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Case Study
Read the case carefully and answer the following questions:
1. Perform fund flow analysis on cash basis for Daewoo Motors for the year ended March 31, 2001.
2. Determine the duration of the weighted operating cycle of Hindustan Motors for the year ended March 31, 2001 and comment on it. Make suitable assumptions wherever necessary and state them.
3. Determine the free cash flows of Daewoo Motors India Limited (DMIL) for the years 1998 – 99 to 2000 –2001. Assume income tax rate to be 35%.
4. Determine the value of equity of Hindustan Motors Ltd. as on March 31, 2001 using Black – Scholes Model. The standard deviation of asset values and continuously compounding risk free interest may be taken as 35% and 8% respectively. Market price of the assets is expected to be more than book value by 10%.
5. Hindustan Motors Ltd. is frantically trying to increase the market share by acquisition route. If they consider to acquire Daewoo Motors, discuss the reasons in favor and against the acquisition of Daewoo Motors by them.
6. How comparable company approach is used for valuing a firm? Can it be used for valuing DMIL in present case?
The Indian passenger car industry as we see today is relatively recent in origins. Except the ubiquitous Ambassador and the Premier Padmini's there was not much moving around with an Indian tag. The restrictive policies of the Indian government did not allow foreign players to set shop in India and in the absence of adequate technology and purchasing power it resulted in the slow growth of the industry even after a long time since independence. The demand for cars increased from 15,714 in FY60 to 30,989 in FY80 at a CAGR of only 3.5%. The entry of Maruti Udyog Ltd, a GoI JV with Suzuki of Japan, in 1983 with a so-called "peoples" car and a more favorable policy framework resulted in a CAGR of 18.6% in car sales from FY81-FY90.
The first motor car on the streets of India was seen in 1898. Mumbai had its first taxicabs in the early 1900. Then for the next fifty years, cars were imported to satisfy domestic demand. Between 1910 and 20's the automobile industry made a humble beginning by setting up assembly plants in Mumbai, Calcutta and Chennai. The import/assembly of vehicles grew consistently after the 1920's, crossing the 30,000 mark in 1930. In 1946, Premier Automobile Ltd (PAL) earned the distinction of manufacturing the first car in the country by assembling 'Dodge DeSoto' and 'Plymouth' cars at its Kurla plant. Hindustan Motors (HM), which started as a manufacturer of auto components graduated to manufacture cars in 1949.
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In 1952, the GOI set up a tariff commission to devise regulations to develop an indigenous automobile industry in the country. After the commission submitted its recommendations, the GOI asked assembly plants, which did not have plans to set up manufacturing facilities, to shut operations. The other control imposed on carmakers related to production capacity and distribution. The GOI control even extended to fixation of prices for cars and dealer commissions. This triggered the start of a protracted legal battle in 1969 between some carmakers and GOI. Simply put, the three decades following the establishment of the passenger car industry in India and leading upto the early 1980s, proved to be the 'dark ages' for the consumer, as his choice throughout this period was limited to two models viz Ambassador and Padmini. It was only in 1985, after the entry of Maruti Udyog, that the car makers were given a free hand to fix the prices of cars, thus, effectively abolishing all controls relating to the pricing of the end product.
In the early 80's, a series of liberal policy changes were announced marking another turning point for the automobile industry. The GOI entered the car business, with a 74% stake in Maruti Udyog Ltd (MUL), the joint venture with Suzuki Motors Ltd of Japan.
In 1985, the GOI announced its famous broadbanding policy which gave new licenses to broad groups of automotive products like two and four-wheeled vehicles.
Industry structure The Indian car industry can be classified, based on the price of the car, into the 'small' car or the economy segment (upto Rs0.25mn), mid-size segment (Rs0.25-0.45mn), luxury car segment (Rs0.45-1mn) and super luxury car segment (above Rs1mn).
The models in the car market can be fitted to different segments as given below :-
Category Models Economy segment (up to Rs0.25mn) Maruti Omni, Maruti 800, Padmini
Mid-size segment (Rs0.25-0.45mn), Premier 118NE, Ambassador Nova, Fiat Uno, Zen, Hyundai Santro, Daewoo Matiz, Tata Indica, Maruti 1000, Contessa
Luxury car segment (Rs0.45-1mn) Peugeot 309, Tata Estate, Tata Sierra, Maruti Esteem, Ceilo Executive, Honda City, Mitsubishi Lancer, Ford Ikon, Opel Astra, Fiat Siena, Opel Corsa, Daewoo Nexia, Hyundai Accent
Super luxury segment (Above Rs1mn) Mercedes Benz and other imported models
The demand for passenger cars can be segmented on the basis of the user segment as those bought by taxi operators, government/non government institutions, individual buyers etc. A major portion of the demand in India accrues mainly from personal vehicle owners.
The distribution of car sales in FY2000 in terms of the above mentioned segments is as given in the chart below.
Segment Market Share (%) Economy 90.2 Mid size and Luxury 9.8
Source : SIAM/Auto Car India The table shows that sales in the economy segment still rules the roost with a large number of entrants purveying their wares in the segment and with a great degree of success too. However, in the past several months, sales in the mid-sized car segment has also picked up thanks to the wider choice set available and a steady rise in income levels. A look at the table below will suffice.
Month Economy cars Mid-sized cars % of mid-sized car sales Aug-00 51,355 4,858 8.6 Sep-00 52,113 5,394 9.4
Oct-00 44,065 3,250 6.9 Nov-00 47,299 3,678 7.2 Dec-00 45,300 6,533 12.6
Jan-01 45,503 6,141 11.9 Feb-01 47,322 6,828 12.6 Mar-01 59,259 10,101 14.6
Apr-01 45,654 7,587 14.3 May-01 43,396 7,447 14.6
Source : Auto Car India
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The last ten months saw sales in the small/economy car segment stagnate while that in the mid-sized category have picked up barring a two-month period of October and November 1999 when it fell below 4,000 units. If the percentage of mid-sized cars sold in August 2000 was 8.6% it jumped to 14.6% in May 2001.
Regionwise car sales
In terms of car sales by region, the north leads by cornering 43.9% of the total car sales in 1998 for which latest data is not available. The western and southern regions come second and third with a market share of 25.3% and 19.5% respectively. The distribution of sales in terms of region is as given below.
States Quantity in Nos. North Zone Delhi 45,832 Himachal Pradesh 3,302 J & K 4,308 Punjab 20,376 Haryana 9,004 Chandigarh 14,512 Uttar Pradesh 23,054 West Zone Goa 2,716 Gujarat 20,925 Madhya Pradesh 9,387 Maharashtra 28,334 Rajasthan 8,149 South Zone Andhra Pradesh 10,640 Karnataka 14,190 Kerala 11,263 Pondicherry 25 Tamil Nadu 17,366 East Zone Assam 3,349 Bihar 6,319 Orissa 3,064 West Bengal 14,985 Tripura 120 Sikkim 111 Nagaland 1,367 Mizoram 359 Meghalaya 404 Arunachal Pradesh 674 A&N Islands 13 Manipur 113 Others 63 Total 274,324
Source: SIAM (Note: The above given figures are exclusive of Maurti Udyog sales and exports)
Delhi leads the others in terms of sales with 38% of sales in the northern region happening there. Its share of nationwide sales is 16.7%. Maharashtra follows next with 10.3% of national sales.
Government Policy
The policy of broadbanding capacities in the eighties led to increased utilization of capacity for four-wheelers in the industry.
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The liberal policy on foreign participation through technical and financial collaboration in early eighties led to substantial product upgradation and introduction of new models. But it was alleged that the policy was discriminatory in favor of MUL, while others like Telco, PAL, HM were denied permission to produce cars in collaboration with Japanese companies.
The GOI controls the car sector by way of framing policies on depreciation norms, import duty on cars and parts used in it, petrol prices and import duty of steel.
During the era of socialist inspired controls, the government protected the car industry from new entrants by making effective use of licenses. However, after liberalization and with the consequent opening up of the auto sector in 1992-93, the license raj ceased to exist .
