42737918 fm management notes

www.SCOrEeduca t ioN.co.in TYBMS SEM V – – Financial Management 1

CHAPTER: 3 – RECEIVABLE MANAGEMENT

SECTION I:- ACCOUNT RECEIVABLE MANAGEMENT

Credit Sales results in Accounts Receivables (AR). Selling goods on credit results into increase in sales and ultimately the profits also. At the same time the funds are blocked in Accounts Receivables. Therefore more funds are required to be raised to meet the Working Capital requirements. Moreover, it involves the risk of Bad Debts. Hence, selling goods on credit is beneficial (return) as well as dangerous (risk). The Finance Manager has to frame proper credit policies and take decisions regarding the sanction of credit to the customers.Therefore, Accounts Receivable Management is the process of decision-making relating to the investments of funds in these assets in such a manner that the return on shareholders’ investments is maximized.

SECTION II:- VARIOUS COSTS ASSOCIATED WITH AR

• Capital Cost: AR blocks the firm’s resources because of the time lag in sale of goods and collection from the customers. The firm has to arrange for additional funds, which involves cost.

• Administrative Cost: The firm has to incur additional cost for maintaining AR. Ex: salaries to the staff, cost of conducting investigations and cost of deciding credit worthiness.

• Collection Cost: Cost incurred for collection dues from the customers. Ex: monitoring state of AR, letters, telephone and legal action.

• Defaulting Cost: Inspite of making all serious efforts some customers may not pay their dues.Hence, such debts are treated as bad debts. It cannot be realized. Hence it is written off.

SECTION III:- CREDIT MANAGEMENT PROCESS/CREDIT POLICY VARIABLES

The need of receivables management arises only when company grants credit to its customers. To manage overall condition of receivables, company needs to frame the policy that will govern this process and there are other aspects that are involved in managing receivables. These aspects can be divided in three parts: (i) Credit policy, (ii) Credit analysis, and (iii) Control of receivable.

(i) Credit polic y :- It generally involves decision relating to period of credit, discount (if any) and other special items.

• Period of credi t :- Credit period generally depends on the demand prevailing in the market. It is also dependent on the custom, the practice followed in the industry, credit risk, and availability of funds and possibility of bad debts.

The credit period is generally stated in term of net days. For example, if the firm’s credit terms are“net 50”, it is expected that customer will repay credit obligations not later than 50 days.

• Discount polic y :- Discounts are normally given to speed up the collection of debts. A cash discount is means of improving the liquidity of the seller. In practice, credit terms are written as follows. “3/15 net 60”. These means that client will get 3% discount if it pays within 15 days of sale, if he does not avail the offer he must make payment within 60 days. Credit period in this includes three important things i.e. (a) rate of cash discount, (b) cash discount period and (c) net credit period.

http://www.SCOrEeducatioN.co.in/

www.SCOrEeduca t ioN.co.in TYBMS SEM V – – Financial Management 2

(ii) Credit appraisal / a n alysi s :- After determining credit terms, firm should test whether customer will be able to pay debts if it grants credit to him. Here analysis regarding 5 Cs (Character, capacity, capital, conditions and collateral) is done to know his position in the market and depending on the analysis, final decision is taken. The credit granting decision is:

DENY CREDIT

GRANT CREDIT

Credit Rating :- An important task for finance manager is to rate the various debtors who seek credit facility. These involves decisions regarding individual parties so as to ascertain how much credit can be extended and for how long. Here finance manager has to look into creditworthiness of a party and sanction credit limit only after he is convinced that the party is sound. This would involve an analysis of the financial status of the party etc.The credit manager has to employ a number of sources to obtain credit information the following are important sources.• Trade Reference s :- The firm can ask the customer to give trade reference of people with whom

he is doing business or has done it. The trade reference maybe contacted by the firm to get the necessary information.

• Bank reference s :- A firm can get credit information from the bank were his customer has account in it. Firm can ask bank officials regarding the relationship that its customer has with bank when it comes to exercise the obligation.

• Credit Bureau Report s :- In some cases the associations for specific industries maintain a credit bureau which provides useful and authentic credit information for their members. Credit rating agencies in India which do the same rate CRISIL (Credit Rating Investment Services of India Ltd), IICRA (Investment Information and Credit Rating Agency)

• Past Experienc e :- In case of existing customers, the past experience of his account would be valuable sources of essential data for security and interpretation.

