case on restrutthis case is to understand capital restructuring

8/13/2019 Case on Restrutthis case is to understand capital restructuring

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Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida.Copyright rests with the authors

RESTRUCTURING AT INFOSYS

Infosys, Indias second largest computer services exporter lost its bellwetherstatus & became less nimble as compared to rivals viz. TCS and HCLTechnologies. The third position holder in Indian IT giants, Infosys had a boardannouncement on Saturday i.e. 1 st June 2013 where it announced the return of itsfore father & great warrior Mr. Narayan Murthy. Murthy is expected to bring

back many strategic changes at Infosys. The present case gives an opportunity toanalyse the desired or proposed change in capital structure policy along with otherstrategic changes expected after Murthys comeback. Infosys can shift from aclosed & conservative capital arrangement to a more aggressive one. The case hasalso touched upon the nuances of Repurchase vs. Cash Dividends as optionsavailable to Infosys for returning cash to shareholders.

Relevant Key Words: Corporate restructuring, Debt, Equity, Cash Dividends,Repurchase

JEL Codes: G12, G32, G34,


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RESTRUCTURING AT INFOSYS

Company Background

Founded in 1981 by 7 engineers, Infosys Limited has come a long way from a $250 startup to

$7.2billions today. A global leader in consulting, technology and outsourcing, Infosys has business

spread across 30 countries of the world. With headquarters in Bangalore, the company has received

many awards and recognitions, some of them are of the likes of Forbes, Boston Consulting Group and

The Wall Street Journal. The company has been successful in the last three decades due to its ability to

adapt, expand at every opportunity and due to its strong culture of innovation. Infosys has a strong

foothold in almost all major sectors, from the airline industry to the financial services, and has helped

its clients in building their success stories. With the ever changing market scenario, Infosys is making

the most of the opportunities and is now a global player, having being listed on the New York Stock

Exchange as well.

Infosys Corporate Culture

Infosys has been one of the best managed companies in India, in its life span of three decades. With

Narayana Murthy as the Founder and Executive Chairman of Infosys for long, the company under his

leadership has come a long way. With the strategy to have superior revenue growth and margins, the

company has been successful in increasing its revenues all throughout. Infosys, since its inception has

had the liquidity policy 1 which aims to minimize the risk in the business and for this very reason, in its

three decades long life, Infosys is still a Zero-Debt company. Infosys; having maintained a zero debt


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position, has always been in a financial position to fund its capital expenditure and working capital

requirements from internal accruals.

Known for its strong innovation based culture, Infosys has qualities that define the group as the one

that promotes merit and performance-driven rewards system. Innovation has always been at the core of

their values and functions, and each Infoscion is encouraged to innovate and to take risks and venture

onto the road less taken. Each individual at Infosys takes pride in their work and has a sense of

ownership towards the company and share their findings and knowledge for the development of not

just Infosys but also their peers. Introduction of ESOPS is one such way to motivate and recognize the

hard work that each employee gives. Infosys came up with ESOP much before any regulatory

guidelines were created in this field.

Infosys and the Shareholders wealth

The Infosys shares were made public through an IPO in February 1993, with the IPO price of Rs 95

per share. However, the shares opened at Rs 145 on its opening day in June 1993. With private placement made to Foreign Institutional Investors and Financial Institutions to the tune of 5.5 lakhs

shares valued at Rs 450 each in 1994, the company has given huge returns to its loyal shareholders

since the inception. The efficiency and the success driven corporate culture and philosophy has helped

Infosys shareholders amass wealth, from Rs 95 in 1993, the share touched a market price of Rs 2,889

on 28 March 2013.

Infosys has a strong cash reserve of $4billion. In recent interviews given by the CFO Rajiv Bansal, he

confirmed that Infosys has set a deadline for itself for a period of 12-15 months for themselves,

wherein either the company would enter into an acquisition or if no such deal was to take place, they


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would consider returning the money to shareholders. The company and its officials are said to have

entered into a risk-taking mode and are open to challenges. Analysts are of the opinion that the change

in Infosys outlook is due to its reduced market share and to keep pace with its peers.

