Idea Transcript
Financial Management - Important questions for IPCC November 2017 BASICS OF FINANCIAL MANAGEMENT
1. Discuss conflict in profit versus wealth maximization objective Answer Conflict in Profit versus Wealth Maximization Objective Profit maximisation is a short–term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow.
Whereas, on the other hand, wealth maximisation, is a long-term objective and means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources.
RATIO ANALYSIS
2. The assets of SONA Ltd. consist of fixed assets and current assets, while its current liabilities comprise bank credit in the ratio of 2 : 1. You are required to prepare the Balance Sheet of the company as on 31st March 2013 with the help of following information: Share Capital Rs 5,75,000 Working Capital (CA-CL) Gross Margin Inventory Turnover Average Collection Period Current Ratio Quick Ratio Reserves & Surplus to Bank & Cash
Rs 1,50,000 25% 5 times 1.5 months 1.5:1 0.8: 1 4 times
Answer Working Notes: (1) Computation of Current Assets (CA) and Current Liabilities (CL) Current Assets = Current Ratio Current Liabilities CA = 1.5 CL 1 ∴ CA = 1.5CL CA - CL = 1,50,000 1.5 CL- CL = 1,50,000 0.5 CL = 1,50,000 CL = 3,00,000 CA = 1.5 x 3,00,000 = 4,50,000 2. Computation of Bank Credit (BC) and Other Current Liabilities (OCL) Other CL = 2 Bank Credit 1 BC = 2 OCL BC + OCL = CL 2 OCL + OCL = 3,00,000 3 OCL = 3,00,000 OCL = 1,00,000 Bank Credit = 2 × 1,00,000 = 2,00,000 3.Computation of Inventory Quick Ratio = Quick Assets Current Liabilities = Current Assets - Inventories Current Liabilities 0.8 = 4,50,000 - Inventories 3,00,000 0.8 × 3,00,000 = 4,50,000 – Inventories Inventories = 4,50,000 – 2,40,000 = 2,10,000 4. Computation of Debtors Inventory Turnover = 5 times Average Inventory = COGS Inventory Turnover COGS = 2,10,000 × 5 = 10,50,000 GP = 25%, COGS % = 75% Sales = 10,50,000/75% = 14,00,000 Debtors = 14,00,000*1.5/12 = 175,000 5. Computation of Bank and Cash Bank & Cash = CA - (Debtors + Inventory) = 4,50,000 – (1,75,000 + 2,10,000)= 4,50,000 – 3,85,000 = 65,000
6. Computation of Reserves & Surplus Reserves & Surplus= 4 Bank & Cash Reserves & Surplus = 4 × 65,000 = 2,60,000
Liabilities Share Capital Reserves & Surplus Current Liabilities: Bank Credit Other Current Liabilities
Balance Sheet of SONA Ltd. Rs Assets 5,75,000 Fixed Assets 2,60,000 Current Assets: Inventories 2,00,000 Debtors 1,00,000 Bank & Cash 11,35,000
Rs 6,85,000 2,10,000 1,75,000 65,000 11,35,000
3. Sohna Limited’s sales, variable costs and fixed cost amount to Rs 75,00,000, Rs 42,00,000 and Rs 6,00,000 respectively. It has borrowed Rs 45,00,000 at 9 per cent and its equity capital totals Rs 55,00,000. (a) What is Sohna Limited’s ROI? (b) Does it have favourable financial leverage? (c) If Sohna Limited belongs to an industry whose asset turnover is 3, does it have a high or low asset leverage? (d) If the sales drops to Rs 50,00,000, what will the new EBIT be? Answer (a) Computation of Sohna Limited’s ROI ROI = EBIT/Investment EBIT = Sales – Variable Cost – Fixed Cost = 75 lakhs – 42 lakhs – ` 6 lakhs = 27 lakhs. ROI = 27 lakhs/100 lakhs = 27 per cent (b) Yes, Sohna Limited has favourable financial leverage as its ROI is higher than the interest on debt. (c) Asset turnover = Sales/ Total assets = 75 lakhs/100 lakhs = 0.75 The asset turnover of Sohna Limited is lower than the industry average of 3.
