the asset selling. As the selling of assets increases the prices starts falling due to excess supply in the market. This loss aversion aggravated the collapse during the crisis. The question which can be raised here is: why the financial institutions had to hold such large holdings of loans despite the associated high risk? The logical implications could be explained using the alternative theories like Cognitive Dissonance as described in behavioural science. The cognitive dissonance is the state where people manipulate their beliefs in order to restrain themselves from the feeling of discomfort and losing out on positive self-image. Many bankers and analysts at investment banks and credit agencies seemed to have manipulated their beliefs against the risks involved in this business model. This could have resulted in overlooking of quality while inspecting the loan applications especially of people who could not afford to pay the mortgage in future. Also while giving the ratings, the analysts would have anticipated the risks involved due to defaults would be low, as the prices have always been

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rising in the past. Or it could be the result of lack of knowledge not because of resources but due to their willingness to remain so. The effects of the Great depression in 1929 had the effects for one whole decade. But after 5 years of sub-prime crisis in 2008, the global economy has proved itself resilient as compared to that of 1930s. The US economy is back on track with high employment opportunities within the state itself. The growth rate is revived with rising investments. The latest Facebook-Whatsapp $19 billion deal restates the fact that companies are willing to invest and expand given the viable environment even when they have to shell out huge chunks of money. The key take-aways and learnings from the 2008 crisis are (with respect to psychological behaviour): • Removing imperfections: The various banking and financial organizations can reorganize the culture in such a way as to remove psychological imperfections namely heuristics and biases. • Incentives: Many individual managers at these banks made huge amounts of money even when the banks went bankrupt. The simplest reason could be that they didn’t care, as their compensations were unaffected by the future risks involved with their current decision making. Hence to avoid any such instances in future, incentives need to be in accordance with the long term performance of the deals done at present. • According to Prospect theory, losses and gains are not weighed linearly. Rather, gains



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have diminishing value while opposite is the case of losses. The figure 1 explains the human behaviour in terms of weighing values for gains and losses. We can see that small gains give very less satisfaction but small losses causes huge disappointments. Gains and losses are evaluated from a subjective reference point and people become more cautious to little changes with respect to their current wealth. We earlier saw how initial losses caused the investor to become risk averse which triggered the market sentiment downward because of its asset selling and finally in sharp declining of prices. So in order to avoid such crisis, small losses should not deter the investors rather they should think of long term gains. • Lack of transparency & poor information sharing could lead to inadequate management practices. In order to avoid poor management decisions like inaccurate ratings by rating agencies etc. they need to be held accountable. • Avoiding underestimation of risks: Bankers, rating agencies, investors should not be blindfolded towards the risk in pursuit of higher returns. Over the years, the overconfidence has proved itself an obstacle in estimating the risks. The managers should avoid extrapolating little information to future prospects, believing it to be sufficient. Instead, they should be information and risk seekers. • Expect the unexpected: Few economists including the then chief economist at IMF, Mr. Raghuram Rajan correctly predicted the US 2008 crisis. But the fall of Lehman brothers in 2008 came as a shock to everyone as it was unexpected. It turned the US recession into a global one. Hence relying on any particular financial institutions irrespective of their size and type (Govt or private) would be dangerous. The

policymakers can instead focus on developing tools which can respond swiftly to the effect of such crisis at a faster pace. The behavioural science thus provides a lot of insights on investors’ as well as the bankers and rating agencies decision making psychology using the belief and preference theories. The overconfidence, extrapolation, belief manipulation, herding, heuristics are the terms explained to understand the US crisis in greater detail. Thus, the financial institutions need to provide tools in order to integrate the human behaviour and the financial regulations which could be utilized effectively by the investors as well as the financial and banking institutions. Recalling from Adam smith’s ‘Moral Sentiments’ which says, to enjoy the praise, the praise worthiness is something to look for. So in order to avoid a 2008 type financial crisis in future, an individual, an organization and an economy must strive to create value and aspirations that is real rather than superficial.



