Financial Management

Fatima Fertilizer Company Limited

Analysis-Capital Structure and Dividend Policy

Zain Ali 22088

Zohaib Malik 22207

Abdul Wasay 22248

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Table of Contents

Introduction............................................................................................................ 3

Chapter 1............................................................................................................ 4

Capital Structure...................................................................................................................................4

Optimality..............................................................................................................................................5

Chapter 2............................................................................................................... 5

Factors affecting capital structure.......................................................................................................5

Cost of Debt v/s Cost of Equity.............................................................................................................6

Chapter 3............................................................................................................... 7

Dividend Policy......................................................................................................................................7

Free Cash Flow and Dividends.............................................................................................................7

Factors affecting Dividends..................................................................................................................8

Trends in Dividend Payout...................................................................................................................8

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Introduction

Fatima Fertilizer, founded in December 2003, is a major player in Pakistan's fertilizer business.
The firm has a credit rating of 'AA-' for long-term and 'A1+' for short-term from PACRA, with
two intermediate products, Ammonia and Nitric acid, and four end products, Urea, Calcium
Ammonium Nitrate (CAN), Nitro Phosphate (NP), and Nitrogen Phosphorus Potassium (NPK).
The company was founded by two business groups, Fatima, and Arif Habib, and now operates
three plants in Sadiqabad, Multan, and Sheikhupura. In 2018, the company stated that it will
merge its activities with Pak Arab, a wholly owned subsidiary. This merger was not
consummated until January of this year. This resulted in a jump in overall output for the
company, as it was able to take use of Pak Arab's gas facilities. Between these years, that is,
2016 and 2020. The company has gone through numerous expansion strategies, which are
represented in the payout ratio trend, which is examined further in the report.

Fatima Fertilizer was able to maintain consistent earnings over the time under consideration, and
hence follows the going-concern criteria. This idea is reinforced by the regular payment of
dividends and the repayment of debts. Fatima fertilizer also issued Sukuk bonds in addition to
ordinary stock, and subsequent adjustments in the weighting of equity and debt are detailed in
the section "Capital Structure."

This study focuses on the company's capital structure and provides an analysis in comparison to
the industry. The company's main problems are discussed when working on the weights assigned
to loan and equity components, and the expenses of both components are contrasted. In addition,
the paper discusses the firm's dividend-paying habit and its repercussions. The factors that
influence this payout are emphasized, and they are compared to the industry.

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 Chapter 1
Capital Structure
The capital structure of a company refers to the mix of debt and equity it uses to fund its
operations and growth. Fatima concentrated her efforts over a five-year period (2016-2020) on
reducing her debt.

Debt : Equity
0.50
0.45
0.40
0.35
0.30
0.25
0.20
0.15
0.10
0.05
0.00
2016 2017 2018 2019 2020

Most of the funding was obtained through the issuance of common stock at a price of Rs. 10 and
preferred stock at a price of Rs. 20. Only 100,000,000 preferred shares are outstanding out of
2,100,000,000 total shares, with the balance being common equity. This consistent downward
trend reflects the company's aversion to taking on debt. Instead of issuing bonds or obtaining
money through a financial institution, the Company approved new 700,010 common shares to
cover the higher expenditures in the post-merger stage in 2019. The largest reduction in the debt-
to-equity ratio was seen between 2016 and 2017. This is due to Fatima's payback of a massive
sum of Rs. 15,747,059 in 2016, which includes repayment of Sukuk certificates and loans
received through banks or other financial organizations. The merger of Fatimafert Limited and
Fatima Fertilizer Company Limited did put some pressure on this constant outlook, as production
capacity rose because of the total integration of all assets, liabilities, and resources. However,
this pressure was alleviated by the issuance of new shares, and long-term financing fell from Rs.
6,887,911 in 2018 to Rs. 6,253,636 in 2019. Additionally, the load was shared by securing short-

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term financing from a variety of institutions for working capital and imported machinery. This
was a little rise, and the debt-to-equity ratio in the capital structure continued to fall, indicating a
greater dependence on equity rather than debt.

This consistent focus on equity financing is fair since, even though the corporation issued
additional shares, earnings per share increased over time. The steady stream of dividends, which
fell from Rs. 3.25 per share to Rs. 1.75 per share between 2016 and 2018, is now on the rise
again, with a 25 percent increase from Rs. 2.0 in 2019 to Rs. 2.50 in 2020 following the merger.
Although this one-dimensional concentration cost the firm money in terms of leverage since the
company was unable to take advantage of the tax benefits that come with debt financing. As a
result, the amount of tax deductions has grown by about 200 percent. As a result, the overall net
income amount is lower than it could have been. Financial leverage, which has remained low on
average, hovering around 0.5 and declining from 0.63 in 2016 to 0.24 in 2020, reflects this over-
reliance on raising the weight of equity component.

