Financial Management - Important questions for IPCC November 2017

Transcription

1 Financial Management - Important questions for IPCC November 2017 BASICS OF FINANCIAL MANAGEMENT 1. Discuss conflict in profit versus wealth maximization objective Conflict in Profit versus Wealth Maximization Objective Profit maximisation is a short term objective and cannot be the sole objective of a company. It is at best a limited objective. If profit is given undue importance, a number of problems can arise like the term profit is vague, profit maximisation has to be attempted with a realisation of risks involved, it does not take into account the time pattern of returns and as an objective it is too narrow. Whereas, on the other hand, wealth maximisation, is a long-term objective and means that the company is using its resources in a good manner. If the share value is to stay high, the company has to reduce its costs and use the resources properly. If the company follows the goal of wealth maximisation, it means that the company will promote only those policies that will lead to an efficient allocation of resources. RATIO ANALYSIS 2. The assets of SONA Ltd. consist of fixed assets and current assets, while its current liabilities comprise bank credit in the ratio of 2 : 1. You are required to prepare the Balance Sheet of the company as on 31st March 2013 with the help of following information: Share Capital Rs 5,75,000 Working Capital (CA-CL) Rs 1,50,000 Gross Margin 25% Inventory Turnover 5 times Average Collection Period 1.5 months Current Ratio 1.5:1 Quick Ratio 0.8: 1 Reserves & Surplus to Bank & Cash 4 times

2 Working Notes: (1) Computation of Current Assets (CA) and Current Liabilities (CL) Current Assets = Current Ratio Current Liabilities CA = 1.5 CL 1 CA = 1.5CL CA - CL = 1,50, CL- CL = 1,50, CL = 1,50,000 CL = 3,00,000 CA = 1.5 x 3,00,000 = 4,50, Computation of Bank Credit (BC) and Other Current Liabilities (OCL) Other CL = 2 Bank Credit 1 BC = 2 OCL BC + OCL = CL 2 OCL + OCL = 3,00,000 3 OCL = 3,00,000 OCL = 1,00,000 Bank Credit = 2 1,00,000 = 2,00,000 3.Computation of Inventory Quick Ratio = Quick Assets Current Liabilities = Current Assets - Inventories Current Liabilities 0.8 = 4,50,000 - Inventories 3,00, ,00,000 = 4,50,000 Inventories Inventories = 4,50,000 2,40,000 = 2,10, Computation of Debtors Inventory Turnover = 5 times Average Inventory = COGS Inventory Turnover COGS = 2,10,000 5 = 10,50,000 GP = 25%, COGS % = 75% Sales = 10,50,000/75% = 14,00,000 Debtors = 14,00,000*1.5/12 = 175, Computation of Bank and Cash Bank & Cash = CA - (Debtors + Inventory) = 4,50,000 (1,75, ,10,000)= 4,50,000 3,85,000 = 65,000

3 6. Computation of Reserves & Surplus Reserves & Surplus= 4 Bank & Cash Reserves & Surplus = 4 65,000 = 2,60,000 Balance Sheet of SONA Ltd. Liabilities Rs Assets Rs Share Capital 5,75,000 Fixed Assets 6,85,000 Reserves & Surplus 2,60,000 Current Assets: Current Liabilities: Inventories 2,10,000 Bank Credit 2,00,000 Debtors 1,75,000 Other Current Liabilities 1,00,000 Bank & Cash 65,000 11,35,000 11,35, Sohna Limited s sales, variable costs and fixed cost amount to Rs 75,00,000, Rs 42,00,000 and Rs 6,00,000 respectively. It has borrowed Rs 45,00,000 at 9 per cent and its equity capital totals Rs 55,00,000. (a) What is Sohna Limited s ROI? (b) Does it have favourable financial leverage? (c) If Sohna Limited belongs to an industry whose asset turnover is 3, does it have a high or low asset leverage? (d) If the sales drops to Rs 50,00,000, what will the new EBIT be? (a) Computation of Sohna Limited s ROI ROI = EBIT/Investment EBIT = Sales Variable Cost Fixed Cost = 75 lakhs 42 lakhs ` 6 lakhs = 27 lakhs. ROI = 27 lakhs/100 lakhs = 27 per cent (b) Yes, Sohna Limited has favourable financial leverage as its ROI is higher than the interest on debt. (c) Asset turnover = Sales/ Total assets = 75 lakhs/100 lakhs = 0.75 The asset turnover of Sohna Limited is lower than the industry average of 3.

4 (d) EBIT at Sales Level of Rs 50 lakhs Particulars Rs Sales Revenue 50,00,000 Less: Variable Costs (50 lakhs 0.56) 28,00,000 Less: Fixed Costs 6,00,000 EBIT 16,00, Diagrammatically present the DU PONT CHART to calculate return on equity Du Pont Chart There are three components in the calculation of return on equity using the traditional DuPont model- the net profit margin, asset turnover, and the equity multiplier. By examining each input individually, the sources of a company's return on equity can be discovered and compared to its competitors Return on Equity = (Net Profit Margin) (Asset Turnover) (Equity Multiplier) (a) ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The Financial leverage ratio for the company is Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent Return on Equity (ROE) = PAT NW Return on Net Assets (RONA) = EBIT NA Financial Leverage (Income) = PAT E BIT Profit Margin = EBIT Sales Assets Turnover = Sales NA Financial Leverage (Balance Sheet) = NA NW 5. ABC Limited has an average cost of debt at 10 per cent and tax rate is 40 per cent. The Financial leverage ratio for the company is Calculate Return on Equity (ROE) if its Return on Investment (ROI) is 20 per cent

