Disinvestment Policy of the Government – Pros and Cons

Chaitanya Kini
Class of 2012
(Winner - Bodhisatva Article Writing Contest)

Disinvestment, which is the dilution of the government’s stake in public sector units, is a policy pursued by the government for bridging the fiscal deficit, raising capital for expansion and growth, repayment of debt and also funding the government’s social welfare programs. After Independence, the Indian economy was at a nascent stage and the objective of the government was to get the economy on the right track. Such a scenario called for maintaining control over major sectors of the economy like Shipping, Mining, Power generation, Railways etc. Until 1990-91, the government closely held these companies and had a major say in their day-to-day operations. The Balance of Payments crisis in 1990-91 led not only to opening up of the economy for private players and foreign investment but also to the government taking the disinvestment route.
The Disinvestment policy, of late, is centered on raising funds for social welfare schemes or to reign in fiscal deficit. This is a myopic view as it concentrates on meeting short-term obligations rather than long term profitability and sustainable growth of the public sector enterprise. The Disinvestment policy should be oriented towards raising fresh capital from the market to fund expansion and growth, increase accountability, and reduce government intervention by providing greater autonomy. The government has already taken steps to provide greater autonomy to the PSUs like elevating the Navaratnas to Maharatnas based on whether these PSUs meet certain criteria set by the government. This has given greater financial autonomy to the PSUs by raising the investment limit (the amount that a PSU can invest without requiring government approval) from Rs 1000 Cr. to Rs. 5000 Cr. Currently, there are 4 Maharatnas – SAIL, NTPC, IOC and ONGC which have been elevated from their previous status of Navaratnas. This has led to greater financial autonomy without disinvesting in major PSUs which have been profitable over the years and are a source of revenue for the government in the form of dividends. ONGC, in which the government has 74.14% stake, paid out a total dividend of Rs 7058.28 Cr in the financial year ending 2010 alone. However, the government is planning to divest their stake in such PSUs. In the financial year ending 2011, it plans to divest 5% of its stake in ONGC to raise around Rs 10,000 Cr, 10% stake in IOC whose FPO will fetch Rs 20,000 Cr. Similar FPOs are planned for SAIL and NTPC as well, which have been very profitable and competitive. Apart from Maharatnas, the government also plans to divest its stake in profit-making Navaratnas and Mini-ratnas to meet the disinvestment target set forth in the budget (The target for the year 2010-11 is Rs 40,000 Cr.). Such a disinvestment policy is oriented towards meeting short term obligations rather than looking at a broader perspective. Disinvestment in profit-making PSUs will lead to more private participation where it is not required. In the current scenario, there is a flood of ‘hot money’ in terms of FII inflows in the economy which will expose these PSUs to global shocks when there is a recession or a crisis in the world economy. Volatility of FII inflows will lead to volatility in share prices and market performance of these units. Moreover, government investment power houses like SBI and LIC which invest heavily in such PSUs will see their investments erode and profits decline. A global crisis can hence have a domino effect on these enterprises and other related businesses owned by the government which have so far been insulated from the latest global recession in 2008-09. Also, such PSUs have substantial weightage in determining the Sensex and the Nifty indexes. Hence, such a policy pursued by the government will not only expose these enterprises to global shocks but also the stock markets leading to dampening of market sentiment.
The government, however, argues that the fiscal deficit which is around 6.8% of GDP, due to the various stimulus packages offered during recession, is unsustainable. The government needs revenues to bridge this deficit to 5.5% in FY11 and to 4% in FY12. Revenues can be easily recognized by disinvestment in profit-making PSUs and hence this route is being taken by the government.
One of the major uses of government revenues are the social welfare schemes. However, due to the inherent bureaucracy and rampant corruption, not even half the benefits reach the target population. This brings a lot of inefficiency in the system as it indicates that revenues from disinvestment in profit making PSUs are used to fund populist schemes which do not reach the common man. In the long run, the government is eroding its revenue base by giving away its stake in these units. As per the policy, the government can divest up to 49% in these PSUs while maintaining the majority shares. Once these targets are reached, keeping in mind the fiscal deficit and the funding for social welfare schemes for the short term, the long term prospects of government revenue from such PSUs look bleak.
Apart from the Maharatnas, Navaratnas and Mini-ratnas which have been profitable, there are sick PSUs which have not seen profit on their books for many years. Pre-liberalization, there was almost zero competition for the PSUs and this had led to complacency and inefficiency. Post-liberalization saw the entry of many private players which led to stiff competition and crowding out of inefficient enterprises. In spite of repetitive capital infusion by the government, these enterprises still make losses and are a drain on the exchequer. Such PSUs can be turned around by bringing in private players who can improve efficiency, reduce wastage and optimize resources. Taking the disinvestment route for these units and providing greater autonomy, the government can reduce its fiscal burden and concentrate the amount spent on these units to reducing public debt. However, a turnaround can happen only if there is a management change as part of the disinvestment policy. A strategic sale is a privatization process whereby a government enterprise is privatized by auctioning the state-owned enterprise. This is different from the sale of minority stake where it does not result in privatization although government stake in the enterprise is reduced. Strategic sale is pursued to infuse private capital and bring managerial acumen of private players into the unit. A case in point is VSNL. Before the year 2000, the government was only selling minority shares in VSNL. The P/E ratio was 6.0 at that time. The strategic sale to Tata Group in April 2002 gave a much higher P/E ratio of 11.0 as an indication of the market expectation of a better performance under private management. After the sale, the government holding became 26% and that of Tata Group was 45%. In 2006, VSNL acquired Teleglobe growing its global reach and operational strengths. In 2008, VSNL, its subsidiaries and acquisitions were combined and renamed as Tata Communications. In the end, to the customer, it was a step towards better quality communication services at competitive prices.
The disinvestment policy is of the view that the markets will provide adequate discipline to the performance of the firm. However, the capital structure of these firms is seldom designed to maximize the returns for the shareholder, which is the government. Capital restructuring should be part of government policy initially to maximize returns from its shareholding in a PSU rather than taking a plunge into disinvestment to raise money in the short-term. The government should emphasize on providing greater autonomy to profitable PSUs, capital restructuring if needed and dilution of its stake in loss-making PSUs to ensure future earnings. Inefficiencies can be removed by reducing government interference by providing autonomy which should lead to higher accountability and better performance.
The National Investment Fund (NIF) was formed in 2005 into which the realization from sale of minority shareholding of the Government in profitable Central PSEs would be channelized. 75% of this fund will be used to finance selected social sector schemes, which promote education, health and employment. The remaining 25% will be used to meet the capital investment requirements of profitable and revivable Central PSEs that yield adequate returns, in order to enlarge their capital base to finance expansion/diversification.
Although the planning is impressive with respect to investment in education and health care, the implementation is flawed. Unless efficiency is brought into these social welfare schemes, they will always be a drain on government revenues and in this case disinvestment of profitable PSUs.
In conclusion, a long-term view of the disinvestment policy must be studied and it should balance the need for meeting short-term obligations while keeping in mind the long term objectives.

