final capital structure in oil and gas sector
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ABSTRACT
The term capital structure refers to the percentage of capital (money) at work in a
business by type. Broadly speaking, there are two forms of capital: equity capital and
debt capital. Each has its own benefits and drawbacks and a substantial part of wise
corporate stewardship and management is attempting to find the perfect capital structure
in terms of risk / reward payoff for shareholders. Oil and Gas industry is a symbol of
technical marvel by human kind. Being one of the fastest growing sectors in the world its
dynamic growth phases are explained by nature of competition, product life cycle and
consumer demand. Today, the global Oil and Gas industry is concerned with consumer
demands for styling, safety, and comfort; and with labor relations and refinery efficiency.The industry is at the crossroads with global mergers and relocation of production centers
to emerging developing economies. Due to its deep forward and backward linkages with
several key segments of the economy, the Oil and Gas industry is having a strong
multiplier effect on the growth of a country and hence is capable of being the driver of
economic growth. It plays a major catalytic role in developing transport sector in one
hand and help industrial sector on the other to grow faster and thereby generate a
significant employment opportunities. Also as many countries are opening the land
border for trade and developing international road links, the contribution of Oil and Gas
sector in increasing exports and imports will be significantly high. As Oil and Gas
industry is becoming more and more standardized, the level of competition is increasing
and production base of most of Oil-giant companies are being shifted from the developed
countries to developing countries to take the advantage of low cost of production.
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1. INTRODUCTION
Indian Oil and Gas Sector:
The Oil and Gas sector is a key player in the global and Indian economy. The global oil
and gas industry contributes 5 per cent directly to the total refinery employment, 12.9 per
cent to the total refinery production value and 8.3 per cent to the total industrial
investment. It also contributes US$560 billion to the public revenue of different
countries, in terms of taxes on fuel, circulation, sales and registration. The annual
turnover of the global Oil industry is around US$5.09 trillion, which is equivalent to the
sixth largest economy in the world. In addition, the Oil industry is linked with several
other sectors in the economy and hence its indirect contribution is much higher than this.
All over the world it has been treated as a leading economic sector because of its
extensive economic linkages. Indias manufacture of 7.9 million s, including 1.3 million
passenger cars, amounted to 2.4 per cent and 7 per cent, respectively, of global
production in number. The Oil-components refinery sector is another key player in the
Indian Oil and Gas industry. Exports from India in this sector rose from US$1.0 billion in
2009-10 to US$1.8 billion in 2010-11, contributing 1 per cent to the world trade in Oil
components in current USD. In India, the Oil and Gas industry provides directemployment to about 5 lakh persons. It contributes 4.7 per cent to Indias GDP and 19
per cent to Indias indirect tax revenue. Till early 1980s, there were very few players in
the Indian Oil sector, which was suffering from low volumes of production, obsolete and
substandard technologies. With de-licensing in the 1980s and opening up of this sector to
FDI in 1993, the sector has grown rapidly due to the entry of global players. A rapidly
growing middle class, rising per capita incomes and relatively easier availability of
finance have been driving the demand in India, which in turn, has prompted the
government to invest at unprecedented levels in roads infrastructure, including projects
such as Golden Quadrilateral and North-East-South-West Corridor with feeder roads. The
Reserve Bank of Indias (RBI) Annual Policy Statement documents an annual growth of
37.9 per cent in credit flow to s industry in 2009. Given that passenger car penetration
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rate is just about 8.5 s per thousand, which is among the lowest in the world, there is a
huge potential demand for Oil and Gass in the country.
Policy Environment and Evolution of Indian Oil Industry:
The policy framework of Indias Oil and Gas industry and its impact on its growth While
the ties between bureaucrats and the managers of state-owned enterprises played a
positive role especially since the late 1980s, ties between politicians and industrialists and
between politicians and labour leaders have impeded the growth. The first phase of 1940s
and 1950s was characterized by socialist ideology and vested interests, resulting in
protection to the domestic Oil industry and entry barriers for foreign firms. There was a
good relationship between politicians and industrialists in this phase, but bureaucrats
played little role. Development of ancillaries segment as recommended by the L.K. JhaCommittee report in 1960 was a major event that took place towards the end of this
phase. During the second phase of rules, regulations and politics, many political
developments and economic problems affected the Oil industry, especially passenger cars
segment, in the 1960s and 1970s. The third phase starting in the early 1980s was
characterized by delicensing, liberalization and opening up of FDI in the Oil sector.
These policies resulted in the establishment of new LCV manufacturers (for example,
Swaraj Mazda, DCM Hindustan Petroleum) and passenger car manufacturers.7 All these
developments led to structural changes in the Indian Oil industry. Pingle argues that state
intervention and ownership need not imply poor results and performance, as
demonstrated by Bharat Petroleum Limited (MUL). Further, the non contractual relations
between bureaucrats and MUL dictated most of the policies in the 1980s, which were
biased towards passenger cars and MUL in particular. However, DCosta (2002) argues
that MULs success is not particularly attributable to the support from bureaucrats.
Rather, any firm that is as good as MUL in terms of scale economies, first-comer
advantage, affordability, product novelty, consumer choice, financing schemes and
extensive servicing networks would have performed as well, even in the absence of
bureaucratic support. DCosta has other criticisms about Pingle (2000). The major
shortcoming of Pingles study is that it ignores the issues related to sector specific
technologies and regional differences across the country.
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Productivity:
The performance of the Indian Oil industry with respect to the productivity growth Partial
and total factor productivity of the Indian Oil and Gas industry have been calculated for
the period from 1990-91 to 2010-11, using the Divisia-Tornquist index for the estimationof the total factor productivity growth. The author finds that the domestic Oil industry has
registered a negative and insignificant productivity growth during the last one and a half
decade. Among the partial factor productivity indices only labour productivity has seen a
significant improvement, while the productivity of other three inputs (capital, energy and
materials) havent shown any significant improvement. Labour productivity has increased
mainly due to the increase in the capital intensity, which has grown at a rate of 0.14 per
cent per annum from 1990-91 to 2010-11.
Organized Oil Sector in India:
While the Original Equipment Manufacturers (OEMs) are at the top of the Oil supply
chain, it should be noted that there are a few OEMs in India which supply some
components to other OEMs in India or abroad. Most of the Indian OEMs are members of
the Society of Indian Oil and Gas Manufacturers (SIAM), while most of the Tier-1 Oil
component manufacturers are members of the Oil and Gas Component Manufacturers
Association (ACMA). All of them are in the organized sector and supply directly to theOEMs in India and abroad or to Tier-1 players abroad. Tier-2 and Tier-3 Oil-component
manufacturers are relatively smaller players. Though some of the Tier-2 players are in the
organized sector, most of them are in the unorganized sector. Tier-3 manufacturers
include all Oil-component suppliers in the unorganized sector, including some Own
Account Manufacturing Enterprises (OAMEs) that operate with one working owner and
his family members, wherein refinery involves use of a single machine such as the lathe.
