The Hindu Business Line : All that goes into an alliance talk

i) If the merger goes through by exchange of equity and the exchange ratio is based on the current market price, what is the new earnings per share for M Ltd.

ii) N Ltd wants to be sure that the earnings available to its shareholders will not be diminished by the merger. What should be the exchange ratio in that case? (8 marks)

Solution: The exchange ratio based on current market price is shown in Table 12.

The new earnings per share for M Ltd would be Rs 5.42

Adjusted EPS for shareholders for N Co holders (4/5) is Rs 4.33

The exchange ratio to retain current earnings of N Co shareholders is shown in Tables 13 and 14.

The new exchange ratio (6 for 5) is: N Co shareholders — new M Co shares;

For each block of five shares in N Co — they will get six shares in M Co.

Marking to market

THIS phrase connotes the process of recording the investments in traded securities (shares, debt-instruments and so on) at a value, which reflects the market value of securities on the reporting date. This process is relevant in the case of investments made by mutual funds for estimating the value of investments in order to derive the net asset value (NAV). This process is also relevant for banks' (within the framework of guidelines laid down for banks by the RBI) reporting purposes.

For financial accounting purposes, investments are generally valued i) at cost, ii) and at market value if it is lower. Long-term investments, investments of mutual funds and investment by banks are excluded from this general rule. The following points are important.

A substantial portion of investments is `long-term'. If these are carried at "cost", any depreciation in market price will not get reflected in the NAV and, in turn, the NAV may get artificially inflated.

Investors in mutual funds must get the most appropriate `user nformation'. Further, the performance of mutual funds is generally evaluated based on the efficiency with which a higher-than-par-NAV can be maintained by them.

Determining carrying amount of investments. The underlying principle is "mark to market". That is, each investment is valued at its market value on reporting date. Nevertheless, exercise of prudence is a priority. Unrealised gains should not be accounted for (see Table 10).

In the context of `derivatives' trading, the futures contract values are updated on a daily basis to their market values. This process of daily updating of future contracts is also known as `marking to market', and on account of this process, the investor who has taken a position in a `futures' contract has to make good the loss or can absorb gains, if any, on a daily basis.

Surplus cash

M LTD has to make a payment on January 30, 2004, of Rs 80 lakh. It has surplus cash today, that is, October 31, 2003; and has decided to invest sufficient cash in a bank's certificate of deposit scheme offering a yield of 8 per cent per annum on simple interest basis. What is the amount to be invested now? (4 marks)

Certificates of deposits (popularly referred to as CDs) are issued by banks on a discount-basis, with maturity value yielding a given rate of return. In other words, an investment in CD today will be for the present value of future cash flows, discounted at the desired rate of return (yield).

Transaction summary:

Period involved — October 31 to January 30 = three months

Bank's offer rate on CD — 8 per cent per annum

This translates to — 2 per cent for three months

Present value factor for 2 per cent — 0.980392

Today's investment should therefore be Rs 78,43,137

This, together with contracted interest rate, will yield a sum of Rs 80 lakh on maturity date.

Go forward

A COMPANY operating in Japan has today effected sales to an Indian company, the payment being due three months from the date of invoice. The invoice amount is yen 108 lakh.

At today's spot rate, it is equivalent to Rs 30 lakh. It is anticipated that the exchange rate will decline by 10 per cent over the three-month period, and in order to protect the yen payments, the importer proposes to take appropriate action in the foreign exchange market.

The three-month forward rate is, at present, quoted at 3.3 yen per rupee. Calculate the expected loss, and to show how it can be hedged by a forward contract. (6 marks)

Transaction summary:

Transaction — import by an Indian company;

Amount — Japanese yen 108,00,000;

Payment tenor — three months;

Current rate — 3.60 yen per rupee (108/30);

Expected decline — 10 per cent in three months;

Likely future rate — 90 per cent of 3.60 = 3.24 yen per rupee

Current spot rate — 3.30 yen per rupee

Normally, the exchange rate changes are shown at as a percentage change for an annual period. The problem, however, indicates that exchange rates will decline 10 per cent over the three-month period, followed by a requirement for computation of `expected loss' and, hence, the decline is taken to be specific for three months.

If the decline is 10 per cent per annum the expected rate at the end of three months would be 3.51 yen per rupee, and a forward cover would not be advantageous.

Analysis leading to a decision on forward contract:

a) Forward rate — Yen 3.30 per rupee

Total yen required — 108,00,000

Conversion — at 3.30 yen per rupee

That is, each rupee will get 3.30 yen

Rupee commitment under forward — Rs 32,72,727

b) Expectations rate — 3.24 per rupee

Total yen required — 108,00,000

Conversion at 3.24 yen per rupee

That is, each rupee will get 3.24 yen

If expectations were to materialise, rupee commitment will be Rs 33,33,333

Forward contract is recommended (see Table 15).

Equity value

THE capital structure of Sun Ltd as at March 31, 2003, is as shown in Table 16. Sun Ltd earns a profit of Rs 32 lakh annually on an average, before deduction of income-tax which works out to 35 per cent, and interest on debentures. Normal return on equity shares of companies similarly placed is 9.6 per cent, provided:

i) PAT covers fixed interest and fixed dividends at least three times;

ii) capital gearing ratio is 0.75; and

iii) yield on shares is calculated at 50 per cent of profits distributed and at 5 per cent on undistributed profits. Sun Ltd has been regularly paying dividends of 8 per cent. Compute the value per equity share of the company. (12 marks)

The estimated market price per share will vary, depending on the assumptions made in the areas of

i) fixed interest/dividend cover,

ii) capital gearing ratio, iii) par value of share, and iv) adjustments to be made on market yield, to factor in the risk levels of the share in question. Assumptions made are brought out in working notes 1 to 6, which are presented in Tables 19 to 24.