Depreciation Of The Indian Rupee – A Short Commentary

On 28^th August 2013 the Indian Rupee plunged to an all time low of 68.85 to the US Dollar – a depreciation of nearly 25% since January 2013. Let’s examine some of the issues that brought the rupee to such a state.

We’ll start by going back in time when after independence in 1947, India adhered to socialist policies. Attempts were made to liberalise the economy in 1966 which was reversed a year later in 1967. Another attempt was made in 1985 by the then Prime Minister Rajiv Gandhi which came to a halt in 1987. In 1991, after India faced a Balance of Payment crisis, it had to pledge 20 tonnes of gold to the Union Bank of Switzerland and another 47 tonnes to the Bank of England as part of a bailout deal with the International Monetary Fund. Additionally the IMF required India to undertake a series of structural economic reforms. The economic liberalization of India started on 24^th July 1991 which included policies such as opening for international trade and investment, deregulation, initiation of privatisation, tax reforms and inflation control measures. These policies started showing results when in 2007 India recorded a GDP growth of 9%. However, the economy slowed to around 5% in 2012-13 as compared to 6.2% in the previous fiscal (considering that there was a global financial meltdown in 2008 the figure of 6.2% is comparatively okay). India’s GDP which had grown by 9.3% in 2010-11, went south by nearly 50% in 2012-13 in a span of just 2 years. (GDP Graph)

Until the liberalisation of 1991, India was largely and intentionally isolated from the world markets to protect its economy and to achieve self-reliance. Foreign trade was restricted and subject to import tariffs, export taxes and quantitative restrictions. Since independence, India’s Balance of Payment had been negative until 1991 (India's Balance of Trade Graph). After liberalisation, India’s exports have risen covering 80.37% of its imports in September 2013, up from 66.20% in 1990-91.

At this juncture a little history here is warranted. The British came to India in 1608 when the East India Company established a settlement in Surat, Gujarat . After the mutiny of 1857 the East India Company’s powers were transferred to the Crown. From 1858 till 1947 India was ruled by the Crown in what is now known as the British Raj. India got freedom from British rule on 15^th August 1947. The Rupee which was linked to the British Pound from 1927 to 1946 had its value at par with the US Dollar. After independence there were no foreign borrowings on India's balance sheet. To finance welfare and development activities, especially with the introduction of the Five-Year Plan in 1951, the government started external borrowings. This required the devaluation of the rupee. On 24^th September 1975, the Rupee’s ties to the British Pound were broken. India conducted a managed float exchange regime with the Rupee’s effective rate placed on a controlled, floating basis and linked to a “basket of currencies” of India’s major trading partners – the US Dollar, the British Pound, the Japanese Yen and the Deutsche Mark. The year 1993 is very important in Indian currency history. It was in this year when the currency was let free to flow with the market sentiments. The exchange rate was freed to be determined by the market, with provisions of intervention by the central bank under the situation of extreme volatility. In 1993, one was required to pay `31.37 to get a dollar. In the last decade, the rupee traded in the range of 40-50 to the US Dollar; touching a high of 44.61 in 2007. The Indian currency has gradually depreciated since the global 2008 economic crisis

Let’s now pay a visit to the final days of World War II. In an effort to create a new global economic order; 44 leaders from all the Allied nations met in Bretton Woods, New Hampshire, USA in what is now known as the Bretton Woods System. The Bretton Woods System of monetary management established the rules for commercial and financial relations among the world's major industrial states in the mid-20th century. The Bretton Woods System was the first example of a fully negotiated monetary order intended to govern monetary relations among independent nation-states. With much of the global economy in tatters, the US emerged as the world’s new economic leader to replace a debt-ridden and war-torn Great Britain. The chief features of the Bretton Woods System were an obligation for each country to adopt a monetary policy that maintained the exchange rate by tying its currency to the US Dollar and the ability of the IMF to bridge temporary imbalances of payments.

This historic meeting created an international gold-backed monetary standard which relied heavily upon the US Dollar. At this point, an appropriate question to be asking yourself is: ''Why would all of the nations be willing to allow the value of their currencies to be dependent upon the US Dollar?".

The answer is quite simple. The US Dollar would be pegged at a fixed rate to gold.

