Financial Management

COST-VOLUME-PROFIT Decisions
ANALYSIS

2.8 Financial Management In Public Sector

This section includes:

l Evolution of Public Sector in India

l Distinction between Public Sector and Private Sector Accounting
l Special Financial Feature
l Formulation, Evaluation and Implementation of Projects
l Genesis of disinvestment in India

INTRODUCTION :
Before independence, there was almost no “Public sector” in Indian economy. The only in-
stances worthy of mention were Railways, The Post & Telegraph, The Port Trust, The Ord-
nance and the Aircraft factories and few Government controlled undertakings.
After independence India adopted the road of planned economic development through Five
year plans. In this India opted for dominance of the Public Sector firmly believing that Politi-
cal independence without economic self-reliance would not enable for Government to fulfill
the aspirations of the countrymen. The passage of Industrial Policy Resolution of 1956 and
adoption of socialist pattern of society as the national economic goal of the country built the
foundation of the dominant public sector as we see it today. It was believed that a dominant
public sector would reduce the inequality of income and wealth and advance the general pros-
perity of the nation.

EVOLUTION OF PUBLIC SECTOR IN INDIA :

The main objectives of setting up the Public Sector enterprises as stated in Industrial policy
Resolution of 1956 were:
l To help in the rapid economic growth and Industrialisation of the country and create
necessary infrastructure for economic development.
l To earn return on investment and utilise resources for development.
l To promote redistribution of income and wealth.
l To create employment opportunities.
l To promote balanced regional development.
l To promote import substitutions, save and earn foreign exchanges for the economy.
The 2nd Five year Plan document clearly stated that “All industries of basic and strategic im-
portance or in the nature of public utility services should be in the public sector. Other indus-
tries, which are essential and require investment on a scale, which only the state, in the present

324 Fianancial Management & international finance

circumstances, could provide have also to be in the public sector”. It further emphasized that,
“The public sector has to expand rapidly. It has not only to initiate developments which the
private sector is either unwilling or unable to undertake, it has to play the dominant role in
shaping the entire pattern of investment in the economy”. The investment in public sector
enterprises has grown from Rs.29 Crore in 5 PSU on 01.04.1951 to Rs.2,52,554 Crore in 240 PSU
on 31.03.2000.
Objectives
The objectives of public sector enterprises may be divided into three categories:
1. Economic objectives
i. Economic development - Public enterprises are established to accelerate the rate or economic
growth, by setting up key and basic industries like iron and steel, petroleum, power
generation, chemicals, machine building, etc. The public sector provides an essential base
for faster economic growth of the country. Expansion of capital goods industries lead to
the development of other industries.
ii. Planned growth - The private sector neglects the industries with long gestation periods
and low rate of returns. Public enterprises step in to fill up gaps in the industrial structure
by setting up industries which are economically unattractive, but nationally essential.
Public sector provides infrastructural facilities for diversified and balanced growth.
iii. Balanced regional development - Public sector concerns are designed to facilitate the growth
of backward regions so as to reduce regional disparities in industrial growth.
iv. Generation of surplus - Public enterprises are expected to generate and distribute surplus
for financing five-year plans and other schemes of public welfare.
v. Provide employment - One of the important objectives of public enterprises is to reduce the
unemployment by creating employment opportunities.
2. Social objectives
i. Control monopoly - Sometimes, public enterprises seek to check private monopoly and
restrictive practices and the resulting evils like exploitation.
ii. Equitable distribution of wealth - Public enterprises are expected to reduce disparities in the
distribution of income and wealth. Reduction of economic disparities is one of the
objectives of our constitution and public enterprises are helpful in checking concentration
of economic power.
iii. Provision of essential goods and services - An important objective of public undertakings is
to provide essential goods and services for consumption at reasonable prices. This helps
in improving the standard of living of the people. Social control over industry ensures
equitable distribution of commodities and helps to protect the consumer from exploitation
by greedy businessmen.
iv. Takeover of sick units - Closure of sick units may result in loss of employment to a large
number of people and wastage of national resources. Public enterprises like the National

