Case: Shivam Cement Financing Decision

Read the following case “Shivam Cement Financing Decision” and answer the questions
that follow:

Nepal’s Hongshi Shivam Cement has announced an additional NPR 20 billion (US$167.34m)
investment to increase production capacity. The company currently has 6000tpd of capacity
and is looking to produce an additional 6000tpd.  The Nepal Electricity Authority (NEA) has
agreed to supply ten industrial users, including cement producers, with an additional 151MW
of electricity as part of a drive to increase domestic consumption. The cement producers
concerned include Maruti Cement, Huaxin Cement, Hongshi Shivam Cement and
Arghakhanchi Cement. The budget for the new Fiscal Year 2022/23 has received applause
from the country’s industrial fraternity. While some quarters of the country’s industrial
community have complained about the arrangements in the budget due to changes in the
import duty structure of certain types of raw materials, those running export-oriented
industries are cheerful that the government has announced an export subsidy that they have
demanded for a long time. 

Surendra Kumar Goel, the Chairman of Shivam Cements Limited, a major Nepali company,
which was founded in 2003 and started commercial production of cement in 2011 expressed
that the newly-introduced policy to provide subsidies to domestic industries will definitely
help the local industries. If the announcements to promote domestic industries are
implemented, then it would help the government reduce the ballooning trade and fiscal
deficits. Nepal has a huge potential to be self-reliant in many products. Such products can
also be exported to foreign markets. A decade ago, Nepal used to import cement. Now, Nepal
is in a position to export its cement production. Though the quality standards may be
different, there is no difference in the quality of cement produced in Nepal and India. Mr.
Goel says, an industry cannot sustain itself only by selling cement for the construction of
residential buildings. Unless the government does not come up with big road and bridge
projects, or hydropower projects, the consumption will not increase. The demand for cement
will only increase if the government works on big infrastructure projects. Then, the market
will keep moving. Money will come to the market. The government has to increase capital
expenditure to bring money to the market. In consideration to these issues, Goel was
contemplating on how to raise the funds required for expansion of the production capacity
and the appropriate long term financing sources in context of the risk inherent in the project.
In view of large sum of financing required and long-term impact it will have on risk and
return as well as value of the company, he thought to arrange a meeting with the finance
manager to discuss tax shield benefits, risk associated with financing, impact of operating and
financial leverage, cost of capital, uncertainty of future cash flows, debt service ability and
other issues associated with the financing. The company has growth strategy and required
funding in future too and he was thinking how the current choice of financing will impact
future financing decisions.

Funding Requirement
Hongshi Shivan Cement Industry is planning to enhance its production capacity by injecting
additional investment. The cement factory requires an additional Rs 20 billion to increase the
production capacity. The company had earlier invested Rs 36 billion for its
establishment. Until now, Hongshi Shivan Cement used to produce cement using diesel
energy. The cement company started received 30 megawatts of electricity from Nepal
Electricity Authority since November 13. 

The company has been producing 6000 metric tons of cement regularly from its Nawalparsi-
based factory. The industry is pouring in more investment to increase its production capacity
by an additional 6000 metric tons a day. The industry will meet its full production capacity
by producing 12000 metric tons of cement a day with the additional investment.

Company Information
Shivam Cement was founded in the year 2003. It began commercial production from the year
2011 and is the largest manufacturing Greenfield project in Nepal. With a broad vision of
business, Shivam Cement Private Limited was converted into Public Limited Company in the
year 2015 to provide its customers and the stakeholders to be a part of the company.
Established with a vision to provide quality OPC cement to the Nepalese market which was
sustaining over the imported cement from India, Shivam cements took the initiatives to
explore the Nepalese limestone for manufacturing of international quality cement in Nepal
and began the journey with manufacturing of Ordinary Portland Cement (OPC) 43 Grade
cement in Nepal and subsequently added OPC 53 Grade Cement.