The perception of a car as a luxury good led to heavy excise duty on cars. The excise duty doubled from 25% in FY87 to 55% in FY91. Till 1987, the GOI followed a discriminatory policy so as to charge lower duty on fuel efficient car with engine capacity of less than 1000cc. This helped MUL to price its car at a lower price in comparison to others. But with lobbying from PAL and HM government withdrew the provision in 1987.
But with the onset of the liberalization process in the early nineties, the government has continually rationalized the excise duty regime. Presently, there is a duty of 40% (16% + 24%) on motor vehicles, designed for transport of not more than six persons (excluding the driver). On vehicles designed for transport of more than six persons, but not more than 12 persons, the duty is 32% (16% + 16%). Over and above the excise duty, cess by the Central Government, states are now charging a uniform sales tax of 12%. This came in being after the 15th of May 2000. Earlier, states used to charge sales tax varying from 3 to 14%.
a. Policy on petroleum products, auto emission and depreciation
The prices of petrol and diesel was regulated till recently by the government as part of its policy on petroleum products management. However, since 1997, the prices of these fuels have been deregulated and linked to the movements in international prices. As a result, already, the price of diesel has been raised twice, the latest by a huge 40%. This dismantling of the Administered Price Mechanism (APM) of petroleum products will reduce the cost disadvantage of petrol driven cars.
On the vehicle emission front, judicial activism has goaded the government to take certain policy measures in the recent past which has led to stricter emission norms for automobiles. As per a Supreme Court judgement, banning registration of all non Euro I compliant cars within Delhi, all vehicles should become Euro I compliant by April 2000. (In the National Capital Region of Delhi, Euro II norms are now in operation) As a result, almost all the existing players and new entrants have started introducing models complying with the said norms. This development has led to an increase in the prices of cars, which by an estimate, could be anywhere between 10-15%.
The depreciation norms have effect on demand for cars as institutions purchase cars for use by managerial staff and claim depreciation in their books. With this the companies are benefited from tax shelter provided by depreciation. Therefore any change in depreciation norms affect the demand from this segment. The depreciation benefits which accrue to institutions & corporate buyers was slashed from 33.33% to 20% in 1990. This led to decrease in demand from this segment for a short period. But with increase in depreciation rate to 25% in 1994, corporate demand was restored.
b. Automotive Policy
In a policy announcement in FY94, the government had permitted foreign car producers to invest in the automobile sector in India and hold majority stakes. The objective of the policy was to build automobile production capabilities in the country, with minimum foreign exchange outflows. The key conditions of the policy related to production, imports, exports, level of indigenisation and foreign equity inflows.
Since all the new ventures involved the import of capital goods and CKD/ SKD kits, the promoters had to fulfill certain export obligations. They were also required to provide an indigenisation program. However, these conditions were framed in the nature of MOUs which the new ventures had to sign with the Directorate General of Foreign Trade (DGFT).
But, in the last three years many of the companies failed to live up to their export commitments, which made it difficult to obtain permission for importing additional CKD/ SKD kits.
In addition, the uncertainty regarding the threshold level for classifying imports as CKD/ SKD or component imports continues. Currently, the threshold level is set on a case to case basis where imports below a certain percentage of the total value of the car are being charged duty that is applicable to components (30%), while imports above this percentage are being charged at the rate applicable to CKD/ SKD (45%). The industry wants the threshold level to be at 70%, while the government wants it to be at 35%.
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In November '97, the Cabinet Committee on Foreign Investment cleared a new policy for permitting new car ventures. It addresses the aspect of indigenisation level and exports by the new ventures. The main proposals of the new policy are :
• The new ventures would have to indigenise up to 50% within 3 years and 70% by the end of seventh year of starting commercial production.
• They will have to invest a minimum of $50 million as equity capital over a period of 3-4 years.
• The venture will have to become foreign exchange neutral over a period of 5-7 years.
• The ventures will be allowed to export components & ancillaries, apart from cars.
• A moratorium of 2 years would be given to companies for meeting the export commitment.
The new policy is expected to provide development of ancillarisation and increase employment opportunities. But for some of the new car ventures, auto policy will be a speed braker as they have to sign a new MOU with the government and make necessary arrangement to meet the new policy.
Technology and manufacturing process
The body panel and engine constitute a major portion of the total cost of car manufacture. A typical cost structure for car is as given below.
Parts/assembly % of total cost Glass 5
Brakes/wheels/tyres 6 Interiors 7 Transmission system 7
Ignition/exhaust system 8 Steering/suspension 9 Comfort fittings 11
Engine 16 Body 18 Others 13
Source : Probity Research
Car manufacturing is basically assembly of components procured from ancillaries or auto component manufacturers. Nearly 80% of auto components are outsourced by the car manufacturers. This helps in reducing the capital cost needed to setup a car manufacturing plant.
Therefore, auto ancillaries play a key role in maintaining the quality and price of the product. But till the entry of MUL in the Indian car industry, vendor development was hardly seen as a part of automobile manufacturing in the country. With the setting up of auto component manufacturing facilities by Indian promoters, in collaboration with Japanese players for supply to MUL, the country was first introduced to the concept of out sourcing.
With the new entrants planning to start manufacturing facilities with a small capacity base in the country, the role of auto component players will substantially become important over the years.
Presently, some of the luxury car manufacturers import CKD/ SKD kits and just carryout assembly operations in the country. But with strict policy guidelines of the GOI in force, all manufacturers have to opt for 70% indigenisation within five years of starting manufacturing operations in the country. This will further boost the operations of auto component manufacturers in the country
Demand-supply scenario and exports
Demand
The demand for cars in the past was supply driven as demand did not match supply. This led to high premium and long waiting periods for the cars. But change in government policies coupled with aggressive capacity additions and upgradation of models by MUL in the early nineties led to increase in supply and subsequently reduced the waiting periods for economy cars.
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The demand for cars was suppressed by various supply constraints. The demand for cars increased from 15,714 in FY60 to 30,989 in FY80 at a CAGR of only 3.5%. The entry of Maruti Udyog Ltd (GoI-Suzuki JV) in 1983 with a "peoples" car and a more favorable policy framework resulted in a CAGR of 18.6% in car sales from FY81-FY90.
After witnessing a downturn from FY90 to FY93, car sales bounced back to register 17% growth rate till FY97. Since then, the economy slumped into recession and this affected the growth of the automobile industry as a whole. As a result car sales remained almost stagnant in the period between FY97 and FY99. CAGR recorded during the FY94-FY99 period was 14.4%, reaching sales of 409,624 cars in FY99. However, during FY2000, with the revival of economy, the segment went great guns posting a sales growth of 56%yoy.
The table below indicates the past sales trend for cars -
Cars FY94 FY95 FY96 FY97 FY98 FY99 FY2000 Volume 209,203 264,822 345,486 410,992 417,736 409,624 638,815 Growth %yoy 27.0 27.0 30.0 19.0 2.0 -2.0 55.8
Source : SIAM
Supply
The supply of cars in Indian industry till 1991, was dependent upon the production capacity of individual players. The production of cars has increased from 42,475 units to 181,420 units from 1981 to 1991 respectively. The growth in production of cars has varied in the last three decades from just 1% in 1970-80 to 21% in 1980-90 and above 15% in 1991- 96. The table below gives the production numbers of passenger cars in the past few years.
Cars FY94 FY95 FY96 FY97 FY98 FY99 FY2000 Production 207,658 264,468 348,146 407,539 401,002 390,355 577,243 Growth %yoy 27.2 27.4 31.6 17.1 (1.6) (2.7) 32.4
Source : SIAM (excludes the figures related to Daewoo and Honda Siel)
The major increase in production of cars in the 80's was due to the entry of MUL in 1983, which helped increase car production by 20,000 to 30,000 cars per annum till the early nineties.
With the entry of MUL, the face of the passenger car industry changed forever. Existing producers who had operated in a protected, high margin environment faced the prospect of not just diminishing market share, but a shift in focus from producing vehicles to selling them. But MUL made use of the opportunity open to its technologically superior product and increased its capacity from 100,000 cars in FY90 to 240,000 cars in FY96 and 350,000 cars in FY98.
This has helped in increasing the number of models available to the customer from 8 to 30 and hence provided a wide choice to him. This has also helped in reducing the average waiting period and premium on cars, which were a part and parcel of car cost in the eighties.
Market share
The market shares of leading players and recent sales figures are as given below.
