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Pros and Cons of Money Markets
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Disadvantages of Defined Contribution Pension Plans
Defined contribution plans have come under a lot of criticism because of the various disadvantages that they have. Many of these plans have been viewed as a covert way to absolve the government of any responsibility related to the retirement of its citizens. Given the many other socio-economic factors which are at play, defined contribution […]
Scenario Analysis: A Primer
Scenario analysis is at the heart of financial modeling. In fact, in many cases, a financial model is created solely so that the management is able to conduct scenario analysis before they can arrive at a decision. This article will provide more information about scenario analysis and its application in the financial modeling domain. What […]
What is Payback Period ?
We have earlier discussed the fact that Net present Value (NPV) is considered to be the gold standard when it comes to financial decision making. If a project has an NPV greater than zero then it is supposed to be a financially viable project and the firm must invest its resources towards that project, if […]
The Infrastructure Leasing and Financial Services (IL&FS) corporation were one of the bellwethers of India’s infrastructure sector. Ever since the government started pushing for better infrastructure, IL&FS was one of the first companies to come into existence. This company is responsible for building thousands of kilometers of roads and several ports. This financial giant has not been able to bid for any new project since the year 2015 for fear of incurring more losses.
Finally, in 2018, this company finds itself in the middle of an economic debacle. IL&FS has started defaulting on its commercial papers. This has come as a shock to many including the rating agencies themselves.
ICRA, which is Fitch’s rating arm in India, has downgraded IL&FS debt from AA+ to D in about two weeks! This sudden move has given investors no time to realign leading to a panic like situation. The sudden deterioration in the financial condition of the IL&FS has led to contagion. It resulted in investors losing confidence in the stocks of some housing finance companies which then further ended up in a flash crash as Sensex lost over 1000 points in a matter of minutes.
In this article, we will have a closer look at the current financial situation of IL&FS as well as the reasons behind this sudden downfall.
IL&FS had become a highly leveraged entity. Just before the crisis, IL&FS had a debt to equity ratio of 18.4! Such a high ratio can be considered to be alarming given the fact that IL&FS is not a banking institution.
A new legislation created in India has changed the way land acquisitions work. The new land acquisition act made it mandatory to compensate the landowners at very high rates. Several other companies such as L&T Infrastructure had given up their projects mid-way because they found some of the rules in the new act to be impossible to comply with. However, IL&FS was already involved with a lot of projects and had to continue building them.
This decision has affected IL&FS considerably given the fact that it had to compensate all landowners based on the new laws. According to the new law, many landowners whose lands were acquired before this legislation also had the right to seek arrears from IL&FS. The result was cost escalations in a lot of projects. The cost escalations were further exacerbated by the extremely high leverage that was part of the capital structure of IL&FS. High leverage and regulatory cost overruns proved to be the cocktail that led to the downfall of IL&FS.
Also, it is a known fact that IL&FS was late to react to these problems. The higher executives have confessed that they were aware of these problems from a long time but could not react. The stock market did not have complete information about the activities of the firm because some of its subsidiaries are not listed. Also, it has been alleged that the senior management was negligent and did not often meet to review the financials of the firm in entirety. It is only after the company started running out of cash and defaulting on its debt that media started to pay attention to the irregularities. By then it was already too late, and IL&FS was trapped in a downward spiral which will be difficult to get out of.
At the present moment, IL&FS has over 90,000 crore rupees in debt! The amount of money owed is so large that it caused many investors to worry that IL&FS may be a systemic risk. This is the reason behind the initial panic. However, on deeper analysis investors found out that the assets held in the portfolio of IL&FS are not toxic. The current crisis seems like a cash flow problem. This is the reason why investors are now convinced that the shares of the company are not really worthless.
Also, the financial condition of IL&FS has been evaluated for the possibility of systemic risks. Firstly, IL&FS has equity of about 7500 crore rupees. This is the money that the equity holders can afford to lose without causing systemic problems.
Also, about 20,000 crore worth of debt issued by IL&FS is held by pension funds and mutual funds. These are also financed by equity and can afford to take a loss without affecting the entire system. Also, it needs to be noted that the debt issued by IL&FS forms only a small portion of the assets under management for these funds. Hence, it will not prove to be an existential crisis for these companies either.
Hence, the final situation is that the investors of IL&FS may have to take a small haircut on their investments. Even if this giant crumbles, the financial situation of the Indian markets will continue to remain intact.
To sum it up, IL&FS was a darling of the India investing community. This sudden decline has caused panic and disbelief. It is possible for IL&FS to recover from this shock. But the road is likely to be long and arduous.
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