Finance Group Assignment-Ver(2)

Running head: COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 1

IN DEPTH ANALYSIS OF FINANCIAL DECISION ON COST STRUCTURE

MODIFICATION OF HVA FOODS LIMITED.

(Group Assignment)

By

P.G.T.M Priyankara 2009/MBA/FIN/ WE/05

H.D.W. Abesekara 2009/MBA/WE /06

W.A.N.A Fernanado 2009/MBA/FIN/WE/14

A.A.M.D. Gunathilaka 2009/MBA/WE/30

M.V.G.S Kumara 2009/MBA/FIN/ WE/42

J.B.A.R Niroshana 2009/MBA/WE/71

Semester III – first Half

February, 2011

Course: MBAFI – 601 Corporate Finance

Lecturer: Dr.P.S.M.Gunaratne

Postgraduate and Mid Carrier Development Unit

Faculty of Management & Finance

University of Colombo

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 2

Abstract

The capital structure is the back born of a corporate. Maintaining a superior healthy of it is very

important and merely appears as the life of that corporate. Careful attention and timely taken

corrective action will gives the opportunity of maintaining sustainable competitive advantage in

efficient decision making by the board of directors.

The effort taken in this paper is to understand and determine the capital structures of a

corporate, how & when to do changes and effect of it change and its impacts on cost of capital

and to do a in depth analysis of financial decision taken by the HVA food limited to become best

corporate in near future.

Keywords: Capital Structure, Cost of Capital


Table of Content

Page

Abstract 2

Table of Contents 3

1.0 Introduction 6

1.1 Introduction to the Company 6

1.2 Group Structure 6

1.3 Products Offered 7

1.4 Patents, Trademarks and Brands Owned by the Company 8

1.5 Corporate Structure 8

1.6 Government Support & Regulations 9

1.7 Technology 10

1.8 Future Expectations 10

1.9 Summary of SWOT Analysis 11

2.0 Financials of HVA Foods Limited 11

2.1 HVA Foods Limited- Summarized Income Statement 11

2.2 HVA Foods Limited- Summarized Balance Sheet 12

2.3 HVA Foods Limited- Summarized Interim Income Statement 12

2.4 HVA Foods Limited- Summarized Interim Balance Sheet 12

2.5 Analysis of Financial Ratios 13

3.0 Calculation of cost of capital of the company 16

3.1 Cost of equity 16

3.1.1 CAPM approach 16


3.1.1.1 The Risk Free Rate ( Rf ) 17

3.1.1.2 The Company Beta ( β ) 17

3.1.1.3 Market Rate of Return ( Ṝm ) 18

3.1.2 Discounted Cash Flow Approach 19

3.2 Cost of Debt 19

3.3 Weighted Average Cost of Capital-Pre IPO 20

4.0 Financing For The Business 21

5.0 Options Available for Financing 22

5.1 Mergers and Acquisition 22

5.2 Bank Borrowings(Loans) 22

5.3 Trade Credits 22

5.4 The Factoring 23

5.5 Government Support 23

5.6 Installments buying 23

5.7 The leasing 24

5.8 Initial Public Offers (IPO) 25

5.9 Right Offering 25

6.0

Initial Public Offering IPO

26

6.1 Decision to IPO

26

6.2 Estimating The Initial Capital Requirements 26

6.3 Valuation of share price for HVA Foods (Pvt) Ltd 29

6.3.1 Review and performance analysis 29

6.3.2 Valuation 31


6.4 Underwriting 31

6.5 Association of Investment Bank 31

7.0 Post IPO Evaluation 32

7.1 Capital Structure & Weighted average cost of capital-Post IPO 32

List of References 33


1.0 Introduction

1.1 Introduction to the Company

HVA Foods Limited was established in 1997 as a Board of Investment approved company under

Section 17 (2) of BOI Law No. 4 of 1978 dated September 04, 1997. It was specially set up to

engage in export of value added branded tea, tea extract based products, tea concentrate based

products and a franchise operation. It is a fully owned subsidiary of HVA Lanka Exports

(Private) Limited which was established in 1990 as an exporting arm of HVA International BV

of Netherlands. Subsequently HVA Lanka Exports (Private) Limited became a complete Sri

Lankan business entity and started exporting tea in bulk form to establish its trade network and to

develop a client base.

HVA Foods Limited created its own brand, “HELADIV” in 1996. “HELADIV” is derived from

the word “Heladiva” which symbolizes a home grown product range and a name that could

easily be identified with Ceylon tea. The “HELADIV” brand is registered in 42 countries around

the world and has also been the pioneers in developing Ready-To-Drink iced tea in the Sri

Lankan market.

1.2 Group Structure

HVA Foods Limited is a subsidiary of HVA Lanka Exports (Pvt.) Limited. The structure of the

Company as at 30th September 2010 is depicted below.

100%

99.9999%

Figure 1: Group Structure

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 7HVA Lanka Exports (Private) Limited is the parent company of HVA Foods Limited and is

principally involved in exporting of bulk tea

HVA Foods Limited – The Company is involved in manufacturing and exporting of value added

tea and tea extract based products.

HVA Holdings (Private) Limited – Owns the international brand rights of “HELADIV”.

1.3 Products Offered

HVA Foods Limited is a leader in the manufacturing, marketing and distribution of four major

product categories; value added tea based products, tea extract based products, tea concentrate

based products and its franchise operations. There are about 80 products presently being

marketed under the “HELADIV” brand which includes a range of flavors and presentations

including black tea, green tea, herbal tea, specialty teas, tea concentrate with pure tea extract,

fruit base, and various other value added tea products.

