Business and Financial Planning for Transformation

1. Business and Financial Planning for Transformation

2. Agenda • The business question • Capital structure • Key considerations

3. 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

4. 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?

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

6. 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?

7. Illustration 1

8. 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?

9. 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

10. 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 interest @ 12% to be serviced in perpetuity • The present value of a perpetuity of 120,000 @ 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

11. 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?

12. 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

13. 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

14. 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

15. 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

16. 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?

17. Illustration 1

18. 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

19. 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

20. 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

21. 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

22. 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?

23. 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

24. 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

25. 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

26. Financial Leverage • Leverage in firms providing financial services is closely related to regulatory capital requirements • Best financial risk management practicesrequire (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)

27. 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

28. 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

29. 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

30. 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

31. 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