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Thursday, January 27, 2011

The tail wagging the horse-how hedge accounting impacts business decisions.

Hedge accounting under IAS-39(the financial instruments omnibus standard under IFRS) mainly aimed at curbing chances for earnings management, and so had tight 'bright line' rules. Like all rules enforced without discretion, this rule also affected genuine transactions. When the clamour from industry became too loud to be ignored, IASB(the standard setter under IFRS) had to consider revising the whole gamut of rules. The example given by IASB here is quite eye opening.

Consider an entity that hedges foreign currency risk on a net basis. It has a foreign currency sale of FC100 and purchase of FC(80). It would usually  hedge the net exposure FC20, but under IAS-39, you need to designate a specific instrument. Now, the entity has 3 options

  1. Artificially split the sale contract of FC 100 into FC80 and FC20(hedging FC-20). This can be accounted but does not represent the 'substance' of hedging the net transaction
  2. Even (1) is not possible when maturity mismatches occur
  3. Enter into two equivalent forwards whose net value is 20
The CFO of any entity would like to avoid the added earnings volatility from option (1)/(2) and so would go for the economically wasteful option of entering into two partially offsetting gross forward contracts(business decision) to match the amount and timing of the hedged items (eg one forward for FC(100) and one forward for FC80). This would allow an entity to apply hedge accounting on a gross basis and present both transactions as hedged.

The options accounting under IAS-39 discussed in an earlier post also prompts using other non-efficient instruments to achieve the desired result.

Impact This may make banks happy but the corporates spend more. Secondly, and maybe more importantly, the capital markets are boosted by 'false'\'economically unnecessary' transactions. Making markets efficient by such means are avoidable.

Why would companies NOT want to use hedge accounting?

The IFRS framing body IASB is grappling with how to account for hedging activities, and has invited comments till Mar-11 here. Analysts and others demand incisive disclosures while companies groan at the documentation involved. In an ideal world, companies would disclose ALL their risks, the quantum & mode of HOW they are hedging it in a format simple for analysts to extract and derive the 'core' earnings. But this is not an ideal world.

Hedge accounting is voluntary but rationally, companies should welcome the chance to 'match' their hedge accounting with their risk management activities. But, as mentioned by the IASB Staff discussion paper 20C here,  there are equally cogent reasons not to do so namely

  • Burden of required documentation of designating the hedging relationship
  • And more importantly, users of financial statements can infer from information in management reports or similar information about risk management outside the financial reporting context what the entity’s hedging activities are. To avoid reverse engineering of their unique risk management strategies by competitors, companies may still want  to avoid hedge accounting. 

Takeaway:- The IASB needs to tread a fine line between improving disclosures and scaring away companies.

Abnormal costs and ineffective hedges-more similar then you think.

At first glance, they seem poles apart. Abnormal variances(amount in excess of the standard costs) are studied in Management accounting whereas gain/loss on ineffective hedges(the profit/loss when the risk is not perfectly 'hedged'-as happens in real life!!)  are studied in risk management/financial reporting.

But the common thread is that these amounts  not transferred to their relevant account(cost account, hedged item account respectively) but are transferred to the P&L directly. The rationale is that one should not 'punish'/'misdepict' the underlying account for uncontrollable deviations. In fact, the whole management accounting edifice does rest on variance analysis which uses the same concept. This common thread is not a coincidence because both financial reporting and management accounting are information systems which aim to give relevant, reliable etc(!) data. So these conceptual overlaps do happen.

ICICI does a CRISIL with its own 2 year course..dismal fate for MBA colleges?

As some of you may know, CRISIL( the India credit rating subsidiary of S&P) has its own 2 year 'internship' program for graduates,at the end of which it absorbs them as analysts. The selection for this program(test, GD/PI, interview) resembles that of a MBA and indeed CRISIL has tied up with NITIE for the conduct of the program. You can read more about CCAP here.This HR strategy ensured that CRISIL got its pick from Day-0 instead of waiting for a 2 yr MBA.