Fianancial Management & international finance 325

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

Textile Corporation was set up to nationalise such units and to make them healthy and
profitable. Public enterprises also facilitate the groups of small-scale industries.
3. Political objectives
i. Public interest - Public enterprises are established in the interest of the country as a whole.
India has become an industrial power because of the development of public sector
concerns. They facilitate self-reliance in strategic sectors.
ii. National defence - Public enterprises are set up for the manufacture of arms, ammunition,
telecommunications, oil, etc., which are essential for the safety and security of the country.
iii. Socialism - Public enterprises are required to future the political ideology of the Government
as well as to serve the constitutional objectives of socialistic pattern of society.
DISTINCTION BETWEEN PUBLIC SECTOR AND PRIVATE SECTOR ACCOUNTING :
Public sector accounts are prepared to show the accountability to the concerned department
and private sector accounts are prepared to find out operating results, profit or loss, out of the
commercial transactions undertaken to earn profit. Other differences are as follows:
l Different Accounting System - Private sector accounts are prepared on accrual basis i.e.
earning and spending etc. Balance of both debit and credit side equates one another, but
public sector accounts are maintained on cash basis i.e. cash receipt and cash payment for
the respective period are taken into consideration.
l Profit or Loss - The purpose of public sector account is to depict accountability to the
legislature while private sector accounts try to depict commercial profit earned for the
year ended.
l Balance Sheet - In private sector accounts, balance sheet shows assets and liabilities on a
cumulative basis but in case of public sector accounting, the current year’s expenditures
as well as capital receipts are shown. In Private sector accounting final accounts consists
of profit and loss account, balance sheet, statement of changes in financial position. In
case of public sector accounts, final accounts consists of public sector account and balancing
accounts. Under balancing account, all the balances of the public sector accounts are
shown along with receivables and payables.
l Equation - In private sector accounting equation of assets and liabilities takes the following
form: Capital, Surplus, Other liabilities; Fixed assets, Current assets, Investments. But in
case of public sector accounting equation takes the following form: Public sector account
receivables-Payables.
l System of Entry - Under private sector accounting, double entry system is followed and
journal, ledger, trial balance can be prepared. But in the case of public sector accounting,
single entry system is followed because of its inability to prepare trial balance for absence
of full information.
l Depreciation - In private sector accounts, depreciation is charged on income statement to
arrive at true profit or loss, so that after the termination of the life of the asset they buy a
new asset for replacing the old asset; and also to claim tax exemption from commercial
profit. But in case of public sector accounting, there is no provision for providing

326 Fianancial Management & international finance

 depreciation. It lost its relevance in providing depreciation in absence of proper value of
asset; but in certain cases like Transportation Company which charges depreciation for
maintaining its assets.
l Form of Accounts - In public sector accounting, the form of accounts takes the following
form: (i) Consolidated Fund; (ii) Public Fund and (iii) Contingency Fund. In case of Private
sector accounting, concerns registered under the Companies Act shall follow the form
prescribed under the Companies Act, 1956.

SPECIAL FINANCIAL FEATURE :