• Published Financial Statement s :- Financial statements are powerful statements itself to determine the creditworthiness of the customers. Using tools like cash flow statement & ratios the financial position of the customer can be determined.

Once the credit-worthiness of a client is ascertained, the next question to resolve is to set a limit on the credit. In all such enquiries, the finance manager must be discreet and should always have the interest of company in view.(iii) Control of receivable s :Another aspect of management of debtors is control of receivables. Merely setting of standardsthrough policy is not sufficient. It is, equally important to control receivables.

Collection policy: Efficient and timely collections of debtors ensure that the bad debts losses are reduced to the minimum and the average collection period is shorter. The collection cell of a firm has to work in a manner that it does not create too much resentment amongst the customers. On the other hand, it has to keep the amount of outstanding on check. Hence, it has to work in a very smooth manner and diplomatically.

http://www.SCOrEeducatioN.co.in/

It is important that clear-cut procedure regarding credit collection is set up. Such procedure must answer questions like the following:• How long should a debtor balance be allowed to exist before collection process is started?• What should be the procedure of follow up with defaulting customer? How reminders are to be

send and how should each successive reminder be drafted?• Should their be collection machinery whereby personal calls by company’s representatives are

made?What should be the procedure for dealing with doubtful accounts? Is legal action to be instituted? How should account be handled?

Collection effort / Collection program:• Monitoring the state of receivables• Sending letters to those whose due date is approaching fast• Telegraphic/telephone advice to customers around the due dates• Threat of legal action in case of overdue accounts• Legal action in the case of customers who are overdue

(FOR MORE DETAILS (THEORY) REFER HIMALAYA

PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)

SECTION - PROBLEMS + SOLUTIONS

Problem 1

The following are the details regarding the operation of a firm during a period of 12 months: Sales Rs.1200000Selling Price per unit Rs.10Variable Cost Price per unit Rs.7Total Cost per unit Rs.9Credit period allowed to customers 1 month

The firm is considering a proposal for a more liberal extension of credit by increasing the average collection period from 1 month to 2 months. This relaxation is expected to increase the sales by25%.You are required to advise the firm regarding adopting the new credit policy, presuming that the firm’s required return on investment is 25%.

Q.1 SolutionEvaluation of Credit Proposal

Particular Present Policy Proposed PolicyCredit Period 1month 2 months

No of Units 120000 150000Sales @ 10(-) Variable cost @ 7

1200000840000

15000001050000

Contribution(-) Fixed Cost (9-7) = 2x120000

360000240000

450000240000

Profit (a). . . . 120000 210000ReceivablesVC + FC x DCP

12

840000 + 24000012 x 1

= 90000

1050000 + 24000012 x 2

= 215000Cost of ARCapital cost (Receivables x ROI)

(b). . . .Net Profit (a-b) . . . .

= 90000 x 25% = 215000 x 25%= 22500 = 5375097500 156250

Incremental NP - 58750

Recommendation:The company is advised to adopt 2 months credit period since it result into incremental net profit ofRs. 58750.

Problem 2Arvind Mills Ltd. manufactures readymade garments and sells them on credit basis through anetwork of dealers. Its present sale is Rs.60 lakhs per annum with 20 days credit period. The Company is contemplating an increase in the credit period with a view to increasing sales. Present variable costs are 70% of sales and the total fixed costs are Rs.8 lakhs per annum. The company expected pre – tax return on investment @ 25%. Some other details are given as under:

ProposedCredit Policy

Average Collection Period(Days)

Expected annual Sales (Rs.Lakhs)

I 30 65II 40 70III 50 74IV 60 75

Which credit policy should the company adopt? (Assume 360 days in a year)

Q.2 SolutionEvaluation of credit proposal

Particulars PresentPolicy

Proposed PolicyI II III IV

DCP (days) 20 30 40 50 60Sales(-) Variable cost (70%) Contribution(-) Fixed cost

60 65 70 74 7542 45.5 49 51.8 52.5188

19.58

218

22.28

22.58

Profit (a)… 10 11.5 13 14.2 14.5ReceivablesVC + FC x DCP

360

42 + 8 x 20360

= 2.78 = 4.46 = 6.33 = 8.31 = 10.08Cost of ARCapital cost (Reci x ROI)

(b)…Net profit (a – b) Incremental NP

2.78 x 25%= 0.70

4.46 x 25%= 1.12 = 1.58 = 2.08 = 2.52

9.30 10.38 11.42 12.12 11.98- 1.08 2.12 2.82 2.68

Recommendation:Select proposed policy III since it result into highest incremental net profit. i.e. 2.82 lakhs.

