Strategic Financial

Management – Frameworks (2)

Sunder Ram Korivi
Capital Allocation
• According to Brealey & Myers, true and enduring value comes only
from making and implementing sound Investment decisions. In this
sense, the Financing and Dividend decisions are support functions
and matters of design
• This is endorsed by Modiglinai & Miller, who propose the ‘separation
principle’. Investment decisions ought to be taken independent of the
financing decision
• This places capital allocation at the centre of strategy
• Unfortunately, a casual attitude is often seen insofar as the
investment decision is concerned
Capital Allocation/2
• Capex can be for capacity enhancement or for cost reduction
• Capex need to be managed to reduce the spikiness of performance
across business cycles
• Capex also needs to be balanced across R&D, Manufacturing and
Market Development, and evaluated by the integrated NPV
Strategic Planning V Financial Analysis

Strategic Planning Financial Analysis

• Balanced goal structure • Maximize shareholder value
• Corporate Planning Department • Finance Department
• Consultant • Investment Banker
• Qualitative • Quantitative
• Comprehensive assessment • Quantitative reasoning
• Lacking in rigour • Omits hard-to-quantify factors
Other factors in capital allocation
• Capital investment is a long-drawn, incremental process
• The planning process is meant to challenge the status-quo and raise
performance standards
• Boards have powers, executives have their feet on the ground
• Changing external dynamics need to be incorporated
Contemporary Aspects
• Anne Marie Knott’s R&D Model: Y = KαLβRγ
• Real Options (Timothy Leuhrman): Consider a wide range of outcomes
under varying scenarios. Investment will be higher under favourable
scenarios. In some cases, investment may be deferred until some of
the uncertainty abates.
Bringing discipline into the capex process
1. Who takes the ownership for failure?
2. Can the investment be deferred?
3. What is the competition doing?
4. Are we duplicating investments?
5. Have we Understood trade-offs between profit and investment?
6. Is the budget padded?
7. Are shared resources being fully utilized?

• Post-audit for creating a better platform for future decisions

Indian Examples
• Reliance Industries – Jamnagar refinery
• NTPC – completion of projects ahead of time
• Mumbai Flyover Projects
• Bajaj Auto – plant in record time, plus vendors’ cluster
Capital Allotraction – new age thinking

