Corporate Finance – A Study On Idea Cellular

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A Corporate Finance Perspective on Idea Cellular, a listed company in India (IDEA) by traditional methods like leverage analysis, EBIT-EPS Analysis, Dividend Policy Analysis and Alternate Funding Policy Analysis

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Corporate Finance – A Study On Idea Cellular

  1. 1. Corporate Finance – A Study on Idea Cellular Beta Analysis, Leverage Analysis, Dividend Policy Analysis and Alternate financing policy analysis for Idea Cellular ( 532822 | IDEA ) Sarang Bhutada, MBA Student at DoMS, IIT Madras Financial Management, under Dr. Thenmozhi [email_address]
  2. 2. Debt Structure Dept. of Management Studies, IIT Madras 2008 2007 2006 2005 Debt 65147.59 42505.04 29156.07 NA Shareholder’s Equity 49525.20 46300.09 28423.68 NA Total Capital 114672.79 88805.13 57579.75 NA EBITDA 22712.65 14859.63 7260.52 NA Interest Expense 4592.27 3293.10 2532.59 2600 EBIT 11168.61+4592.27 = 15760.88 5090.52+3293.10 = 8383.62 1285.05+2532.59 = 3817.64 260.5+2600 = 2860.5 PAT 10443.62 5020.61 1256.03 260.5 Number of shares 2635.36 2592.86 2259.53 2259.53 EPS 3.963 1.936 0.556 0.115
  3. 3. Observations <ul><li>The debt of the company has been steadily rising by around 50% Y-o-Y </li></ul><ul><li>Increase in equity has solely been on account of the change in retained earnings </li></ul><ul><li>Equity Share Capital almost constant, preferential shares marginally increased </li></ul><ul><li>Total capital has been significantly increasing, owing to increase in both – debt and shareholder earnings </li></ul><ul><li>Interest expense has been increasing rapidly (> 30%) over the years </li></ul><ul><li>Telecom industry requires an upfront investment (infrastructure, licence fees, etc) and hence the heavy interest payments. </li></ul>Dept. of Management Studies, IIT Madras
  4. 4. Ratio Analysis Debt is being maintained at around 50% levels Earnings convincingly cover the interest charges DSCR = EBITDA / [ Int exp + Loan Repayment/(1-tax rate )] Dept. of Management Studies, IIT Madras 2008 2007 2006 Debt to total capital ratio 65147.59/114672.79 =0.5681 -> 56.81% debt 42505.04/88805.13 = 0.4786 -> 47.86% debt 29156.07/57579.75 = 0.5063 -> 50.63% debt Debt equity ratio 65147.59/49525.20 = 1.3154 42505.04/46300.09 = 0.9180 29156.07/28423.68 = 1.0258 Interest Coverage ratio 22712.65/4592.27 = 4.946 14859.63/3293.10 = 4.512 7260.52/2532.59 = 2.867 Debt Service Coverage ratio 22712.65/(4592.27 + 1.538*65147.59)= 0.2167 14859.63/(3293.10 + 1.538*42505.04) = 0.2164 7260.52/(2532.59 + 1.538*29156.07) = 0.1532
  5. 5. Observations <ul><li>Capital structuring of the company, has been around the 50-50 mark for debt and equity (ordinary+pref). The interest coverage has been increasing over the years, indicating the company’s increasing strength in its earnings, to cover up its interest costs. </li></ul>Industry Comparison Debt/Total Capital = 69879.58 / (161008.16+69879.58) = 30.26 % Thus, Idea has a higher debt factor than the industry. Source: Capitaline, IIT Subscription Dept. of Management Studies, IIT Madras
  6. 6. EBIT – EPS Analysis for 2008 Dept. of Management Studies, IIT Madras EBIT 5000 10000 20000 25000 Interest 4592.27 4592.27 4592.27 4592.27 PBT 407.73 5407.73 15407.73 20407.73 PAT 265.02 3515.02 10015.02 13265.02 N. Shares 2635.36 2635.36 2635.36 2635.36 EPS 0.1 1.334 3.8 5.033 EBIT EPS 5000 0.1 10000 1.334 15760.88 3.963 20000 3.8 25000 5.033
  7. 7. Leverage Analysis <ul><li>Degree of Operating Leverage (DOL) </li></ul><ul><ul><li>Unavailability of data on fixed costs of company </li></ul></ul><ul><ul><li>For other approach, </li></ul></ul><ul><ul><ul><li>DOL = % Change in EBIT / % Change in Sales </li></ul></ul></ul>Dept. of Management Studies, IIT Madras 2008 2007 2006 2005 EBIT 15760.88 8383.62 3817.64 2860.5 Sales 67199.9 43664 20070.68 16320.4 Calculation DOL For 2008 [ (15760.88 – 8383.62)/15760.88 / (67199.9 – 43664) /67199.9 ] 1.336 For 2007 [ (8383.62 – 3817.64)/8383.62 / (43664 – 20070.68)/43664] 1.08 For 2006 [ (3817.64 – 2860.5)/3817.64 / (20070.68 – 16320.4)/20070.68 ] 1.342
