ZIP ZAP ZOOM CAR COMPANY CASE STUDY SOLUTION
Case 1: Zip Zap Zoom Car Company
Zip Zap Zoom Company Ltd is into manufacturing cars in the small car (800 cc) segment. It was set up 15 years back and since its establishment it has seen a phenomenal growth in both its market and profitability. Its financial statements are shown in Exhibits 1 and 2 respectively.
The company enjoys the confidence of its shareholders who have been rewarded with growing dividends year after year. Last year, the company had announced 20 per cent dividend, which was the highest in the automobile sector. The company has never defaulted on its loan payments and enjoys a favorable face with its lenders, which include financial institutions, commercial banks and debenture holders.
The competition in the car industry has increased in the past few years and the company foresees further intensification of competition with the entry of several foreign car manufactures many of them being market leaders in their respective countries. The small car segment especially, will witness entry of foreign majors in the near future, with latest technology being offered to the Indian customer. The Zip Zap Zoom’s senior management realizes the need for large scale investment in up gradation of technology and improvement of manufacturing facilities to pre-empt competition.
Whereas on the one hand, the competition in the car industry has been intensifying, on the other hand, there has been a slowdown in the Indian economy, which has not only reduced the demand for cars, but has also led to adoption of price cutting strategies by various car manufactures. The industry indicators predict that the economy is gradually slipping into recession.
Exhibit 1 Balance sheet as at March 31,200 x
(Amount in Rs. Crore)
Source of Funds
Share capital 350
Reserves and surplus 250 600
Loans :
Debentures (@ 14%) 50
Institutional borrowing (@ 10%) 100
Commercial loans (@ 12%) 250
Total debt 400
Current liabilities 200
1,200
Application of Funds
Fixed Assets
Gross block 1,000
Less : Depreciation 250
Net block 750
Capital WIP 190
Total Fixed Assets 940
Current assets :
Inventory 200
Sundry debtors 40
Cash and bank balance 10
Other current assets 10
Total current assets 260
-1200
Exhibit 2 Profit and Loss Account for the year ended March 31, 200x
(Amount in Rs. Crore)
Sales revenue (80,000 units x Rs. 2,50,000) 2,000.0
Operating expenditure :
Variable cost :
Raw material and manufacturing expenses 1,300.0
Variable overheads 100.0
Total 1,400.0
Fixed cost :
R & D 20.0
Marketing and advertising 25.0
Depreciation 250.0
Personnel 70.0
Total 365.0
Total operating expenditure 1,765.0
Operating profits (EBIT) 235.0
Financial expense :
Interest on debentures 7.7
Interest on institutional borrowings 11.0
Interest on commercial loan 33.0 51.7
Earnings before tax (EBT) 183.3
Tax (@ 35%) 64.2
Earnings after tax (EAT) 119.1
Dividends 70.0
Debt redemption (sinking fund obligation)** 40.0
Contribution to reserves and surplus 9.1
* Includes the cost of inventory and work in process (W.P) which is dependent on demand (sales).
** The loans have to be retired in the next ten years and the firm redeems Rs. 40 crore every year.
The company is faced with the problem of deciding how much to invest in up
gradation of its plans and technology. Capital investment up to a maximum of Rs. 100
crore is required. The problem areas are three-fold.
• The company cannot forgo the capital investment as that could lead to reduction in its market share as technological competence in this industry is a must and customers would shift to manufactures providing latest in car technology.
• The company does not want to issue new equity shares and its retained earning are not enough for such a large investment. Thus, the only option is raising debt.
• The company wants to limit its additional debt to a level that it can service without taking undue risks. With the looming recession and uncertain market conditions, the company perceives that additional fixed obligations could become a cause of financial distress, and thus, wants to determine its additional debt capacity to meet the investment requirements.
Mr. Shortsighted, the company’s Finance Manager, is given the task of determining the additional debt that the firm can raise. He thinks that the firm can raise Rs. 100 crore worth debt and service it even in years of recession. The company can raise debt at 15 per cent from a financial institution. While working out the debt capacity. Mr. Shortsighted takes the following assumptions for the recession years.
a) A maximum of 10 percent reduction in sales volume will take place.
b) A maximum of 6 percent reduction in sales price of cars will take place.
Mr. Shorsighted prepares a projected income statement which is representative of the recession years. While doing so, he determines what he thinks are the “irreducible minimum” expenditures under
recessionary conditions. For him, risk of insolvency is the main concern while designing the capital structure. To support his view, he presents the income statement as shown in Exhibit 3.
Exhibit 3 projected Profit and Loss account
(Amount in Rs. Crore)
Sales revenue (72,000 units x Rs. 2,35,000) 1,692.0
Operating expenditure
Variable cost :
Raw material and manufacturing expenses 1,170.0
Variable overheads 90.0
Total 1,260.0
Fixed cost :
R & D ---
Marketing and advertising 15.0
Depreciation 187.5
Personnel 70.0
Total 272.5
Total operating expenditure 1,532.5
EBIT 159.5
Financial expenses :
Interest on existing Debentures 7.0
Interest on existing institutional borrowings 10.0
Interest on commercial loan 30.0
Interest on additional debt 15.0 62.0
EBT 97.5
Tax (@ 35%) 34.1
EAT 63.4
Dividends --
Debt redemption (sinking fund obligation) 50.0*
Contribution to reserves and surplus 13.4
* Rs. 40 crore (existing debt) + Rs. 10 crore (additional debt)
Assumptions of Mr. Shorsighted
• R & D expenditure can be done away with till the economy picks up.
• Marketing and advertising expenditure can be reduced by 40 per cent.
• Keeping in mind the investor confidence that the company enjoys, he feels that the company can forgo paying dividends in the recession period.
He goes with his worked out statement to the Director Finance, Mr. Arthashatra, and advocates raising Rs. 100 crore of debt to finance the intended capital investment. Mr. Arthashatra does not feel comfortable with the statements and calls for the company’s financial analyst, Mr. Longsighted.
Mr. Longsighted carefully analyses Mr. Shortsighted’s assumptions and points out that insolvency should not be the sole criterion while determining the debt capacity of the firm. He points out the following :
• Apart from debt servicing, there are certain expenditures like those on R & D and marketing that need to be continued to ensure the long-term health of the firm.
• Certain management policies like those relating to dividend payout, send out important signals to the investors. The Zip Zap Zoom’s management has been paying regular dividends and discontinuing this practice (even though just for the recession phase) could raise serious doubts in the investor’s mind about the health of the firm. The firm should pay at least 10 per cent dividend in the recession years.
• Mr. Shortsighted has used the accounting profits to determine the amount available each year for servicing the debt obligations. This does not give the true picture. Net cash inflows should be used to determine the amount available for servicing the debt.
• Net Cash inflows are determined by an interplay of many variables and such a simplistic view should not be taken while determining the cash flows in recession. It is not possible to accurately predict the fall in any of the factors such as sales volume, sales price, marketing expenditure and so on. Probability distribution of variation of each of the factors that affect net cash inflow should be analyzed. From this analysis, the probability distribution of variation in net cash inflow should be analysed (the net cash inflows follow a normal probability distribution). This will give a true picture of how the company’s cash flows will behave in recession conditions.
The management recognizes that the alternative suggested by Mr. Longsighted rests on data, which are complex and require expenditure of time and effort to obtain and interpret. Considering the importance of capital structure design, the Finance Director asks Mr. Longsighted to carry out his analysis. Information on the behaviour of cash flows during the recession periods is taken into account.
The methodology undertaken is as follows :
(a) Important factors that affect cash flows (especially contraction of cash flows), like sales volume, sales price, raw materials expenditure, and so on, are identified and the analysis is carried out in terms of cash receipts and cash expenditures.
(b) Each factor’s behaviour (variation behaviour) in adverse conditions in the past is studied and future expectations are combined with past data, to describe limits (maximum favourable), most probable and maximum adverse) for all the factors.
(c) Once this information is generated for all the factors affecting the cash flows, Mr. Longsighted comes up with a range of estimates of the cash flow in future recession periods based on all possible combinations of the several factors. He also estimates the probability of occurrence of each estimate of cash flow.
Assuming a normal distribution of the expected behaviour, the mean expected
value of net cash inflow in adverse conditions came out to be Rs. 220.27 crore with standard deviation of Rs. 110 crore.
Keeping in mind the looming recession and the uncertainty of the recession behaviour, Mr. Arthashastra feels that the firm should factor a risk of cash inadequacy of around 5 per cent even in the most adverse industry conditions. Thus, the firm should take up only that amount of additional debt that it can service 95 per cent of the times, while maintaining cash adequacy.
To maintain an annual dividend of 10 per cent, an additional Rs. 35 crore has to be kept aside. Hence, the expected available net cash inflow is Rs. 185.27 crore (i.e. Rs. 220.27 – Rs. 35 crore)
Question:
Analyse the debt capacity of the company.
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