14-07-2023

CORPORATE FINANCE
Prof Amit Puniyani

COURSE TEXTS

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CORPORATE FINANCE: FINANCIAL DECISION

MAKING FOR CORPORATIONS

(Circa 2010) Facebook founder and chief executive officer Mark Zuckerberg is in no
hurry to go public, even though he concedes that it is an inevitable step in the evolution of his
firm. The Facebook CEO is on record saying that “we’re going to go public eventually, because
that’s the contract that we have with our investors and our employees. [but] we are definitely in
no rush.” Nearly all public firms were at one time privately held by relatively few shareholders,
but at some point the firms’ managers decided to go public.

The decision to go public is one of the most important decisions managers can make. Private
firms are typically held by fewer shareholders and are subject to less regulation than are public
firms. So why do firms go public at all? Often it is to provide an exit strategy for its private
investors, gain access to investment capital, establish a market price for the firm’s shares, gain
public exposure, or all of the above. Going public helps firms grow, but that and other benefits
of public ownership must be weighed against the costs of going public.

CORPORATE FINANCE: FINANCIAL DECISION

MAKING FOR CORPORATIONS

Tata Motors ltd. can produce 790,000 cars annually. Given that the Indian economy’s needs keep
growing, how does it decide whether it should add more cars.

Factors affecting the decision

▪ What is the projected growth rate of the Indian economy
▪ How to raise funds ? Debt, equity or convertible bonds.
▪ Whether to invite the public to participate in financing

The last year has been difficult for TaMo. The Indian economy has not been growing at 8.2%. How does
the company deal with lower demand:
▪ Should it extend credit to dealers ?
▪ Does the inventory need a ramp up ?
▪ Are there too many suppliers ?
▪ Does the company need to optimize its cost of production

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CORPORATE FINANCE: FINANCIAL DECISION

MAKING FOR CORPORATIONS

Amalgamation of Sangli Bank Ltd.

Sangli Bank was an unlisted private sector bank headquartered at Sangli in the state of
Maharashtra, India. In the year ended March 31, 2006, it incurred a loss of Rs. 29 crore. Sangli
Bank had 198 branches and extension counters, including 158 branches in Maharashtra and 31
branches in Karnataka. Approximately 50% of the total branches were located in rural and
semi-urban areas and 50% in metropolitan and urban centres. The bank had approximately
1,850 employees. The Board of Directors of ICICI Bank Ltd. and the Board of Directors of
The Sangli Bank Ltd. at their respective meetings approved an all-stock amalgamation of
Sangli Bank with ICICI Bank on December 09, 2006. The amalgamation was subject to the
approval of the shareholders of ICICI Bank and Sangli Bank, Reserve Bank of India and such
other approvals pending. The deal was in the ratio of one share of ICICI Bank for 9.25 shares
of the privately-owned, non-listed Sangli Bank

WHAT IS FINANCE?
Finance can be defined as the science and art of managing the monetary decisions of individuals
or organizations.

At the personal level, finance is concerned with individuals’ decisions about how much of their
earnings they spend, how much they save, and how they invest their savings.

In a business context, finance involves the same types of decisions:

How firms raise money from investors,
How firms invest money in an attempt to earn a profit,
How they decide whether to reinvest profits in the business or distribute them back to investors.

The keys to good financial decisions are much the same for businesses and individuals. The
techniques of good financial analysis will not only help you make better financial decisions as a
consumer, but it will also help you understand the financial consequences of the important
business decisions you will face no matter what career path you follow.

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FINANCE FUNCTIONS
▪ Financial Services
Is the area of finance concerned with the design and delivery of advice and financial products to
individuals, businesses, and governments. It involves a variety of interesting career opportunities within
the areas of banking, personal financial planning, investments, real estate, and insurance.

▪ Managerial (Corporate) Finance

Is the area of finance concerned with the duties of the financial manager working in a business. Financial
managers administer the financial affairs of all types of businesses—private and public, large and small,
profit seeking and not for profit. They perform such varied tasks as developing a financial plan or budget,
extending credit to customers, evaluating proposed large expenditures, and raising money to fund the
firm’s operations.

BUSINESS ORGANIZATION
▪ Sole Proprietorships
A sole proprietorship is a business owned by one person who operates it for his or her own profit. About
73 percent of all businesses are sole proprietorships. The typical sole proprietorship is small, such as a
bike shop, personal trainer, or plumber. The majority of sole proprietorships operate in the wholesale,
retail, service, and construction industries

▪ Partnerships
A partnership consists of two or more owners doing business together for profit. Partnerships account
for about 7 percent of all businesses, and they are typically larger than sole proprietorships. Partnerships
are common in the finance, insurance, and real estate industries. Public accounting and law partnerships
often have large numbers of partners.

