Business valuation, leasing vs buying decision and project financing in bhel

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Business valuation, leasing vs buying decision and project financing in bhel

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Business valuation, leasing vs buying decision and project financing in bhel

  1. 1. A PROJECT REPORT ON : BUSINESS VALUATION,BUSINESS VALUATION, LEASING Vs BUYING DECISIONLEASING Vs BUYING DECISION ANDAND PROJECT FINANCINGPROJECT FINANCING ININ BHARAT HEAVY ELECTRICALSBHARAT HEAVY ELECTRICALS LIMITEDLIMITED .
  2. 2. CONTENTS S.No. PARTICULARS Page No. 1. 2. 3. 4. 5. Company Profile  Bharat Heavy Electricals Ltd. – Introduction  Recent History  Business Segments  Products Offered  Research and Development  Human Resources  Exports  Technology Sourcing  Company Financials  SWOT Analysis of BHEL  Corporate Functional Structure Objectives of the Project Business Valuation  The Value Concept  Business Valuation Services  Accepted Valuation Approaches and Methods  The Approach Applied  Business Valuation of BHEL Leasing Vs Buying Decision  Financing Decision  Factors Effecting Cost of Financing Options (Specifying BHEL’s Practices)  The Decision Platform – Net Cash Outflows  The Standardized Formats Project Financing 5 – 23 24 25 – 40 41 – 73 74 – 100 2
  3. 3. 6. 7.  The Financing Concept  Parties to Project Financing  Project Financing in BHEL – Selection of Bank / Financial Institution  The Decision Platform – NPV & IRR  The Standardized Formats Conclusion References. 101 102 3
  4. 4. Bharat Heavy Electricals Limited INTRODUCTION BHEL was set up by the Government of India in the late 50’s to manufacture power equipment and to bridge the gap between demand and supply of power generations. Over the three decades, BHEL developed capabilities in design manufacture, supply, erection and commissioning of power plant equipment for thermal, hydro and nuclear power stations. It is today a name to reckon with in the industrial world. It is the largest engineering and manufacturing enterprise of its kind in India and one of the leading international companies in the power field. It offers over 180 products organized into thirty major product groups, BHEL met the needs of various sectors of the Indian economy- power generation and transmission, transportation, industry, telecommunication, defense, etc. The liberalization of the power sector during 1991 had a significant impact on BHEL, which had been operating in a protected economy since its inception. The company faced the challenge of competing with international power equipments majors like Siemens, GE, ABB, etc. for obtaining orders. BHEL has a wide-spread network comprising 14 manufacturing divisions, 8 service centers, four power sectors regional centers, 15 regional offices, besides a large number of project sites spread all over India and abroad, enables BHEL to be close to its customers and cater to their specialized needs with total solution-efficiently and economically. An ISO9000 certification has given the company international recognition for its commitment towards quality. BHEL is one of India’s leading public sector companies. With an export presence in more than 50 countries, BHEL is truly India’s industrial ambassador to the world. In recognition of its record of 4
  5. 5. consistent profitability over the years, the Government of India had conferred on it the “Navaratna” status in 1997. THE RECENT HISTORY In the 1970s and the 1980s, power sector projects were either funded by the Government through budgetary resources or through central government undertakings like the NTPC, which largely relied on multilateral organizations like the World Bank. Both sources of funding ensured a steady stream of orders for BHEL, which won these contracts in spite of international competition. The World Bank’s insistence on a 15 percent price preference for local equipment combined with the low cost of BHEL equipment ensured that BHEL won 29 out of the 31 projects that were funded by multilateral institutions during the 1980s. By the late 1990s BHEL has emerged as a company whose products were competitive internationally, in terms of price and quality. In 1998, BHEL gave a renewed thrust to the Total Quality Management (TQM) drive that it had initiated at its plants by following the European Foundation for Quality Management (EFQM) Excellence Model. The company also finalized a Corporate Environment Management Policy, which included a plan of action for various units to qualify for ISO 14001 Environment management System certification in a phased manner. 5
  6. 6. BUSINESS SEGMENTS BHEL’s business could be broadly classified into two categories – Power Equipment Business and Industry Equipment Business. Power equipment business was BHEL’s core business and generated about 52 percent of BHEL’s revenue during 1998. Its range of services included systems design, engineering, manufacturing and project management. Industry equipment business was set up to facilitate BHEL’s entry into growing areas like process industries, telecommunications, non-conventional energy, transmission equipment industry, etc. Lets deal with them segment wise: POWER GENERATION This sector comprises of thermal, gas, hydro and nuclear power plant business. As of 31-3-2002, BHEL-supplied sets account for nearly 67,232 MW or 64 per cent of the total installed capacity of 1,04,917 MW in the country, as against Nil till 1969-70. BHEL has proven turnkey capabilities for executing power projects from concept to commissioning. It possesses the technology and capability to produce thermal sets with super critical parameters up to 1000 MW unit rating and gas turbine-generator sets of up to 250 MW unit rating. Co-generation and combined-cycle plants have been introduced to achieve higher plant efficiencies. To make efficient use of the high-ash-content coal available in India, BHEL supplies circulating fluidized bed combustion boilers to both thermal and combined-cycle power plants. The company has proven expertise in Plant Performance Improvement through renovation, modernization and up rating of a variety of power plant equipment, besides specialized know-how of residual life assessment, health diagnostics and life extension of plants. TRANSMISSION AND DISTRIBUTION (T&D) 6
  7. 7. BHEL offers wide-ranging products and systems for T&D applications. Products manufactured include: power transformers, instrument transformers, dry type transformers, series & shunt- reactors, capacitors banks, vacuum & SF6 circuit breakers, gas-insulated switchgears and insulators. A strong engineering base enables the company to undertake turnkey delivery of electric substations up to 400 kV level, series compensation systems (for increasing power transfer capability of transmission line and improving system stability and voltage regulation), shunt compensation system (for power factor and voltage improvement) and HVDC systems (for economic transfer of bulk power). BHEL has indigenously developed the state-of-the-art controlled shunt reactor (for reactive power management on long transmission lines). Presently, a 400 kV FACTS (Flexible AC Transmission System) project is under execution. INDUSTRIES BHEL is a major contributor of equipment and systems to industries: cement, sugar, fertilizer, refineries, petrochemicals, paper, oil and gas, metallurgical and other process industries. The range of systems and equipment supplied includes: captive power plant, co-generation plants, DG power plants, industrial steam turbines, industrial boilers and auxiliaries, waste heat recovery boilers, gas turbines, heat exchangers and pressure vessels, centrifugal compressors, electrical machines, pumps, valves, seamless steel tubes, electrostatic precipitators, fabric filters, reactors, fluidized bed combustion boilers, chemical recovery boilers and process controls. The company is a major producer of large-size thyristor devices. It also supplies digital distributed control systems for process industries and control & instrumentation systems for power plant and industrial applications. BHEL is the only company in India with the capability to make simulators for power plants, defense and other applications. The company has commenced manufacture of large desalination plants to help augment the supply of drinking water to people. TRANSPORTATION BHEL is involved in the development, design, engineering, marketing, production, installation, maintenance and after-sales service of rolling stock and traction propulsion systems. In the area of 7
