Financial Management Project Capital Structure

- Harsh - Manish - Ritika Singh (47) Rochak Agarwal(48)

- Sachin Gupta Table of Content

1 2

ACKNOWLEDGEMENT...................................................................................................................3 EXECUTIVE SUMMARY..................................................................................................................4

1 CAPITAL STRUCTURE............................................................................................................................5 2 FINANCIAL MARKETS............................................................................................................................5 3 FINANCIAL INTERMEDIARY................................................................................................................6 4 LONG TERM FINANCE ...........................................................................................................................6 4.1 4.2 4.3 4.4 4.5 5.1 5.2 5.3 5.4 5.5 5.6 SHARES....................................................................................................................................................7 DEBENTURES.............................................................................................................................................8 RETAINED EARNINGS.................................................................................................................................9 PUBLIC DEPOSITS....................................................................................................................................10 BORROWING FROM COMMERCIAL BANKS....................................................................................................12 PUBLIC ISSUE..........................................................................................................................................13 RIGHTS ISSUE..........................................................................................................................................13 BONUS ISSUE...........................................................................................................................................14 PRIVATE PLACEMENT................................................................................................................................14 VENTURE CAPITAL...................................................................................................................................14 LEASE FINANCING...................................................................................................................................15

5 RAISING EQUITY CAPITAL.................................................................................................................12

6 DESIGNING CAPITAL STRUCTURE..................................................................................................16 7 CAPITAL STRUCTURE ANALYSIS USING EBIT-EPS....................................................................18 8 COST OF CAPITAL.................................................................................................................................18 8.1 COST OF DEBT........................................................................................................................................18 8.2 COST OF EQUITY.....................................................................................................................................19 8.3 WEIGHTED AVERAGE COST OF CAPITAL.....................................................................................................19 9 SOME APPROACHES TO CAPITAL STRUCTURE..........................................................................19 9.1 9.2 9.3 9.4 9.5 9.6 9.7 10 11 NET OPERATING INCOME APPROACH..........................................................................................................19 NET INCOME APPROACH:..........................................................................................................................19 TRADITIONAL APPROACH...........................................................................................................................20 MODIGLIANI-MILLER THEOREM................................................................................................................20 TRADE-OFF THEORY.................................................................................................................................20 PECKING ORDER THEORY...........................................................................................................................20 AGENCY COSTS.......................................................................................................................................21 COMPANY OVERVIEW..................................................................................21 COMPANY FACTS......................................................................................22 11.1 SHARE PRICE FLUCTUATION OVER THE PAST YEAR........................................................................................23 11.2 PROFIT AND LOSS ACCOUNT......................................................................................................................24 11.3 BALANCE SHEET....................................................................................................................................25

12 ANALYSIS...............................................................................................................................................26 13 FINANCIAL STRATEGIES ANALYSIS.............................................................................................27 1 REFERENCES..........................................................................................................28

.......................................................................................... .............................................................. Acknowledgement

We would like to extend our gratitude to Mr Rajpal Jain who helped us in critically examining the financial decisions of Reliance Industries Ltd. His selfless gesture of taking time out from his professional work to answer our questions is much appreciated. Last but not the least, this acknowledgement would not be complete without thanking Professor N.L. Ahuja, who provided us with an opportunity to work on a challenging assignment and encouraged us to research and probe further, providing timely guidance in his own unique way.

Executive Summary

In this report, we tried to understand and analyze the significance and implications of long term financial decision making by the firms. The report can be classified in two parts. The first part deals with the theory that is essential in understanding the long term financial decisions of a company. This part starts by explaining the capital structure of a company which is essentially how a company employs different financial mix to raise the capital. The risk appetite, current market environment and the future requirements of a company are some of the factors which affect the capital structure. There after the report describes about different financial intermediaries which can help a company in raising the capital. This section is followed by the advantages and disadvantages of using different financial sources such as equity, debenture, loan etc. to build the capital structure. The Government support and financial markets have generated a lot of possible ways for a company to raise equity capital and the same have been described in the report. These different ways of raising equity capital have far reaching effect on the health of the organization as the management needs to consider the different aspects of risk involved. The report then provides guidance in designing the capital structure for a firm. The section emphasizes the fact that planning the capital structure of a firm in advance is very important in this increasingly competitive market. The next section details out an approach, EBIT-EPS that can be used to analyze the capital structure of a firm. The following report deals with the cost of capital and suggests methods for calculating the same. Where upon some common approaches to capital structure have been listed out and described in detail. The second part of the report starts by providing the overview of Reliance Industries Ltd. The functions and the market scope of the organization have been described. Therafter the next section lists out some of the facts about the company which comprises of the board member, financial decisions of the company for the past few years, the share price fluctuations of the company. The section also provides the P&L and Balance Sheet for the company. The next section consists of the capital structure analysis for the firm. The theory described in the earlier part of the report has been used for the purpose. The following section deals with the financial strategy analysis of the company which will affect the

companys capital structure and thus play an important role in determining the robustness of company in dealing with the turbulent market conditions.

1 Capital Structure
In finance, capital structure refers to the way a corporation finances its assets through some combination of equity, debt, or hybrid securities. A firm's capital structure is then the composition or structure of its liabilities. For example, a firm that sells $20 billion in equity and $80 billion in debt is said to be 20% equity-financed and 80% debt-financed. The key issues in capital structure decision are: What is optimal debt-equity ratio of the firm? Which specific instruments of equity and debt finance should the firm employ? Which capital markets should the firm access? When should the firm raise finances? At what price should the firm offer its securities? Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize corporate value while reducing the firm's financial risks.