Public sector: Capital expenditure in projects
A project requires a large amount of investment which is done by creating a variety of financ-
ing arrangements. Often a corporate legal entity is formed to run the project (such as SAIL,
GAIL, IOL, etc.). Suppliers of capital then look at the earnings stream of the project for repay-
ment of their loan or for the return on their equity investment. Often, the project involves
energy: not only the large extrapolations of gas, oil, and coal but also tankers, port facilities,
refineries, and pipelines. Other project includes mineral extraction operations, aluminum plants
fertilizer plants, and very importantly power plants. An example of the latter is a cogeneration
project.
Projects of this sort require huge amounts of capital, often beyond the reach of a single com-
pany. Many times a consortium of companies is formed to spread risk and to finance the
project. Part of the capital comes from equity participation by the companies, and rest comes
from lenders or lessors.
If the loan or lease is on a non-recourse basis, the lender or lessors pays exclusive attention to
the size of the equity participation and to economic feasibility of the project. In other words,
lender can look only to the project for payout, so the larger the equity cushion and the confi-
dence that can be placed on the projections, the better the project. In another type of arrange-
ment, each sponsors may guarantee its shares of the projects obligations. Under these circum-
stances, the lender places emphasis on the credit worthiness of the sponsors as well as on the
economic feasibility of the project.
So it is very important to find the benefits and costs of a project for the sponsors. This financial
appraisal of a project can be viewed as a two step procedure:
l Determination of cash flows (both inflows and outflows) associated with the project.
l Appraise the cash flow stream to determine whether the project is financially viable or
not.
But before this discussion it is important to introduce the assumptions behind it. The assump-
tions are:
l The cash flows occur only once a year,
l The risk characterizing is similar to the risk complexion of ongoing projects of the firm.

Fianancial Management & international finance 327

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

Cash flow determination

Forecasting is a planning tool. It is used for projecting future operational results of all activi-
ties of business-marketing, personnel, finance etc. All this activities has a chain link effect. A
successful business has to anticipate the demand of the product by making a sales forecast. As
the second step, production forecasts are made by estimating the requirement of material,
men, machinery. And finally the requirements for finance are assessed to execute all the ac-
tivities which lead us to make cash forecasting because in a business anything done or to be
done financially affects the cash eventually. However, there is no major difference between
business forecasting covering other functional activities and cash forecasting. All other fore-
casts are on accrual basis whereas cash forecasts are on cash basis. In brief, the following are
the benefits of cash forecasting:
1. It helps to find cash requirements of a business and setting different policies towards
that.
2. It reveals the quantum and period when the business is likely to face cash deficits so that
appropriate action is taken for arranging additional funds before the actual deficit manifests
itself.
3. It also points out the periods of cash surpluses too, so that the same can be utilized by
proper investment in the short term securities. It also helps in pulling the cash and transfer
of funds to other projects, so as to optimize the use of cash resources of the business.
4. Long-term cash forecasting provide necessary input with regard to the working capital
and fixed capital requirement for the implementation of the plan.
5. It may not insulate any business from bankruptcy.

Primarily there are two methods for making cash forecasts:

1. Receipt & disbursement method - Under this method the individual items which involve
movement of cash during the forecast period are estimated. Since such a forecast is for a
shorter period, normally up to one year, estimates are made for all items for receipts and
payments having some significant value. Such forecasts are fairly accurate.
2. Net adjusted income method - This method involves culling out of information pertinent to
movement of cash from the already prepared accounting statements like forecasted profit
and loss account and balance sheet to make future projections of cash requirements. Then,
true to its name the method makes necessary adjustment in the accounting figures
appearing in such forecasted Profit and Loss Account and Balance Sheet which have
prepared on accrual based figures to cash based figures. The statements so prepared are
known as Forecasted Cash Flow Statement.

Time horizons
The variables are forecasted for a predetermined period of time. This in business parlance is
known as “Time horizon”. It refers to the time span for which the forecasting is making. There
cannot be rigid rules to determine length of a time horizon. Conventionally accounts of a

