TABLE OF CONTENTS

S.NO. 1. 2. 3. 4. Company profile Project Profile Review of literature Objectives of the study Scope of the study 5. 6. 6. 7. 8. 9. Research methodology Ratio Analysis Findings Limitations Suggestions Conclusion Bibliography Topics

ABSTRACT

A project work is a mandatory requirement for the Business Management Programme. This type of study aims at exposing the young prospective executive to the actual business world. This project gives me knowledge about the capital structure and theory analysis. Financing decisions involve raising funds for the firm. It is concerned with formulation and designing of capital structure or leverage. The most crucial decision of any company is involved in the formulation of its appropriate capital structure. The best design or structure of the capital of a company helps the management to achieve its ultimate objectives of minimising overall cost of capital, maximising profitability and also maximising the value of the firm. organization. It is very effective way to judge a companys cash flow prospects, as cash is like blood life for any company. The report initially begins with the company profile, followed by the detailed analysis of company, like businesses of the company, products offered by the company, financials of the company, etc The report involves a lot of research to understand what exactly capital structure of the company should be.thats , why companies require appropriate capital structure. The purpose is to develop an action plan that creates such a capital structure that will upgrades and standardize the quality of business analysis.

CHAPTER -1 INTRODUCTION TO COMPANY PROFILE

INTRODUCTION TO VERKA MILK PLANT

1. INTRODUCTION
Verka, a leading dairy brand of Punjab, which provides fresh milk, paneer, dahi and desi ghee to millions of homes across the region, is facing stiff competition from a namesake brand registered in the US which has patented the brand name and the product range. Apart from making the Punjab State Cooperative Milk Products Federation's (Milkfed) task difficult in exporting the product to the North American market, the government feels that the US brand is misguiding unsuspecting patrons. Milkfed is considering going for legal action.

The US-based company in question is Quality Products Inc in California, incorporated in 2002, is owned by an Indian, Kulwinder Dhillion. The company's website provides

details of the company selling dahi, paneer, and ghee under the Verka brand across the North American continent. The smartly packaged products bear the 'Real California Seal' and the status of approval accorded by the US Health Department and the FDA.

Currently, Milkfed exports over 1,100 tonnes of 'desi ghee' worth Rs 14 crore, largely to the Gulf, Philippines, Australia and New Zealand. Milkfed had a turnover of Rs 800 crore in 2006-07 and is targeting a 15% growth this fiscal. With the state government marking on a major revamp of Milkfed's existing capacity, it has to be seen what the government would do to protect the hugely popular Verka brand. One of the leading dairy brands of North India, Verka, is yet another contribution from the state of Punjab. The flagship brand of the Punjab State Cooperative Milk Producers' Federation Ltd (Milkfed), Verka is today enjoying the patronage of customers both within and outside the country. Milkfed's future programmes can never be complete without Verka.

Verka is a brand leader in milk powders particularly in northern & eastern sectors. The Milkfed brand commands a premium price over milk powders manufactured by competitors, which include multinational as well as private trade and other cooperative federations.

Milkfed is serving nationwide consumers through its network of Regional offices and strong distribution channels. Milkfed markets a wide variety of products, which include liquid milk, skimmed milk powder, whole milk powder, infant food, ghee, butter, cheese, lassi, SFM, ice cream, malted food and Verka Vigour etc. The annual turnover of Milkfed has touched to Rs 450 crore. Milkfed states that it has successfully leveraged on the brand equity of Verka to launch new trends, needs, tastes and hopes. Health Drinks like Verka Vigour, Verka Lassi, Sweetened Flavoured Milk and a mango drink called Raseela have also hit the markets. Milkfed has now come out with Verka Curd and a whole lot of different flavours of ice creams. Milkfed has also made a foray into the international markets. They say that it was the domestic competition that drove them to alien destinations. However, Milkfed has already established its ghee market in the Middle East. Verka ghee reaches all the Emirates and is available in almost all super markets. In addition to ghee, SMP is also exported to Asian Countries like Philippines, Bangladesh and Sri Lanka. Verka Malt Plus (Malted Milkfood) is being exported to Bangladesh also.With Technology Mission Programmes, ever widening markets and increasing exports, Milkfed is preparing itself to take Verka to greater heights. The federation has planned to introduce more value-added products like Tetra-Pack Plain Milk and low calorie lassi. 5

Milkfed not only provides assured market to milk producers but also carries inputs to enhance milk to their doorsteps. The District Cooperative Milk Producer's Unions and Milk Plants have attained self-sufficiency or are on the threshold of attaining it. Milkfed has played a very vital role in providing a strong base for remunerative price to the producer; they get more money for their milk and payments are timely. In addition technical input services in feeding, breeding and management are easily accessible.

Value addition is one of Milkfed's thrust areas and the plants produce not only pasturised, homogenised milk but also buttermilk, cream, cheese, ice cream, butter and clarified butter-oil (ghee) and several other products. The Milk Unions have marketed milk and milk products. The Punjab State Milk Federation yesterday launched Verka Sweet Lassi and Mango Rasela in Chandigarh. Verka Lassi is popular in India as well as abroad (Milkfed exported lassi to Japan and Bangladesh).

The managing director of Milkfed, Vikas Partap, said there had been a persistent demand from the consumers to launch the tetra pack and it was the ideal time to hit the market.

Milkfed has 11 plants in Punjab producing 35 products, including traditional sweets. He said there was vast scope for expansion in the milk sweets segment and the firm would launch two more in this category (son papri and dhoda) by the end of this month. Milkfed supplies 50 lakh liter per annum of ultra heat treated milk to eastern command (15 lakh litre per annum) and northern command (36 lakh liter per annum). He informed that the federation procures about 7 lakh litres of milk every day and 7 lakh farmers of Punjab were earning their livelihood through Milkfed.

Pure ghee and toned milk of Verka is in great demand in West Asia and we earned about Rs 13.5 crore from export business last year, he added. The Punjab Milkfed also supplies 40,000 liter of milk every day to Mother Dairy. The custom packaging of milk is done at Patiala and the milk is then dispatched to Delhi for sale. We had a turnover of Rs 700 crore last year and expect to do better this year with the opening up of trade ties with Pakistan, he said. He said a trade delegation was in the city to discuss the feasibility of

business with Milkfed. He pointed out that the government-run milk federation, a lossmaking unit for two years, has clocked in profit due to a up grade of marketing strategies. Milkfed was all set to pose a challenge to the private players, through an aggressive marketing drive in the near future, he added. The Mohali plant of Milkfed had received the National Productivity Award, 2005, on Wednesday. The award was given by the Union minister ofagriculture in New Delhi. Milk Plant Mohali bagged theaward for the third time.

Punjabi drink `Lassi' outscores exotic drinks in competition

Patiala (PTI): Punjab's household drink 'Lassi' has outscored other exotic drinks in a unique entrepreneurship competition held in Europe. 'Lassi' was named the best beverage drink at the "Know Europe-2008" entrepreneurship programme in which a 20-year-old student from Chandigarh, Taman Raj Singh, represented India. The month-long programme, organised under the aegis of Normandy Business School of France, aimed at assessing the entrepreneurship acumen of business school students around the world. The invitees were asked to give marketing presentation of beverages famous in their countries and Taman chose the traditional Punjabi drink.

His presentation was a mix of tradition and modernity - the age-old "lassi" in Verka's tetra packs. It impressed the judges immensely and got a high grading of 90 per cent. And the reason why none other beverage matched "lassi" was its unique qualities - a mix of simplicity, flavour and health. "It was not very difficult to convince people that lassi, a simple mixture of yogurt and water, was a healthy drink that could be consumed by people of all ages, infants and patients, without hitch. And what's more, it can be had sweet, salt, spicy or even plain," Taman said. 'Lassi' outscored exotic wines, fancy coffees - lattes and cappuccino in the competition that was held last month at four places in Brussels, the Netherlands, France and Spain.

East or West, lassi is the best. Believe it or not, Punjabs household beverage has outscored exotic wines, fancy coffees - lattes and cappuccino - and brewed beer at a unique entrepreneurship competition in Brussels, the Netherlands, France and Spain. And the youth, who achieved this rare feat for "lassi", is a 20-year-old B.Com student of S D College-32. Taman Raj Singh represented India at the "Know Europe-2008" entrepreneurship programme, organised under the aegis of Normandy Business School of France. 7

For the month-long programme, aimed at assessing the entrepreneurship acumen of business school students, youth all over the world were invited to give marketing presentation of beverages famous in their countries. Taman chose the traditional Punjabi drink. His presentation was a mix of tradition and modernity - the age-old "lassi" in Verkas tetra packs.The presentation impressed the judges immensely and it bagged an unprecedented grading of 90 per cent.

And the reason why none other beverage matched "lassi" was its unique qualities - a mix of simplicity, flavour and health. "It was not very difficult to convince people that "lassi", a simple mixture of yogurt and water, was a healthy drink , a drink that could be consumed by people of all ages, infants and patients, without hitch. And whats more, it can be had sweet, salt, spicy or even plain," said Taman.

This entrepreneurship programme was conducted at four places at Brussels by Hogeschool Universiteit, at the Netherlands by Inholland University, at France by Normandy Business School and at Spain by the Universitat Politecnica Catalunya. It was held under the auspices of the student exchange programme organised between the Normandy French University and SD College-32. Since the target market was Paris, Taman, along with his fivemember team of foreign students, went to all restaurants and big hotels of the city to promote their respective drinks. An ecstatic Taman said: "The feeling is just out of world.

MILK Production is a very important part of the agricultural economy in the state of Punjab. Punjab is one of the smallest states in Indian union with a total area of 50,362Sq.kms, 9

which is 1.5% of the Indian landmass Dairy Farming is an age-old Subsidiary Profession in the rural areas of Punjab. Punjab is the Second largest milk producing state in India, producing around 10% of the countries milk production i.e. 8 millions tones annually.

First milk plant, of the state was setup at VERKA near Amritsar. The brand name of milk and milk Products was adopted as VERKA. The foundation Stone of milk plant, Ludhiana was laid by Hon.S.Parkash Singh Badal ,the then Minister of Punjab in 1970.

OBJECTIVES OF THE ORGANISATION

1. To Strengthen dairy Sector, Milkfed came into existence in 1978 and

simultaneously Distt. Milk unions were formed.. 2. To give remunerative prices to farmers and to ensure permanent market for the whole year. 3. To provide technical inputs like artificial insemination, to improve the breed animals, animals health services, preventive disease treatment and awareness regarding farm management etc. 4. To provide ISI, marks good quality balanced cattle feed and fodder seeds to the farmers.