Financial Markets
A Financial Market is a market for creation and exchange of financial instruments. Functions of Financial Market: Financial markets facilitate price discovery. The continuous interaction among various buyers and sellers who throng financial markets helps in establishing the prices of financial assets. Financial Markets provide liquidity to financial assets. Investors can readily sell their financial assets through the mechanism of financial markets. Financial Markets considerably reduce the cost of transaction. The two major costs associated with transacting, i.e., search costs and information costs are reduced by financial markets.

Financial Intermediary
Financial Intermediaries are firms that provide services and products that customers may not be able to get more efficiently by themselves in financial markets. They enjoy economies of scale in conducting research, maintaining records and in executing transactions. Hence they offer the customers a more efficient way of investing than what they can generally do on their own. The important products and services of financial intermediaries include checking accounts, savings accounts, loans, mortgages, mutual fund schemes, insurance contracts, credit rating and so on.

Key Financial Intermediaries

Commercial Banks: ICICI Bank, HDFC Bank, State Bank of India etc Financial Institutions: IFCI, IDFC, SIDBI, NABARD etc Insurance Companies: ICICI Prudential, LIC, Tata AIG, Bajaj Alliance etc Mutual Funds: UTI, Reliance mutual fund ICICI Prudential mutual fund etc NBFC: Kotak Mahindra Finance, ICICI Ventures, Sundaram Finance etc

4 Long Term Finance

A business requires funds to purchase fixed assets like land and building, plant and machinery, furniture etc. These assets may be regarded as the foundation of a business. The capital required for these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this part of the working capital and for fixed capital are called long term finance.

Purpose of long term finance:

Long term finance is required for the following purposes: To Finance fixed assets: 6

Business requires fixed assets like machines, Building, furniture etc. Finance required to buy these assets is for a long period, because such assets can be used for a long period and are not for resale. To finance the permanent part of working capital: Business is a continuing activity. It must have a certain amount of working capital which would be needed again and again. This part of working capital is of a fixed or permanent nature. This requirement is also met from long term funds. To finance growth and expansion of business: Expansion of business requires investment of a huge amount of capital permanently or for a long period.

Sources of long-term finance:

4.1

Shares
Issue of shares is the main source of long term finance. Shares are issued by joint stock companies to the public. A company divides its capital into units of a definite face value, say of Rs. 10 each or Rs. 100 each. Each unit is called a share. A person holding shares is called a shareholder. In order to tap the savings of different types of people, a company may issue different types of shares. These are: Preference Shares: Preference Shares are the shares which carry preferential rights over the equity shares. These rights are (a) receiving dividends at a fixed rate, (b) getting back the capital in case the company is wound-up. Investment in these shares is safe, and a preference shareholder also gets dividend regularly. Equity Shares: Equity shares are shares which do not enjoy any preferential right in the matter of payment of dividend or repayment of capital. The equity shareholder gets dividend only after the payment of dividends to the preference shares. There is no fixed rate of dividend for equity shareholders. The rate of dividend depends upon the surplus profits. In case of winding up of a company, the equity share capital is refunded only after refunding the preference share capital. Equity shareholders have the right to take part in the management of the company. However, equity shares also carry more risk. Following are the merits and demerits of equity shares: Merits

 A company can raise fixed capital by issuing equity shares without creating any charge on its fixed assets. The capital raised by issuing equity shares is not required to be paid back during the life time of the company. It will be paid back only if the company is wound up. There is no liability on the company regarding payment of dividend on equity shares. The company may declare dividend only if there are enough profits. If a company raises more capital by issuing equity shares, it leads to greater confidence among the investors and creditors. Demerits No trading on equity: Trading on equity means ability of a company to raise funds through preference shares, debentures and bank loans. On such funds the company has to pay at a fixed rate. This enables equity shareholders to enjoy a higher rate of return when profits are large. The major part of the profit earned is paid to the equity shareholders because borrowed funds carry only a fixed rate of interest. But if a company has only equity shares and does not have either preference shares, debentures or loans, it cannot have the advantage of trading on equity. Conflict of interests: As the equity shareholders carry voting rights, groups are formed to corner the votes and grab the control of the company. There develops conflict of interests which is harmful for the smooth functioning of a company.

4.2

Debentures
Whenever a company wants to borrow a large amount of fund for a long but fixed period, it can borrow from the general public by issuing loan certificates called Debentures. The total amount to be borrowed is divided into units of fixed amount say of Rs.100 each. These units are called Debentures. These are offered to the public to subscribe in the same manner as is done in the case of shares. A debenture is issued under the common seal of the company. It is a written acknowledgement of money borrowed. It specifies the terms and conditions, such as rate of interest, time repayment, security offered, etc. Following are some of the advantages and disadvantages of debentures: Merits

 Debenture holders have no right either to vote or take part in the management of the company. Since debentures are ordinarily issued for a fixed period, the company can make the best use of the money. It helps long term planning. Interest paid on debentures is treated as an expense and is charged to the profits of the company. The company thus saves income tax. Debentures are mostly secured. On winding up of the company, they are repayable before any payment is made to the shareholders. Interest on debentures is payable irrespective of profit or loss. Demerits As the interest on debentures have to be paid every year whether there are profits or not, it becomes burdensome in case the company incurs losses. Usually the debentures are secured. The company creates a charge on its assets in favor of debenture holders. So, a company which does not own enough fixed assets cannot borrow money by issuing debentures. Moreover, the assets of the company once mortgaged cannot be used for further borrowing. Debenture-finance enables a company to trade on equity. But too much of such finance leaves little for shareholders, as most of the profits may be required to pay interest on debentures. This brings frustration in the minds of shareholders and the value of shares may fall in the securities markets. During depression the profits of the company decline. It may be difficult to pay interest on debentures. As interest goes on accumulating, it may lead to the closure of the company.