This made the US Dollar completely convertible into gold at a fixed rate of $35 per ounce within the global economic community. This international convertibility into gold allayed concerns about the fixed rate regime and created a sense of financial security among nations in pegging their currency's value to the Dollar. After all, the Bretton Woods arrangement provided an escape hatch: if a particular nation no longer felt comfortable with the Dollar, they could easily convert their Dollars holdings into gold. This arrangement helped restore a much needed stability in the financial system. But it also accomplished one other very important thing. The Bretton Woods agreement instantly created a strong global demand for US Dollars as the preferred medium of exchange. By the end of the war, nearly 80 percent of the world’s gold was sitting in US vaults and the US Dollar had officially become the world’s undisputed reserve currency. As a result of the Bretton Woods arrangement, the Dollar was considered to be “safer than gold.”

Initially, this Dollar system worked well. However, by the 1960s, the weight of the system upon the United States became unbearable. On 15^th August 1971, President Richard M. Nixon shocked the global economy when he officially ended the international convertibility from US Dollars into gold, thereby bringing an official end to the Bretton Woods arrangement.

Two years later, in an effort to maintain global demand for US Dollars, another system was created called the petroDollar system. In 1973, a deal was struck between Saudi Arabia and the United States in which every barrel of oil purchased from the Saudis would be denominated in US Dollars. Under this new arrangement, any country that sought to purchase oil from Saudi Arabia would be required to first exchange their own national currency for US Dollars. In exchange for Saudi Arabia's willingness to denominate their oil sales exclusively in US Dollars, the United States offered weapons and protection of their oil fields from neighbouring nations, including Israel.

By 1975, all of the OPEC nations had agreed to price their own oil supplies exclusively in US Dollars in exchange for weapons and military protection. This petroDollar system, or more simply known as an "oil for Dollars" system, created an immediate artificial demand for US Dollars around the globe. And of course, as global oil demand increased, so did the demand for US Dollars. Today the most traded currency is the US Dollar having a share of 85% of the global foreign exchange market turnover.

India imports crude oil, precious stones, machinery, fertilizer, iron, steel and  chemicals. Since India is heavily dependent on coal and foreign oil imports for its energy needs; India's main import is crude oil (more than 35% of total imports), and the countries it imports from unfortunately only accept US Dollars or other major currencies. Therefore, India needs to have a large reserve of US Dollars and other currencies to pay for the crude oil (US$ 2,49,324.60 million of foreign currency reserves as on 4^th October 2013). India receives Dollars in three ways: through exports, through foreign investments into India, and through NRI remittances into India. The less Dollars there are in the market, the more the Dollar is worth (basic laws of demand and supply), and, so, the Rupee depreciates.

From 2003 to 2008, the Rupee appreciated against the US Dollar; thereafter, it has sharply depreciated. Between 2010 and 2012, the Rupee value had depreciated by about 30% of its value to the US Dollar in 2010. On 28^th August 2013 it plunged to an all time low of 68.85 to the US Dollar.

Historical Indian Rupee Rate V. US Dollar (Average exchange rate)
Year	INR/USD	Year	INR/USD	Year	INR/USD	Year	INR/USD
1973	7.66	1984	11.36	1995	32.43	2006	45.17
1974	8.03	1985	12.34	1996	35.52	2007	41.20
1975	8.41	1986	12.60	1997	36.36	2008	43.41
1976	8.97	1987	12.95	1998	41.33	2009	48.32
1977	8.77	1988	13.91	1999	43.12	2010	45.65
1978	8.20	1989	16.21	2000	45.00	2011	46.61
1979	8.16	1990	17.50	2001	47.23	2012	53.34
1980	7.89	1991	22.72	2002	48.62
1981	8.68	1992	28.14	2003	46.60
1982	9.48	1993	31.26	2004	45.28
1983	10.11	1994	31.39	2005	44.01

One of the most important questions that many are asking is why the Rupee has fallen to its current state. Exchange rate can be best understood as nothing more than a benchmark for a nation's money supply. When the Rupee depreciates against the Dollar, it simply means value of the Indian currency has gone down relatively against the greenback (US Dollar). This can happen because of two things: 1) increase in Rupees in the market; or 2) decrease of Dollars in the market.

Since the beginning of Quantitative Easing program the emerging markets have been the biggest beneficiaries of the Fed’s loose monetary policy, which has pumped extra liquidity since the global financial crisis of 2008. According to the IMF, emerging markets received nearly $4 trillion in capital flows from 2009 to early this year.