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The Vodafone – Hutchison Essar Deal Gaurav Pilania

IIM Shillong

Company Background at the time of Deal Hutchison Telecommunication International Limited Hutchison Telecommunications International Limited (Hutchison Telecom) was a multinational telecommunications services company headquartered in Hong Kong and a wholly owned subsidiary of Hutchison Whampoa. It operated in GSM mobile telecommunication services under famous brands like Hutch, 3 and Vietnamobile. Essar Group Essar was one of the India’s largest corporate houses with around 20,000 staff members and business interests spanning high growth infrastructure sectors of Steel, Oil & Gas, Power, Telecommunications, Shipping & Logistics and Construction. Essar had begun as a construction company in 1969 and had subsequently diversified into manufacturing, services and retail. Vodafone Vodafone was the world’s leading mobile communications group with operations in 25

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countries across 5 continents and over 200 million proportionate customers by the end of January 2007, as well as 36 partner networks. Hutchison Essar Hutchison Essar was one of the leading Indian telecommunications mobile operators with a 25 million-customer base that represented a 16.4% of the national market share. Hutchison Essar had over 6,000 employees, operating in 16 circles and had licenses in an additional six circles. For the year 2005 as on 31st December, 2005, Hutchison Essar had reported a revenue of US$1.3 billion, EBITDA of US$415 million, and an operating profit of US$313 million. In the six months that ended in June 30, 2006, Hutchison Essar had reported a revenue of US$908 million, EBITDA of US$297 million, and an operating profit of US$226 million. Till January 2006, Hutchison Essar had licenses in 13 circles, of which nine had a spectrum of 900 MHz.. In January 2006, Hutchison Essar acquired BPL Mobile Cellular Limited, thereby adding three circles, each operating with 900 MHz spectrum. In October 2006, Hutchison Essar acquired Spacetel, adding six more licenses.


both parties to expand network coverage more quickly and to offer more affordable services to a broader base of the Indian population Pros and cons of the deal Vodafone had a good motive behind seeking a stake in Hutchison Essar. By the end of 2005, CEO Arun Sarin was under pressure to shore up Vodafone’s languishing stock price and the company needed to make a significant move in the emerging markets - the expected core of its future business - as its traditional European markets were saturating. Vodafone posted better-than-forecasted results as emerging markets’ growth compensated for a saturated Western Europe. For the six months ending on 30th September, 2006 Vodafone tabled adjusted earnings before interest, taxation, depreciation and amortization of £6.24 billion - a 2.8% improvement from £5.91 billion in the previous year. However, some M&A experts believe that Vodafone might have overpaid for Hutchison Essar by almost 30% to 45%. According to the analysts, the fair value of Airtel’s mobile services is about Rs 25,000 (about US$600) per subscriber. However, Vodafone agreed to pay Rs 35,000 per subscriber of Hutchison Essar. Generally, analysts were upbeat about the deal’s implications for the telecom industry as a whole. The deal was seen as a positive sign for the Indian telecom industry as it brought in the expertise of the management of Vodafone, who had a wide experience and presence in several international telecom markets. Even though the deal increased the intensity of competition, eventually, the customers were the beneficiary. However, Vodafone Essar - as the company had been renamed - had built a 100 million customer base in India by 2010 and had started making profits from its Indian operations by 2011. It also paid Rs. 11,618 crore for 3G spectrum in nine circles in 2010. Initially there were reservations about Hutchison Essar’s fit with the rest of Vodafone Group, and even more questions were raised about