4.3

Retained Earnings
Like an individual, companies also set aside a part of their profits to meet future requirements of capital. Companies keep these savings in various accounts such as General Reserve, Debenture Redemption Reserve and Dividend Equalisation Reserve etc. These reserves can be used to meet long term financial requirements. The portion of the profits which is not distributed among the shareholders but is retained and is used in business is called retained earnings or ploughing back of profits. As per Indian Companies Act., companies are required to transfer a part of their profits in reserves. The amount so kept in reserve may be used to buy fixed assets. This is called internal financing. Following are the advantages and disadvantages of retained earnings: Merits

 No expenses are incurred when capital is available from this source. There is no obligation on the part of the company either to pay interest or pay back the money. It can safely be used for expansion and modernization of business. A company which has enough reserves can face ups and downs in business. Such companies can continue with their business even in depression, thus building up its goodwill. Shareholders may get dividend out of reserves even if the company does not earn enough profit. Due to reserves, there is capital appreciation, i.e. the value of shares goes up in the share market.

Demerits This method of financing is possible only when there are huge profits and that too for many years. When funds accumulate in reserves, bonus shares are issued to the shareholders to capitalize such funds. Hence the company has to pay more dividends. By retained earnings the real capital does not increase while the liability increases. In case bonus shares are not issued, it may create a situation of under-capitalization because the rate of dividend will be much higher as compared to other companies. Through ploughing back of profits, companies increase their financial strength. Companies may throw out their competitors from the market and monopolize their position. Capital accumulated through retained earnings encourages management to spend carelessly.

4.4

Public Deposits
It is a very old source of finance in India. When modern banks were not there, people used to deposit their savings with business concerns of good repute. Even today it is a very popular and convenient method of raising medium term finance. The period for which business undertakings accept public deposits ranges between six months to three years. Procedure to raise funds through public deposits: An undertaking which wants to raise funds through public deposits advertises in the newspapers. The advertisement highlights the achievements and future prospects of the undertaking and invites the investors to deposit their savings with it. It declares the rate of interest which may vary depending upon the period for which money is deposited. It also declares the time and mode of payment of interest and the repayment of deposits. A depositor may get his money back before the date of repayment of deposits for which he will have to give notice in advance.

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Following are the main rules governing public deposits: Rules governing Public Deposits Deposits should not be made for less than six months or more than three years. Public is invited to deposit their savings through an advertisement in the press. This advertisement should contain all relevant information about the company. Maximum rate of interest is fixed by the Reserve Bank of India. Maximum rate of brokerage is also fixed by the Reserve Bank of India. The amount of deposit should not exceed 25% of the paid up capital and general reserves. The company is required to maintain Register of Depositors containing all particulars as to public deposits. In case the interest payable to any depositor exceeds Rs. 10,000 p.a., the company is required to deduct income-tax at source. Following are the advantages and disadvantages of public deposits: Merits: The method of borrowing money through public deposit is very simple. It does not require many legal formalities. It has to be advertised in the newspapers and a receipt is to be issued. Public deposits are not secured. They do not have any charge on the fixed assets of the company. Expenses incurred on borrowing through public deposits are much less than expenses of other sources like shares and debentures. Public deposits bring flexibility in the structure of the capital of the company. These can be raised when needed and refunded when not required. Demerits: A concern should be of high repute and have a high credit rating to attract public to deposit their savings. There may be sudden withdrawals of deposits which may create financial problems. Public deposits do not have any charge on the assets of the concern. It may not always be safe to deposit savings with companies particularly those which are not very sound. As the rate of return is low and there is no capital appreciation, the professional investors do not appreciate this mode of investment. The rate of interest paid on public deposits may be low but then there are other expenses like commission and brokerage which make it uneconomical.

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 As it is an easy, convenient and cheaper source of raising money, companies may raise more money than is required. In that case it may not be able to make the best use of the funds or may indulge in speculative activities.

4.5

Borrowing from Commercial Banks

Traditionally, commercial banks in India do not grant long term loans. They grant loans only for short period not extending one year. But recently they have started giving loans for a long period. Commercial banks give term loans i.e. for more than one year. The period of repayment of short term loan is extended at intervals and in some cases loan is given directly for a long period. Commercial banks provide long term finance to small scale units in the priority sector. The merits and demerits of long-term borrowing from banks are as follows: Merits: It is a flexible source of finance as loans can be repaid when the need is met. Finance is available for a definite period; hence it is not a permanent burden. Banks keep the financial operations of their clients secret. Less time and cost is involved as compared to issue of shares, debentures etc. Banks do not interfere in the internal affairs of the borrowing concern; hence the management retains the control of the company. Loans can be paid-back in easy installments. In case of small-scale industries and industries in villages and backward areas, the interest charged is low. Demerits: Banks require personal guarantee or pledge of assets and business cannot raise further loans on these assets. In case the short term loans are extended again and again, there is always uncertainty about this continuity. Too many formalities are to be fulfilled for getting term loans from banks. These formalities make the borrowings from banks time consuming and inconvenient.

