North India Metals1

Dr. Rahul Singh2 and Honey Joshi3

After having a tremendous growth in sales for the last four years, the North India Metals (NIM) was pondering about the stagnation in sales for the current year. This issue finally came to Governing Board for critically evaluating the possibilities to get the momentum going. Mr. James, Managing Director of North India Metals is in a state of confusion to justify the progress path of the organisation. It is a small sector company with a turnover of around INR 1060 million. The company is mainly into exports of casting components and offers a very justified portfolio of low cost and good quality option for foreign companies. Thus the company is enjoying increasing demands for the last four years due to increasing business internationally. There is a minor ratio of domestic business in the profit pie.

1.0 Background
There are more than 5,000 foundry (place of casting metals) units in India, having an installed capacity of approximately 7.5 million tonnes per annum. The majority (nearly 95%) of the foundry units in India fall under the category of Small and Medium Enterprises (SME). The foundry industry is an important employment provider and provides direct employment to about half a million people. Small sector industry being an important part of foundry industry makes it necessary to have proper growth of these small scale units. Thus small scale units require the necessary funds at regular intervals for proper growth; hence the valuation becomes an important parameter for the assessment of these units. The reason of doing valuation of the small companies at a justified interval is that the funds can be made available as evaluated through the valuation of the units and not just on the financial statements provided by the company. North India Metals was established in 1983. NIM is a manufacturer of fully mechanized cast components made of copper, aluminium, zinc and ferrous alloys. Its head office is located in Delhi, India and it has manufacturing facilities in and around Delhi at 5 locations. The range of all the manufacturing units is within 50 kms, except one which is in another state (Rajasthan) close to Delhi. The Company Specialises in Sand Casting, High Pressure Die Casting, Investment Casting, Gravity Die Casting, Stamping, and Forging of Tubes. North India Metals exports its products to USA, Canada, Germany, Australia and China. 1.1 Organisation Structure NIM, a small scale industry, started as a small organisation headed by Managing Director, Mr. A James. This was established under the view of increasing demand of the industry and also the past experience of the Managing Director in the sector. The organisation structure always has been very flat and dependent on very few persons in the initial 15 years. With the increasing work and specially year 2000 onwards organisation had a very strong progress chart which also increased the manpower size of the organisation. Since NIM had developed many manufacturing units, it was
1

This case has been developed on the research conducted on an organisation which is named North India Metal (the real identity of the organisation is hidden). This has been done to avoid attention of critical analysis of the companys financials and its strategy. "(c) 2008, Rahul Singh and Honey Joshi, Birla Institute of Management Technology, all rights reserved. 2 Assistant Professor, Birla Institute of Management Technology, Greater Noida, India. 3 Masters programme student, Birla Institute of Management Technology, Greater Noida, India.

important and critical to transfer some of the powers to the heads of respective units and make them accountable. However MD Mr. James was very good person, he took some time to decide to develop a strong system and performance appraisal on the issue. Figure 1: Organisation structure
Board of Directors

Mr. A James Managing Director

Director of Unit Libaspur

Director of Unit Sahibabad 1

Director of Unit Sahibabad 2

Director of Unit Faridabad

Director of Unit Neemrana

Box: Brief History of NIM

1983- The North India Metals started its business by opening up a production unit in Libaspur, Delhi. The company started with Copper Foundry. This unit was a 100% export unit and manufacturing electrical wiring accessories. The company took over all operations related to export of the assignments and did not involve any outside vendors for any functional service support like assembly, packaging and dispatching. 1989- This year company started with another plant at Sahibabad. This plant was an Aluminium Die Casting plant. The plant is producing electrical wiring accessories. 90% of its output is exported. 1991- In 1991, the company started with Zinc Die Casting at Sahibabad plant. The companys product line remains same and so the process. This was started to increase the product portfolio to meet the fresh demands in the international market. 1997 In order to meet the increasing demand and looking at the growth in the sector, the company started one more plant in Faridabad. This plant was converted to a EOU (export oriented unit) in 2005. Faridabad plant is a Sand Casting unit with semi automatic sand plant and induction furnace to melt copper. It has a capacity of 100 ton of casting and machining of copper, aluminium, stainless steel and CI castings per month. 2001- As a result of high and intensive demand in the USA market, it started wholly owned subsidiary in USA to warehouse and sell North India Metals products. In the same year, the company bought another unit in Sahibabad to strengthen the supply for meeting the demands. 2005 To increase the product portfolio further, NIM started investment casting facility at Faridabad plant. This was initiated to develop the capacity for casting of stainless steel. 2007 The company started the Neemrana unit in Rajasthan for steel tubes based components. Neemrana is approximately 125 kms from Delhi.

