Taking loan to invest in IPO? Stop!

If you have invested in some of the recent initial public offerings like Idea Cellular and Mind Tree, you could have made handsome money in the primary market. Both these IPOs were listed at significant premiums of 23.20 per cent and 40.94 per cent respectively.

But the scenario is not the same anymore. The last five IPO listings (See Table) have been disappointing. The recent one Astral Poly Technik listed at the same price (Rs 115). Over the years, investors have found that borrowing from banks and NBFCs and investing in the IPO market is a lucrative option to make quick money by taking advantage of the listing gains.

In other words, if you were bullish on a certain IPO and did not have the money to invest, the financial institution would help you to invest, provided you have at least 20 per cent of the application money.

This mechanism of investment has worked well in many of the IPOs and investors have gained higher returns. But things are changing and changing fast.

A rising interest rate regime poses greater risk for investors who want to follow this revenue model to make quick buck. And genuine turbulence in the stock markets and lack of good quality IPOs have not exactly helped.

So is IPO funding through loans still a lucrative option? Let us look at a few numbers. A year-and-a-half back, the cost of funds (read interest cost for investing in IPO through a bank loan) was around 10-12 per cent. These numbers have moved northwards and rather sharply. Presently they stand at 18-20 per cent today.

RECENT LISTINGS
	Date of listing	Issue Price	Listing Price	List Gains/ losses
Astral Poly Tec	20/03/2007	115.00	115.00	0.00
Abhishek Mills	19/03/2007	100.00	94.00	-6.00
AMD Metplast	19/03/2007	75.00	65.10	-13.20
Jagjanani Text	19/03/2007	25.00	22.40	-10.40
Lawreshwar Poly	19/03/2007	16.00	15.90	-0.62
Assumptions: Bank rate  20%,  Processing fees 1%  Transaction cost  0.65%, Short term tax –  10%  Funding of total –  80%, Number of days: Fund used– 25 Days, Interest for – 25 Days

 

COST-BENEFIT ANALYSIS
Listing	Allottment (%)
Gains (%)	5	10	20	30	40
10	-1.52	-1.15	-0.40	0.34	1.08
20	-1.12	-0.35	1.20	2.75	4.30
30	-0.72	0.45	2.81	5.16	7.51
40	-0.32	1.26	4.42	7.57	10.73
50	0.09	2.07	6.03	9.99	13.95

Say you applied for 1,000 shares at a offer price of Rs 100 per equity share amounting to a total investment of Rs 1,00,000. With 80 per cent funding (Rs 80,000) from the bank, the interest cost alone would work out to Rs 1,095 (assuming the rate of interest at 20 per cent).

Add another 1 per cent for processing fees of Rs 800 takes this figure to Rs 1,895. The cost of funds is now 1.9 per cent for a 25-day period. The time period of 25 days has been taken because of the time difference between the application and allotment period. Typically, the refund comes back in the above mentioned time.

Now comes the number crunching. If the issue is subscribed by 10 times, you would get only 100 shares out of the application for 1,000 shares. The rest of the money that is, Rs 90,000 will be locked with the bankers to the issue till it is refunded. The investor will have 100 shares to sell in the secondary market.

If we consider an over-optimistic scenario where the shares get listed at 50 per cent premium or Rs 150, the investor will earn only Rs 5,000 (100 shares @ 150) on initial investment of Rs 100,000. This is 5 per cent of the total investment. But if you deduct the cost of funding (interest cost payable to bank is Rs 1895) the returns will be merely 3.1 per cent.

Further, if you factor-in brokerage cost, securities transaction tax and service tax, which is between.065-.075 per cent, the returns come down even further. And as usual, the final punch comes from tax liability. A whopping 10 per cent on short-term capital gain. Now you will be left visibly shaken and with a princely return of Rs 2,070 on an investment of Rs100,000.

Considering that this an overly optimistic scenario, things will definitely get worse as the percentages allotted and listing price come down further (See Table). The best case scenario is where the you are allotted 40 per cent and the scrip lists at 50 per cent gains. You would have gained merely Rs 13,950 (13.95 per cent).

The worst-case scenario would be when you are allotted only 10 per cent and the issue lists at a 20 per cent premium. The result, a loss of Rs 350 on an investment of Rs. 100,000.

So in crux, in times of high interest rates, it is not a very bright idea to take a loan and invest in an IPO.