5 Raising Equity Capital

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5.1

Public issue
When an issue / offer of securities is made to new investors for becoming part of shareholders family of the issuer it is called a public issue. Public issue can be further classified into Initial public offer (IPO) and Further public offer (FPO). The significant features of each type of public issue are illustrated below: (i) Initial public offer (IPO): When an unlisted company makes either a fresh issue of securities or offers its existing securities for sale or both for the first time to the public, it is called an IPO. This paves way for listing and trading of the issuers securities in the Stock Exchanges. IPO in India is done through various methods like book building method, fixed price method, or a mixture of both. The method of book building has been introduced in the country in 1999 and it helps the company to find out the demand and price of its shares. A merchant banker is nominated as a book runner by the Issuer of the IPO. The company that is issuing the Initial Public Offering (IPO) decides the number of shares that it will issue and also fixes the price band of the shares. All these information are mentioned in the company's red herring prospectus. (ii) Further public offer (FPO): When an already listed company makes either a fresh issue of securities to the public or an offer for sale to the public, it is called a FPO.

5.2

Rights issue
When an issue of securities is made by an issuer to its shareholders existing as on a particular date fixed by the issuer (i.e. record date), it is called an rights issue. The rights are offered in a particular ratio to the number of securities held as on the record date.

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5.3

Bonus issue
When an issuer makes an issue of securities to its existing shareholders as on a record date, without any consideration from them, it is called a bonus issue. The shares are issued out of the Companys free reserve or share premium account in a particular ratio to the number of securities held on a record date.

5.4

Private placement
When an issuer makes an issue of securities to a select group of persons not exceeding 49, and which is neither a rights issue nor a public issue, it is called a private placement. Private placement of shares or convertible securities by listed issuer can be of two types: (i) Preferential allotment: When a listed issuer issues shares or convertible securities, to a select group of persons in terms of provisions of Chapter XIII of SEBI (DIP) guidelines, it is called a preferential allotment. The issuer is required to comply with various provisions which interalia include pricing, disclosures in the notice, lockin etc, in addition to the requirements specified in the Companies Act. (ii) Qualified institutions placement (QIP): When a listed issuer issues equity shares or securities convertible in to equity shares to Qualified Institutions Buyers only in terms of provisions of Chapter XIIIA of SEBI (DIP) guidelines, it is called a QIP.

5.5

Venture capital
Venture capital is long-term capital provided to small and medium-sized businesses wishing to grow but which do not have ready access to stock markets. The supply of venture capital (or private equity capital as it is sometimes called) has increased rapidly over recent years since both government and corporate financiers have shown greater commitment to entrepreneurial activity. The main types of investments that are likely to be of interest to venture capitalists and the process by which investments are undertaken are considered below. Venture capitalists provide share capital and loan finance for different types of business situations, including the following: Start-up capital: This is available to businesses that are still at the concept stage of development through to those businesses that are ready to commence trading. The finance provided is usually to help design, develop or market new products and services. Other early stage capital: This is available to businesses that have undertaken their development work and are ready to begin operations. Expansion (development) capital: This aims to provide funding for growing businesses for additional working capital, new equipment, and so on. It may also

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include rescue finance, which is used to turn around a business after a period of poor performance. Refinancing bank borrowings: This is aimed at reducing the level of gearing. Secondary purchases: This refers to finance used to purchase shares in order to buy out part of the ownership of a business or to buy out another venture capitalist. Buy-out capital: This is capital available to acquire an existing business. A management buy-out (MBO) is where the funds are used to help the existing management team to acquire the business, and an institutional buy-out (IBO) is where the venture capitalist acquires the business and installs a management team of its choice. Buy-in capital: This is capital available to acquire an existing business by an external management team. This kind of acquisition is known as a management buy-in (MBI). Buy-outs/buy-ins often occur when a large business wishes to divest itself of one of its operating units or when a family business wishes to sell out because of succession problems.

5.6

Lease Financing
Lease financing denotes procurement of assets through lease. A lease transaction is a commercial arrangement whereby an equipment owner or Manufacturer conveys to the equipment user the right to use the equipment in return for a rental. In other words, lease is a contract between the owner of an asset (the lesser) and its user (the lessee) for the right to use the asset during a specified period in return for a mutually agreed periodic payment (the lease rentals). The important feature of a lease contract is separation of the ownership of the asset from its usage.

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Designing capital structure

Some companies do not plan their capital structure, and it develops as a result of the financial decisions taken by the financial manager without any formal planning. These companies may prosper in the short-run, but ultimately they may face-considerabledifficulties in raising funds to finance their activities. With-unplanned capital structure, these companies may also fail to economize the use of their funds. Consequently, it is being increasingly realized that a company should plan its capital structure to maximize the use of the funds and to be able to adapt more easily to the changing conditions. The board of directors or the chief financial officer (CFO) of a company should develop an appropriate capital structure, which is most advantageous to the company. This can be done only when all those factors, which are relevant to the companys capital structure decision, are properly analyzed and balanced. The capital structure should be planned generally keeping in view the interests of the equity shareholders and the financial requirements of a company. The equity shareholders, being the owners of the company and the providers of risk capital (equity) would be concerned about the ways of financing a company's operations. However, the interests of other groups, such as employee, customers, creditors, society and government, should also be given reasonable consideration. The following factors are considered by a company before designing the capital structure.