(d) EBIT at Sales Level of Rs 50 lakhs Particulars
Rs
Sales Revenue
50,00,000
Less: Variable Costs (50 lakhs × 0.56)
28,00,000
Less: Fixed Costs
6,00,000
EBIT
16,00,000
4. Diagrammatically present the DU PONT CHART to calculate return on equity Answer Du Pont Chart There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier) (a)
ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The Financial leverage ratio for the company is 0.60. Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent
Return on Net Assets (RONA) = EBIT ÷ NA
Return on Equity (ROE) = PAT ÷ NW
Financial Leverage (Income) = PAT ÷ E BIT
Profit Margin = EBIT ÷ Sales
Assets Turnover = Sales ÷ NA
Financial Leverage (Balance Sheet) = NA ÷ NW 5. ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The Financial leverage ratio for the company is 0.60. Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent
Answer [ROI + {(ROI – r) x D/E}] (1 – t) [0.20 + {(0.20 – 0.10) x 0.60}] (1 – 0.40) [ 0.20 + 0.06] x 0.60 = 0.1560 15.60%
ROE = = = ROE =
TIME VALUE OF MONEY
6. Ms. A has purchased a smart phone from a shop for Rs25,000. She has paid Rs5,000 as down payment and the rest will be paid in equated monthly instalments (EMI) for 2 years. The interest rate charged by the bank is 14% p.a. Required:(i) Calculate the amount of EMI and (ii) Calculate the total amount of interest payable to the bank. Answer Purchase price = 25,000 Loan amount = 25000-5000 = 20000 Rate of interest = 14%/12 = 1.1667% p.m Loan = Installment*Annuity factor 20,000 = Installment*AF(1.1667,24) 20,000 = Installment*20.8277 (i)
Installment =20000/20.8277 = 960.26
(ii)
Total interest paid = Installments paid - loan = 960.26*24 – 20000 = 3046.24
7. Gama Limited has borrowed Rs 1,000 to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 15 per cent. You are required to prepare an amortisation schedule for Gama Limited. Answer Instalment =Loan/Annuity factor (15%,3) = 1000/2.2832 =Rs.438
Loan repayment schedule
Sl. No 1 2 3
Amount Outstanding at the beginning 1000 712 381
Interest for the period 150 106.8 57
Installment repaid 438 438 438
Amount Outstanding at the end 712 381 -
CAPITAL STRUCTURE THEORIES
8. What do you mean by capital structure? State its significance in financing decision. Answer Concept of Capital Structure and its Significance in Financing Decision Capital structure refers to the mix of a firm’s capitalisation i.e. mix of long-term sources of funds such as debentures, preference share capital, equity share capital and retained earnings for meeting its total capital requirement.
Significance in Financing Decision The capital structure decisions are very important in financial management as they influence debt – equity mix which ultimately affects shareholders return and risk. These decisions help in deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation. Therefore, such a pattern of capital structure must be chosen which minimises cost of capital and maximises the owners’ return 9. What is Over capitalisation? State its causes and consequences. Answer It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest. Causes of Over Capitalization Over-capitalisation arises due to following reasons: (i) Raising more money through issue of shares or debentures than company can employ profitably. (ii) Borrowing huge amount at higher rate than rate at which company can earn. (iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.
(iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate. (v) Wrong estimation of earnings and capitalization. (Note: Students may answer any two of the above reasons) Consequences of Over-Capitalisation Over-capitalisation results in the following consequences: (i) Considerable reduction in the rate of dividend and interest payments. (ii) Reduction in the market price of shares. (iii) Resorting to “window dressing”. (iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the company may go into liquidation. (Note: Students may answer any two of the above consequences) 10.
X Ltd. is considering the following two alternative financing plans: Plan - I Plan - II Rs Rs Equity shares of Rs 10 each 4,00,000 4,00,000 12% Debentures 2,00,000 Preference Shares of Rs 100 each 2,00,000 Rs 6,00,000 Rs 6,00,000 The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%. Calculate the rate of dividend on preference shares.
Answer Computation of Rate of Preference Dividend EBIT = 2,40,000 Tax rate = 30% (EBIT- Interest) (1- Tax rate) = EBIT (1- Tax rate) -Preference Dividend No. of Equity Shares (N1 ) No.of Equity Shares (N2 ) (2,40,000 - 24,000) (1- 0.30) = 2,40,000 (1- 0.30) -Preference Dividend 40,000 40,000 2,16,000 (1- 0.30) = 1,68,000 -Preference Dividend 1,51,200 = 1,68,000 – Preference Dividend Preference Dividend = 1,68,000 – 1,51,200 Preference Dividend = 16,800 Rate of Dividend = Preference Dividend x 100 Preference Share Capital = 16,800 x 100 = 8.4% 2,00,000
11. Distinguish between net income approach and net operating income approach in capital structure theories Answer Difference between net income approach and net operating income approach Point of difference
Role of Capital Structure
Computation Degree of Leverage and Cost of Capital:
Net income Approach Brings forth the relevance of capital structure in calculating the value of firm With a judicious mixture of debt and equity, a firm can arrive at an optimum capital structure
Net operating income Approach States the irrelevance of capital structure in calculating the value of the firm.
Value of firm = Value of equity + Value of debt Change in degree of leverage will alter the overall cost of capital (WACC) and hence the value of the firm.
Value of Equity (Residual) = Value of firm – Value of debt Degree of leverage of the firm is irrelevant to the cost of capital i.e. the cost of capital is always constant.
12. Company XYZ is unlevered and has a cost of equity of 20 percent and a total market value of Rs10,00,00,000. Company ABC is identical to XYZ in all respects except that it uses debt finance in its capital structure with a market value of Rs4,00,00,000 and a cost of 10 percent. Find the market value of equity, and weighted average cost of capital if the tax advantage of debt is 25 percent Answer Computation of market value of company Market Value of levered company (ABC) = Market value of unlevered company + Debt*Tax rate = 10,00,00,000 + 4,00,00,000 × 0.25% = 11,00,000 The market value of equity of company ABC Equity = Value of firm - Debt = 11,00,000 – 400,000 = 700,000 Weighted average Cost of capital of ABC = Returns expected by unlevered firm/ value of levered firm *100 = 10,00,000*20%/11,00,000* 100 = 18.18%
13.
