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June 2012


poor companies - rich multiples, Pg. 18

how do you do infosys pg. 16

FROM EDITOR’S DESK Dear Niveshaks, Niveshak Volume V ISSUE VI June 2012 Faculty Mentor Prof. N. Sivasankaran

THE TEAM Editorial Team Akanksha Behl Akhil Tandon Chandan Gupta Harshali Damle Kailash V. Madan Nilkesh Patra Rakesh Agarwal Creative Team Anuroop Bhanu Venkata Abhiram M.

All images, design and artwork are copyright of IIM Shillong Finance Club ©Finance Club Indian Institute of Management Shillong

The month of June has witnessed some major financial events that are likely to shape the future of economic development globally. The fear of a dramatic Grexit that kept the world on edge has finally subsided for some time after Greece election results. The emergence of pro-Europe parties in the Greece’s election should relax fears that a country will leave the euro for the first time and unleash global financial turmoil. However, the slim majority won by pro-bailout parties in Greece elections and worries about the Spain’s fiscal and banking problems kept tensions high. Another major event this month has been the meeting of the G20 members in Las Cabos, Mexico. The dangers that Europe’s escalating debt crisis would drive the global economy back into recession for the second time in less than four years dominated the summit of G20 leaders of industrialized and developing nations, which represent over 80 per cent of world output. European countries showed at the Group of 20 summit that they were considering major steps to integrate their banking sectors so as to break the cycle of highly indebted countries and rescue their banks, which only pushes governments ever deeper into debt. This year’s meeting of United Nations Conference on Sustainable Development dubbed Rio+20 aimed at setting an agenda for policymakers to act in the coming decades, and promote cuts in fossil-fuel subsidies, support for the use of renewable energy and measures to protect oceans. However, as any agreement will have no force as a treaty, the Rio +20 ended with a whimper rather than a bang compared to the legacy of its predecessor, the 1992 Rio Earth Summit, which led to major conventions on climate change and biodiversity. In India, RBI kept policy rates unchanged in its mid-quarter monetary policy review because of high headline inflation. The market indices reacted negatively to the news. In spite of a sharper than expected rate cut of 50 basis points in April, slowdown in activity, particularly in investment, showed that the role of interest rates is relatively small and a further rate cut could exacerbate inflationary pressures rather than spur growth. The RBI stance had another adverse impact causing rupee to depreciate to 55.83/84 to a dollar on the day of the review and to its all-time low of 57.12 against the dollar days later. In another major development, Standard & Poor’s warned that India could become the first BRIC economy to lose its investment-grade credit rating. In a similar move, Fitch added further insult to injury by revising India’s outlook from stable to negative at BBB-. This issue brings to you some more interesting and insightful reads. The cover story this month focuses on financial woes of solar power in India. The issue also features articles on regulations in Insider Trading in India, company valuations and implications of regulating propriety trading of financial institutions. The Classroom this month explains the nuances of Leveraged Buyout. We would also like to thank our readers for their constant support through wonderful articles and appreciation. It is your endless encouragement and enthusiasm that keeps us going. Kindly send in your suggestions and feedback to and as always, 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

08 Is India Ready to Fight Insider Trading ?


Financial Woes of India’s Rising Sun

Perspective 16 How Do You Do Infosys?


18 Poor Companies - Rich Multiples

FinGyaan 18 Sir Volcker vs. Prop Trading


21 Leveraged Buyout (LBO)

The Month That Was



The Niveshak Times Team NIVESHAK

IIM, Shillong

May WPI inches up to 7.55% and CPI rises to 10.36% Country’s benchmark inflation rate rose to 7.55% in May as a result of elevated food and fuel prices. A jump of 0.22% in WPI matched the expectations in Reuters Poll. Core inflation, which excludes volatile food and fuel prices, was around 5% in May. Finance Minister talking to reporters on Thursday said “core inflation falling is a silver lining.” He said good monsoon will help ease pressure on inflation and was confident that inflation will be in the range of 6.5% to 7.5% in FY13. At the same time Consumer Price Inflation stood at 10.36% up from 10.26% in April, as a result of high vegetable, egg, meat, fish, oil and fat prices. In the urban areas annual inflation based on the CPI stood at 11.52% while in rural areas it remained in single digit at 9.57%. In April inflation based on the CPI in rural areas stood at 9.67% while in urban areas it was at 11.10%. Europe crisis: Spanish short-term debt costs reach record levels Spain, the euro zone’s fourth largest economy, had to pay 5.07 percent to sell 12-month Treasury bills and 5.11 percent to sell 18-month paper on June 19 - an increase of about 200 basis points on the last auction for the same maturities a month ago. Spain inched closer to becoming the largest euro zone country to be shut out of credit markets when it had to pay a record price to sell its short-term borrowing instruments. The soaring short term borrowing yields showed that Europe’s troubles are much bigger and deeper than just Greece and a considerable action is now needed to tame twoand-a-half year old European debt crisis. Spanish Economy Minister Luis de Guindos, attending G20 summit, told reporters that Madrid’s policies were not to blame for the loss of investor confidence. “We think ... that the way markets

May 2012

are penalising Spain today does not reflect the efforts we have made or the growth potential of the economy,” he said. “Spain is a solvent country and a country which has a capacity to grow.” IIP in April was worse than anticipated Reduction in capital goods and shrinkage in manufacturing output in April has resulted in a IIP at 0.1% versus -3.5% in March. This is worse than what was expected. The slowdown in growth of factory output was expected to force RBI to cut interest rates but RBI kept the rates unchanged in their quarterly mid-term review on June 18. The unexpected lower IIP and unchanged interest rates are expected to put more pressure on Indian Economy which is already suffering from twin problems of lower GDP growth rate and higher inflation. Indian economy is in stagflation: Moody’s Global financial services firm Moody’s, on June 14, said that Indian economy is facing stagflation. “India’s economy is in stagflation, with notably weaker growth but inflation still stubbornly high,” said Glenn Levine, Senior Economist, Moody’s Analytics. As per Moody, the recent plunge in the rupee is pushing up the price, especially imported goods and commodities priced in US dollar and combined with slower GDP growth, this has led to the situation of stagflation for Indian economy. It further said with the rupee, sitting 15 per cent below its peak of lateFebruary, will ensure that WPI inflation remains in the 7 per cent to 8 per cent range for another six months. “Indeed, with the growth side of the economy slowing, the risks have shifted sharply towards growth and they (the RBI and other policy makers) should just grin and bear the higher inflation numbers,” it added RBI Governor announces Mid Term review, disappoints industry with no rate cuts The Reserve Bank of India (RBI) announced its mid-term credit policy review here on June 18, and against the industry expectations, kept the short term lending rate and the Cash Reserve