  8. 8. rolling stock, BHEL manufactures electric locomotives up to 5000 HP, diesel electric locomotives from 350 HP to 3100 HP, both for mainline and shunting duty applications. BHEL is also producing rolling stock for special applications viz., overhead equipment cars, special well wagons, Rail-cum-road vehicle etc. Besides traction propulsion systems for in-house use, BHEL manufactures traction propulsion systems for other rolling stock producers of electric locomotives, diesel – electric locomotive, electrical multiple units and metro cars. The electric and diesel traction equipment of Indian Railways are largely powered by electrical propulsion systems produced by BHEL. BHEL also undertakes retrofitting and overhauling of rolling stock. In the area of urban transportation systems, BHEL is geared up to turnkey execution of electric trolley bus systems, light rail systems, etc. BHEL is also diversifying in the area of port handling equipment and pipelines transportation system. TELECOMMUNICATION BHEL provided total turnkey solution with extensive customer support. BHEL was the first company in India to have installed electronic Private Automatic Branch Exchange (PABX) system, and Rural Automatic Exchange (RAX) system based on indigenous technology from C- DOT. Renewable Energy: technologies that can be offered by BHEL for exploiting non-conventional and renewable sources of energy include: wind electric generators, solar photovoltaic systems, solar heating systems, solar lanterns and battery-powered road vehicles. The company has taken up R&D efforts for development of multi-junction amorphous silicon solar cells and fuel cells based systems. OIL AND GAS BHEL is a major contributor to the Oil and Gas sector industry in the country. BHEL’s product range includes Deep Drilling Oil Rigs, Mobile Rigs, Work Over Rigs, Well Heads and X-Mas Trees (of up to 10,000 psi ratings), Choke and Kill Manifolds, Full Bore Gate Valves, Mud Valves, Mudline Suspension System, Casing Support System, Sub-Sea Well Heads, Block Valves, 8
  9. 9. Seamless pipes, Motors, Compressors, Heat Exchangers, etc. BHEL is the single largest supplier of Well Heads, X-Mass Trees and Oil Rigs to ONGC and OIL. INTERNATIONAL OPERATIONS BHEL is one of the largest exporters of engineering products and services from India, ranking among the major power plant equipment suppliers in the world. Over the years, BHEL has established its references in around 60 countries of the world, ranging from the United States in the West to New Zealand in the Far East. These references encompass almost the entire product range of BHEL, covering turnkey power projects of thermal, hydro and gas-based types, substation projects, rehabilitation projects, besides a wide variety of products, like transformers, insulators, switchgears, heat exchangers, castings and forgings, valves, well-head equipment, centrifugal compressors, photovoltaic equipment, etc. Apart from over 1100 MW of capacity contributed in Malaysia, and execution of four prestigious power projects in Oman, the major successes achieved by the company have been in China, Saudi Arabia, Libya, Greece, Cyprus, Egypt, Bangladesh, Azerbaijan, Sri Lanka, Iraq, Kazakhstan, Indonesia, etc. The company has been successful in meeting demanding customers’ requirements in terms of complexity of the works as well as technological, quality and other requirements viz., associated O&M, financing packages, extended warranties etc. BHEL has proved its capability to undertake projects on fast-track basis. The company has been successful in meeting varying needs of the industry, be it captive power plants, utility power generation or for the oil sector requirements. Execution of overseas projects has also provided BHEL the experience of working with world renowned Consulting Organizations and Inspection Agencies. In addition to demonstrated capability to undertake turnkey projects on its own, BHEL possesses the requisite flexibility to interface and complement with international companies for large projects by supplying complementary equipment and meeting their production needs for intermediate as well as finished products. 9
  10. 10. PRODUCTS OFFERED  THERMAL POWER PLANTS  GAS BASED POWER PLANTS  HYDRO POWER PLANTS  DG POWER PLANTS  INDUSTRIAL SETS  BOILERS  HEAT EXCHANGERS AND PRESSURE VESSELS  PUMPS  POWER STATION CONTROL EQUIPMENT  BUS DUCTS  SWITCHGEAR  COMPRESSORS  SILICON RECTIFIERS  CONTROL GEAR  OIL FIELD EQUIPMENT  TRANSPORTATION EQUIPMENT  POWER DEVICES  THYRISTOR EQUIPMENT  INDUSTRIAL ELECTRICAL MACHINES  ENERGY METERS  CAPACITORS  SYSTEMS AND SERVICES  AVIATION  TELECOMMUNICATION  NON-CONVENTIONAL ENERGY SYSTEMS 10
  11. 11.  SEAMLESS STEEL TUBES  CASTINGS AND FORGINGS  INSULATORS  TRANSFORMERS RESEARCH AND DEVELOPMENT Over the years, BHEL had successfully adapted many global technologies to suit Indian conditions. BHEL had modified boiler designs suitably to accommodate Indian coal, which had high ash contents. It had also indigenized many components for power plants. During the 1960s, R&D activities at BHEL were conducted separately at its various units. During 1997, BHEL’s research wing achieved two major breakthroughs. BHEL succeeded in the development, manufacture and testing of India’s first 200 KVA (kilo volt-ampere) superconducting generator. The company was also successful in developing ‘fuel cell technology.’ Company sources explained that ‘phosphoric acid fuel cells,’ would emerge as a major source of pollution-free electric power in the 21st century. To remain competitive and meet customers’ expectations, BHEL lays great emphasis on the continuous up gradation of products and related technologies, and development of new products. BHEL’s commitment to advancement of technology is reflected in its involvement in the development of futuristic technologies like fuel cells and super conducting generators. BHEL’s investment in R&D is amongst the largest in the corporate sector in India. Products developed in- house during the last five years contributed about 7% to the revenues in 2002-03. 11
  12. 12. HUMAN RESOURCE BHEL has envisioned to becoming “A world-class innovative, competitive and profitable engineering enterprise, providing total business solutions.” For realizing this vision, continuous development and growth of the 48,000 strong highly skilled and motivated people making the Organization, is the only ‘mantra’. BHEL was perceived as a company where the promotions were fast, jobs were challenging, and people enjoyed a great degree of freedom to operate and function. Employees at all levels of BHEL received extensive training in different facets of management, technology and operations. The Human Resource Development Institute (HRDI) at Noida and the company’s other training institutes along with professional management institutes conducted various programs to upgrade the skills of BHEL employees. BHEL sources felt that the strong emphasis on training had resulted in a positive work culture. This had led to the development of a committed and motivated workforce and enhanced productivity and quality. It launched various initiatives to encourage participative management. During 1999, BHEL introduced a Voluntary Retirement Scheme (VRS) for its employees. The VRS aimed to correct imbalances that had crept in due to the government’s decision to extend the retirement age from 58 to 60 years. The response for the VRS was overwhelming. BHEL received applications from 8,600 workers (about 13 percent of its workforce). To formulate strategies for growth and harmonious labor relations in a changing business environment, the company organized a specially designed workshop fro unit level trade union representatives and central trade union leaders. 12
  13. 13. EXPORTS Over the years, BHEL had emerged as one of India’s leading exporters. BHEL’s exports turnover during 1997-98 touched an all time high of Rs.1783.85crore, for which it was conferred the ‘National Export Award.’ Recently it has also crossed that mark in 2001-02 (Rs.2501.95). BHEL received orders from multinational companies like Siemens, Schneider, Toa, GEC, Dresser and Pasau for a variety of products like ceramics, condensers, valves, motors, transformers, castings and forgings, ceralin and insulators. BHEL’s export orders during 1998-99 increased by over two and a half times to Rs.250crore as against Rs.91crore in the previous year. This performance was achieved despite a highly competitive international market affected by the currency crisis in South- East Asia. 0 500 1000 1500 2000 2500 3000 19 92-9 319 93-9 419 94-9 519 95-9 619 96-9 719 97-9 819 98-9 919 99-0 020 00-0 120 01-0 2 year ended totalexports PHYSICAL DEEMED YEAR 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 13
  14. 14. -93 -94 -95 -96 -97 -98 -99 -00 -01 -02 DEEMED 621 612 659 727 1138 1570 1902 1395 1425 1523 PHYSICAL 165 238 138 115 156 213 69 355 247 987 TOTAL 786 850 797 842 1294 1783 1971 1750 1673 2510 TECHNOLOGY SOURCING Over the years, BHEL had successfully adapted many global technologies to remain competitive and meet customers’ expectations, it lays great emphasis on the continuous up gradation of products and related technologies, and development of new products. The company has up graded its products to contemporary levels through continuous in-house efforts as well as through acquisition of new technologies from leading engineering organizations of the world. BHEL had modified boiler designs suitably to accommodate Indian coal, which had high ash contents. It has also indigenized many components for power plants. In its early years, BHEL did not have much choice while selecting its technology suppliers. By the mid-1970s, BHEL had established its credibility and suppliers from the Western countries were vying with each other to provide technology. These agreements enabled BHEL to gain access to the latest technology and products of its collaborators. In 1996, BHEL formed strategic alliances with Siemens and GE to set up two separate 50:50 joint venture companies. The joint venture between Siemens and BHEL, set up with a capital of Rs.6crore, was named Power Plant Improvement Private Ltd. (PPIPL). The joint venture between BHEL and GE, set up with a capital of Rs.7crore, was named BHEL-GE Gas Turbine Services Pvt. Ltd. which would carry out after sales repair and services. 14
