CASE 14.1: CENTRAL EQUIPMENT COMPANY14 1804.0 2005 2006 9.0 9.50 In the beginning of January 2014, Mr L.C. Tandon, Director Table 14.1.1: Central Equipment Company: of Finance of Central Equipment Company (CEC), was Selected Financial Data for the Year ending on 31 March evaluating the pros and cons of debt and equity financing for the purpose of expansion of CEC's existing production Sales PBIT PAT Dividend EPS facilities. At a recent meeting of the board of directors, FY R R SR a heated discussion took place on the best method of million) million) million) million) million financing the expansion. Mr K.C. Soni, Chairman and 34.3 17.1 Managing Director (CMD), had therefore directed Mr 1707.8 15.5 7.8 9.0 4.33 Tandon to critically evaluate the points made by the 2007 1894.0 41.2 20.6 9.0 11.44 various members of the board. He also asked him to 2008 2270.8 52.2 26.1 9.0 14.50 prepare a report on behalf of the company's management 2009 2520.0 58.0 29.0 10.8 16.11 to be presented at the board meeting to be held in the 2010 2775.0 66.6 33.3 10.8 18.50 last week of January 2014. 2011 2949.2 76.8 38.4 14.4 21.33 2012 2433.8 -5.3 -5.3 9.0 2013 3042.3 66.2 43.5 27.0 Background of the Company 24.17 2014$ 3376.9 77.5 50.3 27.0 27.94 CEC was started in the late fifties as a government company. S-Estimates It is one of the important engineering companies in the public sector in India, manufacturing a wide range of $180 million (divided into 1.8 million shares of 100 products. CEC's products include industrial machinery and each) and reserves of 459.6 million. The company's equipments for chemicals, paper, cement, and fertilizers sales have shown a general increasing trend in spite of industries, super heaters, economizers, and solid material a number of difficulties such as recessionary conditions, handling and conveying equipments. high input cost, frequent power cuts and unremunerative CEC had started with a paid-up capital of 710 million regulated prices of certain products. In the last decade, in 1959. As per the estimated balance sheet at the end CEC's sales have increased from $1,804 million in of the financial year 2014, it has a paid-up capital of the financial year 2005 to 3,042 million in 2013. 14. Case adapted from, Pandey, I.M. and Ramesh Bhat, Cases in Financial Management, New Delhi: Tata McGraw, 2nd edition, 2002. The sales for the year ending 31 March 2014 are estimated CEC to obtain budgetary support from the government. to be 23,377 million. Net profit (profit after tax, PAT) has However, in his assessment, CEC being a profitable increased from 17.1 million in FY 2005 to 143.5 million company, government may agree to allow it to come in FY 2013. The company is projecting a profit after tax up with an IPO, provided the government's shareholding of 50.3 million in FY 2014. Due to the recessionary and remains at least equal to 51 per cent of the total paid other economic factors, sales and profits of the company up capital and may also be willing to provide budgetary have shown a cyclical behaviour over the last decade. support for the project. More significantly, he felt that Table 14.1.1 gives sales and profit data since FY 2005. raising equity capital might be difficult and it may dilute equity earnings. The company's merchant banker suggested that in case it wants to go for IPO, it may be able to sell The Expansion Project its shares about 20 to 50 per cent above its par value The need for expansion was felt because the market was fast of 100. Given these facts, CMD decided to reconsider growing and the company has at times reached its existing the company's policy of avoiding long-term debt. It was capacity. The project is expected to cost $200 million, and thought that the use of debt could be justified by the generate an average profit before interest and taxes (PBIT) expected profitable position of the company. of 40 million per annum, for a period of ten years. It Table 14.1.3: CEC: Estimated Balance Sheet as on is expected the new plant will cause significant increase 31 March 2014 in the firm's fixed costs. The annual total expenses of million) the company after expansion are expected to consist of 55 per cent of fixed and 45 per cent variable expenses. Capital Assets The company's financial condition in 2014 is expected as Sundry creditors 151.8 Cash and bank shown in Table 14.1.2 without and with the expansion. balance Table 14.1.2: Central Equipment Company: Tax provision 30.3 Sundry debtors Sales and Profits without and with Expansion Other current 121.5 Inventory Sales liabilities PBIT PAT Dividend EPS FY R Other current RE) assets million) million) million) million) million Current 303.6 Current assets 357.9 Without Liabilities Exp. 3579.5 85.0 59.5 33.06 Paid-up share 180.0 Gross block With capital Exp.