Sales in Nos. Company Market Share as on
May, 2001 September, 2001
October, 2001 % Change
Maruti Udyog 52.4% 28,745 20,172 – 29.82 Hyundai Motors 14.4% 6,781 7,734 14.05 Telco 9.9% NA NA – Daewoo Motors 11.5% NA NA – Hindustan Motors 3.9% 1,653 1,565 –5.32 Ind Auto 2.1% NA NA – Honda Siel 1.7% 1,149 740 –35.60 Others 4.1% NA NA –
Source : SIAM
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MUL has lost market share during the past two years. From a high of around 80%, it has now come down to 52.4% in FY2001. Offerings from new players like Ford, Hyundai, Daewoo and Telco have captured a substantial market share from MUL. PAL Puegeot and Fiat India, which have commanded a good part of the market in FY97, have now fallen back on hard times.
During FY2000, the passenger car rally was as usual headed by the economy cars. Maruti which is facing a constant threat from Hyundai (Santro) and Daewoo (Matiz), came out with Japan's largest selling model Wagon R. Also, the mid sized segment saw some action signifying its growth potential. The car market which had witnessed a flurry of new launches in the economy segment in FY99, was now party to sleek entrants in the mid sized segment from Hyundai (Accent), Ford India (Ford Ikon), Daewoo (Nexia) and Fiat India (Siena). Also MUL (Baleno and Versa) and GM (Opel Corsa) belonging to the higher end mid sized segment also hit the ramp. The constantly escalating competition in the economy segment forced the players into further price cuts. Recently, Maruti lowered the prices of its economy cars by as much as Rs40,000.
Capacity
The present production capacities is detailed in the table below. This has increased from an estimated 600,000 units in FY98 to the present 727,000 units in FY2000.
Car Capacity FY2000 Expected
Maruti Udyog 250,000 350,000
Hyundai 110,000 130,000
Telco 100,000 150,000
Daewoo 72,000 130,000
Ford India 50,000 70,000
Fiat India 60,000 60,000
General Motors 25,000 100,000
Honda Siel 30,000 30,000
Hindustan Motors 30,000 50,000
Total 727,000 1,070,000
Thus, capacity utilization in FY2000 stands at 79.4%. This is still better than utilization levels the world over which stands at around 40%. Production capacities is expected to increase in the next two years as players introduce new models. The major increase in supply, as was witnessed in FY2000, will be in the mid-size and luxury segment. The supply in the future, taking into account the plans announced by the car majors is expected to grow to 1,070,000 cars by 2002.
Exports
The passenger car exports in the eighties and early nineties had been very negligible as the companies were facing capacity constraints, that was not even sufficient to supply to the domestic market. The poor quality of cars compared to international standards led to poor quantity of exports from the country.
In 1985, MUL started exporting cars to neutralize the impact of foreign exchange outflow. The exports of MUL increased from 100 cars in FY87 to 6,000 cars in FY90. The exports witnessed further momentum in the nineties to reach a volume of 37,161 in FY97. But from FY98 onwards, a southward trend was witnessed with declining sales of 20% yoy to 29,747 vehicles. The same continued in FY99 with a further drop of 14%yoy to 25,464 units. FY2000 too saw lackluster exports with a 9% fall in export sales which touched 23,271 units. The reason for sharp drop in car exports has been a drop in MUL exports, which now accounts for 90% of the country's total exports.
In the longer run, as the industry matures, exports should increase as manufacturers strive to attain economies of scale, which will not be possible given the relatively small size of the domestic market.
Overview
The modern day passenger car is a modern economy's draught animal, driving the growth of upstream industries like steel, iron, aluminum, rubber, plastics, glass, and electronics and down stream industries like advertising and marketing, transport and insurance. The car industry generates large amount of employment opportunities in the economy. For example in the US, every sixth worker is involved in the making of an automobile.
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The world car production has increased from 44.66mn in 1996 to an estimated 48.3mn cars in 1999. Japan, Canada and USA brought about the major increase, which contribute to 53% of the world's car production.
The USA and Japan are the leaders with around 42% of the total world market. However, since the last two to three years, the international passenger car industry has been witnessing an over capacity of more than 30%. The trend suggests that industry volumes may grow by just 2% or around 10mn vehicles per year. If this situation continues for the next few years the world car market may witness shakeout in the near future. Already signs towards this are being observed as the phenomenon of mergers catches on. As per industry experts the number of major players in the world car market may come down from present level of 30 to 5 in next ten to fifteen years. The recent mergers in the international car market are Ford-Volvo, Renault-Nissan, Daimler-Chrysler. A few more players are expected to join the fray in the next few years so as to strengthen their hold in the world market.
Among the top car manufacturing companies General Motors and Ford Motors group of USA lead with acontribution of 15.8% and 11.6%, of world car production, respectively. Volkswagen and Toyota stand third and fourth with more than 9% contribution each to the world car production.
The market of Western Europe is spread out more or less evenly among four big players who account for more than 40% of the market. The largest player is Volkswagen, which has market share of around 11.5%. GM and Renault come in next with a market share of around 11% each. They are followed by Ford, Peugeot, Fiat, and Mercedes Benz (all with market share of more than 5%). Toyota is the highest selling Japanese brand with a market share of 3.2%.
International trend
The global automotive car market is growing at a rate of only 2% per annum and is not expected to pick up in the near term. Growth has dropped due to the increasing levels of saturation in the larger car markets of the world. Worldwide the trend is towards ensuring that one's products are superior in terms of quality. This will enhance the useful life of cars and, hence, slow down growth in sales.
The global domination of the larger automotive manufacturers is slowly on the wane and the trend in sales is shifting towards more "regio-centric" products. Automakers that have been enjoying a generally prosperous spell would have to rethink on the way vehicles are designed, manufactured, distributed or sold. Already, players like GM, Volkswagen and Toyota have begun to re-examine their dealer relationships and pricing strategies. Carmakers would now have to think in terms of a new customer focus and provide better financing and servicing. Strategic tie-ups, mergers and acquisitions have become the talk of the day. A few instances are Daimler Benz's tie-up with Chrysler of the US, Ford's acquiring of Daewoo and tie up with Volvo Car Corporation and Renault acquiring a stake in Nissan. Such deals would certainly lead to economy in terms of costs but it remains to be seen whether they will also create significant new opportunities for growth.
Hindustan Motors Limited
HML is involved in the manufacture of passenger cars, heavy commercial vehicles, utility vehicles, car engines, earth moving equipment like dumpers, loaders etc, power shift transmission (power product division) and management consultancy services.
The current range of automobile products include the Ambassador and Contessa cars (both petrol and diesel versions), Trekker (an utility vehicle) and Bedford trucks (exported as CKDs to Bangladesh). It recently launched the Mitsubishi Lancer model of cars in the mid-size segment.
Automobile division
The company sold 26,860 vehicles as compared to 20,115 vehicles in FY99. Sales of its 'Ambassador' model has been lying stagnant at a little more than 1,500 units per month in FY2000. The company has a CNG version of the car called 'Ambassador 1800' which is Euro II compliant. The Ambassador today has lost its earlier dominant status on Indian roads. Other than government orders, the Ambassador has some latent demand in semi-urban and rural areas, where it scores because of its sturdiness. The car is also exported to the UK, Japan, Sri Lanka and Bangladesh.
The company started commercial production of the ‘Lancer’ car in October 1998. Sales of the car has been steady at around 720 units per month in FY2000. The car is presently available in three variants - GLX, SFX and SLX. Dealership networks have been established in most of the important cities of the country and are equipped to provide sales, service and spare parts under one roof. The company is also planning to introduce a CNG version of the car. The car was adjudged the best in the JD Power Survey for two consecutive years. Sales of its ‘Contessa’ model has been languishing at around 20-22 units per month. The company has a market share of 4.2% in FY2000 as compared to 4.9% in FY99.
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The company is also planning to assemble the Proton car model for which it will import parts from Malaysia. It also has plans to import the 'Pajero' model to India.
Sales of its utility vehicles has also suffered during FY2000. The company sold 2,649 units during the year as compared to 2,938 units in FY99. It has a market share of 2.1% in the segment. The company has planned to come out with a new range of its rural transport vehicle - called the ‘Ranger’.