The efforts of Shivam Cement have laid foundation of quality production of cement in Nepal
and helped in reducing the import from other countries, which is a big boon to the Nepalese
economy. In a very short span of production time, it stood as the market leader and was taken
as the most potential company and fasting growing company in Nepal. With a vision to
expand and grow, the company took initiative for the first FDI in Cement industry and invited
Hongshi Group of China and started a new company over 70% and 30% stake between
Hongshi Cements China and Shivam Holding Private limited (Subsidiary of Shivam Cements
Limited) to form a new Joint Venture company as Hongshi Shivam Cement Private Limited
with its production capacity of 6000 TPD Cement & Clinker. This plant has come in
operation in year 2018 and is situated in Sardi, Nawalparasi.

Shivam Cement received approval from the Securities Board of Nepal (SEBON) to launch an
initial public offering in 2018. Shivam Cement is slated to make an initial public offering
(IPO) of shares priced at Rs. 300 apiece (Rs. 100 face value plus Rs. 200 premium).
According to Mr. Goel, the IPO of the cement company offers a good opportunity for
portfolio diversification for investors as the secondary market is dominated by the banking
sector. The country’s only stock exchange is dominated by banks and financial institutions
who account for 80 percent of the listed shares.

Market Condition of Cement Industry in Nepal

There are at present 50+ cement industries in Nepal including both clinker producing as well
as cement producing factories. Nepal’s cement industry has a total demand of 5 million
tonnes of cement yearly of which 80 percent of the total demand is fulfilled by domestic
production and the remaining 20 percent is imported mainly from India. Regarding clinker
production, 70 percent is being fulfilled by domestic industries and the remaining imported
from India.

Financial Condition of Shivam Cement

In process of the raising capital, Shivam had the company get credit rating from ICRA Nepal
for Hongshi Shivam Cement Company (HSCC). Mr. Goel had just finished reading the
summary credit analysis report submitted by the rating agency which highlighted following
details:

The rating action factors in HSCC’s strong operational profile as the country’s largest
integrated greenfield cement unit with progressive capacity utilisation, despite the adversities
caused by the Covid-19 pandemic and the recent economic slowdown impacting the demand
trends. Hongshi’s distinct scale advantages and resulting economies of scale allow it to offer
competitive pricing that has supported its healthy growth in volumetric sales. ICRA Nepal
also takes comfort from the company’s low leverage levels and comfortable debt coverage
indicators (total debt to net worth of 0.4 time and total debt to EBIT of 2.4 times for
FY2022). Additionally, the company’s strong debtor-security mechanism through bank
guarantees (BG) from “Class-A” commercial banks remains a major strength. Hongshi has
also not availed any working capital limits so far, given its healthy internal accruals. Along
with its sizeable cash reserves, this provides it with significant financial flexibility, in case of
exigencies. The rating also draws comfort from the company’s strong promoter profile with
70% stake held by the Hongshi Group (through Hongkong Red Lion Cement No. 3 Limited)
and the rest by Shivam Holdings Limited. Both the promoters are experienced/ established
players in the cement industries of China and Nepal, respectively, which along with
experienced board/ management profile support the company’s incremental operational
profile. The rating also factors in the unconditional and irrevocable BG from two Chinese
banks, Bank of China and China Minsheng Bank, which cover the entire credit limit
throughout the loan tenure.

Nonetheless, the rating is constrained by the significant pressures over the company’s
operating profit margins (OPM) during FY2022, amid the increasing input prices (mainly
coal) and relatively subdued realisations given the intense industry competition. The rating is
further constrained by the company’s modest working capital intensity of 23% for FY2022,
considering that 47% of revenues were driven by clinker sales, which are almost entirely on
cash basis. Working capital intensity could rise further in case of higher proportion of cement
sales in future. The rating is also impacted by the sharp moderation in the company’s debt
service coverage (DSCR) during FY2022 to 1.21 times (3.15 times during FY2021), because
of the margin pressure coupled with sizeable principal repayment falling due as per the
ballooning repayment schedule. ICRA Nepal also notes the company’s limited track record of
operations in the Nepalese cement industry and its high reliance on top customers (albeit with
gradually improving brand presence and dealership network). The company’s margins are
also exposed to the demand cyclicality inherent in the cement industry and the volatility in
interest rates, as seen in recent quarters. Going forward, the company’s ability to protect its
margin amid competitive pressure and manage its liquidity amid the probable strain in cash
flows and sizeable loan repayment obligations would remain the key rating sensitivities.