5 ROE = [ROI + {(ROI r) x D/E}] (1 t) = [ {( ) x 0.60}] (1 0.40) = [ ] x 0.60 = ROE = 15.60% TIME VALUE OF MONEY 6. Ms. A has purchased a smart phone from a shop for Rs25,000. She has paid Rs5,000 as down payment and the rest will be paid in equated monthly instalments (EMI) for 2 years. The interest rate charged by the bank is 14% p.a. Required:(i) Calculate the amount of EMI and (ii) Calculate the total amount of interest payable to the bank. Purchase price = 25,000 Loan amount = = Rate of interest = 14%/12 = % p.m Loan = Installment*Annuity factor 20,000 = Installment*AF(1.1667,24) 20,000 = Installment* (i) Installment =20000/ = (ii) Total interest paid = Installments paid - loan = * = Gama Limited has borrowed Rs 1,000 to be repaid in equal installments at the end of each of the next 3 years. The interest rate is 15 per cent. You are required to prepare an amortisation schedule for Gama Limited. Instalment =Loan/Annuity factor (15%,3) = 1000/ =Rs.438

6 Loan repayment schedule Sl. No Amount Outstanding at the beginning Interest for the period Installment repaid Amount Outstanding at the end CAPITAL STRUCTURE THEORIES 8. What do you mean by capital structure? State its significance in financing decision. Concept of Capital Structure and its Significance in Financing Decision Capital structure refers to the mix of a firm s capitalisation i.e. mix of long-term sources of funds such as debentures, preference share capital, equity share capital and retained earnings for meeting its total capital requirement. Significance in Financing Decision The capital structure decisions are very important in financial management as they influence debt equity mix which ultimately affects shareholders return and risk. These decisions help in deciding the forms of financing (which sources to be tapped), their actual requirements (amount to be funded) and their relative proportions (mix) in total capitalisation. Therefore, such a pattern of capital structure must be chosen which minimises cost of capital and maximises the owners return 9. What is Over capitalisation? State its causes and consequences. It is a situation where a firm has more capital than it needs or in other words assets are worth less than its issued share capital, and earnings are insufficient to pay dividend and interest. Causes of Over Capitalization Over-capitalisation arises due to following reasons: (i) Raising more money through issue of shares or debentures than company can employ profitably. (ii) Borrowing huge amount at higher rate than rate at which company can earn. (iii) Excessive payment for the acquisition of fictitious assets such as goodwill etc.

7 (iv) Improper provision for depreciation, replacement of assets and distribution of dividends at a higher rate. (v) Wrong estimation of earnings and capitalization. (Note: Students may answer any two of the above reasons) Consequences of Over-Capitalisation Over-capitalisation results in the following consequences: (i) Considerable reduction in the rate of dividend and interest payments. (ii) Reduction in the market price of shares. (iii) Resorting to window dressing. (iv) Some companies may opt for reorganization. However, sometimes the matter gets worse and the company may go into liquidation. (Note: Students may answer any two of the above consequences) 10. X Ltd. is considering the following two alternative financing plans: Plan - I Plan - II Rs Rs Equity shares of Rs 10 each 4,00,000 4,00,000 12% Debentures 2,00,000 - Preference Shares of Rs 100 each - 2,00,000 Rs 6,00,000 Rs 6,00,000 The indifference point between the plans is ` 2,40,000. Corporate tax rate is 30%. Calculate the rate of dividend on preference shares. Computation of Rate of Preference Dividend EBIT = 2,40,000 Tax rate = 30% (EBIT- Interest) (1- Tax rate) = EBIT (1- Tax rate) -Preference Dividend No. of Equity Shares (N 1 ) No.of Equity Shares (N 2 ) (2,40,000-24,000) (1-0.30) = 2,40,000 (1-0.30) -Preference Dividend 40,000 40,000 2,16,000 (1-0.30) = 1,68,000 -Preference Dividend 1,51,200 = 1,68,000 Preference Dividend Preference Dividend = 1,68,000 1,51,200 Preference Dividend = 16,800 Rate of Dividend = Preference Dividend x 100 Preference Share Capital = 16,800 x 100 = 8.4% 2,00,000

8 11. Distinguish between net income approach and net operating income approach in capital structure theories Difference between net income approach and net operating income approach Point of difference Net income Approach Net operating income Approach Brings forth the relevance of States the irrelevance of capital capital structure in calculating the structure in calculating the value value of firm of the firm. Role of Capital Structure Computation Degree of Leverage and Cost of Capital: With a judicious mixture of debt and equity, a firm can arrive at an optimum capital structure Value of firm = Value of equity + Value of debt Change in degree of leverage will alter the overall cost of capital (WACC) and hence the value of the firm. Value of Equity (Residual) = Value of firm Value of debt Degree of leverage of the firm is irrelevant to the cost of capital i.e. the cost of capital is always constant. 12. Company XYZ is unlevered and has a cost of equity of 20 percent and a total market value of Rs10,00,00,000. Company ABC is identical to XYZ in all respects except that it uses debt finance in its capital structure with a market value of Rs4,00,00,000 and a cost of 10 percent. Find the market value of equity, and weighted average cost of capital if the tax advantage of debt is 25 percent Computation of market value of company Market Value of levered company (ABC) = Market value of unlevered company + Debt*Tax rate = 10,00,00, ,00,00, % = 11,00,000 The market value of equity of company ABC Equity = Value of firm - Debt = 11,00, ,000 = 700,000 Weighted average Cost of capital of ABC = Returns expected by unlevered firm/ value of levered firm *100 = 10,00,000*20%/11,00,000* 100 = 18.18%