  8. 8. Leverage Analysis <ul><li>Degree of Financial Leverage (DFL) </li></ul><ul><ul><li>Unavailability of data on fixed costs of company </li></ul></ul><ul><ul><li>For other approach, </li></ul></ul><ul><ul><ul><li>DFL = % Change in EPS / % Change in EBIT </li></ul></ul></ul>Dept. of Management Studies, IIT Madras 2008 2007 2006 2005 EBIT 15760.88 8383.62 3817.64 2860.5 EPS 3.963 1.936 0.556 0.115 Calculation DFL For 2008 [ (3.963 – 1.936)/3.963 ] / [ (15760.88 – 8383.62) / 15760.88 ] 1.092 For 2007 [(1.936 – 0.556) / 1.936] / [ (8383.62 – 3817.64) / 8383.62 ] 1.308 For 2006 [ (0.556 – 0.115) / 0.556 ] / [ (3817.64 - 2860.5) / 3817.64 ] 3.163
  9. 9. Leverage Analysis <ul><li>Degree of Combined Leverage (DCL) </li></ul><ul><ul><li>DCL = DOL x DFL </li></ul></ul>Dept. of Management Studies, IIT Madras Year DOL DFL DCL = DOL x DFL 2008 1.336 1.092 1.459 2007 1.08 1.308 1.413 2006 1.342 3.163 4.245
  10. 10. Leverage Analysis - Comments <ul><li>DFL: Degree of financial leverage </li></ul><ul><li>By assessing the DFL, one can understand the impact of change in EBIT on the EPS of the company. In addition to this it also helps in assessing the financial risk of the firm. </li></ul><ul><li>Idea cellular has been able to achieve an increase in RoE by reducing the DFL year-on-year. This implies that the company is managing its debt well and is generating returns much greater than the cost of capital. </li></ul><ul><li>The financial risk associated with Idea Cellular has been decreasing. </li></ul><ul><li>DOL: Degree of operating leverage </li></ul><ul><li>DOL gives a measurement of the degree to which a firm or project incurs a combination of fixed and variable costs. A telecom industry like Idea has certain fixed costs – like license fee, but infrastructure it needs can be classified as a variable costs (number of towers increase with number of users). The processing servers and the towers are a major chunk of the cost and are variable in nature. </li></ul><ul><li>The current DOL is not high, as compared to the market which indicates the high proportion of variable costs in Idea’s business model. </li></ul><ul><li>DCL: Degree of combined leverage </li></ul><ul><li>The degree of combined leverage gives the change in EPS as an effect of the relative change in sales i.e. how much does EPS increase, corresponding to an increase in an unit of sales. </li></ul><ul><li>DCL is the multiplicative sum of DOL and DFL. For Idea, DCL has been reduced from 4.245 to ~1.4 and has been maintained there. We can assume that it is management’s policy to maintain DCL around 1.4 i.e. a change in sales should correspond to a slightly greater change in EPS currently. </li></ul>
  11. 11. Dividend Policy Analysis <ul><li>Quoting from the Annual Reports – “ </li></ul><ul><li>“ “ </li></ul><ul><li>” </li></ul><ul><ul><li>No dividend declared so far </li></ul></ul><ul><ul><li>Not uncommon in telecom sector </li></ul></ul><ul><ul><li>It shouldn’t be long before it starts rolling out dividends </li></ul></ul><ul><ul><li>Dividend-per-share, Dividend Payout ratio, Growth in dividend and dividend yield is 0 </li></ul></ul><ul><ul><li>Conversely, Retention Ratio is 100% </li></ul></ul>Dept. of Management Studies, IIT Madras
  12. 12. Dividend Policy Analysis <ul><li>Earnings Yield or P/E Analysis </li></ul><ul><li>Industry P/E average: 15.10 </li></ul><ul><li>Idea coming in line with Industry P/E </li></ul><ul><li>Fall in P/E cannot be taken as undervaluation, as wild fluctuations immediately post-listing are common in Indian markets </li></ul>Dept. of Management Studies, IIT Madras Year 2008 2007 2006 EPS 3.963 1.936 0.556 Share Price 89.31 120.65 Company not listed Earnings Yield 0.0443 0.016 NA P/E 22.536 62.319 NA
