Running head: COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 1

IN DEPTH ANALYSIS OF FINANCIAL DECISION ON COST STRUCTURE

MODIFICATION OF HVA FOODS LIMITED.
(Group Assignment)

By
P.G.T.M Priyankara 2009/MBA/FIN/ WE/05
H.D.W. Abesekara 2009/MBA/WE /06
W.A.N.A Fernanado 2009/MBA/FIN/WE/14
A.A.M.D. Gunathilaka 2009/MBA/WE/30
M.V.G.S Kumara 2009/MBA/FIN/ WE/42
J.B.A.R Niroshana 2009/MBA/WE/71
Semester III – first Half
February, 2011

Course: MBAFI – 601 Corporate Finance

Lecturer: Dr.P.S.M.Gunaratne

Postgraduate and Mid Carrier Development Unit

Faculty of Management & Finance
University of Colombo
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 2

Abstract

The capital structure is the back born of a corporate. Maintaining a superior healthy of it is very
important and merely appears as the life of that corporate. Careful attention and timely taken
corrective action will gives the opportunity of maintaining sustainable competitive advantage in
efficient decision making by the board of directors.

The effort taken in this paper is to understand and determine the capital structures of a
corporate, how & when to do changes and effect of it change and its impacts on cost of capital
and to do a in depth analysis of financial decision taken by the HVA food limited to become best
corporate in near future.
Keywords: Capital Structure, Cost of Capital
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 3

Table of Content

Page

Abstract 2

Table of Contents 3

1.0 Introduction 6

1.1 Introduction to the Company 6

1.2 Group Structure 6

1.3 Products Offered 7

1.4 Patents, Trademarks and Brands Owned by the Company 8

1.5 Corporate Structure 8

1.6 Government Support & Regulations 9

1.7 Technology 10

1.8 Future Expectations 10

1.9 Summary of SWOT Analysis 11

2.0 Financials of HVA Foods Limited 11

2.1 HVA Foods Limited- Summarized Income Statement 11

2.2 HVA Foods Limited- Summarized Balance Sheet 12

2.3 HVA Foods Limited- Summarized Interim Income Statement 12

2.4 HVA Foods Limited- Summarized Interim Balance Sheet 12

2.5 Analysis of Financial Ratios 13

3.0 Calculation of cost of capital of the company 16

3.1 Cost of equity 16

3.1.1 CAPM approach 16

3.1.1.1 The Risk Free Rate ( Rf ) 17

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 4

3.1.1.2 The Company Beta ( β ) 17

3.1.1.3 Market Rate of Return ( Ṝm ) 18

3.1.2 Discounted Cash Flow Approach 19

3.2 Cost of Debt 19

3.3 Weighted Average Cost of Capital-Pre IPO 20

4.0 Financing For The Business 21

5.0 Options Available for Financing 22

5.1 Mergers and Acquisition 22

5.2 Bank Borrowings(Loans) 22

5.3 Trade Credits 22

5.4 The Factoring 23

5.5 Government Support 23

5.6 Installments buying 23

5.7 The leasing 24

5.8 Initial Public Offers (IPO) 25

5.9 Right Offering 25

Initial Public Offering IPO
6.0 26

6.1 Decision to IPO 26

6.2 Estimating The Initial Capital Requirements 26

6.3 Valuation of share price for HVA Foods (Pvt) Ltd 29

6.3.1 Review and performance analysis 29

6.3.2 Valuation 31

6.4 Underwriting 31
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 5

6.5 Association of Investment Bank 31

7.0 Post IPO Evaluation 32

7.1 Capital Structure & Weighted average cost of capital-Post IPO 32

List of References 33
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 6
1.0 Introduction
1.1 Introduction to the Company

HVA Foods Limited was established in 1997 as a Board of Investment approved company under
Section 17 (2) of BOI Law No. 4 of 1978 dated September 04, 1997. It was specially set up to
engage in export of value added branded tea, tea extract based products, tea concentrate based
products and a franchise operation. It is a fully owned subsidiary of HVA Lanka Exports
(Private) Limited which was established in 1990 as an exporting arm of HVA International BV
of Netherlands. Subsequently HVA Lanka Exports (Private) Limited became a complete Sri
Lankan business entity and started exporting tea in bulk form to establish its trade network and to
develop a client base.
HVA Foods Limited created its own brand, “HELADIV” in 1996. “HELADIV” is derived from
the word “Heladiva” which symbolizes a home grown product range and a name that could
easily be identified with Ceylon tea. The “HELADIV” brand is registered in 42 countries around
the world and has also been the pioneers in developing Ready-To-Drink iced tea in the Sri
Lankan market.

1.2 Group Structure

HVA Foods Limited is a subsidiary of HVA Lanka Exports (Pvt.) Limited. The structure of the
Company as at 30th September 2010 is depicted below.

100%

99.9999%
Figure 1: Group Structure
HVA Lanka Exports (Private) Limited is the parent company of HVA Foods Limited and is
principally involved in exporting of bulk tea
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 7
HVA Foods Limited – The Company is involved in manufacturing and exporting of value added
tea and tea extract based products.
HVA Holdings (Private) Limited – Owns the international brand rights of “HELADIV”.

1.3 Products Offered

HVA Foods Limited is a leader in the manufacturing, marketing and distribution of four major
product categories; value added tea based products, tea extract based products, tea concentrate
based products and its franchise operations. There are about 80 products presently being
marketed under the “HELADIV” brand which includes a range of flavors and presentations
including black tea, green tea, herbal tea, specialty teas, tea concentrate with pure tea extract,
fruit base, and various other value added tea products.

