FINANCIAL MANAGEMENT END-SEMESTER PROJECTSubmitted by: Aruba Khan To: Ms. Fatima Yasir Date: 7th June 2006 Semester: BBA IV (A)

CORPORATE VISION FFCs vision for the 21st century remains focused on harmonizing the company with fresh challenges and encompasses diversification and embarking on ventures within and beyond the territorial limits of the country un collaboration with leading business partners.

MISSION FFC is committed to play its leading role in industrial and agricultural advancement in Pakistan by providing quality fertilizers and allied services to its customers and given the passion t excel, take on fresh challenges, set new goals and take initiatives for development of profitable business ventures.

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CONTENTS1- Corporate Governance Analysis 1.10- Standards and Codes for practices of Management 1.11- Interaction with Financial Markets 1.12- Social Responsibility and Corporate Citizenship 2- Stockholder Analysis 2.10- Categories of Shareholders 3- Risk and Return Analysis 3.10- Risk Analysis 3.11- Return Analysis 4- Cost of Capital and Risk Involved 4.10- Cost of Debt 4.11- Cost of Equity 4.12- Cost of Capital (WACC) 5- Capital Structure Choices 5.10- Types of Financings used by the Company 5.11- Advantages and Disadvantages from using Debt 6- Optimal Capital Structure 6.10- Cases (1-3) 6.11- Optimal Debt Ratio 6.12- Recommended Debt Ratio 6.13- Mechanics of moving to the Optimal Structure 7- Possible Restructuring

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1. CORPORATE GOVERNANCE ANALYSISSTANDARDS OWNERSHIP The Company has built an innovative-adept culture, a culture that promotes transparency and accountability through honesty, integrity and diligence in their dealing with employees, customers, financial market, Government, regulatory authorities and all the other stakeholders. It is the policy of Fauji Fertilizer Company Limited to follow the highest business ethics and standards of conduct. The obligation of every one within the company to act responsibly; is, to be honest, trustworthy, conscientious, and dedicated to the highest standards of ethical business practices. The Companys reputation and its actions as a legal entity depend on the conduct of its Directors and employees. The companys Code of Business Ethics and Standards of Conduct has been enforced at all levels fairly and without prejudice. The code is equally applicable to all the Directors and employees (the management) of the Company who all have been provided with a personal copy. The Companys Code of Business Ethics and Standards of Conduct, as signed and published on November 30th, 2006 by LT Gen Munir Hafez, HI(M) (retired) clearly states to all employees that: 1. One of FFCs competitive strengths has always been the established fact that being a good corporate citizen, they believe in principles and ethical corporate practices. 2. As a market leader in fertilizer industry, they ensure commitment to strong business ethics forming the basis of their relationship with employees, colleagues. 3. To enhance operational transparency they preserve these values and business ethics as a responsibility that encompasses the entire Company 4 customers, partners, competitors, suppliers and AND CODES FOR PRACTICES OF MANAGEMENT AND

The Company has been ranked amongst the Top

Twenty

Five

Companies on the Karachi Stock Exchange for the 12th consecutive year. The Annual Report has secured the top position in the Chemical & Fertilizer sector of the competition. The award has been conferred to the company for the 4th successive year demonstrating the precision with which the Company carries out the Boards governance policies of honesty and accountability through transparency. The managements Commitment to their responsibilities and the companies fair dealing with both its management and stockholders can also be attributed from the fact that the Annual Report also enabled them to achieve laurels for the Country in the SAARC region by winning an award for the Best Presented Accounts in the Manufacturing Sector from the South Asian Federation of Accountants (SAFA) for the 3rd consecutive year. The Boards focus is on facilitating the effective exercise of shareholders rights through efficient discharge of duties imposed on it by law, the Memorandum and Articles of Association of the Company and the listing regulations and adding value in the context of achievement of the Companys business objectives on a sustained basis. The Board has adopted the Code of Corporate Governance, implemented through listing regulations of the Karachi, Lahore and Islamabad Stock Exchanges of Pakistan and as advised by the Audit Committee, the Board is satisfied that in addition to issuance of a Statement of Compliance with the Code of Corporate Governance, the company has been in full compliance, without any material departures, with mandatory and optional provisions of the Code and the international best practices of Governance throughout the year. Board of Directors primary responsibilities include safeguarding the rights of shareholders and the enhancement of business prosperity over time and therefore, the Board fully recognizes the importance of good governance in achieving these objectives.

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The Governance Frameworks have been designed to achieve long-term objectives of the Company. These practices include Core Values, Standard of Conduct of Directors, Standard of conduct for Employees and Policy Statement of Ethics and Business Practices which have been updated to ensure that they remain relevant and appropriate over time. These standards are applicable to the Board members, management and all employees of the Company over time.

The management team ensures execution of smooth business operations including manufacturing and marketing of fertilizers, identification of potential operational, market and business risks, implementation of effective budgetary controls for preparation of annual business plans/ cash forecasts and reporting deviations thereof.

