Corporate Finance – A Study On Idea Cellular

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 protected]

Debt Structure

2008 2007 2006 2005Debt 65147.59 42505.04 29156.07 NAShareholder’s Equity

49525.20 46300.09 28423.68 NA

Total Capital 114672.79 88805.13 57579.75 NAEBITDA 22712.65 14859.63 7260.52 NAInterest Expense 4592.27 3293.10 2532.59 2600EBIT 11168.61+4592.27 =

15760.885090.52+3293.10 =

8383.621285.05+2532.59 =

3817.64260.5+2600 = 2860.5

PAT 10443.62 5020.61 1256.03 260.5Number of shares 2635.36 2592.86 2259.53 2259.53EPS 3.963 1.936 0.556 0.115

2 Dept. of Management Studies, IIT Madras

Observations•The debt of the company has been steadily rising by around 50% Y-o-Y

•Increase in equity has solely been on account of the change in retained earnings

•Equity Share Capital almost constant, preferential shares marginally increased

•Total capital has been significantly increasing, owing to increase in both – debt and shareholder earnings

•Interest expense has been increasing rapidly (> 30%) over the years

•Telecom industry requires an upfront investment (infrastructure, licence fees, etc) and hence the heavy interest payments.


Ratio Analysis

20082007 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

Debt is being maintained at around 50% levels

Earnings convincingly cover the interest charges

DSCR = EBITDA / [ Int exp + Loan Repayment/(1-tax rate )]


ObservationsCapital 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.

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


EBIT – EPS Analysis for 2008EBIT 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 EPS5000 0.110000 1.33415760.88 3.96320000 3.825000 5.033

y = 0.0023x - 6E-06

0

1

2

3

4

5

6

0 5000 10000 15000 20000 25000 30000

EPS - EBIT Analysis

EPS

Linear (EPS)


Leverage Analysis Degree of Operating Leverage (DOL)

Unavailability of data on fixed costs of company For other approach,

DOL = % Change in EBIT / % Change in Sales

2008 2007 2006 2005EBIT 15760.88 8383.62 3817.64 2860.5

Sales 67199.9 43664 20070.68 16320.4

Calculation DOLFor 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


Leverage Analysis Degree of Financial Leverage (DFL)

Unavailability of data on fixed costs of company For other approach,

DFL = % Change in EPS / % Change in EBIT

2008 2007 2006 2005EBIT 15760.88 8383.62 3817.64 2860.5

EPS 3.963 1.936 0.556 0.115

Calculation DFLFor 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


Leverage Analysis Degree of Combined Leverage (DCL)

DCL = DOL x DFL

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


Leverage Analysis - CommentsDFL: Degree of financial leverage 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. 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.

The financial risk associated with Idea Cellular has been decreasing.

DOL: Degree of operating leverage 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.

The current DOL is not high, as compared to the market which indicates the high proportion of variable costs in Idea’s business model.

DCL: Degree of combined leverage 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.

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.

Dividend Policy Analysis Quoting from the Annual Reports – “

“ “”

No dividend declared so far Not uncommon in telecom sector It shouldn’t be long before it starts rolling out dividends Dividend-per-share, Dividend Payout ratio, Growth in dividend and

dividend yield is 0 Conversely, Retention Ratio is 100%


Dividend Policy Analysis Earnings Yield or P/E Analysis

Industry P/E average: 15.10 Idea coming in line with Industry P/E Fall in P/E cannot be taken as undervaluation, as wild fluctuations

immediately post-listing are common in Indian markets

Year 2008 2007 2006EPS 3.963 1.936 0.556Share Price 89.31 120.6

5Company not listed

Earnings Yield

0.0443 0.016 NA

P/E 22.536 62.319

NA


Dividend Policy Analysis – Price of ScripWalter’s Model

Walter’s model was developed on the following assumptions:

The firm finances all investments through retained earnings i.e. no debt or equity

The firm’s rate of return, r, and its cost of capital, k, are constant All earnings are either distributed as dividends or reinvested internally

immediately Constant EPS and DIV The firm has a long and infinite life

The formula is given by – P = (DIV/k) + [ r (EPS-DIV)/k /k]