Old Perspective New Perspective

• Maximize capital returns • Pursue all excess-return opps.
• Investment cycle is annual • Investment cycle is multi-year
• Capital is rationed • Implementation is key
• Physical assets • Intellectual assets
• Project management • Portfolio Management
• One at a time • Inter-dependent, strategic
• ROI • FCF, EVA
Strategic Financial Decisions
• Capital Structure - Decisions and Consequences
• Corporate Actions
Capital Structure –
Decisions & Consequences
• DOL, DFL
• EBIT- EPS Analysis
• Durand, Traditional, and MM Approaches
• Other Approaches: Pecking Order, Agency etc
Capital Structure –
Cases in the Indian Context
• According to Huzaifa Hussain of Pinebridge Investment, India, the tax-subsidy
on interest induces companies to opt for leverage, thereby raising corporate
indebtedness. Thanks to MM.
• This view has also been echoed by Prof. Willam Poole of Cato Institute
• Christine Lagarde of IMF has warned that the tax cuts in the US, and rising
interest rates will shift hot money out of EMs and into DMs
• Financial markets are sensitive to debt. During slumps, investors shun
leveraged firms (flight to quality); at the cusp of recovery, investors return to
leveraged firms (migration to yield)
• Indian firms balance sheets stretched. RBI’s FSR warning came in June 2015.
Banks get nod to take over defaulters. SEBI acts in tandem.
Capital Structure – Indian Context
• When equity secondary markets are down, primary markets also go
down in sync. This leaves little scope for firms to raise equity for
deleveraging
• ARCs – an important component in the financial ecosystem. PE
investors also keen on a piece of the action
• High corporate tax rates and high interest rates keep leveraged firms
on tenterhooks. Need asset sales to keep standing
• Amtek Auto – banks to blame for bloated loan book
• Mallya to Modi-Choksi – a saga of leverage. Capex and Opex
Hybrids and Financial Innovation
• The Murphy’s law of FCCB
• HDFC: debentures attached with warrants, sold to mutual funds
through a bidding process. Each warrant is convertible into equity
shares at a fixed price. The offer witnessed aggressive bidding on
account of the potential to obtain equity through the attached
warrant
• Tata Steel reshuffles its international debt portfolio
• Air India to raise Rs.7000 cr via Sale and Lease Back of Dreamliners
Corporate Actions – Dividend Policy
• MM Dividend Irrelevance Approach
• Walter’s Model
• Gordon’s Growth Model
Dividend Policy
Cases in the Indian Context
• Corporate India dividend payout was the highest in 11 years in 2014-15, rising
34.52% during this year.
• Surprisingly, some companies have borrowed to pay dividends. Earnings are
shrinking. This could hurt their future growth plans, according to Kotak Securities
• Corporate dividends may have peaked in FY 2014, the highest since FY 2005.
Recall that 2011-14 was known as the ‘policy paralysis’ period
• MNCs earn more than Indian promoters. PSUs also pay higher dividends under
FinMin compulsion, due to fiscal concerns
• Investing in high-dividend stocks during market declines is a good strategy. Tax
free income, high yield based on purchase prices, hedge against inflation, capital
appreciation on principal investment. Dividends represent actual cash.
Dividend Cases/2
• Vedanta Ltd doubled its dividend despite falling profits, in order to
provide funds to its London-listed parent, Vedanta Resources plc.
Likewise, Hindustan Zinc, another Vedanta subsidiary also declared a
special dividend (1200%) to help out Vedanta Resources plc
• PSUs face a dividend dilemma, in the need to balance the fiscal deficit
concerns with a ramp-up capex as a job-growth stimulus. One view is
that with better forecasting and strategic planning, the government
must act as a responsible promoter. The government gives leeway to
PSU banks from paying dividends
• SEBI asks companies to disclose dividend policies in IPO documents
Dividend Cases/3
• Investment Advisory firm IIAS had identified 73 companies that should be
paying more dividends: Ashok Leyland, Bharat Electronics, Bosch, Dr
Reddy’s, Eicher Motors, Force Motors, *Gujarat Pipavav Port, HCL
Technologies, *HDIL, *Inox Leisure, ISGEC, *Jaiprakash Power Ventures,
*JSW Holdings, Maruti, Shree Cement, *TV18, Wipro, Whirlpool
• *These companies paid zero dividends despite 3 years of consistent profit
• Whirlpool conserves cash for paying royalties to its US parent
• Dividend must be decided based on payout ratio, rather than on a per
share or % of FV basis. Decisions to retain must be discussed more, with a
rationale
Share Buyback v Dividend

Share Buyback Dividend

PROS
• Tax Efficient • High Tax
• Share capital shrinks • No change in capital structure
• Improves ROE, EPS
• No change
• Liquidity to stocks during down cycles
• No cyclical impact
CONS
• Cumbersome process
• Time-consuming • Easy process
• Changes shareholding structure* • Fast, efficient
• *Case in point: PSU v. other companies • No change in shareholding
Buybacks/2
• Nalco did a buyback of Rs.2835 crore
• Novartis shares jump 17% on buyback
• Dr Reddy’s announced a share buyback
Other Corporate Actions –
Cases in the Indian Context
• Bonus Debentures: HUL, Astra Zeneca, Disa India, Brittania, Dr
Reddy’s, Coromandel Intn’l, Blue Dart and NTPC
• Advantages: 1. Tax shield on interest for the company. 2. No
immediate cash outflow, barring interest payments. 3. Treated as
deemed dividend, and DDT is paid by the company. 4. Investor pays
capital gains tax on redemption only on the appreciation in value. 5.
Equity base remains intact, and EPS is not diluted. 6. Infrastructure
companies have the capacity for leverage (permitted D/E is higher).
7. Market signal is positive
Stock Split
• SEBI may impose a floor price of Rs.500 for stock splits
• Currently, shares offered for more than Rs.500 may have a face value
of upto Rs.10, those offered below Rs.500 must have a face value of
Rs.10
• Out of 50 companies that applied for splits, 35 were priced at above
Rs.500
• The proposed SEBI curb is to prevent manipulation in prices,
especially money laundering via small cap listed stocks. Stock prices
tend to rise post-split due to better liquidity