  15. 15. COMPANY FINANCIALS BHEL completed a successful year in 1997-98, despite a highly competitive environment, a decline in industrial growth from 7.9 percent to 4.15 percent, and a negative growth in the capital goods sector. The company managed an order inflow of Rs.5853crore during 1997-98. the year ended with outstanding orders in excess of Rs.10000crore. In 1998, the Government on India, which held a 77 percent equity stake in BHEL, announced that the company had been identified for further disinvestment in line with its policy of giving Navaratnas more autonomy. The Government intended to reduce its stake to 51 percent. BHEL’s share price had appreciated considerably from Rs.100 in April, 1995 to Rs.223 in May, 2003. In 1997-98, BHEL achieved the highest ever earnings per share (EPS) of 29.4. In comparison, the EPS in 1996-97 was only 18.9. Since then it has kept fluctuating. BHEL’s earnings had constantly grown till now, it is a growing company. Defying the downward trend it has constantly grown and another successful year was completed and has registered a net profit of Rs.4679 million. Net worth of the company has gone up from Rs.36018 million in 2000-2001 to Rs.42203 million in 2001-2002 registering an increase of 17.17%. NAV per share has increased by 17.17% from Rs.147.16 in 2000-2001 to Rs.172.43 in 2001-2002. Order inflow during 2001-2002 stood at Rs.98553 million. The year ended with an outstanding order book of around Rs.1,25,000 million available for execution 2002-2003 and beyond. 15
  16. 16. 16
  17. 17. Financial Summary (1997-98 to 2001-02) Rupees (Million) 2001-02 2000-01 1999-00 1998-99 1997-98 EARNINGS Sale of products & services to customers 72866 63478 66340 67947 64713 Other Income 5046 5350 4959 5824 3785 Changes in stock -373 2507 -237 823 -133 Total earnings 77539 71335 71062 74594 68365 OUTGOINGS Materials 33068 30496 28120 30495 28382 Personnel payments 14446 21702* 11330 12416 9525 Other manufacturing & selling expenses 20735 14180** 21206 20595 18403 Outgoings before interest & depreciation 68249 66378 60656 63506 56310 Operating Profit 9290 4957 10406 11088 12055 Depreciation 1692 1578 1535 1432 1242 Gross Profit 7598 3379 8871 9656 10813 Interest 970 438 217 333 596 Profit before Tax 6628 2941 8654 9323 10217 Provision for Tax 1949 -185 2660 3877 3022 Profit after Tax 4679 3126 5994 5446 7195 Dividend (Including dividend tax) 979 809 855 679 673 Retained profit 3700 2317 5139 4767 6522 WHAT THE COMPANY OWNED Gross block incl. Capital WIP 32387 30652 28833 27306 24871 Net block( incl. Capital WIP) 12333 12038 11603 11358 10220 Investments 103 103 103 151 241 Current assets & loans and advances 80538 75762 70190 65385 60282 Total net assets 92974 87903 81896 76894 70743 WHAT THE COMPANY OWED Borrowings 6658 10256 2407 1701 3896 Current liabilities and provisions 47159 41630 45911 44368 40897 Total liabilities 53817 51886 48318 46069 44793 NET WORTH Share capital 2448 2448 2448 2448 2448 Reserves & Surplus 42248@ 35856 33539 28400 23633 Net worth 42203 36018 33578 30825 25950 VALUE ADDED 30740 26603 28320 29810 28867 Capital Employed 45815 46270 35985 32526 29846 RATIOS Gross Profit to Capital Employed (%) # 16.5% 8.2% 25.9% 30.9% 37.5% Earnings per share (Rs.) 19.12 12.77 24.49 22.25 29.39 Net worth per share (Rs.) 172.43 147.2 137.2 126.0 106.0 Current ratio 1.71 1.76 1.53 1.47 1.47 Total debt/equity 0.16 0.28 0.07 0.05 0.15 * Includes arrears of wage revision of Rs. 7078 Million from 1.1.1997 to 31.3.2000. ** After withdrawal of provision in respect of wage arrears Rs. 5140 Million. @ Includes Rs. 3046 Million towords deferred tax assets as on 31.03.2002. 17
  18. 18. 0 1000 2000 3000 4000 5000 6000 7000 8000 AMOUNT(Rs.Cr.) 1992- 1993 1993- 1994 1994- 1995 1995- 1996 1996- 1997 1997- 1998 1998- 1999 1999- 2000 2000- 2001 2001- 2002 2002- 2003 YEAR TOTAL TURNOVER *** = FOR 3 MONTHS *** PROFIT AFTER TAX 133.2 136.9 140.9 350.2 463.2 719.5 544.6 599.4 312.6 468 376.1 0 100 200 300 400 500 600 700 800 1992- 1993 1993- 1994 1994- 1995 1995- 1996 1996- 1997 1997- 1998 1998- 1999 1999- 2000 2000- 2001 2001- 2002 2002- 2003 YEAR S 18
  19. 19. ANALYSIS THE earnings performance of BHEL for the quarter ended March 2002 has been fairly good. Sales revenues during the period rose around 11 per cent to Rs 3,374.2 crore, compared to the corresponding previous period. Of this, close to 68 per cent of the sales were generated by the power division and the rest from the industrial division. BHEL’s power equipment segment is the undisputed market leader in this segment. Its huge capacity, ability to offer contemporary technologies and competitive prices, make it among the preferred suppliers of power equipment in the country. This is evidenced by the order book position, way ahead of its closest competitors. This trend is likely to continue and be in favour of BHEL’s near-to-medium-term prospects INVESTMENT OUTLOOK Trading at around Rs 167, the BHEL stock may be a good investment option for a moderate-to- high-risk portfolio. It trades at a price earnings multiple of around 12 times its latest quarter’s earnings per share. Its earnings performance for the quarter ended March 2002 has been fairly impressive. Despite tough industry conditions, the company has managed a sedate growth rate in both profits and revenues. Gains have come mainly on account of the company’s dominant position in the industry and also good management of resources. In this backdrop, the valuation of the stock over the next three months should improve. Fresh positions can be considered at current levels. However, investors should also look out for exit opportunities once the stock breaches the Rs 200- 210 levels. Risk-averse investors may consider taking an exposure if the stock declines to Rs 150- 155, and sell if it crosses Rs 200. GENERAL OUTLOOK While the Indian Economy is continuing to grow at slow pace, there are positive impulses like on- going Restructuring and Reforms in the Power Sector, enhanced focus on Distribution, increased outlay for Accelerated Power Development and Reforms Program, creating regulatory system, new Electricity Bill etc. Government’s commitment to enhance private and public investments in 19
  20. 20. the infrastructure is a positive aspect that will spur Industrial Growth and enhance market prospects for industrial products in the coming years. BHEL has put in place a number of initiatives, as follows, for furthering future growth prospects:  Strengthening company’s core businesses of Power Generation, Transmission and Distribution, Transportation and Industrial Systems and Products, through accelerated project completion and consequent benefits to customers, along with new initiatives in marketing, technology, facility up gradation and modernization, enhancing operational effectiveness etc.  Business Development efforts in related and allied areas utilizing the organizational strengths and former customer focused specialized business groups e.g. formation of Oil Sector R&M Business Group to address business in Renovation and modernization of off-shore and on- shore oil platforms, down streams petroleum refining areas and Power Plant Operational Services Group to provide Operation and Maintenance (O&M) Services for Power Plants.  After Market Services being the areas for future growth, spares and R&M services business have been integrated into one focused group. R&M for hydro sets is an area having major growth opportunity, which BHEL is poised to tap.  Exploring Business Opportunities in areas like Energy Conservation, Water Management, Pollution Control and Waste Management, Ports, LNG terminal etc.  Positioning for Information Technology Business leveraging the domain knowledge in Power Sector and Engineering field to provide IT enabled services for Power Sector and software services for Engineering Industry.  Sustain and Enhance Exports for products and services through multi-prolonged approaches. BHEL is also taking steps to re-position itself to meet the demands of the new market economy through suitable strategies keeping in view the ultimate objective of enhancing value for its stakeholders. 20
  21. 21. SWOT ANALYSIS OF BHEL    STRENGTHS • The company has 180 products under 30 major product groups that cater to the needs of the core sector like power, industry, transmission, transportation, defense, telecommunications and oil business. • BHEL's ability to acquire modern technology and make it suitable to Indian conditions has been an exceptional strength of the company. • Strong relationship with NTPC is a strength as NTPC is planning a capacity expansion of Rs. 52 bn and based on the past, 85% of NTPC projects have been bagged by BHEL. The company also enjoys purchase price preference.  WEAKNESSES • PSU status is a big weakness for BHEL as it is subject to their rules and regulations and is forced to carry a huge amount of labor force, which it is not able to retrench. • The company offers very stringent credit facilities to the customers and this is a weakness when compared in the face of rising competition. On the other hand their customers in the power segment, SEBs, have a huge amount of receivables standing against their name in the company's balance sheet. This is a major weakness for the company. • The company is vertically integrated, which could have been avoided by outsourcing its components for power generation and transmission. This could have reduced the cost.  OPPORTUNITIES • 21