Appendix

Industrial Policy statement in 1991

• Public Sector Portfolio of public sector investment will be reviewed with a view to focus the public sector on strategic, high-tech and essential infrastructure. Whereas some reservation for the public sector is being retained there would be no bar for areas of exclusivity to be opened up to the private sector selectively. Similarly the public sector will also be allowed entry in areas not reserved for it.

• Public enterprises which are chronically sick and which are unlikely to be turned around will, for the formulation of revival/rehabilitation schemes, be referred to the Board for Industrial and Financial Reconstruction (BIFR), or other similar high level institutions created for the purpose. A social security mechanism will be created to protect the interests of workers likely to be affected by such rehabilitation packages.

• In order to raise resources and encourage wider public participation, a part of the government's shareholding in the public sector would be offered to mutual funds, financial institutions, general public and workers.

• Boards of public sector companies would be made more professional and given greater powers.

• There will be a greater thrust on performance improvement through the Memorandum of understanding (MoU) systems through which managements would be granted greater autonomy and will be held accountable. Technical expertise on the part of the Government would be upgraded to make the MOU negotiations and implementation more effective.

• To facilitate a fuller discussion on performance, the MoU signed between Government and the public enterprise would be placed in Parliament. While focusing on major management issues, this would also help place matters on day-to-day operations of public enterprises in their correct perspective.
Excerpts relating to public sector taken from Press release on July 24, 1991

References

• Disinvestment and Privatization in India Assessment and Options - A Study by R Nagaraj for the ADB Policy Networking Project
• PSU Disinvestment (2010) – a study by ‘arm’ research
• Privatization of Videsh Sanchar Nigam Limited – A study by Rekha Jain and Krishnan Venkataraman
• http://www.tatacommunications.com/about/history.asp
• Database - Capitaline Plus – Dividend and Shareholding patterns of PSUs
• http://www.divest.nic.in/

Doing Business In India

Saurabh Singh
Class of 2012

Background
India is undergoing a paradigm shift due to change in its competitive position in the world. The Indian economy is on a robust growth trajectory and exhibits a stable annual growth rate, rising foreign exchange reserves and booming capital markets. From 2004 until 2010, India's average quarterly GDP Growth has been 8.37 per cent [1]. India has emerged as the fourth largest economy in the world on the basis of purchasing power parity (PPP). Vast investment potential exists in sectors such as biotechnology, retail, real estate, power, and telecommunications. The investment prospects are strengthened by having a large pool of skilled and competitive manpower, huge research and development base, growth in the Indian domestic market owing to higher disposable incomes and abundant natural resources required to set up industries.
In spite of the above factors, India ranks 134 among 183 nations in a survey called “Doing Business 2011″ - that gauges the ease of doing business in a country — and is ranked behind countries like arch rival Pakistan, Bangladesh and Sri Lanka.


Evaluation System of Survey
The study conducted on the world’s economies gives ranking to countries after executing lot of calculations on various parameters on “ease of doing business”. It takes into account nine areas- (i)starting a business (ii) dealing with construction permits (iii) registering property (iv) getting credit (v) protecting investors (vi) paying taxes (vii) trading across borders (viii) enforcing contracts (ix) closing a business. Out of these, India ranks very low on (i), (ii), (viii) and (xi), as compared to its neighbors. China is way ahead of India in areas of registration of property and enforcing contracts. It shows a much stronger legal system and transparency in proceedings in China. Even, Sri Lanka and Pakistan are ahead of India in these areas.

