RESTRUCTURING AT INFOSYS

Infosys, Indias second largest computer services exporter lost its bellwether status & became less nimble as compared to rivals viz. TCS and HCL Technologies. The third position holder in Indian IT giants, Infosys had a board announcement on Saturday i.e. 1st June 2013 where it announced the return of its fore father & great warrior Mr. Narayan Murthy. Murthy is expected to bring back many strategic changes at Infosys. The present case gives an opportunity to analyse the desired or proposed change in capital structure policy along with other strategic changes expected after Murthys comeback. Infosys can shift from a closed & conservative capital arrangement to a more aggressive one. The case has also touched upon the nuances of Repurchase vs. Cash Dividends as options available to Infosys for returning cash to shareholders.

Relevant Key Words: Corporate restructuring, Debt, Equity, Cash Dividends, Repurchase JEL Codes: G12, G32, G34,

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

RESTRUCTURING AT INFOSYS

Company Background Founded in 1981 by 7 engineers, Infosys Limited has come a long way from a $250 startup to $7.2billions today. A global leader in consulting, technology and outsourcing, Infosys has business spread across 30 countries of the world. With headquarters in Bangalore, the company has received many awards and recognitions, some of them are of the likes of Forbes, Boston Consulting Group and The Wall Street Journal. The company has been successful in the last three decades due to its ability to adapt, expand at every opportunity and due to its strong culture of innovation. Infosys has a strong foothold in almost all major sectors, from the airline industry to the financial services, and has helped its clients in building their success stories. With the ever changing market scenario, Infosys is making the most of the opportunities and is now a global player, having being listed on the New York Stock Exchange as well. Infosys Corporate Culture

Infosys has been one of the best managed companies in India, in its life span of three decades. With Narayana Murthy as the Founder and Executive Chairman of Infosys for long, the company under his leadership has come a long way. With the strategy to have superior revenue growth and margins, the company has been successful in increasing its revenues all throughout. Infosys, since its inception has had the liquidity policy1 which aims to minimize the risk in the business and for this very reason, in its three decades long life, Infosys is still a Zero-Debt company. Infosys; having maintained a zero debt

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

position, has always been in a financial position to fund its capital expenditure and working capital requirements from internal accruals.

Known for its strong innovation based culture, Infosys has qualities that define the group as the one that promotes merit and performance-driven rewards system. Innovation has always been at the core of their values and functions, and each Infoscion is encouraged to innovate and to take risks and venture onto the road less taken. Each individual at Infosys takes pride in their work and has a sense of ownership towards the company and share their findings and knowledge for the development of not just Infosys but also their peers. Introduction of ESOPS is one such way to motivate and recognize the hard work that each employee gives. Infosys came up with ESOP much before any regulatory guidelines were created in this field. Infosys and the Shareholders wealth

The Infosys shares were made public through an IPO in February 1993, with the IPO price of Rs 95 per share. However, the shares opened at Rs 145 on its opening day in June 1993. With private placement made to Foreign Institutional Investors and Financial Institutions to the tune of 5.5 lakhs shares valued at Rs 450 each in 1994, the company has given huge returns to its loyal shareholders since the inception. The efficiency and the success driven corporate culture and philosophy has helped Infosys shareholders amass wealth, from Rs 95 in 1993, the share touched a market price of Rs 2,889 on 28 March 2013.

Infosys has a strong cash reserve of $4billion. In recent interviews given by the CFO Rajiv Bansal, he confirmed that Infosys has set a deadline for itself for a period of 12-15 months for themselves, wherein either the company would enter into an acquisition or if no such deal was to take place, they
Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

would consider returning the money to shareholders. The company and its officials are said to have entered into a risk-taking mode and are open to challenges. Analysts are of the opinion that the change in Infosys outlook is due to its reduced market share and to keep pace with its peers.

Financial Performance

Due to its large scale of products and services, efficient operations and zero debt structure, Infosys has performed quite well and consistently in the past. But for the last two years i.e. from 2011 onwards, its performance has become sluggish. This has been highlighted with the help of its financial results (Exhibit -1) through growth rate in revenue, operating income and net income. The reduction in Gross profit ratio, Operating profit ratio and net profit ratio in last two years i.e. for 2011-12 & 2012-13 puts a question mark on the performance of Infosys ever since the departure of Murthy in 2011. Comparing it with its peers in the Industry the percentage growth in revenue for last two years has considerably reduced. (Exhibit-3) This unenthusiastic financial performance indicated above might be due to companys conservative capital structure and large cash balances which is also justified through the falling ratios of Return on Assets and Return on Equity. In corporate finance, according to the theories of capital structure and liquidity management/working capital management, excess of cash balances affects profitability of the company. This is because at one side it is not bringing any income in the form of interest and not contributing anything to Return and at the same time the amount of total assets is inflated because of cash. The capital structure theory also validates the importance of debt and its impact on the EPS and ROE of the company. Moreover as per capital structure theories the use of debt brings more value to the shareholders provided ROCE is more than interest rate. This holds true for IT Industry which has