The following current data are available concerning Theta Limited: No of Share issued 10,000 Market price per share Rs20 Interest rate 12% Tax Rate 46% Expected EBIT Rs15,000 The company requires an additional Rs50,000 for the coming year. You are required to determine: Which financing option (debt or equity issue) will give higher EPS
Answer Computation of Earnings Per Share (EPS) for the Expected EBIT Particulars Expected earnings before interest & tax Less: Interest (12% of 50,000) Earnings before tax (EBT) Less: Tax (@ 46%) of EBT (9000 X 46%) Earnings available to equity shareholder: (A)
Debt(Rs) 15,000 6,000 9,000 4,140 4,860
Equity(Rs) 15,000 15,000 6,900 8,100
Number of shares issued: (B)
10,000
12,500
Earnings per shares: (A) / (B)
0.486
0.648
(50000/20)+10000
Conclusion: Earnings per share is higher when the company raises additional funds by issue of equity shares
14. Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure of a company. Answer Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital Structure of a Company
The determination of optimum level of debt in the capital structure of a company is a formidable task and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest cost. Determination of optimum level of debt involves equalizing between return and risk.
EBIT – EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective of debt-equity mix.
The indifference point for the capital mix (equity share capital and debt) can be determined as follows (EBIT - I1) (1 – T) = (EBIT – I2) (1 – T) E1
E2
15. Skyline Ltd. is planning an expansion programme which will require 30 crore and can be funded through one of the following three options : Option-1 : Issue further equity shares of 100 at par Option-2 : Raise loans @ 15% interest Option-3 : Issue preference shares @ 12%. Present paid-up capital is 60 crore and average annual EBIT is 12 crore. Assume tax rate at 30%. Post expansion EBIT is expected to be 15 crore p.a. Calculate EPS under the three financing options indicating the alternative giving the highest return to the equity shareholders. Answer
EBIT Int EBT Tax@30% EAT Pref share divi Earning to ESH No of shares Existing New Total EPS
0 15 4.5 10.5
Option 2 Loan@15% 15 30*15% 4.5 10.5 3.15 7.35
0 10.5
0 7.35
Rs Crs Option 3 Pref shares@12% 15 0 0 15 4.5 10.5 30*12% 3.6 6.9
0.6 0.3 0.9 11.67
0.6
0.6
0.6 12.25 (Highest)
0.6 11.5
Option 1 Equity shares 15
WORKING CAPITAL MANAGEMENT
16. PTX Limited is considering a change in its present credit policy. Currently it is evaluating two policies. The company is required to give a return of 20% on the investment in new accounts receivables. The company's variable costs are 70% of the selling price. Information regarding present and proposed policies is as follows: Present Policy Policy Policy Option 1 Option 2 Annual Credit Sales (Rs) 30,00,000 42,00,000 45,00,000 Debtors turnover ratio 4 times 3 times 2.4 times Loss due to bad debts 3% of sales 5% of sales 6% of sales Return on investment in new accounts receivable is based on cost of investment in debtors. Which option would you recommend? Answer Statement of Evaluation of Credit Policies of PTX Limited (based on Total Cost Approach) Present Policy 30,00,000 21,00,000 9,00,000
Policy Option I 42,00,000 29,40,000 12,60,000
Sales Revenue Less: Variable Cost @70% Contribution Less: Other Relevant Costs Bad Debt Losses (90,000) (2,10,000) Investment Cost (VC ÷ DTR) × 20% (1,05,000) (1,96,000) Profit 7,05,000 8,54,000 Recommendation: PTX Limited is advised to adopt Policy Option I.
Policy Option II 4,50,0000 31,50,000 13,50,000 (2,70,000) (2,62,500) 8,17,500
(Note: In the above solution, investment in accounts receivable is based on total cost of goods sold on credit). 17.
State the advantage of Electronic Cash Management System.
Answer Advantages of Electronic Cash Management System (i) Significant saving in time. (ii) Decrease in interest costs. (iii) Less paper work. (iv) Greater accounting accuracy. (v) More control over time and funds. (vi) Supports electronic payments.
(vii) Faster transfer of funds from one location to another, where required. (viii) Speedy conversion of various instruments into cash. (ix) Making available funds wherever required, whenever required. (x) Reduction in the amount of ‘idle float’ to the maximum possible extent
18. 'Management of marketable securities is an integral part of investment of cash.' Comment. Answer “Management of Marketable Securities is an Integral Part of Investment of Cash” Management of marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles namely safety, maturity and marketability.
19. The Sales Manager of AB Limited suggests that if credit period is given for 1.5 months then sales may likely to increase by Rs. 1,20,000 per annum. Cost of sales amounted to 90% of sales. The risk of non-payment is 5%. Income tax rate is 30%. The expected return on investment is Rs. 3,375 (after tax). Should the company accept the suggestion of Sales Manager? Answer Profitability on additional sales:
Rs.