Reasons for Non-conducive Business Environment
The major factors responsible for the appalling condition for starting and operating the business are inefficient bureaucracy, inadequate infrastructure, corruption, weak legal system, and law and order problem.
The red tape hassles inherited in bureaucracy and loads of paperwork makes doing business difficult in India. The Indian bureaucracy seems to carry the legacy of “License Raj”, which appears to be a black box to many entrepreneurs. The plight of Indian bureaucracy is that the structure of district administration in India has not changed since the pre-independence era. The bureaucrats work under the influence of politicians. They decide their promotions, tenure at a place or position so bureaucrats work under an apprehensive environment.
The Indian economy is losing 1.5-2.0 per cent in growth annually due to the poor state of the country's infrastructure. Most of the foreign firms often cite rickety infrastructure like congested ports and poor roads as the biggest challenge in doing in India. India’s trade, for example, could be rendered less competitive because of high transit time and congestion surcharges. India suffers an estimated food grain and agriculture produce loss of Rs50, 000 crore every year due to the lack of adequate post- harvest infrastructure and inefficient supply chain management by the country's farmers [10].
The business environment is very badly affected by the pervasive corruption at all levels of government. The awarding of public contracts is notoriously corrupted, especially at the state level. The numerous bodies charged with combating corruption have conflicting mandates and suffer from lack of qualified staff, funding and easy accessibility. India has slipped three places in global rankings of most corrupt countries, from 84 in 2009 to 87 this year [5].
A country’s law regulate business practices, defines business policies, rights and obligations involved in business transactions. In India, Justice delayed is justice denied" is the oft repeated sentence which itself is delayed and denied both in letter and spirit. In China there are 1, 30,000 courts while it is just 14,000 courts in India [6]. Financial experts had put forward that the delay is dragging down GDP by 2 per cent on an average especially creating a hostile environment for investment and business, in general. Financial investors investing in India has a "legal risk premium" which is an additional cost involved for investment due to the weak legal system. This arises because of the obstacles affecting enforcement of a claim or a contract especially in matters relating to land acquisition, which is one of the criteria in evaluation system.
No country can claim to have a conducive business environment without having robust and effective law and order system in place. It is because business cannot thrive in an environment which cannot guarantee its security. The states like U.P, Bihar and Jharkhand lag in this aspect which is responsible for lesser investments in these states. The threat of naxalities in states of Jharkhand, Chhattisgarh, Orissa and north-east states has led to under utilization of vast natural and human resources in these states.

Improving business scenario
The conditions for doing business in India can surely be improved, provided, the problems are tackled through specific strategic solutions which may require, in some cases, revamping the whole existing system.
We need to have a system in which bureaucrats need to have autonomy. India's bureaucrats need to be insulated from political influence. They deserve transparent appointments and promotions and fixed tenures. The civil service needs a code of ethics which demands a “climate of probity in public life”. Bureaucrats should be able to use their own ways of managing their function, bringing new ways to tackle problems and proposing policy changes. They need to be motivated throughout their serving period through various programs and workshops and a clear aim of placing the interest of “the common man” in the center of their actions should be imparted.
Business prospects in the country increase with better infrastructure. It leads to fast and secure transportation of man and material, expansion of business through investments in various places and projects and high growth rate. Now, for developing infrastructure, we need capital. Experts believe that allowing more FDI propels economic progress, job creation for the people and growth of the economy. For investments into large infrastructure projects, India needs to ensure that it has insurance cover and bonding that will cover large projects that are initiated here. But FDI alone may not provide an overall positive impact because large capital inflows may result in depreciation of currency and widening of trade deficit. So, for a holistic solution, it should be accompanied by trade agreements with major trade partners. This will ensure rise in exports and, at the same time, access to hi-tech goods and technology with the improvements in areas of research and development.
We need to have result oriented organizations with clear goals, time frame and pathway to achieve its mission. For this, there needs to be strong supervision and monitoring, at various levels. Accountability can be a very effective tool in eliminating corruption from the system. Every job in the concerned government organization should have a set-time frame, clear requirements (documents or other essentials), the person responsible for completing the job and the supervisor. Transparency is also needed and information technology can play a vital role in this. We should have public access to status reports of various applications of permits, license, registration etc. in concerned department so that end to end view of functions is facilitated.
Indian legal system needs to have a new framework for delivering accelerated dispute resolution. The main problem is the lengthy and highly intricate court procedures and the resultant deferment due to them. The whole system needs a review, with elimination of unnecessary procedures and formalities. It is still in the frame of pre-independence era, with norms not suitable to conditions in India. The simplicity in the process, easy accessibility to legal service and fast dispute resolution are three required areas to work upon in the legal system. There should be time-bound resolution of cases, depending on the broad categorization of nature of the case. India may have Indian judicial service, on the lines of Indian administrative service, to attract talent in this field with bright and secure career prospects. But, in that system, it should have result oriented approach in dispute resolution and not red tape hassles.
Law and order situation can be improved more by focusing more on implementing the existing laws instead of making the existing ones more stringent. It is because latter one, in absence of transparency and results in increased corruption. All the states should give priority in providing secure environment to resources and business zones to ensure their survival and expansion. Also, experts say that [9], if best practices followed in different states of India are followed throughout the country, it can leap by fifty-five places in the rankings of “ease of doing business survey”. So, efforts should be focused to eliminate the regional disparities of business conditions, which will also help the existing units to come out of radar of officialdom, dodging taxes and ignoring rules.

Conclusion
India surely has a long way to go, getting rid of red-tape and improving infrastructure before it can celebrate being a world power, especially if it wants to encourage new business leaders. But, with a vast pool of talent and focussing towards progress-oriented actions, it can surely make its mark in today’s business world.


References
1. (tradingeconomics.com/economics/GDP-growth, 2010)
2. (http://www.indiainbusiness.nic.in/know India, 2010)
3. (Sampathkumar)
4. (http://blogs.reuters.com/india/2010/11/09/survey-says-doing-business-in-india-is-tough/, 2010)
5. (Dholakia, 2010)
6. (S.Madhu)
7. (soutikbiswas, 2010)
8. ( http://www.hindu.com/2010/11/10/stories/2010111052271300.htm, 2010)
9. (Snipping Off shackles, 2010)
10. (http://www.igovernment.in/site/poor-infrastructure-costs-india-rs-50000-crore-agri-loss-every-year/)

The Road ahead for the Reserve Bank of India

A write up contributed by Yatin Budhiraja PGP1

The collapse of Lehman Brothers in 2008 triggered a global credit crisis. RBI in sync with other central banks slashed the interest rates to make the credit much cheaper in the market. The economies of developing nations and the West have diverged since then. While the West stares at double-dip recession, emerging economies are registering stable growth albeit with high inflation figures.

What started as food price inflation due to a poor monsoon last year slowly spread to manufacturing and service sectors. The ultra-low policy rates spurred demand as confidence returned. Wholesale prices rose 11.23% in April this year, the highest in 19 months. Inflation was close to 14% as per the consumer price index in May, 2010, which was way above than that in other emerging markets.