▪ Corporations
A corporation is an entity created by law. A corporation has the legal powers of an individual in that it
can sue and be sued, make and be party to contracts, and acquire property in its own name. Although only
about 20 percent of all businesses are incorporated, the largest businesses nearly always are; corporations
account for nearly 90 percent of total business revenues

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TABLE Strengths and Weaknesses of the Common Legal Forms of Business Organization

Sole proprietorship Partnership Corporation

Strengths • Owner receives all profits (and • Can raise more funds than sole • Owners have limited liability,
sustains all losses) proprietorships which guarantees that they
• Low organizational costs • Borrowing power enhanced by cannot lose more than they
more owners invested
• Income included and taxed on
proprietor’s personal tax return • More available brain power and • Can achieve large size via sale of
managerial skill ownership (stock)
• Independence
• Income included and taxed on • Ownership (stock) is readily
• Secrecy
partner’s personal tax return transferable
• Ease of dissolution
• Long life of firm
• Can hire professional managers
• Has better access to financing

Weaknesses • Owner has unlimited liability— • Owners have unlimited liability • Taxes generally higher because
total wealth can be taken to and may have to cover debts of corporate income is taxed, and
satisfy debts other partners dividends paid to owners are
• Limited fund-raising power • Partnership is dissolved when a also taxed at a maximum 15%
tends to inhibit growth partner dies rate
• Proprietor must be jack-of-all- • Difficult to liquidate or transfer • More expensive to organize
trades partnership than other business forms
• Difficult to give employees long- • Subject to greater government
run career opportunities regulation
• Lacks continuity when • Lacks secrecy because
proprietor dies regulations require firms to
disclose financial results

GOALS OF THE FIRM

▪ Maximize Shareholder wealth
The finance manager’s primary goal should be to maximize the wealth of the firm’s owners – the
stockholders. The best measure of wealth is the firm’s stock price.

▪ Cost
Since the firm operates in the market, customer satisfaction eventually drives profits. It would be
incorrect to say that wealth is maximized at the cost of society.

▪ Is maximizing wealth = maximizing profit

Corporations measure their profits in terms of earnings per share (EPS), which represent the amount
earned during the period on behalf of each outstanding stock. Profits are a factor influencing share price
but there are others such as risks, growth prospects etc.

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CASE: Lloyds TSB and Value Maximization

Llloyds TSB had accepted value maximization as its stated goal and provided an explicit defence.
According to the company:

Putting value creation first can bring huge benefits, not only to the company but to society as a whole. No
company can survive for long unless it creates wealth. A sick company is a drag on society. It cannot sustain
jobs nor adequately serve customers. It cannot give to philanthropic causes.

We believe there is no better way for us to serve all our stakeholders – not just our shareholders, but our
customers, fellow employees, business partners and the community at large – than by creating value over time
for those who employ us. It is our success in value creation that has enabled Lloyds TSB group to become a
leader in charity

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GOALS OF THE FIRM

▪ Stakeholder management
Stakeholders are groups such as employees, customers, suppliers, creditors, owners, and others who have
a direct economic link to the firm. A firm with a stakeholder focus consciously avoids actions that would
prove detrimental to stakeholders. The goal is not to maximize stakeholder well-being but to preserve it.

▪ The role of Business ethics

Business ethics are the standards of conduct or moral judgment that apply to persons engaged in
commerce. Violations of these standards in finance involve a variety of actions: “creative accounting,”
earnings management, misleading financial forecasts, insider trading, fraud, excessive executive
compensation, options backdating, bribery, and kickbacks.

▪ Ethics and share price

An ethics program can enhance corporate value by reducing risk perception, potential litigation, building
a good corporate image, improving shareholder confidence, enhancing cash flows and reducing perceived
risk.

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CASE OF ETHICS
Will Google Live Up to Its Motto?
in practice Google offers an inter- Google’s business goal is “instantly During the first quarter of 2010,
esting case study on delivering relevant information on any Google’s share price declined by 8.5