Increase in sales
1,20,000
Less: Cost of sales (90% sales)
1,08,000
Less: Bad debt losses (5% of sales)
6,000
Net profit before tax
6,000
Less: Income tax (30%)
1,800 4,200
Advise: Net profit after tax Rs. 4,200 on additional sales is higher than expected return. Hence, proposal should be accepted.
20. A firm has a total sales of Rs. 12,00,000 and its average collection period is 90 days. The past experience indicates that bad debt losses are 1.5% on sales. The expenditure incurred by the firm in administering receivable collection efforts are Rs. 50,000. A factor is prepared to buy the firm’s receivables by charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 16% p.a. after withholding 10% as reserve. Calculate effective cost of factoring to the firm. Assume 360 days in a year. Answer Computation of Effective Cost of Factoring Average level of Receivables = 12,00,000 * 90/360
3,00,000
Factoring Commission = 3,00,000 * 2/100
6,000
Factoring Reserve = 3,00,000 * 10/100
30,000
Amount Available for Advance = Rs. 3,00,000-(6,000+30,000)
2,64,000
Factor will deduct his interest @ 16% :Interest
= 264000*90/360*16% =
10560
Advance to be paid = Rs. 2,64,000 – Rs. 10,560 =
Rs. 2,53,440
Annual Cost of Factoring to the Firm:
Rs.
Factoring Commission (Rs. 6,000 * 360/90)
24,000
Interest Charges (Rs. 10,560 *360/90)
42,240
Total
66,240
Firm’s Savings on taking Factoring Service:
Rs.
Cost of Administration Saved
50,000
Cost of Bad Debts (Rs. 12,00,000 x 1.5/100) avoided
18,000
Total
68,000
Net Benefit to the Firm
(Rs. 68,000 – Rs. 66,240)
Effective Cost of Factoring =66240*100/253440 Effective Cost of Factoring = 26.136%
1760 26.136%
21. MN Ltd. is commencing a new project for manufacture of electric toys. The following cost information has been ascertained for annual production of 60,000 units at full capacity: Amount per unit (Rs.) Raw materials 20 Direct labour 15 Manufacturing overheads: Variable 15 Fixed 10 25 Selling and Distribution overheads: Variable 3 Fixed 1 4 Total cost 64 Profit 16 Selling price 80 In the first year of operations expected production and sales are 40,000 units and 35,000 units respectively. To assess the need of working capital, the following additional information is available: (i) Stock of Raw materials……………………………...3 months consumption. (ii) Credit allowable for debtors…………………………..…1½ months. (iii) Credit allowable by creditors……………………………4 months. (iv) Lag in payment of wages………………………………..1 month. (v) Lag in payment of overheads…………………………..½ month. (vi) Cash in hand and Bank is expected to be Rs. 60,000. (vii) Provision for contingencies is required @ 10% of working capital requirement including that provision. You are required to prepare a projected statement of working capital requirement for the first year of operations. Debtors are taken at cost. Answer Statement Showing Working Capital Requirement A. Current Assets
Rs.
Stock of Raw Materials (Rs. 8,00,000 * 3/12)
2,00,000
Stock of Finished Goods
3,25,000
Debtors at Cost (Rs. 24,40,000 * 3/24)
3,05,000
Cash and Bank
60,000
Total (A)
8,90,000
B. Current Liabilities Creditors for Materials (Rs. 10,00,000 * 4/12)
3,33,333
Creditors for Expenses (Rs. 13,65,000 * 1/24)
56,875
Outstanding Wages (Rs. 6,00,000 * 1/12)
50,000
Total (B)
4,40,208
Working Capital Requirement before Contingencies (A – B)
4,49,792
Add: Provision for Contingencies (Rs. 4,49,792 * 1/9)
49,977
Estimated Working Capital Requirement
4,99,769
Workings Notes: Purchase of Raw Material during the first year
Rs.
Raw Material consumed during the year
8,00,000
Add: Closing Stock of Raw Materials (3 months consumption)
2,00,000
Less: Opening Stock of Raw Material
Nil
Purchases during the year
10,00,000
22. Alpha Limited sells its products on a gross profit of 20 percent on sales. The following information is extracted from its annual accounts for the current year ended March 31. Rs Sales at 3 months’ credit 40,00,000 Raw Material 12,00,000 Wages paid-average time lag 15 days 9,60,000 Manufacturing expenses paid-one month in arrears 12,00,000 Administrative expenses paid-one month in arrears 4,80,000 Sales promotion expenses-payable half-yearly in advance 2,00,000 The company enjoys one month’s credit from the suppliers of raw materials and maintains 2 months’ stock of raw materials and one and a half month’s stock of finished goods. The cash balance is maintained at Rs1,00,000 as a precautionary measure. Assuming a 10 percent margin, you are required to estimate the working capital(based on cost) requirements of Alpha Limited
Answer Statement Showing the Estimation of Working Capital Requirements of Alpha Limited Particulars (A) Current Assets : Cash balance Inventories : Raw materials Finished goods Debtors Prepaid sales expenses Total (B) Current Liabilities Creditors for raw material Wages Manufacturing expenses Administrative expenses Total (C) Net working capital (A−B) Add : Margin (0.10) Working Capital Requirements of Alpha Limited
Workings
Rs 1,00,000
(12,00,000 * 2/12) (40,00,000 * 1.5/12) (32,00,000 *3)/12 (2,00,000 * 6)/12
2,00,000 4,00,000 8,00,000 1,00,000 16,00,000
(12,00,000 * 1) /12 (9,60,000 * 0.5) /12 (12,00,000 * 1)/12 (4,80,000 * 1) / 12
1,00,000 40,000 1,00,000 40,000 2,80,000 13,20,000 1,32,000 14,52,000
FUNDS FLOW STATEMENT
23.
