Professional Documents
Culture Documents
IBA PUBLICATIONS
IBA Campus Lakshmipura, Thataguni Post, Kanakapura Main Road Bangalore 560062. India
Published By: IBA, Publications IBA, Bangalore 2012 Diagrams & Illustrations as credited.
Cover Design & Edited By: Sanjog Behera and Durvankur Suhas Sheth ISBN No. 978-81-920996-7-5
All rights reserved. No part of this publication may be reproduced, or transmitted in any form or by any means, electronic or mechanical, including copying, or by any information storage and retrieval system, without permission in writing from IBA, Bangalore. Enquiries concerning reproduction outside the scope of the above should be sent to the address mentioned below.
Citation: The papers part of this edited book may be cited as: Name: Case Studies in Managment
Preface
Case learning has been the staple diet for B-Schools for ages. I was lucky to get into case writing at the start of my career and my employers tolerated all my experiments into case writing on exotic topics. Over a period of time Ive written exhaustive case studies, study notes and also situation analysis/ caselets suiting to the needs of the course. This is an occasion for compiling all the case studies that I have prepared over the years into a single edition so that it can be used by other teachers. Further I have experiment with varying assignments being given to students. Some of these assignments really turned to be interesting explanations for real life phenomenon a few which I have been able to include here. The idea for documentation of these papers arose in the discussion with Prof. Subhash Sharma, our Director quite some time ago. The idea was dormant was quite long time but found its awakening a few months when I finally decided to put that effort to document the papers presented all these years. I thank our Chairman Sri B.M.L. Jain and our CEO Sri Manish Jain for their support and encouragement all these years. Further without the constant coaxing of Prof. Subhash Sharma, these papers would have been dormant in one corner of my system than being collated as a compilation for future researchers to work. I thank IBA publications for bringing this volume. Id like to thank each and everyone who have supported me during building up these cases and also the students on whose throats some of these were pushed through and made to sit and solve. Further, all those students who were forced to put up with my quixotic and exotic assignments and the endless torture they went through the rewards of which are being visualized in this edition. Id like to acknowledge the efforts of Durvankur and Sanjog who have painstakingly helped me in formatting this edition apart from their involvement in cover design I dont want to have too detailed a preface and would let the readers judge themselves the case studies which are presented here
Contents
1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. Analyzing mergers and takeovers using game theory: the case of TATA-CORUS deal .. 2 The Economics of Exchange Rates: Revaluing Yuan ..................................................... 12 SAFTA: Issues and prospects.......................................................................................... 19 Issues in disinvestment: The IPCL case .......................................................................... 27 Innovative approaches in public services delivery: Case study of Bangalore................. 36 Managing the Public Services in London: Challenges and Opportunities ...................... 54 iGoli 2002- Making Johannesburg a World City ............................................................ 59 Revenue creation in Urban Local Bodies: A Case on Bangalore Mahanagar Palika ...... 65 Information systems in urban governance: Bangalores tryst with MIS as strategic tool 69 Subex Systems Limited: A Case on Financing Decision ............................................ 72 Managing earnings in firms......................................................................................... 84 EVA: A Primer............................................................................................................ 91 To Swim or to Sink: Kingfisher Airlines in 2012 ....................................................... 99 Caselets in Macroeconomics ..................................................................................... 101
Cases In Management
Page 1
1. Analyzing mergers and takeovers using game theory: the case of TATA-CORUS deal
1
Ms. Surabhi Agarwal 2 Prof. Prashant Kulkarni.3 Prof Anantha Murthy N.K.4 The recent spurt in cross border mergers and acquisitions by Indian companies in the last few years seems to suggest the arrival of India Inc. on the global stage. While acquisitions were earlier happening in the IT industry, the phenomenon has spread to other sectors too. Arcelor-Mittal (though Mittal is UK based company run by an NRI), Tatas victory over CSN to take over Corus, Hindalcos acquisition of Novelis, Tatas acquiring Jaguar all reflect these indicators. These acquisitions have been two ways both Indian companies acquiring abroad and overseas companies hunting for Indian firms. Daichiistake over of Ranbaxy is an illustration of the latter. Analysis of these events is done through valuations of the respective firms. We believe that merger and acquisition is a game and should be viewed in that perspective. Surprisingly, we find little evidence of substantiate literature on this subject. This becomes more evident in the case of Indian firms. We hope to fill this gap by introducing game theory models and use it to study the Tata-Corus deal. Mergers and Acquisitions have fascinated academicians, practitioners and laymen alike. With many Indian companies on the shopping spree in the market of takeovers, hardly a day passes without news of some merger or takeover happening in some part of the globe. Mergers mean a common means of restructuring the assets. Cross-border mergers and acquisitions (M&As) have increased dramatically over the last two decades. But little justice has been done in trying to fully understand the drivers of this activity and the consequent implications. This makes it the top of the discussion table for both policy makers as well as academics. This background becomes a natural corollary for us to frame the objectives for the present study
1 The paper is a version of the paper same titled same presented at national conference of management science organized by Chennai 2 Product manager at a leading research firm in Noida 3 Asst. Professor, economics & public policy, IBA Bangalore 4 Faculty , quantitative methods & operations research
Cases In Management
Page 2
Objectives Mergers, while traditional literature view it as an outcome of rational decisions, we view it as a game. Thus our objective becomes an application of how Game Theory is applied in Mergers and Acquisitions. (ii) Addition to the literature on mergers and acquisitions. Methodology We do an extensive literature survey on mergers and game theory. Based on this secondary data collection we adopt the case study approach to present our point. With an eye on the contemporary happenings the corporate world we take the example of the TATA CORUS deal, TATA outbidding CSN. The analysis proceeds with the use of dominance principle as an initial step followed by the use of auction theory to analyze the bidding procedures. With a lot of debate ranging on the strategy of Tatas in paying a premium, some of whom feel is unjustified, we adopt the Winners Curse approach to find whether the critics are really justified. To arrive at the conclusion, we go for traditional valuation models in finance besides bringing in the existing literature treatment for mergers. Literature survey Existing literature on mergers tends to focus on the fact the mergers represent an outcome of firms decisions taken in a rational manner. The rational manner is assumed to comprise of a process that is exhaustive and incorporates all available information implying no information asymmetry (Steiner, 1975, Chaterjee 1986, Jensen 1984 and Srivastva 1994). Economic theory of mergers shows that merger can be welfare enhancing instead of welfare reduction (Roller 2001). Further empirical studies have attempted to approach mergers as outcome of IO theory and thus a function of firm specific attributes. In IO literature, mergers are often discussed using the game theory approach. The seminal contribution has been of Horn and Perrson (2001) who develop an endogenous market model. The pioneering work however was by Manne (1965). He proposed that the corporates are best run by efficient and competent managers. He advocated a market for corporate control as best way of achieving this in a free market mechanism. The market would comprise of tender offers, mergers and proxy fights. Traditional financial theories focused on the presence of frictionless capital markets with complete information. This however had its critics and limitations in the fight for corporate control. The large premiums over initial stock market valuations paid for targets appeared to be at variance with market efficiency. This anomaly remained a puzzle for many academicians until the introduction of game theory concepts and techniques. Grossman and Hart (1980) pointed out that the tender offer mechanism involved a free rider problem. The introduction of this new problem aroused considerable interest. They argued that a firm makes a bid for a target in order to replace its management and run it more efficiently would provide an incentive for each of the targets shareholders to reject the bid. The new price would reflect their perception of the likely value addition to the firm by the new management. This free rider problem would then exclude the possibility of takeovers. Grossman and Harts Cases In Management Page 3 (i)
solution to this dilemma was to enable the acquirors to obtain benefits unavailable to other shareholders after the acquisition through the process of dilution which could be incorporated in the corporate charter. Shleiferand Vishny (1986a), favor toeholds by the bidders in the target before making any formal tender thus benefiting from the price appreciation in the toehold of shares. They already own. However Bradley, Desai and Kim (1988) find that the majority of bidders own no shares prior to the tender offer making this empirically limited. Contrary to theory of auctions, bidding in takeover contests occurs through several large jumps rather than many small ones. This was supported by the study of Jennings and Mazzeo (1993) who found that the majority of the initial bid premiums were over 20% of the market value of the target 10 days before the offer. Fishman (1988) argument rests on the foundation that the large initial premium deters potential competitors and reduces the likelihood of competition. He argues that a second bidder will find it worthwhile to spend the cost to investigate the target of if the initial bidders price was low. Shleifer and Vishny (1986b) develop a model where the payment of greenmail to a bidder, signals to other interested parties that no white knight is waiting to buy the firm. This puts the firm in play and can lead to a higher price being paid for it than initially would have been the case. Gort (1969) and Mitchell and Mulherin (1996) find that M&A activity is significantly correlated with technological shocks and generally with disturbance to the economy or a specific industry. This line is also followed by Jovanovic and Rousseau (2002). In this view, a merger wave is the effect of inefficiencies caused by exogenous shifts in the economic environment. Other contribution include Faria (2002) stating mergers serve as a vehicle for the transfer of managerial skills (intangible assets), and Lambrecht (2001) and Morellec and Zhdanov (2003) emphasizing non-strategic real options aspects of the merger decision. Last, Rhodes-Kropf and Viswanathan (2003) show that in situations with economy-wide misvaluations, targets may have a larger propensity to accept takeover offers. Horn and Persson (2001), Bjorvatn (2004) and Norbck and Persson (2004) provide theoretical models where foreign firms may acquire domestic acquisition targets, with the acquisition price being determined endogenously in a bargaining process. In these models, contrary to the tariff-jumping argument, high trade costs do not necessarily induce crossborder M&As. High trade costs not only encourage tariff-jumping mergers, but also increase the incentives for domestic mergers as they reduce the degree of competition in the domestic market thereby increasing the acquisition price domestic acquirers are prepared to pay for domestic targets (pre-emptive domestic mergers) Hietala, Kaplan, and Robinson (2004) present a framework for determining the information that can be extracted from stock prices around takeover contests. They use this framework to infer synergies and overpricing in the takeover contests. They use the takeover contest for Paramount in 1994 in which Viacom overpaid by more than $2 billion. Our findings are consistent with theories of managerial overconfidence Cases In Management Page 4
Bhagat and Hirshleifer (1997) estimate overpayments and synergies using movements in the bidders and targets stock prices around an intervening offer from another firm. They identify their empirical analysis by using ex post data (the sample average) to estimate the exante probabilities of success for initial and subsequent bidders and the expected price that a winning bidder will have to pay. Fuller et al. (2002) estimate bidder returns for frequent or serial acquirers. Schurman (1999) uses a related intervention technique to estimate proposed overpayments in acquisitions that were rejected by anti-trust authorities.
Critics opine that Tatas have overpaid for the Corus deal. The final bid was nearly 455pence which rose to the final offer of 608 pence was nearly 33% of the initial bid amount. The Tata Steel stock shed over 10 per cent since the acquisition. This was a continuation of its sharp under-performance relative to the broad market and its sectoral peers since it announced its intention of taking over Corus. Financing the deal will come from the debt markets, with the borrowings secured against the cash flows of both Corus and Tata. An implication could be that Corus may have to struggle to service its debts and may even go Tata also has to manage several variables including steel prices, raw material supplies, and interest costs on the $8 billion debt that is being raised to fund the deal. Besides it also has to deal with sensitive issues of possible retrenchment and layoffs in Coruss manufacturing plant.
Analysis
Tata Steel made a friendly takeover offer for Corus for 7.6 billion dollar at 455 pence a share in cash on October 17, 2006. This was culmination of the sequence starting a week earlier when Tata Steel evinced its interest in Corus. Three days later, the bid offer got the nod from the Board of Directors of Corus. Things seemed to be moving towards logical end Cases In Management Page 5
for Tatas when CSN entered in to the fray. The CSN board made an indicative bid of 475 pence per share on November 20, 2006. In early December the Corus board postponed its meeting to consider the offer of CSN. Tata Steel made its counter move on December 10th offering 500 pence per share. The total bid amount was $9.2 billion. This evoked a prompt response from CSN which upped its price to 515 pence per share amounting to $9.6 billion. Corus board accepted this offer but the matter went up to the UK regulators. In its judgment, on December 19, 2006 the UK Takeover Panel watchdog set a January 30 deadline for Tata Steel and CSN to make revised offers. On Dec 22, Tata Steel won t the approval from the European Commission to buy Corus. The stage was set for the final auction on January 26, 2007 when the Takeover Panel says it will launch an auction on January 30. Meanwhile CSN got the EU nod for its bid on January 29, 2007, leading to the auction on January 30. On Jan 31, the Tatas outbid CSN with 608 pence a share offer. The above bid actions and transactions can be presented as a payoff matrix as
Bidding 1
CSN
TATA
1 2 3
According to this pay off matrix prepared by the above given data, there are two players TATA and CSN, where TATA is the main player and CSN is the secondary player. The player on the vertical axis is the main player. The columns and rows numbered 1, 2, 3 are the number of the biddings of both the players in the CORUS game and the two numbers in every row and column are the pay offs which indicate the value of the bidding. The first value in every cell is the bidding value of TATA and the second value in each cell is the counter bidding of CSN against TATA. For obtaining solution we can reduce the above pay off matrix which shows the difference between values in each cell of the above pay off matrix as:
CSN
Bidding 1 1 - 20 25 133 2 - 60 -15 93 3 - 148 -103 5
TATA
2 3
The values in each cell in the above pay off matrix are the difference between the values of the biddings made by the two players i.e. TATA and CSN. The negative values indicate that TATA has lost the bidding and the positive values indicate that TATA has won the bidding. Cases In Management Page 6
Now, this pay off matrix can be used to calculate the saddle point by the application of the Dominance Principle. In the Dominance Principle, the row having the highest values dominates the row having the lowest values and the row with the lowest row is eliminated. Similarly, the column having the lowest values dominates the column having the highest values and the column with the highest values is eliminated. While doing this either row or column is taken into consideration. The process continues till we are left with one cell, the value in that cell is called the Game Value and the intersection of that point is called the Saddle Point. Thus, using Dominance Principle in the above pay off matrix, we get 5 as the Game Value and its intersection i.e. (3, 3) is the Saddle Point. When we get a Saddle Point then the strategy adopted by the two players is called the PURE STRATEGY as it gives a unique solution. Thus, we arrived to the conclusion derived from the Dominance Principle is that Overvaluation = 5 pence TATA and CSN both adopt the 3rd strategy The strategy adopted is a Pure Strategy TATA is the winner by 5 pence and CSN is the loser
Cases In Management
Page 7
Forward Valuations
Stock Forward Price/Earnings PEG Ratio PEG Payback (Yrs) 15.3 --NMF Industry Average 11.8 3 9 S&P 500 Average 17.5 1.6 9.1
Source: www.morningstar.com In this scenario Tatas paying a hefty premium has led to question marks. If we were to compare the Tatas performance over the past few months, it has been underperforming relatively to the industry and the BSE Sensex. The trend line is shown below. Cases In Management Page 8
Price of stock
5t h
Bidding dates
Looking at the graph it seems that particularly when CSN entered the fray, the market did not approve Tatas decision to raise the price. The market prices of Tatas have been going down. In the end the victory also doesnt get reflected in the enthusiasm of the market. While the prices are slightly above the trend line the narrow margin seems that that market is wary about the deal. This again reflects a case of overvaluation likely to have happened.
Inferences
Based on our analysis we draw the following conclusions 1. The trend of the events does follow the theoretical underpinnings. While the initial offer of a high premium was intended to minimize the possibility of a competitor entering, Tatas could not prevent it. 2. The next theory that psychology plays a role in bidding did seem to have happened with Tatas increasing their bid to more than 25% of the initial offer to outbid Corus. 3. While initially it does seem that there is some overvaluation, Tatas feel that their management would add value to Corus. In other words Corus was sharply undervalued. 4. If this were to be the case we feel that we need to wait and watch the prices over the next year before arriving at any definitive conclusion. 5. The market reaction however shows it is not exactly buoyant about the deal. The frequent underperformance of Tata Steel stock during the run up to the deal and the lukewarm reaction by the market on Tata Steels victory is pointers to this. 6. Our analysis too points out to a similar conclusion that Tatas did overvalue Corus.
