Gopal Plastics: Capital Structure Decision

Molded plastic furniture industry had grown significantly in India in

recent years. Venu Gopal, a young entrepreneur and owner of Gopal
Plastics was considering an expansion to molded furniture from
household articles. So far, he had financed his business with equity
financing using his own source and generated funds internally.
Though he was aware of financing a business through debt; still he
was unable to decide which mode of financing was ideal for his
business. Incidentally, he met his professor in a social event and
discussed this matter with him.

Venu Gopal: “Professor, I am considering an expansion of my business to a

different segment of the same industry, however I am not sure whether
debt financing is appropriate in my case. I can recall from your
lecture during my MBA course, in which you discussed about the
benefits of debt financing”.

Professor: “The use of debt is very common as it gives tax benefits but experts
have many opinions. Do you have any specific question?”

Venu Gopal: “I am in plastic furniture manufacturing and currently making

products for household use. This is the right time to expand my
product portfolio  to molded office furniture segment. This requires an
expansion in my manufacturing capacity with an investment of Rs. 120
million. Should I finance it using equity or debt or by a cobination?”

Professor: “What is the industry trend on debt-equity ratio? How do your

competitors financing their venture?”

Venu Gopal: “There is no consistency in the financing pattern of the other players
in the industry. One is debt free firm, while many have higher debt
than equity”.

Professor: “Have you explored all possible options for financing?”

Venu Gopal: “I had some discussion with few of my business associates and they
have shown interest in investing in the business as equity holders. On
the other hand, I had several meetings with my bankers and they too
have assured a bank loan of Rs. 60 million at the existing lending rate
of 10.5 per cent. However, the rate of interest will be 11 per cent for
next Rs. 30 million and  12 per cent for a loan amount above 90
million.

Professor: “The loan facility would help you to save tax, as the interest on the loan
is a tax deductible item. At the current tax rate of 34 per cent your tax
shield would be 34% of the interest paid. For dividend payment to
 equity shareholders, no such benefit is available. Although, debt
financing will give you tax shield, it is compulsory to make timely
payment of interest irrespective of the success or failure of your
project. On the other hand, payment of dividend is optional.
Therefore, debt financing will increase your financial risk and that is
the reason, your bankers are asking for a higher interest rate for
additional financing. In order to make specific comment on the
financial structure of your business, I need to analysis financial
statements of your company”.

Venu Gopal: “Professor, tomorrow I will send you the financial statements of my
company”.

Before Studying the financial structure of Venu Gopal’s business

Professor apprised himself with the industry trends and also with the
brief input on Gopal Plastics (Venu Gopal’s Venture).

ABOUT THE PLASTIC INDUSTRY

Plastic industry in India has made significant progress since 1957,
from its modest beginning in the production of Polystyrene. Over the
last few decades, the industry has grown leaps and bounds.
Continuous development and advancement in polymer technology,
cost efficient manufacturing, and growing expertise in the field have
influenced the growth. On the basis of their collective value, the
plastic product constituted around 0.5 per cent of the country’s GDP
and 1 per cent of the country’s export. Small companies accounts 50
per cent of the total turnover of the industry.   They 

also constitutes a majority share in numbers. The plastic industry expected to

grow at a compound annual growth rate of around 15 per cent. The per
capita plastic product consumption in India is very low compared to the
developed world and it indicates the huge growth potential in plastic
products in coming year (Exhibit 1). Molded plastic furniture is one of the
export product from India and this segment has grown at an annual rate of
11.2 per cent. Sales realization of plastic furniture increased significantly
over the years. Out of 19 companies operating in the plastic industry, 6 are
operating in furniture segment and Gopal Plastic is also a part this industrial
segment.

ABOUT THE COMPANY

Gopal Plastic was established in 2005 with a small manufacturing
facility to  make molded plastic furniture at a small town in southern
India. ‘Proper furniture can improve the utility and aesthetic value of
any place’. With this value proposition the company launched a
number of products and became successful within a small period.
Gopal Plastic has positioned itself for outstanding style, design and
durability. Over the years. Company expanded its market and become
well-known brand in plastic chair, dinning chairs, plastic fix tables,
baby chairs, center tables, stools, racks and trolley for various
occasions.

Venu started the business with a paid up capital of Rs. 30 million in

2005. As per the balance sheet at the end of 2012-13 the paid up
capital was Rs. 36.7 million (divided into
3.67 million of share of Rs. 10 each) with a reserve of Rs. 98.7
million. Exhibit 2 presented the financial position of the company for
the past five years. The company’s sales has grown despite of number
of difficulties such as recessionary market conditions, higher material
cost, frequent power cuts, and increased labour cost due to inflation. In
the past five years, sales revenue has increased from Rs. 145.9 million
to Rs. 246.9 million. Although the company incurred a loss in 2008-
09, it made a net profit of Rs.
7. million in 2012 -13. Exhibit 3 gives data on sales and income for the last five years.

THE EXPANSION PROJECT

Considering the growth of the plastic industry in India, Gopal Plastic
realized a growth opportunity in furniture segment and want to expand
its operation from household products to modular office furniture. The
project was expected to cost Rs. 120 million

and would increase profit according to the current return on assets

(ROA). Venu had already checked the financial viability of the project
and found it acceptable. He also decided that the production should
start as early as possible. The pro-industry image of the new
government specifically for SME sector also boost Venu’s confidence
in his project.