Given here is the Balance Sheet as on March 31, years 1 and 2 for Zeta Limited. March 31, Year 1 Rs Liabilities Accounts Payable Accrued expenses Income Tax payable Equity share capital Retained earnings Total Assets Cash Accounts receivable Inventory Prepaid Insurance Prepaid rent Pre-paid property tax Land Plant & Equipment Less: Accumulated Dep. Total
March 31, Year 2 Rs
20,000 2,000 1,000 30,000 12,650 65,650
18,000 4,000 1,100 37,000 13,650 73,750
5,000 14,000 22,000 200 150 300 4,000 30,000 10,000 20,000 65,650
6,000 14,000 8,000 250 100 400 8,000 48,000 11,000 37,000 73,750
Sales for year 2 was Rs2,10,000. Net income after tax was Rs7,000. In arriving at net profit, items deducted from sales included, Cost of goods sold – Rs1,65,000; Depreciation - Rs5,000; Wages and Salaries – Rs20,000 and a gain of Rs1,000 on the sale of a plant. The plant had a historical cost of Rs6,000, a depreciation of Rs4,000 had been accumulated for it and it was sold for Rs3,000. This was the only asset written off during the year. The company declared and paid Rs6,000 as dividends during the year. You are required to prepare funds flow statement
Answer Funds Flow Statement of Zeta Limited for the year 2 Rs Sources of funds: Funds from business operations(Refer to working note (i))
11,000
Sale of Plant
3,000
Issuance of shares
7,000
Total :
21,000
Application of funds: Purchase of Land
4,000
Purchase of Plant & Equipment (Refer to working note (ii))
24,000
Dividend paid
6,000
Decrease in working capital (Refer to working note (iii))
13,000
Total :
21,000
Working Notes:
(i) Funds from business operations: Rs 7,000 5,000 1,000 11,000
Particulars Net income after taxes Add: Depreciation Less: Gain on sale of plant Funds from business operations: (ii)
Plant and Equipment Account
Particulars To Balance b/d To P & L A/c (Profit on the sale of plant) To Cash (Purchases, balancing figure) Total
Rs Particulars 20,000 By Cash (sale of plant) 1,000 By Depreciation By Balance c/d 24,000 45,000
Total
Rs 3,000 5,000 37,000
45,000
(iii) Statement of changes in working capital Year1 Particulars Rs Current Assets : Cash Accounts receivable Inventory Prepaid Insurance Prepaid Rent Prepaid Property taxes Less: Current Liabilities: Accounts payable Accrued expenses Income tax payable Working capital Change in working capital
Year2 Rs
5,000 14,000 22,000 200
6,000 14,000 8,000 250
150 300
41,650
100 400
28,750
23,000
18,000 4,000 1,100
23,100
20,000 2,000 1,000
18,650
5,650
13,000 (Decrease)
LEVERAGES
24.
“Financial leverage is a double edged sword” . Comment
Answer Financial Leverage –A double edged sword 1. A “double-edged sword” has two cutting edges; in finance, a “double-edged sword” means something that has both potential benefits and liabilities. 2. Financial leverage can multiply gains, but it also multiply losses. 3. Positive leverage a. A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income b. For example, XYZ company obtains a long term debt at a rate of 12%. The company can use the funds to earn an after-tax rate of 14%. The interest on debt is tax deductible. If the tax rate is 40%, the after-tax interest rate would
be 7.2% [12% × (1 – 0.4)]. The difference of 6.8% (14% – 7.2%) is, therefore, the benefit of equity shareholders. 4. Negative Leverage a. A negative financial leverage occurs when the assets acquired with the debts generate a rate of return that is less than the rate of interest Negative financial leverage is a loss for common stockholders. b. For example in the situation above, if company makes return of 5% instead of 14%, then The difference of 2.2% (5% – 7.2%) would be loss to equity shareholders
25. “Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern.” Critically examine this statement. Answer “Operating risk is associated with cost structure whereas financial risk is associated with capital structure of a business concern”. Operating risk refers to the risk associated with the firm’s operations. It is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses, which are affected by demand of firm’s products, variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm’s shareholders as a result of debt and preference shares used in the capital structure of the concern. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity
26. From the following financial data of Company A and Company B: Prepare their Income Statements. Company A Company B Rs. Rs. Variable Cost 56,000 60% of sales Fixed Cost 20,000 Interest Expenses 12,000 9,000 Financial Leverage 5:1 Operating Leverage 4:1 Income Tax Rate 30% 30% Sales 1,05,000 Answer Working Notes: Company A (i) EBIT = 12000*5/1 = 12000 (ii) Contribution = EBIT + Fixed Cost = 15,000 + 20,000
= Rs. 35,000
(iii) Sales = Contribution + Variable cost = 35,000 + 56,000= Rs. 91,000 Company B (i) Contribution = 40% of Sales (as Variable Cost is 60% of Sales) = 40% of 1,05,000 = Rs. 42,000 (ii) Financial Leverage = 42000/4 = 10500 (iii) Fixed Cost = Contribution – EBIT = 42,000 – 10,500 = Rs. 31,500
Income Statements of Company A and Company B Company A(Rs)
Company B (Rs).