value maximization and corporate topic” to the world. However, when the percent, compared to an increase of
ethics. In 2004, Google’s founders pro- company launched its search engine in 45.2 percent for Google’s main rival in
vided “An Owner’s Manual” for share- China in early 2006, it agreed to the China, Baidu.com.
holders, which stated that “Google is Chinese government’s request to censor Google’s founders seemed to antici-
not a conventional company” and that search results. Some observers felt that pate the current situation in the firm’s
the company’s ultimate goal “is to the opportunity to gain access to the “Owner’s Manual.” According to the
develop services that significantly vast Chinese market led Google to firm, “If opportunities arise that might
improve the lives of as many people as compromise its principles. cause us to sacrifice short-term results
possible.” The founders stressed that it In January 2010, Google but are in the best long-term interest of
was not enough for Google to run a announced that the Gmail accounts of our shareholders, we will take those
successful business but that they want to Chinese human-rights activists and a opportunities. We have the fortitude to
use the company to make the world a number of technology, financial, and do this. We would request that our
better place. The “Owner’s Manual” defense companies had been hacked. shareholders take the long-term view.”
also unveiled Google’s corporate The company threatened to pull out of It remains to be seen whether Google’s
motto, “Don’t Be Evil.” The motto is China unless an agreement on uncen- short-term sacrifice will benefit share-
intended to convey Google’s willing- sored search results could be reached. holders in the long run.
ness to do the right thing even when Two months later, Google began rout-
3 Is the goal of maximization of
doing so requires the firm to sacrifice in ing Chinese web searches to their
the short run. Google’s approach does uncensored servers in Hong Kong, a shareholder wealth necessarily
ethical or unethical?
not appear to be limiting its ability to move that was cheered by activists and
maximize value—the company’s share human-rights groups, but criticized by 3 How can Google justify its actions
price increased from $100 to approxi- the Chinese government. In the short in the short run to its long-run
mately $500 in 6 years. term, Google’s shareholders suffered. investors?

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THE FINANCE FUNCTION

▪ Finance function and the size of the firm
The size and importance of the managerial finance function depend on the size of the firm. In small firms,
the finance function is generally performed by the accounting department. As a firm grows, the finance
function typically evolves into a separate department linked directly to the company president or CEO
through the chief financial officer (CFO).

▪ Treasurer and Financial controller

The treasurer (the chief financial manager) typically manages the firm’s cash, investing surplus funds
when available and securing outside financing when needed. The treasurer also oversees a firm’s pension
plans and manages critical risks related to movements in foreign currency values, interest rates, and
commodity prices.

The controller (the chief accountant) typically handles the accounting activities, such as corporate
accounting, tax management, financial accounting, and cost accounting.

The treasurer’s focus tends to be more external, whereas the controller’s focus is more internal.

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GOVERNANCE AND AGENCY

▪ Corporate Governance
Corporate governance refers to the rules, processes, and laws by which companies are operated,
controlled, and regulated. It defines the rights and responsibilities of the corporate participants such as the
shareholders, board of directors, officers and managers, and other stakeholders, as well as the rules and
procedures for making corporate decisions.

▪ Individual investors
Individual investors own relatively small quantities of shares and as a result do not typically have
sufficient means to directly influence a firm’s corporate governance. In order to influence the firm,
individual investors often find it necessary to act as a group by voting collectively on corporate matters.
The most important corporate matter individual investors vote on is the election of the firms board of
directors.

▪ Institutional investors
Institutional investors are financial entities that are paid to manage and hold large quantities of securities
on behalf of individuals, businesses, and governments. Institutional investors include banks, insurance
companies, mutual funds, and pension funds. These large investors can also threaten to exercise their
voting rights or liquidate their holdings if the board does not respond positively to their concerns.

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GOVERNANCE AND AGENCY

▪ The Board of Directors is responsible for:
• Acting on behalf of the shareholders
• The vision and mission of the company
• The strategic policy framework of the company
• Appointing the CEO/Managing Director and senior managers
• Responsible for overseeing the management and ensuring high standards of
corporate governance
• Appointing committees to take decisions on audit/compliance, ethics, operations, human
resources, risk reporting and management etc.

▪ Board members are appointed by the shareholders through an election at the general meeting of all
stockholders.

▪ The AGM (Annual General Meeting) is held to review and ratify the decisions of the board.
Shareholders have to be present at this meeting and being owners have the prerogative to vote on all
matters.

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CASE: CORPORATE GOVERNANCE at RAYMOND Ltd

Raymond Ltd., a premier textile company, planned to sell real estate owned in a posh expensive area of
Mumbai, Breach Candy to the promoters, the Singhania family. It presented a resolution in its AGM
(Annual General Meeting) on 5 June 2017 for shareholder approval. The market rate was Rs. 117,000 per
sq. ft. which would make the property worth Rs 7,100 million. The resolution proposed to sell the
property to the Singhania’s at Rs 9200 per sq. ft. for a total value of Rs. 600 million, which was less than
10% of the market rate.

IIAS (Institutional Investor Advisory Services India Limited) advised the shareholders to vote against the
resolution to protect their interests. The resolution was defeated with a 97.67 percent vote. In 2013, SEBI
had introduced a law barring promoters from voting.