Optimality
When considering the industrial environment in which the firm operates, there has been a herd
behavior, with all the key companies, such as Fauji Fertilizers Company ltd., focusing on
lowering debt levels. This can be justified in the context of the national economy. Interest rates
have been rising in response to rising inflationary pressures and central bank policy. This raises
the cost of borrowing and, as a result, the cost of financing. Although it may be argued that the
tax benefits of debt financing would make the profit and loss statement seem favorable.
However, owing to strained demand-supply situations and India meeting most regional demand,
the corporation may reason that it wants to reduce the risk of defaulting in any manner.
Furthermore, given the structure and scope of the firm, it only makes sense to not issue any
additional shares owing to the continued decline in market return, especially after the merger
when output has expanded by more than 100 percent. This may cause investors' perceptions of
stock to worsen, resulting in shares being underpriced because of lower demand. By studying the
trend, Fatima Fertilizer is pleased with its present capital structure, as evidenced by the fact that
the debt-to-equity ratio remained unchanged in the quarter ended report of 2021. It demonstrates
that the firm is playing it safe and does not want to take advantage of the tax benefit at the risk of

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growing borrowing costs. It is also extremely pleasing because it has made a nice profit under
adverse circumstances, expanded under the cover of a merger, and given attractive dividends, all
while paying this considerable taxation.

Chapter 2
Factors affecting capital structure
The fluctuating policy rate over the time under consideration is the most important factor that the
company must consider. The cost of borrowing rises when interest rates rise, diminishing the
appeal of debt financing. This rate has risen from 6.5 percent in 2016 to 7.25 percent currently.
This is reflected in a lower reliance on debt and, as a result, a lower weightage in the capital
structure.

Furthermore, if the firm wants to utilize additional stock, the secondary market's faith in the
company's shares is critical. Despite rising inflation during the period, the stock price stayed
stable, averaging Rs. 31 throughout the 5-year period.

As previously said, the firm must have been lured to use the benefits of tax shield by increasing
the tax rate from 16 percent in 2016 to 29 percent in 2020, but it appears that Fatima is content to
pay more tax if it is kept out of bankruptcy danger. To highlight, the government's rise in gas
prices in the nation entails a significant duty on the part of the government to ensure that all urea
production units in the country continue to operate. This ensures that the company's most popular
goods, CAN and NP, will continue to be in high demand in the future. The majority of this may
be attributed to the Sheikhupura plant's operations, which continued to function despite the
temporary stoppage of the Sadiqabad facility shortly after the facilities were merged in 2019.
Despite this, productivity increased by 8.3 percent. This ensures a constant stream of earnings
soon, enhancing the company's ability to bear the burden of higher taxes due to lower debt and
greater equity financing.

Other elements that correspond with the capital structure position include a nearly 111 percent
increase in free cash flow, a cost of equity calculated using CAPM that is virtually equivalent to

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the return on market, and a generous dividend distribution despite expansion in 2019 through
merger.

Cost of Debt v/s Cost of Equity

The effective interest rate that a firm pays on its issued bonds and other loans is referred to as the
cost of debt. Finance cost, which is simply the interest paid, was divided by total liabilities,
which is practically all the debt. The rate of return that a corporation pays to its shareholders is
referred to as the cost of equity. It is computed using the CAPM equation, which is rf+ beta*
(rm-rf). The beta in this equation is computed by drawing a Security Characteristic Line (SCL)
with the x-axis representing market return and the y-axis representing FFERT's stock return.
Both numbers came from the website investing.com. The return on the KSE-100 index, which
covers the top 100 businesses by market capitalization, represents market return. Both KSE-100
points and FFERT stock values are calculated on a weekly basis, with the week ending on
Friday. The value for RF, or risk-free rate, in the CAPM equation is an auctioned rate on a 3-M
Market Treasury Bill, which has no liquidity issues due to its short term of three months and no
danger of default because it is backed by the government.

In comparison, the cost of debt is far lower (almost half) than the cost of equity, which is
virtually always the case and expected. This is because debt is less risky than equity, therefore
debt investors need a lower return on their investments than stock investors. Interest is a burden
that the company must pay to debt holders. Even if the firm goes bankrupt, debtors will be
compensated by the liquidation of the company's assets. As a result, the cost of debt is often
lower (4.40 percent in this case) than the cost of equity (7.9293 percent in this case).

Fatima appears to be comfortable paying a significantly higher price on stock since it has kept
shareholders happy by giving consistent dividends and, above all, excellent earnings per share
over the years. But it's worth noting that Fatima has 5-year Sukuk bonds in the market as well,
with semi-annual payments based on 6-month KIBOR + 1.10 percent each year. These bonds are
likewise rated "AA-" by PACRA, therefore it should be noted that with this credit rating, the
firm might issue further bonds, but it has chosen not to, demonstrating its happiness with its
present capital structure once again.