Sales
91,000
1,05,000
Less: Variable cost
56,000
63,000
Contribution
35,000
42,000
Less: Fixed Cost
20,000
31,500
Earnings before interest and tax (EBIT)
15,000
10,500
Less: Interest
12,000
9,000
Earnings before tax (EBT)
3,000
1,500
Less: Tax @ 30%
900
450
Earnings after tax (EAT)
2,100
1,050
27. The capital structure of the Shiva Ltd. consists of equity share capital of Rs 10,00,000 (shares of Rs 100 per value) and Rs 10,00,000 of 10% Debentures, sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs 10 per unit: variable costs amount to Rs 6 per unit and fixed expenses amount to Rs 2,00,000. The income-tax rate is assumed to be 50%. You are required to calculate the following: (i) The percentage increase in earnings per share; (ii) Financial leverage at 1,00,000 units and 1,20,000 units. (iii) Operating leverage at 1,00,000 units and 1,20,000 units. (iv) Comment on the behaviour of Operating and Financial leverages in relation to increase in production from 1,00,000 units to 1,20,000 units.
Answer Particulars Sales at Rs 10 per unit Less: Variable costs at Rs 6 per unit Contribution (C) at Rs 4 per unit Less: Fixed expenses Operating Profit or EBIT Less Interest on Debentures (10% on Rs 10 Lakhs) Profit before tax (PBT) Less Tax at 50% Profit after tax (PAT) or net profit (i) Earnings per Share (EPS) [10,000 equity shares]
1,00,000 units 10,00,000 6,00,000 4,00,000 2,00,000 2,00,000
1,20,000 units 12,00,000 7,20,000 4,80,000 2,00,000 2,80,000
1,00,000 1,00,000 50,000 50,000
1,00,000 1,80,000 90,000 90,000
5
9
% increase in EPS (ii) Financial leverage EBIT/PBT (iii) Operating leverage Contribution/EBIT
9-5/5 *100 = 80% 2 1.56 2 1.714
(iv) In relation to increase in Production & Sales of 1,00,000 units to 1,20,000 units (20% increase), EPS has gone from Rs 5 to Rs 9 i.e. increased by 80%. But both the Financial Leverage and Operating Leverage have decreased with increase in sales. Due to this reduction, both the risks i.e. business risk & financial risks of the business are reduced.
28. Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms : N S D Production (in units)
17,500
6,700
31,800
Fixed costs Rs
4,00,000
3,50,000
2,50,000
Interest on loan Rs
1,25,000
75,000
Nil
Selling price per unit Rs
85
130
37
Variable cost per unit Rs
38.00
42.50
12.00
Answer Computation of Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL) and Degree of Combined Leverage (DCL)
Output (Units) Selling Price/Unit Sales Revenue (A) Variable Cost/Unit Less: Variable Cost (B) Contribution (A-B) Less: Fixed Cost EBIT Less: Interest on Loan PBT Operating Leverage Contribution/EBIT Financial Leverage EBIT/EBT Combined Leverage OL*FL
Firm N 17,500 85 14,87,500 38.00 6,65,000 8,22,500 4,00,000 4,22,500 1,25,000 2,97,500 1.95 1.42 2.77
Firm S 6,700 130 8,71,000 42.50 2,84,750 5,86,250 3,50,000 2,36,250 75,000 1,61,250 2.48 1.47 3.65
Firm D 31,800 37 11,76,600 12.00 3,81,600 7,95,000 2,50,000 5,45,000 5,45,000 1.46 1.00 1.46
SOURCE OF FINANCE
29. State the main elements of leveraged lease. Answer Main Elements of Leveraged Lease Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender. The asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance. 30. What is Virtual Banking? State its advantages. Answer Virtual banking refers to the provision of banking and related services through the use of information technology without direct recourse to the bank by the customer. The advantages of virtual banking services are as follows: Lower cost of handling a transaction. The increased speed of response to customer requirements. The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.
Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience. (Note: Students may answer any two of the above advantages) 31. Explain the concept of Indian depository receipts. Answer
The concept of the depository receipt mechanism which is used to raise funds in foreign currency has been applied in the Indian capital market through the issue of Indian Depository Receipts (IDRs). Foreign companies can issue IDRs to raise funds from Indian market on the same lines as an Indian company uses ADRs /GDRs to raise foreign capital. The IDRs are listed and traded in India in the same way as other Indian securities are traded.
