Blue Economy – Sagarmala Financial Engineering: Yet Another Dig. Skeletal Sketch of an Upcoming Talk in Somnath, Gujarat.

untitled

Authorized Share Capital in the case of Sagarmala happens to be INR 1000 crore, and is the number of stock units Sagarmala Development Company Limited (SDCL) has issued in its articles of incorporation. This ASC is open, in that share capital isn’t fully used, and there is ample room for future issuance of additional stock in order to raise capital quickly as and when a demand arises. SDCL can increase the authorized capital at anytime with shareholders’ approval and paying an additional fee to the RoC, Registrar of Companies. 

Capital Budgeting: Business determines and evaluates potential large expenditures/investments. Capital Budgeting is generally a long-term venture, and is a process that SDCL would use (and uses) to identify hat capital projects would create the biggest returns compared with the funds invested in the project. The system of ranking helps establish a potential return in the future, such that the SDCL management can choose where to invest first and most. Let us simply call it the first and most principle of budgeting. Blue Economy that instantiates itself via Sagarmala in India has options to choose from as regards its Capital Budgeting, viz. 

  1. Throughput analysis – This defines the main motives behind a project, where all the costs are operating costs, and the main emphasis is on maximizing profits in passing through a bottleneck. The best example for Sagarmala speculatively thought out is the marking of Western Shipping Corridor for container traffic and posing a livelihood threat to traditional fishermen. Throughput is an alternative to the traditional cost accounting, but is neither accounting, not costing, since it is focused on cash flows. It does not allocate fixed costs to products and services sold or provided and treats direct labour as a fixed expense. Decisions made are based on three critical monetary variables: throughput, investment or inventory and operating expenses. Mathematically, this is defined as revenue minus totally variable expenses, the cost of raw materials or services incurred to produce the products sold or services delivred. T = R – TVE. 
  2. Net Present Value (NPV) – this s the value of all future cash flows, either positive or negative over the entire life of an investment discounted to the present. NPV forms a part of an intrinsic valuation, and is employed for valuing business, investment security, capital project, new venture, cost reduction and almost anything involving cash flows. 

NPV = z1/(1 + r) + z2/(1 + r)2 – X

      , where z1 is the cash flow in time 1, z2 is the cash flow in time 2, r is the discount       range, and X is the purchase price, or initial investment. NPV takes into account the timing of each cash flow that can result in a large impact on the present value of an investment. It is always better to have cash inflows sooner and cash outflows later. this is one spect where SDCL might encounter a bottleneck and thereby take recourse to throughput analysis. Importantly, NPV deliberates on revolving funds.  

  1. Internal Rate of Return (IRR) – this is an interest rate at which NPV from all cash flows become zero. IRR qualifies attractiveness of an investment, whereby if IRR of a new project exceeds company’s required rate of return, then investment in that project is desirable, else project stands in need of a rejection. IRR escapes derivation analytically, and must be noted via mathematical trial and error. Interestingly, business spreadsheets are automated to perform these calculations. Mathematically, IRR is:

0 = P0 + P1/(1 + IRR) + P2/(1 + IRR)2 + …. + Pn/(1 + IRR)n

, where P0, P1,…, Pn are cash flows in periods of time 1, 2, …, n. 

 With a likelihood of venture capital and private equity expected in Sagarmala accompanied with multiple cash investments over the life-cycle of the project, IRR could come in handy for an IPO. 

     4. Discounted Cash Flow – this calculates the present value of an investment’s future            cash flows in order to arrive at  current fair value estimate for an investment. Mathematically, 

DCF =  CF1/(1 + r) + CF2/(1 + r)2 + CF3/(1 + r)3 + … + CFn/(1 + r)n

, where CFn are cash flows in respective n periods, and r is discount rate of return. 

DCF accounts for the fact that money received today can be invested today, while money we have to wait for cannot. DCF accounts for the time value of money and provides an estimate of what e should spend today to have an investment worth a certain amount of money at a specific point in the future. 

       5. Payback period – mathematically, this is defined as: 

Payback Period = Investment required/Annual Project Cash flow

This occurs the year plus a number of months before the cash flow turns positive. Though seemingly important, payback period does not consider the time value of investment/money, and is quite inept at handling projects with uneven cash flows. 

As a recap (and here, here, here)

Sagarmala is a 3-tier SPV structure

untitled

Private Players/PPPs OR EPCs/Turnkey – the latter are used for projects with high social impact or low IRR. 

Expenses incurred for project development will be treated as part of equity contribution by SDCL, or, in case SDCL does not have any equity, or expenses incurred are more than the stake of SDCL, SPV will defray SDCL. Divestment possibilities cannot be ruled out in order to recoup capital for future projects. 

