Case studies in Financial Management Solved

Description
Case studies in Financial Management Solved

COMPREHENSIVE
CASES
CHAPTER 5
Cash Flow Statement
LINK LEVER LIMITED
(Cash Flow Statement) Link Lever Limited is a medium sized enterprise, specialising in
manufacturing of industrial locks, fasteners, ?xers and holdfasts. The company began its journey
from Gorakhpur in Eastern UP in 2002. It was co-founded by two friends – Arunashu Pal and
Tamal Bose. They started making small locks for residential purposes which were sold in the
local markets of Eastern UP The locks were fairly successful as they were priced competitively
and soon became popular amongst the people.
Buoyed up by their success, the owners decided to expand operations. From 5-worker organi-
sation, working in a garage, they went on to become a 50-member strong company working
out of a small unit in Kanpur and catering to the markets of UP within a year of operation. For
?nancing their expansion, the owners took a loan from the State Bank of India and got their
company registered as Pal and Bose Ltd.
By 2004-end, the Pal and Bose (PB) Ltd. had become brand name in UP and was manufac-
turing fasteners, ?xers and holdfasts apart from locks, which also were available for various
purposes from residential needs to industrial requirements.
Arunashu Pal, CEO of PB Ltd. had seen huge market potential for PB Ltd and was already
planning ahead. He planned for opening up of a modern manufacturing plant oustside UP,
say, in Jharkhand or Madhya Pradesh, so that he could expand business and create a brand
name which would be recognisable throughout India. Tamal Boase, the Joint CEO, was also
enthusiastic about the growth of PB Ltd. and wished to diversify into more areas like automobile
locks, electronically operated locking mechanism and surveillance security systems.
To meet the additional fund requirements to (1) open up the proposed new plant outside UP
(2) buy modern machinery (3) train employees (4) advertise to crate brand awareness and (5)
license advanced technology from foreign collaborators, the management of PB Ltd. decided
to take additional loan from the State Bank of India, having already paid the past loan.
The manager of the State Bank of India, Kanpur Green Park Branch, Mr. Kuber Chand, visited
the premises of PB Ltd. and undertook a detailed appraisal to ascertain its credit worthiness.
After his satisfaction with the processes of the plant, he asked for the balance sheet, income
statement and the cash ?ow statement as per AS-3. He assured the two promoters that once
the bank received all these documents in proper form, they would process the loan application
quickly.
However, as things were looking bright and rosy for PB Ltd. and it was at the threshold of
a massive expansion, a mishap took place. A ?re broke out at PB Ltd’s manufacturing unit at
Kanpur. Some important documents were lost as the ?re engulfed the administrative block.
The debtors’ ledger and the stock ledger were completely destroyed in the ?re.
On instructions from the CEO of PB Ltd., Alok Mehta, the CFO, prepared from the available
records an incomplete balance sheet as shown in Exhibit 1 and additional information (Exhibit
2).
Comprehensive Cases 3
EXHIBIT 1 Incomplete Balance Sheet (Rs ’000)
Particulars Year 2 Year 1
Long-term Assets:
Plant and machinery (net of depreciation) 8,211 2,260
Land and buildings 1,950 2,000
Long term investments 720 720
Current Assets:
Marketable securities 4,550 230
Sundry debtors * *
Inventories * *
Prepaid expenses 100 50
Interest receivable 150 100
Cash in hand 1,620 730
Cash at bank 971 600
Total Assets * *
Long-term Liabilities:
Share capital 3,580 2,750
Preference share capital 1,000 1,200
Reserves and surplus 7,951 2,210
18% Convertible debentures 1,905 2,230
Current Liabilities:
Sundry creditors 680 890
Wages outstanding 85 55
Income tax payable 600 680
Total Liabilities 15,801 10,015
EXHIBIT 2 Additional Information
1. Debentureholders holding 25 per cent of the debentures outstanding as on 31
st
March, Year 1
exercised the option for conversion into equity shares during the ?nancial year and the same
was put through.
2. Only one plant was sold during the year for Rs 1,00,000. The original cost of the machine was
Rs 6,00,000.
3. During Year 2, interim dividend of Rs 2,00,000 was paid, ?nal dividend paid being Rs 3,00,000.
4. Preference share redemption was carried out at a premium of 8 per cent.
5. Accumulated depreciation on plant and machinery at the end of Year 2 was Rs 10,20,000 and
at the end of Year 2 was Rs 11,90,000.
6. The current ratio at the end of Year 1 and Year 2 was 3.098462 and 3.604396.
7. The quick ratio at the end of Year 1 and Year 2 was 3.015 and 3.443.
Required From the above information, prepare (a) income statement for Year 2, (b) recon-
structed balance sheet for Years 1 – 2 and (c) AS-3 - based cash ?ow statement. Show the
detailed computations in Working Notes.
Solution
The income statement for Year 2, the reconstructed balance sheet, the cash?ow statement and
the working notes are shown in Exhibit 3 to 6.
4 Financial Management
EXHIBIT 3 Income Statement for Year 2 (Rs ’000)
Sales 53,250
Less: Cost of goods sold (42,300)
Add: Gain on sale of plant 20
Gross pro?t 10,970
Less: depreciation
Plant and machinery (690)
Land and building (50)
Selling and administration expenses (3,210)
Interest paid (343)
Add: Interest income 100
Dividend income (gross) 135
Net pro?t before extraordinary items 6,912
Less: Provision for income tax
@
(680)
Net pro?t after taxes 6,232
@
Tax deducted at source on dividends received (included in provision for taxes amounts to Rs 25,000.
EXHIBIT 4 Reconstructed Balance Sheet (Rs ’000)
Particulars Year 1 Year 2
Long-term Assets:
Plant and machinery (net of depreciation) 8,211 2,260
Land and buildings 1,950 2,000
Long term investments 720 720
Current Assets:
Marketable securities 4,550 230
Sundry debtors 2,820 3,240
Inventories 120 85
Prepaid expenses 100 50
Interest receivable 150 100
Cash in hand 1,620 730
Cash at bank 971 600
Total 15,801 10,015
Long-term Liabilities:
Share capital 3,580 2,750
Preference share capital 1,000 1,200
Reserves and surplus 7,951 2,210
18% convertible debentures 1,905 2,230
Current Liabilities:
Sundry creditors 680 890
Wages outstanding 85 55
Income tax payable 600 680
Total 15,801 10,015
Comprehensive Cases 5
EXHIBIT 5 Cash Flow Statement
Particulars Amount (Rs ’000)
Cash Flows From Operating Activities:
Cash receipts from customers 53,670
Cash paid to suppliers and employees (45,775)
Cash generated from operations 7,895
Income taxes paid (760)
Net cash from operating activities 7,135
Cash Flows From Investing Activities:
Purchase of plant and machinery (6,721)
Proceeds from sale of plant 100
Interest received 100
Dividend received 110
Net cash from investing activities (6,411)
Cash Flows From Financing Activities:
Proceeds from issuance of equity share capital 272
Proceeds from issuance of debentures 232
Redemption of preference shares (216)
Interest paid (343)
Dividends paid (500)
Net cash from ?nancing activities (554)
Net increase in cash and cash equivalents 170
Cash and cash equivalents at the beginning of the year 1,560
Cash and cash equivalents at the end of the year 1,730
EXHIBIT 6 Working Notes (Amount Rs ’000)
1. Calculation of Sundry Debtors and Inventories:
Current assets (year 2) = Current liabilities (year 2) ? Current ratio = 4,920
Sundry debtors + Inventories = 4,920 – 1,980 = 2,940
Quick assets (year 2) = Current liabilities (year 2) ? Quick ratio = 4,700
Inventories + Prepaid expenses = CA – Quick assets = 220
Inventories = 220 – 100 = 120
(i) Hence, Sundry debtors = 2,940 – 120 = 2,820
Current assets (year 1 – Current liabilities (year 1) ? Current ratio = 5,305
Sundry debtors + Inventories = 5,035 – 1,710 = 3,325
Quick assets (year 1) = Current liabilities (year 1) ? Quick ratio = 4,900
Inventories + Prepaid expenses = CA – Quick assets = 135
Inventories = 135 – 50 = 85
(ii) Hence, Sundry debtors = 3,325 – 85 = 3,240
2. Calculation of Depreciation:
Opening balance + Depreciation charged during the year - Accumulated depreciation of sold
plant = Closing balance
1,120 + Depreciation charged during the year – 520 = 1,190
Hence, depreciation charged during the year = 690
3. Cash Receipts From Customers:
Debtors at the beginning of year 3,240
Add: Net sales during the year 53,250
6 Financial Management
Less: Debtors at the end of year (2,820)
Total 53,670
4. Cash Paid to Suppliers and Employees
Cost of goods sold 42,300
Add: Selling and administrative expenses 3,210
Add: Current year prepaid expenses 100
Less: Previous year prepaid expenses (50)
Add: Creditors at the beginning of the year 890
Less: Creditors at the end of the year (680)
Add: Inventories at the end of the year 120
Less: Inventories at the beginning of the year (85)
Add: Wages payable at the beginning of the year 55
Less: Wages payable at the end of the year (85)
Total 45,775
5. Income Tax Paid:
Income tax for Year 2 680
Add: Income tax liability at the beginning of Year 2 680
Less: Income tax liability at the end of Year 2 (600)
Total 760
6. Purchase of Plant and Machinery
Gross block at end of the year 9,401
Less: Gross block at beginning of the year (3,280)
Add: Original value of plant sold 600
Total 6,721
7. Proceeds From Issuance of Equity Share Capital:
Equity capital at the end of year 3,580
Less: Equity capital at beginning of the year (2,750)
Less: Debentures converted into equity (558)
Total 272
8. Proceeds From Issuance of Debentures:
Debenture at the end of the year 1,905
Less: Debentures at beginning of the year (2,230)
Add: Debenture converted into equity shares 558
Total 233
9. Redemption of Preference Share at 8% Premium
Cash out?ow due to redemption = 200 ? 1.08 = 216.
CHAPTER 7
Volume-Cost-Profit Analysis
THANDAK DESERT COOLERS
Mr Coolguy of ‘Thandak’ desert coolers enjoys a monopoly in his local market catering to around 10,000 customers
every year. His friend Mr Imandar Singh of ‘Zordar’ pumps supplies him good quality pumps at very reasonable
rates (Rs 400 per pump). The year 2003 was not a good year for Mr. Coolguy. He lost his good friend Mr Imandar
in a road accident. He also lost most of his savings in share market scam. The Sun God did not bless him with
a hot summer and the sales were expected to fall by 20 per cent. To make the matter worse, the new head of
‘Zordar’ pumps, Mr Opportunist Singh increased the price of pumps by 30 per cent.
Mr Coolguy asked his chief accountant, Mr Calculator Singh, to show the current ?nancial data and the
projected ?nancial data if the supply from Zordar pumps were to be maintained. Mr Calculator Singh came out
with the following reports.
Cost Data
The cost data is divided into two parts: ?xed cost and variable cost. The ?xed and the variable components of
the mixed costs are separated. The variable costs are divided into three major categories: direct material cost,
direct labour costs and the variable overheads. The division of all the cost data is tabulated, for 10,000 units as
well as 8,000 units, as follows:
(I) Present Scenario (10,000 units)
Item Fixed cost Variable cost and expenses
Direct material Direct labour Variable overheads
Labour Rs 12,10,000 Rs 20,00,000
Steel sheets Rs 60,00,000
Electricity 35,000 Rs 1,00,000
Depreciation 15,06,620
Pumps (@ 400 per unit) 40,00,000
Khus 9,00,000
Tubes 5,00,000
Wires 50,000
Fan 14,50,000
Telephone 4,580 4,60,000
Rent (of?ce) 1,20,000
Of?ce expenses 22,000 3,46,000
Bank charges 18,000
Insurance 35,000
Repair and maintenance 25,000 2,40,000
Recruitment 64,000
Travel 3,80,000
Conveyance 16,800 1,90,000
Post, courier and parcel 7,000 1,70,000
Miscellaneous 1,50,000
Total 30,00,000 129,00,000 20,00,000 21,00,000
8 Financial Management
(II) Future Scenario If Pumps Are Bought From Zordar Pumps (8,000 units)
Item Fixed cost Variable cost and expenses
Direct material Direct labour Variable overheads
Labour Rs 12,10,000 Rs 16,00,000
Steel sheets Rs 48,00,000
Electricity 35,000 Rs 80,000
Depreciation 15,06,620
Pumps (@ 520 per unit) 41,60,000
Khus 7,20,000
Tubes 4,00,000
Wires 40,000
Fan 11,60,000
Telephone 4,580 3,68,000
Rent (of?ce) 1,20,000
Of?ce expenses 22,000 3,46,000
Bank charges 18,000
Insurance 35,000
Repair and maintenance 25,000 2,76,800
Recruitment 51,200
Travel 3,04,000
Conveyance 16,800 1,52,000
Post, courier and parcel 7,000 1,36,000
Miscellaneous 1,20,000
Total 30,00,000 112,80,000 16,00,000 18,34,000
(III) Comparative Analysis of Both Scenarios
Item 10,000 units 8,000 units
Sales revenue @ Rs 2,500 per unit Rs 250,00,000 Rs 200,00,000
Less: Variable costs
Direct material 129,00,000 112,80,000
Direct labour 20,00,000 16,00,000
Variable overheads 21,00,000 18,34,000
Total contribution 80,00,000 52,86,000
Less: Total ?xed costs 30,00,000 30,00,000
Operating pro?ts 50,00,000 22,86,000
After going through the report Mr Coolguy realised that his pro?ts would drop by Rs 27.14 lakh if he continued to
purchase pumps from Zordar pumps and sales drop to 8,000 units. Since there were no other pump manufacturers
in the market, the only alternative for Mr Coolguy was to manufacture the pumps indigenously. But he had lost
most of his money and for manufacturing pumps he needed to expand his factory and purchase a new machinery
(overall Rs 5 lakh more was needed). Raw material for pumps would be needed which would cost Rs 300 per
unit. Additional labour would be required to make the pumps, thus increasing the labour costs to Rs 250 per
unit. The making of pumps would also draw more electricity etc. thereby increasing the variable overhead costs.
The banks were not willing to ?nance him. Mr Lalchi Singh, the loan shark, saw opportunity to make money and
offered to loan money to Mr Coolguy for a period of one year at the rate of more than 20 per cent, the loan to
be paid in two instalments of, Rs 3 lakh each, the ?rst one is to be made in the ?rst six months and the second
instalment at the end of the year. The interest would be paid at the end of the year. If Mr Coolguy fails to pay
Comprehensive Cases 9
back the interest and the principal on the due date, Mr Lalchi would be entitled to auction off the factory and get
back his sum. Mr Coolguy now has to decide whether to accept the offer or not.
Mr Coolguy asked Mr Calculator to ?nd out the implications of the above mentioned factors on the pro?ts and
whether he would be able to satisfy Mr Lalchi’s conditions. Mr Calculator came out with the following reports:
(IV) Cost if Loan Is Taken For Production of Pumps
Item Fixed cost Variable cost and expenses
Direct material Direct labour Variable overheads
Labour Rs 12,10,000 Rs 20,00,000
Steel sheets Rs 48,00,000
Electricity 35,000 Rs 360,000
Depreciation 15,06,620
Khus 7,20,000
Tubes 4,00,000
Wires 40,000
Fan 11,60,000
Telephone 4,580 3,68,000
Rent (of?ce) 1,20,000
Of?ce expenses 22,000 3,46,000
Bank charges 18,000
Insurance 35,000
Repair and maintenance 25,000 2,76,800
Recruitment 51,200
Travel 3,04,000
Conveyance 16,800 1,52,000
Post, courier and parcel 7,000 1,36,000
Machinery 5,00,000
Miscellaneous 1,20,000
Pump shaft 800,000
Pump wires 400,000
Pump cylinder 10,00,000
Lubrication and insulation 200,000
Total 3500,000 95,20,000 20,00,000 21,14,000
(V) Projected Pro?t When Pumps Are Produced
Sales revenue @ Rs 2,500 per unit (8,000 units) Rs 200,00,000
Less: Variable costs
Direct material 95,20,000
Direct labour 20,00,000
Variable overheads 21,14,000
Total contribution 63,66,000
Less: Fixed costs 35,00,000
Operating pro?t 28,66,000
Less: Interest + Principal 6,00,000
EBT 22,20,000
10 Financial Management
Contribution per unit = Rs 63,66,000/ 8,000 = Rs 795.75
BEP (units) = Total ?xed cost/contribution margin per unit
= Rs 41,00,000/795.75 = 5152 units
Attributing no ?xed cost in the ?rst six months so as to pay the ?rst instalment comfortably:
Number of units to be sold in the ?rst six months = Rs 300,000/contribution margin per unit
= Rs 300,000/Rs 795.75 = 377 units
Number of units to be sold in the next six months = Rs 38,00,000/Rs 795.75 = 4,775 units
Attributing half the ?xed costs in the ?rst six months:
Number of units to be sold in the ?rst six months = Rs 20,50,000/Rs 795.75 = 2,576 units
Number of units to be sold in the next six months = Rs 20,50,000/Rs 795.75 = 2,576 units
Mr Calculator’s Inference:
Manufacturing pumps indigenously would eat away the pro?ts by another Rs 66,000. There is also an inherent risk
of default of the ?rst instalment to Mr Lalchi as it would not be possible to sell even 377 units in the off season.
There is no reason why Mr Coolguy should go ahead with the idea of indigenous pumps.
After seeing the income statement and break-even analysis, Mr Coolguy decided not to take the loan but
since his son, Mr Cooldude (doing MBA from IIT Delhi) had come home for a few days. He thought it wise to
take his opinion too.
Cooldude came up with a radically different opinion. He suggested that since the machinery was meant for
long-term use, it would not be prudent to charge its cost in the current year itself. It would be better to amortise
the cost over a period of ?ve years. He suggested to amortise Rs 1 lakh per year (assuming no sale value at
the end of 5 years). This gave a different picture altogether.
(VI) Cost Estimate (Revised)
Item Fixed cost Variable cost and expenses for 8,000 units
Direct material Direct labour Variable overhead
Labour Rs 12,10,000 Rs 20,00,000
Steel sheets Rs 48,00,000
Electricity 35,000 Rs 360,000
Depreciation 15,06,620
Khus 7,20,000
Tubes 4,00,000
Wires 40,000
Fan 11,60,000
Telephone 4,580 3,68,000
Rent (of?ce) 1,20,000
Of?ce expenses 22,000 3,46,000
Bank charges 18,000
Insurance 35,000
Repair and maintenance 25,000 2,76,800
Recruitment 51,200
Travel 3,04,000
Conveyance 16,800 1,52,000
Post, courier and parcel 7,000 1,36,000
Miscellaneous 1,20,000
Depreciation on machinery 100,000
(Contd.)
Comprehensive Cases 11
Interest 1,00,000
Pump shaft 800,000
Pump wires 400,000
Pump cylinder 10,00,000
Lubrication and insulation 200,000
Total 32,00,000 95,20,000 20,00,000 21,14,000
(VII) Projected Pro?ts (Revised)
Sales revenue @ Rs 2,500 per unit Rs 200,00,000
Less: Variable costs
Direct material 96,00,000
Direct labour 20,00,000
Variable overheads 20,34,000
Total contribution 63,66,000
Less: Fixed costs 32,00,000
EBIT 31,66,000
Cooldude then explained his father that charging the entire cost of the machine in the current year leads to the
reduction in pro?ts of the current year. Such purchases (capital expenditures) should be amortised over a period
of time. Besides, payment of loan is not an expense. It is expense only to the extent of interest paid. Thus, what
seemed to be a decrease in pro?t by Rs 66,000 was actually an increase by Rs 8,80,000.
At this juncture, Mr Coolguy became very enthusiastic about taking the loan. Cooldude then warned his father
that Mr. Lalchi might have set up a trap for him as it was the beginning of February. Generally, desert coolers are
not bought in these months. It would be dif?cult to sell even a modest target of 377 units (not taking the ?xed
costs into account in the ?rst six months) in these months. However, by offering heavy off-season discount (up
to 20 per cent) the sales can be pushed up signi?cantly. Proper advertising should be done so as to inform the
people that the discount would be available only for a short-term. As Thandak has a monopoly in the region, the
people would like to cash on this opportunity, and the sales would go up. The discount should be discontinued
as soon as the cash position (with respect to the ?rst payment of instalment) is reached.
New selling price = Rs 2,000
Revise contribution per unit = Rs 295.75
Rs 300,000/Rs 295.75 = 1,014 units.
As soon as 1,014 units are sold the discount should be discontinued.
(VIII) Projected Pro?ts With Change in Selling Price
Total contribution = 1,014* Rs 295.75 + (8,000 – 1014)* Rs 795.75 Rs 58,59,000
Less: Fixed costs 32,00,000
EBIT 26,59,000
Thus, the proposition of Mr Lalchi is not devoid of connivance. In order to pay the ?rst instalment of Rs 3 lakh
to Mr Lalchi, Mr Coolguy would have to forego a substantial pro?t.
Recommendation
Mr Coolguy should not take the loan this year.
A mild summer one year is usually a harbinger of a scorching summer in the following year, in the city of Mr
Coolguy. The demand for desert coolers is likely to shoot up the next year. It would not be prudent then to
keep up purchasing pumps from Mr Opportunity Singh.
Investment for making pumps should me made next year’s winter from the pro?ts of this year’s summer.
(Contd.)