Financial Performance

Due to its large scale of products and services, efficient operations and zero debt structure, Infosys has

performed quite well and consistently in the past. But for the last two years i.e. from 2011 onwards, its

performance has become sluggish. This has been highlighted with the help of its financial results

(Exhibit -1) through growth rate in revenue, operating income and net income. The reduction in Gross profit ratio, Operating profit ratio and net profit ratio in last two years i.e. for 2011-12 & 2012-13 puts

a question mark on the performance of Infosys ever since the departure of Murthy in 2011. Comparing

it with its peers in the Industry the percentage growth in revenue for last two years has considerably

reduced. (Exhibit-3)

This unenthusiastic financial performance indicated above might be due to companys conservative

capital structure and large cash balances which is also justified through the falling ratios of Return on

Assets and Return on Equity . In corporate finance, according to the theories of capital structure and

liquidity management/working capital management, excess of cash balances affects profitability of the

company. This is because at one side it is not bringing any income in the form of interest and not

contributing anything to Return and at the same time the amount of total assets is inflated because of

cash. The capital structure theory also validates the importance of debt and its impact on the EPS and

ROE of the company. Moreover as per capital structure theories the use of debt brings more value to

the shareholders provided ROCE is more than interest rate. This holds true for IT Industry which has


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around 25% to 30% of Return & 12%-14% of the interest rate. Does this mean that Infosys can reach

out to these by changing its policies on capital structure and cash management ?

Framework of capital structure

The companys zero debt c apital structure corresponds to industry standards of having no or very less

debt in capital structure and is very much in line with its rivals - TCS and WIPRO who also dont

have any debt in their balance sheets for the year ending 2013. Infosys equity m arket value is 4 times

its book value; which as per 2012-2013 financial statements stands at Rs 627.95. Theoretically

putting it up, according to the capital structure theories (static trade off theory) optimal capital

structure is achieved at a point where tax advantage of debt is offset by bankruptcy cost. As per the

theories, a judicious mix of debt and equity capital can increase the value of the firm by reducing the

weighted average cost of capital (WACC) up to certain level of debt. This way the WACC decreases

only within the reasonable limit of financial leverage and upon reaching the minimum level, it starts

increasing with financial leverage. Hence, a firm with an optimum capital structure that occurs when

WACC is minimum which will directly maximize the value of the firm. Though unlevered

companies have the advantage of low interest -rate risk, however, there are a few disadvantages that

follow too. For instance, the company is perceived to be a less proactive one when it comes to

expansion plans, and could be left behind in the race to make the most of a bullish phase. It further

reiterates that even the most profitable companies should have debt in their capital structure not only

to cater to financing needs of the company but in order to generate wealth for the shareholders.

Based on above notions, lets assume that Infosys decides to incorporate debt in its capital structure.

The different levels of debt finance and risks associated with each of the alternative capital structures

have been given in the Exhibit -4. It also shows the impact of this new edition of capital structure into


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Infosys and its impact on the financial performance of the company. The financial performance has

been indicated through EPS and DPS.

Finding out the ideal Debt to capital ratio is very sensitive and complex decision to make. But

generally it is a function of internal factors, financial market signals, comparison within industry, and

reactions of adding debt in terms of changes in P/E Ratio, Bond ratings and debt yields etc.

The companys conservative capital structure is being discounted by the markets, despite being

efficient and profitable its P/E multiple and stock price are not reflecting the same as compared with

its peers (Annexure-4). By adopting a more aggressive capital structure policy and using excess cash

for paying dividends or repurchasing the stocks, the company can send positive signals to investors &

shareholders.

