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Bottomline: Smart Inc is set to lever up

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Cheap money doesn’t last forever, and the smart are making the most of the opportunity. Keep them on your radar.

Bottomline: Smart Inc is set to lever up
Interest rates have bottomed out. I'm not saying that HDFC's Keki Mistry has told CNBC-TV18 on more than a few occasions that interest rates for all practical purposes have bottomed. With the US Federal Reserve set to tighten liquidity and most other central bankers (ex-China) looking at similar measures, the cost of money is set to rise, even though it may not be sharply.
In this context, Reliance Industries' $4 billion long-term money raise at fine rates should be taken as a cue. There is money to be had today with financiers in the US parking on average surplus cash of about $1.5 trillion in the overnight reverse repo window.
But how long that big money will be available, and at fine rates remains the big question. Irrespective of the answer, though, as is often opined in the corporate world, it is wiser to raise money when you can than when you need it. Given this, one could expect the smart and nimble to lever up in the near future on low-cost debt. And that has relevance for equity investors and their returns too. We’ll get into that, but first, let's look at the lay of the land.
Capex revival ahead
Large banks like State Bank of India have indicated to CNBC-TV18 recently that they are seeing an uptick in credit for capex after a hiatus, and that’s a healthy sign for the economy. At the same time, though, economic pundits point to the output gap, suggesting there is still scope at current capacity to enhance output. My hunch is, that while the output may be there, the existing output in weaker hands may well be displaced by increased output in stronger hands. Simply put, many of the smaller units would be displaced by the large (dominating the listed universe).
If our focus is on the leaders and large players across sectors, we may well see capex pick-up in the near future. Some have already announced plans independent of policy push, while others are expanding to capture the incentives and opportunity accorded by the Production Linked Incentive (PLI) scheme for specified sectors. And if that's the case, the cost of capital becomes key in determining returns for shareholders.
It is here that the debt component kicks in. The cost of debt used to fund such projects can significantly impact long-term returns and shareholder value.
Assume a Rs 2,000 crore loan taken at 6 percent and alternatively at 7 percent simple interest. The difference in annual cost is Rs 20 crore. That's Rs 20 crore that could make its way to you as a dividend.
Debt isn't always a good thing. In fact, many frown upon it. But the truth about debt is a little more nuanced. Nothing in business or life is good or bad, as long as there is moderation and balance. The same holds true for debt. You may not be able to afford to buy a house in cash, hence the housing loan. Similarly, it may not always be prudent for a business to build capacities with just equity.
The leverage picture
India Inc has had its trysts with debt. Many have learned that it is a double-edged sword, if not managed well. It is often easy to raise, but tough to repay. Many a corporate has had to resort to asset sales and restructuring to get their debt profile in order. In fact, deleveraging has been the mantra of late, and investors have generally turned averse to debt-laden companies. Zero debt, isn't always a great thing. That's something we'll delve into. But first, let's try and get a fix on how highly India Inc is levered.
A study of the BSE-500 non-financial companies over the past 15 years shows that debt-equity weighted by value and on average (unweighted) has declined from its peak in fiscal 2014 to fiscal 2015. The weighted debt hit a high in financial year 2020, but the average debt-equity of companies had declined significantly. The weighted number in fiscal 2020 was driven by big debt additions by several public sector enterprises and a few top conglomerates and large metals and auto players. A lot of this was corrected in 2021, as buoyant equity markets helped these big corporations pay down debt.
 
At the end of the last fiscal, both the weighted and average debt-equity stood at a comfortable 0.6-0.66x level. This provides some comfort and room for prudent expansion.
Why debt is an option
A business should be driven by one key motive: the maximization of profit, but with managed risks and social responsibility. Given this, it makes sense to evaluate the cost of capital before opting for a debt or equity raise. Whatever maximizes profit, without enhancing risk beyond a reasonable limit should be the path to take.
Let’s look at a simplified illustration of how the cost of capital can impact profitability for shareholders. The key variables used here are the quantum of debt and the price per share for a fresh issue to raise an amount of Rs 1,000 crore for capex. The impact is indicated for the first 12 months, when this money yields nothing and adds nothing significant to productive capital assets.
It is clear from the illustration that below a certain price, equity becomes earnings dilutive — Rs 100 per share issue price in this instance. And hence debt would be the preferred option. Given that equity raise may not be as cheap as it has been in the recent past and debt could get dearer, this could be a good time to garner the best of both worlds.
How much profit you generate is also a key function of the cost of capital. Several companies have a better earnings profile than peers because despite similar productivity metrics, they score on the cost of capital. Ability to raise capital cheap is a significant contributor to return on equity and capital. Given this, it pays for investors to track capital moves by corporates to assess what it spells for earnings expansion going forward.
EARNINGS SENSITIVITY
EBIDTA10001000100010001000100010001000100010001000
Debt10009008007006005004003002001000
Interest @6.5%6558.55245.53932.52619.5136.50
Depreciation300300300300300300300300300300300
PBT635642648655661668674681687694700
Tax @25%159160162164165167169170172173175
PAT476481486491496501506510515520525
No. of Shares (cr)100100100100100100100100100100100
CMP (Rs/shr)5050505050505050505050
Fresh Issue (shr cr)02468101214161820
EPS (Rs)4.764.724.674.634.594.554.514.484.444.414.38
CMP (Rs/shr)7575757575757575757575
Fresh Issue (shr cr)01.32.745.36.789.310.71213.3
EPS (Rs)4.764.754.734.724.714.694.684.674.664.644.63
CMP (Rs/shr)100100100100100100100100100100100
Fresh Issue (shr cr)012345678910
EPS (Rs)4.764.764.764.774.774.774.774.774.774.774.77
CMP (Rs/shr)125125125125125125125125125125125
Fresh Issue (shr cr)00.81.62.43.244.85.66.47.28
EPS (Rs)4.764.774.784.794.84.814.824.834.844.854.86
Amount in Rs crore
Capital cost & returns
As a rule, when it comes to a choice between a highly credited rated company vis-à-vis a weaker credit profile company, you must opt for the higher-rated business, other things remaining constant.
Think of it as buying a stock 10 percent cheaper than you did. Imagine what that does to your returns. Happy investing.
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