ICICI, on the other hand, used to absorb entry level front office staff from those who cleared IFBI courses. But to fill the middle management void, it has adopted a novel way. It has launched its own 2 yr program for experienced professionals(atleast 3 yrs) who will be trained by ICICI and NIIT. The program fee is Rs 4.5Lakh but ICICI will give a loan @ 2.5%(EMIs to start after person works for ICICI). It gives a job guarantee of 15 Lakh+ CTC(with a 5 yr bond for Rs 20 Lakhs!!!). More details are available here.

What is somewhat alarming is that ICICI does not want to use the executive MBA option to develop its employees, nor does it see any value in equivalent profiles from the IIMs/XLRI/SP Jain/MDI etc. A CTC of 15Lakh+ and a mid-management type senior position would not be scoffed at even at those campuses. If other organizations continue like this, the lower rung colleges may need to replicate NIIT-IFBI or shut shop.

Tuesday, January 25, 2011

How today's companies are getting paid for their digital content

While few of us would steal even an apple('tangible good'), there is little shame attached to stealing digital goods like information, music, software('intangible'). Actually, even 'stealing' is a misnomer because using copies without paying deprives the owner of his dues but does not reduce the content available to others(long run effects apart). Anyway, this post is not a rant for/against piracy but as the title suggests gives examples of how media companies are monetizing their content online
  1. Give space to sponsors:- Taking a cue from the in-film product placements done by cinema chains, book publishers(www.bookboon.com) and broadcasters(NDTV 18 clips/ Hulu.com) are embedding advertisements in their books/video clips respectively. And as it is difficult to ignore these commercials, the pay per view may even be more here.
  2. Have a sponsor who will subsidize the content:- The Economist is currently free on the Ipad, and the Wall Street Journal Future Leadership program(under which they give a daily pdf of WSJ Asia) is free to students of top Bschools. Both are courtesy sponsors who get brand recognition
I'll add to this list as I encounter more examples on the internet but the bottomline is that 'Content need not be free even in the era of near-zero 'marginal cost to the creator'

Onmobile plans an Apple-setting up a VAS platform for developers.

ODN(Onmobile developer network) is a platform to allow small VAS companies to take their product live to all Onmobile accessible customers. This of course entails investment by the operator but is a win-win for the developer who does not spend any upfront distribution costs. Such an approach may seem benevolent but as explained by the CEO during the ConCall,
we believe that if VAS is to realize its full potential of growing to 50,000 crores by 2015...it’s not going to happen with innovation coming out of OnMobile on its own. So this is going to have to involve a whole bunch of small companies innovating with a whole bunch of small products whether it is a local product that works very well only in a particular region of India or whether  it’s a vertical product in a specific area and banking or telemedicine where somebody
can bring innovation that the OnMobile R&D team, which is working on so many different things just can’t get to.
So our unique position in the market, given our cross operator presence, is to actually create a platform to allow these small companies to take a jumpstart and get that product live, that’s it is in the interest of the industry the reason why we’re doing it.

Takeaway:- This move if successful will will help the industry, to say nothing of the Apple like power Onmobile will have . Apple demands 25% revenues from developers selling apps on Ipad. Imagine what can happen if Onmobile can replicate this in India. And then the profits will flow.

Onmobile uses 2 yr payback period to guide capex

Onmobile is India's first(and biggest) Mobile VAS operator. During the 2Q'11 conference call(transcript available here), an analyst quizzed the CEO about the 'commercial visibility' of development expenditure. The CEO, instead of stating NPV/IRR etc stated that the payback period is used. To quote him
when we do our internal business planning and our ROIC and all the analysis, investing in a product, we feel relatively comfortable after doing all the haircuts, making the necessary adjustments and reselling it to customers that we will be able to recover the investment capital well before two years. That’s the sort of the thumb rule that we use.
As conventional finance theory goes, this decision to use payback period over NPV is not that surprising, given the high risk in the VAS industry. After all, it is the VAS player(like Onmobile) who invests upfront in 'developing' an application and then resells it to the telecom company/media house. Given the dynamic consumer preferences, such a strategy may prove risky, and so the 2 yr rule allows Margin of Safety