Figure 1: Present Market Concentration

ASIA/FAR EAST USA/CANADA CIS EUROPE

China Canada Russia Germany

Japan USA Ukraine United Kingdom

Malaysia Barbados Latvia Belarus

Singapore Jamaica Lithuania

Taiwan St. Lucia

Thailand St. Vincent

Hong Kong Trinidad


1.4 Patents, Trademarks and Brands Owned by the Company

HVA Foods Limited has the local brand rights for its brand “HELADIV” while HVA Holdings

(Private) Limited; now a 100% owned subsidiary of HVA Foods Limited has the international

brand rights. Internationally, the brand name has been registered in 42 countries. Furthermore,

the Company is also expecting approval for its sub brand “INFINI-T” in the near future.

Given below is the ownership structure of HVA Holdings (Private) Limited from incorporation

to date.

Table 2: Ownership Structure of HVA Holdings (Private) Limited

Entity

No. of

Shares Transferred

Mr. A.R.H. Fernando 1

Mrs. V.S. Amunugama Fernando 1 Transferred

Dothodana Jayantha Gunawardena 1000 Transferred

Vallibel Holdings (Pvt) Ltd. 9368 Transferred

HVA Lanka Exports (Pvt.)Ltd. 18367 Transferred

Lake Drive Holdings (Pvt.) Limited 18367 Transferred

HVA Foods Limited 18367

1.5 Corporate Structure

The Board of Directors

The Board of Directors guides and supervises the business and operations of HVA Foods

Limited. The Board consists of two (02) Non-Executive Independent Directors, one Non-

Executive Director (01) and three (03) Executive Directors including the Chairman. The Board

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 9has the power to appoint the Executive Directors including the Chairman. As at the date of this

Prospectus, the Board comprises of the following six (06) Directors.

Name Age Address Designation

Mr. A.R.H. Fernando 55No. 220,Lake Drive,

Colombo 08Chairman

Mrs. V.S. Amunugama

Fernando41

No. 220,Lake Drive,

Colombo 08Non Executive Director

Mr. H.J.Fernando 27No. 220,Lake Drive,

Colombo 08Executive Director

Mr. J.Raddalgoda 39No.8/4,Sri Jinarathana

Mawatha,RathmalanaExecutive Director

Mr. N.C. Vitharana 79No.14,Alwis

Terrace,Colombo 03

Non Executive Director

(Independent) Director

Mr.J.H.P. Rathnayaka 61995/7,Park

Lane ,Rajagiriya

Non Executive Director

(Independent) Director

1.6 Government Support & Regulations

The Sri Lanka Tea Board (“SLTB”) is presently the key governing body of the tea industry.

SLTB provides a range of services to tea planters, tea manufacturers and tea exporters which

include maintaining quality standards of tea, the marketing and promotion of Ceylon tea both

locally and abroad, promoting investment in the tea industry etc. As a regulator, SLTB requires

all tea planters, manufacturers and exporters to be registered under the Board in terms of the

SLTB Regulations 1986 published in the Government Gazette Extraordinary No.386/13 of 28th

January 1986. SLTB has carried out a pivotal role in campaigning to ensure producer countries

only ship teas that meet the ISO 3720 standard, in an attempt to prevent an abundance of low

quality teas flooding the market. In 2008,major tea producing countries agreed to adhere to ISO

3720 as a minimum quality level to prevent oversupply from depressing prices. As such, SLTB

as part of its role in maintaining quality, assesses quality standards at all points of disposal of

made tea.


1.7 Technology

State of the art manufacturing facility with manufacturing support for Ice tea currently under

way as an expansion to the present factory which would increase from present capacity of

100000 Litres to 300000 litres per month.. As for the expansion of the existing factory, most of

the current machines need backups and increased capacity. The current tea bagging capacity of

the Company is well below the required demand.

HVA takes every effort to ensure that its information technology systems are current and up to

date in line with the Company goals and strategies. The Company’s e-mail servers are based in

the US and have 99.9% guaranteed uptime. The Company apart from its servers in Kandana has

an offsite backup storage which demonstrates management’s commitment towards disaster

recovery.

1.8 Future Expectations

The Company’s long-term objective is to become one of the most recognized and respected tea

brands in the world. In order to achieve this, the Company plans to consolidate the brand in

countries where there is already a presence whilst endeavoring to increase the market share. In

this regard an aggressive marketing campaign will be launched from the beginning of 2011 to

attract new buyers/agents particularly in countries where representation is not significant.

It is also the vision of the Company to have offices in strategic markets. In order to fulfill tea

requirements from other origins, the Company has already initiated a programme for joint

ventures in India, Indonesia and Vietnam. In the next few years these strategic partnerships will

be enhanced to undertake marketing in multi origin teas. Strategy will be focused primarily to

project the goodness of tea from other origins in the specialty range such as the Darjeeling’s

from India, Keemun’s from China, Japanese Sencha etc.

Within the next 5 years of operation the company hopes to be a well recognized and well

established tea brand in the world catering to beverage and non-beverage sectors harnessing the

maximum potential in tea.