Practical considerations in determining capital structure

The determination of capital structure in practice involves additional considerations in addition to the concerns about EPS, value and cash flow. Attitudes of managers with regard to financing decisions are quite often influenced by their desire, not to lose control, to maintain operating flexibility and to have convenient and cheaper means of raising funds. The most important considerations are Concern for dilution of control: In designing the capital structure, sometimes the existing management is governed. by its desire to continue control over the company. This is particularly so in the case of the firms promoted by entrepreneurs. The existing management team not only wants control and ownership but also to manage the company, without any outside interference. The holders of debt do not generally have voting rights. Therefore, it is suggested that a company should use debt to avoid the loss of control. Desire to maintain operating flexibility: Flexibility is one of the most serious considerations in setting up the capital structure. Flexibility means the firm's ability to adapt its capital structure to the needs of the changing conditions. The company should be able to raise funds, without undue delay and cost, whenever needed, to finance the profitable investments. It shou1d also be in 16

a position to redeem its preference capital or debt whenever warranted by the future conditions. It should also be able to substitute one form of financing for another to economize the use of funds. Capacity of Raising Funds The size of a company may influence its capital and availability of funds from different sources small company finds great difficulties in raising long-term loans. If it is able to obtain some long term loan it will be available at a higher rate of interest and inconvenient terms. The highly retentive covenants in loan agreements in case of small companies make their capital structures vein flexible and management cannot run business freely without any interference. Small company therefore, depends on share capital and retained earnings for their long-term funds. Market Conditions If the share market is depressed, the company should not issue equity shares, but issue debt and we to issue equity shares till the share market-revives. During boom-period in the share market, it may be advantageous for the company to issue shares at high premium. This will help to keep its de capacity unutilized. The internal conditions of a company may also dictate the marketability securities. Nature of Industry The nature of industry is one of the most important elements in determining the degree of financial leverage a firm can carry safely without any risk of bankruptcy. If an industrys sales are subject to wide fluctuations, over a business cycle, the firm should have a low degree of financial leverage. Hence seasonal industries with uncertain and uneven cash flows should not go for higher levels of financial leverage. On the other hand, industries with even cash flows such as hose dealing with nondurable consumer goods can go for higher debt proportions in their capital structure. Legal Framework: At the time of evaluation of different proposed capital structure, the financial manager should also take into account the legal and regulatory framework. For ex-In case the redemption period of debenture is more than 18 months, then credit rating is required as per SEBI guidelines. Moreover, approval from SEBI is required for raising funds from capital market whereas; no such approval is required- if the firm avails loans from financial institutions. All these and other regulatory provisions must be taken into account at the time of deciding and selecting a capital structure for the firm. Inflation Another factor to consider in the financing decision is inflation. By using debt financing during periods of high inflation, we will repay the debt with dollars that are worth less. As expectations of inflation increase, the rate of borrowing will increase since creditors must be compensated for a loss in value. Since inflation is a major driving force behind interest rates, the financing decision should be cognizant of inflationary trends.

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Capital Structure Analysis Using EBIT-EPS

One way of determining the right mix of capital is to measure the impacts of different financing plans on Earnings Per Share (EPS). The objective is to find the level of EBIT (Earnings Before Interest Taxes) where EPS does not change; i.e. the EBIT Breakeven. At the EBIT Breakeven, EPS will be the same under each financing plan we have under consideration. As a general rule, using financial leverage will generate more EPS where EBIT is greater than the EBIT Breakeven. Using less leverage will generate more EPS where EBIT is less than EBIT Breakeven. EBIT Breakeven is calculated by finding the point where alternative financing plans are equal according to the following formula: (EBIT - I) x (1.0 - TR) / Equity number of shares after implementing financing plan. I: Interest Expense, TR: Tax Rate Formula assumes no preferred stock. The formula is calculated for each financing plan. For example, we may be considering issuing more stock under Plan A and incurring more debt under Plan B. Each of these plans will have different impacts on EPS. We want to find the right plan that helps maximize EPS, but still manage risks within an acceptable range. EBIT-EPS Analysis can help find the right capital mix for high returns and low costs of capital.

Cost of Capital

The cost of capital is an expected return that the provider of capital plans to earn on their investment. Capital (money) used for funding a business should earn returns for the capital providers who risk their capital. For an investment to be worthwhile, the expected return on capital must be greater than the cost of capital. In other words, the risk-adjusted return on capital (that is, incorporating not just the projected returns, but the probabilities of those projections) must be higher than the cost of capital. It is divided into various sections such as:

8.1

Cost of Debt
The cost of debt is computed by taking the rate on a non-defaulting bond whose duration matches the term structure of the corporate debt, then adding a default premium. This default premium will rise as the amount of debt increases (since the risk rises as the amount of debt rises). Since in most cases debt expense is a deductible expense, the cost of debt is computed as an after tax cost to make it comparable with the cost of equity (earnings are after-tax as well). Thus, for profitable firms, debt is discounted by the tax rate. Basically this is used for large corporations only.