Problem 3Ponds Ltd. has present sales level of 10,000 units at Rs. 300 per unit. Variable cost is Rs.200 per unitand the fixed cost amounts to Rs.300000 per annum. The present credit period allowed by the company is 1 month. The company is considering a proposal to increase the credit periods to 2 months and 3 months and has made the following estimates:

Credit Policy Existing Proposed1 month 2 months 3 months

Increase In Sales - 15% 30%% Of Bad Debts 1% 3% 5%

There will be increase in fixed cost by Rs.50000 on account on increase of sales beyond 25% of present level. The company plans on a pretax return of 20% on investment in receivables. You are required to calculate the most paying credit policy for the company.

Q.3 Solution

Evaluation of credit proposal

Particular PresentPolicy

Proposed PolicyI II

DCP 1month 2 months 3 monthsNo of Units 10000 11500 13000Sales @ (300 p.u.)(-) Variable cost @ 200 p.u. Contribution(-) Fixed Cost

30000002000000

34500002300000

39000002600000

1000000300000

1150000300000

1300000350000

Profit (a). . . . 700000 850000 950000ReceivablesVC + FC x DCP

12= 191667 = 433333 =737500

Cost of AR• Capital cost (Receivables x

ROI)• Defaulting cost (1% of sales)

(b) . . . . .Net Profit (a-b) . . . . . .

38333

30000

86667

103500

147500

19500068333 190167 342500

63166.7 659833 607500Incremental NP - 28166 (24167)

Recommendation: i.e. 2 monthsSelect proposed policy I since it results into highest incremental net profit. i.e. Rs.28166

Problem 4

Samsung Ltd. manufacturers of Color TV sets are considering the liberalization of existing credit terms to three of their large customers A, B and C. The credit period and likely quantity of TV sets that will be lifted by customers are as follows:

Credit period (days) Quantity lifted (No of TV sets)A B C

0 1000 1000 -30 1000 1500 -60 1000 2000 100090 1000 2500 1500

The selling price per TV set is Rs.9000. The expected contribution is 20% of the selling price. Thecost of carrying debtors averages 20% per annum.a. Determine the credit period to be allowed to each customer. (1year = 360 days)b. What other problems the company might face in allowing the credit period as determined in (a)

above.

Q.4 Solution.Evaluation of credit proposal for ASelect Credit period 0 days since Quantity remains same inspite of increase in Credit period. Evaluation of credit proposal for B.

Particulars Proposed Policy1 2 3 4

DCP 0 30 60 90No. of units 1000 1500 2000 2500Sales @ 9000 p.u(-) Variable cost (80%) Contribution (20%) (a)…

90000007200000

1350000010800000

1800000014400000

2250000018000000

1800000 2700000 3600000 4500000ReceivablesSales x DCP360

- 1125000 3000000 5625000

Cost of ARCapital cost (Recv x ROI)

(b)…Net profit (a – b)

- 225000 600000 1125000- 225000 600000 1125000

1800000 2475000 3000000 3375000Recommendation:Select proposed policy 4 i.e. 90 days credit period as it results into highest net profit Rs.3375000.

Note: In absence of information of fixed cost, receivables have been valued at sales.

Evaluation of credit proposal for C.

Particulars Proposed Policy3 4

DCP 60 90No. of units 1000 1500Sales @ 9000 p.u(-) Variable cost (80%)

90000007200000

1350000010800000

Contribution (20%) (a)… 1800000 2700000

ReceivablesSales x DCP360

1500000 3375000

Cost of ARCapital cost (Recv x ROI)

(b)…Net profit (a – b)

300000 675000300000 6750001500000 2025000

Recommendation:Select proposed policy 4 i.e. 90 days credit period, as it results into highest net profit Rs.2025000

Note :- In absence of information of fixed costs, Receivable have been valued at sales.

b) The problems to be faced by the company in allowing credit period as determined in A above.1) Customer A on discovering that B & C are allowed higher credit period 90 days at same price

will feel is treated by the company in an unfair manner, and may stop doing business with company.

