Hero Honda Motors Ltd.

A look at the capital structure of Hero Honda and its competitors.

A Project for Corporate Finance II Taught by Dr. P. Banerjee

Group Members:

Aashir Agarwal (10FN-001) Ravi Bhambhani (10DM-123) Rohan Dawani (10DM-124) Sanjay Rughwani (10DM-137)

Industry Background: The Automotive industry in India is one of the largest in the world and one of the fastest industries growing globally. India manufactures over 12 million two and fourwheeled vehicles and exports about 1.5 million every year. It is the worlds second largest manufacturer of motorcycles, with annual sales exceeding 9 million in 2010.

Hero Honda Company Background: Hero Honda Motors Ltd. is the world's largest manufacturer of two wheelers, based in India. The company was a joint venture between India's Hero Group and Honda Motor Company, Japan that began in 1984. In 2011, Honda decided to part ways from the Hero Honda JV and focus on its Indian subsidiary HMSI (Honda Motor & Scooter Indian Limited.) In 2001, the company achieved the coveted position of being the largest two-wheeler manufacturing company in India and the World No.1 two-wheeler company in terms of unit volume sales in a calendar year by a single company. Hero Honda has retained that coveted position till date. Today, every second motorcycle sold in the country is a Hero Honda bike. Every 30 seconds, someone in India buys Hero Honda's top-selling motorcycle Splendor. Vision The Hero Honda story began with a simple vision the vision of a mobile and an empowered India, powered by Hero Honda. This vision was driven by Hero Hondas commitment to customer, quality and excellence, and while doing so, maintaining the highest standards of ethics and societal responsibilities. Hero Honda believes that the fastest way to turn that dream into a reality is by remaining focused on that vision. Strategy Hero Hondas key strategy has been driven by innovation in every sphere of activity building a robust product portfolio across categories, exploring new markets,

aggressively expanding the network and continuing to invest in brand building activities. Manufacturing Hero Honda bikes are manufactured across three globally benchmarked manufacturing facilities. Two of these are based at Gurgaon and Dharuhera which are located in the state of Haryana in northern India. The third and the latest manufacturing plant is based at Haridwar, in the hill state of Uttrakhand. Technology In the 1980s Hero Honda pioneered the introduction of fuel-efficient, environment friendly four-stroke motorcycles in the country. Today, Hero Honda continues to be technology pioneer. It became the first company to launch the Fuel Injection (FI) technology in Indian motorcycles, with the launch of the Glamour FI in June 2006. Products Hero Honda's product range includes variety of motorcycles that have set the industry standards across all the market segments. The company also started manufacturing scooter in 2006. Hero Honda offers large no. of products and caters to wide variety of requirements across all the segments. Distribution The company's growth in the two wheeler market in India is the result of an intrinsic ability to increase reach in new geographies and growth markets. Hero Honda's extensive sales and service network now spans close to 4500 customer touch points. These comprise a mix of authorized dealerships, Service & Spare Parts outlets, and dealer-appointed outlets across the country. Brand The company has been continuously investing in brand building utilizing not only the new product launch and new campaign launch opportunities but also through innovative marketing initiatives revolving around cricket, entertainment and groundlevel activation. Hero Honda has been actively promoting various sports such as hockey, cricket and golf. Hero Honda was the title sponsor of the Hero Honda FIH Hockey World Cup that was played in Delhi during Feb-March 2010. Hero Honda also partners the Commonwealth Games Delhi 2010.

Main Competitors of Hero Honda: 1. Bajaj Auto Ltd.: The Bajaj Group is amongst the top 10 business houses in India. Its footprint stretches over a wide range of industries, spanning automobiles (twowheelers and three-wheelers), home appliances, lighting, iron and steel, insurance, travel and finance. The group's flagship company, Bajaj Auto, is ranked as the world's fourth largest two- and three- wheeler manufacturer and the Bajaj brand is well-known across several countries in Latin America, Africa, Middle East, South and South East Asia. Founded in 1926, at the height of India's movement for independence from the British, the group has an illustrious history. The integrity, dedication, resourcefulness and determination to succeed which are characteristic of the group today, are often traced back to its birth during those days of relentless devotion to a common cause. Jamnalal Bajaj, founder of the group, was a close confidant and disciple of Mahatma Gandhi. In fact, Gandhiji had adopted him as his son. This close relationship and his deep involvement in the independence movement did not leave Jamnalal Bajaj with much time to spend on his newly launched business venture. His son, Kamalnayan Bajaj, then 27, took over the reigns of business in 1942. He too was close to Gandhiji and it was only after Independence in 1947, that he was able to give his full attention to the business. Kamalnayan Bajaj not only consolidated the group, but also diversified into various manufacturing activities. The present Chairman of the group, Rahul Bajaj, took charge of the business in 1965. Under his leadership, the turnover of the Bajaj Auto the flagship company has gone up from INR.72 million to INR. 120 billion, its product portfolio has expanded and the brand has found a global market. He is one of Indias most distinguished business leaders and internationally respected for his business acumen and entrepreneurial spirit.