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8.2

Cost of Equity
In financial theory, the return that stockholders require for a company is called cost of equity. The traditional formula is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. There are various methods used to determine cost of equity such as: SML Approach Bond yield plus risk premium approach Dividend growth model approach Earning price ratio approach

8.3

Weighted Average Cost of Capital

The Weighted Average Cost of Capital (WACC) is used in finance to measure a firm's cost of capital. The total capital for a firm is the value of its equity (for a firm without outstanding warrants and options, this is the same as the company's market capitalization) plus the cost of its debt (the cost of debt should be continually updated as the cost of debt changes as a result of interest rate changes).

9 Some approaches to capital structure

9.1 Net Operating Income Approach
This approach to capital management concludes that it does not matter how we mix the capital structure. The value of the business is not determined by how we arrange the right side of the Balance Sheet. Additionally, the overall cost of capital will not change as we change the mix of capital. Therefore, values are determined by the capitalization of operating income or EBIT.

9.2

Net Income Approach:

In contrast to the Net Operating Income Approach, the Net Income Approach concludes that the capital structure of an organization has a major influence on the value of the organization. Therefore, the use of leverage will change both the cost of capital and the value of the firm. Net Income is capitalized in arriving at the market value of the firm.

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9.3

Traditional approach
Traditional approach is a midway between the net income and net operating income approach. It argues that cost of capital and total value of the firm are not independent of the capital structure. But it does not subscribe to the view that the value of a firm will necessarily increase for all degrees of leverage. Its states that at the optimal capital structure, the marginal real cost, defined to include both implicit and explicit will be equal to the real cost of equity. For a debt equity ratio before that level, the marginal real cost of debt would be less than that of equity capital while beyond that level, the marginal real cost of deft would exceed that of equity.

9.4

Modigliani-Miller Theorem
The Modigliani-Miller theorem (of Franco Modigliani, Merton Miller) forms the basis for modern thinking on capital structure. The basic theorem states that, in the absence of taxes, bankruptcy costs, and asymmetric information, and in an efficient market, the value of a firm is unaffected by how that firm is financed. It does not matter if the firm's capital is raised by issuing stock or selling debt. It does not matter what the firm's dividend policy is. Therefore, the Modigliani-Miller theorem is also often called the capital structure irrelevance principle. Modigliani and Miller concluded that capital structure is not a major factor in the determination of values. Values are determined by the investment and operating decisions that generate cash flows. It is cash flows that give rise to values.

9.5

Trade-off theory
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage to financing with debt (namely, the tax benefit of debts) and that there is a cost of financing with debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt declines as debt increases, while the marginal cost increases, so that a firm that is optimizing its overall value will focus on this trade-off when choosing how much debt and equity to use for financing. Empirically, this theory may explain differences in D/E ratios between industries, but it doesn't explain differences within the same industry.

9.6

Pecking order theory

Pecking Order theory tries to capture the costs of asymmetric information. It states that companies prioritize their sources of financing (from internal financing to equity) according to the law of least effort, or of least resistance, preferring to raise equity as a financing means of last resort. Hence internal debt is used first, and when that is depleted debt is issued, and when it is not sensible to issue any more debt, equity is issued. This theory maintains that businesses adhere to a hierarchy of financing sources and prefer internal financing when available, and debt is preferred over equity if external financing is required. Thus, the form of debt a firm chooses can act as a signal of its need for external finance. The pecking order theory is popularized by Myers when he argues that equity is a less preferred means to raise capital because when managers (who are assumed to know better about true condition of the firm than investors) issue new equity, investors believe that managers think that the firm is

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overvalued and managers are taking advantage of this over-valuation. As a result, investors will place a lower value to the new equity issuance.

9.7

Agency Costs
There are three types of agency costs which can help explain the relevance of capital structure. Asset substitution effect: As D/E increases, management has an increased incentive to undertake risky (even negative NPV) projects. This is because if the project is successful, share holders get all the upside, whereas if it is unsuccessful, debt holders get all the downside. If the projects are undertaken, there is a chance of firm value decreasing and a wealth transfer from debt holders to share holders. Underinvestment problem: If debt is risky, the gain from the project will accrue to debt holders rather than shareholders. Thus, management have an incentive to reject positive NPV projects, even though they have the potential to increase firm value. Free cash flow: Unless free cash flow is given back to investors, management has an incentive to destroy firm value through empire building and perks etc. Increasing leverage imposes financial discipline on management.

Reliance Industries Limited 10

Company Overview

The Reliance Group, founded by Dhirubhai H. Ambani (1932-2002), is India's largest private sector enterprise, with businesses in the energy and materials value chain. Group's annual revenues are in excess of US$ 34 billion. The flagship company, Reliance Industries Limited, is a Fortune Global 500 company and is the largest private sector company in India. Backward vertical integration has been the cornerstone of the evolution and growth of Reliance. Starting with textiles in the late seventies, Reliance pursued a strategy of backward vertical integration - in polyester, fiber intermediates, plastics, petrochemicals, petroleum refining and oil and gas exploration and production - to be fully integrated along the materials and energy value chain.

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The Group's activities span exploration and production of oil and gas, petroleum refining and marketing, petrochemicals (polyester, fiber intermediates, plastics and chemicals), textiles, retail and special economic zones. Reliance enjoys global leadership in its businesses, being the largest polyester yarn and fiber producer in the world and among the top five to ten producers in the world in major petrochemical products. The Group exports products in excess of US$ 20 billion to 108 countries in the world. Major Group Companies are Reliance Industries Limited (including main subsidiaries Reliance Petroleum Limited and Reliance Retail Limited) and Reliance Industrial Infrastructure Limited.

