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Finding Out the Leverage Trends across the Sector

The following Table describes the debt equity ratio as a measure of leverage across the FMCG sector in India. The period for the data is December 2000December 2009. The table also shows the average of the industry during the period.

Dec '00 HUL Nestle ITC Dabur Colgate Palmolive Marico Brittania 0.04 0.33 0.24 0.71 0.04 0.02 0.67

Dec '01 0.03 0.33 0.15 0.54 0.05 0.02 0.59

Dec '02 0.02 0.33 0.04 0.40 0.02 0.04 0.45

Dec '03 0.80 0.33 0.02 0.22 0.01 0.05 0.24

Dec '04 0.70 0.33 0.03 0.15 0.01 0.18 0.05

Dec '05 0.02 0.33 0.02 0.09 0.02 0.58 0.02

Dec '06 0.03 0.33 0.02 0.05 0.02 0.85 0.01

Dec '07 0.06 0.33 0.02 0.04 0.02 1.02 0.08

Dec08 0.20 0.33 0.02 0.13 0.02 0.95 0.08

Dec09 0.00 0.33 0.01 0.17 0.02 0.73 0.37

Average

0.29

0.24

0.19

0.24

0.21

0.15

0.19

0.22

0.25

0.23

Debt-Equity during the period under study Hindustan Unilever Limited in the period under study breached the industry average from downside to a position above industry average. On the other hand Nestle maintained a constant ratio of 0.33 during the period.

The following figure shows the Graphical representation of D/E trends in the industry. In the figure the Dark Bold Dotted line shows the Industry average during the period under study.

Tracing out the Movement in respect of the Industry Average

This section aims to illustrate the correlation of the Debt-Equity of various players of the FMCG sector to the Industry average. In other words, it depicts the comparative movement between two.

Analyzing the correction by various players in FMCG sector to the industry average.
The period under study is 2000-2009. As on year ending December 31, following players were operating above the industry average: ➢ Marico ➢ Nestle ➢ Brittania While the following players were operating below the industry average for D/E: ➢ Hindustan Unilever Limited ➢ ITC Limited ➢ Dabur ➢ Colgate-Palmolive

The following table shows squared differences of the D/E of respective companies to the industrial average

Dec '00 HUL Nestle ITC Dabur Colgate Palmolive Marico Brittania 0.0618 0.0013 0.0029 0.1735 0.0643 0.0748 0.1418

Dec '01 0.046 8 0.007 3 0.008 8 0.087 7 0.037 6 0.050 1 0.119 8

Dec '02 0.028 6 0.020 9 0.021 0 0.046 2 0.027 2 0.021 0 0.070 2

Dec '03 0.312 3 0.008 4 0.047 6 0.000 3 0.052 0 0.035 4 0.000 0

Dec '04 0.245 5 0.014 9 0.031 5 0.003 3 0.039 0 0.000 8 0.024 8

Dec '05 0.017 0 0.030 5 0.018 2 0.004 2 0.018 2 0.180 7 0.018 2

Dec '06 0.025 6 0.020 4 0.027 8 0.018 7 0.027 8 0.440 1 0.031 2

Dec '07 0.026 5 0.011 0 0.041 8 0.034 0 0.041 8 0.632 9 0.020 9

Dec08 0.001 9 0.006 7 0.051 9 0.013 9 0.051 9 0.493 2 0.028 1

Dec09 0.054 2 0.009 4 0.049 6 0.003 9 0.045 3 0.247 2 0.018 8

Over the period under study, ITC & Marico have deviated from industry average. Their squared difference from the industry average has increased from 0.0029 to .0496 & 0.0748 to 0.2472 respectively. While in case of Britannia, there has been marginal improvement in the squared difference towards industry average. Dabur is the player operating closest to the industry average. Nestle seems to be close the industry average while its worth noting that it has not changed its Debt equity position over the period. While commenting about HUL & ITC we should keep in mind that they have debt equity ratios very close zero. Colgate Palmolive and Marico have deviated from the industry average over the period under study.