RBI has signalled that inflation is on the top of its agenda by raising the key policy rates for the fifth time this year. Recently, the central bank has raised the reverse repurchase (Reverse Repo) rate, at which it drains out liquidity from banks, to 5% from 4% and repurchase (Repo) rate, at which it lends to banks, to 6% from 5.5%. Tightening the liquidity will help taking care of the demand-side factors and as far as supply-side factors are concerned, they are already easing due to the above normal monsoon.

Taking cues from increased policy rates, commercial banks have also raised the deposit rates and will soon be raising the base lending rate, making credit even more expensive for households and industries.

The Governor has repeatedly said that he is less worried about the domestic growth, which is accelerating more than his expectations. But is the growth momentum facing no risk? Industrial growth is already on its way down, but faster than expected. In the first revision to the provisional numbers for April, Index for Industrial Production (IIP) fell by more than a percentage point. The economy is expected to grow at 8.5% this year, but with the tightening of money supply this may become difficult.

It’s high time that RBI and Government start realizing that we need an official policy to raise output levels across the board. Raising policy rate by RBI is a short-term policy to curb inflation. In the long term, government needs to invest massively in large dams, supportive policy to improve irrigation facilities, power supply to farmers and a big boost to organised retail that has the potential to step in where the official machinery of Public Distribution System and middlemen has failed. If this is not done, and RBI continues to squeeze demand in the face of persistent inflation, the great Indian growth story would come to a grinding halt.

Moreover, the slowdown has taken a toll on the central banks across the world. A feeling of fear and caution has increased to a great extent, particularly regarding the issues of capital markets, credit and money supply. This sentiment will not serve the purpose in the long run. India is a nation which has an internal consumption rate of more than 60%, which makes it more dependable on the domestic demand and income figures rather than foreign demand and income figures. RBI, in these times, should trigger the domestic demand in such a way that industrialists, traders, servicemen and the poor are benefitted.

Yatin Budhiraja

PGP-1

Goa Institute of Management

A case for long term investment in the stock markets

If you are an active watcher of the stock market trends chances are that you must have heard the saying “Time in the market is more important than timing the market”, this saying essentially means that spending time in the market can yield one better returns than following the strategy of “attempting” to invest money when the market hits lows and pulling out just when the market touches its peaks. This post will try to test the first part of the saying, i.e. that is whether spending time in the market yields good returns or not.
Consider an investor who invested Rs 100 in a bank FD which promised to pay him 7% compound interest on 31st Dec 1979. The 100 Rs invested then would have become 761 on 31st Dec 2009. This can be seen using the compound interest calculator available at this link
http://www.moneychimp.com/calculator/compound_interest_calculator.htm

Other than the option of investing money in the FD, the investor could have chosen to follow the active index investing strategy i.e. money could have been invested in various stocks comprising the index in proportion to their weight in the index. Under this strategy whenever one stock in the index gets replaced by another the investor will have adjust the portfolio to reflect this change. However with the emergence of index funds in the year 2000 index investing is a job best left to the mutual funds. Index Mutual Funds relieve the investor from the pain of tracking the index, by taking upon them to maintain the portfolio that completely mirrors the index. The pdf attached(masterindexfund.pdf) shows the returns generated by the UTI master Index fund since inception. A cursory glance at the graph with the heading “Rs 100,000 invested at inception: UTI Master Index vs Sensex” gives a fair idea that the fund performance has mirrored the Sensex performance.

It will be hard to understand the essence of this post without the aid of the excel sheet attached ( Sensex.xlsx), So the readers are requested to open the sheet attached to this post. The column “C” in the attached excel shows the Sensex values on the last day of each calendar year since inception. For instance it can seen that the Sensex value on the 31st 1979 was 118 which 3110 on Dec 31 1995.
The column “D” shows the annual returns given by the Sensex from 1979 through 2009.
The cell E3 has a value of 38.4 this essentially means that Sensex gave average returns of 38.4% in the two year period from 31st Dec 1979 to 31st Dec 1981. Similarly E4 gives the returns generated by the Sensex portfolio from 31st Dec 1980 to 31st Dec 1982, likewise for other cells in the column E.
The column F gives the average Sensex portfolio returns over a three year period, for instance the cell F4 gives the average returns of the three year period ending December 1982 and F5 gives the average annual returns generated by the Sensex portfolio during the three year ending Dec 1983. Likewise for all cells in the column.
Finally since the data spans a 30 year period, it follows that there is only one average return for the full 30 year period i.e. 18.045. On the face of this figure looks slightly higher than the 7% returns yielded by a bank Fixed Deposit. But while with a 7% return a bank FD will turn Rs 100 to Rs 100*(1.07)^30 to Rs 760, at 18.045% return , the Rs100 will result into 100*(1.18045)^30 =Rs 17200(approx). Thus while a bank FD will expand your money only 6 times, an index investment would have expanded the money by a whopping 172 times. If we account for average Indian inflation rate of 7%, Rs 100 in 1979 is equivalent to 100*(1.07) ^30=Rs760 today. So, effectively remaining invested in the index for 30 years has multiplied the money by 17200/760(inflation adjusted returns) i.e. almost 23 times. Thus while money invested in FD may remain constant or may decline in value, it is quite likely that the value of money invested in equities would multiply manifold

Now we look at the probability of negative returns .

The following graph shows that if an investor stays invested only for one year there is a 26% probability that he/she would lose some of the money invested. However if the investor stays invested for 4 years the probability of negative returns is only 7.41 .i.e there is only 1/14 chance that an index investment will yield negative returns over a period of 4 years. Now, if the investor who can quit with negative returns after four years decides to stay put for 2 years more, he will end up with positive returns. Further no matter when you decide to invest and when the money is pulled out, the investor earns positive returns if she/remains invested for 6 years or more.