CONCLUSION: After a detail and through analysis of the Companys Code of Governance and standards it can be rightly concluded that the Company duly appreciate its work force for their commitment, diligence and perseverance. They are grateful for their contribution to the results achieved by the Company during the year. They are also extremely grateful to their shareholders, customers, dealers, suppliers, contractors, bankers and other business partners for their enduring relationships and their continued support towards the prosperity of the Company. It can be inferred that there is no such relationship gaps between the management and stockholders (ownership) of the company as the management is working both for their as well as of the shareholders interest which has led this Company today, as the Market Leader in the Agriculture Fertilizer Industry. This has enabled the company to grow into a mature and capable organization INTERACTION WITH FINANCIAL MARKETS: The Fauji Fertilizer Company Limited interacts with financial markets through following ways: i) Capital Markets:- consisting of stock and bond markets. 6

ii) Commodity Markets:- consisting of fertilizer products in the agricultural sector. iii) Money Markets:- consisting of short-term debt financing and investment. iv) Derivatives Markets:- consisting of instruments for the management of financial risk. v) Foreign Exchange Markets:- consists of facilitating trading in foreign exchange. 1) CAPITAL MARKETS: The company interacts with capital markets through the issuance of bonds (both long-term and short-term borrowings) as well as through shares of its stocks. Fauji Foundation held 44.35% ordinary shares of the Company at the year-end. a) Bond Market: The bond market includes both non-current liabilities of the Company. These liabilities represent secured long-term financings by issuing bonds to the following banking companies: ABN Amro Bank- Syndicated MCB Bank Limited National Bank of Pakistan Habib Bank Limited Askari Commercial Bank Limited United Bank Limited

In addition, the Company has also issued securities such as Term Finance Certificates (TFCs) which represents private placements with two institutional investors for a period of 5 years. These borrowings are secured by an equitable mortgage on hypothecation of current and fixed assets of the Company. Besides this, some finances have been obtained to meet the debottlenecking requirements of the company. The noncurrent liabilities of the company also include some current portion, which are approximately 74.33% of the long-term borrowings. b) Stock markets: 7

The stock market of the Company includes its share capital, which is raised through the issuance of shares (both ordinary and preference shares) in the general market. All trading of the company is done through the brokers of the Stock Exchange. The Companys authorized share capital represents 500,000,000 ordinary shares of Rs.10 each amounting to Rs.5,000,000 thousand. The Company has issued

493,474,230 shares, which include approximately 236,978,328 bonus shares of Rs.10 each as well. Dividend on these shares is recognized as a liability in the period in which it is declared. 2) COMMODITY MARKETS: FFC has formulated governance practices and procedures important for the South Asian Region aimed at sustained economic growth. The products, which are manufactured and then sold in the commodity market, include fertilizer for crops in the agricultural sector. These include fertilizers such as: Urea Nitrogenous fertilizers Di-Ammonium phosphate (DAP) Agricultural performance affects the Countrys growth and the livelihood of about 66% of Countrys total rural population. Agriculture employs 45% of total work force. The government also enhanced agricultural credit allocation through various banks and financial institutions to Rs.130 billion from Rs.85 billion last year, with an increase of 53% to assist farmers in the procurement of important farm inputs including fertilizers, seeds, pesticides, machinery, equipment etc. through various forms of farming credit. Fertilizer is a basic agricultural input and its timely availability is crucial for agricultural output. In addition, the fertilizer sector provides support to the leather, textile, pesticide, financial and other sectors of the Countrys economy. Nitrogenous fertilizer production contributed about 4.5% to the overall growth of 9% related to large-scale manufacturing during the year. Fertilizer off-take has been increasing in the recent past and is anticipated to increase further in the medium term. 8

The Urea market posted a modest growth of 1% over last year with off-take of 5,236 thousand tones as compared to 5,179 thousand tones during 2005. Industry urea production of 4,803 thousand tones during the year improved by 2% over last years production of 4,693 thousand tones. The Trading Corporation of Pakistan imported 625 thousand tones during the year. Di-Ammonium Phosphate (DAP) market carried 292 thousand tones of DAP at the beginning of the year. 846 thousand tones were imported during the 2006 while 450 thousand tones, at almost last years level, were supplied by FFBL. DAP market during the year was recorded at 1,157 thousand tones, comprising imported stock and indigenous production, which improved by 11% over last years sales of 1,367 thousand tones. 3) MONEY MARKETS: This includes short-term borrowings and investments (both longterm and short-term) by the Company. The short-term loans are gathered from banks described in the above-mentioned capital markets section. The investment portfolio of the company is fairly diversified, ranging from investments in Government bonds to mutual funds, which aim at trapping the positive developments in the financial sector. The short-term secured borrowings from banking companies include following categories: Short-term loan Short-term import credit Short-term running finance Investment in joint venture-at cost Investment in subsidiary-at cost Investment available for sale Investment held to maturity

The long-term investments of the company are categorized as:

The investment available for sale and investment held to maturity contains Certificates of Investment and Term Finance Certificates (TFCs) with Pakistan Investment Bonds respectively. 9

The short-term investments include: Term deposits with banks and financial institutions Investments at fair value through profit and loss Current maturity of long-term investments

The Company has done Investments at fair value through profit and loss, in the funding areas such as Meezan Balanced Fund, National Investment Trust and Nafa Cash Fund. Fair value of these investments is determined using quoted market price and redemption/repurchase price, whichever is applicable. 4) DERIVATIVES MARKET: The board has established formal and transparent arrangements for application of the financial reporting and internal control principles and for maintaining an appropriate relationship with the Companys External Auditors through the Audit Committee. The Audit Committee includes regular reviews of the effectiveness and adequacy of the Companys system of internal control for safeguarding the Company assets. The review covers evaluations of the findings contained in the internal Audit Reports, financial, operational and compliance controls, risk management and adequacy and effectiveness of the internal control systems. The instrument used for managing risk and maintaining it within reasonable limits includes risk mitigation for risk involved in credit, liquidity, interest rate and foreign exchange sectors. 5) FOREIGN EXCHANGE MARKETS: Foreign exchange markets consist of foreign currency investments, bank balances and short-term financing. Both foreign currency assets and liabilities are denominated in US Dollars. Monetary assets and liabilities in foreign currencies at each period end are translated into rupees at the dates prevailing in the balance sheet date. Exchange differences are recorded in the profit and loss account for the year. The Companys Foreign Exchange markets also consist of imports from other countries. The bank balances, which are held in other countries, include a total amount of Rs.11, 922 thousand. The investments done in other countries include a total of Rs.882,322 thousand that are held until maturity.