Cases In Management
Page 9
References
1. Betton, S and Eckbo, B E (2000) Toeholds, Bid-Jumps and Expected Payoffs in Takeovers, Review of Financial Studies, 13, pp841-882. 2. Berkovitch, E and Narayanan, M P (1993) Motives for Takeovers: An Empirical Investigation, Journal of Financial and Quantitative Analysis, 28, pp347-362. 3. Bradley, M, Desai, A and Kim, E H (1988) Synergistic Gains from Corporate Acquisitions and Their Division Between the Stockholders of Target and Acquiring Firms, Journal of Financial Economics, 21, pp3-40. 4. Bulow, J, Huang, M and Klemperer, P (1999) Toeholds and Takeovers, Journal of Political Economy, 107, pp427-454. 5. Burkart, M (1995) Initial Shareholding and Overbidding in Takeover Contests, Journal of Finance, 50, pp1491-1515. 6. Chowdhry, B and Jegadeesh, N (1994) Pre-Tender Offer Share Acquisition Strategy in Takeovers, Journal of Financial and Quantitative Analysis, 29, pp117-129. 7. Eckbo, B.E., 1985, Mergers and the Market Concentration Doctrine: Evidence from the Capital Market, Journal of Business 58, 325-349. 8. Eckbo, B E and Langohr, H (1989) Information Disclosure, Method of Payment and Takeover Premiums: Public and Private Tender Offers in France, Journal of Financial Economics, 24, pp363-403. 9. Engelbrecht-Wiggans, Richard (1994) Auctions with Price-Proportional Benefits to Bidders, Games and Economic Behavior, 6, pp339-346. 10. Ettinger, D (2002) Auctions and shareholdings, working papers Ceras. 11. Franks, J R and Harris, R S (1989) Shareholder Wealth Effects of Corporate Takeovers, Journal of Financial Economics, 23, pp225-249. 12. Goergen, MandReneboog, L (2002) Shareholder Wealth Effects of European 13. Domestic and Cross-border Takeover Bids, Working paper 2002-50, Center, Tilburg University. 14. Grossman S J and Hart, O D (1980) Takeover Bids, the Free-Rider Problem and the Theory of Corporation, Bell J. of Econ., 11, pp42-64. 15. Gupta, A, LeCompte, R and Misra, L (1997) Acquisitions of Solvent Thrifts: Wealth Effects and Managerial Motivations, Journal of Banking and Finance, 21, pp14311450. 16. Hirshleifer, D (1995) Mergers and Acquisitions: Strategic and Informational 17. Issues in Finance, edited by R A Jarrow, V Maksimovic and W T Ziemba. 3d ed Handbook in Operations Research and Management Science, vol 9, Amsterdam, North-Holland. 18. Hirshleifer, D and Titman, S (1990) Share Tendering Strategies and the Success of Hostile Takeover Bids, Journal of Political Economy, 98, pp295-324. 19. Jarrell, G A and Poulsen, A B (1989) Stock Trading before the Announcement of Tender Offers: Insider Trading or Market Manipulation?, Journal of Law, Economics and Organization, 5, pp225-248 20. Kaplan, S.N., 1994a, Paramount 1993, Case, University of Chicago Graduate School of Business. 21. Kaplan, S.N., 1994b, Paramount 1994, Case, University of Chicago Graduate School of Business. Cases In Management Page 10
22. Maasland, E and Onderstal, S (2002) Auctions with Financial Externalities, Working paper 2002-22, Center, Tilburg University. 23. Roll, R., 1986, The Hubris Hypothesis of Corporate Takeovers, Journal of Business 59, 97-216. 24. Shleifer, A and Vishny, R W (1986) Large Shareholders and Corporate Control, Journal of Political Economy, 94, pp223-249. 25. Singh, R (1998) Takeover Bidding with Toeholds: the Case of the Owners Curse, Review of Financial Studies, 11, pp679-704. 26. Stulz, R M (1988) Managerial Control of Voting Rights: Financing policies and the Market for Corporate Control, J. of Financial Econ., 20, pp25-54. 27. Stulz, R M, Walkling, R A and Song, M H (1990) The Distribution of Target Ownership and the Division of Gains in Successful Takeovers, Journal of Finance, 45, pp817-833. 28. Walkling, R A (1985) Predicting Tender Offer Success: A Logistic Analysis, Journal of Finance and Quantitative Analysis, 20, pp461-478. 29. Walker, M.M., 2000, Corporate Takeovers, Strategic Objectives, and AcquiringFirm Shareholder Wealth, Financial Management 29, 53-66.
Cases In Management
Page 11
Background Note
The Yuan had been pegged to the dollar at 8.28 since 1995. The strong economic growth which China had been experiencing since the mid-1990s was attributed to large scale foreign investments flowing into the country. These investments were, in turn, facilitated by the dollar Yuan exchange rate. China was also able to come out of the currency crisis that shook South East Asia during the late 1990s, relatively unscathed. But, with the passage of time, many analysts began to see the fixed exchange regime as a liability for China. By early 2005, Chinas forex reserves were growing at around $17 billion per month6. In contrast, India, the country often compared with China, was receiving just a quarter of this amount. Chinese central bank was facing problems in utilizing these reserves. Most of it was going towards keeping Yuan pegged at 8.28. The surplus on the current account had touched more than 4% of the GDP. Besides, the policy makers in the US and Europe, who saw a weak Yuan as a threat to their domestic industry and economy, too started pressurizing China to allow its currency to float. In early 2005, the US threatened to take retaliatory measures in the form of tariffs, if China did not let Yuan appreciate. There were, however, equally vociferous voices opposing any change in the currency peg. Domestic pressure was mounting on Chinese authorities not to take any action under external pressure. Various reasons including cheaper exports by China rising US Trade deficit, need for a strong monetary policy by China, overheated Chinese economy, etc. were cited by both the parties to advance their arguments.
5 Asst. Professor, Economics & Public Policy, IBA Bangalore 6 Whats it Worth?, The Economist, May 21, 2005
Cases In Management
Page 12
Exhibit I Exchange Rates Exchange rates were defined as the price of one countrys currency relative to another countrys currency. Exchange rates were classified into two types, viz. Fixed Exchange rates and Floating Exchange rates. In the case of fixed exchange rates, the central bank of the country, in concurrence with the government, fixed the rate for exchange of the domestic currency with the external currency. The currencies were generally tied to the dollar. In some cases, the rates were tied to basket of currencies. While the basket was supposed to be a secret, in general it was tied to the leading currencies. The rate remained stable and the central banks intervened by selling or buying foreign currencies to keep the rate fixed. In the case of floating exchange rates, the domestic currency was allowed to float freely in the market against external currencies. In some cases, the central bank enforced some restrictions on the movement of the currency. The currency could be traded within the fixed band. Sometimes, this practice was termed as managed float or even dirty float. Source: Compiled from various sources by Research Team, ICBR
Financial System
Analysts felt that Chinas financial system was still fragile and underdeveloped as compared to that of the Western countries. Many firms had little experience in hedging and remained financially backward. The presence of foreign banks was limited. Managing currency risk was yet to take off. Securities and futures markets were a recent phenomenon. Observers feared that speculators might take advantage of this to book profits and then exit the market. A small revaluation might be taken by speculators as a hint of further revaluation. This in turn, might lead to inflow of more speculative capital causing greater volatility in the financial markets. As a result of these factors the markets may not be able to withstand the revaluation of the currency. Chinese banks on the other hand also feared of the possible increase in loan defaults. The system was already troubled by the large percentage of Non-Performing Loans (NPLs) (about 40% in 2002-03). These NPLs were securitized and traded with US investors being the dominant players in the market. Revaluing Yuan would increase the value of these NPLs while the dollar assets held by central banks to keep Yuan pegged would lose its value. Worst case scenarios drawn by economists pointed out the danger of even the Chinese Central bank going insolvent.
7Nouriel Roubini, Ten Reasons why China should move its peg and pull the plug on the US reckless policies, May 11, 2005, www.roubiniglobal.com
Cases In Management
Page 14
Inflationary pressures
Though inflation had come down to around 3% in mid-2005, from about 5% the year before, some studies predicted that China could experience a high inflation in the forthcoming years. Prices were controlled and there were discrepancies in measuring the price indices. China was in the midst of real estate investment boom. The low interest rates on deposits seemed to have made investors turn towards real estate where returns were far higher. Investment to GDP ratio was around 45% by early 20058. The fall in prices of agricultural commodities was being seen as a temporary phenomenon. Given the widespread perception that the Yuan was undervalued (some figures quote to the extent of 60%), experts warned about the possibility of a further rise in inflation.
US Trade Deficit
By 2004, the US economy was facing the prospect of a trade deficit crisis. By May 2005, the deficit had touched nearly $60 billion. The administration believed that the undervalued Yuan was largely responsible for this crisis. They argued that low cost Chinese exports flooding into the US markets were hurting local producers and causing unemployment. Euro zone countries which were bearing the effects of the falling dollar were also keen on appreciation of the Yuan and other Asian currencies. A section of analysts, however, argued that trade with China accounted just about 10% of the total. Revaluation of Yuan even by 20% would still fall well short of the target required to peg the deficit levels at 2-3%, levels considered manageable by most. Moreover, Chinese exports were found to have high import content, thus considerably reducing the impact of any revaluation. Moreover, Chinese Central Bank was one of the leading buyers of the dollar. If the Asian Central Banks were to diversify their foreign exchange reserves, dollar could experience a steeper fall. Some analysts went to the extent of claiming that but for China buying the dollars to shore up its reserves; the dollar would have experienced a further fall. Others attributed the rising deficit to high consumption rates in the US. The US was believed to have one of the lowest savings rates in the world at around 1% of the GDP.
Cases In Management
Page 15
revaluation. If China were to go in for small correction, it might lead to expectation of further revaluation coming about. Speculators might exploit this sentiment. Reports from China were already discussing about the rise in the inflows of hot money into the country. Other Central Banks in Asia too limited the appreciation of their respective currencies to maintain competitiveness with Yuan. Any possible Chinese move was likely to have a chain reaction with these currencies too getting appreciated. Some expected a possible diversification of forex reserves by central banks in Asia which had been leading buyers of gold. This school of thought believed that this would lead to upward pressure on US interest rates besides rise in import prices. With foreign banks generally sensitive to prices of financial assets and a good percentage of US imports coming from the Asia Pacific Rim, the belief seemed to have found some credence. However, others argued that though the central bank purchase of US treasury bills had slowed down, demand from private investors remained strong. Moreover, it seemed extremely unlikely that the central banks would stop purchasing dollars altogether. Further, even a slight rise in interest rates would curb American consumption, which some felt, was the cause of American economic woes. Moreover, critics of US administration felt that China should call US bluff by letting Yuan appreciate. They pointed out that with other central banks going in for diversification of reserves, it might be China that would ultimately have to take up the burden of financing the US deficits. Meanwhile, large multinationals, which had a strong presence in China (either they had production units there or sourced raw materials from China), were calling for status quo in the price of Yuan. They feared that a stronger Yuan would result in rise in prices hurting their bottom line. Some experts reckoned that China would have to let its currency appreciate sooner or later. According to them, the least China could do was to widen the peg against the dollar or go in for a gradual shift from the dollar peg to one based on a weighted basket of currencies. The advantage was likely to stem from the fact China would have the advantage of adjusting its movement in relation to multiple currencies unlike now where its fortunes were completely dependent on the fortunes of the dollar. The second option for China seemed to widen the band within which Yuan was trading. The band could be a range of 1-1.5% on either side of the central value. Some analysts however argued that China would have to go in for one time revaluation of 10-15% to be followed by managed float. Given the rising prices in real estate, revaluation was likely to ease the pressure on inflation apart from giving Chinese central bank more flexibility in framing its monetary policy. Besides, Chinas external debt had crossed $200 billion by late 2004. With a large percentage of the debt denominated in dollars, appreciation of the Yuan was likely to reduce its debt value in dollar terms. While Chinese policy makers seemed to be thinking on the possible revaluation, they seemed determined not to do it under pressure. Any sign of revaluing Chinese currency was being seen in the domestic quarters as surrender to the international pressure. Besides, it was being equated to surrendering of national respect.
Cases In Management
Page 16
There was also a feeling that the economic overheating was confined to a few sectors. Moreover, with China in the process of undertaking structural reforms in its banking and financial sector, they were concerned with the systems ability to bear the likely impact. They cited the experiences of Hong Kong and Japan when they went in for revaluation (Exhibit II). They further warned of likely repeat by China of these instances.
Exhibit II Revaluation: Other Experiences In November 1974, Hong Kong floated its dollar after abandoning its fixed rate mechanism. This action resulted in volatility in the financial markets. By 1983, the volatile markets had taken their toll resulting in a sharp fall of the Hong Kong dollar. People had even resorted to hoarding toilet paper, rice and cooking oil to protect themselves from rising prices. Hong Kong had to abandon the floating rate mechanism and switch back to fixed rate system. Japan floated its yen in 1971 following the collapse of the Bretton Woods system. The banking system had collapsed consequent to the rise in NPLs in the economy. Strong Yen was often seen as the cause for recessions in Japan. In 1989, Japan witnessed a peak in property and share market. During this bubble, a single square mile of Tokyo was worth more than many other countries in the world. Even by 2005, Japan had not been able to recover completely from that crisis. Source: Compiled from various sources by Research team, ICBR While the debate raged on the probable course of actions and counter actions, what China might exactly do continued to remain anybodys guess.
Cases In Management
Page 17
References 1. Chinas Currency Impact, Textile World, December 2004 2. Yuan Step at a time, Economist, January 22, 2005 3. Paul Freedenberg, Balancing Economic Opportunity and Strategic Risk in China, American Machinist, February 2005. 4. Cock-a-doodle-doo, Economist, February 5, 2005 5. James Haughey, Fair Exchange?, Electronic Business, March 2005 6. Nouriel Roubini, Ten reasons why China should remove its peg and pull its plug on the US reckless policies, www.roubiniglobal.com, March 11,2005 7. Nouriel Roubini, Is the US Really Serious or Masochist About Demanding a Revaluation of the Chinese Currency? Playing with Fire and the Risk of a Market Crash, http://www.roubiniglobal.com/archives/2005/04/is_the_us_reall.html, April, 2005 8. Ted H. Chu, The Chinese RMB: its Peg, its Value and its Future, Business Economics, April 2005 9. Yuan Revaluation: Pros and Cons, www.refcofx.com, April 2005 10. Softly, Softly , Economist, April 2, 2005 11. Chinas Central Bank says no plan for imminent revaluation- says report, www.forbes.com, April 24, 2005. 12. Global Impact of Yuan Revaluation, www.emerging-markets-online-com, April 25, 2005 13. Revaluing the Yuan: Where Politics and Economics Collide, Knowledge@Wharton, May 2005 14. Prospects and Implications on Chinese Yuan Revaluation, Report by Economic Research Department, Northern Trust Company, May 6, 2005, www.northerntrust.com 15. Pressure on Chinas Revaluation wont work, www.chinadaily.com.cn, May 12, 2005 16. Paul Krugman, The Chinese Connection, New York Times, May 20, 2005
Cases In Management
Page 18
9Asst. Professor Economics & Public Policy, IBA Bangalore 10Dr.KhwajaAmjadSaeed, South Asian Economic Union by 2010, www.pakistaneconomist.com 11M.Aftab, Can SAFTA lead to a South Asian Economic Union, Dawn Jan 19th 2004, www.dawn.com
Cases In Management
Page 19
Countries. But post 1998 onwards with the deteriorating situation between India and Pakistan cast its shadow over SAPTA and delayed the introduction of SAFTA.
Proposals of SAFTA
It aims to move to a higher level of trade and economic co-operation by eliminating the restrictions that have hampered intra-region trade. It classifies the countries into two categories. The first was Least Developed Countries (LDCs) which comprised Bangladesh, Sri Lanka, Nepal, Maldives and Bhutan. India and Pakistan were categorized as Non Least Developed Countries (NLDCs). While affirming the existing rights of Marrakesh agreement on WTO, the framework provided for the free movement of goods in the region by seeking to eliminate tariffs and para-tariffs and non-tariff restrictions on movement of goods within the region12. The member countries would harmonize their legislations so as to facilitate trade and commerce among the member countries. The NLDCs were also needed to accommodate the LDCs by offering concessions on a non reciprocal basis. The arrangement would come into effect on January 1st 2006. The framework talked about India and Pakistan undertaking the reduction in tariffs from the existing rates to 20% within a two year period while the corresponding rate for the other countries will be 30%. While the NLDCs will have to bring down their tariffs in the range 0-5% in a five year period starting from Jan.1st 2008 Sri Lanka would get six years and the other countries 8 years. There is also the provision for unilateral accelerated reduction of tariffs. The provision of Sensitive Lists was provided for to protect domestic industry subject to Ministerial Review after every four years. The LDCs however would receive special considerations and flexibilities in regard to anti-dumping measures and quantitative restrictions and also a suitable mechanism for loss of revenue on account of elimination of trade barriers. The framework also provides for safeguards on Balance of Payments, dispute settlements, and harmonization of standards, custom clearance and documentation issues. The framework works for the promotion of investments within the region and also development of transport and communication faculties which would enhance the development in the region.
Cases In Management
Page 20
The negative impact would be due to flight of capital from the less developed countries to the more developed ones. This could result in adjustment problems for the less developed countries. There is also the distinct possibility of giant firms emerging taking advantage of mergers and acquisitions and this could result monopolist or oligopolistic tendencies in the market. In the case of South Asia, the presence of high barriers on account of non economic considerations the trade between member regions is minimal. India and Pakistan do not even accord Most Favored Nation (MFN) status to each other though they are obliged to do so by the provisions of WTO. The intra-SAARC trade is at a very low 3.8% of the total trade in the region with comparative figures for ASEAN and NAFTA being 40% and 37% respectively. The intra-European Union (EU) trade is at a high figure of 65%. Indias imports from SAARC countries account for 0.11%, 0.9% and 2.7% of the total imports under SAPTA1, 2 and 3 respectively implying India imports from outside the region.13.