The graph below shows that if an investor invests for 15 years or more the probability of him/her getting less than 7% is zero. Also it can be noted with some exceptions that the longer the investor remains invested in the stock markets the lower is the probability of below bank returns. Also, 6 years into investment onwards the probability of below the bank always remains below 20%.




Moral of the story: In the long term equities generate a return far superior than some of the debt instruments available and the return differential that may look small on paper actually causes the money to grow significantly in the long run(i.e Rs 760 vs Rs 17200,take your pick!). Therefore even if you can spare a small amount of money which you think you will have no use for in the next 10 year, by all means invest in the stock markets. If don’t consider yourself to be an expert in stock picking restrict yourself to the purchase of Index mutual funds , sit back and watch your money and not your financial woes compound.

Acknowledgement : SOFIA thanks Selvakumar N(PGP2) for his efforts in giving us the year end Sensex values

Disclaimer: This post tries to arrive at the probabilities of negative and below Bank FD returns by using the past market data. SOFIA does not take any responsibility for losses arising due to following this strategy as the past market behaviour may or may not get repeated in the future.

Finance finesse : Careers in finance

MBA in finance can be your ticket to a lucrative career, writes Anvay Bhargava

Source :http://www.tribuneindia.com/2010/20100623/jobs.htm#1

Globalisation has created an environment of fierce competition in which companies are trying hard to reduce their overhead costs in order to maximise their profits. This, in turn, has led to search for professionals who can manage finances properly to maintain the financial viability and soundness of the companies.

The financial managers with a specialised MBA (Finance) degree can achieve this Herculean task. The roles of a financial manager are to supervise the preparation of financial reports, guide investment activities, and execute cash-management strategies.

The Path

Finance Management is taught as part of the MBA curriculum at all B-Schools across India. MBA is a two-year course after graduation or equivalent degree. Admission into the MBA course is generally held on the basis of a written test, group discussion and personal interview. Separate tests are conducted by different institutes like CAT by IIMs, MAT by All India Management Association, XAT by Xavier Institutes, MAT conducted by different states, etc. Besides, there are executive MBA (Finance) programmes offered by some institutions which require a minimum two years of corporate experience.

Job Scope

MBA (Finance) graduates can be employed as a finance controller, treasurer and finance officer, credit manager, cash manager, risk and insurance manager. There is a wide range of job opportunities for these professionals in banks, financial institutions, insurance companies, mutual funds and investment companies. Financial institutions such as commercial banks, savings and loan associations, credit unions, mortgage and finance companies also employ financial managers. To reduce risks and maximise profits, firms rely more and more on the guidance of experienced and knowledgeable financial managers in mergers and consolidations, and in international expansion and related financing. Firms increasingly hire financial managers as temporary consultants to advise senior managers on these types of business operations. In fact, some small firms hire contracting companies to handle all of their accounting and financial needs.

Nine roads to success

The wide range of financial careers can be simplified in nine broad categories like Commercial Banking, Investment Banking, Corporate Finance, Hedge Funds, Insurance, Financial planners, Private Equity and Real Estate.
Commercial banks are in the business of providing banking services to individuals, small businesses and large organisa tions. The opportunities may start as a teller to a wide vari ety of other services such as leasing, credit card banking, international finance and trade credit.

Investment Bankers help companies and governments issue securities, help investors purchase securities, manage finan cial assets, trade securities and provide financial advice; be ori ented toward an industry vertical, bond-trading, M&A advi sory, technical analysis or programme trading.

The key to being successful is to have discipline, be broad- minded and be willing to admit defeat if an investment goes awry. Many money managers buy and hold fixed income secu rities including mortgaged-backs, corporate bonds, munis, agency securities and asset-backed securities. Others focus on equities, including small stocks, large caps and emerging market stocks.

A Corporate finance professional would help a company to find money to run the business, grow the business, make acquisitions, plan for its financial future and manage any cash on hand. The work includes designing, implementing and monitoring financial policies, planning and executing the financing program, managing cash resources, and interfac ing with the financial community and investors.

Unlike traditional money managers of mutual funds and closed ended funds, hedge fund managers routinely engage in short selling — that is betting that a security will decline in value. There are many flavours of hedge funds but the most common variety is a long/short equity fund. At present, we are in a period of unusual turbulence in the hedge fund world. Due to the financial crisis many hedge funds have shut down and undoubtedly more closures are to come. Depending on the size and structure of the hedge fund, there may be many positions like working at a hedge fund as a junior trader; strategist; analyst; quant; software developer; risk manager; and in various administrative roles.

As the population ages and wealth grows, the demand for insurance professionals will increase dramatically. Jobs in insurance involve helping individuals and business manage risk to protect themselves from cat astrophic losses and to anticipate potential problems. Work in this area is not only per sonally rewarding, but can be financially rewarding as well. You will help clients understand their insurance needs, explain their options to them and hopefully help them purchase appropriate insurance poli cies. You could work in a variety of areas in insurance, including as an underwriter, a sales representative, an asset manager, a cus tomer service rep or an actuary. Major areas of opportunity include auto insurance, life insurance, P&C (property & casualty) insurance, and health insurance.

Financial planners and wealth managers help individuals plan their financial futures. They help in planning for future needs like marriages, education for children, retirement needs, etc. This work requires excellent interpersonal skills. A good financial planner understands investments, taxes, estate planning issues and knows how to listen.

The role of private equity is to raise funds from large investors and invest the money directly into businesses. The usual manner is to raise money from overseas investors and then find businesses in the growth stage. Most private equity funds ‘exit’ the investment after a period of time by selling their holding in the business to some other investors or doing an initial public offering of the shares.
The entry level job in private equity is as an analyst (undergrad) or associate (fresh MBA pass outs or masters degree). You would typically be involved in a combination of one or more activities like spreadsheet analysis of the economics of a potential leveraged buyout, sourcing of new deals through industry research and screening of potential buyout candidates, preparation of materials for a senior partner on a potential investment target or company already subject to investment or coordination of the many diligence and research items required to carry out a transaction.