Ratio (CRR) unchanged at 8 and 4.75 percent respectively. Industry expected RBI to bring down the repo rate by at least 0.25-percentage point to 7.75 percent, and the Cash Reserve Ratio (CRR) up by 1 percentage point. “Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small. Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures,” the RBI said in a statement. RBI, targeting GOI, also said that government has failed to follow the path of fiscal consolidation while it is trying its best to link monetary policy with fiscal policy. Finance Minister Pranab Mukherjee said high inflation weighed on RBI’s mind but Commerce and Industry Minister Anand Sharma expressed his anguish over RBI choosing a status quo when the industrial growth was down. Stock market reacted strongly to the announcement and tanked, suffering a loss of 244 points at closing. India’s stand on infrastructure investment sanctioned by G20 The G20 meeting held recently in Mexico concluded with an approval of India’s stand on investment in infrastructure by the leaders that included US President Barack Obama, German Vice Chancellor Angela Morkel, Chinese Prime Minister Wen Jiabao and Russian President Vladimir Putin. The G20 comprises of the world’s prominent and developing economies. India was of the viewpoint that investment in infrastructure is critical for continued growth, worldwide economic retrieval, poverty reduction and job creation. India requires a minimum of $1 trillion in infrastructure in the coming five years. Manmohan Singh announced that the much needed investment in infrastructure in emerging economies can play a crucial role in firming expansion and stimulating the process of recovery world-wide. A clear

communication was given that growth cannot be overlooked and while austerity is important for countries facing too much debt, surplus nations must counter it with expansion. The affirmation also had other observations which were in line with what was being pushed for by Indian debaters at G20 Summits and other forums. Indian money has risen after five years in Swiss Banks At the end of 2011, the amount of money held by Indians in Swiss banks totalled 2.18 billion Swiss francs. This figure has risen for the first time in the last five years. The latest data by the Swiss National Bank has revealed that the total fund is inclusive of 2.025 billion Swiss francs held directly by the Indian individuals and 158 million held through fiduciaries or wealth managers. This figure does not indicate the much-debated alleged black money held by Indians in safe tax havens of Switzerland. Also, the figure is exclusive of money held by Indians in the names of others. The quantum of funds by Indians in Swiss banks has last increased in 2006 by over 1 billion Swiss francs but fell to less than one third by the end of year 2010. SBI does not agree to RBI’s move to prevent Rupee from falling RBI has directed the oil companies to purchase half of their dollar requirements directly from a selected group of PSU banks as they believe that this move would prevent the Rupee from falling. It maintains that this would help check volatility and seize the free-fall of the rupee. However, State Bank of India stated that it doesn’t think that such a move would increase the overall availability of dollar or enhance the rupee-dollar prices and considers the move to be a step by the RBI to keep away the criticism that RBI is not doing enough.


The Month That Was

The Niveshak Times




Article Market of Snapshot the Month Cover Story

Market Snapshot


MARKET CAP (IN RS. CR) BSE Mkt. Cap Index Full Mkt. Cap Index Free Float Mkt. Cap

60,08,120 28,54,377 14,37,177

LENDING / DEPOSIT RATES Base rate Deposit rate

10%-10.75% 8.5% - 9.25%


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

56.99 71.57 70.88 88.97



4.75% 24%

POLICY RATES Bank Rate Repo rate Reverse Repo rate

9.00% 8.00% 7.00%

Source: 23rd May to 22nd June 2012 Data as on 22nd June 2012

June 2012


BSE Index Sensex

Open 15995.14

Close 16972.51

% Change 6.11%


5845.02 6275.06 9140.47 10620.53 6376.56 8724.07 4587.90 6595.40 5504.10 9876.02 7455.43 1766.58 6617.44 1562.39 3190.29

6010.21 6407.50 9202.50 11561.05 6175.39 9737.67 4875.32 6709.57 5663.69 10344.99 7895.03 1893.62 7089.80 1630.87 3293.54

2.83% 2.11% 0.68% 8.86% -3.15% 11.62% 6.26% 1.73% 2.90% 4.75% 5.90% 7.19% 7.14% 4.38% 3.24%



Article Market of Snapshot the Month Cover Story

Market Snapshot



Article of the the Month Article of Month Cover Story


Is India ready to fight Insider Trading ? Kailash V. Madan

IIM Shillong

All of us, as investors seek the best avenues to invest our hard earned money. As a prerequisite to this, we expect the equity markets we invest in to be free of any manipulation or bias. However, there have been an increasing number of cases where board members or top executives of companies have manipulated the markets purely on the basis of certain information privy to them. Such acts of insider trading are growing in number and if not acted upon swiftly could deprive regular investors of a clean and an efficient market. Insider trading is the buying, selling or dealing in the securities of a listed company by a director, member of the management, employee of the company, or by any other person such as internal auditor, advisor, consultant, analyst etc., who has material and non-public information. One of the most common indications of insider trading is the spike in stock prices ahead of some important corporate announcement, especially mergers and acquisitions. To put the entire scenario in perspective, we can consider the case of the United States. The Indian born Managing Director of McKinsey & Co, Rajat Gupta, was recently found guilty on three cases of securities fraud and one case of

conspiracy. He, along with his business partner Anil Kumar and close friend Raj Rajaratnam, the Sri Lankan born head of the Galleon group are believed to have indulged in insider trading and are now held guilty by the law. Mr. Gupta could face up to 20 years in prison, proving that no corporate honcho is above the law in the US. As much as it’s against the law for company executives to profit from inside information, these laws seldom apply to the Congress. They call their Congress members “representatives,� but they are far wealthier and live far different lives than those they are supposed to represent. Election to the House or Senate puts members in esteemed company, replete with respect and perks most of their constituents can barely imagine. And since wealth accompanies power, that means they are often surrounded by wealthy people, who invite them to restaurants, golf clubs and resorts frequented by the very rich. The wealth gap and disparity between Congress members and their constituents appears to be growing. A recent New York Times analysis of public records found that nearly half of the members of the House and Senate are now millionaires. And while many Americans have lost

One of the most common indications of insider trading is the spike in stock prices ahead of some important corporate announcement, especially mergers and acquisitions.