THE

PUNJAB

STATE

COOPERATIVE

MILK

PRODUCERS

FEDERATION LIMITED:
The Punjab State Cooperative Milk Producers Federation Limited popularly known as MILKFED Punjab, cam into existence in 1973 with a twin objective. One, to carry activities for promoting production, procurement and processing of milk for the economic development of milk producers by providing remunerative milk market to them at their door step. Two, to provide quality milk and milk products to consumers at reasonable rates.

Although the federation was registered much earlier, but it came to real self in the year 1983 when all the milk plants of the erst6while Punjab Dairy Development Corporation Limited were handed over to Cooperative sector and the entire State was covered under

10

Operation Food programme to give the farmers a better deal and our valued customers better products. Today, when we look back, we have fulfilled the promise to great extent.

The setup of the organization is a three tier system, Milk Producers Cooperative Societies at the village level, Milk Unions at District Level and Milk Federation as an Apex Body at State level. MILK PROCUREMENT NETWORK:

Working on Anand Pattern the process of organizing societies at village level started in Punjab as early as 1978. Presently, there is strong Network of about 6000 (as on 31.3.2007) Milk Producers Cooperative Societies organized at village level. About 3.60 Lakh milk producer members are attached to these societies. Fresh milk is procured from the milk producers twice a day through village level societies directly without the assistance of any middleman.

INPUT SERVICES
It is one of the fundamental objectives of Milkfed to carry out activities for promoting milk production in the State. In the view of this, various technical input services like veterinary health care, artificial insemination services, vaccination, supply of VERKA balanced cattle feed and quality fodder seed etc. are provided for enhancing milk production and economic development of farming community.

CATTLE INDUCTION PROGRAMME

Government of Punjab has identified dairy sector as thrust area for rural development. Recently, Milkfed Punjab has signed memorandum of understanding (MOU) with State Bank of India, State Bank of Patiala and Oriental Bank of Commerce for providing loan up to Rs. 50,000/- without any collateral security to milk producer farmers for purchase of mulch cattle on soft terms and low rate of interest.

CLEAN MILK PRODUCTIOIN PROGRAMME:

For improving quality of raw milk right from milk producers level, q massive programme called CMP has been launched under which 152 Bulk Milk Coolers have been installed in the societies and many more are in pipe line. Besides, more than 1000 Automotive Milk Collection Stations have been provided to the societies for bringing 11

efficiency and total transparency in the system. Traditional manual method milk testing at society level is being replaced with Electronic Milk Testers.

WOMEN DAIRY PROJECT

Household level dairying is largely the domain of women especially inn in small and marginal household families. In the view of this fact, Milkfed has undertaken Women Dairy Project in six Milk Unions namely Hoshiarpur, Ropar, Patiala, Jalandhar, Ludhian and Amritsar with an objectives to empower rural women in the field of dairy. This Programme is being implemented under Support to Training & Employment Programme (STEP) with the assistance of Government of India. Under this programme, 390 women societies with 19860 women beneficiary members will be organized.

MARKETING
MILKFED is serving nationwide consumers through its net work of Regional offices and strong Distribution channels. MILKFED markets a wide Variety of Products which include liquid milk, skimmed milk powder, whole milk powder, infant food, ghee, butter, cheese, lassi, SFM, Ice Cream, Malted food Verka Vigour etc. etc. The annual turn over of MILKFED has crossed Rs 500 crores. Verka is a brand leader in milk powders particularly in northern eastern sectors and SMP marketed by MILKFED commands a premium price 12

over powders manufactured by competitors which include multi-national as well as private trade and other Cooperative Federations. Now Verka has arrived on the sheer strength of its quality, freshness and purity. And of course, its home made taste. And all this, at the most affordable prices. To people today, Verka is the part of their daily lives.,

THE EXTENSION OF THE BRAND

After winning faith of innumerable consumers, Verka did not stop. For there was a scope for more. Changing times brought new trends, needs, tastes and hopes. Verka dynamic as ever,too ac-quired newer forms.By adding value to milk to satisfy a quality - conscious society. And what success! for,consumers could have their own pick as we came up with varied varieties of cheese like the Processed Cheddar Cheese, Cheese Spread, and cheese Singles. And there were milk powders like Dairy Whitener,Skimmed Milk Powder and Infant Milk Powder. Health Drinks like Verka Vigour, Verka Lassi, Sweetened Flavoured Milk and a mango drink called Raseela. Then there were Verka Curd and a whole lot of different flavours of Ice Creams. Milk had never meant so much before.

EXPORT OF MILK PRODUCTS

With competition in the national market zooming up efforts to export products have been made. MILKFED has established its ghee market in Middle East Market. Verka ghee reaches all the emirates and is available almost in all super markets. The penetration is so deep that verka ghee is available in far off labour camps. In addition to ghee, SMP was also exported to Asian Countries like Philippines, Bangla Desh and Sri-Lanka. Verka Malt Plus (Malted Milkfood) have also been exported to Bangla Desh.

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QUALITY ASSURANCE PROGRAMME

Quality Assurance Programme (QAP) which is a part and parcel of Dairy Plant Improvement Programme (DPIP) was taken up in Ludhiana Milk Union with the Technical guidance from NDDB. The main objective of the programme is to improve efficiency of Plants coupled with loss management to bring down the cost of production, im-prove the quality of milk and milk products manufactured to ameliorate the general hygienic and house keeping standards and above all to enhance the profitability and financial viability of the Milk Plants to enable milk producers to get better price for their produce.

VERKA MILK PLANT MAY GO ON STIR

Cutting across party affiliations, all 12 directors on the board of the Verka Milk Plant, Ludhiana, have got together to threaten an agitation if the Milkfed management does not increase the procurement price of milk from producers At a meeting held at the Verka Milk Plant here today, the directors, belonging to the Shiromani Akali Dal (SAD) and the Congress, said the management of Milkfed had not taken the board of directors into confidence before reducing the purchase price of milk. They said bureaucrats running Milkfed took decisions sitting in Chandigarh without consulting the directors, who were elected representatives of the milk producers

14

The directors alleged that the Milkfed management deliberately ignore them at the instance of the Punjab government which wanted to benefit private companies like Reliance. The directors say Milkfed is purchasing milk at lower rates, the private companies are paying more and gradually the milk produc The directors have demanded that the rates of purchase of milk from milk producers should be increased immediately. They want an end to interference too ers might turn to the private companies. This might lead the Verka Milk Plants to shut down which would also result in Speaking to the media after their meeting, the directors, including Ajmer Singh Bhagpur (SAD), Paramjit Singh Ghawadi (Congress) and five directors each from SAD and Congress, said the Milkfed management never takes up development is employment. The directors have demanded that the rates of purchase of milk from milk producers should be increased immediately. They want an end to interference too. Metro coming to South Delhi in 10Udaynarayanpur suicides: Poor job forced you...Toyota to launch Fortuner in India by Sept26/11 attackers got significant support from...Drunk couple jumps into Yamuna, rescued by...Orkut posts class 12 boys cell phone number...

Ludhiana, November 11 In the backdrop of seizure of adulterated milk in the city, the Verka Milk Plant has installed a free milk-testing centre outside its main gate on Ferozpur Road. The centre will be providing free milk testing facility from 9 am to 5 pm on all working days, said Balwinder Singh, general manager, Verka Milk Plant. The company is mulling over the idea to extend the facility even on Sundays. It has asked consumers to get 250 ml of unpasturised milk at the centre and get the tests, including for synthetic milk, done there. Within ten to fifteen minutes a report will be handed over to the consumer, said a company employee. In the past few weeks, the Health department has seized a huge quantity of adulterated milk from several shops in the city. There is an increase in the supply of spurious and adulterated milk in the market. So it was the need of the hour to open this kind of center, Balwinder Singh said.

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Due to unawareness and lack of facilities of getting milk tested, the residents had no option but to use low-level milk and its products, he added. The Verka Milk Plant receives about 2.50 lakh litres of milk daily from 750 villages of Luhdiana district through villagelevel milk cooperative societies. In the last five months I have cancelled the contracts of many contractors whose supply was not up to the mark, said Balwinder Singh. Although there was a lot of political pressure on me, I didnt bow to it and cancelled the contracts of 20 to 25 years old contractors. The company says it tests the milk at milk cooperative societies first and then again at Verka Milk Plant just to rule out any adulteration in it. To keep a strict vigil on private dairy owners, Balwinder Singh said the company was planning to raid some private dairy owners along with the Health authorities. We will take random milk samples from dairies and the Health department will take strict action against those indulging in adulteration, he added.

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CHAPTER 2 PROJECT PROFILE

17

CAPITAL STRUCTURE: THEORY AND ANALYSIS

CAPITAL STRUCTURE

Financing decisions involve raising funds for the firm. It is concerned with formulation and designing of capital structure or leverage. The most crucial decision of any company is involved in the formulation of its appropriate capital structure. The best design or structure of the capital of a company helps the management to achieve its ultimate objectives of minimising overall cost of capital, maximising profitability and also maximising the value of the firm. The capital structure decision of a firm is concerned with the determination of debt equity composition. Capital structure ordinarily implies the proportion of debt and equity in the total capital of a company. The term capital may be defined as the long term funds of the firm. Capital is the aggregation of the items appearing on the left hand side of the balance sheet minus current liabilities.

In other words capital may be expressed as follows:

Capital = Total Assets Current Liabilities.

Further, capital of a company may broadly be categorised into equity and debt. The total capital structure of a firm is represented in the following figure:

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TOTAL CAPITAL

EQUITY CAPITAL

DEBT CAPITAL

EQUITY SHARE CAPITAL PREFERENCE SHARE CAPITAL SHARE PREMIUM RETAINED EARNINGS

TERM LOANS DEBENTURES DEFERRED PAYMENTS LIABILITIES OTHER LONG TERM DEBT

Established companies generally have track record of their profit earning capacity, which helps them to create their creditworthiness. The lenders feel safe to invest their funds in such companies. Thus, there is ample scope for this type of companies to collect debt. But a company cannot freely i.e. without having any limit. The company must have to chalk out a plan to collect a debt in such a way that the acceptance of debt becomes beneficial for the company in terms of increase in EPS, profitability and value of the firm. If the cost of capital is greater than the return, it will have an adverse effect on companys profitability, value of the firm and its EPS. Similarly, if company is unable to repay the debt within the scheduled period it will affect the goodwill of the company in the credit market and consequently may create problems in future for collecting further debt. Other factors remaining constant, the company should select its appropriate capital structure with due consideration.

