MILKINDO PLC Case 1

Part I
(How to evaluate the profitability of investment in a new company) 1

The background
Healthy Milk Indonesia (Milkindo) Plc is a company operates in a food and beverage
industry, which produces mainly baby foods, including dairy products. It established
at the end of fifties, and the main brand name, Bayi Sehat Indonesia (BSI), has
achieved quite successful results and become well known in the market particularly
for middle-low income consumers. During the first years of operation the sales were
very good, the sales growth reached more than 15% annually. For a new company, the
market share enjoyed by the company was quite satisfactory.
However, started at the beginning of sixties, the Indonesian economy had faced hard
times. The government deficit, which was financed by printing money, triggered
inflation. Moreover, the export - which was still relied on raw materials and agricultural
products - could not generate enough foreign exchange to finance the imports. The
depletion of foreign exchange reserves led the government to impose foreign exchange
control. As a result, the imported materials became less and less available in the
market, and sometimes they simply disappeared from the market.
This situation created a big headache for companies use imported materials. The
problem was also faced by Milkindo since it could not buy skim milk, sugar, and tin
package. As a result, the production decreased substantially. Although some
modification of the raw materials used in the production processes had been made, the
company was forced to operate on very low capacity.
However, the situation was much different in the seventies. The development of the
Indonesia economy had a positive impact to the businesses. The availability of
imported goods and materials in the market relieved the company. When the company
decided to go public by issuing new stocks at the end of 1980s (hence it becomes a
public limited company [Plc.]), more than 70 percent of revenue and income was
generated from the brand name of Bayi Sehat Indonesia (BSI) (although it also launched
several products and brand names).

The financial policies and data

All stocks have been listed in the market, with the nominal value of Rp1,000 per share
when the shares initially were listed. During the Indonesian financial crisis in 1998,
when the lending rate reached around 40-50% annually, the controlling shareholders
decided to replace the debt with the external equity. In 1998 the company issued
additional new equity through rights offering of Rp100 billion to replace Rp90 billion of
debt with the rest (Rp10 billion) to increase the working capital. Raising new equity

1
The case was prepared by Suad Husnan for the purpose of discussion, not to show the correct or
incorrect practices. It is based on real problem although some names and financial information have
been changed to protect confidential information without altering the nature of managerial decisions.

Case 1 – Investment in a new company Page 1

through rights offering means that the company sells the new shares to the existing
shareholders. Each shareholder is issued an option to buy certain number of shares,
and the terms of the option are listed on a certificate called a right. As a result, in 1998
the company was still able to post positive profit after tax, since quite substantial
amount of interest expenses were saved. The profitability of the firms kept improving
after 1998. Since the company distributed very low dividend until 2002 (one of the
reasons was that the controlling shareholder did not need the dividend), not only the
company’s capital structure consists of 100% equity, the cash and equivalent was very
substantial. At the end of 2003, the cash and equivalent reached around 55% of total
assets. The summary of balance sheets at the end of 2003 and 2004 is presented in
Table 1.

Table 1
Summary of Balance Sheets Milkindo Plc, 2003 and 2004 (in billion rupiah)
2003 2004 2003 2004
Current assets* 850 961 Current liabilities 127 170
Non-Current assets 268 259 Non-current 16 29
liabilities
Equity** 975 1.021
Total assets 1.118 1.220 Total equity & liab. 1.118 1.220
*Notes: The cash and equivalent is Rp590 and Rp620 billion in 2003 and 2004 respectively
** 940 million shares issued and outstanding

The current liabilities consist mainly of trades payable and accrued expenses, while
non-current liabilities consist mainly of provision of employees benefits. The sales, cost,
expenses and profit for the year 2003 and 2004 are presented in Table 2.

Table 2
Summary of Income Statement for the year 2003 and 2004 (in billion rupiah)
2003 2004
Net sales 1.100 1.250
Cost of goods sold 575 670
Gross profit 525 580
Operating expenses 195 230
Operating income 330 350
Net Income 220 240

The founders, who control 70% of the listed shares, also own other businesses. The
dividend policy of Milkindo is determined by the need for the cash for other businesses
in the group. When the businesses in the group do not need external financing, usually
the payout ratio of Milkindo is very low which was practiced for 1999-2002. However,
when the group needs rather substantial funds (for example in 2003 and 2004), the
profitable companies in the group are requested to pay rather generous dividend to
finance the cash need businesses. This policy has been carried out for the last ten years,
and is expected to continue.

