Are Infrastructure bonds a win-win situation both for infrastructure financiers as well as investors ?

LONG TERM INFRASTRUCTURE BONDS U/s 80CCF OF INCOME TAX ACT 1961

In the last budget Finance Minister in Union Budget had introduced a new section 80CCF under the Income Tax Act, 1961 that provide income tax deduction of Rs. 20,000 in addition to Rs 1 Lakh available under other provisions for claiming tax deductions for investments made in the Long Term Infrastructure Bonds that are notified by the central government.

Few months back these  bonds were the talk of the town . Most taxpayers are happy that they have one more source to save taxes from this year. Till last to last year, they could invest only Rs 1 lakh and save tax of Rs 30,900 if they were in the highest tax bracket(30.9 %) under Section 80C of the Income Tax Act. Now, from the last year, investors can invest an additional Rs 20,000 in infrastructure bonds under Section 80CCF.The deduction can be claimed by individuals or HUFs(under the income tax Act, a Hindu undivided family is treated as a separate entity for the purpose of assessment.Generally the head of h.u.f is called as KARTHA . As long as h.u.f. exists, individual members cannot be separately assessed in respect of h.u.f's income ) for the investments made in subscribing the long term infrastructure bonds during the FY 2010-11.


As per the notification given by the central government, the bonds issued by following entities are eligible to subscribe as long term infrastructure bonds and eligible for a deduction under new section 80CCF
Industrial Finance Corporation of India (IFCI), Life Insurance Corporation of India (LIC), Infrastructure Development Finance Company (IDFC) and Non-Banking Finance Company (NBFCs) who are classified as an infrastructure finance company by the Reserve Bank of India (RBI).

Benefits of Tax savings for Long Term Infrastructure Bonds
Any investment in long term infrastructure bonds up to Rs. 20,000 is eligible for tax deduction from the taxable income. In effect, people in the highest tax bracket (30.9%) can now save an additional Rs 6,180 from this year.This means for an individual falling under 30% tax bracket will effectively save Rs 6,180 and a lower tax bracket individual of 10% will save tax up to Rs 2,060.

Lock-in period & Yield of the bond These long term infrastructure bonds will be available for tenure of minimum 10 years and the lock-in period of 5 years. It means investors can not exit from the bonds before 5 years and after 5 years they have an option to exit in the secondary market or via buyback offer given by the issuer. Investors can also pledge the bonds in some specified banks to obtain the loan against the bonds only after completing the lock-in period.Yields of the long term infrastructure bonds and other detailed terms and conditions are specified by the issuers at the time of launch on the respective bonds. However, the important thing to note is the yield will not be higher than the yield of government securities of corresponding residual maturity schemes. Currently, the 10-year government bonds is close to 8% and the interest rate offered by L&T Infra issue, currently open, is between 7.5% and 7.75%, depending on the options the investor  choose.

Who are Eligible Investors?

Only Resident Individual (Major) and HUF can invest in these bonds.

Is interest earned on these bonds taxable?

The interest received in these bonds is not tax free. The investor is liable to pay tax on the interest received. The interest received on these bonds shall be treated as income from other sources and shall form part of the total income of the assessee in that financial year in which it is received. However no TDS shall be deducted on the interest received as these bonds if issued in Demat mode and listed stock exchange.

Should one Invest ?

This is the most interisting question :)

Though, it’s mentioned that the interest rate on these bonds are 8% or 7.5%, the interest earned would reduce further to 5.5%-6% range when we count the tax paid on interest. But if we look at it from a different perspective, and count your money saved due to the tax-exemption at the time of investing, in that case the return would turn out to be around 9.5%-10%, but  I do you think it’s the right way of looking at returns .

But if one fall in 30% tax slab -he would directly save 6180 .

What may be potential pitfalls

1. One could potentially be stuck with a lower interest rate if interest rates climb up in the future.

2. Most Infrastructure bonds compound annually, whereas some of the bank fixed deposits might compound quarterly which gives one a  if one slight  advantage if one invest in FD .

What Infrastructure bond gurantee ?

Boost in the financing for infrastructure projects in India.