2.0 Industry Profile

The Indian Metal casting (Foundry Industry) is well established industry and has a long history of
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more than 150 yea India produces an estimated of 6 million Metric Tonnes of various grades of castings with International standards as per the recent survey of World Census of Castings by Modern Castings, USA4. The different types of castings which are produced are ferrous, non ferrous, aluminium alloy, graded cast iron, ductile iron, steel etc for application in automobiles, railways, pumps compressors and valves, diesel engines, cement/electrical/textile machinery, aero and sanitary pipes & fittings etc and castings for special applications. The business of the casting products is quite equally spread except the Grey iron castings which commands the major share of the market and accounts for approx. 70 % of total castings produced in India. The casting business is spread in cluster locations around India; however it has some dominant clusters in and around Batala, jalandar, Ludhiana, Belgaum, Chennai, Kolhapur, Rajkot, Coimbatore, Howrah, Agra, and Pune. Out of approximately 4500 units in India, 80% can be classified as Small Scale units and 10% each as Medium & Large Scale units5. The quality issue is one of the sensitive characters of the industry for international market which leads to a small number of companies eligible for international market. As such around 500 units are having International Quality Accreditations in India. If categorised at small and medium level companies, the capacity utilisation is not found very high and it ranges between 50-65 % of the total capacity. The large foundries are demanding, equipped with modern technology and are globally competitive. Due to obvious vision and goals of the organisations, large organisations are working at nearly full capacity. Most of the foundries have been following similar processing methods and install cupolas (furnace) which uses LAM Coke (burning material). Due to increasing environmental compliances which are restricting organisations in many ways to use inappropriate processing methods, there is growing awareness about environment and many foundries are switching from the cupolas to induction furnaces which follow the coke less cupolas and reduce the environmental hazards. Figure 2: Share of small & medium foundry industry in India

2.1 Employment The manpower feed to the industry is quite extensive. It directly employs about half a million people and indirectly about quarter a million people which very clearly indicates that it is labour intensive industry. The small units (employing manpower upto 30 persons) are mainly dependant on manual labourer. However, the medium and large units are semi or fully mechanized and some of the large units operating in India are world class. India has major competitive advantage over the foundry industries in the developed countries and one of the reasons of this leadership is low cost manpower. The labour cost of the industry account for 12-15% of the cost of the products. 2.2 Exports Though most of the consumption is from the domestic market only, export has been increasing in last few yea The exports are showing healthy trends which is increasing at 25-30% year on year basis as can be seen from the charts below. The current exports for financial year 2005-06 are
4 5

http://www.indianfoundry.com/commercial/index.html, extracted on 23rd May 2008. http://www.foundryinfo-india.org/About_Us/profile_of_indian.aspx, extracted on 28th June 2008.

approximately USD 800 Million. Since the export demand is mainly from the high value added products, the market size is special but not very large. As shown the export happens mainly from sanitary and industrial castings which contribute to approximately 80 % of the export market value. Figure 3: Trend of export of castings from India

2.3 Product Mix The produce of industry are mainly in the product list of Sand Casting, High Pressure Die Casting, Investment Casting, Gravity Die Casting, Stamping, Forging of Tubes and few other bi-products. The Indian Foundry Industry is trying to focus on higher value added castings to beat the competition developing from country competitors. With the increasing global demand and infrastructure development, grey iron is the major component of production followed by steel, ductile iron and non ferrous as shown below. Figure 4: Product mix of foundry industry in India