  22. 22. • The power sector reforms are expected to pick up in the near future in India, which would directly benefit BHEL. • Increase in defence budget will increase the topline for the company. • NTPC is planning additional capacities to the tune of 2,800 MW, at a cost of Rs 52 bn. BHEL could benefit a lot as it has happened in the past that significant portion of the project of NTPC is handled by BHEL. Nearly 85% of the NTPC projects were assigned to BHEL only. • The business of modernization and renovations of power plants is expected to grow in India. • The disinvestment plans of the government would bring in new resources and experience into the company. • Joint Venture with Siemens in the name of Powerplant Performance Improvement Ltd. (PPIL), is a major strength for the company. This tie-up will be beneficial as there is a lot of scope for business. During FY00 the PPIL received orders worth Rs. 320 crore.  THREATS • The global trend of consolidation has already resulted in a fall in turnover of the company and this will prove to be a major threat in the years to come as well. • The company is dependent on NTPC to a great extent. • Recently, the government has permitted the import of second hand capital goods that are 10 years old without the need for a license. This move will definitely increase competitive pressures for BHEL. 22
  23. 23. CORPORATE FUNCTIONAL STRUCTURE At the top most level are the Board of Directors under whom is Chairman and Managing Directors. Under this level are corporate functions, business sectors and management committee. Under Corporate functions there are four directors. They are:- • Director Engineering Research and Development • Director Human Resources • Director Finance • Chief Vigilance Officer Under Director Finance comes Executive Director Finance under whom there are following departments:-  Finance Administration  Cash Management  Financial Services  Budgeting  Corporate books  Internal Audit  Provident Fund Trust  Establishment  Taxation  Direct Taxes  Indirect Taxes 23
  24. 24. OBJECTIVES OF THE PROJECT: • To Carry out Valuation of BHEL • To develop standard formats for Leasing Vs. Buying decisions • To standardize Purchase of Asset using Own Vs Borrowed funds decision formats • To develop standard formats for Project Financing Decisions 24
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  26. 26. THE VALUE CONCEPT “The fundamental goal of all business is to maximize shareholder value” This statement is now universally accepted as a guide to enhancing shareholder value. In United States, top management is traditionally expected to seek shareholder value maximization. Failure to do so results in pressure from board of directors and activist shareholders or even hostile takeover bids. Elsewhere in the world, companies make different implicit tradeoffs among their various stakeholders. Earlier, maximizing shareholder value was often seen as short sighted, inefficient, simplistic and even antisocial. But the evidences against these arguments and in favor of Shareholder wealth maximization—are mounting. Winning companies have higher productivity, greater increase in shareholder wealth and greater employment gains than their competitors. There is no evidence of any conflict between shareholders and other stakeholders. A value-based system grows in importance as capital becomes mobile. In wake of economic liberalization, companies are relying more on capital market, acquisitions and restructuring are becoming commonplace, strategic alliances are gaining popularity, employee stock options are proliferating, and regulatory bodies are struggling with tariff determination. In these exercises a crucial issue is: How should the value of a company or division thereof be appraised ? 26
  27. 27. For the purpose of finding out a firm’s value, various methods are used and many a times, an indepth appraisal of the company and it’s assets and liabilities has to be carried out. The goal of such an appraisal is essentially to estimate a fair market value of a company. The most widely accepted definition of fair market value was laid down by Internal Revenue Services of the US. It defined fair market value as “the price as which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell , both parties have reasonable knowledge of relevant facts.” When the asset being appraised is “a company”, the property the buyer and the seller are trading consists of the claims of all the investors of the company. This includes outstanding equity shares, preference shares, debentures, and loans. BUSINESS VALUATION SERVICES Business valuations provides the information necessary to make sound business decisions in regards to assessing the value of assets owned by businesses or individuals. Business valuation helps to meet individual and business needs in many situations of need or adversity, including: Adequacy of Life Insurance Allocation of Acquisition Price Buy/Sell Agreements Bankruptcy and Foreclosures Charitable Contributions Eminent Domain Employee Stock Ownership Plans (ESOPs) Estate and Gift Taxes Fairness Opinions Insurance Claims Financial Statements for a Business Loan Financing Franchise Valuation or Evaluation Gifting Programs Incentive Stock Option Programs 27
  28. 28. Initial Public Offerings (IPOs) Lease vs. Buy Disruption of Business Dissenting Shareholder Actions Economic Loss Analysis Liquidation or Reorganization Mediation and Arbitration Mergers and Acquisitions Sale of a Business Split-ups/Spin-offs Succession Planning ACCEPTED VALUATION APPROACHES AND METHODS Valuing a company is hardly a precise science and can vary depending on the type of business and the reason for coming up with a valuation. There are a wide range of factors that go into the process -- from the book value to a host of tangible and intangible elements. In general, the value of the business will rely on an analysis of the company's cash flow. In other words, it's ability to generate consistent profits will ultimately determine its worth in the marketplace. A company’s value can be examined using 16 different methods in order to arrive at a supportable conclusion of value:  Asset Valuation Methods: • Book Value • Adjusted Asset Value • Liquidation Value  Income Valuation Methods: • Capitalization of Earnings • Discounted Future Earnings 28
  29. 29. When determining discount and capitalization rates, you have the option to use either the Build-Up method or the Capital Asset Pricing Model (CAPM) method. If you are valuing the company on a debt-free basis, you can convert the discount and capitalization rates to their debt-free equivalents based on the company’s weighted average cost of capital. In valuing the company’s historic and/or future earnings, you can use any of the following: Normalized Net Income, EBT, EBIT, EBITDA, Net Cash Flow and Free Cash Flow.  Market and Comparable Company Approaches: • Price to Earnings  From Mergerstat database (uses Net Income)  From Done Deals/Completed Transactions database (uses Net Income)  Other selected data source (you select earning base) • Price to Revenue • Price to Cash Flow from Operations • Price to Gross Cash Flow • Price to Dividends • Price to Total Assets • Price to Equity / Book Value  From Done Deals/Completed Transactions database  Other selected data source  Other Valuation Methods: • Capitalization of Excess Earnings • Rule of Thumb  Preferred Stock Valuation: • Market yield of the preferred stocks of comparable companies 29
  30. 30. The commonly used approaches are : ADJUSTED BOOK VALUE APPROACH The simplest approach to valuing a firm is to rely on the information found on its balance sheet. There are two equivalent ways of using the balance sheet information to appraise the value of the firm. First the book value of investor’s claims may be summed directly. Second, the assets of the firm may be totaled and from this total non-investor claims (like accounts payable and provisions) may be deducted. The accuracy of the book value approach depends on how well the net book values of the assets reflect their fair market values. There are three reasons why book values may diverge from market values. • Inflation drives a wedge between the book value of an asset and it’s current value. The book value of an asset is it’s historical cost less depreciation. Hence it does not consider inflation which is definitely a factor influencing market value. • Thanks to technological changes some assets become obsolete and worthless even before they are fully depreciated in the books. 30