Oil-component manufacturers cater not only to the OEMs, but also to the after-sales
market. In the recent years, there has been a rapid transformation in the character of the
Oil and Gas aftermarket, as a fast maturing organized, skill-intensive and knowledge
driven activity. Hence, the Oil industry in India possesses a very diverse and complex
structure, in terms of scale, nature of operation, market structure, etc.
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Unorganized Oil Sector in India:
The unorganized sector consists of enterprises that are not registered under certain
sections of the Factories Act.20 In this section, data on the unorganized refinery sector
from the National Sample Survey Organization (NSSO) is used. The unorganized Oilsector in India has grown in terms of number of enterprises, employment, output, capital,
capital intensity and labour productivity. However, capital productivity has fallen
considerably. Very similar trends are observed in OAME, NDME and DME21 in rural
and urban areas. However, it is evident that the growth of this sector has been quite low
in the rural areas than in the urban areas.
Commercial s:
The commercial production in India increased from 156,706 in 2007 to 350,033 in 2010.
This segment can be divided into three categories heavy commercial s (HCVs), medium
commercial s (MDVs or MCVs) and light commercial s (LCVs). Medium and heavy
commercial s formed about 62 per cent of the total domestic sales of CVs in 2004. These
segments have also been driving growth, having grown at a CAGR of nearly 24.7 per
cent over the past five years. The key trends facilitating growth in this sector are the
development of ports and highways, increase in construction activities and agricultural
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output. With better roads and highway corridors linking major cities, the demand for
larger, multi-axle trucks is increasing in India.
Passenger s:
Passenger s consist of passenger cars and utility s. This segment has been growing at a
CAGR of 11.3 per cent for the past four years. A key trend in this segment is that with
rising income levels and availability of better financing options, customers are
increasingly aspiring for higher-end models. There has been a gradual shift from entry-
level models to higher-end models in each segment. For example, in passenger cars, till
recently, the Maruti 800 used to define the entry level car, and had a predominant market
share. Over the last 3-4 years, higher-end models such as ONGC Santro, Maruti Wagon
R, Alto and Tata Indica have overtaken the Maruti 800. Another development has been
the blurring of the dividing line between utility s and passenger cars, with models like
Mahindra & Mahindras Scorpio attracting customers from both segments. Upper end
sports utility s (SUVs) attract potential luxury car buyers by offering the same level of
comfort in the interiors, coupled with on-road performance capability.
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Competitive Advantages:
India has several competitive advantages in the Oil and Gas sector, which have been
analyzed using the following framework. Availability of skilled manpower with
engineering and design capabilities India has a growing workforce that is English-speaking, highly skilled and trained in designing and machining skills required by the Oil
and Gas and engineering industries. In a combined assessment of manpower availability
and capabilities, India ranks much ahead of other competing economies.
Many Indian and global players are leveraging this advantage by increasingly
outsourcing activities like design and R&D to their Indian arms. The Society of Indian
Oil and Gas manufacturers (SIAM) estimates that Oil and Gas manufacturers are
expected to invest US$ 5.7 billion in the Indian market from 2005 to 2010. Of this, about
US$ 2.3 billion will be on research and development and the rest probably on capex.
Some examples of investment in areas leveraging the engineering and design capabilities
of India include:
MICO, the Indian operation of Bosch and a key player in fuel injection
equipment, ignition systems and electricals, has invested in the MICO Application
Centre (MAC) for R&D. It has emerged as a key global R&D competency centre
catering to the entire Bosch Group. It is the first of its kind in India and the Bosch
Groups first outside Europe.
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GM set up a technical centre at Bangalore that became fully operational in
September 2003. The centre focuses on both R&D and engineering, and takes up
high-value work to complement current research programs, as well as new
exploratory research projects.
Large market with significant potential for growth in demand:
India offers a huge growth opportunity for the Oil and Gas sector the domestic market
is large and has the potential to grow further in the future due to positive demographic
trends and the current low penetration levels.
Government Regulations and Support:
The Government of India (GoI) has identified the Oil and Gas sector as a key focus area
for improving Indias global competitiveness and achieving high economic growth. The
Government formulated the Oil Policy for India with a vision to establish a globally
competitive industry in India and to double its contribution to the economy by 2010. It
intends to promote Research & Development in Oil and Gas industry by strengthening
the efforts of industry in this direction by providing suitable fiscal and financial
incentives. Some of the policy initiatives include:
Oilmatic approval for foreign equity investment upto 100 per cent of manufacture
of Oil and Gass and component is permitted.
The customs duty on inputs and raw materials has been reduced from 20 per cent
to 15 per cent. The peak rate of customs duty on parts and components of battery-
operated s have been reduced from 20 per cent to 10 per cent. These new
regulations would strengthen Indias commitment to globalization. Apart from
this, custom duty has been reduced from 105 per cent to 100 per cent on secondhand cars and motorcycles.
National Oil and Gas Fuel Policy has been announced, which envisages a phased
program for introducing Euro emission and fuel regulations by 2010.
Tractors of engine capacity more than 1800 cc for semi-trailers will now attract
excise duty at the rate of 16 per cent.
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Excise duty is being reduced on tyres, tubes and flaps from 24 per cent to 16 per
cent. Customs duty on lead is 5 per cent.
A package of fiscal incentives including benefits of double taxation treaty is now
available.
These government policies reflect the priority government accords to the Oil and Gas
sector. A liberalized overall policy regime, with specific incentives, provides a very
conducive environment for investments and exports in the sector.
The outlook for Indias Oil and Gas sector appears bright:
The outlook for Indias Oil and Gas sector is highly promising. In view of current growth
trends and prospect of continuous economic growth of over 5 per cent, all segments of
the Oil industry are likely to see continued growth. Large infrastructure development
projects underway in India combined with favorable government policies will also drive
Oil and Gas growth in the next few years. Easy availability of finance and moderate cost
of financing facilitated by double income families will drive sales in the next few years.
India is also emerging as an outsourcing hub for global majors. Companies like GM,
Ford, Hindustan Petroleum and ONGC are implementing their expansion plans in the
current year. While Ford and Hindustan Petroleum continue to leverage India as a sourceof components, ONGC and Suzuki have identified India as a global source for specific
small car models. At the same time, Indian players are likely to increasingly venture
overseas, both for organic growth as well as acquisitions. The Oil and Gas sector in India
is poised to become significant, both in the domestic market as well as globally.