CHAPTER 8
Budgeting and Profit Planning
SOUND FUTURE COMMUNICATIONS LIMITED
Sound Future Communications Limited (SFCL) is planning pro?t for the current year. The Chairman and Managing
Director of the Company, Mr Wise has asked the Accounts and Finance Department to prepare the budget
outlining the implications of achieving the pro?t goal of Rs 7 lakh. The Budgeting Department has compiled the
information related to its operating and ?nancing activities as detailed in schedules I to VIII.
I. Balance Sheet as at March 31 of the Current Year
Liabilities Amount Assets Amount
Share capital Rs 31,77,428 Fixed assets Rs 48,00,000
Retained earnings 18,96,400 Less: Accumulated
Creditors 44,000 depreciation (12,00,000) Rs 36,00,000
Taxes payable 74,000 Inventories:
Direct materials 1,35,828
Finished goods 1,60,000 2,95,828
Debtors 11,20,000
Less: Provision for
bad debts (64,000) 10,56,000
Cash 2,40,000
51,91,828 51,91,828
Notes: (i) Debtors include Rs 1,60,000 from the third quarter sales of Rs 20,00,000 and Rs 9,60,000
from fourth quarter sales of Rs 12,00,000; (ii) Direct materials include 6,300 kgs of material A @
Rs 5.88 per kg and 12,600 kgs of material B @ Rs 7.84 per kg; and (iii) Finished goods include
4,000 units @ Rs 40 per unit.
II. Budget assumptions
(i) Selling price, Rs 60 per unit
(ii) Quarterly sales forecast (units)
Quarter Next year Year following next year
First 20,000 30,000
Second 30,000
Third 40,000
Fourth 20,000
III. Inventory policy
— Finished goods: 20 per cent of the following quarter’s requirements at the end of each quarter.
— Raw materials: 30 per cent of the following quarter’s requirements at the end of each quarter.
— The ?rm wishes to have 9,200 kgs of each type of direct material on hand at March 31 of the next year.
IV. Manufacturing cost per unit
Direct materials:
1 kg of A @ Rs 5.88 Rs 5.88
2 kgs of B @ Rs 7.84 15.68 Rs 21.56
Direct labour: 0.5 ? direct labour-hour @ Rs 8 4.00
(Contd)
Comprehensive Cases 13
Overheads:
Variable (0.5 ? direct labour-hour @ Rs 12) 6.00
Fixed (Rs 8,44,000 per year/Normal level of activity, 1,00,000 units) 8.44 14.44
Total 40.00
The quarterly ?xed manufacturing costs of Rs 2,11,000 include depreciation totaling Rs 50,000. All production
variances are written off as an adjustment to the cost of goods sold in the period in which they occurred. The
?rm follows absorption costing method for income determination.
V. Selling and administrative costs:
Commission and distribution, Rs 6 per unit sold
Advertising, Rs 10,000 per quarter
Administrative, Rs 20,000 per quarter.
VI. Cash disbursement policy: Raw materials are purchased on terms of 2/10, net/30. Discount is always taken
and purchases are recorded at net; 90 per cent of the purchases are paid for in the quarter of purchase and
remainder are paid for in the following quarter. The list prices of materials A and B are Rs 6 per kg and Rs 8
per kg respectively. With the exception of income taxes, which are paid during the following quarter, all other
payments are made when incurred.
VII. Cash collection experience: 20 per cent sales are for cash and 80 per cent are on credit. The terms of sales
are 2/10, net/60 days. However, for payments, the sales are billed to customers on the ?rst day of the following
quarter; 50 per cent of the credit sales are collected during the discount period and another 40 per cent are
received after the discount period but during the quarter in which the billing is done; 7.5 per cent are received
during the following quarter and 2.5 per cent are bad debts. These accounts are written off at the end of the
2
nd
quarter following the sales. A provision of 2 per cent of sales is made for bad debts at the time of sales.
Sales discounts are recorded as a deduction from sales in the quarter the discounts are taken. Based on prior
experience, this deduction equals 0.8 per cent of the previous quarter’s sales (0.8 ? 0.5 ? 0.02).
VIII. Other information:
— Income tax rate is 50 per cent.
— Cash dividends amount to Rs 80,000 at the end of quarter 2 and quarter 4.
— At the end of the 4
th
quarter, equipment costing Rs 6,00,000 was purchased.
Prepare a comprehensive, quarter-wise, budget to show the projected income of SFCL for the year.
Solution
Quarter-wise Sales Forecast Schedule
Quarter First Second Third Fourth Total
Units sales 20,000 30,000 40,000 20,000 1,10,000
Unit sale price ? Rs 60 ? Rs 60 ? Rs 60 ? Rs 60 ? Rs 60
Sales revenue 12,00,000 18,00,000 24,00,000 12,00,000 66,00,000
Production Budget (Units)
Quarter First Second Third Fourth Total
Sales 20,000 30,000 40,000 20,000 1,10,000
Add: Desired closing inventory
(0.20 ? next quarter) 6,000 8,000 4,000 6,000 6,000
Total ?nished goods
requirement 26,000 38,000 44,000 26,000 1,16,000
Less: Opening Inventory 4,000 6,000 8,000 4,000 4,000
Required production 22,000 32,000 36,000 22,000 1,12,000
(Contd)
14 Financial Management
Quarterly Manufacturing Cost Budget
Quarter First Second Third Fourth Total
Required production (units) 22,000 32,000 36,000 22,000 1,12,000
Variable costs:
A (Rs 5.88 per unit) Rs 1,29,360 Rs 1,88,160 Rs 2,11,680 Rs 1,29,360 Rs 6,58,560
B (Rs 15.68 per unit) 3,44,960 5,01,760 5,64,480 3,44,960 17,56,160
Direct labour (Rs 4 per unit) 88,000 1,28,000 1,44,000 88,000 4,48,000
Overheads (Rs 6 per unit) 1,32,000 1,92,000 2,16,000 1,32,000 6,72,000
6,94,320 10,09,920 11,36,160 6,94,320 35,34,720
Fixed costs:
Depreciation 50,000 50,000 50,000 50,000 2,00,000
Other overheads 1,61,000 1,61,000 1,61,000 1,61,000 6,44,000
2,11,000 2,11,000 2,11,000 2,11,000 8,44,000
Total costs 9,05,000 12,20,920 13,47,160 9,05,320 43,78,720
Budgeted ?xed costs 2,11,000 2,11,000 2,11,000 2,11,000 8,44,000
Less: Fixed costs charged
(@Rs 8.44 per unit) 1,85,680 2,70,080 3,03,840 1,85,680 9,45,280
Capacity variance 25,320 59,080 92,840 25,320 1,01,280
(Unfavourable)* (Favourable)** (Favourable) (Unfavourable) (Favourable)
*Under-recovery/under-absorption of ?xed costs;
**Over-recovery/over-absorption of ?xed costs.
Quarterly Purchase Budget of Raw Materials
Quarter First Second Third Fourth Total
Material (A):
Production requirement
(in units) 22,000 32,000 36,000 22,000 1,12,000
Raw material required
@ 1 kg per unit 22,000 32,000 36,000 22,000 1,12,000
Add: Desired ending
inventory (30 per cent
of the next quarter’s
requirement) 9,600 10,800 6,600 9,200 9,200
Total requirement 31,600 42,800 42,600 31,200 1,21,200
Less: Opening inventory 6,300 9,600 10,800 6,600 6,300
Purchase requirement (kgs) 25,300 33,200 31,800 24,600 1,14,900
Purchase cost
(@ Rs 5.88 per kg) Rs 1,48,764 Rs 1,95,216 Rs 1,86,984 Rs 1,44,648 Rs 6,75,612
Material (B):
Raw material
required @ 44,000 64,000 72,000 44,000 2,24,000
2 kg per unit)
Add: Desired ending
inventory (30 per cent
of the next quarter’s
requirement) 19,200 21,600 13,200 9,200 9,200
Total requirements 63,200 85,600 85,200 53,200 2,33,200
Less: Opening inventory 12,600 19,200 21,600 13,200 12,600
Purchase requirement (kgs) 50,600 66,400 63,600 40,000 2,20,600
Purchase cost
(@ Rs 7.84 per kg) Rs 3,96,704 Rs 5,20,576 Rs 4,98,624 Rs 3,13,600 Rs 17,29,504
Total purchase cost (A + B) 5,45,468 7,15,792 6,85,608 4,58,248 24,05,116
Comprehensive Cases 15
Quarterly Selling and Administrative Expenses Budget
Quarter First Second Third Fourth Total
Units sales 20,000 30,000 40,000 20,000 1,10,000
Variable costs:
Commission and
distribution
(Rs 6 per unit) Rs 1,20,000 Rs 1,80,000 Rs 2,40,000 Rs 1,20,000 Rs 6,60,000
Fixed costs:
Advertising 10,000 10,000 10,000 10,000 40,000
Administrative 20,000 20,000 20,000 20,000 80,000
30,000 30,000 30,000 30,000 1,20,000
Total 1,50,000 2,10,000 2,70,000 1,50,000 7,80,000
Qarterly Budgeted Income Statement (Absorption Costing)
Quarter First Second Third Fourth Total
Sales revenue Rs 12,00,000 Rs 18,00,000 Rs 24,00,000 Rs 12,00,000 Rs 66,00,000
Less: Provision for bad
and doubtful debts
(0.02 ? sales) 24,000 36,000 48,000 24,000 1,32,000
Less: Sales discount
(0.8 ? previous
quarter’s sales) 9,600 9,600 14,400 19,200 52,800
Net sales 11,66,400 17,54,400 23,37,600 11,56,800 64,15,200
Less: Cost of goods
sold (@ Rs 40 per unit) 8,00,000 12,00,000 16,00,000 8,00,000 44,00,000
Gross margin (unadjusted) 3,66,400 5,54,400 7,37,600 3,56,800 20,15,200
Add: Capacity variance
favourable
Less: Unfavourable (25,320) 59,080 92,840 (25,320) 1,01,280
Gross margin (adjusted) 3,41,080 6,13,480 8,30,440 3,31,480 21,16,480
Less: Selling and
administrative costs 1,50,000 2,10,000 2,70,000 1,50,000 7,80,000
Earnings before taxes 1,91,080 4,03,480 5,60,440 1,81,480 13,36,480
Less: Taxes (0.50) 95,540 2,01,740 2,80,220 90,740 6,68,240
Earnings after taxes 95,540 2,01,740 2,80,220 90,740 6,68,240
Quarterly Budgeted Statement of Retained Earnings
Quarter First Second Third Fourth Total
Opening balance Rs 18,96,400 Rs 19,91,940 Rs 21,13,680 Rs 23,93,900 Rs 18,96,400
Add: Earnings after
taxes 95,540 2,01,740 2,80,220 90,740 6,68,240
Closing balance 19,91,940 21,93,680 23,93,900 24,84,640 25,64,640
Less: Dividends paid — 80,000 — 80,000 1,60,640
Closing balance 19,91,940 21,13,680 23,93,900 24,04,640 24,04,640
16 Financial Management
Quarterly Schedule Relating to Collection from Debtors
Quarter First Second Third Fourth Total
Opening balance Rs 11,20,000 Rs 10,56,000 Rs 15,36,000 Rs 20,64,000 Rs 11,20,000
Add: Credit sales 9,60,000 14,40,000 19,20,000 9,60,000 52,80,000
Total amount due 20,80,000 24,96,000 34,56,000 30,24,000 64,00,000
Less: Collection:
(i) During discount
period (0.50 ? prior
quarter credit sales) 4,80,000 4,80,000 7,20,000 9,60,000 26,40,000
(ii) After discount period
(0.40 ? prior quarter
credit sales) 3,84,000 3,84,000 5,76,000 7,68,000 21,12,000
(0.075 ? 2nd prior
quarter credit sales) 1,20,000 72,000 72,000 1,08,000 3,72,000
Written-off bad debts
(0.025 ? credit sales
of 2nd prior quarter
credit sales) 40,000 24,000 24,000 36,000 1,24,000
Closing balance 10,56,000 15,36,000 20,64,000 11,52,000 11,52,000
Quarterly Schedule Relating to Payment to Creditors
Particulars First Second Third Fourth Total
Opening balance Rs 44,000 Rs 54,546.80 Rs 71,579.20 Rs 68,560.80 Rs 44,000
Add: Credit
purchases
(net of discount) 5,45,468 7,15,792.00 6,85,608.00 4,58,248 24,05,116
Total amount payable 5,89,468 7,70,338.80 7,57,187.20 5,26,808,80 24,49,116
Less: Payments:
(i) During the
same quarter
(0.90) 4,90,921.20 6,44,212.80 6,17,047.20 4,12,423.20 21,64,604.4
(ii) For the prior
quarter (0.10) 44,000.00 54,546.80 71,579.20 68,560.80 2,38,686.8
Closing balance 54,546.80 71,579.20 68,560.80 45,824.80 45,824.8
Quarterly Cash Budget
Particulars First Second Third Fourth Total
Cash in?ows:
Cash sales (0.20) Rs 2,40,000 Rs 3,60,000 Rs 4,80,000 Rs 2,40,000 Rs 13,20,000
Collection from
debtors:
Credit sales subject
to discount (0.50) 4,80,000 4,80,000 7,20,000 9,60,000 26,40,000
Less: Discount (0.02) 9,600 9,600 14,400 19,200 52,800
Net amount 4,70,400 4,70,400 7,05,600 9,40,800 25,87,200
0.40 ? prior quarter
credit sales 3,84,000 3,84,000 5,76,000 7,68,000 21,12,000
0.075 ? 2
nd
prior quarter
sales 1,20,000 72,000 72,000 1,08,000 3,72,000
(Contd)
Comprehensive Cases 17
Total collections from
debtors 9,74,400 9,26,400 13,53,600 18,16,800 50,71,200
Total cash in?ows 12,14,400 12,86,400 18,33,600 20,56,800 63,91,200
Cash out?ows:
Payment to creditors Rs 5,34,921.20 Rs 6,98,759.60 Rs 6,88,626.40 Rs 4,80,984.00 Rs 24,03,291.20
Direct labour 88,000 1,28,000.00 1,44,000 88,000 4,48,000.00
Variable overheads 1,32,000 1,92,000 2,16,000 1,32,000 6,72,000.00
Fixed overheads 1,61,000 1,61,000 1,61,000 1,61,000 6,44,000.00
Selling and administrative 1,50,000 2,10,000 2,70,000 1,50,000 7,80,000.00
overheads
Income taxes 74,000 95,540 2,01,740 2,80,220 6,51,500.00
Dividends — 80,000 — 80,000 1,60,000.00
Equipment — — — 6,00,000 6,00,000.00
Total cash out?ows 11,39,921.20 15,65,299.60 16,81,366.40 19,72,204 63,58,791.20
Net cash in?ows 74,478.80 (2,78,899.60) 1,52,233.6 84,596.00 32,408.8
Opening balance 2,40,000.00 3,14,478.80 35,579.2 1,87,812.80 2,40,000.0
Closing balance 3,14,478.80 35,579.20 1,87,812.80 2,72,408.80 2,72,408.8
Budgeted Balance Sheet as at March 31, Next Year
Liabilities Amount Assets Amount
Share capital Rs 31,77,428 Fixed assets Rs 54,00,000
Retained earnings 24,04,640 Less: Accumulated
Creditors 45,824.80 depreciation 14,00,000 Rs 40,00,000
Taxes payable 90,740 Inventories:
Direct material 1,26,224
(Material A, 9,200 ? Rs 5.88)
(Material B, 9,200 ? Rs 7.84)
Finished goods
(6,000 ? Rs 40) 2,40,000 3,66,224
Debtors 11,52,000
Less: Allowances for bad debts
(Rs 64,000 + Rs 1,32,000 –
Rs 1,24,000) 72,000 10,80,000
Cash 2,72,408.80
57,18,632.8 57,18,632.8
(Contd)
CHAPTER 9
Capital Budgeting I: Principles and Techniques
REMOTE ADDICTION LTD
Remote Addiction Ltd makes 53 cm colour TV sets. They curerntly sell 40,000 units per year which corresponds
to 100 per cent of their manufacturing capacity. The marketing team, based on the market information from their
dealers, feels that Remote Addiction Ltd could sell 50,000 units per year at the existing selling price, level of
advertising, and existing dealer commissions. However, the plant is not geared up to produce at these levels. The
bottleneck is the speed of the assembly line which will support only 40,000 units per year even when operating
in round the clock shifts. The only way to increase manufacturing capacity would be to replace the current as-
sembly line with a new higher speed assembly line.
The marketing manager, Mr Becho Kumar, strongly feels that it is extremely important for the Remote Ad-
diction Ltd to grab the additional market share that is available to them for the asking. He is, therefore, keen to
instal a high speed assembly line instal to boost the manufacturing capacity so as to meet the anticipated level
of 50,000 units per year. He approached the managing director, Mr Dhanda Singh, to explore the possibility of
replacing the existing assembly line with a higher speed assembly line.
Mr Dhanda Singh called the ?nance manager, Mr Rupaya Gupta, and asked him to make a recommendation
regarding the replacement of the existing assembly line with a higher speed assembly line. He clearly stated that
the recommendation should be based on a required rate of return of 15 per cent. Mr Rupaya Gupta sought some
time to collect information and perform a ?nancial analysis in order to make his recommendation. Mr Dhanda
Singh asked him to go ahead with the necessary ?nancial analysis.
Mr Gupta made inquiries regarding a higher speed assembly lines and decided that the next higher speed
compared to what they currently had would support a manufacturing capacity of 80,000 units per year. This could
be purchased for Rs 1,00,00,000 and would have a useful economic life of 5 years with no salvage value at the
end of 5 years. For comparison, he determined that the existing assembly line would also have a useful life of
another 5 years with no salvage value at the end of 5 years. The current book value of the existing assembly
line is Rs 16,00,000 with a market value of Rs 12,00,000. The tax laws as a special case allow straight line
depreciation for TV manufacturing assembly lines.
Mr Gupta then collected all other relevant ?nancial information corresponding to the existing assembly line
operating at a manufacturing level of 40,000 units per year as well as the proposed new assembly line operating
at a manufacturing level of 50,000 units per year. This information is summarised in Exhibit 1.
EXHIBIT 1
Particulars Existing assembly line New assembly line
(40, 000 units per year) (50,000 units per year)
Selling price (Rs per unit) 19,900 19,990
Material cost (Rs per unit) 7,500 7,500
Labour cost (Rs per unit) 1,600 2,700
Manufacturing overherads (Rs per unit) 1,800 2,350
Dealer commissions (Rs per unit) 800 800
Advertising cost (Rs per year) 2,00,00,000 2,00,00,000
Depreciation (Rs per year) 3,20,000 20,00,000
Working capital requirement (Rs) 41,00,000 48,00,000
Income tax rate (per cent) 35 35
Comprehensive Cases 19
Based on the above information, Mr Rupaya Gupta performed the necessary ?nancial analysis and provided
Mr Dhanda Singh with the report that is shown in Exhibit 2. The NPV as given in this report is (Rs 61,69,604).
Mr Rupaya Gupta’s recommendation is that since the NPV is negative, Remote Addiction Ltd should not replace
the existing assembly line with a new higher speed assembly line.
Mr Becho Kumar was very disappointed to hear this and met Mr Rupaya Gupta to understand what should
be done so that the proposal for a new higher speed assembly line could be accepted. Mr Gupta explained
that even though the projected sales of 50,000 units per year was signi?cantly higher than the existing sales of
40,000 per units per year, it was still not high enough. Mr Becho Kumar needed to ?gure out a way to increase
the sales further. He hired the market research ?rm of Bazaar Pulse Pvt Ltd to determine ways to increase sales
beyond 50,000 units per year. They came up with the following three mutually exclusive options.
1. Increase sales through trade push. This involves increasing dealer commission from Rs 800 per unit to
Rs 1,100 per unit to attain a sales level of 53,000 units per year.
2. Increase sales through customer pull. This involves increasing the advertising expenditure from
Rs 2,00,00,000 per year to Rs 4,00,00,000 per year to attain a sales level of 55,000 units per year.
3. Increase sales by exploiting the price elasticity of demand. This involves reducing the selling price of the
TV sets from Rs 19,900 per unit to Rs 18,900 per unit to attain a sales level of 59,000 units per year.
Mr Becho Kumar approaches Mr Rupaya Gupta with the three options and requested him to perform a ?nancial
analysis to determine if purchasing the new higher speed assembly line could now be justi?ed. Before starting
the detailed ?nancial analysis, Mr Rupaya Gupta ?rst assessed whether any of the previous data he had col-
lected and estimated would change for the above three options over and above the speci?c changes that are
mentioned in the options. He concluded that the only additional data that would change would be the working
capital requirement at the different sales levels. He estimated these working capital requirerments as follows.
Sales level (units per year) Working capital requirement
53,000 Rs 50,00,000
55,000 51,00,000
59,000 53,00,000
With Mr Dhanda Singh’s approval, Mr Rupaya Gupta then proceeded with a detailed ?nancial analysis for all
three options. He presented three reports for each of the three options.
Exhibit 3 shows the report for the option corresponding to increasing sales through trade push. The NPV
as given in this report is Rs 24,88,572. Mr Rupaya Gupta’s initial recommendation was that since the NPV is
positive, this option could be considered. Exhibit 4 shows the report for the option corresponding to increasing
sales through customer pull. The NPV as given in this report is Rs 2,24,39,656. Mr Rupaya Gupta’s initial rec-
ommendation was that since the NPV is positive, this option could be considered. Exhibit 5 shows the report for
the option corresponding to increasing sales by exploiting the price elasticity of demand. The NPV as given in
this report is Rs 47,65,216. Mr Rupaya Gupta’s recommendation was that since the NPV is negative, this option
should be rejected straight away.