11
Registered Address 3rd Floor, Maker Chambers IV, Mumbai Maharashtra 400021

Company Facts

Management Reliance Name Designation

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Mukesh D Ambani Hital R Meswani Nikhil R Meswani Hardev Singh Kohli Ramniklal H Ambani Yogendra P Trivedi Mahesh P Modi Ashok Misra Raghunath A Mashelkar Mansingh L Bhakta Dharam Vir Kapur S Venkitaramanan Dipak C Jain

Chairman and Managing director Executive Director Executive Director Executive Director Director Director Director Director Director Director Director Director Director

Some major financial activities over the past few years 2001 RPL raises USD 750 million syndicated loan - deal named capital market deal of the year by IFR Asia. 2004 Reliance Industries concludes re-pricing of USD 687.50 million Syndicated Term Loan facilities. 2005 Launches US $ 348 Million Syndicated Term Loan Facility. Aims To Replace Existing High Cost Loans. 2006 RIL places $300 million in US Private Placement Market. First ever Indian company to raise money through this route. 2007 RIL sells 4.01% of RPL's equity for Rs.4,023 crore to maximize overall shareholder value.

11.1

Share price fluctuation over the past year

1 Year 23 Current % Gain/Loss

Open Price High Price Low Price Last Price Volume

2778.00 2800.00 2700.00 2722.00 984749

1021.00 1158.30 1021.00 1127.35 3150840

-58.58 219.96

11.2 Profit and loss account

Rs in Cr.

Operating Income
Expenses Material Consumed

Mar ' 08 133,805.7 8 100,699.3 0 2,768.03 2,119.33 3,229.59 2,732.47 -175.46 111,373.2 6 22,432.52

Mar ' 07 111,699.0 3 80,137.05 3,373.86 2,094.09 3,661.45 2,137.88 -111.21 91,293.12 20,405.91

Mar ' 06 80,877.79

Mar ' 05 65,918.8 3 47,942.3 9 1,211.91 846.40 1,824.95 1,392.62 -9.60 53,208.6 7 12,710.1 6

Mar ' 04 51,849.63

57,608.10 1,814.57 978.45 4,733.75 1,439.32 -155.14 66,419.05 14,458.74

36,590.17 1,048.55 804.75 2,262.22 1,556.42 -26.43 42,235.68 9,613.95

Manufacturing Expenses Personnel Expenses Selling Expenses Administrative Expenses Expenses Capitalized Cost Of Sales Operating Profit

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Other Recurring Income Adjusted PBDIT Financial Expenses Depreciation Other Write offs Adjusted PBT Tax Charges Adjusted PAT Non Recurring Items Other Non Cash adjustments Reported Net Profit Earnings Before Appropriation Equity Dividend Preference Dividend Dividend Tax Retained Earnings

772.17 23,204.69 1,162.90 4,847.14 0.00 17,194.65 3,559.85 13,634.80 5,823.49 48.10 19,458.29 22,271.76 1,631.24 0.00 277.23 20,363.29

457.00 20,862.91 1,298.90 4,815.15 0.00 14,748.86 2,585.35 12,163.51 -220.11 0.51 11,943.40 14,973.00 1,440.44 0.00 202.02 13,330.54

588.22 15,046.96 893.61 3,400.91 0.00 10,752.44 1,642.72 9,109.72 -41.26 0.88 9,069.34 18,037.20 1,393.51 0.00 195.44 16,448.25

1,384.82 14,094.9 8 1,486.54 3,784.57 0.00 8,823.87 1,505.00 7,318.87 188.88 -1.31 7,571.68 13,098.5 0 1,045.13 0.00 146.58 11,906.7 9

837.31 10,451.26 1,443.40 3,331.39 0.00 5,676.47 1,148.00 4,528.47 547.30 -13.03 5,160.14 8,405.80 733.10 0.00 91.64 7,581.06

11.3
Sources of funds Owner's Fund Equity Share Capital Share Application Money Preference Share Capital Reserves & Surplus Loan Funds Secured Loans Unsecured Loans Total Uses of funds Fixed Assets Gross Block

Balance Sheet
Mar ' 07 Mar ' 06 Mar ' 05 Rs in Cr. Mar ' 04

Mar ' 08

1,453.39 1,682.40 0.00 77,441.55

1,393.21 60.14 0.00 59,861.81

1,393.17 0.00 0.00 43,760.90

1,393.09 0.00 0.00 36,280.35

1,395.95 0.00 0.00 30,322.97

6,600.17 29,879.51 117,057.02

9,569.12 18,256.61 89,140.89

7,664.90 14,200.71 67,019.68

7,972.90 10,811.69 56,458.03

11,451.14 9,493.52 52,663.58

104,229.10

99,532.77

84,970.13

55,125.82

53,502.91

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Less : Revaluation Reserve Less : Accumulated Depreciation Net Block Capital WIP Investments Net Current Assets Current Assets, Loans & Advances Less : Current Liabilities & Provisions Total Net Current Assets Miscellaneous expenses not written Total