328 Fianancial Management & international finance

business are prepared for a period of twelve months; forecasts are also made for twelve months
so as to have an equitable ground for comparison of the forecasts with the accounting results.
We have seen that cash forecasts act as a hub of all other forecasts like sales forecasts, purchase
forecasts, production forecasts etc. It, therefore, is prepared for identical period of twelve months
too, to synchronize with the period of other forecasts. Depending on the time horizon, cash
forecast is divided into two different categories:
l Short term cash forecasts— it is for a shorter period. Minimum period may be as near as
next day but the maximum period is not stretched beyond twelve months.
l Long term cash forecasts – long term cash forecasts are not much concerned with display of
detail of cash receipts and payments. The forecasts concentrate on issues like cash resource
requirements for fixed assets, change in working capital funds etc. thereby educating
management on financial consequences of the strategic plans which a business intends to
pursue.
Cost-Benefit analysis
The important principles underlying measurement of costs and benefits are as follows:
1. It is measured in terms of cash flows. This implies that all non cash charges (expenses)
like depreciation which are considered for the purpose of determining the profit after tax
must be added back to arrive at net cash flows for our purpose.
2. Since the net cash flows relevant from the firm’s point of view are what accrue to the firm
after paying tax, cash flows for the purpose of appraisal must be defined in post tax terms.
And from the suppliers point of view net cash flows are defined as long term funds.
3. Interest on long term loans are not considered for estimating the net cash flows since it is
defined from the supplier’s point of view.
4. The cash flows must be measured in incremental terms.
Some implications of this principle are as follows:
l If the proposed project has a beneficial or detrimental impact on say, the other product
lines of the firm, then such impact must quantified and must be considered for ascertaining
the net cash flows.
l Sunk cost must be ignored.
l Opportunity cost must be considered which is associated with the utilization of the
resources available with the firm.
l The share of existing overhead costs which is to be borne by the end products of the
proposed projects must be ignored.

Pricing policy in Public Sector

The pricing policy of public enterprises in India differ form that of private enterprises in that it
has a macro objective with micro implications. Since public sector enterprises are bound by
the promise of fulfilling certain socialistic objectives and providing impetus to industrial de-
velopment, their pricing policy is required to conform to that rationale which takes into ac-

Fianancial Management & international finance 329

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

count its impact on inter-enterprises and inter-industries, besides the impact on the enterprise
itself and its final consumers.
The different pricing followed by public enterprises can be broadly grouped under three major
heads:
1. Promotion-oriented pricing;
2. Surplus generation-oriented pricing;
3. Stabilization-oriented pricing.
Where external benefits arising from the operations of public enterprises outweigh surpluses
at the enterprise level, relatively lower prices, implying an indirect subsidy to the beneficia-
ries, may be adopted. Public utilities, financial intermediaries, etc. are examples of promotion-
oriented pricing in India. Public enterprises may follow a pricing policy to raise surpluses
either to plough back for their own development or contributing to the development and over-
all progress of the economy. The typical example of surplus generation-oriented pricing is
provided by the operations of the State Trading Corporation where the pricing of certain im-
ported items is meant for scrapping off fortuitous profits by taking advantage of the prevailing
domestic shortage.
The stabilization or regulation-oriented pricing in the public enterprise is intended to produce
a countervailing effect on private enterprise in certain market conditions in respect of goods
which are of primary necessity. As a result of such pricing policy, private enterprises are forced
to sell their products at lower prices. This type of operations in public enterprises can be suc-
cessful only if the public sector is in a position to release adequate supplies at lower prices so
that the restrictive and monopolistic trade practices by the private enterprises can be brought
under control. Besides, public enterprises may offer their products like intermediate inputs for
the benefit of private enterprises on the understanding that the end products be sold at fair
prices to final consumers. These kinds of operations have been confined largely to mass con-
sumption goods in India.
Pricing Principles
The pricing principles followed in public enterprises have been varied and diverse in nature.
The following, however may be distinguished.
(a) Cost plus pricing - The objective of cost plus pricing is to recover fully the cost and return
on investment. The cost plus pricing is employed in public enterprises like Indian
Telephone Industries, Hindustan Aeronautics, etc. wherein the government is a major
buyer.
(b) Marginal costing - In industries where cost decreases with increase in the scale of production,
marginal cost pricing entails a price subsidy to the extent of the difference between average
cost and marginal cost. This principle is justified provided the goods and services in
question have consumption and / or production externalities (external benefits) and high
price elasticity of demand which inhibits full utilization of productive capacity. In public
enterprises like BHEL, HEC and Electricity Boards where under utilization has been
perennially an inhibiting factor, the application of marginal cost pricing principle has
enabled them to recover a portion of the total cost. In multi-product enterprises, the