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SOCIAL RESPONSIBILITY AND CORPORATE CITIZENSHIP: Human rights, labour standards and the environment are key issues, which have universal importance for FFC as reflected in their conduct. As a matter of fact and principle, FFC does not use any child labour or forced labour. The operations carried by the Company in view of its social obligations include the following: Operations by the Sona Welfare Hospital administered through the Mirpur Mathelo plant site commenced during the year, which treats around 1,200 patients per month. Construction of Coronary care unit at District Hospital Ghotki and Sona Public School is also under progress for the neighbouring community. The Company also continues to provide financial support to Hazrat Bilal Trust Hospital. Aggregate donations by the Company amounted to Rs.28.5 million, representing 0.61% of their net profit for the year, and which in addition to the above social contributions include contributions to various welfare institutions and societies and sporting bodies to promote healthy activities. The Marketing Division of the Company held various special farmers meetings and group discussions on profitable cultivation, balanced fertilizer use and increased acreage. In addition, numerous demo plots, experiments and field days were organized. Hundreds of farms were visited, numerous soil/water tests were performed and Farm Advisory Services were extended. These services were performed free of cost to the farmers. The Technical Training Centre of the Company continued to extend customized training services to other companies including OMV Pakistan Ltd and Bosicor Pak Ltd. In addition, services to other companies including Pak Arab Fertilizers were provided as part of their professional commitment. Developmental work of Mirpur Mathelo township is in progress including construction of new BOQs, C-type bungalows and renovation of various types of old residential facilities.

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2. STOCKHOLDER ANALYSISCATEGORIES OF SHAREHOLDERS:

Serial No. 1. 2. 3. 4.

Particulars

Number of Shareholders 26 22 167 30 12

Shares held 47,683,116 49,402,418 6,316,888 27,242,028

Percentage

Investment Companies Insurance Companies Joint Stock Companies Financial Institutions

9.66 10.01 1.28 5.52

5. 6. 7. 8. 9. 10.

Modarabas Foreign Investors Leasing Companies Mutual Funds Charitable Trusts & Others Individuals TOTAL

24 49 5 34 115 9832 10,304

501,692 30,632,281 380,973 27,919,699 240,663,545 62,731,590 493,474,230

0.10 6.21 0.08 5.66 48.77 12.71 100.00

It can be concluded from the above analysis of the Companys shareholder categories that investors of its stock include both individuals as well as companies such as investment and insurance. They are all liable to pay tax to the government. The company also contains pension fund categories of investors as well as foreign investors. The major portion of the Companys stock is held by the Charitable Trusts and Institutions, which holds approximately 49% of the Companys, share wealth. Fauji Foundation holds 44.35% shares of FFC at the year-end. Therefore, all subsidiaries and associated undertakings of Fauji Foundation are related parties of FFC and FFBL. The Board of Directors of FFC in their meeting held on January 26th, 2007 has proposed a final dividend of Rs.3.90 per share on its outstanding stock items.

3. RISK AND RETURN ANALYSISRISK ANALYSIS: The risk profile of Fauji Fertilizer Company Limited is not that high as compared to other fertilizer companies such as Pak Arab Fertilizer. This Company is market leader in fertilizer industry and the performance of management is attributed to be 100% in bringing the Company towards success and prosperity. The major risk of the company is coming from credit, foreign exchange, interest rate and liquidity. However, the overall risk involved is quite low and the Board of Directors as well as management has developed standardized procedures for the control of risk within reasonable limits. The risk 13

profile of the company is moving towards positive direction as it is a stable and mature Company and has covered or completed its riskness phase in the first few years of its operations. Credit Risk: Credit risk represents the accounting loss that would be recognized at the reporting date if counter parties failed completely to perform as contracted. All the financial assets of this Company except cash in hand are subject to credit risk. The Group companies believe that it is not exposed to major concentration of credit risk. To manage exposure to credit risk, the Group companies apply credit limits to its customers besides obtaining guarantees and by dealing with variety of major banks and financial institutions. Foreign Exchange Risk: Financial assets and liabilities exposed to foreign exchange risk amount to Rs.894,244 thousand and Rs.4,301,090 thousand respectively at the year-end. Currently, the Group companies foreign exchange risk exposure is restricted to foreign currency investments and financing. As both foreign currency assets and liabilities are denominated in US Dollars, the Group companies exposure emanating from any fluctuations in the Pak Rupee/ US Dollar parity gets hedged to a large extent.