1.9 Summary of SWOT Analysis

2.0 Financials of HVA Foods Limited

2.1 HVA Foods Limited- Summarized Income Statement

For the year ended Mar 31

2006 2007 2008 2009 2010

Revenue 299,121,853 253,852,267 386,865,694 402,379,235 488,206,319

Gross Profit 44,957,269 1,662,730 54,593,941 84,892,616 93,483,325

Operating Profit 9,557,904 17,963,604 14,828,634 76,422,054 85,513,225

Finance Cost 1,761,079 23,226,461 31,287,044 58,385,691 29,925,028

PBT 11,318,983 (5,262,857) (16,458,410) 18,036,363 55,588,197

Net Profit 9,959,394 (5,273,480) (16,463,446) 14,817,965 54,274,768

2.2 HVA Foods Limited- Summarized Balance Sheet

As at Mar 31

The Organization

Strength Own brand name and spread

in 42 countries Strong R&D team in house Move from push to pull to

dominant consumer plateau

Opportunities Increased market share for

RTD Tea Availability of BM fannings

for iced tea Enter to the giant Chinese

market

Threat Competition from the

rivalrys Substitute products Impact of weather condition

for the tea production Aroomat as the only

distributor in Russia

Weaknesses Difficult to enter to giant

markets with own reputation

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 122006 2007 2008 2009 2010

Non Current Assets 64,868,023 161,438,801 160,852,603 158,110,838 236,285,570

Current Assets 13,974,378 230,920,219 177,445,251 177,009,676 281,371,485

Total Assets 178,842,401 392,359,020 338,297,854 335,120,514 517,657,055

Capital & Reserves (75,233,184) 9,417,737 (7,045,710) 7,772,255 99,911,117

Non Current Liabilities 82,422,970 115,871,638 55,516,826 136,297,102 145,945,728

Current Liabilities 171,652,615 267,069,645 289,826,737 191,051,157 271,800,210

Total Equity & 178,842,401 392,359,020 338,297,854 335,120,514 517,657,055

Liabilities

2.3 HVA Foods Limited- Summarized Interim Income Statement

For the six months ended 30 Sep 2010 2009

Rs. Rs.

Revenue 285,220,778 252,133,381

Gross Profit 48,660,907 40,571,975

Operating Profit 43,954,499 31,898,825

Finance Cost (14,310,351) (15,331,290)

PBT 29,644,148 16,567,535

Net Profit 27,067,622 16,567,535

2.4 HVA Foods Limited- Summarized Interim Balance Sheet

As at Sep 30 2009 2010

Rs. Rs.

Non Current Assets 290,756,832 153,591,941

Current Assets 313,994,275 233,847,081

Total Assets 604,751,107 387,439,022

Capital & Reserves 126,978,742 24,339,790

Non Current Liabilities 146,970,330 129,722,324

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 13Current Liabilities 330,802,035 233,376,908

Total Equity & Liabilities 604,751,107 387,439,022

2.5 Analysis of Financial Ratios

Year Ended 31 st March Six Months Ended 30 th Sep

2010 2009 2010 2009

Profitability

Revenue Growth 21% 4% 13% (2%)

COS/Revenue 81% 79% 83% 84%

GP Margin 19% 21% 17% 16%

Adm Exp Growth Rate 8% (52%) 36% 9%

Operating Profit Margin 18% 19% 11% 12%

Net Profit Margin 11% 4% 10% 7%

ROA 13% 4% 6% 3%

ROE 145.6% 4079% 36% 101%

Liquidity

Current Ratio 1.04 1.03 0.95 1.00

Quick Asset Ratio 0.88 0.76 0.82 0.85

Investor Ratio

EPS 1.17 0.32 0.62 0.36

NAV per share 1.44 0.17 2.77 0.52

Gearing

LT Debt/Equity 425% 3387% 217% 1151%

Interest Coverage 2.86 1.31 3.02 2.08

Total Liability/Equity 6.08 41.84 3.62 14.92

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 14Company’s turnover shows an ever increasing trend over years in the year 2010, revenue has

increased by 21% over the previous year. Interim result also shows an increase in turnover. This

positive trend will continue in the foreseeable future as the company will acquire the ‘heladiv”

brand rights from HVA Holdings (Pvt) Ltd after the IPO and due to fact that there is a growing

demand for the value added teas.

Company maintains a fairly consistent Gross Profit margin of around 18% which is sufficient to

cover the administrative and financial expenditure of the company.

With regard to the Net Profit Margin also, financial statements shows a healthy position. Except

in the years 2007 and 2008, company has recorded net profits margin of around 10%. Out of the

total overhead expenditure, finance cost alone accounts for about 50% of the total overhead cost.

This shows the company’s high leverage position at the moment. As shown by the summarized

income statement, Finance cost has suddenly increased from Rs. 1.7 Mill in the year 2006 to Rs.

23 Mill in 2007. During the last six months administrative expenditure also has increased

shapely by 36% over corresponding period of the year 2009.

ROA of the company remains at a comparatively low level of around 5%. This ratio indicates of

how profitable a company is relative to its total assets. ROA gives an idea as to how

efficient management is at using its assets to generate earnings. ROA for companies can vary

substantially and will be highly dependent on the industry. Therefore it is best to compare it

against the company's previous ROA numbers or the ROA of a similar company. Most probably

the company’s asset base is high that is why the ROA is taking a low value when it is making

profits. The assets of the company are comprised of both debt and equity. Both of these types of

financing are used to fund the operations of the company. The ROA figure gives investors an

idea of how effectively the company is converting the money it has to invest into net income.

The higher the ROA number, the better, because the company is earning more money on less

investment.