Figure 1: Present Market Concentration

ASIA/FAR EAST USA/CANADA CIS EUROPE

China Canada Russia Germany
Japan USA Ukraine United Kingdom
Malaysia Barbados Latvia Belarus
Singapore Jamaica Lithuania
Taiwan St. Lucia
Thailand St. Vincent
Hong Kong Trinidad

1.4 Patents, Trademarks and Brands Owned by the Company

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 8

HVA Foods Limited has the local brand rights for its brand “HELADIV” while HVA Holdings
(Private) Limited; now a 100% owned subsidiary of HVA Foods Limited has the international
brand rights. Internationally, the brand name has been registered in 42 countries. Furthermore,
the Company is also expecting approval for its sub brand “INFINI-T” in the near future.
Given below is the ownership structure of HVA Holdings (Private) Limited from incorporation
to date.

Table 2: Ownership Structure of HVA Holdings (Private) Limited

No. of
Entity Shares Transferred
Mr. A.R.H. Fernando 1
Mrs. V.S. Amunugama Fernando 1 Transferred
Dothodana Jayantha Gunawardena 1000 Transferred
Vallibel Holdings (Pvt) Ltd. 9368 Transferred
HVA Lanka Exports (Pvt.)Ltd. 18367 Transferred
Lake Drive Holdings (Pvt.) Limited 18367 Transferred
HVA Foods Limited 18367

1.5 Corporate Structure

The Board of Directors

The Board of Directors guides and supervises the business and operations of HVA Foods
Limited. The Board consists of two (02) Non-Executive Independent Directors, one Non-
Executive Director (01) and three (03) Executive Directors including the Chairman. The Board
has the power to appoint the Executive Directors including the Chairman. As at the date of this
Prospectus, the Board comprises of the following six (06) Directors.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 9

Name Age Address Designation

No. 220,Lake Drive,
Mr. A.R.H. Fernando 55 Chairman
Colombo 08
Mrs. V.S. Amunugama No. 220,Lake Drive,
41 Non Executive Director
Fernando Colombo 08
No. 220,Lake Drive,
Mr. H.J.Fernando 27 Executive Director
Colombo 08
No.8/4,Sri Jinarathana
Mr. J.Raddalgoda 39 Executive Director
Mawatha,Rathmalana
No.14,Alwis Non Executive Director
Mr. N.C. Vitharana 79
Terrace,Colombo 03 (Independent) Director
995/7,Park Lane Non Executive Director
Mr.J.H.P. Rathnayaka 61
,Rajagiriya (Independent) Director

1.6 Government Support & Regulations

The Sri Lanka Tea Board (“SLTB”) is presently the key governing body of the tea industry.
SLTB provides a range of services to tea planters, tea manufacturers and tea exporters which
include maintaining quality standards of tea, the marketing and promotion of Ceylon tea both
locally and abroad, promoting investment in the tea industry etc. As a regulator, SLTB requires
all tea planters, manufacturers and exporters to be registered under the Board in terms of the
SLTB Regulations 1986 published in the Government Gazette Extraordinary No.386/13 of 28th
January 1986. SLTB has carried out a pivotal role in campaigning to ensure producer countries
only ship teas that meet the ISO 3720 standard, in an attempt to prevent an abundance of low
quality teas flooding the market. In 2008,major tea producing countries agreed to adhere to ISO
3720 as a minimum quality level to prevent oversupply from depressing prices. As such, SLTB
as part of its role in maintaining quality, assesses quality standards at all points of disposal of
made tea.

1.7 Technology
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 10
State of the art manufacturing facility with manufacturing support for Ice tea currently under
way as an expansion to the present factory which would increase from present capacity of
100000 Litres to 300000 litres per month.. As for the expansion of the existing factory, most of
the current machines need backups and increased capacity. The current tea bagging capacity of
the Company is well below the required demand.
HVA takes every effort to ensure that its information technology systems are current and up to
date in line with the Company goals and strategies. The Company’s e-mail servers are based in
the US and have 99.9% guaranteed uptime. The Company apart from its servers in Kandana has
an offsite backup storage which demonstrates management’s commitment towards disaster
recovery.

1.8 Future Expectations

The Company’s long-term objective is to become one of the most recognized and respected tea
brands in the world. In order to achieve this, the Company plans to consolidate the brand in
countries where there is already a presence whilst endeavoring to increase the market share. In
this regard an aggressive marketing campaign will be launched from the beginning of 2011 to
attract new buyers/agents particularly in countries where representation is not significant.
It is also the vision of the Company to have offices in strategic markets. In order to fulfill tea
requirements from other origins, the Company has already initiated a programme for joint
ventures in India, Indonesia and Vietnam. In the next few years these strategic partnerships will
be enhanced to undertake marketing in multi origin teas. Strategy will be focused primarily to
project the goodness of tea from other origins in the specialty range such as the Darjeeling’s
from India, Keemun’s from China, Japanese Sencha etc.
Within the next 5 years of operation the company hopes to be a well recognized and well
established tea brand in the world catering to beverage and non-beverage sectors harnessing the
maximum potential in tea.