2.4 Investments India would need approximately USD 3 billion in investment to meet the demand of growing domestic industry and strong export drive. Following the economic reforms the Government of India has reduced tariffs on imported capital goods. As a result of this initiative, the annual average amount of FDI is reported to have increased; however on the comparison of the flow of FDI India is still one tenth of the annual FDI in China in this industry. The reform package offered many other incentives to develop the market which included the privatization of industry enabling foreign companies to invest or enter into joint ventures with Indian Foundries. FDI projects are permitted through an automatic approval process. Many global organisations belonging to countries such as USA, France, Denmark, Germany, Netherlands, Ireland and few East Asian Countries have increased their overseas foundry operations in India. For example; VOLVO foundries in Chennai
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and Suzuki in Haryana have invested significant amount to enhance the operational facilities and capacity. Sundaram Clayton has joined hands with Cummins, Hyundai Motors, and Delphi. Ford India, Tata-Cummins, GM and Ford have contracts of foundry products for export with a value of USD 40 million. 2.5 Raw Material & Energy Since the market has been growing in casting business, there has been a steep increase in cost of raw materials and energy since year 2003. This has resulted in the closure of approximately 500 units all over India which have been killed due to competition. Though India is exporting the pig iron as a finished product however it has to import scrap metals and coke etc. to produce the finished products. Most of the time, cost recovery for material and energy is very difficult in a product volatile costing and fixed product price market, as most contracts are long term contracts to fix up the finished good price without any clause for price adjustment, however costs of raw material keeps changing its cost behaviour. On the raw material side, India has to import coke and scrap and moulding sand is locally available. The energy cost typically varies between 12-15% on the final product cost. 2.6 Technology The changing policies of Government of India (GOI) have encouraged technology transfer through joint ventures with foreign companies. They have also collaborated with UNIDO for producing the value added products by many foundry clusters. This has been mainly taken into due to technology support provided by UNIDO. Indian foundry industry has an edge over China for producing complex mechanised and precision castings as per international quality standards. The clusters in Belgaum, Coimbatore and Howrah are undergoing modernization under the industrial infrastructure upgradation scheme of the governments. More of such clusters are likely to follow in future to meet the domestic and international demands. 2.7 Government Policy After liberalisation, privatisation and globalisation starting in India in 1911, many policies have undergone review and change. Export and import issues being one of the major concerns, have received very encouraging response. Along with many changes taking place with the passage of time, the improvements after year 2000 made significant difference in the performance of the industry. Some of the developments are like treating Sales from DTA to SEZ as export and therefore eligible for DEPB and refund / exemption of CST and Service Tax. Foreign bound passengers allowed taking goods from SEZ and EOU units6. Domestic Sales by SEZ exempted from Special Additional Duty. Requirement of realizing export proceeds within 1 year from the date of export removed for SEZ units and requirement of maintaining value addition as per export performance as per value addition for EOUs substituted by net foreign exchange earning. In addition to his, there are many other benefits by running operations through EOU7. The incentives and facilities offered to the units in SEZs for attracting investments including foreign investment include: 1. Duty free import/domestic procurement of goods for development, operation and maintenance of SEZ units 2. 100% Income Tax exemption on export income for SEZ units under Section 10AA of the Income Tax Act for first 5 years, 50% for next 5 years thereafter and 50% of the ploughed back export profit for next 5 yea
6

http://www.ibef.org/artdisplay.aspx?cat_id=60&art_id=16798 , policy paper extracted on 22nd May 2008.

http://cii.in/menu_content.php?menu_id=624, and http://goidirectory.nic.in/ , extracted on 14th May 2008. http://www.ibef.org/artdisplay.aspx?cat_id=60&art_id=16798

3. Exemption from minimum alternate tax under section 115JB of the Income Tax Act. 4. External commercial borrowing by SEZ units up to US $ 500 million in a year without any maturity restriction through recognized banking channels. 5. Exemption from Central Sales Tax. 6. Exemption from Service Tax. 7. Single window clearance for Central and State level approvals. 8. Exemption from State sales tax and other levies as extended by the respective State Governments. 2.8 Exchange Rate Indian rupee has been very volatile in its performance in last few years. The low and high of the market has been disturbing sign for various stakeholders of the market. The weakening of the value of rupees against US dollar has uplifted the exporters and created a favourable market. Figure 4: Indian rupees against US Dollar from 2001 to 2008