Over a third of the world’s wealth is tied up in real estate. Real estate is collateral for mortgages and a large amount of financial assets. Jobs in real estate fields such as title insurance, construction, mortgage banking, property management, real estate appraisals, brokerage and leasing, and real estate development are good avenues for those with an MBA in Finance. In addition, many opportunities are there in corporate real estate and in real estate lending in commercial banks, savings and loans, and insurance companies. Of course, at present, the markets are weak in housing and real estate but this field is not going away.

There is a huge scope in this area as the economies are firming up.

Source : http://www.tribuneindia.com/2010/20100623/jobs.htm#1

An introduction to Forward Contracts

Consider a scenario in which an Indian software major is expecting a 100 million USD payment from one of its biggest US clients on the 1st of August. Even if the payment is assured, the software firm faces foreign exchange risk (also called forex risk or exchange rate risk or currency risk) i.e. the risk that USD may depreciate vis-a-vis the INR and the 100 m USD which is worth 4.6 billion INR (since 1 USD =46INR at the time of writing) today may reduce in value to say, 4.3billon INR (or even lower) by the date of receipt of the USD payment. The company can eliminate its risk if it enters a forward contract to sell 100 m USD on August 1 at a fixed price. This fixed price at which the company can sell the USD at the forward date will typically be close to price of the USD at the day when the contract is made. This is due to arbitrage (we will look at arbitrage a little later in this post). Let’s say the price at which the contract in question is made is 46.5 .The counterparty (i.e. in this case the party which agrees to buy the pre-specified amount of USDs at the pre-decided rate on the contract settlement/expiry date) may have entered the contract for one of the following 3 different reasons-
1) It wants to shield itself from the currency risk it faces, for instance it expects an INR payment in the month of July, which it wants to convert to 100 million USD to import expensive machinery from the US. It like the software major is concerned with the exchange rate it will face when it needs to convert the rupees to USD.
2) It expects the USD to trade higher than 46.5 INR at the day of the contract settlement (i.e. contract expiry) so that it can immediately sell the dollars bought at 46.5 for a profit on the day of expiry.
3) In order to profit from arbitrage.
The party which has agreed to buy the asset (here USD) is said to be holding a “long” position on the asset whereas the party which has agreed to sell the asset is said to be holding a “short” position on the asset. If the party has entered the contract to insulate itself from the asset (here USD) price risk it faces, it said to be “hedging” against the risk. Thus while the software firm is engaging in “short hedging” the counterparty is engaging in either “long hedging”(if it has entered the contract for reason 1) or speculation(i.e if it has entered the contract for reason 2). If the party enters the contract to profit from difference between the price agreed upon in the contact and the price of the asset on the day of the expiry, there is a probability that it suffers a loss, if the asset price moves in the direction adverse to which the party expected it to move (i.e. if in the present example the dollar rather depreciating, appreciates versus rupee to a value of say say 42.5 per USD).

A company like Indigo which is doing exceedingly well on operational parameters, will surely not like to make a loss just because it had to purchase Air Turbine Fuel (ATF) at a very high price due to the spiralling oil prices. It in this case it will probably enter a series of long contracts on the ATF (depending upon its future fuel requirements), whereas and oil refiners like RIL may choose to enter the contract on ATF on the short side thereby securing the right to sell the produce at a fixed price.

Contract Settlement

There are two major ways in which a forward contract may be settled on the expiry date
1) Delivery- The short delivers the pre-specified quantity of the asset to the long for the pre-agreed payment on the contract settlement date.
2) Cash settlement – This is the most commonly way to settle the contract if both the parties to the contract are speculating. In this type of settlement the disadvantaged party simply makes a cash payment to the gaining party on the contract settlement date i.e neither of the parties is actually interested in buying/selling the asset but simply want to gain from correctly predicting the direction of the price movement. Suppose two parties enter a contract to buy/sell 100kgs of rice at Rs 35 per kg on a future date. If the price of 1kg of rice on the settlement date is Rs 38, the long party’s right to buy the rice at Rs 35, confers a positive value to the party and an equal negative value to the short. If the long buys rice at Rs 35 and sells them at Rs 38 in the market , it will gain Rs (38-35)*100=300 and the short loses an equal amount , having to buy rice at rs 38 to eventually sell them at Rs 35.i.e short party’s loss is Rs(35-38)*100 =-300. So the parties instead of buying/selling the asset can simply exchange a sum of Rs 300 to settle the contract.
Contract Offsetting –Assume that a party assumes a long position in a forward contract to buy 1000kgs of a particular variety of wheat on the 15th Sept at the rate of Rs 10 per kg (the market rate of the wheat being Rs 9.8/kg). Subsequent to the entry in the contract the asset price starts falling, and the speculator looking at market conditions and other factors decides that the price should fall further by the expiry of the contract. To limit their losses the party can enter an offsetting contract.

The quantity and quality of the asset and the date of expiry of the contract will be the same in both the offsetting and the original contract. The difference being that the party assumes a reverse position (i.e. short position in this case) in the offsetting contract and the offsetting contract confers a right upon the parties to buy/sell the asset albeit at a different price than specified in the original contract. Let’s suppose the contract is to buy/sell a kg of wheat at Rs 8(when the prevailing price is Rs 7.9/kg). Now the party has a short position in the offsetting contract and long position in the original contract. This way the party has locked in a loss of Rs 2 per kg. Let’s see how. At expiry if the price of a kg of wheat is Rs 20, the right to buy wheat at the rate of Rs 10 per kg has a value of (20-10)*1000=10000 and the right to sell wheat at Rs 8 has a value of Rs(8-20)*1000=-12000, thus in totality both the rights have a value equal to -2000 .i.e a loss of 2 rupees per kg, this is true for irrespective of the spot price of wheat at the time of expiry. Another way to look at this is to consider that the party has a right to buy 1000kg of rice for Rs10000 and is required to sell those 1000kgs at Rs8000, thus incurring a loss of Rs 2000.