330 Fianancial Management & international finance

 subsidy on account of the marginal cost being lower than average cost in some products
is offset by average cost being lower than marginal cost in some other products.
(c) Discriminatory pricing - Discriminatory pricing is commonly used in some of the multi-
product and multi-service enterprises. The typical examples are provided by public
enterprises such as Railways, Indian Airlines and State Trading Corporation. It is well
known that in Indian Railways and Airlines, the passenger traffic is subsidized by the
goods traffic.
(d) Import-based pricing - Import-based is normally followed in those public enterprises which
have no domestic competition and whose production costs are higher than the price of
similar imported products. Under such conditions, in order to safeguard the interests of
domestic consumers, the import-based price constitutes the basis for price fixation.
(e) Externally determined pricing - In some areas, the prices of public enterprises are externally
determined. Prices of some essential commodities are controlled by the government and
it is likely that some public enterprises are involved in the manufacture of these
commodities. Typical examples of such price fixation are the prices of steel and fertilizers.
In certain cases, government fixes the prices between the two public enterprises. Such
inter-enterprise price fixation does not involve the application of basic principle
determination and is normally tentative and informal.
Price policies pursued by state enterprises therefore need to be directed by the governments
towards the fulfillment of certain primary economic aims, such as the following:
1. Improvement in the distribution of income by laying greater emphasis on wages rather
than mere profits;
2. Self reliance in initiation of new projects and the operations, expansion and financing of
existing projects;
3. Securing of improved inter-industrial distribution of resources;
4. Stimulation of market demand or restriction on consumption;
5. Providing stimulus to the growth of private industries;
6. Reduction of economic irregularities among consumers;
7. Implementation of the concept of full employment;
8. Maximizing utilization of existing stock of capital;
9. Provision for the strongest possible incentives to efficiency and
10. Accumulation of the projected rate.

Fianancial Management & international finance 331

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

Keeping in view the above objectives, while fixing prices and profits of public sector products
and emphasizing state undertaking should not only pave their way but make legitimate prof-
its, a variety of consideration need to be done in mind. Some of them are indicated below:
l The general market price;
l The question as to what part of the economy in cost should be passed on to the consumer
and what portion to the tax payer;
l The likelihood of non-availability and, therefore, scarcity in the near future;
l The principle of what the traffic can bear.
Guidelines to Pricing
It is very necessary to have suitable guidelines for public enterprises which operate under
monopolistic or semi monopolistic conditions in order to derive externalities and direct ben-
efits to the consumers under the guidance of socialistic objectives. Pricing policies to be adopted
may follow the following guidelines:
1. The pricing of products should be within the landed costs of comparable imported goods
which would be the normal ceiling (and not on the basis of C.I.F prices).
2. Within the ceiling of landed cost, it would be open to the enterprises to have price
negotiation and fixed prices at suitable levels for their products which would give them a
reasonable return on the capital invested. It is also desired that the price so fixed should
be operative for a period of two to three years.
3. Ordinarily, the landed cost should be regarded as the absolute ceiling. If, however, in
accessing the landed costs, there are reasons to believe that imported F.O.B. / C.I.F prices
are artificially low, or in other exceptional circumstances, where our own cost of production
is very high, it may be necessary to have the prices higher than the landed costs. In such
circumstances, the matter is required to be referred to the administrative ministry
concerned for examination in depth in consultation with the M.O.F and Bureau of Public
Enterprises, etc.
FORMULATION, EVALUATION AND IMPLEMENTATION OF PROJECTS :
While evaluating a capital expenditure we assume that the risk or quality of all investment
proposals under consideration does not differ from the risk of existing investment projects of
the firm and that the acceptance of any proposals or group of investment proposals does not
change the relative risk of the firm. The investment decision will be either to accept or to reject
the proposals. These criteria can be classified as follows:

332 Fianancial Management & international finance

 Payback period
No Discounting
Criteria
ARP

Evaluation
NPV
Criteria

BCR
Discounting
Criteria
IRR

Annual Capital
Charge

Pay-Back Period (PBP)