With the complete ?nancial analysis for all three options in front of him, Mr Gupta concluded that it would
be advisable to replace the existing assembly line with a new higher speed assembly line in conjunction with
increasing sales through customer pull affected by an increase in the advertising expenditure. Even though the
NPV was positive for both increasing sales through trade push as well as increasing sales through customer
pull, Mr Gupta preferred the option of increasing sales through customer pull because it had a higher NPV. A
20 Financial Management
higher NPV would result in a higher net addition to the wealth of the ?rm consistent with the overall objective of
maximising the wealth of the corporate ?rm.
A qualitative bene?t would arise from Remote Addiction Ltd’s garnering a higher market share resulting from
the increased sales along with enhanced brand equity resulting from the increased advertising expenditure. Mr
Rupaya Gupta also felt that Remote Addiction Ltd should utilise the excess capacity of the higher speed assem-
bly line by exploring possibilities in the export market. This had the potential of further increasing the NPV and,
therefore, increasing the net addition to the wealth of the ?rm.
Recommendation
Mr Rupaya Gupta made his ?nal recommendations to Mr Dhanda Singh as follows:
1. Replace the existing assembly line with a new higher speed assembly line that would support a manufactur-
ing capacity of 80,000 units per year.
2. Increase the advertising expenditure from Rs 2,00,00,000 per year to Rs 4,00,00,000 per year to attain a
sales level of 55,000 units per year.
3. Explore opportunities in the export market to utilise the excess manufacturing capacity of 25,000 units per
year that would be available.
EXHIBIT 2 Financial Analysis for Replacement Decision Using the NPV Method (Projected Sales
Level of 50,000 Units per Year)
(I) Incremental Cash Out?ow (t = 0)
Cost of new assembly line Rs 1,00,00,000
Less: Sales of existing assembly line 12,00,000
Tax advantage (Rs 4,00,000, loss on sale x 0.35) 1,40,000
Add: Incremental working capital 7,00,000
93,60,000
(II) Incremental Cash In?ow
Particulars Existing assembly lineNew assembly line
(40,000 units per year) (50,000 units per year)
Sales revenue Rs 79,96,00,000 Rs 99,95,00,000
Less:
Material cost 30,00,00,000 37,50,00,000
Labour cost 6,40,00,000 13,50,00,000
Manufacturing overheads 7,20,00,000 11,75,00,000
Dealer commissions 3,20,00,000 4,00,00,000
Advertising cost 2,00,00,000 2,00,00,000
Depreciation 3,20,000 20,00,000
EBT 31,12,80,000 31,00,00,000
Less: Tax 10,89,48,000 10,85,00,000
EAT 20,23,32,000 20,15,00,000
Add: Depreciation 3,20,000 20,00,000
CFAT 20,26,52,000 20,35,00,000
Incremental CFAT Rs 8,48,000
Comprehensive Cases 21
(III) Determination of NPV
Years CFAT PVIF @ 15 per cent Total PV
1 to 5 Rs 8,48,000 3.352 Rs 28,42,496
5 (recovery of incremental 7,00,000 0.497 3,47,900
working capital assuming
100 per cent recovery) 31,90,396
PV of cash out?ows 93,60,000
NPV (61,69,604)
(IV) Recommendation Since NPV is negative, do not accept the proposal to buy a replacement the as-
sembly line
EXHIBIT 3 Financial Analysis for Replacement Decision Using NPV method [Projected Sales Level
of 53,000 Units Per Year (Trade Push Option)]
(I) Incremental Cash Outflow (t = 0)
Cost of new assembly line Rs 1,00,00,000
Less: Sales of existing assembly line 12,00,000
Tax advantage (Rs 4,00,000, loss on sale 3 0.35) 1,40,000
Add: Incremental working capital 9,00,000
95,60,000
(II) Incremental Cash Inflow
Particulars Existing assembly line New assembly line
(40,000 units per year) (50,000 units per year)
Sales revenue Rs 79,96,00,000 Rs 105,94,70,000
Less:
Material cost 30,00,00,000 39,75,00,000
Labour cost 6,40,00,000 14,31,00,000
Manufacturing overheads 7,20,00,000 12,45,50,000
Dealer commissions 3,20,00,000 12,45,50,000
Advertising cost 2,00,00,000 2,00,00,000
Depreciation 3,20,000 20,00,000
EBT 31,12,80,000 31,40,20,000
Less: Tax 10,89,48,000 10,99,07,000
EAT 20,23,32,000 20,41,13,000
Add: depreciation 3,20,000 20,00,000
CFAT 20,26,52,000 20,61,13,000
Incremental CFAT Rs 34,61,000
22 Financial Management
(III) Determination of NPV
Years CFAT PVIF @ 15 per cent Total PV
1 to 5 Rs 34,61,000 3.352 Rs 1,16,01,272
5 (recovery of incremental working 9,00,000 0.497 4,47,300
capital assuming 100 per cent recovery) 1,20,48,572
PV of cash out?ows 95,60,000
NPV 24,88,572
(IV) Recommendation Since NPV is negative, this option should be rejected.
EXHIBIT 4 Financial Analysis for Replacement Decision Using NPV method [Projected Sales Level
of 55,000 Units per Year (Customer Pull Option)]
(I) Incremental Cash Outflow (t = 0)
Cost of new assembly line Rs 1,00,00,000
Less: Sales of existing assembly line (12,00,000)
Tax advantage (Rs 4,00,000, loss on sale 3 0.35) 1,40,000
Add: Incremental working capital 10,00,000
96,60,000
(II) Incremental Cash Inflow
Particulars Existing assembly line New assembly line
(40,000 units per year) (50,000 units per year)
Sales revenue Rs 79,96,00,000 Rs 1,09,94,50,000
Less:
Material cost 30,00,00,000 41,25,00,000
Labour cost 6,40,00,000 14,85,00,000
Manufacturing overheads 7,20,00,000 12,92,50,000
Dealer commissions 3,20,00,000 4,40,00,000
Advertising cost 2,00,00,000 4,00,00,000
Depreciation 3,20,000 20,00,000
EBT 31,12,80,000 32,32,00,000
Less: Tax 10,89,48,000 11,31,20,000
EAT 20,23,32,000 21,00,80,000
Add: Depreciation 3,20,000 20,00,000
CFAT 20,26,52,000 21,20,80,000
Incremental CFAT Rs 94,28,000
Comprehensive Cases 23
(III) Determination of NPV
Years CFAT PVIF @ 15 per cent Total PV
1 to 5 Rs 94,28,000 3.352 Rs 3,16,02,656
5 (recovery of incremental working 10,00,000 0.497 4,97,300
capital assuming 100 per cent recovery) 3,20,99,656
PV of cash out?ows 96,60,000
NPV 2,24,39,656
(IV) Recommendation Since NPV is negative, this option can be considered.
EXHIBIT 5 Financial Analysis for Replacement Decision Using NPV method [Projected Sales Level
of 59,000 Units Per Year (Exploiting Price Elasticity of Demand Option)]
(I) Incremental Cash Outflow (t = 0)
Cost of new assembly line Rs 1,00,00,000
Less: Sales of existing assembly line 12,00,000
Tax advantage (Rs 4,00,000, loss on sale x 0.35) 1,40,000
(loss in selling existing assembly line)
Add: Incremental working capital 12,00,000
98,60,000
(II) Incremental Cash Inflow
Particulars Existing assembly line New assembly line
(40,000 units per year) (50,000 units per year)
Sales revenue Rs 79,96,00,000 Rs 1,12,04,10,000
Less:
Material cost 30,00,00,000 44,25,00,000
Labour cost 6,40,00,000 15,93,00,000
Manufacturing overheads 7,20,00,000 13,86,50,000
Dealer commissions 3,20,00,000 4,72,00,000
Advertising cost 2,00,00,000 2,00,00,000
Depreciation 3,20,000 20,00,000
EBT 31,12,80,000 31,07,60,000
Less: Tax 10,89,48,000 10,87,66,000
EAT 20,23,32,000 20,19,94,000
Add: Depreciation 3,20,000 20,00,000
CFAT 20,26,52,000 20,39,94,000
Incremental CFAT Rs 13,42,000
24 Financial Management
(III) Determination of NPV
Years CFAT PVIF @ 15 per cent Total PV
1 to 5 Rs 13,42,000 3.352 Rs 44,98,384
5 (recovery of incremental working 12,00,000 0.497 5,96,400
capital assuming 100 per cent recovery) 50,94,784
PV of cash out?ows 98,60,000
NPV (47,65,216)
(IV) Recommendation Since NPV is negative, this option should be rejected.
CHAPTER 10
Capital Budgeting II: Additional Aspects
SMOOTHDRIVE TYRE LTD
Smoothdrive Tyre Ltd manufacturers tyres under the brand name ‘Super Tread’ for the domestic car market. It
is presently using 7 machines acquired 3 years ago at a cost of Rs 15 lakh each having a useful life of 7 years,
with no salvage value.
After extensive research and development, Smoothdrive Tyre Ltd has recently developed a new tyre, the ‘Hy-
perTread’, and must decide whether to make the investments necessary to produce and market the HyperTread.
The HyperTread would be ideal for drivers doing a large amount of wet weather and off road driving in addition
to normal highway usage. The research and development costs so far total Rs 1,00,00,000. The HyperTread
would be put on the market beginning this year and Smoothdrive Tyre expects it to stay on the market for a total
of three years. Test marketing, costing Rs 50,00,000, shows that there is a signi?cant market for a HyperTread
type tyre.
As a ?nancial analyst at Smoothdrive Tyre, Mr Mani is aksed by the Chief Financial Of?cer (CFO), Mr Tyrewala
to evaluate the HyperTread project and to provide a recommendation on whether or not to proceed with the
investment. He has been informed that all previous investments in the HyperTread project are sunk costs and
only future cash ?ows should be considered. Except for the initial investments, which occur immediately, assume
all cash ?ows occur at the year-end.
Smoothdrive Tyre must initially invest Rs 72,00,00,000 in production equipments to make the HyperTread.
They would be depreciated at a rate of 25 per cent as per the written down value (WDV) method for tax pur-
poses. The new production equipments will allow the company to follow ?exible manufacturing technique, that
is, both the brands of tyres can be produced using the same equipments. The equipment is expected to have a
7-year useful life and can be sold for Rs 10,00,00,000 during the fourth year. The company does not have any
other machines in the block of 25 per cent depreciation. The existing machines can be sold off at Rs 8 lakh per
machine with an estimated removal cost of one machine for Rs 50,000.
Operating Requirements
The operating requirements of the existing machines and the new equipment are detailed in Exhibits 10.1 and
10.2 respectively.
EXHIBIT 10.1 Existing Machines
Labour costs (expected to increase 10 per cent annually to account for in?ation):
(a) 20 unskilled labour @ Rs 4,000 per month
(b) 20 skilled personnel @ Rs 6,000 per month
(c) 2 supervising executives @ Rs 7,000 per month
(d) 2 maintenance personnel @ Rs 5,000 per month
Maintenance cost:
Years 1-5: Rs 25 lakh
Years 6-7: Rs 65 lakh
Operating expenses: Rs 50 lakh expected to increase at 5 per cent annually.
Insurance cost/premium:
Year 1 : 2 per cent of the original cost of machine
After year 1 : Discounted by 10 per cent
26 Financial Management
EXHIBIT 10.2 New Production Equipment
Savings in cost of utilities: Rs 2.5 lakh
Maintenance costs:
Year 1-2: Rs 8 lakh
Year 3-4: Rs 30 lakh
Labour costs:
9 skilled personnel @ Rs 7,000 per month
1 maintenance personnel @ Rs 7,000 per month
Cost of retrenchment of 34 personnel: (20 unskilled, 11 skilled, 2 supervisors and 1 maintenance person-
nel): Rs 9,90,000, that is, equivalent to six months salary
Insurance premium
Year 1 : 2 per cent of the purchase cost of machine
After year 1 : Discounted by 10 per cent
The operating expenses do not change to any considerable extent for the new equipment and the difference
is negligible compared to the scale of operations.
Smoothdrive Tyre intends to sell the HyperTread to two distinct markets:
1. The original equipment manufacturer (OEM) market: The OEM market consists primarily of the
large automobile companies who buy tyres for new cars. In the OEM market, the HyperTread is expected to
sell for Rs 1,200 per tyre. The variable cost to produce each HyperTread is Rs 600.
2. The replacement market: The replacement market consists of all tyres purchased after the automobile
has left the factory. This markets allows higher margins and Smoothdrive Tyre expects to sell the HyperTread
for Rs 1,500 per tyre. The variable costs are the same as in the OEM market.
Smoothdrive Tyre expects to raise prices by 1 per cent above the in?ation rate. The variable costs will also
increase by 1 per cent above the in?ation rate. In addition, the HyperTread project will incur Rs 2,50,00,000 in
marketing and general administration cost in the ?rst year which are expected to increase at the in?ation rate
in subsequent years.
Smoothdrive Tyre’s corporate tax rate is 35 per cent. Annual in?ation is expected to remain constant at 3.25
per cent. Smoothdrive Tyre uses a 15 per cent discount rate to evaluate new product decisions.
The Tyre Market
Automative industry analysts expect automobile manufacturers to have a production of 4,00,000 new cars this
year and growth in production at 2.5 per cent per year onwards. Each new car needs four new tyres (the spare
tyres are undersized and fall in a different category). Smoothdrive Tyre expects the HyperTread to capture an
11 per cent share of the OEM market.
The industry analysts estimate that the replacement tyre market size will be one crore this year and that it would
grow at 2 per cent annually. Smoothdrive Tyre expects the HyperTread to capture an 8 per cent market share.
You also decide to consider net working capital (NWC) requirements in this scenario. The net working capital
requirement will be 15 per cent of sales. Assume that the level of working capital is adjusted at the beginning of
the year in relation to the expected sales for the year. The working capital is to be liquidated at par, barring an
estimated loss of Rs 1.5 crore on account of bad debt. The bad debt will be a tax-deductible expenses.
As a ?nance analyst, prepare a report for submission to the CFO and the Board of Directors, explaining to
them the feasibility of the new investment.
Comprehensive Cases 27
Solution
Financial Analysis Whether to Implement the New Project
Incremental Cash Out?ows
Cost of new production equipment Rs 72,00,00,000
Additional working capital (15 per cent of the expected ?rst year sales) 21,16,80,000
Less: Sale proceeds of existing machines (7 machines 3 Rs 8 lakh each) (56,00,000)
Add: Removal cost of the existing machines (7 machines 3 Rs 50,000) 3,50,000
Tax on pro?t from sale of machines (Working note I) 2,87,109
Cost of laying off workers and personnel (Working note II) 6,43,500
92,73,60,609
Cash In?ows
Particulars Year 0 Year 1 Year 2 Year 3 Year 4
Production equipment Rs 72,00,00,000
(+) Working capital 21,16,80,000 Rs 22,52,55,060 Rs 23,97,01,847 Rs 25,50,76,331
(–) Sales of machine 56,00,000
(+) Tax on sale 2,87,109
(+) Removal cost 3,50,000
(+) Cost of layoff 6,43,500
Sales revenue 141,12,00,000 150,17,00,400 159,80,12,311 170,05,08,870
Add: Cost savings:
Maintenance 17,00,000 17,00,000 35,00,000 35,00,000
costs (Working
note III ) 2,50,000 2,50,00 2,50,000 2,50,000
Cost of utilities
Labour costs 18,48,000 20,32,800 22,36,080 24,59,688
(Working note IV )
Less: Incremental
costs: 17,86,00,000 13,39,50,000 10,04,62,500 Nil
(Working note VI )
Bad debt loss (2) 1,50,00,000
Insurance 1,42,47,000 1,28,22,000 1,15,40,000 1,03,86,000
(Working note V )
Less: Total costs 61,06,00,000 64,90,60,700 68,99,66,744 73,34,78,839
Earning before tax 61,15,51,000 70,98,50,500 80,20,29,147 94,78,53,719
Tax @ 35 per cent 21,40,42,850 24,84,47,675 28,07,10,202 33,17,48,802
Earnings after
tax (c) 39,75,08,150 46,14,02,825 52,13,18,946 61,61,04,917
CFAT (a+b+c) 57,61,08,150 59,53,52,825 62,17,81,446 63,11,04,917
Add: Net
salvage value of
equipment (A) 10,00,00,000
Add: Tax
bene?t on short
term capital loss (B) 7,04,85,625
Release of
working capital (C) 24,00,76,331
Initial investment 92,73,60,609
(Contd.)
28 Financial Management
Change in
working capital 1,35,75,060 1,44,46,787 1,53,74,484
Terminal cash
in?ow (A+B+C) 41,05,61,956
Net cash ?ow (92,73,60,609) 56,25,33,090 58,09,06,038 60,64,06,962 104,16,66,873
PV factor @ 15
per cent 1.000 0.870 0.756 0.658 0.572
Present value of
cash ?ows (92,73,60,609) 48,94,03,788 43,91,64,965 39,90,15,781 59,58,33,452
NPV 99,60,57,377
Since the NPV of the project HyperTread is positive and is signi?cant enough for the company to go in for a
similar project four year hence, the Smoothdrive Tyre Ltd should go in for production of this new tyre.
Working Notes
I. Tax on Pro?ts From Sale of Existing Machine
Sales proceeds from existing machines Rs 56,00,000
Less: Book value of existing machine (Working note VI) 44,29,688
Gross pro?t 11,70,312
Less: Removal costs (7 3 Rs 50,000) 3,50,000
Net proft 8,20,312
Tax payable on pro?ts (Pro?t 3 0.35, tax rate) 2,87,109
II. Cost of Laying off 34 Personnel
Salary paid as compensation Rs 9,90,000
Tax bene?t (at 35 per cent) 3,46,500
Cost of layoff 6,43,500
III. Savings in Maintenance Costs (lakh of rupees)
Years Existing machine New equipment Cost savings
1 25 8 17
2 25 8 17
3 65 30 35
4 65 30 35
IV. Savings in Labour and Employee Costs
Existing costs:
Unskilled labour (20 3 12 months 3 Rs 4,000) Rs 960,000
Skilled labour (20 3 12 months 3 Rs 6,000) 14,40,000
Supervisors (2 3 12 months 3 Rs 7,000) 1,68,000
Maintenance personnel (2 3 12 months 3 Rs 5,000) 1,20,000
26,88,000 (A)
Proposed labour and employee costs:
Skilled labour (9 3 12 months 3 Rs 7,000) 7,56,000
Maintenance Personnel (1 3 12 months 3 Rs 7,000) 84,000
8,40,000 (B)
Labour cost savings (A + B) 18,48,000
Note: Savings in subsequent years will increase by 10 per cent.
(Contd.)
Comprehensive Cases 29
V. Insurance (lakh of rupees)
Years Existing machine New equipment Incremental insur-
ance
1 1.53 144.00 142.47
2 1.38 129.60 128.22
3 1.24 116.64 115.40
4 1.12 104.98 103.86
VI. Incremental Depreciation
WDV of the existing machine in the beginning of year 4:
Initial cost of machine (7 machines 3 Rs 15 lakh) Rs 1,05,00,000
Less: Depreciation charges
Year 1 (Rs 105 lakh 3 0.25) 26,25,000
Year 2 (Rs 78.75 lakh 3 0.25) 19,68,750
Year 3 (Rs 59.0625 lakh 3 0.25) 14,76,563
WDV of existing machine 44,29,687
Depreciation base of new equipment
WDV of existing machine 44,29,687
Add: Cost of new machine 72,00,00,000
Less: Sale value of existing machine 56,00,000
71,88,29,687
Base for incremental depreciation
Rs 71,88,29,687 – Rs 44,29,687 = Rs 71,44,00,000
Incremental depreciation (t = 1 – 4)
Years WDV Depreciation
1 Rs 71,44,00,000 Rs 17,86,00,000
2 53,58,00,000 13,39,50,000
3 40,18,50,000 10,04,62,500
4 30,13,87,500 Nil
Short term capital loss: Rs 30,13,87,500 – Rs 10,00,00,000 = Rs 20,13,87,500
Tax bene?t on short-term capital loss = Rs 20,13,87,500 3 0.35 = Rs 7,04,85,625
Cash Flows and Net Working Capital Requirement for Year 1
Total cash revenues:
OEM market (0.11 3 4,00,000 cars 3 4 tyres 3 Rs 1,200) Rs 21,12,00,000
Replacement market (0.08 3 1,00,00,000 tyres 3 Rs 1,500) 1,20,00,00,000
1,41,12,00,000
Total costs:
OEM market + Replacement market:
(0.11 3 4,00,000 cars 3 4 tyres 3 Rs 600)
+ (0.08 3 1,00,00,000 tyres 3 Rs 600) 58,56,00,000
Selling and administrative costs 2,50,00,000
61,06,00,000
Net working capital (15% of sales) 21,16,80,000
30 Financial Management
Cash Flows and Net Working Capital Requirement for Year 2
Total cash revenues:
OEM market (0.11 3 4,10,000* cars 3 4 tyres 3 Rs 1,251**) Rs 22,56,80,400
Replacement market (0.08 3 1,02,00,000
@
tyres 3 Rs 1,563.75
@@
) 1,27,60,20,000
1,50,17,00,400
Total costs:
OEM market + Replacement market
(0.11 3 4,10,000 cars 3 4 tyres 3 Rs 625.50)
+ (0.08 3 1,02,00,000 tyres 3 Rs 625.50) 62,32,48,200
Selling and administrative costs 2,58,12,500
64,90,60,700
Net working capital (15 per cent of sales) 22,52,55,060
* 4,10,000 = 4,00,000 + 4,00,000 3 2.5 per cent
** Rs 1,251 = Rs 1,200 + Rs 1,200 3 3.25 per cent in?ation 3 1 per cent price rise
@
1,02,00,000 = 1,00,00,000 + 1,00,00,000 3 2 per cent market growth
@@
Rs 1,563.75 = Rs 1,500 + Rs 1,500 3 3.25 per cent in?ation 3 1 per cent price rise
Cash Flows and Net Working Capital Requirement for Year 3
Total cash revenues:
OEM market (0.11 3 4,20,250 cars 3 4 tyres 3 Rs 1,304.18) Rs 24,11,55,924
Replacement market (0.08 3 1,04,00,000 tyres 3 Rs 1,630.21) 1,35,68,56,387
1,59,80,12,311
Total costs:
OEM market + Replacement market
(0.11 3 4,20,250 cars 3 4 tyres 3 Rs 652.08)
+ (0.08 3 1,04,00,000 tyres 3 Rs 652.08) 66,33,15,338
Selling and administrative costs 2,66,51,406
68,99,66,744
Net working capital 23,97,01,847
Cash Flows and Net Working Capital Requirement for Year 4
Total cash revenues:
OEM market (0.11 3 4,30,756 cars 3 4 tyres 3 Rs 1,359.61) Rs 25,76,90,473
Replacement market (0.08 3 1,06,12,080 tyres 3 Rs 1,699.50) 1,44,28,18,397
1,70,05,08,870
Total costs:
OEM market + Replacement market
(0.11 3 4,30,756 cars 3 4 tyres 3 Rs 679.79)
+ (0.08 3 1,06,12,080 tyres 3 Rs 679.79) 70,59,61,262
Selling and administrative costs 2,75,17,577
73,34,78,839
New working capital 25,50,76,331
CHAPTER 11
Concept and Measurement of Cost of Capital
COMPUTATION OF COST OF CAPITAL OF PALCO LTD
In October 2007, Neha Kapoor, a recent MBA graduate and newly appointed assistant to the Financial Controller
of Palco Ltd, was given a list of six new investment projects proposed for the following year. It was her job to
analyse these projects and to present her ?ndings before the Board of Directors at its annual meeting to be held
in 10 days. The new project would require an investment of Rs 2.4 crore.