Investment decisions - Capital budgeting (NPV vs IRR)

 What is Capital Budgeting?

Capital budgeting is the process of allocating capital after determining project feasibility.

Determining project feasibility is a 3 step process:-

Step 1] Qualitative Analysis – Relationship/Branding feasibility, Socio-Cultural & Political feasibility

Step 2] Forecasting Performance – Financial Modelling & Structural analysis

Step 3] Quantitative Analysis –IRR (or MIRR), NPV, Payback period and other quantitative analysis

In capital budgeting, there are a number of different approaches that can be used to evaluate any given project, and each approach has its own distinct advantages and disadvantages.

What is NPV method?

The NPV method aims to capture the amount available after meeting the cost of all capital contributors (all claim holders).This method ‘discounts’ operating cash flows at a rate that captures the cost of capital (i.e. the capital used/contributed to generate cash flows). In fact, the NPV method is what leads to the concept of value creation through Economic Profit.

·         Net Present Value (NPV) = Total PV of future CF’s - Initial Investment

Estimating NPV:

1.      Estimate future cash flows: how much? and when?

2.      Estimate discount rate

3.      Estimate initial costs

·      Minimum Acceptance Criteria: Accept if NPV > 0

·      Ranking Criteria: Choose the highest NPV

In Short: A positive NPV is a must and the higher the better.

What is IRR method?

 Internal Rate of Return measures the return generated by an asset assuming that the reinvestment rate of cash flows thus generated, is the same as the IRR itself.

Limitation of IRR method - Major shortfall associated with the IRR method is the fact that it cannot be conclusively used in circumstances where the cash flow is inconsistent. While working out figures in such fluctuating circumstances may prove tricky for the IRR method, it would pose no challenge for the NPV method since all that it would take is the collection of all the inflows-outflows and finding an average over the entire period in focus.

IRR may not exist or there may be multiple IRR

The relationship between NPV and IRR is that “IRR is the rate at which NPV = Zero”

When Cost of Capital is more than IRR the NPV will be Negative

If we graph NPV versus discount rate, we can see the IRR as the x-axis intercept.

Difference between NPV vs. IRR

1.     NPV is calculated in cash, the IRR is a percentage value expected in return from a capital project.

2.    There may be conflicting results under NPV and IRR

NPV and IRR methods may give conflicting results in case of mutually exclusive projects, i.e., projects where acceptance of one would result in non-acceptance of the other.  Such conflict of result may be due to any one or more of the following reasons:

1.      The projects require different cash outlays.

2.      The projects have unequal lives.

3.      The projects have different patterns of cash flows.

In such a situation, the result given by the NPV method should be relied upon.  This is because the objective of a company is to maximize its shareholders' wealth.  IRR method is concerned with the rate of return on investment rather than total yield on investment hence it is not compatible with the goal of wealth maximization.  NPV method considers the total yield on investment.  Hence, in case of mutually exclusive projects, each having a positive NPV, the one, with the largest NPV will have the most beneficial effect on shareholders'

WHY NPV IS BETTER

Both the Net Present Value Method and Internal Rate of Return Method proceed on this presumption that cash inflows can be reinvested at the discounting rate in the new projects.  However, reinvestment of funds at the cut-off rate i.e cost of capita is more possible than at the internal rate of return.  Hence, Net Present Value Method is more reliable than the Internal Rate of Return Method for ranking two or more capital investment projects.

Similarities in results under NPV and IRR

Both NPV and IRR will give up the same result (i.e., acceptance or rejection) regarding an investment proposal in following cases:

                i.            Projects involving conventional cash flows, i.e., when an initial outflow is followed by a series of inflows.

                  ii.            Independent investment proposals, i.e., proposals the acceptance of which does not preclude the acceptance of others.

The reason for similarity in results in the above cases is simple.  In case of NPV method, a proposal is acceptable if its NPV is positive. NPV will be positive only when the actual return on investment is more than the cut-off rate.  In case of IRR method a proposal is acceptable only when the IRR is higher than the cut-off rate.  Thus, both methods will give consistent results since the acceptance or rejection of this proposal under both of them is based on the actual return being higher than the cut-off rate.

