The CFO's Need:
Flexibility In The Financing Mix
To Match The Project Cash-Flows

Every project generates a cash-flow profile. Typically, large projects suck in funds in the first few years and churn out regular cash-flows later. The rule-of-thumb when deciding the financing mix that best accommodates the project profile: the bigger the project, the bigger should be the share of debt financing since equity is a permanent liability while debt can be paid off. However, the greater the risk attached to the cash-flows, the greater should be the reliance on equity financing. For, dividends, unlike interest payments, are not contractual obligations.

Apart from these considerations, the CFO has to weigh a number of trade-offs when chalking out the project financing strategy. Sure, since dividends are a post-tax obligation while interest is a pre-tax charge, higher gearing ratios could translate into a lower weighted average cost of capital. But every rupee of additional debt pushes away the break-even point, stretching out the cash-draining gestation period, and increasing the overall vulnerability of the project.

Clearly, the optimal financing mix is not static over the life of a project. In a volatile environment, the CFO must be able to smoothly adjust the capital structure to the changing market conditions. Unfortunately, illiquid secondary markets and a blizzard of regulations have often locked in one financing mix, leaving little room to cope with, say, time and cost over-runs.

THE STRUCTURED SOLUTIONS: Improving liquidity and deregulation will, no doubt, boost financial flexibility. But CFOs will still scour for innovations that combine both debt and equity to achieve the lowest cost of funds while simultaneously ensuring that project cash-flows are able to service their financing requirements. Observes Anish Modi, 30, associate vice-president, Kotak Mahindra Finance: "Financing solutions will be designed to match a company's debt-equity profile, cash-flow projections, and its debt-servicing capability. Since these factors vary widely across companies, every product will have to be tailor-made."

SHARE BUYBACKS. Too much attention has been paid to share buybacks as a defence mechanism to ward off hostile takeovers. Do not forget that the repurchase of shares is an excellent tool for capital restructuring. Equity capital need no longer be a permanent liability; like debt, it can be extinguished. Notes Hari Mundra, 47, the CFO of the Rs 5,641-crore RPG Group: "Corporates will have tremendous flexibility in future when planning the optimum capital structure of new projects."

For starters, mega-projects need not be associated with permanent equity bloat. Once the project is on stream, the cash-flows thus generated can be used to buy back the equity issued to finance the project. The CFO will, therefore, be able to rein in gearing ratios without inflating the equity base. Alternatively, if gearing ratios are low, debt can be issued to finance the equity buyback.

Second, buybacks will enable corporates to pump up their cash reserves through the deft navigation of the familiar financial cycle of boom and bust. The strategy is simple: buy back shares when the stockmarket is depressed, pushing up the value of the remaining shares. Then, when the market revives, issue fresh equity at a higher price, pocketing the premium to augment your net worth.

The Companies Act, 1956, explicitly precluded such manoeuvres. The proposed Companies Bill, 1997, will allow buybacks provided the repurchased shares are cancelled. Sure, the shares cannot be held as treasury stock, but companies will be allowed to issue fresh equity one year after the buyback. Shares can be repurchased from shareholders (on a basis proportionate to the holdings of each), from the open market, from odd lots, through negotiations, or from shares issued to employees under stock option plans. But fresh issues cannot be made to finance the repurchase.

Despite these restrictions, several corporates, like the Rs 1,639-crore Videocon International, are rushing into buybacks. Others in the queue include the Rs 863.20-crore Arvind Mills, the Rs 3,244-crore Bajaj Auto, the Rs 9,004-crore Reliance Industries, the Rs 791-crore Great Eastern Shipping, the Rs 3,024-crore Mahindra & Mahindra (M&M), and the Rs 366.30-crore Proctor & Gamble.

CONVERTIBLES. As the name suggests, convertibles provide the holder with the right to exchange one type of financial instrument for another. The classic conversion is that of debt into equity; indeed, the repayment streams generated by this hybrid instrument often match project cash-flow profiles. Offering the investor the option of conversion keeps the cost of his convertible debt lower than straight debt, thus minimising the cash outflows during the gestation period. Sure, once the project yields steady profits, the equity conversion results in a relatively-expensive dilution. But such conversion avoids the necessity of a bullet repayment of the principal sum.

Globally, conversion is an option that can be exercised by the investor at any point of time after an initial lock-in period. In India, however, for a significant number of debenture issues, conversion into equity--either in part or wholly--was mandatory. Worse, the bonds had to be converted at a pre-determined price and time. Blame a virtually-inert secondary market for debt for this. As the rush of debt issues brings the secondary market to life, the basic convertibles can now be loaded with an array of options.

Using creative combinations of coupon rates, conversion premia, and redemption premia, CFOs can now design convertibles that yield the target debt-equity mix. For instance, to minimise the equity dilution at the time of conversion, choose a mix of high coupon rates, large conversion premia, and attractive redemption premia. Notes Y.M. Deosthalee, 50, senior vice-president (finance) of the Rs 5,305-crore Larsen & Toubro (L&T): "There is a great deal of flexibility when structuring a convertible, and that allows for better financial planning."

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