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The Deal In one of the biggest telecom M&A deal for India, in May 2007, Vodafone Plc. (UK) acquired a majority interest in Hutchison Essar Limited, an Indian telecommunications company in a deal worth $11.1 billion. Vodafone acquired a 67% stake in Hutchison Essar from the Hong Kong-based Hutchison Telecommunications International (HTIL). Sullivan & Cromwell advised Goldman Sachs & Co, the financial adviser to HTIL. Not only was this one of India’s largest foreign takeovers, this deal also attracted an unprecedented array of blue-chip legal teams from India and abroad. Linklaters, Thawar Thakore & Associates and Trilegal represented Vodafone Group, while Freshfields Bruckhaus Deringer, Khaitan & Co and Paul, Weiss, Rifkind, Wharton & Garrison advised HTIL. Herbert Smith and AZB & Partners represented the minority shareowner Essar Group. For Vodafone the deal was not an easy one and a numerous financial and regulatory roadblocks presented themselves. While it had already made an entry into the India markets in 2005, when it bought a 10% stake in Bharti Tele-Ventures, which owned Airtel, India’s leading mobile telecommunications operator in terms of subscriber numbers. However, Vodafone announced that it had agreed to acquire a controlling interest in Hutchison Essar Limited (“Hutch Essar”), a leading operator in the fast growing Indian mobile market via its subsidiary, Vodafone International Holdings B.V. It also announced that it had signed a memorandum of understanding (“MOU”) with Bharti Airtel Limited (“Bharti”) on infrastructure sharing. Infrastructure sharing MOU with Bharti • Whilst Hutch Essar and Bharti continued to compete independently, Vodafone and Bharti had entered into a MOU relating to a comprehensive range of infrastructure sharing options in India between Hutch Essar and Bharti • Infrastructure sharing was expected to reduce the total cost of delivering telecommunication services, especially in rural areas, enabling



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why Hutchison Whampoa would sell off its most profitable business. Shares of Hutchison Telecom fell sharply following the news of the deal. However, HTIL shareholders later approved the sale of the stake since it was realized that Hutchison needed funds for its own 3G expansion in Australia, Hong Kong and Italy and establish new ventures in Indonesia, Sri Lanka and Vietnam and losses from the group’s global 3G business were still enormous. In addition, it was seen that there were frictions between Hutchison and Essar over two transactions: the sale of a stake in the venture to Egypt’s Orascom (which had interests in neighboring Bangladesh and Pakistan) and the abortive purchase of Mumbai-based BPL Mobile. Post Deal Maneuvers British mobile phone giant, Vodafone took full control of its Indian joint venture by buying out its local partner, Essar Group in May 2011. Vodafone, who sought to make India a key player in its emerging markets portfolio, paid Essar Group companies $5.46 billion for the onethird holdings in its Indian mobile-phone services provider, Vodafone-Essar. The settlement marks the end of a four-year partnership b e t w e e n Vodafone and Essar in India during which, Vodafone Essar has grown to reach almost 140 million subscribers. Vodafone’s pact with Essar gave the Indian conglomerate an option to sell its stake in Vodafone Essar to the British firm for $5 billion. Vodafone Tax Dispute and its Impact In August 2007, the Income Tax (IT) Department of India issued a show cause notice to Hutchison Essar, and subsequently in September 2007 levied Vodafone with a tax demand of around Rs. 11,000 crore. The IT Department believed that even if the transaction was between two non-resident companies, still Vodafone is liable to pay taxes

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because the transaction involved capital assets deriving revenues from operations in India. It was also alleged by the tax authorities that the Vodafone transaction involved capital gains for Hutchison. Therefore, Vodafone was supposed to deduct at source the tax due from Hutchison before making the final payment to Hutch. However, Vodafone failed to make this deduction due to which the company was held responsible for tax evasion and asked to pay the tax due to the Indian Government. Vodafone, on the contrary, believed from the beginning that the Indian Government has no jurisdiction to levy taxes on them since the transaction was between two non-resident companies and involved assets that might have been in India but were not under any Indian ownership. CGP (a Cayman Island based Company) controlled 67 per cent stakes in Hutchison Essar Limited and Vodafone, which is not an Indian company, had purchased those stakes from CGP. It was Vodafone International Holdings, a Netherlands based company, which had bought CGP. And even if taxes have to be paid, Vodafone believed that it should be paid by Hutchison and not by them. On top of that, there was legal ambiguity in this case because at that time Indian IT Act did not cover “failure to deduct tax at source” with clarity. On the basis of these arguments, Vodafone went to the Bombay High Court (HC) in October 2007, challenging the IT Department’s notice. It seems that Vodafone’s strategy was to stall the claim process legally and later use the above mentioned anomalies in the tax act to make its case viable and stronger. However, in February 2008, the parliament amended Section 201 of IT Act, the sub-section (1) of section 201, to clarify that where a person,