32. Discuss the advantages of preference share capital as an instrument of raising funds. Answer
No dilution in EPS on enlarged capital base. There is no risk of takeover as the preference shareholders do not have voting rights. There is leveraging advantage as it bears a fixed charge. The preference dividends are fixed and pre-decided. Preference shareholders do not participate in surplus profit as the ordinary shareholders Preference capital can be redeemed after a specified period.
33. Write short notes on following a. Floating rate bonds b. Packing credit Answer a. Floating rate bonds
These are the bonds where the interest rate is not fixed and is allowed to float depending upon the market conditions. These are ideal instruments which can be resorted to by the issuers to hedge themselves against the volatility in the interest rates. They have become more popular as a money market instrument and have been successfully issued by financial institutions like IDBI, ICICI etc.
b. Packing credit
Packing credit is an advance made available by banks to an exporter.
Any exporter, having at hand a firm export order placed with him by his foreign buyer on an irrevocable letter of credit opened in his favour, can approach a bank for availing of packing credit. An advance so taken by an exporter is required to be liquidated within 180 days from the date of its commencement by negotiation of export bills or receipt of export proceeds in an approved manner. Thus Packing Credit is essentially a short-term advance
34. What is venture capital financing? State the factors which are to be considered in financing any risky project. Answer Venture Capital Financing and Factors to be considered in financing any Risky Project Under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success. The factors to be considered in financing any risky project are: (i) Quality of the management team is a very important factor to be considered. They are required to show a high level of commitment to the project. (ii) The technical ability of the team is also vital. They should be able to develop and produce a new product / service. (iii) Technical feasibility of the new product / service should be considered. (iv) Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk. (v) A research must be carried out to ensure that there is a market for the new product. (vi) The venture capitalist himself should have the capacity to bear risk or loss, if the project fails. (vii) The venture capitalist should try to establish a number of exit routes. (viii) In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say on all significant matters affecting the business. (Note: Students may answer any two of the above factors)
CAPITAL BUDGETING
35. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State Government of Rs. 25,00,000 on capital investment. Initial equipment cost will be Rs. 1.75 crores. Additional equipment costing Rs. 12,50,000 will
be purchased at the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be needed and it will be released at the end of eighth year. The project will be financed with sufficient amount of equity capital.
The sales volumes over eight years have been estimated as follows: Year 1 2 3 4-5 Units 72,000 1,08,000 2,60,000 2,70,000
6-8 1,80,000
A sales price of Rs. 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash operating costs will amount Rs. 18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent to be an appropriate after tax cost of capital for this project. The company follows straight line method of depreciation. Required: Calculate the net present value of the project and advise the management to take appropriate decision. Note: The PV factors at 12% are Year 1 2 3 .893 .797 .712
4 .636
5 .567
6 .507
7 .452
8 .404
Answer
(Rs. ’000)
Year 1 2 3 4 to 5 6 to 8
Sales 86.4 129.6 312 324 216
VC 51.84 77.76 187.2 194.4 129.6
FC 18 18 18 18 18
Dep. 21.875 21.875 21.875 24.125 24.125
Profit -5.315 6.65* 84.925 87.475 44.275
Tax PAT 0 0 1.995 4.655 25.4775 59.4475 26.2425 61.2325 13.2825 30.9925
Dep. 21.875 21.875 21.875 24.125 24.125
Cash inflow 16.56 26.53 81.3225 85.3575 55.1175
*11.965 –(5.315) =6.65 After adjustment of loss Cost of New Equipment Less: Subsidy Add: Working Capital Outflow Year 1 2
1,75,00,000 25,00,000 20,00,000 1,70,00,000 Cash inflows 16,56,000 26,53,000
DF 0.893 0.797
DCF 14,78,808 21,14,441
3 4 5 6 7 8
81,32,250 - 12,50,000 = 68,82,250 85,35,750 85,35,750 55,11,750 55,11,750 55,11,750 + 20,00,000 + 1,25,000 = 76,36,750 PV of inflows
PV of inflows Less: Out flow NPV
0.712 0.636 0.567 0.507 0.452 0.404
49,00,162 54,28,737 48,39,770 27,94,457 24,91,311 30,85,247 2,71,32,933
2,71,32,933 1,70,00,000 1,01,32,933
Advise: Since the project has a positive NPV, therefore, it should be accepted. 36. A Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8 years. Initial equipment cost will be Rs 150 lakhs and additional equipment costing Rs 10 lakhs will be needed at the beginning of third year. At the end of the 8 years, the original equipment will have resale value equivalent to the cost of removal, but the additional equipment would be sold for Rs 1 lakh. For tax purpose assume depreciation of Rs.150000 on additional equipment. Working capital of Rs 25 lakhs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the production and sales-volume expected are as under: Year 1 2 3-5 6-8