Trade Flows
To understand how SAFTA is likely to change the trade patterns it will pertinent to see the changes witnessed in the trade patterns between India and Sri Lanka following the Free Trade Agreement between the two countries. The Agreement was signed in Dec.1998. Indo Sri Lankan trade was hampered by historical reasons and the mindset of the people. The fruits which were imported at expensive rates from outside the region now are imported from India. In case of coconut oil, there was widespread smuggling when the industry was protected. The FTA formalized these channels enabling the bilateral trade to cross $1billion mark by the June 200214. UNCTAD reports that Sri Lanka's exports to India increased from $71 million in 2001 to $168 millions in 2002 while India's exports to that country went up to $ 831 million in 2002 from $604 million in 200115. The free trade agreement apart from imparting dynamism in the trade between the two countries also helped in reducing trade surplus of India with Sri Lanka from 8.6:1 to 4.9:1 within two years16. The scope of FTA is being expanded to the Services sector also. A closer scrutiny of the trade flows between the member countries revealed that the exports from India in the informal sector comprise to a large extent the locally produced goods. On the other hand the third country goods account for a lions share in the goods being imported by India. Therefore analysts feel that the rules of origin (ROO) should be built into the framework of SAFTA so that no country takes undue advantage of dumping third country goods into the other member countries. This would ensure the survival of the domestic industry.
Cases In Management
Page 21
the formation of the European common market led to a substantial restructuring in the industry taking full advantage of pan regional set up. This enabled the industry to reap fully the economies of scale and focus on scope and specialization leading to greater efficiency and increased welfare. RTAs thus become a matter of investments and industrial restructuring as much as they are a matter of trade. The evolution of SAFTA may help in horizontal specialization across the region. This would help in optimal utilizations of the synergies of various member countries for mutual advantage. The major areas are likely to be Sri Lanka for rubber based industries, Bangladesh for energy based industries owing to the high unexploited reserves of natural gas it sits on and Bhutan for forest based products. However it should also be noted except in case of Bangladesh, the other specializations are in case of commodities that fall in the lower end of the value chain and therefore may not really help in kick starting the economic growth. The measure of success of any regional trading arrangement depends to a great extent on the complementarities it generates among three member countries. Textiles are the major export item among the SAARC countries particularly India, Sri Lanka and Bangladesh17. The major items of import are POL products, machinery and industrial raw material. Except India the trade complementary index falls very low. This is due to the narrow trade base for those countries whereas India with its diversified base commands a significant share in global market in sectors like engineering goods, pharmaceuticals and information technology. However with the changing focus on vertical specializations as opposed to the traditional viewpoint of horizontal one, there appeared to be tremendous potential for the SAARC countries to take advantage of.
Cases In Management
Page 22
undertaken in Nepal, hydroelectric projects in Bhutan and the Dhaka-Agartala bus service in Bangladesh.
Conflict of Interests: Indias Attempts for Trade Arrangements with Other Countries
Indias size and population despite making it an ideal candidate for an important role in the global economic set up has been bogged down by the relationship with the neighborhood particularly Pakistan. These conflicts affecting the progress of SAARC made India think about other avenues to fulfill its aspirations. This lead to the formulation of Look East policy, focusing on enhancing relationship with ASEAN as Full Dialogue Partner and concluding FTA with Thailand and Singapore. BIMSTEC initiative to promote co-operation in tourism, education, culture, transport and communication is also an integral part of this approach. McKinsey reported that the Indian trade with ASEAN would reach $24-30 billion by the year 2007 from $9 billion in the year 2000. However experts felt that India had woken up too late and it will be difficult catch up with China which has already signed a FTA with ASEAN resulting in creation of the largest FTA in the region with the likely trade generation of $ 1.2 trillion. However there is ample scope for expansion in trade with ASEAN given the fact while Indias trade with it accounts for about 7% of its world trade, ASEANs is less than 1% of its global trade. With Bangladesh also part of these economic forays and Sri Lanka and Nepal likely to join suit the danger is present of the derailing SAFTA due to shift in focus. However analysts also believe that while to an extent this diversion could hamper SAFTA, it will lead to formation of new opportunities for the Indian business in South Asia the access to which had been hitherto hampered by extraneous factors and pave way for emergence of a new regional identity.
Cases In Management
Page 23
Pakistans imports come from India. Conversely in cotton while Pakistan is one of the largest growers, India is a traditional importer to feed its textile industry. The current trade between the two to the tune of $2 billion which takes place through third country channels like Hong Kong and Singapore was expected to reach $10 billion if the bottlenecks like lack of communication and transport linkages eased. India is one of the largest consumers of energy and therefore a potential market for energy producer in Central Asia. The development of SAFTA was being seen by analysts as a positive measure for Turkmenistan Afghanistan Pakistan (TAP) pipeline which could benefit India through cheaper imports from the region and also the Central Asian economies by giving them easier access to a large market. Though there is a question mark among the experts on the nature of stabilization of the Indo Pak relationship there is optimism that given the economic gains likely to accrue, the treaty will take off.
Cases In Management
Page 24
could be formalized it would come as shot in the arm for these industries. The industry expected that it can look towards Pakistan as a bridge for trading with Central Asian countries. The energy pipeline which was expected to get a fresh lease of life would solve Indias energy problems to a great extent and act as an aid to growth. However the industry was also expected to face stiff competition from other member countries. The very threat of Indian industry garnering lions share among the region had put a question mark on the future of SAARC which the industry has to address. But with SAARC seemingly stuck in limbo, India has gone ahead with enhancing economic ties through other avenues. Apart from the FTA with Sri Lanka, India is looking towards the East Asian countries by entering into FTAs with Thailand and Singapore. It also went ahead with a new concept BIMSTEC (Bangladesh India Myanmar Singapore Thailand Economic Co-operation).
Cases In Management
Page 25
The success of SAFTA would determine on how far the regional business communities exhibit their dynamism and how best they institute the economic measures to strengthen the complementarities. As the history has shown more often the countries have fallen into the cobweb of politics and other extraneous issues hampering the progress of SAARC and unless they come out of this mindset skepticism was bound to remain among the industry watchers. However they felt that this was a significant positive step which would benefit the smaller countries facilitating the stabilization of political environment in the region.
Cases In Management
Page 26
The scene
On May 19th 2002 Reliance won the battle against the other competitors in the global competitive bidding for the 26% stake in the Indian Petrochemicals Corporation Ltd.(IPCL) held by the Government of India. It was a culmination of a long saga. IPCL had been put on the chopping block by the government as part of it ambitious programme to exit from the business of running the industry. It was a hard battle for all the parties concerned. It seemed to cross a maze of numerous legal intricacies. Besides, critics had questioned the very process of disinvesting the petrochemical sectors which was seen by them as a strategic sector. Reliances acquisition of 26% stake valued at Rs. 1491 crores (US$ 303 mm) worked out to Rs. 231 per share (US$ 4.7 / share), 74 % premium to IPCLs last traded share price. The transaction value of Rs 1491 crores was the highest public sector unit disinvestment proceeds received by the Government in a single transaction exceeding Rs.1153.68 crores from IBP and Rs.1439 crores from VSNL22 till then. Under the law Reliance would have to make another 20% open offer at the same price. Reliance was expected to incur Rs.2638 Crores (US $ 536mm) for this acquisition. Reliance was expected to command in excess of 70% share of the market in most product categories of the petrochemicals industry in the country. With the per capita consumption of polymers in India one of the lowest in the world the prospects seemed to very bright. But the victory was not an easy one. The sale of government stake not just in IPCL but also in other sectors had long been embroiled in controversies. It was marked by political battles, legal battles and questions were often raised on issues of transparency. The critics questioned the very need of disinvestment of the public sector and argued that the public sector should be recapitalized and not sold out. Also there has been the issue of what is the preferred mode of disinvestment whether should it be a strategic sale or would the open offering in the domestic market be the better way? To understand this whole gambit of disinvestment and why these questions are being raised it is necessary to go into the background of the whole set-up. It means the need to know why the public sector was set up in the first place, how the experiment worked and now why the question of government exiting from this sector.
Background
When India achieved freedom from the yokes of British colonialism, the state of Indian industry was pathetic. The economy had been ruined and had become a sourcing base for cheap raw materials for the British industry and also a market for the British finished products. This had totally destroyed the industry. Even before the British colonial rule industrial set up in India was mainly restricted to the small scale cottage industry. India had been traditionally dependent on cotton, spices, silk and other agro based industries. The
22 Business Line May20th 2002, Reliance Makes it Big With IPCL.
Cases In Management
Page 27
Industrial Revolution which kick stated the European economy was wholly absent in the India. There were a few attempts by visionaries like J.N.Tata, G.D.Birla and others to set up infrastructure and develop an industrial base but the amount required for that was huge. The problem of non-accessibility to capital resources hindered the progress of these enterprising entrepreneurs. It was in this scenario that the government had to step in to develop the industrial base and establish India as one of the leading industrialized countries in the world. Prime Minister Nehru was a believer in Socialist Model of Economy wherein a dominant role was given to the government in the economic sector. Under his vision, the public sector was expected to reach the commanding heights of the economy. However as the time progressed, flaws crept into the experiment. There was over transgression the and the Public Sector Undertakings(PSUs) as they came to be known became too many to be handled .Added to it the autonomy provide to the PSUs was encroached upon. There was lot interference in their functioning, the efficiency took a back seat and they became a source of patronage for those in power. The bogey of nationalization became to be used as a tool of populism and also as a stick for the private industries that refused to fall in line with the establishment. In spite of this several PSUs flourished and made it to the Big League. Indian Oil Corporation (IOC) was the first Indian company to make it to the Fortune 500. In 1991 with the winds of change began to appear and the business environment started to ease out. Liberalization, Privatization and Globalization became the buzz words and in these change settings the debate arose on the very question of whether the government has any right to be in business. The changed contours of the policy parameters made the government to set up the Disinvestment Commission head by Mr. G.V. Ramakrishna to examine how the Public Sector Companies could be liberalized and made free from government encroachments on their powers. The government though broadly accepted its recommendations however did not proceed entirely in tune with it. The push for disinvestment was achieved by the Vajpayee government when it disinvested Modern Foods. The company was sold off to Hindustan Lever for an amount of Rs.125.5 crores at an average cost of Rs.11490 per share. The big ticket disinvestments were however the ones of Tatas capturing Videsh Sanchar Nigam Limited (VSNL) and Computers Maintenance Corporation (CMC), IOC taking over Indo Burma Petroleum(IBP) and Reliances acquisition of IPCL. Ceding control to Suzuki in Maruti Udyog Limited (MUL) was a slightly different one since the company was formed as a joint venture of 50-50 between the government and Suzuki of Japan in the first place. The reasons for the slack and sometimes fits and starts approach in the process of disinvestment are many. They are examined below using the disinvestment of IPCL case as an illustration.
Cases In Management
Page 28
Cases In Management
Page 29
offerings. This raises the point on the effective mode of selling i.e. if we are top sell then how to sell?
Valuations
Valuation of the company in case of strategic sale is done by the bidders during the process of due diligence. The government would fix the reserve price. For IPCL the reserve price was fixed at Rs131 per share, the figure being arrived at using the Discounted Cash Cases In Management Page 30
Flow (DCF) method. This price of chosen by the evaluation committee form a set of four alternative valuations offered by UBS Warburg which functioned as the advisor to the deal26. IOC pitched its bid at Rs128 per share while Nirma was even lower at Rs.110 per share However critics alleged that considering the assets and equity base of IPCL the price should be much higher,. Based on the working committees report of disinvestment which placed the price at Rs.265 per share (arrived at using Replacement costs method), they contended that Reliances price of Rs.231 per share represent a loss to the government. They further contend that the acquisition would also result in the monopolization of the market which implies that the price should even be higher. Reliance justified the price it bid for by claiming thats its valuation rested on the premise of EBITDA. This approach meant assessing the overall earnings of IPCL without factoring the interest costs, depreciation and taxes. Reliance believed that with the recovery phase on in the Petrochemical industry the net value of equity of IPCL would go up to Rs.240 per share. Along with this quantitative assessment the Reliances bid was also based on the opportunities the acquisition would provide. Reliance-IPCL would become a monopoly in the Indian market. With the market for polymers expected to grow by 15-20% the value would go even more higher27. Interestingly this was also the pint the critics had been raising. They argued that it is just not just one approach should be taken into account but also the qualitative aspects like the possible emergence of the monopoly the industry growth prospects and demand for the polymers in India which was expected to become the third largest in the world after US and China. This issue of valuations had always been thorny. There are different approaches to valuations and it is possible to arrive at different prices based on different methods used to evaluate the companies. The issue had been dragged many a time before the Supreme Court. The Apex Court has held that the valuations are a matter of technical expertise and it cannot go into its merits or demerits unless it is established that the process is vitiated by fraud and mala fide. In the Hindustan Lever case the court held that the court would not interfere merely because the determination by different methods has resulted in arriving at slightly different conclusions28. Irrespective of what is the right valuation method to be used to arrive at the price, Reliances acquisition of the stake at a premium of 74% over the market traded price was in recognition of the fact that the position of Reliance would be considerably strengthened in the market post acquisition of the stake. This brings to the question of whether monopolies are desirable, can the process of disinvestment be conducted so as to avoid formation of monopolies and the perceived double standards of the government in regard to different cases as will be discussed below.
26V.Sridahar and AnupamaKatakam, Birth of a Monopoly, Frontline June 8-21 2002 27 Ibid 28http://dca.nic.in/Valuation_Report.pdf. pg 44
Cases In Management
Page 31
Monopoly
Reliance-IPCL combine will garner at least 70% share and in some even 100% share in the Indian market in most product segments. The capacity share in the new scenario is displayed under the exhibit 3. The aim of the government is to prevent the emergence of monopolies. This was exactly the reason why the government prevented IOC a public sector company form biding for Bharat Petroleum and Hindustan Petroleum (both since aborted). Now in this case Reliance a private sector firm which already was the dominant player in the market was allowed bidding for IPCL which too commanded a major presence in the Indian market. The next rung players like Haldia Petro are nowhere even in the picture. If the purpose of the government was to encourage competition and discourage monopolies this would serve exactly the opposite. There was considerable opposition even within the ruling alliance over the possible of Reliance acquiring the stake. The then Finance Minister Mr. Yashwant Sinha and Mr.Arun Jaitley were among those who expressed of replacing a public sector monopoly with a private sector one29. The supporters contend that the products being produced by PICL fall in the Open General License OCGL) which implies that they can freely imported. Moreover in the post WTO it is very difficult to charge exorbitant prices. Bu the fears still persist. Incidentally the government had made it clear it would allow the formation of a monopoly in the services sector. However it feels in the production sector with foreign competition in the fears of monopolization may be unfounded.
Autonomy to IPCL
In 1997 as part of the new policy the government had decided Navaratna status to the major companies of which IPCL was one. The aim of this policy was to ensure that these Navaratna companies would be given functional autonomy and encourage them to emerge as global players. However IPCL was left headless for a long period of time and this had an impact on its bottom-line. Analysts opined that there was hardly any attempt made to understand the changing competitive scenario or in trying to chalk out a new strategy. The low prices prevailing in the international market added to the woes. This created a suspicion that the IPCL was being deliberately let down to lower its market value and became a strong weapon at the hands of the critics.
Concessions to Bidders
The government in the bidding process offered three concessions to the bidders, the advantage of which would be fully taken by Reliance. The Central Excise had duty claim of Rs.600 crores on IPCL. The government withdrew it justifying on the grounds that contingent
29Ravi Kapoor , DoD to finalize IPCL shareholders' agreement soon , Financial Express dt: Sep 4th 2000
Cases In Management
Page 32
liability would depressed the quoted prices. The government also sorted out the issues relating to IPCLs long term contract for supply of gas and its pricing with ONGC and Gas Authority of India Limited (GAIL). The critics felt that this was secured by pressuring the two PSUs in agreeing to a favorable deal. While on one hand the government claimed to be dismantling the Administered Pricing Mechanism (APM) in the industry, on the other it was forcing ONGC and GAIL to enter into a long term kerb-side transaction30. The issue could also be seen in the light that the prospective bidder would be constrained in his source for raw materials by this agreement instead of leaving it to the new management to negotiate on what it considers the favorable terms. The third sop was the decision of the Finance Ministry to extend Sovereign guarantee to IPCL which was negotiation with the World Bank for a loan of about $100 million31. It needs to be seen whether the government would extend the sovereign backing to the loans being acquired by the private sector.