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GOVERNANCE AND AGENCY

▪ Government Regulation
Government regulation generally shapes the corporate governance of all firms. Corporate governance
issues often grab the limelight due to corporate scandals involving abuse of corporate power and, alleged
criminal activity by corporate officers, false disclosures in financial reporting and other material
information releases etc.

▪ Regulatory bodies in India

▪ The Reserve Bank of India (RBI)
▪ The Securities and Exchange Board of India (SEBI) and the
▪ Insurance regulatory development authority are regulatory bodies in India and the
▪ PRA and SEC are respectively the regulatory bodies in the UK and the USA.

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GOVERNANCE AND AGENCY

▪ Agency Issue

Agency problems arise when managers deviate from the goal of maximization of shareholder wealth by
placing their personal goals ahead of the goals of shareholders. These problems in turn give rise to agency
costs. Agency costs are costs borne by shareholders due to the presence or avoidance of agency problems,
and in either case represent a loss of shareholder wealth. For example, shareholders incur agency costs
when managers fail to make the best investment decision or when managers have to be monitored to
ensure that the best investment decision is made, because either situation is likely to result in a lower
stock price.

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GOVERNANCE AND AGENCY

▪ Mitigating Agency costs

Shareholders endeavor to minimize agency costs through:

▪ Monitoring by the board of directors via regular audit of performance. Poor performance can lead to the
dismissal of even the CEO.
▪ Compensating the CEO and his team with equity stake to align his interests with the shareholders.
(ESOPs)

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CORPORATE FINANCE AREAS

▪ Capital Budgeting
Capital budgeting refers to decision making and process of investing in long term assets. Firms invest in
buildings, plant, machinery and other intangibles.

▪ Working Capital Management

Besides the fixed and long term investments, a firm also needs to make short term investments in
inventory and accounts receivables, which comprise its working capital. Working capital management is
concerned with day to day management of the short-term assets and liabilities – the level of inventory to
maintain, how much credit to give customers.

▪ Fund Raising and Capital Structure

Companies need to raise funds for investment in both long-term assets and working capital. Funds can be
raised through equity, debt or instruments that combine features of both equity and debt ex. Convertible
bonds.

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CASE: Citibank Innovative Instrument

A US$200 million par amount of floating rate notes was issues by Citicorp on 26 th June 1978. The coupon
of the floater was indexed to the six month t-bill rates, that is, to the arithmetic average of the weekly
market rate of the six month US treasury bills, as published by the Federal Reserve Bank during the 14-
day calendar days immediately prior to the last 10 days of Feb and August.

The actual coupon was the average plus 120 basis points (1.2%) during 1978-83, 1% over the average in
the period 1984-88 and 0.75% above the average in the period 1989-98. Citicorp was rated AAA/AA+ at
that time.

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HYBRID INSTRUMENTS
▪ Convertible Bond

A bond which can be converted to equity at a pre-specified ratio of shares to bonds. It is a bond with
embedded optionality. The bond pays interest until conversion. After conversion it becomes an equity
share.

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FINANCIAL MARKETS
▪ Financial markets are forums in which suppliers of funds and demanders of funds can transact
business directly.

▪ The two key financial markets are the money market and the capital market. Transactions in short-
term debt instruments, or marketable securities, take place in the money market. Long-term
securities—bonds and stocks—are traded in the capital market.

▪ To raise money, firms can use either private placements or public offerings. A private placement
involves the sale of a new security directly to an investor or group of investors, such as an insurance
company or pension fund. Most firms, however, raise money through a public offering of securities,
which is the sale of either bonds or stocks to the general public.

▪ When a company or government entity sells stocks or bonds to investors and receives cash in
return, it is said to have sold securities in the primary market. After the primary market transaction
occurs, any further trading in the security does not involve the issuer directly, and the issuer receives
no additional money from these subsequent transactions. Once the securities begin to trade between
investors, they become part of the secondary market.

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FINANCIAL MARKETS
▪ Money markets
The money market is created by a financial relationship between suppliers and demanders of short-term
funds (funds with maturities of one year or less). The money market exists because some individuals,
businesses, governments, and financial institutions have temporarily idle funds that they wish to invest in
a relatively safe, interest-bearing asset.

▪ Capital markets
The capital market is a market that enables suppliers and demanders of long-term funds to make
transactions. Included are securities issues of business and government. The key capital market securities
are bonds (long-term debt) and both common stock and preferred stock (equity, or ownership).