2) Customer A might also spread disinformation in market resulting into Loss at reputation /goodwill for Samsung Ltd.

Problem 5X & Co. whose current sales are Rs.600000 per annum and an average collection period of 30dayswants to pursue a more liberal policy to improve sales.

Credit Policy Increase In CollectionPeriod (Days)

Increase In SalesRs.

% DefaultAnticipated

A 10 30000 1.5%B 20 48000 2%C 30 75000 3%D 45 90000 4%

Selling price per unit is Rs.3, average cost per unit is Rs.2.25 and variable cost per unit is Rs.2Current Bad Debt loss is 1%. Required Return on additional Investment is 20%. Assume 360 days a year.Which of the above policies would you recommend for adoption?

Q.5 SolutionEvaluation of credit proposal

Particulars PresentPolicy

Proposed PolicyA B C D

DCP (days) 30 40 50 60 75No. of units 200000 210000 216000 225000 230000Sales @3 p.u.(-) Variable cost @ 2 p.u. Contribution(-) Fixed cost (2.25 – 2) x 200000

600000400000

630000420000

648000432000

675000450000

690000460000

20000050000

21000050000

21600050000

22500050000

23000050000

Profit (a)… 150000 160000 166000 175000 180000ReceivablesVC + FC x DCP

36037500 52222 66944 83333 106250

mailto:@3

Cost of AR• Capital cost (Recv x ROI)• Defaulting cost

(b)… Net profit (a – b) Incremental NP

75006000

104449450

1338912960

1666720250

2125027600

13500 19894 26349 36917 48850136500 140106 139651 138083 131150

- 3606 3151 1583 (5350)

Recommendation:Select proposed policy A since it results into highest incremental net profit. i.e. Rs.3606

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER

HIMALAYA PUBLICATION FINANCIAL MANAGEMENT

PROF. PAWAN JHABAK BOOK)

Problem 7Extra Practise Problem

Many times Customers play a very smart game. They pay the bills before time in initial period and once they get used to Company’s working, they start delaying payment beyond agreed terms. It is observed that company suffers loss not because of higher costs but slow, low and less recovery of the outstanding from customers. And here comes the role of a Credit Manager.

You are required to prepare a list of the precautions to be taken while extending credit terms to a new customer. (BMS EXAM) (May 2010)

Problem 8System Failure in USA, Economic Slowdown in Europe and Stock Market Meltdown in Asia havetheir root cause in SUB PRIME CRISIS. The SUB PRIME crisis arose because of “Lending without knowing”. In the light of the above enlist the issues involved in formulating a sound Credit Policy.

Problem 9As a Marketing Executive, before extending credit facilities to the customers introduced by yourSalesman, what precaution would you take to protect the interest of the Company.

Problem 10Construct of a Credit Rating Index (based on a 5-point rating scale)

Factor FactorWeight

Rating

Past PaymentNet profit Margin Current ratio Debt-equity ratio Return on equity

0.25 50.25 30.15 40.15 20.20 3

Problem 11Ageing Schedule – The ageing schedule (AS) classifies outstanding accounts receivables at a givenpoint of time into different age brackets. An illustrative AS is given below.

Age Group ( in days ) A Ltd. B Ltd. Percent of Receivables (Standard) 0 – 30 60 25 45

31 – 60 30 15 3561 – 90 10 35 15

> 90 0 25 5 Comment on above ageing schedule of A Ltd. & B Ltd.

Problem 12Kalpataru Ltd.

Collection Matrix

Percentage of receivablescollected during the

JanuarySales

FebruarySales

MarchSales

AprilSales

MaySales

JuneSales

Month of Sales 15 17 18 19 21 25First following month 20 22 23 24 26 28Second following month 35 37 38 39 41 43Third following month 15 17 18 18 12 4Fourth following month 15 7 3 0 0 0

Comment on collection matrix.

REVIEW QUEST I ON S :-

Q.1 Concept Testing(a) Concept of Receivable Management.(b) Various costs associated with Accounts Receivable. (c) 5 c’s of credit / Traditional credit Analysis.(d) Numerical credit scoring. (e) DSO(f) Collection Matrix. (g) Ageing Schedule.