Impact on the country The Vodafone judgment was important for the company, but it had greater ramifications for India. Many of the issues involved are yet to be resolved conclusively. The Supreme Court verdict also apparently soothed a lot of nerves in foreign companies that had acquired stakes and interests through holding companies based in countries outside India. According to newspaper reports, the government is examining the possibility of putting in place a formal framework for resolving tax disputes, possibly keeping in mind the dispute with Vodafone. The mechanism is speculated to be similar to the advance pricing agreements used to resolve transfer pricing cases. This move although have a negative impact of encouraging the foreign corporate companies to be incentivized to start evading tax liabilities by acquiring Indian capital assets through taxhaven based holding companies. However, the chain of events involving Vodafone, Hutchison Essar and the Government of India has brought out the contradiction between policies, attracting foreign investment and sound public finance policies. For the time being, status quo is maintained as far as anti-avoidance is concerned, but unlike in issues related to fiscal deficit, the “loss to the exchequer” point of view has been missing from mainstream debate and discussion of the Vodafone case till now. A prolonged slowdown in the economy and a mounting current account deficit has created a panic among the Indian policy makers, who always see the ghost of the 1991 balance of payments crisis in everything, but fail to understand the efficacy of simple import control, capital control and exchange rate control mechanisms. As a result, today the country may face some bad public finance policy making for blanket appeasement of foreign investment. This appeasement, as we can see in this particular case also, invariably takes the form of creating new policies to clear all legal hurdles in favor of foreign investments. Even if we forget the legalities for a moment, it is impossible to find any sound economic logic behind such waivers as far as public finance is concerned. We can only hope for more responsible and thought out policies from our policy makers in the future.


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including the principal officer of a company who is required to deduct any sum in accordance with the provisions of Income-tax Act does not deduct, or does not pay, or after deducting fails to pay, the whole or any part of the tax, as required by or under the Income-tax Act, he shall be deemed to be an assesse in default under section 201. The amendments to consequences of non-deduction of tax at source were made applicable with retrospective effect from June 1, 2002. In December 2008, the Bombay High Court rejected the plea of Vodafone and pronounced its judgment in favor of the Government of India, stating that Vodafone was liable to pay taxes since the 2007 transaction with Hutchison Essar Limited, involving purchases of capital assets of an Indian company. So, the Court rejected Vodafone’s petition and said that IT Department has the right to investigate the case. Vodafone was not satisfied with the decision of the Bombay High Court and decided to challenge it in the Supreme Court (SC). In January 2009, the SC dismissed Vodafone’s appeal. The Court left the decision on jurisdiction of the IT department. Subsequently in October 2009, the IT Department issued a fresh show cause notice and Vodafone replied once again, in January 2010, saying that the IT Department had no jurisdiction. Next in this never-ending tussle in May 2010, the IT Department issued an order emphasizing that it has jurisdiction; and Vodafone filed a petition in the Bombay High Court challenging this order in June 2010. In September 2010, the Bombay HC turned down Vodafone’s petition and asked the company to pay up. Vodafone appealed to the Supreme Court once again, against the court order. After directing the IT Department to quantify the tax liability, SC asked Vodafone to deposit Rs. 2,500 crore and provide bank guarantees of Rs. 8,500 crore, pending final verdict in November 2010. Although in January 2012, there was a change in the Supreme Court’s stance and it decided in favor of Vodafone – stating that the transactions were made between two non-resident companies outside India and involved assets that were not part of an Indian entity. It also asked the IT Department to return Rs. 2,500 crore to Vodafone with a 4 per cent interest. The IT Department was still not satisfied with the verdict and filed a review petition at the apex court which is currently pending.