Interest Rate Risk: Financial assets and liabilities include balances of Rs.8,465,064

thousand and Rs.13, 215,173 thousand respectively, which are subject to interest rate risk. The Group companies have long-term Rupee and foreign currency based loans at variable and fixed rates. Variable rate long-term financing except Term Finance Certificates (TFCs) is held against interest rate risk by holding prepayment option, which can be exercised upon any adverse movement in the underlying interest rates. TFCs are held against the interest rate risk by instituting interest rate caps and floors. Liquidity Risk: 14

Prudent liquidity risk management implies maintaining sufficient cash and marketable securities, the availability of funding to an adequate amount of committed credit facilities and the ability to close out market positions due to the dynamic nature of the business. The Group companies treasury aims at maintaining flexibility in funding by keeping committed credit lines. RETURN ANALYSIS: The investment profile of this Company is quite stable and profitable as compared to the market in which it operates and keeps a significant edge in this regard. The earnings per share on this company shares have increased substantially, about Rs.3 to Rs.4 from the year 2001 till 2006. The final dividend paid on the outstanding ordinary shares has increased from Rs.1.00 to Rs.4.00 during the period from 2001 to 2006. The Company has calculated earnings per share of Rs.14.16 in the year 2006; however, the final dividend declared for the year amounted to Rs.3.90, which concludes that the Company has retained most of its earnings as reserves or for its own operations. One earns a considerable return after investing in this Company. A person who invested 20,000 shares in FFC last year (2005) has earned a profit of almost Rs.1.65 above the initial value of the share. This means a profit of Rs.33,000. The dividend paid last on last years outstanding share amounted to Rs.2.25 whereas final dividend paid this year, 2006 is Rs.3.90 per share. The performance of management in this aspect is attributed to be 100% as the stability and efficiency of the operations of the Company is highly dependent on its management committee. The Companies debt or borrowings on loan have increased as compared to the last years borrowing amount. This increase is amounted to be approximately 18.74% from the 2005 borrowings. However, the Company in the current year does not hold any obligation to the Murabaha financing in contrast to the last year in which it was liable to pay Rs.41,667 to Murabaha. These financings have matured and therefore paid by the company. The Companys long-term borrowings have been financed at interest rates ranging from 3.5% to 12.03% and the short-term borrowings interest rate is from 4.49% to 11.12%. 15

4. COST OF CAPITAL AND RISK INVOLVEDCOST OF DEBT (Kd): The Company uses only non-current liabilities or long-term fundings under its debt portion. However, some portion of theses non-current debt is based to be current and that amount is subtracted from the non-current liabilities to get the 16

exact amount of long-term debt. Approximately 42.64% of non-current liabilities are considered treated as current liability. Rupees 000NAME OF BANKING COMPANY ABN Amro Bank MCB Bank Limited National Bank-1 Habib Bank Ltd1 Habib Bank Ltd2 United Bank Ltd-1 National Bank-2 Habib Bank Ltd3 Askari Bank Ltd Term Finance Certificates (TFCs) BORROWING AMOUNT 52,582 57,360 95,600 161,325 35,850 35,850 286,800 286,800 57,360 124,180 1,193,707 (a) WEIGHT 0.044 0.0481 0.0801 0.1351 0.03 0.03 0.2403 0.2403 0.0481 0.104 1.00

(b) INTEREST RATES (%)9.591% 9.591% 9.591% 9.591% 9.291% 9.291% 9.55% 10.50% 9.45% 13.00%

(c)=(a)*(b) WEIGHTED INTEREST RATE0.422 0.4613 0.76824 1.2957 0.2787 0.2787 2.29487 2.52315 0.45455 1.352

Total

Kd= 10.13%

Hence, Cost of debt of FFC Ltd (Kd) is 10.13% The finances described above are secured by an equitable mortgage on assets of the Company and hypothecation of all assets including plant, machinery, tools and spares and all other moveable properties. However, some finances are also secured against lien on Pakistan Investment Bonds and some have been obtained to meet the debottlenecking requirements of the Company. The interest rates against the financings of ABN Amro, MCB Bank, National Bank (1), Habib Bank (1&2) and United Bank have been obtained under rates of 6-months Treasury bill rate + mark-up ranging from 1.0 to 1.3. In addition, the interest rates on National Bank (2), Habib Bank (3) and Askari Commercial Bank Ltd have been made under 6-moths KIBOR rate + mark-up ranging from 0.4 to 1.45. The TFCs represent private placements with two institutional investors of the Company. The annual rate of profit is State Bank of Pakistan discount rate plus 1.5% with a floor of 11% and cap of 16%. 17

The debt of the Company is very low i.e. about 2%. Therefore, the Company is not facing much financial distress cost and the related agency cost on its amount of borrowings. In addition, the bankruptcy costs have been avoided through low use of debt and greater use of equity stocks. The debt of the Company is not at all risky and the liquidity value of the Firm is also very low. COST OF EQUITY (KS): Under CAPM approach: Ks = KRF + (KM KRF) Where: Ks = KFFC =? KRF = Rate of return on 3-months T-bill = 8.291% KM = KSE 100 Index annual return = 29% = Calculation shown below:FFC Shares Monthly Opening & Closing Prices (2005-2006)Month O/P Price January-05 February-05 March-05 April-05 May-05 June-05 July-05 August-05 September-05 October-05 November-05 December-05 January-06 February-06 March-06 April-06 May-06 June-06 July-06 August-06 September-06 October-06 November-06 December-06 C/L Price 149.20 156.15 148.30 145.00 139.00 119.95 133.95 137.10 130.25 135.30 148.75 137.00 136.75 126.80 134.65 129.90 123.60 121.00 117.50 115.00 117.00 116.90 116.40 RETUR N (R) % 149.20 156.15 148.30 145.00 139.00 119.95 133.95 137.10 130.25 135.30 148.75 137.00 136.75 126.80 134.65 129.90 123.60 121.00 117.50 115.00 117.00 116.90 116.40 107.00 ER= R-ER 4.651162791 -5.027217419 -2.22521915 -4.137931034 -13.70503597 11.6715298 2.35162374 -4.996353027 3.877159309 9.940872136 -7.899159664 -0.182481752 -7.276051188 6.190851735 -3.527664315 -4.849884527 -2.127315377 -2.892561983 -2.127659574 1.739130435 -0.085470085 -0.427715997 -8.075601375 1.266999673 (R-ER)2 5.918162 -3.76022 -0.95822 -2.87093 -12.438 12.93853 3.618623 -3.72935 5.144159 11.20787 -6.63216 1.084518 -6.00905 7.457851 -2.26066 -3.58288 -0.86032 -1.62556 -0.86066 3.00613 1.18153 0.839284 -6.8086 35.02465 14.13924 0.918185 8.242247 154.7047 167.4055 13.09444 13.90808 26.46237 125.6164 43.98555 1.176179 36.1087 55.61955 5.110605 12.83706 0.740143 2.642453 0.740735 9.036818 1.396012 0.704397 46.35706 33.73788 = Variance