ROE ratio has recorded a very abnormal figure of 4079% in the year 2009 and reduced to

145.7% in 2010 and further reduced to 36% in the interim period. ROE measures the amount of

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 15net income returned as a percentage of shareholders equity. In other words, Return on

equity measures a corporation's profitability by revealing how much profit a company

generates with the money shareholders have invested. The reason for the abnormal ROE in the

year 2009 is mainly due to the low equity value of Rs. 7.7 Mill which has resulted from a

negative retained profit of Rs. 103 Mill. In the year 2010, company has further revalued its assets

up to Rs. 134 Mill and increased profits have reduced the retained loss up to Rs. 49 Mill. As a

result ROE has decreased significantly.

Current ratio of the company remains at 1.00, this is below the accepted norms and company will

have to face the liquidity problems. However one objective of the IPO is to obtain funds for

working capital requirements, company expect use Rs. 76 Mill of the proceeds from share issue

for the working capital requirement. Therefore company will improve its liquidity in the future.

Quick asset ratio prevails close to 1.00 which enables the company to meet its short term

obligation effectively.

2010 2009 2008

Stated Capital (Rs.) 15,000,020 15,000,020 15,000,020

No of Ordinary Shares in issue 46,500,062 1,500,002 1,500,002

As at the date of prospectus, the stated capital of the company is Rs 15,000,020 divided into

46,500,062 fully paid ordinary shares. The company has sub divided each ordinary share into 31

ordinary shares on 29th September 2010. Above mentioned EPS ratios have been calculated to

reflect the new number of post split shares. As a result EPS shows a very low amount of Rs.

1.00.

NAV per share of the company has a value of Rs.2.77 as at 30th September 2010, this value is

very low because of the share split carried out by the company. This is more commonly referred

to as book value per share, is usually below the market price per share. The historical cost

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 16accounting principle, which tends to understate certain asset values, and the supply and demand

forces of the market place generally push stock prices above book value per share valuations.

When it comes to gearing strategy HVA Foods LTD has followed a high leveraged policy

and as at 30th September 2010, it recorded 217%. The total liabilities were 3.6 times more than

the equity capital. The business of the company is still in early stage of its life cycle and business

risk is high, therefore financing through debt capital which is also risky is not suitable method

and company has not adopted the correct strategy as far as its capital structure is concerned.

However since the company was a private entity, they did not have many option other than the

debt capital. Most of these long term loans are term loans obtained from Seylan Bank. However

company has been able to harvest the full benefit from the low interest regime now prevailing in

the market by obtaining loan capital. It is vital that company should reduce its leverage

immediately. The main objective for the company to go public is to reduce leverage. In order to

increase the equity capital, company has decided to go for a Public Offering. There is a very

conducive environment prevailing in the country for equity capital raising, which is to the

advantage of the company.

3.0 Calculation of cost of capital of the company

3.1 Cost of equity

3.1.1 CAPM approach

From the company’s perspective, the expected rate of return is the cost of equity capital. Under

the CAPM, the expected return on the stock is:

Ke = Rf + β (Ṝm- Rf)

Where,

Rf = The risk free rate

β = The company beta

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 17Ṝm = Market Rate of Return

3.1.1.1 The Risk Free Rate ( Rf )

In this assignment we used annual interest rate of Sri Lankan government Treasury bill rate as

the risk free interest rate. As at 22nd February 2011 primary rate of 364 days Treasury bill rate is

7.33%

Treasury Bills- End Week- 364 days

Date Rate

18.02.2011 7.33%

11.02.2011 7.33%

03.02.2011 7.33%

28.01.2011 7.33%

3.1.1.2 The Company Beta ( β )

The beta coefficient is a key parameter in the Capital Assets Pricing Model. This measures the

part of the asset’s statistical variance that can’t be mitigated by the diversification provided by

the portfolio of many risky assets, because it is correlated with the return of the other assets that

are in the portfolio. Beta can be estimated for individual companies using regression analysis

against a stock market index.

Beta also referred to as financial elasticity or correlated relative volatility, and can be referred to

as a measure of the sensitivity of the asset’s returns to market returns, its non- diversifiable risk,

its systematic risk, or market risk.

HVA Foods does not have its beta value yet therefore we had to take the Beta value of a similar

company for our calculations. We have taken the Beat value of Watawala Plantation of which

beta value is 1.46 against All Share Price Index (ASPI) as of 22nd February year 2011. (Declared

by Colombo Stock Exchange) This beta value includes positive sign and means that the asset

generally follows the market.

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 183.1.1.3 Market Rate of Return ( Ṝm )

Market rate of return consists of two parts as the dividend paid at the end of period and the

change in the market value of equity shares over period. Therefore we assumed that the change

in the all Share Price Index reflects the change in the market values of the total equity market

portfolio while market dividend yield rate was taken as the dividends of the market portfolio.

Monthly ASPI for the year 2010 is shown in the below table.

Month Index Value

Jan-10 3636.4

Feb-10 3807.9

Mar-10 3992.5

Apr-10 4188.9

May-10 4237.2

Jun-10 4612.5

Jul-10 5161.2

Aug-10 5668.0

Sep-10 6997.2

Oct-10 7147.77

Nov-10 6434.0

Dec-10 6360.84

The growth rate of the ASPI for the year 2010 is about 100%. But market overreaction is the

main reason for high growth when compared to the previous year. Hence we would not take this

abnormal growth rate and take the average rate of 13% as market growth rate, while dividend

yield of the equity market is 1.2 in January 2011.

