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Finance II Case Assignment 51 Sec E & F KBCL Inc. is a public firm incorporated in 1982.

KBCL is an Indian telecom firm which has faced a relatively low growth industry trends up till now. KBCL has a history of making stock buybacks to avail of undervaluation and mispricing of its stock in the market. Dividends were never paid in KBCL. While the debt structure was 17% debt/capital in 1995, it has increased to 68% debt/capital at the year-end 2005. In search for undervalued opportunities KBCL has resorted to extensive stock buybacks every year during this period. These buybacks are now seen as a regular affair at KBCLs dividend policy. Due to such policy and investors expectations, KBCL often need to borrow and make such buybacks. Analysts believe that this has made KBCL an overlevered firm, even when cash flow from operations remains strong. They believe that if such a magnitude of payments were not there to be made, KBCL will be accumulating cash from its operation. With the perception of a stagnant industry, with nominal growth and excessive leverage, cost of equity for KBCL went up sharply in recent times. This can be seen from the falling stock prices in the market. With the advent of modular technological waves in the form of 2G and 3G, telecom industry is witnessing a change where firms will compete more aggressively and successful firms would have bigger opportunities to grow. KBCL remains a strong player in telecom industry with sound operational base and infrastructure to leverage new technology. Managers are feeling confident that they can score high with the advent of new technology provided they can convince shareholders in the market. For this managers need to relook into the distribution policy of cash to shareholders immediately. To understand the tax effects of cash payouts, Mr. Rajnikant, the senior financial manager at KBCL has provided with the following information to Mr. Amitabh, the CEO. A marginal shareholder has bought the stock with a cost basis of Rs. 54. This investor faces a ordinary tax rate of 40%, a capital gain tax of 15% (assume no difference between short term and long term gain tax) and a special security transaction tax (STT) of 8% paid on half of the capital gains (no tax on losses) while selling security. This special STT needs to be paid in by the seller only. If dividend of Rs. 2 per share is announced, an investor can sell the stock just before the ex-dividend date at Rs. 66.67. A partially tax exempt nonmarginal investor in the firm faces an ordinary tax rate of only 5%.

Prepared by Gaurav S Chauhan, to be exclusively used for academic learning at IIM Indore. Please do not reproduce without the written consent of the author.

Further, KBCL has paid extensively to its managers in the form of stock options. This was also one of the reasons cited quite often for making stock buybacks frequently. While KBCL would not relinquish the policy of rewarding managers with stock options, it may consider issuing options in a manner so that it may not be detrimental to the firms future. For this purpose Mr. Rajnikant has proposed some measures as to alter the features of the option, where strike price can be made variable if needed. This is Jan 2006, you are required to analyze/workout the following: 1. Estimate the stock price just after the stock goes ex-dividend. Write the expression clearly explaining the terms how they are incorporated in the expression and then show calculations. (5+2) 2. Estimate the arbitrage opportunity (in Rs. per share), if any, for the partially tax exempt nonmarginal investor. Write steps for calculations. (5) 3. For a distribution sum of Rs. 1000 (assume 500 shares outstanding), compare the dividend payout Vs. stock buyback alternative for impact of taxes on investors. Which is better based on taxations only? (3+3+2) 4. What do you suggest managers need to do to signal the strength of KBCL to the markets in the present situation. Please analyze the interaction between dividend policy, investment decisions and financing policy for this question (not more than 50-60 words analysis). Then, suggest in 23 bullet points steps to sync all these finance functions (10-20 words each bullet point). (3+2) 5. Evaluate the agency issues involved, specifically: a. See how debtholders would behave/react about your suggestions (20 words). (1) b. See how managers might behave/react about your suggestions (20 words). (1) c. Is there something we can do to address concerns of debtholders/managers, if any, to correct any anomaly (20 words). (3)