Earth moving equipment division The company sold 581 earth moving equipments including bulldozers, dumpers, scrapers, loaders, shovels etc in FY2000 as compared to 677 units in FY99. Sales were affected by the fact that recessionary conditions continued to prevail in the mining industry, particularly in the cement and coal segments. With a renewed emphasis placed on infrastructure development by the Government of India, the company expects better sales growth in the current financial year. However, there is one area for concern. The company’s license partner, Caterpillar of the USA, has obtained permission from the government to manufacture a range of excavators, track-type tractors and off-highway trucks. Though these products are not covered under the license agreement, there will remain concerns about the long term competitive scenario in the sector.
Power products division
The division sold 303 transmissions in FY2000 as against 400 in FY99. Sales was affected due to lower sales offtake by OEMs. During the year, the company entered into an arrangement with Allison Transmissions Division of General Motors, USA for marketing on-highway transmissions. As part of the arrangement, HML will start marketing these transmissions from FY01 and would later review local production depending upon volumes.
Exports
During FY2000, HML exports of transmissions, Isuzu make petrol engines and CKD kits and truck parts amounted to Rs147mn.
Expansion plans
With most of the projects been commissioned, HML's expansion and modernization schemes have more or less been completed during FY2000. During the year, the company introduced upgraded versions of the 'Ambassador - Classic 1500 Diesel' and 'Trekker'. Earlier, HML implemented a Rs750mn modernization program at its Uttarpara plant.
Outlook The near term outlook for HML does not seem positive. The ‘Lancer’ has been well accepted by the market but being in the premium segment, the market for its is still limited in the country. The company’s seemingly outdated ‘Ambassador’ and ‘Contessa’ models are not expected to pose any major threat to the other car models currently plying our roads. The UV segment is expected to grow in FY01 as various infrastructure projects getting off the ground. UVs are the preferred mode of transportation to project sites. It has done well by planning to introduce five new variants of its rural transport vehicle. However, the company’s presence in the segment is a minor one and, moreover, it has to contend with competition from new customized models being introduced by both local and foreign players. HML’s future success could well depend upon the success of its new offerings.
Net sales recorded a 22%yoy growth on the back of growth in volume sales of automobiles. PBIDT margin continued to suffer, dropping to 5.9% from 7.2% in FY99. This was due to a sharp rise in the price of raw materials. The rise could be attributed to a larger proportion of imported raw materials which went up to 48% from 37% in FY99. Unit prices of CKD assemblies increased sharply while that of steel sheets, plates and flats fell. Other expenses and employee costs, however, dropped as a percentage of net sales in FY2000. This helped in keeping total cost of sales at 94.8% of net sales as compared to 93.8% in FY99. As in the past year, the bottomline has been hit by rising interest and depreciation costs. Interest cost has increased by 86% to Rs1.08bn in the past two years while depreciation has increased 72% to Rs429mn in the same period. This has been entirely on account of capex in the 'Lancer' and 'Rural Transportation Vehicle' projects carried out by HML in the past two years. This has meant a more than doubling of the company's losses to Rs622.8mn in FY2000.
Return on networth has remained negative during the year. Return on capital employed dropped to 5.7% from 6.4% in FY99 despite a fall in net worth mainly due to a transfer of Rs500mn from the general reserves to the Profit & Loss account. Turnover ratios, however, improved on the back of a fall in working capital and fixed assets. The rise in the debt portfolio has been arrested during the year with total debt rising by only Rs208mn as compared to Rs1.14bn in FY98 and Rs1.38bn in FY99. However, the debt-equity ratio deteriorated sharply to 3.2x from 2.2x in FY99 as a result of a fall in net worth. Current and interest cover ratios remained more or less stagnant.
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Cash losses increased sharply during the year mainly as a result of higher pre-tax loss. Cash used in trade working capital has decreased by Rs4.4mn after rising sharply by Rs357mn last year. As the company has more or less completed its investments in capex, fixed asset portfolio increased by just Rs124mn this year as compared to Rs1.45bn in FY98 and Rs1.14bn in FY99. Coupled with a fall in the investment portfolio, cash used in financing activities fell by Rs30.5mn as compared to an increase of Rs1.08bn last year.
Profit & Loss Account
Rs. mn Period ended 03/98 03/99 03/00 03/01
No. of months 12 12 12 12
Gross Sales 12,987.3 14,744.6 18,127.0 16,841.5
Excise Duty (2,952.5) (2,563.2) (3,159.7) (2,952.6)
Net sales 10,034.8 12,181.4 14,967.3 13,888.9
Other income 90.1 115.9 118.2 1,088.5
Total income 10,124.9 12,297.3 15,085.5 14,977.4
Raw materials 6,056.7 8,186.3 10,818.8 9,631.0
Stock adjustment (Inc)/ Dec (194.3) (60.1) (111.5) 642.0
Cost of material 5,862.4 8,126.2 10,707.3 10,272.9
Employee cost 1,393.3 1,463.4 1,545.6 1,558.6
Power & fuel 236.1 224.2 279.2 266.9
Advertising/ promotion/ public 12.1 21.8 11.6 5.8
Other expenses 1,305.2 1,588.4 1,652.0 1,608.1
Cost of sales 8,809.1 11,423.9 14,195.8 13,712.4
PBIDT 1,315.8 873.3 889.7 1,265.0
Interest & finance charges 583.2 834.6 1,082.1 1,001.3
PBDT 732.6 38.8 (192.4) 263.7
Depreciation 249.6 320.5 429.4 452.5
PBT 483.1 (281.7) (621.8) (188.8)
Provision for taxation 89.5 0.8 1.0 0.9
Extraordinary items/ Prior year adj. 85.9 4.7 7.0 210.5
Adjusted PAT 479.5 (277.8) (615.8) 20.8
Dividend payout 118.2 - - -
Forex inflow 276.1 1,581.8 1,148.2 147.0
Forex outflow 1,568.1 3,316.7 2,833.1 2,805.6
Book value of quoted investments 52.7 52.7 51.0 51.0
Market value of quoted investments 114.9 80.1 40.6 26.7
Investment in affiliate/ subsidiary 2.5 2.5 2.5 2.5
Contingent liabilities 911.9 1,312.1 2,115.1 1,272.6
11
Balance Sheet
Rs. mn
Period ended 03/98 03/99 03/00 03/01
No. of months 12 12 12 12
SOURCES OF FUNDS
Equity capital 1,075.7 1,078.3 1,078.3 1,612.6
Capital reserve 0.4 230.0 180.0 133.2
Share premium account 267.9 243.9 149.2 149.2
Profit & Loss/ General reserve 1,222.9 945.1 329.3 350.1
Other reserves 435.4 199.8 192.8 27.1
Reserves and surplus 1,926.6 1,618.8 851.4 659.7
Net worth 3,002.3 2,697.1 1,929.7 2,272.2
Secured loans 4,315.7 5,227.3 5,371.0 3,439.7
Unsecured loans 205.2 678.5 742.4 434.3
Total debt 4,520.9 5,905.7 6,113.4 3,874.0
Capital employed 7,523.3 8,602.9 8,043.1 6,146.2
APPLICATION OF FUNDS
Gross block 6,760.5 7,710.8 8,190.2 7,246.0
Accumulated depreciation (2,593.9) (2,891.1) (3,336.7) (3,187.4)
Capital work in progress 186.4 356.2 17.1 2.2
Total fixed assets 4,353.0 5,175.8 4,870.6 4,060.8
Investments 305.9 305.8 219.1 134.0
Inventories 2,549.1 3,845.6 3,375.5 2,116.2
Sundry debtors 1,532.4 2,368.2 2,215.0 2,019.5
Cash & bank balance 536.2 412.9 348.0 241.7
Total loans & advances 623.1 556.2 488.3 492.0
Sundry creditors/ Acceptances (2,028.0) (3,395.6) (3,056.7) (2,611.0)
Other liabilities (308.5) (367.9) (233.1) (273.3)
Provisions (121.6) (470.0) (324.8) (173.1)
Net current assets 2,782.7 2,949.3 2,812.1 1,811.9
Miscellaneous expenses 81.7 171.9 141.3 139.5
Capital deployed 7,523.3 8,602.9 8,043.1 6,146.2
Daewoo Motors India Ltd
DMIL is involved in the production of passenger cars and LCVs. It also manufactures transaxles and other spare cars.