Determinants of market share of Oil and Gas industry:
Costs: sales ratio has a significant positive impact on market share. This could be
attributable to the fact that firms that manufacture high-value items are likely to
have a higher market share, since their sales, in value terms, could be higher than
others.
Emolument share has a negative effect on market share, showing that labour cost
constraints can distort a firms competitiveness.
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Export: sales ratio has a significant positive effect on market share, implying that
export-oriented firms are more competitive, perhaps because of their versatility
and other merits that are required for catering to international markets.
Power/fuel cost share has a significant negative effect on market share, implying
that efficient technologies may go a long way in improving the firms
competitiveness.
Imported material expenses share in total material expenses has a negative
significant impact on market share, indicating that import of Oil-components from
abroad does not guarantee competitiveness of the firms, unless it is an item that is
unavailable in Indian industry
Borrowings share in total investments and interests share in total costs have
negative significant effect on market-share, which means that too much
dependence on credit may adversely affect a firms competitiveness. This also
calls for improvements in credit system and its cost in India.
Inventory cost share significantly distorts competitiveness, and hence, firms
following lean refinery are more likely to be competitive than others.
Share of imported know-how expenses in overall is competitiveness-enhancing,
and hence, firms could aggressively go for importing know-how that is required
for various aspects of production, so as to be more competitive.
Advertising costs as a share of total costs, has a significant negative effect on
market share, implying that unless the structural factors such as price and quality
are good, mere propaganda by advertising may in fact turn harmful for market
share.
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- ( Capital Spending - Depreciation) (1-Debt Ratio)
- Working Capital (1- Debt Ratio)
= Free Cashflows to Equity
Lenders Interest Expenses (1 - tax rate)
+ Principal Payments
Firm Free Cashflows to Firm
= Equity = Free Cashflows to Equity
+ Lenders + Interest Expenses (1 - tax rate)
+ Principal Payments
Optimum Capital Structure and Cost of Capital:
If the cash flows to the firm are held constant, and the cost of capital is minimized, the
value of the firm will be maximized.
RETURN DIFFERENTIAL APPROACH
THE ADJUSTED PRESENT VALUE APPROACH:
In the adjusted present value (APV) approach, we begin with the value of the firm
without debt. As we add debt to the firm, we consider the net effect on value by
considering both the benefits and the costs of borrowing. To do this, we assume that the
primary benefit of borrowing is a tax benefit and that the most significant cost ofborrowing is the added risk of bankruptcy.
The mechanisms of APV valuation:
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We estimate the value of the firm in three steps. We begin by estimating the value of the
firm with no leverage. We then consider the present value of the interest tax savings
generated by borrowing a given amount of money. Finally, we evaluate the effect of
borrowing the amount on the probability that the firm will go bankrupt, and the expected
cost of bankruptcy.
Value of unlevered firm:
The first step in this approach is the estimation of the value of the unlevered firm. This
can be accomplished by valuing the firm as if it had no debt, i.e., by discounting the
expected free cash flow to the firm at the unlevered cost of equity. In the special case
where cash flows grow at a constant rate in perpetuity, the value of the firm is easily
computed.
Value of Unlevered Firm =FCFFo (1+g)/ Bu-g
Where FCFF0 is the current after-tax operating cash flow to the firm, u is the unlevered
cost of equity and g is the expected growth rate. In the more general case, you can value
the firm using any set of growth assumptions you believe are reasonable for the firm.
The inputs needed for this valuation are the expected cash flows, growth rates and the
unlevered cost of equity. To estimate the latter, we can draw on our earlier analysis and
compute the unlevered beta of the firm.
Bunlevered= (Bcurrent) / 1+(1-t)D/E
Where,
unlevered = Unlevered beta of the firm
current = Current equity beta of the firm
t = Tax rate for the firmD/E = Current debt/equity ratio
This unlevered beta can then be used to arrive at the unlevered cost of equity.
Expected tax benefit from borrowing:
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The second step in this approach is the calculation of the expected tax benefit from a
given level of debt. This tax benefit is a function of the tax rate of the firm and is
discounted at the cost of debt to reflect the riskiness of this cash flow. If the tax savings
are viewed as a perpetuity,
Value of Tax benefits=(Tax rate)(Cost of Debt)(Debt)/(Cost of debt)
=(Tax rate)(Debt)
The tax rate used here is the firms marginal tax rate and it is assumed to stay constant
over time. If we anticipate the tax rate changing over time, we can still compute the
present value of tax benefits over time, but we cannot use the perpetual growth equation
cited above.
Estimating Bankruptcy Costs and Net Effect:
The third step is to evaluate the effect of the given level of debt on the default risk of thefirm and on expected bankruptcy. In theory, at least, this requires the estimation of the
probability of default with the additional debt and the direct and indirect cost of
bankruptcy. Ifa is the probability of default after the additional debt and BC is the
present value of the bankruptcy cost, the present value of expected bankruptcy cost can
be estimated.
PV of Expected Bankruptcy Cost = Probability of bankruptcy * PV of bankruptcy cost
This step of the adjusted present value approach poses the most significant estimationproblem, since neither the probability of bankruptcy nor the bankruptcy cost can be
estimated directly.
There are two basic ways in which the probability of bankruptcy can be estimated
indirectly. One is to estimate a bond rating, as we did in the cost of capital approach, at
each level of debt and use the empirical estimates of default probabilities for each rating.
Cost of Capital versus APV valuation:
In an APV valuation, the value of a levered firm is obtained by adding the net effect of
debt to the unlevered firm value.
Value of Levered Firm =
In the cost of capital approach, the effects of leverage show up in the cost of capital, with
the tax benefit incorporated in the after-tax cost of debt and the bankruptcy costs in both
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the levered beta and the pre-tax cost of debt. Will the two approaches yield the same
value? Not necessarily. The first reason for the differences is that the models consider
bankruptcy costs very differently, with the adjusted present value approach providing
more flexibility in allowing you to consider indirect bankruptcy costs. To the extent that
these costs do not show up or show up inadequately in the pre-tax cost of debt, the APV
approach will yield a more conservative estimate of value. The second reason is that the
APV approach considers the tax benefit from a dollar debt value, usually based upon
existing debt. The cost of capital approach estimates the tax benefit from a debt ratio that
may require the firm to borrow increasing amounts in the future. For instance, assuming a
market debt to capital ratio of 30% in perpetuity for a growing firm will require it to
borrow more in the future and the tax benefit from expected future borrowings is
incorporated into value today.