1.9 Summary of SWOT Analysis

Threat
Weaknesses
Strength Opportunities
• Competition from the
• Difficult
Own brandto enter
name to
and
giant
spread • Increased
rivalrys market share for
in 42 countries
markets with own reputation • RTD Tea products
Substitute
• Strong R&D team in house •• Availability of BMcondition
Impact of weather fannings
• Move from push to pull to The
for iced tea
for the tea production
dominant consumer plateau •• Aroomat
Enter to the giant
as the Chinese
only
Organization
market
distributor in Russia
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 11

2.0 Financials of HVA Foods Limited

2.1 HVA Foods Limited- Summarized Income Statement

For the year ended Mar 31
2006 2007 2008 2009 2010
Revenue 299,121,853 253,852,267 386,865,694 402,379,235 488,206,319
Gross Profit 44,957,269 1,662,730 54,593,941 84,892,616 93,483,325
Operating Profit 9,557,904 17,963,604 14,828,634 76,422,054 85,513,225
Finance Cost 1,761,079 23,226,461 31,287,044 58,385,691 29,925,028
PBT 11,318,983 (5,262,857) (16,458,410) 18,036,363 55,588,197
Net Profit 9,959,394 (5,273,480) (16,463,446) 14,817,965 54,274,768

2.2 HVA Foods Limited- Summarized Balance Sheet

As at Mar 31
2006 2007 2008 2009 2010
Non Current Assets 64,868,023 161,438,801 160,852,603 158,110,838 236,285,570
Current Assets 13,974,378 230,920,219 177,445,251 177,009,676 281,371,485
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 12
Total Assets 178,842,401 392,359,020 338,297,854 335,120,514 517,657,055
Capital & Reserves (75,233,184) 9,417,737 (7,045,710) 7,772,255 99,911,117
Non Current Liabilities 82,422,970 115,871,638 55,516,826 136,297,102 145,945,728
Current Liabilities 171,652,615 267,069,645 289,826,737 191,051,157 271,800,210
Total Equity & 178,842,401 392,359,020 338,297,854 335,120,514 517,657,055
Liabilities

2.3 HVA Foods Limited- Summarized Interim Income Statement

For the six months ended 30 Sep 2010 2009

Rs. Rs.
Revenue 285,220,778 252,133,381
Gross Profit 48,660,907 40,571,975
Operating Profit 43,954,499 31,898,825
Finance Cost (14,310,351) (15,331,290)
PBT 29,644,148 16,567,535
Net Profit 27,067,622 16,567,535

2.4 HVA Foods Limited- Summarized Interim Balance Sheet

As at Sep 30 2009 2010

Rs. Rs.
Non Current Assets 290,756,832 153,591,941
Current Assets 313,994,275 233,847,081
Total Assets 604,751,107 387,439,022
Capital & Reserves 126,978,742 24,339,790
Non Current Liabilities 146,970,330 129,722,324
Current Liabilities 330,802,035 233,376,908
Total Equity & Liabilities 604,751,107 387,439,022

2.5 Analysis of Financial Ratios

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 13
Year Ended 31 st March Six Months Ended 30 th Sep
2010 2009 2010 2009
Profitability
Revenue Growth 21% 4% 13% (2%)
COS/Revenue 81% 79% 83% 84%
GP Margin 19% 21% 17% 16%
Adm Exp Growth Rate 8% (52%) 36% 9%
Operating Profit Margin 18% 19% 11% 12%
Net Profit Margin 11% 4% 10% 7%
ROA 13% 4% 6% 3%
ROE 145.6% 4079% 36% 101%

Liquidity
Current Ratio 1.04 1.03 0.95 1.00
Quick Asset Ratio 0.88 0.76 0.82 0.85

Investor Ratio
EPS 1.17 0.32 0.62 0.36
NAV per share 1.44 0.17 2.77 0.52

Gearing
LT Debt/Equity 425% 3387% 217% 1151%
Interest Coverage 2.86 1.31 3.02 2.08
Total Liability/Equity 6.08 41.84 3.62 14.92

Company’s turnover shows an ever increasing trend over years in the year 2010, revenue has
increased by 21% over the previous year. Interim result also shows an increase in turnover. This
positive trend will continue in the foreseeable future as the company will acquire the ‘heladiv”
brand rights from HVA Holdings (Pvt) Ltd after the IPO and due to fact that there is a growing
demand for the value added teas.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 14

Company maintains a fairly consistent Gross Profit margin of around 18% which is sufficient to
cover the administrative and financial expenditure of the company.

With regard to the Net Profit Margin also, financial statements shows a healthy position. Except
in the years 2007 and 2008, company has recorded net profits margin of around 10%. Out of the
total overhead expenditure, finance cost alone accounts for about 50% of the total overhead cost.
This shows the company’s high leverage position at the moment. As shown by the summarized
income statement, Finance cost has suddenly increased from Rs. 1.7 Mill in the year 2006 to Rs.
23 Mill in 2007. During the last six months administrative expenditure also has increased
shapely by 36% over corresponding period of the year 2009.

ROA of the company remains at a comparatively low level of around 5%. This ratio indicates of
how profitable a company is relative to its total assets. ROA gives an idea as to how
efficient management is at using its assets to generate earnings. ROA for companies can vary
substantially and will be highly dependent on the industry. Therefore it is best to compare it
against the company's previous ROA numbers or the ROA of a similar company. Most probably
the company’s asset base is high that is why the ROA is taking a low value when it is making
profits. The assets of the company are comprised of both debt and equity. Both of these types of
financing are used to fund the operations of the company. The ROA figure gives investors an
idea of how effectively the company is converting the money it has to invest into net income.
The higher the ROA number, the better, because the company is earning more money on less
investment.