HSCC’s Credit Analysis

Credit strengths
Strong operational profile: Hongshi derives sizeable economies of scale, being the largest
integrated greenfield cement plant in Nepal with an installed capacity of 2 million metric
tonnes per annum (MTPA) for clinker and 2.3 million MTPA for the grinding unit. The
company and its production process benefit from the expertise of the promoter group in the
sector, which has led to production efficiencies, enabling the company to price its products
competitively and penetrate the market despite a limited track record. The company’s
capacity utilisation has been gradually improving over the years, both in terms of clinker and
cement production. The company’s reported revenues of NPR 17 billion in FY2022 was the
highest in the industry, with 47% driven by the clinker segment (56% in terms of volume).
The sales mix is gradually shifting towards high margin cement sales (53% of revenues in
FY2022 over 42% in FY2021), which remains a positive.

Comfortable leverage and coverage indicators: With a relatively low reliance on debt
funding for initial capex, Hongshi has been maintaining comfortable gearing or leverage
levels and debt coverage metrics (total debt to net worth of 0.36 time and total debt to
OPBDITA of 2.43 times during FY2022, declining from 0.61 time and 2.69 times during
FY2020, with accumulation of internal accruals and debt repayments). These gearing
indicators are expected to further improve over the medium term, with scheduled debt
repayments. However, given the sizeable principal repayment falling due over the medium
term, the near-term coverage indicators will remain dependent on the company’s operating
profit margins.

Strong promoter profile and experienced directors/ management: The company is a part of
the Hongshi Group (70% stake of through Hongkong Red Lion Cement No. 3 Limited),
which operates 50 large-scale cement companies in China. It is also present in other
countries, namely Laos, Indonesia, and Myanmar. The Group’s extensive track record in the
cement industry and the experienced board/management are likely to help the company in
maintaining healthy business performance, mainly by adapting the best practises among the
Group companies in terms of technology and policies. The remaining 30% stake is held by
Shivam Holdings Limited of Nepal, which is an 88% subsidiary of Shivam Cements Limited,
one of the established and strong players in the Nepalese cement industry. The shared brand
image of both the promoters and their extensive experience in the industry remain positives
for incremental growth outlook.

Credit challenges
Sharp decline in margins during FY2022 : In line with global trends, coal prices as well as
other input prices sharply increased during FY2022. However, industry competition
prevented the company from passing on the increased cost to end-customers. Further, the
pandemic and liquidity constraints induced demand slowdown led to significant pressure over
the company’s OPM, which fell to ~16% in FY2022 from 25% in earlier years. Given the
margin pressures coupled with high interest expenses (in a rising interest rate environment)
and sizeable principal instalment falling due, the Debt Service Coverage Ratio (DSCR)
sharply declined to 1.2 times for FY2022 from 3.2 times for FY2021. The margin pressures
are likely to persist over the near term and hence DSCR is expected to remain largely around
similar levels.

Intense industry competition: The cement industry in Nepal is highly fragmented with several
players and stiff competition from other large/ established cement manufacturers. As of mid-
July 2022, 55 cement manufacturing units and 20 clinker manufacturing units were already
operational with a few large greenfield units still in the pipeline. Additionally, many older
players have undergone sizeable capacity enhancements in recent years. Hence, the pricing
flexibility has gradually reduced in recent years and is likely to decline further, going
forward, as capacity creation in the country remains higher than the current demand. Any
significant upward movements in input prices could impact the company’s margins given the
competitive pressure.