Palco Ltd was founded in 1965 by Late Shri A.V. Sinha. It gained recognition as a leading producer of high
quality aluminium, with the majority of its sales being made to Japan. During the rapid economic expansion of
Japan in the 1970s, demand for aluminium boomed, and Palco’s sales grew rapidly. As a result of this rapid
growth and recognition of new opportunities in the energy market, Palco began to diversify its products line.
While retaining its emphasis on aluminium production, it expanded operations to include uranium mining and the
production of electric generators, and, ?nally, it went into all phases of energy production. By 2007, Palco’s sales
had reached Rs 14 crore level, with net pro?t after taxes attaining a record of Rs 67 lakh.
As Palco expanded its products line in the early 1990s, it also formalised its capital budgeting procedure.
Until 1992, capital investment projects were selected primarily on the basis of the average return on investment
calculations, with individual departments submitting these calculations for projects falling within their division. In
1996, this procedure was replaced by one using present value as the decision making criterion. This change was
made to incorporate cash ?ows rather than accounting pro?ts into the decision making analysis, in addition to
adjusting these ?ows for the time value of money. At the time, the cost of capital for Palco was determined to be
12 per cent, which has been used as the discount rate for the past 5 years. This rate was determined by taking a
weighted average cost Palco had incurred in raising funds from the capital market over the previous 10 years.
It had originally been Neha’s assignment to update this rate over the most recent 10-year period and determine
the net present value of all the proposed investment opportunities using this newly calculated ?gure. However, she
objected to this procedure, stating that while this calculation gave a good estimate of “the past cost” of capital,
changing interest rates and stock prices made this calculation of little value in the present. Neha suggested that
current cost of raising funds in the capital market be weighted by their percentage mark-up of the capital struc-
ture. This proposal was received enthusiastically by the Financial Controller of the Palco, and Neha was given
the assignment of recalculating Palco’s cost of capital and providing a written report for the Board of Directors
explaining and justifying this calculation.
To determine a weighted average cost of capital for Palco, it was necessary for Neha to examine the cost
associated with each source of funding used. In the past, the largest sources of funding had been the issuance
of new equity shares and internally generated funds. Through conversations with Financial Controller and other
members of the Board of Directors, Neha learnt that the ?rm, in fact, wished to maintain its current ?nancial
structure as shown in Exhibit 1.
EXHIBIT 1 Palco Ltd Balance Sheet for Year Ending March 31, 2007
Assets Liabilities and Equity
Cash Rs 90,00,000 Accounts payable Rs 8,50,000
Accounts receivable 3,10,00,000 Short-term debt 1,00,000
Inventories 1,20,00,000 Accrued taxes 11,50,000
Total current assets 5,20,00,000 Total current liabilities 1,20,00,000
(Contd)
32 Financial Management
Net ?xed assets 19,30,00,000 Long-term debt 7,20,00,000
Goodwill 70,00,000 Preference shares 4,80,00,000
Total assets 25,20,00,000 Retained earnings 1,00,00,000
Equity shares 11,00,000
Total liabilities and equity
shareholders’ fund 25,20,00,000
She further determined that the strong growth patterns that Palco had exhibited over the last ten years were
expected to continue inde?nitely because of the dwindling supply of US and Japanese domestic oil and the grow-
ing importance of other alternative energy resources. Through further investigations, Neha learnt that Palco could
issue additional equity shares, which had a par value of Rs 25 per share and were selling at a current market
price of Rs 45. The expected dividend for the next period would be Rs 4.4 per share, with expected growth at
a rate of 8 per cent per year for the foreseeable future. The ?otation cost is expected to be on an average Rs
2 per share.
Preference shares at 11 per cent with 10 years maturity could also be issued with the help of an investment
banker with a par value of Rs 100 per share to be redeemed at par. This issue would involve ?otation cost of
5 per cent.
Finally, Neha learnt that it would be possible for Palco to raise an additional Rs 20 lakh through a 7-year loan
from Punjab National Bank at 12 per cent. Any amount raised over Rs 20 lakh would cost 14 per cent. Short-term
debt has always been used by Palco to meet working capital requirements and as Palco grows, it is expected
to maintain its proportion in the capital structure to support capital expansion. Also, Rs 60 lakh could be raised
through a bond issue with 10 years’ maturity with a 11 per cent coupon at the face value. If it becomes necessary
to raise more funds via long-term debt, Rs 30 lakh more could be accumulated through the issuance of additional
10-year bonds sold at the face value, with the coupon rate raised to 12 per cent, while any additional funds raised
via long-term debt would necessarily have a 10-year maturity with a 14 per cent coupon yield. The ?otation cost
of issue is expected to be 5 per cent. The issue price of bond would be Rs 100 to be redeemed at par.
In the past, Palco had calculated a weighted average of these sources of funds to determine its cost of capital.
In discussion with the current Financial Controller, the point was raised that while this served as an appropriate
calculation for external funds, it did not take into account the cost of internally generated funds. The Financial
Controller agreed that there should be some cost associated with retained earnings and need to be incorporated
in the calculations but didn’t have any clue as to what should be the cost.
Palco Ltd is subjected to the corporate tax rate of 40 per cent.
From the facts outlined above, what report would Neha submit to the Board of Directors of Palco Ltd?
Solution
Report Submitted by Neha Kapoor on Cost of Capital
For investment decisions, the company has already incorporated the use of discounted cash ?ow techniques.
However, it is using the past cost of capital for discounting the future cash ?ows. This approach is not justi?ed
as the cost of capital is undergoing frequent changes in the present volatile environment because the interest
rates and equity prices are changing very fast. Hence, for investment decisions, the company should rely on
weighted marginal cost of capital rather than the weighted average cost of capital because
the former is based on the cost of funds raised for forthcoming projects while the later is based on the existing
capital structure.
Currently the company has 50 per cent of the funds raised through equity, 20 per cent through preference share
capital and 30 per through the debt funds as shown in Exhibit 2. Since the capital structure policy of company
(Contd)
Comprehensive Cases 33
is to maintain the same level of debt-equity ratio, the additional amount of Rs 2.4 crore would be raised in the
following manner:
Equity Funds (Rs crore)
New issue of equity shares 1.10
Retained earnings 0.10 1.20
Debt Funds
Bank ?nancing/bonds 0.72
Preference Share Capital 0.48
2.40
Computation of Cost of Capital
Cost of Equity Funds
New issue of equity shares
K
e
=
?
? ?
0
Dividend Rs 4.4
=
flotation cost Rs 45 Rs 2
g
P
+ 8 = 18.23 per cent
Retained Earnings
Retained earnings do not carry any explicit cost. The opportunity cost of retained earnings is the rate of
return on dividend foregone by equity shareholders. The shareholders generally expect dividend and capital
gain from their investment. Hence, the cost of retained earnings will be equal to the shareholder’s required
rate of return as computed above. However, no ?otation cost would be involved unlike the new issue of
shares.
K
RE
=
?
?
0
Dividend Rs 4.4
=
flotation cost Rs 45
g
P
+ 8 = 17.78 per cent
Cost of Debt Funds
In this case the Palco Ltd has two alternatives available before it. Either it can go for bank ?nancing which
carries a higher interest rate or it can go in for raising funds by issuing bonds which carries substantial issu-
ance cost.
K
d
=
?
Interest (1 – Tax rate) + Flotation cost/maturity period
( ) / 2 RV SV
Cost of Bonds
For ?rst Rs 60 lakh:
K
d
=
? Rs 11(1 40%) + (Rs 4/10)
Rs (100 + 96)/2
= 7.14 per cent
For second Rs 12 lakh:
K
d
=
? Rs 12(1 40%) + (Rs 4/10)
Rs (100 + 96)/2
= 7.75 per cent
Total cost of debt if the funds are raised through bonds:
K
d
= 7.14% 3 (60/72) + 7.75% 3 (12/72) = 5.95 + 1.29 = 7.24 per cent
Cost of Bank Financing
For ?rst Rs 20 lakh:
K
d
= Rs 12(1 – 40%) = 7.2 per cent
For second Rs 52 lakh:
K
d
= Rs 14(1 – 40%) = 8.4 per cent
34 Financial Management
Total cost of debt if the funds are raised through bank loan:
K
d
= 7.2% 3 (20/72) + 8.4% 3 (52/72) = 8.07 per cent
Hence, the company should choose bonds for raising funds as they carry lower cost, assuming the other
factors being constant.
Cost of Preference Shares
K
p
=
?
Dividend + Flotation cost/maturity period
( ) / 2 RV SV
=
Rs 11 + Rs 5/10
Rs(100 + 95)/2
= 11.8 per cent
Weighted Marginal Cost of Capital
WMCC = f
n
{K
e
, K
RE
, K
d
, K
p
}
= 18.23% 3 (1.1/2.4) + 17.78% 3 (0.10/2.4) + 7.24% 3 (0.72/2.4) + 11.8% 3 (0.48/2.4)
= 13.62 per cent
Hence, 13.62 per cent is the cost of capital that is relevant for appraising the new investment proposals. This
would enable the company to arrive at better decisions as the cost of capital input used here is realistic rather
than historical as used in the past.
CHAPTER 12
Analysis of Risk and Uncertainty
PELLON COMPANY LIMITED
During union negotiations this year, the Pellon Company Ltd management realised that it must offer its employees
greater retirement bene?ts. The company is considering offering either one of the following:
Plan A: an increase in the amount of the company’s share of the annual contribution to the funded pension
plan now in existence.
Plan B: elimination of the existing pension plan and its replacement by a new plan calling for variable payback
where the amount of the company’s payment would depend upon the level of pro?ts for the year.
The actual cost of the pension plan to Pellon would depend upon many factors, such as age of employees,
number of years they have been with the company, and employee’s current earnings. However, the prime causes
of uncertainty for the new retirement offers are that since employees are given options as to the extent to which
they wish to participate in the pension plan, their individual decisions would determine the amount of employer’s
contribution under Plan A. This uncertainty would, however, be resolved in the ?rst year of the new plan. For Plan
B, the level of future pro?ts would be the main consideration. However, the success or failure of a new product
line to be introduced in the last part of the coming year would greatly reduce the uncertainty.
The Management of Pellon Company Ltd wished to make a two-year cost comparison for the two plans, and
has, therefore, made the following cost and probability estimates:
Probability First year cost
0.1 Rs 6,00,000
Plan A: 0.3 7,50,000
0.6 9,00,000
0.2 5,00,000
Plan B: 0.5 7,50,000
0.3 10,00,000
In the second year for Plan A, uncertainty is negligible, since all employees would have selected their
participation in the programme. The Management estimates the second-year cost of Plan A to be Rs 6,00,000
greater than its ?rst-year cost. For Plan B, uncertainty about second-year pro?ts would still exist, so estimates
of costs are also still uncertain.
Given ?rst-year cost Probability Second year cost
(i) Rs 5,00,000 0.60 Rs 5,00,000
5,00,000 0.40 7,50,000
(ii) 7,50,000 0.50 8,50,000
7,50,000 0.50 10,50,000
(iii) 10,00,000 0.40 11,00,000
10,00,000 0.60 13,00,000
(a) Construct a decision tree for management to use in evaluating the two plans. Assuming that all costs are
incurred at the end of the year for they apply and that 10 per cent discount (risk-free) rate is appropriate,
compute the PV of costs for each plan at each branch terminal of tree. Also, ?nd the expected PV of costs
for each project as a weighted average of these terminal PVs.
(b) Which project is more risky?
(c) Which plan should the ?rm offer to the union?
36 Financial Management
(a) Decision Tree (Amount in Rs lakh)
Year 1 Year 2 NPV at
Probability Cash PV Probability Cash PV 10% rate of Joint Expected
out?ow out?ow discount Probability NPV
0.1 1 Rs 12.0 Rs 9.9 Rs (–15.35) 0.1 Rs (–1.53)
Rs 6.0 Rs 5.45
0.3 1
7.5 6.8 13.5 11.1 ( –17.9) 0.3 (–5.37)
0.6 1
9.0 8.18 15.0 12.39 (–20.57) 0.6 (–12.34)
Plan A (–19.24)
Decision
Point
0.6
Plan B 5.0 4.13 (–8.63) 0.12 (–1.04)
0.2
5.0 4.5
0.4
7.5 6.19 (–10.69) 0.08 (–0.86)
0.5
8.5 7.02 (–13.82) 0.25 (–3.45)
0.5
7.5 6.8
0.5
10.0 8.26 (–15.06) 0.25 (–3.76)
0.4
11.0 9.08 (–18.17) 0.12 (–2.18)
0.3
10.0 9.09
0.6
13.0 10.73 (–19.82) 0.18 (–3.56)
(–14.85)
(b) Determination of the Value of Coef?cient of Vairation (NPV/Standard Deviation)
Plan A Plan B
NPV Probability Expected NPV NPV Probability Expected NPV
(Rs lakh) (Rs lakh) (Rs lakh) (Rs lakh)
(–15.35) 0.1 (–1.53) (–8.63) 0.12 (–1.04)
(–17.9) 0.3 (–5.37) (–10.69) 0.08 (–0.86)
(–20.57) 0.6 (–12.34) (–13.82) 0.25 (–3.45)
(–15.06) 0.25 (–3.76)
(–18.17) 0.12 (–2.18)
(–19.82) 0.18 (–3.56)
NPV –19.24 –14.85
Determination of Standard Deviation About the Expected NPV
Project A (Amount in Rs lakh)

——
NPV
i

——
NPV NPV
i
–
——
NPV (NPV
i
–
——
NPV)
2
P
i
(NPV
i
–
——
NPV)
2
P
i
(–15.35) (–19.24) 3.89 15.13 0.1 1.51
(–17.9) (–19.24) 1.34 1.80 0.3 0.54
(–20.57) (–19.24) (–1.33) 1.77 0.6 1.06

——
NPV
A
3.11
s
A
=
3.11
= 1.26
Coef?cient of variation (V
A
)
V
A
=
?
?
Standard deviation
1.76
Expected net present value 19.24 lacs
= –0.091
Comprehensive Cases 37
Project B (Amount in Rs lakh)
NPV
i

——
NPV NPV
i
–
——
NPV (NPV
i
–
——
NPV)
2
P
i
(NPV
i
–
——
NPV)
2
P
i
(–8.63) (–14.85) 6.22 38.69 0.12 4.64
(–10.69) (–14.85) 4.16 17.31 0.08 1.38
(–13.82) (–14.85) 1.03 1.06 0.25 0.26
(–15.06) (–14.85) (–0.21) 0.04 0.25 0.01
(–18.17) (–14.85) (–3.32) 11.02 0.12 1.32
(–19.82) (–14.85) (–4.97) 24.70 0.18 4.45
(
——
NPV
A
)
2
12.06
s
B
=
12.06
= 3.47
Coef?cient of variation (V
B
)
V
B
=
?
?
Standard deviation
3.47
Expected Net Present Value 14.85
= (–0.233)
As such the Plan A is more risky.
(c) The expected NPV out?ow with Plan B is less (–Rs 14.85 lakh) than Plan A (Rs –19.24 lakh).
Therefore, the company is advised to adopt Plan B to offer to the union.
CHAPTER 13
Working Capital Management—An Overview
COOKING LPG LTD DETERMINATION OF WORKING CAPITAL
Introduction
Cooking LPG Ltd, Gurgaon, is a private sector ?rm dealing in the bottling and supply of domestic LPG for household
consumption since 1995. The ?rm has a network of distributors in the districts of Gurgaon and Faridabad. The
bottling plant of the ?rm is located on National Highway – 8 (New Delhi – Jaipur), approx. 12 kms from Gurgaon.
The ?rm has been consistently performing well and plans to expand its market to include the whole National
Capital Region.
The production process of the plant consists of receipt of the bulk LPG through tank trucks, storage in
tanks, bottling operations and distribution to dealers. During the bottling process, the cylinders are subjected to
pressurised ?lling of LPG followed by quality control and safety checks such as weight, leakage and other defects.
The cylinders passing through this process are sealed and dispatched to dealers through trucks. The supply and
distribution section of the plant prepares the invoice which goes along with the truck to the distributor.
Statement of the Problem
Mr I. M. Smart, DGM (Finance) of the company, was analysing the ?nancial performance of the company during
the current year. The various pro?tability ratios and parameters of the company indicated a very satisfactory
performance. Still, Mr Smart was not fully content-specially with the management of the working capital by the
company. He could recall that during the past year, in spite of stable demand pattern, they had to, time and
again, resort to bank overdrafts due to non-availability of cash for making various payments. He is aware that
such aberrations in the ?nances have a cost and adversely affects the performance of the company. However,
he was unable to pinpoint the cause of the problem.
He discussed the problem with Mr U. R. Keenkumar, the new manager (Finance). After critically examining the
details, Mr Keenkumar realised that the working capital was hitherto estimated only as approximation by some rule
of thumb without any proper computation based on sound ?nancial policies and, therefore, suggested a reworking
of the working capital (WC) requirement. Mr Smart assigned the task of determination of WC to him.
Profile of Cooking LPG Ltd
(1) Purchases: The company purchases LPG in bulk from various importers ex-Mumbai and Kandla, @
Rs 11,000 per MT. This is transported to its Bottling Plant at Gurgaon through 15 MT capacity tank trucks
(called bullets), hired on annual contract basis. The average transportation cost per bullet ex-either location
is Rs 30,000. Normally, 2 bullets per day are received at the plant. The company makes payments for bulk
supplies once in a month, resulting in average time-lag of 15 days.
(2) Storage and Bottling: The bulk storage capacity at the plant is 150 MT (2 ? 75 MT storage tanks)
and the plant is capable of ?lling 30 MT LPG in cylinders per day. The plant operates for 25 days per
month on an average. The desired level of inventory at various stages is as under:
LPG in bulk (tanks and pipeline quantity in the plant) – three days average production/sales.
Filled Cylinders – 2 days average sales.
Work-in-process inventory – zero.
(3) Marketing: The LPG is supplied by the company in 12 kg cylinders, invoiced @ Rs 250 per cylinder. The
rate of applicable sales tax on the invoice is 4 per cent. A commission of Rs 15 per cylinder is paid to the
distributor on the invoice itself. The ?lled cylinders are delivered on company’s expense at the distributors’
godown, in exchange of equal number of empty cylinders. The deliveries are made in truck-loads only,
Comprehensive Cases 39
the capacity of each truck being 250 cylinders. The distributors are required to pay for deliveries through
bank draft. On receipt of the draft, the cylinders are normally dispatched on the same day. However, for
every truck purchased on pre-paid basis, the company extends a credit of 7 days to the distributors on
one truck-load.
(4) Salaries and Wages: The following payments are made:
Direct labour – Re 0.75 per cylinder (Bottling expenses) – paid on last day of the month.
Security agency-Rs 30,000 per month-paid on 10
th
of subsequent month.
Administrative staff and managers – Rs 3.75 lakh per annum, paid on monthly basis on the last working
day.
(5) Overheads:
Administrative (staff car, communication etc) – Rs 25,000 per month – paid on the 10
th
of subsequent
month.
Power (including on DG set) – Rs 1,00,000 per month paid on the 7
th
of subsequent month.
Renewal of various licenses (pollution, factory, labour, CCE etc.) – Rs 15,000 per annum-paid at the
beginning of the year.
Insurance-Rs 5,00,000 per annum to be paid at the beginning of the year.