In case of projects requiring different cash outlays, the problem can also be resolved by adopting incremental approach, a modified form of IRR method.  According to this approach in case of two mutually exclusive projects requiring different cash outlays, the IRR of incremental outlay of the project requiring a higher investment is calculated.  In case this IRR is higher than the required rate of return, the project having greater non-discounted cash flows should be accepted otherwise it should be rejected.

Pay Back Period rule

·         How long does it take the project to “pay back” its initial investment?

·         Payback Period = number of years to recover initial costs

·         Disadvantages:

o   Ignores the time value of money

o   Ignores cash flows after the payback period

o   Biased against long-term projects

·         Advantages:

o   Easy to understand

o   Biased toward liquidity

Profitability Index

 PI =Total PV of future cash flows/Initial Investment or 1  +(NPV/Initial Investment)

• Minimum Acceptance Criteria:
• Accept if PI > 1
• Ranking Criteria:
• Select alternative with highest PI
• Disadvantages:
• Problems with mutually exclusive investments
• Advantages:
• May be useful when available investment funds are limited
• Easy to understand and communicate

Earthquake -Whose Fault is this ?

When I watch in news about recent earthquakes in Japan I get frightened. I am sure that most of us think that what will happen if there is earthquake in our city (say Delhi or Mumbai). Moreover fear of nuclear meltdown in Japan has put question marks on safety and security of nuclear plants across the world. Here are some questions about earthquakes which I tried to answer   

What is an earthquake and how does it occur ?

Source : http://www.bennett.karoo.net/images/nathaz/earthquake.gif

visit

http://video.nationalgeographic.com/video/player/environment/environment-natural-disasters/earthquakes/earthquake-101.html

What is different between Magnitude and Intensity?

Earthquake magnitude is a measure of the size of the earthquake reflecting the energy released by the earthquake .It is represented by some real number on Richter scale say 5.8 .

Earthquake intensity indicates the extent of shaping experience at a given location due to a particular earthquake (For eg VIII on MSK scale)

It can be simply understood if we take an analogous .Consider a 60 Watt Bulb. It dissipates energy of 60 Watts. However, the brightness of light at different distances is different .In this case the former is magnitude and the latter is intensity

The Japanese use a special ‘shindo’ scale for measuring earthquakes, which is different from the more common Richter scale. Shindo refers to the intensity of an earthquake at a given location, while the Richter scale measures the magnitude – the energy an earthquake releases at the epicenter. The shindo scale ranges from shindo one (a slight earthquake felt only by people who are not moving) to shindo seven – an earthquake which causes severe damage.

How dangerous is an earthquake of magnitude 8 compared to 6 or 7 on Richter scale.

Usually an earthquake greater than 5.0 can cause strong enough ground motion to be potentially damaging to structures .Earthquakes of magnitude greater than 8.0 are often termed as great earthquake.

Log₁₀ E= 1.5M +11.8 is the empirical equation which relates the earthquake magnitude  to the elastic energy released .By a increase in magnitude by 1 ,the energy released by the earthquake goes up by a factor of about 31 .Thus , a magnitude 8.0 earthquake releases about 31 times more energy as compared to an earthquake of 7 magnitude .

What are seismic zones?

The new earthquake zoning map of India divides India into 4 seismic zones (Zone 2, 3, 4 and 5) unlike its previous version which consisted of five or six zones for the country. According to the present zoning map, Zone 5 expects the highest level of seismicity whereas Zone 2 is associated with the lowest level of seismicity

How safe is Delhi & nearby areas from an Earthquake?

Delhi is located in seismic zone IV, the second highest earthquake hazard zone in India. Delhi has some heavily populated colonies on deep deposits of alluvium in various locations, particularly in the trans-Yamuna area. These areas are seismically vulnerable as large ground motion amplifications are expected due to their typical ground compositions. In the past, since 1720 AD, five earthquakes of Richer Magnitude of 5.5 to 6.7 are known to have occurred in the UT of Delhi or close to it. Two major lineaments, namely the Delhi-Haridwar ridge and Delhi-Moradabad faults, pass through the territory, both having a horrible potential of generating earthquakes of magnitude upto 7.0 on the Richter scale