Capital structure involves a choice between risk and expected return. The optimal capital structure strikes the balance between these risks and returns and thus examines the price of the stock. 19

Significant variations with regard to capital structure can easily be noticed among industries and firms within the same industry. So it is difficult to generate the model capital structure for all business undertakings. The following is an attempt to consolidate the literature on various methods to suggested by researchers in arriving at optimal capital structure.

Notations used:
V = value of firm FCF = free cash flow WACC = weighted average cost of capital rs and rd are costs of stock and debt re and wd are percentages of the firm that are financed with stock and debt.

Operating and Financial Leverages

The term leverage refers to the ability of a firm in employing long term funds having a fixed cost, to enhance returns to the owners. In other words leverage is the employment of fixed assets or funds for which a firm has to meet fixed costs or fixed rate of interest obligation irrespective of the level of activities attained or the level of operating profit earned. Higher the leverage, higher the profits and vice versa. But a higher leverage obviously implies higher outside borrowings and hence riskier if the business activity of the firm suddenly takes a dip. But a low leverage does not necessarily indicate prudent financial management, as the firm might be incurring an opportunity cost for not having borrowed funds at a fixed cost to earn higher profits.

Operating Leverage
Operating leverage is concerned with the operation of any firm. The cost structure of any firm gives rise to operating leverage because of the existence of fixed nature of costs. This leverage relates to the sales and profit variations.

Operating Leverage =

Contribution EBIT

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Contribution = Sales Variable Costs EBIT = Earnings Before Interest and Taxes.

Disadvantages of Operating Leverages

The reliability of operating ratios rests to a large extent on the correctness of the fixed costs identified with a product. Faulty apportionment would distort the usefulness of the ratio. The published accounts does not give details of the fixed cost incurred and the contribution from each product and for an outsider it is difficult to calculate the firms operating leverage.

Firms cost structure and nature of the firms business affects operating leverage. A degree change in sales volume results in more than proportionate change (+/-) in operating (or loss) can be observed by use of operating leverage.

Financial Leverage
This ratio indicates the effects on earnings by rise of fixed cost funds. It refers to use the use of debt in the capital structure. Financial leverage arises when a firm deploys debt funds with fixed charge. The ratio is calculated with the following: Earnings before interest and tax / Earnings after interest The higher the ratio, the lower the cushion for paying interest on borrowings. A low ratio indicates a low interest outflow and consequently lower borrowings. A high ratio is risky and constitutes a strain on profits. This ratio is considered along with the operating ratio, gives a fairly and accurate idea about the firms earnings, its fixed costs and the interest expenses on long term borrowings. Earnings per Share Higher financial leverage leads to higher EBIT resulting in higher EPS, if other things remain constant. Financial leverage affects the variability and expected level of EPS. The more debt the firm employs the higher its financial leverage. Financial leverage generally raises expected EPS, but it also increases the riskiness of securities as the debt / asset ratio rises.

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Financial Leverage EBIT = EBT

EBIT Earnings Before Interest and Tax EBT Earnings Before Taxes.

Consider Two Hypothetical Firms

Firm U
No debt 20,000 in assets 40% tax rate

Firm L
10,000 of 12% debt 20,000 in assets 40% tax rate

Both firms have same operating leverage, business risk, and EBIT of 3,000. They differ only with respect to use of debt.

Impact of Leverage on Returns

EBIT Interest EBT Taxes (40%) NI ROE Firm U 3,000 0 3,000 1, 200 1,800 9.0% Firm L 3,000 1,200 1,800 720 1,080 10.8% (Fig. in Rs000)

More EBIT goes to investors in Firm L. Total dollars paid to investors: U: NI = Rs.1,800. L: NI + Int = Rs.1,080 + Rs.1,200 = Rs.2,280. Taxes paid: U: Rs.1,200; L: Rs.720.

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Now consider the fact that EBIT is not known with certainty. Determining the impact of uncertainty on stockholder profitability and risk for Firm U and Firm L Firm U: Unleveraged
Economy Bad Prob. EBIT Interest EBT Taxes (40%) NI Firm L: Leveraged Economy (Fig. in Rs000) Bad Prob.* EBIT* Interest EBT Taxes (40%) NI *Same as for Firm U. Firm U BEP ROIC ROE TIE Firm L BEP ROIC ROE TIE Bad 10.0% 6.0% 6.0% n.a. Avg. 15.0% 9.0% 9.0% n.a. Good 20.0% 12.0% 12.0% n.a. 0.25 2,000 1,200 800 320 480 Avg. 0.50 3,000 1,200 1,800 720 1,080 Good 0.25 4,000 1,200 2,800 1,120 1,680 0.25 2,000 0 2,000 800 1,200 (Fig. in Rs000) Avg. 0.50 3,000 0 3,000 1,200 1,800 Good 0.25 4,000 0 4,000 1,600 2,400

Bad Avg. Good 10.0% 15.0% 20.0% 6.0% 9.0% 12.0% 4.8% 10.8% 16.8% 1.7x 2.5x 3.3x U L

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Profitability Measures: E(BEP) E(ROIC) E(ROE) Risk Measures: sROIC 2.12% sROE 2.12% 2.12% 4.24% 15.0% 9.0% 9.0% 15.0% 9.0% 10.8%

Conclusions
Basic earning power (EBIT/TA) and ROIC (NOPAT/Capital = EBIT(1-T)/TA) are unaffected by financial leverage. L has higher expected ROE: tax savings and smaller equity base. L has much wider ROE swings because of fixed interest charges. Higher expected return is accompanied by higher risk. In a stand-alone risk sense, Firm Ls stockholders see much more risk than Firm Us. U and L: sROIC = 2.12%. U: sROE = 2.12%. L: sROE = 4.24%. Ls financial risk is sROE - sROIC = 4.24% - 2.12% = 2.12%. (Us is zero.) For leverage to be positive (increase expected ROE), BEP must be > rd. If rd > BEP, the cost of leveraging will be higher than the inherent profitability of the assets, so the use of financial leverage will depress net income and ROE. In the example, E(BEP) = 15% while interest rate = 12%, so leveraging works.

Choosing the Optimal Capital Structure for Verka Milk Plant Based on the ratio analysis done above it can be concluded that Verka Milk Plant is an unleveared firm with very less debt component in its capital structure. The company is in a position to increase its debt component by resorting to external debt financing. However it should be kept in mind that, there could be two opposite effects if debt is increased in the capita structure. The first effect may be an overall reduction in the cost of capital as the

24

proportion of debt increases in the capital structure due to low cost of debt. On the other hand, because of fixed contractual obligation the financial risk of the company increases. Thus, it is said that the optimum capital structure implies a ratio of debt and equity at which weighted average cost of capital would be least and the market value of the firm would be highest. Keeping the above thought in mind I have tried to compute what would be the optimal capital structure for Verka Milk Plant Report 2005: EBIT being 37,273,800; Assuming that the firms expects zero growth 225,557,810 shares outstanding; rs = 12%; T = 35%; b = 1.0; rRF = 6%; RPM = 6%. Estimates of Cost of Debt Percent financed with debt, wd 0% 20% 30% 40% 50% rd 8.0% 8.5% 10.0% 12.0% Ltd., based on the following information as per the Annual

If company recapitalizes, debt would be issued to repurchase stock.

The Cost of Equity at Different Levels of Debt: Hamadas Equation MM theory implies that beta changes with leverage. bU is the beta of a firm when it has no debt (the unlevered beta) 25

bL = bU [1 + (1 - T)(D/S)]

The Cost of Equity for wd = 20% Use Hamadas equation to find beta: bL = bU [1 + (1 - T)(D/S)] = 1.0 [1 + (1-0.35) (20% / 80%) ] = 1.16 Use CAPM to find the cost of equity: rs = rRF + bL (RPM)

= 6% + 1.16 (6%) = 12.98% Cost of Equity vs. Leverage wd 0% 20% 30% 40% 50% The WACC for wd = 20% WACC = wd (1-T) rd + we rs WACC = 0.2 (1 0.35) (8%) + 0.8 (12.98%) WACC = 11.42% Repeat this for all capital structures under consideration. D/S 0.00 0.25 0.43 0.67 1.00 bL 1.00 1.16 1.28 1.43 1.65 rs 12.00% 12.98% 13.67% 14.60% 15.90%

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WACC vs. Leverage wd 0% 20% 30% 40% 50% rd 0.0% 8.0% 8.5% 10.0% 12.0% rs 12.00% 12.98% 13.67% 14.60% 15.90% WACC 12.00% 11.42% 11.23% 11.36% 11.85%

Corporate Value for wd = 20% V = FCF / (WACC-g) g=0, so investment in capital is zero; so FCF = NOPAT = EBIT (1-T). NOPAT = (Rs.37,273,800)(1-0.35) = Rs.24,227,970 V = Rs.24,227,970/ 0.1142 = Rs.212,153,852.89

Corporate Value vs. Leverage wd 0% 20% 30% 40% 50% WACC 12.00% 11.42% 11.23% 11.36% 11.85% Corp. Value Rs.201,899,750.00 Rs.212,153,852.89 Rs.215,791,315.97 Rs.213,274,383.80 Rs.204,455,443.04

Debt and Equity for wd = 20% The value of debt is: = wd V = 0.2 (Rs.212,153,852.89) = Rs.42,430,770.58. S=VD S = Rs.212,153,852.89 Rs.42,430,770.58 = Rs.169,723,082.31 27

Debt and Stock Value vs. Leverage wd 0% 20% 30% 40% 50% Debt, D 0 Rs.42, 430,770.58 Rs.64, 737,394.79 Rs.85, 309,753.52 Rs.102, 227,721.52 Stock Value, S Rs.201,899,750.00 Rs.169,723,082.31 Rs.151,053,921.18 Rs.127,964,630.28 Rs.102,227,721.52

Wealth of Shareholders Value of the equity declines as more debt is issued, because debt is used to repurchase stock. But total wealth of shareholders is value of stock after the recap plus the cash received in repurchase, and this total goes up (It is equal to Corporate Value on earlier slide).

Stock Price for wd = 20% The firm issues debt, which changes its WACC, which changes value. The firm then uses debt proceeds to repurchase stock. Stock price changes after debt is issued, but does not change during actual repurchase (or arbitrage is possible). The stock price after debt is issued but before stock is repurchased reflects shareholder wealth: S, value of stock

Cash paid in repurchase. D0 and n0 are debt and outstanding shares before recap. D - D0 is equal to cash that will be used to repurchase stock.