Q.2 Explain Credit Management process / credit policy variables.




CHAPTER: 4 – CASH MANAGEMENT

SECTION I :- CASH BUDGET MEAN ING AND OBJECTIVES

Cash is the most liquid asset. It is most important for the daily operation of the firm. Efficient management of cash is very crucial for the solvency of the firm. Hence, it is considered as life blood of business organization.

Cash budget represents the cash receipts and cash payments and estimated cash balance for each month of the period for which budget is prepared. Cash budget is a device for controlling and co- ordaining the financial side of a business. Cash budget serves the following purposes:a. To ensure that sufficient cash is available whenever requiredb. To point out any possible shortage of cash so that necessary steps can be taken to meet the

shortage by making arrangement with the bank for overdraft or loan,c. To point out any surplus cash so that management can invest it in interest fetching securities etc.

Distinguish between cash budget and cash forecast:

Cash Budget Cash ForecastCash budget is usually prepared for shortperiods ranging up to one year.

Cash forecast is for longer terms exceedingone year such as 3 years, 5 years, etc.

Objective is to ensure short term liquidityan avoid default in timely discharge of current liabilities.

Objective is to study sources of funds forvarious future requirements.

Thrust is on current assets and liabilitiesand maintaining cash cushion for safety.

Capital receipts and capital expenditureinvestment dominate this number game.

Usually prepared by junior managementteam for perusal of senior managers.

Usually prepared by senior management forperusal of directors owners.

It is working capital management activity. It is more of investment planning activity.

Distinguish between Cash Flow Statement and Cash Budget:

Cash Flow Statement Cash BudgetCash flow statement is prepared based on pastdata of income statement and balance sheet.

Cash budget is prepared based on estimatesof collection and outgo of cash.

Is historical in nature. Is futuristic in nature.Analytical tool. Planning tool.Is based on real data. Is based on estimates.

SECTION II :- MOTIVES FOR HOLDING CASH

There are 3 important motives for holding cash:

Transaction MotivesBusiness organization needs cash for conducting business transactions. The collection of cash is notperfectly matched with payment of cash. Hence, some cash balance is required to be maintained.

Precautionary MotiveThere maybe uncertainties regarding receipt of cash and payment of cash. In order to protect againstsuch uncertainties, it is necessary to maintain some cash balance.

Speculative MotiveBusiness organization would like to tap business opportunities arising from fluctuations incommodity prices, share prices, foreign exchange rates etc. A firm which has sufficient cash can exploit opportunities.

SECTION III :- STRATEGIES OF CASH MANAGEMENT:

Strategies of Cash Management

The cash budget, as a cash management tool, would throw light on the net cash position of a firm. After knowing the cash position, the management should work out the basic strategies to be employed to manage its cash. The present section attempts to outline the basic strategies of cash management.The broad cash management strategies are essentially related to the cash turnover process, that is, the cash cycle together with the cash turnover. The cash cycle refers to the process by which cash is used to purchase material from which are produced goods, which are then sold customers, who later pay the bills. The firm receives cash from customers and the cycle repeats itself. The cash turnover means the number of times cash is used during each year. The cash cycle involves several steps along the way as funds flow from the firm’s accounts.

Cash Cycle is the amount of time cash is tied up between payment for production inputs and receipt of payment from the sale of resulting finished product; calculated as average age of inventory plus average collection period minus average accounts payable period.

Cash turnover is the number of times cash is used during the year; calculated by dividing number of days in a year by the cash cycle.

Example – A firm which purchases raw materials on credit is required by the credit terms to make payments within 30 days. On its side, the firm allows its credit buyers to pay within 60 days. Its experience has been that it takes, on an average, 33 days to pay its accounts payable and 70 days to collect its accounts receivable. Moreover, 85 days elapse between the purchase of raw materials and the sale of finished goods, that is to say, the average age of inventory is 85 days. What is the firm’s cash cycle? Also, estimate the cash turnover.

Solution – The cash cycle of the firm can be calculated by finding the average number of days that elapse between the cash outflows associated with paying accounts payable and the cash inflows associated with collecting accounts receivable:(i) Cash cycle = 85 days + 70 days – 33 days = 122 days.(ii) Cash turnover = The assumed number of days in a year divided by the cash cycle = 365 / 122 = 3

Cash management strategies are intended to minimize the operating cash balance requirement. The basic strategies that can be employed to do the needful are as follows.

(a) Stretching Accounts Payable,(b) Efficient Inventory-Production Management.(c) Speedy Collection of Accounts Receivable, and(d) Combined Cash Management Strategies.

(a) Stretching Accounts PayableOne basic strategy of efficient cash management is to stretch the accounts payable. In other words, afirm should pay its accounts payable as late as possible without damaging its credit standing. It should, however, take advantage of the cash discount available on prompt payment. Stretching Accounts payable should not result into higher prices / lower quality.

(b) Efficient Inventory-Production ManagementAnother strategy is to increase the inventory turnover, avoiding stock-outs, that is shortage of stock.This can be done in the following ways:1. Increasing the raw materials turnover by using more efficient inventory control techniques.2. Decreasing the production cycle through better production planning, scheduling and control

techniques; it will lead to an increase in the work-in-progress inventory turnover.3. Increasing the finished goods turnover through better forecasting of demand and a better

planning of production.

(c) Speeding Collection of Accounts ReceivableYet another strategy for efficient cash management is to collect accounts receivable as quickly aspossible without losing future sales because of high-pressure collection techniques. The average collection period of receivables can be reduced by changes in (i) credit terms, (ii) credit standards, and (iii) collection policies. These are elaborated in the receivable management chapter. In brief, credit standards represent the criteria for determining to whom credit should be extended. The collection policies determine the effort put forth to collect accounts receivable promptly. Speeding collection will also reduce bad debts.

(d) Combined Cash Management StrategiesWe have shown the effect of individual strategies on the efficiency of cash management. Each oneof them has a favourable effect on the operating cash requirement. We now recommend their combined effect, as firms will be well advised to use a combination of these strategies.The foregoing discussion clearly shows that the three basic strategies of cash management related to (1) accounts payable, (2) inventory, and (3) accounts receivable, lead to a reduction in the cash balance requirement. But, they imply certain problems for the management. First, if the accounts payable are postponed too long, the credit standing of the firm may be adversely affected. Secondly, a low level of inventory may lead to a stoppage of production as sufficient raw materials may not be available for uninterrupted production or the firm may be short of enough stock to meet the demands for its product that is, ‘stock-out’. Finally, restrictive credit standards, credit terms and collection policies may jeoparadise sales. These implications should be constantly kept in view while working out cash management strategies. The company needs to adopt a balanced approach.

METHODS / TOOLS / TECHNIQUES / PROCESSES OF CASH MANAGEMENT:

The following are the popular methods of cash management, required to implement cash management strategies.

1. Cash budgets.2. Long term cash forecastin g : This involves planning for cash requirements for a period of over

a year and includes capital expenditure decisions, sale of fixed assets, issue of shares, redemption etc.

3. Report s : Most firms used there management information system (MIS) to prepare regular and sometimes even daily treasury reports to report the cash position.

4. Prompt billin g : Invoices should be promptly sent to customers to minimize billing float.

5. Obtaining favorable credit terms of purchas e : This depends on the company’s bargaining power with the suppliers.

6. Concentration bankin g : In concentration banking the company establishes a number of strategic collection centers in different region instead of a single collection at the head office. Payments received by the different collection centres are deposited with their respective local bank which in turn transfers all surplus funds to the concentration bank of the head office. The concentration bank with which the company has its major bank account is generally located at the headquarters. This system reduces the period between the time a customer mails in his remittances and time when they become spendable funds with the company. Concentration banking is one important and popular way of reducing the size of the float. (Float is the time taken to convert a transaction into cash.) Any where banking across nation wide Branches is another new facility offered (SBI, ICICI, etc.)

7. Lock Box Syste m :- Under this system, customers deposit their cheques in special boxes and the local branch collects them and deposits them immediately. For example, the system used by mobile phone and electric companies.

8. Playing the floa t :- Playing the float can maximizes availability of cash. In this, a firm estimates accurately the time when the cheques issued will be presented for payment and thus utilizes the float period to its advantage by issuing more cheques but having in the bank a lesser cash balance.