  31. 31. • Organizational capital, a very valuable asset is not shown on the balance sheet, is not shown on the balance sheet. Organizational capital is created by bringing together employees, customers, suppliers and managers in a mutually beneficial and productive relationship. An important characteristic of organizational capital is that it cannot be easily separated from the firm as a going entity. Hence, their values are adjusted to reflect either Replacement cost or Liquidation values. Using any of these methods was out of the purview of this project. CAPITALIZATION OF INCOME METHOD This method places no value on fixed assets such as equipment, and takes into account a greater number of intangibles. Capitalization refers to the return on investment that is expected by an investor. There may be many variations in how this method is applied. In one method, factors effecting income of the business are listed, rated and then averaged to get capitalization rates which are multiplied with buyer’s discretionary cash to determine the market value of business. Another method compares risk free returns or income of business are compared with same level of returns being generated by other risk free investments. The business is then valued equal to those investments. EXCESS EARNING METHOD This method is similar to the capitalization method. The difference is that it splits off return on assets from other earning (the excess earnings). The financially rational reason for owning business assets is to produce a financial return. A reasonable return here should be based on industry averages for return on assets adjusted to current economic conditions. This excess earning is typically multiplied by a factor of 2 to 5 based on such factors as the level of risk involved in the business, the attractiveness of the business and the industry, competitiveness, and growth potential. The higher the factor used, the higher the estimate of the business will be. A typical number is 3 for a solid, profitable company. That is, a good business that is judged to be average in terms of the level of risk involved, the attractiveness of the business, the industry, 31
  32. 32. competitiveness, and growth potential would use three as a multiplier. The actual factor used is a mix of opinion, comparison to others in the industry, and industry outlook. These Capitalization methods is best used in non asset intensive businesses and ones that derive their income primarily from tangible assets such as a utility (such as gas or electric companies) like service companies, hence was not put to use in this project MULTIPLIER OR MARKET VALUATION This approach finds the value of a business by using an "industry average" sales figure as a multiplier. This industry average number is based on what comparable businesses have sold for recently. As a result, an industry-specific formula is devised, usually based on a multiple of gross sales. This is the trouble point with these formulas, because they often don't focus on bottom line profits or cash flow. Also, they don't take into account how different two businesses in the same industry can be. Here are a few industry multiplier examples, as mentioned in "The Complete Guide to Buying a Business" by Richard Snowden (Amacom, 1994): Travel agencies - .05 to .1 X annual gross sales Ad agencies - .75 X annual gross sales Retail businesses - .75 to 1.5 X annual net profit + inventory + equipment To find the right multiplier for an industry, their trade associations may be contacted. Another option is to utilize the services of a broker or appraiser who specializes in similar businesses. RULE OF THUMB METHOD One of the most common approaches to small business valuation is the use of industry rules of thumb. While most financial analysts cringe at the use of these approaches, they do have their place as adjuncts to other methods. 32
  33. 33. One industry rule of thumb says an Internet Service Provider company is worth $75 to $125 per subscriber plus equipment at fair market value. Another says that small weekly newspapers are worth 100% of one year's gross income. The problem with these and all rule of thumb formulas is that they are statistically derived from the sale of many businesses of each type. The rule of thumb averages may be accurate for those businesses whose performances are right about at the average. The business with expenses and profits that are right on target with industry averages may well sell for a price in line with the rule of thumb formula. Others will vary. To apply the rule of thumb to a business that varies significantly from the average is not appropriate. THE APPROACH APPLIED Making good decisions usually depends on having good information and value is the performance metric that uses the best and most complete information. For understanding value creation, a long term approach needs to be adopted, managing all cash flows across both income statement and balance sheet and understanding how to compare cash flows from different periods on a risk adjusted basis. It is this dependence on full picture that makes value the best metric. No other measure of corporate performance is as comprehensive or as well correlated with a company’s market value. Earnings per share or market value tend to be used myopically, looking only a few years ahead at best. Furthermore the earnings measure generally focuses on managing the income statement and plays down actual amount and timing of cash flows. Even the difference between return on invested capital (ROIC) and cost of capital can be a bad metric. If it is used only in the short term it tends to encourage under investment in or the harvesting of – a business to increase ROIC. The Discounted Free Cash Flow approach is ideally suited when fairly credible business plans are available for the explicit forecast period and the firm is expected to reach a steady state at 33
  34. 34. the end of the explicit period. Also this approach considers the cash flows and growth of invested capital in the forecasted period as well as beyond it. With the nature data available at BHEL, this was the most suitable approach to carry our Business Valuation. DISCOUNTED FREE CASH FLOW FORECAST APPROACH Valuing a firm using discounted cash flow approach is conceptually identical to valuing a capital project using present value method. However, there are two important differences: • While a capital project is deemed to have a definite life, a firm is considered as an entity that has an indefinite life. This means that when we value a capital project we define it’s economic life and impute a salvage value to the assets of the project at the end of it’s economic life; however, for a firm we do not define an economic life and impute a salvage value to it’s assets at the end of such a period. • A capital project is typically valued as a ‘one-off ‘ investment. We do not ordinarily look at the follow on investments on the assumption that these will be evaluated separately as and when they crystallize. A firm, however, is viewed as a growing entity and for valuing a firm we take into account all the investments in fixed assets and net working capital that are expected to be made over time to sustain the growth of the firm. Thus, Valuing a firm using the discounted cash flow approach calls for forecasting cash flows over an indefinite period of time for an entity that is expected to grow. To carry out this task, in practice the value of firm is separated into two time periods: Value of the firm = Present Value of cash flow + Present value of cash flow During an explicit forecast after the explicit forecast Period period During the explicit forecast period – which is often a period of 5 to 15 years – the firm is expected to evolve rather than rapidly and hence a great deal of effort is expended to forecast it’s cash flow on an annual basis. At the end of the forecast period, the firm is expected to 34
  35. 35. reach a ‘steady state’ and hence a simplified procedure is used to estimate the continuing value at the end of the explicit forecast period. Thus, the discounted cash flow approach to valuing a firm involves the following steps: A. Forecast the cash flow during the explicit forecast period. B. Establish the Weighted Average cost of capital. C. Determine the continuing value at the end of the explicit forecast period. D. Calculate the firm value. A Forecast the cash flow during the explicit forecast period. i) Select the explicit forecast period – as in case of BHEL taken to be of four financial years from 2003-04 to 2006-07. ii) Define Free Cash Flow to firm. FCFF = NOPLAT – Net Investment + Non-Operating Cash Flow  NOPLAT (Net Operating Profit Less Adjusted Tax) = EBIT – Adjusted Tax on EBIT • EBIT (Earnings Before Interest and Tax) = Profit Before Tax (PBT) + Interest expense - Interest Income - Non-operating income • Adjusted Tax on EBIT = Tax provision from income statement + Tax shield on interest expense - Tax on interest income - Tax on non operating income  Net Investment = Gross Investment - Depreciation 35
  36. 36.  Adjusted Non-Operating Income = Interest / Dividend Income - Tax on Non-Operating Income B. Establish the Weighted Average Cost of Capital (WACC) WACC = [Cost of Debt (Cd) * Avg. Debts / (Avg Debts + Avg Net Worth) ] + [Cost of Equity (Ce) * Avg. Net Worth / (Avg Debts + Avg Net Worth) ]  Cost of Debt = Total Interest Cost / Avg Borrowings * 100  Cost of Equity = Risk Free Rate of Return + Risk Premium * Beta • Risk Premium = Market Expected Rate of Return - Risk Free Rate C. Determine the Continuing Value at the end of the explicit forecast period. Continuing Value (CV) = [ Free Cash Flow n+1 (1 + Growth Rate of last year of Explicit Period) ] / ( WACC – Growth Rate )  Growth Rate (g) = (Net Investment / Invested capital ) * 100 D. Calculate the firm value Firm Value = Present Value of Free Cash Flow in Explicit Forecast Period + Present Value of Continuing Value. 36