2. TVS Motors Ltd.:

TVS Motor Company is the third largest two-wheeler manufacturer in India and one among the top ten in the world, with annual turnover of more than USD 1 billion in 2008-2009, and is the flagship company of the USD 4 billion TVS Group. Penchant for Quality The company has 4 plants - located at Hosur and Mysore in South India, in Himachal Pradesh, North India and one at Indonesia. The company has a production capacity of 2.5 million units a year. Innovation at the helm TVS Motor's strength lies in design and development of new products - the latest launch of 7 products on the same day seen as a first in automotive history. We at TVS deliver total customer satisfaction by anticipating customer need and presenting quality vehicles at the right time and at the right price. The customer and his ever changing need is our continuous source of inspiration.

15 million smiles on the Road TVS has always stood for innovative, easy to handle, environment friendly products, backed by reliable customer service. No wonder, then, that our 15 million customers on the road have a reason to smile.

Other competitors of Hero Honda: There are other, smaller competitors of Hero Honda:

Honda Motor & Scooter of India Ltd. (A direct subsidiary of Honda Motors Japan). Kinetic Motors Suzuki Motorcycle India Pvt. Ltd. Mahindra Two Wheelers. Yamaha Motor India Pvt. Ltd.

The Capital Structure of a firm:

Capital structure of a firm is a reflection of the overall investment and financing strategy of the firm. The capital structure of a company is the particular combination of debt, equity and other sources of finance that it uses to fund its long term functioning. The key division in capital structure is between debt and equity. Debt comes in the form of bond issues, long-term notes payable or loans, while equity is classified as common stock, preferred stock and retained earnings. Short-term debt such as working capital requirements is also considered to be a part of the capital structure. The ModiglianiMiller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, under a certain market price process (the classical random walk), in the absence of taxes, bankruptcy costs, agency costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the ModiglianiMiller theorem is also often called the capital structure irrelevance principle. The Trade-Off Theory of Capital Structure refers to the idea that a company chooses how much debt finance and how much equity finance to use by balancing the costs and benefits. The classical version of the hypothesis goes back to Kraus and Litzenberger who considered a balance between the dead-weight costs of bankruptcy and the tax saving benefits of debt. Often agency costs are also included in the balance. This theory is often set up as a competitor theory to the Pecking Order Theory of Capital Structure. A review of the literature is provided by Frank and Goyal. An important purpose of the trade-off theory is to explain the fact that corporations usually are financed partly with debt and partly with equity. It states that there is an advantage to financing with debt, the tax benefits of debt and there is a cost of financing with debt, the costs of financial distress including bankruptcy costs of debt and non-bankruptcy costs (e.g. staff leaving, suppliers demanding disadvantageous

payment terms, bondholder/stockholder infighting, etc). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. The Pecking Order Theory or Pecking Order Model was developed by Stewart C. Myers and Nicolas Majluf in 1984. It states that companies prioritize their sources of financing (from internal financing to equity) according to the Principle of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence, internal funds are used first, and when that is depleted, debt is issued, and when it is not sensible to issue any more debt, equity is issued. In this theory, when Myers argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm then investors) issue new equity, investors believe that managers think that the firm is overvalued and managers are taking advantage of this over-valuation. As a result, investors will place value to the new equity issuance. Agency Cost Theory: There are three types of agency costs which can help explain the relevance of capital structure.

Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This Is because if the project is successful, the shareholders get the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of the firm value decreasing and a wealth transfer from debt holders to shareholders.

Underinvestment problem: If the debt is risky (e.g., in a growth company), the gain from the project will accrue to debt holders rather than shareholders. Thus, management has an incentive to reject positive NPV projects, even though they have the potential to increase firm value.