The term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process. Four kinds of float with reference to management of cash are:

• Billing float: An invoice is the formal document that a seller prepares and sends to the purchaser as the payment request for goods sold or services provided. The time between the sale and the mailing of the invoice is the billing float.

• Mail float: This is the time when a cheque is being processed by the post office, courier messenger service or other means of delivery.

• Cheque processing float: This is the time required to sort, record and deposit the cheque after it has been received by the company.

• Banking processing float: This is the time from the deposit of the cheque to the crediting of funds in the sellers account.

9. RTGS (Real Time Gross Settlement):- i.e. Online Payment to suppliers and from customers can reduce ‘float’.



SECTION : PROBLEM AND SOLUTION

Q.1 Prepare a cash budget of a company for April, May and June 2010 in a columnar form using the following information:

Month 2010 Sales Rs. Purchase Rs. Wages Rs. Expenses Rs.January (actual) 80,000 45,000 20,000 5,000

February (actual) 80,000 40,000 18,000 6,000March (actual) 75,000 42,000 22,000 6,000April (budgeted) 90,000 50,000 24,000 7,000May (budgeted) 85,000 45,000 20,000 6,000June (budgeted) 80,000 35,000 18,000 5,000

You are further informed that:10% of the purchases and 20% of sales are for cash.The average collection period of the company is 2 month and credit purchase is paid off regularly after one month.Wages are paid half monthly in arrears and the rent of Rs.500 included in expenses is paid monthly. Cash and Bank balance as on April 1, was Rs.15,000 and the company wants to keep it on the end of every month below this figure, the excess cash being put in fixed deposits.

Q.1 SolutionCash budget for 3 months ending 30th June 2010.

Particulars April May JuneOpening Balance b/fAdd:- Cash Receipts• Cash Sales• Collection from debtors.

i)……ii) Cash Payment• Cash purchase• Payment to suppliers• Wages• Rent• Other expenses ii)

…… (i-ii)

Less:- Fixed deposits * Closing balance c/f

15000

1800064000

15000

1700060000

14500

1600072000

97000 92000 102500

50003780023000

5006500

45004500022000

5005500

35004050019000

5004500

72800 77500 68000242009200

14500-

3450019500

15000 14500 15000

W.N.1) Collection from debtors.Feb Mar April

Total Sales 80000 75000 90000 (-) Cash Sales 20% 16000 15000 18000Credit Sales 64000 60000 72000

2 m

Due & received April May JuneW N 2) Payment to Suppliers.

Mar April MayTotal Purchase 42000 50000 45000(-) Cash Purchase 10% 4200 5000 4500Credit Purchase

1 m

Due & Paid

37800

April

45000

May

40500

June

W N 3) WagesApril May June

½ of Previous month 11000 + 12000 + 10000½ of Current month 12000 10000 9000

23000 22000 19000

Q.2 From the following information prepare a monthly cash budget for the three months ending 31st

December, 2009:

Months 2009SalesRs.

MaterialsRs.

WagesRs.

ProductionRs.

Admin. AndSelling Rs.

June 3,000 1,800 650 225 160July 3,250 2,000 750 225 160August 3,500 2,400 750 250 175September 3,750 2,250 750 300 175October 4,000 2,300 800 300 200November 4,250 2,500 900 350 200December 4,500 2,600 1,000 350 225

Credit terms are:Sales: 4months to debtors, 10% of sales are on cash.On an average, 50% of credit sales are paid on the due dates while the other 50% are paid in the following month.Creditors for material: 2months. Lag in payment:Wages: ¼ monthOverheads: ¼ monthCash and bank balance: On 1st October it is expected to be Rs. 15,000Other Information is:→ Plant and machinery to be installed in august at a cost of Rs.24,000. It will be paid for by

monthly of Rs.500 each from 1st October.→ Preference share dividend @ 5% on Rs.50,000 is to be paid 1st December.→ Calls on 250 equity shares @ Rs.2 per share expected on 1st October.→ Dividends from investments amounting to Rs.250 are expected to 31st December.→ Income tax (advance) to be paid in December Rs.1500Q.2 SolutionCash budget for 3 months ending of 31st December, 09

Particulars Oct Nov DecOpening Balance b/fAdd:- Cash receipts • Cash sales• Collection from debtors.• Dividend from Investment.• Call on shares (250 x 2)

i)……ii) Cash Payment Payment to suppliers WagesOHsPlant & MachineryPreference dividend (5% x 50000) Income tax advance

ii)…… Closing balance (i-ii)

