The book-building process allows for price and demand discovery. Also, the costs of the public could be kept at minimum, and the time taken for completing the process is relatively shorter than a normal public issue. In a normal public offering, the demand for shares, that is, how many shares will be subscribed for, would not be known in advance.

The likely demand for shares (as also the likely price) can be estimated more realistically under book-building, and if there were to be no bids, the issue can even be deferred.

Establishing an MF

IN ESTABLISHING a mutual fund, at the minimum three entities are involved: a sponsor company; a trustee company; and an asset management company (AMC or investment managers).

In addition, a fourth entity, an entity to act as Custodian is also associated by the MF.

SEBI compliance: A mutual fund is required to be registered with the Securities and Exchange Board of India (SEBI) before it can collect funds from the public. All mutual funds are governed by the same set of regulations and are subject to monitoring and inspections by SEBI.

MF-SEBI approval: The sponsor is the entity that promotes the MF. A mutual fund is set up in the form of either a trustee company, or a trust under the Indian Trust Act. The trust is established by one or more sponsors, and their position is similar to that of a promoter of a company. The trustees of the mutual fund hold its property for the benefit of the unit holders. This board of trustees, acts as an umbrella organisation (and as MF) that floats various schemes.

The AMC — compliance with the Companies Act, 1956 and SEBI approval: The AMC is set up as a limited liability company and is approved by SEBI. The minimum net worth prescription for the AMC is Rs 10 crore. This AMC manages the funds by making investments in various types of securities.

The custodian: Registered with SEBI, the custodian holds the securities of various schemes of the fund in its custody. The trustees are vested with the general power of superintendence and direction over AMC. They monitor the performance and compliance of SEBI regulations by the mutual fund.

SEBI regulations require that at least two-thirds of the directors of the trustee-company or board of trustees must be independent, that is, they should not be associated with the sponsors. Also, 50 per cent of the directors of AMC must be independent.

Treasury bills

POPULARLY known as T-Bills, these are short term, discount debt instruments, maturing in a period of less than one year. Such instruments are issued by the RBI, both for absorbing surplus, if any, in the money market, and for providing a safe avenue to wholesale investors such as banks and State governments. T-Bills are virtually risk-free. The risk of inflation during a 360-day period affecting the real interest rates cannot be eliminated even under T-Bills.

Up to first half of 2001, the RBI was issuing T-Bills of four different maturities — 14-day bills, 91-day bills, 182-day bills and 364-day bills.

The RBI raises funds through these debt instruments and the interest rate decided under a weekly auction process, enabling the RBI to accept a bid which is the lowest, although non-competing bids made by State governments are also accepted. After June 2001, however, the auctions of 14- and 182-day T-Bills stood deferred.

By this, the RBI has synchronised the dates of payment for both 91-day and 364-day T-Bills, such that they mature for payment on the same date.

Together they provide adequate fungible stock of T-Bills of varying maturities in the secondary market. The market-clearing yields and the increased floating stock which are fungible are expected to activate the secondary market in T-Bills which form a sizeable portion of outstanding government debt. Currently, the notified amounts in the auctions of 91-day T-Bills is Rs 500 crore.

The yield on T-bills serves as a benchmark for evaluating other long-dated bonds, as also the risk-free rate of return in assessing the market-premium on risk-bearing securities.

Credit rating

CREDIT rating means an assessment carried out from the limited standpoint of credit-risk evaluation, translated into a current opinion — as on a specific date — on the quality of a specific debt-security issued or an obligation undertaken by an enterprise in terms of the ability and willingness of the obligant to meet principal and interest payments on the rated debt instrument in a timely manner.

In some cases, credit rating is also accorded for the issuer-entities, rather than on the debt instrument per se.

The importance of these opinions to investors, and other market participants, and the influence of these opinions on the securities markets have significantly increased over time.

This is on account of the increase in the number of issues, and the advent of new and complex financial products, such as asset-backed securities and credit derivatives.

Credit rating does not mean a general purpose evaluation of either the credit or performance of the rated entity (although ratings may be relevant for an entity per se), nor does it mean a recommendation from or by the rating agency to invest or not to invest in a debt instrument, shares or debentures

Credit ratings are sought by issuers, for a variety of reasons. Issuers need to meet regulatory requirements, for example, SEBI guidelines provide mandatory rating of debt-instruments in many areas. In addition, the issuers recognise the fact that prospective investors place a value on the ratings and this, in turn, will affect their ability to raise debt or equity capital.