9 13. The following current data are available concerning Theta Limited: No of Share issued 10,000 Market price per share Rs20 Interest rate 12% Tax Rate 46% Expected EBIT Rs15,000 The company requires an additional Rs50,000 for the coming year. You are required to determine: Which financing option (debt or equity issue) will give higher EPS Computation of Earnings Per Share (EPS) for the Expected EBIT Particulars Debt(Rs) Equity(Rs) Expected earnings before interest & tax 15,000 15,000 Less: Interest (12% of 50,000) 6,000 - Earnings before tax (EBT) 9,000 15,000 Less: Tax (@ 46%) of EBT (9000 X 46%) 4,140 6,900 Earnings available to equity shareholder: (A) 4,860 8,100 Number of shares issued: (B) 10,000 12,500 (50000/20) Earnings per shares: (A) / (B) Conclusion: Earnings per share is higher when the company raises additional funds by issue of equity shares 14. Discuss the concept of Debt-Equity or EBIT-EPS indifference point, while determining the capital structure of a company. Concept of Debt-Equity or EBIT-EPS Indifference Point while Determining the Capital Structure of a Company The determination of optimum level of debt in the capital structure of a company is a formidable task and is a major policy decision. It ensures that the firm is able to service its debt as well as contain its interest cost. Determination of optimum level of debt involves equalizing between return and risk.

10 EBIT EPS analysis is a widely used tool to determine level of debt in a firm. Through this analysis, a comparison can be drawn for various methods of financing by obtaining indifference point. It is a point to the EBIT level at which EPS remains unchanged irrespective of debt-equity mix. The indifference point for the capital mix (equity share capital and debt) can be determined as follows (EBIT - I 1 ) (1 T) = (EBIT I 2 ) (1 T) E 1 E Skyline Ltd. is planning an expansion programme which will require 30 crore and can be funded through one of the following three options : Option-1 : Issue further equity shares of 100 at par Option-2 : Raise 15% interest Option-3 : Issue preference 12%. Present paid-up capital is 60 crore and average annual EBIT is 12 crore. Assume tax rate at 30%. Post expansion EBIT is expected to be 15 crore p.a. Calculate EPS under the three financing options indicating the alternative giving the highest return to the equity shareholders. Rs Crs Option 1 Option 2 Option 3 Equity shares Loan@15% Pref shares@12% EBIT Int 30*15% EBT Tax@30% EAT Pref share divi 30*12% Earning to ESH No of shares Existing New 0.3 Total EPS (Highest)

11 WORKING CAPITAL MANAGEMENT 16. PTX Limited is considering a change in its present credit policy. Currently it is evaluating two policies. The company is required to give a return of 20% on the investment in new accounts receivables. The company's variable costs are 70% of the selling price. Information regarding present and proposed policies is as follows: Present Policy Policy Policy Option 1 Option 2 Annual Credit Sales (Rs) 30,00,000 42,00,000 45,00,000 Debtors turnover ratio 4 times 3 times 2.4 times Loss due to bad debts 3% of sales 5% of sales 6% of sales Return on investment in new accounts receivable is based on cost of investment in debtors. Which option would you recommend? Statement of Evaluation of Credit Policies of PTX Limited (based on Total Cost Approach) Present Policy Policy Option I Policy Option II Sales Revenue 30,00,000 42,00,000 4,50,0000 Less: Variable 21,00,000 29,40,000 31,50,000 Contribution 9,00,000 12,60,000 13,50,000 Less: Other Relevant Costs Bad Debt Losses (90,000) (2,10,000) (2,70,000) Investment Cost (VC DTR) 20% (1,05,000) (1,96,000) (2,62,500) Profit 7,05,000 8,54,000 8,17,500 Recommendation: PTX Limited is advised to adopt Policy Option I. (Note: In the above solution, investment in accounts receivable is based on total cost of goods sold on credit). 17. State the advantage of Electronic Cash Management System. Advantages of Electronic Cash Management System (i) Significant saving in time. (ii) Decrease in interest costs. (iii) Less paper work. (iv) Greater accounting accuracy. (v) More control over time and funds. (vi) Supports electronic payments.