Free cash flow: unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Hero Honda: The capital structure of Hero Honda Motors Ltd. is unlike that of any of its peer companies. It has almost no debt involved in the capital structure. Hero Honda is a highly unlevered company. Mar '06 Sources Of Funds Total Share Capital Equity Share Capital Share Application Money Preference Share Capital Reserves Revaluation Reserves Networth Secured Loans Unsecured Loans Total Debt Total Liabilities 39.94 39.94 0 0 1,969.39 0 2,009.33 0 185.78 185.78 2,195.11 Mar '07 39.94 39.94 0 0 2,430.12 0 2,470.06 0 165.17 165.17 2,635.23 Mar '08 39.94 39.94 0 0 2,946.30 0 2,986.24 0 132 132 3,118.24 Mar '09 39.94 39.94 0 0 3,760.81 0 3,800.75 0 78.49 78.49 3,879.24 Mar '10 39.94 39.94 0 0 3,425.08 0 3,465.02 0 66.03 66.03 3,531.05

Bajaj Auto Ltd. and TVS Motors Ltd.: Both the major competitors of Hero Honda have a highly levered capital structure.

Hero Honda Mar '10 Sources Of Funds Total Share Capital Reserves Networth 39.94 3,425.08 3,465.02

Bajaj Auto Mar '10 144.6 8 2,783. 66 2,928.

TVS Motor Mar '10

23.75 841.63 865.3

Secured Loans Unsecured Loans Total Debt Total Liabilities

0 66.03 66.03 3,531.05

34 12.98 1,325. 60 1,338. 58 4,266. 92

8 829.98 173.31 1,003. 29 1,868. 67

Calculating the Cost Of Capital: Cost of Debt: Total Debt: A company uses various kinds of debt to finance its operations which can broadly be classifies into Secured and Unsecured Loans. In case of Hero Honda Motors Ltd., we can see from the balance sheet that:

Secured Loans Rs. 0 crores Unsecured Loans Rs. 66.03 crores

Therefore, the value of total debt is Rs. 66.03 crores. Interest on Debt: The interest paid on 31st March, 2010 is Rs. 2.10 crores. Tax Rate: Taxe Rate (t) taken for the computation of cost of debt is 30%. Calculation of Cost of Debt: Kd = Interest on Debt x (1 t) Total Debt Kd = 2.10 x (1 0.3) / 66.03 = 0.022262608 or 2.23% Similarly, the cost of debt for Bajaj Auto and TVS Motors is also calculated:

Cost Of Equity: The Capital Asset Pricing Model: The CAPM is used to determine an appropriate required rate of return of an asset, if that asset is to be added to an already well diversified portfolio, given that assets non-diversifiable risk. The model takes into account the assets sensitivity to non-diversifiable risk (also known as systematic risk), often represented by the quantity beta () in the financial industry, as well as the expected return of the risk-free asset. We have taken the beta for Hero Honda from the EVA Statement given in its Annual Report for 2009-2010. Therefore, = 0.63 (This is the levered beta)

Risk Free Rate Of Return: The Risk Free Rate of Return (Rf) for computation of Cost of Equity is taken as a return on 364-day Treasury Bills issued by the Indian Government. Rf = 7.58% Market Rate of Return: The Market Rate of Return (Rm) is calculated as percentage change in BSE Sensex for a 5 year period compounded annually. We have obtained the following rate of return: Rm = 10.52% The reason for taking the past five year market return is that the markets have been performing with high level of volatility for the past two years. The past one year market return has only been 1.71%, whereas returns for the past two years have been exceedingly high at 37.74%. Therefore, it seemed more reasonable to take a long term view of the market. Calculation of Cost of Equity: Ke = Rf + x (Rm Rf) = 7.58 + 0.63 x (10.52 7.58) = 9.43%

We found the approximate beta for Bajaj Auto to be 2.1 and for TVS Motor to be 1.3 from another research study. Therefore, the cost of equity of the three companies compares as follows:

Cost of Retained Earnings: The company has retained earnings of Rs. 3425.08 crores. Tax Rate will be taken as was taken in the case of Cost of Debt, i.e. 30% Cost of Retained Earnings = Ke (1 t) = 9.43 * (1 0.3) = 6.6% WACC Weighted Average Cost of Capital Book Value in Rs. Crores 39.94 3,425.08 66.03 Weights (W) 0.0113111 0.9699891 0.0186998

Particulars Equity Share Capital Reserves Total Debt

Cost 9.43 6.6 2.23

Weighte d Cost 0.10666 6.40193 0.0417 6.55029

Total 3531.05 1 Similarly, WACC for the three companies has been calculated:

From this exercise, we can see that Hero Honda has the lowest weighted average cost of capital of the three biggest manufacturers in the Indian two wheeler industry.