The recovery in the US economy is expected to prompt the central bank there to end the loose monetary policy by the year end. There is ample reason for concern that capital outflows from India and other emerging markets will rapidly accelerate if the Federal Reserve decides to curtail its bond-buying program on 17^th September 2013. This move would lead to higher interest rates in the US and investors may dump risky emerging markets assets in favour of safe havens. Anticipating this, foreign investors are pulling out their money from India to invest it back in the US, which is resulting in a scarcity of Dollars in India. This has created a shortfall in supply of the Dollar in India. This is not India specific. All emerging market currencies are witnessing a similar capital flight. US recovery is also boosting the dollar strength. The FIIs have also been heading to greener pastures like Singapore owing to the greater operational efficiency and lesser bureaucratic problems that have unsettled the Indian business fraternity and hampered its overall economic growth.

Secondly, importers (mostly oil companies since we import most of our crude oil) are the major entities who are in need of the Dollar for making their payments. This again creates a demand for the US Dollar.

This situation can only be addressed by exporters who can bring in dollars in the system. Secondly, if somehow the FIIs can be wooed back, then this situation can also be addressed to a certain extent. FII net investments have plunged from `1,78,537.80 crores in 2012-13 to `(-)37,062.40 crores as on 30^th September 2013. From June 2013 till September 2013 the FIIs have withdrawn from the Indian markets. Despite a modest recovery in the rupee’s value between 4^th and 12^th September 2013, the investors remain wary of India’s excessive dependence on volatile “hot money” flows to finance its current account deficit. The investors borrowed cheap short-term money in the US and invested in higher yielding assets in India, Indonesia, South Africa and other emerging markets. This resulted in more money flowing into debt, equity and commodity markets in these countries. In India, many companies resorted to heavy borrowings overseas (since interest rates were lower there). The massive capital inflows also enabled India to comfortably finance its trade and current account deficits rather than addressing the structural aspects of Current Account Deficit (CAD).

India's Gross Domestic Product grew only at 4.4 percent in the second quarter of 2013, the worst quarterly rate since 2002, hurt by a decline in mining and manufacturing. When a country’s imports far exceeds its exports the CAD increases which is a cause for worry. This certainly seems to be a large contributor to the depreciation of the rupee. Over the past 2 years, India's money supply grew at around 29 per cent, while it's GDP grew at a much lower pace. This caused inflation to go into the two figure realm. By limiting the money supply, inflation and, potentially, the rupee's value would be controlled- but it would severely impact the country's growth. India's GDP has dropped from 6.2 per cent to 4.4 per cent in latest quarter of this fiscal year, so India's growth would be hampered by lowering its money supply.

India should let the markets remain open and democratic- eventually, Indian goods will be cheap enough to a point where they will be easily exported. India's urbanisation is not going to stop, wages will continue to rise, and inflation will be controlled since the money supply can be kept at par with GDP growth. The rupee will probably rise in the short term but at a certain point, equilibrium will kick in. There is a high level of pessimism in the markets. It goes without saying that India needs to address the rising current account deficit and slow growth on a war footing to ensure that the rupee does not depreciate any further.

Discounted Cash Flow - Part 3

Part 3 – The Basics Continued

Today we continue with our discussion. We’ll cover Terminal Value, WACC and solve a simple problem based on the discussions that have been done so far.

Terminal Value

Most projects require an initial investment and then eventually they give off positive net cash flows for a given period then stop. An appropriate example could be a mine which produces some ore or gold or coal only for a finite time. Other projects or assets could produce positive cash flows in perpetuity e.g. a piece of land which can be utilised for anything. If you keep the cash flows going for years (including Year 0) and discount them, you’ll notice they get smaller and smaller as you go further in time until eventually they are a fraction of a rupee. You could keep going another 5,000 years but the discounted cash flows are already so small that it wouldn’t really make a difference. Eventually by adding up all the discounted cash flows we get the NPV.

However, it would not be practical to forecast the cash flows beyond a certain time horizon (probably 5 to 10 years). Please recall what I had said in the part 2 of this article –

“we (also) know that cash flows are dependent on earnings; earnings being the super-set. Earnings can be volatile both as a result of the normal ebb and flow of business and as a result of accounting transactions. As a corollary, uncertainty in cash flow projection increases for each year in the forecast. We  may have a good idea of what cash flows will be for the current year and the following year, but beyond that, the ability to project earnings and cash flow diminishes rapidly.  In my opinion anything beyond a couple of years is suspect.”