12 (vii) Faster transfer of funds from one location to another, where required. (viii) Speedy conversion of various instruments into cash. (ix) Making available funds wherever required, whenever required. (x) Reduction in the amount of idle float to the maximum possible extent 18. 'Management of marketable securities is an integral part of investment of cash.' Comment. Management of Marketable Securities is an Integral Part of Investment of Cash Management of marketable securities is an integral part of investment of cash as it serves both the purposes of liquidity and cash, provided choice of investment is made correctly. As the working capital needs are fluctuating, it is possible to invest excess funds in some short term securities, which can be liquidated when need for cash is felt. The selection of securities should be guided by three principles namely safety, maturity and marketability. 19. The Sales Manager of AB Limited suggests that if credit period is given for 1.5 months then sales may likely to increase by Rs. 1,20,000 per annum. Cost of sales amounted to 90% of sales. The risk of non-payment is 5%. Income tax rate is 30%. The expected return on investment is Rs. 3,375 (after tax). Should the company accept the suggestion of Sales Manager? Profitability on additional sales: Rs. Increase in sales 1,20,000 Less: Cost of sales (90% sales) 1,08,000 Less: Bad debt losses (5% of sales) 6,000 Net profit before tax 6,000 Less: Income tax (30%) 1,800 4,200 Advise: Net profit after tax Rs. 4,200 on additional sales is higher than expected return. Hence, proposal should be accepted.

13 20. A firm has a total sales of Rs. 12,00,000 and its average collection period is 90 days. The past experience indicates that bad debt losses are 1.5% on sales. The expenditure incurred by the firm in administering receivable collection efforts are Rs. 50,000. A factor is prepared to buy the firm s receivables by charging 2% commission. The factor will pay advance on receivables to the firm at an interest rate of 16% p.a. after withholding 10% as reserve. Calculate effective cost of factoring to the firm. Assume 360 days in a year. Computation of Effective Cost of Factoring Average level of Receivables = 12,00,000 * 90/360 3,00,000 Factoring Commission = 3,00,000 * 2/100 6,000 Factoring Reserve = 3,00,000 * 10/100 30,000 Amount Available for Advance = Rs. 3,00,000-(6,000+30,000) 2,64,000 Factor will deduct his 16% :- Interest = *90/360*16% = Advance to be paid = Rs. 2,64,000 Rs. 10,560 = Rs. 2,53,440 Annual Cost of Factoring to the Firm: Rs. Factoring Commission (Rs. 6,000 * 360/90) 24,000 Interest Charges (Rs. 10,560 *360/90) 42,240 Total 66,240 Firm s Savings on taking Factoring Service: Rs. Cost of Administration Saved 50,000 Cost of Bad Debts (Rs. 12,00,000 x 1.5/100) avoided 18,000 Total 68,000 Net Benefit to the Firm (Rs. 68,000 Rs. 66,240) 1760 Effective Cost of Factoring =66240*100/ % Effective Cost of Factoring = %

14 21. MN Ltd. is commencing a new project for manufacture of electric toys. The following cost information has been ascertained for annual production of 60,000 units at full capacity: Amount per unit (Rs.) Raw materials 20 Direct labour 15 Manufacturing overheads: Variable 15 Fixed Selling and Distribution overheads: Variable 3 Fixed 1 4 Total cost 64 Profit 16 Selling price 80 In the first year of operations expected production and sales are 40,000 units and 35,000 units respectively. To assess the need of working capital, the following additional information is available: (i) Stock of Raw materials...3 months consumption. (ii) Credit allowable for debtors.. 1½ months. (iii) Credit allowable by creditors 4 months. (iv) Lag in payment of wages..1 month. (v) Lag in payment of overheads..½ month. (vi) Cash in hand and Bank is expected to be Rs. 60,000. (vii) Provision for contingencies is 10% of working capital requirement including that provision. You are required to prepare a projected statement of working capital requirement for the first year of operations. Debtors are taken at cost. Statement Showing Working Capital Requirement A. Current Assets Rs. Stock of Raw Materials (Rs. 8,00,000 * 3/12) 2,00,000 Stock of Finished Goods 3,25,000 Debtors at Cost (Rs. 24,40,000 * 3/24) 3,05,000 Cash and Bank 60,000 Total (A) 8,90,000

15 B. Current Liabilities Creditors for Materials (Rs. 10,00,000 * 4/12) 3,33,333 Creditors for Expenses (Rs. 13,65,000 * 1/24) 56,875 Outstanding Wages (Rs. 6,00,000 * 1/12) 50,000 Total (B) 4,40,208 Working Capital Requirement before Contingencies (A B) 4,49,792 Add: Provision for Contingencies (Rs. 4,49,792 * 1/9) 49,977 Estimated Working Capital Requirement 4,99,769 Workings Notes: Purchase of Raw Material during the first year Rs. Raw Material consumed during the year 8,00,000 Add: Closing Stock of Raw Materials (3 months consumption) 2,00,000 Less: Opening Stock of Raw Material Nil Purchases during the year 10,00, Alpha Limited sells its products on a gross profit of 20 percent on sales. The following information is extracted from its annual accounts for the current year ended March 31. Rs Sales at 3 months credit 40,00,000 Raw Material 12,00,000 Wages paid-average time lag 15 days 9,60,000 Manufacturing expenses paid-one month in arrears 12,00,000 Administrative expenses paid-one month in arrears 4,80,000 Sales promotion expenses-payable half-yearly in advance 2,00,000 The company enjoys one month s credit from the suppliers of raw materials and maintains 2 months stock of raw materials and one and a half month s stock of finished goods. The cash balance is maintained at Rs1,00,000 as a precautionary measure. Assuming a 10 percent margin, you are required to estimate the working capital(based on cost) requirements of Alpha Limited

