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Saturday, January 8, 2011

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

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