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CAPM- Telecom Rishi Pawar & Saurabh Karodi

IIM Lucknow

The Indian telecom industry is characterised with intense competition, and continuous price wars. Currently, there are around a dozen telecom service providers who operate in the wired and wireless segment. The government has been periodically implementing suitable fiscal and promotional policies to boost domestic demand and to create volumes for the industry. Telecommunication has been recognized world-over as an important tool for socioeconomic development for a nation and plays a phenomenal role in growth and modernization of various sectors of the economy. Over the last few years, Indian telecom market has shown overwhelming growth. The fact that India is one of world’s fastest growing telecom markets in the world, has acted as the primary driver for foreign and domestic telecommunication companies investing into the sector. It is also recognized as one of the most lucrative m a r k e t s g l o b a l l y, resulting in massive investments being made in the sector both by the

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private and government sector in the last decade. So we have tried to look upon the cost of capital used by the telecom sector companies and for this we have taken 10 telecom companies and calculated their cost of capital by CAPM method. Indian Telecom Industry is one of the fastest growing sectors in the world. This is mainly because of various factors: • It is the second largest in the world based on the total number of telephone users. • It has one of the lowest call tariffs in the world enabled by the mega telephone networks and hyper-competition among them. • It has the world’s third-largest Internet user-base. • India possesses a diversified communications system, which links all parts of the country by telephone, Internet, radio, television and satellite. I n d i a n t e l e c o m industry underwent a high pace of market liberalisation and growth since the 1 9 9 0 s


premium of the market as whole times a multiplier - called “beta” which measures the risk in a security is relative to the total market. Cost of capital is defined as “the opportunity cost of all capital invested in an enterprise.” According to the CAPM theory, there are two types of risks - systematic and nonsystematic. Beta represents systematic risk. The level of systematic risk of an individual security depends on how correlated it is with the overall market. This risk can be diversified if one invests in a portfolio of securities. Thus, cost of equity capital = Risk-Free Rate + (Beta times Market Risk Premium) i.e., Re = Rf + β( Rm – Rf ) Mergers and acquisition deals in Indian telecom sector:

1. Vodafone sold its 5.6% stake in Bharti Airtel to promoters Mittal group for Rs. 7000 crore. The deal took place in Feb. 2007. The total stake of Vodafone has now reduced to 4.4% from 10%. Calculations of Ke for the deal are as below: Ke= E1/P0+g 2. Telekom Malaysia picked up a little less than

15% stake in Aditya Birla group’s company Idea Cellular at a price of Rs. 158 a share through a preferential offer paying above $2 billion for the acquisition. It valued the Birla Company over $10 billion. The preferential offer had been made to Telekom Malaysia (TM) at a substantial premium to the current market price of Idea Cellular. The deal took place in 2008. 1 USD=42.88 INR 3. Aditya Birla group bought Tata group’s stake in Idea Cellular in 2006. The deal was valued at more than 4400 crore. Following this deal, the shareholding changed and 98.3% was held through various Aditya Birla Group companies. 1 USD=42.88 INR P0 (Total market value E1 (Net profit of of Bharti Airtel as per Bharti Airtel Ltd. for the deal) based on the year 2008)(in Rs. the value of the deal Crores) for 5.6% shares (in Rs. Crores) 6244.19 7000/ 5.6%= 125000.00 Ke=4.995%+g At g=7% Ke=11.995% At g=8% Ke=12.995% At g=9% Ke=13.995% P0 (Total market value of Idea Cellular as per the deal) based on the value of the deal for 48.18% shares (in Rs. Crores) 14736.34 9311.53 Ke=161.363%+g At g=7% Ke=168.363% At g=8% Ke=169.363% At g=9% Ke=170.363%

E1(Net profit of Idea Cellular Ltd. for the year 2007)(in Rs. Crores)

P0 (Total market value of Idea Cellular as per the deal) based on the value of the deal for 15.0% shares (in Rs. Crores) 57173.33 Ke=16.286%+g Ke=23.286% Ke=24.286% Ke=25.286%