Now, having estimated the cash flows for the horizon period we need to come up with a reasonable value of the cash flows beyond this period. Forecasting results beyond the horizon period is impractical and exposes such projections to a variety of risks limiting their validity, primarily the great uncertainty involved in predicting industry and macroeconomic conditions beyond a few years. Instead of an attempt to forecast the cash flow for each individual year beyond the horizon period, one can use a single value representing the discounted value of all subsequent cash flows. This single value is referred to as the terminal value (TV). Thus, the terminal value allows for the inclusion of the value of future cash flows occurring beyond a several-year projection period while satisfactorily mitigating many of the problems of valuing such cash flows. Depending on what is being valued the terminal value can be calculated either based on the value if liquidated or based on the value of the firm as an ongoing concern. A mine, for example, will have a small terminal value vis-à-vis a business which leases a piece of land.

There are three methods in vogue in which the TV can be calculated –

Liquidation method: By assuming a firm will cease operations and liquidate its assets at the end of the discounted cash flow analysis, you can simply calculate the value of the firm's existing assets and adjust for inflation. However, this approach is limited as it doesn't reflect the earning power of the firm's assets.

Multiple approach: The value of the firm is estimated by applying a multiple to the firm's earnings or revenues. For example, one might multiply an appropriate industry price to earnings ratio to the estimated earnings in order to arrive at a terminal value for the firm.

Stable growth model: This model assumes that the company will grow at a constant rate forever. To calculate this, use the formula –

TV_t =  Cash Flow _t+1

            -------------------

              r - g_stable

Cash Flow t+1 represents the first year beyond the discounted cash flow analysis, r is the interest rate and g is the stable growth rate. If the company is assumed to disappear at some point in the future, a negative growth rate can be used. Please also refer to the web page available on terminal value Estimating Terminal Value from NYU Stern.

When applied to the discounted cash flow, the terminal value should be discounted by dividing the terminal value by (1 + r)^t.

It would be prudent to mention here that a detailed study of stable growth model is beyond the scope of this article. We’ll cover this topic at a later stage. However, for those of you interested at this stage I suggest a reference to Professor Aswath Damodaran’s notes titled  Valuation: Estimating Terminal Value.

Please appreciate that as with any forecast or prediction, the further out it is, the greater the chance of error. Keep in mind that terminal value is typically forecasted for some X periods into the future, for an indefinite amount of time beyond. A number of assumptions must hold true to obtain even a modestly accurate terminal value.

Because of this, many analysts may opt to instead use a 'base case' terminal value, with as conservative assumptions as possible - while this has the potential benefit of limiting downside and maximizing upside, it does not necessarily imply accuracy (which is typically how the greatest returns are generated).

All this goes to say is that while terminal value is a useful and sometimes necessary metric for valuation, it should be subject to significant scrutiny, as even small changes in the underlying assumptions can have meaningful overall impact.

Weighted Average Cost of Capital

Companies raise money from a number of sources: common equity, preferred stock, straight debt, convertible debt, exchangeable debt, warrants, options, pension liabilities, executive stock options, governmental subsidies, and so on. Different securities, which represent different sources of finance, are expected to generate different returns. The WACC is the minimum acceptable return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. The WACC is calculated taking into account the relative weights of each component of the capital structure. The more complex the company's capital structure, the more laborious it is to calculate the WACC.

The rate used to discount future cash flows and the terminal value (TV) to their present values should reflect the blended after-tax returns expected by the various providers of capital. The discount rate is a weighted-average of the returns expected by the different classes of capital providers (holders of different types of equity and debt), and must reflect the long-term targeted capital structure as opposed to the current capital structure. While a separate discount rate can be developed for each projection interval to reflect the changing capital structure, the discount rate is usually assumed to remain constant throughout the projection period.

In its simplest form the WACC formula is -

WACC = (E/V) × R_e + [(D/V) × R_d] × (1 - T_c)

where: 
R_e = cost of equity 
R_d = cost of debt 
E = market value of the firm's equity 
D = market value of the firm's debt 
V = E + D = firm value 
E/V = percentage of financing that is equity 
D/V = percentage of financing that is debt 
T_c = corporate tax rate

Calculating the Cost of Equity

The cost of equity is usually calculated using the Capital Asset Pricing Model (CAPM), which defines the cost of equity as follows:

R_e = R_f + β X (R_m – R_f)

Where:

R_{f =} Risk free rate (normally the government bond rate)

β = Predicted equity beta

(R_m – R_f) = Market risk premium

A short commentary on Beta will be appropriate at this point. Beta is a measure of the volatility of a stock's returns relative to the equity returns of the overall market. It is determined by plotting the stock's and market's returns at discrete intervals over a period of time and fitting (regressing) a line through the resulting data points. The slope of that line is the levered equity beta. When the slope of the line is 1.00, the returns of the stock are no more or less volatile than returns on the market. When the slope exceeds 1.00, the stock's returns are more volatile than the market's returns.