▪ Bonds are long-term debt instruments used by business and government to raise large sums of
money, generally from a diverse group of lenders.
▪ Preferred stock is a special form of ownership that has features of both a bond and common
stock. Preferred stockholders are promised a fixed periodic dividend that must be paid prior to
payment of any dividends to common stockholders
▪ Common stock is a share of equity in return for dividends and ownership responsibilities

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FINANCIAL MARKETS
▪ Primary market
When a company or government entity sells its stocks or bonds to investors and receives cash in return, it
is said to have sold securities in the primary market. After the primary market transaction occurs, any
further trading in the security does not involve the issuer directly, and the issuer receives no additional
money from these subsequent transactions

▪ Secondary market
Once the securities begin to trade between investors, they become part of the secondary market. On
large stock exchanges, billions of shares may trade between buyers and sellers on a single day, and these
are all secondary market transactions. Money flows from the investors buying stocks to the investors
selling them, and the company whose stock is being traded is largely unaffected by the transactions.

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FINANCIAL INSTITUTIONS
▪ Financial Institutions

Financial institutions serve as intermediaries by channeling the savings of individuals, businesses, and
governments into loans or investments. Many financial institutions directly or indirectly pay savers
interest on deposited funds; others provide services for a fee (for example, checking accounts for which
customers pay service charges). Some financial institutions accept customers’ savings deposits and lend
this money to other customers or to firms; others invest customers’ savings in earning assets such as real
estate or stocks and bonds; and some do both. Financial institutions are required by the government to
operate within established regulatory guidelines.

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J. P. MORGAN CHASE DURING

THE FINANCIAL CRISIS

In the summer of 2007, data began to emerge that prices of single-family homes were falling
in many U.S. cities and homeowners were starting to default on their mortgages. Rumors
swirled that JPMorgan and other banks held large investments in securities tied to residential
mortgages. On September 15, 2008, the venerable investment banking firm, Lehman
Brothers, filed for bankruptcy, and JPMorgan shares fell 10 percent in a single day. Bad news
about the economy and the financial sector continued through the fall, and Chase’s stock hit a
low point on November 21 near $20, losing more than half its value in roughly 18 months.
All of this prompted JPMorgan management to make two difficult decisions. The first was to
accept a $25 billion “investment” (some referred to it as a bailout) from the U.S. Treasury on
October 28, 2008. The second was to cut its quarterly dividend by almost 87 percent, from
$0.38 to $0.05 per share. These decisions, combined with a slowly improving economy,
helped JPMorgan survive the 2008 financial crisis and the subsequent recession. By the
summer of 2009, JPMorgan Chase repaid the $25 billion (with interest) that it had received
from the government, and the bank’s stock had recovered most of the value that it had lost.

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FINANCIAL INSTITUTIONS
▪ Key Customers of Financial Institutions

For financial institutions, the key suppliers of funds and the key demanders of funds are individuals,
businesses, and governments. The savings that individual consumers place in financial institutions
provide these institutions with a large portion of their funds. Individuals not only supply funds to financial
institutions but also demand funds from them in the form of loans. However, individuals as a group are
the net suppliers for financial institutions: They save more money than they borrow.
Business firms also deposit some of their funds in financial institutions, primarily in checking accounts
with various commercial banks. Like individuals, firms borrow funds from these institutions, but firms
are net demanders of funds: They borrow more money than they save.

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FINANCIAL INSTITUTIONS
▪ Commercial banking

Commercial banks are among the most important financial institutions in the economy because they
provide savers with a secure place to invest funds and they offer both individuals and companies loans to
finance investments, such as the purchase of a new home or the expansion of a business.

Public sector banks like the State Bank of India (SBI) dominated the retail banking sector until private
sector banks like ICICI and HDFC gained momentum, and until foreign banks like Citibank and
Standard Chartered Bank PLC began expanding their retail presence in the country. Both have been
facilitated by liberalization in the 1990s.

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FINANCIAL INSTITUTIONS
▪ Investment banking

Investment banks are institutions that

▪ assist companies in raising capital,
▪ advise firms on major transactions such as mergers or financial restructurings, and
▪ engage in trading and market making activities.

Many commercial banks have a merchant banking or investment banking arm.

Examples are SBI Capital Markets, ICICI Securities, Edelweiss, JP Morgan, HSBC Securities and
Capital markets etc.
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FINANCIAL INSTITUTIONS
▪ Insurance Companies

Historically, there were just two insurance companies in India, the Life Insurance Corporation of India
(LIC) and the General Insurance Corporation of India (GIC), the latter being a holding company with
several subsidiaries. Liberalization allowed private sector players like ICICI-Prudential, Tata AIG,
Bajaj ALLIANZ, Birla Sunlife, and HDFC Standard to open their doors to Indian consumers.

Insurance companies use actuarial science (actuarial modeling) to determine premia for various
probabilistic loss events based on available data.