June 2012



Hindustan Lever Limited


ABS Industries


Alliance Capital Mutual Fund




Problem The case involved HLL purchasing a sizeable chunk of Brooke Bond Lipton shares from UTI, prior to its public announcement related to the merger of the two outfits ABS' MD purchased his own company's shares from the market prior to the takeover deal between ABS and Bayer Their Asia-Pacific head was charged with indulging in unfair trade practices for disposing off a considerable quantity of shares held by the fund under his management which resulted in a sharp decline in the valuation of Alliance The CFO of Wockhardt, along with his immediate family members, was alleged to have traded in the pharma company's shares on the basis of unpublished price-sensitive information

Table 1: Instances of insider trading in India

ground in the last few years, Congress members have gotten wealthier. There have been several cases where speakers and other politicians have been invited on the ground floor when private companies went public through their IPO’s. It is not a rare sight to see politicians and bureaucrats make millions from stock market killings. If the goal is to root out corruption and ensure an information-efficient market, and raise the public’s low opinion of the Congress, the House should ensure that the Senate Bill is applied for everyone in the same effect. Closer home, in India, any broker, dealer, analyst, securities lawyer or even someone in the

stock market will accept that insider trading is not only rampant on Dalal Street, but also interlinked with stock trading. Insider trading was branded as illegal only about two decades ago after the regulator SEBI (Securities and Exchange Board of India) enacted the Prohibition of Insider Trading Regulations, 1992. Earlier, phone calls, emails and internet chats were the preferred mode of communication for sharing information. Nowadays, messages through Blackberry, which make tracking at the source and recipient after deletion impossible in India, has emerged as the preferred medium among market players. Because of such loopholes, there have been

If the goal is to root out corruption and ensure an information-efficient market, and raise the public’s low opinion of the Congress, the House should ensure that the Senate Bill is applied for everyone in the same effect.


Article of Month Article of the the Month Cover Story




Article of the the Month Article of Month Cover Story


many instances of stock price manipulation and insider trading on Indian bourses. The most famous example is Hindustan Lever Limited’s purchase of 8 lakh shares of Brooke Bond Lipton India days before the announcement of the merger between the two companies. SEBI had initiated criminal action against HLL but the quantum of punishment was mainly monetary and prohibitive in nature. The more recent case is that of the founder of erstwhile Satyam Computers, Ramalinga Raju, who committed a heinous fraud of nearly 8,000 crore on his shareholders and even admitted to manipulating the company’s accounts. White collar criminals in our country usually go scotfree as there is one set of laws for the rich and powerful and another set for the poor. Our regulatory bodies, like the SEBI, or even the CBI, are reportedly understaffed. In the case of SEBI, the surveillance system is not as efficient as it should be, making the enforcement against insider trading less effective. However, lately, SEBI has been using market data analytics tools and is also taking vital cues from the Income Tax department, CBI and the Intelligence Bureau to crack down on market manipulators. The market regulator has set up an integrated market surveillance system (IMSS) and a data warehousing and business intelligence system both together capable of generating and recognizing patterns from stock prices and volumes to detect crimes like insider trading.

FIN-Q Solutions May 2012 1. Black Scholes Model 2. JM Hurst, Father of Modern Cyclical Theory 3. VaR 4. Facebook 5. Printed on its coins 6. Payment Float 7. Joint Float 8. Both have indices named after them: Big Mac Index and Hot Waitress Index 9. Bridge Loan 10. Golden Boot

June 2012


Akhil Tandon

Introduction India is located in the equatorial sun belt of the earth, thereby receiving abundant radiant energy from the sun. As per the data published by The India Meteorological Department (IMD), in most parts of India, clear sunny weather is experienced 300 to 330 days a year. The annual global radiation varies from 1600 to 2200 kWh/sq. m. which is comparable with radiation received in the tropical and subtropical regions. The equivalent energy potential is about 6,000 million GWh of energy per year, which qualifies solar to be one of the most lucrative options for fuelling India’s power requirement in the near future. In an effort to provide impetus to the adoption of solar power, the government has taken numerous initiatives, notably setting up of Ministry of new and renewable energy(MNRE), introduction of Renewable Purchase Obligations(RPOs) and Renewable energy certificates(RECs). However, the most significant effort has been the launch of the Jawaharlal Nehru National Solar Mission (JNNSM) in 2010. Under JNNSM, the government adopted a unique mechanism of inviting bids from developers at which they were to supply solar power to the state utilities. The tariff was to last a period of 25 years. Till date, two round of bidding have successfully taken place, which saw the participation from both national and international behemoths. The two rounds of bidding saw the average bids to decline from Rs 12.16 per Kwh to Rs 8.77 per kWh. Solaire Direct SA, a French company, surprised the entire globe by offering an ultra-low bid of Rs 7.49 per kWh, which was more than 50% lower than the benchmark tariff quoted by the Central Electricity Regulatory Commission (CERC). With such aggres-