This is the simplest way in which the Beta can be worked out. However, Professor Aswath Damodaran says Avoid regression betas. Regression betas, commonly used in calculating the cost of equity, generally have large standard errors. Betas should reflect the business the firm operates in, its operating leverage, and its debt level. Damodaran calls for the use of sector betas as a way to eliminate the noise that comes with regression betas calculated on individual firms. A reading of chapter 2 in  Aswath Damodaran’s book “Damodaran on valuation” and chapter 6 in I M Pandey’s book “Financial Management” will be helpful.

Simply put, R_d reflects the current market rates the firm pays for debt. Interest paid on debt reduces the Net Income and therefore, reduces the tax payments for the firm. This interest tax shield depends on the tax rate.

We have covered everything on the basics of DCF. Advanced topics in DCF will be discussed later. For now the discussions till date should suffice for our purpose.

Let us now try to solve a few problems taking into account all that has been discussed.

Problem 01:  Determine the NPV (at discount rate of 30%) and IRR for two mutually exclusive projects that cost ` 5,00,000 each and would yield after-tax cash flows as given in the chart below.

	Cash Flows
Year	Project A	Project B
0	-500000	-500000
1	400000	100000
2	300000	200000
3	200000	300000
4	100000	400000

Solution

Project A
Year	Cash Flows	PV @ 30%	PV @ 40%	PV @ 50%
0	-500000	-500000	-500000.00	-500000.00
1	400000	307692.3	285714.29	266666.67
2	300000	177514.8	153061.22	133333.33
3	200000	91033.23	72886.30	59259.26
4	100000	35012.78	26030.82	19753.09
NPV		111253.11	37692.63	-20987.65
IRR (Using Excel function)				46.17%
IRR (Calculated)				46.42%

Project B
Year	Cash Flows	PV @ 20%	PV @ 30%
0	-500000	-500000.00	-500000.00
1	100000	83333.33	76923.08
2	200000	138888.89	118343.20
3	300000	173611.11	136549.84
4	400000	192901.23	140051.12
NPV		88734.57	-28132.77
IRR (Using Excel function)			27.27%
IRR (Calculated)			27.59%

I have used the method of graphing and constructing similar triangles and then solving for IRR which we had discussed in part 2 of this series.

I would like to comment some more on the IRR at this point. IRR allows managers to rank projects by their overall rates of return rather than their net present values, and the investment with the highest IRR is usually preferred.  Also, IRR does not measure the absolute size of the investment or the return. This means that IRR can favour investments with high rates of return even if the rupee amount of the return is very small. For example, a `1 investment returning `3 will have a higher IRR than a `1 million investment returning `2 million. Finally, IRR does not consider cost of capital and can’t compare projects with different durations.

Problem 02: The ABC Company has consulted with its investment bankers and determined that they could issue new debt with a yield of 8%. If the firm’s ' marginal tax rate is 39%, what is the after-tax cost of debt to the firm?

Solution

r_d = 0.08 (1 – 0.39) = 0.0488 or 4.88%

Problem 03: The XYZ Company has common stock outstanding that has a current price of  `20 per share and a `0.5 dividend. XYZ’s dividends are expected to grow at a rate of 3% per year, forever. The expected risk-free rate of interest is 2.5%, whereas the expected market premium is 5%. The beta on XYZ’s stock is 1.2. What is the cost of equity for XYZ using the Capital Asset Pricing Model (CAPM)?

Solution

r_e = 0.025 + (0.05) 1.2 = 0.025 + 0.06 = 8.5%

Problem no. 3 is the kind where examiners try to confuse the student. The additional information given regarding the current price of the stock, the dividend and the growth rate are not utilized in CAPM but only in the Dividend Valuation Model. We’ll discuss this topic when we do valuation later.

I end this discussion on DCF at this point. We’ll try to cover other topics in subsequent posts.