Financial Aspects of Regulation

1. Financial Aspects of Regulation Dushyant Mahadik Money, Banking, Corporate Finance and Governance Area Centre for Economics and Finance ASCI, Tuesday, 28th February 2012

2. Agenda Business decision making Net Present Value Cost of Capital

3. Business Decision Making Foundations of management Non-financial criteria Financial criteria

4. Foundations of Management Division of labour Centralization and Decentralization Business Policy Values and Culture

5. Criteria for Making Business Decisions Profitability Strategic Fit Long term sustainability Best use of available resources Employee First, Customer Second Triple Bottom Line Administrative Reasons Logistic Convenience

6. Financial Criteria • Break Even Analysis • Cost-Benefit Analysis • Net Present Value • Economic Value Added • Adjusted Present Value • Payback period • Rates of return • Return on Investments • Accounting Rate of Return • Internal Rate of Return

7. Exercise: Limited Power Project Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW Site available to your company on lease is perfectly suited Entire land mass will get used in the plant and accessories Your company does not have any cash reserve Site available to your company on lease is perfectly suited Entire land mass will get used in the plant and accessories Your company does not have any cash reserve

8. Exercise: Limited Power Project Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW Each 10 MW plant costs $3 MN Accessories and other costs are $1 MN Over next 10 years, the plants are expected to generate revenue of $35 MN and incur cost worth $15 MN The plant costs $13 MN Accessories and other costs are $2 MN Over next 10 years, the plants are expected to generate revenue of $48 MN and incur cost worth $20 MN

9. Net Present Value

10. Discounting the future cash flows • Money today is worth more than having money tomorrow Ci Present Value of Ci = ----------------- (1 + r )i where, • r is the discount rate • Ci is the net cash flow coming in during the ith year • More distant cash flows are more risky, hence they are discounted more

11. Exercise: Limited Power Project all figures in million $ Option 1 : 3 x 10 MW Option 2 : 1 x 60 MW NPV = $6.22 M > 0 NPV = $7.71 M > 0

12. What is measured ? Future cash flows – ignore sunk cost Operating cash flows Incremental cash flows over status quo Non-cash expenses like depreciation, overheads, etc. Changes in capital (working capital) Include opportunity cost Expectations about inflation Effects of tax

13. Net Present Value Appreciates time value of money Only cash profits are important Additive method Provides a direct link between management decision and shareholder value Mutually exclusive projects are handled better Able to absorb term structure of interest rates

14. Exercise : Illustrating Timing Differences • Stakeholders may view the projects differently • Differences in time horizon • Different perception of risk • Different tolerance for risk

15. Cost of Capital Introduction WACC CAPM

16. Cost of Capital • Returns to an operator attract investors • Opportunity Cost of Capital • Investors may not be attracted for many reasons • Too much debt or too little debt • Management efficiency of the operator • Country/region of the operator • Other risks taken by the operator • Lack of transparency or clarity about future course of action • Discount rate for NPV and Hurdle rate for IRR

17. Weighted Average Cost of Capital • Returns for the operator should be greater than the operator’s post-tax WACC WACC = where, • D – value of debt • E – value of equity shares • t – corporate tax rate (marginal) • rD – average rate of interest on debt • rE – returns required by the shareholders

18. Cost of Debt for Tata Power Limited Refer to hand out given (excerpts of annual report 2010-11) Schedule C: Secured Loans (Rs 47539 MN) Schedule D: Unsecured Loans (Rs 22354 MN) Schedule 3: Interest Charges (Rs 4489.5 MN) Cost of debt (weighted average) = 6.42%

19. Also known as market capitalization rate or • required rate of return by equity investors Cost of Equity

20. Dividend Discount Models • Walter Model • H Model • Multi-stage Growth Model • Gordon Growth Model DIV1 Market Capitalization Rate = -------- + Growth Rate P0 • where, DIV1 = dividend to be paid in next year • P0 = Current share price

21. Growth Rate for Dividend Discount Models • Security Analysts • Industry Experts • Fundamentals of the company • Revenue from year n+1 will be more than revenues from year n • To the extent to which operating assets are higher Growth Rate of Profits = Plough Back Ratio x Return on Equity • What is the reinvestment policy of the company ? • Plough back = 50% and Return on equity = 12% • Growth = 50% x 12% = 6%

22. Capital Asset Pricing Model Equity Market Risk Premium Extra Returns (risk premium) from an investment are dependant on the underlying risks Security Market Line r - rf =  (rm - rf)  (beta) is the measure of sensitivity of the investment to market movements

23. Capital Asset Pricing Model • Assumptions • Markets are efficient • There is no information asymmetry • Transaction costs are negligible, i.e. Borrowing and lending rates are same • There are no taxes • Risk/Return Contribution to a Portfolio • Because unique risk is already diversified in a portfolio

24. WACC for Tata Power Limited

25. Roadblocks to finding WACC Unlisted company or part of a conglomerate Nominal vs Real WACC Marginal WACC and Average WACC Measurement of risk Inefficient capital structure

26. Back-up Slides

27. Economic Value Added • Introduced and popularized by Stern Stewart & Company • EVA in year n = cash inflow (or outflow) minus the cost of capital (cost of financing) • Also, any additional investment done in the year n is to be subtracted • Total EVA by taking the project is the sum of discounted EVA for each year

28. Adjusted Present Value NPV is calculated by treating the project as an unlevered firm That is the value of the project on its own When the project is financed with debt, it helps the firm save taxes because interest is a tax-deductible expense The present value of all future tax savings are the financing side effects of the project Adjusted present value = NPV as unlevered firm + PV of Tax Shields

29. Dividend Discount Model Perpetuity formula – Value of perpetuity = periodic payment / discount rate If perpetuity is growing – Value of perpetuity = first periodic payment / (discount rate – growth rate) So, dividend to be paid in next year Share Price = ---------------------------------------- (required rate) – (growth rate)

30. Calculation of Beta Covariance with the market Variance of the market

31. References • Data about Tata Power Limited taken from • http://www.tatapower.com/investor-relations/pdf/92Annual-report-2010-11.pdf • Beta of major Indian companies • http://www.bseindia.com/about/abindices/betavalues.asp • Further reading on the topic is given in the references section of Chapter III: Management and Analysis of Financial and Other Data • http://www.regulationbodyofknowledge.org/documents/bok/chapter3.pdf