Garuda Udyog

8/16/2019 Garuda Udyog

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Garuda Udyog Financing Strategy- TCS Smart Manager Case By NarendraL Ahuja and Sweta Gupta

Rickie smiled to himself as he collected his papers and proceeded to the conferenceroom. He was going to make a presentation on what should be the future long-termfinancing strategy of Garuda Udyog.

As he mentally reviewed what he was going to say, he felt a sense of satisfaction andpride. He had made a foolproof case for debt financing that no one in the meeting wouldbe able to oppose. t was an open-and-shut case.

!he coming up of Garuda Udyog "imited in #$%& was the beginning of e'citing times for the ndian passenger car market, which had been dominated by two ma(or car makers)remier Automobiles and Hindustan *otors for over three decades after independence.Garuda+s first model G% became an instant hit and the company en(oyed a near monopoly in the market until mid-#$$s.

However, the liberalisation of the ndian economy and de-licensing of the passenger car industry in the #$$s led to the entry of global players like Hyundai, ord and General*otors as well as domestic giants such as !ata *otors.

!he intense competition that followed had an adverse affect on Garuda+s market shareas well as profit margins, which along with other factors resulted in a substantialdownturn in the company+s fortunes.

!he company+s profit before ta' declined from Rs $ crore /Rs $. billion0 in 1$%/ending &# *arch0, to Rs %2 crore /Rs .%2 billion0 in 1$$, and further to Rs 3%4 crore/Rs &.%4 billion0 in 1 before incurring a net loss of Rs 35$ crore /Rs 3.5$ billion0 in1#.

"ater the company made a spectacular come-back and its profit before ta' rose to Rs crore /Rs . billion0 in 12 and further to Rs #,& crore /Rs #& billion0 in 14.!he company had to fight on many fronts /including product design, 6uality control andcost reduction0 in order to revive its profitability and gain a position of sustainablecompetitiveness.

!he company also aggressively pursued locali7ation of the high value components thatwere previously imported. !hese efforts resulted in a decline in the +materials cost to netsales+ ratio from $.$8 in 3# to 5.58 in 34, thus improving profit margins.

9imilarly, the cost of debt was lowered by repaying a substantial part of borrowed capital

between 3# and 34. !he company+s debt that stood at Rs #,##3 crore /Rs ###.#3billion0 was brought down to Rs &,.5 crore /Rs &.5 billion.0 :uring the same period,the company ploughed back profits by restricting dividend payout, as well as made apublic issue of e6uity in 3& which together raised the shareholders+ funds from Rs3,52& crore /Rs 35.2& billion0 in 3# to Rs 2,&$ crore /Rs 2&.$ billion0 in 34.

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;ow the company was planning to take up further investment pro(ects to the tune of Rs5, crore /Rs 5 billion0 in the ne't four to five years, and had to decide whether torely more on debt or e6uity capital to finance these future pro(ects.

Rickie had been studying the company financial data related to the past eleven years(see Annexure 01) and (ust knew how the company+s financing strategy should change

in the future.

He worked in the finance department of Garuda Udyog where a higher position was tobecome vacant soon, and Rickie wanted to establish himself as its main claimant. Hewanted to assert his position in today+s meeting that would be attended by Harsh :i'it,the <hief General *anager of inance, and two other senior managers, 1ashiro *oriand 1ashwant Ra(.

!herefore, when :i'it asked him to present his viewpoint on the issue, Rickie did notwaste any time and said in a heavy and concluding tone, ++As all of you can see it, thereis no doubt that the company should primarily focus on debt financing in the ne't fewyears. . . =

Ra( who came from a technical background cut him short, =>hy do you say that? thought debt would be a financial burden for the company and hence undesirable.=

Rickie who was not e'pecting any opposition to his ideas, and in any case not so early inhis presentation, became alert, =>ell, was going to e'plain myself any way. n my view,debt financing has three undisputable advantages over the e6uity capital. :ebt capitalbrings in the ta' advantage, the company has the fle'ibility to repay and reduce the debtas well as the related cost of interest and finally it has a favorable impact on the returnavailable to e6uity holders.=

Ra( once again stopped him, =!he advantages you claim come at a cost. :ebt financingincreases the financial risk of the company. t also means having to agree to and abideby the debt covenants that could put lots of restrictions on the company.=

*ori who was a @apanese national and generally regarded as a confidante of the grouprepresenting foreign shareholders in the company, asked, =How do you say that debtfinancing would increase the return on e6uity capital?=

Rickie was glad to get a breather from Ra(+s unnecessary interruptions, =y investing inprofitable pro(ects, the company would earn more on the borrowed capital than the costof interest it would pay. !he surplus earned in this way would go to enhance the earningsavailable to e6uity holders.=

Garuda Udyog was established as a result of the (oint collaboration between !okyo*otors of @apan and the ndian government. 9ince then, !okyo *otors had purchased aconsiderable part of the government+s stake in the company and now held 458shareholding in the company.

!he company+s corporate ob(ectives were to remain the market leaders in the small car segment, increase its market share, create entry barriers for competitors by ensuringma'imum customer satisfaction /for e'ample, by providing highly efficient cars at

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affordable prices and low maintenance cost throughout the life of the car0 whilesimultaneously enhancing shareholder welfare by enhancing share values and paymentof dividends.