Cases In Management
Page 33
Epilogue
The government further downloaded 5% of its residual stake in the company. Reliance which had 46% stake and had the first right of refusal in any further downloading by the government politely declined to exercise of the option of buying 5% stake. If it had Reliance would have got majority stake in IPCL. Analysts feel that Reliance may go in for purchases form the market. However the price of offer for this residual issue was fixed at Rs.170 per share. The issue got oversubscribed by about 10% on the first day itself. Though the acquisition went off well unlike the problems faced by the Tata-VSNL deal it is imperative for the government to formulates appropriate strategies so as to avoid controversies. While there is no one formula for the disinvestment process
Sales Stock Adjustment Raw Material Consumed Power And Fuel Employee Expenses Excise Admin And Selling Expenses Research And Development Expenses Other Expenses Total Expenses Operating Profit Other income Total interest Net depreciation Tax Net Profit/Loss Extra-ordinary item Prior Year Adjustments Adjusted Net Profit/Loss Equity capital EPS(Rupees) Equity Dividend Rate (%) OPM (%) NPM (%)
57,980.0 0 -2,810.00 20,500.0 0 0.00 4,170.00 7,690.00 0.00 0.00 18,050.0 0 47,600.0 0 10,380.0 0 1,050.00 3,690.00 4,550.00 590.00 2,600.00 0.00 -560.00 2,040.00 2,490.00 8.19 0.00 17.90
47,398.9 0 1,928.20 18,681.5 0 0.00 4,014.20 0.00 0.00 0.00 15,329.1 0 39,953.0 0 7,445.90 1,641.90 3,736.70 4,244.10 87.90 1,019.10 0.00 55.60 1,074.70 2,490.50 4.32 20.00 15.70
50,059.7 0 -760.30 18,898.8 0 0.00 4,390.60 0.00 0.00 0.00 17,429.0 0 39,958.1 0 10,101.6 0 1,677.20 4,909.50 4,149.00 231.30 2,489.00 0.00 0.00 2,489.00 2,490.50 9.99 0.00 20.17
40,600.4 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 32,684.5 0 32,684.5 0 7,915.90 1,121.00 3,875.50 3,189.80 83.10 1,888.50 0.00 0.00 1,888.50 2,490.50 7.58 19.49
31,148.1 0 0.00 0.00 0.00 0.00 0.00 0.00 0.00 26,291.7 0 26,291.7 0 4,856.40 794.90 2,618.70 2,703.80 35.20 293.60 0.00 0.00 293.60 2,490.50 1.18 15.59
Source: www.indiainfoline.com
Cases In Management
Page 34
Equity Share Capital Share Application Money Preference Share Capital Reserves & Surplus Loan Funds Secured Loans Unsecured Loans Total Fixed Assets Gross Block Less : Revaluation Reserve Less : Accumulated Depreciation Net Block Capital Work-in-progress Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written Total Book Value of Unquoted Investments Market Value of Quoted Investments Contingent liabilities Number of Equity shares outstanding
87,566.90 0.00 26,982.73 60,584.17 859.08 1,091.04 25,321.33 13,714.64 11,606.69 568.31 74,709.29 1,091.04 0.00 4,147.89 248,225,52 2.00
85,833.80 0.00 22,852.40 62,981.40 1,304.89 741.03 27,178.32 15,134.62 12,043.70 715.64 77,786.66 741.03 0.00 7,576.88 248,224,89 2.00
60,548.04 0.00 19,746.72 40,801.32 20,505.50 696.63 27,508.95 13,364.44 14,144.51 672.76 76,820.72 696.63 0.00 8,529.30 248,223,79 2.00
Source: www.indiainfoline.com
Cases In Management
Page 35
Cases In Management
Page 36
These moves were seen as helping various stakeholders like the elected representatives, corporation officials, citizens, stat government, media etc. by giving them access to timely, structured and accurate information.
enact laws suiting the local conditions. The devolution of powers and functions to the ULBs was left to the discretion of the State governments. Comprising of City Corporations, Municipalities and Town Panchayats, these ULBs numbered nearly 3500 including 101 Corporations. The Twelfth Schedule provides for 18 items and also gives an illustrative list of functions that could be delegated to the municipal bodies. Article 243W read with the Twelfth Schedule is the basis for the delegation of powers to the local bodies but it is left to the discretion of the State Government to decide which functions are to be handed over and to what extent they are to be handed over. However, very few states devolve all or even substantial powers in practice. The functions of the bodies can also be classified based on the nature of the functions.33. They are 1. 2. 3. 4. 5. Essential Municipal Function Environmental Management Functions Planning Functions Agency Type Functions Functions Relating to Governance
The City
By late 2004, Bangalore was being described as the IT Capital and the most happening place in the country. Bangalore had recorded phenomenal growth over the last few decades and was widely acclaimed as the IT capital of India. The software industry in Bangalore was expected to be worth $1.75 billion growing at Compounded Annual Growth Rate of 52% over the period over the previous five years. Apart from this, biotechnology and IT Enabled Services (ITES) industries maintained a strong presence in the city. The city was the home to a number of public sector units in the strategic sector like BHEL, HAL, BEML, HMT, BEL etc. With prestigious institutes like Indian Institute of Management and the Indian Institute of Science making their base in Bangalore, it is also one of the leading academic centers in India. The Bangalore Mahanagar Palike (BMP) founded in 1949 was spread over 100 wards comprising an area of 225 sq. kms. It had a population of nearly 5.5 million and an equally large floating population. As per the BMP Act 1976, there were thirty functions that were classified as obligatory functions while another 23 were grouped as discretionary functions. Bangalore Agenda Task Force was set up in 1999 to suggest and undertake reforms in the city. The council of BMP adopted the BMP (Accounts) Regulation in 2001 containing the prescribed formats and statements needed to conform to the FASB requirements.
33Kulwant Singh Trends and Issues in Decentralization and Urban Governance in India
Cases In Management
Page 38
Functions of BMP
The functions of Urban Local Bodies (ULBs) including BMP were classified into obligatory functions and discretionary functions. It was incumbent of the local body to perform the functions assigned to it by the State Act under the obligatory functions. The discretionary functions, as the name suggested, were left to the City Government on whether to undertake those functions or not. Based on the nature of the work, the functions of the BMP were classified into five categories. Essential management functions constituted the first charge on the Municipalities. They included functions such as erection of boundary marks, construction and maintenance of roads and streets, provision of public amenities like gardens, parks and playgrounds, maintaining schools, maintaining of vital statistics like births and deaths, provision for collection, disposal, and treatment of garbage and solid waste, water supply and sanitation, maintenance of street lights etc. Environmental management functions included protection of environment, promotion of urban forestry etc. and were undertaken usually in co-ordination with the State Government. The Planning functions were usually taken up at the State level but implementation had to be done at the local level. These functions included slum upgradation and improvement, rehabilitation of the mentally and physically handicapped, protection and welfare of weaker sections of society etc. Agency functions like firefighting services, public transport, and electricity supply were undertaken by the ULB as an agent of the State Government. The Governance functions were the ones mandated under law as the representative government of the city. According to experts there was broad similarity in the nature of functions undertaken by the local bodies across the country. To undertake these functions the local bodies needed financial resources. The abolition of octroi had starved the local bodies of a good source of funds. The had to depend on advertising tax, property tax and the grants by the State Government to meet their financing needs. BMP relied to the extent of nearly 20% on the Government grants to meet its requirements. However it was becoming clear to many city managers that the cities should raise resources on their own and undertake a better management of those resources in order to fulfill their functions. There was a view that the Fund Based Management Accounting System (FBAS) would provide a better solution to the city managers.
Cases In Management
Page 39
Financial management in a corporate set up required information to facilitate decision making and also in understanding the financial health of that set up. This principle was sought to be adopted in the setup of the urban local bodies. Using FBAS was thought to help in identifying the different sources that could be used to tap the financial resources and then identifying the uses these could be used best. It also would help in assessing and analyzing the financial health of the local body. The system was expected to provide information about compliance with legal and statutory requirements. This information could be handy not only for elected representatives and the local body officials but also the citizens who would be the ultimate beneficiaries of the various projects undertaken by the ULB. This information could be used by the ULB in tapping the financial markets since the lenders would get an accurate of what is happening inside the Corporation. FBAS envisaged the creation of funds each having a set of self-balancing accounts and key financial statements, a balance sheet and revenue and expenditure account. These funds were to be of three types. The first was the government type. The second was known as proprietary type and the third category of funds created was known as Agency & Trust Type Fund. (Exhibit I).
Cases In Management
Page 40
Exhibit I Types of Funds Government funds These comprised the accounts in use for the normal operation of the local bodies. The focus here was on spending and implementation of the program. Cash based accounting was the norm and capital items too were accounted under revenue/expenditure. Tracking of fixed assets and long term debts were done by a Special method. Fixed assets and long term liabilities were left out of the purview of the balance sheet with the result only the current assets and liabilities were included in the statement. Depreciation was not done on infrastructure assets. These funds were further classified into general, capital projects, special revenue and debt service. Proprietary Funds These funds were envisaged for the discharge of commercial function of the corporation. These included activities like construction of market complexes, provision of urban amenities etc. the ULB collected user charges to fund these activities. Accrual system of accounting with depreciation was the norm while accounting for these activities. This was used for helping the management to revise the user charges and also in maintaining and up gradation of assets. These funds were further classified into external or internal funds. Fiduciary Funds These known as Agency and Trust Type was essentially funded by an outside agency but the ULBs was held accountable for the activity. The outside agencies, could be the World Bank funded projects or a philanthropists coming forward to construct a project. Assets would be created by the external parties; they would operate them for a few years and later transfer those assets to the BMP. It would be put under Governmental or Proprietary based on the nature of the activity though there were suggestions that this could remain as fiduciary fund since BMP had invested any amount in creating the assets. Fiduciary funds were classified further into agency and trust type.
Cases In Management
Page 41
The first step towards introduction of FBAS was taken when the BMP (Accounts) Regulations 2001 was passed. The adoption of FBAS was to come into effect on April 1, 2001. A Memorandum of Understanding (MoU) was signed with the Government of Karnataka (GoK) in July 2001. A MoU was signed with HUDCO in November 2002. Online accounting entries were introduced in January 2003 and the opening balance sheet was prepared in the same month. On May 17, 2003, the BMP published the financial statements for the financial year (FY) 2002-03. This was the first instance in the country of such publication by any City government. By the end of the year the system was fully computerized to provide timely information. The financial statements were also published in leading newspapers in the city as part to inform the citizens about the financial health of the Corporation. MIS requirements had to be understood. Effective functioning of MIS needed the providing of timely, structured and accurate information. Timely information was provided by computerizing the system. Departmental heads were trained in the usefulness of the new system. The reporting system was designed so as to customize it to each department. The Cases In Management Page 42
finance related MIS information was transmitted to the finance department to draw up the budgetary plans. This was to be the core of the finance department. The rest of the data generated was to be in the departmental records which would be available for the Finance officials when needed. The departments also had to undertake verification of records to ensure that the records were accurate. It took nearly 30 months for the BMP to impellent the system. A team of officials at all levels worked to create the groundwork for implementation. Bangalore Agenda Task Force (BATF) also put in lot of efforts and was assisted by NCRCL in creating the system.
Impact of FBAS
It helped in reducing the time of information flow cycle. This meant that the flow of information was fast and timely. It became a better measure for performance appraisal. Under the previous system, it was difficult to appraise the performance of both departments and employees in the absence of any reliable indicators. It brought greater transparency and credibility in the financial functioning of the body. It was felt that this increased the confidence of the people in the activities of the Corporation. It enabled a better enforcement of accountability among the officials. It served to bring the ULB in line with international standards. These standards were to be maintained to secure acceptance from international agencies like World Bank, IDA, ADB and national bodies like ICAI, CAG etc. While the citizens got a greater scope in participating in the activities of the BMP, there was better understanding among the corporators about the activities. The impact on the finance department was felt in the reduced time for information flow. The flow time which was 48 days prior to the introduction of the system got reduced to 48 hours. Work was decentralized. Daily Reports (TL-2) were possible. Review of the activities could be undertaken more easily with the publishing of Budget Variance Report (BV1). Liability position of each project and asset position vis a vis the target for collection was possible. Classification of entries under accounts was made more scientific. Real time knowledge of revenue position helped the officials compare the collection vs. target position easy. Revenue analysis could now be done even at ward level. A single data source of information was created. It streamlined the works in the engineering department. It had the largest allocation among all departments. The infrastructure projects of the BMP were undertaken through this department. The system made a provision for a report on Works Liability Registers vs. Bill Registers. Real time liability position was available with the top official and this helped them decide on the future allocations. The system introduced a coding system for tracking the works. Payments to the contractors were made only on the production of the work code. This gave the department complete control over the works being executed. Payroll was computerized leading to creation of an electronic database that carried the information about all employees. Employee related reports could be generated easily. It provided for the timely and hassle free payment of salaries.
Cases In Management
Page 43
BMP signed a MoU with the banks that enabled BMP to get reports from the banks as per requirements. BMP specific daily and weekly reports were generated to bring about greater clarity in the works. The classification was also done as per the requirements of BMP and not under the heads specified by the banks. This made reconciliation of accounts easy. The MoU also had provisions for offering of different value added services by banks to meet BMP needs.
Outlook
The information regarding the position of assets and liabilities was more structured and easy to interpret. There was better verification process Tracing of assets and liabilities became streamlined and effective. This reduced the risk of corruption and brought in transparency. The MoU with the GoK had provided for specific performance indicators in finance and accounting streams. BMP was able to report these measures to the government. 24 of the 33 indicators listed under the MoU had been complied with the by the BMP by the end of 2004. Citizens were involved for the first time in budget related activities. Presentations were made at quarterly public meetings organized by Public Record of Operational Finance (PROOF) for dissemination of data at wider level. The use of technology provided the basis for scientific methods of budgeting and accounting. Bringing out balance sheets and other financial statements helped the Corporation in bringing out transparency. The effectiveness of the system could be judged by understanding the financial performance of the Corporation. The financial year 2003-04 began with an opening balance of Rs. 41.69 crore and ended with a closing balance of Rs. 36.58 crore. Property tax collection rose to Rs. 198 crores from Rs. 113 crores in 1999-00. Revenues under Building License fees showed an increase of nearly 135% as compared to the previous year. However the collections under stamp duty reduced and were attributed to the amendment passed in the Stamp Paper Act on levy of surcharge. Rents from shops and markets improved marginally and the overall receipts increased by nearly Rs. 25 crores to close the year 2003-04 at Rs. 648 crores. Though expenditures on salary and garbage outsourcing showed an increase they were within the budgetary estimates. Cost of interest payments was sought to be kept low by enforcing a policy of drawing of loans strictly based on physical progress of the work Exhibits II, III and IV show annual reports for the three years 2002-03, 2003-04, 2004-05 (half yearly). As the year 2004-05 was to close officials were optimistic of surpassing the performance of the previous year.
Cases In Management
Page 44
Cases In Management
Page 45
Cases In Management
Page 46
Cases In Management
Page 47
Cases In Management
Page 48
Exhibit IV BALANCE SHEET as on 30/09/2004 As on 30-09-2004 Funds Accounting Group Long Term Debt Memor andum Total As on 30/09/2003
Govern mental
Enter prise
Fidu ciary
Total
Fixed Assets
Total
LIABILITIES 1,490.8 3 245,1 35.05 279. 69 246,9 05.58 246,90 5.58 251,4 25.70
Fund Balance
35,1 63.4 3
35,16 3.43
35,163. 43
26,40 9.25
Current Liabilities and Provisions 5,524.5 9 2,442.9 8 13,091. 37 21,058. 95 Cases In Management 5,551 .80 2,529 .91 13,09 1.37 21,17 3.09 5,551.8 0 2,529.9 1 13,091. 37 21,173. 09 4,752 .76 1,978 .83 8,616 .98 15,34 8.57 Page 49
Current Liabilities
27.21
Deposits
86.92
Provisions
114.1 4
71.32
71.32
71.32
3.54
70,170 .42
70,17 0.42
70,170. 42
40,23 9.96
Total
22,549. 78
245,3 20.51
279. 69
268,1 49.98
70,170 .42
35,1 63.4 3
105,3 33.85
373,48 3.84
333,4 27.02
ASSETS Fixed Assets 68,46 0.82 267. 71 68,72 8.54 5,944. 18 53,296 .87 8,294. 45 2,483. 05 5,944 .18 53,29 6.87 8,294 .45 2,483 .05 151.8 7 70,17 0.42 74,672. 72 53,296. 87 183,81 6.09 2,489.4 4 72,29 2.56 30,78 7.36 180,0 79.68 1,056 .65
Buildings
Infrastructure Assets
Lands
175,5 21.64
175,5 21.64
Other Assets
6.39
6.39
Vehicles
151.87
151.87
76.87
243,9 88.85
267. 71
244,2 56.57
70,170 .42
314,42 6.99
284,2 93.13
Cases In Management
Page 50
86.41
86.41
86.41
105.0 0
Current Assets 178.8 6 7,969 .65 1,033 .10 1,462 .71 10,64 4.31 358.8 6 8,615 .15 3,514 .30 1,510 .80 13,99 9.12
Inventory
178.86
178.86
Receivables
7,558.2 0
411.4 5 920.2 1
100.91
11.9 8
1,462.7 1 9,300.6 8
1,331 .66
11.9 8
71.32
71.32
71.32
3.54
35,1 63.4 3
35,16 3.43
35,163. 43
26,40 9.25
Work in Progress
13,091. 37
13,09 1.37
13,091. 37
8,616 .98
Total
22,549. 78
245,3 20.51
279. 69
268,1 49.98
70,170 .42
35,1 63.4 3
105,3 33.85
373,48 3.84
333,4 27.02
Cases In Management
Page 51
State Govt.