  13. 13. Dividend Policy Analysis – Price of Scrip <ul><li>Walter’s Model </li></ul><ul><li>Walter’s model was developed on the following assumptions: </li></ul><ul><li>The firm finances all investments through retained earnings i.e. no debt or equity </li></ul><ul><li>The firm’s rate of return, r, and its cost of capital, k, are constant </li></ul><ul><li>All earnings are either distributed as dividends or reinvested internally immediately </li></ul><ul><li>Constant EPS and DIV </li></ul><ul><li>The firm has a long and infinite life </li></ul><ul><li>The formula is given by – </li></ul><ul><li>P = (DIV/k) + [ r (EPS-DIV)/k /k] </li></ul>Dept. of Management Studies, IIT Madras
  14. 14. Dividend Policy Analysis – Price of Scrip <ul><li>Walter’s Model </li></ul><ul><li>Now, the company has not issued any dividend so far. Thus, DIV =0 </li></ul><ul><li>Thus, P = r x EPS / k 2 </li></ul><ul><li>Where r  firm’s rate of return </li></ul><ul><li> K  firm’s cost of capital </li></ul><ul><li>For Idea, </li></ul><ul><li>R -> Return on Investment ROI = PAT / Total Capital = 10443.62 / 114672.79 </li></ul><ul><li>P = 0.0917 x 3.963 / 0.1092 2 </li></ul><ul><li>P = 30.475 </li></ul><ul><li>Yesterday’s (28/03/09) closing price = Rs. 52 </li></ul>Dept. of Management Studies, IIT Madras
  15. 15. Dividend Policy Analysis – Price of Scrip <ul><li>Walter’s Model - Recommendations </li></ul><ul><li>Almost all the assumptions by Walter are flouted by Idea Cellular scrip convincingly </li></ul><ul><li>As per Walter’s model, Idea Cellular is a Growth Firm as its rate of return (r ) is greater than its cost of capital (k). </li></ul><ul><li>For such firms, the model recommends that payout ratio should be 0 and all earnings must be reinvested in the company. </li></ul>Dept. of Management Studies, IIT Madras
  16. 16. Dividend Policy Analysis – Price of Scrip <ul><li>Gordon’s Model </li></ul><ul><li>P0 = EPS1 (1-b) / k(1-b) = EPS1 / k </li></ul><ul><li>Thus, P0 = 3.963 / 0.1092 = 36.29 </li></ul><ul><li>As per this model, if payout is 0%, then the theoretical value of P0 achieves infinity or a very large value. </li></ul><ul><li>To get a meaningful value of share, value of b should be less than k/r. </li></ul><ul><li>Now for Idea, </li></ul><ul><li>k/r = 10.92 / 21.08 = 0.518 or 51.8% i.e. the company should retain less than 52% of its earnings. </li></ul><ul><li>However, as of now, since startup costs are not recovered, the company is not declaring dividends. However, in the longer term, the company can think of shifting the retention ratio to 50%, as per this model </li></ul>Dept. of Management Studies, IIT Madras
  17. 17. Dividend Policy Analysis – Comments <ul><li>Company has a low cost of capital and a higher return on equity This means that the firm can turn around capital really well. </li></ul><ul><li>The zero-dividend rate does not reflect company’s policy but rather the company’s inability – since full costs haven’t been recovered yet. </li></ul><ul><li>The growth rate is not sustainable in a really long term, in the business that the company is in. The telecom service space is hugely competitive and margins cannot be forever maintained. </li></ul><ul><li>Dividend policy cannot be the only factor to be looked into, while performing a valuation exercise for this company. </li></ul><ul><li>Telecom sector has certain key assets like spectrum allocations, tower-infrastructure and brand values which must be looked into quite methodically, while valuing such companies. </li></ul>Dept. of Management Studies, IIT Madras
  18. 18. Additional Financing Policy Analysis <ul><li>Consider a situation where Idea Cellular wants to raise 100% of its total capital. Alternate financing policy analysis is restricted to 2008 – and based on data available in year 2008. </li></ul><ul><li>As per Annual report 2008, </li></ul><ul><li>Total Capital  Debt + Equity  49525.20 + 65147.59 = 114672.79 </li></ul><ul><li>Additional Capital to be raised  114672.79 </li></ul><ul><li>Total New Capital Base  229345.58 </li></ul><ul><li>Now, observing the growth in EBIT over the last few years, we can find out the ‘natural growth rate’ for the company. </li></ul>Dept. of Management Studies, IIT Madras EBIT 15760.88 8383.62 3817.64 2860.5 Growth 46.8% 54.46% 25.07%