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FINANCIAL INSTITUTIONS
▪ Mutual Funds

A mutual fund is an organization that manages a corpus of money derived from personal savings of a
large collection of investors. Investments usually include market tradeable debt and equity securities and
are managed very regularly by a Portfolio manager based on his judgement/speculation and the risk
appetite of the investors.

Debt based mutual funds are perceived to be less risky. Equity based funds are further classified by the
size of the companies as Large Cap, Mid Cap and Small cap funds or by the sector such as BFSI
(Banking Financial Services and Insurance) or Energy fund.

Since they are professionally managed, they provide a relatively less risky means of gaining equity
market exposure to individuals willing to invest their savings. However, they may be used by larger
organizations/big investors who do not have dedicated portfolio management resources.

Popular mutual funds in India are SBI, HDFC, ICICI Prudential, Reliance Mutual Fund etc.

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FINANCIAL INSTITUTIONS
▪ Non-Banking Financial Companies (NBFCs)

A Non-Banking Financial Company (NBFC) is a company registered under the Companies Act, 1956
engaged in the business of loans and advances, acquisition of shares/stocks/bonds/debentures/securities
issued by Government or local authority or other marketable securities of a like nature, leasing, hire-
purchase, insurance business.

Kinds of NBFCs:
Asset Finance Company.
Loan Company.
Mortgage Guarantee Company.
Investment Company.
Core Investment Company.
Infrastructure Finance Company.
Micro Finance Company.
Housing Finance Company

HDFC began as a mortgage financing company. It did not take deposits for a long time.

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FINANCIAL INSTITUTIONS
▪ Credit Rating Agencies

CRISIL, CARE, ICRA and Fitch are some rating agencies in India. They rate lenders by the probability
of defaulting on debt obligations.

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FINANCIAL INSTITUTIONS: REGULATION

The organizations involved with regulation in the Indian financial sector are:

❑ Ministry of Finance
❑ Reserve Bank of India (RBI)
❑ Securities and Exchange Board of India (SEBI)
❑ Insurance Regulatory and Development Authority (IRDA)
❑ Pension Fund Regulatory and Development Authority (PFRDA)

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FINANCIAL INSTITUTIONS: REGULATION

▪ Reserve Bank of India

Is the central banking authority of India. It performs the following traditional function of the central bank:
▪ It provides currency and operates the clearing system for the banks
▪ It formulates and implements monetary and credit policies
▪ It functions as the bankers bank
▪ It supervises the operations of credit institutions
▪ It regulates foreign exchange transactions
▪ It moderates the fluctuations in the exchange value of the rupee
▪ It influences credit related decision making
▪ It promotes the development of new institutions

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FINANCIAL INSTITUTIONS: REGULATION

▪ Securities and Exchange Board of India

Is the main regulator of capital markets. SEBI’s main responsibilities are:

▪ Regulation of business in stock exchanges and securities markets
▪ Register and regulate the capital market intermediaries (brokers, investment bankers, portfolio
managers, and so on)
▪ Register and regulate the working of mutual funds
▪ Prohibit fraudulent and unfair trade practices in securities markets
▪ Prohibit insider trading in securities
▪ Regulate substantial acquisition of shares and takeovers of companies

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FINANCIAL MARKETS: FLOW OF FUNDS

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EQUITY MARKET
▪ Is the market where shares issued by corporates are traded. The stock exchanges are primarily where
equity is traded.

▪ The company is owned by shareholders and all governance decisions must meet their approval -
Investment in new projects, funding plans, dividend payments and appointment of the board of
directors and senior managers. All decisions have to be ultimately approved by the shareholders.

▪ Equity instruments are risky. The returns on shares are not fixed and could even be negative. The rapid
movement of prices over a small time is often quantified and referred to as volatility.

▪ Shareholders are paid dividends after the company pays back its debt obligations. Capital gains refers
to the increase in the value of traded shares. Dividend decisions are made by the board of directors
after final approval at the annual general meeting (AGM). Usually dividends are a small portion of the
returns to the shareholders.

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FIXED INCOME MARKETS

▪ The fixed income market is the market for debt instruments. A debt instrument is essentially a loan
taken by either an individual, a government body, a municipal corporation or a corporate. This loan
can then be traded in a secondary market between investors and its price can fluctuate much like a
share.

▪ A bond has a face value, a coupon rate and a schedule of payment. The face value is the amount due at
maturity. Coupons are periodic payments made to the owner of the bond or the lender. The market
price of the bond is computed from all future payments the issuer must pay to the owner.

▪ Bonds can be of many types:

• Zero coupon bonds
• Floating rate bonds
• Callable bonds
• Convertible bonds
• Equity linked bonds
• Foreign currency bonds

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FIXED INCOME MARKETS

Treasury Bonds:

▪ The government issues bonds to finance its functioning. Since the government can always print money
to pay back its obligations, government securities are usually perceived as risk free or very low risk.