Debt Financing- how risky

With assumed debt proportion equivalent to 5%, 7%, 10% & 20%, the Interest Coverage Ratio which

is an indicator of business risk of a company is 60 times, 32 times, 19 times & 15 times respectively

(Exhibit 5). The above average Interest coverage ratio indicates that the company can go back on its

decision by paying off debt as and when the need arises. After Murthys com eback the company is

planning to revamp on many aspects even capital structure. Since theoretically also because of its

contractual nature and priority claim, debt is considered to be less expensive than equity and also the

interest payments are deductible for income tax purposes. The information on interest rates for bonds

has been used as are given in Exhibit- 6.

Though sufficient evidences prove that the company is not using debt financing since its efficient

internal operations, sound products, and strong cost control measures help it in generating desired


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internal funds and its culture of caution and risk aversion also go along with this but simultaneously it

cannot deny the need to have debt in its capital structure to increase the shareholders wealth. The

management should not continue its business in sub-optimal manner, i.e. restraining itself from the

optimal debt-equity version of capital structure theories. Even the Pecking order theory promotes the

usage of debt over equity. Moreover due to information asymmetry, managers know more about the

company than outsiders, raising debt gives a positive signal about the company's future prospects &

recurring cash flows.

Repurchase vs Cash Dividend

When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another way of

paying cash to shareholders is to repurchase its own shares also know as share buyback.

Repurchase of shares increases the shareholders wealth by paying them premium on shares during a

buyback & also the share price at the announcement of buyback might increase. From the companys

perspective it can achieve desired capital structure by incorporating debt & also prevent hostile

takeovers by others. But, the company has to quote a higher price in order to complete its repurchase

even for an overvalued share.

The companies which pay a good dividend rate to its shareholders will not necessarily see the drastic

fall in its market price during the bear market as compared to other shares. One of the biggest

disadvantages of cash dividend is that upon paying cash dividends, the company has lesser cash

reserves left for its utilization. Also, another negative aspect of this can be that shareholders may

expect the cash dividend again in the near future. In case the company is unable to live up to the

expectation, the shareholders might doubt the credibility of the company and its operations.


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Infosys can utilize the funds equivalent to excess cash reserves & debt raised, either through share

repurchase or by paying more cash dividends to its shareholders. The impact of such a decision on

EPS, DPS, ROE is shown in Exhibit- 5. In Exhibit-5, Option I talks about Repurchase option & Option

II talks about Cash dividend option. Ratio of Cash & bank balances to sales of Infosys is 60% in 2013

which is just 8.37% in 2013 for its rival & number one in Industry i.e TCS. Hence keeping around 3

times of the same for Infosys, rest of the excess cash i.e. around 35% of cash can be utilized.

Debt is assumed to be incorporated in the proportion of 5%, 7%, 10% & 20% in the total capital. The

quality of Debt issued decreases and the interest rate increases as the amount of debt increases based

on the size of recapitalization. At 5% debt-to-capital, bond is assumed to have AAA rating with

interest rate of 9.28%. At 7% debt-to-capital, the rating is AA+ with interest rate of 12.22% and with

10% debt-to-capital, the rating falls to AA- with the interest rate increased to 14.71% (Exhibit 6)

If the total amount of excess cash & debt raised is to be utilized for stock repurchase, the shares are

assumed to be repurchased at a premium of 10% at 5% debt to capital ratio, at 15% premium for 7%

debt to capital ratio, at 20% premium for 10% debt to capital ratio & 25% premium is to be offered for

debt to capital ratio of 20%. The premium would be over & above the market price of 2889.35 per

share as on 28 th March 2013.

Deciding upon Cash Dividend vs Repurchase of shares, the company should also look into the taxation

aspect where it has to pay taxes on dividend distributed to shareholders or in share buyback along with

the impact on EPS, DPS & ROE. From the shareholders perspective the decision would depend upon

tax liabilities on capital gains in case of repurchase & dividend income.