28

S + (D - D0) is wealth of shareholders after the debt is issued but immediately before the repurchase.

P = S + (D D0) n0 P = Rs.169,723,082.31+ (Rs. 42,430,770.58 0) 225,557,810 P = Rs.94.06 per share. # Repurchased = (D - D0) / P # Rep. = (Rs.42,430,770.58 0) / Rs.94.06 = 45,116. # Remaining = n = S / P n = Rs.169,723,082.31 / Rs.94.06 = 1,804,462. Price per Share vs. Leverage # shares wd 0% 20% 30% 40% 50% P Rs.89.51 Rs.94.06 Rs.95.67 Rs.94.55 Rs.90.64 Repurch. 0 451,116 676,673 902,231 1,127,789 # shares Remaining 2,255,578 1,804,462 1,578,905 1,353,347 1,127,789

Optimal Capital Structure wd = 30% gives: Highest corporate value 29

Lowest WACC Highest stock price per share

But wd = 40% is close. Optimal range is pretty flat.

Modigliani and Miller Theory (Modern View)

The traditional view of capital structure explained in weighted average cost of capital is rejected by the proponents Modigliani and Miller (MM) (1958). According to them, under competitive conditions and perfect markets, the choice between equity financing and borrowing does not affects a firms market value because the individual investor can alter investment to any mix of debt and equity the investor desires.

Assumptions of MM Theory
The MM Theory is based on the following assumptions: Perfect capital markets exist where individuals and companies can borrow unlimited amounts at the same rate of interest. There are no taxes or transaction costs. The firms investment schedule and cash flows are assumed constant and perpetual. Firms exist with the same business or systematic risk at different levels of gearing. The stock markets are perfectly competitive. Investors are rational and except other investors to behave rationally.

MM Theory: No Taxation
The debt is less expensive than equity. An increase in debt will increase the required rate of return on equity. With the increase in the levels of debt, there will be higher level of interest payments affecting the cash flow of the company. Then equity shareholders will demand for more returns. The increase in cost of equity is just enough to offset the benefit of low cost debt, and consequently average cost of capital is constant for all levels of leverage as shown in Figure 1.

30

Cost of Capital

Cost of Equity

Average cost of Capital

Cost of Debt

Level of leverage

Figure 1: MM view of Capital Structure

In MM theory the following notations will be used: Vu = Market value of ungeared company i.e. company with 100% equity financing. Vg D Ve Vg Ku Kg Kd = Market value of a geared company i.e. capital structure of the company includes both debt and equity capital. = = = = = = Market value of debt in a geared company. Market value of equity in a geared company. Ve + D Cost of equity in an ungeared company. Cost of equity in a geared company. Cost of Debt.

31

M M Theory: Proposition I
The market value of any firm is independent of its capital structure, changing the gearing ratio cannot have any effect on the companys annual cash flow. The assets in which the company has invested and not how those assets are financed determine the market value. Thus, the market value of a firm is unaffected by its financing decisions, its capital structure, or its debt-equity ratio. In simple words, M & M theory views the value of the company as a whole pie. The size of the pie does not depend on how it is sliced i.e. the firms capital structure but rather the size of the pie pan i.e. the firms present value based on its future cash flows and its asset base. The value of the geared company is as follows: Vg = Vu Vg = Profit before interest WACC Vg = Vu = Earnings in ungeared company Ku WACC is independent of the debt / equity ratio and equal to the cost of capital which the firm would have with no gearing in its capital structure. Proof by example Consider holding 1% of stock in an all-equity firm with value VU. Then your wealth is 0.01VU. Also, you receive a cash flow of 0.01CFt every period. Alternatively, consider holding 1% equity and 1% debt in levered version of the same firm with value Vg=E+D. Your wealth then is [0.01E+0.01D] = 0.01Vg. Cash Flows each period? [0.01(Int)+0.01(CFt-Int)]=0.01CFt. As the inherent risk of the firm is the same, then the discounted value of the cash flows must be the same, i.e., Vg= VU.

WACC

Prop. I

M&M

Traditional

32

B E

MM Theory: Proposition I M M Theory: Proposition II

The rate of return required by shareholders increases linearly as the debt / equity ratio is increased i.e. the cost of equity rises exactly in line with any increase in gearing to precisely offset any benefits conferred by the use of apparently cheap debt. MM went on arguing that the expected return on the equity of a geared company is equal to the return on a pure equity stream plus a risk premium dependent on the level of capital structure. The premium for financial risk can be calculated as debt / equity ratio multiplied by the difference between the cost of equity for ungeared company and risk free cost of debt.

The cost of equity depends on the following three variables: 1. The 2. required The required rate rate of of return return on on the the firms firm debt (Ku). (Kd).

3. The firms debt/equity ratio (D/E)

Kg Ku

D K Kd Vg u

MM proposition II can be summed up in following points: Equity holders require a premium over what everyone is paid if the firm has debt. The premium DOES depend upon the firms financing mix. The wealth of equity holders, however, is unaffected. Any increase in leverage raises both the risk of equity and its required return. Stockholders are indifferent to capital structure and to change in leverage.

33

RE

Prop. II
M&M Slope = RA RD

RA

Traditional

B E

MM Theory: Proposition II M M Theory: Proposition III

MM theorys third proposition asserts that the cut-off rate for new investment will in all cases be average cost of capital and will be un affected by the type of security used to finance the investments.

M M Theory: Arbitrage
The cost of equity will rise by an amount just sufficient to offset any possible saving or loss. The lenders determine the supply of debt. The optimal level is simply the maximum amount of debt which lenders are prepared to subscribe in any given circumstances e.g. level of inflation, rate of economic growth, level of profits etc. the investors will exercise their own leverage by mixing their own portfolio with debt and equity. The investors call this the arbitrage process. Under these conditions of investment the average cost of capital is constant. If two different firms with same level of business risk but different levels of gearing sold for different values, then shareholders would move from over valued firm to the under value firm and adjust their level of borrowing through the market to maintain financial risk at the same level. The shareholders would increase their income through this method while maintaining their net investment and risk at the same level. This process of arbitrage would drive the price of the two firms to a common equilibrium total value. The word arbitrage is a technical term referring to a situation where two identical commodities are selling in the same market for different prices, then the market will reach equilibrium by the dealers start at the lower price and sell at the higher price, thereby making 34

profit. The increase in demand will force up the price of the lower priced goods and increase in supply will force down the price of the high priced commodities. The arbitrage in MM theory shows that the investors will move quickly to take advantage and will make profit in an equilibrium capital market, then this would represent an arbitrage opportunity.

MM Theory: Corporate Taxation

In above discussion, MM theory has ignored the tax relief on debt interest. MM has further modified their theory by considering tax relief available to a geared company when the debt component exists in the capital structure. The tax burden on the company will lessen to the extent of relief available on interest payable on the debt, which makes the cost of debt cheaper, which reduces the weighted average capital of the lower where capital structure of a company has debt component. Consider a firm with no debt (i.e. all equity or unlevered) with a value of Vu. Suppose firm changes capital structure by issuing debt and retiring some equity. The firm will realize gain since interest payments on debt are tax-deductible, so tax liability will decline! For perpetual debt: Yearly Tax Savings (Tax Shield) = Interest TC = r D TC = RD B TC Tax shield will be realized each year forever. Since it goes to bondholders, it should be discounted at RD, thus PV of tax shield = (RD B TC)/ RD = B TC Value of firm with debt VL (i.e. levered firm) will be : VL = Vu + B TC Value increases by PV of tax shield. Tax advantage of debt increases as TC increases. In M&M world (TC = 0), VL = V

35

VL

Slope = TC

PV of Tax Shield

VU

M&M Value

B MM Theory: Corporate Taxation

Under the assumption of tax relief being available on debt interest, the total market value of the company is increasing function of the level of gearing. MM theory cost of equity formula for a geared company:

Kg = Ku + (1 T) (Ku Kd) MM theory assumes that the value of the geared company will always be greater than an ungeared company with similar business risk but only by the amount of debt associated tax saving of the geared company. Value of geared company: Vg = Vu + DT When corporation taxation is introduced, the tax deductibility of debt interest creates value for shareholders via the tax shield, but this is a wealth transfer from taxpayers. The value of a geared company equals the value of an equivalent ungeared companys shareholders is less than that in the all equity company, reflecting the tax benefits. A further effect of corporate taxation is to lower WACC, which falls continuously as gearing increases.

MM Theory: Personal Taxation MM theory considered only corporate taxes. It was left to a subsequent analysis by Miller (1977) to include the effects of personal as well as corporate taxes. He argued that the existence of tax relief on debt interest but not on equity dividends would make debt capital 36

more attractive than equity capital to companies. The market for debt capital under the laws of supply and demand, companies would have to offer a higher return on debt in order to attract greater supply of debt. When the company offers after personal tax return on debt at least as equal to the after personal tax return on equity, the equity supply will switch over to supply debt to the company. It is assumed that, from the angle of the company, it will be indifferent between raising debt or equity as the effective cost of each will be the same and there is no advantage to gearing.

Financial Distress and Capital Structure

The assumption is that when firm has very high level of borrowing they are more likely to run into the cost of final distress and cost of bankruptcy. When the leverage of the firm is extremely high then it is very likely that at some stage it will not be able to make annual interest payments and loan repayments. Dividends for shareholders can be bypassed but failure to pay interest on loans often gives the lender the right to claim on the firms operating assets thereby preventing the firms continuity of activity. The following illustrative list of activities which may cause increase in cost of the firm. Successive borrowings beyond the companys target debt equity ratio. Borrowing higher levels of interest Skip off or cut in dividend which may cause the fall of market rate of shares. Loss of trade credit from suppliers Distress sale of highly profitable instruments. Abandonment of promising new projects. Reduced credit period resulting in loss of business. Corporate image may be tarnished. Demand for withdrawal of loans made to the firm previously. Reduction in stock levels result in reduction in sales etc.

Bankruptcy Costs

The cost of bankruptcy may be of two types: Direct costs Those directly associated with bankruptcy, both legal and administrative. 37

Indirect costs Costs associated with a firm experiencing financial distress (creditors, bankers, customers, employers, etc.)