Team Niveshak

sive bids, it is a no brainer to assume solar power to be a solution the panacea to India’s “Carbonized” power sector. Though solar power seems to be a lucrative option, a question worth pondering upon is why solar power fuels only 0.48% of India’s electricity demand? One of the major reasons behind this is the “Bankability” of solar power plants. As these projects require a heavy upfront capital investment, the developers rely on banks for funding. However, the bankers are apprehensive about the same, which leaves the cash crunched developers in a difficult situation. Even the successful bidders under JNNSM have faced problems to achieve financial closure within the stipulated time. The particular risks that make solar power project financing a concern for banks are as follows: • Technology Given the fact that solar technologies are relatively a new concept in India, there exists numerous risks with respect to execution of the projects. Crystalline cells and modules are comparatively easier to execute and come with a guarantee of more than 20 years, rendering them to be less risky both for developers as well as banks. However, in the last couple of years, novel technologies like thin-film modules have emerged which involve a lower upfront investment, but are unproven and therefore considered more risky. • Power Purchase Agreements The current draft of the JNNSM provides for a “Trader PPA” with Nation Vidyut Vyapar Nigam Ltd. (NVVN), under which the developers will receive the predefined tariff for supplying solar power to the state utilities. This may appear a sure shot money making project on paper, but the financial health of the


Cover Story Article of the Month Cover Story




Article Cover of the Story Month Cover Story


Fig. 1: Cuurent capacity in India

state utilities puts a question mark on the assumed to be ‘assured’ return. Many state discoms are notorious about delaying and even defaulting on payments which results in financial institutions refusing to consider these PPAs bankable. • Estimation of Solar Radiation The output of a solar power plant is contingent upon the Direct Normal Irradiance (DNI) at the plant site. High quality solar radiation data is a pre-requisite for determining the viability of a plant. Given the sensitivity of the generation capacity to the solar radiation received, solar radiation assessment is deemed to be a very important activity and typically requires several months for ground measurement of solar radiations. Any error in solar resource estimation adds an uncertainty to expected future returns. As of now, on-ground solar radiation data is sketchy and the simulation models are at a preliminary stage. • Evacuation Infrastructure In India, the interiors of states of Rajasthan, Gujarat, Maharashtra and Tamil Nadu are considered to be the best sites for installing solar power plants. Evacuation of the electricity generated from power plants located in these isolated areas is a challenging task. Extending the grid to these sites requires development of new transmission lines which are often controversial, both because of their expense and the potential of damage to property and environment. Given the above factors, it is highly unlikely for the banks to consider Solar Projects as bankable in the near future, which makes recourse based lending a distant dream. In wake of such circumstances, let us examine the possible options which can help reviving India’s ‘Setting Sun’. Options for debt financing Solar power is at a nascent stage in India. However, nations like Germany, Italy and France have been successful in arranging for finance for solar projects. This provides a ray of hope for Indian developers.

June 2012

There exist primarily two routes by which developers can raise finance: • Balance-sheet based financing This option can be effectively tapped by large conglomerates having a healthy balance sheet, which would interest the bankers. The companies can use their liaison with their banks to provide debt at a cheaper rate. Also, the large asset base of these companies provides them with the necessary armour to support large projects, which helps in lowering the cost of operations and operating efficiently. However this would put the company balance sheets at risk and the entire burden of the project failing or underperforming falls on the developers. In India, companies like GAIL, IOCL, Punj Lloyd have successfully availed of this option to fund their projects. • Non-recourse project financing Non-recourse financing refers to a loan where the lending bank is only entitled to repayment from the profits of the project the loan is funding, not from other assets of the borrower. This is the preferred financing structure where the lending financial institution funds a special purpose vehicle (SPV) set-up especially for the project or for a group of projects. In such a framework, the financial institution has a lien on the project’s cash-flows. However as this structure does not provide recourse to the developer’s balance sheet, lending institutions require rock-solid agreements for revenues from the projects. Given the uncertainty of cash flows, the spread for non-recourse financing is typically higher than what banks are willing to accept for balance sheet financing. In India, many conglomerates such as Mahindra & Mahindra, Reliance Industries, Jindal Group, etc. have undertaken this route to fund their projects. While entering into a negotiation with the banks, the developers also need to ensure that the following are in place to make the lending institutions comfortable: 1. Performance – The viability of a solar power plant is contingent on the Capacity Utilization factor (CUF)



Article of the Month Cover Story

Fig. 2: Grid parity projections (Source: Internal Analysis)

of the equipment, which is a measure of the ability of the equipment to convert solar radiations into electricity. Contractual guarantees from technology providers for the long-term performance of the plant is one possible way out which can assure the bankers that the plant will be able to sustain the promised performance. 2. Revenues – As discussed above, the PPAs provide assured revenues only on paper. With the current structure of the JNNSM, PPA may not be bankable due to the credibility of many states. There has been a buzz around that government has been contemplating a tri-partite agreement between the developer, state discom and the Reserve Bank of India to ensure the PPAs bankability, however this is not confirmed yet. Another source of revenue for the projects can be the Renewable Energy Certificate (REC). The developers can forego the preferential tariff and trade the RECs on the energy exchange. In India, the trading of RECs has started in two exchanges – Indian Energy Exchange (IEX) and Power Exchange India Limited (PXIL). However, the market is in its nascent stage and depends on the state’s renewable purchase obligations. 3. Project viability – In addition to the above, developers must be able to take the lenders into confidence that projects are viable and have the capability of repaying debt without outside assistance. This could mean that the project has to fund a Debt-ServiceReserve-Account in addition to having healthy Debt Service Coverage Ratios. Other options for financing Other non-conventional options for obtaining funding that can be considered by developers are: • EXIM financing The United States export-import bank provides funding for projects which import a significant chunk of their equipment from the United States. This is a good option in case the main technology provider is from the US and has relations with the EXIM bank. US EXIM bank has committed $7 billion to India. Ear-

lier this month, Azure power announced long-term financing of $70.35 million by Export Import Bank of the United States for its solar power plant at Nagaur in Rajasthan. Indian behemoths like Reliance Power have also availed of these concessional loans. • Foreign funding Large project developers can tap international banks to get lower rates of finance. Financing of Solar projects is not a new prospect for banks abroad, which makes the spread relatively lower than that offered by their Indian counterparts. However, hedging can put a substantial dent in the rate differential and only someone ready to take the currency risk should resort to this option. Given the current macro-economic scenario, it will be a bold move to discount currency fluctuations while taking a call on foreign funding. • Joint Ventures Many companies have also entered into JVs with foreign companies for technical as well as financial assistance. Companies like Tata group have taken a lead here, and have tied up with BP Solar to set up Tata BP Solar Ltd. • Green Energy funds There are many green energy funds currently in the market and these can provide equity, quasi-equity and mezzanine financing. Conclusion In view of the policy support and the abundant solar radiation available in India, solar projects are an attractive investment option and can provide equity returns in the 15%-20% range. However until the banks get comfortable with the proposed solar PPA, developers rely on non-conventional sources of financing; and support from the government, in terms of finalizing the PPA,REC and RPO structures, can go a long way in getting the projects financed in a nonrecourse manner.


