CASE STUDY CAPITAL CONUNDRUM It was past mid-night and the customary Christmas party at the offices of Star

industries (Star) was in full swing. In addition to the companys staff and managers, present at the annual bash for the first time were several of Stars business associates including its vendors, financiers, and, of course, customers. Amidst the merry-making, Mr. Ajay Patel, the 31 year old chairman and managing director of the company, sat anxiously huddled together with his finance director, Mr. Prashant Saxena, 37, 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 companys lead banker, the First Guardian Bank, the next day. Incorporated in Maharashtra in 1978 as a private limited company, Star had turned itself into a public limited company in 1985 and had simultaneously arranged to list itself on the stock exchanges in Mumbai, Kolkata, Chennai and, later, on the National Stock Exchange. Starting with a small printing press in a Mumbai suburb, Star had specialized over the years in designing, typesetting, printing, binding, and direct-mailing printed products for its clients. Over the years, Star had learnt to handle both large and small printing assignments for its customers who typically consisted of blue-chip companies, transnationals, and financial institutions. Stars luminous logo enjoyed considerable brand equity, and symbolised quality in the market place. Six years earlier, in step with the boom in the printing industry, Star had gone in for a related diversification by venturing into the manufacture 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 Star in 1982 as its general manager (operations), after completing his masters in printing technology at an American University, he had taken over as Stars CEO when his father died in 1990. But Patel Junior 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 Stars 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 companys day-to-day operations. A qualified chartered accountant had company secretary, Saxena had worked with Star ever since it had gone public. His financial acumen was in no small measure responsible for the companys pace of growth as well as its financial health (Exhibit 1). Exhibit 1 The Financials for the year ending March 31 (Rs. in crore) 1993-94 Sales Other Income Total Income Manufacturing Expenses PBDIT Term-Loan Interest Working Capital Depreciation Preliminary Expenses** Profit Before Tax Tax Profit After Tax *Projections 110 110 120 64.80 39.10 10.20 2.40 9.60 0.80 16.10 2.00 14.10 1994-95 267 2.25 289.50 179.50 78.40 9.70 4.00 21.60 0.80 42.30 2.90 39.40 1995-96 345.50 28.80 374.20 233.90 102.10 9.20 5.20 21.60 0.80 65.30 19.70 45.60 1996-97* 392.50 32.50 425.00 267.20 115.60 7.50 5.90 21.60 0.80 79.80 26.10 53.70

** Written Off

Since 1991, Patel and his team had increasingly become conscious of the fact that liberalization had provided new growth opportunities. Among the Greenfield areas they had been able to identify for Star to venture into were the printing of week-end 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 could become a profit 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 that Star had started planning a in November, 1996, Patel had identified a British collaborator, Simpson and Sons, from whom Star could commission a printing press and a design studio. These facilities which would be located in New Mumbai, would boast of computerized systems for combining text, graphics, and images, highspeed 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 industry (Exhibit 2). Exhibit 2 The Project Cost (Rs. in crore) Land and Building Plant and Machinery: Imported Indigenous Miscellaneous Fixed Assets Margin Money for Working Capital Preliminary and Pre-Operative Expenses Contingency Expenses Total Cost 7.50 60.00 57.50 2.50 15.00 22.50 6.00 4.00 115.00

By mid-December 1996, Star had signed a Memorandum of Understanding with Simpson and Sons, and the Christmas party provided an ideal opportunity for Patel to formally announce his gameplan. It was after making the announcement that Patel had sougth out Saxena for a discussion. By the time the party was over, they had agree that a time-frame of six months was reasonable for the implementation of the project. And they reckoned before the onset of the next monsoon the capital markets would become buoyant and the money market would turn easy. Meanwhile, Saxena worked out the financing pattern for the Rs. 100 plus crore project, which was incorporated into the detailed report (see Exhibit 3). According to the plan, Star would finance less than 50 per cent of the cost of the project through borrowings. And the rest would be funded by internal accruals as well service both its existing and fresh debt and, because of the fall in interest rates he anticipated the average cost of capital to the company would eventually fall. But according to his plan Patels shareholding in the company would decline to 35 per cent from 50 per cent. However, Patel had little hesitation in approving the proposals since he was quite comfortable with a personal stake of 35 per cent 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 earlier, 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 printing units in the free trade zones which bade well for Stars future business.

Exhibit 3 The Financing Pattern (Rs. in crore)

Means of Finance Equity Issue: - To Promoter - To Public Term-Loan Internal Accruals Total Capital Structure Before Public Issue Equity: - Promoters Stake - Public Holding Long-Term Debt Debt Equity Ratio (Times) 20 20 50 1.25 40 24.50 45.50 100* 1.43 30.00 4.50 25.50 50.00 35.00 115.00 After Public Issue 70

Authorized Equity Capital: Rs. 100 crore *Post Rs. 50 crore term-loan. That is why, the next week, Saxena and Patel were more than a little surprised to receive this reply from the First Guardian Banks manager (credit), Mr. 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 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, and a reasonable rate of return is earned on the funds deployed. It must also be mentioned that the printing industry is becoming more competitive, and Star will face a tough challenge from both existing and potential entrants. We believe that the market share and margins of Star will soon come under pressure. Your expectations of a fall in interest rates may also not materialize as the demand for capital is projected to grow, outstripping the supply from both 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 (as shown in Exhibit 4). We request you to revise your financial projections appropriately, and submit it afresh for appraisal. Your Sincerely, .. (P. T. Basu) 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 per cent. Would it be possible to ward off future takeover bids with such a small shareholding, 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 overcautious banker pressurizing his client to tone down the demand for funds? How could Star manage the trade-off between Patels interest, the bankers requirements, and its own future? Exhibit 4 The Banks Counter-Proposal (Rs. in crore) Means of Finance Equity Issue: - To Promoter - To Public Term-Loan Internal Accruals Total Capital Structure Before Public Issue Equity: - Promoters Stake - Public Holding Long-Term Debt Debt Equity Ratio (Times) 20 20 50 1.25 40 25 75 70 0.70 60.00 5.00 55.00 20.00 35.00 115.00 After Public Issue 100

Authorized Equity Capital: Rs. 100 crore *Post Rs. 20 crore term-loan.