E1 (Net profit of Idea Cellular Ltd. for the year 2009)(in Rs. Crores) 9311.53 At g=7% At g=8% At g=9%


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and now has become the world’s most competitive and one of the fastest growing telecom markets. The Industry has grown over twenty times in just ten years, from under 37 million subscribers in the year 2001 to over 946 million subscribers in the year 2013. “Capital Asset Pricing Model” (CAPM) says that equity shareholders demand a minimum rate of return equal to return from a riskfree investment plus a return for bearing an extra risk. This extra risk is called “equity risk premium”, and is equivalent to the risk



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4. Qualcomm to pick up a 4% stake in Reliance Infocomm now it is Reliance Telecom Ltd. The deal was taken up in 2004 at the value of $200 million. It was a strategic investment by Qualcomm. Reliance benefitted from it by gaining the usage of Qualcomm’s CDMA based Evolution Data Optimized technology. P0 (Total market value of Reliance E1 (Net profit of ReliTelecom Ltd. as per ance Telecom Ltd. for the deal) based on the year 2005)(in Rs. the value of the deal Crores) for 4.0% shares (in Rs. Crores) 11721.94 23175.00 Ke=50.58%+g At g=7% Ke=57.58% At g=8% Ke=58.58% At g=9% Ke=59.58% Assumptions: 1. Time period for returns : 4 , i.e. A,B,C,D 2. Market rate of return : Arithmetic and Geometric 3. Risk free rate of return : Long Term Rate of return 4. Beta and Debt Equity Ratio: Levered Beta using three target D/E ratios of 0.50,1.00 & 1.50 Considering the complexity of the case we have shortened our assumptions to taking Time Period : “A” Market rate of return, Rm : 17.7244% Debt equity ratio : For individual companies the value is as per calculations , but for the industry as a whole it is 1.02. COS





Airtel Idea MTNL Netlinx OnMobile Quadrant Reliance Tata Tata MH Tulip Industry

8.92% 8.92% 8.92% 8.92% 8.92% 8.92% 8.92% 8.92% 8.92% 8.92% 8.92%

17.72% 17.72% 17.72% 17.72% 17.72% 17.72% 17.72% 17.72% 17.72% 17.72% 17.72%

8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.80% 8.80%

0.08 0.19 2.05 0.16 0.05 1.64 0.63 0.10 1.14 4.13 1.02

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Levered Beta : Calculated for each individual company, but for the industry the value of Unlevered Beta is 0.55 , hence applying the above D/E ratio the value of Levered Beta for the industry is (.55*(1+1.02) = 1.111. Risk free rate of return, Rf = 8.9% p.a. (as above) Computation: Findings WE note that the Average of the Re for each company is not equal to the computed industry’s Ke as per CAPM. i.e. 16.41% over 18.66%.. This is mainly due to the Levering effect of Beta, taking it as 1.111 and not 0.85 (average of all Levered Betas) as a result of the debt equity ratio. The computation of Cost of capital is based on assumptions and averaged valued which tend to differentiate the final results from the original ones. If we would not have averaged the D/E ratio rather the Levered beta the results would have been different. The WACC would have been higher by approximately 0.38% and the valued would have been differed by approximately 3%. Say if perpetual income is INR 1.00 p.a. and ignoring growth rate then in either case the values of equity would be : INCOME/Ke. Case when WACC = 12.20% Value = 1/.1220 =INR 819.82

Case when WACC = 12.58% Value = 1/.1258 =INR 794.74

Due to these variations in computation of cost of equity we find different valuations derived by different values over different spans of time.

