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.
INDIAN COMMUNICATIONS LTD.
Indian Communications Ltd was a telecommunication company headquartered in Mumbai, India. It was a leading player in next generation, integrated (wireless and wire line), and digital network, covering over 20,000 cities and towns and over 2, 00,000 villages . It had business operations in more than 20 countries. With US $ 10bn revenues in FY 14 it had been a great last year.
It was India's truly integrated telecommunication service provider. The company had a Customer base of around 100 million including over 2 million individual overseas retail customers and corporate clientage over 30,000 Indian and multinational corporations. .
Two friends started it in 1997 with just US$ 1000. From the beginning, the company had followed a conservative financing policy. For them loan was a synonym of headache. That’s why; despite advised by their financial controller never borrowed long-term loan for business operations though they had to lose out various business opportunities at times.
The global telecom market landscape had changed remarkably in the last few years. “The Indian telecommunication industry captured a sizeable chunk of the global market and was now the world’s market. 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 income, i.e. income to cover the interest cost, financial leverage would decrease equity value and thus reduced the value of the company.
In the context of shareholders’ wealth maximization, the financial controller also shared a Research report by one of the leading research organizations on ‘interrelationship between financial leverage and market performance.’ The report showed a positive correlation between leverage and share price of most of the companies in the telecommunications sector.
He further highlighted the concept of Acceptable Leverage Metrics and Target leverage Metrics and shared the telecommunication industry comparison. .
B. Indian Telecommunication industry
The Indian telecom industry too presented a very conservative capital structure. Leading companies, like Bharti Airtel, Aircel, Idea cellular etc. were equity dominated companies. They either had a low debt-equity ratio or negligible. The reason being was mainly because the telecom industry did not need huge amount of investment in plant and machinery. This resulted in lower debt in their capital mix. Their running expenses were mostly covered by via cash flow. Their business risk was very high. Thus, to cut their overall risk they liked to lower the financial risk and fund their operations through internal cash .
C. Global Telecommunication Industry
The world economy was on a revival phase after the financial crisis of 2008, and everyone was exploring new opportunities for consolidating growth. “According to a report by Infonetics Research, telecom operators globally generated about $2 trillion in revenues in 2013. Notably the report also stated that telecom carriers were increasing spending on capital expenditures in order to update their networks with the latest technologies. In 2013 carriers’ expenditures rose to 6% year over year and are expected to rise at a CAGR of 2% from 2012-2017, most likely to reach a significant $355 billion by that time. While the telecom growth momentum was expected to be maintained in the U.S. over the near term, the major impetus was likely to come from emerging markets of China, India, Brazil and Russia.”
“The average debt to equity ratio for the communication sector (S&P 500) had been 1.66 for the last three-quarters of 2014. On one hand, AT&T Corp. had a ratio of 0.81, where Verizon Communications Inc. presented the highest ratio of 6.59 for 2014. The global industry indicated leverage in the sector with mixed trends.
THE BOARD DECISION
Finally, the board decided to finance the project with debt for the first time in the History of Indian Communications for shareholders’ interest. They knew that there was a need to facelift the company to make it competitive in regard to value creation for shareholders . Equity shareholders were the one who were the permanent stakeholders of company and they only decided the fortune of a company. They had already seen the effect of their dissatisfaction in the stock market. Therefore, they did not want to risk it further.
But, they were also aware of the fact that they were operating in a volatile sector where revenue model was not very stable. The global meltdown of 2008 has affected telecom sector as well besides banking and financial services sector. “At the end of December 2012, the total revenue of the Indian telecom industry was Rs. 14, 87,920 million. To make matters worse, the industry was experiencing negative growth due to high costs and low tariffs. Currently India had the world's lowest voice tariffs. As the tariff was about 35 paisa per minute. On the data front, India was one of the lowest penetrated markets for wireless broadband in Asia-Pacific, much lower than Malaysia, Philippines and China.”
So, more risk might prove costly to them. The major driving reason for financial leverage to them in the present case was shareholders wealth maximization. .
This project was an entry into the international circuit of top 3 telecom players and would open the gates of world. It would also act as a stepping stone for them to become the preferred organizations. They had worked on the project documentation, tied up with international technical agencies for the necessary know-how required for the project.
The Road Ahead.
Everyone was geared for the results. The Board was aware that these benefits must come quickly for controlling shareholders dissatisfaction. They knew that if they had to grow bigger at international level, they needed the much required facelift soon. But, the question in picture remained, “Would financial leverage be fruitful to the company or cause a dent?”

Exhibit I

Balance Sheet of Indian Communications Ltd. As at 31st March, 2014 | |

(US $bn)

SOURCES OF FUNDS:` | 31-03-2014 | 31-3-2013 | Share Capital | 200 | 200 | Total Reserve | 41806 | 35772 | Shareholder's Funds | 42006 | 35972 | Secured Loans | | 0 | Total Liabilities | 42006 | 35972 | APPLICATION OF FUNDS | | | Gross Block | 10420 | 8060 | Less: Accumulated Depreciation | 4688 | 3607 | Net Block | 5732 | 4453 | Capital Work in Progress | 954 | 1135 | Investments | 8996 | 5904 | Current Assets, Loans & Advances | | | Inventories | 1200 | 1000 | Sundry Debtors | 7336 | 6365 | Cash & Bank | 22900 | 19401 | Loans & Advances | 2799 | 2453 | | 2253 | 1939 | Total current assets | 36488 | 31158 | Les: Current Liabilities and Provisions | | | Current Liabilities | 4139 | 3005 | Provisions | 6117 | 3788 | Net Current Assets | 10256 | 6793 | Deferred tax Assets/ Liabilities | 26232 | 24365 | Tax | 92 | 115 | Total Assets | 42006 | 35972 |

| | | | Exhibit IIPresent capital structure of Indian Communications Ltd. as at 31st March, 2014 | | 100% Equity | | US$ | | | | | | (20 bn@$10) | | 200 bn | |

Exhibit III Financial Projections of the Project | | US$ bn | Sales | 7 | Operating expenses | 3 |

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