  37. 37. 37
  38. 38. FINANCING DECISIONS The lease-versus purchase (or lease-versus-buy) decision is one that commonly confronts firms contemplating the acquisition of new long-term assets. Ultimately, a company or business must pay for new equipment either from its own accumulated capital resources 'equity financing' or by using borrowed funds 'debt financing' or have another party acquire the desired equipment and lease it to the company or business. In most cases, equipment acquisition becomes a choice between purchase (either by equity or debt financing) and lease. The main feature distinguishing leasing from other forms of financing like loans or mortgages is the separation of usage from ownership. Throughout the term of the lease, the lessor retains legal ownership while the lessee has possession and use. The lease will not normally confer on the lessee either the right or the obligation to acquire the leased equipment from the lessor during the lease term but may do so at its expiry. BUYING 38
  39. 39. If the business has excess cash to pay for an asset, purchasing it with that cash will be the least expensive option since interest will be charged on any loan or lease option. Consideration though would be that if cash that will be needed for day-to- day operations is used to purchase a long-term asset, cash flow difficulties might arise. Even if the company is doing well in terms of sales when purchase of asset is being considered buying the asset, what is the likelihood of the situation changing over the next 3 years? This is what is called Opportunity Cost. Opportunity Cost is defined simply as that cost incurred by investing (utilizing cash) in one item over another. BORROWING If the interest rates in the market are dipping and the company hasn’t got a flush of resources to invest in asset purchase, borrowing is the best option. It helps avoid large initial expenditure as well as blocking of internal funds. Moreover since the repayment is spread over a long time period, it helps to capture the Time Value advantage. LEASING A Lease represents a contractual arrangement whereby the lessor grants the lessee the right to use the asset in return of periodic leases rental payments. While Leasing of land, Buildings, and animals has been known from times immemorial, the leasing of industrial equipment is a relatively recent phenomenon especially on the Indian Scene. Leasing and Hire-Purchase have emerged as a supplementary source of intermediate to long term finance, provided mainly by Non-Banking financial companies, financial institutions, and other organizations. An equipment lease transaction can vary along many dimensions such as – extent to which the risks and rewards of ownership are transferred, number of parties to the transaction, domicilies of the equipment manufacturer, the lessor and the lessee, etc. Lease transaction are primarily classified as :  Financial Lease  Operating Lease 39
  40. 40. A finance lease, or Capital Lease, is essentially a form of borrowing. Its Salient features are:  It is an intermediate term to long term non-cancelable arrangement. During the initial lease period, referred to as ‘primary lease period’, which is usually 3yrs, 5yrs or 8yrs, the lease cannot be cancelled.  The Lease is more or less fully amortized during the primary lease period. This means that during this period, the lessor recovers through the lease rentals his investment in the equipment with an acceptable rate of return.  The Lessee is responsible for maintenance, Insurance and Taxes.  The Lessee usually enjoys the option for renewing the lease for further periods at substantially reduced rentals An Operating Lease can be defined as any lease other than financial lease. The salient features of an operating lease are:  The lease term is significantly less than the economic life of the equipment.  The Lessee enjoys the right to terminate the lease at short notice without any significant penalty.  The lessor usually provides the operating know-how and the related services and undertakes the responsibility of insuring and maintaining the equipment. Such an Operating lease is called a ‘Wet Lease’. An Operating Lease where the Lessee bears the cost of insuring and maintaining the leased equipment is called a ‘Dry Lease’. From the above features of an Operating Lease, it is evident that this form of a lease does not result in substantial transfer of the risks and rewards of ownership from the lessor to the lessee. The Lessor structuring an operating lease transaction has to depend upon multiple leases or on the realization of a substantial resale value (on expiry of the first lease) to recover the investment cost and a reasonable rate of return thereon. Therefore specializing in operating Lease calls for an in- depth knowledge of the equipments per-se and the secondary (re-sale) market of such equipments. 40
  41. 41. FACTORS EFFECTING COSTS OF THE FINANCING OPTIONS (Specifying BHEL’s practices) :  Nature of Asset  Nature of Lease  Insurance, Annual Maintenance and Other Expenses  Timing of Cash Outflows and the Repayment Schedule  Rate of Depreciation  Opportunity Cost  Interest on Borrowed Funds  Tax Considerations  Expected end of the lease Contract 41
  42. 42.  Salvage Value  Organization’s asset management capabilities NATURE OF ASSET Leasing or buying—which is better? Isn’t it always better to be an owner? The answer: sometimes. According to oil baron Paul Getty, “If it appreciates, buy it. If it depreciates, lease it.” There are many benefits to both buying and leasing, depending on the type of property involved. Businesses have two property types— real and personal. Real property encompasses buildings and other permanent structures, and the land on which they stand. Personal property includes furniture, fixtures, and equipment—everything from shelving to desks. Buying is often most beneficial when financing real property, because it will appreciate and gain value over time. Owning real estate— and the structures on it—is almost always a good investment for the long haul. Property owners build equity and reap the benefits of the property’s increasing value. However, shops are heavily comprised of machinery—which is in the category of personal property and, therefore, depreciates in value over time. What’s more, technology is always changing, systems are always improving, and the equipment needs to be updated and replaced every few years. For everything that needs to be replaced every few years, therefore, leasing is very often the best option. 42
  43. 43. Nature of asset determines the rate of depreciation of the asset and thus it’s worth at the end of the lease period. The amount of lease rental bears an effect of the residual value since that would be the amount that the lessor would be recovering at the end of Lease period and thus wouldn’t recover it through Lease rentals, thereby bringing down the overall cost of Leasing the asset i.e. the lease rentals. NATURE OF LEASE The kind of lease contract i.e. Financial or Operating brings up differences in many aspects since the treatment of several items is done in different manners according the rules and provisions of various laws applicable in this context, such as:  Accounting Standards of India Operating Lease are capitalized in the books of the lessor. Lease payments are treated as income of the lessor and expense of the lessee. The depreciation of leased assets should be on a basis consistent with the normal depreciation policy of the lessor for similar assets. Financial Lease according to recent accounting standards of ICAI, must be capitalized in the books of lessee. This means that: a) At, the time of inception the leased equipment is shown as an asset on the balance sheet of the lessee. It’s Value is equated to the present value of committed lease rentals. The leased asset is matched by a corresponding liability called the ‘Lease Payable’ b) Lease payments are split into two parts : Finance Charge and Principal Amount. The Finance Charge (Interest payment) is treated as an expense on the profit and loss account and the principal amount is deducted from the liability ‘lease payable’. c) The leased asset is depreciated in the books of lessee as per its depreciation policy.  Income Tax Provisions a) The depreciation is claimed by the person in whose books, the asset has been capitalized. b) Tax benefit on maintenance and insurance to be claimed by the person who bears them. c) The Lease rentals paid by lessee are tax deductible expenses for the lessee. 43