Hedging( whether long or short ) is of course not without its costs, a company like the software major above , is required by the contract terms to sell the dollars at a pre-agreed price, even if the prevailing price is much higher than this pre-agreed price. A long hedger on the other hand has an obligation to buy the asset at the predetermined price even if the asset is trading at a much lower price in the market at the time of contract settlement.

Default Risk
An unscrupulous party may however choose not to perform as per the terms of the contract, for instance a the party holding the long position (sometimes simply called the “long”) may choose not to perform if the free market price of the asset is lesser than the price it has agreed to buy upon as per the contract. Similarly, the short may breach the contract if it can sell the asset at a price higher than stipulated in the contact. The risk a party faces due to possible non performance of a disadvantaged counterparty is termed as the default risk. The most commonly appointed measure to reduce (if not totally eliminate) the default risk is to sign up a trusty third party dealer. When the two parties sign up the contract the parties deposit some amount of money with the dealer as a guarantee of performance.

Arbitrage
Apart from speculation and hedging there is a third reason as to why a company many choose to enter a forward contract. Suppose that the current exchange rate of the USD is 46 rupees. The price at which at asset can be currently bought or sold is called the spot price of the asset. The price at which the asset can be bought or sold in the future is called the future price. Suppose the Future price of USD for August 1 delivery is 47 INR. A party wanting to profit from arbitrage will buy the USDs now and sell them at the contract price on the contract settlement date (i.e buy at 46 now and sell at 47 on the contract settlement date). Such arbitrage opportunities and the consequent buying support for the USD will tend to increase the demand for USDs and hence will tend to increase the USD price to the point where spot prices and the future price become equal and the arbitrage opportunities are effectively eliminated. There are two potential barriers to arbitrage
1) The transaction costs may be so high that they effectively nullify the possibility of profiting from the price difference.
Before we discuss the 2nd factor that makes arbitrage ineffective let’s discuss what is the Risk Free Rate. In order to meet their financial obligations governments around the world issue bonds. Buying (or investing in) such a bond is considered akin to lending money to the government, i.e. the government’s promise to pay a fixed rate of interest to the bond holders (“the borrowers”) and the principal upon bond expiry/maturity. Now it is very unlikely that the government will default on its obligation to pay the bond holders the promised interest and principal payments. Therefore these bonds which can be issued for various durations and carry different rate of interest depending upon the duration for which they are issued are regarded to be free of default risk. While this assumption may be true in normal circumstances, the bonds issued by an economy in a bad shape like that of Greece (where Debt/GDP ratio is greater than 1) is regarded to be carrying a good degree of default risk. The debt issued by various companies is generally considered less safe than government issued debt and is thought to be having various degrees of default risk. How much risk the company’s debt obligations carry is determined by its business position, ability and credibility of its management, past payment record etc. Determination of the degree of risk is a task best left to the credit rating agencies like Moody and Fitch in the US and ICRA and CRISIL in India. The greater the default risk of the bond the greater is the interest rate required by the investors to invest in such a bond.
So much for the Risk free rate (RFR), let’s come to second hurdle against arbitrage. As discussed above forward contracts carry default risk. So if the returns from arbitrage are less than the returns on the government bonds (i.e. the RFR), the sane investors instead of attempting to profit from arbitrage will invest at the RFR in the government bonds. It is therefore true that greater the time to expiration of the contract, greater is the potential price difference between the future price and the spot price.
There are other derivative instruments available in the market apart from forwards. In one of the subsequent posts we will cover two such instruments namely futures and options .Happy Reading!

The PE Ratio: Calculation and Interpretation

Price to Earnings (PE) is ratio often considered to be the most important ratio in the fundamental analysis of stocks. While looking at PE ratio alone may not be sufficient, it is unlikely that a dyed-in-the-wool analyst to will ignore it. Price to earnings ratio links the operational efficiency of a business to the market price of its shares. In this piece we will first see how this simple ratio is calculated and then look at possible ways to interpret it .The price in the PE (or P/E) refers to the market price of the shares of the company for which the ratio is to be calculated. The Earnings “E” in the ratio refers to the annual earnings (read profits) of the company on a per share basis. Suppose a company has issued 100 crore shares, with each share currently trading at Rs52, the
and the company earned a profit of Rs 278 crores in the Financial Year 10(FY10 i.e. April 1st 09 to March 31st 10).The earnings per share (EPS) as you might have guessed are 278/100=Rs 2.78(Since profits are in rupee units and the no of shares do not have units). Since this EPS is calculated on the basis of past (known) profits it is called “trailing” EPS. Another popular version of EPS called the forward EPS which utilizes future earnings for the next four quarter is called the “forward” EPS. Since the future earnings of a business are not known but have to be estimated, it goes without saying that correctness of these earnings estimates is heavily dependent upon the ability of the analyst and different analysts will arrive at their of estimates of earnings.

Now if you own 1000 shares of the company your share of company profits is Rs (278 crores/100 crores)*1000(=Rs 2780), which is quite simply the Earning per share times the No of shares held. The company management may decide to do any of the three things with the Rs 278 crore profits earned.