Bankruptcy costs = direct costs + indirect costs

An increase in debt is associated with increased tax savings but also an increased probability of running into cost of financial distress and bankruptcy. The value of the leveraged firm is its capitalised after tax operational cash flow plus the present value of the tax savings incorporating the anticipated cost of financial distress and bankruptcy.

V = X + DT BC R Where, V X R D T BC = = = = = = Value of leverage firm Anticipated net operational cash flows Capitalisation Rate Market Value of Debt Corporate tax rate Anticipated costs of bankrupting

38

Cost of Debt V PV of Bankruptcy Cost

PV of Tax Shield VU Cost of Equity

Optimum Capital Structure

Figure: Optimum Capital Structure and Costs of Financial Distress

The existence of tax benefit for modest amounts of debt, and the need to avoid the costs of financial distress, suggest that there is an optimal capital structure as illustrated in figure which shows that there is an optimal capital structure at the point where the market value of the firm is maximized, that is where (DT BC) is maximized.

Debt Financing and Agency Costs Agency theory models a situation in which a principal (a superior) delegates decision making authority to an agent (the subordinate) who receives reward in return for performing some activity on behalf of the principal. The outcome of the agents effects the principals welfare in some way, for example sales revenue, output or contribution margin. The principal attempts to combine a reward system with an information system, in order to motivate the agent to choose the action, which maximizes the principals welfare. In respect of debt finance, the suppliers of debt are much concerned, about their investment in the company, about their investment in the company, about the risk involved in financing 39

debt to the company. In order to minimize the risks in debt finance, the suppliers of loan will impose restrictive conditions in loan agreements that constraint managements freedom of action and it is known as agency costs. The more money the suppliers of debt lend to the company then the more constraints they are likely to impose on the managements in order to secure their investments. Therefore, agency costs are more in highly geared firms.

Difficult to identify and estimate, but exist V = VU + BTC PVBC PV of agency costs PVBC + PVAC eventually dominate over PV of tax shield. PV of agency costs , as B generally.

PVBC + PVAC

PV of Tax Shield VU

Debt Financing and Agency Cost Signaling Theory

In a pioneering study published in 1961, Gordon Donaldson examined how companies actually establish their capital structure. The findings of his study are summarised below: 1. Firms prefer to rely on internal accruals, i.e. on retained earnings and depreciated cash flow. 40

2. Expected future investments oppurtunities and expected future cash flow influence target dividend payout ratio. Firms set the target pay out ratio at such a level that capital expenditures, under normal circumstances, are covered by internal accruals. 3. Dividends tend to be sticky in the short run. Dividends are raised only when the firm is confident that the higher dividend can be maintained; dividends are not lowered unless things are very bad. 4. If a firms internal accruals exceed its capital expenditure requirements, it will invest in marketable securities, retire debt, raise dividends, resort to acquisitions, or buyback its shares. 5. If a firms internal accruals are less than its non-postponable capital expenditure, it will first draw down its marketable securities portfolio and then seek external finance. Noting the inconsistencies in the trade off theory, Myers proposed a new theory, called the signalling, or asymmetric information, theory of capital structure. The main points of the theory are: Managers often have better information. Sell stock if stock is overvalued. Sell bonds if stock is undervalued. Investors understand this, so view new stock sales as a negative signal.

Corporate Finance Practices

The capital structure decision is a difficult decision that involves a complex trade off among several considerations like income, risk, flexibility, etc. given the over riding objective of maximising the market value of a firm, the following guidelines should be kept in mind while hammering out the capital structure of the firm.

Avail of the Tax Advantage of Debt. Interest on debt finance is a tax deductible expense. Hence finance scholars and practitioners agree that debt financing gives rise to tax shelter which enhances the value of the firm.

Preserve Flexibility

41

Flexibility implies that the firm maintains reserve borrowing power to enable it to raise debt capital to respond to unforeseen changes in business and political environment. Hence the firm must maintain some unused debt capacity as an insurance against adverse future developments. Ensure that the Total Risk Exposure is Reasonable The affairs of the firm should be managed in such a way that the total risk borne by the equity shareholders is not unduly high. Subordinate Financial Policy to Corporate Strategy Financial policy and corporate strategy are often not integrated well. This may be because financial

Mitigate Potential Agency Costs. Due to separate ownership and control in modern corporations, agency problems arise. Shareholders scattered and dispersed as they are not able to organise themselves effectively. Hence, very little monitoring takes place in the security markets. Since agency costs are borne buy shareholders and the management, the financing strategy of a firm should seek to minimise these cost by employing external agents who specialise in low cost monitoring.

Issue innovative Securities Thanks to SEBI guidelines introduced in 1992, issues have considerable freedom in designing financial instruments. There is greater scope for employing innovative securities to the advantage of the firm. The important securities innovations have been as follows: floating rate bonds (or notes), collateralised mortgage obligations, dual currency bonds, extendible notes, medium term notes.

Widen the Range of Financing Sources In as dynamically evolving financial environment, traditional sources of financing may diminish in importance. They may not be adequate or optimal. Hence, it behoves on a firm to employ new modes of finance like commercial paper, factoring, Euro issues, and securitisation.

42

CAPITAL STRUCTURE (GEARING)

1.0 INTRODUCTION

The cost of capital of a firm is fundamental in the decision as to whether a proposed project is acceptable. If the return from a project (r) exceeds the cost of capital (ko) then the project should be accepted. If the cash flows from the project were to be discounted at ko then the project would have a positive net present value (N.P.V.).

This would be profitable for the firm and will mean an increase in the present net worth.

Initial assumptions of all models (1) (2) (3) (4) (5) No taxation Immediate change in gearing All earnings distributed All shareholders expect same future earnings No growth in earnings

Basic equations
kd annual interest charges Market value of debt

ks
ko

earnings available to shareholde rs Market value of equity

Net operating earnings Total market value of firm

ko is the WACC weighted by market values.

2.0

THE NET INCOME APPROACH

According to this approach the average cost of capital (ko) declines as gearing increases. The cost of shareholders funds (ks) and the cost of debt (kd) are independent. Since kd is usually less than ks as debt is less risky than equity from the investors point of view, an increase in gearing should lead to a decrease in ko.

43

The strict net income approach assumes that ks and kd remain constant.

2.1

The traditional View

The traditional view is that there is an optimal capital structure. As gearing increases so financial risk increases because the fixed charges increase. Illustration 2.2 Two companies have the same EBIT but different capital structures Company A: Company B: E (EBIT) = $80,000 all equity capital E (EBIT) = $80,000 DEBT = $500,000 @ 6%, remainder equity.

The debt service cost (interest) = $30,000 p.a. For both companies future earnings are randomly distributed with

A B $40,000
The expected earnings of shareholders are Company A = $80,000 Company B = $50,000 ($80,000 30,000) Shareholders earnings have greater relative dispersion for Company B than for Company A (coefficient of variation).

The dispersion of income = business risk The dispersion of shareholders earnings = financial risk Coefficient of variation for Company A = Coefficient of variation for Company B = The financial risk of Company B is greater.

$40,000 = 0.5 $80,000 $40,000 = 0.8 $50,000

44

The traditional view follows the net income approach in that it suggests there is a benefit to be gained from increased gearing. However, increased gearing increases financial risk and ks will, therefore, increase with gearing, but this increase is not sufficient to offset the gearing effect on ko until a certain point is reached when the increase in ks is such as to increase ko. The traditional model usually incorporates an increase in kd at a certain level of gearing due to increased risk to debt holders.

This implies there is an optimal capital structure.

It can be show graphically as:

The graph demonstrations that there is a range of gearing where ko is fairly constant and is not sensitive to small changes in the financing mix.

3.0

THE NET OPERATING INCOME APPROACH

According to this approach, there is no optimal capital structure. The financing mix does not effect the average cost of capital of the company; and the total value of the firm remains unchanged with changes in the gearing. i.e. ko remains constant. This can be shown graphically as:

45

ks

ko kd gearing All capital structures are optimal.

The increase in ks is exactly sufficient to offset the effect of the increased importance of kd so ko is constant.

Illustration 3.1 Firm R.C. has an EBIT of $900,000. There is debt of $4 million in the capital structure. kd = 7.5% and WACC (ko) = 10%. The total value of the firm V is given by:

EBIT = $9,000,000 ko

The value of debentures = $4,000,000 Thus equity is worth $5,000,000

ks

9,000,000 4 m x .075 .12 or 12% 5,000,000

WACC

$4 m x .075 $5 m x .12 10% $9 m

If debt is increased to $5 million, ko remains constant. Value of the firm is still $9 m. 46

as V

EBIT $900,00 = $9m. ko .10

The value of equity goes up:

ks

9 m - (5 m x .075) 13.12% 4m

ko

5 m x .075 .1312 x 4 m 10% (as before) 9m

3.1

The Modigliani Miller Model

One of the leading arguments in favor of the net operating income approach is the behavioural model developed by Modigliani and Miller.

Modigliani and Miller favor the net operating income approach that ko is constant. Their model has some crucial assumptions:

(1) (2) (3) (4)

Capital Markets are perfect All investors have perfect cost-free information Expected future earnings constant Initial assumption of no taxes Firms can be classified into equivalent risk classes.

Their propositions are

(1) (2) (3)

Total market value of firm is independent of capital structure ks increases to exactly offset use of cheaper debt Required rate of return for investment is independent of the financing decision.

47

Illustration 3.2(a)

Two companies (A & B) have identical capital requirements of $500,000. Company B is 30% geared with 5% debt; Company a is ungeared.

Company A

Company B

Net operating income Debt interest

50,000 -----------

50,000 7,500 ----------42,500 .11 ----------386,364 150,000 ----------$536,364

Equity earnings

= =

50,000 .10 ----------

assumed equity capitalization rate

Market value of equity Market value of debt

500,000 -----------

Market value of firm

$500,000

ko

50,000 10% 500,000

50,000 536,364

9. 3%

Midgliani Miller argue that the above situation is not stable. A shareholder in company B will take advantage of the better share price the lower ko for company B gives him, by selling shares in B and buying them in A. This process is called arbitrage and will have the effect of decreasing the market value of shares in B and increasing the market value of shares in A (supply and demand function). This process will continue until the share prices stabilize at a value that gives an equal ko in both companies.