Housekeeping, etc – Rs 10,000 per month paid on the 10
th
of the subsequent month.
Regular maintenance of plant – Rs 50,000 per month paid on the 10
th
of every month to the vendors.
This includes expenditure on account of lubricants, spares and other stores.
Regular maintenance of cylinders (statutory testing) – Rs 5 lakh per annum – paid on monthly basis
on the 15
th
of the subsequent month.
All transportation charges as per contracts – paid on the 10
th
of subsequent month.
Sales tax as per applicable rates is deposited on the 7
th
of the subsequent month.
(6) Sales: Average sales are 2,500 cylinders per day during the year. However, during the winter months
(December to February), there is an incremental demand of 20 per cent.
(7) Average Inventories: The average stocks maintained by the company as per its policy guidelines:
Consumables (caps, ceiling material, valves etc) – Rs 2 lakh. This amounts to 15 days consumption.
Maintenance spares – Rs 1 lakh.
Lubricants – Rs 20,000.
Diesel (for DG sets and ?re engines) – Rs 15,000.
Other stores (stationary, safety items) – Rs 20,000.
(8) Minimum cash balance including bank balance required is Rs 5 lakh.
(9) Additional Information for Calculating Incremental Working Capital During Winter
No increase in any inventories take place except in the inventory of bulk LPG, which increases in the
same proportion as the increase of the demand. The actual requirements of LPG for additional supplies
are procured under the same terms and conditions from the suppliers.
The labour cost for additional production is paid at double the rate during winters.
No changes in other administrative overheads.
The expenditure on power consumption during winter increases by 10 per cent. However, during other
months, the power consumption remains the same as the decrease owing to reduced production is
offset by increased consumption on account of compressors/ACs.
Additional amount of Rs 3 lakh is kept as cash balance to meet exigencies during winter.
No change in time schedules for any payables/receivables.
The storage of ?nished goods inventory is restricted to a maximum 5,000 cylinders due to statutory
requirements.
40 Financial Management
Solution
EXHIBIT 1 A Statement Showing Determination of Net Working Capital
Particulars (Amount in Rs lakh)
(A) Current Assets
Inventories holding
Raw material inventory (90 MT ? (Rs 11,000 + (Rs 30,000/15MT)) 11.70
LPG in transit (10 days ? 2 Truck ? 15 MT ? Rs 11,000) 33.00
Consumables 2.00
Maintenance spare 1.00
Lubricants 0.20
Diesel 0.15
Other stores 0.20
Finished goods (5,000 CYL ? (Rs 162.08 + Rs 4.61)) (see working note 1) 8.33
Debtors (25,000 CYL ? 7 days ? 50% ? Rs 180.69) (see working note 1) 15.81
Cash in bank 5.00
Renewal of license and insurance (Rs 15,000 + Rs 5,00,000) 5.15
Total 82.54
(B) Current Liabilities
LPG credit (30 MT ? Rs 11,000) ? 15 days 49.50
Bulk transportation cost (25 days ? 2 Trucks ? Rs 30,000/30) ? ((30 days/2)
+ 10 days) 12.50
Cylinder transportation credit (((25 days ? 10 Trucks per day ? Rs 1,000)/30)
? 25 days) 2.08
Labour (((Rs 0.75 ? 2,500 ? 25)/30) ? 15) 0.23
Plant security agency (Rs 30,000 ? 25/30 days) 0.25
Administration staff/Manager ((Rs 3,75,000/12) ? (15/30)) 0.16
Administration expenses ((Rs 25,000 ? 25/30 days) 0.21
Power (Rs 1,00,000 ? 22/30 days) 0.73
House-keeping (Rs 10,000 ? 25/30) 0.08
Plant maintenance ((Rs 50,000/30) ? 25 days) 0.42
Cylinder testing ((Rs 5,00,000/12) ? (30/30)) 0.42
Sales tax (2,500 ? 25 days ? Rs 250 ? 4/100) ? (22/30) 4.58
Total 71.16
(C) Net Working Capital (A – B) 11.38
Working Note 1
Cost per cylinder
A Bottling/cylinder (12 Kgs)
Direct labour (Rs 0.75 per cylinder) Rs 0.75
Materials consumables (Rs 2,00,000/(2,500 ? 15 days)) 5.33
LPG (Rs 11,000/1,000 = Rs 11 ? 12 Kgs.) 132.00
Bulk transportation cost ((Rs 30,000/15,000 Kg) ? 12 Kg) 24.00
Total ‘A’ 162.08
(Contd)
Comprehensive Cases 41
B Production and administrative overheads (Rs lakh)
Security (Rs 30,000 ? 12 months) 3.6
Administrative staff/Manager Rs 3,75,000 per annum 3.75
Other administration expenses (Rs 25,000 ? 12 months) 3.00
Power (Rs 1,00,000 ? 12 months) 12.00
House-keeping (Rs 10,000 ? 12 months) 1.20
Plant maintenance (Rs 50,000 ? 12) 6.00
Cylinder testing 5.00
Total cost 34.55
Annual production (of cylinders) 7.50
Overheads per cylinder (Rs 35.55 lakh/7.5 lakh) 4.61
C Transportation overheads (Rs 1,000/250 CYL) 4.00
D Sales tax (4 per cent of Rs 250) 10.00
E Total (A + B + C + D) 180.69
EXHIBIT 2 Incremental Working Capital Requirement From December to February
Particulars (Amount in Rs lakh)
(A) Current Assets
LPG in transit (10 days ? (500 ? 12/15,000) truck ? 15 MT ? Rs 11,000) Rs 6.60
Raw material inventory (90 MT ? (Rs 11,000 + (30,000/15MT)) ? 0.2 2.34
Debtors (500 CYL ? 7 days ? 50% ? Rs 182.24) (see working note 2) 3.19
Cash in bank 3.00
Total 15.13
(B) Current Liabilities (incremental)
LPG credit (500 ? 12 Kg/1000) MT ? Rs 11,000) ? (15/2) 9.9
Bulk transportation cost ((6 ? 25/15 Trucks ? Rs 30,000)/30) ?
(30 days/2) + 10 days) 2.50
Cylinder transportation credit (((25 days ? 2 Trucks per day ? Rs 1000)/30) ?
25 days) 0.42
Labour (((Rs 0.75 ? 2 ? 500 ? 25)/30) ? 15) 0.05
Power (10% ? Rs 1,00,000 ? 22/30 days) 0.07
Sales tax (500 ? 25 days ? Rs 250 ? 4/100 ? 22/30) 0.92
Total 13.86
(C) Net Working Capital (Incremental) (A – B) 1.27
During December to February there will be 20 per cent increase in demand.
The ?nished goods stock will be restricted to 5,000 cyls only.
The raw material inventory is maintained for 3 days consumption.
The stock of consumables and other store items remains unchanged.
The receivables increased in proportion to increase in sales.
(Contd)
42 Financial Management
Working Note 2
Incremental cost per cylinder
Direct labour ((Rs 1.50 – Rs 0.75) per cyl) Re 0.75*
Power (Rs 1,00,000 ? 0.1/(500 cyl ? 25 days)) 0.80**
Incremental cost/Additional Cylinder 1.55
Total cost of each additional cylinder bottled = 180.69 + 1.55 182.24
* The direct labour is paid at double the rate i.e. Rs 0.75 x 2 for each additional cylinders bottled
** Power requirement increased by 10 per cent.
Recommendation
It is recommended that Cooking LPG Ltd., should maintain the net working capital at following levels for its
smooth operations:
The average net working capital required is Rs 11.38 lakh. This should be made available from long-term
sources of ?nances.
During winter months (December to February), an additional Rs 1.55 lakh will be required over and above
the average net working capital requirements. The same may be met by short-term ?nancing.
CHAPTER 14
Management of Cash and Marketable Securities
M/S HI-TECH ELECTRONICS
M/s Hi-tech Electronics, a consumer electronics outlet, was opened two years ago in Dwarka, New Delhi. Hard
work and personal attention shown by the proprietor, Mr Sony, has brought success. However, because of
insuf?cient funds to ?nance credit sales, the outlet accepted only cash and bank credit cards. Mr Sony is now
considering a new policy of offering instalment sales on terms of 25 per cent down payment and 25 per cent per
month for three months as well as continuing to accept cash and bank credit cards.
Mr Sony feels this policy will boost sales by 50 per cent. All the increases in sales will be credit sales. But to
follow through a new policy, he will need a bank loan at the rate of 12 per cent. The sales projections for this
year without the new policy are given in Exhibit 1.
EXHIBIT 1 Sales Projections and Fixed Costs
Month Projected sales without Projected sales with
instalment option instalment option
January Rs 6,00,000 Rs 9,00,000
February 4,00,000 6,00,000
March 3,00,000 4,50,000
April 2,00,000 3,00,000
May 2,00,000 3,00,000
June 1,50,000 2,25,000
July 1,50,000 2,25,000
August 2,00,000 3,00,000
September 3,00,000 4,50,000
October 5,00,000 7,50,000
November 10,00,000 15,00,000
December 8,00,000 12,00,000
Total sales 48,00,000 72,00,000
Fixed cost 2,40,000 2,40,000
He further expects 26.67 per cent of the sales to be cash, 40 per cent bank credit card sales on which a 2
per cent fee is paid, and 33.33 per cent on instalment sales. Also, for short term seasonal requirements, the ?rm
takes loan from chit fund to which Mr Sony subscribes @ 1.8 per cent per month.
Their success has been due to their policy of selling at discount price. The purchase price per unit is 90 per
cent of selling price. The ?xed costs are Rs 20,000 per month. The proprietor believes that the new policy will
increase miscellaneous cost by Rs 25,000.
The business being cyclical in nature, the working capital ?nance is done on trade-off basis. The proprietor
feels that the new policy will lead to bad debts of 1 per cent.
(a) As a ?nancial consultant, advise the proprietor whether he should go for the extension of credit facilities.
(b) Also prepare cash budget for one year of operation of the ?rm, ignoring interest. The minimum desired cash
balance is Rs 30,000, which is also the amount the ?rm has on January 1. Borrowings are possible which
are made at the beginning of a month and repaid at the end when cash is available.
44 Financial Management
Solution
Decision Analysis Whether M/s Hi-Tech Electronics Should Extend Credit sales
Particulars Amount
Incremental sales revenue Rs 24,00,000
Less: Incremental variable costs 21,60,000
Contribution margin 2,40,000
Less: Other incremental costs:
Bad debts (1%) 24,000
Investment cost (Working note 1) 22,754
Additional operating expenses (miscellaneous) 25,000
Incremental pro?t 1,68,246
Working Note 1
Calculation of Investment Requirement Using Trade-off Approach
Month Incremental Incremental Monthly funds Long-term Short-term
sales variable cost requirement funds funds
January Rs 3,00,000 Rs 2,70,000 Rs 1,95,000 Rs 1,86,875 Rs 8,125
February 2,00,000 1,80,000 1,30,000 1,86,875 0
March 1,50,000 1,35,000 97,500 1,86,875 0
April 1,00,000 90,000 65,000 1,86,875 0
May 1,00,000 90,000 65,000 1,86,875 0
June 75,000 67,500 48,750 1,86,875 0
July 75,000 67,500 48,750 1,86,875 0
August 1,00,000 90,000 65,000 1,86,875 0
September 1,50,000 1,35,000 97,500 1,86,875 0
October 2,50,000 2,25,000 1,62,500 1,86,875 0
November 5,00,000 4,50,000 3,25,000 1,86,875 1,38,125
December 4,00,000 3,60,000 2,60,000 1,86,875 73,125
2,19,375
Cost of long-term funds = Rs 1,86,875 3 0.12 = Rs 22,425
Cost of short-term funds = [Rs 2,19,375 4 12] 3 0.018 = Rs 329
Total cost = Rs 329 + Rs 22,425 = Rs 22,754.
Recommendation From the incremental analysis, I would suggest that Mr Sony should go for extending
credit to the customers. Further, I suggest that he should hire independent agency to assess the creditworthiness
of the customer. Also, the projection that there will be only 50 per cent increase in customers due to credit may
turn out to be wrong. A large number of cash purchasers will buy on credit scheme. In order to retain the cash
purchases, he will have to sell goods at further discount.
Comprehensive Cases 45
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CHAPTER 15
Receivables Management
IND INSTRUMENTS LTD
The Ind Instruments Ltd (IIL) manufactures industrial components for the heavy machinery industry. It mainly sells
to industrial companies at a retail price of Rs 50 per component. Its current balance sheet and income statement
is summarised in Exhibits 1 and 2 respectively.
EXHIBIT 1 Comparative Balance Sheet of Ind Instruments Ltd (Rs lakh)
Liabilities Year 1 Year 2 Year 3 Assets Year 1 Year 2 Year 3
Capital 30.55 30.55 30.55 Fixed assets 59.36 63.46 68.22
Pro?t 66.40 67.07 69.43 Current assets:
Secured loan 27.08 20.07 17.27 Inventory 50.87 65.80 76.07
Unsecured loan 5.00 5.00 5.00 Debtors 70.94 76.90 80.65
Current liabilities Cash 24.39 24.60 28.88
and provisions: Prepaid expenses 32.43 37.44 36.51
Sundry creditors 107.35 142.71 165.32
Expenses payable 1.61 2.80 2.66
237.99 268.20 290.23 237.99 268.20 290.23
EXHIBIT 2 Comparative Summary Income Statement of Ind Instruments Ltd (Figures in lakh)
Particulars Year 1 Year 2 Year 3
Opening stock (units) 0.24 0.39 0.79
Production (units) 13.50 13.85 14.50
Sales (units) 13.35 13.45 14.39
Closing stock (units) 0.39 0.79 0.90
1 Sales revenue (sales unit ? Rs 50) Rs 667.46 Rs 672.46 Rs 719.23
2 Variable cost (0.65 ? sales revenue) 433.85 437.09 467.50
3 Contribution 233.61 235.37 251.73
4 Fixed cost 150.00 150.00 160.00
5 Bad debt 13.21 14.26 16.54
6 Cash discount (sales revenue ? 0.30 ? 0.02) 4.00 4.03 5.75
7 Pro?t 66.40 67.07 69.43
8 Average collection period (days) 21 21 21
9 Average investment in debtors 34.06 34.25 36.60
10 Cost of investment (RoR = 0.18) 6.13 6.16 6.59
11 Collection costs 0.45 0.50 0.55
12 Adjusted pro?ts [7 – (10 + 11)] 59.82 60.40 62.29
The IIL has recently appointed Avinash as its new ?nancial controller. Immediately after taking over, he examines
the working capital management policy of the company. Against the industry norm of 10-12 per cent, the IIL’s
ratio of net working capital to annual turnover (sales) was, as shown below, on the basis of data in Exhibits 1
and 2, low as well as declining.
Comprehensive Cases 47
Year Networking capital (NWC) (Rs lakh) Annual turnover (Rs lakh) NWC ? Sales (%)
1 69.67 667.46 10.4
2 59.23 672.45 8.8
3 54.03 719.23 7.5
Mr Avinash also ?nds that the current and quick ratios of the IIL, summarised below, are inadequate.
Year Current ratio Quick ratio
1 1.64 0.87
2 1.41 0.70
3 1.32 0.65
These ?ndings convinced Mr Avinash that all was not well with the working capital management of the company.
He discussed the problem with CFO of the company, Mr Keemti Lal. To ?nd a solution, he undertook a detailed
analysis of the income statement of the company. The following points emerged from the study of the income
statements.
(a) The company was retailing the component for the sale price of Rs 50, while the variable cost was
65 per cent;
(b) The ?xed cost was Rs 150 lakh as long as production levels were below 14,50,000 units per annum;
(c) For production levels of 14,50,000 units per annum above, the ?xed costs rose to Rs 160 lakh;
(d) The bad debt levels (i.e. sales ? bad debts) had been 1.98 per cent (year 1), 2.11 per cent (year 2) and
2.3 per cent (year 3);
(e) Sales had never equated production in all the three years, and the left over inventory for one year had become
the opening inventory for the next year;
(f) The credit policy followed by the company is “2/10 net 30”.
(g) On an average, only 30 per cent of the customers availed of the cash discount over all the last three years;
(h) The pre-tax rate of return that IIL was expecting for the last three years was 18 per cent, using which Avinash
calculated the cost of average investment made in debtors as shown in the same statements;
(i) The cost of collection from debtors was Rs 45,000 in year 1, which had been continuously increasing by
Rs 5,000 per year for the next two years.
From the above facts Avinash was convinced that the solution to the ills that besieged that company lay with
the customers. So he sought to meet the major customers of IIL. What he found startled him. He found the
following main facts from the customer of IIL:
(a) Many of the customers, the ones with the large orders worth nearly 65 per cent of the annual sales of IIL,
were of the opinion that it was high time that IIL reviewed its credit terms extended to its debtors;
(b) Many customers were asking for more credit period, though some were also ready to forego the 2 per cent
discount that IIL was endowing as of now; in fact, they were ready to settle with discounts as low as 1-1.5
per cent, as was the industry norm, in return for an extension of the credit period by IIL;
(c) Some accounts that had become bad debt in the recent years had the same complaint that the credit terms
of IIL were too stringent, and had to be relaxed for them to continue doing business with IIL as they had been
in the past, else they may be forced to look for alternative sources.
From the talks he had with the customers and internal management of IIL, Avinash thought of three alterna-
tives to offer to IIL. These are:
(i) To extend credit period to 45 days, with the cash discount of 2 per cent available to those customers paying
up within the grace period of 20 days;
48 Financial Management
(ii) To extend credit period to 60 days, with the cash discount of 1.5 per cent available to those customers paying
up within the grace period of 30 days;
(iii) To extend credit period to 75 days, with the cash discount of 1 per cent available to those customers paying
up within the grace period of 40 days.
He then showed these three alternatives to the customers and management of IIL. From consultations with
both, he was able to come to the following estimations:
(A) For ?rst option (2/20 net 45),
(a) for production of 14.50 lakh units, a sales of 14.55 lakh units (after taking into account the previous
year’s closing inventory);
(b) the ?xed cost would be Rs 160 lakh;
(c) the bad debts are expected to be 2 per cent of sales revenue;
(d) 50 per cent of the customers would avail of the cash discount;
(e) the pre-tax RoR expected by IIL, 18 per cent;
(f) the average collection cost would be Rs 0.53 lakh.
(B) For second option (1.5/30 net 60),
(a) for production of 14.5 lakh units, a sales of 14.65 lakh units (after taking into account the previous
year’s closing inventory);
(b) the ?xed cost would be Rs 160 lakh;
(c) the bad debts are expected to be 1.5 per cent of sales revenue;
(d) 55 per cent of the customers would avail of the cash discount;
(e) the pre-tax RoR expected by IIL, 18 per cent;
(f) the average collection cost would be Rs 0.52 lakh.
(C) For third option (1/40 net 75),
(a) for production of 15 lakh units, a sale of 14.75 lakh units (after taking into account the previous year’s
closing inventory);
(b) the ?xed cost would increase to Rs 170 lakh;
(c) the bad debts are expected to be 1 per cent of sales revenue;
(d) 70 per cent of the customer would avail of the cash discount;
(e) the pre-tax RoR expected by IIL, 18 per cent;
(f) the average collection cost would be Rs 0.52 lakh.
As an alternative to the above in-house options of receivables management of IIL, a factoring proposal from
the Forward Looking Bank of India (FLBI) is also available. It has two options: (i) with recourse, and (ii) without
recourse. Even within these options, there were two options each that FLBI was offering IIL. The details of the
offer follow:
(A) For ?rst option (F-I),
(a) the option is with recourse;
(b) the up front advance is 80 per cent of the total amount;
(c) the discount charged on the amount payable would be at the rate of 20 per cent;
(d) the commission rate would be 1.5 per cent per annum;
(e) the bad debts would be assumed at 1 per cent of the total sales revenue;
(B) For second option (F-II),
(a) the option is without recourse;
(b) the up-front advance is 85 per cent of the total amount;
(c) the discount charged on the amount payable would be at the rate of 18 per cent;
Comprehensive Cases 49
(d) the commission rate would be 3 per cent per annum;
(e) there would be no bad debts.
(C) For third option (F-III),
(a) the option is with recourse;
(b) the up-front advance is 85 per cent of the total amount;
(c) the discount charged on the amount payable would be at the rate of 20 per cent;
(d) the commission rate would be 2 per cent per annum;
(e) the bad debts would be assumed at 1 per cent of total sales revenue;
(D) For fourth option (F-IV),
(a) the option is without recourse;
(b) the up-front advance is 90 per cent of the total amount;
(c) the discount charged on the amount payable would be at the rate of 18 per cent;
(d) the commission rate would be 4 per cent per annum;
(e) there would be no bad debts.
In addition, FLBI is guaranteeing (for both the with- and without-recourse options):
(a) Sales of 14.75 lakh units, (i.e. Rs 737.50 lakh per annum);
(b) Payment of the whole amount payable to IIL within a period of 30 days.
Which option of in-house receivables management should be recommended by Avinash to the CFO of the
IIL? Should he prefer the factoring arrangement? Which factoring option should he recommend? Why?