Dividend Policy Analysis – Price of ScripWalter’s Model

Now, the company has not issued any dividend so far. Thus, DIV =0 Thus, P = r x EPS / k2

Where r firm’s rate of return K firm’s cost of capital

For Idea,R -> Return on Investment ROI = PAT / Total Capital = 10443.62 / 114672.79P = 0.0917 x 3.963 / 0.10922

P = 30.475

Yesterday’s (28/03/09) closing price = Rs. 52


Dividend Policy Analysis – Price of ScripWalter’s Model - Recommendations

Almost all the assumptions by Walter are flouted by Idea Cellular scrip convincingly

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).

For such firms, the model recommends that payout ratio should be 0 and all earnings must be reinvested in the company.


Dividend Policy Analysis – Price of Scrip

Gordon’s Model

P0 = EPS1 (1-b) / k(1-b) = EPS1 / k Thus, P0 = 3.963 / 0.1092 = 36.29 As per this model, if payout is 0%, then the theoretical value of P0 achieves

infinity or a very large value. To get a meaningful value of share, value of b should be less than k/r. Now for Idea,

k/r = 10.92 / 21.08 = 0.518 or 51.8% i.e. the company should retain less than 52% of its earnings.

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


Dividend Policy Analysis – Comments

Company has a low cost of capital and a higher return on equity This means that the firm can turn around capital really well.

The zero-dividend rate does not reflect company’s policy but rather the company’s inability – since full costs haven’t been recovered yet.

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.

Dividend policy cannot be the only factor to be looked into, while performing a valuation exercise for this company.

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.


Additional Financing Policy Analysis 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.

As per Annual report 2008,Total Capital Debt + Equity 49525.20 + 65147.59 = 114672.79Additional Capital to be raised 114672.79Total New Capital Base 229345.58Now, observing the growth in EBIT over the last few years, we can find out the ‘natural growth rate’ for the company.

EBIT 15760.88 8383.62 3817.64 2860.5Growth 46.8% 54.46% 25.07%


Additional Financing Policy Analysis Raising Additional Capital

1. 100% equity2. 50% equity – 50% debt3. 100% debt

Average share price – 120.37A premium of Rs. 95 can be charged over the face value of the share for raising funds through equity.

New issue can be issued at Rs. 105 (95 premium + 10 face value) comfortably.Thus, No. of shares for100% equity = 114672.79 / 105 = 1092.12 50% equity = 0.50 x 114672.79 / 105 = 546.06

12% is reasonable as the latest corporate debt instrument – from Tata Capital – is available at 12%.

Interest is assumed at 12% since this is current PLR.


Additional Financing Policy Analysis


Additional Financing Policy Analysis – Leverage Analysis between alternatives

Between Existing and Alternative 1:DFL (E-1) = %Change in EPS/%Change in EBIT = (4.696-3.963)/3.963 / (31521.76-15760.88)/15760.88 = 0.185

Between Existing and Alternative 2:DFL (E-2) = %Change in EPS/%Change in EBIT = (4.096-3.963)/3.963 / (31521.76-15760.88)/ 15760.88 = 0.033

Between Existing and Alternative 3:DFL(E-3) = %Change in EPS/%Change in EBIT = (3.248 – 3.963)/3.963 / (31521.76-15760.88)/ 15760.88 = -0.18

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


Additional Financing Policy Analysis – Plotting Indifference Curves

Alternative 1: 100% Equity


Additional Financing Policy Analysis – Plotting Indifference Curves

Alternative 2: 50% Debt – 50% Equity

Alternative 3: 100% Debt


Alternate Financing Policy Analysis –Indifference Curve


In Conclusion 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.

The firm has moved on from being a highly leveraged one to one of stable leverage. This indicates stabilization of operations.

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.

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.

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.

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.


Thank You. Comments, requests, feedback and suggestions to [email protected] please


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Corporate Finance – A Study On Idea Cellular