Lenders
Revenue
Infrastructure
SWM Engineering
Education
Citizen
Elected Rep
Cases In Management
Page 52
Intermediaries
BMP Employee
BMP Admin
Media
FBAS
Citizens
State Government
Advocacy Gaps
Elected Reps
Cases In Management
Page 53
Cases In Management
Page 54
be elected by a direct election. However the boundaries of the cities remained the same as demarcated under the GLC. The 32 boroughs of London and the London City Corporation form a regional tier of Corporation and they are responsible for services like education, solid waste management, housing and local planning. The boroughs are effectively independent of the GLA.
Londons Economy
Londons economy was worth more than $160 billion. It was higher than counties like Finland and Portugal. It accounted for nearly a fifth of the total GDP of UK. The extent of Londons contribution could be gauged that its per capita GDP was nearly 25% higher than the per capita GDP for the rest of UK. For almost fifty years since 1945, the growth rates in rest of UK have been higher than London. But over the last decade or so, the growth rate in London has been exceeding the growth rate in the rest of UK. Analysts felt that this growth was not in expense of the rest of UK but was complementing and supporting growth in the rest of country. Interestingly this pattern has been witnessed even in New York. London also served as a source of demand for goods and services produced in the rest of the country. In 2003, goods and services worth more than $100 billion were imported into London from the rest of the country. Nearly 40% of these were financial and business services products while manufacturing products constituted nearly a third of imports. On the other hand, London also exported goods and services worth nearly $125 billion to the rest of the country. It accounted for nearly 10% of the total manufacturing output of Great Britain. London also provided jobs to nearly 70-80,000 people migrating from rest of the country every year. Nearly 750,000 people commute to London every day for jobs while another 250,000 commute from London to outer areas for work. London was the home to many key activities like media and entertainment, capital and financial markets, publishing, property management, telecommunications and a host of professional services. London was also the nerve center for financial activities not only in UK but across Europe. Nearly 30% of the people engaged in financial services industry worked in London. Nearly For a long time it had held the position of the financial capital of the world till it got replaced by New York. Even now the London foreign exchange market had a turnover that exceeded New York and Tokyo combined. Nearly a third of the Fortune-500 companies had their base in London to co-ordinate European operations. This was way ahead of both Paris and Frankfurt. The city was home to one of the largest bus networks in the world. The city comprised of nearly 14,000 kms of roads and more than 300 kms of underground railway lines. Heathrow Airport in London was considered to be one of the busiest while the Port of London was believed to be the largest in Europe.
under the purview of the local bodies, the GLA Act mandates the GLA to be responsible for almost all these activities in London. Surveys have shown that performance of London schools was on average higher than the rest of the country. The health services were found to be on par with cities in the other developed countries. Crime rate was low though it was slightly higher than prevalent rate in the rest of the urban areas in UK. However the access to health care is one of the poorest in UK. The emergency services were overstretched and the response was not quick. The private healthcare force attracted top professional talent. This however created an inequality since most wealthy and middle income groups shifted to private care. The lack of incentives in the government sector caused a brain drain towards private facilities affecting the performance in the government health care sector. In some public services the presence of high performance groups created in improved services. The level of services was higher in spite of the challenging circumstances in which the workers performed their duties. These poor conditions often acted as a deterrent to the workforce performance. It also resulted in high turnover rates many a times. The delivery systems of public services was often complex. They had to cater to varying segments of society which of which had their own distinct features. There were also complaints of services being misused by sections of the population. In spite of these circumstances analysts have opined that London was much better prepared in handling emergency crises than many other cities across Europe. Studies have also found that there were linkages between the deprivation of service, income levels, and poverty and crime rates. The diversity which London was known for was believed to act as a hindrance at times for delivery of services. It created communication barriers between the providers and the recipients owing to language problem. Lack of awareness of services provided also acted as a barrier. The diversity of the workforce while creating a potential for high performance in some segments also created conditions for lack of cohesion. This lack of cohesion across communities resulted in lower productivity. The differences in lifestyles attitudes and the culture and faith also played a role in shaping the responses of the citizens to various services being provided by the city. These often resulted in difficulties in policing as intelligence and data gathering became difficult and also the historical prejudices that were known to affect the British society at large. Some of the communities remained backward owing to lack of access to education facilities. It also resulted in higher costs in provision of services by catering to these diverse segments. Generic campaigns were found to be somewhat ineffective and customized campaigns provided logistical problems. Few experts believe that different ethnic groups are prone to certain diseases. Drug usage is also high an adds to the problem. In the education sector, people of certain ethnic groups perform better than certain other groups. This has resulted in imbalance among the educational qualifications among different sections of the society. Ethnic groups also have a fear of insecurity. They have to be provided effective protection. This adds pressure on the local police force. The diverse population of London seems to have made the task of the police force more difficult. Certain groups like asylum Cases In Management Page 56
seekers and migrants are more vulnerable to crime and they are also being increasingly drawn in the criminal networks. London, as seen above, witness a large number of commuters who visit the city daily for work. Even many local residents have to commute from one part to another. This places a burden on the transport services. Apart from the labor force, students commute around the city to attend schools and colleges. Migrants who seek temporary accommodation in London also use the London transport system to commute to their places to work and for other essential needs. There are also fears about the impact the mobility would have on the performance of the students. Most of the time is spent in commuting and this deprives valuable time that could be used for studies. Mobility also seemed to have made community-police relations difficult since the authorities find it tough to build a long relationship with the communities. There also internal problems for the public services. Though the public sector attracts good and highly skilled talent, the lure of the private sector causes retention problems. Public services account for high turnover and vacancies are higher compared to the private sector in similar activities. Turnover rate in nurses was around 20%, in police force it was around 10%. Nearly 10% of the teachers were not qualified to required need. There was also pay disparity among the workforce in the public services. While the private sector employees earned an average gross weekly pay of around 700 pounds, the corresponding average in the public sector was only 500 pounds. However for the female workforce the disparity was much less and the public services maintained gender equity as far as pay was concerned. The bureaucracy, working conditions particularly in deprived areas, low wages, language barriers in attending to various ethnic communities, fear of crime, seemed to be acting as a deterrent to work force in Londons public services.
Responding to Challenges
The Mayor of London Ken Livingston introduced the scheme of congestion tax. The aim of the tax was to reduce congestion in the city. The scheme came into effect in February 2003. Vehicles entering the central part of London on weekdays were required to pay a tax of $5 per day. Bicycles, mopeds and motorbikes were exempted. Some other vehicles were eligible for discount. The discount and exemptions were provided on the basis of their meeting strict environmental criteria. More than 150 check points were set up to monitor the vehicles that entered and left the congestion zone. Penalties were imposed on evaders. Traffic congestion and journey times reduced significantly both inside and outside the zone. While the average speed in the zone was around 8 miles per hour in 2002, it had increased to nearly 11 miles per hour by 2005. Traffic congestion fell by 40% against targeted 25%. Journey times fell more than 10%. The revenues surpassed the targets every year. The congestion tax became the focal point of the transport strategy for London. Londons bus transport system was dominated by private players who were unregulated. Fares were high. The city government regulated the private operators. Prices fell down and passenger growth picked up by 7% in 2003 within the year of regulation. London operated highest passenger mileage in almost 40 years. The revenues in 2003 were also the highest in more than 40 years. The city managers felt that the presence of policeman itself can often deter crime. It found that people were ready to pay for having more policemen on the streets. It was also felt that this would Cases In Management Page 57
act to strengthen the relationship between police officers and the communities. London increased its police force to nearly 30,000 by 2004 and expected to increase it further.
Cases In Management
Page 58
The City
South Africa underwent a transition from apartheid regime to democracy in the early 1990s. Led by Nelson Mandela was considered an idol, ANC started its programmes that aimed at uplifting the nations black majority. The community had been impoverished and suffered during the apartheid regime that had lasted for more than 100 years. Johannesburg was home to various races, ethnicities and nationalities. It was believed that distribution of income was highly uneven across the different communities in the city. Crime rates were high and experts warned that this conflict could lead to undermining of local democracy and peace. There were multiple sources of authority in the city of Johannesburg. Till 1995, the city was ruled by 13 different authorities with differing capacities and often overlapping powers and functions. The system resulted in imbalances in allocation and delivery of services to the residents accentuated by rapid urbanization. In 1995, the system was overhauled to make it a two tier structure. It was to comprise GJMC and four local metropolitan councils (MLCs). This authority was to be replaced by a unicity authority by the end of 2001. ANC which was the ruling party supported this initiative to meet it objective of one city, one tax base. Though was ANC was reelected in the Presidency, the priorities seemed to undergo a change with a greater focus on delivery. The changes in the functioning of the government were thought to contribute to the problem. Though each MLC and GJMC had its own budget and was responsible for its implementation, it was felt that it was as good as having one budget. However each council had its own tax structure and tax base. It seemed too many that it was an attempt to slowly integrate different races and ethnicities into an unified structure. However the political contest between the councils over tax allocation and collection caused divisions among the local councils. There was also lack of clarity among the roles responsibility and accountability of the different bodies. In late 1997, the city officials appointed a team of consultants to study the problem and suggest the remedies. The primary focus of the team was to review the process of urbanization and the
35 Asst. Professor Economics & Public Policy, IBA Bangalore
Cases In Management
Page 59
accompanying problems like housing, public transport, environment, infrastructure development activities etc. It studied the functions of the various different departments including the Mayors office. The report criticized the structure of the local body, the mode of operation and concentration on non core activities as the core problems facing the city. It reported extensive duplication and lack of prioritization among the city officials. It classified the functions into asset based, agency based and others. Asset based functions included local public transport, gas, electricity, water supply, sanitation and sewerage, fresh produce markets, cemeteries, beer halls, sports facilities, parking lots etc. Agency functions comprised of housing social welfare and ambulance services. The rest of the functions included museums, maintaining zoological and botanical gardens etc. Even though the review was on it was becoming evident that the city was coming under financial strain. By early 1998, it owed 3 months of dues to the local power company. It recorded a deficit of R338 million. In what was seen as an insult to injury, it had to use an overdraft of R400 million to pay punitive interest rates on overdrafts and call bonds. The city administration had to take some steps to control the situation. The urgency to solve the crisis became more apparent due to the fact that Johannesburg was the richest local body in the country. The central government also saw it as an opportunity to reform the local bodies across the country.
Cases In Management
Page 60
The central government also reduced its grants to the local bodies which seemed to make things worse.
Cases In Management
Page 61
iGoli 2002 It was a three year plan which thought as a solution to address the institutional, financial and service delivery problems affecting the city. It called for creation of a unicity structure. As a consultancy report put it36: It introduces the unicity concept by transforming local government through changed governance, financial viability, institutional transformation, sustainable development and enhanced delivery iGoli 2002 had acquired deep significance in the debate over the future of Johannesburg both within the ANC and outside. According to the City Mayor37: iGoli 2002 is an innovative transformation and development plan with primary goal of effective, efficient and sustainable democratic governance ensuring stimulation of socio-economic investment opportunities which have local provincial, national and international significance But it resulted in a strong debate across the city and the country. The left wing which was dominant and felt threatened argued that it resulted in bowing before the market forces. They further questioned the need for privatizing the services. Most experts felt that the debate was more on the nature of proposals formulated by iGoli 2002 rather than the need for the restructuring the city. What iGoli 2002 Proposes? The first step in the process was the proposal to create a unicity structure. The proposal envisaged creation of a political body with functional and management independence. The utilities and corporatized entities were to be delinked from the centralized administrative processes. The creation of the new body involved notification of the council, demarcation of wards, elections to the council followed by the constitution of the metropolitan Council which would ten constitute, sub committees, ward committees etc. It envisaged creation of 10 companies that would run Johannesburgs utilities autonomously. The units would be run on business lines rather than the government lines. The councilors would not constitute more than 20% of the board that would be formed to run the companies. It also sought to keep the role of trade unions minimum. The plan identified half the functions of the new structure as utilities of agencies. Nearly 20% of those functions were to be corporatized and the balance to be run as under the existing arrangements. Proponents of the plan stressed this fact the only 10% of the functions were to be corporatized and these mostly comprised the non-core functions of the body. The administration was also to be divided into eleven regional administrations with one core. Public utilities were to be created to manage the water supply and sanitation, electricity and solid waste management. It further proposed to create separate agencies for constructing and maintaining roads, storm water drains parks and cemeteries. These agencies were to be arm length agencies and the aim of the council was to create conditions for entry of private sector into these
36Prem Govender and James Aiello Johannesburgs Strategic Plan for Municipal Services Partnerships, Development South Africa, Summer 1999 37Mogase, I, Message from the City Mayor in GJMC 1999, iGoli 2002: Making the City Work, 1999
Cases In Management
Page 62
activities. All these utilities and agencies would be corporatized and run as companies. However they would remain the ownership of the Metropolitan Council. The corporatized units would enjoy autonomy in their functions. They had to raise revenues to meet their costs. In case of shortfall there was a provision of the government stepping in and providing the grants. This was however to be in exceptional circumstances. The city council would normally act as a client to these utilities. The other entities that were to be corporatized included the city zoos and the Civic Theatre. Functions like managing Metro gas, Rand Airport, fresh produce market and the Sports Stadium were to be sold off the private parties. Supporters of privatization argued these activities constituted only 3% of total activities undertaken by the Metropolitan Council. They argued further that the money raised by selling off these units could be utilized to develop and strengthen the other units that were being corporatized. Critics however argued that the process was largely driven by the City Manager and his team advised by the donor agencies. Consultations outside this group seemed minimal. The information technology division had been outsourced in the past but experts felt that it had not yielded desired results. The new plan was to keep the core with the administration while the ancillary activities
Though the administrators could not secure a total support on the iGoli 2002, SAWMU did give tacit support on some of the issues. Observers believed that the dues owned by the users of the utilities to the government were the primary factor that led to the crisis. According to estimates, by 1999, nearly R2.1 billion was owed by the consumers to the government. The basic premise of the new plan was the restructuring of the utilities and the pricing mechanisms would make consumers pay their dues in a prompt manner. However a section of citizens particularly the affluent classes were believed to be unhappy at the cross subsidization proposed in the pricing structure. This section believed that the utility providers lacked in accountability and transparency. They held that the quality of service provided did not measure upto the tariffs charged. The poorer sections could not afford to pay even the subsidized rates in some cases. Another problem that was haunting the service providers was the nature of logistics involved in providing services to a large scale of population. By the late 1990s, more than 150,000 households did not have a metered connection for water supply. This was causing a great loss to the council. Political constraints were believed to be a difficulty in regularizing the connections. Analysts however suggested the adoption of innovative measures like staggered payment of dues to solve the problem. The plan also came in for some criticism from the environmentalists. Supporters however argued that the plan advocated the efficient and balanced use of resources and took care of environmental concerns. The termination of illegal water and electricity connections was thought to help saving of water and electricity. The plan also called for stricter environmental supervision and stringent measures. Critics believed that the major aim of the plan was to please the financial community and the international agencies on which the city depended for its finances. Though few supported the criticism, they felt that it helped identification of revenues streams and the utilization of the revenues. There had been no linkage between the revenue and the expenditure. This plan was thought to bring about the linkages between the two. The staff and officials of the city government had to trained and motivated. It was felt there was lack of trained staff and often their responsibilities overlapped. It was felt that demarcation of responsibilities and prioritization of functions had to be taken up for smoother implementation.
Cases In Management
Page 64
Functions of ULBs
The functions of the corporation can be classified into core functions, environment management function, planning functions, agency functions and governance functions (Kulwant Singh, Issues and Trends in Decentralization) The core functions constituted the first charge on the city corporation and these included basic amenities like providing of water supply and sewerage, solid waste management, construction and maintenance of roads and streetlights, recording and maintaining of vital statistics like births and deaths etc, providing of urban amenities like schools, playgrounds, parks, gardens, libraries etc. The environment management functions included promotion of urban forestry and environmental measures in the city. Agency functions were undertaken as an agent of the state and included firefighting services etc. The planning functions included slum development, rehabilitation, providing shelter etc. it also involved functions relation to protection of weaker sections of society.Governance functions involved the discharge of functions as the statutory body of the government. The functions are statutorily classified as Obligatory functions and discretionary functions. While the bodies are obliged to discharge functions listed under obligatory list, they are within their discretion to undertake the functions under discretionary category. Generally the core functions come under the purview of obligatory functions. The planning functions fall usually under discretionary mechanism. The functions relating to environmental
38 Asst. Professor Economics & Public Policy, IBA Bangalore
Cases In Management
Page 65
management fall under discretionary category. Most of the planning functions are under discretionary list while the agency functions by its name suggest it is discretionary. Local bodies need resources to manage these functions. While in many cases it has been an indirect form, experts have felt that market mechanism could be introduced while discharging the functions that fall under the ambit of discretionary functions.
A cause of concern is the decline of service charges levied for providing various services like infrastructure and parking lots, storm water drains etc. these have fallen by Rs 1000 lakhs between 2002-03 and 2004-05. The mechanism is moving towards loans from bodies like HUDCO and KUIDFC which have nearly doubled.
and in some cases to generate a surplus. This would be beneficial because if the corporation could generate surplus in these activities it could reduce taxes. Taxes are involuntary and are independent of the services used, these new measure would bring make the revenues earned directly dependent on services offered.