Advertisement

Delta Hedging.

AAEAAQAAAAAAAAZiAAAAJDkxMWNiZjI2LWI3NTUtNDlhYS05OGU2LTI1NjVlZWY5OGFiNA

The principal investors in most convertible securities are hedge funds that engage in convertible arbitrage strategies. These investors typically purchase the convertible and simultaneously sell short a certain number of the issuer’s common shares that underlie the convertible. The number of shares they sell short as a percent of the shares underlying the convertible is approximately equal to the risk-neutral probability at that point in time (as determined by a convertible pricing model that uses binomial option pricing as its foundation) that the investor will eventually convert the security into common shares. This probability is then applied to the number of common shares the convertible security could convert into to determine the number of shares the hedge fund investor should sell short (the “hedge ratio”).

As an example, assume a company’s share price is $10 at the time of its convertible issuance. A hedge fund purchases a portion of the convertible, which gives the right to convert into 100 common shares of the issuer. If the hedge ratio is 65%, the hedge fund may sell short 65 shares of the issuer’s stock on the same date as the convertible purchase. During the life span of the convertible, the hedge fund investor may sell more shares short or buy shares, based on the changing hedge ratio. To illustrate, if one month after purchasing the convertible (and establishing a 65-share short position) the issuer’s share price decreases to $9, the hedge ratio may drop from 65 to 60%. To align the hedge ratio with the shares sold short as a percent of shares the investor has the right to convert the security into, the hedge fund investor will need to buy five shares in the open market from other shareholders and deliver those shares to the parties who had lent the shares originally. “Covering” five shares of their short position leaves the hedge fund with a new short position of 60 shares. If the issuer’s share price two months after issuance increases to $11, the hedge ratio may increase to 70%. In this case, the hedge fund investor may want to be short 70 shares. The investor achieves this position by borrowing 10 more shares and selling them short, which increases the short position from 60 to 70 shares. This process of buying low and selling high continues until the convertible either converts or matures.

The end result is that the hedge fund investor is generating trading profits throughout the life of the convertible by buying stock to reduce the short position when the issuer’s share price drops, and borrowing and selling shares short when the issuer’s share price increases. This dynamic trading process is called “delta hedging,” which is a well-known and consistently practiced strategy by hedge funds. Since hedge funds typically purchase between 60% and 80% of most convertible securities in the public markets, a significant amount of trading in the issuer’s stock takes place throughout the life of a convertible security. The purpose of all this trading in the convertible issuer’s common stock is to hedge share price risk embedded in the convertible and create trading profits that offset the opportunity cost of purchasing a convertible that has a coupon that is substantially lower than a straight bond from the same issuer with the same maturity.

In order for hedge funds to invest in convertible securities, there needs to be a substantial amount of the issuer’s common shares available for hedge funds to borrow, and adequate liquidity in the issuer’s stock for hedge funds to buy and sell shares in relation to their delta hedging activity. If there are insufficient shares available to be borrowed or inadequate trading volume in the issuer’s stock, a prospective issuer is generally discouraged from issuing a convertible security in the public markets, or is required to issue a smaller convertible, because hedge funds may not be able to participate. Alternatively, an issuer could attempt to privately place a convertible with a single non-hedge fund investor. However, it may be impossible to find such an investor, and even if found, the required pricing for the convertible is likely to be disadvantageous for the issuer.

When a new convertible security is priced in the public capital markets, it is generally the case that the terms of the security imply a theoretical value of between 102% and 105% of face value, based on a convertible pricing model. The convertible is usually sold at a price of 100% to investors, and is therefore underpriced compared to its theoretical value. This practice provides an incentive for hedge funds to purchase the security, knowing that, by delta hedging their investment, they should be able to extract trading profits at least equal to the difference between the theoretical value and “par” (100%). For a public market convertible with atypical characteristics (e.g., an oversized issuance relative to market capitalization, an issuer with limited stock trading volume, or an issuer with limited stock borrow availability), hedge fund investors normally require an even higher theoretical value (relative to par) as an inducement to invest.

Convertible pricing models incorporate binomial trees to determine the theoretical value of convertible securities. These models consider the following factors that influence the theoretical value: current common stock price; anticipated volatility of the common stock return during the life of the convertible security; risk-free interest rate; the company’s stock borrow cost and common stock dividend yield; the company’s credit risk; maturity of the convertible security; and the convertible security’s coupon or dividend rate and payment frequency, conversion premium, and length of call protection.