Saturday, January 22, 2011

Analyzing financial statement of banks-some pointers

As an avid investor(and MBA student), I track a few banking stocks(both Indian and global). Considering the rather complex/opaque reporting, it is often difficult (for someone used to non-financial stocks) to make sense of this all. Investopedia provides a good base with its article on analyzing bank financials and its banking industry handbook but there's more to know.
  1. There's no 'revenue':-Banks generally prefer to club interest & other income into an omnibus 'operating income' category. This also reflects the ground reality of shared infrastructure, common staff and management where legally distinct entities in retail banking, trading etc are managed together. While breakup of operating income is there in the notes, that is not much useful
  2. Distinguish 'Operating Income' from 'Operating Profit':- Operating income is a proxy for REVENUE but operating profit means EBIT. These are NOT the same. 
  3. Gross interest is meaningless- Look at 'Net interest expense/margin':- Considering that banks generally lend basis their own borrowings, net interest income(Interest Income minus interest expense) is a good lever on the competitive position of a bank(when compared to other banks)
  4. Operating Expenses only(not S&D etc):- In the service sector where majority costs are fixed, the conventional breakup into S&D/Admin does not make much sense and so the title comes 'Operating Costs'. Increasingly, companies like Vodafone are following this for their expense reporting
  5. Look at average assets NOT year end ones for ratio analysis:-After Lehman's infamous repo 105 gimmick, it becomes important to know the average numbers on the balancesheet. Good banks should typically report this. 
  6. Return on Assets(RoA) is better than RoE:- A bank uses all its assets(not merely equity) and a good measure of operating performance is RoA. RoE merely signifies how lucky the bank was with its capital structure decision. In a volatile market, good RoA stay but if interest rates swing, the impact on RoE would be more due to the financial leverage involved. So, RoA is a good measure.
  7. Note the key moves in/out of the bank:- Banking, specially investment banking, is still a more people than process driven one(if you exclude retail banking). So, key people make much more difference here than in say auto/steel. While this is true of any service oriented business, banking is emphasized because relationship profitability is quite high here, also because too many outward moves to other banks may indicate losing competitive position. 
  8. P/BV works for lending business not advisory:- The rationale for P/BV is that banks can use their book value to lend more. But for advisory business like trading, investment banking etc, the P/E/ MCap/Turnover may be a better way to analyze.
This is all for now..track this post for updates.

Reducing tax payment via overhead allocation-lessons from Ganesh Polytex

While reading the 1Q'11(June 2010 quarter) conference call transcript of Ganesh Polytex(India's largest PET bottle recycler), I noticed an interesting explanation of how their 1Q'11 tax payments had gone down. The company has 2 plants in Kanpur & Uttaranchal, the latter being exempt from income tax under 80IB of the Income Tax Act 1961(being located in a low industry state). Now, the company used to allocate expenses of the Kanpur plant to the Uttaranchal one only at the year end. So the interim profits of Kanpur used to be low. Now, in the interest of investor transparency, the company decided to allocate the expenses more often. So the Kanpur plant profits went up and the Uttaranchal plant profits decreased-thus leading to greater interim tax outflow. By year end, the profits would have been equalized  between the two but the more frequent allocation pushes up the present value of tax payments to the Govt
Takeaway:- While the Income Tax Officer has powers to reassess the income under 80IB if he feels that cost allocation is unfair, no court will order the company to apportion costs more often than annually. So this seems a strategy to defer tax payments-which Ganesh Polytex has not used.

Thursday, January 20, 2011

Why has'nt the ICT revolution led to lower bank charges?

While the banking channels have become more technology driven and less costly(ATM's, mobile/internet banking etc), the service charges have not gone down proportionately. While foreign banks did always charge high for 'services' like DD issue, even Indian pedigree banks like HDFC and ICICI have followed suit. As the RBI Dy Governor(and ex-MD Punjab National Bank) Dr KC Chakrabarty said in Jan-11
I must admit that one reason for costing of electronic products at a higher band in comparison with the traditional products has been the banks’ attempt to part-recover the cost of deployment of technology. The process of introducing innovative products in India has been costly for the banks due to the unsystematic developments during the initial stage of technology deployment by the banking industry. In a country of our size, co-operative efforts and sharing of infrastructure while deploying technology is a lost opportunity story.
In the telecom sector, infrastructure sharing has become a fine art, to the extent that SPV's are existing to operate and monetize telecom towers. But RBI did not mandate sharing of banking infrastructure till recently(making upto 5 withdrawals/month free in third party ATM's). So when the regulator does not mandate sharing of infrastructure, why would any incumbent dilute its competitive advantage by permitting sharing? While sharing would be improved utilization(thus lowering per unit costs), it was not done and so the consumer pays for this decision of banks.
Point to ponder:- Suppose banks start sharing their core IT platforms, Can virtual banks exist like OrangeDirect in the USA?