Cases In Management
Page 68
9. Information systems in urban governance: Bangalores tryst with MIS as strategic tool
Mr. Prashant Kulkarni39 By the early years of the 21st century, Bangalore had turned into the fifth largest city in India. It had become the preferred location for many companies particularly in the IT and biotech sector. Many MNCs had located their offices in Bangalore and they included GE, Oracle, IBM, Cisco etc. Many Indian stars like Infosys, Wipro, and Biocon had their base in Bangalore. The city was also known for its high standards in education and a number of premier educational institutes like Indian Institute of Management (IIM), Indian Institute of Science (IISc) and a host of engineering, medical and business schools were located in the city. Consequent to this spurt in economic activities the city was witnessing a strong growth in its population. Added to the resident population of nearly five million, it boasted of an equally large floating population. This was putting severe pressure on the city managers. The city was being governed by the Bangalore Mahanagar Palike (BMP) under the Karnataka Municipalities Act (1976). It was established in 1949 and was spread over an area of 225 sq. kms. The Corporation was responsible for maintaining the City services. These functions were usually classified into core functions, agency functions, environmental functions and governance functions. Essential management functions constituted the first charge on the Municipalities. They included functions such as erection of boundary marks, construction and maintenance of roads and streets, provision of public amenities like gardens, parks and playgrounds, maintaining schools, maintaining of vital statistics like births and deaths, provision for collection, disposal, and treatment of garbage and solid waste, water supply and sanitation, maintenance of street lights etc. Environmental management functions included protection of environment, promotion of urban forestry etc. and were undertaken usually in co-ordination with the State Government. The Planning functions were usually taken up at the State level but implementation was done at the local level. These functions included slum upgradation and improvement, rehabilitation of the mentally and physically handicapped, protection and welfare of weaker sections of society etc. Agency functions like firefighting services, public transport, and electricity supply were undertaken by the ULB as an agent of the State Government. BMP however did not undertake any of these agency functions. The governance functions were the ones mandated under law as the representative government of the city.
Cases In Management
Page 69
provide information to various stakeholders like corporators, corporation officials, state governments, media, citizens etc. This needed there should be classification of essentials and non essentials. Certain activities were confined only to the respective departments and would not have an impact on other activities. These non finance activities had to be left out of the core budget making and preparation of financial statements. Integrating the different departments was undertaken. The functions of the corporation were being undertaken manually. The growing size and the functions created a necessity of having an advanced information mechanism. There was a delay in the conversion of data into information and then in using that information in planning for the future. This necessitated the need to modernize the Management Information System (MIS). It was not as if MIS did not exist previously. What was done was to improvise the existing MIS and bring it on par with the modern technological changes.
Elements of MIS
The earlier system of MIS was event based. The transactions were recorded based on the event. An instance could be given of the tax collection. Previously, tax collection was viewed in comparison to the past year. If suppose Rs. 10 lakhs were collected in the previous year and this year the tax collection was Rs 15 lakhs it would record that tax collection had increased by 50% which would claim to represent a healthy achievement. But it would not be the case if looked from the point of demand vs. collection. This necessitated the transition to the activity based system. In the new system, tax collection would be viewed as percentage of demand. If the tax base was Rs 50 lakhs and Rs 10 lakhs was collected, it was seen as 20% collection. If the tax collection was Rs 15 lakhs the next year in comparison to demand of Rs 100 lakhs, it amounted to collection of 15% down by 5% from last time. Earlier this would have been projected as an increase of 50%. This made the comparison of revenues and expenditure more reliable. Effective functioning of MIS required providing of timely, structures and accurate information. People had to be trained to use these systems. The first component in the MIS element was providing timely information. This was done by computerizing the whole set up. This facilitated access of records easily and the records could be stored more efficiently than the cumbersome storage in files. But this was only part of the story. These records would be redundant if there was no mechanism to separate the chaff from the grain. It called for creating structure for storage of information. The information may be available timely but would be rendered useless if it cannot be retrieved. This led to the development of a structure that provided for easy retrieval of information. The software was customized to suit each department. Only the information pertaining to financials was transmitted to the financial department for further action .the rest of the information was maintained in the respective department. This information could be however be sought by the financial department as supplementing of the financial information. These records would have to be verified and only the verified data was accepted by the financial department. This verification ensured in accuracy of data. The information thus generated was integrated with both event and activity creating a holistic picture of financial health of the urban body.
Cases In Management
Page 70
Impact
The system helped in setting up more efficient indicators for measuring the performance of various departments, projects and personnel. It sought to create a system that helped in bringing greater transparency in the system. It was in line with alignment with the international standards. Prior to the introduction of the system, the information flow time to the finance department was 48 days. Work was decentralized. Daily Reports (TL-2) were possible. Review of the activities could be undertaken more easily with the publishing of Budget Variance Report (BV1). Liability position of each project and asset position vis a vis the target for collection was possible. Classification of entries under accounts was made more scientific. More importantly it also facilitated easier verification of records. Real time knowledge of revenue position helped the officials compare the collection vs. target position easy. Revenue analysis could now be done even at ward level. A single data source of information was created. It streamlined the works in the engineering department. It had the largest allocation among all departments. The infrastructure projects of the BMP were undertaken through this department. The system made a provision for a report on Works Liability Registers vs. Bill Registers. Real time liability position was available to the top officials and this helped them decide on the future allocations. The system introduced a coding system for tracking the works. Payments to the contractors were made only on the production of the work code. This gave the department complete control over the works being executed. While in the previous system, the disbursement occurred based on the cost of the project without assessing the actual need of the project, the new system provided for reviewing the past performance while allocating fresh amount. If there underutilization in the earlier years, the allocation would be cut down accordingly and the project managers had to spend the unutilized amount before they get fresh allocations. This allocation based on activity rather than a pure statistical event created a potential for savings and helped in better planning for expenditure and revenue for the next year. The proper interpretation of the indicators was also handy in deciding the tax base. If the ULB finds that is can raise revenues or undertake savings in expenditure it could even result in lower tax rates thus benefiting the common man. This also introduces scientific methods of determining the tax rates for the future years.
Cases In Management
Page 71
Company background
Two first generation entrepreneurs, Subash Menon and Alex J Puthenchira founded the Subex group in 1992. Headquartered in Bangalore, the company had about 150 employees and had branches in US, Canada and Cyprus. The company started as a systems integrator in the areas of coverage for wireless networks and test and measurement for voice and data. Gaining substantial domain expertise in the telecom space over a span of six years and identifying the huge growth opportunity presented by telecom software applications business, the company entered this lucrative field in 1998. By mid2000, it transitioned fully into a telecom software solutions player. The company provided telecom companies with tools to maximize revenues and software consultancy. It had a revenue maximization suite called Rev Max that comprised of two productsRanger, which was a telecom fraud management system, and INcharge, which was a revenue assurance system (See Exhibit 1). In January 2000, the company acquired IV Generation, Inc. of New Jersey, USA and converted the same into a wholly owned subsidiary called Subex Technologies Inc. In May 2001, Subex acquired the product line of Magardi Inc. of Canada. The products include OUTsmart (was later merged with Ranger) and INcharge. AT&T was the biggest international client, while others included France Telecom, Vodafone, and Connex etc. In the domestic market, they served almost all players including Hutch, Reliance, and Bharti etc. Revenue had touched Rs89.13crores for 2003-04, up 27 percent on the previous year and net profit stood at Rs17.75crores, up 78 percent over the previous year. The products business grew sharply by 60 percent thereby accounting for nearly 45 percent of the revenues. Product revenue as a percentage of the total revenue was 45 percent during the fiscal year 2003-04, compared to 36 percent in 2002-03 and 30 percent in 2001-02. See Exhibit 2 for segmental reporting for 2003-04. Subex went public in 1999 and by 2004 shares was listed in Mumbai, Hyderabad, Bangalore and the National Stock Exchanges.
40 Program head Manipal Universal learning, Bangalore 41 Asst. Professor Economics & Public Policy, IBA Bangalore
Cases In Management
Page 72
Investments
Telecom products took about 15-18 months for the launch of commercial version from the time the product was conceptualized in the board rooms. After the launch, it took another 8 to 10 months before the company could bag a commercial contract. This required investments to be made in development, sales and marketing over a span of two years. About 20 percent of the costs in the product development stage were associated with development and the balance 80 percent in sales and marketing costs. Apart from creating software products like RevMax, the company also went in for acquisitions. The two main acquisitions were:
42 www.sme.nasscom.org
Cases In Management
Page 73
a. In January 2000, the Company acquired IVth Generation, Inc. New Jersey, USA, which used to provide turnkey project development, services to American telecom companies for Rs33.6crores. Roughly Rs19.79crores was paid in the year of acquisition and the balance was paid in next three years, as per the terms of the agreement. The balance amount was reported as Deferred Consideration payable under unsecured loans. b. In May 2001, the Company acquired the intellectual property rights (IPR) comprising software codes and licenses of OUTsmart, a Wireline Fraud Management System and INcharge an intercarrier billing verification system from Marardi, Inc. of Canada for Rs15.89crores. Nearly Rs11.56crores was paid in 2001 and the remaining was paid in the next two years and was reported as Deferred Consideration payable under unsecured loans. The debtors collection period stood at 210 days as on March 31, 2003 which was much higher than the industry average of 120-150 days. As on 31st March 2003 the net working capital stood at Rs50.4crores much larger than the investment in strategic investments and fixed assets.
Financing needs
The company had been raising capital in various form equity, debt and hybrid instruments to meet its growing capital requirements. The company raised Rs32.10crores in 1999, Rs7.281crores through initial public offerings (IPO) when it issued 9,71,000 equity shares at premium of Rs65 per share and Rs24.81crores by issuing 3,30,800 equity shares at a premium of Rs740 per share to Mutual funds and Bodies Corporate on a preferential basis. During 2002-03, the company, in order to raise money for its product development efforts and repayment of deferred payments on acquisitions, had placed Redeemable Optionally Convertible Cumulative Preference Shares (ROCCPS), 15.71lakh preference shares with strategic investors Intel Capital and UTI Venture Funds at Rs88 premium per share. The preference shares carried dividend of 12.5 percent payable semiannually with an option to convert their preference shares into equity shares of the company at 1:1 ratio during six month period of April 1, 2004 to September30, 2004. In case of preference shareholders not opting for the option of conversion during the stipulated period, preference shares were to be redeemed in three years period. With the same above terms 2.13 lakh preference shares were also issued to Toronto Dominion Bank but with a premium of Rs90 per share. The total amount raised was Rs17.52crores. Upon conversion the shareholding pattern for the company is shown in Exhibit VI. The Capital History of the Company is displayed under Exhibit VII The debt to equity (defined as Total liabilities/Equity) had been fluctuating as shown in Table 1 Table 1 1998 1999 2000 2001 2002 2003 2004 Year Debt to Equity 1.96 2.14 0.57 0.38 0.70 0.58
Future outlook
According to SubashMenon, president and chief executive officer: We now have two promising products-one of which is expected to attain the largest installed base globally during financial year 2005 while the other is gathering momentum in its march towards a similar position Cases In Management Page 74
within the next 2 to 3 years. The company has set a target of becoming a $50 million company by 2007. The company expects revenue from products to grow by about 30-35 percent, while the services business is tipped to grow by 7-10 percent, leading to the overall top line growth of 15-20 percent. Profits after tax are expected to grow by 25-30 percent. The software telecom products would contribute around 70-80 percent of total revenues in the next three years43. Exhibit VIII-A to VIII-D show the graphical representation of performance of key indicators of Subex Systems Ltd. Select Financial Data under Stock and Debt Financing (2004)(in Rs. Millions) Stock Shareholder Equity Debt Capital Interest Payments Principal Payments No. of outstanding shares (million) Dividend payments (in Rs.) Debt
1475 800 168 843 14.30 68.3 56 140.4 32.12 25.17 33.12 25.17
Assumptions
Only two types of financing available- Debt and Equity to raise $ 15 million (15*45 Rs/$=Rs.675 m) Equity to be raised @ Rs.100 per share Tax rate applicable for firm is 25%. All ROCCP to be converted into equity. Cost of debt is 8% for period of 8 years. Existing debt to be repaid in 3 years time. The company wants to maintain dividend ratio of Re 1 per share
Cases In Management
Page 75
4. Discuss how the stock price of the company would react on announcement of raising debt and equity. ( Hint: Market Signaling, Timing of Issue, Asymmetric Information) 5. The cost of debt Kd =8.5%, cost of equity Ke=17% (Risk free return Rf =7%, Beta b= 1.54, Market risk premium 6.5%). Cost of debt is much lower compared to cost of equity, hence it makes sense to raise capital through debt Comment. 6. Discuss the issue of control (ownership) and agency problems associated with capital structure decisions. Exhibit I Product Range of Subex The product range comprised of three products 1. Ranger - Fraud Management System 2. INcharge - Revenue Assurance Solution 3. The RevMax suite- combination of the above two The RevMax suite Ranger - Fraud Management System Ranger is an end-to-end Fraud Management System (FMS) for wireless and wireline networks that has been designed specifically to address fraud in roaming, pre-paid and post-paid environments. Ranger accepts input from data sources like IPDR, CDR, subscriber information, information from the IN platform etc, thus enabling it to address fraud detection in the emerging areas like GPRS and other 3G technologies. More on Ranger INcharge - Revenue Assurance Solution Subex'sINcharge is a Revenue Assurance solution that enables the revenue assurance department to fully support the carriers expanding product portfolio, subscribers, interconnect partners and traffic volumes. The flexible modules are designed to identify and address issues such as unbilled subscriber usage, overpayment of interconnect charges and discrepancies between multiple OSS in order to provide the carrier with an overall view into the revenue leaks that are occurring within the network.
