Case 044Forensic accountingCore

Kesarvan Industries buys Rs 500 crore of raw material a year from a promoter-owned supplier at 12% above market. How much margin leaks, and what does it do to fair value at 20x earnings?

The situation

Kesarvan Industries makes engineered plastic components. Its annual report shows Rs 500 crore a year of raw material bought from a company wholly owned by the promoter family, which also owns 55% of Kesarvan; minority shareholders own the other 45%. Comparing invoices with published prices for the same grades, you estimate Kesarvan pays 12% above market.

Kesarvan's profit after tax is Rs 400 crore, tax is 25%, and the stock trades at 20x earnings.

Your task

How much profit leaks each year, what is it worth, who bears it, and what would you do about it as an analyst?

Quick check

How much does Kesarvan overpay each year, before tax?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

Kesarvan overpays about Rs 53.6 crore a year, Rs 40.2 crore after tax, which at 20x is about Rs 804 crore of value. Profit would be 10% higher at market prices. The promoter bears 55% of the loss through Kesarvan but collects all of it at the supplier, netting about Rs 18.1 crore a year; minority shareholders lose the same Rs 18.1 crore, about Rs 362 crore of their value. That is a direct transfer from them to the promoter.

Step 1How do you size the leak correctly?

If a housing society buys all its cleaning supplies from the secretary's brother at 12% above the shop price, the extra cost is the gap between what it pays and the shop price. A price 12% above market means market is the price divided by 1.12, so the leak is Rs 500 crore less Rs 446.4 crore, Rs 53.6 crore, not 12% of Rs 500 crore. After tax at 25%, Kesarvan's profit is Rs 40.2 crore a year lower than it would be at market prices, 10% of today's Rs 400 crore.

Follow the money: Rs 500 crore paid, Rs 446 crore of material receivedKesarvan Industrieslistedpromoter 55%, minorities 45%Supplier100% owned by the promoterunlistedpays Rs 500 crore a yearmaterial worth Rs 446.4 crore at marketLeak: Rs 53.6 crore a yearRs 40.2 crore after taxNot 12% of 500 = 60:12% above market means 500 - 500/1.12 = 53.6Minorities fund 45% of the leak: Rs 18.1 croreThe promoter nets +Rs 18.1 crore a year after taxThe supplier is assumed to pay the same 25% tax, so the promoter keeps the after-tax leak there.
Kesarvan pays its promoter's supplier Rs 500 crore for material worth Rs 446.4 crore at market, so Rs 53.6 crore a year, Rs 40.2 crore after tax, leaks to a company the promoter owns outright.
Step 2Why is this a transfer, not just a cost?

Follow who owns what. The promoter owns 55% of Kesarvan but 100% of the supplier, so every rupee overpaid costs the promoter 55 paise through Kesarvan and returns a full rupee through the supplier. On Rs 40.2 crore after tax, the promoter bears Rs 22.1 crore and collects Rs 40.2 crore, netting Rs 18.1 crore a year. Minority shareholders bear the other Rs 18.1 crore and get nothing back. A related party transactionA deal between a company and someone who controls or influences it, such as a promoter, a director or a firm they own; the risk is that the price favours the insider. priced above market is money moving from minorities to the controller.

Each year, after tax: the leak is a transfer, Rs croreKesarvan profit-40.2Promoter, via 55% of Kesarvan-22.1Promoter, via the supplier+40.2Promoter, net+18.1Minority shareholders, 45%-18.1
Each year Kesarvan's profit falls Rs 40.2 crore after tax; the promoter bears Rs 22.1 crore of it but gains the full Rs 40.2 crore at the supplier, netting Rs 18.1 crore, while minority shareholders lose Rs 18.1 crore.
The relationship
Leak=500−5001.12=53.6Value=53.6×(1−0.25)×20≈804\text{Leak} = 500 - \frac{500}{1.12} = 53.6 \qquad \text{Value} = 53.6 \times (1 - 0.25) \times 20 \approx 804
500annual purchases from the related supplier, Rs crore
1.12price paid relative to market
0.25tax rate
20the P/E the market applies to Kesarvan's earnings
What it says in wordsThe leak is what Kesarvan pays above market, and its value is the after-tax leak capitalised at the stock's own multiple.
Step 3What does it do to fair value, and what do you do about it?

Two views are defensible. If you expect the arrangement to continue, today's earnings already carry the leak and the Rs 8,000 crore market value is the right base; the Rs 804 crore is value the minority will not see. If shareholders can force market pricing, fair value rises by about Rs 804 crore, 10%. Most analysts do the first and apply a governance discount on top, because a promoter who prices one contract this way may price others the same way. Then ask how the audit committee tested the price, and check how Indian listing rules treat material related party transactions; the thresholds and approval rules change, so confirm the current SEBI requirements.

Where candidates lose it

The common loss is computing 12% of Rs 500 crore, Rs 60 crore, and overstating the leak by Rs 6.4 crore. The premium is on the market price, and interviewers set the question up to catch exactly this.

The second is treating the leak as an ordinary cost that hurts everyone equally. The whole point is that the promoter is on both sides of the deal and comes out ahead.

What the interviewer asks next

  • The promoter's stake falls to 40%. How does the promoter's net gain change?
  • What disclosures would you check in the annual report for related party pricing?
  • How would you apply a governance discount without double counting the leak?

Company names and figures are illustrative.