Racy Cases 16 Equity – A twist in the tale


First published in HBL
A V Vedpuriswar and V Pattabhi Ram

“How would it be if you could raise money that need not be repaid?” asked Chatshow, the mercurial professor who taught corporate finance. The class sat up in high alert knowing that the man had something up his sleeve. “It wouldn’t be legal,” roared a backbencher. “It wouldn’t be moral” floated in another voice. As the class’s eyes lit up, Bhoka, the bright guy with unconventional wisdom, raised his hand. “Sir, companies have been doing that for ages. Legally, they do not have to repay equity capital”. He was bang on target. His friend joined in. “There is no moral issue since the investor knows that his investment can be realized only from the stock market”. Chatshow was pleased. The class had identified that equity funds need not be returned.

He moved on. “How would it be if you could borrow money free of cost?” The girl from the middle row stood up. “Sir, whenever I raise money from my dad I neither have to return it nor do I have to pay any interest on it.” “Baap ka maal hai na” said someone by way of explanation. As the class roared in approval, lest the prof think that she was being flippant the girl said, “Equity is like Baap ka maal.” “How?” asked Chatshow. “Sir, because companies are not compelled to pay dividends even if they make bumper profits” she said. “Microsoft”, “Microsoft” came shouts from various parts of the class. Chatshow was pleased.

He was now moving towards the board. “A father may invest in a son without expectation of a quid pro quo. But why should an investor put his hard earned after tax money if the company isn’t going to reward him or return the money?” The lad sporting a flowered shirt reminiscent of the fashions of the seventies (they called him Flowers) caught Chatshow’s attention. Seeing the professor, Flowers said, “Because they buy shares for capital appreciation than for dividend payment”.

Chatshow was mighty pleased that the class knew its marbles. Having shown them that equity need not be repaid, that it need not be rewarded and that investors were still happy dating equity, he moved to Act 2, Scene 1. Debt.

“Debt is everything that equity is not” he began. The silence in the class was palpable. They knew the professor had a way with words. “Debt has to be repaid. Worse still, it has to be serviced, come hell or high water. Then why at all do companies use debt?” “Sir, that’s simple.” It was the girl from the middle row standing up again. Chatshow disliked the word “Sir”. He had once famously remarked, “Hey, I haven’t been knighted as yet.” The girl said, “Sir, debt is cheaper than equity. Because interest is tax deductible and dividends are not.” Chatshow made a mental point that while she was right on the fact she was wrong on the conclusion. “Debt is cheaper even otherwise” he said. And left it at that.

Someone interjected. “Sir, what is the cost of equity?” As Chatshow turned in the direction of the voice, a backbencher roared, “the cost of equity is the rate of return which equity investors expect from the firm”. The professor was thrilled. This group appeared to be well groomed in finance. “Could someone tell me how is this return computed?” As the class turned silent the professor prompted, “What is the expected return in case of equity?” “Dividends” said a lone voice. “But people don’t buy shares for dividends” said Bhoka. And added, “They buy in expectation of capital appreciation. They buy when the prices are low and sell when they are high.” He was sounding like Peter Lynch!

Sensing that the class was “in-the-mood” Chatshow prompted, “What kind of capital appreciation do investors expect?” “More than the interest rate,” said a husky voice. “Because equity investors are taking more risk than those who invest in debt” called out another. This was great. The entire class, not just one or two students, was participating. With a broad grin on his face, Chatshow concluded: “Now do you understand why equity is more expensive? And it is because equity is more expensive that companies also use debt.”

It was then that the guy in the flowered shirt sporting a disinterested look made a point: “Sir, the investor who is selling and encashing his reward is not selling to the company. He is selling in the open market. Okay, he makes profits but as far as the company is concerned he is simply passing the parcel. So why is his expected return a cost to the company?” There was pin drop silence. And stunning admiration. It was a chilling point. For a moment, the mercurial Chatshow looked flummoxed. “Any answers?” he asked. Bhoka realized that the professor wasn’t asking “Any questions?” The previous night Bhoka had studied Van Horne. And Brealy and Myers. He had the same doubt. Neither of the books had clarified it.

The girl from the middle row stood up. “Sir, its like this. An investor invests in a rights issue, say, at Rs 100. He has a one-year time horizon with an expected return of 20%. He doesn’t care how the return comes, whether from dividend or from capital appreciation, so long as they come. If the returns do not come he would start selling in the market taking the price southwards. Further, next time around when the company does a rights at Rs 100 he wouldn’t care to invest. Hence it is in the company’s interest to take the price to Rs 120/-. Hence it is cost for the company”. Bhoka nodded.

The girl had got the insight from her friend Wafers, the CA trainee. Wafers’ professor had given a cute example from employee compensation. He had explained, “A company is on the look out for a CFO. The candidate wants an annual cheque of Rs 50 lakhs. The company offers him Rs 25 lakhs plus equity options which in one year’s time would hopefully be saleable at Rs 25 lakhs. A year later the market value is Rs 10 lakhs. The company thinks that the CFO has effectively cost it only Rs 35 lakhs. The CFO resigns and the hunt is on for his successor. He too wants Rs 50 lakhs. The company offers him what it offered his predecessor. He refuses because he knew what happened last year. So the company offers him Rs 35 lakhs plus Rs 15 lakhs of equity options. A year later the options are saleable at Rs 10 lakhs. The company thinks that the CFO has effectively cost it only Rs 45 lakhs. He resigns and a new CFO joins. He wants Rs 50 lakhs. The company offers Rs 35 lakhs cash and Rs 15 lakhs equity options. The CFO refuses because he knew what happened last year. So he asks for Rs 50 lakhs cash. The moral: before long the cost catches up with the company”.

Even Chatshow smiled.

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About Pattabhi Ram

A chartered accountant by profession, a writer by passion and a teacher by accidental choice.
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