▪ Government bond defaults do occur nevertheless when governments face a severe deficit and cannot
afford to deflate their currency. There are several prominent examples of govy bond default – Argentina,
Portugal, Greece. In these cases a larger international entity such as the IMF offers a bail out.

▪ US securities were once the safest investment and the term ‘flight to safety’ referred to buying US
treasuries. They are the benchmark for other securities.

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FIXED INCOME MARKETS

Corporate Bonds

▪ Corporates raise money for their operations – working capital is raised through debt. Corporates are
legally obliged to pay back their debtors before declaring dividends for common equity holders (the
owners of the company).

▪ Risk: Since corporates may or may not be able to meet these obligations, the debt instruments issued by
corporates are inherently risky. As a result, corporate bonds usually have a rating below treasuries. The
more uncertain the cash-flows, the lower the rating.

▪ Rating agencies: Indian corporate debt has to be periodically rated by a SEBI recognized rating agency.
India has four major credit rating companies, namely CRISIL, ICRA, CARE and Fitch. In the USA,
these are Standard and Poor, Moody and Fitch.

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FIXED INCOME MARKETS

Municipal Bonds
Popularly referred to as munis, are issued by local city or district governments and by local government
authorities. Munis cover short term imbalances and could be used to finance long-term projects. Much of
the infrastructure developed in the US was financed by munis.

Mortgage loans
Mortgages are collateralized loans offered on a physical asset such as a house or a commercial property.
In the event of non-payment (default), the bank or financial firm can liquidate the collateral and recover
the amount. Mortgage loans are usually paid back monthly in EMIs.

The Housing Development Finance Corporation (HDFC) created the mortgage loan industry. In the US,
mortgages are collected and sold as a bond to investors – ie. Investors loan money and collect a
proportional share of the EMI routed through a financial entity (usually a bank such as Capital One or
Wells Fargo).

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FX MARKETS
The Foreign Exchange Market is where (primarily) currency bonds are traded. The price points at which
currencies are exchanged is the FX rate. Foreign currencies are required to facilitate international trade
which happens in the form of import/export and foreign capital investments.

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DERIVATIVES MARKETS
Derivatives are complex products which are used for hedging and speculation. The most common
derivatives are futures and options and they are often traded on the BSE and NSE. In the international
context, derivatives are traded OTC as well as on exchanges. Derivatives are not always tradeable or
liquid and could often just be embedded into another financial product such as a bond. Example. Callable
bond.

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RISK VS RETURN
▪ The efficient market hypothesis implies that higher returns usually come with higher risk.

▪ If, for example, this is violated in some situation, financial entities would bid up the price until returns
become standard.

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DEBT VS EQUITY
Companies have a choice of whether to raise money through debt or equity. From the corporate
perspective, equity payments can be zero and can allow the company to survive bankruptcy even in a bad
economic climate, however, the company would end up losing a lot of profit to public investors in a good
economic situation.

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FINANCIAL CRISIS
▪ Prior to the 2008 financial crisis, most investors viewed mortgage-backed securities as relatively safe
investments. The below figure illustrates one of the main reasons for this view. The figure shows the
behavior of the Standard & Poor’s Case-Shiller Index, a barometer of home prices in ten major U.S.
cities, in each month from January 1987 to February 2010 .

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FINANCIAL CRISIS
▪ In part because real estate investments appeared to be relatively safe, lenders began relaxing their
standards for borrowers. This led to tremendous growth in a category of loans called subprime
mortgages. Subprime mortgages are mortgage loans made to borrowers with lower incomes and poorer
credit histories as com- pared to “prime” borrowers. Often, loans granted to subprime borrowers have
adjustable, rather than fixed, interest rates. This makes subprime borrowers particularly vulnerable if
interest rates rise, and many of these borrowers (and lenders) assumed that rising home prices would
allow borrowers to refinance their loans if they had difficulties making payments

▪ Partly through the growth of sub- prime mortgages, banks and other financial institutions gradually
increased their investments in real estate loans. In the year 2000, real estate loans accounted for less
than 40 percent of the total loan portfolios of large banks. By 2007, real estate loans grew to more than
half of all loans made by large banks, and the fraction of these loans in the subprime category increased
as well.

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FINANCIAL CRISIS
▪ Unfortunately, as the figure shows, home prices fell almost without interruption from May 2006 through
May 2009. Over that three-year period, home prices fell on average by more than 30 percent. Not
surprisingly, when home-owners had difficulty making their mortgage payments, refinancing was no
longer an option, and delinquency rates and foreclosures began to climb. By 2009, nearly 25 percent of
subprime borrowers were behind schedule on their mortgage payments. Some borrowers, recognizing
that the value of their homes was far less than the amount they owed on their mortgages, simply walked
away from their homes and let lenders repossess them.