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3. LITERATURE REVIEW
Evaluating a Company's Capital Structure:
For stock investors that favor companies with good fundamentals, a "strong" balance
sheet is an important consideration for investing in a company's stock. The strength of a
company' balance sheet can be evaluated by three broad categories of investment-quality
measurements: working capital adequacy, asset performance and capital structure. In this
article, we'll look at evaluating balance sheet strength based on the composition of a
company's capital structure. A company's capitalization (not to be confused with market
capitalization) describes the composition of a company's permanent or long-term capital,
which consists of a combination of debt and equity. A healthy proportion of equity
capital, as opposed to debt capital, in a company's capital structure is an indication of
financial fitness.
Clarifying Capital Structure Related Terminology:
The equity part of the debt-equity relationship is the easiest to define. In a company's
capital structure, equity consists of a company's common and preferred stock plus
retained earnings, which are summed up in the shareholders' equity account on a balance
sheet. This invested capital and debt, generally of the long-term variety, comprises a
company's capitalization, i.e. a permanent type of funding to support a company's growth
and related assets. A discussion of debt is less straightforward. Investment literature often
equates a company's debt with its liabilities. Investors should understand that there is a
difference between operational and debt liabilities - it is the latter that forms the debt
component of a company's capitalization - but that's not the end of the debt story. Among
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financial analysts and investment research services, there is no universal agreement as to
what constitutes a debt liability. For many analysts, the debt component in a company's
capitalization is simply a balance sheet's long-term debt. This definition is too
simplistic. Investors should stick to a stricter interpretation of debt where the debt
component of a company's capitalization should consist of the following: short-term
borrowings (notes payable), the current portion of long-term debt, long-term debt, two-
thirds (rule of thumb) of the principal amount of operating leases and redeemable
preferred stock. Using a comprehensive total debt figure is a prudent analytical tool for
stock investors.
Is there an optimal debt-equity relationship?
In financial terms, debt is a good example of the proverbial two-edged sword. Astute use
of leverage (debt) increases the amount of financial resources available to a company for
growth and expansion. The assumption is that management can earn more on borrowed
funds than it pays in interest expense and fees on these funds. However, as successful as
this formula may seem, it does require that a company maintain a solid record of
complying with its various borrowing commitments. A company considered too highly
leveraged (too much debt versus equity) may find its freedom of action restricted by its
creditors and/or may have its profitability hurt as a result of paying high interest costs. Ofcourse, the worst-case scenario would be having trouble meeting operating and debt
liabilities during periods of adverse economic conditions. Lastly, a company in a highly
competitive business, if hobbled by high debt, may find its competitors taking advantage
of its problems to grab more market share. Unfortunately, there is no magic proportion of
debt that a company can take on. The debt-equity relationship varies according to
industries involved, a company's line of business and its stage of development.
However, because investors are better off putting their money into companies with strong
balance sheets, common sense tells us that these companies should have, generally
speaking, lower debt and higher equity levels.
Capital Ratios and Indicators:
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In general, analysts use three different ratios to assess the financial strength of a
company's capitalization structure. The first two, the so-called debt and debt/equity
ratios, are popular measurements; however, it's the capitalization ratio that delivers the
key insights to evaluating a company's capital position. The debt ratio compares total
liabilities to total assets. Obviously, more of the former means less equity and, therefore,
indicates a more leveraged position. The problem with this measurement is that it is too
broad in scope, which, as a consequence, gives equal weight to operational and debt
liabilities. The same criticism can be applied to the debt/equity ratio, which compares
total liabilities to total shareholders' equity. Current and non-current operational
liabilities, particularly the latter, represent obligations that will be with the company
forever. Also, unlike debt, there are no fixed payments of principal or interest attached tooperational liabilities. The capitalization ratio (total debt/total capitalization) compares
the debt component of a company's capital structure (the sum of obligations categorized
as debt + total shareholders' equity) to the equity component. Expressed as a percentage,
a low number is indicative of a healthy equity cushion, which is always more desirable
than a high percentage of debt.
Additional Evaluative Debt-Equity Considerations:
Companies in an aggressive acquisition mode can rack up a large amount of purchased
goodwill in their balance sheets. Investors need to be alert to the impact of intangibles on
the equity component of a company's capitalization. A material amount of intangible
assets need to be considered carefully for its potential negative effect as a deduction (or
impairment) of equity, which, as a consequence, will adversely affect the capitalization
ratio.
Funded debt is the technical term applied to the portion of a company's long-term
debt that is made up of bonds and other similar long-term, fixed-maturity types of
borrowings. No matter how problematic a company's financial condition may be, the
holders of these obligations cannot demand payment as long the company pays the
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interest on its funded debt. In contrast, bank debt is usually subject to acceleration clauses
and/or covenants that allow the lender to call its loan. From the investor's perspective, the
greater the percentage of funded debt to total debt disclosed in the debt note in the notes
to financial statements, the better. Funded debt gives a company more wiggle room.
Lastly, credit ratings are formal risk evaluations by credit-rating agencies - Moody's,
Standard & Poor's, Duff & Phelps and Fitch of a company's ability to repay principal
and interest on debt obligations, principally bonds and commercial paper. Here again, this
information should appear in the footnotes. Obviously, investors should be glad to see
high-quality rankings on the debt of companies they are considering as investment
opportunities and be wary of the reverse.
Seeking the Optimal Capital Structure:
Many middle class individuals believe that the goal in life is to be debt-free. When you
reach the upper echelons of finance, however, that idea is almost anathema. Many of the
most successful companies in the world base their capital structure on one simple
consideration: the cost of capital. If you can borrow money at 7% for 30 years in a world
of 3% inflation and reinvest it in core operations at 15%, you would be wise to consider
at least 40% to 50% in debt capital in your overall capital structure. Of course, how muchdebt you take on comes down to how secure the revenues your business generates are - if
you sell an indispensable product that people simply must have, the debt will be much
lower risk than if you operate a theme park in a tourist town at the height of a boom
market. Again, this is where managerial talent, experience, and wisdom come into play.
The great managers have a knack for consistently lowering their weighted average cost of
capital by increasing productivity, seeking out higher return products, and more. To truly
understand the idea of capital structure, you need to take a few moments to read Return
on Equity: The DuPont Model to understand how the capital structure represents one of
the three components in determining the rate of return a company will earn on the money
its owners have invested in it. Whether you own a doughnut shop or are considering
investing in publicly traded stocks, it's knowledge you simply must have.