16 Statement Showing the Estimation of Working Capital Requirements of Alpha Limited Particulars Workings Rs (A) Current Assets : Cash balance 1,00,000 Inventories : Raw materials (12,00,000 * 2/12) 2,00,000 Finished goods (40,00,000 * 1.5/12) 4,00,000 Debtors (32,00,000 *3)/12 8,00,000 Prepaid sales expenses (2,00,000 * 6)/12 1,00,000 Total 16,00,000 (B) Current Liabilities Creditors for raw material (12,00,000 * 1) /12 1,00,000 Wages (9,60,000 * 0.5) /12 40,000 Manufacturing expenses (12,00,000 * 1)/12 1,00,000 Administrative expenses (4,80,000 * 1) / 12 40,000 Total 2,80,000 (C) Net working capital (A B) 13,20,000 Add : Margin (0.10) 1,32,000 Working Capital Requirements of Alpha Limited 14,52,000

17 FUNDS FLOW STATEMENT 23. Given here is the Balance Sheet as on March 31, years 1 and 2 for Zeta Limited. March 31, Year 1 March 31, Year 2 Rs Rs Liabilities Accounts Payable 20,000 18,000 Accrued expenses 2,000 4,000 Income Tax payable 1,000 1,100 Equity share capital 30,000 37,000 Retained earnings 12,650 13,650 Total 65,650 73,750 Assets Cash 5,000 6,000 Accounts receivable 14,000 14,000 Inventory 22,000 8,000 Prepaid Insurance Prepaid rent Pre-paid property tax Land 4,000 8,000 Plant & Equipment 30,000 48,000 Less: Accumulated Dep. 10,000 20,000 11,000 37,000 Total 65,650 73,750 Sales for year 2 was Rs2,10,000. Net income after tax was Rs7,000. In arriving at net profit, items deducted from sales included, Cost of goods sold Rs1,65,000; Depreciation - Rs5,000; Wages and Salaries Rs20,000 and a gain of Rs1,000 on the sale of a plant. The plant had a historical cost of Rs6,000, a depreciation of Rs4,000 had been accumulated for it and it was sold for Rs3,000. This was the only asset written off during the year. The company declared and paid Rs6,000 as dividends during the year. You are required to prepare funds flow statement

18 Funds Flow Statement of Zeta Limited for the year 2 Sources of funds: Funds from business operations(refer to working note (i)) 11,000 Sale of Plant 3,000 Issuance of shares 7,000 Total : 21,000 Application of funds: Purchase of Land 4,000 Purchase of Plant & Equipment (Refer to working note (ii)) 24,000 Dividend paid 6,000 Decrease in working capital (Refer to working note (iii)) 13,000 Total : 21,000 Working Notes: (i) Funds from business operations: Particulars Rs Net income after taxes 7,000 Add: Depreciation 5,000 Less: Gain on sale of plant 1,000 Funds from business operations: 11,000 Rs (ii) Plant and Equipment Account Particulars Rs Particulars Rs To Balance b/d 20,000 By Cash (sale of plant) 3,000 To P & L A/c 1,000 By Depreciation 5,000 (Profit on the sale of plant) By Balance c/d 37,000 To Cash 24,000 (Purchases, balancing figure) Total 45,000 Total 45,000

19 (iii) Statement of changes in working capital Particulars Year1 Current Assets : Cash 5,000 6,000 Accounts receivable 14,000 14,000 Inventory 22,000 8,000 Prepaid Insurance Rs Year2 Prepaid Rent Prepaid Property taxes , ,750 Less: Current Liabilities: Accounts payable 20,000 18,000 Accrued expenses 2,000 4,000 Income tax payable 1,000 23,000 1,100 23,100 Rs Working capital 18,650 5,650 Change in working capital 13,000 (Decrease) LEVERAGES 24. Financial leverage is a double edged sword. Comment Financial Leverage A double edged sword 1. A double-edged sword has two cutting edges; in finance, a double-edged sword means something that has both potential benefits and liabilities. 2. Financial leverage can multiply gains, but it also multiply losses. 3. Positive leverage a. A business entity can leverage its revenue by buying fixed assets. This will increase the proportion of fixed, as opposed to variable, costs, meaning that a change in revenue will result in a larger change in operating income b. For example, XYZ company obtains a long term debt at a rate of 12%. The company can use the funds to earn an after-tax rate of 14%. The interest on debt is tax deductible. If the tax rate is 40%, the after-tax interest rate would

20 be 7.2% [12% (1 0.4)]. The difference of 6.8% (14% 7.2%) is, therefore, the benefit of equity shareholders. 4. Negative Leverage a. A negative financial leverage occurs when the assets acquired with the debts generate a rate of return that is less than the rate of interest Negative financial leverage is a loss for common stockholders. b. For example in the situation above, if company makes return of 5% instead of 14%, then The difference of 2.2% (5% 7.2%) would be loss to equity shareholders 25. Operating risk is associated with cost structure, whereas financial risk is associated with capital structure of a business concern. Critically examine this statement. Operating risk is associated with cost structure whereas financial risk is associated with capital structure of a business concern. Operating risk refers to the risk associated with the firm s operations. It is represented by the variability of earnings before interest and tax (EBIT). The variability in turn is influenced by revenues and expenses, which are affected by demand of firm s products, variations in prices and proportion of fixed cost in total cost. If there is no fixed cost, there would be no operating risk. Whereas financial risk refers to the additional risk placed on firm s shareholders as a result of debt and preference shares used in the capital structure of the concern. Companies that issue more debt instruments would have higher financial risk than companies financed mostly by equity

