Capital Budgeting. Questions 4, 5, 8, 9, 12, 15, 16, 19, 22, 23, 24, 25, 27, 45, 61, 62, 63, 64, 65, 66

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1 Financial Management 1 Capital Budgeting LIST OF IMPORTANT QUESTIONS MUST TO REVISE Questions 4, 5, 8, 9, 12, 15, 16, 19, 22, 23, 24, 25, 27, 45, 61, 62, 63, 64, 65, 66 Rest also to be done but list of above questions is very-very important. Question 14 of book Page no Chappu Ltd. is evaluating two mutually exclusive proposals, A and B. Following information is available about these projects: Project A Project B Project Cost ` 5,00,000 ` 7,00,000 Annual cash expenses ` 1,00,000 ` 1,20,000 Life 10 years 10 years Salvage Value ` 80,000 ` 1,00,000 Tax rate 40%. Required rate of return 12%. Evaluate the proposal on the basis of incremental cash flows. (Proposal B over Proposal A) Solution 14 Project cost 5,00,000 7,00,000 2,00,000 Add: PV of Annual expenses (w.n. 1) 2,44,080 2,71,200 27,120 Less: PV of Terminal Value (w.n. 2) (25,760) (32,200) (6,440) Total 7,18,320 9,39,000 2,20,680 Since, Proposal B has more outflow over A, thus Proposal A is preferred over B. Working Note 1 Annual cash expenses (A) 1,00,000 1,20,000 20,000 Add: Depreciation 42,000 60,000 18,000 Total deductible expenses 1,42,000 1,80,000 38,000 Tax saving on 40% (B) 56,800 72,000 15,200 Net outflow of expenses (A - B) 43,200 48,000 4,800 PVAF PV of Annual expenses 2,44,080 2,71,200 27,120 Working Note - 2 Terminal Value 80,000 1,00,000 20,000 PVF PV of terminal value 25,760 32,200 6,440

2 2 Financial Management Cost of Capital Flotation cost is to be charged on the basis of issue price or market price whichever is given in question. Generally market price will be used in case of already existing company which is going to issue new securities in the market. In case of new companies, issue price will be used which is as follows: Issue price = Face value + Premium Discount Although, in case if securities are issued at discount i.e. less than the face value, then charge flotation cost on the basis of FACE VALUE and give a note in exam that, the other way can be to charge flotation cost on the basis of issue price also. Leverage Financial breakeven point It is that level of EBIT at which EPS is zero. In other words, at this level financial fixed cost is equal to EBIT. Financial BEP (in Rs.) = Interest + Preference dividend 1- t IMP If question says to double the EBIT or Sales or any other value than take % change equal to 100%. If question says to triple the value then take % change equal to 200%. Question The following data are available for ABC Ltd.: Sales 5,00,000 Variable 40% 2,00,000 Contribution 3,00,000 Fixed cost 1,50,000 Interest _25,000 EBT 1,25,000 a) Using the concept of operating leverage by what percentage will EBIT increase if there is 10% increase in sales, and b) Using the concept of financial leverage by what percentage will the taxable income increase if EBIT increases by 6%. c) Using the concept of leverage by what percentage will the taxable income increase if the sale increase by 8%. Also verify the results in view of the above figures. Solution Contribution 3,00,000 a) Degree of operating leverage = = = 2 % change in EBIT = DOL % change in sales = 2 10% = 20% Costing, Management Accounting and Financial Management classes by CA SUNIL KESWANI

3 Financial Management 3 b) Degree of Financial Leverage = = = 1.2 EBT 1,25, 000 % change in EBT = DFL % change in EBIT = 1.2 6% = 7.2% c) Degree of Combined Leverage = DOL DFL = = 2.4 % change in EBT = DCL % change in Sales = 2.4 8% = 19.2% Verification: Particulars Existing After sales increase by 10% Sales 5,00,000 5,50,000 Less: Variable cost 2,00,000 2,20,000 Contribution 3,00,000 3,30,000 Less: Fixed cost 1,50,000 1,50,000 1,80,000 30,000 % increase in EBIT = 100 = 20% 1,50,000 Particulars Existing After EBIT increase by 6% 1,59,000 Less: Interest 25,000 25,000 EBT 1,25,000 1,34,000 9,000 % increase in EBT = 100 = 7.2% 1,25,000 Particulars Existing After sales increase by 8% Sales 5,00,000 5,40,000 Less: Variable cost 2,00,000 2,16,000 Contribution 3,00,000 3,24,000 Less: Fixed cost 1,50,000 1,50,000 1,74,000 Less: Interest 25,000 25,000 EBT 1,25,000 1,49,000 24,000 % increase in EBT = 100 = 19.2% 1,25,000

4 4 Financial Management Working Capital Management If question is silent regarding the method of working capital i.e. Total basis or cash cost basis, in such case follow Total Basis and give a note in solution that, other way to solve the question is to use cash cost basis and in such situation debtors value will be Rs.. Cash Management IMPORTANT QUESTIONS MUST TO REVISE CASH BUDGET Questions 8, 9, 12, 13, 14, 15 Rest also to be done but list of above questions is very-very important. Inventory Management Question A company manufactures a product from a raw material which is purchased at ` 60 per kg. The company incurs a handling cost of ` 360 plus freight of ` 390 per order. The incremental carrying cost of inventory of raw material is ` 0.50 per kg per month. In addition, the cost of working capital finance on the investment in inventory of raw material is ` 9 per kg per annum. The annual production of the product is 1,00,000 units and 2.5 units are obtained from one kg of raw material. Required: (a) Calculate the economic order quantity of raw material (b) Advise, how frequently should orders for procurement be placed. (Assuming 360days in the year) (c) If the company proposes to rationalize placement of orders on quarterly basis, what percentage of discount in the price of raw materials should be negotiated? Solution Annual requirement = 1,00,000/2.5 = 40,000 kg O = Rs Rs. 390 = Rs. 750 C = (Rs ) + 9 = Rs. 15 (a) EOQ = 2 A O 2 40, = = 2,000 kg C 15 (b) No. of orders = 40,000/2,000 = 20 orders (c) No. of order to be placed p.a. = 4 orders Proposed order size (on quarterly basis) = 40,000/4 = 10,000 kg Costing, Management Accounting and Financial Management classes by CA SUNIL KESWANI

5 Financial Management 5 Particulars Order 2,000 Kg Order 10,000 Kg Annual purchase cost (` 60 per kg) Annual Ordering cost (` ) (` 750 4) Annual carrying cost [(2,000/2) 15]/[(10,000/2) 15] 24,00,000 15,000 15,000 24,00,000 3,000 75,000 Total Cost ` 24,30,000 ` 24,78,000 Extra cost to be incurred = 24,78,000 24,30,000 = Rs. 48,000 Annual requirement of raw material = 40,000 kg Extra cost per unit/ Min. discount per unit to be negotiated = 48,000/40,000 = Rs. 1.2 Purchase price per kg = Rs. 60 Minimum % discount to be negotiated = 1.2/60 = 2%

Sree Lalitha Academy s Key for CA IPC Costing & FM- Nov 2013

Sree Lalitha Academy s Key for CA IPC Costing & FM- Nov 2013 1. a. Question No.1 is compulsory Answer any 5 questions from the remaining 6 questions (Key Covers only Problems does not include theory) i. Annual Demand 60,000 Units Cost Rs. 10 Per unit Cost of Placing