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Median
Oil Companies
Average
Oil Companies
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STDAV
Oil Companies
Examining the results above we can see that there seems to have been a change in the
debt pattern amongst the Oil companies. Just as Lev and many others presented in the
there is a change taking place in the way that we see and evaluate the corporate world and
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its value drivers. Maybe the search for security has made the banks and the market
extending the wrong companies credit; if there is a correlation between the value of the
underlying assets and the loan capacity of a corporation then companies who cannot
securitize their assets will be worse off in a recession. The Oil company has up until now
been assessed as once whole entity which gives it a lower leverage compared to the
traditional company; but this would also make it better positioned and less volatile in
recession. Unfortunately the lack of further data to conclude the regression analysis and
finalize this study the data just shows us that we can identify but not explain a change.
This article did not have the aim to further increase or change the amount of information
provided to the creditors; what we can see is that suddenly corporations without any real
assets have a proportionally large amount of debt in their capital structure. The reason for
this is almost without a doubt that their market value on equity has deteriorated; but whatis interesting is that the trend related to the traditional companies has changed. This can
indicate that the loans given to the conceptual companies prior to the deterioration of the
market value of equity were proportionally larger than in the past. Further tells us that the
there has been a market driven change in how we assess corporate without any substantial
securities; if this change was driven by increased liquidity or a fundamental assessment
change in the market is for future research to tell. To conclude; there been a change in
capital structure where the proportion of debt and in long term debt over the last ten years
has increased amongst conceptual companies; it is though far away from being in the
same proportions as for the Oil companies.
Growth opportunities:
For companies with growth opportunities, the use of debt is limited as in the case of
bankruptcy, the value of growth opportunities will be close to zero. This show that firms
should use equity to finance their growth because such financing reduces agency costs
between shareholders and managers, whereas firms with less growth prospects should use
debt because it has a disciplinary role. This shows that firms with growth opportunities
may invest sub-optimally, and therefore creditors will be more reluctant to lend for long
horizons. This problem can be solved by short-term financing or by convertible bonds.
From a pecking order theory perspective, growth firms with strong financing needs will
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issue securities less subject to informational asymmetries, i.e. short-term debt. If these
firms have very close relationships with banks, there will be less informational
asymmetry problems, and they will be able to have access to long term debt financing as
well. A common proxy for growth opportunities is the market value to book value of total
assets. IT companies with growth opportunities should exhibit a greater market-to-book
than firms with less growth opportunities, but it is suggest that this is not necessarily the
case. This will typically occur when assets whose values have increased over time have
been fully depreciated, as well as when assets with high value are not accounted for in the
balance sheet. They find a negative relationship between growth opportunities and
leverage. They suggest that this may be due to firms issuing equity when stock prices are
high. As mentioned by them, large stock price increases are usually associated with
improved growth opportunities, leading to a lower debt ratio.
Size:
Oil companies tend to be more diversified, and hence their cash flows are less volatile.
Size may then be inversely related to the probability of bankruptcy. They suggest that
large firms have easier access to the markets and can borrow at better conditions. For
small firms, the conflicts between creditors and shareholders are more severe because themanagers of such firms tend to be large shareholders and are better able to switch from
one investment project to another. However, this problem may be mitigated with the use
of short term debt, convertible bonds, as well as long term bank financing. Most
empirical studies report indeed a positive sign for the relationship between size and
leverage. Less conclusive results are reported by other authors. For India, however, they
find that a negative relationship exists. They confirm the finding of them for company
and argue that the negative relationship is not due to asymmetrical information, but rather
to the characteristics of the bankruptcy law and the system which offer better protection
to creditors than is the case in other countries.
Profitability:
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One of the main theoretical controversies concerns the relationship between leverage and
profitability of the firm. According to the pecking order theory, firms prefer using
internal sources of financing first, then debt and finally external equity obtained by stock
issues. All things being equal, the more profitable the firms are, the more internal
financing they will have, and therefore we should expect a negative relationship between
leverage and profitability. This relationship is one of the most systematic findings in the
empirical literature In a trade-off theory framework, an opposite conclusion is expected.
When firms are profitable, they should prefer debt to benefit from the tax shield. In
addition, if past profitability is a good proxy for future profitability, profitable firms can
borrow more as the likelihood of paying back the loans is greater. Dynamic theoretical
models based on the existence of a target debt-to-equity ratio show (1) that there are
adjustment costs to raise the debt-to-equity ratio towards the target and (2) that debt caneasily be reimbursed with excess cash provided by internal sources. This leads firms to
have a pecking order behavior in the short term, despite the fact that they aim at
increasing their debt-to-equity ratio.
Collaterals:
Tangible assets are likely to have an impact on the borrowing decisions of a firm because
they are less subject to informational asymmetries and usually they have a greater value
than intangible assets in case of bankruptcy. Additionally, the moral hazard risks are
reduced when the firm offers tangible assets as collateral, because this constitutes a
positive signal to the creditors who can request the selling of these assets in the case of
default. As such, tangible assets constitute good collateral for loans. According to them, a
firm can increase the value of equity by issuing collateralized debt when the current
creditors do not have such guarantee. Hence, firms have an incentive to do so, and one
would expect a positive relation between the importance of tangible assets and the degree
of leverage. Based on the agency problems between managers and shareholders, they
suggest that firms with more tangible assets should take more debt. This is due to the
behavior of managers who refuse to liquidate the firm even when the liquidation value is
higher than the value of the firm as a going concern. Indeed, by increasing the leverage,
the probability of default will increase which is to the benefit of the shareholders. In an
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agency theory framework, debt can have another disciplinary role: by increasing the debt
level, the free cash flow will decrease. As opposed to the former, this disciplinary role of
debt should mainly occur in firms with few tangible assets, because in such a case it is
very difficult to monitor the excessive expenses of managers. From a pecking order
theory perspective, firms with few tangible assets are more sensitive to informational
asymmetries. These firms will thus issue debt rather than equity when they need external
financing, leading to an expected negative relation between the importance of intangible
assets and leverage. Most empirical studies conclude to a positive relation between
collaterals and the level of debt. Inconclusive results are reported for instance by them.
Operating Risk:
Many authors have included a measure of risk as an explanatory variable of the debt
level. Leverage increases the volatility of the net profit. Firms that have high operating
risk can lower the volatility of the net profit by reducing the level of debt. By so doing,
bankruptcy risk will decrease, and the probability of fully benefiting from the tax shield
will increase. A negative relation between operating risk and leverage is also expectedfrom a pecking order theory perspective: firms with high volatility of results try to
accumulate cash during good years, to avoid under investment issues in the future.