DMIL also manufactures LCVs and sold 89 units in FY99 as compared to 364 units in FY98. Sales of LCVs contributed to less than 1% to the gross sales turnover. The rest of the turnover comes from sale of spare parts (mainly engines and transmissions), which amounted to Rs269mn in FY99 as compared to Rs302mn
12
DMIL is a 92% subsidiary of Daewoo Corporation of Korea. The Daewoo group has 12 firms within its fold out of which one is Daewoo Motors, which had sales of US$3.6bn in 1999. The company is the one of the leading carmakers in the world and had a share of 0.6% (3.1mn cars) of the world market. However, in recent years, with the South Korean economy passing through difficult times, the group has seen its debt burden rise to a huge US$27bn. These developments have been responsible for the company’s low valuations. The group is on a restructuring course with its stake in DMIL getting transferred to Daewoo Motors. The management at DMIL has come out with products, which have been received well in the market. Its strategy of focusing on exports will pay in the long run as the Indian market gets more and more competitive DMIL posted a loss of Rs401.3mn in FY99 mainly due to the lower capacity utilization on account of tough competition from the host of existing and new entrants in the passenger car market. The company launched ‘Matiz’ in the high selling small car segment in October 1998 and a mid-size car ‘Nexia’ in April 1999. Its old ‘Cielo’ model was also upgraded during the year. FY2000 started well for the company thanks largely to the fact that the market gave an encouraging response to Matiz. Extending its presence in the higher reaches of the passenger car segment, DMIL has introduced Nexia, which has also been well received in the market. The company also has a minor presence in the light commercial vehicle (LCV) market. .
The past few months has seen DMIL’s sales increase in both the domestic and export markets especially after the launch of Matiz. However, this has put strain on its working capital requirements, which has seen the company posting losses due to higher interest costs. This has forced the company to raise funds through an equity offer to its Korean plant. With a very high debt portfolio of Rs30bn on a networth of nearly 7.5bn, the company plans to issue shares of about US$100mn on a preferential basis. Performance in the first half of FY2000 has been excellent with sales rising by 63%yoy to Rs1.91bn. However, with interest cost rising to Rs163.3mn from Rs9.4mn, losses mounted to Rs138.7mn.
Exports
DMIL has increased its exports of its passenger cars in FY99. The company has exported 300 Matiz cars to Egypt and a small number is also exported to Sri Lanka. It has also got orders to export 2,500 Matiz's to Europe. Export of engines and transaxles to Daewoo, Korea has continued during the year.
Future plans and outlook
DMIL has achieved about 92% localization of the Cielo and Nexia models while for Matiz it is 74%. The company has entered into JVs with several vendors for localizing components and the process is set to continue in the years to come. The company is also working towards bringing more models in the Indian market including one in the utility vehicle segment. It plans to launch the "Legnaza" (1800-2000cc) and the "Nubira" (1500-1700cc) car models. The company has plans to increase capacity to 150,000 cars by 2001 from the present 72,000. Its Korean parent plans to source about 6% of its global requirement from its Indian subsidiary by 2002.
The passenger car segment is set to grow at a rate of 25% pa in FY2000 and 15% in the next two years. This would certainly benefit players in the car segment and DMIL, with the advantage of strong parental support, should do well. However, with capacity utilization of only around 12% in FY99 and a huge debt portfolio, DMIL faces high interest cost, which would put pressure on bottomlines. Moreover, concerns as to the overall disintegration of the Daewoo group could act as a damper.
13
Profit & loss account
(Rs. mn)
Period ended 03/98 03/99 03/00 03/01
No. of months 12 12 12 12
Gross sales 9,456.5 3,835.0 3,598.5 12,419.6
Excise duty (2,784.3) (781.2) (942.7) (2,863.6)
Net sales 6,672.1 3,053.8 2,655.8 9,556.0
Other income 189.1 584.3 160.2 661.6
Total income 6,861.3 3,638.1 2,816.0 10,217.7
Raw materials 6,061.3 1,305.3 1,417.9 5,560.2
Stock adjustment (Inc)/ Dec (1,434.3) 869.7 67.9 197.3
Purchase of finished goods 250.1 239.0 131.4 125.2
Cost of material 4,877.1 2,414.0 1,617.1 5,882.8
Employee cost 304.8 407.2 498.0 604.0
Power & fuel 67.6 105.1 86.4 116.4
Advertising/ promotion/ public 372.9 614.0 259.8 -
Other expenses 682.4 313.4 369.4 1,530.7
Cost of sales 6,304.8 3,853.8 2,830.7 8,133.9
PBIDT 556.5 (215.7) (14.6) 2,083.8
Interest & finance charges 394.4 33.6 214.6 1,151.9
PBDT 162.0 (249.4) (229.3) 931.9
Depreciation 127.7 177.9 181.7 2,092.4
PBT 34.3 (427.3) (411.0) (1,160.5)
Provision for taxation 2.1 - - -
Extraordinary items/ Prior year (17.9) - 9.6 -
Adjusted PAT 14.3 (427.3) (401.3) (1,160.5)
Forex inflow 175.7 505.2 1,194.3 1,982.3
Forex outflow 21,733.3 1,825.6 2,939.4 3,546.8
Book value of quoted investments - - - 170.0
Market value of quoted investments - - - 173.4
Contingent liabilities 419.1 156.6 48.5 6.9
14
Balance sheet
(Rs mn)
Period ended 03/98 03/99 03/00 03/01
No. of months 12 12 12 12
SOURCES OF FUNDS
Equity capital 5,111.8 5,111.8 5,111.8 5,111.8
Share premium account 2,814.5 2,814.5 2,814.5 2,814.5
Profit & Loss/ General reserve 48.0 (379.3) (780.7) (1,941.2)
Other reserves 1.5 1.5 1.5 1.5
Reserves and surplus 2,864.0 2,436.7 2,035.4 874.9
Net worth 7,975.8 7,548.5 7,147.2 5,986.7
Secured loans 16,592.4 21,058.5 28,263.3 27,713.4
Unsecured loans 8,853.9 9,574.5 8,591.8 6,043.1
Total debt 25,446.3 30,633.0 36,855.1 33,756.5
Capital employed 33,422.0 38,181.5 44,002.3 39,743.1
APPLICATION OF FUNDS
Gross block 2,347.8 3,186.6 39,433.4 40,513.2
Accumulated depreciation (421.4) (600.5) (815.4) (2,859.9)
Capital work in progress 23,427.8 29,365.0 164.6 52.9
Total fixed assets 25,354.2 31,951.2 38,782.6 37,706.3
Investments 15.6 69.8 84.2 231.4
Inventories 5,214.2 4,084.5 3,944.0 2,683.6
Sundry debtors 2,181.2 1,212.5 779.1 782.2
Cash & bank balance 1,356.3 577.5 489.3 976.2
Total loans & advances 1,192.2 1,786.0 1,901.7 639.6
Sundry creditors/ Acceptances (895.2) (849.6) (1,439.0) (2,850.3)
Other liabilities (1,202.6) (1,065.9) (1,094.1) (719.1)
Provisions (10.6) (11.0) (13.7) (20.7)
Net current assets 7,835.6 5,734.0 4,567.3 1,491.4
Miscellaneous expenses 216.7 426.6 568.2 314.1
Capital deployed 33,422.0 38,181.5 44,002.3 39,743.1
15
Part E : Caselets (50 Points)
• This part consists of questions with serial number 7 - 13.
• Answer all questions.
• Points are indicated against each question.
• Do not spend more than 80 - 90 minutes on Part E.
Caselet 1
Read the following caselet carefully and answer the following questions:
7. If the debt is low cost source of finance then why do the corporates at all go for additional equity issue? Discuss.
(7 points)
8. Describe briefly the theories relating to the level of debt and its impact on the cost of capital.
(7 points)
9. Some companies who earlier had gone for high doses of debt have now embarked upon corporate debt restructuring. What pitfalls do you see in this strategy?