Source : http://www.fxstreet.com/rates-charts/advanced-charts/

3.0 NIM Transition Phase

The company was growing at the industry average growth rate which has been the normal progress for long till year 2004. In the changed scenario, the sales of the company suddenly started picking up year on year significantly till early 2007. The company also, on the other hand, planned to build its strength by constantly increasing the production capacity in order to sustain the demand pressure. As singular economics works, with the increase in production of finished goods other variables also increase which were alarming indicators for the organisation such as inventory storage, raw material cost etc. NIM is exporting around 90-95 % of the production since inception. That means it is heavily dependent on the global market demands and fluctuations in the demand. Not only the demand has been a critical issue but also the exchange rate between INR and USD has created its pressure on the financials of the organisation. The red signal comes this point in time in year 2007, which stagnated the demand side from the global market after few years of steep rise.
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This global dependency became a real snob for the organisation and NIM was slashed in the sales mid 2007 onwards. The near future estimations also were not very encouraging. The production capacity of the company has been decided to be under utilized at around 45-50 % at all the production facilities of the NIM. The management of the company is now ready to look at various possibilities to increase the market share of the organisation or keep the market share and increase the sales of the products or enhance the organisation in a professional way for all purposes. The company is a closely held firm, so the promoters are very conscious about taking any decision or initiative that may have implications on the equity of the firm. The other side is the unutilized capacity which is increasing the cost structure of the company. 3.1 Debt Portfolio and Working Capital Management Debt being cheaper source of finance always attracts the attention of the shareholder. But the rising level of brings with it the risk of bankruptcy which can leads to the complete destruction of the value of the shareholders assets. The debt portfolio of the company has grown consistently over the years. NIM being a manufacturing company has been able to keep its debt at comfortable levels. The working capital requirement of the company is partly met by the unsecured loans. This strategy is working out pretty well but the low level of capacity utilization may have a bearing on this front.

4.0 Board Decision for Valuation

Mr. James was confused in the present scenario and also tired of the individual analysis and assessment. He decided, on the suggestion of the Board of Directors, to go for organised study for Valuation of the Firm for some specific purpose. The purpose has not been disclosed by the Board to the heads of the nits. He selected three brilliant Finance Managers from the list available from all units and invited them separately to make one valuation model and suggest the valuations. He was not afraid of hiding any information and provided quite a good piece of information to complete the assignment. In brief, the findings of the three finance managers were as follows.

4.1 Model A: The Free Cash Flow to The Firm The free cash flow to the firm8 is the sum of the cash flows to all claim holders in the firm, including stockholders, bondholders and preferred stockholders. There are two ways of measuring the free cash flow to the firm (FCFF). One is to add up the cash flows to the claim holders, which would include cash flows to equity (defined either as free cash flow to equity or dividends), cash flows to lenders (which would include principal payments, interest expenses and new debt issues) and cash flows to preferred stockholders (usually preferred dividends). FCFF = Free Cash Flow to Equity + Interest Expense (1 - tax rate) + Principal Repayments - New Debt Issues + Preferred Dividends

Kindly note that we are reversing the process that we used to get to free cash flow to equity, where we subtracted out payments to lenders and preferred stockholders to estimate the cash flow left for
8

http://pages.stern.nyu.edu/~adamodar/, corporate finance by Aswath Damodaron, Kaplan, S.N. and R.S. Ruback, 1995, The Valuation of Cash Flow Forecasts: An Empirical Analysis, Journal of Finance, v50, 1059-1093

stockholders. A simpler way of getting to free cash flow to the firm is to estimate the cash flows prior to any of these claims. Thus, we could begin with the earnings before interest and taxes, net out taxes and reinvestment needs and arrive at an estimate of the free cash flow to the firm. FCFF = EBIT (1 - tax rate) + Depreciation - Capital Expenditure change in Working Capital