Taxes:
The impact of taxation on leverage is twofold. On the one hand, companies have an
incentive to take debt because they can benefit from the tax shield. On the other hand,
since revenues from debt are taxed more heavily than revenues from equity, firms also
have an incentive to use equity rather than debt. As suggested by them, the financial
structure decisions are irrelevant given that bankruptcy costs can be neglected in
equilibrium. They show that if non-debt tax shields exist, then firms are likely not to use
fully debt tax shields. In other words, firms with large non-debt tax shields have a lower
incentive to use debt from a tax shield point of view, and thus may use less debt.
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Empirically, this substitution effect is difficult to measure as finding an accurate proxy
for the tax reduction that excludes the effect of economic depreciation and expenses is
tedious. According to them, the tax shield accounts on average to 4.3% of the firm value
when both corporate and personal taxes are considered.
A capital structure is the mix of a company's financing which is used to fund its day-to-
day operations. This source of funds can originate from equity, debt and hybrid
securities. The equity will come in the form of common and preferred stocks. The debt
is broken out into long-term and short-term debts. Lastly hybrid securities are a group of
securities that are a combination of debt and equity. When analyzing a company it is
important to note their mix of debt and equity, because it gives a firm picture of the
financial health of the company.
If capital structure is irrelevant in a perfect market, then imperfections which exist in the
real world must be the cause of its relevance. The theories below try to address some of
these imperfections, by relaxing assumptions made in the M&M model.
Trade-off theory:
Trade-off theory allows the bankruptcy cost to exist. It states that there is an advantage tofinancing with debt (namely, the tax benefit of debts) and that there is a cost of financing
with debt (the bankruptcy costs of debt). The marginal benefit of further increases in debt
declines as debt increases, while the marginal cost increases, so that a firm that is
optimizing its overall value will focus on this trade-off when choosing how much debt
and equity to use for financing. Empirically, this theory may explain differences in D/E
ratios between industries, but it doesn't explain differences within the same industry.
Pecking order theory:
Pecking Order theory tries to capture the costs of asymmetric information. It states that
companies prioritize their sources of financing (from internal financing to equity)
according to the law of least effort, or of least resistance, preferring to raise equity as a
financing means of last resort. Hence: internal financing is used first; when that is
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depleted, then debt is issued; and when it is no longer sensible to issue any more debt,
equity is issued. This theory maintains that businesses adhere to a hierarchy of financing
sources and prefer internal financing when available, and debt is preferred over equity if
external financing is required (equity would mean issuing shares which meant 'bringing
external ownership' into the company. Thus, the form of debt a firm chooses can act as a
signal of its need for external finance. The pecking order theory is popularized by Myers
(1984) when he argues that equity is a less preferred means to raise capital because when
managers (who are assumed to know better about true condition of the firm than
investors) issue new equity, investors believe that managers think that the firm is
overvalued and managers are taking advantage of this over-valuation. As a result,
investors will place a lower value to the new equity issuance.
Agency Costs:
There are three types of agency costs which can help explain the relevance of capital
structure.
Asset substitution effect: As D/E increases, management has an increased
incentive to undertake risky (even negative NPV) projects. This is because if the
project is successful, share holders get all the upside, whereas if it is unsuccessful,
debt holders get all the downside. If the projects are undertaken, there is a chance
of firm value decreasing and a wealth transfer from debt holders to share holders.
Underinvestment problem: If debt is risky (e.g., in a growth company), the gain
from the project will accrue to debt holders rather than shareholders. Thus,
management have an incentive to reject positive NPV projects, even though they
have the potential to increase firm value.
Free cash flow: unless free cash flow is given back to investors, management has
an incentive to destroy firm value through empire building and perks etc.Increasing leverage imposes financial discipline on management.
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Other:
The neutral mutation hypothesisfirms fall into various habits of financing,
which do not impact on value.
Market timing hypothesiscapital structure is the outcome of the historicalcumulative timing of the market by managers.
Accelerated investment effecteven in absence of agency costs, levered firms
use to invest faster because of the existence of default risk.
Following Modigliani and Miller's pioneering work on capital structure, we are left with
the question, "Is there such a thing as an optimal capital structure for a company? In
other words, is there a best way to finance the company: an optimal debt/equity ratio?"
According to the trade-off theory, the answer is yes - in fact, you might even say that
there is an optimal range. There is a specific debt/equity ratio that will minimize a
company's cost of capital. (This is also the point at which the value of the company will
be maximized.) However, because the cost of capital curve is fairly shallow (like the
bottom of a bowl), you can deviate from this optimal debt/equity ratio without
appreciably increasing the cost of capital This creates a range in the bottom portion of
the curve where the cost of capital is essentially the same throughout the range. There is a
danger of getting outside of this range however. The cost of capital will increase rapidlyonce you get outside the range, as shown by the blueAverage Cost of Capitalline in the
graph below.
The Trade-off View of the Cost of Capital
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A company's overall cost of capital is a weighted average of the cost of debt and the cost
of equity. For example, if a company's debt/equity ratio is 30/70 and the after-tax cost of
debt is 4% and the cost of equity is 10.5%, the company's overall cost of capital is 0.30 *
4% plus 0.70 * 10.5%, or 8.55%.
Let's take a company from its inception:
1. When a company is new, it will likely be financed entirely with equity, so its
average cost of capital is the same as its cost of equity (10% in the graph above
for a 0/100 debt/equity ratio).
2. As the company grows, it establishes a track record and attracts the confidence oflenders. As the company increases its use of debt, the company's debt/equity ratio
increases and the average cost of capital decreases. In essence, the company is
substituting the cheaper debt for the more expensive equity, thereby decreasing its
overall cost. (It might be useful to think of the company borrowing money, then
using that borrowed money to buy back some of its common stock. The debt goes
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up, the equity goes down, and the company's average cost of capital decreases
because the company has substituted the cheaper debt for the more expensive
equity.)
3. Eventually, as the company's debt/equity ratio increases, the cost of debt and the
cost of equity will increase. Lenders will become more concerned about the risk
of the loan and will increase the interest rate on its loans. Common shareholders
will become more concerned about default on the loans (and, in bankruptcy,
losing all of their investment) and will insist on receiving a higher rate of return to
compensate them for the higher risk. Since both the cost of debt and equity
increases, the average cost of capital will also increase.
4. This results in a minimum point on the cost of capital curve. However, the curve
(for most industries) is relatively shallow. This means that the financial manager
has considerable flexibility in choosing a debt/equity ratio. He or she wants to
move to the shallow portion of the curve and, once there, remain there. However,
there is a range of debt/equity ratios that will allow the company to stay in this
shallow portion of the curve.
Just remember that there is a danger in getting outside of this range.
If you move too far to the left-hand side of the curve, you are paying too much to
raise money - you would be better off borrowing money (at a relatively low after-
tax interest rate) and buying back some of the more expensive equity. (The cost
of financing with debt is always considerably lower than financing with equity.)