21 26. From the following financial data of Company A and Company B: Prepare their Income Statements. Company A Company B Rs. Rs. Variable Cost 56,000 60% of sales Fixed Cost 20,000 - Interest Expenses 12,000 9,000 Financial Leverage 5 : 1 - Operating Leverage - 4 : 1 Income Tax Rate 30% 30% Sales - 1,05,000 Working Notes: Company A (i) EBIT = 12000*5/1 = (ii) Contribution = EBIT + Fixed Cost = 15, ,000 = Rs. 35,000 (iii) Sales = Contribution + Variable cost = 35, ,000= Rs. 91,000 Company B (i) Contribution = 40% of Sales (as Variable Cost is 60% of Sales) = 40% of 1,05,000 = Rs. 42,000 (ii) Financial Leverage = 42000/4 = (iii) Fixed Cost = Contribution EBIT = 42,000 10,500 = Rs. 31,500

22 Income Statements of Company A and Company B Company A(Rs) Company B (Rs). Sales 91,000 1,05,000 Less: Variable cost 56,000 63,000 Contribution 35,000 42,000 Less: Fixed Cost 20,000 31,500 Earnings before interest and tax (EBIT) 15,000 10,500 Less: Interest 12,000 9,000 Earnings before tax (EBT) 3,000 1,500 Less: 30% Earnings after tax (EAT) 2,100 1, The capital structure of the Shiva Ltd. consists of equity share capital of Rs 10,00,000 (shares of Rs 100 per value) and Rs 10,00,000 of 10% Debentures, sales increased by 20% from 1,00,000 units to 1,20,000 units, the selling price is Rs 10 per unit: variable costs amount to Rs 6 per unit and fixed expenses amount to Rs 2,00,000. The income-tax rate is assumed to be 50%. You are required to calculate the following: (i) The percentage increase in earnings per share; (ii) Financial leverage at 1,00,000 units and 1,20,000 units. (iii) Operating leverage at 1,00,000 units and 1,20,000 units. (iv) Comment on the behaviour of Operating and Financial leverages in relation to increase in production from 1,00,000 units to 1,20,000 units.

23 Particulars 1,00,000 units 1,20,000 units Sales at Rs 10 per unit 10,00,000 12,00,000 Less: Variable costs at Rs 6 per unit 6,00,000 7,20,000 Contribution (C) at Rs 4 per unit 4,00,000 4,80,000 Less: Fixed expenses 2,00,000 2,00,000 Operating Profit or EBIT 2,00,000 2,80,000 Less Interest on Debentures (10% on Rs 10 Lakhs) 1,00,000 1,00,000 Profit before tax (PBT) 1,00,000 1,80,000 Less Tax at 50% 50,000 90,000 Profit after tax (PAT) or net profit 50,000 90,000 (i) Earnings per Share (EPS) [10,000 equity shares] 5 9 % increase in EPS 9-5/5 *100 = 80% (ii) Financial leverage EBIT/PBT (iii) Operating leverage Contribution/EBIT (iv) In relation to increase in Production & Sales of 1,00,000 units to 1,20,000 units (20% increase), EPS has gone from Rs 5 to Rs 9 i.e. increased by 80%. But both the Financial Leverage and Operating Leverage have decreased with increase in sales. Due to this reduction, both the risks i.e. business risk & financial risks of the business are reduced. 28. Calculate the degree of operating leverage, degree of financial leverage and the degree of combined leverage for the following firms : N S D Production (in units) 17,500 6,700 31,800 Fixed costs Rs 4,00,000 3,50,000 2,50,000 Interest on loan Rs 1,25,000 75,000 Nil Selling price per unit Rs Variable cost per unit Rs

24 Computation of Degree of Operating Leverage (DOL), Degree of Financial Leverage (DFL) and Degree of Combined Leverage (DCL) Firm N Firm S Firm D Output (Units) 17,500 6,700 31,800 Selling Price/Unit Sales Revenue (A) 14,87,500 8,71,000 11,76,600 Variable Cost/Unit Less: Variable Cost (B) 6,65,000 2,84,750 3,81,600 Contribution (A-B) 8,22,500 5,86,250 7,95,000 Less: Fixed Cost 4,00,000 3,50,000 2,50,000 EBIT 4,22,500 2,36,250 5,45,000 Less: Interest on Loan 1,25,000 75,000 - PBT 2,97,500 1,61,250 5,45,000 Operating Leverage Contribution/EBIT Financial Leverage EBIT/EBT Combined Leverage OL*FL SOURCE OF FINANCE 29. State the main elements of leveraged lease. Main Elements of Leveraged Lease Under this lease, a third party is involved beside lessor and lessee. The lessor borrows a part of the purchase cost (say 80%) of the asset from the third party i.e., lender. The asset so purchased is held as security against the loan. The lender is paid off from the lease rentals directly by the lessee and the surplus after meeting the claims of the lender goes to the lessor. The lessor is entitled to claim depreciation allowance. 30. What is Virtual Banking? State its advantages. Virtual banking refers to the provision of banking and related services through the use of information technology without direct recourse to the bank by the customer. The advantages of virtual banking services are as follows: Lower cost of handling a transaction. The increased speed of response to customer requirements. The lower cost of operating branch network along with reduced staff costs leads to cost efficiency.