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ER = Average rate of return

Average FFC = 5.808431%

KSE 100 Index Monthly Opening & Closing Rates (2005-2006):Month January-05 February-05 March-05 April-05 May-05 June-05 July-05 August-05 Septembe-05 October-05 November-05 December-05 January-06 February-06 March-06 April-06 May-06 June-06 July-06 August-06 Opening 6747.39 8260.06 7770.33 7104.65 6857.67 7405.12 7178.93 7796.86 8225.66 8247.34 9025.93 9556.61 10524.16 11456.27 11485.9 11342.17 9800.69 9989.41 10497.63 Closing 6747.39 8260.06 7770.33 7104.65 6857.67 7405.12 7178.93 7796.86 8225.66 8247.34 9025.93 9556.61 10524.16 11456.27 11485.9 11342.17 9800.69 9989.41 10497.63 10064.13 Return % (R) 22.41859445 -5.92889156 -8.56694632 -3.47631481 7.983032138 -3.05450823 8.60755015 5.499649859 0.263565477 9.440498391 5.879504937 10.12440604 8.856858885 0.258635664 -1.25136036 -13.5906974 1.925578709 5.087587755 -4.12950352 R-ER 20.38151 -7.96597 -10.604 -5.5134 5.945951 -5.09159 6.570469 3.462569 -1.77352 7.403418 3.842424 8.087325 6.819778 -1.77845 -3.28844 -15.6278 -0.1115 3.050507 -6.16658 (R-ER)2 415.4061 63.45672 112.4454 30.39753 35.35434 25.92428 43.17107 11.98938 3.145357 54.81059 14.76422 65.40483 46.50937 3.162867 10.81385 244.2274 0.012433 9.305593 38.02676 X 120.6211 29.95379 10.16099 15.82858 -73.956 -65.8777 23.77605 -12.9131 -9.12324 82.97656 -25.4836 8.770849 -40.9804 -13.2634 7.434063 55.99253 0.095927 -4.95879 5.307332

Average KSE = 7.778667 CoV = (R-ERFFC * R-ERKSE ) CoV = 13.128960 = CoV/(FFC * KSE) = 0.29058 Therefore; KFFC = 8.291 + (29-8.291)0.29058 KFFC = 14.31% Hence, cost of Capital of FFC Ltd (Ks) is 14.31% As the Companys debt is, low so the risk premium on its stock shares is small and hence the interest rate on the outstanding shares of the Company is 19

comparatively less. This has resulted into high value or high price of shares in the market. Currently, the Companys shares are selling at a premium price. This implies that there is low or little risk involved in the equity of FFC Ltd. Due to low risk and consequently less financial distress and bankruptcy related cost, the Company can use leverage to finance its risky new investments. Projects although risky but with positive net present values can be undertaken by the Company through the issue of long-term bonds. COST OF CAPITAL: (WACC - Weighted Average Cost of Capital) Total debt= Rs.1,193,750 Total Equity= Rs.12,956,543 D/E Ratio= 1,193,750/12,956,543= 0.092135 Total Debt + Equity= 1,193,750 + 12,956,543= Rs.14,150,293 Wd= 1,193,750/14,150,293= 0.08436 Ws= 12,956,543/14,150,293= 0.91564 WACC= WdKd (1-T) + WsKs WACC= (0.08436) (10.13) (1-0.35) + (0.91564) (14.31) WACC= 13.66% Therefore, the current Cost of Capital (WACC) of FFC Ltd is 13.66%

5. CAPITAL STRUCTURE CHOICESIt should be mentioned that the Fauji Fertilizer Company Limited during the year 2006 has used only 2% debt and around 98% equity in order to finance its investments or the ongoing projects of the year.

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TYPES OF FINANCINGS USED BY THE COMPANY: The Fauji Fertilizer Company Ltd has used the following sources and methods to finance its capital requirements for the assets and ongoing projects. These represents the securities the Firm has issued in the market for investment decisions. i. ii. iii. iv. Long-term bonds Short-term bonds Term Finance Certificates (TFCs) Equity Shares The long-term bonds represent the non-current liabilities or the debt of the Company. These borrowings have been obtained from the banking sector in the market under interest rates which are the 6-months T-bill rate alongwith the mark-up rate the Company has decided. Some long-term financings have been obtained from banks under the KIBOR rate and the mark-up on it by the Company. TFCs represent private placement securities which are secured by the Company and its rate depends upon the floor and cap limits made by the State Bank of Pakistan under the discount rate and mark-up introduced by the Company. Short-term borrowings have not been included in the debt of the Company by the management and the current portion of long-term debt have also been excluded from debt and included in the short-term or current liabilities of the Company. The short-term borrowings are secured and currently the Company has no short-term loan in the year 2006 however, it does contain shortterm import credit and short-term running finance which have been arranged from various banks under mark-up arrangements at 6-months LIBOR (4.68%) + 0.5%-0.6% per annum and 1-month to 6-months KIBOR + 0.25% to 0.80% per annum respectively. The Company presently is using 98% equity stock to capitalize for its funds as according to its management raising funds through issuing debt or bonds increases their risk in the market place and consequently leads to higher returns on outstanding shares. The management is deciding and working for the interest of their stockholders and for effective management decisions they have reduced their number of bondholders. The prevailing prices of the shares of this Company in the KSE 100 Index list ranges from Rs.103.70 to Rs.129.50. During the year 21