Solution
Financial Evaluation of Credit Term Options for IIL (?gures in lakh)
Particulars Plan I Plan II Plan III
(2/20 net 45) (1.5/30 net 60) (1/40 net 75)
1. Opening stock (units) 0.90 0.90 0.90
2. Production (units) 14.50 14.50 15.00
3. Sales (units) 14.55 14.65 14.75
4. Closing stock (units) 0.85 0.75 1.15
5. Sales revenue [(1) ? Rs 50] 727.50 732.50 737.50
6. Variable cost [(5) ? 0.65] 472.88 476.13 479.38
7. Contribution [(5) – (6)] 254.63 256.38 258.13
8. Fixed costs 160.00 160.00 170.00
9. Bad debts 14.55 10.99** 7.38
10. Cash discount 7.28
@
6.04
@@
5.16
@@@
11. Pro?t [(7) – (8 + 9 + 10)] 72.80 79.34 75.59
12. Average collection period (days) 32 43 50
13. Average investment in debtors 56.26 75.98 90.19
14. Cost of investment [(13) ? 0.18] 10.13 13.68 16.23
15. Collection costs 0.53 0.52 0.52
16. Adjustment pro?t [(11) – (14 + 15)] 62.14 65.15 58.83
@
(0.2 ? 0.50 ? Rs 727.50 lakh)
@@
(0.15 ? 0.55 ? Rs 732.50 lakh)
@@@
(0.01 ? 0.70 ? Rs 737.50 lakh)
** 1.5 per cent
50 Financial Management
Recommendation The best option is Plan II [i.e. 1.5/30 net 60]
Financial Evaluation of In-house Option: Plan II
Relevant cost Amount (Rs lakh)
1. Cash discount 6.04
2. Cost of funds/investments in receivables 15.75
3. Bad debt 10.99
4. Contribution in foreign sales 1.75
5. Avoidable administrative overheads 0.22
Total 34.75
Financial Evaluation of Factoring Arrangement (Amount in Rs lakh)
Relevant costs Factoring options
I II III IV
(With recourse and (Without recourse and (With recourse and (Without recourse and
80 per cent advance) 85 per cent advance) 85 per cent advance) 90 per cent advance)
Factoring commission 11.06 22.13 15.75 29.50
Bad debts (1%) 7.38 0.00 7.38 0.00
Discount charge 9.69 9.12 10.24 9.56
Cost funds/investment
in receivables 2.61 2.16 2.05 1.67
Total 30.74 33.40 34.42 40.73
Recommendation Option I of factoring arrangement should be chosen in place of Plan II of in-house
receivables management.
CHAPTER 17
Working Capital Financing
SMART CHIP HARDWARE COMPANY
The Smart Chip Hardware Company is a reputed company in industry with of?ces at Delhi, Chennai, and Mumbai.
The company was founded by Mr Mahendra Kapoor and at present he is the chairman of the company.
Since the last few years, his son Gyanendra, a postgraduate in Finance has been involved in the business.
Soon after joining, Gyanendra began to question a number of practices. He experimented with distribution chan-
nels and discovered that he could eliminate many dealers while increasing the sales. After being comfortable with
the company’s production activities and sales efforts, he began to work on its cash ?ows and credit problems.
The Company sold most of its southern accounts to a subsidiary, Arrow Chip Company. The resulting cash
from the sale of accounts was used to modernise the company’s machinery. Some of the funds were also used
to improve the distribution system.
These actions brought about a considerable improvement in the service of western and northern customers
and resulted in substantial increase in sales.
The next years sales are being forecast at Rs 9.8 crore if the ?rm continues to market its products aggres-
sively.
At the end of the previous year, Gyanendra looked at past balance sheets and forecasted expenses. The
?rm was budgeting three stable items for the next year: of?ce and marketing salaries, Rs 45,00,000; sales and
promotion expenses, Rs 70,00,000 and miscellaneous overheads, Rs 22,00,000. Gyanendra knew that if the
?rm did not borrow any additional funds, Smart Chip would have likely interest expenses of approximately Rs
45,00,000 next year.
Having gathered these data, Gyanendra needed to look at collection costs and bad debt losses not included
in general and administrative expenses. He decided to forecast these items using data from ?rm’s risk–class
approach to receivables management. All accounts were assigned to a risk-class category, which was reviewed
on regular basis. The credit manager normally prepared an estimate of the collection costs and bad debts losses
of each category of customer. These estimates were compared against actual data at the end of each year. For
the past ?ve years, the estimates proved to be fairly accurate. The bad debt losses were based on actual losses
over the past ?ve years, and the collection cost was allocated based on the routine expenses and the special
collection efforts required for each category of customers.
During the past four years, Smart Chip Hardware sold on the terms 2/10 net 30. Based on past data, 30 per
cent of the total customers would take the 2 per cent discount while others would pay on an average in 45 days.
After giving some thought to the data, Gyanendra spoke with Chatur Singh, the ?rm’s sales manager. Two months
earlier, Chatur Singh had suggested that the ?rm should increase its terms of trade to 2/10 net 60. This would
increase receivables, collection costs and bad debts losses but would result in additional sales and pro?ts to
the ?rm. He estimated that the of?ce and marketing expenses will rise by Rs 15,00,000, selling expenses would
rise by approximately Rs 20,00,000 and miscellaneous overheads will rise by Rs 5,00,000. The money required
to ?nance additional receivables will be borrowed at 16 per cent. Gyanendra asked Chatur Singh to check the
effect on sales if ?rm changes its terms to net 15. Two weeks later Chatur Singh submitted his appraisal.
From his past experience Gyanendra knew that cost of goods sold would be approximately 70 per cent of
net sales of Rs 9.8 crore. He estimated that they would be 73 per cent at Rs 8.5 crore net sales and 68.5 per
cent at Rs 11.9 crore sales. The tax rate for planning purposes should be assumed at 40 per cent.
Using the above mentioned information, Gyanendra was prepared to analyse and take a decision about ap-
propriate credit policy for Smart Chip Hardware Company. He decided in advance that he would not change the
policy unless the new policy gives either an increase in sales of 20 per cent or an increase in pro?t of 10 per
52 Financial Management
cent. He would prefer both but would accept a decline in sales of 25 per cent as long as pro?ts rose by 10 per
cent or more.
While he was in the middle of his analysis, he received an offer to avail services from M/s Fair Factoring
Ltd (FFL) as an alternative to in-house management of receivables collection and credit monitoring. As a result
of factoring agreement, Gyanendra estimated that miscellaneous overhead would decline from Rs 27,00,000 to
Rs 22,00,000.
According to factoring proposal, the FFL offers a guaranteed payment within 60 days. The other details are
listed below: (1) Advance, 80 per cent, (2) Up-front discount, 22 per cent, and (3) Commission 4 per cent.
Before taking ?nal decision, Gyanendra thought to analyse the factoring proposal along with other terms.
What decision should he take?
Solution
Collection Costs and Bad Debt Losses by Category of Customer
Risk category Collection costs as a Actual bad debt losses as a
percentage of sales (%) percentage of sales (%)
1 2 1
2 3 2
3 4 3
4 6 5
Forecast General and Administrative Expenses (’000s)
Particulars Trade terms
2/10 net 60 2/10 net 30 Net 15
Of?ce and marketing salaries 6,000 4,500 4,000
Sales and promotion 9,000 7,000 6,000
Miscellaneous overheads 2,700 2,200 2,000
Interest expenses 4,500 4,500 4,500
Terms of Trade and Actual Practices Reported by Credit Managers
Terms of trade Average collection period in actual practice
Net 15 22 to 26 days
2/10 net 30 40 to 50 days
2/10 net 60 60 to 70 days
Next Year’s Sales Estimates (in ’000s)
Particulars Trade terms
Net 15 2/10 net 30 2/10 net 60
Gross sales 88,000 1,02,000 1,25,000
Returns 3,000 4,000 5,400
Percentage of customers availing discount (%) 0 30 15
Cost of goods sold as a percentage of
net sales (i.e. sales – returns)(%) 73 70 68.5
Net credit sales 85,000 98,000 1,19,600
Sales by credit category:
1 28,000 30,000 30,000
(Contd)
Comprehensive Cases 53
2 38,000 42,000 44,000
3 19,000 24,000 28,000
4 2,000 15,600
Total credit sales 85,000 98,000 1,17,600
Estimated Receivables With Each Credit Policy
Terms of trade Average collection period Average receivables
Net 15 24 Rs 5,667
2/10 net 30 45 12,250
2/10 net 60 65 21,594
Savings for Added Cost for Each Trade Policy
Terms of Level of Original level Funds freed Cost of funds Savings Added cost
trade receivables of receivables or tied-up
Net 15 Rs 5,667 Rs 12,250 Rs 6,583 0.16 Rs 1,053
2/10 net 30 12,250 12,250 0 0.16 0
2/10 net 60 21,594 12,250 (–9,344) 0.16 Rs (–1,495)
Schedule for Collection Costs and Bad Debts for Trade Terms 2/10 Net 30 (’000s)
Risk category Credit sales Collection costs Bad debts
1 Rs 30,000 Rs 600 Rs 300
2 42,000 1,260 840
3 24,000 960 720
4 2,000 120 100
Total 98,000 2,940 1,960
Schedule for Collection Costs and Bad Debts for Trade Terms 2/10 Net 60 (’000s)
Risk category Credit sales Collection costs Bad debts
1 Rs 30,000 Rs 600 Rs 300
2 44,000 1,320 880
3 28,000 1,120 840
4 15,000 936 780
Total 1,17,600 3,976 2,800
Pro Forma Income Statement for Smart Chip Hardware Company for Different Trade Terms
Particulars Trade terms
Net 15 2/10 net 30 2/10 net 60
Gross sales Rs 88,000 Rs 1,02,000 Rs 1,25,000
Less: Returns 3,000 4,000 5,400
Net sales 85,000 98,000 1,19,600
Cost of goods sold 64,240 71,400 85,625
Gross pro?t 20,760 26,600 33,975
(Contd)
(Contd)
54 Financial Management
Collection costs 2,460 2,940 3,976
Bad debts 1,610 1,960 2,800
Of?ce and marketing expenses 4,000 4,500 6,000
Sales and promotion expenses 6,000 7,000 9,000
Miscellaneous overheads 1,800 2,200 2,700
Discounts 0 588 359
Operating income 4,890 7,412 9,140
Saving or added cost of receivables 1,053 0 (–2,495)
EBIT 5,943 7,412 7,645
Present interest on debt 4,500 4,500 4,500
EBT 1,443 2,912 3,145
Taxes (40%) 577 1,165 1,258
EAT 866 1,747 1,887
Terms of Factoring Arrangement
Particulars Terms
Advance (%) 80
Discount charge (%) 22
Upfront commission (%) 4
Cost of own funds (%) 18
Guaranteed payment date (days) 60
Advantages to Smart Chip Hardware By Factoring Deal
Particulars Amount (’000s)
Sales 1,19,600
Miscellaneous 2,200
Cost of In-house Collection and Financing
Particulars Amount (‘000s)
Cost of discount Rs 359
Cost of collection 3,976
Cost of overheads 2,700
Bad debts 2,800
Cost of investment in debtors (Rs 21,594 ? 0.16) 3,455
Total cost 13,290
Cost of Factoring Without Recourse
Particulars Amount (’000s)
Commission upfront Rs 4,784
Discount charges 2,526
Working capital ?nancing cost 878
Saving in overheads (500)
Total cost 7,688
(Contd)
Comprehensive Cases 55
Pro Forma for Income Statement After Factoring Deal
Particulars 2/10 Net 60
Gross sales Rs 1,25,000
Less: Returns 5,400
Net sales 1,19,000
Cost of goods sold 85,624
Gross pro?t 33,975
Commission upfront 4,784
Discount charges 2,526
Of?ce and marketing salaries 6,000
Sales and promotion expenses 9,000
Miscellaneous overhead 2,200
Cost of working capital ?nancing 878
EBIT 8,587
Present interest on debt 4,500
EBT 4,087
Taxes (40%) 1,635
EAT 2,452
Recommendation
1. If Smart Chip changes terms from 2/10 net 30 to 2/10 net 60, sales increases by little more than 20 per
cent but pro?ts does not increase by 10 per cent because of increased bad debts and administrative and
selling expenses incurred to achieve more sales. This increase can be attributed to pressure of selling to
non-worthy and far-?unged customers.
2. If the term is changed to net 15, sales decrease by 14 per cent only but pro?ts decrease by around 50
per cent. This decrease in pro?ts is not desirable.
3. After taking into account the factoring deal for term 2/10 net 60, sales increased by 20 per cent and sav-
ings achieved through factoring increased the pro?ts by around 20 per cent.
4. Thus, Gyanendra should change the terms to 2/10 net 60 along with factoring arrangement; otherwise
stick to current policy of 2/10 net 30.
CHAPTER 20
Designing Capital Structure
ZIP ZAP ZOOM CAR COMPANY
Zip Zap Zoom Company Ltd is into manufacturing cars in the small car (800 cc) segment. It was set up 15 years
back and since its establishment it has seen a phenomenal growth in both its market and pro?tability. Its ?nancial
statements are shown in Exhibits 1 and 2 respectively.
The company enjoys the con?dence of its shareholders who have been rewarded with growing dividends year
after year. Last year, the company had announced 20 per cent dividend, which was the highest in the automobile
sector. The company has never defaulted on its loan payments and enjoys a favourable face with its lenders,
which include ?nancial institutions, commercial banks and debentureholders.
The competition in the car industry has increased in the past few years and the company foresees further
intensi?cation of competition with the entry of several foreign car manufacturers many of them being market
leaders in their respective countries. The small car segment especially, will witness entry of foreign majors in the
near future, with latest technology being offered to the Indian customer. The Zip Zap Zoom’s senior management
realises the need for large scale investment in upgradation of technology and improvement of manufacturing
facilities to pre-empt competition.
Whereas on the one hand, the competition in the car industry has been intensifying, on the other hand, there
has been a slowdown in the Indian economy, which has not only reduced the demand for cars, but has also
led to adoption of price cutting strategies by various car manufacturers. The industry indicators predict that the
economy is gradually slipping into recession.
EXHIBIT 1 Balance Sheet as at March 31, 200X
(Amount in Rs crore)
Source of Funds
Share capital 350
Reserves and surplus 250 600
Loans:
Debentures (@ 14%) 50
Institutional borrowing (@ 10%) 100
Commercial loans (@ 12%) 250
Total debt 400
Current liabilities 200
1,200
Application of Funds
Fixed assets:
Gross block 1,000
Less: Depreciation 250
Net block 750
Capital WIP 190
Total ?xed assets 940
Current assets:
Inventory 200
Sundry debtors 40
(Contd)
Comprehensive Cases 57
Cash and bank balance 10
Other current assets 10
Total current assets 260
1,200
EXHIBIT 2 Profit and Loss Account for the Year Ended March 31, 200X
(Amount in Rs crore)
Sales revenue (80,000 units ? Rs 2,50,000) 2,000.0
Operating expenditure:
Variable cost:
Raw material and manufacturing expenses 1,300.0
Variable overheads 100.0
Total 1,400.0
Fixed cost:
R&D 20.0
Marketing and advertising 25.0
Depreciation 250.0
Personnel 70.0
Total 365.0
Total operating expenditure 1,765.0
Operating pro?ts (EBIT) 235.0
Financial expense:
Interest on debentures 7.7
Interest on institutional borrowings 11.0
Interest on commercial loan 33.0 51.7
Earnings before tax (EBT) 183.3
Tax (@ 35%) 64.2
Earnings after tax (EAT) 119.1
Dividends 70.0
Debt redemption (sinking fund obligation)** 40.0
Contribution to reserves and surplus 9.1
* Includes the cost of inventory and work in process (W/P) which is dependent on demand (sales)
** The loans have to be retired in the next ten years and the ?rm redeems Rs 40 crore every year.
The company is faced with the problem of deciding how much to invest in upgradation of its plans and technol-
ogy. Capital investment up to a maximum of Rs 100 crore is required. The problem areas are three-fold.
The company cannot forgo the capital investment as that could lead to reduction in its market share as
technological competence in this industry is a must and customers would shift to manufacturers providing
latest in car technology.
The company does not want to issue new equity shares and its retained earnings are not enough for such
a large investment. Thus, the only option is raising debt.
The company wants to limit its additional debt to a level that it can service without taking undue risks. With
the looming recession and uncertain market conditions, the company perceives that additional ?xed obliga-
tions could become a cause of ?nancial distress, and, thus, wants to determine its additional debt capacity
to meet the investment requirements.
(Contd)
58 Financial Management
Mr Shortsighted, the company’s Finance Manager, is given the task of determining the additional debt that the
?rm can raise. He thinks that the ?rm can raise Rs 100 crore worth debt and service it even in years of recession.
The company can raise debt at 15 per cent from a ?nancial institution. While working out the debt capacity, Mr
Shortsighted takes the following assumptions for the recession years:
(a) A maximum of 10 per cent reduction in sales volume will take place.
(b) A maximum of 6 per cent reduction in sales price of cars will take place.
Mr Shortsighted prepares a projected income statement which is representative of the recession years. While
doing so, he determines what he thinks are the “irreducible minimum” expenditures under recessionary condi-
tions. For him, risk of insolvency is the main concern while designing the capital structure. To support his view,
he presents the income statement as shown in Exhibit 3.
EXHIBIT 3 Projected Profit and Loss Account
(Amount in Rs crore)
Sales revenue (72,000 units ? Rs 2,35,000) 1,692.0
Operating expenditure:
Variable cost:
Raw material and manufacturing expenses 1,170.0
Variable overheads 90.0
Total 1,260.0
Fixed cost:
R&D —
Marketing and advertising 15.0
Depreciation 187.5
Personnel 70.0
Total 272.5
Total operating expenditure 1,532.5
EBIT 159.5
Financial expense:
Interest on existing Debentures 7.0
Interest on existing institutional borrowings 10.0
Interest on commercial loan 30.0
Interest on additional debt 15.0 62.0
EBT 97.5
Tax (@ 35%) 34.1
EAT 63.4
Dividends —
Debt redemption (sinking fund obligation) 50.0*
Contribution to reserves and surplus 13.4
*Rs 40 crore (existing debt) + Rs 10 crore (additional debt)
Assumptions of Mr Shortsighted
R&D expenditure can be done away with till the economy picks up.
Marketing and advertising expenditure can be reduced by 40 per cent.
Keeping in mind the investor con?dence that the company enjoys, he feels that the company can forgo
paying dividends in the recession period.
He goes with his worked out statement to the Director Finance, Mr Arthashatra, and advocates raising Rs
100 crore of debt to ?nance the intended capital investment. Mr Arthashatra does not feel comfortable with the
statements and calls for the company’s ?nancial analyst, Mr Longsighted.
Comprehensive Cases 59
Mr Longsighted carefully analyses Mr Shortsighted’s assumptions and points out that insolvency should not
be the sole criterion while determining the debt capacity of the ?rm. He points out the following:
“Apart from debt servicing, there are certain expenditures like those on R&D and marketing that need to be
continued to ensure the long-term health of the ?rm.
“Certain management policies like those relating to dividend payout, send out important signals to the inves-
tors. The Zip Zap Zoom’s management has been paying regular dividends and discontinuing this practice
(even though just for the recession phase) could raise serious doubts in the investor’s mind about the health
of the ?rm. The ?rm should pay at least 10 per cent dividend in the recession years”.
“Mr Shortsighted has used the accounting pro?ts to determine the amount available each year for servicing
the debt obligations. This does not give the true picture. Net cash in?ows should be used to determine the
amount available for servicing the debt.”
“Net cash in?ows are determined by an interplay of many variables and such a simplistic view should not
be taken while determining the cash ?ows in recession. It is not possible to accurately predict the fall in
any of the factors such as sales volume, sales price, marketing expenditure and so on. Probability distribu-
tion of variation of each of the factors that affect net cash in?ow should be analysed. From this analysis,
the probability distribution of variation in net cash in?ow should be analysed (the net cash in?ows follow a
normal probability distribution). This will give a true picture of how the company’s cash ?ows will behave in
recession conditions.”
The management recognises that the alternative suggested by Mr Longsighted rests on data, which are complex
and require expenditure of time and effort to obtain and interpret. Considering the importance of capital structure
design, the Finance Director asks Mr Longsighted to carry out his analysis. Information on the behaviour of cash
?ows during the recession periods is taken into account.
The methodology undertaken is as follows:
(a) Important factors that affect cash ?ows (especially contraction of cash ?ows), like sales volume, sales price,
raw materials expenditure, and so on, are identi?ed and the analysis is carried out in terms of cash receipts
and cash expenditures.
(b) Each factor’s behaviour (variation behaviour) in adverse conditions in the past is studied and future expecta-
tions are combined with past data, to describe limits (maximum favourable, most probable and maximum
adverse) for all the factors.
(c) Once this information is generated for all the factors affecting the cash ?ows, Mr Longsighted comes up
with a range of estimates of the cash ?ow in future recession periods based on all possible combinations
of the several factors. He also estimates the probability of occurrence of each estimate of cash ?ow.
Assuming a normal distribution of the expected behaviour, the mean expected value of net cash in?ow in
adverse conditions came out to be Rs 220.27 crore with standard deviation of Rs 110 crore.
Keeping in mind the looming recession and the uncertainty of the recession behaviour, Mr Arthashastra feels
that the ?rm should factor a risk of cash inadequacy of around 5 per cent even in the most adverse industry
conditions. Thus, the ?rm should take up only that amount of additional debt that it can service 95 per cent of
the times, while maintaining cash adequacy.
To maintain an annual dividend of 10 per cent, an additional Rs 35 crore has to be kept aside. Hence, the
expected available net cash in?ow is Rs 185.27 crore (i.e. Rs 220.27 crore – Rs 35 crore).
Analyse the debt capacity of the company
Solution The additional cash available in recession conditions to service debt (catering for 5% risk tolerance)
is given by the following:

? ì
ó
X
= –1.64
60 Financial Management
Here:
X is the additional cash available each year for servicing ?xed obligations
? = Rs 185.27
? = Rs 110 crore
–1.64 is that value of Z which gives 95 per cent of the area of the standard normal curve.
