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CASE SUMMARY:

The case talks about Central Equipment Company. CEC was started in the late fifties as a government company. It is one of the important engineering companies in the public sector in India, manufacturing a wide range of products. CECs products include industrial machinery and equipments for chemicals, paper, cement, and fertilizers industries, super heaters, economizers, and solid material handling and conveying equipments.

In the beginning of january 2009, Mr. L.C. Tandon, Director of Finance of Central Equipment Company was evaluating the pros and cons of debt and equity financing for the purpose of expansion of CECs existing production facilities. At a recent meeting of the board of directors, a heated discussion took place on the best method of financing the expansion. Mr. K.C. Soni, Chairman and Managing Director (CMD), had therefore directed Mr. Tandon to critically evaluate the points made by the various members of the board. He also asked him to prepare a report on behalf of the companys management to be presented at the board meeting to be held in the last week of January 2009. CEC had started with a paid-up capital of Rs 10 million in 1959. As per the estimated balance sheet at the end of the financial year 2009, it has a paid-up capital of Rs 180 million (divided into 1.8 million shares of Rs 100 each) and reserves of Rs 4459.60 million. Company felt the need for expansion because the market was fast growing and the company has at times reached its existing capacity. The project is expected to cost Rs 200 million, and generate an average profit before interest and taxes (PBIT) of Rs 40 million per annum, for a period of ten years.The annual total expenses of the company after expansion are expected to consist of 55 per cent of fixed and 45 per cent variable expenses. The management has already evaluated the financial viability of the project and found it acceptable even under adverse economic conditions. Mr. Soni felt that there would not be any difficulty in getting the proposal approved from the board and relevant government authorities. He also thought that the production could start as early as from April 2009. Projections include financial impact of proposed expansion and assuming equity finance at issue price of Rs 100 each share. The company has been meeting its requirements for working capital finance from the internal funds. The company has, however, negotiated a standing credit limit of Rs 50 million from a large nationalized bank. CECs capital employed included paid-up share capital and reserves without any debt. The CMD feels that raising equity capital might be difficult and it may dilute equity earnings. The companys merchant banker suggested that in case it wants to go for IPO, it may be able to sell its shares about 20 to 50 per cent above its par value of Rs 100. Given these facts, CMD

decided to reconsider the companys policy of avoiding long-term debt. It was thought that the use of debt could be justified. Mr. Tandon has determined that the company could sell Rs 1,000 denomination bonds for an amount of Rs 200 million either to the public or to the financial institutions through private placement. The interest rate on bonds will be 10 per cent per annum, and they could be redeemed after seven years in three equal annual instalments. The bonds and interest thereon will be fully secured against the assets of the company. In Mr. Tandons opinion the bond was a cheaper source of finance, since interest amount was tax deductible. Given the companys tax rate of 34 per cent, the 10 per cent interest rate was equal to 6.6 per cent from the companys point of view. On the other hand, he thought that equity capital would be costly to service, as CEC is currently paying a dividend of 15 per cent on its paid-up capital.

PROBLEM IDENTIFIED:
The underlying problem in the case is described below: The expansion project that was presented was immediately accepted but the problem aroused when members in the board were informed about the possibility of raising finance by Bond issue. The members in the board meeting disagreed to the use of bond as the felt that the use of bond was risky and also that this would mean higher cost of bond as compared to equity capital; Some members emphasized that companies main objective is to maximize shareholders fund and that equity return would be diluted if the company was unable to earn sufficient profit from the existing business and the new project. \CASE OBJECTIVE The objective of the case is to analyse the interaction between operating risk and financial risk. It also focuses on the practical considerations of managers in understanding the operating conditions and risks that have a bearing on a firm's borrowing decision (capital structure). From the facts of the case, one can argue that a low debt-equity ratio might prove to be risky for a firm with high operating risk. We can focus on break-even analysis and EPS analysis to ilustrate the concepts of and interaction between operating and financial risks. We can close the case by pointing out the inadequacy of this analysis, and set the background for the need for analysing the impact of capital structure on the value of the firm. Q.1.Calculate EPS under the alternatives of employing (a)Rs 200 million debt and no fresh equity.(b)Rs 100 million debt and 100 million equity and (c) Rs 200 million equity and no debt. Also make calculations for uncommitted-EPS. Draw a chart showing PBIT on X axis and EPS and uncommitted EPS on Y axis for debt equity mix. What inferences do you derive? Solution:
(1) Operating risk: It helps to understand the operating risk faced by the firm. Sales PBIT Total cost Variable cost Fixed cost Variable cost ratio Contribution ratio B/E sales 4,032.3 125.0 3,907.3 1,758.3 2,149.0 43.6% 56.4% 3,810.6