Faridabad is more vulnerable to damage even by a moderate earthquake because they are on alluvial soil up to 200 m deep. These regions face a very grave problem of soil liquefaction during an earthquake. Moreover, earthquakes are amplified by the alluvial soils

Over 58.6 per cent of land in India is highly vulnerable to earthquakes and 38 cities fall under moderate to high risk seismic zones . Delhi, Chennai, Pune, Greater Mumbai, Kochi, Kolkata, Thiruvananthapuram, Patna, Ahmedabad, Dehradun are some of the cities falling in the vulnerability zone

source :  http://m.thehindu.com/sci-tech/energy-and-environment/article1684745.ece/?secid=3044

To know please visit http://www.iitk.ac.in/nicee/EQTips/EQTip04.pdf

Do's & don'ts of an earthquake

http://www.fema.gov/hazard/earthquake/eq_during.shtm

I think  that it is time for us to  understand that India has high frequency of great earthquakes and low frequency of moderate earthquake .The only good thing about moderate earthquake is that they lead to improvements in construction at relatively low cost .Presently Indian earthquake problem is not receiving the due attention due to infrequent moderate earthquakes .   

Types of Privatization

BOT –It is a relatively new approach to infrastructure development, which enables direct private sector investment in large-scale infrastructure projects.

The theory of BOT is as follows:

Build – A private company (or consortium) agrees with a government to invest in a public infrastructure project. The company then secures their own financing to construct the project.

Operate – the private developer then owns, maintains, and

manages the facility for an agreed concession period and recoups

their  investment through charges or tolls.

Transfer – after the concessionary period the company transfers ownership and operation of the facility to the government or relevant state authority.

ADVANTAGES OF BOT PROJECTS

BOT projects have several advantages such as :-

1. The government gets the benefit of the private sector to mobilize finances and to use the best management skills in the construction, operation and maintenance of the project.
2. The private participation also ensures efficiency and quality by using the best equipment. 
3.  The projects are conducted in a fully competitive bidding situation and are thus completed at the lowest possible cost. 

Following models for privatization of road infrastructure is available.

Sl No	NAME	Description
1	Build operate transfer (BOT)	Concession is given to private party to finance, build, operate and maintain the facility. Investors collect the user fee during the concession to recover the cost of construction, debt servicing and operation cost. At the end of the concession, the facility reverts back to Govt. who has given the concession.
2	Build own operate (BOO)	Similar to the BOT but without the transfer of ownership
3	Build own operate transfer (BOOT)	Same as BOT but the project is transferred to the Govt. after a negotiated period.
4	Build transfer lease operate (BTLO)	Govt. provides the right of way on which the highway is built. Private party has to pay a nominal rent of payment for the use of the land
5	Develop build operate (DBO)	This is a new concept. Initially the company does not assume commercial risk but is financially accountable for building and operating the system as per specification. Later on the company assumes commercial risk as per the appropriate regulations laid by Govt.

We can classify BOT projects into three types
1. BOT Toll
2. BOT Annuity
3.Hybrid

In case of  BOT (annuity) model, no viability gap funding (VGF) is made available to the developer and he has to bear the entire project cost. The project investment cost is recouped by the developer through annuity payments made byNHAI after the construction is over, while the toll collected goes to the NHAI.

In case of  BOT (toll) model, the developer has to recover his investments through toll collection. Depending upon the viability of the project, he may ask for a viability gap funding (currently capped at 40% of the project cost) from the NHAI or may agree to share revenues with the NHAI.

However  hybrid model had proposed that in case the amount of VGF quoted by the developer is more than 40% of the project cost, the funding requirement in excess of 40% of the cost would be paid to the developer in the form of annuity payments. Significantly, even while the incremental payment would have been made by the government, the developer would have been allowed to collect the toll through the concession period.

Under the current mechanism followed by NHAI, a project is first invited under the BOT-toll mode. In case of inadequate response, the BOT–annuity mode is used. In case even this fails, the project is given on cash contract basis.

SPV (Special Purpose Vehicle)

SPV is an entity which is formed for a single, well-defined and narrow purpose. An SPV can be formed for any lawful purpose & generally  to raise funds by collateralising future receivables.