  19. 19. Additional Financing Policy Analysis <ul><li>Raising Additional Capital </li></ul><ul><ul><li>100% equity </li></ul></ul><ul><ul><li>50% equity – 50% debt </li></ul></ul><ul><ul><li>100% debt </li></ul></ul><ul><li>Average share price – 120.37 </li></ul><ul><li>A premium of Rs. 95 can be charged over the face value of the share for raising funds through equity. </li></ul><ul><li>New issue can be issued at Rs. 105 (95 premium + 10 face value) comfortably. </li></ul><ul><li>Thus, No. of shares for </li></ul><ul><li>100% equity = 114672.79 / 105 = 1092.12 </li></ul><ul><li> 50% equity = 0.50 x 114672.79 / 105 = 546.06 </li></ul><ul><li>12% is reasonable as the latest corporate debt instrument – from Tata Capital – is available at 12%. </li></ul><ul><li>Interest is assumed at 12% since this is current PLR. </li></ul>Dept. of Management Studies, IIT Madras
  20. 20. Additional Financing Policy Analysis Dept. of Management Studies, IIT Madras
  21. 21. Additional Financing Policy Analysis – Leverage Analysis between alternatives <ul><li>Between Existing and Alternative 1: </li></ul><ul><li>DFL (E-1) = %Change in EPS/%Change in EBIT </li></ul><ul><li> = (4.696-3.963)/3.963 / (31521.76-15760.88)/15760.88 = 0.185 </li></ul><ul><li>Between Existing and Alternative 2: </li></ul><ul><li>DFL (E-2) = %Change in EPS/%Change in EBIT </li></ul><ul><li> = (4.096-3.963)/3.963 / (31521.76-15760.88)/ 15760.88 = 0.033 </li></ul><ul><li>  </li></ul><ul><li>Between Existing and Alternative 3: </li></ul><ul><li>DFL (E-3) = %Change in EPS/%Change in EBIT </li></ul><ul><li> = (3.248 – 3.963)/3.963 / (31521.76-15760.88)/ 15760.88 = -0.18 </li></ul><ul><li>Financial leverages do not change greatly with choosing either option and hence leverage analysis confirms that we need not worry about leverage risks while choosing between options </li></ul>Dept. of Management Studies, IIT Madras
  22. 22. Additional Financing Policy Analysis – Plotting Indifference Curves <ul><li>Alternative 1: 100% Equity </li></ul>Dept. of Management Studies, IIT Madras
  23. 23. Additional Financing Policy Analysis – Plotting Indifference Curves <ul><li>Alternative 2: 50% Debt – 50% Equity </li></ul><ul><li>Alternative 3: 100% Debt </li></ul>Dept. of Management Studies, IIT Madras
  24. 24. Alternate Financing Policy Analysis –Indifference Curve Dept. of Management Studies, IIT Madras
  25. 25. In Conclusion <ul><li>Idea cellular is sufficiently cash-rich and the coverage ratios are promising. It appears that the firm was looking at a target 50-50 model for debt equity and ratios of all years revolve around this. </li></ul><ul><li>The firm has moved on from being a highly leveraged one to one of stable leverage. This indicates stabilization of operations. </li></ul><ul><li>A telecom firm is indeed subject to many risks, both internally and externally. However, the external risks have been decreasing every year due to favorable government policy on telecom. </li></ul><ul><li>The firm has not yet recovered costs and hence not declared a dividend since its listing. However, it can be concluded from feelers gathered that this is certainly not the policy of the company. Once costs are recovered, adequate dividend will certainly be disbursed. </li></ul><ul><li>The firm can gain on the profitability front if it moves towards more debt in the longer run, as indicated by the EBIT-EPS analysis. </li></ul><ul><li>It is not possible for this firm to move to a 100% debt or 100% equity models, however, it does throw an interesting analysis to the - what if? question in capital structuring. </li></ul>Dept. of Management Studies, IIT Madras
  26. 26. Thank You. Comments, requests, feedback and suggestions to [email_address] please Dept. of Management Studies, IIT Madras

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