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: