Term Loan Appraisal

Term Loan Appraisal A new manufacturing unit wants a term loan – will the bank appraise it ?

What to look at ? Credit Cash Flows Risk Worthiness Dalaal-Street.com

Credit Worthiness Repayment Personality of capacity of the the borrower borrower Results of Willingness to Management economic repay talents activities Dalaal-Street.com

3 stages of any new business Project Gestation Period Earning Profits Implementation Dalaal-Street.com

3 stages of any new business This is the period when no cash is generated from the operations. During this period the movement of money is only from bank to Project the borrower. Implementation Dalaal-Street.com

3 stages of any new business Gestation Period The unit comes into operation and starts generating cash but takes time to reach the Interest is accrued break-even point. during this period to include it into the cost of product. No money movement takes place between the borrower and the bank. Dalaal-Street.com

3 stages of any new business This is the stage when enough cash flows are expected to be generated from the business to meet the instalments (including interest and principle). The cash-flows should be at least 1.5 times the instalments amount. Earning Profits The movement of money is from borrower to bank now. Purpose for having more cash-flows than the instalment is two-fold: 1) The borrower must also get the part of earnings (else he might not work if all proceeds go to bank). 2) The cash flows are not actual but estimated, this provides the security to margin of error. Dalaal-Street.com

Evaluation of a Business Economic Management Technical Evaluation Evaluation Evaluation Financial Evaluation Dalaal-Street.com

Economic Evaluation The demand of the product is evaluated. There should be a demand-supply gap, price advantage, timing and other such benefits. The prime attention is that the project should survive the three stages of the business (implementation, gestation and operations). Dalaal-Street.com

Economic Evaluation Thus the bank prefers loans where there is a large gap between the supply and current demand. E.g.: Where a manufacturer of tables needs a loan: 1) Demand = 10000 Units The market already Supply = 12000 Units has enough supply New Project = 2000 Units (prices might also fall). 2) Demand = 10000 Units Not enough demand Current Supply = 8000 Units supply gap. New Project = 2000 Units 3) Demand = 10000 Units Large gap, thus the Current Supply = 2000 Units product has a wide New Project = 2000 Units market. Dalaal-Street.com

Economic Evaluation Case Study #1: A company specialising in plastic engineered goods wants to setup a plant for manufacturing large computer keyboards (back in 90‟s) seeing the large market demand. Dalaal-Street.com

Economic Evaluation Case Study #1: A company specialising in plastic engineered goods wants to setup a plant for manufacturing large computer keyboards (back in 90‟s) seeing the large market demand. Banks rejects it as it was found that the new types of keyboard were soon to be introduced with new additional features. The survival of the project throughout the loan period was doubtful. Dalaal-Street.com

Economic Evaluation Case Study #2: A person wants to set up a mini cement plant in the local area. However UltraTech, Ambuja etc rule the current market. Dalaal-Street.com

Economic Evaluation Case Study #2: A person wants to set up a mini cement plant in the local area. However UltraTech, Ambuja etc rule the current market. Cement plants are basically of three sizes, Ultra – Mega and Mini Cement Plant. The Ultra Projects have lower fixed costs but higher transportation costs. The mini plants though higher on fixed costs have the benefit of low transport costs, thus if there is potential of cement market (good book orders) within 100 kilometres, then the project is economically viable. Dalaal-Street.com

Economic Evaluation Case Study #3: A Power Project in Himachal or in New Delhi ? Dalaal-Street.com

Economic Evaluation Case Study #3: A Small Power Project in Himachal or in New Delhi ? The electricity produced is supplied to the national grid (at a fixed price). The areas such as Himachal have very low stealing of electricity while there is always a power crisis in Delhi due to high stealing of electricity. Thus a small power project in New Delhi is preferred as the demand – supply gap increases. This is one of those “harsh realities.” Dalaal-Street.com

Management Evaluation Case Study #1: A “Lalaji” from Bihar (with enough land there), seeing the rise in IT Industry, too wants to start a new IT Company. Dalaal-Street.com

Management Evaluation Case Study #1: A “Lalaji” from Bihar (with enough land there), seeing the rise in IT Industry, too wants to start a new IT Company. Bank might rate him good with the entrepreneur skills but rate him very low for the lack of experience in the business. Dalaal-Street.com

Management Evaluation Case Study #1: A “Lalaji” from Bihar (with enough land there), seeing the rise in IT Industry, too wants to start a new IT Company. “Lalaji” still enthusiastic about the business hires 2 genius (one from Infosys and another from Wipro). Dalaal-Street.com

Management Evaluation Case Study #1: A “Lalaji” from Bihar (with enough land there), seeing the rise in IT Industry, too wants to start a new IT Company. “Lalaji” still enthusiastic about the business hires 2 genius (one from Infosys and another from Wipro). Bank still rates low. Like “Lalaji” took them from Infosys and Wipro, someone else might take them away from him someday too. Bank needs to have safety and surety of survival throughout the three periods. Dalaal-Street.com

Management Evaluation Thus the “promoters” MUST be in the core of the business. Good Collaterals are often taken as enough security to skip any other evaluation. However a term loan is a loan where the instalments are to be paid by earning from the assets (not from selling the assets – though bank can always do so). Dalaal-Street.com

Technical Evaluation Technical Evaluation is closely linked to the Economic and Managerial Evaluation. The technical competencies of the Management and technicalities are evaluated in economic specifications. These ensure the technical feasibility of a project as to whether a particular capacity machine is available in market or not and all other such technical evaluations. Dalaal-Street.com

Financial Evaluation This is the ultimate part of the evaluation process where all the things are summed up in the terms of money. The cash flows are estimated, the instalments periods are fixed, the interest rate is computed and the project is made bankable. Dalaal-Street.com

Cash Flow Structure Cash from Operations: Profit generated by the production & sales of goods and services +/- Adjustments for the expansion and tightening of working assets +/- Adjustments for non-cash income and expense items Cash from Investments: Cash generated by changing the asset base Cash from Financing: Cash associated with borrowings, dividends paid and private withdrawals + Consideration of opening cash balance Dalaal-Street.com

Analysis of Cash Flows The most commonly used indicators for doing this are: • Debt Service Coverage Ratio (DSCR); and • net cash flow after loan repayment or “free net cash flow.” Dalaal-Street.com

Debt Service Coverage Ratio (DSCR); Cumulative Net Cash Flow over Loan Period Total Loan Repayment plus Interest > 1.5 This indicator is calculated by adding up all the monthly/quarterly balances during the envisaged loan term and comparing this figure to the total amount to be repaid (including both principal and interest). Since the cumulative net cash flow needs to be higher than the total repayment obligation which the applicant would have towards the lender, this indicator must be above 1 (recommended at 1.5). Dalaal-Street.com

Case Study The new manufacturing which wants a four year term loan has following projected cash flows: All amounts in Rs. crores Loan Application Net Cash Flow before Loan repayment Loan amount 200 First Year 50 Equal annual Second Year 100 instalments @ Third Year 175 15% per annum 69.93 Fourth Year 300 TOTAL 279.72 TOTAL 625 Dalaal-Street.com

Case Study The new manufacturing which wants a four year term loan has following projected cash flows: All amounts in Rs. crores Loan Application Net Cash Flow before Loan repayment Loan amount 200 First Year 50 Equal annual Second Year 100 instalments @ Third Year 175 15% per annum 69.93 Fourth Year 300 TOTAL for 4 years 279.72 TOTAL 625 Accumulated Repayment Capacity = 625 / 279.72 = 2.23 However, it does not show whether the applicant will be able to cover every individual repayment instalment (as in first year). Thus comes the “free net cash flow” method. Dalaal-Street.com