Case 1 – Investment in a new company Page 2

The meeting
The purpose of the meeting is to discuss the possibility of setting up a new line of
business, e.g. a distribution company. Although the company has distributed more than
Rp300 billion in June 2005, the cash and equivalent is still very substantial. Since 1985,
the company has had an agreement with a distributor that distributes and markets the
products. By doing so, the company can concentrate only on production activities,
hence, the directors considered it would relieve the directors from marketing
problems. Although this is partly correct, they started to realize that slowly the
distributor has been dictating the pricing policies. The president director of the
company also suspected that the margin enjoyed by the distributor is much higher
compared to other distributors. Since the agreement would expire, the president
director would like to propose to the shareholders that it would not be extended if
setting up the division of distribution were considered more profitable than
maintaining the agreement. The founder, however, suggested that it would be more
practical if the new business is set in the form of a new company rather than a division.
The shares of the new company will be owned by PT. Milkindo, hence it will control the
new company.
Before the meeting was carried out, the president director had asked the vice-director
of finance to provide some estimates on the financial aspects of the new Distribution
Company. The financial director appointed the financial manager and his staffs to
provide the estimates.
It is estimated that the new company will need investment of around Rp50.0 billion,
invested in fixed assets and working capital when it starts. The company will distribute
mainly the products of PT. Milkindo, although it is also possible to distribute other
products. The estimates of the net operating working capital, gross fixed assets,
depreciation charges and operating income (EBIT) are presented in Table 3. The income
tax rate is 30%.

Table 3
Estimates of net operating working capital, gross fixed assets, and EBIT (in billion
rupiah) for the distribution company
Year 0 1 2 3 4
(when the
company
starts)
Net operating working capital 24 30 36 40 44
Gross fixed assets 26 30 34 39 44
Depreciation - 2 3 4 5
Operating Income (EBIT) 10 12 15 18

It is expected that after year 4, the net operating capital (net operating working
capital plus net fixed assets) and the operating income (EBIT) will grow by 5%
annually indefinitely. The distribution company will be financed entirely by equity.

Case 1 – Investment in a new company Page 3

The marketing director commented that for the first four years, the average EBIT
would be Rp13.75 billion before tax which means equivalent to Rp9.625 billion after
tax, since the income tax rate is 30%. Because the company would be financed
entirely by equity, the average Rp9.625 billion is equivalent to Earnings After Tax.
The average net operating assets would be Rp63.4 billion, which means that the
average annual return on equity (ROE) for the first four years would be 15.2%. A
good figure compared to, for example, the interest rate of Sertifikat Bank Indonesia
(Bank Indonesia Certificate, a proxy of a risk free investment) which is only 9.0%.
When the report is consolidated to the Milkindo financial report, it would be
expected to send a good signal to the market. Therefore he supports for the setting
up of the distribution company.
The production director was not convinced with the argument. He said that certainly
is not comparable to compare the average annual ROE to the SBI rate since the risk is
different. Even to compare it to the ROE of the Milkindo (the baby foods company) is
misleading, he continued. Therefore he asked for supporting data to estimate the
risk of the (candidates of) distribution company. The financial manager, then,
showed some estimates of risk (beta), and other relevant data as shown in Table 4.

Table 4
Estimates of equity betas, rates of return, and other data
Value
Beta of equity of Milkindo 1.00
Beta of equity of distribution companies (average) 1.10
Debt to equity ratio of distribution companies (average) 0.70
Market (represented by IHSG*) rate of return (annually) 16.0%
Risk free rate of return (represented by SBI) (annually) 9.0%
*Market Composite Index

The production director commented that it seemed that the new distribution
company would have a little bit higher risk compared to the baby food business.
Although the size of the distribution company is small compared to the baby food
company, does it mean that the new company will contribute to the higher risk of
the group?
The president director was rather surprised that the discussion was mainly on the
profitability of the distribution company. He thinks that something is missing in the
discussion.

The task
After listened to the discussion, the president director then assign a report of the
profitability of the new distribution company, which should address the following
questions.
1. Is the argument put forward by the marketing director, which is the
distribution company is profitable because the average ROE is higher than
the SBI rate, correct? Does reporting higher profit increase share price? Why?

Case 1 – Investment in a new company Page 4

 2. Is the argument put forward by the production director, which is the
company should not venture to higher risk business, correct? What
theoretical justification might explain the arguments?
3. Suppose the company decides to use IRR as a measure of the profitability.
What is the cut-off rate, and what is the IRR figure? (You should adjust the
beta to incorporate the difference in leverage. Use Hamada formula in the
text book). Does the project look profitable?
4. If investors agree with the financial director estimate, what is the impact of
the project to the Milkindo’s stock price?
5. In your opinion what aspect is forgotten in the analysis of the distribution
company? How to include the aspect in the analysis?

---sh---
Yogyakarta, August 2010

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