ponderings & pennings

When I started my career, this MPBF (Maximum Permissible Bank Finance) was something I took pretty long to understand and by the time I understood as required by RBI under the Tandon’s 2 of the 3 Methods, the RBI decided that Indian banks were mature enough to be deregulated on MPBF and hence gave the banks freedom to assess the borrowing requirements of their borrowers (over a threshold). But many banks, due to lack of any other methodology continued with either of the 2 methods of Mr. Tandon.

The delinking was very logical given that two different companies in exactly same business line would have significantly different MPBF owing to their internal efficiencies (asset turnovers, holding periods, tax plannings etc) but the banks were financing the lesser efficient company based on the MPBF (which was always relatively higher than more efficient firm) and hence not encouraging it to improve its processes.

Unfortunately, despite the regulation, the MPBF or its ghost still lingers and there is not widely accepted alternate method of assessing the borrowing capacity. Last week I met one of my classmates and we had a short discussion around this and converged on an alternate method (or so did we think). It has its shortcoming moreso in form of assumptions that it is based on (discussed later).

Each company aspires to increase its value and we know that the value of the company depends on the WACC (Weighted Average Cost of Capital) which further is determined by the level of equity and debt. Though MM’s first proposition was of an ideal world, under the second and third proposition the value of the firm does change with changing levels of equity, debt due to changing cost of capital. Thus, the Debt:Equity ratio is one prime ratios that moves the value of firm. While additional debt increases the value of the firm it does so only upto a point beyond which the value starts falling as per the average and marginal cost of capital (provided the beta & equity of the company does not change). The company then has to bring in more equity to move to a new curve and space where further debt again helps it increase value. Or, the company can also work to improve its beta by increasing operating efficiencies (operating leverage). Thus, bankers can therefore assess the debt that the company can raise by this method.

If lenders finance a firm upto the extent its WACC is optimum (value is maximum), it will encourage the firm to strive for operating efficiencies to improve its WACC determinants especially the beta to seek more finance/debt.

However, few shortfalls/assumptions that make this model weak are:

1.       Assumes that value of equity remains same. But on the other side, with changing equity which reflects market perception, lenders can also take a call on the company;

2.       This assumes, that debt levels on companies’ can be easily changed which is not true;

3.       This model falls short of implementation because valuation of debt is a big issue in Indian markets where the yield curve is under-developed;

4.       The method does not take into account the specific lending for example lending for working capital, for capex, for short term activities etc;

A robust financial markets system and environment can address some of these concerns and I believe that once that is achieved this method should then won’t be impractical.

And to have the usual end, here’s a video. Song’s not my fav but the band is:

The current issue of BusinessWorld is centered around the India’s cost of growth and the article “The Price of Growth” by Rajeev Dubey made a very interesting read (you can read it HERE). Some key points that he highlights are:

Corporate India’s interest expense has increased by ~ 29% in Jan-Mar 2008 which is fastest in the past 10 quarters and compares starkly with the range of 2 to 7% in the western hemisphere and the salaries and wages have increased 22% (the second highest in past 10 quarters) leading to lowest net profit margins in the period under consideration;

HR costs are increasing 15-20% every year against global average of 2-5%. I was surprised to know that Rahul Dhir, CEO of Carin India earns Rs.7 crores given the Rs.34 crores size of his company! (i guess he is either very confident of his company’s prospects or has given up - if the former, I should be going long on Cairn - LOL)

People efficiency (note that this is not labor efficiency – so it should include, I guess, white collar jobs too) is around 50-60% against global average of 80-90%;

Estate prices for businesses have always been high in India’s Mumbai against better locations with better living standards;

Three years back, a cement plant cost $60 per ton while today it takes $120 per ton to build it;

There are many other such instances that have been cited which are known. Though the report/article does not delve into great depths, it cites regulatory hurdles in land acquisition and setting up power projects as the main reasons that have led India to become a costly place for business and may in the medium term endanger the flows of FDI and GDP growth.

While I agree on the preliminary couple of reasons given for increased costs, I believe that the cause and solution is available in the economics textbooks. We know how the costs behave under the economies of scale. We know the relationship between Average costs(fixed, variable and total) and Marginal costs and that is what is making India costly and threatening its growth.

Beyond a point, both average variable costs and marginal costs start increasing while the average fixed costs tend to remain more or less constant and that is what has happened - we have reached that critical point in production where the costs start increasing. Now, if we want to remain low cost in comparison to our competing countries we need to move this point further away from the origin.

And how can we do that? By making sure that growth is not concentrated in the four metros and another 4/5 metropolitan cities. If we can have over a dozen cities where a business can look to set up its plant/office, we will surely move the point of inflexion further away and make sure that cost reversal takes place at later stages. I wish each state to have atleast one city on the lines of Mumbai/Delhi/Chennai/Kolkatta and each state bigger than Gujarat to have two such cities. A healthy competition among the states would make sure that the inflexion point is driven farther and farther and as a whole India remains one of the most competitive advantageous countries for any business in the world. This would need India to adopt a more federal nature of governance and would also fit well with Porter’s Diamond for the Competitive Advantage of Nations.

While we ponder this, here a nice video:

In the current issue of “MoneyLife”, R Balakrishnan in the article “Minority Shortchanged” has argued that Minority Shareholders need a better deal than the offer of 20% which the acquirer is required to make to the shareholders of the target company under SEBI’s regulations. The reason being that promoters get a better deal if they sell their 100% stake to the acquirer at a premium while the other shareholders get to offload only 20% of the stake (He cites the Ranbaxy-Daiichi deal to explain the minority shareholders’ disadvantage). I am unable to give a link to the article as surprisingly, the magazine has not updated its website!

I have a few doubts on this premise of minority shareholders being “shortchanged”. Firstly, if minority shareholders are to be given the option of offloading their entire holding too to the acquirer then on the same argument, we can say that all shareholders should get the shares at the same price as the promoters – in most cases being the face value. I believe that promoters who take the maximum risk beyond staking their money (in way of giving personal guarantees to banks for debt taken by the companies etc) are entitled to extra benefits.

Secondly, minority shareholders are not followed by anyone. Their holdings are more volatile than the promoters’. So they already have an option which theoretically is available to the promoters also but is not a practical one unlike in the case of minority shareholders.

Thirdly, one buys shares of a company when one is confident of the management, business model & strategy, and the future of the company. Now if an acquirer takes-over the promoters’ stake then it can be considered that the acquirer also has confidence in company’s future though it is another side of the same coin that promoters exhibit their negative confidence by selling their entire stake. Now the minority shareholders who will abide by the promoters and not management, business model & strategy would like to get out along with the promoters. My understanding is that such shareholders would be in the range of 20% only and hence SEBI’s laxman rekha of 20% seems fine.

Finally, regarding the tax benefit that is available to the benefit does seem unreasonable but it then forces the promoters to do the deal at 1% premium to the traded price if they want to save tax and if they want better price they shell out tax. I think it to be fair.

I’d like to have clarifications on this matter and while they come lets watch another of my favs: