Title: Financial Leverage Practice of Indian Communications Ltd.: Bane or boon
Indian Communications Ltd. had been a zero debt company since start. Of late, shareholders of the company were pressurizing to include debt in the capital structure as shareholders competitor company were getting a higher yield on account of financial leverage. The shareholders’ movement from Indian Communications has resulted in decline in the market price of the company. The board of the company was under a dilemma- should they go for debt not? If they went for debt, it might be risky, and if they did not would- shareholders would withdraw. In both the cases, it would affect the company’s survival. ...view middle of the document...
Driven by strong adoption of data consumption on hand held devices, services market revenue in India would reach US $29.8 billion in 2014 and was expected to touch US$37 billion in 2017, registering a compound annual growth rate of 5.2 per cent, according to research firm ID.”
“The number of telephone subscribers in India increased from 933 million in March 2014 to (Wireless-907.44million, Wire line- 28.36 million) in April 2014, as per data released by Telecom Regulatory Authority of India (TRAI). The country’s GSM operators added 2.10 million rural users in June 2014 taking their total to 302.73 million, according to data released by Cellular Operators Association of India (COAI).”
“The mobile phone industry in India would contribute US$ 400 billion in terms of gross domestic product of the country in 2014. This sector which was growing exponentially was expected to generate about 4.1 million more jobs by 2020 as per Groupe Speciale MobileAssociation (GSMA).”
“India would emerge as a leading player in the virtual world by having 700 million internet users of the 4.7 billion global users by 2025, as per a Microsoft report.”
CAPITAL STRUCTURE & FINANCIAL
A. Indian Communications Ltd.
Indian Communications’ capital mix had owned funds only consisting of common stock (see Exhibit I). After the first public issue in 2000, they never had any further issue of shares. All these years, they used internal financing for growth
The company had a plan to expand in one of the Asian countries. The capital outlay of the project was US$ 5bn. As a practice, they wanted to finance it with equity. But seeing the shareholders pressure from all corners, they sought the advice of their financial controller about the capital structure decision of the project. He was also of the view that capital structure decision is relevant to the shareholders value.” Shareholders value can be increased by changing its capital mix. He supported the view point of shareholders and suggested to finance the project with debt funds as higher debt in the capital structure would lead to a decline in the overall cost of capital and thereby result in increase in the value of the equity shareholders. See exhibit II for the present capital structure of the company. .
Accordingly, the Board asked the financial controller to make a presentation about the comparative analysis of financing the project with (i) 100% equity or (ii) 60% debt and 40% equity. The cost of debt was 10%. See exhibit III for the estimated financial summary of the project.
In his presentation the financial controller shared with the board the comparative financing picture of the proposed project. He impressed upon them that financial leverage had value not only due to the interest shield but also on account of earnings higher that the cost od debt. So the use of financial leverage increased the company’s profit
But on the same hand, warned them if the company did not have enough operating...