25 Virtual banking allows the possibility of improved and a range of services being made available to the customer rapidly, accurately and at his convenience. (Note: Students may answer any two of the above advantages) 31. Explain the concept of Indian depository receipts. The concept of the depository receipt mechanism which is used to raise funds in foreign currency has been applied in the Indian capital market through the issue of Indian Depository Receipts (IDRs). Foreign companies can issue IDRs to raise funds from Indian market on the same lines as an Indian company uses ADRs /GDRs to raise foreign capital. The IDRs are listed and traded in India in the same way as other Indian securities are traded. 32. Discuss the advantages of preference share capital as an instrument of raising funds. No dilution in EPS on enlarged capital base. There is no risk of takeover as the preference shareholders do not have voting rights. There is leveraging advantage as it bears a fixed charge. The preference dividends are fixed and pre-decided. Preference shareholders do not participate in surplus profit as the ordinary shareholders Preference capital can be redeemed after a specified period. 33. Write short notes on following a. Floating rate bonds b. Packing credit a. Floating rate bonds These are the bonds where the interest rate is not fixed and is allowed to float depending upon the market conditions. These are ideal instruments which can be resorted to by the issuers to hedge themselves against the volatility in the interest rates. They have become more popular as a money market instrument and have been successfully issued by financial institutions like IDBI, ICICI etc. b. Packing credit Packing credit is an advance made available by banks to an exporter.

26 Any exporter, having at hand a firm export order placed with him by his foreign buyer on an irrevocable letter of credit opened in his favour, can approach a bank for availing of packing credit. An advance so taken by an exporter is required to be liquidated within 180 days from the date of its commencement by negotiation of export bills or receipt of export proceeds in an approved manner. Thus Packing Credit is essentially a short-term advance 34. What is venture capital financing? State the factors which are to be considered in financing any risky project. Venture Capital Financing and Factors to be considered in financing any Risky Project Under venture capital financing, venture capitalist makes investment to purchase debt or equity from inexperienced entrepreneurs who undertake highly risky ventures with potential of success. The factors to be considered in financing any risky project are: (i) Quality of the management team is a very important factor to be considered. They are required to show a high level of commitment to the project. (ii) The technical ability of the team is also vital. They should be able to develop and produce a new product / service. (iii) Technical feasibility of the new product / service should be considered. (iv) Since the risk involved in investing in the company is quite high, venture capitalists should ensure that the prospects for future profits compensate for the risk. (v) A research must be carried out to ensure that there is a market for the new product. (vi) The venture capitalist himself should have the capacity to bear risk or loss, if the project fails. (vii) The venture capitalist should try to establish a number of exit routes. (viii) In case of companies, venture capitalist can seek for a place on the Board of Directors to have a say on all significant matters affecting the business. (Note: Students may answer any two of the above factors) CAPITAL BUDGETING 35. XYZ Ltd. is planning to introduce a new product with a project life of 8 years. The project is to be set up in Special Economic Zone (SEZ), qualifies for one time (at starting) tax free subsidy from the State Government of Rs. 25,00,000 on capital investment. Initial equipment cost will be Rs crores. Additional equipment costing Rs. 12,50,000 will

27 be purchased at the end of the third year from the cash inflow of this year. At the end of 8 years, the original equipment will have no resale value, but additional equipment can be sold for Rs. 1,25,000. A working capital of Rs. 20,00,000 will be needed and it will be released at the end of eighth year. The project will be financed with sufficient amount of equity capital. The sales volumes over eight years have been estimated as follows: Year Units 72,000 1,08,000 2,60,000 2,70,000 1,80,000 A sales price of Rs. 120 per unit is expected and variable expenses will amount to 60% of sales revenue. Fixed cash operating costs will amount Rs. 18,00,000 per year. The loss of any year will be set off from the profits of subsequent two years. The company is subject to 30 per cent tax rate and considers 12 per cent to be an appropriate after tax cost of capital for this project. The company follows straight line method of depreciation. Required: Calculate the net present value of the project and advise the management to take appropriate decision. Note: The PV factors at 12% are Year (Rs. 000) Year Sales VC FC Dep. Profit Tax PAT Dep. Cash inflow * to to * (5.315) =6.65 After adjustment of loss Cost of New Equipment 1,75,00,000 Less: Subsidy 25,00,000 Add: Working Capital 20,00,000 Outflow 1,70,00,000 Year Cash inflows DF DCF 1 16,56, ,78, ,53, ,14,441