Therefore Total Market rate of Return = Growth Rate of ASPI+

Market Dividend Yield

Rm = 13+1.2

Rm = 14.2%

By substituting; Rm = 14.2%

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 19Rf = 7.33%

β = 1.46

Ke = Rf + β (Ṝm- Rf)

Ke = 7.33%+ 1.46( 14.2%-7.33%)

Ke = 17.36

3.1.2 Discounted Cash Flow Approach

Ke = D1 + g

P0

Dividend per share in 2010 = Not Declared

Market Value per Share in Feb 2011 = 25.00

Since the company has not disclosed any dividend from the inception, we are unable to use

discounted cash flow method to calculate the cost of equity.

3.2 Cost of Debt

The company is presently having a 12.0% of interest bearing long term loan. The company

enjoys a concessionary tax rate of 15% for 20 years from 1997 according to the BOI agreement.

Budget for 2011 has further reduced it to 10%.Therefore the cost of debt can be calculated as

Kd = Kd (1- T)

Therefore the cost of debt of the company can be calculated as,

Kd = 12.0% (1- .10)

= 10.8%

3.3 Weighted Average Cost of Capital-Pre IPO

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 20The WACC is the minimum return that a company must earn on an existing asset base to satisfy

its creditors, owners, and other providers of capital, or they will invest elsewhere. Therefore the

WACC can be calculated as follows.

WACC = KeWe+ KdWd

Value Weights

(approximately)

Ordinary shares = 15,000,020 5%

Long Term loan = 283,000,000 95%

Total = 298,000,020 100%

The WACC can be calculated as,

WACC = KeWe+ KdWd

Ke = 17.36

Kd = 10.8%

We = 5%

Wd = 95%

WACC = 17.36% X 0.05 + 10.8% X 0.95

WACC = 11.12% (Pre IPO)

The Above financial summarization and indexes shows the unhealthy capital structure with

heavy financial obligations. The gearing and the financial leverage of the company is high and

drain-out of earning by way of interest payment for the borrowing is observed. The cost of

capital is around 11% and some concern on that should also maintain as the industry average is

little less than the company’s prevailing cost of capital. Further, the company has identified the

requirement of technology updating in manufacturing new products such as ice tea, Herbal tea,

and tea based personal care products etc. in order to be competitive in the market. Such activity

substitutively demands fund for working capital requirements too. This emerge the requirement

of funding and hence the company has to focus on fund raising options which also match with

the requirements of solving the current ill effected financial position of the company.

4.0 Financing For The Business

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 21For any kind of small businesses, financing is the key to unlocking exporting deals. Whether

Starting a Company or expanding one, raising capital is the most basic of business needs. For

both startup businesses and growing & mature businesses, there are a number of financing

options and alternatives available. The companies need to acquire raw materials, materials,

components, to upkeep the production process long before cashing the sold production

equivalent value. Therefore, in order to cope with the necessary cash, the firm needs to have a

considerable reserve fund. There are two general types of financing: equity and debt financing.

The more money, or equity, you have invested in your business, the easier it is to attract

financing. If your firm has a high ratio of equity to debt, you should probably seek debt

financing. However, if your company has a high proportion of debt to equity, you should

increase your equity before you borrow additional money. That way a company won't be over-

leveraged to the point of jeopardizing your company's survival.(Hodgman,2005). In the light of

above, export oriented businesses, such as HVA Foods Limited can tap into a variety of other

financing resources to assist them with exporting their goods and services overseas.

5.0 Options Available for Financing

5.1 Mergers and Acquisition

As we all know Mergers and acquisitions improve market efficiency by capturing synergies

between firms. Mergers and acquisitions (more generally, takeovers) are an important means

through which companies achieve economies of scale, remove inefficient management, or

respond to economic shock (Croson et al.,2004).However issues such as corporate culture

mismatching , corporate governance issues, downsizing, employee layoff, etc., can be occurred

due to the Mergers and Acquisition. Some time the identity of the original organizations may be

totally changed. Therefore although financial benefits are embedded with Mergers and

Acquisition, this cannot be considered as good means of alternative finance specially due to

above mention cultural and social problems which directly affect the employees of the

organization.


5.2 Bank Borrowings(Loans) :

Used especially when the liquidity necessity exceeds the temporary firm‘s needs and usually

used for the acquisition of fixed tools and capital goods, the costs

concerning the credit depending on the loan duration, on the risk level, on the requested

sum and on the creditor‘s reputation. The bank’s long-term financing generally

used for large capital goods .However current Bank Borrowings for this organization is

very high and therefore this is not a good alternative for this organization.

5.3 Trade Credits:

Trade credits can be explained as follows: for example, a raw materials provider accepts to cash

the equivalent value of the delivered products on a subsequent date, crediting this way the

producer).

5.4 The Factoring:

As per Ross et al(2009) factoring refers to the sale of a firm’s accounts receivable to a financial

institution known as a “Factor.”The firm and the factor agree on the basic credit terms for each

customer. The customer sends payment directly to the factor , and the factor bears the risk of non

paying customers. The factor buys the receivables at a discount, which usually ranges from 0.35

to 4 percent of the value of the invoice amount. The average discount throughout the economy is

probably about 1 percent.

The biggest disadvantage to factoring is the fees and discount that the selling company must pay.

The seller of the receivables must determine that the fees and discount are less than what he

would spend to collect all of the receivables in a timely fashion.

Additionally, it can be difficult to manage customer accounts that have been sold to a factoring

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 23agency. Some customers may find this practice misleading and think they have been turned over

to a collection agency

5.5 Government Support:

Government can support to the organization by means of Interest free loans, Tax benefits, etc.