Free net cash flow method Net Cash Flow after Repayment Loan Repayment Instalments > 0.5 This indicator is ratio of the net cash flow after repayment and the loan repayment instalments. A “free net cash flow” indicator must be positive (recommended at 0.5). Dalaal-Street.com

Case Study The new manufacturing which wants a four year term loan has following projected cash flows: All amounts in Rs. crores Loan Application Net Cash Flow before Loan repayment Free Net Cash Flow Loan amount 200 First Year 50 -0.28 Equal annual Second Year 100 0.43 instalments @ Third Year 175 1.50 15% per annum 69.93 Fourth Year 300 3.29 TOTAL 279.72 TOTAL 625 Accumulated Repayment Capacity = 625 / 279.72 = 2.23 The free Net Cash Flow is negative in the first year and too low in the second year. Thus, it is recommended to reschedule the loan and provide necessary moratorium period. Dalaal-Street.com

Financial Evaluation The interest rates are fixed based on the degree of risk. This risk is computed based on the concepts of probability and margin of safety. Margin of Safety- is how much output or sales level can fall before a business reaches its breakeven point. Thus where the margin of safety is riskier, the interest premium applied is also higher (above the PLR – Prime Lending Rate) Dalaal-Street.com

RISK “The only man who sticks closer to you in adversity than a friend is a creditor.” Dalaal-Street.com

RISK Webster‟s Dictionary- “exposing to danger or hazard.” Chinese Symbol- “The first symbol is the symbol for „danger‟, while the second is the symbol for „opportunity‟, making risk a mix of danger and opportunity.” Financial Terms- Risk, as we see it, refers to the likelihood that we will receive a return on an investment that is different from the return we expected to make. Thus, risk includes not only the bad outcomes, i.e. returns that are lower than expected, but also good outcomes, i.e., returns that are higher than expected. In fact, we can refer to the former as downside risk and the latter is upside risk; but we consider both when measuring risk. Dalaal-Street.com - From “Damodaran on Valuation” by Aswath Damodaran

RISK There are 3 types of business decisions: 1)Certainty: These are those decisions relating to events which are bound to happen. Thus these are risk free. The good companies (often with a very high credit rating) even bargain for loans at below the PLR (Prime Lending Rate). The reason being, they take their borrowings as almost risk free. Dalaal-Street.com

RISK The second is not “Uncertainty” but “Risk” 2)Risk: These are those decisions relating to events which are risky and might not happen as expected. These are the decisions where the profits are made. The banks give the loans on evaluation of risk and thus charge a higher interest. This is based on the same principle as the principle of insurance business. Dalaal-Street.com

RISK In insurance business the loss of few people is distributed among a large group (via premiums). Similarly the bank operates, based on the probability. Say that out off every 100 borrowers – 4 make a default. Thus the bank charges around 4% higher interest (i.e. above PLR) from each of the borrower. Thus these “risky” lending are more generous. Also, if the bank is able to recover from those 4% who default, then the are the even higher super profits resulting from risks. Dalaal-Street.com

RISK The third is “Uncertainty” 3)Uncertainty: The decisions relating to events which can not be predicted. These are baseless. A gambling is an example of “Uncertainty” as the results cannot be predicted but only hoped for. The result of such is mostly LOSS. Dalaal-Street.com

Common Practices One of the common practices in the market is that once a person gets a loan, he floats it in the market at even higher rates. Thus a person may get a loan @ 15% and he might float it in the market at 25% as there are many who are unable to get the loans sanctioned from the banks. Thus the evaluation in all the four areas needs to be careful and well evaluated. Dalaal-Street.com

A Good Bank ? Overall, a good bank is not the one that rejects “not-so-good” loans, but the one that makes every loan appraisal bankable. Dalaal-Street.com

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Term Loan Appraisal

by Pratyush Mittal on May 28, 2009

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Term Loan Appraisal — Presentation Transcript