Ans: 1(a)

It is given that IADB can issue, at max, 2% on all dollar debts for all maturities. We take the
maturity period to be 10 years in this case. Assuming perfect markets, whatever be the yield of
IADB’s rupee debt, it must not exceed the 2% in absolute dollar debt terms. Now consider Rs.
100 issued as rupee debt by IADB today. Let the rupee yield of IADB be x%. Using forward
market data, we can form the equation

{[(100+x)%](Maturity period) }* [100/$ forward exchange rate after maturity] =

{[(100+2)%](Maturity period)}*[100/$present exchange rate]

Now forward exchange rate after maturity $1= Rs. 96.22, Present exchange rate $1= Rs. 65

Maturity period= 10 years. Plugging them in the equation, we get

X= 6% yield of IADB’s rupee debt

1(b): The difference could be because of several reasons:

a) Now cost of debt(capital) is risk free rate plus the spread (determined by the ratings-
better ratings lead to smaller spread and vice versa). IADB is an AAA rated transnational
entity akin to world bank. As such, the spread will be less, and investors will view IADB’s
rupee bond issuance comparatively more secure than the Indian Government bonds
that might not have AAA rating.
b) There is a limit to the number of foreign investors and the amount that they can invest
in Indian government bonds. As such an alternate rupee debt bond offered by IADB,
even at 1 percentage points less than Indian government bond will be quite lucrative.

1(c) : For IADB to raise low capital debt, the absolute dollar debt issue should come out to be
less than 2%. Therefore, the equation will be

{[(100+x)%](Maturity period) }* [100/$ forward exchange rate after maturity] <

{[(100+2)%](Maturity period)}*[100/$present exchange rate]

Now it is given in the question, x= 5%.

Therefore, at this rate of rupee debt issue, the dollar debt issue rate comes out to be = 1%

So savings will be 500*(1.02)10 – 500*(1.01)10

Question 2: Adverse Inc., an all-equity private firm, wants to invest $110 million in a new project and
fund it through an IPO. Adverse’s current equity has expected value of $500 million, reflecting possible
future values of $700 million in the good state of

the economy or $300 million in the bad state of the economy, with the good and bad states having
equal probability, i.e. ½. The new project is such that it will have an NPV of $100 million with
probability 1/2 and $0 with probability 1/2.

1(b)

1. Assuming symmetric information, what is the current market value of Adverse Inc. if it raises $110
million through an IPO and funds its new project? (2)

2. Still assuming symmetric information, what percentage of Adverse's equity stake must be sold in
the IPO? (2)

3. For the remaining questions, assume that Adverse knows the project is good and has an NPV of
$100. Investors know that Adverse has inside information about the project but do not know what
that information is. a. What would be Adverse's market value if it does an IPO to raise $110 million?
(2) b. What is the cost of the informational asymmetry to Adverse from doing an IPO? (2) c. Assume
that doing an IPO costs 7% in terms of underwriting spread and other costs of the IPO come to $5
million. Should Adverse do the IPO? (2)

Ans: 3(a)

Securitization is issuance of bond by assets that generate known or estimable cash flows. As
such, ideally the asset should have less risk associated with it. In the case of projects such as toll
roads and smart cities, the overall revenue model is unclear and often there are delays in
receiving payments by lenders. As such these assets don’t ideally fit the asset requirement for
securitization at the onset. However, toll road in isolation may or may not have a certain
estimate of cash flow and revenue model. In case the toll roads have an established cash flow
estimation, these assets will qualify for securitization and will allow the good toll road assets to
be segregated from other riskier infrastructure ones by following the SPV route. The
government can then issue higher credit rated bonds against these assets. In case the toll roads
have uncertainties regarding revenue model In India, securitization against them will not be
feasible. So, there is another way to go about it. Bank credit is preferred during the initial
development stage as most projects require a smooth and gradual disbursement of funds.
Moreover, restructuring a loan is easier.

Once the initial phase and commissioning stage are over and demand and revenue model of the
toll roads meets the expectations, going for securitization makes sense. By doing so, the bank’s
loan exposure is reduced and offer diversification of the risk profile. Moreover, doing this will
attract different pool of investors and make enough capital available by say foreign investors or
mutual funds to the cash strapped capital-intensive infrastructure projects. Moving forward, as
the disciple of the system will be maintained, the risk associated with the system will reduce
further leading to lowering of the cost of capital.

3(b) :

There are several ways in which the cost of capital is reduced by securitization.

Firstly, by Tranching or segregating assets, the information/knowledge gap between the

investors and the company is reduced. As assets become more transparent to analyze, the risk
associated with them is clearly known. This lowers uncertainty and reduces cost of capital.

Secondly, market imperfections can be exploited. In case the market values the segregated
assets more than that valued internally by the company, the overall cost of capital after taking
the weighted average may reduce. For example:

Earlier, say $25 asset at 6% and $25 at 4%. Here Weighted Average Cost of Capital(WACC) = 5%

Now say $25 at 6% and $40 (segregated asset valued more by market) at 4%. Here WACC =
4.769 %
Thirdly, the assets can be bucketed into three categories based on the risks associated- factors
such as location, traffic demand, political dynamics, etc. Moreover, the terms of return can also
be structured as the need be.

The three categories can be:

1) High risk: Long term maturity level with interest and principal paid in the end
2) Medium risk: medium maturity level and option with interest paid annually and then
speeded up delivery of principal amount
3) Low risk: Mostly low maturity level and option of gaining both interest and principal
together

Now based on the risk appetite of the investor, he/she can choose any of the above three
categories of debt. This system will attract a varying/different pool of investors. Over a period,
if incentives are in place and everyone follows the discipline of the system, there would be
lesser and lesser instances of default leading to reduction in risk. This will eventually lead to
lowering of the cost of capital because of lower risk association.

Fourthly, Bankruptcy cost is lowered by securitization. The assets under the SPV route are
separated from the original pool of assets. In case of the failure of SPV, only the assets in the
SPV will be forfeited and there is no tracing back of assets to the original company. Thus,
bankruptcy charges are also reduced.