Capacity in percentage 20 30 75 50
A sale price of Rs100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed Operating Cash Costs are likely to be Rs16 lakhs per annum. In addition to this the advertisement expenditure will have to be incurred as under: Year 1 Expenditure each year (Rs in lakhs) 30
2 15
3-5 10
6-8 4
The company is subjected to 50% tax, straight-line method of depreciation, (permissible for tax purposes also) and taking 12% as appropriate after tax cost of Capital, should the project be accepted? Answer
Computation of initial cash outlay
(Rs in lakhs)
Equipment Cost
150
Working Capital
25 175
Calculation of Cash Inflows: Years Sales in units Contribution @ Rs 60 p.u. Fixed cost Advertisement Depreciation Profit /(loss) Tax @ 50% Profit/(Loss) after tax Add: Depreciation Cash inflow
1 80,000 48,00,000 16,00,000 30,00,000 15,00,000 13,00,000) NIL 13,00,000) 15,00,000 2,00,000
2 1,20,000
3 to 5 3,00,000
6 to 8 2,00,000
72,00,000 1,80,00,000 1,20,00,000 16,00,000 16,00,000 16,00,000 15,00,000 10,00,000 4,00,000 15,00,000 16,50,000 16,50,000 26,00,000 1,37,50,000 83,50,000 13,00,000 68,75,000 41,75,000 13,00,000 68,75,000 41,75,000 15,00,000 16,50,000 16,50,000 28,00,000 85,25,000 58,25,000
Computation of PV of Cash Inflow Year 1 2 3 4 5 6 7 8 Working Capital Scrap Value (A) Cash Outflow: Initial Cash Outlay Additional Investment (B) Net Present Value (NPV)
Cash Inflow (Rs) 2,00,000 28,00,000 85,25,000 85,25,000 85,25,000 58,25,000 58,25,000 58,25,000 15,00,000 1,00,000
PV Factor @ 12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.404 0.404
1,75,00,000 10,00,000
1 0.797
(A)-(B)
(Rs) 1,78,600 22,31,600 60,69,800 54,21,900 48,33,675 29,53,275 26,32,900 23,53,300 6,06,000 40,400 2,73,21,450 1,75,00,000 7,97,000 1,82,97,000 90,24,450
Recommendation: Accept the project in view of positive NPV. 37. Beta Limited receives Rs 15,00,000 a year after taxes from an investment in an automatic plant that has 12 more years of service life. The company’s required rate is 12%. Beta Limited can make improvements to the plant to raise its service life to 20 years and its annual after tax cash flow to Rs 48,00,000 per year. These investments would cost Rs 2,10,00,000. With the improvements, the plant’s value at the end of 12 years would rise
from Rs7,50,000 to Rs75,00,000. Would the improvements produce a return satisfactory to Beta Limited? Answer
Calculation of the Present value of the inflows before improvements to the automatic plant Particulars Income after taxes for 12 years(15,00,000 × 6.194) Plant value at the end of 12 years (7,50,000 × 0.257) Total present value of the inflows before improvements to the plant: (A)
Amount(Rs) 92,91,000 1,92,750 94,83,750
Calculation of the Present value of the inflows after improvement to the automatic plant Particulars Income after taxes for 12 years(48,00,000 × 6.194) Plant value at the end of 12 years (75,00,000 × 0.257) Total present value of the inflows before improvements to the plant: (A)
Amount(Rs) 2,97,31,200 19,27,500 3,16,58,700
Differential Present value of the inflow after improvements to the automatic plant = 3,16,58,700 (B) – 94,83,750 (A)
= 2,21,74,950
Net Present value from the investments in the automatic plant = P.V. of Cash Inflow – Cash Outflow= 2,21,74,950 – 2,10,00,000 = 11,74,950 Advice: Since the NPV is positive, the improvements produce a satisfactory return to the firm. 38. APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two machines have identical capacity, do exactly the same job, but designed differently. Machine 'A' costs Rs 8,00,000, having useful life of three years. It costs Rs 1,30,000 per year to run. Machine 'B' is an economy model costing Rs 6,00,000, having useful life of two years. It costs Rs 2,50,000 per year to run. The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore taxes. The opportunity cost of capital is 10%. The present value factors at 10% are : Year t1 PVIF(0.10,t) 0.9091 PVIFA(0.10,2) = 1.7355 PVIFA(0.10,3) = 2.4868
t2 0.8264
t3 0.7513
Which machine would you recommend the company to buy? Answer
Statement Showing Evaluation of Two Machines Particulars
Machine A
Machine B
Purchase Cost (Rs) : (i)
8,00,000
6,00,000
Life of Machines (in years)
3
2
Running Cost of Machine per year (Rs) : (ii)
1,30,000
2,50,000
Cumulative PVF for 1-3 years @ 10% : (iii)
2.4868
-
Cumulative PVF for 1-2 years @ 10% : (iv)
-
1.7355
(v) = [(ii) x (iii)]
3,23,284
4,33,875
Cash Outflow of Machines (Rs) : (vi) = (i) + (v)
11,23,284
10,33,875
4,51,698.57
5,95,721.69
Present Value of Running Cost of Machines (Rs):
Equivalent Present Value of Annual Cash Outflow [(vi) ÷ (iii)]
Recommendation: APZ Limited should consider buying Machine A since its equivalent Cash outflow is less than Machine B.