ROE ratio has recorded a very abnormal figure of 4079% in the year 2009 and reduced to
145.7% in 2010 and further reduced to 36% in the interim period. ROE measures the amount of
net income returned as a percentage of shareholders equity. In other words, Return on
equity measures a corporation's profitability by revealing how much profit a company
generates with the money shareholders have invested. The reason for the abnormal ROE in the
year 2009 is mainly due to the low equity value of Rs. 7.7 Mill which has resulted from a
negative retained profit of Rs. 103 Mill. In the year 2010, company has further revalued its assets
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 15
up to Rs. 134 Mill and increased profits have reduced the retained loss up to Rs. 49 Mill. As a
result ROE has decreased significantly.

Current ratio of the company remains at 1.00, this is below the accepted norms and company will
have to face the liquidity problems. However one objective of the IPO is to obtain funds for
working capital requirements, company expect use Rs. 76 Mill of the proceeds from share issue
for the working capital requirement. Therefore company will improve its liquidity in the future.
Quick asset ratio prevails close to 1.00 which enables the company to meet its short term
obligation effectively.

2010 2009 2008

Stated Capital (Rs.) 15,000,020 15,000,020 15,000,020

No of Ordinary Shares in issue 46,500,062 1,500,002 1,500,002

As at the date of prospectus, the stated capital of the company is Rs 15,000,020 divided into
46,500,062 fully paid ordinary shares. The company has sub divided each ordinary share into 31
ordinary shares on 29th September 2010. Above mentioned EPS ratios have been calculated to
reflect the new number of post split shares. As a result EPS shows a very low amount of Rs.
1.00.

NAV per share of the company has a value of Rs.2.77 as at 30th September 2010, this value is
very low because of the share split carried out by the company. This is more commonly referred
to as book value per share, is usually below the market price per share. The historical cost
accounting principle, which tends to understate certain asset values, and the supply and demand
forces of the market place generally push stock prices above book value per share valuations.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 16
When it comes to gearing strategy HVA Foods LTD has followed a high leveraged policy
and as at 30th September 2010, it recorded 217%. The total liabilities were 3.6 times more than
the equity capital. The business of the company is still in early stage of its life cycle and business
risk is high, therefore financing through debt capital which is also risky is not suitable method
and company has not adopted the correct strategy as far as its capital structure is concerned.
However since the company was a private entity, they did not have many option other than the
debt capital. Most of these long term loans are term loans obtained from Seylan Bank. However
company has been able to harvest the full benefit from the low interest regime now prevailing in
the market by obtaining loan capital. It is vital that company should reduce its leverage
immediately. The main objective for the company to go public is to reduce leverage. In order to
increase the equity capital, company has decided to go for a Public Offering. There is a very
conducive environment prevailing in the country for equity capital raising, which is to the
advantage of the company.

3.0 Calculation of cost of capital of the company

3.1 Cost of equity

3.1.1 CAPM approach

From the company’s perspective, the expected rate of return is the cost of equity capital. Under
the CAPM, the expected return on the stock is:
Ke = Rf + β (Ṝm- Rf)
Where,
Rf = The risk free rate
β = The company beta
Ṝm = Market Rate of Return

3.1.1.1 The Risk Free Rate ( Rf )

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 17
In this assignment we used annual interest rate of Sri Lankan government Treasury bill rate as
the risk free interest rate. As at 22nd February 2011 primary rate of 364 days Treasury bill rate is
7.33%

Treasury Bills- End Week- 364 days

Date Rate
18.02.2011 7.33%
11.02.2011 7.33%
03.02.2011 7.33%
28.01.2011 7.33%

3.1.1.2 The Company Beta ( β )

The beta coefficient is a key parameter in the Capital Assets Pricing Model. This measures the
part of the asset’s statistical variance that can’t be mitigated by the diversification provided by
the portfolio of many risky assets, because it is correlated with the return of the other assets that
are in the portfolio. Beta can be estimated for individual companies using regression analysis
against a stock market index.
Beta also referred to as financial elasticity or correlated relative volatility, and can be referred to
as a measure of the sensitivity of the asset’s returns to market returns, its non- diversifiable risk,
its systematic risk, or market risk.
HVA Foods does not have its beta value yet therefore we had to take the Beta value of a similar
company for our calculations. We have taken the Beat value of Watawala Plantation of which
beta value is 1.46 against All Share Price Index (ASPI) as of 22nd February year 2011. (Declared
by Colombo Stock Exchange) This beta value includes positive sign and means that the asset
generally follows the market.

3.1.1.3 Market Rate of Return ( Ṝm )

Market rate of return consists of two parts as the dividend paid at the end of period and the
change in the market value of equity shares over period. Therefore we assumed that the change
in the all Share Price Index reflects the change in the market values of the total equity market
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 18
portfolio while market dividend yield rate was taken as the dividends of the market portfolio.
Monthly ASPI for the year 2010 is shown in the below table.
Month Index Value
Jan-10 3636.4
Feb-10 3807.9
Mar-10 3992.5
Apr-10 4188.9
May-10 4237.2
Jun-10 4612.5
Jul-10 5161.2
Aug-10 5668.0
Sep-10 6997.2

Oct-10 7147.77
Nov-10 6434.0
Dec-10 6360.84

The growth rate of the ASPI for the year 2010 is about 100%. But market overreaction is the
main reason for high growth when compared to the previous year. Hence we would not take this
abnormal growth rate and take the average rate of 13% as market growth rate, while dividend
yield of the equity market is 1.2 in January 2011.