Article Finsight of the Month Cover Story



Poor Companies - Rich Multiples Preetam Mittal

Welingkar Institute of Management

A premium earning multiple is hard to come to a company and even harder to maintain. In recent times when everybody seems to be in a hurry, investors too have discovered a quick short hand for their investment – P/E ratio. Countless investors, individuals and professionals alike, spend their time seeking out cheap stocks with very low P/E ratios. Sometimes the stocks are cheap for negative reasons like uncomplimentary industries or poor fundamentals hidden within. And as a result, the stock prices stay stagnant... sometimes for years. But sometimes investors do not pay attention to this fact and companies take undue advantage and modify the P/E ratio by various means – the most common being inclusions of debt in the capital structure. When companies are financially leveraged then the company with higher debt in the capital structure has lower P/E ratio and is more preferable among its peers. Company with debt

Company with only equity



Taking the example of two energy firms Apache Corp (APA) and Anadarko Petroleum (APC), each

with an EV/EBITDA multiple of just over 5 in the year 2010, the average EV/EBITDA multiple in their peer group being just under 7. This seems to indicate APA and APC were relatively undervalued. However, looking at these companies strictly on a P/E basis, one would wonder why shares in these companies hold any appeal when they are trading at P/E multiple of nearly 30x.

There are more detailed valuation models available in the market that incorporates not only the past Interest -20 0 performance but also forecast future ones. However, Net Income 30 50 these models are complex for the general investing Enterprise Value 1,000 1,000 public and they seldom make the headline. This is (EV) generally a cause of concern for senior executives Debt -500 0 as their claim that their company has great growth Market Capitaliza500 1000 prospects and many investments projects in hand tion are not properly valued in their company’s stock EV/EBITA 20.0x 20.0x price. Actually, they are not necessarily wrong. Even Debt/Interest 25.0x N/A financial theories suggest that companies which 16.7x 20.0x P/E Ratio have higher growth prospects should have higher earnings ratios and hence better market value. Table 1: Leverage distorts the P/E ratio (Hypothetical case) But the problem with the P/E ratio is that it’s a Table 1 clearly shows that though both the com- retroactive metric. It pits a company’s current marpany has same EV value, their P/E ratios have ket cap against its trailing-12-month (TTM) profit. changed substantially due to inclusion of debt. But when you buy shares of a company, you are Earnings (EBITA)

.. Countless investors, individuals and professionals alike, spend their time seeking out cheap stocks with very low P/E ratios

June 2012


inclusion of gains from recently sold businesses to produce an artificially inflated earnings and a lower P/E as a result. The denominator of the ratio can also be manipulated by changing the revenue recognition, depreciation and capitalizing cost. In late 2000, software-maker Oracle ORCL had a very low P/E based on its prior four quarters’ earnings giving the impression that it is a good investment opportunity until a deeper investigation into the numbers revealed that the company had booked a $7 billion gain by selling its stake in Oracle Japan. Based on operating earnings, the stock was not cheap at all. So what’s the solution? The solution is to account for the growth rate of the company or expected growth rate if it can be calculated. Thus, it gives birth to a new and better ratio - PEG ratio computed as: PEG Ratio = Price-to-Earnings (P/E) Ratio / Annual Earnings per Share Growth A crude analysis suggests that companies with PEG values between 0 to 1 may provide higher returns (the closer to 0 the more undervalued a company). In fact, if one goes back a decade then one may find that Apple’s P/E ratio at the time was 297. So, anyone making investment on the basis of P/E ratios would not have considered it a very profitable investment then based on its high P/E value. However investors who had bought shares of the company then have made whooping returns of 7,300% today. But if someone calculated the PEG ratio, it would be something close to 1 indicating that PEG can better guide investors in their investments. Finally, as an investor, it is important to continually sharpen your skills and put new tools in the toolbox. It makes sense to go through and calculate different multiples such as EV multiple (EV/EBITDA, EV/EBIT, EV/NPAT, EV/Invested Capital etc.), PEG and Dividend yield ratio etc. for all current holdings and for future investments to reduce the likelihood of making poor bets.

.. Even financial theories suggest that companies which have higher growth prospects should have higher earnings ratios and hence better market value


Article Finsight of the Month Cover Story

not purchasing its history – you are purchasing its future cash flows. What matters is what the company is going to do and not what it has done. Another very common form of manipulation used by companies is called the “big bath,” and this can make stocks seem undervalued to investors. This happens when the company incurs a big loss to their bottom line. In this method the company takes the complete loss in a single accounting period, instead of spreading these losses over years. This will cause the earnings per share to drop significantly for the time period involved due to the large losses posted and move earnings from the present to the future. The intention of the company is to foster the idea among investors that this charge is a once only deal, and that the stock will rise considerably after the loss has been absorbed. This will cause investors to see the stock as undervalued and an attractive investment and thus will cause the demand and price for the stock to rise artificially. One must always keep in mind that using only P/E ratios on a relative basis means that the analysis can be skewed by the benchmark being used. After all, there are periods when industries in entire market become overvalued. In 2000, an Internet stock with a P/E of 75 might have looked cheap when the rest of its peers had an average P/E of 200. In hindsight, neither the price of the stock nor the benchmark made sense. This shows that being less expensive than a benchmark does not mean that the stock is cheap because the benchmark itself may be vastly overpriced. Also, these ratios are completely ineffective for cyclical firms that go through boom and bust cycles--semiconductor companies and auto manufacturers are good examples and these requires a bit more investigation. Although one would typically think of a firm with a very low trailing P/E as cheap, for a cyclical industry it would be the wrong time to buy because it means that earnings have been very high in the recent past and are likely to fall off soon. Other things that can distort the P/E ratio include