SPV vis a vie Company

The company, as distinguished from an SPV, may be called a general purpose vehicle. A company may do many things which are mentioned in the  (MoA) memorandum of association or permitted by the Companies Act. An SPV may also do the same, but its scope of operation is limited and focused. If it is not so, the SPV had better be called a company. The MoA is quite narrow in the case of an SPV.

This is basically to provide comfort to lenders who are concerned about their investment.

Process of Establishment of SPV

Generally, a sponsoring corporation hives off assets or activities from the rest of the company into an SPV. This isolation of assets is important for providing comfort to investors.The assets or activities are distanced from the parent company hence the performance of the new entity will not be affected by the ups and downs of the originating entity.

The SPV will be subject to fewer risks and thus provide greater comfort to the lenders

 

The above figure shows the general model of the structure of project finance. There may be a many variations to this basic model. For instance, bonds may not be issued in a project, and lenders may include international lending agencies such as the World Bank and Asian Development Bank. Further, each party may assume several roles.

Advantages of setting an SPV

Risk sharing: Corporate may use SPVs to legally isolate a high risk project/asset from the parent company and to allow other investors to take a share of the risk.

Securitization: SPVs are commonly used to securitize loans (or other receivables). For example, a bank may wish to issue a mortgage-backed security whose payments come from a pool of loans. However, these loans need to be legally separated from the other obligations of the bank. This is done by creating an SPV, and then transferring the loans from the bank to the SPV. 

For competitive reasons: For example, when Intel and Hewlett-Packard started developing IA-64 (Itanium) processor architecture, they created a special purpose entity which owned the intellectual technology behind the processor. This was done to prevent competitors like AMD accessing the technology through pre-existing licensing deals.

Financial engineering: SPVs are often used in complex financial engineering schemes which have, as their main goal, the avoidance of tax or the manipulation of financial statements.

Regulatory reasons: A special purpose entity can sometimes be set up within an orphan structure to circumvent regulatory restrictions, such as regulations relating to nationality of ownership of specific assets.

Property investing: Some countries have different tax rates for capital gains and gains from property sales. For tax reasons, letting each property be owned by a separate company can be a good thing. These companies can then be sold and bought instead of the actual properties, effectively converting property sale gains into capital gains for tax purposes.

For details about SPV in Indian highways & road projects please look at

http://morth.nic.in/index2.asp?langid=2&sublinkid=103

Indian Highways & Roads need a retrofitting ?

                     

             Though India has an extensive road network of 3.3 million kilometres & is the second largest in the world but the question is - Is it matching the demand ?

As per the Global Competitiveness Report 2008-09, inadequate infrastructure is the biggest

Impediment  in India’s economic growth.The report ranks the country at a dismal 87th position as far

as the quality of roads is concerned, way below neighbours .

The index scores 133 economies from 0 to 7, with 7 being the best possible score. For the quality of roads index, survey respondents were asked "How would you assess roads in your country? (1 = extremely underdeveloped; 7 = extensive and efficient by international standards)"

 The percentage growth of road traffic from the year 1991 to 1995 has been about 42%, whereas the percentage growth of road length has been only 8.7%. This has also led to severe congestion on the roads. Indian roads carry about 61% of the freight and 85% of the passenger traffic. All the highways and expressways together constitute about 66,590 kilometers (only 2% of all roads), whereas they carry 40% of the road traffic.

Indian Road Network
Class	Length (km)
Access Controlled Expressways	200 km
4-6 lane Divided Highways (with service rd in crowded areas)	10,000 km
National Highways	66,590 km
State Highways	131,899 km
Major district roads	467,763 km
Rural & other roads	2,650,000 km
Total (approx)	3,300,000 km

Source: http://en.wikipedia.org/wiki/Indian_road_network dated 12/04/2011  & http://www.iimcal.ac.in/community/finclub/dhan/dhan7/FINANCING%20INFRASTRUCTURE%20PROJECTS.pdf

Given the growing population, income levels and rapid urbanization, the need to develop the road network of the country to match heightened economic activity is of vital importance . In the last fiscal year  government decided to spend about Rs 1,20,000 crore per annum on building new highways and very recently fixed a staggering investment target of $60 billion to build 35,000km of roads in the next five years .This means that they want to build 7000 km road annually (20 km per day ) .most analyst think that it is over ambitious & I think that they are right because the  first five years of the UPA rule (from 2004) had seen construction at the pace of four km a day .

