Business and Financial Planning for Transformation

Agenda The business question Capital structure Key considerations

The business question MFIs need productive assets to generate revenues –How are these assets created? Assets represent use (investment) of funds How does one get these funds? –In order to lend “X” amount to “N” number of borrowers, an MFI needs “NX” amount of funds

The business question What are the options? –Use own money –Ask friends to jointly own the assets created by investing in equity –Ask friends to provide loan funds in assurance of attractive interest –Look for institutional support What are the considerations?

Capital structure Cost of funds Scale Rights and recourses available to funders Tenor and maturity Other considerations –Regulations –Currency

Investing in an MFI Lets look at its projected financials (illustration 1) Does the MFI cover its operating expenses in Year 1? –How does it fund its portfolio? –How does it fund its short-fall? –What returns would funders expect? What alternative investment opportunities do they have?

Illustration 1

Investing in an MFI Lets look at the cost of funding the loan portfolio of the MFI –Assuming the cost of funds at 12% In the first three years, the surplus of Income over operating expenses (EBIT) is less than this cost How do we service the cost on this fund? How do we fund the operating deficit in Year 1?

Investing in an MFI Lets assume the portfolio as well as the operating deficits are funded at 12% cost How would the financials look then? What are the insights we can derive from the projected financials? –Additional funds are required to meet the operating deficits & cost of funds in the early years –If these funds are made available, there could be profits later

Investing in an MFI Is this scenario an attractive proposition for a lender? Lets look at the kind of cashflows a loan entails, assuming a loan of 1 million with 12% to be serviced in perpetuity The present value of a perpetuity of 12% is 1 million, equal to the loan amount Lenders are most interested in assured cashflows as loans carry fixed obligations If these obligations are not met, it is seen as a default on obligations

Investing in an MFI Lenders are also concerned with –If the loan is only one element of financing necessary to fund the business fully or are there other sources of finance in place and secure? –Will sufficient cash be generated in the business to meet interest payments on the loan and to repay the principal? –Are there physical assets, or other forms of collateral, within the business against which a loan can be secured so that, were the business to fail, the lender will be get all or some of its money back?

Investing in an MFI Quite clearly not all the required funds can come as loans –Service of debt requires new loans in Years 1 to 3, which may not be acceptable to lenders We need a funder who is willing to take the risks involved? –What would be the expectations of such a funder of risk capital? –We need an investor who owns up the initial losses as well as potential future profits: Equity

Contrasting Equity and Debt: Seniority Debt (Loan) –Carries a fixed obligation to pay interest and principal as per terms and conditions irrespective of profits or losses –Paying off loan may even require liquidation of assets Equity (Ownership) –Profits increase net equity, losses diminish it –Only residual claim on assets of the organization, after the claims of the lenders have been satisfied –Is junior to debt Returns on equity is uncertain and it depends on multiple factors

Equity Scenario -1 Lets see what happens for the same operational projection when –Loan portfolio is created from on-lending debt which carries an interest of 12% –All losses are met by equity investments Equity infusion is required in the initial years to –Ride over operating losses –Service interest on debt –Maintain safe cash balances

Equity Scenario -1 How does the net equity value (net worth) change over this period? –Losses in Years 1 and 2 lead to an erosion of net equity value Is this form of financing a viable proposition? –Lets consider the financials the financial statements

Equity Scenario -1 In the Year 1, the net equity turns negative, this means: –All the assets are funded by debt (loan) –The losses also are funded by debt (loan) –The interest burden is high, reflecting risk In Years 3 to 5, in spite of profits ~ 95% of assets are funded by debt This is not a desirable scenario for lenders, why?