Article Perspective of the Month Cover Story


How do you do Vibhu Gangal

SCMHRD,Pune With Infosys witnessing steep falls in stock price, with stagnant salaries to continue for one more year and with attrition rates to blow up, the headwind of squatty guidances has hit the bellwether company badly from all sides. In the wake of these developments, this article is an analysis of a few aspects of Infosys’ financials and policies. Using concepts of leverage, cost of equity, human-resource accounting and balanced scorecard, the analysis tries to explore the possibilities which the management, particularly finance department, might have partially or fully missed to attend; overlooking which can be hazardous to Infy’s health. Why didn’t CFO Mr. Balakrishnan deem it essential to burn up….? Any company would and should take pride in maximizing profits through leverage. By leverage, I mean that you step up your revenue by x%, but your net and operating profits jump by (x+ ∆)% where ∆ >0. But this happens only when you incur a “Fixed Cost” for your operations.

In absence of fixed costs, ∆revenue = ∆profits. It’s because of fixed costs that a 50% rise in revenue results in 80% rise in profits. Now, had the fixed cost been 4000 instead of 3000, the leveraging effect would have been better. A 50% ∆revenue could have led to 100% ∆profits, bringing leverage multiple to 2 from 1.6. Thus, more the fixed cost, the better leverage your firm enjoys. In other words, to bring your company in a better condition, so that it enjoys better leverage, you “need” to expend some “additional” fixed cost. The moment I say “fixed” cost, it has absolutely no proportionate relation with revenues. One such fixed cost is “Salaries”. Coming to Infosys, where the mantra to be harped upon in FY 201213 is to maximize profits,with financial leverage almost absent, to capitalize on operating leverage, why didn’t CFO Mr. Balakrishnan deem it essential to burn up some money on salary increments and so incur the additional fixed cost?

June 2012


With this decision not at all favoring a rise in profits in any which way, what good has been cited in slashing variable….? Let’s try to understand the aspect of distribution of costs between fixed and variable on leverage effect. A higher leverage multiple also means a higher risk of losing profits substantially on a relatively smaller fall in revenues. So, if a company senses a slowdown in future, it ought to “divert” its spending under fixed costs to variable costs. As a manifestation of this idea, the company may decrease fixed salary component and increase the performance-based incentives. On the other hand, if the company senses a brighter market ahead, it diverts the salary components in the reverse manner to make the leverage multiple higher. Surprisingly, what Infosys has done is that it has made steep cuts to variable pay of their employees with no diversion of the same to the fixed component of the salary. Oops..! This falls in neither of the two categories of decisions… Check table 1 for a few numbers to get a clearer picture. The only difference between the three cases in table 1 is of the variable cost. Relative to case1, the decrease in variable costs in case 3 is more than that of case 2. Observe that lesser the variable costs, lesser is the increase in net profits for the same 50% rise in the revenues of the company from Rs. 10000 to Rs. 15000. Even though one may say that more than the percent increase in profits, the rise in absolute profits due to variable cost cut makes more sense for a firm, what I wish to say is, this is possible only when two things are ensured. One, if the variable cost cut is in salaries, it should not result in a fall in top-line (revenues), as a salary cut is enough to cause exodus of top talent. If revenues fall, profits are destined to plummet. Second, to still maintain a fair result compared to case 1, the firm needs to at least ensure the same 50% rise in revenues for growth. Practically speaking; how is it possible for any company to “enhance” its sales by “reducing” variable costs and by keeping the fixed costs “the same”? With respect to Infosys, the departure of a few people from top management is already an event of recent past. The blow of this verdict has fallen harder on the 300 top executives whose variable salaries shall be cut by 70%, and the already existing leverage has been substantially tarnished due to this.


With this decision, not at all favoring a rise in profits in any which way, what good has been sighted in slashing variable salaries heftily and giving a null hike in fixed component of salaries by Infosys to its employees? Has Infosys also succumbed to the trap of……? Any company aims to earn substantially more than its cost of capital. Thus, if a firm has missed to learn its true cost of capital, the target set for earnings and revenues is also virtual. This eventually leads to disappointing “actual earnings” and leaves the management puzzled. Equity is often considered as a “less expensive” source of capital. Let’s give a second thought to this. Owners carry the maximum risk, which gets accentuated by the fact that they have zero security of assets to fall back in case the company drowns tomorrow unlike the lenders which have the first preference during liquidation of company assets. More the risk more should be the returns. Following this, company is obliged to consider the “true” cost of equity much more than the rest of the sources. If the firm falters here, it gets into the trap of setting false targets and landing in trouble as mentioned above. Infosys has been the legacy for being a zero-debt company in its sector and functioning purely based on stockholders’ money. So, the question is, has Infosys also succumbed to the trap of underestimating cost of equity, setting stumpy guidances, pursuing and achieving them and causing shares ultimately to plummet? One may contest this with the stand that Infosys has declared a massive 940% dividend per share this year and so has taken due care of its owners. To this, let’s understand that that the activity of maximizing shareholders’ interests is based on two legs: Paying considerable dividends and performing such that share price in secondary market keeps on rising. What Infy has chosen to do could strengthen the first leg, but will badly knock and punch the second. And that’s what seems to be happening- the worst fall of stock in the last 3 years. Without “directly” spending more, how can this massive asset be churned to.….? Say a firm targets to earn 25% based on its Cost of