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EXHIBIT -1

Infosys indicators from 2008-09 to 2012-13(Rs. In crores)

Particulars 2013 2012 2011 2010 2009

Total Revenue (Income fromsoftware , services & products) 36765 31,254.00 25,385.00 21,140.00 20,264.00

Growth rate in Revenue (%) NA 17.63 23.12 20.08 4.32Operating Income (PBDIT) 11,015.00 10,061.00 8,821 7,360 6,906.00

Net Income (after tax but b4exceptional) 9,116.00 8,470.00 6,443.00 5,755.00 5,819.00

Growth rate in Net Income (%) NA 13.29 23.95 11.95 -1.10

Cash & Cash Equivalents at the endof the period 20,401.00 19,557.00 15165 11297 10289

Total Assets 43,028.00 35,815.00 28,854.00 26,066.00 21,151.00Debt 0 0 0 0 0owners' Equity (book value) 36,059.00 29,757.00 24,501.00 22,268.00 17,809.00ordinary shares (outstanding) 57.42 57.42 57.40 57.33 57.25

Source: Company annual reports


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EXHIBIT -2

Ratio analysisProfit Ratios (%) 2013 2012 2011 2010 2009Gross Profit /total revenue (%) 41.07 42.94 43.8 45.32 45

Operating Profit (PBIDTA)/Total revenue (%) 29.96 32.19 33.15 34.82 34.08Profit after Tax/total revenue (%) 24.61 25.55 25.38 27.22 28.72

Returns (%) 2013 2012 2011 2010 2009PAT/Average net worth (ROE) (%) 25.28 29.44 27.69 28.89 37.18PBIT/Average Capital employed (ROCE) (%) 37.3 40.87 37.58 37.25 42.9

Growth 2013 2012 2011 2010 2009Net Profit(before exceptional items) (%) 13.29 23.95 11.95 -1.1 30.18Basic EPS Rs. 157.55 139.07 112.26 100.37 101.65

Price /Earnings times 18.34 20.61 28.87 26.06 13.08Dividend per share(excluding special dividend) Rs. 42 37 30 25 23.5Dividend payout (%) 26.7 26.6 29.34 29.09 27.03

Balance Sheet (%) 2013 2012 2011 2010 2009Cash & Cash Equivalents /Total Revenue (%) 60.63 63.67 60.21 70.03 50.78Cash & Cash Equivalents /Total Assets (%) 51.1 55.56 52.97 66.48 57.65Source: Company annual reports


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Exhibit -3

Revenue Growth (%)2013 2012 2011 2010 2009

TCS 13.7 24 29.1 5.4 23

Cognizant 20 33 40 16 32Infosys 5.8 15.8 25.8 3 11.7Wipro 5 13.4 18.9 1.6 18.5HCL 17.1 31.1 24.1 17.1

Source: Company Financial reports

Exhibit 4

Pro forma statement - Financial Information for Alternative Capital Structure(Rupees in crores)

ACTUAL With 5% Debt With 7%Debt

With 10%Debt

With 20%Debt

Rate of Interest on Debt NA 9.28% 12.22% 14.71% 14.71%

A. Revenue 36,765 36,765 36,765 36,765 36,765

B. Operating profit (EBIT) 10,059 10,059 10,059 10,060 10,059

(C) Interest Expense 0 167.3 308.4 530.4 1060.9

D. Other Income 2,298 2,298 2,298 2,299 2,298

D. Net Profit before Tax(B+D)

12,357 12,189.69 12,048.55 11,828.57 11,296.14

D. Income Tax (E*26.2%) 3,241 3,193.70 3,156.72 3,099.09 2960

D. Profit After Tax (E - F) 9,116 8,995.99 8,891.83 8,729.49 8,336.55

Source : Company annual reports

The corporate income tax rate as per annual report is 26.22% Interest is calculated as per rates given in Exhibit-6


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Exhibit 5: Option 1 - Repurchase of Shares

Actual AssumedParticulars 2013 5% Debt to

Capital7% Debt to

Capital10% Debt to

Capital20% Debt to

Capital

A. Excess Cash Used - 7,140.35 7,140.35 7,140.35 7,140.35B. Debt issued - 1,802.95 2,524.13 3,605.90 7,211.80

Total stock repurchase (A+B) - 8,943.30 9,664.48 10,746.25 14,352.15

Price per share repurchased (atpremium of 10%, 15%, 20%,25%)