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VISA IPO

The largest US IPO ever was by Visa Inc., amounting to US$19.65 billion in March 2008. Each
share was priced at US$44. The issue surpassed the earlier record of US$11 billion by AT&T in
2007. The share surged 28% to US$56.5 on the opening day of trading.

The issue was underwritten by JP Morgan and Goldman Sachs. The total fees at 2.80 per cent paid
to various intermediaries – the sellers, managers and underwriters – amounted to over US$550
million.

Visa operates the largest electronic retail network in the world. It has the highest number of debit
and credit cards in circulation. It is the largest US card company in terms of the number and value
of transactions undertaken.

In 2013, Visa was included amongst the 30 shares that comprise the DJIA (Dow Jones Index).
Subsequently, Alibaba raised an even larger amount at US$25 billion through its IPO in 2014.

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SHARE SWAP ACQUISITION

In February 2008, HDFC bank acquired Centurion Bank of Punjab (CBP) for ₹95.10 billion.
This was the largest ever M&A transaction in the financial sector and overall the seventh-
largest in India at the time. HDFC did not pay cash to the shareholders of CBP and instead
financed the transaction by paying shareholders through its own shares. The CBP shareholders
received 1 share of HDFC Bank for every 29 shares of CBP held by them. Financing M&A
transactions with the acquirer’s shares is a common practice, especially in large value
transactions, and is possible only if the shares of the acquiring company are traded in the
secondary market and the price of the share is easily obtainable.

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BHARATI IPO

Bharati Televentures Limited raised ₹8.3 billion through an IPO of 185 million shares in
January/February 2002. The entire bidding was conducted online. The price band was from ₹45
to 54. Despite the fact that the issue generated high demand and there were willing buyers at a
higher price, the company chose to sell shares at the lower end of the band at ₹45. The 185
million equity share issue formed 10% of the post-equity shareholding. Sixty per cent of the
issue was sold to qualified institutional investors. The IPO was oversubscribed 2.5 times. The
issue was managed by JM Morgan Stanley and DSP Merril Lynch.

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WARBURG PINCUS IN INDIA

Warburg Pincus is a large Private Equity firm which has been active in India since 1999. It
tasted success when it sold its initial investment of US$292 million in Bharati Airtel Ltd for
US$1.6 billion. This gave a fillip to private equity investments in India, which has continued to
increase steadily. Warburg Pincus itself invested over a billion dollars every year in the Indian
PE space.

With more than $53 billion in assets under management, Warburg Pincus has an active
portfolio of more than 185 companies globally. The PE firm, which established its first
institutional fund in 1971, has raised 19 private equity funds that have invested more than $84
billion in over 900 companies in more than 40 countries.

It has wide exposure to IndiaFirst Life, SBI General Insurance, CAMS, Avanse, AU Small
Finance Bank and Fusion Microfinance, but the fund is equally bullish on consumer-facing
domestic demand-driven industries like PVR and Kalyan Jewellers.

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VERIZON COMMUNICATIONS DEBT

In 2012 companies raised US$1.36 trillion in corporate debt and US$278.9 billion in equity in the
USA.

In 2013, Verizon Communications sold US$49 billion bonds in the biggest corporate debt offering
ever. Verizon used the proceeds to finance its US$130 billion buyout of Vodafone’s 45 percent stake
in the Verizon wireless joint venture.

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MUNICIPAL BONDS IN THE USA

Between 2003 and 2012, US counties, states and other municipalities raised US$3.2 trillion for
infrastructure development by issuing municipal bonds. These are

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PMC MUNI BOND

Pune Municipal Corporation (PMC) raised $2 billion through a municipal bond issue in June 2017.
The bond is listed on the BSE. Pune Municipal Corporation has earned itself a long–term credit
rating of AA+, indicating a stable outlook. Pune MC is the second-largest corporation in
Maharashtra and earns the bulk of its revenue from property taxes and local body taxes. The
corporation plans to use the funds for a 24/7 water supply project for the city, as it attempts to meet
its smart city mission. The bond has been guaranteed by the Maharashtra government.

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MASALA BONDS

Masala bonds are rupee-denominated bonds, issued by Indian entities in foreign markets.
Interestingly, the first such bond was issued by the International Finance Corporation (IFC) to
finance its projects in India and create interest for its bond offering. Recently, HDFC raised ₹30
billion through masala bonds. Unlike a typical bond raised in overseas markets, when a bond is
denominated in INR, the FX risk is passed on to the investor.

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