The pay back period of an investment tells us the number of years required to recover our
initial cash investment. It can be written as:
Initial Fixed Investment
Pay Back Period =
Annual Cash Inflows (if equal installments)

If the pay back period calculated is less than some maximum acceptable pay-back period then
the proposal is accepted if not it is rejected. However, in most of the cases firms specify the
cut off, so a good project may be rejected. Another drawback of this method is it does not
consider time value of money and it does not consider cash flows beyond payback time. So
no useful result is obtained form it. However a new payback method has been introduced
which takes time value of money into account, known as discounted payback method.
Accounting Rate of Return (ARR)
Accounting rate of return can be defined as the ratio of the average profit after tax to the
average book value of investment. Firm accepts the project if its accounting rate of return
exceed the target average rate of return.
Internal Rate of Return (IRR)
It can be defined as the rate of return at which NPV = 0.
Because of the various shortcomings in the average rate of return and pay back methods, it
generally is felt that discounted cash-flow method provide a more objective basis for evaluating
and selecting investment projects. This method takes account of both the magnitude and
timing of expected cash-flows in each period of a project’s life. In this method the internal rate
of return for an investment proposal is the discounted rate that equates the present value of
expected cash outflows with the present value of the expected inflows.

Fianancial Management & international finance 333

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

N
⎛ At ⎞
∑ ⎜⎜ ⎟ = o
t ⎟
t=o ⎝ (1 + r ) ⎠

Where At is the cash flows for the period t, where it maybe a net outflow or inflow, and N is
the last period in which a cash flow is expected. ‘r’ is the required rate of return.
The acceptance criteria generally employed with the internal rate of return method is to compare
the internal rate of return with a required rate of return, also known as the cutoff rate, or
hurdle rate. If the internal rate of return exceeds the required return, the project is accepted;
if not the project is rejected. For one period project IRR gives correct result (where IRR = C1 /
C0 - 1). But in most of the cases when IRR is very high for a project all NPV also becomes
higher than that, so it becomes impossible to draw the conclusion. The pitfalls of IRR are:
Lending borrowing — IRR is the same for lending and borrowing but NPV lines are in different
directions.
Multiple rates of return — for changing signs of CF’s there may be more than one IRR’s for the
same project.
Mutually exclusive projects — projects with higher IRR need not have higher NPV and a
different rate NPV gives different ranking.
IRR non existent — for some CF’s IRR may not exist.
Assumption about expected rate of return—to solve for IRR we will have to assume that
different expected returns gives same results (r1 = r2 = r3 ……….), indicating a flat term
structure.
Net Present Value (NPV)
This is also a discounted cash flow approach. With the present-value method, all cash flows
are discounted to present value, using the required rate of return. The net present value of an
investment proposal is
N
⎛ ⎞
∑ ⎜⎜ (1 +Atr ) t
⎟⎟ = NPV
t=o ⎝ ⎠
Where, r = required rate of return.
If the sum of these discounted cash flows is zero or more, the proposal is accepted, if not, it is
rejected.
Another way to express the acceptance criterion is to say that the project will be accepted if the
present value of cash inflows exceeds the present value of cash out flows.
Profitability index (PI)
The profitability index, or benefit cost ratio, of a project is the present value of future cash
flows over initial outlay. It is expressed as follows:

334 Fianancial Management & international finance

 BCR = PV / I
Where the BCR = Benefit Cost Ratio
PV = Present value of future cash flows
I = Initial investment
If BCR > 1 the project is accepted, if not it is rejected.
GENESIS OF DISINVESTMENT IN INDIA :
Disenchantment with public sector started in 1970s. It was observed in many countries that
the performance of the public enterprises was far below the expectations. The weakness and
defects of public enterprises started manifesting with grave danger to Government and
economy in many countries, with no solution in sight. So there started, the reversal of trend in
this decade. By the mid 1980 globally the political opinion was veering round to the view that
proportion of GNP due to Government economic activity should be reduced to the extent
possible and business activities should be left to private sector as far as possible.
During the 1980s, collapse of the socialist economy of the Soviet block, introduction of economic
reform by Russia, East European countries and China knocked the bottom out of protagonists
of Government intervention in every commercial activity for the benefit of the masses.
India, for almost four decades was pursuing a path of development in which public sector
was expected to be the engine of growth. But by mid-eighties their short comings and
weaknesses started manifesting in the form of low capacity utilization, low efficiency, lack of
motivation, over-manning, huge time and cost overrun, inability to innovate and take quick
decision, large scale political and bureaucratic interference in decision making etc. But instead
of trying to remove these defects and to increase the rate of growth of national economy,
gradually the concept of self-reliant growth was given a quiet burial. The Government started
to deregulate the imports by reducing or withdrawing import duty in phases. This resulted in
dwindling of precious foreign exchange reserve to abysmally low level. The foreign debt
repayment crisis compelled Government of India to raise loan from IMF against physical deposit
of RBI gold reserve, on conditions harmful to the interest of the country.
Thus started the reversal of policies towards PSU. The Industrial policy of 1991 started the
process of delicensing and except 18 industries, Industrial licensing was withdrawn. The
market was opened up to domestic private capital and foreign capital was provided free entry
up to 51% equity in high technology areas. The aim of economic liberalization was to enlarge
competition and allowing new firms to enter the market. Thus the emphasis shifted from
PSEs to liberalization, of economy and gradual disinvestment of PSEs. A paradigm shift of
Government’s economic policy orientation originated in 1991 from a foreign debt servicing
crisis.
Rationale for Disinvestment

Because of burgeoning revenue deficit in Central Budget year after year on account of current
revenue expenditure on items such as interest payments, wages and salaries of Government
employees and subsidies, the Government is left with hardly any surplus for capital expenditure

Fianancial Management & international finance 335

 Financial Management
COST-VOLUME-PROFIT Decisions
ANALYSIS

on social and physical infrastructure. Huge amount of public resources are blocked in several
non-strategic PSEs giving meager return. Government is forced to commit further resources
for sustenance of many non-viable PSEs in absence of exit route. Above all it has to service
huge amount of outstanding debt before any money is available for investment in infrastructure.
All these Government economic woes led to an obviously straight forward option of divestment
of Government stake in PSEs.

l Releasing large amount of public resources locked up in non-strategic PSEs.

l Stopping further outflow of resources for sustaining unviable PSEs.
l Reducing burgeoning public debt.
l Transferring commercial risk to private sector.
The other benefits expected to be derived from privatization are:
l Disinvested companies would be exposed no market discipline and they would become
more efficient and survive or will cease on their own.
l Disinvestment would have a beneficial effect on the capital market.
l New private investor will put in more money in privatized PSEs and economic activity
will increase.
l Consumers will be benefited as they would have more choices and cheaper and better
quality products and services.
The quantum of divestment of equity in PSEs was gradually increased from 20% to 49% to
76% and 100% in some cases. From divestment of Government stake to other PSEs, Financial
Institutions etc., Government has now adopted the path of strategic sale of PSEs to private
industrialists.
The main features of Government’s present Policy towards Public sector are:
l Restructure and revive potentially viable PSEs.
l Close down PSEs which cannot be revived.
l Bring down Government equity in all Non-strategic PSEs to 26% or lower, if necessary.
l Fully protect the interests of workers.
The issues regarding disinvestment which are still being debated and which will remain
relevant in the coming days are:
l Which areas should not be divested.
l Whether defence, production & services should be disinvested and to what extent it is
desirable in view of national security.
l To what extent the method of divestment can be made open and transparent.
l Out of the various methods of divestment which path will lead to fulfillment of declared
objectives.
l Should the foreign private investors be allowed to acquire controlling interest in PSEs.
l How the social security net be instituted to train and re-employ active and able employees
retiring under VRS.

336 Fianancial Management & international finance