Beta.E Re(CAPM) 0.87 0.89 0.93 0.35 0.82 0.70 1.38 0.94 0.94 0.70 1.11

16.57% 16.78% 17.07% 11.98% 16.16% 15.05% 21.10% 17.18% 17.18% 15.05% 18.66%





11.34% 10.21% 6.90% 11.60% 1.49% 5.86% 5.08% 13.40% 12.73% 9.09% 8.77%

0.93 0.84 0.33 0.86 0.96 0.38 0.61 0.91 0.47 0.19 0.50

0.07 0.16 0.67 0.14 0.04 0.62 0.39 0.09 0.53 0.81 0.50

15.93% 15.18% 8.69% 11.39% 15.48% 8.12% 14.25% 16.43% 12.55% 7.81% 12.20%

CLASSROOM FinFunda of the Month

Chinese wall Dwaipayan chakraborty

IIM Shillong the recommended stock, their prices will move up and thus he would bet on selling the same stocks to book profit; as the bank sells its shares the prices fall and your client does not get the benefit from your recommendation and end up making a loss.

Sir, Last night in the news many were debating on whether the bankers should Ok! That’s a severe breach of trust indeed. be put to Jail for breaking the Chinese wall, This is not the only example where a why would the bankers break the Great Chinese wall is needed and may be required Wall of China? in many other areas. For example, suppose Student, they were not talking about XYZ bank has a long-term relationship with breaking the Great Wall of China, in the a Steel company which is not doing well in world of Finance Breaking the Chinese wall the market. As the company has a relationship with means a breach of trust. the bank, the investment department of the bank does not suggests its clients to sell the stocks as Breach of Trust? Well, sir what kind of a fall in prices would harm the steel company and breach is that? thus it would struggle to repay its loan to the bank. A Chinese wall is an information separation Although it saves the bank’s interest, the clients who mechanism where firms develop were working on the recommendation of holding the frameworks and guidelines such that information of stock would be eventually hurt as the stock price of different departments of an organization are the steel company falls due to its poor performance. kept confidential from each other. Oh! Never imagined that there may be so many cases of contradiction inside one institution. But why is it called the Chinese If it is within an organization, then why wall? such an information descreation necessary? The Great Wall of China was erected to This is necessary in order to maintain protect the citizens from enemy invasion; ethical business practices, otherwise one similarly the Chinese wall in banking aims may use information in one department to to protect the investor’s interest and thus take undue advantage in the functioning of prevent financial institutions from passing information another department. between different departments. Well can you please explain it with an example which many help me to understand Why were they talking about jailing the it better? bankers? It is so because the recent financial crisis Yeh Sure! Consider that you are working as has been largely been caused due to the an analyst in the investment department unethical information exchange between of XYZ bank. Based on your analysis many of your departments that had led to the loss of clients would invest heavily on the stocks that you investor’s trust on banks and eventually the collapse recommend them to buy. At the same time your friend is working in the trading division of the same bank of many financial institutions and the markets. and if you pass on the information of your investment analysis to him, he may take undue advantage. Since he knows that a lot of your clients will buy

This clears a lot of questions that I had. Thank you Sir for the explanation.


Classroom Cover Story







JAYDIP MUKHOPADHYAY Phd, ERS Manager, Deloitte & Touche LLP

How important and useful is predictive modelling and forecasting is in today’s era and which industries require it the most? What kind of tools are used for this? Predictive modelling is useful in any industry but I have experience working mainly in the financial and life sciences industry. Predictive modelling is extensively used in the major industries to address different business questions and finally data driven conclusions are drawn. Lot of different techniques are being used to build predictive models , primarily different regression (simple/generalised linear models) and data mining techniques (clustering, classification, discriminant analysis etc.). However, at the end of the day all that really matters is how efficiently you address them. There are pros and cons of all these techniques but you need to make sure that you are increasing the likelihood of drawing correct inference.

What is it that stimulates the financial crisis? Do you think that formulating more regulations can prevent this, as the industry has become quite an expert in circumventing rules and keep coming up with new products? Also, just as dot com burst, do you think that the social media bubble is building up? Well, if you are taking about prevention, after the 2008 crisis. all regulators have their eyes open and they are trying to make sure that even if there is any severe crisis in the market, the financial institutions have enough capital to serve as credit intermediaries, to meet their obligations to creditors/counterparties and to continue the operations. But, it is really difficult to control/predict if something outside this boundary takes place and something worse than what they expect happens. If that happens, regulations will become more stringent and banks will have no choice other than to meet the requirements.