Source: www.subex.com
Cases In Management
Page 76
Exhibit II Segment Reporting of Subex Systems Ltd. Particulars of Segment Assets And Liabilities (in Rs. Million)
Products 2003-04 Segment Assets 421,052, 294 2002-03 272,541, 563 Services 2003-04 175,186, 913 2002-03 127,336, 266 Unallocable 2003-04 151,669, 562 76,628,4 61 2002-03 260,532, 032 66,552,2 95 Consolidated 2003-04 747,908, 769 76,628,4 71 2002-03 660,409, 861 66,552,2 95
337,849, 666 Unallocable Liabilities Include Loans Secured 147,203, 061 1,748,50 8 18,883,6 19 40,077,1 36 Tax 1,570,00 0 209,482, 324
337,264, 024
300,542, 718
Cases In Management
Page 77
Exhibit III Income Statement Subex Systems Ltd. (in Rs. Million) 0403-(12) 0303-(12) 0203-(12) 0103-(12) 0003-(12) Income Operating Income 879.25 700.10 591.83 552.38 312.14 Expenses Material Consumed Manufacturing Expenses Personnel Expenses Selling Expenses Administrative Expenses Expenses Capitalized Cost Of Sales Operating Profit Other Recurring Income Adjusted PBDIT Financial Expenses Depreciation Other Write offs Adjusted PBT Tax Charges Adjusted PAT Non Recurring Items Other Non Cash adjustments Reported Net Profit
15.64 2.38 522.86 13.60 64.52 0.00 618.99 260.26 9.15 269.41 14.30 41.20 1.47 212.43 14.67 197.76 -26.92 6.66 177.50
2.65 2.10 473.42 7.19 49.55 0.00 534.91 165.19 4.10 169.29 22.46 36.50 1.47 108.85 5.31 103.53 -9.31 1.90 96.44
1.34 6.39 417.51 6.07 64.54 0.00 495.85 95.98 0.64 96.61 12.08 34.20 1.47 48.86 3.20 45.66 -0.95 -2.87 44.72
53.01 1.39 338.89 3.40 32.08 0.00 428.77 123.61 4.98 128.59 3.72 19.33 1.47 104.07 0.06 104.01 -0.12 -1.11 103.88 109.41 14.25 0.00 93.70
126.70 1.16 97.70 1.62 22.78 0.00 249.96 62.18 3.64 65.82 5.60 2.54 1.23 56.45 6.00 50.45 -0.19 0.00 50.26 59.54 11.48 0.00 46.63
Earnings Before Appropriation 315.20 148.04 60.54 Equity Dividend 14.71 7.34 7.13 Preference Dividend 22.65 0.05 0.00 Retained Earnings 273.05 139.69 53.42 Source:www.indiainfoline.com
Cases In Management
Page 78
Balance Sheet of Subex Systems Ltd. (Rs. Millions) 0403-(12) 0303-(12) 0203-(12) 0103-(12) 0003-(12) SOURCES OF FUNDS Owner's Fund Equity Share Capital 73.54 73.44 71.26 71.26 35.62 Share Application Money 0.24 0.00 0.00 0.00 0.00 Preference Share Capital 184.93 153.88 0.00 0.00 0.00 Reserves & Surplus 403.26 458.01 421.82 369.05 540.94 Loan Funds Secured Loans Unsecured Loans Total USES OF FUNDS Fixed Assets Gross Block Less : Revaluation Reserve Less : Accumulated Depreciation Net Block Capital Work-in-progress Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written Total Book Value of Unquoted Investments Market Value of Quoted Investments Contingent liabilities Number of Equity shares outstanding 166.09 1.75 967.49 240.24 43.08 913.90 269.16 35.48 833.91 130.09 0.00 623.17 128.52 0.00 533.19
209.17 0.00 119.95 89.22 0.44 326.90 670.99 120.33 550.67 0.26 967.49 326.90 0.00
161.56 0.00 83.72 77.84 0.00 328.69 589.42 83.78 505.64 1.73 913.90 328.69 0.00
163.77 0.00 54.28 109.50 0.03 330.18 294.29 62.26 232.03 162.16 833.90 330.18 0.00
109.76 0.00 24.32 85.44 0.06 326.22 262.98 56.21 206.76 4.68 623.16 326.22 0.00 0.30 7,125,680. 00
46.55 0.00 5.73 40.82 4.19 337.20 257.91 111.79 146.11 4.87 533.19 337.20 0.00 2.24 3,562,840. 00
Cases In Management
Page 79
Profit Before Tax Depreciation P and L On Sale Of Assets Interest Income Interest Paid Net Interest Net Assets Written Off Provision And WO Net Provisions For Bad Debts NPA Trade And Other Receivables Inventories Trade Payables Direct Taxes Paid Loan And Advances Other Operating Activity Net Cash Flow-Operating Activity Purchase Of Fixed Assets Sale Of Fixed Assets Sale Of Investments Acquisition Of Companies Interest Received Dividend Received Inves Activity Others From Investment Activity Net Cash Used In Investing Activity Proceeds From Issue Of Equity Capital Proceed From Issue Of Cap. Incl. Sh. Prem. Proceed from bank Borrowings -50.15 31.82 Proceed from other. L Term 0.00 0.00 Borrowing Repayment Of Borrowings 0.00 0.00 Dividend Paid -21.05 -7.00 Interest Paid -12.63 -22.16 Others From Fin Activity 0.00 0.00 Of Short Term Borrowings 0.00 0.00 Net Cash Used in Fin. Activity -51.69 175.36 Net Inc/Dec In Cash And Equivalent -128.75 143.53 Cash And Equivalent Begin of Year 162.36 18.83 Cash And Equivalent End Of Year 33.61 162.36 Source:www.indiainfoline.com
0403(12) 189.05 42.68 -0.20 -1.68 14.30 0.00 1.27 0.00 0.00 -196.39 0.06 10.05 -12.03 -8.10 1.58 40.58 -55.39 1.31 0.00 -65.34 0.00 0.00 1.78 -117.64 32.14 0.00
0303(12) 101.75 37.98 -0.51 -0.30 22.46 0.00 1.10 0.00 3.47 -166.15 2.63 20.81 -1.80 3.97 -0.20 25.21 -8.96 3.56 0.00 -53.14 0.00 0.00 1.50 -57.04 172.69 0.00
0203(12) 47.92 35.68 -0.12 -0.51 12.08 0.00 0.99 0.00 20.57 -78.13 0.88 -18.73 -6.07 5.98 1.08 21.61 -59.84 0.74 0.00 -115.65 0.00 0.00 -3.96 -178.71 0.00 0.00 165.61 0.00 -5.30 -15.70 -11.56 0.00 0.00 133.04 -24.06 42.89 18.83
0103(12) 103.94 20.80 0.00 -4.98 2.16 0.00 0.65 0.00 0.00 -10.09 11.65 -49.32 -1.14 -18.77 1.30 56.21 -62.85 2.39 1.40 7.97 0.00 0.14 0.00 -50.95 0.03 0.00 -3.79 0.00 0.00 -12.90 2.68 -1.28 0.00 -15.27 -10.01 52.90 42.89
0003(12) 56.30 2.50 0.30 0.00 -5.40 1.80 0.00 1.20 0.00 -117.30 -2.10 50.30 -7.80 -6.50 0.00 -26.70 -27.10 0.20 0.00 -197.90 3.60 0.00 0.00 -221.20 0.00 322.10 0.00 2.70 0.00 -3.50 0.00 -6.10 -21.30 293.90 46.00 6.90 52.90
Cases In Management
Page 80
Exhibit VI Shareholding Pattern of Subex Systems Ltd. Holding Pattern as on : Face Value (in Rs.) Share Holder 30/09/2004 10.00 % No. Of Holding Shares 30/06/2004 10.00 % No. Of Holding Shares 0.00 47.59 0.00 47.59 0 4021600 0 4021600 31/03/2004 10.00 % Holding 0.00 54.69 0.00 54.69
No. Of Shares
PROMOTER'S HOLDING Foreign Promoters 0 0.00 0 Indian Promoters 4020480 43.45 4021600 Person Acting in 0 0.00 0 Concert Sub Total 4020480 43.45 4021600 NON PROMOTER'S HOLDING Institutional Investors Mutual Funds and UTI 1024677 11.07 946340 Banks Fin. Inst. and 0 0.00 0 Insurance FII's 1344038 14.53 1103279 Sub Total 2368715 25.60 2049619 Other Investors Private Corporate 219862 2.38 228744 Bodies NRI's/OCB's/Foreign 1004896 10.86 524469 Others GDR/ADR 0 0.00 0 Directors/Employees 113419 1.23 113810 Government 0 0.00 0 Others 87260 0.94 87240 Sub Total 1425437 15.41 954263 General Public 1438060 15.54 1424858 GRAND TOTAL 9252692 100.00 8450340 Source: www.indiainfoline.com
11.20 0.00 13.06 24.25 2.71 6.21 0.00 1.35 0.00 1.03 11.29 16.86 100.00
302552 0 1097048 1399600 294533 34902 0 70780 0 113842 514057 1418554 7353811
4.11 0.00 14.92 19.03 4.01 0.47 0.00 0.96 0.00 1.55 6.99 19.29 100.00
Cases In Management
Page 81
(Rs.) Jul-99 Jun-00 Mar-03 Apr-03 PUBLIC Equity BONUS PPL PPL Equity Equity Cumulative Convertible Pref. Shares Equity Equity 10 10 10 100 10 10 7.28 0 0.01 18.87 0.02 0.02
(Rs. Crore) 0.97 3.56 0 0 0 0 1.06 7.13 7.34 7.34 7.34 7.35
Source: Annual Report Subex Systems Source: Annual Report Subex Systems Ltd
Cases In Management
Page 82
References 1. 2. 3. 4. 5. 6. Subex may go for Buyout this Year, Business Standard, May 1, 2004 Annual Reports, Subex Systems Ltd. 2000-2004, www.subex.com www.indiainfoline.com www.hdfcsec.com www.sme.nasscom.org CMIE-Prowess Database
Cases In Management
Page 83
Flexibility in GAAP
The flexibility in GAAP offers considerable latitude for companies to manipulate their earnings. There are areas in GAAP which call for discretionary accruals. These relate to events and transactions which call for judgments, estimates and projections on the part of management. The fact that a number of accounting maneuvers require the exercise of judgments make it difficult, if not impossible, to judge whether the company is presenting its earnings prudently or is indulging in some manipulation. The accounting procedures being nebulous add to the freedom that companies get in presenting their accounting statements. This is often done legally and the reported earnings though different from actual earnings do not change the underlying cash flows. This subjectivity in accounting practices which has resulted in the growth of manipulation and managing of earnings has made few analysts call for a need to have more comprehensive accounting rules and procedures. This is often referred to as cookbook accounting. William Parfet, a well-known financial analyst, however
Cases In Management
Page 84
argues against this. He feels that trying to write rules that cover every eventuality and possible circumstances is bound to end as a futile exercise.
Accelerating Revenue
GAAP allows the flexibility to record higher revenues in the current quarter while allowing for certain expenses to be delayed. Richard Wayman gives the example of Global Crossing to highlight this problem. Global Crossing is a telecom company that sold long term contracts that allows other telecom companies to use its fiber routes. The payment it received for providing these services was booked as revenue in a single quarter though the service to be provided was to spread over a period of several years. On the other hand, the company also entered into contract with other telecom firms to buy capacity on their fiber routes. But this facility was spread over a period of several years thus creating small quarterly expenses over the period of contract. In short, what Global was doing was recording the revenues it earned in a single quarter while the expenses were spread out over the period of contract thus resulting in a misrepresentation of facts in the financial statement.
Delayed Expenses
GAAP provides the companies the flexibility to match the expenses with the benefits they accrue. In case of investment in machinery or a plant the company may incur expenses today whereas the benefit will be realized in the future. To match these benefits accruing in the future, companies can match the expenses incurred on these plants and equipments to the benefit accruing over the useful period of the asset. However, companies misuse this principle of delaying expenses to manage their earnings. The example one can quote is of AOL. AOL got around the rules by capitalizing on the expenses. It had produced millions of CDs and it capitalized on the expenses for producing these CDs. Though the increasing trade brought in revenue the cost of making and distributing the CDs was spread over a longer period of time. However, the regulators were successful in making AOL restate its earnings and expense the capitalization of producing the CDs over a shorter period of time.
Accelerating Expenses
Companies can boost their earnings in the markets at times by showing off miraculous recoveries from what had appeared to be in dire straights. The companies usually take a hit in a quarter by usually writing off a huge charge. Though the company may suffer in that quarter, the charge being written off at one go will enable it to show increased profits in the succeeding quarters even though the cash flows remain the same and the expenses occur. This is done broadly by writing off charge on R&D, goodwill, and the non recurring expenses.
Cases In Management
Page 85
Goodwill Charges
Another manifestation of accelerating expenses emerges in the writing off goodwill costs. This too is prevalent in mergers and acquisitions. Goodwill is paying above the book value of the asset to buy owing to the perception of the buyer that there is something extra to the asset which he intends to buy. When the company pays more than book value to buy another company they record it as goodwill in their balance sheets. They may pay more than the value for the acquisition since they may perceive value in the brand or technology they are acquiring. The accounting procedure required the companies to amortize the goodwill costs over a period of years. But the new amendment made it necessary for the companies to write off the goodwill costs at one go if the current value of the company is less than the book value of goodwill. This is known as goodwill impaired.
Cases In Management
Page 86
Intermediate Parking
The process works in the following manner. The companies, to show a much better picture of their sales or to meet their sales projections, shift their inventory from the factory to the distributors or other intermediaries. While the distributors may not be able to make a sale of those products the company can always show it as a sale since there had been physical movement of the goods. However, no economic value would have been added to the inventory. The methods used are deferred deliveries and intermediate parking. The example can be quoted of Sunbeam. In 1997 Sunbeam realized that it would fall short of the projected expectations. To overcome that it sold spare parts to a company called EPI Printers. The sale which fetched it $11 million enabled it to record a profit of $8 million. After the close of the income statement of the calendar year 1997 EPI Printers was allowed to cancel the contract. The method basically followed was intermediary parking by which the goods were shown as been sold to EPI Printers whereas in reality it was just a parking slot.
Cases In Management
Page 87
Spin-offs
The companies can spin off a subsidiary into a separate public traded entity. The major difference between a SPE and a spin-off is that the spin-off must publicly disclose its financial statements just as its parent. The example of spin-off is Dell Financial Services (DFS) entering into joint venture with Tyco to create DFS. According to the Dell Balance Sheet, DFS generated business of $2.5 billion. But since Dell, even though it owns 70% shares in DFS, claims it doesnt control it, it has managed to keep its debts off the parents balance sheet.
Securitization Transactions
Some assets like loans, credit card balances can be transferred by securitizing them. This process is known as securitization. Financial companies including banks, insurance companies, and loan associations undertake securitization of their assets as a means of risk management. These transactions are recorded as a sale in the companys financial statements and the risks associated with the transferor even after the sale are omitted from mention.
Leasing Transaction
Companies own assets to run their operations and they finance it with debt. They have to record both the asset and the debt (liability) that is associated with it. However if the company structures the same asset as a lease and records as an operating lease, then it need not report either the asset or the liability. The most interesting example here would be of an airline which used leased aircraft to report that it doesnt have any aircraft!!
Synthetic Leasing
Synthetic leasing is a method by which companies finance their acquisitions of a new plant or build a new facility and also boost their financial ratios. If the companies were to go for financing in the existing mode the cost of financing would be higher and would also affect the bottom line since it is reflected in the balance sheet. To overcome this hassle the companies go in for SPEs. Synthetic leases allow 97% financing for the new plants or facilities but allow the companies to keep it off their financial statements. The company sets up an SPE which borrows money to build the facility and then leases it out to the parent company. It is recorded as operating and hence out of purview of the balance sheet. The rent is the interest payable for financing the acquisition. The company acts as Cases In Management Page 88
owner and manager of the property assuming all risks and benefits. However, the law does state that the synthetic lease should not exceed more than seven years and at the end of the lease the company must acquire the ownership of the asset and refinance the debt.
Cases In Management
Page 89
the company was able to provide analyst and investor a deceptively positive picture of its performance. Since the charge was non-recurring the company was very much within the letter of law even though against the spirit by ignoring this charge.
Conclusion
From the discussion above, it emerges that while companies are well within the rights to use the discretion provided under GAAP while preparing financial statements, there is no license to misuse either the letter or the spirit of law. While in most cases the misuse is not against the letter of law per se it nevertheless affects the investors by hiding from them the real facts and providing a deceptive picture of the company than what the actual position is.
Cases In Management
Page 90
Cases In Management
Page 91
study will try to highlight this contradiction and understand how the unsystematic risk and not systematic risk is the primary concern of the managers. Most importantly the very definition of EVA has been questioned both in theory and practice. There is no statutory or widely accepted definition for EVA. The study will also highlight this factor and show how variances occur due to this lack of definition.
Terminology
ECONOMIC VALUE ADDED (EVA) It is measured as Net operating Profit after Tax less Capital Charge (Cost of Capital * Invested Capital) Equals Economic Value Added (EVA) . NET OPERATING PROFIT AFTER TAX (NOPLAT) It is the operating profit (EBIT) minus the taxes. Another name for NOPLAT is PAT (Profit after Tax) MARKET VALUE ADDED (MVA)47 It measures the value added by the management over and above the capital invested by the investors MVA=Market Value of the firm minus Economic Capital.
Literature survey
EVA has been described by Fortune in its cover story in Sep.1993 as the hottest thing in the financial world and getting hotter. Prof. V. Raghunathan of IIM-A explains EVA is one measure that can practically assess the economic contribution of a company short of accounting anomalies. It is a relevant management tool since it unifies the concepts of Net Present Value (NPV), market price and book value48. Bennet Stewart in his Quest for Value (91) describes EVA as 1. 2. 3. 4. Operating profits less the cost of capital employed to produce those earnings. One and the same thing (as NPV) The only measure to tie directly to intrinsic market value and The fuel that fires up the premium in the stock market value
47Business Today Feb 22nd 2000 48 Quoted in Business Today Feb 22nd , 2000 pg 82-83
Cases In Management
Page 92
As Stewart(94) himself notes As a concept EVA starts simple in practice can be made as comprehensive as needed to accommodate managements needs and preferences. 49 While the term EVA appeared as early as 1989 it received little attention until Fortune in its article in Sep 93 provided a detailed description of the concept, Stern Stewarts practice and successful adoptions by major US Corporations led to a flurry of papers being published primarily in the popular press and practitioner journals to promote EVA. Although anecdotal stories may differ in detail among EVA users, a common claim seems to be that EVA adoption leads to dramatic improvement in stock performance. According to an advertisement of Stern Stewart in 1995 Forget EPS, ROE and ROI. EVA is what drives stock prices50. While successful EVA stories are quite encouraging there is another side of the story. The research which exists in support of the EVA claim of supremacy is primarily anecdotal with insufficient empirical research. Moreover most of the research has been conducted by consultants who stand to gain financially and independent research is limited. In countries like India empirical evidence is very insufficient. EVA is measured by the difference of the net operating profit after deducting taxes and the cost of capital multiplied by capital employed. This implies the marriage of two concepts one the NOPLAT which is an accounting concept to be derived from the companys account books the second being the cost of capital which is an economic concept based on perception of investors. This gives rise to two issues one computational issue and secondly systematic issues. While the calculation of NOPLAT relates to computational problems, the problems in calculating cost of capital results in systematic issues. We will deal these issues one by one. The shortcomings in acceptance of EVA as a performance measure lie in two aspects. One is computational and the other is systemic. EVA is measured as the excess of NOPLAT over the cost of capital. However the calculation of NOPLAT itself is subjective. It has become a source of manipulation. While NOPLAT is an accounting concept the introduction of cost of capital leads to introduction of the market concept. So the measurement of EVA becomes a combination of accounting and market based concepts. Since both NOPLAT and Capital Employed are derived for accounting figures they require to be converted to economic profit from accounting profit and this is subject to be manipulated. According to Weaver Due to measurement differences, Economic Value Added is a limited tool that cannot be used for competitive analysis. In practice there is no consistent definition of EVA and numerous fundamental differences exist with regard to NOPLAT51. Weaver brilliantly analyses the difficulties in computation in arriving at these figures and show how they could be a very wide variation. He argues that the measurement practices vary widely and in some cases significantly52. He finds of all the 28 companies which responded to his questionnaire, none of the companies made the same combination of adjustments to NOPLAT. He goes on to argue that the measurement practices the companies are using for NOPLAT are inconsistent applications of EVA theory.