48

Illustration 3.2 (b)

Assume that a shareholder owns 10% of company B. This has a market value of $38,636, and gives him a return of $4,250 (10% of $42,500). Note that he owns 10% of a company that is 30% geared and is presumably satisfied with the risk of a 30% gearing. He will now substitute a personal gearing of 30% for the corporate gearing and invest in company A in the following way: Step I Step II - He will sell his shares in company B and realize $38,636. - He will borrow $15,000 at 5% giving him total funds of $53,636. N.B. He is now geared in the same proportion as company B. i.e. Step III

$150,000 $536,364

$15,000 $53,636

- He will buy 10% of company A, which will cost $50,000. This will give him a return of $5,000 from which he must pay his debt interest of $750 leaving a net return of $4,250. This is the same as he was receiving in company B but he now has $3,636 available for consumption.

The behavioral model suggests that the arbitrage process will continue until no shareholder can make a gain from the process and at that point ko will be identical in both companies. 3.2 Assumptions and criticism of the Modigliani Miller Model

Assumptions (1) Shareholders can obtain the same personal gearing as companies at the same cost. This is very unlikely. (2) Firms can be classified into equivalent risk classes. Note: it is possible to demonstrate that the arbitrage proof of the M-M thesis is not dependent on equivalent risk classes. All propositions can be illustrated by general equilibrium analysis where arbitrage occurs across firms with different risk.

49

(3)

Capital markets are perfect. information.

All investors have access to perfect, cost-free

(4)

There are no transaction costs in the arbitrage process.

The crucial factor is the assumption of rational investors who will substitute personal gearing for corporate gearing. Arguments against the Modigliani Miller position These are based on reasons why the arbitrage process may not work perfectly (1) If there is a possibility of bankruptcy and if these costs are significant a geared firm may be less attractive. In perfect markets if the firm is liquidated all assets are realized with zero costs. (2) The perceived risks of personal and corporate gearing may be different because of limited liability on corporate debt. (3) (4) (5) Personal borrowing costs are generally higher than corporate costs. Transaction costs restrict arbitrage. Some institutional investors may be precluded from personal borrowing by the articles or by law. (6) Investors do not have access to perfect, cost-free information.

M-M deny the importance of these criticisms by arguing that they are too general. They suggest that as long as there are enough market participants at the margin to behave in a manner consistent with homemade gearing the total value of the firm cannot be altered through gearing. The M-M approach is most vulnerable at extreme levels of gearing.

Extreme Gearing
When gearing reaches a certain level kd will rise as debt investors expect the firm to pay a higher interest rate on debt. The greater the gearing the lower the coverage of fixed charges and the riskier the loan.

Even if kd rises, M-M maintain the ko will be constant because ks will increase at a decreasing rate to offset the increase in kd.

50

Many authorities object strongly to the contention that shareholders became relatively less risk-averse with extreme gearing. Modigliani Miller are on much weaker ground in

defending their thesis for the extreme gearing case.

3.3

The Introduction of Taxation

When corporate taxation is introduced into the models kd must be decreased as debt interest is allowed against corporation tax. Therefore gearing must lower ko and increase the value of the firm. Modigliani Miller recognize that by introducing corporation tax into the model ko can be lowered by gearing. Effectively the government is subsidizing debt so the greater the debt the greater the subsidy and the greater the value of the firm. The implication of this is that a firm should maximize its debt. Proponents of the traditional model argue that extreme gearing must increase financial risk and eventually ko will rise. The Modigliani Miller thesis is again on weakest ground for extreme gearing. Modigliani Miller recognize that by introducing tax-allowances as a subsidy, ko can be reduced by increasing gearing and they argue that a firm should aim for a target debt ratio that does not violate any limits on gearing imposed by creditors. The implication is that debt funds are simply refused beyond a certain point. This implies that ko would rise beyond this point and that there is an optimal capital structure.

51

Certainly this is a position with which Modigliani Miller should feel uncomfortable (Van Horne).

CONCLUSIONS ON CAPITAL STRUCTURE

In the absence of perfect capital markets and with the existence of corporate taxes, an optimal structure is implied by both the M-M and the traditional view. Over a fairly extensive range of gearing ko is relatively less sensitive to changes in the financing mix. Decisions on the optimum level of debt will differ from firm to firm and should involve considerations of the firms future strategies and external factors like the rate of inflation. One other factor which influences the capital mix is the attitude of company management. As employees, management will tend to put constraints on the level of gearing as they will perceive a decrease in their job security with an increase in financial risk.

EBIT E.P.S. ANALYSIS

One way of examining the question of issuing debt or equity is by examining the effect on earnings per share (EPS) of possible capital structures. At different levels of earnings, different combinations of debt and equity in the capital structure would give different earnings per share. Since EPS is usually an important factor in determining the actual market value of a companys shares, the financial manager should carefully consider the implications of issuing one type of capital as opposed to another. An E.B.I.T. E.P.S. chart shows graphically the relation between E.P.S. and the Earnings before tax and interest for various capital structures.

Illustration 5.1
Firm H.V. Ltd. are considering raising $200,000 for a new project. At present the entire capital comprises equity of $800,000 in shares of $1 each. It is estimated that either debt at 8% or shares at per can be issued to raise the finance required. A likely level of earnings before tax is estimated to be $300,000 p.a. and the rate of corporation tax to be used is 50%.

52

Earnings per share under the two alternatives (at an EBIT level of $300,000) would be: Debt $ EBIT Interest @ 8% 300,000 16,000 --------284,000 Tax @ 50% 142,000 ====== Number of shares in issue 800,000 Equity $ 300,000 --------300,000 150,000 ====== 1,000,000

Earnings per share

.1775

.15

An EBIT/EPS chart can now be drawn. The starting point for debt and equity can be arrived at by calculating the required EBIT under both alternatives to give a zero EPS. 1. 2. For equity EBIT = 0, when EPS is zero. For debt EBIT = 16,000 (the amount of the debt interest) when EPS is zero.

53

The point where the two lines cross each other is the breakeven or indifference point. It can be seen that the breakeven point in the above chart is at an EBIT figure of $80,000. At this point, both debt and equity give the same EPS. At EBITs of over this figure, using debt gives a higher EPS, while below this figure, use of equity results in a higher EPS. this can be confirmed as follows: Debt EBIT Interest @ 8% 60,000 16,000 --------44,000 Tax @ 50% 22,000 --------22,000 ===== Number of shares in issue EPS 800,000 .275 Equity 60,000 --------60,000 30,000 --------30,000 ===== 1,000,000 .03

54

The breakeven point can also be calculated algebraically (figures in $000).

Equity

Debt

50% (x - 0) 1,000
800 (x 0) 800 (x 0) 800 x x

50% (x - 16) 800

= = = =

1,000 (x 16) 1,000 x 16,000 16,000 80

It should be noted that EBIT EPS analysis takes only the explicit costs of debt into account. The increase in the financial risk of the business by taking on debt should also be considered. The probability of future profits being above a breakeven point would also effect the financial managers decision to introduce debt in the capital structure.

55

CAPITAL EXPENDITURE: AN OVERVIEW

Factors

Organizations engaged in manufacturing and marketing of goods or services require assets in their operations. An asset can be thought of as any expenditure, which creates or aids in creation of a revenue-generating base. Companies incur various expenditure to carry on standard flow of work, expenditure intended to yield returns over a period of time, and usually exceeding one year is regarded as capital expenditure. Various factors are considered before Board of Directors approves any expenditure. All that factors can further be divided into:

Operational Factors I. To meet future requirements based on market forecast. II. To maintain coordination with the vision of the company as Verka Milk Plant vision states to be top five generic players in the world by 2012 and achieve sales of 5 billion. To achieve this target company has to incur heavy expenditure on acquisition of fixed assets. III. To increase market penetration. IV. To maintain, renew, expand, upgrade existing physical assets that helps to facilitate and enhance revenue-generating capacity. V. To create, acquire and develop revenue generating activities/ capacities that is imperative for an organizations healthy growth and existence.

Financial Factors In deciding which assets to create, acquire or develop, the benefits to be gained from the expenditure have to be weighed against the costs that will be incurred. While costs can always be expressed in financial terms, the benefits may or may not be similarly quantifiable. Nevertheless, an attempt must be made to express the benefits expected, in a manner that facilitates comparison with costs and helps formulate a rational basis for the decision making process. Following are the financial tools that are taken into account for approving capital expenditure.

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Discounted Cash Flow (DCF) This is one of the techniques for financial evaluation of Capexs. DCF techniques are based on the concept of time value of money and provide a methodology of taking into account the timing of cash proceeds and outlays over the life of the investment. The procedure underscores the need to state cash flow streams arising in different time periods thus differing in value and, hence comparable only in terms of a common denominator viz. present values.

I. Discounted Payback Period (DPP) DPP is the number of years it takes for the present value of inflows to equal the initial investment. Apart from giving due importance to time value of money it serves as a reasonable tool of risk approximation. It favors projects, which generate substantial cash inflows in initial years, and discriminates against those that bring in substantial inflows in later years (risk tending to increase with tenure). Thereby implying that an early resolution of uncertainty enables the decision maker to take prompt corrective action by modifying/ changing other investment decisions. However, by the same logic it cannot be used as a principal tool for analysis because it ignores any substantial cash flows arising after the pay back period.

II. Internal Rate of Return (IRR) IRR is the discount rate that equates the present value of the expected future cash inflows to the present value of the expected future cash outflows. It is the post tax return from investment and hence the excess of IRR over the cost of capital indicates a surplus after paying for the capital employed. IRR presupposes an equivalent rate of return on the cash flows generated during the life of the asset i.e., it assumes reinvestment of intermediate cash flows at the rate of return equal to the project's IRR. Internal rates of return are most often used as useful additions to NPV computations. This has in turn justified the use of IRR as a good substitute to NPV. IRRs have the merit of indicating whether a project is worthwhile, in that - an IRR above the cost of capital represents a positive NPV project, an IRR equal to the cost of capital is a zero NPV project and an IRR less than the cost of capital is associated with a negative NPV project.

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Inspite of its merits, it needs to be understood that IRRs helps only to identify projects that maximizes the ratio of rupee-value to rupee-capital in percentage terms. What NPV will help in determining is the projects that maximizes the rupee-spread between value and capital.

III. Net Present Value (NPV) NPV is equal to the present value of cash inflows minus the present values of cash outflows. A positive NPV is a prerequisite for the 'acceptance' of the project. The primary tool of appraisal would be the NPV method. Its superiority over other methods arises out of its principal merit of incorporating all benefits and costs occurring over the life of the asset

IV. Profitability Index (PI) The Profitability Index essentially measures the Present value of benefits times the initial investment. Under unconstrained conditions, the profitability index will accept and reject the same projects as the NPV criterion. It is possible that a project may have no critical risks. Or the financial are extremely favorable (high NPV, high IRR, high PI, low DPP etc.) and the occurrence of consequent risks may not compromise the success of the project. It is also possible that there is a conscious corporate decision to accept certain risks. In such cases, no measures are required. These risks, in any case, must be explicitly stated in the Quantitative assessment of Risk Capital investments are essentially committed in expectation rather than in certainty, which implies that investments are subject to risk contribute to removing the shortcomings of an unstructured workings.