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 Chapter 3
Dividend Policy
The dividend payout ratio indicates how much of the company's profits is allocated as dividends
to shareholders. A low dividend payment ratio may indicate that shareholders want a higher
return, but it also indicates that the company is striving to expand. High dividend payout ratios
reduce the firm's growth prospects by implying that it has no viable investments available, but
they keep shareholders happy by allowing them to invest their payments elsewhere, needing less
return.

In 2016, Fatima had a high payout ratio of 69.74 percent. However, throughout time, this altered,
and in 2018, the ratio was as low as 27.69 percent. This might be ascribed to the company's
significant investment in a nitrogen fertilizer production in the United States, as well as the
merger that occurred in 2019. This statement is supported by the fact that, following the merger,
the payout ratio began to rise again, indicating that the prospects appear promising.

Fatima looks to be a poor payer in relation to the rest of the sector, at least since 2016. Other
companies, such as Engro Fertilizer, have kept payout ratios between 60% and 80%, except for
Fauji Fertilizer bin Qasim, which did not pay a dividend in 2019 and 2020 due to a net loss in
2019 and a profit in 2020. The reasons for the low payout may be summed up as follows:
building of a new nitrogen fertilizer plant and the merger of the Fatima group.

Free Cash Flow and Dividends

The cash available to pay all creditors, interest on bonds, and dividends to stockholders is
referred to as free cash flow to the business. As a result, the bigger the amount, the higher the
dividend expectations. It should be remembered, however, that the corporation must pay
debtholders before it can pay dividends, thus the anticipation of larger dividends may not always
be realized. In practice, this can be observed in the fact that FCF in 2017 was Rs. 11,784,078.17,
up 187 percent from 2016, owing to a very little change in net operational working capital.
Despite this significant change, the payout in 2018 was smaller, at Rs. 1.75 as opposed to Rs.
2.25 in 2017. In 2017 and 2018, the payout ratio fell from 44.64 percent to 27.69 percent,
respectively. This leads to the conclusion that payout and dividend per share are dependent on

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several other factors, including the company's net profits and the projects undertaken or to be
undertaken. For example, Fatima's Fertilizer Complex was at its "construction peak" in 2018, and
there were significant capital investments in lieu of long-term growth.

The former idea, on the other hand, can be seen between FY2019 and FY2020, when free cash
flow grew by 63 percent in 2019 and the expectation was realized when the dividend was
increased from Rs.2 to Rs.2.5 and the payout ratio was increased from 34.78 percent to 39.56
percent. This is almost definitely owing to the eventual financial relaxation that occurred after
the merger, as productivity and sales grew.

Factors affecting Dividends

Before paying a dividend, there are a few things to consider. Stability of Income stays at the top
of the list since a firm can only afford to pay dividends to shareholders if it generates a consistent
stream of income. FFERT sweeps a growing Profit and Free Cash Flow over a five-year period.
As a liability, Fatima must consider its debt commitments, which must be paid before dividends.
Fatima must also forecast its future growth prospects. It is crucial to highlight that if a firm has a
promising investment opportunity, it is preferable to pursue it and reduce or eliminate the
dividend for a set period. It can be noted that throughout the merging process, Fatima reduced
the payout ratio to 27.69 percent in 2018 from 44.64 percent in 2017 to preserve more money for
expansion in 2019. On the contrary, if a company has no ambitions, it is better to give out large
dividends to shareholders so that they can invest the money elsewhere. Due to the breakout of
COVID-19 in the year 2020, there was nothing going on in the economy, and nearly everything
came to a standstill. Following the assumption, FFERT boosted the payout ratio to 39.56 percent
in 2020.

Trends in Dividend Payout

The payout has changed dramatically between 2016 and 2020, going from 69.74 percent in 2016
to 27.69 percent in 2018, then climbing from 34.78 percent in 2019 to 39.56 percent in 2020. In
2017, the company returned Rs. 8,003,000 in Sukuk bonds and acquired Midwest Fertilizer
Company's project. As a result of the increasing debt obligation and expansion possibilities, the
dividend was reduced. This decline will continue until 2018, when the firm and its subsidiary,
Fatimafert Limited, are merged into one. Then, because of a more relaxed environment and a

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significant rise in Free Cash Flow (from Rs. 9,348,423.89 in 2018 to Rs. 15,242,419.44 in 2019),
the company's profit increased dramatically. This was attributed to an increase in operational
income (EBIT) as a result of the improved and extended operating facilities. Even with
government assistance programs such as lowering natural gas costs and delivering Regasified
Liquefied Natural Gas (RLNG), this spike was exacerbated by a shortage of investment
possibilities during the peak of the epidemic. As a result, FFERT had no choice but to raise the
payout ratio, which it did to 39.56 percent, as previously stated.

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