# 125.0 87.5 57.0 23.03 Reserve & surplus 459.6 Accumulated 234.6 depreciation # Projections include financial impact of proposed expansion Net worth Net block and equity financing 100 per share is assumed. Total Capital 943.2 Total Assets 943.2 The management has already evaluated the financial 89.0 180.7 41.1 47.1 27.0 819.9 4032.3 639.6 585.3 viability of the project and found it acceptable even under Mr Tandon has determined that the company could adverse economic conditions. Mr. Soni felt that there would sell #1,000 denomination bonds for an amount of 200 not be any difficulty in getting the proposal approved million either to the public or to the financial institutions from the board and relevant government authorities. He through private placement. The interest rate on bonds will also thought that the production could start as early as be 10 per cent per annum, and they could be redeemed from April 2014 after seven years in three equal annual instalments. The bonds and interest thereon will be fully secured against Financing of the Project the assets of the company. In Mr Tandon's view, the company will have to sell a large number of bonds to the CEC has so far followed a very conservative financing financial institutions as CEC being a new company in the policy. All these years, the company has financed its capital market, the public may not fully subscribe to the growth through budgetary support from the government in issue. The bond-holders shall have right to appoint one the form of equity capital and internally generated funds. nominee director on the board of the company which The company has also been meeting its requirements shall, however, be exercised by the bond trustees only for working capital finance from the internal funds. if the company defaults in the payment of interest or The company has, however, negotiated a standing credit repayment on the due date. limit of 50 million from a large nationalized bank. In In Mr Tandon's opinion the bond was a cheaper source the past, it has hardly used the bank limit because of of finance, since interest amount was tax deductible. Given sufficient internal resources. As may be seen from the the corporate tax rate of 30 per cent, the 10 per cent interest estimated balance sheet as on 31 March 2014 in Table rate was equal to 7 per cent from the company's point of 14.1.3, CEC's capital employed included paid-up share view. On the other hand, he thought that equity capital would capital and reserves without any debt. The CMD feels be costly to service, as CEC is currently paying a dividend that given the government's current attitude whereby it of 15 per cent on its paid-up capital. Further, as per the would like profitable companies to raise funds from the current tax laws in India, the company would have to pay capital markets for their investments, it may look odd for fax on dividends. Thus, the bond alternative looked attractive profit from the existing business and the new project. o Mr Tandon on the basis of the comparison of costs. The discussion on bond versus equity financing was so The expansion proposal was discussed in the January involved that there did not seem to be any sign of a 2009 meeting of the board. As most of the members unanimous agreement being reached. At this juncture, were convinced about the profitability and desirability of Mr Tandon suggested that the discussion on financing the project, they did not take much time to approve it. alternatives might be postponed until January end to allow Immediately after this decision, Mr Tandon informed the him sufficient time to come up with a fresh analysis members about the possibility of raising finance through incorporating the various points raised in the current a bond issue. He then presented his report highlighting meeting. Mr Tandon was wondering what he should do the comparison between bond and equity financing. His so that a unanimous decision could be reached. conclusions clearly showed that bond financing was better for the company. Mr Tandon was surprised to note that substantial disagreement existed among the members Discussion Questions regarding the use of bond. One director questioned the correctness of Mr Tandon's 1. Calculate EPS under the alternatives of employing calculation of the cost of the bond as he had ignored the (a) 200 million debt and no fresh equity, (b) 100 million debt and #100 million equity implications of the repayment of loan. According to him, this would mean higher cost of bond as compared to equity and (c) $200 million equity and no debt. Also make calculations for uncommitted-EPS. Draw capital. Yet another director emphasized that a lot of annual cash outflow will also take place under the bond a chart showing PBIT on x-axis and EPS and alternative. He felt that the issue of bond would thus add uncommitted-EPS on y-axis for debt-equity mix. What inferences do you derive? to the company's risk by pressurizing its liquidity. Most of the directors, however, were in agreement with the estimate 2. Debate the issues raised in the case for and of post expansion profit before interest and taxes (PBIT) of against the use of debt. Why do a large number 1125 million. of board members seem to be against the use of One of the directors argued that given the expected debt? What are the real risks involved? How higher PBIT, the post-expansion equity return would would you measure them? significantly increase if the funds are raised by issuing 3. In addition to profitability and risk factors, what bonds. He even emphasized that the job of the management are other considerations before CEC to decide should be to maximize profitability of equity owners about its debt policy? Should it employ debt to by taking reasonable risks. Another director countered finance its expansion? this argument by stating that the equity return could 4. Is there a relationship between debt and value The diluted if the company was unable to earn sufficient of the firm