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CHAPTER -3 REVIEW OF LITERATURE

59

REVIEW OF LITERATURE
Capital structure is a mix of debt and equity capital maintained by a firm. Capital structure is also referred as financial structure of a firm. The capital structure of a firm is very important since it related to the ability of the firm to meet the needs of its stakeholders. Modigliani and miller (1958) were the first ones to landmark the topic of capital structure and they argued that capital structure was irrelevant in determining the firms value and its future performance. On the other hand, lubatkin and chatterjee (1994) as well as many other studies have proved that there exists a relationship between capital structure and firm value. Modigliani and miller (1963) showed that their model is no more effective if tax was taken into consideration since tax subsidies on debt interest payments will cause a rise in firm value when equity is traded for debt. In more recent literatures, authors have showed that they are less interested on how capital structure affects the firm value. Instead of the firm. Modigliani and miller (1963) argued that the capital structure of a firm should compose entirely of debt due to tax deductions on interest payments. However, brigham and gapenski (1996) said that, in theory, the modigliani-miller (mm) model is valid. But, in practice, bankruptcy costs exist and these costs are directly proportional to the debt level of the firm. Hence, an increase in debt level causes an increase in bankruptcy costs. Therefore, they argue that that an optimal capital structure can only be attained if the tax sheltering benefits provided an increase in debt level is equal to the bankruptcy costs. In this case, managers of the firms should be able to identify when this optimal capital structure is attained and try to maintain it at the same level. This is the only way that the financing costs and the weightedaverage cost of capital (wacc) are minimised thereby increasing firm value and corporate performance.

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CHAPTER -4 OBJECTIVES OF THE STUDY

61

OBJECTIVES OF THE STUDY

To understand how capital structure helps in achieving competitive cost of capital. How to enhance capital efficiency To understand how a firm can create value through its financial decisions.

62

SCOPE OF THE STUDY

This is a Report on the Capital Structure and Capital Expenditure of Verka Milk Plant . The purpose and scope of the project can be listed as:

Understanding the organizational structure and functioning of Verka Milk Plant Analysing and comparing the financial health of the firms in the Indian Milk Products Industry.

Identifying and analysing the capital structure of Verka Milk Plant . Conducting a Review of the Capital Expenditure done at Verka Milk Plant Identifying loopholes in the functioning and in the area of study and recommending the suggestions for the same.

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CHAPTER 5 RESEARCH METHODOLOGY

64

RESEARCH METHODOLOGY
The methodology adopted for the study was as follows: Familiarization, examination and evaluation of the procedures relating to capital structure and capital expenditure. Collection of relevant data form company records and cross checking of this data. Calculations of financial ratios, parameter and norms, as also their financial implications. Broadly the data were collected for the report on the project work has been through the primary and secondary sources. The primary data is collected by various approaches so as to give a precise, accurate, realistic and relevant data. The main goal in the mind while gathering primary data was investigation and observation. The ends were thus achieved by a direct approach and personal observation from the officials of the company. The other staff members and the employees were interviewed for the sake of maintaining reasonable standard of accuracy. The secondary data as it has always been important for the completion of any report provides a reliable, suitable equate and specific knowledge. The annual reports, the fixed asset register and the Capex register provided the knowledge and information regarding the relevant subjects. The valuable cooperation and continued support extended by all associated personnels, head of the department, division and staff members contributed a lot to fulfil the requirement in the collection of data in order to present a complete report on the project work.

RESEARCH DESIGN
Research methodology is a way to systematically solve the research problem. It may be understood as a science of studying how research is done scientifically. Research type Many investors were reluctant to reveal their investment details especially the amount of money invested so, referral sampling method is used for this study. Sample description 65

The sample was drawn from the population of the potential investors from India. A survey was conducted to understand the investors behaviour with the help of questionnaire. It was carried out with a sample size of 250 investors.

TOOLS OF DATA COLLECTION

Primary data: The data has been collected directly from respondent with the help of structured questionnaires. Secondary data: The secondary data has been collected from various magazines, journals, newspapers, text books and related websites.

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CHAPTER 6 RATIO ANALYSIS

67

CLASSIFICATION OF RATIOS ANALYSIS

Ratio analysis is used by many parties according to their interest. There are various types of ratios in use varies from person to person. The following is a brief explanation of these ratios which are considered necessary for the study. These ratios are explained as under.

ANALYSIS OF SHORT- TERM FINANCIAL POSITION The short-term obligations of a firm can be met only when there are sufficient liquid assets. Therefore a firm must ensure that it does not suffer form lack of liquidity or the capacity to pay its current obligations. It is very important to have a proper balance in regards to the liquidity of the firm. Two type of ratio can be calculated for measuring short-term solvency of the firm.

(A) LIQUIDITY RATIOS:

Current ratio: = Current Assets Current Liabilities

Quick or Acid Test or Liquid Ratio: = Quick or Liquid Assets Current Liabilities

Absolute Liquid Ratio or Cash position Ratio: = Absolute liquid assets Current liabilities

CURRENT RATIO: Current may defined as the relationship between current assets and current liabilities. Thus ratio, also known as working capital ratio, is a measure of liquidity and is most widely used to make the analysis of short term financial position or liquidity of a firm it is calculated with the help of following formula: 68

FORMULA:= Current ratio= current assets Current liabilities

2009-2010

2010-2011

5534484380.43 282521884.74

489063838.36 189116321.33

=1.89:1

=2.58:1

Interpretation: In 2009-2010 current ratio was 1.89:1 and in 2010-2011it was 2.58:1. The thumb rule of current ratio is 2:1. From the year 2010-2011current ratio of verka milk plant is above the thumb rule. It shows satisfied liquidity position.

Quick ratio: also known as Acid Test or Liquid ratio is a more rigorous test of liquidity than the current ratio. The term 'liquidity' refers to the ability of a firm to pay short-term obligations as and when they become due. An asset is said to be liquid if it can be converted into cash within a short period without loss of value. Quick ratio can be calculated with the help of the following formula:

FORMULA : =Quick or Acid Test or Liquid Ratio: = Quick or Liquid Assets Current Liabilities

2009-2010

2010-2011

129959643.29 282521884.74

124716376.84 189116321.33

= 0.45:1

= 0.65:1

Interpretation: In 2009-2010 liquid ratio was 0.45:1 and in 2010-2011it was 0.65:1. It means liquid assets are sufficient to meet the current liabilities. 69

Absolute Liquid Or Cash Ratio: Some authorities are of opinion that the absolute liquid should be calculated together with current ratio and acid test ratio so as to exclude even receivable from current assets and find out absolute liquid assets.

FORMULA Absolute Liquid Ratio or Cash position Ratio: = Absolute liquid assets Current liabilities Absolute Liquid Assets= Cash Bank + Short-term Securities

2009-2010

2010-2011

60264112.19 282521884.74

92981639.76 189116321.33

=0.21:1

=0.49:1

Interpretation : absolutes liquid ratio is high as this 0.21:1 in 2009-2010 and 0.49 in 20102011where as the accepted standard is 0.5:1 in current year liquid position is not more deteriorated.

(B) CURRENT ASSETS MOVEMENT OR EFFECIENCY/ ACTIVITY RATIO

Funds are invested in various assets in business to make sales and earn profits. The efficiency with which assets are managed directed directly affects the volume of sales. The better the management of assets, the larger is the amount of sales and the profits. Activity ratios measure the efficiency or effectiveness with which a firm manages its resources or assets. These ratios are also called turnover ratio because they indicate the speed with which assets are converted or turned over into sales. Current ratio and acid test ratio ignore the movement of current assets, it is important to calculate the following turnover or efficiency ratios to comment liquidity or the efficiency with which the liquid used by the firm. Inventory/ Stock turnover Ratio Debtor Turnover Ratio

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Creditors/ Payable Turnover Ratio Working Capital Turnover Ratio Fixed Assets Turnover Ratio

INVENTORY/ STOCK TURNOVER RATIO: Every firm has to maintain a certain level of inventory of finished goods to be able to meet the requirements of business. But the level of inventory should be neither is too high nor too low. Inventory turnover ratio is also known as stock velocity ratio. It would indicate whether inventory has been efficiently used or not. The purpose is to see whether the require minimum funds have been locked up in inventory.

FORMULA: = Cost of goods sold Average inventory at cost

2009-2010 2186139096.33 311303615.3 = 7.02

2010-2011 2591088550.92 350610904.745 = 7.39

Interpretation : In inventory/stock turnover ratio of 2009-2010 was 7.02 and in the year 2010-2011it was increased by 7.39 .

Inventory conversion period= Days in a year Inventory turnover ratio

2009-2010

2010-2011

365 7

365 7

52.14 52.14

52 days

52 days

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Interpretation : the stock turnover ratio in 2010-2011was 7.02 and in 2009-2010it was 7.39 so it increased and inventory conversion period of both year it was 52 days approx.

FIXED ASSETS TURNOVER RATIO: This ratio establishes the relationship between sales and fixed assets. The purpose is to judge whether the firm is generating adequate sales for the investment in fixed asset of firm. The assets include land and building, plant and machinery, furniture etc., after the depreciation.

Fixed asset turnover ratio = Sales or cost of goods sales Total fixed asset 2009-2010 2186139096.33 273508146.38 = 7.9 2010-2011 2591088550.92 289809226.40 = 8.9

Interpretation: In 2009-2010 fixed asset turnover ratio was 7.9 and in 2010-2011it was 8.9. it was more in the 2008-2009.

ANALYSIS OF LONG-TERM FINANCIAL POSITION: The term solvency to

the

ability of the concern to meet its long term obligations. The long term indebtedness of a firm includes debenture holders, financial institution providing medium and long term loans and other credit selling goods on installment basis. Long term solvency ratios indicate a firm's ability to meet the fixed interest and cost and repayment schedules associated with its long term borrowing. The following ratios serve the purpose of determining the solvency of the concern.