the Company has issued ordinary shares as well as bonus shares of its stock portfolio. The management is in a position to issue shares in the trading market and to reduce its risk appetite and increase its stability or earnings through higher stable sales of its product in the given fertilizer industry. This does not correspond to the fact that the firms financial situation is weak but leads to the fact that the firm can better finance its funds requirement through more equity usage then debt as nowadays equity market under KSE is more reliable and appropriate then bond market. If the Company were to use bond financing than the Firm will face serious risk of default due to unstable bond market and in such a situation managers will surely be in situation of loosing their jobs. ADVANTAGES AND DISADVANTAGES FROM USING DEBT: As mentioned above the Company is currently using very low levels of debt approximately 2% therefore its financial risk is quite low and this leads to less risk premium on return rates of outstanding stock shares. The advantages from low use of the debt lies in the fact that as the Company is in the fertilizer industry rather than the utility market its sales are relatively less stable and due to unstable sales of its fertilizer products the Companys management doesnt tend to increase its bankruptcy and financial stress related costs and risks through the issuance of bonds. In addition, as the major portion of the firms assets are fixed such as machinery and equipment and the other liquid assets are low so security loans are not preferred for this firm and the equity is issued to raise funds. The Company has significantly increased its amount of equity in capital structure from the year 2002 till 2006. In 2002 the debt to equity ratio of the firm was 35:65 compared to 2006 where this ratio is 2:98. However, although the firm has decreased the amount of debt but the value of earnings per share (EPS) has increased significantly from Rs.9.81 per share to Rs.14.16 per share during this period. This shows that the Company is in a better position to avoid risk and its related costs through using debt/bonds and capitalize by using equity financing. The Fauji Fertilizer Company limited is among the Top 25 Companies of KSE 100 Index for the past 3 years and due to well performance of its stock, it relies more heavily on share financing. The Company is at first 22

position in the fertilizer market and this is due solely to its higher sales and revenue on manufactured products which leads to higher earnings after profit and the tax-shelter benefits which are not realized due to low debt are overcome through high sales turnover and low premium on stock dividends. This also leads to the fact that the firms operating leverage are high with high business risk and consequently financial leverage is kept at minimum level. As the firm is growingfaster so it relies more heavily on external capital and avoids the uncertainty through debt financing. In addition, due to high rates of return on investment the Company has used relatively little debt. From the Qualitative, trade-off model the Company has too little debt, which includes the fact that using high level or optimum levels of debt provides the firm with tax-shelter benefits as the interest on bonds is a taxdeductible expense. The Company is currently paying 35% of tax on its earnings. However the company is being able to avoid such losses of little debt through better management of its stock shares in the market place (as described above) which have resulted in significant increase in earnings per share of outstanding ordinary shares.

6. OPTIMAL CAPITAL STRUCTURECASE : 1:Debt = Rs.1,193,750,000 23

Suggested debt = Rs.1,850,000,000 Equity = Rs.12,956,543,000 Let shares to be repurchased = x Hence; As, re-purchase price of FFC shares = Rs.130.94 Therefore; 130.94 * x = 1,850,000,000 x = 1,850,000,000/130.94 x = 14,128,609 shares Debt Ratio = 21.51% New outstanding shares = 493,474,230 14,128.609 Equity Ratio = 78.49% = 479,345,621 shares New equity value = 479,345,621 * 10 = Rs.4,793,456,210 Now; Ksd = 9.5% Tax rate = 35% ORIGNAL PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax = Rs.6,444,535,000 Tax = (Rs.2,255,587,250) Profit after Tax = Rs.4,188,947,750 EPS = Rs.8.49 /share SUGGESTED PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax and Interest =Rs.6,444,535,000 Interest Expense* = (Rs.175,750,000) Tax Shield* = Rs.61,512,500 Profit before Tax = Rs.6,330,297,500 Tax = (Rs. 2,255,587,250) Profit after Tax = Rs.4,074,710,250 EPS = Rs.8.51 /share *Interest Expense = 1,850,000,000 * 0.095 = Rs.175,750,000 *Tax Shield = 175,750,000 * 0.35 = Rs.61,512,500 Calculating WACC after taking debt: Wd = 1,193,750/14,150,293 = 0.08436 24

Wsd = 1,850,000,000/14,150,293,000 = 0.13074 Ws = 11,106,543,000/14,150,293,000 = 0.7849 Now; by Hamada Equation:b = bu [1+ (1-T) (D/S)] b = 0.29058 [1+ (1-0.35) (3,043,750,000/11,106,543,000)] b = 0.29058 [1+ (0.65) (0.2741)] b = 0.3424 As; Ks = KRF + (KM KRF) Ks = 8.291 + (29 8.291) 0.3424 Ks = 15.38% And as; WACC = [ WdKd (1 T) + WsdKsd (1 T)] + WsKs WACC = [(0.08436) (10.13) (0.65) + (0.13074) (9.5) (0.65)] + (0.7849) (15.38) WACC = ( 0.5555 + 0.80732 ) + 12.0718 WACC = 13.43% RESULT: By introducing a debt of Rs.850,000,000, WACC of the Firm reduced to 13.43% from 13.66% and EPS increased to Rs.8.51 from Rs.8.49.