Illustration 1

Contrasting Equity and Debt: Control Debt (Loan) –Lenders have limited control over the management of the assets of an organization –While, lenders may insist on a board seat, and restrictive covenants, they do not have voting rights Equity (Ownership) –Equity providers have control over the management of the assets of an organization –They have voting rights and make important decisions regarding the organization’s future Owners may take risky decisions if most of the assets are funded by debt

Equity Scenario -1 Lets also look at this scenario with an Asset Liability Management (ALM) lens: –at least some portion of short term assets should be financed through long term capital –this represents the permanent part of working capital and helps in ensuring smooth liquidity

Contrasting Equity and Debt: Maturity Debt (Loan) –Short term debts (current liabilities) have a maturity of one year or less –Long term debts have an average maturity of more than one year Equity (Ownership) –Equity represents long term capital Asset liability mismatch occur when the financial terms of assets and liabilities do not match

Equity Scenario -2 Lets see what happens for the same operational projection: –10% - 15% of the loan portfolio is created from equity –Remaining is created from on-lending debt which carries an interest of 12% –All losses are met by equity investments Higher amount of equity infusion is required over the five years to: –Ride over operating losses, and fund part of the portfolio –Service interest on debt initially –Maintain safe cash balances

Equity Scenario -2 How does the net equity value (net worth) change over this period? –Losses in Years 1 and 2 still lead to an erosion of net equity value, however additional equity ensures comfortable levels of net equity –Profits in Year 3 increase the value –Profits in Years 4 and 5, result in net equity increasing by 26% and 27% respectively Is this form of financing a viable proposition?

Equity Scenario -2 Even in the Year 1, the net equity remains positive, and funds 15% of assets apart from the operating losses In all the Years, net equity funds > 15% of assets (capital adequate) The interest burden is lower indicating lower financial risks This situation reflects a desirable ratio of debt to equity or Financial LEVERAGE

Financial Leverage Leverage (or gearing) is using given resources in such a way that the potential positive or negative outcome is magnified and/or enhanced –generally refers to using loan, so as to attempt to increase the returns to equity If the firm's EBIT/Assets is higher than the rate of interest on the loan, then its return on equity (ROE) will be higher than if it did not borrow If the firm's EBIT/Assets is lower than the interest rate, then its ROE will be lower than if it did not borrow

Financial Leverage Measures of financial leverage Debt-to-equity ratio = Debt/Equity Debt-to-assets ratio = Debt/Assets = Debt/(Debt + Equity) Leverage allows greater potential returns to the equity than otherwise would have been available, through higher scale of operations Potential for loss is also greater, if there are losses, the loan principal and all accrued interest on the loan still need to be repaid

Financial Leverage Leverage in firms providing financial services is closely related to regulatory capital requirements Best financial risk management practices require (may also be required by regulations): –adequate level of capitalization is maintained –capital adequacy refers to the proportion of own capital to risk weighted assets of the firm for simplicity, think of it as Equity/ Total assets Capital adequacy is related to leverage –Equity/Total Assets = Equity/ (Debt + Equity)\ = 1/(1+Debt/Equity)

Contrasting Equity and Debt: Leverage Debt (Loan) –Increase in borrowings lead to increase in leverage –Higher the leverage, higher the debt burden, higher the perception of financial risk Equity (Ownership) –Increase in equity leads to reduction of leverage (de-leveraging) –Increase in equity improves capital adequacy Optimal leverage helps an organization in scaling up operations

Debt, Equity and Value Value of a firm is equal to value of debt and equity in the firm –Book value of the firm is equal to the sum of the book values of debt and equity –Book value of equity is also called Net Worth or Net Equity –Book value is backward looking - created by past actions

Debt, Equity and Value Value of a firm is equal to value of debt and equity in the firm –Market value of the firm is equal to the sum of the market values of debt and equity –Market value of firm is independent of the capital structure Why? –Market value is forward looking – based on the expectations of the returns generated by the ASSETS of the firm

Contrasting Equity and Debt: Value Debt (Loan) –Present value of all cashflows to lenders –Constitutes principal and interest payments, which are pre- contracted Equity (Ownership) –Present value of all cash that comes to equity investors through the period of their investment –May be through dividends or sale of equity –Returns on equity cannot be pre- contracted Value generated by the assets of the firm is shared between providers of debt and equity

Recapitulate Capital structure refers to the way a firm finances its assets through some combination of debt, equity and hybrid securities There are many considerations in financial planning for MFIs –Scale, Cost, Control, Leverage, Maturity Value generated by the assets of the firm is shared between providers of debt and equity While lenders look for assured returns, equity investors get returns only when the firm makes profits