The model is implemented for valuation in year 2007 only. The valuation of the company found by FCFF model is close to INR 3.36 billion. The company is having good sales growth of around 21% which brings the company above than around 25 companies listed in the stock exchange. This gives a positive sign for the listing the company, however decision of course belongs to the Board. Though the company is not considering the interest paid on the funds made available by the internal accruals but in the FCFF valuation it has to be taken into consideration. The current assets of the company are much more than liability, leading to increase in working capital. As the company is mainly into exports and depends upon the other countries for sales the risk premium attached to it gets increased depending on the market volatility. As a result, with lower debt equity ratio, the company valuation gets affected as getting the funds is comparatively cheaper than the cost of equity. 4.2 Model B: EVA Valuation The purpose of EVA-Valuation9 is to measure the total value added of a companys operations, i.e. the net cash generated in excess of claimholders return requirements. The computation of EVA is closely related to DCF. Hence, it starts with EBIT and ends with the fair value of the share. The share price potential (which the investors are interested in) is computed by comparing the fair value with the current market price of the share. The basic formulation of EVA valuation is as follows: EVA is computed so that the "fair rate of return to invested capital", i.e. WACC times the invested capital, is subtracted from the Net Operating Profit Less Added Tax (NOPLAT). The EVA valuation, on the model used with adjusted values, has indicated the valuation of the firm at INR 5.11 billion. The factor of illiquidity discount is also taken into consideration, as the value so created can not be channelized at the time of selling the business or coming up with an IPO. The EVA valuation is done keeping all the data same as projected profit figures and the WACC calculated for the FCFF model. The model also takes into the consideration of stable growth, ROC and capital invested in the business. The significant difference in the valuation between FCFF and EVA is a point of further analysis. This may have many reasons including the assumptions and treatments of the variables by the finance manager. 4.3 Model C: Relative Valuation Relative valuation10 is a generic term that refers to the notion of comparing the price of an asset to the market value of similar assets. In relative valuation, the value of an asset is derived from the pricing of 'comparable' assets, standardized using a common variable such as earnings, cash flows,
9

http://pages.stern.nyu.edu/~adamodar/, corporate finance by Aswath Damodaron, Kaplan, S.N. and R.S. Ruback, 1995, The Valuation of Cash Flow Forecasts: An Empirical Analysis, Journal of Finance, v50, 1059-1093
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http://pages.stern.nyu.edu/~adamodar/, corporate finance by Aswath Damodaron, Kaplan, S.N. and R.S. Ruback, 1995, The Valuation of Cash Flow Forecasts: An Empirical Analysis, Journal of Finance, v50, 1059-1093

book value or revenues. Examples include 1. Price/Earnings (P/E) ratios and variants (EBIT multiples, EBITDA multiples, Cash Flow multiples) 2. Price/Book (P/BV) ratios and variants (Tobin's Q) 3. Price/Sales ratios While comparing the company financials with the financials of the industry some basic similarity has to be taken into consideration. Through relative valuation, the market position of the company is determined to check the various options like selling a part, or inviting a private equity. The following assumptions have been honoured to establish the valuation; 1. The sector itself is, on average, fairly priced 2. The earnings of the firms in the group are being measured consistently 3. The firms in the group are all of equivalent risk 4. The firms in the group are all at the same stage in the growth cycle 5. The firms in the group are of equivalent risk and have similar cash flow patterns. As the main objective of the relative valuation is to compare the assets and other financials of companies of similar nature and risk, the position of NIM compared with the listed companies of similar risk and approximately similar turnover, has been found rather satisfactory. NIM is proving to be a low cost manufacturing company and as such it has comparatively higher margins. Looking at the industry average margins of comparable group which stands at 6.35%, the NIM is earning at a very healthy rate of 21.33%. Also the return on capital invested is quite above the industry average. The company is close to industry average in payout ratio. But having generated a net profit margin of 21.33% the company is providing good amount of funds for distribution. Following is the presentation of some fo the relative scales.

5.0 Closing Statement

After getting the three models by the finance managers, Mr. James is not very clear with the decision. The financial models of valuation indicate a high variability in them selves and represent very different picture all together. Board has several options and little confusion such as existing capacity utilisation vs. expansion, raising debt vs. getting IPO, creating a joint venture, domestic market vs. export market, selling of organisation. He wants to have clearer picture thus he invites a group of consultants and provide them with the details of the situations which are company profile, market scenario, the financial valuations, balance sheet etc. and ask them to suggest the most close to perfect solution. Issues to Ponder on:
1. Given the understanding and data, which valuation method is the best suitable for the

organisation and why? 2. As expressed in the concluding statement by Board, what should be best two decisions by Board in priority. Produce support statements to your view. 3. What should be the strategy to increase the long term profitability given the industry scenario?