(6 points)
Traditionally, debt has been a low cost source of finance as compared with the equity market and usually companies have found it to their advantage that some amount of their capital requirement comes from debt. The interest paid to creditors is tax deductible in most countries. Another advantage of debt is that it does not dilute the ownership of the business and the cost is limited to the interest paid till the time the principal is to be returned back. In addition, the interference of creditors in the affairs of the business is minimal unless they supply a very large amount of the capital, which retains the operational freedom of the management in conducting business. Further, creditors are only interested in the return of their funds and the return on investment thereon. Prior to liberalization, companies depended heavily on institutions like IDBI, ICICI and banks for their long-term and short term funding requirements respectively. But after liberalization, the development in the debt markets has led to the use of debentures, corporate bonds and commercial paper. In addition, the decade of reforms was also a time when many business were on an expansion spree and the off-take of debt was good from all the various sources along with the booming equity markets.
Firms such as Steel Authority of India Ltd. (SAIL) undertook huge amounts of funds for modernizing their plants. Other such as ITC, Essar Steel, Tisco etc., also took in a lot of loans for various reasons in the high interest rate regime. Arvind Mills is another example of a company, which put all its money (borrowed though) on the hope of an expanding denim market.
There are a number of theories regarding the significance or the lack of debt in the capital structure of the firm. There have been extreme views ranging from a decided impact to those, which maintain that the existence or non-existence of debt has nothing to do with the valuation of a firm. Each view offers its own examples but the fact remains that the use of debt does have some impact on the profitability of the company. An empirical study on the correlation between debt and various other ratios of companies, which was conducted on a sample of 208 companies covering a span of eight years between 1978 to 1986 proves that there is correlation between the companies. The study indicates a strong negative correlation between the growth rate in EBIT and a firm’s debt levels. The study further found that firms whose size is increasing are using a higher debt ratio.
The falling interest rates have triggered debt restructuring, retiring high cost loans across corporate India. A study conducted by one of the leading newspapers showed that 218 companies in the private corporate sector retired secured and unsecured borrowings of Rs.64.62 bn during the financial year 2000 – 01. During the same period these firms repaid secured loans of Rs.54.26 bn and unsecured loans of Rs.10.36 bn, with most of the repayment being of bank loans (71.02). In addition, they also paid off Rs.10.12 bn in loans from the financial institutions.
16
Caselet 2
Read the following caselet carefully and answer the following questions:
10. How does outsourcing result in better performance of corporates?
(8 points)
11. As per the caselet 20 to 25% of all outsourcing relationships (Manufacturing, finance, information tech and so forth) fail within 2 years and 50% fail within five. What are the reasons for such failures?
(8 points)
If all manufacturers sang from the same hymnal—and many do—they would outsource almost everything: management gospel holds that manufacturing is too labor- and capital-intensive to support the high margins and fast growth that investors demand. Indeed, Standard & Poor’s reports that in the year 2000, the market-to-book ratio of the S&P 500 was six times greater than it had been in 1981—a reflection of the declining importance of tangible assets.
Such pressures and perceptions make outsourcing an almost irresistible impulse for manufacturers. Obviously, the decision to outsource usually doesn’t produce such a drastic outcome; done right, outsourcing manufacturing or services can deliver game-changing levels of value. But by assuming that outsourcing is the answer rather than critically assessing its pros and cons, companies may be failing to do what really matters: improving a company’s performance and maximizing value. Outsourcing can be instrumental in realizing these goals—but not always.
We are not suggesting a return to the time when Ford’s River Rouge complex made its own glass, steel, and tires; an original-equipment manufacturer facing the complexities and asset intensiveness of that level of vertical integration would now collapse under its own weight. Indeed, about two-thirds of the North American auto industry’s $750 billion in value now resides with suppliers. This year, the average electronics OEM was hoping to outsource 73 percent of its manufacturing, according to Bear Stearns, and 40 percent of all OEMs were hoping to outsource the manufacture of 90 percent or more of their final product. Pharmaceuticals companies have been witnessing the emergence of a $30 billion contract drug-development and -manufacturing market with annual growth rates of 17 to 20 percent. In general, the outsourcing of operations and facilities across industries rose by 18 percent in the period from 1999 to 2000.
In the wireless-telephone industry, as well, important players are grappling with such make-or-buy questions. One of the industry’s most aggressive practitioners of outsourcing has found that it alone doesn’t satisfy the investment community. By contrast, industry leader Nokia has been working to improve the productivity of its existing assets and to integrate its sourcing, sales, and manufacturing efforts. The company has designed its new Beijing complex, for example, to assemble phones with zero inventory for the supply base that it manages and the functions it hasn’t already jobbed out.
Many practitioners of outsourcing clearly recognize that some difficulties exist. One-fifth of the executives in a recent survey say that they are dissatisfied with the results of their outsourcing arrangements, while another fifth of the respondents say that they are neither satisfied nor dissatisfied—which suggests that they are not seeing clear benefits. Dun & Bradstreet reports that 20 to 25 percent of all outsourcing relationships (manufacturing, finance, information technology, and so forth) fail within two years and that 50 percent fail within five. Nearly 70 percent of the companies responding to a Dun & Bradstreet survey asserted that suppliers "didn’t understand what they were supposed to do" and that "the cost was too high and they provided poor service” .
Therefore, whether to outsource is one of the most significant decisions any executive team ever makes.
17
Caselet 3
Read the following caselet carefully and answer the following questions:
12. Do you feel that before crash of NASDAQ the dot-coms have been unduly valued very high? Justify your answer.
(6 points)
13. Can an old valuation tool like Discounted Cash Flow (DCF) be used for valuing dot-coms? Explain.
(8 points)
It was inevitable. Last year's decline in the NASDAQ composite index brought a sudden halt to a heady—some would say reckless—time for investors and acquisition-minded companies, particularly those focused on anything and everything connected with the Internet. Predictably, this slump has now sent the pendulum swinging in the other direction: many investors are staying away from the sector entirely, and established brick-and-mortar companies are scaling back their on-line initiatives. The survival of even leading Internet firms is being questioned.
Although investors and companies can no longer throw money at every dot-com idea, they shouldn't abandon the Internet. In the business-to-consumer (B2C) market, companies can sell physical products, services, information, entertainment, and financial products; earn revenue from advertising; and collect fees for facilitating transactions. In short, B2C companies must collect their revenue either from consumers or from other businesses that use their sites to reach consumers. Sources of revenue are similar in the business-to-business (B2B) market.
Be cautious about business models based on future revenue for anything that people wouldn't pay for today. America Online managed to build its business on membership fees from the start by offering consumers something they were willing to buy. Yet too many so-called lifestyle sites first aim to build a user base and then try to figure out how to generate revenue from sources beyond mere advertising. Similarly, Internet banks that use low prices and little else to lure customers could well see cost-sensitive ones go elsewhere when prices rise.
Industries earn high returns on capital if their products, such as patented pharmaceuticals, are non-substitutable and legally protected; if branding is important and consumers are indifferent to price; and if a product, such as Microsoft's Windows operating system, becomes more valuable to customers as more people use it.
How big is the relevant market?
Most analysts focus on the size of a market, but these estimates can be inflated or even irrelevant. Many Internet companies, for example, rely on advertising for revenue, but it is fairly certain that ad expenditures will be a relatively small part of the total economy, though they might rise somewhat over time.
Be wary, too, of the way companies assess the size of the relevant market or even measure their own revenue. In airline travel services, for example, the relevant market isn't the entire revenue of the airlines but rather the much smaller fees that they pay to on- or off-line agents.