If you move too far to the right-hand side of the curve, you are paying too much
to raise money - lenders and stockholders perceive your company as being too
risky. You should either pay down the debt or issue new equity in the next round
of financing in order to reduce the risk and to move back into the shallow portion
of the curve.
Pecking Order Theory:
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PetroleumHindustan Motors 2.18 0.78 0.3 0.7Skoda 0.8 0.94 0.43 0.57Mahindra &
Mahindra 1.56 0.19 0.43 0.57
Moving Average for 2002/03 to 2006/07
Company Return (2007-08) Debt-Equity Dividend Payout Retention RatioIndian Oil
Corporation 0.37 1.39 0.49 0.51ONGC 0.2 0.13 0.21 0.79Bharat Petroleum 0.09 0.06 0.2 0.8Hindustan
Petroleum -0.24 0.22 0.12 0.88Hindustan Motors 0.11 0.73 0.24 0.76Skoda 0.32 0.94 0.41 0.59Mahindra &
Mahindra 0.09 0.15 0.49 0.51
Moving Average for 2003/04 to 2007/08
Company Return (2008-09) Debt-Equity Dividend Payout Retention RatioIndian Oil
Corporation 1.14 1.32 0.46 0.54ONGC 1.79 0.14 0.22 0.78Bharat Petroleum 1.55 0.08 0.23 0.77Hindustan
Petroleum 0.91 0.17 0.22 0.78Hindustan Motors 0.67 0.65 0.21 0.79Skoda 0.87 0.9 0.46 0.54Mahindra &
Mahindra 0.63 0.14 0.56 0.44
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Moving Average for 2004/05 to 2008/09
Company Return (2009-10) Debt-Equity Dividend Payout Retention RatioIndian Oil
Corporation -0.06 1.12 0.36 0.64ONGC 0.0087 0.12 0.22 0.78
Bharat Petroleum -0.1 0.11 0.25 0.75Hindustan
Petroleum 0.02 0.12 0.24 0.76Hindustan Motors 0.01 0.6 0.22 0.78Skoda 0.03 0.79 0.44 0.56Mahindra &
Mahindra -0.22 0.14 0.59 0.41
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Cross Sectional Regression Results
Model Y = a + b 1 X 1 + b 2 X 2
The above table shows the year wise regression results of all the samples studied. Here Y
denotes the return on the equity shares, X 1 denotes debt equity ratio and X 2 denotes
dividend payout.
From the P- Values ascertained, we can conclude that:-
In the year 2005/06 there is no relationship between debt- equity ratio and return
on equity whereas there is relationship between dividend payout ratio and return
on equity
In the year 2006/07 there is no relationship between debt- equity ratio and return
on equity whereas there is relationship between dividend payout ratio and return
on equity.
In the year 2007/08 there is no relationship between debt- equity ratio and return
on equity whereas there is relationship between dividend payout ratio and return
on equity.
In the year 2008/09 there is relationship between debt- equity ratio and return on
equity and also between dividend payout ratio and return on equity.
In the year 2009/10 there is relationship between debt- equity ratio and return on
equity and also between dividend payout ratio and return on equity.
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2007/08 0.42 1.42 0.42 0.492008/09 1.2 1.35 0.31 0.482009/10 -0.03 1.1 0.4 0.61
Bharat
Petroleum
Return on
Shares
Debt-Equity
Ratio
Dividend Payout
Ratio Retention2000/01 -0.24 1.17 1.07 -0.32001/02 0.06 1.24 0.06 0.72002/03 0.1 1.37 0.04 22003/04 0.09 1.21 0.13 0.122004/05 -0.12 1.43 0.23 0.062005/06 -0.23 1.33 0.65 0.132006/07 0.10 1.32 0.05 0.332007/08 0.38 1.44 0.34 0.452008/09 1.08 1.30 0.29 0.442009/10 -0.09 1.09 0.06 0.59
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Hindustan
Petroleum
Return on
Shares
Debt-Equity
Ratio
Dividend Payout
Ratio Retention2000/01 -0.39 1.13 1.5 -0.42001/02 0.04 1.19 0.6 0.392002/03 0.21 1.24 0.3 02003/04 0.13 1.23 0.12 0.292004/05 -0.05 1.42 0.33 0.062005/06 -0.09 1.39 0.66 0.092006/07 0.78 1.37 0.22 0.322007/08 0.28 1.33 0.39 0.462008/09 1.04 1.32 0.45 0.432009/10 -0.23 1.13 0.05 0.58
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New Issues of shares, which may be made by a company when it requires further
funds. Such new shares are usually offered at a discount to existing shareholders,
based on a predetermined ratio, without having to pay brokerage. The entitlements to
the new shares offered are known as Rights, as shareholders have the right to acquire
the shares or to sell the rights to these new shares on the stock market. A company
may also make a Bonus Issue to shareholders at no cost.
1. DIVIDEND PAYOUT A ratio showing the percentage of net profits paid out in
dividends on common stock, after reducing net profits by the amount of dividends paid
on preferred stock. It calculated as the percentage of dividend paid on profit after tax. In
this study dividend payout ratio is expressed as the ratio of dividend paid to the net profit
after tax. D/P Ratio = Dividend Paid / Net profit after tax
2. RETENTION RATIOS Retention ratio shows the rate of earnings retained by the
company for financing the investments needs. Retained earnings are the main internal
source of finance for the company. This explains to what extent the earnings of the firm
are ploughed back to the business. Technically it is one minus the dividend paid out ratio.
Retention Ratio = 1 D/P Ratio.
3. DEBT EQUITY RATIOS Debt Equity ratio shows capital structure of the firm. This
represents the capital structure of the company. It is defined as the ratio of debt to equity
of the firm. D/E Ratio = Debt / Equity
4. RETURNS ON SHARES Return on shares is calculated by dividing the previous year
s price from the current year price and the log natural of the resultant figure is
calculated as it gives a continuously compounded rate of return
5. VALUE OF THE FIRM The effect on the value of the firm is analyzed by studying thereturn on equity shares. Return on Equity share = P1 / P0, where P1 is the market price of
equity share for current year and P0 is the market price of the equity share for the
previous year.
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Net Sales & PAT Chart:
P/E Chart:
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Calculation of WACC when cost of equity is to be calculated through first formula,
As we have calculated the WACC for ONGC motors, Infosys, Indian oil, Bharat
Petroleum, Maruti, and Ranbaxy for past five years are given below.