CASE : 2:Debt = Rs.1,193,750,000 Suggested debt = Rs.6000,000,000 Equity = Rs.12,956,543,000 Let shares to be repurchased = x 25

Hence; As, re-purchase price of FFC shares = Rs.130.94 Therefore; 130.94 * x = 6000,000,000 x = 6000,000,000/130.94 x = 45,822,514 shares = 447,651,716 shares New equity value = 447,651,716 * 10 = Rs.4,476,517,160 Now; Ksd = 9.5% Tax rate = 35% ORIGNAL PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax = Rs.6,444,535,000 Tax = (Rs.2,255,587,250) Profit after Tax = Rs.4,188,947,750 EPS = Rs.8.49 /share SUGGESTED PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax and Interest=Rs.6,444,535,000 Interest Expense* = (Rs.570,000,000) Tax Shield* = Rs.199,500,000 Profit before Tax = Rs.6,074,035,000 Tax = (Rs.2,255,587,250) Profit after Tax = Rs.3,818,447,750 EPS = Rs.8.53 /share *Interest Expense = 6000,000,000 * 0.095 = Rs.570,000,000 *Tax Shield = 570,000,000 * 0.35 = Rs.199,,500,000 Calculating WACC after taking debt: Wd = 1,193,750/14,150,293 = 0.0843 Wsd = 6000,000,000/14,150,293,000 = 0.42402 Ws = 6,956,543/14,150,293 = 0.49162 Now; by Hamada Equation:26 Debt Ratio = 50.83%

New outstanding shares = 493,474,230 45,822,514 Equity Ratio = 49.17%

b = bu [1+ (1-T) (D/S)] b = 0.29058 [1+ (1-0.35) (7,193,750,000/6,956,543,000)] b = 0.29058 [1+ (0.65) (1.0341)] b = 0.4863 As; Ks = KRF + (KM KRF) Ks = 8.291 + (29 8.291) 0.4863 Ks = 18.36% And as; WACC = [ WdKd (1 T) + WsdKsd (1 T)] + WsKs WACC = [(0.08436) (10.13) (1 0.35) + (0.42402) (9.5) (1 0.35)] + (0.49162) (18.36) WACC = ( 0.5555 + 2.6183 ) + 9.026 WACC = 12.20% RESULT: By introducing a debt of Rs.6000,000,000, WACC of the Firm further reduced to 12.20% from 13.66% and EPS increased to Rs.8.53 from Rs.8.49.

CASE : 3:Debt = Rs.1,193,750,000 Suggested debt = Rs.10,000,000,000 Equity = Rs.12,956,543,000 Let shares to be repurchased = x Hence; As, re-purchase price of FFC shares = Rs.130.94 27

Therefore; 130.94 * x = 10,000,000,000 x = 10,000,000,000/130.94 x = 76,370,857 shares New outstanding shares = 493,474,230 76,370,857 = 417,103,373 shares New Equity = 417,103,373 * 10 = Rs.4,171,033,730 Now; Ksd = 9.5% Tax rate = 35% ORIGNAL PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax = Rs.6,444,535,000 Tax = (Rs.2,255,587,250) Profit after Tax = Rs.4,188,947,750 EPS = Rs.8.49 /share SUGGESTED PROFIT AND LOSS Operating Income = Rs.9,708,679,000 Net Operating Income = Rs.6.961.897.000 Finance Cost = (Rs.517,362,000) Profit before Tax & interest= Rs.6,444,535,000 Interest expense* = (Rs.950,000,000) Tax Shield* = Rs.332,500,000 Profit before Tax = Rs.5,827,035,000 Tax = (Rs.2,255,587,250) Profit after Tax = Rs.3,571,447,750 EPS = 8.56 /share *Interest Expense = 10,000,000,000 * 0.095 = Rs.950,000,000 *Tax Shield = 950,000,000 * 0.35 = Rs.332,500,000 Calculating WACC after taking debt: Wd = 1,193,750/14,150,293 = 0.0843 Wsd = 10,000,000,000/14,150,293,000 = 0.7067 Ws = 2,956,543/14,150,293 = 0.2089 Now; by Hamada Equation:b = bu [1+ (1-T) (D/S)] b = 0.29058 [1+ (1-0.35) (11,193,750,000/2,956,543,000)] 28 Debt Ratio = 79.10% Equity Ratio = 20.9%

b = 0.29058 [1+ (0.65) (3.7861)] b = 1.0057 As; Ks = KRF + (KM KRF) Ks = 8.291 + (29 8.291) 1.0057 Ks = 29.12% And as; WACC = [ WdKd (1 T) + WsdKsd (1 T)] + WsKs WACC = [(0.08436) (10.13) (1 0.35) + (0.7067) (9.5) (1 0.35)] + (0.2089) (29.12) WACC = ( 0.5555 + 4.3639 ) + 6.0832 WACC = 11.00% RESULT: By introducing a debt of Rs.10,000,000,000, WACC of the Firm further reduced to 11.00% from 13.66% and EPS increased to Rs.8.56 from Rs.8.49. OPTIMAL DEBT RATIO: According to the above analysis of the Firms capital structure the optimal debt ratio for this Firm comes out to approximately 80% debt and 20% equity capitalization. At this ratio the Companys earnings per share is maximized and its cost of capital (WACC) is minimized. Taking debt above this ratio will increase the risk related factor of the Company i.e. the bankruptcy, financial distress and agency costs will offset the Tax-shelter benefits of the firm from using high debt and consequently this will increase the WACC or the cost of capital of the Company as well as the survival of the management of the firm will be at stake. This will also lead to a very high rate of return on the Companys shares due to increased risk premium. RECOMMENDED DEBT RATIO: The Fauji Fertilizer Company Limited is a private organization with Fauji Foundation holding almost 45% of the Companys stock. So the 29