871.26 42,345.47 61,012.37 23,005.84 22,063.60

2,651.97 35,872.31 61,008.49 7,528.13 16,251.34

4,650.19 29,253.38 51,066.56 6,957.79 5,846.18

2,729.88 24,872.83 27,523.11 4,829.29 17,051.46

2,733.53 21,713.74 29,055.64 3,356.81 13,971.40

43,196.37 32,221.16 10,975.21 0.00 117,057.02

30,210.99 25,858.06 4,352.93 0.00 89,140.89

24,696.15 21,547.00 3,149.15 0.00 67,019.68

28,819.15 21,764.98 7,054.17 0.00 56,458.03

23,046.36 16,766.63 6,279.73 0.00 52,663.58

Note : Book Value of Unquoted Investments Market Value of Quoted Investments Contingent liabilities Number of Equity shares outstanding (in Lacs) 12,746.75 53,126.09 37,157.61 14,536.49 9,438.20 24,454.46 46,767.18 13,935.08 5,322.60 780.71 24,897.66 13,935.08 13,582.43 4,156.40 6,579.47 13,935.08 13,435.29 948.40 8,559.77 13,963.78

12 Analysis
Ratio Debt Equity Ratio Debt to Assets Ratio Interest Coverage Ratio 2004 2008 0.6603200 9 0.45272877 0.3016646 5 0.24437383 7.2407232 9 19.95

Debt equity ratio It is calculated by dividing long term debt by total equity. It implies the proportion of long term debt employed in a firm for every Re 1 of equity. We can see that over 2004 to 2008, this ratio has come down. However as we can see, this is not because of additional equity raised by the firm or redemption of debt. This is because of the increase in shareholders equity out of increase in reserves from 30,322.97 in 2004 to 77,441.55 in 2008. Thus the company is using ploughing back of profits as a major source of funds.

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The decrease if D/E ratio also implies that the company has become financially sound over that years and it can face difficult situations more effectively as it will has lesser amount of interest liabilities. Also the company is in a better position to avail debt as and when required. But it also means that the company is reducing its financial leverage because of which it wont be able to trade on equity. Debt to assets ratio It is calculated by dividing long term debt by total assets of the firm. It shows how much of the total assets of the firm is financed by debt. It is also an indicator of the financial soundness of the firm and also the risk of the lenders. We can see that over 2004 to 2008 this ratio has also come down from .244 to .302 as the value of its assets have increased more than the increase in debt. Hence, it is in a better position to repay debt over the long term. Interest coverage Ratio It is calculated by dividing profit before interest and tax by the interest paid to lenders. It shows the ability of the company to paid interest charges out of its current earnings. It has increase from 7.2 to 19.95 which is a good news for the lenders as the company is in a better position to meet the interest obligations. Hence from the analysis of the financial statement of the firm, we can see than the company is reducing the proportion of debt in its capital structure which is a conservative approach. It is using reserves as a major means to finance its operations. This has advantages as well as disadvantages which have already been explained in the theory above.

13 Financial Strategies analysis

By analyzing the past history of the company and through some secondary research, we came to the following conclusion about the financial strategy followed by the company Promoting the institutional investors In 1994 individual investors held more than 50 percent of the equity of Reliance. Anticipating the institutionalization of the capital market, Reliance has taken initiatives to encourage greater institutional participation in the equity and has succeeded immediately in that endeavor. International perspective Aware of the compulsions of globalization, Reliance believes in thinking in international terms. It is the first Indian company to appoint an international of auditor and to get the ratings from Moodys. It uses the language of the dollar extensively.

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 Ensuring that the primary Market Investor is properly rewarded Reliance is rightly credited as the company, which has promoted equity in India. It protects the interest of those who participate in primary issues of the company and ensures that they are rewarded adequately. Flexibility Speed is the essence of financing. The treasury of Reliance keeps a draft prospectus, which is up on weekly basis. A rating is also kept ready. Once Reliance decides on a financing option it hardly waste any time, thanks to its perennial readiness. Be the first Reliance has a number of firsts to its credit. It has been the first Indian company to issue Global Depository Receipts. To privately place a large chuck of equity shares with financial institutions at a price close to the prevailing market price, to go for a syndicated loan, to make a eurobond issue, to issue 20- year Yankee bonds, 50-Years Yankee bonds, and even 100-years bonds.(Yankee bonds are issued in the US market.) Delink Financing and investment Decisions Opportunity for smart moves on investment and financing sides of the business often do not synchronies. Hence it makes sense to decouple investment and financing decisions. Reliance seems to be doing this it raises finances whenever the market conditions are favorable irrespective of whether it has immediate investment projects on hand or not. Dedicate a Team to Treasury Management Reliance has a team dedicated to treasury management. It continually assesses the developments in various markets to identify opportunities.

References
Financial Management and Policy, 12th Edition by James C Van Horne Financial Management, 5th Edition by MY Khan and P K Jain Financial Management, 7th edition by Prasanna Chandra www.ril.com www.moneycontrol.com www.kotaksecurities.com

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External Financing and Future Stock Returns Rodney L. White Center for Financial Research Working Paper No. 03-03 Scott A. Richardson and Richard G. Sloan Barclays - Barclays Global Investors (BGI) and Barclays Global Investors Date Posted: April 3, 2003 The Role of Venture Capital in Financing Small Businesses Journal of Entrepreneurship and Finance, Forthcoming Marjan Petreski University American College Skopje Date Posted: June 8, 2006. Mr Rajpal Jain, Chartered Accountant (9810114233)

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