49Weaver, Samuel.C, Measuring Economic Value Added:A Survey of the Practices of EVA proponents, Journal of Applied Finance, 50 quoted in Pablo Fernandes, EVA, Economic Profit and Cash Value Added Do not measure Shareholder Value Creation ICFAI Journal of Applied Finance Vol 9, No.3 May 2003 51 quoted in Measuring Economic Value Added: A Survey of Practices of EVA Properties, Samuel Weaver, Professor of Finance, Leigth University, Bethlem PA 18015 , Journal of Applied Finance 2001. 52 ibid Summary and Conclusions
Cases In Management
Page 93
Further his findings about the calculation of net assets also bring about interesting revelations. The EVA theory led to a Net Asset Value of $810 using a hypothetical data. Applying the respondents approaches to that same data produces 15 different net asset values ranging from $560 to $100053. In his analysis he takes the example of food processing industry. Of the three companies he surveyed in that industry he found that while company 1 makes 16 adjustments, company 2 and 3 make 24 and 31 adjustments respectively. He goes on to show how NOPLAT and Invested Capital can arrived using different approaches even when the same industry economics and dynamics are in place.
Computational issues
The computational problems have their root in the fact that there seems to be no statutory definition for EVA nor there seems to be any broad based acceptance for the definition. The concept developed by a consultant Stern Stewart makes it open for manipulation. In fact many companies have made selective adjustments and developed their own versions of EVA. E.g. AMP uses their version called AMP Value Added (AVA) which is measured as NOPLAT divided by Invested Capital54. Interestingly Business Today in its survey on EVA acknowledges.... since the cost of capital is determined by the prevailing interest rate in the country, the ranking of each company on the cost of capital and percentage growth is a purely mathematical exercise and not indicator of efficiency55. The computational problems stem from the fact that Stern Stewart advocates as many as 164 adjustments to the accounting items for arriving at NOPLAT and cost of capital which become a tool for manipulation. But the companies have been selective in their adjustments. As Biddle points out (97) for their publicly database... Stern Stewart makes a handful of standard adjustments. For their corporate clients, Stern Stewart makes additional custom adjustments not available to public56. The lack of universally acceptable definition for NOPLAT could result in the manipulation of figures and the different methods could even lead to different figures. This is evident when we compare Stern Stewart-BT survey with the annual reports of companies. Comparing the BT-Stern Stewart survey with the annual reports of companies brings this picture vividly. For the year 2002 there is a wide difference between NOPLAT calculations of Hindustan Lever Ltd in their annual report and in the survey. While Hindustan Lever Ltd in their annual report a NOPLAT of Rs.1722 crores the survey puts the figure at Rs.1535crores57. But more importantly while NOPLAT calculations can be explained because of the different methods used the fact that the EVA itself is different draws home the deficiency of EVA. Take the example of Hindustan Lever Ltd. The following table illustrates it.
53 ibid 54 quoted in Measuring Economic Value Added: A Survey of Practices of EVA Properties, Samuel Weaver, Professor of Finance, Leigth University, Bethlem PA 18015
55 Business Today Feb 22nd 2000 op.cit. 56 Does EVA Beat Earnings? Evidence on Associations with Stock Returns and Firm Values ,Gary.C.Biddle, Robert Bowen,, James Wallace ; papers.ssrn.com 57 BT-Stern Stewart survey of India Incs Biggest Wealth Creators Apr.13-2003 and Hind Lever Report and Accounts 2002 pg.F33
Cases In Management
Page 94
2000(Rs.Crores) 2001(Rs.Crores) 2002(Rs.Crores) Annual Report BT-Stern Stewart 858 570 1080 765 1236 1003
Let us look at the example of Infosys. In the year 2002 while Infosys projects a figure of Rs. 510 crores, BT-Stern Stewart arrive at a figure of Rs. 242 crores58. The difference in EVA cannot be explained easily when the gap is so huge. As analyzed by Weaver, if there is a difference between two reports then the implication some other calculation may result in another figure being floated. If the purpose of EVA is to be an indicator of efficiency and result in reward system for the managers then the different figures being floated would result in the whole exercise becoming a mockery.
Systemic issues
The other half in measuring EVA is calculating the cost of capital. The cost of capital as shown above is measured as the product of weighted average cost of capital (WACC) expressed as percentage and the total capital employed. The cost of capital depends on the perception of the investors or the shareholders. Therefore it implies that the persons whose wealth is sought to be maximized themselves decide the cost of capital. When this becomes the case the manager develops strategies catering to market fads which are prone to change quite rapidly. The market is driven by herding momentum which creates volatility in the market. In handling these situations the manager loses sight of the long term objectives of the company. This obviously results in company loosing the value in the long run and the investors who maximize their wealth anyhow may ditch it when the going becomes tough. Hence this strategy is a Loss-Loss strategy for the firm. The cost of capital depends on cost of two components i.e. debt and equity. The cost of equity is calculated using the CAPM model. The cost is measured by Re=Rf+ b (MR-Rf) Where, Re - Expected Rate of Return Rf - Risk-free rate of return (usually the return on government bonds) MR - Market rate of return b - Beta which measures market risk
The calculation of cost of capital leads us to the systemic problems. The cost of capital is subjective and depends on the perception of investors. This implies that the beneficiaries themselves decide the measure of EVA. The cost of capital is calculated by the weighted average of cost of equity (key) and cost of debt (kid). The cost of equity is calculated by the CAPM model. CAPM model incorporates only systematic risk and totally ignores unsystemic risk. This leads to conclusion
58 Sources: Annual report of Infosys 2002, the EVA statement and BT-Stern Stewart Survey of Wealth Creators April 13-2003
Cases In Management
Page 95
that the managers are being encouraged to ignore unsystematic risk. But the management of the unsystematic distinguishes one company form another and thus lies at the heart of the strategy team. The expected rate of return depends on the perception of the investors. Beta measures the market risk. But the CAPM model takes into account only the systematic risk. According CAPM, the unsystematic risk is eliminating by holding a wide portfolio which will cancel out unsystematic risks. But this is not the case. The manager is differentiated by the way he handles the unsystematic risk. It is in this management where the heart of strategy lies. CAPM ignores this unsystematic risk and thus there is danger of the manager being encouraged to unsystematic risk and being actually rewarded for that. Therefore EVAs ignorance of unsystematic risk is one of its major drawbacks. Beta is itself subjective and prone to manipulations. The beta measures the market risk and is concerned only about the systematic component. Each company has its own beta based on the risk perception of the market about the company. The industry beta gives the average systematic risk associated with the industry as a whole. This cannot be taken as representative for any individual company. This is what Infosys has actually done. Till 2002 they have adopted the software industry beta of the US market as their beta. This can lead to erroneous conclusions since the beta represents only the average of the industry and within the industry there could be wide gap for betas of different individual companies. Interestingly Infosys uses the Indian GAAP procedures for arriving at EVA while using the beta for the US market. Then last year for 2003 they have used the beta of the company in the Indian market. This change in beta also has an impact. This usage of different betas by different sources for arriving at EVA and the mixtures highlights another aspect of the drawbacks associated with EVA calculation and thus the possibility of erroneous conclusions. The risk free rate of return (Rf) itself is not constant. It is subject to changes and is not entirely risk free though usually it is measured based on the return of government bonds. CAPM owes its existence from the Efficient Market Hypothesis (EMH). In the EMH world the asset prices are plotted on the Securities Market Line (SML) where Asset prices (market prices) correspond to Asset Values (book prices). On the SML, Expected Rate of Return (ERR) will always be equal to Required Rate of Return (RRR). In such a case the EVA which measures the difference between these two values will be zero. The EVA therefore becomes a quantum whose existence itself cannot be defined. Even if there is a difference between ERR and RRR it will be statistically insignificant to worth such a value. In reality however EMH world doesnt exist which leads to the possibility of arbitrage and thus the CAPMs effectiveness is open to question. The primary drivers in stock market are the effects of volatility, momentum and herding. The concept of EVA ignores this vital fact. These are the computational and systematic issues that are raised by the adoption of EVA. Based on the above findings the next section will draw the conclusions and ascertain whether EVA is and effective measure in the context of Indian conditions.
Cases In Management
Page 96
Conclusions
As one journeys through the maze of the above findings one cannot help but comment that the measure of EVA seems more like a fad oriented one than anything concrete or substantial measure to measure companys productivity. The measure of the efficiency and productivity has been traditionally measured by the metrics like ROI and ROA. EVA gives the same result as these traditional metrics. Therefore there seems to be no reason why one should use EVA instead of these relatively cheaper and easier modes of measurement. As seen above the lack of statutory definition for EVA acts as a biggest inhibitor for its effectiveness since this lack of suitable definition gives ample scope for manipulation and arbitrariness. There are many companies e.g. AMP which have developed their own measures and this defeats the very purpose of EVA. The very complexity of this model which deters the companies from proceeding with EVA and now the added possibility of manipulation is a great handicap and works against the concept. Traditionally the managers in the company are concerned with achieving two objectives one is the profitability and the second growth. These act in conflict with each other and though desirable to have both are very difficult to achieve simultaneously. The concept of EVA leads the managers to look at short term goals which is rather dangerous and detrimental to companys long term interests. Stock markets always tend to be driven by factors like volatility and momentum rather than companys prospects over the long term but as research as shown the association between stock market performance and key financial indicators have reduced over the period of time. In fact only a quarter of financial and other economic announcements have any effect on the stock markets and this has been investigated extensively by Cutler et al.(1989), Haughen (1991) etc. The question of transmission of EVA into MVA is an area that requires additional research and thus one cannot conclusively say about the positive co-relation between EVA and MVA. In fact in the BT-Stern Stewart survey on Wealth Creation 42 companies have positive MVA and negative EVA (among the top 100 performers). At this moment it is worthwhile to have a look at the BT-Stern Stewart survey on Wealth Creation which they have been coming off with for the last few years. While the survey talks about the wealth creation of the Indian companies in terms of Economic Value Added it ranks the companies in terms of Market Value Added. In case of Banking and Financial services companies (BFS Companies) the cost of equity is taking as cost of capital which leads to the conclusion that the BFS companies might have be overvalued. In fact after considering the fact that they have been overvalued most of the BFS companies have negative EVAs. The survey leads us to believe that the companies with higher MVA are wealth creators while those with negative values are wealth destroyers. In fact as shown above very little empirical evidence is available on the transmission of EVA into MVA. The survey itself acknowledges the fact that the negative EVA of ICICI Bank is mainly due to the reverse merger of ICICI with ICICI Bank. Interestingly the survey leads us to come to another important conclusion that the concept of EVA ignores the possibility of future returns. If future returns are ignored then it is unreliable to use EVA in measuring the performance of the company. In fact the stock market depends on the investors perception about the future returns of the company as demonstrated by the CAPM model which exists on the Expected Rate of return which in turn depends on how the investor perceives the company is going to perform in the future. The companys performance depends mainly on the management of the unsystematic risk which is ignored by the EVA. Ignorance of this key differential factor leads us to arbitrary and erroneous conclusions. Since the measure of EVA is determined by the perception of investors who are more concerned about their wealth maximization the managers may be forced to cater to their Cases In Management Page 97
needs rather than the firms which in the long run destroys value than create it. This conflict of interest between shareholders and the managers is detrimental and leads to the situation wherein the managers are performing to the tunes of the market than the other way round. In countries like India where growth is more important and the markets have just opened up there is always the possibility of the Value Addition being negative in the initial stages. The addiction to the concept of Value Based Measures like EVA is going to shift the focus to the short run and will at to detriment to the companys long term interest and divert funds from projects which create wealth in the long run towards those projects which add to the EVA though not necessarily in the companys interests. Therefore the practice of EVA should not be encouraged in the emerging markets like India. One of the majors claims by the proponents of the EVA is that is helps in assessing performance at divisional level. The very complexity of the model makes it rather difficult if not impossible to disaggregate the metric at divisional levels. Moreover the term being an absolute figure it is very difficult even to assess the competitor strength. In all one can say that since there is little difference between the traditional metrics like ROI, ROA etc and the EVA it makes little sense to depart from the easier and relatively cheaper metrics to shift to the new metric like EVA which is more complex, more costly, more time consuming and ultimately prone to arbitrariness and manipulation which will defeat the very purpose for what it has been claimed to have been created for. Ultimately one can say EVA can only be one of the metrics used in performance measurement and assessment but cannot be the only metric or even the superior metric.
Cases In Management
Page 98
595 biggest worries for Kingfisher Airlines, www.ndtv.com, June 26, 2012, Accessed on June 26, 2012 60 Nathalie Thomas, Crisis deepens at Kingfisher Airlines, March 12, 2012, http://www.telegraph.co.uk/finance/newsbysector/transport/9143502/Crisis-deepens-atKingfisher-Airlines.html, Accessed on June 24, 2012. 61 Dont Bail Out, The Hindu, November 13, 2011 62 The Ethics of Bailing Kingfisher Out, http://mg-singh.hubpages.com/hub/The-Ethics-of-Bailing-out-King-fisher-Airline, Accessed June 26, 2012 63Rumi DattaHardasmalani, Is Kingfisher Airlines Really in Trouble?, Business Standard, June 28, 2012.
Cases In Management
Page 99
For Bailing In
With many airliners operating on high cost platforms and below cost airfares, the crisis seemed imminent. A view was for the government to take pragmatic approach and offer a onetime bailout to ensure the sector remained afloat. Relaxing limits on FDI or allowing direct imports of jet fuels did not seem to impress analysts. Fuel costs comprised 40-50% of total airline costs. The logistics associated with setting up the infrastructure for direct imports seemed to deter the airliners64. To some, it appeared nave to suggest bailing out Kingfisher would equate with bailing out Mallyas lavish lifestyle. Mallya would lose only to the extent of his shareholding (58.6% in December 2011) apart from the prestige. In contrast the loss experienced by others was likely to be higher. Other shareholders would lose money. SBI and other banks which had lent a large amount of money would lose causing a loss to its shareholders and depositors alike. With Kingfisher opting for leasing aircraft left these lenders with little choice in case of default. Estimates suggested Kingfisher owing nearly Rs. 1000 crore of credit to state-run oil companies like HPCL, BPCL etc. There were defaults on provident fund dues direct tax payments and service tax which would remain unrecovered. Further, their employees would be rendered jobless.
Future outlook
While several methods were being discussed in the media and the policy circles, the million dollar question on a win-win solution to Kingfishers woes continued to elude the key participants.
Question: Should Kingfisher be allowed to Survive or Fail? Present your take on the caselet.
64ShailendraTyagi, Open Sky Policy: Act IV, Scene I, February 25, 2012, http://www.openthemagazine.com/article/business/open-sky-policy-act-iv-scene-1 Accessed on June 23, 2012
Cases In Management
Page 100
Cases In Management
Page 101
impact of inflationary pressures in the economy on the retail industry in terms of its sales and profitability. (Note: Need to build a financial statement for the industry showing the projected figures in the normal and the projected figures in the current period. Reasons for variations have to be clearly explained)
Cases In Management
Page 102
(Note: Financial statements to reflect to projected sales and profits and the reasons for this upturn to happen before other industries start to recover)
Caselet VIII- Repo and reverse repo rates and housing industry
RBIs ambitious policy of inflation targeting through interest rate hikes has seen rate hikes in the last year and a half. With the increase in repo and reverse repo rates, the cost of funds for banks has increased. Implied is a shifting of this burden to the consumers particularly in the housing sector. The loan amounts available has reduced by 25% besides the EMIs have increased by one and half times for an average buyers. All these factors spell a negative sentiment in the housing market and thus adds to troubled bottom lines of the housing sector firms. As a CFO of the leading housing sector company, present your projections to your shareholders on the impact of repo and reverse repo rate hikes by RBI in terms of profitability of the firm. Also present your future anticipation of interest rates and its impact on your company (Note: Build the financial statements incorporating the sensitivity of the housing sector industry to the changes in repo and reverse repo rates )
domestic infrastructure company wants to take advantage of the proposed expenditure but is short of funds. Hence it is looking at a collaborator from abroad. Apart from the FDI inflows, the overseas collaborator will bring in its technical expertise. As the financial consultant for the domestic firm, prepare financial projections to convince overseas collaborator the benefits of investing in India. (Note: Financial statements will have to be prepared showing the projected and sales and profit trends and how sensitive the industry is to increase in government expenditure. For every Rupee increase in expenditure, there is a multiplier effect in firms profitability)
Cases In Management
Page 104
Cases In Management
Page 105
Cases In Management
Page 106
Contribution III- Virtual Cultures and Social Movements (Mr. Vishnu U.)
Cases In Management
Page 107
Cases In Management
Page 108
Cases In Management
Page 109
Cases In Management
Page 110
Cases In Management
Page 111
Cases In Management
Page 112
Contribution IX- Slums in the Global Economy (Mr. Soumya Ranjan Panda)
Cases In Management
Page 113
HIGH
Exporting their manufactured goods and importing food RUSSIA Provide opportunity for employment Provide food
Feed the future initiative by US Govt Transferring their technology to other countries UNITED STATES OF AMERICA Micro finance, Improving distribution channels Good refrigeration during storage INDIA HIGH
Food accessibility
LOW
Food availability
Ive tried to capture some original contributions which reflect the ability of students to inherenty absorb the prinicples of the subject being taught.
Cases In Management
Page 114