1) It can give away all the profits to the owners (i.e shareholders) in the form of dividends. In this case since you hold 1000 shares you will get Rs 2780 and an investor who holds 1 lac shares will get EPS* No of shares held i.e. Rs 2.78 lacs.
2) Companies in their growth phase are usually cash hungry and they need a large amount of cash for activities such as setting up a new plant, setting up business in new geographies, setting up R & D facilities so on and so forth. If this is the case with the company at hand, it may not choose to distribute dividends to its owners but reinvest the profits earned to fund to the growth of the business.
3) The third approach a company can use is the mixture of the two approaches above, that is the company may distribute the fraction of its profits and choose to reinvest the rest into the business. Suppose the company above chooses to distribute 115 crores as dividends. Then the dividend per share (DPS) is 115crores/100 crores(=Rs 1.15 ) and the Dividend payout ratio is DPS/EPS or alternatively Total Dividends/Total profits=115/278=0.413

Having seen what the earnings are and what are the ways a company deals with the earnings, let’s come to the P/E ratio. PE ratio is simply the division of the current market price of the company shares with the earnings per share. So in the case of the company above if the shares are trading at a price of Rs 52, the PE ratio of the company would be Rs 52/Rs 2.78 = (18.7). If the company stock price goes to Rs 50 a day later the PE would change to 18. PE ratio can be expressed in multiple forms. Lets look some of the ways an analyst may state the PE ratio of the above company.

X’s share is trading at 52 and it discounts its trailing 4 quarter earnings by 18.7
X’s share is trading at 18.7x (x stands for times) its trailing 4 quarter earnings
X’ share is trading at a PE (FY10 earnings) ratio of 18.7
X’s share is trading at 52 and at an earnings multiple of 18.7 on a trailing basis.
so on and so forth

The higher the PE the more you are paying for every rupee of earnings the company generates. So seen in this sense higher PE stocks are more expensive then lower PE ones.

Consider a hypothetical scenario of 4 companies, A, B, C, D identical in every respect (Industry, Products, Sales, assets, profits, debt, ownership structures, share price etc). Now suppose company A announces the discovery of a raw material source close its factories, which would significantly lower its transportation costs and hence enhance its profitability. Even if the trailing earnings of all the four companies are equal, the next 4 quarter expected profits of company A are higher than that of other companies. The company A which was identical in all respects till a few moments back, now appears to be likely to outdo the other companies in the current year expected profits. In neutral market conditions the markets will re-rate the stock of company A. By rerating we simply mean that the post the arrival of good news the increased demand for the company shares will cause their market price to surge and hence its PE gets automatically rerated to higher value. This adjustment may be slow or may be fast, according to the Efficient Market Hypothesis, markets react quickly to the arrival of new news (good or bad) and rerating process typically takes a few minutes. Experience sometimes shows that markets are not always efficient and it typically takes some time before the change in supply and demand situation, adjusts the stock price so that it starts hovering around a new equilibrium value post a good or a bad news. After the adjustment it can be said that the market is paying a premium (i.e. assigning a higher PE value) for the shares of company A with respect to its peers (B, C, D). So in this example above while the trailing PE of the stock A is higher than that of its peers(same EPS but higher stock price), the forward PE of the stock A may be higher , lower or equal to its peers( higher forward EPS and higher stock price).

PE ratios generally make more sense when comparing two or more companies in the same industry. Consider an industry, in which the PE for the various stocks ranges between 20-22 .An analyst discovers a stock that is trading at a trailing PE of 12, next the analyst through his analysis of the company (using business model, its ability to generate profits, analysis of the Balance Sheet, Profit and Loss statements so on so forth) estimates that the company is likely to grow as fast in profits as the industry on an average. So, the analyst will start believing that the company is undervalued compared to its peers and will buy the stock for himself or will issue a BUY call. In real practice, the analyst will look at some other ratios (ex Price to Sales, Price to book value) before deciding that the stock is undervalued. The buy call is issued In the hope that slowly and gradually the market participants will turn its attention towards the company and the price of it will soar relative to its peers so that it becomes “fully valued” relative to its industry. There can be several reasons as to why the company may be undervalued relative to its industry. Lets look at three of these reasons

1) There was a company specific bad news around 6 months back, so the markets decided to punish the company by lowering its share price, the bad news did not quite have its expected effect on the company’s financial situation but at the same time the share does not recover from the fall
2) Generally bigger players in any industry trade at a higher PE than the smaller ones. The reasons are not too far to seek, a bigger company is deemed to be “higher up on the learning curve” and generally has better access to resources to manage its financial risks and the business risks. Now suppose an analyst finds that a smaller company has recently executed orders which augur well of its ability to compete with some of the big boys in the industry. The company however is trading at a significant discount to the bigger boys in the industry (let us 9x vs 20x) and is growing a bit faster than the industry average. The analyst may expect the discount to reduce going forward so that the company starts trading at PE of say, 12-13 as compared to the industry’s average of 20.
3) The earnings of the company are unlikely to be sustained in the future or the company is subject to greater risks than the industry as a whole.

Here we reproduce a table from Wikipedia (http://en.wikipedia.org/wiki/P/E_ratio) with some alterations. When looking at PE ratio the following points may come in handy

A company with negative earnings (A loss making company)- By convention, companies with losses (negative earnings) are usually treated as having an undefined P/E ratio, although a negative P/E ratio can be determined, mathematically. In these case of these companies forward PE may be used if it is positive or the analyst can look towards other ratios (Price to Book Value, Price to Sales) etc.
PE lower than the industry average- Either the stock is undervalued or the company's earnings are thought to be in decline or of unstable nature. So a low PE does not always mean a good BUY
PE more or less equals the industry average-For many companies a P/E ratio in this range may be considered fair value.
PE is above the industry average (let’s say 25 vs. 20) either the stock is overvalued (and should be sold) or the company's earnings have increased since the last earnings figure was published. The stock may also be a growth stock with earnings expected to increase substantially in future.
PE is way above the industry average (let’s say 40 vs. 20) -A company whose shares have a very high P/E may have high expected future growth in earnings or the stock may be the subject of a speculative bubble. Example of such a stock is RNRL

While this article may serve as an introduction to the highly useful concept of PE ratio,the infomation given above is by no means exhaustive, the ratio is subject to a considerable degree of interpretation. Some extensive reading on the topic and experience in fundamental analysis can help an analyst sharpen his expertise in dealing with ratio.