ONGC
YEAR 2011 2010 2009 2008 2007
WACC0.174
50.228
30.20
80.27
60.14
6OPTIMAL MIX 90% 90% 90% 90% 90%
Hindustan Petroleum
YEAR 2011 2010 2009 2008 2007WACC 0.096 0.057 0.061 0.044 0.042OPTIMAL MIX 90% 90% 90% 90% 90%
INDIAN OIL
YEAR 2011 2010 2009 2008 2007
WACC 0.4029 0.5787 0.6011.312
6 0.6072
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OPTIMAL MIX 90% 90% 90% 90% 90%
Bharat Petroleum
YEAR 2011 2010 2009 2008 2007
WACC 0.6733 0.7448 0.96280.962
8 0.7524OPTIMAL MIX 90% 90% 90% 90% 90%
Calculation of WACC when cost of equity is to be calculated through second formula,
As we have calculated the WACC for ONGC motors, Infosys, Indian Oil, Bharat
Petroleum, Maruti, Ranbaxy for past five years are given below.
ONGCYEAR 2011 2010 2009 2008 2007WACC 0.5545 0.6633 0.111 -0.3892 -0.5668OPTIMAL MIX 90% 90% 90% 10% 10%
Hindustan Petroleum
YEAR 2011 2010 2009 2008 2007WACC 0.086 0.156 0.025 0.047 0.042OPTIMAL MIX 90% 90% 90% 90% 90%
INDIAN OIL
YEAR 2011 2010 2009 2008 2007WACC 2.462 2.809 0.979 0.708 0.968OPTIMAL MIX 90% 90% 90% 90% 90%
Bharat Petroleum
YEAR 2011 2010 2009 2008 2007WACC -1.608 0.5985 2.1677 1.304 1.145OPTIMAL MIX 10% 90% 90% 90% 90%
Calculation of WACC when cost of equity is to be calculated through third formula,
As we have calculated the WACC for ONGC motors, Infosys, Indian oil, Hll, Maruti,
Ranbaxy for past five years are given below.
ONGC
YEAR 2011 2010 2009 2008 2007
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WACC 0.018 0.1513 0.014 0.0183 0.0241OPTIMAL MIX 0% 90% 0% 0% 0%
Hindustan Petroleum
YEAR 2011 2010 2009 2008 2007WACC -0.0204 -0.0204 -0.0204 -0.0204 -0.0204OPTIMAL MIX 90% 90% 90% 90% 90%
INDIAN OIL
YEAR 2011 2010 2009 2008 2007WACC 0.0722 0.073 0.0542 0.0731 0.07OPTIMAL MIX 0% 0% 90% 0% 0%
Bharat Petroleum
YEAR 2011 2010 2009 2008 2007WACC 0.0129 -0.003 -0.0043 0.0289 0.0291OPTIMAL MIX 0% 90% 90% 0% 0%
5. RECOMMENDATION
At the current market price of Rs.602.00 the stock is trading at a P/Ex of 19.26xfor FY10E and 17.41x for FY11E.
The EPS of the stock is expected to be at Rs.31.26 and Rs.34.58 for FY10E and
FY11E respectively.
On the basis of price to book value, the stock trades at 4.84x and 3.79x for FY10E
and FY11E respectively.
Oil Products business added 37 new clients during the quarter taking the total
active clients to 840 clients up from 830 at the end of sequential quarter.
Indian Oil Corporation has entered into a multi-year contract with an iconic
beverage company
Indian Oil Corporation has entered into a 5 year agreement with BP to provide IT
Applications Development and Maintenance (ADAM) services for BP's Fuels
Value Chain and Corporate businesses globally.
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Despite the weakness in demand, the healthcare, energy & utility &
communication media service segments have experienced double-digit growth in
the last six quarters. This will help the Company in offsetting the impact of the
slowdown in the other verticals.
ONGC crossing, a tata subsidiary signed a significant and large multi-year
outsourcing contract with a large outsourcer of data processing services in the US.
Some large UK based dealers have chosen Tata, as its IT partner, to deliver a new
and robust operating model that supports the retailers strategic and commercial
objectives.
The Net sales and PAT of the company is expected to grow at a CAGR of 15%
and 16% respectively over FY08 to FY11E.
6. CONCLUSION
This study tests DeAngelo and Masulis' (1980) and Masulis' (1983) theory that Indian Oil
Corporation would seek an "optimum debt level," and that a firm could increase or
decrease its value by changing its debt level so that it moved toward or away from the
industry average. Our results do not find support for the argument. We defined industry
using two different databases and calculated the leverage ratio based on book and market
values for equity, but the results did not change. Our overall conclusion is that the
relationship between a firm's debt level and that of its industry does not appear to be of
concern to the market. A single post-event interval (day 2 to 90) depicted a slow,
negative effect following the debt issue (a 3.2% loss). The High Debt firms hadsignificant negative market reactions for several intervals; however, the difference
between this group and the Low Debt firms was not statistically significant. These results
suggest, overall, that the market does not consider industry averages for leverage as
discriminators for firms' financial leverage.
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The findings were surprising. The above review of empirical research cited numerous
studies which had documented a relationship between industry membership and capital
structure. Firms in a given industry tend to have similar capital structures. Our study
shows that the market does not appear to consider the relationship between a firm's
leverage ratio and the industry's leverage ratio important. This finding is consistent with
the original Modigliani and Miller (1958) proposition that financial leverage is irrelevant
to the value of the firm. Further research that employs additional leverage ratios and
alternate industry classifications will provide additional evidence and insight into this
problem.
7. RFERENCES
Jensen, M. C., "Agency Costs of Free Cash Flow, Coporate Finance and
Takeovers,"American Economic Review 76, 1986, pp. 323-339.
Jensen, M.C., and W.H. Meckling, "Theory of the Firm: Managerial Behavior,
Agency Costs and Ownership Structure," Journal of Financial Economics 3,
December 1976, pp. 305-360.
Kim, E.H., "A Mean-Variance Theory of Optimal Capital Structure and Corporate
Debt Capacity,"Journal of Finance 33, March 1978, pp. 45-63.
Kraus, A. and R.H. Litzenberger, "A State Preference Model of Optimal Financial
Leverage,"Journal of Finance, September 1973, pp. 911-922.
Lev, B., "On the Association Between Operating Leverage and Risk," Journal of
Financial and Quantitative Analysis, September 1974, pp. 627-641.
Websites:
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http://myiris.com/shares/research/firstcall/WIPRO_20091109.pdf
http://en.wikipedia.org/wiki/Capital_structure
http://www.rhsmith.umd.edu/faculty/Gphillips/courses/bmgt640/Capstr.pdf
http://www.igidr.ac.in/~money/mfc_5/malabika.pdf