Market acceptance of an agency's ratings is directly linked to an agency's perceived credibility in the market. Potential investors do face entry barriers, if their perception of credibility of a rating agency were to be low. In the Indian context, market participants have, over the last decade and a half, gained well-informed and adequate exposure to credit rating concepts, methodologies and utility, and the size of the debt market has registered remarkable growth.

The credit-rating process involves the following:

Green shoe option

THE term `green shoe' is derived from the fact that over-allotment option technique was first used in the initial public offer of securities of a company called The Green Shoe Company.

In international parlance, it is sometimes called an over-allotment option and again internationally, this provision gives either the members of a syndicate of underwriters to buy, or the issuer to sell, additional shares at the original offer price (even after the issue is closed)

In the Indian context, however, it has a limited connotation. An option or choice is vested in an issuer raising funds from the market (either debt or shares), to retain a portion of the additional amounts subscribed by the investors, and make the allotment, beyond the levels initially envisaged. SEBI guidelines governing public issues contain appropriate provisions for accepting over-subscriptions, subject to a ceiling, say, 15 per cent of the offer made to public.

A hypothetical case would be:

XYZ Ltd announces a public issue of 100,000 shares of Rs 10 each at par, payable fully on application. The company may receive applications for 200,000 shares. In other words, the response from the public has been encouraging, and the company may allot 1,15,000 shares (15 per cent above the initially indicated level), rather restricting the allotment to 1,00,000 shares. The fact that such an option would be exercised by the issuer will have to be brought out in the prospectus.

In certain situations, the green-shoe option can even be more than 15 per cent. Consider the following:

a) IDBI had come up earlier with their Flexi bonds (Series 4 and 5). This is a debt-instrument. Each of the series was initially floated for Rs 750 crore. SEBI had permitted IDBI to retain an excess of an equal amount of Rs 750 crore.

b) Similarly, ICICI had launched their first tranchè of safety bonds through unsecured redeemable debentures of Rs 200 crore, with a green-shoe option for an identical amount. In both these cases, the debt-issuer could raise additional funds at a given rate (prevailing at the material time), by exercising the green-shoe option.

c) More recently, Infosys Technologies had exercised the green-shoe option to purchase up to 782000 additional ADSs, representing 391,000 equity shares. This offer initially involved 5.22 million depository shares, representing 2.61 million domestic equity shares.

On the negative side, in a debt-issue with green-shoe option exercised, the debt-servicing ability of the issuer could come under severe pressure, even if the repayment is by raising fresh debt-capital at a future date. In the case of equity shares, an issuer planning to list a share at a given price, in the hope of a rise soon after listing, may (if the green-shoe option is exercised) find the share prices ruling at lower than expected levels — since, the denominator (number of shares) changes without a significant or corresponding change in the market expectations of total capitalisation.

Project appraisal

PROJECT appraisal normally involves feasibility evaluation from technical, commercial, economic and financial angles. Under conditions of inflation, the project cost estimates that are relevant for a future date will suffer escalation.

a) Hence, it is always prudent to make adequate provision to take into account possible escalations, covering all heads of costs, keeping in view the anticipated inflation rate, during project implementation and subsequent gestation periods. This includes an evaluation of the adequacy or otherwise of depreciation charge, since the normal depreciation may not be adequate to take care of replacement costs.

b) Sources of finance have to be tested for possible revision in interest rates which, in turn, will cause a dent on profitability

c) Based on both (a) and (b), profits and cash flow estimates will have to be readjusted, to assess financial justification for undertaking the project

d) The cash flow streams of the project as also the discount rate applied to evaluate the present value of future cash flows should be comparable and compatible.

e) If the cash flow streams are in money-terms (inflation included), then the discount rate should be adjusted for inflation risk, and discount rate should also be in money terms. Alternatively, the over all capital budgeting exercise will be subjected to inflation adjusted discount rates, to see if the resultant net present value is positive.

In this connection, it is useful to remember that 1+real rate x 1+inflation rate, will provide inflation adjusted discounted rate. In either case, the decision-maker ought to be scrupulously consistent in determining the cash flow streams and the discount rate on compatible terms (be it real, or money rate)

f) If mutually exclusive projects are considered, projects with early paybacks (discounted paybacks) should be preferred over others with longer pay periods

Despite these adjustments, and careful readjustments to cash-flow analysis, there may still be difficulties:

In anticipating realistically, the `rate of inflation' that may occur in one or more future periods

The acuteness or severity of a negative impact, if any, on demand for products (which is a core factor for determining future cash flows)

These difficulties, which cannot be easily ignored, are handicaps in tackling appraisal of a project under inflationary conditions.

(Concluded)

(Suggested answers to the November 2003 CA (Final) paper on management and financial analysis.)

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