Therefore Total Market rate of Return = Growth Rate of ASPI+

Market Dividend Yield
Rm = 13+1.2
Rm = 14.2%
By substituting; Rm = 14.2%
Rf = 7.33%
β = 1.46
Ke = Rf + β (Ṝm- Rf)
Ke = 7.33%+ 1.46( 14.2%-7.33%)
Ke = 17.36

3.1.2 Discounted Cash Flow Approach

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 19
Ke = D1 + g
P0
Dividend per share in 2010 = Not Declared
Market Value per Share in Feb 2011 = 25.00
Since the company has not disclosed any dividend from the inception, we are unable to use
discounted cash flow method to calculate the cost of equity.

3.2 Cost of Debt

The company is presently having a 12.0% of interest bearing long term loan. The company
enjoys a concessionary tax rate of 15% for 20 years from 1997 according to the BOI agreement.
Budget for 2011 has further reduced it to 10%.Therefore the cost of debt can be calculated as

Kd = Kd (1- T)
Therefore the cost of debt of the company can be calculated as,
Kd = 12.0% (1- .10)
= 10.8%

3.3 Weighted Average Cost of Capital-Pre IPO

The WACC is the minimum return that a company must earn on an existing asset base to satisfy
its creditors, owners, and other providers of capital, or they will invest elsewhere. Therefore the
WACC can be calculated as follows.
WACC = KeWe+ KdWd
Value Weights
(approximately)
Ordinary shares = 15,000,020 5%
Long Term loan = 283,000,000 95%
Total = 298,000,020 100%
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 20
The WACC can be calculated as,
WACC = KeWe+ KdWd
Ke = 17.36
Kd = 10.8%
We = 5%
Wd = 95%
WACC = 17.36% X 0.05 + 10.8% X 0.95
WACC = 11.12% (Pre IPO)

The Above financial summarization and indexes shows the unhealthy capital structure with
heavy financial obligations. The gearing and the financial leverage of the company is high
and drain-out of earning by way of interest payment for the borrowing is observed. The
cost of capital is around 11% and some concern on that should also maintain as the
industry average is little less than the company’s prevailing cost of capital. Further, the
company has identified the requirement of technology updating in manufacturing new
products such as ice tea, Herbal tea, and tea based personal care products etc. in order to be
competitive in the market. Such activity substitutively demands fund for working capital
requirements too. This emerge the requirement of funding and hence the company has to
focus on fund raising options which also match with the requirements of solving the
current ill effected financial position of the company.

4.0 Financing For The Business

For any kind of small businesses, financing is the key to unlocking exporting deals. Whether
Starting a Company or expanding one, raising capital is the most basic of business needs. For
both startup businesses and growing & mature businesses, there are a number of financing
options and alternatives available. The companies need to acquire raw materials, materials,
components, to upkeep the production process long before cashing the sold production
equivalent value. Therefore, in order to cope with the necessary cash, the firm needs to have a
considerable reserve fund. There are two general types of financing: equity and debt financing.
The more money, or equity, you have invested in your business, the easier it is to attract
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 21
financing. If your firm has a high ratio of equity to debt, you should probably seek debt
financing. However, if your company has a high proportion of debt to equity, you should
increase your equity before you borrow additional money. That way a company won't be over-
leveraged to the point of jeopardizing your company's survival.(Hodgman,2005). In the light of
above, export oriented businesses, such as HVA Foods Limited can tap into a variety of other
financing resources to assist them with exporting their goods and services overseas.

5.0 Options Available for Financing

5.1 Mergers and Acquisition

As we all know Mergers and acquisitions improve market efficiency by capturing synergies
between firms. Mergers and acquisitions (more generally, takeovers) are an important means
through which companies achieve economies of scale, remove inefficient management, or
respond to economic shock (Croson et al.,2004).However issues such as corporate culture
mismatching , corporate governance issues, downsizing, employee layoff, etc., can be occurred
due to the Mergers and Acquisition. Some time the identity of the original organizations may be
totally changed. Therefore although financial benefits are embedded with Mergers and
Acquisition, this cannot be considered as good means of alternative finance specially due to
above mention cultural and social problems which directly affect the employees of the
organization.

5.2 Bank Borrowings(Loans) :

Used especially when the liquidity necessity exceeds the temporary firm‘s needs and usually
used for the acquisition of fixed tools and capital goods, the costs
concerning the credit depending on the loan duration, on the risk level, on the requested
sum and on the creditor‘s reputation. The bank’s long-term financing generally
used for large capital goods .However current Bank Borrowings for this organization is
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 22
very high and therefore this is not a good alternative for this organization.

5.3 Trade Credits:

Trade credits can be explained as follows: for example, a raw materials provider accepts to cash
the equivalent value of the delivered products on a subsequent date, crediting this way the
producer).

5.4 The Factoring:

As per Ross et al(2009) factoring refers to the sale of a firm’s accounts receivable to a financial
institution known as a “Factor.”The firm and the factor agree on the basic credit terms for each
customer. The customer sends payment directly to the factor , and the factor bears the risk of non
paying customers. The factor buys the receivables at a discount, which usually ranges from 0.35
to 4 percent of the value of the invoice amount. The average discount throughout the economy is
probably about 1 percent.