capital calculations and has an asset size of 1000, which currently is earning 20%. To get this additional 5%, the firm may increase the asset size, but before that a wiser decision would be to check if the capabilities of these assets have been exploited to maximum. If yes, then the firm shall incur cost to acquire more assets. If not, the firm shall spend to augment productivity of existing assets. In the latter case, the firm shall prudently choose to spend money more on those assets which directly contribute to the revenue rather than spending on ancillary activities and non-performing assets which just facilitate the performing assets to perform (like furniture and transport). Let’s understand that with the presence of NPAs, even if the asset size stands tall, the actual pressure on each unit of PA to earn 25% profit is much more (its 50% if PAs are half of total assets) than it appears and so, firm’s responsibility to keep these PAs pepped-up to perform is indispensable. For this analysis, employees are considered as assets; with reference to concept of human resource accounting. Coming to Infosys, where an employee-base of 1.5 lacs a huge performing asset, how can this massive asset be churned to contribute more to earn revenue without “directly” spending more on them? In other words, how could a “zero” salary hike enable these PAs to be more productive? Even though HR accounting is not followed commercially in India, has Infosys missed to understand that employees are its significant “Performing” Assets? Infosys was the one which kept its promise to absorb recruited candidates when the industry was gripped with job crunch in 2009, which paid salary hikes of 10% even during recession, which rolled out ESOPs in 2010, and which was uniquely efficient with excellent cash management practices. With due credits and acknowledgement for all this to you, CFO Mr. Balakrishnan, the present speaks of a totally different picture. I am really curious to know what’s going on in your mind. Looks like either you have a big surprise to throw or you’ve faltered badly….


Article Perspective of the Month Cover Story

Table 1: Three cases with different variable costs



Article of the Month Cover Story FinGyaan


Sir Volcker vs.

Prop Trading Savio Fernandes

Goa Institute of Management

The Volcker Rule coming to effect from July 2012 is an effort by the US to restrict the propriety trading done by financial institutions. The article also reflects the trading scenario in India. This is an important step in the light of the recent trading losses seen by JP Morgan. The regulation currently seeks to restrict the trading and the FDI in the institutions carrying on such trading.

Everybody “Rest Assured Sir, Just wish us Luck” says the big banker to his customer. If the deal turns sweet, it’s the bankers to praise and if it doesn’t well they are “Too Big to fall”. This very stance of power and autonomy achieved by these institutions is what Paul Volcker is adamant about ending but then who is Paul Volcker and how is he planning to do so? Paul Volcker is an economist and former head of the Federal Reserve who currently heads President Barack Obama’s Economic Recovery Advisory Board and is credited with ending the high periods of inflation during the 1970’s and 1980’s. But then he is more famous among the biggies of the financial markets because of the Volcker rule established by him.

Wiki states the rule as “a ban on proprietary trading by commercial banks, whereby deposits are used to trade on the bank’s personal accounts, although a number of exceptions to this ban were included in the Dodd-Frank law”, such as the mu-

June 2012

nicipal, Treasury and federal agency securities. The rule’s provisions are scheduled to be implemented as a part of Dodd–Frank Wall Street Reform and Consumer Protection Act on July 21, 2012 and were publicly endorsed by President Obama on January 21, 2010. (Refer Fig 1). There has been a constant tussle between the Regional Bond Dealers Association being supportive of the rule while the Securities Industry and Financial Markets Associations oppose the provision. “The Volcker rule remains highly problematic and is likely to have the unintended consequence of constricting market liquidity, as evidenced by the fact that Treasuries, agencies and munis are exempted,” said Michael Decker, managing director and co-head of municipal securities at SIFMA. Let’s delve deeper into the various provisions and technicalities of the rule and leave such decisions to the avid readers. The financial industries started off with the banking industry and investment banking being at bipolar ends but as time passed these were brought under a common umbrella holding for e.g. Citibank has retail banking as well as an investment arm though the line has blurred being under the same cap. Let us rather use the term investment banks to generalize the commonality between the bank and the investment arm. The main motive of such banks is to make a market for themselves (market-maker) to survive in terms of the services offered



Article of the Month Cover Story FinGyaan

Figure 1: Timing of Volcker Rule implementation

(trading stocks, derivatives, currencies, loans in capital raising etc.). Say, a new trader decides to sells his shares through private placement, since his repute is limited, there would be few takers but then suppose an investment bank say Citibank agrees to purchase the shares and then sells the same at a marginal profit, it would definitely lead to quick liquidity.

This is the basis of proprietary trading which has come to the phase wherein banks employ traders devoted to the sole cause of trading though now with more focus on profits. These proprietary desks usually have the highest value at risk compared to other internal divisions. Many famous financial entities belonging to the 200708 crises have been known to garner a significant portion of their annual profits through the means described. History speaks of traders such as Brian Hunter who brought down the hedge fund Amaranth Advisors when his massive positions in natural gas futures went bad. The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance, which guarantees the safety of deposits in member banks, up to $250,000 per depositor per bank similar to the

DICGC guarantee of Rupees 1 lakh in India. Thus banks were basically handed a silver platter for proprietary trading knowing very well that any loss would be stalled by the government, in short a Win-Win situation. In contrast financial entities such as Goldman Sachs, speak of the huge reduction of liquidity in the US equity markets as well as international bond markets. Another issue lies in the operation difficulty of distinguishing “permitted” activities such as underwriting, hedging, trading of government securities etc. from the restricted ones. This entails additional spends on technology and infrastructures by banks to comply with these rules thus claiming these as higher fees for the corporate customers. Ponder on the following example. The same banking entity as before, acting as a market maker, has purchased one of the several 40,000 corporate bond issues in the U.S market and wants to resell the same though a match is not readily found. During this holding period the bank can experience risks such as counterparty risk, price movement risk etc. But then when the bank is able to liquidate the same and it so happens that at a profit, the question is “Is it a form of proprietary trading?” The repercussions have been felt on the Indian soil too with the Reserve Bank of India becoming ever more cautious towards such trading firms who seldom divulge their contact information. Recently the finance ministry imposed a ban on proprietary trading by finance arms or group companies of foreign banks and a complete restriction on foreign direct investment (FDI) in Indian finance companies that only trade in financial assets on their own account. Sources also speak of a rejection of about three to four proposals regarding proprietary trading in India,



