Arbitrage opportunities of a Fully Paid vs. Partly Paid Equity Share

Arbitrage opportunities of a Fully Paid vs. Partly Paid Equity Share

While a super majority of the shares listed in the Indian Markets are fully paid up, in the coming future there stands a good possibility of Indian Cos. raising share capital by means of issuing partly paid shares for eg. the DLF issue, ICICI Bank. The benefits in theory that is, we all know are that the companies are able to facilitate easier subscriptions, however for some reason Indian investors resist subscribing partly paid shares. Below is the explanation that holds partly paid shares in a better light as against what is generally conceived by general retail investors (RI) and why subscribing to partly paid shares (PPS) might in certain instances be a superior option to subscribing to the fully paid share (FPS).

To facilitate easy understanding we shall take ICICI Bank’s issue with its characteristics.

Now, ICICI under its partly paid scheme allowed an upfront payment of Rs.250 on application + Rs.250 at the time of allotment, further the partly paid shares would list in close proximity with the other FPO shares allotted. Below is illustrated the pricing of the PPS assuming that the PPS and the FPS list in close proximity.

As the issue was sold to retailers at Rs.890, the RIs would have to pay Rs.500 within a month’s time and the balance within 6 months time period. What happens is because of this the RI is left with a cash of Rs.390 lying with him for 6 months unlike the RI who applied for the FPS had put in Rs.890 all at once! So there is a case of interest earning for the PPS Retail investor. The PPS retail Investor would have to pay Rs.390 at the end of 6 months so, he would make availability of that much only at the end of 6 months, this is by depositing Rs.373 today that will become Rs.390 at the end of 6 months at 9% annualized or 4.5% half yearly. So what this means is that the PPS RI pays actually Rs.250 (at the time of application) + Rs.250 (the amount of allotment money can be discounted as there would be a time lag of 15 days though this makes sense only if the amount involved is meaty) + Rs.374 (Today’s Value of Rs.390 receivable at the end of 6 months) = Rs.873 to convert his PPS into a FPS. Hence while his counterpart has paid Rs.890, the PPS RI actually saves Rs.17 due to the option chosen by him and that to, to own practically the same share as the FPS Retail Investor!

Now skeptics may argue that dividend would possibly be paid on the Equity Share and the PPS RI would not get dividend, this though is true but the fact of the matter is that the ICICI Bank PPS option calls for Rs.9 of the F.V. of Rs.10 share in the first go and hence as dividend would be paid on F.V. of equity share the PPS RI just loses Rs.1 F.V. on which he would have got dividend, last year’s dividend was Rs.10 per share and this further assuming a Rs.12 on the Rs.10 F.V.(For the sake of argument Rs.12 has been taken, though it is a little on the higher side as the share capital now stands increased by 20%) the PPS RI stands to lose Rs.1.2 for the Rs.1 of value that is outstanding, moreover this dividend is for an entire year so theoretically he would miss out on Rs.0.6 dividend divided by two (As Rs.1.2 is for the full year and we assume that the company declares dividend in the middle of the year and hence Rs.0.6 for the half year), this Rs.0.6 actually would have to be brought to today’s terms by discounting it at 9% annualized that brings it to Rs.0.56. Hence, for the ICICI bank issue it can safely be argued that the dividend amount hypothetically forgone would be minimal and hence not material, provided the investment is not huge.

Having assumed the fact above that the RI would hold the PPS till call, we shall now proceed to value the share at the time of listing. As the PPS RI would be getting a benefit of Rs.16.50 (Interest earned – Dividend foregone) if this amount is paid to the RI on the day of listing he should therefore sell! Why? The chart below explains…

Chart I

	Price of FPS at a point of time (Say)		830
(A)	Theoretical Listing of PPS (less Rs.390)		440
(a)	Balance to be paid Value of PPS		390
	Invested amt at 0 date which becomes RS.390 after 6 months		373
(B)	Interest earned on 390 at PV terms		17
	Assumed Dividend on FPS for Yr		12.00
	Dividend Lost for Yr		1.20
(C)	P.V. of Lost Dividend for 1/2 Yr		0.57
(A)+(B)-(C)	Minimum Traded Value of PPS		456
If at Rs. (C)	PV Payable (D) = (a) - (C) + (B)	Cost of Share (C + D)	Beneficial for
600	374	974	Seller
576	374	950	Neutral
435	374	809	Buyer

The above aspect of discounting would also hold true during the listed period of the PPS as during this stretch of 6 months there would be in most probability arbitrage situations wherein the theoretical value as per discounting and the traded price of the PPS would be in disequilibrium due to demand and supply factors – for example FII’s interest, shortage of fully paid shares. Thus, one can make use of the above shown discounting to determine the fair value of the PPS vis-à-vis the FPS and make a shift into the undervalued option of the two types of Shares. However it is to be noted that the discounting difference would reduce as the time of the final call approaches and the difference in the price of the FPS and the PPS will at a point of time be only the balance payable call of Rs.390 and hence arbitrages possibilities may be very less and very low.

Now the other factors that would help the RI is that his % return on the amount invested would be higher than his counterpart who had been allotted the FPS {Chart II}. Moreover in case of a fall in prices in the 6 month period, the ratio of return of PPS/FPS which occurs if there a positive return is not the same in case of a downfall in prices i.e. the magnitude of the gain ratio is not the same as the magnitude of the loss, hence the loss ratio is comparatively lesser to the Gain ratio.

It is assumed that:

(I) For Income Tax purposes this income is assessed under the head Profit Gains from Business or Profession or both the buyer and the seller are either short term traders i.e. their holding the stock for a period less than a year and hence no Long term Capital Gains Vs. Short term Capital Gains situation arises, however if one investor is in it for the short term and the other for long term, comparison would have to be made against (a) the lowered gain % of the short term investor à the capital gain reduced by 10% (the short term Capital Gains tax is 10%) with (b) the full gain of the long term investor as there is no capital gains tax on securities held for more than a year.

(II) Selling Price = Traded Price (-) 0.5% for Brokerage Costs and STT

(III)The PPS have been assumed to list at the minimum traded value for a PPS i.e. traded price of FPS (-) Rs.373 (Present Value of Rs.390).

Chart II

Optimistic I	Traded Price	Selling Price	Cost	Return	PPS/ FPS Return
FPS	950	945	890	6.2%	2.36
Hence, PPS	576	573	500	14.7%
Optimistic II	Traded Price	Selling Price	Cost	Return	PPS/ FPS Return
FPS	900	896	890	0.6%	7.64
Hence, PPS	526	524	500	4.7%
Pessimistic I	Traded Price	Selling Price	Cost	Return	PPS/ FPS Return
FPS	835	831	890	-6.6%	-1.24
Hence, PPS	461	459	500	-8.2%
Pessimistic II	Traded Price	Selling Price	Cost	Return	PPS/ FPS Return
FPS	800	796	890	-10.6%	-1.44
Hence, PPS	426	424	500	-15.2%

Hence, one can see that the PPS option is actually a better option to invest in an IPO/ FPO of a company, albeit the company issuing the share should be expected to list strongly/ above cut off else the loss ratio % under the PPS option would accentuate as compared to the gain.

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