The graph below the difference between awarded and completed in the last 10 years

To bridge the gap we have to improve not just the pace of contracting but also push the pace of implementations. Govt must make sure that there is healthy private sector interest for upcoming projects by ensuring that projects remain attractive through various means available at its end like grant for projects, increase in concession period etc.

Moreover World Bank study has assessed that every rupee invested in the highways sector yields 7x returns in economic value. With this kind of multiplier effect, it is high time for India to increase its investment in improving its road network, both in terms of length and quality.

Important links of Project Finance & Infrastructure reports/Articles/sites etc

1. http://www.projectfinancemagazine.com/
2. http://www.nbmcw.com/
3. http://www.pppinindia.com/
4. http://www.ft.com/reports/india-infrastructure-2009
5. http://www.skyscrapercity.com/showthread.php?t=1259909  
6. http://www.indiainfraguru.com/ 
7. http://xa.yimg.com/kq/groups/8518353/2071778359/name/BNP-RoadTransport.pdf

Project Finance vs Corporate Finance

Project finance involves the creation of a legally independent project company financed with nonrecourse debt for the purpose of investing in a capital asset, usually with a single purpose and a limited life .

• What is non recourse debt Non recourse debt - It is a type of loan that is secured by collateral, which is usually property. If the borrower defaults, the issuer can seize the collateral, but cannot seek out the borrower for any further compensation, even if the collateral does not cover the full value of the defaulted amount. This is one instance where the borrower does not have personal liability for the loan. These types of projects are characterized by high capital expenditures, long loan periods and uncertain revenue streams. Analyzing them requires a sound knowledge of the underlying technical domain as well as financial modeling skills.

The above definition highlights the following features of Project Finance:

• First, Project Finance involves creating a legally independent project company to invest in the project; the assets and liabilities of the project company do not appear on the sponsors’ balance sheet. As a result, the project company does not have access to internally-generated cash flows of the sponsoring firm. Similarly, the sponsoring firm does not have access to the cash flows of the project company. In contrast, in Corporate Finance, the same investment is financed as part of the company’s existing balance sheet.

• Second, the purpose for Project Finance is to invest in a single purpose capital asset, usually a long-term illiquid asset. In contrast to a company which may be investing in many projects simultaneously, a project financed company invests only in the particular project for which it is created. The project company is dissolved once the project gets completed.


• Third, in Project Finance, the investment is financed with non-recourse debt. Since the project company is a standalone, legally independent company, the debt is structured without recourse to the sponsors. As a result, all the interest and loan repayments come from the cash flows generated from the project. This is in contrast to Corporate Finance where the lenders can rely on the cash flows and assets of the sponsor company apart from those of the project itself.

Project finance solves two financing problems:

1. It reduces the cost of agency conflicts inside project companies-The creation of a project company provides an opportunity to create a new, asset-specific governance system to address the conflicts between ownership and control. Because project companies are new and independent firms, project sponsors have the opportunity to create asset-specific governance systems to address these agency conflicts in ways that cannot be replicated under corporate finance .


2. It reduces the opportunity cost of underinvestment due to leverage and incremental distress costs in sponsoring firms.

How does Project Finance creates more value

The key to understanding why project finance creates value is to recognize that firms bear “deadweight costs” (DWC) when they invest in and finance new assets. Investment value = (Project value) - (Project DWC) - (Incremental Firm DWC)

In summary, this combination of structural features (extensive contracting, concentrated debt and equity ownership, separate legal incorporation, and high leverage) effectively controls managerial discretion at the project level. Relative to corporate governance systems, project governance systems are much more effective at eliminating wasteful expenditures, discouraging sub-optimal investment, and inducing coordinated, value increasing effort

The table below shows how Equity finance ,Project finance ,Corporate finance & Hybrid finance differ from each other .