Divisional cost of Capital of ITC
What is Pure Play Approach?
In financial management, a pure play is a company whose shares are publicly traded and that either has, or is very close to having, a single business focus. Coca-Cola is an example of a pure play in this context because it retails only beverages. On the other hand, PepsiCo is not a pure play because it also owns the Frito-Lay snack foods brand. The pure play approach or pure play method is a method for estimating the cost of capital for a proposed new project or product line. It involves examining other companies which are pure plays in the proposed line of business and inferring a cost of capital based on their capital structures (example: Debt-toEquity ratio) and betas.

Methodology
Business segments of ITC Ltd are: • FMCG ○ Cigarette ○ Others Hotels Agri-business Paperboards, Paper and Packaging

• • •

Use of Pure Play Companies as Proxy

For calculating Divisional cost of capital of ITC, proxy Pure Play firms are selected who are purely operating in the required particular business domain. Their Beta is calculated and is Unlevered using Hamada’s formula. Beta of an Unlevered Firm BU=BL/1+ (1-T)*D/S Where, BU= Beta of an unlevered firm BL=Beta of a levered firm T=tax rate D=component of Debt in capital structure S=component of Equity in capital structure The unlevered Beta are again Re-Levered using the Leverage Factor of ITC.

Beta of a Levered Firm BL=BU*(1+ (1-T)*D/S) Where, BL=Beta of a levered firm BU= Beta of an unlevered firm T=tax rate D=component of Debt in capital structure S=component of Equity in capital structure Calculating the composite weighted average Beta The next step is to calculate a composite weighted average Beta. The Capital employed in the various segments is used as base for weights. The capital employed in the segment is calculated is the difference between segment assets and segment liabilities. The final step is to calculate the overall cost of capital.

The Computation
The following table shows the various Pure players and their respective Beta(s). These Beta(s) are levered with the debt-equity of the respective player and thus needs to be unlevered.

Pure Player Cigarettes FMCG Hotel Industry Paper Agri-Business Agri-Business Godfrey Phillips Dabur Indian Hotels BILT Bambino Foods DFM Foods

Beta (levered) 0.26048397 3 0.37830485 6 0.93383465 5 0.82944073 2 0.98388460 4 0.31601679 5

The table shows the respective D/E ratios. Pure Player Cigarettes FMCG Hotel Industry Paper Agri-Business Agri-Business Godfrey Phillips Dabur Indian Hotels BILT Bambino Foods DFM Foods D/E 0.13 0.17 0.78 0.58 2.16 0.85

Using Hamada’s Formula we get unlevered Beta. BU=BL/1+ (1-T)*D/S

Unlevered Beta Cigarettes FMCG Hotel Industry Paper Agri-Business Agri-Business Godfrey Phillips Dabur Indian Hotels BILT Bambino Foods DFM Foods 0.23972801 0.33982885 5 0.61457199 9 0.59831871 0.40346593 4 0.20178473 9

The Unlevered Beta(s) above is then Re-Levered according to the D/E of the ITC. D/E (ITC) Cigarettes FMCG Hotel Industry Paper AgriBusiness AgriBusiness Godfrey Phillips Dabur Indian Hotels BILT Bambino Foods DFM Foods 0.01 0.01 0.01 0.01 0.01 0.01 Relevered Beta 0.2413246 22 0.3420921 5 0.6186651 1 0.6023035 73 0.4061530 58 0.2031286 46

Relevered Beta Cigarettes FMCG Hotel Industry Paper AgriBusiness 0.2413246 22 0.3420921 5 0.6186651 1 0.6023035 73 0.3046408 52

Segment Capital 3139.67 1841.69 2535.87 3699.98 1626.61

Weigh t 0.244 45 0.143 391 0.197 439 0.288 075 0.126 645

Beta 0.05899 177 0.04905 298 0.12214 857 0.17350 844 0.03858 135

12843.82

1

0.4422

The re-levered beta(s) of various divisions of ITC are used for calculating weighted average beta of ITC. The capitals employed in the various divisions are used as weights.