:i'it, who was highly 6ualified and had been with the company for a long time, knew thatthe financing decision must be integrated with the overall ob(ectives of the company. He

said, = think the financing strategy would be different in various stages of the life cycle of a company+s e'istence. At its inception, Garuda had to access debt capital due tomodest availability of e6uity capital. !he debt to e6uity ratio at that time was close to #B#.However, as the company grows and has internal accruals of funds through retainedearnings, the dependence on borrowed capital would reduce.=

Rickie continued, =!here are other advantages of debt capital too. !he mi' of e6uity anddebt capital reduces the overall cost of capital. !he e6uity capital is more e'pensivebecause such investors re6uire a greater risk premium.

Assume the cost of e6uity capital is #%8 and the gross cost of interest is #8. f thecorporate ta' rate is &48, the net cost of debt would work out to only 5.48 Ci.e. # D /# -.&40E. ;ow if debt and e6uity are combined in e6ual proportions by maintaining the :B Fratio #B#, the overall cost of capital would be (ust #3.348 C#3 D #% � D 5.4E.=

He paused for breath before continuing, =Ra(+s worries about the financial risk arebaseless. At present, the debt to e6uity ratio of the company is so low that even asubstantial increase in debt would not raise the financial risk to any threatening level inthe foreseeable future. inancial risk arises when a company+s debt servicing capacityas reflected by the +interest coverage ratio+ is low, as it was for Garuda in the 1# whenthe operating profit (see Annexure 02) was low and the relative interest payments high.

9ince then our operating profits have grown many fold and, more importantly, the

foreseeable future looks bright. would therefore say that the company should maintaina target debt-e6uity ratio of #B# and finance its investments pro(ects in the ne't few yearsthrough debt.=

Ra( asked, =How do you think the stock market would react to increasing the debt at thisstage?=

Rickie continued confidently, ="et+s look at it this wayB under what circumstances wouldthe management of any company agree to use debt capital? "et me tell youB only when itis sure that its investment pro(ects would succeed and generate ade6uate cash flows toservice and repay the loans. 9o, when we take debt capital, our confidence inde' asperceived by the investors would go up and the stock markets would react positively.=

:i'it said, =!hat is a good point. ut while thinking about debt versus e6uity financing, letus not forget about the company+s heavy operating fi'ed costs related to production,sales and administration. n our industry, we have to fre6uently introduce new car models, which would re6uire regular investments in plant and e6uipments. Garuda hasgone through three phases of heavy investments in fi'ed assetsB first in #$%&-%2, thenduring the capacity e'pansion of #$$4-3, and finally the more recent investmentssince 3# resulting from the introduction of a number of new models such as theGaruda >agon, Garuda Uno and the Garuda 9UI. >hile the earlier investments have

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been depreciated, the recent ones are still being depreciated and that+s a huge fi'ed costeach year, in addition to other items. 9o, do you think the company can commit to heavyfi'ed financial and operating costs at the same time?=

Rickie had thought of that, =As you know, the interest rates on borrowed capital havecome down considerably during the past two years, isn+t it, would say from #48 to #58

to about $8 to #8. Jn top of it, the interest cost brings in certain ta' advantages. !hatis a substantial saving and the company must capitali7e on it.=

:i'it was aware of it, but also knew that the interest rates in ndia had already startedhardening from the end of 34 and he e'pected them to rise further during the ne'tcouple of years. He said, =<ost control and reduction are crucial to remainingcompetitive, and this applies to financial as well as other costs.=

Rickie continued, =Jf course, as in past, we can use interest rate swaps to keep the costof debt under control. As you would recall, in 3# we had taken loans at fi'ed interestterms of when the interest rates were pretty high, but since we e'pected the rates to fall,we had swapped the fi'ed rate interest liability of #38 on borrowings of the remainingRs #, crore /Rs # billion0for a fle'ible rate by paying a one time premium to a bank.!he swapping had saved the company a considerable amount. And if we issuedebentures to raise debt capital, we+ll include a put-call option that will give us the twinadvantages of fle'ibility with manageable cost of debt, thereby reducing our overall risk.>e have already had some useful e'perience of this in @uly 32 when the companyutili7ed the call option on its ##.38 secured non-convertible debentures and paid backthe entire borrowed amount of Rs 3, <rores /Rs 3 billion0.=

=Rickie must say your observations are not based on facts,= said Ra( as he glared atRickie from behind his thick reading glasses, = think debt capital is not warranted for cash rich companies like Garuda. As you have seen from the company+s balance sheet,we have a huge amount of money invested in mutual funds and other financialsecurities. f we have a cash crunch, why can+t we sell off some of these investments tofinance the company+s future investment pro(ects? !hat would save the company a lot of interest cost.=

or the first time, Rickie seemed to be uncomfortable. He had not considered thisaspect. ut he knew there had to be a better answer, if the theory of optimum allocationof capital was to hold. He said, =!hese investments in mutual funds etc representshareholders+ funds, so the relevant cost of capital of such funds is the same as the costof e6uity. !hey should fetch us higher returns than the cost of e'ternal debt which islower. "et these investments remain as a stand by li6uidity cushion, (ust in case we havea funds problem in the future.=

At this (uncture, *ori politely said, =*y friends, all this is fine, but the company cannotignore the interests of the ma(ority shareholders. eing a part of a multinational whichwants to avoid financial risk, Garuda should remain a debt free company. Fven if it hasto resort to debt financing, it should be to the minimum e'tent and be redeemed as6uickly as possible. Garuda-!okyo *otors should be a 7ero debt company.= :i'it addedthe concluding remarks, =>ell, thank you all for attending the meeting. +ll brief the oardabout this discussion, and let you know what the oard decides.=

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Garuda Udyog