Wednesday, January 19, 2011

Trust listed on a stock exchange!! The reason why Singapore beat out Hong Kong

While surfing Bloomberg, I read that Hutchison Whampoa had decided to spin off some of its HK-Chinese trust operations. So far nothing surprising-these restructurings keep happening. What surprised me was the choices to
  1. Use a 'business trust' as an investment vehicle
  2. List the above trust in Singapore(instead of their primary domicile Hong Kong)
The company website itself had a jargon filled description of the transaction without clearly describing the rationale. Then I saw this website of Norton Rose(a Singapore law firm) where they clearly described why the trust is an appropriate investment vehicle for capital intensive businesses.
One of the main reasons in their words is(besides tax reasons, access to finance etc)

Distributions can be made out of cash flows rather than accounting profits, which is likely to be attractive to investors. In capital intensive sectors such as shipping and infrastructure, which also boast steady income streams, this could prove to be a significant advantage for investors.
 No wonder that Hutchison decided to use a trust as their vehicle. They need to raise funds for expansion yet this expansion will increase depreciation lowering accounting profits. This way, dividend seeking investors can still tap the operating cash flows for income.And HK does not permit listing such trusts, as yet.

Takeaway:- With such innovations, no wonder Singapore has remained a global financial hub. Contrast this to India where the only novel business structure launched(after plenty of delay) recently was Limited Liability Partnership(LLP)-and you see why the dream of a 'International Financial Centre' at Mumbai seems far fetched.

Monday, January 10, 2011

RBI Governor believes in the 'Wisdom of Crowds'.

In his excellent and readable speech on Central Bank communication dilemmas, the RBI Governor Dr Subbarao made an interesting point regarding seeking public opinion before actual policy framing. He said
Communication can be a potentially powerful tool for getting feedback when the implications and the impact of proposed policy are uncertain. For example, the Reserve Bank has thrown open the issue of whether we should deregulate the interest rate on savings accounts, which incidentally is one of the very few interest rates that remains administered. There are persuasive arguments both for and against deregulating this. In the Reserve Bank, we realized that this is, like all big decisions, a judgement call and that we needed the ‘wisdom of the crowds’ in reaching a judgement. Discerning people would no doubt have realized that eliciting views and feedback is now standard practice for most policy decisions of the Reserve Bank.
The RBI has become far more transparent than it a year ago, with periodic conference calls and transcripts. Given the remarkable foresight of the RBI in averting subprime fallout on India, it could well have stuck to its old ways. But being more transparent shows that even winners can learn from others. 

Sunday, January 9, 2011

Internal Audit-the 'safest' and 'most rewarding' ever support role in Finance?

When I asked my freshly minted CA friends(cleared in Jun-10) about their career plans, more often than not, Internal Audit figured. Even in the articled trainee market, internal audit is sought after. This post tries to explain the reason for that. 

In this age of 'lean organizations',  not being in the 'revenue producing' side of business would some day qualify your job for being outsourced. This is true specially for corporate finance jobs. Where earlier firms would have an army of clerks(for billing/receivables etc), they have managed to outsource it to specialist firms for a much lesser rate. And this trend is only increasing. The Tata Group outsources( among other things) some routine accounting to its group company E-Nxt. Other Indian conglomerates are following suit and slowly the remaining staff are made to adapt to demonstrate more value or be forced out. In this regard, internal audit may be an interesting role to pursue.

