The central government is proposing to adopt the famous Haryana model for compensating displaced people whose land is acquired for big industrial projects. Along the lines of the Haryana model, the central government plans to provide an annuity of Rs 15,000 for 33 years for land acquired for government projects and an annuity of Rs 30,000 for 33 years for land acquired for private projects. Let us try to analyse the optimal method of payment to landowning farmers by applying the principles of corporate finance. The key messages from such an analysis are easily summarised: First, land acquisition transactions between private parties and the farmers involve situations where one party has more information than the other, i.e., situations involving ?asymmetric information?. To mitigate these information asymmetry problems, the optimal method of payment to the farmers should mix features of debt and equity. The current Haryana model proposes fixed annuity payments that resemble features of debt; in settings involving asymmetric information, such payments are usually suboptimal.

What is the fair price to pay when the government/a private party acquires land from a farmer? To answer this question, recognise that market transactions enhance the welfare of the seller and the buyer only if market imperfections do not exist. However, an important market imperfection indeed exists in land acquisition transactions: the buyer of the land has more information about the potential value derived from its use compared to the seller of the land. To understand this in more detail, consider an automobile manufacturer that wants to build an automobile factory by acquiring land from farmers. The automobile manufacturer is much more informed about how the price of land will escalate in future once the agricultural land is converted into an industrial district and the automobile factory is set up on that land. In contrast, the farmer who parts with this land is not as well-informed about the potential for increase in the price of his land. In economic jargon, this situation is labelled to be one where there is ?asymmetric information? between the buyer and the seller.

In corporate finance, we value an asset as the sum of two components: (i) the value of the asset as it is in its current condition, i.e., the book value of the assets; and (ii) the present value of the growth opportunities that can be created using this asset, i.e., the difference between the market value of the asset and its book value. A cursory glance at the market and book values of firms traded on the BSE or the NSE would inform us that for most firms, the market value is considerably higher than the book value. Since firms are after all collections of tangible and intangible assets that they own or control, this also implies that for most assets the market value dominates the book value.

In the land acquisition context, the value of the asset in its current condition equals the current market price of the land while the present value of growth opportunities equals the present value of the future increases in the price of the land due to: (i) setting up of factories; (ii) conversion of the land from an agricultural tract to an urban/semiurban area; and (iii) economic development in the area and adjoining regions. Note that in a typical real estate transaction, where you buy a house, the present value of growth opportunities is minimal. Therefore, paying the real estate developers the current market price amounts to a fair transaction. However, in our land acquisition context, the present value of growth opportunities from industrial activities is enormous. Therefore, when the government/private party pays only the current price of the land to the farmer, they deprive the farmer the value of growth opportunities created using his piece of land; this value is owed to the landowner. It is scarcely a surprise then that the farmers feel that the government does not pay them a fair price for the land.

In the corporate finance context, when a firm approaches the capital markets for financing, the transaction is saddled with asymmetric information about the present value of future growth opportunities. Specifically, the owners and managers of a company are more informed about its growth opportunities compared to its investors. When the degree of such asymmetric information is large, hybrid securities, i.e., securities that combine features of debt and equity, enable the firm to raise financing and thereby mitigate problems associated with asymmetric information. This is because hybrid securities offer the upside associated with equity while at the same time assuring the steady cash flows associated with debt. By enabling the investors to share the upside and thereby mitigate the uncertainty associated with future growth opportunities, a hybrid security enables the firm to circumvent problems stemming from asymmetric information. At the same time, the steady cash flows similar to debt limit the downside risk associated with uncertainty about future growth opportunities.

(To be concluded)

The author teaches finance at the Indian School of Business, Hyderabad