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

around 25% to 30% of Return & 12%-14% of the interest rate. Does this mean that Infosys can reach out to these by changing its policies on capital structure and cash management? Framework of capital structure The companys zero debt capital structure corresponds to industry standards of having no or very less debt in capital structure and is very much in line with its rivals - TCS and WIPRO who also dont have any debt in their balance sheets for the year ending 2013. Infosys equity market value is 4 times its book value; which as per 2012-2013 financial statements stands at Rs 627.95. Theoretically putting it up, according to the capital structure theories (static trade off theory) optimal capital structure is achieved at a point where tax advantage of debt is offset by bankruptcy cost. As per the theories, a judicious mix of debt and equity capital can increase the value of the firm by reducing the weighted average cost of capital (WACC) up to certain level of debt. This way the WACC decreases only within the reasonable limit of financial leverage and upon reaching the minimum level, it starts increasing with financial leverage. Hence, a firm with an optimum capital structure that occurs when WACC is minimum which will directly maximize the value of the firm. Though unlevered companies have the advantage of low interest-rate risk, however, there are a few disadvantages that follow too. For instance, the company is perceived to be a less proactive one when it comes to expansion plans, and could be left behind in the race to make the most of a bullish phase. It further reiterates that even the most profitable companies should have debt in their capital structure not only to cater to financing needs of the company but in order to generate wealth for the shareholders. Based on above notions, lets assume that Infosys decides to incorporate debt in its capital structure. The different levels of debt finance and risks associated with each of the alternative capital structures have been given in the Exhibit -4. It also shows the impact of this new edition of capital structure into
Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Infosys and its impact on the financial performance of the company. The financial performance has been indicated through EPS and DPS. Finding out the ideal Debt to capital ratio is very sensitive and complex decision to make. But generally it is a function of internal factors, financial market signals, comparison within industry, and reactions of adding debt in terms of changes in P/E Ratio, Bond ratings and debt yields etc. The companys conservative capital structure is being discounted by the markets, despite being efficient and profitable its P/E multiple and stock price are not reflecting the same as compared with its peers (Annexure-4). By adopting a more aggressive capital structure policy and using excess cash for paying dividends or repurchasing the stocks, the company can send positive signals to investors & shareholders. Debt Financing- how risky With assumed debt proportion equivalent to 5%, 7%, 10% & 20%, the Interest Coverage Ratio which is an indicator of business risk of a company is 60 times, 32 times, 19 times & 15 times respectively (Exhibit 5). The above average Interest coverage ratio indicates that the company can go back on its decision by paying off debt as and when the need arises. After Murthys com eback the company is planning to revamp on many aspects even capital structure. Since theoretically also because of its contractual nature and priority claim, debt is considered to be less expensive than equity and also the interest payments are deductible for income tax purposes. The information on interest rates for bonds has been used as are given in Exhibit- 6. Though sufficient evidences prove that the company is not using debt financing since its efficient internal operations, sound products, and strong cost control measures help it in generating desired

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

internal funds and its culture of caution and risk aversion also go along with this but simultaneously it cannot deny the need to have debt in its capital structure to increase the shareholders wealth. The management should not continue its business in sub-optimal manner, i.e. restraining itself from the optimal debt-equity version of capital structure theories. Even the Pecking order theory promotes the usage of debt over equity. Moreover due to information asymmetry, managers know more about the company than outsiders, raising debt gives a positive signal about the company's future prospects & recurring cash flows. Repurchase vs Cash Dividend

When a firm wants to pay cash to its shareholders, it normally pays a cash dividend. Another way of paying cash to shareholders is to re- purchase its own shares also know as share buyback.

Repurchase of shares increases the shareholders wealth by paying them premium on shares during a buyback & also the share price at the announcement of buyback might increase. From the companys perspective it can achieve desired capital structure by incorporating debt & also prevent hostile takeovers by others. But, the company has to quote a higher price in order to complete its repurchase even for an overvalued share.

The companies which pay a good dividend rate to its shareholders will not necessarily see the drastic fall in its market price during the bear market as compared to other shares. One of the biggest disadvantages of cash dividend is that upon paying cash dividends, the company has lesser cash reserves left for its utilization. Also, another negative aspect of this can be that shareholders may expect the cash dividend again in the near future. In case the company is unable to live up to the expectation, the shareholders might doubt the credibility of the company and its operations.

