Case Study – Capital Conundrum

It was past midnight and the customary x’mas party at the offices of Star Industries (Star) was
in full swing. In addition to the company’s staff and the managers, present at the annual bash
– for the first time – were several of Star’s business associates including its vendors,
financiers, and of course, customers. Amidst the merry making, Ajay Patel, the 37 year old
chairman and the managing director of the company, sat anxiously huddled together with his
finance director Prashant Saxena, 43, providing the finishing touches to a Rs. 115 crore
expansion proposal – formally announced at the party a few hours ago – to be submitted to
the company’s lead banker, the First Guardian Bank, the next day.

Incorporated in Maharashtra in 1998 as a private limited company, Star had turned itself into
a public limited company in 2005 and had, simultaneously, arranged to list itself on the
National Stock Exchange. Starting with a small printing press in Mumbai suburb, Star had
specialised, over the years, in designing, typesetting, printing, binding and direct-mailing
printed products for its clients. Over the years, Star had learned to handle both large and
small printing assignments for its customers who, typically, consisted of blue-chip
companies, transnationals, and financial institutions.

Star’s luminous logo enjoyed considerable brand equity, and symbolised quality in the
marketplace. Six years earlier, in step with the boom in the printing industry, Star had gone in
for a related diversification by venturing into the manufacturing of printing accessories.
Actually, Ajay – the only son of the promoter of the company, the late Ghanshyam Patel –
was the one who had spearheaded that move. Having joined in Star in 2002 as its general
manager (operations), after completing his masters in printing technology at an American
university, he had taken over as Star’s CEO when his father died in 2010. But Patel Jr too had
always focused on what he knew best.

His mission statement was simple : to provide world class printed products and offer the
highest standards of quality to Star’s clients. While his own faculties were honed to the
strategic imperatives of tracking developments in printing technologies worldwide, Patel had
built a team of managers – including Saxena – to handle the company’s day-to-day
operations. A qualified Charted Accountant and Company secretary, Saxena had worked with
Star ever since it had gone public. His financial acumen was in no small measure responsible
for the company’s pace of growth as well as its financial health.

Since 2001, Patel and his team had, increasingly, become conscious of the fact that
liberalisation had provided new growth opportunities. Among the green field areas they had
been able to identify for star to venture into were the printing of weekend colour sections for
newspapers, special supplements for magazines, corporate brochures, calendars, diaries, and
greeting cards. Also, Star had latched on to the potential of publishing niche products like
Yellow Pages directories, industrial directories, and top-of-the-line coffee-table books. So,
the creation of a full-fledged design centre – which would become a profile centre – had
become necessary.

At the same time it was imperative for Star to remain a step ahead of its rivals, especially
since competition was likely to intensify after the reduction of the import duties on printing
machinery. It was because of this the Star had started planning a crash expansion-cum-
modernisation programme. During a visit to trade fair in London in November 2021, Patel
had identified a British collaborator, Simpson & Sons, from whom Star would commission a

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printing press and a design studio. These facilities, which would be located in New Mumbai,
would boast of computerised systems for combining text, graphics, and images, high-speed
web-offset printing, and a fully automatic bindery. Obviously, the Rs. 115 crore project
would provide a competitive edge to Star, firmly establishing it as the number one in the
printing industry.

By mid-December, 2021, Star had signed a Memorandum Of Understanding with Simpson &
Sons, and the Christmas party provided an ideal opportunity for Patel to formally announce
his game plan. It was after making the announcement that Patel had sought out Saxena for a
discussion. By the time the party was over, they had agreed that a time frame of six months
was reasonable for the implementation of the project. And, they reckoned, before the onset of
the monsoon, the capital markets would become buoyant and the money market would turn
easy. Meanwhile, Saxena worked out the financing pattern of the Rs.100-plus crore project,
which was incorporated into the detailed project report.

According to the plan, Star would finance less than 50% of the cost of the project through
borrowings. And the rest would be funded by internal accruals as well as a public issue of
equity. Saxena was convinced that Star would be in a position to service both its existing and
fresh debt and, because of the fall of interest rates he anticipated, the average cost of the
capital to the company would, eventually, fall. But, according to his plan, Patel’s share
holding in the company would decline to 35% from 50%. However, Patel has little hesitation
in approving the proposals since he was quite comfortable with a personal stake of 35% in
Star.