  The Bombay Chartered Accountants Society(BCAS) recently held a lecture series on 'Careers in Internal Audit'(you may download the PPT's here) . Each speaker emphasized that internal audit is seen as a leadership pipeline, critical and value adding function etc. While it is often outsourced for reasons of corporate governance or legal requirements(like SEBI directives), companies still need an in house expert(s).
And that expert need not be a Chartered Accountant(though they are often preferred over other professionals). A good internal audit professional can ensure savings much more than what he is paid. If the company outsources the function, the professional can still shift to the business side/Corporate Planning side to use the broad business knowledge he has gathered. That is why I call it 'safe'.

And 'rewarding' because intellectually, it is a challenging field. Fields like taxation are a zero sum game(just take away stuff from the Govt) but internal audit is a real value creation-appealing to people who look for 'meaning in their work'. Finding points is simple(nitpicking) but winning buy-in and ensuring implementation, is what separates the wheat from the chaff. In the short term, the salaries may not match what an external consultant makes but the long term career potential(CEO/CFO) more than makes up for that.

Saturday, January 8, 2011

Bartronics-the next Satyam?

In the latest available annual report of Bartronics(2009-10), there were some alarming points. That, coupled with the reputation of the stock as 'operator driven' should raise some concerns. The 09-10 report prompted me to see the 08-09 report as well. And this is what I found.
  1. Chances of Fake transactions done electronically:-Fake invoices and confirmations were the Satyam scam modus operandi as well. Reading the audit qualification that such a big amount of sales/purchases could not be verified AND were outstanding at year end gives jitters. To quote the 09-10 audit report "The trading sales and purchases includes software transmitted through electronic form without adequate documentary evidence with respect to transfer of significant risks and rewards incidental to the ownership aggregating to Rs.8837.59 lakhs and Rs.8461.87 lakhs respectively.... and are outstanding..on which we are unable to express our opinion..". While the net impact is small vis-a-vis the profit of 6000+ lakhs, a fraud done interim 2010-11 would go undetected till Dec-11. Given that the profit is less than 75% of the suspect sales, chances of manipulation cannot be ruled out.
  2. Wish to avoid statutory audit requirements:- When the foreign subsidiaries were initially set up, Bartronics did not appoint an auditor immediately but submitted unaudited subsidiary accounts in the 2008-09 annual report. The comment was " Since the management is seeking technical opinion on Audit Requirements in case of Bartronics America Inc. and Bartroncis Asia Pte. Ltd., in their
    respective countries of incorporation, their Audited Financial Accounts have not been attached".
    This is not illegal but reflects lowly on the corporate governance levels
  3. Internal Audit inadequacies: They have used the same CA firm for 'perpetual' internal audit. Till 2008-09, there was no audit qualifications. But suddenly in 2009-10, where the firm size and scale had not materially changed, the same statutory auditor(Deloitte) suddenly found the internal audit inadequate. In their words "In our opinion the internal audit functions carried out during the year by a firm of Chartered Accountants appointed by the management which is not commensurate(emphasis added) with the size of the Company and the nature of its business". To censure another CA firm(and an old client) like this points to the fact that the Big 4 auditor is suddenly uncomfortable with the systems. 
  4. Weak Internal Controls:- Deloitte again opened its account in 2009-10 by stating that "there is inadequate internal control system commensurate with the size of the Company and the nature of its business for the purchase of inventory and fixed assets and for the sale of goods and services, which needs further improvement and needs to strengthen systems and procedures relating to documentation.". Strangely, this point has not been given attention in the press. Considering that frauds on/by the company can occur via internal control weaknesses, this matter is significant in my view
         Considering that the share was dropped from F&O segment, there is no way to short it easily. Investors in this position should beware of 'surprises'. To be fair, the company claims in 09-10 annual report,  to be 'reviewing the system of controls...". But the question is-What was it doing all this while?Unless the company is more transparent with investors, quality risk prevails.

Reliance Industries Ltd_2009-10 _some oddities

While reading the RIL annual report, I noticed a few interesting things
-It has purchased 19.85 Lakh of shares of Den Networks Ltd @ Rs 191(Pg 187). Considering that the issue was soundly criticized on the street, this is interesting.