The biggest disadvantage to factoring is the fees and discount that the selling company must pay.
The seller of the receivables must determine that the fees and discount are less than what he
would spend to collect all of the receivables in a timely fashion.
Additionally, it can be difficult to manage customer accounts that have been sold to a factoring
agency. Some customers may find this practice misleading and think they have been turned over
to a collection agency

5.5 Government Support:

Government can support to the organization by means of Interest free loans, Tax benefits, etc.
Still it is depend of countries Political, Economic, Socio cultural, Technical and Legal factors.
Therefore uncertainty is very high for this kind of financing.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 23

5.6 Installments buying:

It eliminates the integral financing problem of the equipments‘acquisition; the difference

between the leasing and the installments buying is that at the end of the period, the goods remain
automatically to the person who used them if they are paid by installments. However this is
particularly applicable machine and therefore this cannot be considered as good overall financing
method.

5.7 The leasing:

It offers the possibility to obtain equipments, machines, installations etc. without being necessary
to pay the integral equivalent value; through leasing, these are given to the beneficiary by a
specialized firm, in exchange of 3-5 year installments; It has become increasingly more common
in recent years for companies to lease equipment. A lease is an agreement whereby the lessor
conveys to the lessee in return for a payment or series of payments the right to use an asset for an
agreed period of time (ICASL, 2005).

Typically a lease can run anywhere from one to five years. Most equipment necessary in
commercial businesses today, including technical equipment, can be leased. Some leases provide
an option to then purchase the equipment at substantially less money when at the end of the term
of the lease. By leasing equipment, if structured properly, company can maintain its credit
availability, as the lease debt does not have to be considered a direct liability on your financial
statements (ICASL, 2005).. This is advantageous, as it does not limit your ability to borrow from
lending sources. Apart from that some obvious advantages of lease financing are: an option to
buy equipment at end of lease term; it is easier to obtain lease financing than loans from
commercial lenders; offers potential tax benefits (depending on how the lease is structured);
Leasing better utilizes equipment (i.e. the company lease and pay for equipment only for the time
they need it); less upfront cash outlay (i.e. do not need to make large cash payments for the
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 24
purchase of needed equipments); upgrading of equipments can be done easily, as new equipment
becomes available, the company can upgrade to the latest models each time where lease is ended.
As we know technology change very fast, and hence the cost of continually buying new
equipment to meet changing and growing business needs can be difficult for most small
businesses. For this reason leasing is very advantageous.
However some of the obvious disadvantages of lease financing are: The Company has an
obligation to continue making payments; no equity until you decide to purchase the equipment at
the end of the lease term, at which point the equipment has depreciated significantly; Although
the company is not the owner, they are still responsible for maintaining the equipment as
specified by the terms of the lease. Failure to do so can prove costly.

5.8 Initial Public Offers (IPO)

Initial Public Offers (IPO), also known as public offering, are usually issued by those companies,
mainly small and young, who ask for capital to grow. Sometimes, some big private organizations
also issue IPO to trade publicly. Initial Public Offering is basically the first sale of stock to the
public by a private organization.

By issuing either equity or debt a company can earn money. If the company does not issue equity
to public then it will be called an IPO. If a company wishes to go public then it has to hire an
investment bank, a financial intermediary which does several services including underwriting,
facilitating the mergers, acting as an intercessor between the investing public and a security
issuer. In an Initial Public Offer, the issuer gets the help of an underwriting, method of issuing
the insurance policies, firm regarding the determination of security to issues. That firm also
assists the issuer to determine the best prices of the issues that can be offered and the time of
bringing it into the market. (Ross et al, 2009).
To get to a filing for an IPO, the work required usually entails up to a year of
preparation, including completion of audits and due diligence, and the inevitable cleanup and str
aightening out of corporate and financial records. Obviously, a company will also be
required to support the revenue and other business metrics that can lead to a successful
IPO before the underwriters will take a company to market.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 25
5.9 Right Offering
As defined by Morgenson and Harvey (2002), Right offering is a popular means of raising
capital by offering shareholders the opportunity to buy additional share of the same stock at a
price bellow the current market value. Company uses a right offering when it sells new share to
existing shareholders rather than selling new shares to the entire investment community. The
rights are used as a means to distribute new shares to existing holders on the basis of the share
each holder already owns.

6.0 Initial Public Offering IPO

6.1 Decision to IPO

The Company’s Financial Statements shows that negative net cash flow of Rs, 9,648,090 and
Current liablities exceeded current assets by Rs. 14,041,481/-. Therefore, it shows company has
liquidy problems.
To solve that the company can go for one of the following alternatives.
1. Debt Financing

2. Lease Financing

3. IPO ( Initial Public Offering)\

If the company go for a debt financing, they should go for long term debt, However, curent debt
equity ratio does not permits for futher borrowings, therefore the debt finacing would not make
sense. .
Lease financing is also a method of financing. Since there is advantage in some aspects such as
depriciation & tax shealds, the comany can utilized the tool in fulfiling the requirement of
updating the techneoloy by way of purchasing machinery. However, leaseing would not
contribute to reduce the company's gearing position. Therefore, use of lease financing would be a
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 26
parial solution for the problem. By contrast, IPO has come to the attention of the company. There
were evidences that latest IPO is the country had immense succesess and the govenment support
and the tax benefits are also there. therefore, company has decided to go for an IPO to solve thier
liquidity issues and fund reqiremnt in updating the technology reaqirement of the company

6.2 Estimating The Initial Capital Requirements

The Company intends to raise funds through an initial public offering to finance the following
activities, in the order of priority.