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Infosys can utilize the funds equivalent to excess cash reserves & debt raised, either through share repurchase or by paying more cash dividends to its shareholders. The impact of such a decision on EPS, DPS, ROE is shown in Exhibit- 5. In Exhibit-5, Option I talks about Repurchase option & Option II talks about Cash dividend option. Ratio of Cash & bank balances to sales of Infosys is 60% in 2013 which is just 8.37% in 2013 for its rival & number one in Industry i.e TCS. Hence keeping around 3 times of the same for Infosys, rest of the excess cash i.e. around 35% of cash can be utilized. Debt is assumed to be incorporated in the proportion of 5%, 7%, 10% & 20% in the total capital. The quality of Debt issued decreases and the interest rate increases as the amount of debt increases based on the size of recapitalization. At 5% debt-to-capital, bond is assumed to have AAA rating with interest rate of 9.28%. At 7% debt-to-capital, the rating is AA+ with interest rate of 12.22% and with 10% debt-to-capital, the rating falls to AA- with the interest rate increased to 14.71% (Exhibit 6) If the total amount of excess cash & debt raised is to be utilized for stock repurchase, the shares are assumed to be repurchased at a premium of 10% at 5% debt to capital ratio, at 15% premium for 7% debt to capital ratio, at 20% premium for 10% debt to capital ratio & 25% premium is to be offered for debt to capital ratio of 20%. The premium would be over & above the market price of 2889.35 per share as on 28th March 2013.

Deciding upon Cash Dividend vs Repurchase of shares, the company should also look into the taxation aspect where it has to pay taxes on dividend distributed to shareholders or in share buyback along with the impact on EPS, DPS & ROE. From the shareholders perspective the decision would depend upon tax liabilities on capital gains in case of repurchase & dividend income.

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

EXHIBIT -1

Infosys indicators from 2008-09 to 2012-13 Particulars Total Revenue (Income from software , services & products) Growth rate in Revenue (%) Operating Income (PBDIT) Net Income (after tax but b4 exceptional) Growth rate in Net Income (%) Cash & Cash Equivalents at the end of the period Total Assets Debt owners' Equity (book value) ordinary shares (outstanding)
Source: Company annual reports

2013 36765 NA 11,015.00 9,116.00 NA 20,401.00 43,028.00 0 36,059.00 57.42

2012 31,254.00 17.63 10,061.00 8,470.00 13.29 19,557.00 35,815.00 0 29,757.00 57.42

2011 25,385.00 23.12 8,821 6,443.00 23.95 15165 28,854.00 0 24,501.00 57.40

(Rs. In crores) 2010 2009 21,140.00 20.08 7,360 5,755.00 11.95 11297 26,066.00 0 22,268.00 57.33 20,264.00 4.32 6,906.00 5,819.00 -1.10 10289 21,151.00 0 17,809.00 57.25

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

EXHIBIT -2

Ratio analysis
Profit Ratios Gross Profit /total revenue Operating Profit (PBIDTA)/Total revenue Profit after Tax/total revenue Returns PAT/Average net worth (ROE) PBIT/Average Capital employed (ROCE) Growth Net Profit(before exceptional items) Basic EPS Price /Earnings Dividend per share(excluding special dividend) Dividend payout Balance Sheet Cash & Cash Equivalents /Total Revenue Cash & Cash Equivalents /Total Assets Source: Company annual reports (%) (%) (%) (%) (%) (%) (%) 2013 41.07 29.96 24.61 2013 25.28 37.3 2013 13.29 157.55 18.34 42 26.7 2013 60.63 51.1 2012 42.94 32.19 25.55 2012 29.44 40.87 2012 23.95 139.07 20.61 37 26.6 2012 63.67 55.56 2011 43.8 33.15 25.38 2011 27.69 37.58 2011 11.95 112.26 28.87 30 29.34 2011 60.21 52.97 2010 45.32 34.82 27.22 2010 28.89 37.25 2010 -1.1 100.37 26.06 25 29.09 2010 70.03 66.48 2009 45 34.08 28.72 2009 37.18 42.9 2009 30.18 101.65 13.08 23.5 27.03 2009 50.78 57.65

(%) Rs. times Rs. (%) (%) (%) (%)

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Exhibit -3 Revenue Growth (%) 2013 2012 2011 13.7 24 29.1 20 33 40 5.8 15.8 25.8 5 13.4 18.9 17.1 31.1