2.14

-3.88

45% 55%

94.5%

EPS under different alternatives:


(2) EPS Analysis (vis--vis changes in sales and EBIT/PBIT) Equity option Change in sales Sales Varible cost Contribution Fixed cost PBIT Interest PBT Tax PAT Debt repayment Uncommited profit Number of shares EPS Uncommited EPS -0.05 3,830.7 1,670.4 2,160.3 2,149.0 11.3 0.0 11.3 4.0 7.3 1.0 6.3 38 0.19 0.17 Expect. 4,032.3 1,758.3 2,274.0 2,149.0 125.0 0.0 125.0 43.8 81.3 1.0 80.3 38 2.14 2.11 0.05 4,233.9 1,846.2 2,387.7 2,149.0 238.7 0.0 238.7 83.5 155.2 1.0 154.2 38 4.08 4.06 Debt option -0.05 3,830.7 1,670.4 2,160.3 2,149.0 11.3 200.0 -188.7 -66.0 -122.7 1.0 -123.7 18 -6.81 -6.87 Expect. 4,032.3 1,758.3 2,274.0 2,149.0 125.0 200.0 -75.0 -26.3 -48.8 1.0 -49.8 18 -2.71 -2.76 0.05 4,233.9 1,846.2 2,387.7 2,149.0 238.7 200.0 38.7 13.5 25.2 1.0 24.2 18 1.40 1.34

Debt-Equity Mix -0.05 3,830.7 1,670.4 2,160.3 2,149.0 11.3 100.0 -88.7 -31.0 -57.7 1.0 -58.7 28 -2.06 -2.09 Expect. 4,032.3 1,758.3 2,274.0 2,149.0 125.0 100.0 25.0 8.8 16.3 1.0 15.3 28 0.58 0.54 0.05 4,233.9 1,846.2 2,387.7 2,149.0 238.7 100.0 138.7 48.5 90.2 1.0 89.2 28 3.22 3.18

Chart showing PBIT on x axis EPS on y axis for debt equity mix

PBIT-EPS Chart
50 40 30 20 EPS 10 0 140 280 420 560 700 840 980 1,120 1,260 1,400 -10 -20 PBIT 1,540 -140 0

ANALYSES OF SALES AND PBIT


Year 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2000# Sales 1,804.0 1,707.8 1,894.0 2,270.8 2,520.0 2,775.0 2,949.2 2,433.8 3,042.3 3,376.9 3,579.5 4,032.3 PBIT 34.3 15.5 41.2 52.2 58.0 66.6 76.8 -5.3 82.1 94.6 85.0 125.0 PAT 17.1 7.8 20.6 26.1 29.0 33.3 38.4 -5.3 43.5 50.3 55.2 81.3 DIV 9.0 9.0 9.0 9.0 10.8 10.8 14.4 9.0 18.0 18.0 18.0 38.0 EPS 0.95 0.43 1.14 1.45 1.61 1.85 2.13 -0.29 2.42 2.79 3.07 2.14 AVG SD Sales g -5.3% 10.9% 19.9% 11.0% 10.1% 6.3% -17.5% 25.0% 11.0% 6.0% 12.6% 7.5% 12.7% PBIT/S 1.9% 0.9% 2.2% 2.3% 2.3% 2.4% 2.6% -0.2% 2.7% 2.8% 2.4% 3.1% 1.9% 1.0%

Financial analysis: The company sales have grown at an average rate of 7.5%. But its shows great varibility as well. Twice during last decade sales growth was negative, a drop of 5.7% in 1991 and 17.5% in 1997.Margin has hovered around 2%. The company has high level of current assets. If the company realises its debtor and uses surplus cash balance, it can perhaps reduce its dependence on external funds. The firm is very conservatively financed.

Q.2. Debate the issue raised in the case for and against the use of debt. Why do a large no of board members seem to be against the use of debt? What are the real risk involved? How would measure them?

Q.3. In addition to profitability and risk factor, what are other considerations before CEC to decide about its debt policy? Should it employ debt to finance its expansion?

Q.4. Is their a relation between debt and the value of firm?