(i.) Allocation of LKR 45 million for payment for the acquisition of HVA Holdings (Private)
Limited for the assignment of international brand rights of “HELADIV” to HVA Foods Limited.
The ‘HELADIV’ trademark is owned and registered under HVA Foods (Private) Limited and for
commercial purposes is employed by the HVA Group. This trademark has enabled consumers
with a means of identifying and distinguishing the ‘HELADIV’ brand of products produced by
HVA Group against the goods supplied by any other entity.
The value of the ‘HELADIV’ brand as at 31st December 2009 has been estimated at USD 1.08
million to USD 1.24 million (with a mid-point value of USD 1.16 million). At a US dollar to Sri
Lankan rupee exchange rate of USD 1 : LKR 114 this implies a value range in the order of LKR
124.0 million to LKR 141.6 million (with a mid-point of SLR 132.8 million). This brand value
has been assessed employing the relief from royalty approach, a generally accepted valuation
approach where value attributed to an intangible asset is estimated based on the notional royalty
expense savings from ownership of the brand vis-à-vis royalties or franchise fees payable on an
arm’s length basis to a third party in return for the right of use of such brand.
‘HELADIV’ brand value has been estimated based on the five-year forecast sales amounts
provided by management, estimated royalty rate applicable to the associated brand sales
generated and computation of notional post-tax royalty streams, net of any associated marketing
expenses generated thereafter. These post-tax royalty streams have been discounted at the
company’s post-tax weighted average cost of capital in order to arrive at the assessed brand
value.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 27
Further, different market segments catered to by the ‘HELADIV’ brand have been reviewed in
order to assess the brand proposition within the respective market segments.
(ii.) Approximately LKR 95 million will be utilized to reduce gearing of the Company.
Term Loan Settlement
Seylan Bank (USD 650,000 @ LKR 115/-) LKR 74,750,000.00
Bank of Ceylon LKR 20,000,000.00
Total LKR 94,750,000.00

(iii.) Approximately LKR 102 million will be utilized for Ice Tea plant to be upgraded from a
pilot plant to a commercial plant and for expansion of facilities in the existing factory. Current
capacity of the pilot plant is 100,000 litres of ice tea per month. Subject to the current trial
shipments and initial marketing efforts bringing in improved orders, the capacity in the medium
term needs to be increased to 300,000 litres per month. This will require approximately LKR 26
million which will cover the securing and expansion of land and building and installation of
machinery.
As for the expansion of the existing factory, most of the current machines need backups and
increased capacity. The current tea bagging capacity of the Company is well below the required
demand. Hence, approximately LKR 76 million will be utilized for expansion of the current
operations.

(iv.) Company will need about Rs. 76 Mn to finance the incremental working capital
requirements of HVA Foods Limited such as retiring expensive short term borrowings and to
ensure smooth and efficient operations at the factory by maintaining adequate buffer stocks.

Altogether Rs. 318.8 Mn has been estimated as the total capital requirement of the company. A
summary is given below.

Sources of funds (Rs in millions):

Funds to be raised through IPO 318.86

COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 28
Utilization of funds (Rs. in millions):

Acquisition of HVA Holdings (Pvt.) Ltd. 45.00

Settlement of term loans 94.75

Expansion and Technology Upgradation 102.00

Incremental Working Capital Requirements 77.11

Total 318.86

6.3 Valuation of share price for HVA Foods (Pvt) Ltd

6.3.1 review and performance analysis

Income 2008 2009 2010 2011 2012 2013 2014 2015
Statement
(in 000
LKR)
Revenue 386,866 402,379 488,206 749,241 935,782 1,123,075 1,260,018 1,327,821
Gross Profit 54,594 84,893 93,483 168,963 209,464 270,641 302,632 381,792
Finance Cost (31,287) (58,386) (29,926) (21,168) (15,292) (13,920) (13,010) (12,800)
Net (16,463) 14,818 54,275 79,350 118,680 176,382 208,610 294,582

Profit/Loss

Balance
Sheet
Fixed Assets 160,853 158,111 197,643 230,308 260,686 265,688 270,340 274,666
Current 177,445 174,815 274,690 565,910 661,288 834,784 1,050,978 1,337,330

Assets
Total Assets 338,297 332,926 472,333 796,217 921,974 1,100,472 1,321,318 1,611,996
Stated 15,000 15,000 15,000 333,857 333,857 333,857 333,857 333,857
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 29
Capital
Revaluation 96,136 96,136 96,136 96,136 96,136 96,136 96,136 96,136

Reserve
Accumulated (118,182) (103,364) (44,401) 34,948 153,628 330,010 538,620 833,202