Vulnerability to cyclicality and seasonal demand; risk of regulatory changes: The cyclical/
seasonal nature of the cement industry creates uncertainty over demand and cash cycles for
Hongshi; more so because it is based in a single region. This could impact the company’s
capacity utilisation, revenues and profit margins. Volatility in cash flow due to this could
pose challenges, especially during periods of weak demand. Since the cement industry in
Nepal is insulated from cheaper imports with duty safeguards, unfavourable changes in
government policies could have a bearing on the performance of the industry players. Any
other regulatory changes affecting raw material prices and availability could also impact the
overall cement industry.

Financial Indicators

The four-year key financial indicators of the company submitted to Mr. Goel by the finance
department of Shivam Cement is as follows:

Key financial ratios (FY 2019 to 2022)

 FY2019 FY2020 FY2021 FY2022
(Audited) (Audited) (Audited) (Provisional)
EBIT (in millions) 784 1,271 1,457 1,845
Long term debt/Equity (times) 0.48 0.61 0.48 0.36
Total debt/ Equity (times) 0.96 0.81 0.57 0.48
Total debt/EBIT (times) 1.91 2.69 1.77 2.43
Interest coverage ratio (times) 5.38 3.19 5.90 4.65
Debt Service Coverage Ratio (times) 5.46 2.49 3.15 1.21
Net-working capital/EBIT (%) 21% 31% 22% 23%
Current ratio 0.91 1.79 2.47 2.01
Source: Company data

The finance department at Shivam have made following 5-year forecast:

Projected Five-year Financial Indicators

Particulars FY 2023 FY 2024 FY2025 FY2026 FY2027
EBIT (in millions) 2,120 2,340 2,950 3,155 3,575
Interest 221 256 321 343 365
Depreciation 272 353 374 414 475
Change in Net working
capital 180 210 240 320 350
Capital Expenditures 76 86 92 112 125
The current key financial indicators of Shivam Cement Company are as follows:
Number of shares outstanding = 15 million New Worth Per Share = Rs. 230
Market price per share = Rs. 410 Dividend Per Share = Rs. 60
Earning per share = Rs. 155 Return on equity = 22%
Avg. EPS growth rate (past 5 year) = 7.5% P/E ratio = 12.33
Tax Rate = 30%

Capital Structure Ratio (Debt to Value) based on:

Book Value = 65%
Market Value = 52%
Target Capital Structure = 55%

Current Stock Market Condition

Nepal Stock Exchange (Nepse) is currently in what experts call a “bearish trend” mainly
triggered by the uncertainties raised by the worsening performance of the country’s
macroeconomic indicators. Amidst post-pandemic impacts, rising inflation, shrinking foreign
reserves and a turbulent international environment, experts speculate on the cause of the
declining stock exchange and its possible effect on the economy. Less than 10 months ago,
on August 18, 2021, Nepse closed at an all-time high at 3,198.60 points. On November 11,
2022 the secondary market closed with its index at 1,922.11. Stock market analysts agree
that the bearish trend of the stock exchange has been due to liquidity crunch and soaring
interest rate of the banks. The records with Nepal Rastra Bank (NRB) show that the country’s
banking sector has been in a massive liquidity crunch for the past few months. Policy
measures employed by NRB is another factor influential in the state of the stock exchange.
The central bank, as a part of its monetary policy for the fiscal year 2021/22, had constricted
share-based payment, limiting an entity or individual to take marginal loans — loans taken to
invest in stocks by using the existing shares as collateral — of up to Rs 40 million from one
BFI and Rs 120 million in total. Many investors have had to sell their shares to reduce their
loan size to the limit. In addition to this, experts see the rising inflation in the country to be a
reason for the bearish trend. The global share markets have also been dwindling as the
Russia-Ukraine conflict is heading towards its peak. “Overall there is a weak incentive for
investors to invest in the stock market,” a stock market analyst comments about NEPSE’s
current state.
The key stock market indicators collected by the finance department of Shivam is as follows:
Market Return = 14%
T-bills rate = 5%
Yield on 10-year govt bond = 8%
Average yield to maturity of cement company debentures = 10.5%
Beta of Shivam Cement = 1.23
Growth rate of Shivam stock price = 14%
Average Market Value/EBIT ratio of listed cement companies = 2.1 times