Taking all the above into account, Mr Longsighted works out the additional debt capacity as shown in
Exhibit 4. The additional debt capacity as calculated by him is Rs 73.16 crore.
Mr Arthashastra too is convinced that there is no need to take up debt which can lead to a risk of cash
inadequacy, especially in the present economic scenario. Mr Shortsighted too, realises the importance of maintain-
ing cash adequacy even in the most unfavourable conditions. Thus, it decided that the ?rm will raise an additional
debt of only Rs 73.15 crore at present and not take any undue risk. Further investments can be undertaken when
the industry conditions revive.
EXHIBIT 4 Financial Analaysis
(Rs crore)
Determination of Cash Flows:
Cash available for dividends = [EAT + Depreciation –
Debtors – Sinking fund obligation] Rs 259.15
Cash available at 15% contraction 220.27
Cash required for dividends 35.00
Average cash ?ow available for additional obligations 185.27
Determination of Debt Capacity:
Tolerance limit (%) 5
Standard deviation 110
Cash ?ow under most adverse conditions* 4.45
Existing cash reserve 10.00
Cash available 14.45
Debt obligation per crore rupee of additional debt:
Interest (15% less Tax shield) 0.0975
Sinking fund obligation 0.1000
Total 0.1975
Debt capacity (Rs 14.45 crore/0.1975 crore) 73.16
*Calculation of cash ?ow under most adverse conditions is based on the normal distribu-
tion (Z distribution):
Z value =
? Cash inflow Mean value of cash inflow
Standard deviation
The Z value corresponding to tolerance limit = –1.64.
Replacing the value in the above equation, we get the value cash in?ows = Rs 4.45 crore.
CHAPTER 25
Lease Financing and Hire-purchase Finance
ARQ LTD
ARQ Ltd is an Indian company based in Greater Noida, which manufactures packaging materials for food items.
The company maintains a present ?eet of ?ve ?at cars and two Contessa Classic cars for its chairman, general
manager and ?ve senior managers. The book value of the seven cars is Rs 20,00,000 and their market value is
estimated at Rs 15,00,000. All the cars fall under the same block of depreciation @25 per cent.
A German multinational company (MNC) BYR Ltd, has acquired ARQ Ltd in all cash deal. The merged company
called BYR India Ltd is proposing to expand the manufacturing capacity by four folds and the organisation
structure is reorganised from top to bottom. The German MNC has the policy of providing transport facility to
all senior executives (22) of the company because the manufacturing plant at Greater Noida was more than 10
kms outside Delhi where most of the executives were staying.
Prices of the Cars to be Provided to the Executives have been as follows:
Manager (10) Santro Xing Rs 3,75,000
DGM and GM (5) Honda City 6,75,000
Director (5) Toyota Corolla 9,25,000
Managing Director (1) Sonata Gold 13,50,000
Chairman (1) Mercedes Benz 23,50,000
The company is evaluating two options for providing these cars to executives
Option 1: The company will buy the cars and pay the executives fuel expenses, maintenance expenses, driver
allowance and insurance (at the year-end). In such case, the ownership of the car will lie with the company. The
details of the proposed allowances and expenditures to be paid are as follows:
(a) Fuel Expenses and Maintenance Allowances per Month
Particulars Fuel expenses Maintenance allowance
Manager Rs 2,500 Rs 1,000
DGM and GM 5,000 1,200
Director 7,500 1,800
Managing Director 12,000 3,000
Chairman 18,000 4,000
(b) Driver Allowance: Rs 4,000 per month (Only Chairman, Managing Director and Directors are eligible
for driver allowance).
(c) Insurance Cost: 1 per cent of the cost of the car.
The useful life for the cars is assumed to be ?ve years after which they can be sold at 20 per cent salvage value.
All the cars fall under the same block of depreciation @ 25 per cent using written down method of depreciation.
The company will have to borrow to ?nance the purchase from a bank with interest at 14 per cent repayable in
?ve annual equal instalments payable at the end of the year.
Option 2: ORIX, The ?eet management company has offered the 22 cars of the same make at lease for the
period of ?ve years. The monthly lease rentals for the cars are as follows (assuming that the total of monthly
lease rentals for the whole year are paid at the end of each year).
Santro Xing Rs 9,125
Honda City 16,325
Toyota Corolla 27,175
Sonata Gold 39,250
Mercedes Benz 61,250
62 Financial Management
Under this lease agreement the leasing company, ORIX will pay for the fuel, maintenance and driver expenses
for all the cars. The lessor will claim the depreciation on the cars and the lessee will claim the lease rentals
against the taxable income. BYR India Ltd will have to hire fulltime supervisor (at monthly salary of Rs 15,000
per month) to manage the ?eet of cars hired on lease. The company will have to bear additional miscellaneous
expenses of Rs 5,000 per month for providing him the PC, mobile phone and so on.
The company’s effective tax rate is 40 per cent and its cost of capital is 15 per cent.
Analyse the ?nancial viability of the two options. Which option would you recommend? Why?
Solution
(I) Buying/Borrowing Option
(a) Total Investment
Particulars Cost of one car Number of cars Total cost
Santro Xing Rs 3,75,000 10 Rs 37,50,000
Honda City 6,75,000 5 33,75,000
Toyota Corolla 9,25,000 5 46,25,000
Sonata Gold 13,50,000 1 13,50,000
Mercedes Benz 23,50,000 1 23,50,000
1,54,50,000
(b) Present Value of Future Cash Out?ows
Year- Gross cash out?ows Tax advantage on Net cash PV factor Total PV
end Loan Fixed out?ows at 8.4%**
instalment operating costs Interest Depreciation Fixed
(schedule 1) (schedule 2) (schedule 3) operating costs
1 Rs 45,00,437* Rs 22,84,500 Rs 8,65,200 Rs 13,95,000 Rs 9,13,800 Rs 36,10,937 0.922 Rs 33,29,284
2 45,00,437 22,84,500 7,34,304 10,46,250 9,13,800 40,90,583 0.851 34,81,086
3 45,00,437 22,84,500 5,85,087 7,84,688 9,13,800 45,01,362 0.785 35,33,569
4 45,00,437 22,84,500 4,14,975 5,88,516 9,13,800 48,67,646 0.724 35,24,175
5 45,00,437 22,84,500 2,21,265 4,41,387 9,13,800 52,08,485 0.669 34,84,476
3.951 1,73,52,590
*Rs 154,50,000/3.433 = Rs 45,00,437
** (14% ? 0.6)
(II) Leasing Option
Total Lease Rent
Model of car Lease rent of a car Number of cars Total lease rent
Santro Xing Rs 9,125 10 Rs 91,250
Honda City 16,325 5 81,625
Toyota Corolla 27,175 5 1,35,875
Sonata Gold 39,250 1 39,250
Mercedes Benz 61,250 1 61,250
Total monthly lease bill 4,09,250
Comprehensive Cases 63
Total Monthly Expenses
Lease rent Rs 4,09,250
Salary of supervisor 15,000
Miscellaneous charges 5,000
Total monthly charges 4,29,250
Total annual expenses (Rs 4,29,250 ? 12) 51,51,000
Tax shield on annual expenses @40% 20,60,400
Cash out?ows after taxes 30,90,600
Short-term Capital Loss on account of Sale of Existing Cars
Book value of the existing seven cars Rs 20,00,000
Salvage value of seven cars 15,00,000
Short-term capital loss 5,00,000
Tax advantage on short term capital loss (Rs 5,00,000 ? 0.4) 2,00,000
Present value of Cash Out?ows
Total annual expenses Rs 30,90,600
Annuity for Re 1 for 5 years @8.4% 3.951
Present value of future cash out?ows 1,22,10,961
Less: Tax advantage on short-term capital loss 2,00,000
Less: Sales proceeds of existing cars 15,00,000
Present value of incremental cash out?ows 1,05,10,961
Recommendation Since the present value of the proposal for buying cars is more than the present value of
leasing the cars from the leasing company ORIX, it is recommended that the company should opt for leasing.
Schedule 1: Annual Fixed Operating Cost
Fixed Monthly Expenses
Executive Car Number Fuel Maintenance Driver Total monthly
of cars expenses expenses expenses expenses
Manager Santro Xing 10 Rs 2,500 Rs 1,000 0 Rs 35,000
DGM and GM Honda City 5 5,000 1,200 0 31,000
Director Toyota Corolla 5 7,500 1,800 Rs 4,000 66,500
Managing Director Sonata Gold 1 12,000 3,000 4,000 19,000
Chairman Mercedes Benz 1 18,000 4,000 4,000 26,000
Total monthly expenses 1,77,500
Fixed Yearly Expenses
Fixed monthly expenses @ Rs 1,77,500 ? 12 months Rs 21,30,000
Insurance cost @1% 1,54,500
Total ?xed operating costs 22,84,500
64 Financial Management
Schedule 2: Schedule of Debt Payment
Year- Loan Loan at the Interest Principal Principal outstanding
end instalment beginning of the year payment 14% repayment at the end of the year
1 Rs 4,500.437 Rs 1,54,50,000 Rs 21,63,000 Rs 23,37,437 Rs 1,31,12,563
2 4,500.437 1,31,12,563 18,35,759 26,64,572 1,04,47,991
3 4,500.437 1,04,47,991 14,62,719 30,37,718 74,10,273
4 4,500.437 74,10,273 10,37,438 34,62,999 39,47,274
5 4,500.437 39,47,274 5,53,163 39,47,274 Nil
Schedule 3: Schedule of Depreciation for Buying (Borrow) Option
Rate of depreciation: 25% (Written down method)
Book value at the start of year = Opening balance of the block + Purchases – Salvage value of sold assets:
Opening balance of the 25% block Rs 20,00,000
Add: Buying cost of cars 1,54,50,000
Less: Salvage value of cars 15,00,000
Book value at the start of year 1,59,50,000
Base for incremental depreciation
Depreciation based for new block Rs 1,59,50,000
Less: Depreciation base for existing block 20,00,000
1,39,50,000
Year Depreciation
1 (Rs 1,39,50,000 ? 0.25) Rs 34,87,500
2 26,15,625
3 19,61,719
4 14,71,289
5 11,03,467*
* It is assumed that company would be buying the new cars again in the sixth year. So the 25 per cent depreciation
block will continue to exist. So tax advantage on short-term capital loss because of selling of assets at market
price lower than the book value in the sixth year is not considered.
CHAPTER 32
Business Valuation
TATA MOTORS LIMITED
Tata Motors Limited (TML) is one of the leading automobile manufacturing companies in India. TML manufactures
both commercial as well as passenger vehicles. The ?nancial statements of the company for year 2006 are as
follows:
Balance Sheet of TML as at 31st March 2006 (Amount in Rs. crore)
Liabilities Amount Assets Amount
Shareholders Fund Long term / Fixed assets 4,382
Paid up equity capital 383
Reserves 5,154 Long term ?nancial investments 1,470
Deferred tax liabilities 771 Deferred tax assets 151
Intangible assets 150
External Liabilities
8.5% Long term borrowings 2,219 Current assets
12% Debentures 76
15% Other long-term borrowings 642 Inventories 2,012
Creditors and other liabilities 7,118 Receivables 6,534
Cash and bank balance 1,119
Marketable securities 545
16,363 16,363
Pro?t and Loss Account of TML for the years ended March, 2001 - 2006
(Amount in Rs. crore)
Particulars Mar Mar Mar Mar Mar Mar
2001 2002 2003 2004 2005 2006
Income
Sales revenues from current product lines 7976 8715 10704 15312 20277 23568
Non-operating income (dividend, interest
& miscellaneous) 171 135 150 263 385 609
Expenditures
Raw materials, stores, etc. 4886 4882 5900 8578 12263 14633
Wages and salaries 608 692 720 882 1039 1143
Energy (power and fuel) 185 185 194 215 238 259
Indirect taxes (excise, etc.) 1319 1407 1768 2292 3092 3436
Advertising and marketing expenses 206 305 398 322 409 498
Distribution expenses 111 127 140 185 239 335
Other operating expenses 397 494 666 1006 1221 1392
Pro?t before depreciation, interest and taxes 434 759 1068 2094 2160 2481
Financial charges 491 424 317 217 218 295
Pro?t before depreciation and taxes -57 334 750 1877 1942 2187
Depreciation 347 355 362 383 424 524
Pro?t before taxes -404 -21 388 1495 1519 1663
Tax provision 2 1 210 483 416 525
Pro?t after tax -406 -22 178 1012 1103 1138
66 Financial Management
Note:
1. Income from “change in stock” and non-recurring income has not been considered above,
2. Non-recurring expenses also have been ignored
The domestic industry is projected to grow at 10% to 15% (y-o-y basis) for next 5 years. The company is looking
for international expansion and is investing to expand abroad through acquisitions, and dealership expansions.
The TML is also investing in various companies abroad as a minority stakeholder as a strategic decision.
The TML has taken the cognizance of boom in the economy and the marketing and sales department has
projected the (y-o-y) growth for next 8 years (2007-2014) as follows:
Sales revenue projection for current product lines, 2007-2014 (In percentages)
Projection Probability Y-o-Y Growth in Sales
Scenario 2007 2008 2009 2010 2011 2012 2013 2014
Optimistic 30% 20% 15% 15% 12% 12% 12% 12% 12%
Most Likely 40% 20% 15% 12% 10% 10% 10% 10% 10%
Pessimistic 30% 15% 12% 10% 8% 6% 6% 6% 6%
Volume sales projection for new product lines, 2007-2014 (In units)
Projection Probability Sales Volume
Scenario 2007 2008 2009 2010 2011 2012 2013 2014
Optimistic 30% 120,000 240,000 360,000 432,000 475,200 522,720 574,992 632,491
Most Likely 40% 100,000 200,000 300,000 360,000 396,000 435,600 479,160 527,076
Pessimistic 30% 50,000 100,000 125,000 143,750 158,125 173,938 191,331 210,464
The realizable price (gross revenue per product including excise duty) on new product is to be Rs. 1,60,000 per
unit for ?rst two years. Subsequently price is to be reduced to Rs. 1,40,000 per unit.
Sales revenue projection for new product lines, 2007-2014 (Amount in Rs. crore)
Projection Probability Projected Sales Revenues
Scenario 2007 2008 2009 2010 2011 2012 2013 2014
Optimistic 30% 1,920 3,840 5,040 6,048 6,653 7,318 8,050 8,855
Most Likely 40% 1,600 3,200 4,200 5,040 5,544 6,098 6,708 7,379
Pessimistic 30% 800 1,600 1,750 2,013 2,214 2,435 2,679 2,947
Also, the new product is to be manufactured from a separate production facility wherein Government is offering
income tax exemption.
To cater to the demand, The TML has been investing regularly (as shown below) in new product lines as well
as expanding its regular product lines.
Investment planned for years, 2007-2014 (Amount in Rs. crore)
Investment made at beginning Current Product Lines New Product Lines
of Financial Year
2007 100 500
2008 100 400
2009 100 100
2010 200 100
(Contd)
Comprehensive Cases 67
2011 250 150
2012 100 0
2013 200 300
2014 200 100
Adhering to its policy of reducing excise duties across the industry, Government is planning to reduce the excise
duty on automotive products to 12% from its existing 16% from 2009. Moreover, increased focus on achieving
cost ef?ciency through six sigma implementation, inventory management, e-procurement and better supply chain
management may lead to a decrease in operating cost per unit. The overall operating cost is likely to reduce to
90% of the gross revenues in year 2007 onwards.
The TML has a sound debt equity ratio of 1:2 and intends to maintain the same. The company has BETA of
1.19 historically. The yearly market return of stocks on local stock exchanges has been around 14%. The risk
free rate of return could be considered at 6%.
Additional information:
Historically, current assets (excluding marketable securities) were around 35% of the gross sales. The same
percentage is likely to exist for automotive businesses across all product lines in future years as well.
In year 2006, current ratio was 1.35. However, in years before that, TML was able to manage with current
ratios around 1.1. It has now set a target to maintain current ratio of 1.2 now onwards.
TML has planned its non-operating (?nancial investments) investments to increase by 10% y-o-y. Investments
in long-term instruments like equities and bonds form part of such investments.
Dividends and interests income from long-term investments form around 70% of the non-operating revenues
in year 2006. Other miscellaneous incomes could be considered as non-recurring in nature and will not
occur in future.
Historically, company has been trading at local stock exchanges with PE ratio of 22.
Free cash ?ows are to grow at 2% y-o-y (pessimistic) and 3% y-o-y (most likely and optimistic) after its
explicit projected period.
Effective corporate tax could be safely assumed to be around 32%.
On an average, deferred tax liabilities have been increasing by 6% year on year basis.
On an average, deferred tax assets have been decreasing by 30% year on year basis.
The market valuation of the company is in the range of Rs. 31,000 – Rs. 33,000 crore as per April, 2006 data
of the Bombay Stock Exchange. The management of TML assigns the task of valuation of TML to, Alok Verma,
a ?nancial consultant. Mr. Verma is of the view that given the fact about the TML, free cash ?ow approach to
valuation would be appropriate.
Using a three step approach: (1) The present value of free cash ?ows to ?rm during the explicit forecast
period, (2) The present value of continuing value of free cash ?ows to the ?rm after the explicit period, and (3)
Value of non-operating assets at the end of the explicit period, the ?nancial consultant has prepared a valuation
report shown in Exhibit 32.1.
EXHIBIT 32.1 FCFF based valuation of TML
Cost of capital
Cost of equity:
Cost of Equity for the company using CAPM approach is 15.5% as shown below:
= Rf + (Rm – Rf) * BETA
= 6% + (14% - 6%)*1.19 = 15.52% or 15.5%
(Contd)
68 Financial Management
Cost of debt:
Particulars Interest Amount Interest paid
Rate (%) (Rs. Crore) (Rs. Crore)
Long term debt 8.50% 2,219 188.61
Debentures 12% 76 9.12
Other long-term loan 15% 642 96.3
Total 2,937 294.03
Overall Interest rate 10%
Corporate Tax 32%
Effective interest rate 6.8%
Cost of capital
Debt: Equity 0.53:1
Cost of Capital = 6.8 %*( 0.53/1.53) + 15.5 %*( 1/1.53)
= 2.36% + 10.14% = 12.5%
Value of the company with optimistic scenario (Amount in Rs. crore)
Particulars March-end
2007 2008 2009 2010 2011 2012 2013 2014
Sales revenues
Current product line 28,282 32,524 37,403 41,891 46,918 52,549 58,854 65,917
New product line 1,920 3,840 5,040 6,048 6,653 7,318 8,050 8,855
Total 30,202 36,364 42,443 47,939 53,571 59,867 66,904 74,772
Cash operating expenditure-
Current product line (90%) 25,454 29,272 33,663 37,702 42,226 47,294 52,969 59,325
Cash operating expenditure-
New product line (90%) 1,728 3,456 4,536 5,443 5,988 6,586 7,245 7,969
Depreciation-Current product
line 896 737 610 528 472 398 358 327
Depreciation-New product
Line 100 160 148 138 141 113 150 140
Operating earnings-Current
product line 1,932 2,515 3,131 3,661 4,220 4,857 5,527 6,265
Operating earnings-New
product line 92 224 356 466 525 619 655 745
Taxes-Current product line 618 805 1,002 1,172 1,350 1,554 1,769 2,005
Taxes-New product lines — — — — — — — —
Increase in deferred tax
liabilities 46 49 52 55 58 62 66 70
Decrease in deferred tax
assets (45) (32) (22) (16) (11) (8) (5) (4)
NOPAT* 1,405 1,917 2,455 2,917 3,346 3,868 4,353 4,940
After tax non-operating income
(dividend and interest) 319 351 386 424 467 513 565 621
Gross cash ?ow** 2,720 3,165 3,599 4,007 4,426 4,892 5,426 6,028
Capital expenditures 600 500 200 300 400 100 500 300
Investment in ?nancial
instruments 147 162 178 196 215 237 260 286
(Contd.)
Comprehensive Cases 69
Increase in working capital (784) 359 355 321 329 367 411 459
Free cash ?ows 2,757 2,144 2,866 3,191 3,482 4,188 4,255 4,982
Continuing value of free
cash ?ows 54,017
Present value factor for
FCFF 0.889 0.790 0.703 0.624 0.554 0.493 0.438 0.388
Present values of free
cash ?ows 2,451 1,694 2,015 1,991 1,929 2,064 1,864 22,892
Company Value 36,900
Growth of free cash ?ows
after the projected period 3%
* Operating earnings of current and new product lines – Taxes – Increase in deferred tax liability
+ Decrease in deferred tax assets.
