In the beginning of January 2009, Mr. L.C. Tandon, Director of Finance of Central Equipment Company (CEC)

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In the beginning of January 2009, Mr. L.C. Tandon, Director of Finance of Central Equipment Company (CEC) was evaluating the pros and cons of debt and equity financing for the purpose of expansion of CEC's 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 company's management to be presented at the board meeting to be held in the last week of January 2009.

Background of the 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. CEC's products include industrial machinery and equipments for chemicals, paper, cement, and fertilizers industries, super heaters, economizers, and solid material handling and conveying equipments.

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. The company's sales have shown a general increasing trend in spite of a number of difficulties such as recessionary conditions, high input cost, frequent power cuts and unremunerative regulated prices of certain products. In the last decade, CEC's sales have increased from Rs 1,804 million in the financial year 2000 to Rs 3,042 million in 2008. The sales for year ending 31 March 2009 are estimated to be Rs 3,377 million. Net profit (profit after tax, PAT) has increased from Rs 17.1 million in FY 2000 to Rs 43.5 million in FY 2008. The company is projecting a profit after tax of Rs 50.3 million in FY 2009. Due to the recessionary and other economic factors, sales and profits of the company have shown a cyclical behaviour over the last decade. Table

14.1.1 gives sales and profit data since FY 2000.

Table 14.1.1: Central Equipment Company: Selected Financial Data for the Year ending on 31 March

FY	Sales (Rs million)	PBIT (Rs million)	PAT (Rs million)	Dividend (Rs)	EPS (Rs)
2000	1804.0	34.3	17.1	9.0	9.50
2001	1707.8	15.5	7.8	9.0	4.33
2002	1894.0	41.2	20.6	9.0	11.44
2003	2270.8	52.2	26.1	9.0	14.50
2004	2520.0	58.0	29.0	10.8	16.11
2005	2775.0	66.6	33.3	10.8	18.50
2006	2949.2	76.8	38.4	14.4	21.33
2007	2433.8	-5.3	-5.3	9.0	—-
2008	3042.3	66.2	43.5	27.0	24.17
2009$	3376.9	77.5	50.3	27.0	27.94

$ Estimates

The Expansion Project

The need for expansion was felt 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. It is expected the new plant will cause significant increase in the firm's fixed costs. 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 company's financial condition in the year 2009-2010 is projected in Table 14.1.2 without and with the expansion.

Table 14.1.2: Central Equipment Company:

Sales and Profits Without and With Expansion

Sales

(Rs million)

PBIT

(Rs million)

PAT

(Rs million)

Dividend

(Rs)

EPS

(Rs)

Without Expansion

3579.5

85.0

56.1

27.0

31.2

With Expansion#

4032.3

125.0

82.5

57.0

21.7

# Projections include financial impact of proposed expansion and assuming equity finance at issue price of Rs 100 each share.

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.

Financing of the Project

CEC has so far followed a very conservative financing policy. All these years, the company has financed its growth through budgetary support from the government in the form of equity capital and internally generated funds. The company has also 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. In the past, it has hardly used the bank limit because of sufficient internal resources. As may be seen from the estimated balance sheet as on March 31, 2009 in Table 14.1.3, CEC's capital employed included paid-up share capital and reserves without any debt. The CMD feels that given the government's current attitude whereby it would like profitable companies to raise funds from the capital markets for their investments, it may look odd for CEC to obtain budgetary support from the government. However, in his assessment, CEC being a profitable company, government may agree to allow it to come up with an IPO, provided the government's shareholding remains at least equal to 51 per cent of the total paid up capital and may also be willing to provide budgetary support for the project. More significantly, he felt that 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 its shares about 20 to 50 per cent above its par value of Rs 100. Given these facts, CMD decided to reconsider the company's policy of avoiding long-term debt. It was thought that the use of debt could be justified by the expected profitable position of the company.

Table 14.1.3: CEC: Estimated Balance Sheet as on 31 March 2009

Capital		Assets
Sundry creditors	151.8	Cash and bank balance	89.0
Tax provision	30.3	Sundry debtors	180.7
Other current liabilities	121.5	Inventory	41.1
		Other current assets	47.1
Current Liabilities	303.6	Current assets	357.9
Paid-up share capital	180.0	Gross block	819.9
Reserve & surplus	459.6	Accumulated depreciation	234.6
Net worth	639.6	Net block	585.3
Total Capital	943.2	Total Assets	943.2

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. Tandon's view, the company will have to sell a large number of bonds to the financial institutions as CEC being a new company in the capital market, the public may not fully subscribe to the issue. He also felt that from the individual investors' point of view, CEC might have to give an option to the bondholders to sell back to the company bonds up to an amount of Rs 10 million each year. Also, bondholders shall have right to appoint one nominee director on the board of the company which shall however be exercised by the bond trustees only if the company defaults in the payment of interest or repayment on the due date.

In Mr. Tandon's opinion the bond was a cheaper source of finance, since interest amount was tax deductible. Given the company's tax rate of 34 per cent, the 10 per cent interest rate was equal to 6.6 per cent from the company's 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. Further, as per the current tax laws in India, the company would have to pay tax on dividends. Thus, the bond alternative looked attractive to Mr. Tandon on the basis of the comparison of costs.

The expansion proposal was discussed in the January 2009 meeting of the board. As most of the members were convinced about the profitability and desirability of the project, they did not take much time to approve it. Immediately after this decision, Mr. Tandon informed the members about the possibility of raising finance through a bond issue. He then presented his report highlighting the comparison between bond and equity financing. His conclusions clearly showed that bond financing was better for the company. Mr. Tandon was surprised to note that substantial disagreement existed among the members regarding the use of bond.

One director questioned the correctness of Mr. Tandon's calculation of the cost of the bond as he had ignored the implications of the annual requirement arising out of investors exercising the option. According to him, this would mean higher cost of bond as compared to equity capital. Yet another director emphasized that a lot of annual cash outflow will also take place under the bond alternative. He felt that the issue of bond would thus add to the company's risk by pressurizing its liquidity. Most of the directors, however, were in agreement with the estimate of post expansion profit before interest and taxes (PBIT) of Rs 125 million.

One of the directors argued that given the expected higher PBIT, the post-expansion equity return would significantly increase if the funds are raised by issuing bonds. He even emphasized that the job of the management should be to maximize profitability of equity owners by taking reasonable risks. Another director countered this argument by stating that the equity return could be diluted if the company was unable to earn sufficient profit from the existing business and the new project. The discussion on bond versus equity financing was so involved that there did not seem to be any sign of a unanimous agreement being reached. At this juncture, Mr. Tandon suggested that the discussion on financing alternatives might be postponed until January end to allow him sufficient time to come up with a fresh analysis incorporating the various points raised in the current meeting. Mr. Tandon was wondering what he should do so that a unanimous decision could be reached.

Question 1:

Debate the issue raised in the case for and against the use of debt. Why do a large number of board members seem to be against the use of debt? What is the real risk involved? How would you measure them?

Question 2: In addition to profitability and risk factors, what are other considerations before CEC decides about its debt policy? Should it employ debt to finance its expansion?

Question: 3

Is there a relationship between debt and the value of the firm?

Question: 4

Calculate EPS under the alternatives of employing (a) 200 million debt and no fresh equity, (b) 100 million debt and 100 million equity and (c) 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 a debt-equity mix. what inferences do you derive?