Finally, ask yourself if the management, technology, brand, and head start of a company will allow it to beat the industry average. Keep in mind that few companies do so for long
END OF PART E
END OF QUESTION PAPER
18
Suggested Answers Strategic Financial Management – II : January 2002
Part D : Case Study
1. Daewoo Motors India Limited. Cash flow statement (Rs.mn)
Period ended 03/01
a. No. of months 12
b. Pre tax income from operation (1,822.1)
c. Depreciation 2,092.4
d. Expenses (deferred) / written off 254.1
e. Other income / prior period adj 661.6
f. Tax –
g. Cash profits (b + c + d + e + f) 1,186.0
h. (Inc) / Dec in trade working capital
- Inventories 1,260.4
- Sundry debtors (3.1)
- Sundry creditors 1,411.3
- Other liabilities (375)
i. Net adjustment 2293.6
j. Operating activities (g + i) 3479.6
k. (Inc)/Dec in fixed assets [38,782.6 – (37,706.3 + 2092.4)]
(1016.1)
l. (Inc)/Dec in investments (147.2)
m. (Inc)/Dec in loans & advances 1,262.1
n. Investing activities 98.8
o. Inc/(Dec) in debt (3,098.6)
p. Inc/(Dec) in equity/premium –
q. Direct add/(red) to reserves spl. Item –
r. Financing activities (3,098.6)
s. Cash generated / (utilized) 479.8
t. Cash at start of the year 489.3
u. Cash at end of the year 969.1
Since, the financial statements available in the case are in abridged form, hence, a minor difference of Rs.7.1 mn is noticed in the final cash amount appearing in balance sheet from that arrived above.
2. Since the details for raw material, work-in-process and finished goods do not appear separately in the financial statements let us club them.
Assumptions i. A year consists of 365 days ii. Value of cost of sales has been taken as a substitute for cost of goods sold iii. Minimum cash balance required is the average cash balance of the company over last 4 years.
19
Therefore, for the year ended March 31, 2001:
Duration of inventory = daypersoldgoodofcostAverage
inventoryoflevelAverage
= 365/)4.13712(
2/)2.21165.3375( +
= 73.09 days i.e., 73 days. Duration of Accounts payable
= dayperpurchaseAverage
payablesoflevelAverage
= 365/9631
2/)261107.3056( +
= 107.4 days. Duration of Accounts receivable
= daypersalesAverage
sReceivableoflevelAverage
= 365/9.13888
2/)5.20190.2215( +
= 55.64 days. Hence operating cycle = 73 + 55.64 – 107.4 = 21.24 days For weighted operating cycle the durations of inventory and accounts payable should have corresponding
weights
Weight for inventory = salesNet
soldgoodofCost =
9.13888
4.13712 = 0.987
Weight for Accounts payable = SalesNet
MaterialRawofCost =
9.13888
9.10272 = 0.74
Weight for Accounts receivable = 1 Weighted operating cycle = 0.987 × 73 + 1 × 55.64 – 0.74 × 107.4 = 48.22 day
As sales per day = 13888.9/365 = Rs.38.05 mn Hence working capital required for the company = 48.22 × 38.05 + minimum cash balance = Rs.1834.86 + minimum cash balance Average cash balance of the company over 4 years
= 4
7.2413485.4122.536 +++ = Rs.384.7 mn
Therefore, working capital required for the company for present level of operation = 1834.86 + 384.7 = Rs.2219.5 mn or say Rs.222.0 mn.
20
3. Let us first calculate the free cash flow of Daewoo Motors
03/98 03/99 03/00 03/01
PAT 14.3 (427.3) (401.3) (1160.5)
Interest (I) 394.4 33.6 214.6 1151.9
I × (1 – Tax) 256.4 21.8 139.5 748.7
NOPLAT = PAT + I (1 – T) 270.7 (405.5) (261.8) (411.8)
Depreciation (Dep) 127.7 177.9 181.7 2092.4
Gross cash flow = (NOPLAT + Dep) 398.4 (227.6) (80.1) 1680.6
Gross investment* 4938.5 6035.7 (2214.7)
Free cash flow – (4710.9) (6115.8) 3895.3
* Calculation for gross investment
Increase in Gross Block 838.8 36246.5 1079.8
Capital work in progress 5937.2 -29200.4 -111.7
Investments 54.2 14.4 147.2
Net current Assets 2101.6 -1166.7 -3075.9
Miscellaneous Expenses 209.9 141.6 -254.1
Gross investment during the year 4938.5 6035.7 -2214.7
Free cash flow has become positive in year ended March, 2001 primarily due to liquidation of investments.
4. Book value of assets as on 03/2001 = Capital employed + Current liabilities = 6146.2 + 2611 + 273.3 + 173.1 = Rs.9203.6 mn Total claim on the firm’s assets = Total debt + Current liabilities = 3874.0 + 2611 + 273.3 + 173.1 = 6931.4 The value of equity share of the company can be understood as the value of the call option on the firm’s
assets where exercise price is substituted by all claims outstanding against the company Using Black and Scholes equation.
C = So N (d1) - )d(Ne
E2rt
and
d1 = tx
t)x5.0r(E
Soln 2
σ
σ++
&
d2 = d1 - σ t
So = 1.1 × 9203.6 = 10123.96 E = 6931.4
d1 = 1x35.0
1x)]35.0x5.0(08.0[4.6931
96.10123ln 2++
= 35.0
1413.03788.0 + i.e., 1.486
d2 = d1 – σ t = 1.486 – 0.35 × 1 = 1.136
N (d1) = N(1.486) = N (1.48) + 0.6 [N(1.49) – N (1.48)] = 0.9306 + 0.6 (0.9319 – 0.9306) = 0.9314 N (d2) = N(1.0824) = N(1.13) + 0.6 [N(1.14) – N(1.13)] = 0.8729 + 0.6 [0.8749 – 0.8729] = 0.8741
21
C = So N(d1) – )d(Ne
E2rt
= 10123.96 × 0.9314 – 8741.0e
4.6931108.0
××
= Rs.3836.54 million.
5. Reasons in favour of merger a. Industry structure justifies merger as the models of Hindustan Motors and Daewoo Matriz both
belong to mid-size segment which is the fastest growing segment in the car industry. b. It will help in improving the Debt equity ratio of merged company. Daewoo has D/E ratio of 5.64
before merger in comparison to 1.13 of Hindustan Motors. c. Hindustan Motor’s will get much needed access to new technology.
Reasons against merger a. Size of balance sheet of Hindustan Motor is much smaller hence it would be an uphill task for them to
arrange such large resource to take over. b. Cultural mismatch may surface as the automaker of ailing South Korean parent is primarily
professionally owned whereas Hindustan Motors is yet under family owned business of Birlas. c. Daewoo will loose the access to newer technology and model which is a prerequisite for survival in
the fiercely competitive automarket.
d. From market share point of view merging of Daewoo with Hundai makes much more sense as a fierce competition may be avoided between the two Korean firms.
6. Comparable Firms Approach
This approach is also called as the relative approach. In this approach, the value of any firm is derived from the value of comparable firms, based on a set of common variables like earnings, sales, cash flows, book value, etc. The most common manifestation of the comparable approach is in the use of the industry average Price-Earnings multiple (P/E ratio) for valuation of equity. Another commonly used tool for valuing equity is the Price-Book Value multiple (P/BV ratio).
The comparable firms model is essentially a top-down approach. The valuation process applying this approach is a four staged exercise. They are:
Analysis of the Firm The valuer is required to make an indepth analysis of the firm to get rich insights into the financial and operational aspects.
The profitability of the firm may be analyzed by looking at the operating profit margins and the net profit margins. Further analysis may be made by analyzing the return on capital employed and return on net worth. The liquidity position may be analyzed from the current ratio and quick ratio. The interest coverage and the debt service coverage would provide pointers to the solvency position. The efficiency of the operations can be captured from ratios like inventory turnover, fixed assets turnover, debtors turnover, etc. The cash flows of the firm need to be carefully studied and a sensitivity analysis may be conducted. The capital structure of the firm also needs to be analyzed.
The qualitative analysis includes assessing the position of the firm in the industry, market share, competitive advantage (if any).
Identification of Comparable Firms The next stage involves identification of comparable firms. This process begins with a thorough analysis of the industry in which the firm operates. The valuer is to carefully assess the general profile of the industry, competitive structure, demand-supply position, installed capacities, pricing system, availability of inputs, government policies and regulatory framework, long-term trends, etc. The next step involves identification of firms with comparable profile. The parameters used for identification of such firms include product profile, scale of operations, markets served, cost structures, geographical location, technology, etc.
Comparison and Analysis The historical financial statements (Balance Sheet, Profit & Loss account and cash flow/funds flow statement) of both the firm being valued as well as the comparable firms are to be analyzed so as to identify the dissimilarities between them. The dissimilarities essentially arise due to variations in accounting policies. Some of the common areas of dissimilarities are method of inventory valuation, depreciation
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policies. Some of the common areas of dissimilarities are method of inventory valuation, depreciation policies, consolidation of accounts with subsidiaries, valuation of intangible assets, provisioning policies, treatment of off balance sheet items, etc. Once the dissimilarities are identified, appropriate adjustments have to be made to make them comparable.