** NOPAT + After-tax non-operating income + Depreciation of current and new product lines.
Value of the company with most likely scenario (Amount in Rs. crore)
Particulars March-end
2007 2008 2009 2010 2011 2012 2013 2014
Sales revenues
Current product line 28,282 32,524 36,427 40,070 44,077 48,485 53,333 58,666
New product line 1,600 3,200 4,200 5,040 5,544 6,098 6,708 7,379
Total 29,882 35,724 40,627 45,110 49,621 54,583 60,041 66,046
Cash operating expenditure-
Current product line (90%) 25,454 29,272 32,785 36,063 39,669 43,636 48,000 52,800
Cash operating expenditure-
New product line (90%) 1,440 2,880 3,780 4,536 4,990 5,489 6,037 6,641
Depreciation-Current product
line 896 737 610 528 472 398 358 327
Depreciation-New product
Line 100 160 148 138 141 113 150 140
Operating earnings-Current
product line 1,932 2,515 3,033 3,479 3,935 4,451 4,975 5,540
Operating earnings-New
product line 60 160 272 366 414 497 521 598
Taxes-Current product line 618 805 971 1,113 1,259 1,424 1,592 1,773
Taxes-New product lines — — — — — — — —
Increase in deferred tax
liabilities 46 49 52 55 58 62 66 70
Decrease in deferred tax
assets (45) (32) (22) (16) (11) (8) (5) (4)
NOPAT 1,373 1,853 2,305 2,692 3,042 3,469 3,844 4,299
After tax non-operating
income (dividend and
interest) 319 351 386 424 467 513 565 621
Gross cash ?ow 2,688 3,101 3,448 3,782 4,122 4,493 4,917 5,387
Capital expenditures 600 500 200 300 400 100 500 300
Investment in ?nancial
instruments 147 162 178 196 215 237 260 286
(Contd.)
(Contd.)
70 Financial Management
Increase in working capital (803) 341 286 261 263 289 318 350
Free cash ?ows 2,744 2,098 2,784 3,025 3,244 3,867 3,838 4,450
Continuing value of free
cash ?ows 45,615
Present value factor for
FCFF 0.889 0.790 0.703 0.624 0.554 0.493 0.438 0.388
Present values of free
cash ?ows 2,439 1,658 1,957 1,888 1,797 1,906 1,681 19,426
Company Value 32,752
Growth of free cash ?ows
after the projected period 3%
Value of the company with pessimistic scenario (Amount in Rs. crore)
Particulars March-end
2007 2008 2009 2010 2011 2012 2013 2014
Sales revenues
Current product line 27,104 30,356 33,392 36,063 38,227 40,520 42,952 45,529
New product line 800 1,600 1,750 2,013 2,214 2,435 2,679 2,947
Total 27,904 31,956 35,142 38,075 40,441 42,956 45,630 48,475
Cash operating expenditure-
Current product line (90%) 24,393 27,320 30,052 32,457 34,404 36,468 38,656 40,976
Cash operating expenditure-
New product line (90%) 720 1,440 1,575 1,811 1,992 2,192 2,411 2,652
Depreciation-Current product
line 896 737 610 528 472 398 358 327
Depreciation-New product Line 100 160 148 138 141 113 150 140
Operating earnings-Current
product line 1,814 2,298 2,729 3,079 3,350 3,654 3,937 4,226
Operating earnings-New
product line (20) — 27 63 81 131 118 155
Taxes-Current product line 580 735 873 985 1,072 1,169 1,260 1,352
Taxes-New product lines — — — — — — — —
Increase in deferred tax
liabilities 46 49 52 55 58 62 66 70
Decrease in deferred tax
assets (45) (32) (22) (16) (11) (8) (5) (4)
NOPAT 1,212 1,546 1,853 2,117 2,311 2,562 2,735 2,963
After tax non-operating income
(dividend and interest) 319 351 386 424 467 513 565 621
Gross cash ?ow 2,528 2,793 2,997 3,207 3,391 3,585 3,808 4,051
Capital expenditures 600 500 200 300 400 100 500 300
Investment in ?nancial
instruments 147 162 178 196 215 237 260 286
Increase in working capital (918) 236 186 171 138 147 156 166
Free cash ?ows 2,699 1,895 2,433 2,540 2,638 3,102 2,891 3,298
Continuing value of free
cash ?ows 32,038
(Contd.)
(Contd.)
Comprehensive Cases 71
Present value factor for
FCFF 0.889 0.790 0.703 0.624 0.554 0.493 0.438 0.388
Present values of free
cash ?ows 2,399 1,497 1,710 1,585 1,461 1,529 1,266 13,710
Company Value 25,160
Growth of free cash ?ows
after the projected period 2%
Estimation of the value of the company (Amount in Rs. crore)
Projection Scenario Optimistic Most Likely Pessimistic
Probability 30% 40% 30%
Present value of FCFF 36,900 32,752 25,160
Weighted Average Present Value of FCFF 31,719
Value of Marketable Securities* 545
Estimated Value of the Firm 32,264
*According to Copeland, Marketable securities are short-term cash investments that the company holds
over and above its target cash balances to support operations. The investment in marketable securities is zero-
net-present value investment. The return on this investment just compensates for its risk. Therefore, the present
value of the cash ?ow related to these marketable securities must equal the market value of these securities on
the company’s books at the time of the valuation.
Conclusion: The estimated value of the ?rm is Rs. 32,264 crore in April, 2006 (Very closely with the stock
(Contd.)
72 Financial Management
M/S DHODA SWEETS BUSINESS VALUATION
M/s Dhoda Sweets (DS) is a popular confectionary manufacturer in North India. DS has reached its ?fth year of
trading. It has been successful in developing its business after a slow start. At the end of its fourth year of trading
it obtained a new equity capital. Its summarised balance sheet at the end of year 5 is shown in Exhibit 1.
EXHIBIT 1 Dhoda Sweets’ Balance Sheet as on March 31, year 200X (Rs ’000)
Fixed assets Rs 1,000
Current assets Rs 1,500
Less: Current liabilities 500
Net current assets 1,000
Total assets 2,000
Share capital (1,00,000 shares 3 Rs 10) 1,000
Reserves 500
Shareholders funds 1,500
10% Debt 500
Shareholders fund and liabilities 2,000
EAT (tax at 50 per cent) 150
The management of DS is now planning to expand its operations to enter the novelty sweets market. Since
they lack the expertise in manufacturing in this segment, instead of setting up a new unit, they propose to acquire
a unit in this segment.
Mr Vin Market (Marketing Manager) has been deployed to seek out such a player because of high good
connections in the market. He comes out with a lot of options but one company in particular catches his attention.
Khemchand Halwaai (KH) is into the manufacturing of novelty sweets with a product range and market which
would perfectly complement that of DS’s.
The Finance Manager, Mr Money Minded is summoned by Mr Vin Market to help him with the ?nancial
aspects.
Mr Money Minded immediately gets on to the job and at ?rst he looks at the balance sheet of KH summarised
in Exhibit 2.
EXHIBIT 2 Balance Sheet of KH as on March 31, Year 200X (Rs ’000)
Fixed assets Rs 250
Current assets Rs 500
Less: Current liabilities 250
Net current assets 250
Total assets 500
Share capital (30,000 shares 3 Rs 10) 300
Reserves 100
Shareholders funds 400
10% Debt 100
Total liabilities 500
EAT (tax at 50 per cent) Year 2,001 19
2,002 22
2,003 25
Comprehensive Cases 73
Mr Money Minded has estimated that the acquisition will result in some ?nancial synergy. Upon careful delib-
erations, the management of DS arrives at a conclusion that it can raise the level of ef?ciency at KH to the level
at which it operates. The current levels are summarised in Exhibit 3.
EXHIBIT 3
DS KH
Return on capital employed (%) 17.50 15
Pro?t growth rate (%) 20 14
3 years average earning (Rs ’000)
EBT 125 44
EAT 63 22
Earnings per share 1.5 0.833
Market price 18 —
PE ratio (times) 12 —
Dividend per share 0.5 0.5
Mr Money Minded, as a MBA graduate, had studied the following valuation methods:
1. Market valuation
2. Earning capacity
3. Net book value of assets
4. Liquidation
On dwelling deeper the ?gures that in the absence of market quotation for Ms KH, market valuation is irrel-
evant. Also, the net book value of assets is irrelevant for a going concern but it can provide a starting point for
negotiations. Liquidation value gives distress prices, but they do not involve intangible assets for which DS will
have to pay a price.
He also feels that the most appropriate basis for valuation in going concern is the stream of earnings that is
being purchased, re?ected in the earnings capacity.
Earnings: To get the feel of possible earnings, Mr Money Minded decides to use a range of earnings coming
from: (1) Most recent earnings, (2) Average earnings, (3) Earnings increased to re?ect DS’s return on capital,
(4) Projected earnings, and (5) Return on capital required. The respective valuations are summarised in Exhibits
4-11.
EXHIBIT 4 [Valuation 1 (Most Recent Earnings)]
2003 earnings Rs 0.833
P/E ratio 12
Price per share (Rs 0.833 3 12) 10
EXHIBIT 5 Valuation 2 (Average Earnings)
Average earnings (Rs ’000s) (19 + 22 + 25)/3 22
EPS (average) (Rs) (Rs 22,000/30,000) 0.73
Price per share (Rs 0.73 3 12) 8.8
74 Financial Management
EXHIBIT 6 Valuation 3 [Earnings Increased to Reflect DS’s Return on Capital (i.e. KH’s ROC
will be at 17.5%)]
Capital employed (Rs) Rs 5,00,000
Required ROC (%) 17.5
EBIT 87,500
Interest (0.10 3 Rs 1,00,000) 10,000
EBT 77,500
Tax (0.50) 38,750
EAT 38,750
EPS = Rs 38,750/30,000 1.29
Price per share (Rs 1.29 3 12) 15.5
EXHIBIT 7 Valuation 4 (Projected Earnings)
It is unrealistic to believe that KH will grow at the same rate as DS immediately. Hence, 20 per cent is too
optimistic but according to Mr Money Minded it provides a ceiling for the bid.
KH’s average pro?t Rs 22,000
At 20 per cent growth projected pro?t [(Rs 22,000 (1 + 0.2)] 26,400
New EPS (Rs 26,400/30,000) 0.88
Price per share (Re 0.88 3 12) 10.6
EXHIBIT 8 Valuation 5 (ROC Required)
DS’s ROCE (%) 17.5
DH’s EAT Rs 25,000
Add: Tax 25,000
EBT 50,000
Add: Interest 10,000
EBIT 60,000
DS can pay: (Rs 60,000 3 100/17.5) 3,43,000
Price per share (Rs 3,43,000/30,000) 11.4
EXHIBIT 9 Valuation 6 (Book Value of Assets)
Net total assets Rs 5,00,000
Less: Debentures 1,00,000
Net book value 4,00,000
Book value per share (Rs 4,00,000/30,000) 13.3
EXHIBIT 10 Summary of Valuation
Valuation Method Share price
Most recent earnings Rs 10.00
Average earnings 8.80
Earnings increased to re?ect DS’s return on capital 15.5
Projected earnings 10.60
ROC required 11.4
Book value of assets 13.30
Now the management of DS has broad parameters to start with the negotiations.
The only valuation which seems out of line to the management is the valuation by ‘earnings increased to re?ect
DS’s return on capital’ because they could not hope to increase the level of ROC of KH immediately to 17.5 per
cent and it would be unreasonable to believe so. Hence, the management of DS will have to pay anywhere from
Rs 8.8 per share to Rs 13.3 per share in the negotiations for them to be right to both the companies.
CHAPTER 33
Corporate Restructuring
PANDA SYSTEMS
Panda Systems is a four month old ?rm software solutions provider. It was conceived by a group of entrepreneurs
who wanted to make it big in life. Although the set-up was small, it offered state of the art facilities to motivate
its employees.
The company has the right blend of domain experts, programmers and administrators working as a team,
committed to take the organisation to a higher level. The US has always been a lucrative market for Indian software
companies. Panda Systems is no exception and is on the lookout for potential partners in the US.
An opportunity came in the form of ‘Bigboy & Company’. It is a one year old company basically located in the
New Jersey area. They are looking for a reliable partner in India. Both the companies think that they have the
synergy and can do good business if they join hands.
The Director of Panda Systems is interested in the proposal and wants to evaluate the issue from the ?nancial
perspective. He approaches his ?nance team to analyse the case and report to the management in a week’s
time. Bigboy & Company wants Panda Systems to become 50 per cent partner of the merged ?rm by investing
in their ?rm.
The available data about the companies are summarised in Exhibit 1.
EXHIBIT 1
Particulars Panda Systems Bigboy & Company
Knowledge workers 10 5
Last year’s revenue (US $) N.A. 50,000
Place of operation New Delhi New Jersey
Partners 3 2
Capital structure (% equity) 100 100
The terms mentioned in the contract in black and white are:
The new company will take the name of Bigboy & Company.
It will be 100 per cent equity owned ?rm.
US operations will be handled by Bigboy & Company.
Indian operations will be handled by Panda Systems under the new name of Bigyboy & Company.
Development base will be in India only because of cheap labour.
The revenues estimated by the Bigboy & Company are:
Year 1 = US $ 8,00,000
2 40,00,000
3 90,00,000
Methodology
To study and analyse the merger proposal, a two-step approach elaborated below was adopted by the ?nance
team:
(a) Valuation: The current value of both the companies in order to arrive at the amount to be invested in merged
?rm should be established.
(b) Evaluation: Once the amount to be invested is ?nalised, the Panda Systems should ?nd out whether the
agreed revenues from the US operations will give the desired returns on investment or not.
76 Financial Management
Valuation
For Panda Systems
Land and building: (a large building in posh colony) Rs 70,00,000
Hardware and software: (includes desktops, laptops,
UPS & related software) 40,00,000
Human capital 50,00,000
1,60,00,000
For Bigboy & Company
Last year’s turnover US $ 50,000
Conversion rate: (1$ = Rs 46) Rs 23,00,000
Multiplication factor: 3
*

Total value (Rs 23,00,000 ? 3) Rs 69,00,000
*
As per valuation system in US, the last year’s turnover is multiplied with the multiplication factor which
is between 3 to 30 depending upon the age of the ?rm. The older the company, the higher will be the
multiplication factor. Since this is only one year old company, we have taken the least multiplication
factor.
Net amount to be invested by Panda Systems for 50 per cent equity will be: Rs 5,30,00,000.
Work Sheet
Particulars Year 1 Year 2 Year 3
Sales revenue (US $) 8,00,000 40,00,000 90,00,000
Conversion factor 46 46 46
Sales revenue (Rs) 3,68,00,000 18,40,00,000 41,40,00,000
Safety factor (%) 30 30 30
Adjusted revenues
(sales revenue X 70%) 2,57,60,000 12,88,00,000 28,98,00,000
Less: Expenses:
Orgaware (Annexure 1) 39,45,000 1,79,75,000 3,70,55,000
Humanware (Annexure 2) 1,00,50,000 3,90,20,000 9,18,00,000
Software (Annexure 3) 31,50,000 60,00,000 86,50,000
Hardware (Annexure 4) 31,07,000 49,84,000 85,52,000
Running cost (Annexure 5) 2,28,000 5,17,600 10,06,400
Total expenses 2,04,80,000 6,84,96,600 14,70,63,400
Safety factor (%) 30 30 30
Adjusted expenses
(Total expenses X 130%) 2,66,24,000 8,90,45,580 19,11,82,420
Less: Depreciation (Annexure 6) 24,42,800 29,70,720 46,09,088
EBT (–33,06,800) 3,67,83,700 9,40,08,492
Less: Tax (@ 40 per cent) (–13,22,720) 1,47,13,480 3,76,03,397
EAT (–19,84,080) 2,20,70,220 5,64,05,095
Add: Depreciation 24,42,800 29,70,720 46,09,088
CFAT 4,58,720 2,50,40,940 6,10,14,183
PV factor (@ 20 per cent) 0.833 0.694 0.579
Present value 3,82,114 1,73,78,412 3,53,27,212
Total present value 5,30,87,738
Total cash out?ow 5,30,00,000
NPV 87,738
Comprehensive Cases 77
Assumptions
We have made following assumptions in four ?nancial analysis:
The conversion rate of rupee vis-a-vis US dollar is ?xed as US $1 = Rs 46.
The valuation is done as practiced in different countries and no effort is made to change it.
The discounting is done @ 20 per cent because investor expectation in the IT sector, is very high as the
industry is going through a growth phase. This prompted us to take higher discounting factor.
We have in?ated out costs by 30 per cent in order to cover any unforeseen increase in different cost heads
and to keep some buffer for us.
We have reduced the revenue by 30 per cent as we do not want to take chances with our partners
commitment. Also, it will give us some cushion.
The block of assets continue to exist as company will continue its operations after three years.
The rate of depreciation is 60 per cent for IT products.
Opening balance at year 1 is assumed to be Rs 30,00,000 for calculation of depreciation.
We have assumed that no equipment is sold during these three years.
IT is a fast changing industry, so we have taken analysis up to three years only.
We have gone for all branded IBM products for hardware.
We will use licensed software only as per our company policy. We are against piracy.
Recommendations After our analysis we feel that quantitatively this proposal of merger will be pro?table
for our company. However, certain qualitative aspects are to be considered before making the ?nal decision.
We, as a company will loose our identity after the merger.
The Bigboy & Company is only one year old so they do not have a brand equity as such. So they are almost
as new as us in US.
The kind of returns we are expected can be achieved inspite of merger if we open of?ce in the US.
The Bigboy & Company has recently split with some US partners. So their credibility is doubtful.
We will have 100 per cent dependency on them.
We understand that we should get into US market as early as possible, but we will advise you to defer this
deal and look for some alternatives before ?nalising this proposal.
Opening up our own of?ce in US.
Evaluating an alliance with established US companies.
ANNEXURE 1
Orgaware Calculation principle Year 1 Year 2 Year 3
Rs 17,70,000 Rs 59,90,000 Rs 1,18,00,000
0 24,00,000 36,00,000
Fully fur-
nished of?ce
space
Vehicles
Rs 59,000 per person. It
includes lighting, furniture
and other Rs 6,00,000 per
vehicle for all years with 0,
4 and 6 vehicles in the 1
st
,
2
nd
& 3
rd
years respectively.
This includes different kinds
of cars starting from Maruti
Zen to Mitsubishi Lancer
(Contd.)
78 Financial Management
(Contd.)
18,40,000 92,00,000 2,07,00,000
6L + 1F + 5M 4L + 1F + 5M 10L+2F+10M
2,15,000 75,000 1,55,000
1,20,000 3,10,000 8,00,000
TOTAL 39,45,000 1,79,75,000 3,70,55,000
ANNEXURE 2
Humanware Calculation principle Year 1 Year 2 Year 3
30 100 200
Rs 90,00,000 Rs 3,60,00,000 Rs 8,64,00,000
1,50,000 5,00,000 10,00,000
3,00,000 10,00,000 20,00,000
6 20
30 76 120
6,00,000 15,20,000 24,00,000
TOTAL 1,00,50,000 3,90,20,000 9,18,00,000
Advertising
and market-
ing
Communi-
cation
Parties and
recreation
activities
At the rate of 5 per cent of
the yearly revenues (unad-
justed)
L – Landline, F – Fax, M –
Mobile. These are the new
connections installed along
with 10 landlines and 2
Faxes & 5 Mobiles with
yearly costs of
Aggregate
Number of
knowledge
workers per
year
Salaries:
Product
training
New
technology
training
Number of
employee
leaving
New
employees
recruited
Recruitment
expenses
These are the total number of
employees at the end of year
Average 25000 * person
* month with 20 per cent
increase every year
Rs 5,000 per person
Rs 10,000 per person
20 per cent of the previous
years strength
Rs 20,000 per person
Comprehensive Cases 79
ANNEXURE 3
Software Calculation principle Year 1 Year 2 Year 3
Rs 10,00,000 Rs 25,00,000 Rs 40,00,000
10,00,000 20,00,000 30,00,000
5,00,000 8,00,000 12,00,000
6,50,000 7,00,000 4,50,000

TOTAL 31,50,000 60,00,000 86,50,000
ANNEXURE 4
Hardware Calculation principle Year 1 Year 2 Year 3
Servers Quantity 2 4 7
Value IBM 600 @ Rs 2,66,000 Rs 5,32,000 Rs 10,64,000 Rs 18,62,000
Desktops/PCs Quantity 25 58 96
Value IBM P III, M Hz 16,25,000 34,80,000 57,60,000
Laptops Quantity 5 2 4
Value IBM Celeron 15" Screen 7,00,000 2,40,000 4,80,000
Networking
Infrastructure 1,50,000 1,00,000 2,50,000
Printers 1 1 2
Value 1,00,000 1,00,000 2,00,000
TOTAL 31,07,000 49,84,000 85,52,000
Acquiring
base soft-
ware
Acquiring
application
software
Software
packages
Lease line
Operating system – Windows
NT, Win 2K professional version
with licences
Licensed software Rational
Rose, Adobe, Max etc.
Anti Virus – Norton, JDK etc.
64 K Lease line year 1, 128 K
lease line year 2, 128 K in the
year 3. We have to incur ad-
ditional cost of new 64 K pipe
in year 2. Hence, the cost is
higher in year 2
80 Financial Management
ANNEXURE 5
Running cost Calculation principle Year 1 Year 2 Year 3
0 4 6
0 Rs 57,600 Rs 86,400
6L+1F+5M 10L+2F+10M 20L+4F+20M
1,98,000 3,60,000 7,20,000
30 100 200
30,000 1,00,000 2,00,000
TOTAL 2,28,000 5,17,600 10,06,400
ANNEXURE 6
Year Opening New Sale of old Net balance Depreciation Closing book
balance equipments equipment value
1 Rs 30,00,000 Rs 31,07,000 0 Rs 61,07,000 Rs 36,64,200 Rs 24,42,800
2 24,42,800 49,84,000 0 74,26,800 44,56,080 29,70,720
3 29,70,720 85,52,000 0 1,15,22,720 69,13,632 46,09,088
Vehicles
Communi-
cation
Total lines
Estab-
lishment
charges
Number of vehicles
(petrol + servicing) Rs 14,400/
vehicle
L – Landline = Rs 18,000 per
year
F-Fax = Rs 18,000 per year
M-Mobile = Rs 14,400 per year
Number of persons
(Elec+water etc 1,000per per-
son)

doc_244440897.pdf