TCS Cognizant Infosys Wipro HCL

2010 5.4 16 3 1.6 24.1

2009 23 32 11.7 18.5 17.1

Source: Company Financial reports

Exhibit 4 Pro forma statement - Financial Information for Alternative Capital Structure (Rupees in crores) ACTUAL With 5% Debt With 7% With 10% Debt Debt Rate of Interest on Debt A. Revenue B. Operating profit (EBIT) (C) Interest Expense D. Other Income D. Net Profit before Tax (B+D) D. Income Tax (E*26.2%) D. Profit After Tax (E - F) Source : Company annual reports The corporate income tax rate as per annual report is 26.22% Interest is calculated as per rates given in Exhibit-6 NA 36,765 10,059 0 2,298 12,357 3,241 9,116 9.28% 36,765 10,059 167.3 2,298 12,189.69 3,193.70 8,995.99 12.22% 36,765 10,059 308.4 2,298 12,048.55 3,156.72 8,891.83 14.71% 36,765 10,060 530.4 2,299 11,828.57 3,099.09 8,729.49

With 20% Debt 14.71% 36,765 10,059 1060.9 2,298 11,296.14 2960 8,336.55

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Exhibit 5: Option 1 - Repurchase of Shares

Actual Particulars
A. Excess Cash Used B. Debt issued Total stock repurchase (A+B) Price per share repurchased (at premium of 10%, 15%, 20% ,25%) Shares of common stock repurchased Owners equity(book value) Dividends paid (26.7% on PAT) Shares Outstanding (After Repurchase) Earnings per Share Dividends per Share ROE Interest Coverage Ratio(times) Debt share price @PE 18.34 Source: self compiled 2013 2899.92 5% Debt to Capital 7,140.35 1,802.95 8,943.30 3189.912

Assumed
7% Debt to Capital 7,140.35 2,524.13 9,664.48 3334.908 10% Debt to Capital 7,140.35 3,605.90 10,746.25 3479.904 20% Debt to Capital 7,140.35 7,211.80 14,352.15 3625

36,059 2434.0

28528339.99 27,115.70 2401.9

32230151.67 26,394.52 2374.1

37395918.36 25,312.75 2330.8

52025108.54 21,706.9 2225.860034

574232838.00 545704498.01 542002686.33 536836919.64 522207729.47 158.76 164.85 164.06 162.6 159.6 42.4 44.0 43.8 43.4 42.6 25.28 33.18 33.69 34.49 38.41 0 60.12 32.61 18.97 9.48 0 1,802.95 2,524.13 3,605.90 7,211.80 2911.6584 3,023.39 3,008.79 2,982.47 2,927.85

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Exhibit 5: Option II - Cash Dividend

Particulars

Actual 2013

5% Debt to Capital

7% Debt to Capital

10% Debt to Capital

20% Debt to Capital

Excess Cash ( to be used for dividends) Debt issued Total Funds available Owners equity(book value) Dividends paid (original) Additional Dividends paid Total Dividends Paid Shares Outstanding (After Dividend) Earnings per Share Dividends per Share ROE Interest Coverage Debt PAT share price @PE 18.34 Source: self compiled

7,140.30 1,802.95

7,140.30 2,524.13 9,664.43 33,534.87 2086.87 9,664.43 11,751.30 57,42,32,837.98 154.86 204.7 26.52 5.7 14,423.60 8892 2840.06

7,140.30 3,605.90 10,746.20 32,453.1 1807.26 10,746.20 12,553.46 57,42,32,837.98 152.03 218.6 26.90 3.2 21,635.40 8729 2788.21

7,140.30 7,211.80 14,352.10 28,847.2 2302.42 14,352.10 16,654.52 57,42,32,837.98 145.19 290.0 28.90 15 7,211.80 8337 2662.70

36,059 2433.9 0 2433.9

8,943.25 34,256.05 2302.42 8,943.25 11,245.67

57,42,32,837.98 57,42,32,837.98 158.76 42 25.28 0 0 9116 2911.66 156.67 195.8 26.26 15 7,211.80 8996 2873.33

Exhibit 6 Bond Rating

Interest rates on corporate bonds AAA AA+ AAYTM 9.28% 12.22% 14.71% Source: http://www.hdfcsec.com/data/docs/NCDs%20which%20available%20currently%20for%20trading%20in%20th e%20secondary%20market.pdf Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Annexure -1

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Annexure -2

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

Annexure -3

Annexure -4

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors

References: 1. Infosys 2013 Annual Report www.infosys.com/investors/reports-filings/annual-report/ 2. http://articles.economictimes.indiatimes.com/2013-03-14/news/37713942_1_lodestoneinfosys-management-infosys-board 3. CAPITAL STRUCTURE THEORY AND POLICY, Unit 5 MODULE 2 http://application.dbuglobal.com/assets/Pu18FM1004/CPu18FM1004/UNIT%205%20CAPIT AL%20STRUCTURE%20THEORY%20AND%20POLICY.pdf 4. http://in.reuters.com/finance/stocks/chart?symbol=INFY.NS

Authored by Dr. Anubha Gupta & Ms. Swati Sharma, IILM GSM Greater Noida. Copyright rests with the authors