The next step involves computation of a set of key valuation ratios for the comparable firms. The most commonly used ratio is the Price to Earnings multiple. This ratio relates the market value of the firm to the current earnings after tax (PAT). The idea behind applying this ratio is that the valuation of a firm should be based on its proven earnings power.
Valuation of the Firm The final step involves valuing the firm in relation to the comparable firms. This entails applying the multiples identified, to the firm being valued. This is a highly subjective process. This exercise may provide several different values depending on the multiple applied. In such eventuality, average value may be computed based on the values arrived at using different multiples. In case the valuer believes that particular multiple(s) is/are more significant, weighted arithmetic average may be used by assigning appropriate weightages that reflect the relative importance of each multiple.
Valuation of DMIL using comparable company approach In the given case considering the market structure and the product range one company which is comparable to DMIL is Hyundai Motors., Others players who have products in mid-size and luxury segment and who can be compared are Maruti and Telco. Market share of others like Hindustan Motors, Ford India, General Motors, Honda Siel as well as Fiat India are low and do not give confidence for comparision.
Moreover, the financial data of Hyundai, Maruti as well Telco are not available in the case for using the comparable company method to find out value.
Part E: Caselets
Caselet 1
7. At the prevailing interest rate of 12% the cost of post tax debt comes to 12 × 0.70 = 8.4% (Considering effective tax rate of 30%). Compared to this required rate of return of an investor today is 15 – 16%, Therefore, it is really debatable – why should an organization use debt for future fund requirements? The other benefits of debt are
i. It does not dilute the control of present owner ii. The operational freedom is also maintained. Arguably, the debt entails a fixed cash outflow of the organization irrespective of its earnings. As a result in
event of change in business scenario / recession liquidity crisis will arise. It is the prime reason for calculation of leverage ratios; viz, Debt – Equity ratio and interest coverage ratio. A company with high debt-equity ratio (say more than 2:1) and low interest coverage ratio (say less than 2) is perceived as high degree of financial risk. Obviously equity investors will demand a high rate of return to compensate high degree of business and financial risk.
In normal case even if dividend is less or nil the equity holders wait in hope of capital gains later. The dissatisfied investor may sell the share in secondary market and exits. In case of debt the debt holder may like early redemption in view of decreased credibility of the organization or deploy funds elsewhere at higher interest rate thereby putting the company at a disadvantage.
Further as the level of debt increases the restrictive covenants will appear and the operational freedom may be restrained.
8. Different approaches for capital structure decision is given as under: a. Net Income Approach This approach postulates that the cost of debt and the cost of equity of a firm remains constant. Hence,
overall capitalization rate can be changed by varying the financing mix in the capital structure. Normally, the cost of debt is lower than that of equity therefore, with the increase in leverage the overall capitalization rate reduces. However, this decrease is at a decreasing rate.
b. Net approach income approach: This theory assumes that each firm has a predetermined capitalization rate. Further it assumes the cost of debt is constant at all levels of leverage. In case the firm increases leverage by employing debt, it becomes riskier and as a result cost of equity increases.
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c. Traditional approach: This is the only approach which talks of optimal capital structure. The theory postulates that the cost of debt remains constant upto a certain level of leverage and rises gradually thereafter. The cost of equity rises at a slow pace upto a certain level of leverage and increases rapidly thereafter. The cost of capital initially declines due to moderate application of leverage and rises beyond the optimum point.
d. Modigliani Miller Approach: As per it the market valuation of a firm is independent of its capital structure and is determined by capitalizing its expected return at a rate appropriate to its class. Further, the expected yield on common stock is equal to the sum of capitalization rate for a pure equity stream of that specific class and the premium based on financial risk.
9. As in the caselet we find many of the corporates like SAIL, Essar & Arvind etc who had earlier gone for high doses of debt found their dreams getting soared because of changed market. The industrial slump and heavy reduction in the revenues brought the best names to the red and companies began to worry about the ways and means of servicing their massive debt.
The pitfalls of the rest structuring are as under: i. Since most of the corporates are compelled to go for it due to particular situation the resulting capital
structure may not be the one targeted by the company. ii. With the increase of leverage bankruptcy and agency cost increases which may far outweigh the
benefits accrued due to tax shield resulting in increase of cost of capital. iii. If the restructuring is carried out to take advantage of falling interest rates then the asset liability
mismatch of the firm may surface which may push it to liquidity crisis at a later date.
iv. Prepaying the high cost debt may not be always possible due to lock-in period of the debt. Further, there may be some changes for the prepayment. The long term relationship with the FIs may warrant to maintain status quo rather than aggressively shuffling the debt portfolio.
Caselet 2
10. Value chain is the linked set of value creating activities. These activities span right from the supply of basic raw material to the final product delivered to the hand of a customer. No individual firm can span today the entire value chain.
In fact, vertically integrated manufacturing units are no longer the lowest cost producer. Boing, the aircraft manufacturer today does not manufacture their own engine, on even the aircraft body. If they start manufacturing every thing that goes into making a final aircraft then because of the complexities faced by it as well as the due to the level of asset intensiveness the firm would collapse under its own weight. Improved information technology and communications links has helped in global access to vendors and the interaction costs have continuously fallen. For the firm, it has opened the unprecedented choice in structuring their business.
By outsourcing – the companies can avoid their operational bottlenecks and reduce inventory cost substantially. This would as well help in avoiding labour conflicts. Rightly, today the OEMs (Original equipment manufactures) are outsourcing 60 to 70% of their manufacturing.
11. Value chain requires external focus, unlike conventional management accounting in which focus is internal to the firm. If a firm has resorted to outsourcing only to dump operational headaches and inventory cost to the supplier then no benefit can be derived. The component price will increase due to the increased cost of vendors. Each firm must be understood in context of overall value chain of value creating activities. Therefore, if one can reduce the whole chain’s inventory, then only one can be competitive.
Further, each firm develops certain skills and process in due course which distinguish it in the market place. By resorting to outsourcing the firms run the risk of sharing then proprietary information with their vendors which may be used to disadvantage of the firms.
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The pitfall discussed above, clarifies that the companies which go for outsourcing for the prime consideration of cost saving soon run into supplier – management problems. This ultimately results in the failure of outsourcing relationship sooner or later.
Caselet 3
12. During the dot – com boom the investors were queuing up for every dot – com idea. They were primarily guided by the herd instinct to make a big killing. The price of dot – com shares were defying gravity and every one was excited about the imaginative potential of internet. Some of the dot – com shares were having P/E multiple as high as 2000.
Most of the dot – com companies who had started shop of late had no profits and were having negative cash flows. Financial analysts were finding difficult to use traditional tools to value such firms. Some of the tools used were price to sales ratio, time to eye ball and number of clicks etc.
One should remember that ultimate driver for value creation comes from potential revenue for a company and its ability to convert the revenue into cash flows.
This ability is measured by long-term return on invested capital. Since, this aspect was overlooked due to greed and the investors who thronged to internet firms for above normal return have fallen flat.
13. Discounted cash flow (DCF) can be used for the valuation of dot – com firms as detailed under: i. The attempt should be made to project how the company would look like in a state of sustainable,
moderate growth and then work that estimate back to current performance. For internet firms, the economic stability is probably a decade away.
Asking following questions will help in making the estimate: a. How will the company generate revenue? b. What will be average return on capital once the industry matures? c. How big is the relevant market?
ii. Valuation based on a single forecast may be hazardous. Instead, working with probably – weighted scenarios of future performance is more plausible. It will help in highlighting inherent uncertainty in valuing the high growth technology companies. Further, these scenario, should include extreme outcomes, such as very high returns as well as bankruptcy.
iii. Since the revenue projection is based on number of users, it is advisable to use tools like customer value analysis to cross check the value arrived under DCF approach.
However, this fundamental approach to valuation is by no means a panacea. Continual innovation and an ever changing consumer behaviour will ensure volatility and risk will remain an important part of dot –com landscape.