How do you assess the risks associated with financial institutions apart from non- compliance of regulations? Different types of risks like credit risk, operational risk, market risk etc. are associated with all these financial institutions. I have mostly worked in the credit and operational risk area. For example, Comprehensive Capital Analysis and Review (CCAR) is an annual exercise by the Federal Reserve to ensure that financial institutions have a robust, forward looking capital planning process that ensures the sufficient capital to continue operations during financial crisis. As part of this exercise, it is mandatory for all large/mid-size banks to assess the capital adequacy, internal capital adequacy assessment processes, and their plans to make capital distributions during the recession period. Prediction of capital requirements/adequacy is being done using different types of predictive modelling techniques.

How accurate are quantitative techniques like risk adjusted returns etc.? Do qualitative analysis and business intuition still find relevance? Majorly I believe in numbers. If you have data, quantitative data analysis is very important for drawing final conclusions. However, I think qualitative analysis and business intuition also play a very important role and there should be a proper balance between these two while drawing the final conclusion.

APRIL 2014



1. Identify below:

2. Identify the images and state the link between the two.

3. The EUR/USD spot exchange rate is 0.70145 and 1-year interest rates are 3% in EUR and 2% in USD. The forward USD/EUR exchange rate is equal to? 4. Which is the world’s most expensive stock? 5. Which type of information is fully reflected by stock prices according to the weak form Efficient Market Hypothesis? 6. What is Bear Hug Letter? 7. What is the risk measure associated with the capital market line (CML)? 8. An investor paid a full price $1059.04 each for 100 bonds. The purchase was between coupon dates and accrued interest was $23.54 per bond. What is the bond’s clean price? 9. Which is the oldest stock exchange in Asia?



10. Name its CEO and the company that had to recently recall the product that it manufactures due to a defect in it that had also caused loss of human lives. This company is also currently recovering from the bankruptcy that it had filed a few years ago. 11. This company recently went for an IPO. The owner of this company joined the Billionaires league. This thrives on the “Buy Low- Sell High” mantra and is known for acquisitions. Which company are we talking about? With which telecom firm has it signed a deal with? 12. Which is the only country having paper currency and have no coins and it introduced cheque only in 1997? 13. The Euro interest rate is 3% and the AUD interest rate is 4%. The spot EUR/AUD is 0.8213. The 90-day forward EUR/AUD no-arbitrage rate is equal to ? 14. How is it referred to when an organization’s actual bank balance in balance sheet is more than shown in the books? 15. This Japanese drug maker was imposed a hefty fine (fine amount more than that of imposed on Exxon Mobil in 2008 for oil spill) recently alleging that the company had concealed the cancer risks associated with its diabetes drug. Identify the company 16. Identify the person

17. Which banking group’s logo is this?

18. Question (Connect the dots)

All entries should be mailed at by 10th May, 2014 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-


WINNERS Article of the Month

Prize - INR 1000/-

Vinita J. and Vishak E.B. XIME Bangalore

ANNOUNCEMENTS ALL ARE INVITED Team Niveshak invites articles from B-Schools all across India. We are looking for original articles related to finance & economics. Students can also contribute puzzles and jokes related to finance & economics. References should be cited wherever necessary. The best article will be featured as the “Article of the Month” and would be awarded cash prize of Rs.1000/- along with a certificate. Instructions »» Please send your articles before 10th May, 2014 to »» The subject line of the mail must be “Article for Niveshak_<Article Title>” »» Do mention your name, institute name and batch with your article »» Please ensure that the entire document has a wordcount between 1200 - 1500 »» Format: Microsoft WORD File, Font: - Times New Roman, Size: - 12, Line spacing: 1.5 »» Please do NOT send PDF files and kindly stick to the format »» Number of authors is limited to 2 at maximum »» Mention your e-mail id/ blog if you want the readers to contact you for further discussion »» Also certain entries which could not make the cut to the Niveshak will get figured on our Blog in the ‘Specials’ section


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