Still it is depend of countries Political, Economic, Socio cultural, Technical and Legal factors.

Therefore uncertainty is very high for this kind of financing.

5.6 Installments buying:

It eliminates the integral financing problem of the equipments‘acquisition; the difference

between the leasing and the installments buying is that at the end of the period, the goods remain

automatically to the person who used them if they are paid by installments. However this is

particularly applicable machine and therefore this cannot be considered as good overall financing

method.

5.7 The leasing:

It offers the possibility to obtain equipments, machines, installations etc. without being necessary

to pay the integral equivalent value; through leasing, these are given to the beneficiary by a

specialized firm, in exchange of 3-5 year installments; It has become increasingly more common

in recent years for companies to lease equipment. A lease is an agreement whereby the lessor

conveys to the lessee in return for a payment or series of payments the right to use an asset for an

agreed period of time (ICASL, 2005).

Typically a lease can run anywhere from one to five years. Most equipment necessary in

commercial businesses today, including technical equipment, can be leased. Some leases provide

an option to then purchase the equipment at substantially less money when at the end of the term

of the lease. By leasing equipment, if structured properly, company can maintain its credit

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 24availability, as the lease debt does not have to be considered a direct liability on your financial

statements (ICASL, 2005).. This is advantageous, as it does not limit your ability to borrow from

lending sources. Apart from that some obvious advantages of lease financing are: an option to

buy equipment at end of lease term; it is easier to obtain lease financing than loans from

commercial lenders; offers potential tax benefits (depending on how the lease is structured);

Leasing better utilizes equipment (i.e. the company lease and pay for equipment only for the time

they need it); less upfront cash outlay (i.e. do not need to make large cash payments for the

purchase of needed equipments); upgrading of equipments can be done easily, as new equipment

becomes available, the company can upgrade to the latest models each time where lease is ended.

As we know technology change very fast, and hence the cost of continually buying new

equipment to meet changing and growing business needs can be difficult for most small

businesses. For this reason leasing is very advantageous.

However some of the obvious disadvantages of lease financing are: The Company has an

obligation to continue making payments; no equity until you decide to purchase the equipment at

the end of the lease term, at which point the equipment has depreciated significantly; Although

the company is not the owner, they are still responsible for maintaining the equipment as

specified by the terms of the lease. Failure to do so can prove costly.

5.8 Initial Public Offers (IPO)

Initial Public Offers (IPO), also known as public offering, are usually issued by those companies,

mainly small and young, who ask for capital to grow. Sometimes, some big private organizations

also issue IPO to trade publicly. Initial Public Offering is basically the first sale of stock to the

public by a private organization.

By issuing either equity or debt a company can earn money. If the company does not issue equity

to public then it will be called an IPO. If a company wishes to go public then it has to hire an

investment bank, a financial intermediary which does several services including underwriting,

facilitating the mergers, acting as an intercessor between the investing public and a security

issuer. In an Initial Public Offer, the issuer gets the help of an underwriting, method of issuing

the insurance policies, firm regarding the determination of security to issues. That firm also

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 25assists the issuer to determine the best prices of the issues that can be offered and the time of

bringing it into the market. (Ross et al, 2009).

To get to a filing for an IPO, the work required usually entails up to a year of

preparation, including completion of audits and due diligence, and the inevitable cleanup and str

aightening out of corporate and financial records. Obviously, a company will also be

required to support the revenue and other business metrics that can lead to a successful

IPO before the underwriters will take a company to market.

5.9 Right Offering

As defined by Morgenson and Harvey (2002), Right offering is a popular means of raising

capital by offering shareholders the opportunity to buy additional share of the same stock at a

price bellow the current market value. Company uses a right offering when it sells new share to

existing shareholders rather than selling new shares to the entire investment community. The

rights are used as a means to distribute new shares to existing holders on the basis of the share

each holder already owns.

6.0 Initial Public Offering IPO

6.1 Decision to IPO

The Company’s Financial Statements shows that negative net cash flow of Rs, 9,648,090 and

Current liablities exceeded current assets by Rs. 14,041,481/-. Therefore, it shows company has

liquidy problems.

To solve that the company can go for one of the following alternatives.

1. Debt Financing

2. Lease Financing

3. IPO ( Initial Public Offering)\

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 26 If the company go for a debt financing, they should go for long term debt, However, curent debt

equity ratio does not permits for futher borrowings, therefore the debt finacing would not make

sense. .

Lease financing is also a method of financing. Since there is advantage in some aspects such as

depriciation & tax shealds, the comany can utilized the tool in fulfiling the requirement of

updating the techneoloy by way of purchasing machinery. However, leaseing would not

contribute to reduce the company's gearing position. Therefore, use of lease financing would be a

parial solution for the problem. By contrast, IPO has come to the attention of the company. There

were evidences that latest IPO is the country had immense succesess and the govenment support

and the tax benefits are also there. therefore, company has decided to go for an IPO to solve thier

liquidity issues and fund reqiremnt in updating the technology reaqirement of the company

6.2 Estimating The Initial Capital Requirements

The Company intends to raise funds through an initial public offering to finance the following

activities, in the order of priority.

(i.) Allocation of LKR 45 million for payment for the acquisition of HVA Holdings (Private)

Limited for the assignment of international brand rights of “HELADIV” to HVA Foods Limited.