  44. 44.  Sales Tax provisions a) The lessor is not entitled for the concessional rate of Central Sales Tax because the asset purchased for leasing is meant neither for resale nor for use in manufacture. b) The 46th Amendment Act has brought lease transactions under the purview of ‘sale’ and has empowered the central and state governments to levy sales tax on lease transactions. While the central sales tax has yet to be amended, in this respect, several state govt. have amended their sales tax laws in this respect. As of yet, the Sales Tax provision is not applicable on the transactions entered into by BHEL. Nature of lease In Financial Lease, since the Lessor has to recover whole of the asset cost within one Lease period (primary lease period) only, the rentals are expected to be higher than those in Operating Lease, in which, Lessor may re-let the asset at for another lease period. But due to the Insurance and Maintenance charges, the Operating Lease Rentals tends to rise. If the nature of your industry demands that you have the latest technology, a short-term operating lease can help you get the equipment and keep your cash. Lease equipment that you expect to depreciate quickly. Your risk of getting caught with obsolete equipment is lower because you can upgrade or add equipment to meet your ever-changing needs. INSURANCE, ANNUAL MAINTENANCE AND OTHER EXPENSES In the options of Buying ( using own or borrowed funds) and Financial Leasing, since the asset is capitalized in the hands of the person using it i.e. Lessee , he has to bear the Insurance and maintenance charges and he only gets the Tax Benefits on them. But in Operating Lease, the Lessor bears the Insurance and maintenance expenses, therefore he includes them in the Lease Rentals. These two elements shall be common to all the options. If purchased or taken on financial Lease, the business shall have to bear these expenses itself and if taken on Operating Lease, the Lessor will load these expenses in the Lease Rentals. The nature of asset also has a hand in determining 44
  45. 45. TIMING OF CASH OUTFLOWS AND THE REPAYMENT SCHEDULE In case of buying using own funds, substantial cash outlays have to be made in the initial phase for acquisition of the asset, which renders this option costlier than buying using borrowed funds and leasing. While in case of buying using borrowed funds, monthly EMI payments have to be made according to the repayment schedule, periodic payment of lease rentals is spread over the lease tenure. The repayment schedule has a bearing on the Present Value of outflows. The longer the spread of Lease rentals, the lesser will be it’s present value. Thus the impact of timing of cash outflows shows up in the NPV of outflows of these options. RATE OF DEPRECIATION The Rate of Depreciation that BHEL uses for it’s calculation is according to the IT provisions, whereas the Lessors use the depreciation rate prevalent in market depending upon the nature of asset. During the analysis, when the lease options are weighed using the IT rate, they generally prove to be expensive since actually it’s difficult to realize that high salvage value of the depreciated asset from the market. OPPORTUNITY COST Opportunity cost is the profit foregone in choosing the current option that could have been earned in the second best option. While using own funds to purchase the asset in addition to cash outlays, we are incurring opportunity cost by blocking the funds in that asset instead of investing them in productive business operations or any other investment option. Whereas when the asset is leased out or purchased using borrowed funds, funds are not blocked and are available for alternative investment. This variable is used to compute the present values of the cash flows associated with both the leasing and purchase options However while assessing proposals in BHEL this element was not considered since the assumption of availability of funds free for reinvestment every year couldn’t hold true here. Also a constant rate of return is assumed for the calculation of Opportunity cost, which might not actually be possible to earn over a long period of time due to the volatility in market rate of returns. 45
  46. 46. INTEREST ON BORROWED FUNDS The Rate taken for the option of Purchase using borrowed funds is generally SBI MTLR (State Bank of India – Medium Term Lending Rate.) TAX CONSIDERATIONS Tax Rates and the Tax Shield earned on the cash outlays and expenses incurred have a substantial impact on the costs and thus the viability of various options. In all these options, tax shield is availed by the person who is actually bearing the charges. Tax shields bring down the costs substantially Lease payments are deductible expenses for tax purposes. This is an important point because it means every Rupee one pays as a lease payment reduces one’s taxable income. This is not the case when a one elects to purchase an asset and finance the purchase with a loan. In this latter case only depreciation expenses and interest paid on loans are tax deductible expenses. This difference in the deductions that can be claimed depending on whether an asset is leased or purchased is something one needs to consider when determining whether it is preferable to lease or own an asset. EXPECTED END OF LEASE CONTRACT Many lease arrangements (generally financial lease) give the lessee (user) the option of purchasing the leased asset at the termination of the lease. This right to purchase a leased asset can be beneficial to a person because it can put them in essentially in the same position they would have been if they had initially purchased the asset in question. In cases where the lessee purchases an asset that was previously leased, the price paid for the asset may be pre-decided or at or near the current fair market value of the asset. While in others (like operating lease) the Lessor takes back the asset at the end of lease period. The expected end of lease would determine whether the lessor or the lessee would recover the salvage value of the asset. SALVAGE VALUE 46
  47. 47. Depending upon the expected end of lease agreement, the salvage value is recorded in the books of Lessee or Lessor. If the Lessee retains the asset and recovers the salvage value, the lessor would include it for the purpose of lease rental calculation. Whereas if the Lessor takes back the asset at the end of lease period, its effect shows on the reduced rentals. Thus Salvage value is an important determinant of the amount of lease rentals. ORANISATION’S ASSET MANAGEMENT CAPABILITIES Leasing and asset management go hand in hand. The process of buying, maintaining and disposing of equipment can distract valuable organizational resources from mission- critical priorities. Leasing can be implemented as outsourced asset management. Hence the choice of asset finance depends upon the organization’s efficiency levels in asset management. THE DECISION PLATFORM- NET CASH OUTFLOW The techniques for comparing lease and purchase alternatives may be applied in different ways. Like most financial decisions, the lease-versus-purchase decision requires a certain degree of judgment or intuition. There are basically 2 prime considerations in evaluating the financial options available. These are: • The net (after tax benefit) cash flow; and • The net present value of the cash flows. THE NET CASH OUTFLOW CALCULATION The amount of money spent on purchasing an asset or in lease or loan repayments does not reflect the net cost of financing the acquisition of the asset. This is because tax deductions are available in relation to each option. These deductions may take the form of: • A straight deduction for repayments • Depreciation of the plant or equipment acquired, or . The interest pertaining to the loan etc. 47
  48. 48. The net cash flow calculation involves taking the cash outlay on financing the purchase using own funds / purchase using borrowed funds / leasing and subtracting the tax saving from that figure in order to arrive at the net cash outflow. The results generated by the standardized decision spreadsheet developed in this project reflect the net present values of the cash costs and savings (tax savings) one would experience depending on whether an asset is leased or purchased. A net present value is reported for the lease option and another one is reported for the case where the asset is purchased. By comparing these net present values it can be determined whether it is less or more costly to lease an asset. In cases where the net present value for leasing is less than it is for purchasing, leasing would be the least costly method for acquiring an asset. Alternatively, leasing would be more costly, and therefore not preferable, any time the net present value reported for leasing is greater than it is for purchasing the asset. These spreadsheets were successfully used for analysis of proposals such as Asset Lease, Equipment Purchase etc. that came for consideration to the Financial Services Deptt. The working of the worksheet is being presented using assumed values. 48
  49. 49. THE FINANCING CONCEPT The Projects are building blocks of a development plan. Creation of utilities is the sine qua non of business. Schemes in which investment is made in anticipation of deriving future benefits therefrom are known as projects. Project is thus a package of measures selected to reach an objective that has been precisely designated beforehand and is objectively verifiable. The basic characteristic of project is that it involves current outlay of funds in the expectation of future benefits. The inputs of the project come in the form of equipment, supplies, personnel, etc. An efficient project makes productive use of land and other natural resources with the help of capital applying technical capability of human resources, giving an output adequate to enhance the nation’s economic growth. Project Financing involves raising funds for the acquisition of fixed assets such as land and buildings, plant and machinery, vehicle furniture and fittings etc. which are used in business to 49