At that level, Patel was convinced, he would not be vulnerable to a takeover threat. Although
such a bid had not been perceived either, he was aware that several transnational publishing
firms – with deep pockets – were eyeing the domestic market. Given its low wage costs and
sophisticated printing facilities, India had become a global publishing centre. Foreign firms
had become keen on using it as a base for the re-export of printed products to West Asia and
the Far East. Many of them were already negotiating with the printing units in the free trade
zones – which boded well for Star’s furniture business.

That’s why, the next week, Saxena and Patel were more than a little surprised to receive this
reply from the First Guardian Bank’s manager (credit), P. T. Basu :

Dear Sirs,

This is with reference to the project report submitted by Star Industries for our appraisal. In
this connection we have to state that we have broadly reviewed the project report and,
without prejudice to the various contentions that might be raised at the time of detailed
scrutiny, we advise you as under.

The financing pattern suggested in the project report is derived on the basis of two
assumptions. One, Star will be able to generate sufficient revenue to service its existing and
future debt. Two, interest rates will decline in future.

As regards the first assumption we believe that the market for high value printed products is
only in its nascent stages. The proposed project will, therefore, have a long gestation period
before the demand for such products develops, a reasonable rate of return is earned on the
funds deployed.

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It must also be mentioned that the printing industry is also becoming more competitive, and
star will face a tough challenge from both existing and potential entrants. We believe that
market share and margins will soon come under pressure. Your expectations of a fall in
interest rates may also not materialise as the demand for capital is projected to grow,
outstripping the supply from both the domestic savings and foreign capital.

Under the circumstances, it would be advisable to prune the weightage of debt in the mix for
financing the project, and augment the proportion of equity. We have suggested a financing
pattern for the project in the annexure.

We request you to revise your financial projections appropriately, and submit it afresh for
appraisal.

Yours etc.

Clearly, Patel was now on the horns of a dilemma. If he were to accept his bankers’
recommendations, Star would be able to attain a conservative leverage ratio, but his stake in
the company would fall to just 25%. Would it be possible to ward off future takeover bids
with such a small share holding, particularly, when transnational publishing firms were
beginning to knock on the doors of local printers? Moreover, would the primary market be
able to absorb a larger issue of equity capital by Star? Was this merely another case of an
over cautious banker pressurising his client to tone down the demand for funds? How could
Star manage the trade off between Patel’s interests, the banker’s requirements, and its own
future?

Annexure 1 : The Financials

(All figures in Rs. Crore for the year ending 31st March)
2018-19 2019-20 2020-21 2021-22*
Sales 110.00 267.00 345.40 392.50
Other Income 10.00 2.25 28.80 32.50
Total Income 120.00 289.50 374.20 425.00
Manufacturing Expenses 64.80 179.50 233.90 267.20
PBDIT 39.10 78.40 102.10 115.60
Term Loan Interest 10.20 9.70 9.20 7.50
Working Capital 2.40 4.00 5.20 5.90
Depreciation 9.60 21.60 21.60 21.60
Preliminary Expenses** 0.80 0.80 0.80 0.80
PBT 16.10 42.30 65.30 79.80
Tax 2.00 2.90 19.70 26.10
PAT 14.10 39.40 45.60 53.70
(* Projections)
(**Written off)

Annexure 2 : The Project Cost

Land & Building 7.50

Plant & Machinery Imported 57.50
Indigenous 2.50 60.00
Miscellaneous Fixed Assets 15.00

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Margin Money for Working Capital 22.50
Preliminary and Pre-operative Expenses 6.00
Contingency Expenses 4.00

Annexure 3 : The Financing Pattern

Means of Finance
Authorised Equity Capital 100.00
Equity Issue to Promoter 4.50
to Public 25.50 30.00
Term Loan 50.00
Internal Accruals 35.00
Total 115.00

Capital Structure
Before Public Issue After Public Issue
Equity Promoter’s Stake 20.00 24.50
Public Holding 20.00 40.00 45.50 70.00
Long term Debt 50.00 100.00*
Debt – Equity Ratio (Times) 1.25 1.43
(* Post Rs. 50 crore term loan)

Annexure 4 : The Bank’s Counter Proposal

Means of Finance
Authorised Equity Capital 100.00
Equity Issue to Promoter 5.00
to Public 55.00 60.00
Term Loan 20.00
Internal Accruals 35.00
Total 115.00

Capital Structure
Before Public Issue After Public Issue
Equity Promoter’s Stake 20.00 25.00
Public Holding 20.00 40.00 75.00 100.00
Long term Debt 50.00 70.00*
Debt – Equity Ratio (Times) 1.25 0.70
(* Post Rs. 20 crore term loan)