Article of the Month Cover Story FinGyaan


from firms such as Morgan Stanley India Company Pvt Ltd and UBS Securities India Pvt Ltd. Domestic banks are not allowed proprietary trading as a standalone activity but are allowed to do so through separate subsidiary or a joint venture though the maximum market exposure cap stands at 40%. Currently, FDI is regulated through foreign investment promotion board (FIPB) in India. However, in 18 NBFC activities, 100% FDI is permitted through the automatic route. This has been viewed by the RBI as a “clear possibility of regulatory arbitrage by foreign investors for then can directly pump in their money into these firms without having themselves subject to the regulations of SEBI. This uniform amount of higher capital inflow can subsequently weaken the Indian rupee thus harming the nation. Rough estimates during the April-June 2010 period state that nearly 24% of total trading on the stock market was a part of proprietary trading. On a different perspective, we are limiting a huge chuck of the bank’s assets which could be used for the trading activities benefiting not only the bank but also the customers through lower transaction charges. True we already have Capital adequacy ratio based on the BASEL norms which restrict reserves in bank but a ban on proprietary trading may actually increase the systemic risk by accumulating assets into the banking system thus only fuelling the too big to fail scenario. The new norms release by RBI for banking licenses states that a minimum capital of 500 crore needs to be held hence the banks will lose a significant amount of returns which could be passed on to customers. Overall, calling for a sudden closure of such trades may lead to a huge increase in the bank’s administrative costs such as costs of regulatory compliance, which would be passed on to consumers thus making capital investments costs much higher in turn affecting the GDP negatively. Studies state this as an additional 6.6 million work hours coupled with 1.8 million hours per year for enforcement. It would also entail an additional 3000 employees per bank along with a cost increase of around $350 million. The effect may also make foreign interest rates

June 2012

attractive thus affecting trade and devaluation of the domestic currency. Small time firms and start-ups would also be left devoid of funds due to these high fees and interest rates. In conclusion it can be said that these regulation don’t merely remove risk but simply transfer it. Say a company that would be protected by hedging strategies used by a bank may now undergo currency risk, operational risks, currency risks etc. Of course the end customer seems to be at a loss but then frequent financial crisis such as the collapse of MF Global Holdings Ltd, attributed to proprietary trading, left the authority no other option but to tighten the regulatory cords which come into effect post July 21, 2012.


Leveraged Buyout (LBO) Shirish jain IIM Shillong company do not go the predicted way. Company in such cases, therefore, is unable to service high debt obligations and goes bankrupt. Which companies are the likely targets to be acquired through a LBO?

Sir, I recently read about Leveraged Buyout, what is a Leveraged Buyout? In a leveraged buyout, the Investor / Private Equity fund acquires controlling interest in another company through substantial proportion of debt. Apart from very high proportion of debt, what distinguishes LBO from a normal acquisition is that the assets of the acquired company are used as collateral for the debt, which is usually non-recourse to the investor. Also cash flows of the acquired company are used to make interest and principal payments. Sir, it all looks very confusing. Can you please explain the concept with the help of an example? It is similar to buying a rental house through mortgage. As in a rental house, mortgage is secured by the house; in LBO the assets of the target company are used to secure the mortgage. Rental income generates cash flows for servicing debt, while in a LBO target company’s earnings are used for paying the mortgage. Normally institutional investors and private equity funds use LBO to acquire large companies without contributing much capital of their own. But sir, as we have read in our finance course, high debt also increases the risk. Isn’t LBO a risky acquisition strategy considering the high degree of leverage involved? Correct, high debt involves both high gain and high risk. A very high proportion of debt sometimes results in downfall of the company, if the cash flow projections of the

Some features like low debt, high assets (useful for collateral), stable cash flows, and synergies make a company highly attractive and more vulnerable to takeovers. Also the acquiring firms look for companies with viable exit options. LBO funds or investors typically try to exit within three to five years through an outright sale, IPO or recapitalisation i.e. replacing equity with more debt. If suppose, the company management wants to avoid this takeover, what should they do? A number of strategies are adopted by companies to avoid hostile takeovers. A company may adopt ‘Poison Pill’ strategy, i.e. making the company less attractive to the investor by strategies like loading the company with debt, selling its priced assets etc. Another strategy used is ‘White knight’, where the company approaches another party for a friendly takeover, to counter the hostile takeover. When did the LBOs originate, and are they actually practiced? LBOs started around the post-world war period and were hugely successful during the 1980’s. However, its popularity has faded since due to stricter lending norms and sceptical perception of the company’s management. Tata’s acquisitions of Tetley, Corus and Jaguar, Hindalco’s acquisition of Novelis, and Suzlon’s acquisition of Re-power are some of the examples of LBOs. Sir, thank you for explaining Leveraged Buyout to us.


Article of the Month Classroom Cover Story

CLASSROOM FinFunda of the Month



FIN-Q 1. Established in 1998 “X” does the work of 17 national banks. What is “X”?

2. Find the next and state the link: Real- Sol- ?? - ??

3. Established in 1929, “X” is the 3rd largest Bourse of Africa. Name “X”.

4. “X” owns “Delaire Sunrise”, “The Magnificence”, “Letseng Legacy”, etc. What was “X” recently in news for?

5. Developed by Lars Kestner, this ratio which helps measure the performance of an equity. Which ratio is this?

6. Find Odd man out: Economic Affairs, Financial Services, Disinvestment, Grants.

7. Identify the country:

8. Name the country which will host the next G20 Summit.

9. “X” is the financial regulator of the banks where India is reported to be the 55th biggest client. Identify “X”.

10. “X” is a term in bond valuation which represents the value of a bond, exclusive of any commissions or fees mostly used in European Markets. What is “X”?

All entries should be mailed at by 7th July, 2012 23:59 hrs One lucky winner will receive cash prize of Rs. 500/-

June 2012


WINNERS Article of the Month

Prize - INR 1000/-

Kailash V. Madan IIM Shillong


Prize - INR 500/-

Chhavi Saluja NMIMS, Mumbai

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