2899.92 3189.912 3334.908 3479.904 3625

Shares of common stockrepurchased - 28528339.99 32230151.67 37395918.36 52025108.54Owners equity(book value) 36,059 27,115.70 26,394.52 25,312.75 21,706.9Dividends paid (26.7% on PAT) 2434.0 2401.9 2374.1 2330.8 2225.860034

Shares Outstanding (AfterRepurchase) 574232838.00 545704498.01 542002686.33 536836919.64 522207729.47Earnings per Share 158.76 164.85 164.06 162.6 159.6Dividends per Share 42.4 44.0 43.8 43.4 42.6ROE 25.28 33.18 33.69 34.49 38.41Interest Coverage Ratio(times) 0 60.12 32.61 18.97 9.48Debt 0 1,802.95 2,524.13 3,605.90 7,211.80share price @PE 18.34 2911.6584 3,023.39 3,008.79 2,982.47 2,927.85

Source: self compiled


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Exhibit 5: Option II - Cash Dividend

Particulars Actual 5% Debt toCapital

7% Debt toCapital

10% Debt toCapital

20% Debt toCapital

2013

Excess Cash ( to beused for dividends)

- 7,140.30 7,140.30 7,140.30 7,140.30

Debt issued 1,802.95 2,524.13 3,605.90 7,211.80

Total Funds available - 8,943.25 9,664.43 10,746.20 14,352.10

Owners equity(bookvalue)

36,059 34,256.05 33,534.87 32,453.1 28,847.2

Dividends paid(original)

2433.9 2302.42 2086.87 1807.26 2302.42

Additional Dividends

paid0 8,943.25 9,664.43 10,746.20 14,352.10

Total Dividends Paid 2433.9 11,245.67 11,751.30 12,553.46 16,654.52

Shares Outstanding(After Dividend)

57,42,32,837.98 57,42,32,837.98 57,42,32,837.98 57,42,32,837.98 57,42,32,837.98

Earnings per Share 158.76 156.67 154.86 152.03 145.19

Dividends per Share 42 195.8 204.7 218.6 290.0

ROE 25.28 26.26 26.52 26.90 28.90

Interest Coverage 0 15 5.7 3.2 15

Debt 0 7,211.80 14,423.60 21,635.40 7,211.80

PAT 9116 8996 8892 8729 8337

share price @PE18.34

2911.66 2873.33 2840.06 2788.21 2662.70

Source: self compiled

Exhibit 6

Bond Rating

Interest rates on corporate bonds AAA AA+ AA-YTM 9.28% 12.22% 14.71%Source:http://www.hdfcsec.com/data/docs/NCDs%20which%20available%20currently%20for%20trading%20in%20the%20secondary%20market.pdf


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Annexure -1


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Annexure -2


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Annexure -3

Annexure -4


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References:

1. Infosys 2013 Annual Report www. infosys .com/investors/ reports -filings/ annual -report /2. http://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-

infosys-management-infosys-board

3. CAPITAL STRUCTURE THEORY AND POLICY, Unit 5 MODULE 2http://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPITAL%20STRUCTURE%20THEORY%20AND%20POLICY.pdf

4. http://in.reuters.com/finance/stocks/chart?symbol=INFY.NS
http://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-boardhttp://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-boardhttp://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-boardhttp://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-boardhttp://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPITAL%20STRUCTURE%20THEORY%20AND%20POLICY.pdfhttp://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPITAL%20STRUCTURE%20THEORY%20AND%20POLICY.pdfhttp://in.reuters.com/finance/stocks/chart?symbol=INFY.NShttp://in.reuters.com/finance/stocks/chart?symbol=INFY.NShttp://in.reuters.com/finance/stocks/chart?symbol=INFY.NShttp://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPITAL%20STRUCTURE%20THEORY%20AND%20POLICY.pdfhttp://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPITAL%20STRUCTURE%20THEORY%20AND%20POLICY.pdfhttp://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-boardhttp://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestone-infosys-management-infosys-board

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