management of the Company is working more for the interest and benefits of its stockholders instead of bondholders. The recommended debt ratio of this firm is 50% debt and 50% equity as at this level the Companys debt related costs will be very less or in other words at a minimum level and the earnings per share will also be higher then the current level and hence the WACC of the firm will also be minimized then the present one. This suggestion is recommended as this will result into a trade-off between the benefit of debt (the interest tax shelter) and the costs of debt (financial distress and agency costs). However, the goal should be in maintaining financial flexibility which from an operational point of view means maintaining adequate reserve borrowing capacity and this depends upon firms forecasted need for funds, predicted market conditions, and the consequences of a capital shortage. MECHANICS OF MOVING TO THE OPTIMAL STRUCTURE: In one context, the optimal capital structure is the one that maximizes the price of the firms stock and this generally calls for a debt ratio that is lower than the one that maximizes expected EPS because with the increase in debt the firms risk in portfolio increases and this leads to high risk premium on stocks and works to reduce the stock price. In this perspective the Company should increase its debt level relatively slowly taking in due consideration of the market trend during the period in order to manage the resulting risk in an appropriate and precise manner. The use or increase of debt in capital structure also depends upon the Companys bond ratings by the rating agencies in the financial market as this affects cost of debt of the Company. Hence, increasing the debt immediately will be quite risky for the firm. If the Fauji Fertilizer Company has potential investments with positive net present values, then high levels of debt can be doubly costly because the expected financial distress and bankruptcy costs are high and the company will lose potential value by not making some potentially profitable investments. On the other hand, if the Fauji Fertilizer Company has very few profitable investment opportunities then high levels of debt can keep the management of the firm from vesting money by investing in poor projects and this can also increase the value of the firm. In addition to this, it should also be considered that 30

the Company should in normal times, use more equity and less debt then is suggested by the optimal or recommended debt ratio because this can avoid the Company from omitting signals which will not be favorable for the firm in bad times when competitors are taking lead in the market place as this will help in preventing the Companys sale from declining. In analyzing the Firm from the sectors point of view in which it is operating then the Fauji Fertilizer Company has required ratio of debt and equity because it is an industrial firm so its sales are comparatively less stable and in this way it has taken less debt to avoid the uncertainty arising from the sales of its product. In addition to this the Company has less security loans which can be used as debt and more fixed assets required for daily operations so it is better that they should take less debt in comparison with equity to finance their projects. From the general markets point of view the company has very low debt ratio as companies in normal times keep a mix in capital of about 35% debt and 65% equity. The Company should maintain a mix of both short-term and longterm financing as this would be helpful for retiring its previously held debt and in managing the newly attained debt in capital structure.

7. POSSIBLE RESTRUCTURINGThe Fauji Fertilizer Company Limited is operating in an industry, which manufactures and sells agricultural fertilizer in the market. The Company main 31

stockholder or owner of the Company is Fauji Foundation Corporation, which currently holds 44.35% of the Companies outstanding shares. The Companys management is comparatively less aggressive as the Company contains low debt and high equity in its capital structure and so the management is not making an effort to boost its profits or earnings. This also implies that the Company is facing some major risk in its operations, as its optimal debt ratio is lower. However, due t low levels of debt, the Companys debt is less risky and consequently it is not facing major bankruptcy or financial distress related costs. The Company should maintain a financial flexibility so that it can raise capital on reasonable terms under adverse market conditions or when money is tight in the economy. As the Companys has high business risk so this implies that the Company has higher degree of operating leverage, which means the Company contains more fixed costs in its expenses than variable cost. However, the Companys financial risk is quite less due to low levels of debt. The management of FFC is working to maximize the earnings or dividends of shareholders than the bondholders however some restrictive covenants have been brought into effect by the law, which protects the rights of bondholders and give them adequate protections from the exploitation of the management. This phenomenon has brought some agency cost in the Firms capital structure. As according to theory, value of a firm is maximized by using more debt than equity and currently as the firm is using low level of debt so as a manager, I will tend to increase the value of the firm by reducing its equity and putting it into the debt or loan of the Firm. More precisely, I will try to lead the Company towards its suggested optimal debt ratio in order to gain tax-shelter benefits and reduce the cost of capital or WACC of the Firm, keeping in view the related bankruptcy and financial distress costs so that the benefits of tax-shelter are not offset by these direct and indirect costs as they will reduce the value of the Company. As FFC is a fertilizer company and being in an industry, it has unstable sales so its debt ratio relative to the market will have to be kept lower but in an industry, it this ratio should be more in order to gain capital advantage over the competitors. In addition, as the Company has less security loans and more fixed assets so keeping high debt will be risky and there should be maintained a trade-off between debt and equity due to these underlying factors. 32

For these reasons, a reserve borrowing capacity will be brought into effect, which will help the Company to finance funds when there are only few profitable investment opportunities for the Firm and in such situations high debt will be preferred, as this will help to increase the value of the firm.

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