28 3 81,32,250-12,50,000 = 68,82, ,00, ,35, ,28, ,35, ,39, ,11, ,94, ,11, ,91, ,11, ,00, ,25,000 = 76,36, ,85,247 PV of inflows 2,71,32,933 PV of inflows 2,71,32,933 Less: Out flow 1,70,00,000 NPV 1,01,32,933 Advise: Since the project has a positive NPV, therefore, it should be accepted. 36. A Ltd. an existing profit-making company, is planning to introduce a new product with a projected life of 8 years. Initial equipment cost will be Rs 150 lakhs and additional equipment costing Rs 10 lakhs will be needed at the beginning of third year. At the end of the 8 years, the original equipment will have resale value equivalent to the cost of removal, but the additional equipment would be sold for Rs 1 lakh. For tax purpose assume depreciation of Rs on additional equipment. Working capital of Rs 25 lakhs will be needed. The 100% capacity of the plant is of 4,00,000 units per annum, but the production and sales-volume expected are as under: Year Capacity in percentage A sale price of Rs100 per unit with a profit volume ratio of 60% is likely to be obtained. Fixed Operating Cash Costs are likely to be Rs16 lakhs per annum. In addition to this the advertisement expenditure will have to be incurred as under: Year Expenditure each year (Rs in lakhs) The company is subjected to 50% tax, straight-line method of depreciation, (permissible for tax purposes also) and taking 12% as appropriate after tax cost of Capital, should the project be accepted? Computation of initial cash outlay (Rs in lakhs) Equipment Cost 150 Working Capital

29 Calculation of Cash Inflows: Years to 5 6 to 8 Sales in units 80,000 1,20,000 3,00,000 2,00,000 Rs 60 p.u. 48,00,000 72,00,000 1,80,00,000 1,20,00,000 Fixed cost 16,00,000 16,00,000 16,00,000 16,00,000 Advertisement 30,00,000 15,00,000 10,00,000 4,00,000 Depreciation 15,00,000 15,00,000 16,50,000 16,50,000 Profit /(loss) 13,00,000) 26,00,000 1,37,50,000 83,50,000 50% NIL 13,00,000 68,75,000 41,75,000 Profit/(Loss) after tax 13,00,000) 13,00,000 68,75,000 41,75,000 Add: Depreciation 15,00,000 15,00,000 16,50,000 16,50,000 Cash inflow 2,00,000 28,00,000 85,25,000 58,25,000 Computation of PV of Cash Inflow Year Cash Inflow (Rs) PV 12% (Rs) 1 2,00, ,78, ,00, ,31, ,25, ,69, ,25, ,21, ,25, ,33, ,25, ,53, ,25, ,32, ,25, ,53,300 Working Capital 15,00, ,06,000 Scrap Value 1,00, ,400 (A) 2,73,21,450 Cash Outflow: Initial Cash Outlay 1,75,00, ,75,00,000 Additional Investment 10,00, ,97,000 (B) 1,82,97,000 Net Present Value (NPV) (A)-(B) 90,24,450 Recommendation: Accept the project in view of positive NPV. 37. Beta Limited receives Rs 15,00,000 a year after taxes from an investment in an automatic plant that has 12 more years of service life. The company s required rate is 12%. Beta Limited can make improvements to the plant to raise its service life to 20 years and its annual after tax cash flow to Rs 48,00,000 per year. These investments would cost Rs 2,10,00,000. With the improvements, the plant s value at the end of 12 years would rise

30 from Rs7,50,000 to Rs75,00,000. Would the improvements produce a return satisfactory to Beta Limited? Calculation of the Present value of the inflows before improvements to the automatic plant Particulars Amount(Rs) Income after taxes for 12 years(15,00, ) 92,91,000 Plant value at the end of 12 years (7,50, ) 1,92,750 Total present value of the inflows before improvements to the plant: (A) 94,83,750 Calculation of the Present value of the inflows after improvement to the automatic plant Particulars Amount(Rs) Income after taxes for 12 years(48,00, ) 2,97,31,200 Plant value at the end of 12 years (75,00, ) 19,27,500 Total present value of the inflows before improvements to the plant: (A) 3,16,58,700 Differential Present value of the inflow after improvements to the automatic plant = 3,16,58,700 (B) 94,83,750 (A) = 2,21,74,950 Net Present value from the investments in the automatic plant = P.V. of Cash Inflow Cash Outflow= 2,21,74,950 2,10,00,000 = 11,74,950 Advice: Since the NPV is positive, the improvements produce a satisfactory return to the firm. 38. APZ Limited is considering to select a machine between two machines 'A' and 'B'. The two machines have identical capacity, do exactly the same job, but designed differently. Machine 'A' costs Rs 8,00,000, having useful life of three years. It costs Rs 1,30,000 per year to run. Machine 'B' is an economy model costing Rs 6,00,000, having useful life of two years. It costs Rs 2,50,000 per year to run. The cash flows of machine 'A' and 'B' are real cash flows. The costs are forecasted in rupees of constant purchasing power. Ignore taxes. The opportunity cost of capital is 10%. The present value factors at 10% are : Year t1 t2 t3 PVIF(0.10,t) PVIFA(0.10,2) = PVIFA(0.10,3) =

31 Which machine would you recommend the company to buy? Statement Showing Evaluation of Two Machines Particulars Machine A Machine B Purchase Cost (Rs) : (i) 8,00,000 6,00,000 Life of Machines (in years) 3 2 Running Cost of Machine per year (Rs) : (ii) 1,30,000 2,50,000 Cumulative PVF for % : (iii) Cumulative PVF for % : (iv) Present Value of Running Cost of Machines (Rs): (v) = [(ii) x (iii)] 3,23,284 4,33,875 Cash Outflow of Machines (Rs) : (vi) = (i) + (v) 11,23,284 10,33,875 Equivalent Present Value of Annual Cash Outflow [(vi) (iii)] 4,51, ,95, Recommendation: APZ Limited should consider buying Machine A since its equivalent Cash outflow is less than Machine B.