The ‘HELADIV’ trademark is owned and registered under HVA Foods (Private) Limited and for

commercial purposes is employed by the HVA Group. This trademark has enabled consumers

with a means of identifying and distinguishing the ‘HELADIV’ brand of products produced by

HVA Group against the goods supplied by any other entity.

The value of the ‘HELADIV’ brand as at 31st December 2009 has been estimated at USD 1.08

million to USD 1.24 million (with a mid-point value of USD 1.16 million). At a US dollar to Sri

Lankan rupee exchange rate of USD 1 : LKR 114 this implies a value range in the order of LKR

124.0 million to LKR 141.6 million (with a mid-point of SLR 132.8 million). This brand value

has been assessed employing the relief from royalty approach, a generally accepted valuation

approach where value attributed to an intangible asset is estimated based on the notional royalty

expense savings from ownership of the brand vis-à-vis royalties or franchise fees payable on an

arm’s length basis to a third party in return for the right of use of such brand.

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 27‘HELADIV’ brand value has been estimated based on the five-year forecast sales amounts

provided by management, estimated royalty rate applicable to the associated brand sales

generated and computation of notional post-tax royalty streams, net of any associated marketing

expenses generated thereafter. These post-tax royalty streams have been discounted at the

company’s post-tax weighted average cost of capital in order to arrive at the assessed brand

value.

Further, different market segments catered to by the ‘HELADIV’ brand have been reviewed in

order to assess the brand proposition within the respective market segments.

(ii.) Approximately LKR 95 million will be utilized to reduce gearing of the Company.

Term Loan Settlement

Seylan Bank (USD 650,000 @ LKR 115/-) LKR 74,750,000.00

Bank of Ceylon LKR 20,000,000.00

Total LKR 94,750,000.00

(iii.) Approximately LKR 102 million will be utilized for Ice Tea plant to be upgraded from a

pilot plant to a commercial plant and for expansion of facilities in the existing factory. Current

capacity of the pilot plant is 100,000 litres of ice tea per month. Subject to the current trial

shipments and initial marketing efforts bringing in improved orders, the capacity in the medium

term needs to be increased to 300,000 litres per month. This will require approximately LKR 26

million which will cover the securing and expansion of land and building and installation of

machinery.

As for the expansion of the existing factory, most of the current machines need backups and

increased capacity. The current tea bagging capacity of the Company is well below the required

demand. Hence, approximately LKR 76 million will be utilized for expansion of the current

operations.

(iv.) Company will need about Rs. 76 Mn to finance the incremental working capital

requirements of HVA Foods Limited such as retiring expensive short term borrowings and to

ensure smooth and efficient operations at the factory by maintaining adequate buffer stocks.

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 28Altogether Rs. 318.8 Mn has been estimated as the total capital requirement of the company. A

summary is given below.

Sources of funds (Rs in millions):

Funds to be raised through IPO 318.86

Utilization of funds (Rs. in millions):

Acquisition of HVA Holdings (Pvt.) Ltd. 45.00

Settlement of term loans 94.75

Expansion and Technology Upgradation 102.00

Incremental Working Capital Requirements 77.11

Total 318.86

6.3 Valuation of share price for HVA Foods (Pvt) Ltd

6.3.1 review and performance analysis

Income

Statement

(in 000

LKR)

2008 2009 2010 2011 2012 2013 2014 2015

Revenue 386,866 402,379 488,206 749,241 935,782 1,123,075 1,260,018 1,327,821

Gross Profit 54,594 84,893 93,483 168,963 209,464 270,641 302,632 381,792

Finance Cost (31,287) (58,386) (29,926) (21,168) (15,292) (13,920) (13,010) (12,800)


Net

Profit/Loss

(16,463) 14,818 54,275 79,350 118,680 176,382 208,610 294,582

Balance

Sheet

Fixed Assets 160,853 158,111 197,643 230,308 260,686 265,688 270,340 274,666

Current

Assets

177,445 174,815 274,690 565,910 661,288 834,784 1,050,978 1,337,330

Total Assets 338,297 332,926 472,333 796,217 921,974 1,100,472 1,321,318 1,611,996

Stated

Capital

15,000 15,000 15,000 333,857 333,857 333,857 333,857 333,857

Revaluation

Reserve

96,136 96,136 96,136 96,136 96,136 96,136 96,136 96,136

Accumulated

Profit

(118,182) (103,364) (44,401) 34,948 153,628 330,010 538,620 833,202

EPS(Diluted) (0.25) 0.32 1.17 1.58 1.79 2.66 3.14 4.43

HVA has an edge over its competitors in the industry due to innovation and diversification in to

Tea extract based products and tea concentrate. In 2009 export volume of value added tea market

decline by 9.4% where as the companies volume is increased by 18%. The company owns the

brand, unlike other exports who packed for third party brands. Heladive is recognized as one of

the top five brands in Sri Lanka. Overall prices were expected to fall by 37% in 2010. The

Middle East region import bulk tea while the company’s presence is growing in Europe and

USA.

Half yearly position from April to September 2010 of Year 2010/11 has recorded the 13%

growth in revenue and 63% in Net Profit. The growth was lower than anticipated. The Net Profit

for six months ended September 2010 is Rest 27.07 Man as against Rs. 16.57Mn recorded during

the corresponding period of year 2009/10 and Net Profit margins are at 7% and 10%

respectively.

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 30The revenue of the company has recorded a compound annual growth rate of 10% during the five

year period from year 2005/06 to year 2009/10 during 2009 the overall tea industry adversely

affected due to bad weather condition. HVA was able to sustain positive growth backed with

price escalation. From 2007-09 export price of HVA have shown a growth rate of 9%.