NOTE: In case of Agri-business division the Average of pure players (Bambino Foods & DFM Foods) are taken. Thus, Beta=0.4422.

Calculation of Cost of Debt (kd) kd= Interest/Debt *(1-t)
=16/107.17 * (1-0.3399) =0.09554 or 9.554%

Calculation of Cost of Equity (ke) ke= Rf + B (Rm-Rf ) =>

Calculation of overall cost of capital

Rs. in crore Share Capital Reserves Debt 381.82 13682.5 6 107.71

Weight 0.0269 42 0.9654 58 0.0076

Cost

. 09554

ko =

14172.0 9

1

Analysing the impact of stock split

The board of ITC Limited decided to split or sub-divide the Rs 10 face value share into 10 shares of Rs 1 each. The following table shows the earning per share. It is worth noticing the steep fall in EPS in year 2006 as compared to the preceding years as the EPS is not adjusted to account for stock split. 2001 200 2 200 3 200 4 200 5 200 6 200 7 200 8 200 9 201 0

Earnings Per Share

39.98

48. 48

53. 48

61. 75

83. 92

5.5 8

6.6 5

7.6 8

8.0 2

8.9 8

The steep fall is characterised by tenfold increase in number of shares resulting from the split.

To offset the impact of such corporate actions, adjusted EPS is calculated. Such EPS are adjusted for corporate actions with retrospective effect. 200 1 Adjusted EPS 4.1 200 2 4.8 1 200 3 5.5 4 200 4 6.4 3 200 5 7.3 6 200 6 6.0 7 200 7 7.1 8 200 8 8.2 8 200 9 8.6 5 201 0 10. 64

In 2005 ITC announced a stock split- sub division into 10 shares for every 1 share held. And a bonus issue was subsequently announced in the ratio of 2:1. This made 15 shares for every one share held. The market price before these corporate actions was around Rs. 1900. After the split it came down to around Rs. 120 (Around 1/15th). In June 2010 ITC Ltd. announced a bonus issue in the ratio of 1:1.ITC Ltd’s shareholders will get one share for every existing share by way of a bonus issue. The last time they got a similar ratio was in 1994, with the previous bonus issue giving them one share for every two held. Bonus issues in India generate a lot of excitement, chiefly among retail investors who like the sound of free shares falling into their demat account. There is also a belief that companies typically issue bonus shares when they are optimistic about their future. But there is one thing that is real about bonus shares; if the company maintains its dividend ratio, the payout shoots up. In ITC’s case, it would double. And this would be on the back of a step-up in ITC’s dividend payout in fiscal 2010. It will pay Rs4.50 a share, or 22% more than the previous year, an outflow of around Rs1,700 crore. It is also paying a special dividend of Rs5.50 a share, or an additional Rs2,100 crore. While the special dividend would be a one-time payout, if it keeps the dividend constant at Rs4.50, after the bonus issue, its dividend payout will double to Rs3,500 crore. And, this does not include dividend distribution tax. Whether ITC keeps its dividend constant or not only time will tell, but shareholders will surely expect it to do so.

ITC can afford to pay out more as a dividend for several reasons. For starters, it generates a lot of cash, for which it has no big capital expenditure plans lined up. In fiscal 2010, its cash flows from operations were up 40% to Rs6,620 crore. It has already made significant investments in the capital-intensive portion of its business portfolio—paper and hotels. The paper division is doing quite well and an improving economic environment should see it do well. The hotels business went through a bad phase in 2010, but the worst is behind it. Its flagship cigarettes business continues to do well, generating profits and cash. Its noncigarette consumer business, too, has seen performance improve, with revenue rising and losses declining. This business also saw its capital employed fall by 18%, a sign that it is becoming more self-sufficient. The bonus issue, thus, will give ITC a way of getting rid of that extra cash it generates, which will allow it to preserve or even improve important ratios such as return on capital employed.

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