Debt-Equity Ratio Proprietors or Equity Ratio Solvency Ratio Fixed Assets to Proprietor's Fund Ratio Fixed Assets to Total Long-Term Funds Ratio of Current Assets to Proprietor's Funds

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DEBT-EQUITY RATIO: Debt-Equity ratio, also known as External-Internal Ratio is calculated to measure the relative claims of outsiders and the owner (i.e. shareholders) against the firm's assets. This Ratio indicates the relation between the external equities or outsider's funds and internal equities or the shareholders' funds, thus:

FORMULA: Debt-Equity Ratio= Outsiders Fund Shareholders Funds or internal Equities

Outsiders Funds = All debts/liabilities to outsiders, Whether Long term or Short term

Shareholders Funds = Equity share capital + preference Share Capital + Capital reserve + Revenue reserve + Accumulated profits and surpluses accumulated losses + Deferred expenses.

2009-2010

2010-2011

282521884.74 434024258.15

226386321.33 432485384.22

=0.65

=0.523

Interpretation: In 2009-2010 the debt equity ratio was 0.65 and in 2010-2011it was 0.523. It decreases in 2008-2009.

PROPRIETORS OR EQUITY RATIO: A variant to the debt-equity ratio is the proprietary ratio. This ratio establishes the relationship between the shareholder's funds to the total assets of the firm. It is an important ratio of determining long-term solvency of a firm. The ratio can be calculated as under: FORMULA:= Proprietors ratio = Proprietor Funds Total Assets

Proprietor's Fund= equity share capital+ preference share capital+ undistributed profits+ reserves& surpluses-( accumulated losses+ deferred expenses). 73

2009-2010 434024258.15 X 100 808095537.81 = 53.70%

2010-2011 432485384.22 X 100 784146982.76 = 55.15%

Interpretation: in 2009-2010 the proprietor's ratio it was 53.70% in 2008-2009it was 55.15% it was increased in 2008-2009.

SOLVENCY RATIO: Solvency ratio is the small variant of equity ratio. The ratio indicates the relationship between the total liabilities to outsiders to total assets if a firm and can be calculated as follows:

FORMULA: = Solvency Ratio = Total liabilities to outsiders Total Assets

2009-2010

2010-2011

282521884.74 X 100 808095537.81

226386321.33 X 100 784146982.76

= 34.96%

= 28.87%

Interpretation: in 2009-2010 solvency ratio was 34.96% and in 2010-2011it was 28.87%. It was low as compared 2009-2010.

FIXED ASSETS TO PROPRIETOR'S FUND RATIO: The ratio establishes the relationship between fixed assets and shareholders funds. The ratio can be calculated as follows

FORMULA: = Fixed assets to proprietor's funds= fixed assets (after depreciation) Proprietor's funds

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FIXED ASSETS TO TOTAL LONG- TERM FUNDS : A variant to the ratio of the fixed assets to net worth is the ratio of fixed assets to total long term funds which are calculated as:

FORMULA: = Fixed assets ratio= fixed assets(after depreciation) Total long-term funds

Long term funds = shareholder's fund+ long-term borrowings

RATIO OF CURRENT ASSETS TO PROPRIETOR'S FUNDS : This ratio is calculated by dividing the current assets by the amount of shareholder's funds.

FORMULA: Current assets to proprietor's funds =Current assets X 100 Proprietor's funds

2009-2010

2010-2011

534484380.43 X 100 434024258.15

489063838.36 X 100 432485384.22

= 123.144%

= 113.08%

Interpretation: In 2009-2010 ratio of current assets to proprietor's funds it was 123.144% in 2010-2011it was 113.08%. it was low as compared 2009-2010

ANALYSIS OF PROFITABILITY OR PROFITABILITY RATIO:

The primary

objective of a business undertaking is to earn profits. Profit earning is considered essential for the survival of the business. In the words of Lord Keynes, '' profit is the engine that derives the business enterprise". A business needs profits not only for its existence but also for expansion and diversification. Profits are, thus, a useful measure of overall efficiency of business. The various profitability ratios are discussed below:

(A) GENERAL PROFITABILITY RATIO

(a) Gross profit ratio 75

(b) Operating profit ratio (c) Net profit ratio GROSS PROFIT RATIO: The gross profit ratio indicates the extents to which selling price of goods per unit may decline without resulting in losses on operations of a firm. It reflects the efficiency with which a firm produces its product. It measures the relationship of gross profit to net sales and it us usually represented as percentage. It is calculated as per following formula.

FORMULA: Gross profit ratio= Gross profit X 100 Net sales

2009-2010

2010-2011

141119897.50 X 100 2327258993.83

177010539.65 X 100 2768099090.57

=6.0%

=6.3%

Interpretation: in 2009-2010 gross profit ratio was 6 % in 2010-2011it was 6.3% so in 2008 -2009 it increased with6 .3%

OPERATING PROFIT RATIO: This ratio is calculated by dividing operating profit by sales.

FORMULA: = Operating net profit ratio= operating profit X 100 Sales Operating profit= net sales-operating cost

2009-2010 110145065.09 X 100 2327258993.83

2010-2011 12486957.67 X 100. 2768099090.57

= 4.73%

= 4.51%

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Interpretation: in 2009-2010 operating ratio was 4.73% in 2010-2011its ratio decreased by 4.51%.

NET PROFIT RATIO : This ratio tells us about the relationship between net profit after interest and taxes and net sales

FORMULA: = Net profit after interest and tax X 100 Net profit 2009-2010 102468862.92 X 100 2327258993.83 = 4.4% 2010-2011 145744523.21 X 100 2768099090.57 = 5.26%

Interpretation : in 2009-2010 net profit ratio was 4.4% in 2010-2011it was 5.26% with increasing profit 5.26%

IN RELATION TO INVESTMENT Return on shareholder fund or ROI Return on equity share capital Earning per share or EPS ratio

Return on shareholder fund or ROI : This ratio tell us about the relationship between net profit after interest and taxes and shareholders funds.

FORMULA:= Net profit after interest and taxes X 100 Shareholder fund

2009-2010 102468862.92 X 100 434024258.15

2010-2011 145744523.21 X 100 432485384.22

= 23.60%

= 33.60%

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Interpretation : in 2009-2010 return on shareholder fund was 23.60% in 2010-2011it was increased with 33.60% hence ROI of 2010-2011was more profitable.

RETURN ON EQUITY SHARE CAPITAL: This ratio tells us about the relationship between net profit (after interest, taxes and preference share dividend) and equity share capital (paid up)

FORMULA : = Net profit after interest and taxes Preference share dividend X100 Equity share capital

2009-2010

2010-2011

102468862.92 X 100 39637400

145744523.21 X 100 39644400

=258.5%

= 367.62%

Interpretation: in 2009-2010 return on equity share capital was 258.5% and in 2010-2011it was increased with 367.62% which was more profitable.

EARNING PER SHARE OR EPS RATIO: This ratio tells us about the relationship between net profit (after interest and taxes and preference share dividend) and number of equity shares.

FORMULA: = Net profit after interest and taxes preference share dividend Number of equity share 2009-2010 102468862.92 38115923 2010-2011 145744523.21 38115930

=2.68 per share

=3.82 per share

Interpretation: in 2009-2010 earning per share was 2.62 per share in 2010-2011it was 3.82 per share which was more than 2009-2010 EPS ratio and more profitability 78

CHAPTER 7 LIMITATIONS OF THE STUDY

79

LIMITATIONS
Following are the limitations of the study: Balance sheets of only 3 years have been studied but the company is in operation for so many years. Only specific tools (i.e. ratio analysis) have been used for data analysis, while so many other tools are also there. Organizational rules & regulations. Availability of data. Financial figures for 2008 of Verka Milk Plant available. Limitations of the financial tools used. were not

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CHAPTER 10 SUGGESTIONS

81

SUGGESTIONS
Indian co-operative society scene is fast changing. Consumer expectations are going up leading to more difficulties for co-operative society marketing professionals. Change in the character profile of the doctors with socio-economic changes have also affected many cooperative society companies. Thus verka milk plant should also concentrate on following areas to strengthen :

The company should carry an audit of all its activities. This activity analyses different marketing activities and suggest the bench mark for the company. This is self supportive the operations and cutting the cost. It also helps to remove unnecessary activities, which may be redundant for tomorrow. This gives also an insight to the future scenario.

Steps required to boost the competitiveness of the milk products industry : Extension of deduction of 150% of R&D expenses. To rationalize price control order. An academic industrial relationship can be further explored. Grants Venture capital Factoring Leasing Debentures Other loans Overdraft facilities Lines of credit from creditors Increased R&D focus Exports driven growth MNCs showing growing interest in India

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CONCLUSION
The successful strategy for Verka Milk Plant in a post will include: (a) Attain right product-mix (b) Augment skills (c) Use M&A options for either companies or products. (d) Building Innovation Engine at R&D (e) Attain critical mass in Europe and Latin America. (f) Specialty products focus for Brand marketing. (g) Fortifying home business leverage India Base. (h) Seeding the Japanese market. (i) Networking, licensing and acquisitions. (j) Technology, new market entry vehicles, brands/ proprietary products (k) Global talent pool to fuel growth.

The increasing importance of biotech industry and its symbiotic relationship to Milk Products will also be very relevant in Verka Milk Plant s strategy. However Verka Milk Plant should not close its eyes on the ever increasing Global competition, which is a big threat for the company. The entry of international and new domestic players would intensify the competition significantly. Further there is threat from other low cost countries like China and Israel. The short-term threat for the Milk Products industry is the uncertainty regarding the implementation of VAT. Though this is likely to have a negative impact in the short-term, the implications over the long-term are positive for the industry. The Indian Co-operative Society industry is at the center stage in the global healthcare arena and Verka Milk Plant endeavors to be at the forefront in delivering the India centric

advantages to the advanced and developing countries of the world.

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It is with the unwavering ' dedication ' and the ' will to win ' of Team Verka Milk Plant across the globe that Verka Milk Plant has traversed this journey so far. The management feels that the next league is a greater challenge, as the company has other milestones to achieve. Whilst Verka Milk Plant continues to enhance the momentum of its generics business in its key geographies, parallel to that it is also accelerating its drug discovery program. The company is committed to provide quality generics at affordable prices to the patients worldwide with a view to help bring down the healthcare costs. Verka Milk Plant s management is confident that its efforts would see the Company emerge as a leading player in the global generic space in the years to come.

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Bibliography

www.verkamilkplant.com Financial Management (Sixth edition) By Prasanna Chandra (Tata McGraw Hill Publishing Company Ltd.)

Financial Management (Fourth edition) By Ravi M Kishore

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