It is expected the group revenue to record the 53% growth in year 2010/11 and 31% in 2011/12

with export, local sales and contract packaging contributing 25%,50% and 18% respectively.

Commercial production of 5000 Lts to 7000Lts of tea concentrate would be produced, which in

the year 2011/12 will amount to marketable value of approximately Rs. 100 Mn.

HVA has ventured in to new businesses such as tea, cosmetics and pharmaceutical market which

include skin care, oral care, body care, facial care and tea tablets which will generate additional

business in other countries. HVA has also moved in to Chinese market by setting up franchise

outlets adding to growth in revenues.

GP margins are below the industry average due to high cost of sales however operating margins

at average 13% is in line with the industry average of 16%.GP margins are assumed to be

maintained in the range of 22-23% in the years 2010/11 and 2011-12. substantial brand building

expenses led to high financing cost and volatile net profit growth during the previous year.

However, the last two financial years have recorded significant growth as against the lost of Rs.

16.46Mn reported for the year 2007/08, with year 2008/09 net profit being Rs. 14.82Mn and year

2009/10 recording a 266% growth to Rs 54.27Mn with net profit margin of 11% improving from

4% net profit margin in year 2008/09 as the finance cost decrease by 49%.

6.3.2 valuation

Valuation Range

PE Multiples(x) 9 10 11 12

Value per Share 16.11 17.9 19.69 21.48

Price Earnings Ratio(x)

2011 2012 2013 2014 2015

10.12 8.93 6.01 5.09 3.61

It is expected that HVA will report net earnings of Rs 79Mn in year 2010/11 recording a 46.21%

growth and Rs 118.68Mn in year 2011/12 with 50% growth. The valuation range for HVA on PE

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 31multiples ranging from 9x to 12x on year 2011/12 values give the share a valuation of Rs 16.11

to Rs 21.48.

The IPO Price is an attractive on the basis of offering PE of 10.12x for year 2010/11 and 8.93x

for year 2011/12 respectively, compared to the Beverage, Food and Tobacco sector, which

currently trade at 22.4,the stock has strong potential for growth value appreciation in the

secondary market

6.4 Underwriting

The offer is not underwritten and is not conditional upon any minimum subscription is being

met.

6.5 Association of Investment Bank

They have decided to use the services of DFCC Vardhana Bank as the Bankers to the offering

maily due to the investment expertise of them.

The IPO was a success and went oversubscribing. The countries economy is at a transition period

since the Government policies highly influencing to reduce the interest rates. The debt interest &

risk free interest rates have gone down shown high enthusiasm in the stock market. This has lead

to improve cost of equity. And hence investors are highly keen to invest in stock market. This

has being the key factor for the success of the IPO.

7.0 Post IPO Evaluation

7.1 Capital Structure & Weighted average cost of capital-Post IPO

The company has been able to achieve a sound capital structure after the IPO and debt equity

ratio has improved. The Company offered 19,928,598 ordinary shares at Rs. 16 per share, which

generated Rs. 318 Mn and after the proposed debt settlement the debt equity position of the

company as follows.


Value Weights

(approximately)

Ordinary shares = 333,000,000 64%

Long Term loan = 188,000,000 36%

Total = 521,000,000 100%

And the WACC can be calculated as,

WACC = KeWe+ KdWd

Ke = 17.36

Kd = 10.8%

We = 64%

Wd = 36%

WACC = 17.36% X 0.64 + 10.8% X 0.36

WACC = 15% (Post IPO)

The compression of pre and post waited average cost of capital shows an increase. This is an

unfavorable situation for company’s expectation. However, ease out the operation by improving

the cash flows by volumes. Current financial leverage will ease out the company to forecast with

future projects since those projects could be finance by bank borrowings resulting to reduce the

overall cost of capital.

There is no such time frame to comment on whether the shares has been under priced as the

issues was perform recently. However, during this small period the share price of the company is

observed that taking the normal behavior and has increased up to Rs. 26/-. This indicates that the

company is able to keep the promise to it stakeholders and IPO has been performed on fire

grounds. The Vital achievement that the company has obtained is the flexibility in its financing

and should focus to increase debt: equity ratio to 60:40 in reaching health cost of capital by

borrowing for future projects.


8.0 Reference & Bibliography

Ross, S. A., Westerfield, R. W., Jaffe, J. F.,Kakani, R.K. (2009) Corporate Finance, Advanced

Corporate Finance :Tata McGraw Hill,8th Edition

Hodgman.,B.,Small Bussiness, December 12, 2005 Inside Tucson Business pp9

Croson R.T.A.,Gomes. A, Mcginn.,K.L.,Noth.,M., (2004)Mergers and Acquisitions: An

Experimental

Analysis of Synergies, Externalities and Dynamics Kluwer Academic Publishers. Printed in the

Netherlands

Institute of Charted Accountants Sri Lanka (ICASL), Sri Lanka Accounting Standards,SLAS 19

Revised(2005)

http://www.ehow.com/about_5157898_disadvantages-factoring

receivables.html#ixzz1F7l2VhLv

http://www.ehow.com/about_5157898_disadvantages-factoring%20receivables.html#ixzz1F7l2VhLv

http://www.ehow.com/about_5157898_disadvantages-factoring%20receivables.html#ixzz1F7l2VhLv

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 34http://www.ces.lk

http://www.ces.lk/

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