-Though nearly 90% of total assets/ liabilities have been allocated to segments, interest income/expense has not been thus allocated. Strange(Pg 176)

-The company proudly boasts of contributing 5.6% to the Govt's indirect tax revenues BUT firstly we should take the net amount paid in cash(post Cenvat credit) and THEN this amount comes from the customers who have really paid it. If RIL had paid 5.6% of direct tax revenues that would be commendable but what can you expect from a company which first began paying Corp taxes from 1997(according to Hamish Mc Donald's new book)

This is not to detract from the company's other achievements but these are the things that strike the eye. 

Financial Management & Power Sector Series_Bidding assumptions

Generally in a tender involving multiple year supplies, assumptions about inflation, operating efficiency changes etc are vital. In nearly all tenders, the bidder runs the risk of wrong estimation but in the power sector there is too much at stake.

If a bidder(for power project) cannot complete a project due to under-costing, everyone loses. Also, there are many technical details at play. The regulator who scrutinizes all the firms may be in a better position than the bidding firms,  to estimate the various variables for bidding. That is why the CERC itself notifies the various rates to be used for bidding evaluation and payment. In the interest of transparency, the detailed methodology of calculating these rates is also mentioned so that people who differ, can use their own internal rates. For anyone with an interest in macroeconomics/financial management, the methodology document is a goldmine.

Wonder how is your electricity tariff calculated? Read on

This post explains how the generating companies calculate(and get approved from Electricity Regulatory Commissions) the tariff for their power. It does not cover UMPP/long term PPP based tariffs. The basis for this post is the National Tariff Policy.

Infrastructure economics have certain unique issues. They have high fixed costs(both initial and operating) relative to variable costs. Debt financing being in vogue to extent of 70%+ project cost, interest and(in case of foreign debt-forex MTM fluctuations) becomes a major chunk of recurring costs. Given that the facility once set up is a monopolist(atleast in a few areas), smart pricing is the key to profit maximization. However, as any micro economics textbook would tell you, producers may be tempted to lower the output(not in public interest) to maximize their profits.

The power sector can be broadly divided into
  1. Generation. Here, regulators design incentives to encourage producers to operate the plant efficiently and to the fullest possible capacity. Competition via free markets is the eventual goal.
  2. Transmission & Distribution :-This was, is, and is likely to remain a natural monopoly where prices have to be regulated.

The objectives mentioned in the tariff policy(with my comments in bold italics) are to

(a) Ensure availability of electricity to consumers at reasonable and competitive rates(no monopoly abuse)
(b) Ensure financial viability of the sector and attract investments(Since Govt cannot fund(or properly execute) the necessary power projects)
(c) Promote transparency, consistency and predictability in regulatory approaches across jurisdictions and minimize perceptions of regulatory risks(change of coalition Govt in the states etc)
(d) Promote competition(to eventually determine basis for PPP/free market rates), efficiency in operations(allow pass through only for controllable costs) and improvement in quality of supply(increase the expected Plant Load Factor(PLF) yearly).

For a five year period(say 2009-14), the utility gets its capex plans and projections approved at a public hearing where consumer and industry associations can voice objections(which they usually do). Then each year, the utility estimates the operating parameters in advance and projects its operating costs accordingly. Depending on forecasted output and consumer classes, the tariff is proposed. The aforementioned associations try to bring down the costs while the utilities inflate it. If you want to really understand the economics of this industry, try reading any of the tariff petition proceedings on the CERC site. They are quite illuminating(the behind the scenes fight for every rupee!!). Typically, the regulator fixes a mid-way value for most items.  If the utility achieves/surpasses its operating benchmarks, it can charge an incentive tariff from the customer.

It is on the basis of this forecasted cost that your bill is prepared. At the year end, the surplus/deficit is calculated and then passed on. Since there cannot be any direct bill refund(so far infeasible), consumers as a class get that bill adjustment.

Financial Management & Power Sector Series_Hedging

The policy states that "Foreign exchange variation risk shall not be a pass through. Appropriate costs of hedging and swapping to take care of foreign exchange variations should be allowed for debt obtained in foreign currencies"

This seems fair. The producer is paid to hedge his risks to take care of forex variations. Imperfect hedging will be at his expense/profit. Given this, power companies are prime candidates for derivatives in this regard. 