FINANCING OF THE PROJECT

Venu has followed a very conservative financing policy. From the
inception, the company has financed its growth through the internally
generated funds and promoters support. The company met its entire
working capital requirement using their own funds. Although, the
company had negotiated a standing credit facility of Rs. 10 million
with  his bankers, the company hardly availed itself of this facility
because of  sufficient internal resources.

He had a discussion with his bankers and they were ready to finance
the expansion requirement by extending a term loan to his business.
During his discussion with the bankers, they discussed about the debt
equity ratio of the company and offered following lending rates:
  Upto Rs. 60 million 10.5 per cent per annum,
 Next 30 million at 11 per cent per annum and
 Additional 30 million at 12 per cent per annum.

On the other side, some of his business associates also wanted to join
his business by contributing through equity. Venu was paying 10 per
cent dividend, which remained unchanged for last five years. Venu
analyzed the debt ratio of other plastic furniture manufacturers in India
(see Exhibit 4) but could not derive any specific trend on the financing
pattern. Therefore, he sought advice of the Professor on using debt for
the expansion plan. The corporate tax rate in India remained around 34
per cent during the last decade.

Professor was now prepared with sufficient inputs to analyze the

financial statements of Gopal Plastics and guide his ex-student to
foray into the molded plastic office furniture segment without any
hiccups.
Exhibit 1: Annual Plastic Consumption

Source: “Opportunities in Emering Plastics – Automobile.

Telecommunication, Healthcare and Other Emerging Areas”,
www.ficci.com/spdocument/20248/Knowledge-Paper-Poly- India-
2013.pdf
Exhibit 2: Balance Sheet of Gopal Plastic Pvt. Ltd.
(Rs. Million)
Year Mar Mar Mar Mar Mar
13 12 11 10 09
SOURCES OF FUNDS :
Share Capital 36.7 36.7 36.7 36.7 36.7
Reserves Total 98.7 94.2 91.1 86.6 80.8
Total Shareholders’ Funds 135.4 130.9 127.8 123.3 117.5
Current Liabilities 40.8 21.3 25.2 33.3 16.6
Total Liabilities 176.2 152.2 153 156.6 134.1

APPLICATION OF FUNDS :
Gross Block of Fixed Assets 139.3 133.8 132.4 126 127.1
Less : Accumulated 96 91.2 88.2 83.1 82.7
Depreciation
Net Block 43.3 42.6 44.2 42.9 44.4
Investments 17.6 19.7 12.6 7.7 7.7
Inventories 42.7 13.6 30.2 41.9 15.3
Sundry Debtors 46.7 50.1 41.1 41.5 41.1
Cash and Bank 6.7 7 7 6.2 6.1
Loans and Advances 19.2 19.2 17.9 16.4 19.5
Total Current Assets 132.9 109.6 108.8 113.7 89.7
Total Assets 176.2 152.2 153 156.6 134.1
Source: compiled by authors

Exhibit 3: Income Statement of Gopal Plastic Pvt. Ltd.

(Rs. Million)
Year Mar-13 Mar-12 Mar-11 Mar-10 Mar-09
INCOME :
Sales 252.3 220.9 207.5 172.8 151.1
Other Income 23.4 7 0.4 16.7 -0.1
Total Income 275.7 227.9 207.9 189.5 151
EXPENDITURE :
Raw Materials 171.9 139.8 131.6 116.9 98.9
Power & Fuel Cost 7.8 6.6 5.7 5.9 4.6
Employee Cost 14.3 12.4 10 8.4 6.9
Other Manufacturing Expenses 14.2 11.4 8.8 14.4 6.7
Selling and Administration 26.8 24.6 20.7 15.8 16
Expenses
Miscellaneous Expenses 11.7 6.8 5.4 5.5 11.6
Total Expenditure 246.7 201.6 182.2 166.9 144.7
Operating Profit 29 21.3 20.4 17.4 1.1
Interest 0 0 0 0 0
Depreciation 5.4 5 5.3 5.2 5.2
Profit Before Tax 23.6 16.3 15.1 12.2 -4.1
Tax 8.024 5.542 5.134 4.148 -
1.394
Reported Net Profit 15.57 10.75 9.966 8.052 -
6 8 2.706
Equity Dividend % 10 10 10 10 0
Source: compiled by authors

Exhibit 4: Selected Particulars of other Plastic Furniture Manufacturers

Particulars National Plastic Nilkamal Prima Wim
Ltd. Ltd Plastics Plast
Equity (Rs. Million) 224.60 4291.00 406.00 1509.10
Debt (Rs. Million) 304.70 3941.10 45.20 0.00
Gross Block (Rs. Million) 526.30 6807.40 417.90 1164.50
Sales (Rs. Million) 780.30 16459.50 789.10 2956.60
Net  Profit (Rs. Million) 9.70 400.30 31.90 325.10
Dividend Payout Ratio 0.00 40.00 10.00 90.00
(%)
Book Value per Share (in 27.10 310.10 38.60 251.50
Rs)
Earning per Share (in Rs.) 1.10 26.80 2.90 54.20
Market Price (in Rs.) 16.00 354.00 20.00 900.00
Market Capitalisation (in 141.50 5281.70 220.60 5397.00
Rs.)
P/E 14.10 13.20 6.90 16.60
P/BV 0.59 1.14 0.52 3.58
Beta 0.53 0.85 0.37 0.67
Source: compilation of the data collected from www.capitaline.com