  50. 50. earn income. It is necessary to define the financial requirements of a project at the investment and initial operational stage. During the period of construction or the project stage usually called the gestation period, the investment does not give anything in return. The investments in procurement of assets are illiquid and are known as Sunk Capital. Hence the project planners try to get such assets financed through external sources such as Buyer’s Credit. PARTIES TO PROJECT FINANCING The principal parties to a project financing includes the following:  SPONSORS – The parties behind the project, which may be single entity or a consortium of, for example, the principal contractors and the prospective buyers of the output of the project when it is completed.  SUPPLIERS – The party which is supplying the equipments or assets to the sponsors and arranging credit through banks and financial institutions for them. They have to analyze the sponsors for their creditworthiness and the project for it’s feasibility to ensure timely payment of their dues.  BORROWERS – The choice of legal entity to act as a borrower will be dependent upon, for example, the applicable laws, taxes and exchange controls. If the sponsor is a consortium then two or more than one borrower for that project. 50
  51. 51.  FINANCIERS / LENDERS – Because the amounts involved are usually large and the risks high it is normal for any facility to be syndicated between two or more providers of finance. One bank is usually “mandated” by the other to act as the “arranger”, putting together the funding package. That bank, or another as appropriate then acts as “agent” to coordinate the syndicate of financiers once the funds have been made available. Those banks providing the most are often named as “managers” or “lead managers”. Some banks may, instead of lending themselves, provide guarantees to other banks or organizations able to provide subsidized or lower cost-finance since they either cannot or do not want to carry the credit risk. Finance may be provided in the form of a loan or, for example, bonds, guarantees, export credits, commercial paper or leases. Interest on the facility is often “rolled up” and added to capital during the construction phase of a project . Charges on the project asset and revenue streams( Escrow Account ) are sometimes taken by lenders solely to stop third parties obtaining prior charges. PROJECT FINANCING IN BHEL As per the needs and demands of the customers interested in purchasing equipments from BHEL, proposals for financing the asset purchase are called from a selected group of banks and financial institutions. The marketing division refers the proposal of customers to Financial Services Deptt. (FSD) .The details of the project and other financials supplied by the customer thoroughly analyzed to establish his creditworthiness. Thereafter proposals are sent to the selected banks and financial institutions. SELECTION OF THE BANK / FINANCIAL INSTITUTION All the banks and financial institutions verify the receipt of these proposals and upon carrying out the feasibility analysis from financing point of view, they respond with their terms and conditions, clearly defined. On receipt of proposals from banks and financial institutions BHEL carries out their analysis to arrive upon the best suited and cheapest source of finance for it’s customer. 51
  52. 52. The major aspects of the analysis are:  Principal Amount  Moratorium Period  Interest During Construction Capitalized (IDC)  Interest Rate on Borrowings  Drawdown Schedule  Repayment Schedule and timing of outflows.  Commitment Charges  Other Charges. PRINCIPAL AMOUNT It is the amount of financing agreed upon by the bank / FI. This amount may be equal or less than the value of the equipment or asset. It may be in Indian or foreign currency in case any foreign bank has come up with a financing proposal. In case the principal amount is less than value of the asset, the supplier of asset may himself finance the remaining part. MORATORIUM PERIOD It is the Initial period (Construction or Gestation) of the project in which no repayment of the borrowed funds has to be made. Moratorium may be allowed either on Principal amount or Interest or both. The length of moratorium period depends upon the ability of project to start generating returns and the terms acceptable to the Lender. 52
  53. 53. INTEREST DURING CONSTRUCTION CAPITALISED (IDC) Generally, the amount of interest not paid during Moratorium period is capitalized and added to the principal. At the end of Moratorium period, a revised principal is calculated by adding up the accumulated interest into original principal. This revised principal is repaid as per the repayment schedule after the Moratorium period. Higher the capitalized amount, costlier the financing option becomes. RATE AND COMPUNDING OF INTEREST ON BORROWINGS The Banks / FIs use the Term lending rates for the purpose of Project Financing since these are generally long term projects spreading from 5-10 years. These rates may be fixed , floating or a combination of both. Generally, the benchmark used in floating rates is LIBOR( London Inter- Bank Offered Rate). This is a major contributory factor rendering any financing option viable or unviable. The rate of compounding of interest during moratorium period effects the cost of financing. Higher the frequency of compounding, the costlier the option becomes. DRAWDOWN SCHEDULE Banks / FIs do not release whole of the borrowed amount at the time of sanctioning of the loan itself. Instead a schedule is finalized by the bank / FI according to the funding requirements of various stages of project completion. This schedule is called the drawdown schedule. The longer stretched the drawdown schedule, higher would be the commitment charges but lower shall be the PV. REPAYMENT SCHEDULE AND TIMING OF OUTFLOWS This factor majorly affects the present value of different financing options. A quarterly repayment schedule will be dearer than a six monthly repayment schedule since the earlier repaid amount is 53
  54. 54. discounted by a lower discounting rate. The rate used for discounting is generally the minimum rate of return, the project is expected to generate or the interest rate being charged by the bank. COMMITMENT CHARGES These are charged on the undrawn or otherwise unutilized portion of a facility, to compensate the lender for any capital adequacy costs for tying up its funds or limits in case they are needed by the borrower. These add up to the cost of financing option and are payable over the moratorium period. OTHER CHARGES These charges may include Management fees, Success fee, processing fee etc. THE DECISION PLATFORM – NET PRESENT VALUE AND INTERNAL RATE OF RETURN For arriving at the best suited and cheapest source of financing for the project, both the NPV and IRR of each option are considered. Considering all these factors, standard formats in MS Excel were developed for various possibilities of variation in these factors such that only the initial details had to be put in to find out the most viable financing option. 54
  55. 55. The variants were :  Without Moratorium on Interest (18 months moratorium on principal) • Monthly Compounding Monthly Payment of Interest • Monthly Compounding Quarterly Payment of Interest • Quarterly Compounding Six monthly Payment of Interest • Six monthly Compounding Six monthly Payment of Interest  Without Moratorium on Interest (36 months moratorium on principal) • Monthly Compounding Monthly Payment of Interest • Monthly Compounding Quarterly Payment of Interest • Quarterly Compounding Six monthly Payment of Interest • Six monthly Compounding Six monthly Payment of Interest  With Moratorium on Interest (18 months moratorium on principal) • Monthly Compounding Monthly Payment of Interest • Monthly Compounding Quarterly Payment of Interest • Quarterly Compounding Six monthly Payment of Interest • Six monthly Compounding Six monthly Payment of Interest  With Moratorium on Interest (36 months moratorium on principal) • Monthly Compounding Quarterly Payment of Interest • Quarterly Compounding Quarterly Payment of Interest • Quarterly Compounding Six monthly Payment of Interest • Six monthly Compounding Six monthly Payment of Interest 55
  56. 56. These Standardized formats were successfully utilized for analyzing the projects that came up consideration in the duration of the project. Changes in these formats whenever required depending upon the individual cases were made from time to time. Enclosed are two of such worksheets i.e. With Moratorium on Interest (36 months moratorium on principal) with Quarterly Compounding Quarterly Payment of Interest and Without Moratorium on Interest (36 months moratorium on principal) with Quarterly Compounding Quarterly Payment of Interest using Assumed Figures. CONCLUSION  The Valuation of BHEL carried out through this projects was accepted as fairly correct by the internal officials since the expected valuation of BHEL stands between 10000 to 15000 crore.  In General, while going for an asset lease, company’s own funds should not be used untill the funds are lying absolutely idle or their opportunity cost is quite low.  Project Financing proposals can be analysed quite accurately and objectively using the tools of NPV and IRR. 56
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