Financial Management & Power Sector Series_ROE v/s ROCE

Debates still range on which is the better metric to use for performance evaluation-ROE or ROCE. Those proposing ROE take the narrow shareholder perspective but those wanting ROCE maintain that ROE may lead to too much 'leveraging' and risk taking. Notionally, the policy does permit  the CERC to adopt either approach but The National Tariff Policy and the various State policies I have seen so far seem to favour ROE as the basis for tariff determination. The D/E ratio is optimal at 70:30 for the project so focus does seem ROE.

The reason may be that the intent is to ensure that resources flow into the power sector. So the risk capital rate should be ROE. Also, interest costs are allowed as 'pass through' so the producer can earn only on his equity infusion considering that consumers pay his debt service costs.

Financial Management & Power Sector Series_Debt Equity Ratio

Debt/Equity Ratio is that famous unresolved issue in financial management. There is no certain solution in sight. Firms assess their cash flows, risk, tax structure and capital raising options before deciding their optimal debt equity ratio. But the GOI has devised a solution at last.

As per the National Tariff Policy, a Debt/Equity Ratio of 70:30 is the norm. While promoters can infuse equity in excess of 30%, that excess equity will earn a return at the weighted average debt interest rate(and NOT at the higher ROE). Needless to say, equity less than 30% will not get any 'credit' for the deficit but will earn its actual ROE.

Given the terms, it would be foolish to infuse excess equity when you are compensated at the rate of debt only. That seems the intent of GOI to ensure that project cost of capital does not cross a certain ceiling

How brands licensing can serve as a poison pill(Reid & Taylor & Tatas)

Typically, securities law deals with shark repellents, convertible bonds as anti takeover defenses. But strategic licensing of trademarks and brand names can serve the purpose even more effectively-specially in consumer goods and other IPR intensive sectors. Generally, the holding company licenses brands to subsidiaries perpetually with option to terminate if change of management happens. The termination clause for change in control is standard but it is the perpetual licensing which distinguishes a 'takeover pill" from a genuine transaction.

For example, R&T's clause reads "The Agreement grants an exclusive and perpetual license to use the „Reid & Taylor‟ trademark in India and other territories specified in the Agreement. The Agreement shall continue in perpetuity unless .....it is terminated by either party for reasons such as liquidation, change of management ....".

Tata's clause is much more restrictive(no perpetual) but then it has much more at stake so that is understandable.

Takeaway:-Before investing in a company hoping for M&A takeover battles, check out the IPR assets and how they are structured for the company

Tata Autocomp Systems IPO_qualitative concerns_AVOID

Like most Indians, I believe(rightly so) that the Tata brand stands for trust, loyalty, faith etc. So when I noticed the first(in a long time) IPO offer from the group in terms of Tata Autocomp Systems (TAC), I initially thought of subscribing to it w/o reading the prospectus. But remembering the RPower IPO fiasco, I decided to read the full DHRP available here And quite a few aspects of it are surprising, in a negative way.
  • Entirely a stake sale by promoters:-The company will not receive anything from the IPO. It reflects on the confidence of the selling shareholders that they do not want to sell their sales in the secondary market but want an assured exit via IPO. This does not infuse funds into the company-and therefore is a risk factor when there are other opportunities out there that actually infuse funds into the firms.
  • Qualified accounts;-To quote from the prospectus(risk factor 6), "The Company has not made provision for any possible diminution in the value of long-term investments aggregating Rs. 919 million in two of its joint venture companies, Tata AutoComp GY Batteries Limited and Tata Yazaki Autocomp Limited, whose net worth has each substantially eroded on account of losses". This IS a regrettable practice followed by several Indian companies-postpone write downs calling the investment 'strategic' etc but is hardly expected from a Tata Group company.
  • Breach of covenants without renegotiating:-As per risk factor 8, the interest cover covenant on a   $23MM loan from HSBC  was breached in Oct-08. The default still continues with the only penalty being a higher interest rate. For such a small loan, it is surprising why the breach continues.
Despite all this, the company still remains a Tata Group company post IPO(with 75% majority holding) so may be considered as "Too Big to fail". But still, investing in better quality paper of the same group may be advisable from a fundamental aspect.

I have not considered the industry fundamentals or the pricing. This analysis is purely qualitative.