Financing Decision at Shivam Cement

In order to raise the Rs. 20 billion, Shivam cement was required to decide for the best
financial alternative. In consultation with the finance managers, Mr. Goel was considering
whether debt financing through issue of debenture or equity financing through Follow-on
Public Offering (FPO) was suitable given the creditworthiness, capital costs, debt service
capacity and stability of future cash flows. During the period when stock market is bearish
and the market share price of Shivam is thought to be significantly undervalued, Mr. Goel
was contemplating whether it will be appropriate to issue equity. Hence, he was also
considering issue of hybrid securities like warrants and convertibles.

QUESTIONS

Attempt ALL the questions. The figures in the margin indicate the full marks. The answers
should be based on the information provided in the above case and should link the concepts
discussed in the classroom with the financing decision at Shivam Cement.

1. “A company’s financing decision is concerned with the sources of funds from where long-
term finance is raised and the proportion in which the total amount is raised using these
sources of funds. An appropriate capital structure is a critical decision for any business
organization. The decision is important not only because of the need to maximize returns to
the shareholders, but also because of the impact such a decision has on an organizations
ability to deal with its competitive environment.” In light of the statement, discuss how
capital structure decision at Shivam Cement can affect value of the company. With reference
to the information given in the above case, offer your expert recommendation on whether
Shivam should raise the long-term funds of Rs. 20 billion it requires for doubling its
production capacity through issue of debenture or common stock? Justify your arguments.
20

2. Compute the fair value of Shivam Cement Ltd. using DCF approach of corporate
valuation. If the company considers Follow-on Public (FPO) offering for raising the capital,
what offer price per share will you recommend for issuing the common stock to the public?
Do you recommend equity issue? Justify.
30

3. Mr. Goel was also considering whether Shivam Cement can create value by issuing hybrid
security instead of straight debt. In consultation with the investment banker Sidhartha Capital,
he is considering issue of one of the following hybrid securities with specification given in
the following table: 50

Financing Debenture Convertible Debenture with

Debenture Warrants
Coupon Rate 11% 7% 7.5%
Maturity 12 years 12 Years 12 Years
Face Value/ Issue Price Rs. 1000 Rs. 1000 Rs. 1000
Call feature No Yes No
Call premium - 20% -
Call protection period - 5 years -
Conversion/Exercise 2 2
Ratio
Exercise Price Rs. 450

a. What are the benefits Shivam Cement will receive from issue of convertible or
warrants? Explain with reference to the case information and calculations done in the
above questions.
b. Under convertible financing, calculate:
i. The conversion price, conversion value and conversion premium.
ii. What will be the conversion value after 3 year? Will it be beneficial for
convertible holders to convert?
iii. If the convertible bond were called at the end of 5 th year, what should the
convertible debenture holder do? Should they accept the call or convert?
Elucidate.
iv. Calculate the implied value of conversion option.
v. Compute the holding period yield for convertible holders (Assume they
convert at the end of 6th year). Use approximate yield to maturity.
vi. Compute the fully diluted EPS.
vii. Mr. Goel requires to compute the intrinsic value of call options embedded in
conversion option. Compute the fair value of the conversion option.
(Additional information: The standard deviation of annual return of Shivam
Cement Stock is 0.45 and the time to expiration of conversion option which
corroborates with the call protection period is 5 years.)

c. Under the debenture with warrants financing, compute:

i. The theoretical value of a warrant.
ii. With reference to major differences between warrants and convertibles,
discuss whether convertible or warrants financing will be appropriate for
Shivam Cement.
iii. Explain why the market value of warrant should always be higher then its
theoretical value before the expiration date.

d. On the basis of above analysis, what long term financing decision will you
recommend to Mr. Goel for raising the Rs. 20 billion. Justify your arguments.