Appendix 1: Variables of choosing the right valuation model

Sign +'ve +'ve +'ve +'ve +'ve +'ve +'ve +'ve +'ve +'ve +'ve +'ve -'ve -'ve -'ve -'ve -'ve -ve Earnings Normalcy Normal Normal Normal Normal Normal Normal Normal Normal Normal Normal Abnormal Abnomal Cyclical Cyclical Troubled Troubled Start-up Start-up Growth Stable Stable Stable Moderate Moderate Moderate Moderate High High High NA NA NA NA NA NA NA NA Source of g NA NA NA General Specific Specific Either Either Either Either NA NA NA NA NA NA NA NA Dividends vs. FCFE =FCFE FCFE NA =FCFE =FCFE FCFE NA =FCFE FCFE NA NA NA NA NA NA NA NA NA Leverage Stable Stable Unstable Stable Stable Stable Unstable Stable Stable Unstable Stable Unstable Stable Unstable Either Either Either Either Other Factors NA NA NA NA NA NA NA NA NA NA NA NA NA NA Turn around Bankruptcy Many lines Single line Valuation Model Gordon Growth FCFE Stable FCFF Stable H Model 2 stage DDM 2 stage FCFE 2 stage FCFF 3 stage DDM 3 stage FCFE 3 stage FCFF Normalized EPS Normalized FCFF Normalized EPS Normalized FCFF FCFF Model Option Model FCFF Model Option Model

Appendix 2: Profit and loss account (amount in INR millions) Particulars Schedul 2004 2005 2006 2007 10

e Income Sales Other Income Incr./(Decr.) in WIP and Finished Goods H I J 383.28 25.41 (13.19) 395.5 Expenditure Consumption of Raw Materials Manufacturing Expenses Administrative Expenses Selling and Distribution Expenses Financial Expenses Depreciation K L M N O D 153.14 74.83 50.2 27.65 1.18 21.05 328.05 Profit Before Taxation Less: Provision For Taxation Less: Provision Of Debt Profit After Tax Balance B/F from Last Year Investments Written Back Profit Available For Appropriation 67.465 17.5 49.965 5.79 0.034 55 465.8 8 35.01 22.25 523.1 4 250.05 89.51 52.22 33.25 3.47 25.01 453.5 1 69.64 15.5 54.14 33.87 88.011 566.94 16.021 10.94 593.90 1 293.33 91.35 53.69 40.98 4.74 26.077 510.16 7 83.734 10 0.75 72.984 26.326 99.31 1061.76 16.81 49.43 1128 570.026 130.057 76.95 60.76 14.072 27.75 879.615 248.384 21 0.9 226.484 18.628 245.112

Appendix 3: Balance sheet of NIM

PARTICULARS Share holder's fund Capital Reserves and surplus Loan funds Secured loans Unsecured loans Deferred tax liability Total Application of funds Fixed assets Gross block Less :- depreciation Net block Capital work in progress Investments Current assets, loans and advances Inventories Sundry debtors Cash and bank balances 2004 21,120,000 443,527,863 2005 21,120,000 485,978,125 2006 21,120,000 528,280,060 2007 21,120,000 704,954,399

25,343,763 0 12,483,779 502,475,406

80,523,184 0 12,197,531 599,818,840

89,022,907 10,000,000 12,767,978 661,190,945

239,574,544 7,000,000 13,368,299 986,017,243

288,736,036 147,843,380 140,892,655 30,230,789 6,716,750

333,212,068 158,245,838 174,966,229 18,858,150 216,750

348,753,688 182,552,494 166,201,193 37,400,742 216,750

415,784,992 209,606,454 206,178,537 55,584,199 216,750

126,058,260 119,429,897 66,398,791

16,958,557 156,152,068 44,428,443

24,329,885 162,367,548 44,220,376

346,756,757 313,465,222 42,668,733

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Loans and advances Total Less:- current liabilities and provisions Liabilities Provisions Total Net current assets Total

70,447,241 382,334,191

113,119,271 483,298,341

105,364,059 555,250,840

168,428,119 871,318,833

12,256,164 45,442,816 57,698,980 324,635,211 599,818,840

26,705,681 50,814,949 77,520,630 405,777,711 502,475,406

19,476,533 78,402,047 97,878,580 457,372,259 661,190,945

25,619,432 121,661,646 147,281,078 724,037,755 986,017,243

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