Profit
EPS(Diluted) (0.25) 0.32 1.17 1.58 1.79 2.66 3.14 4.43

HVA has an edge over its competitors in the industry due to innovation and diversification in to
Tea extract based products and tea concentrate. In 2009 export volume of value added tea market
decline by 9.4% where as the companies volume is increased by 18%. The company owns the
brand, unlike other exports who packed for third party brands. Heladive is recognized as one of
the top five brands in Sri Lanka. Overall prices were expected to fall by 37% in 2010. The
Middle East region import bulk tea while the company’s presence is growing in Europe and
USA.
Half yearly position from April to September 2010 of Year 2010/11 has recorded the 13%
growth in revenue and 63% in Net Profit. The growth was lower than anticipated. The Net Profit
for six months ended September 2010 is Rest 27.07 Man as against Rs. 16.57Mn recorded during
the corresponding period of year 2009/10 and Net Profit margins are at 7% and 10%
respectively.
The revenue of the company has recorded a compound annual growth rate of 10% during the five
year period from year 2005/06 to year 2009/10 during 2009 the overall tea industry adversely
affected due to bad weather condition. HVA was able to sustain positive growth backed with
price escalation. From 2007-09 export price of HVA have shown a growth rate of 9%.
It is expected the group revenue to record the 53% growth in year 2010/11 and 31% in 2011/12
with export, local sales and contract packaging contributing 25%,50% and 18% respectively.
Commercial production of 5000 Lts to 7000Lts of tea concentrate would be produced, which in
the year 2011/12 will amount to marketable value of approximately Rs. 100 Mn.
HVA has ventured in to new businesses such as tea, cosmetics and pharmaceutical market which
include skin care, oral care, body care, facial care and tea tablets which will generate additional
business in other countries. HVA has also moved in to Chinese market by setting up franchise
outlets adding to growth in revenues.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 30
GP margins are below the industry average due to high cost of sales however operating margins
at average 13% is in line with the industry average of 16%.GP margins are assumed to be
maintained in the range of 22-23% in the years 2010/11 and 2011-12. substantial brand building
expenses led to high financing cost and volatile net profit growth during the previous year.
However, the last two financial years have recorded significant growth as against the lost of Rs.
16.46Mn reported for the year 2007/08, with year 2008/09 net profit being Rs. 14.82Mn and year
2009/10 recording a 266% growth to Rs 54.27Mn with net profit margin of 11% improving from
4% net profit margin in year 2008/09 as the finance cost decrease by 49%.
6.3.2 valuation
Valuation Range
PE Multiples(x) 9 10 11 12
Value per Share 16.11 17.9 19.69 21.48

Price Earnings Ratio(x)

2011 2012 2013 2014 2015
10.12 8.93 6.01 5.09 3.61

It is expected that HVA will report net earnings of Rs 79Mn in year 2010/11 recording a 46.21%
growth and Rs 118.68Mn in year 2011/12 with 50% growth. The valuation range for HVA on PE
multiples ranging from 9x to 12x on year 2011/12 values give the share a valuation of Rs 16.11
to Rs 21.48.
The IPO Price is an attractive on the basis of offering PE of 10.12x for year 2010/11 and 8.93x
for year 2011/12 respectively, compared to the Beverage, Food and Tobacco sector, which
currently trade at 22.4,the stock has strong potential for growth value appreciation in the
secondary market

6.4 Underwriting
The offer is not underwritten and is not conditional upon any minimum subscription is being
met.

6.5 Association of Investment Bank

They have decided to use the services of DFCC Vardhana Bank as the Bankers to the offering
maily due to the investment expertise of them.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 31

The IPO was a success and went oversubscribing. The countries economy is at a transition period
since the Government policies highly influencing to reduce the interest rates. The debt interest &
risk free interest rates have gone down shown high enthusiasm in the stock market. This has lead
to improve cost of equity. And hence investors are highly keen to invest in stock market. This
has being the key factor for the success of the IPO.

7.0 Post IPO Evaluation

7.1 Capital Structure & Weighted average cost of capital-Post IPO

The company has been able to achieve a sound capital structure after the IPO and debt equity
ratio has improved. The Company offered 19,928,598 ordinary shares at Rs. 16 per share, which
generated Rs. 318 Mn and after the proposed debt settlement the debt equity position of the
company as follows.

Value Weights
(approximately)
Ordinary shares = 333,000,000 64%
Long Term loan = 188,000,000 36%
Total = 521,000,000 100%

And the WACC can be calculated as,

WACC = KeWe+ KdWd
Ke = 17.36
Kd = 10.8%
We = 64%
Wd = 36%
WACC = 17.36% X 0.64 + 10.8% X 0.36
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 32
WACC = 15% (Post IPO)

The compression of pre and post waited average cost of capital shows an increase. This is an
unfavorable situation for company’s expectation. However, ease out the operation by improving
the cash flows by volumes. Current financial leverage will ease out the company to forecast with
future projects since those projects could be finance by bank borrowings resulting to reduce the
overall cost of capital.

There is no such time frame to comment on whether the shares has been under priced as the
issues was perform recently. However, during this small period the share price of the company is
observed that taking the normal behavior and has increased up to Rs. 26/-. This indicates that the
company is able to keep the promise to it stakeholders and IPO has been performed on fire
grounds. The Vital achievement that the company has obtained is the flexibility in its financing
and should focus to increase debt: equity ratio to 60:40 in reaching health cost of capital by
borrowing for future projects.
COST STRUCTURE MODIFICATION OF HVA FOODS LIMITED 33

8.0 Reference & Bibliography

Ross, S. A., Westerfield, R. W., Jaffe, J. F.,Kakani, R.K. (2009) Corporate Finance, Advanced
Corporate Finance :Tata McGraw Hill,8th Edition
Hodgman.,B.,Small Bussiness, December 12, 2005 Inside Tucson Business pp9
Croson R.T.A.,Gomes. A, Mcginn.,K.L.,Noth.,M., (2004)Mergers and Acquisitions: An
Experimental
Analysis of Synergies, Externalities and Dynamics Kluwer Academic Publishers. Printed in the
Netherlands
Institute of Charted Accountants Sri Lanka (ICASL), Sri Lanka Accounting Standards,SLAS 19
Revised(2005)
http://www.ehow.com/about_5157898_disadvantages-factoring
receivables.html#ixzz1F7l2VhLv
http://www.ces.lk