15000

4001350

-500

13075

4252812.5

--

12162.5

4503037.5

250-

17250 16312.5 15900

24007875048750

500--

2250875525500

--

2300975

562.5500

25001500

4175 4150 8337.513075 12162.5 7562.5

W N 1) Wages (¼ month)Oct Nov Dec

¼ of Previous month 187.50 + 200 + 225¾ of Current month 600 675 750

787.50 875 975

W N 2) Overheads (Production + A + S)

Oct Nov Dec¼ of Previous month 237.5 + 250 + 275¾ of Current month 250 275 287.50

487.50 525 562.50

W N 3) Collection from debtorsJune July August

Total Sales 3000 3250 3500(-) Cash Sales (10%) 300 325 350 Credit Sales 2700 2950 3150

(4 M)

Due Oct Nov Dec50% in due month 1350 + 1462.5 + 157550% next month - _ 1350 1462.5

1350 2812.5 3037.5

Q.3 Prepare cash budget for the three months ending 30th June 2010 from the following information:

Month Sales Rs. MaterialPurchase Rs.

Wages Rs. OverheadsRs.

February 14,000 9,600 3,000 1,700March 15,000 9,000 3,000 1,900April 16,000 9,200 3,200 2,000May 17,000 10,000 3,600 2,200June 18,000 10,400 4,000 2,300

→ Sales: 10% sales are on cash. Of the remaining sales, 50% are collected in the next month and remaining balance in next month.

→ Creditors: materials-2 months. Wages-1/4 month. Overheads- ½ month.→ Cash and bank balance on the 1st April, 1990 is expected to Rs.6,000/- Other information

provided is as follows:→ Plant and machinery will be installed in February 2003 at a cost Rs.96,000/-. The monthly

installment of Rs.2,000/- is payable from April onwards.→ Dividend at 5% on preference share capital of Rs.2,00,000/- is to be paid on 1st June.→ Advance to be received for sale of vehicles Rs.9,000/- in June.→ Dividend on investment accounting to Rs.1,000/- is expected to be received in June.→ Income tax (advance) to be paid in June is Rs.2,000/-. (MU, BAF, April 2006)

Q.3) Solution

Cash budget for 3 months ending of 30th June 2010Particulars April May June

Opening Balance b/fAdd:- Cash Receipts• Cash Sales• Dividend on Investment• Collection from debtors.• Advance to be received vehicle

i)……

i) Cash Payment• Payment to suppliers• Wages• OHs• Plant & Machinery• Dividend on preference share capital• Advance to be paid

ii)……Closing balance c/f (i-ii)

6000

1600-

13050-

3950

1700-

13950-

3000

18001000

148509000

20650 19600 29650

9600315019502000

--

9000350021002000

--

9200390022502000

100002000

16700 16600 29350

3950 3000 300

W N 1) Collection from debtorsFeb March April May

Total Sales 14000 15000 16000 17000 (-) Cash Sales 1400 1500 1600 1700Credit Sales 12600 13500 14400 15300

April May June50% of credit sale 2m 6300 6750 720050% of credit sales 1m 6750 7200 7650

13050 13950 14850W N 2) Overheads

April May June½ of Previous month 950 + 1000 + 1100½ of Current month 1000 1100 1150

1950 2100 2250

W N 3) Wages (1/ 4 th month) April May June

¼ of Previous month 750 + 2800 + 900¾ of Current month 2400 2700 3000

3150 3500 3900

Q.4 Prepare cash budget on Alpha Co. Ltd. for three months ended 30th June 2010 from the following information:

Month Sales Rs. Purchase Rs. Wages Rs. Other Expenditure Rs.January 1,20,000 40,000 30,000 20,000

February 1,00,000 40,000 30,000 20,000March 1,60,000 80,000 30,000 30,000April 2,00,000 1.00,000 50,000 40,000May 2,80,000 1,40,000 50,000 40,000June 3,20,000 1,20,000 60,000 40,000

Additional information:1. Sales are 20% cash and the balances are two months credit.2. Purchases are at one month credit subject to a cash discount of 5%.3. Wages are paid in ½ month and other expenditure on the month’s interval.4. During May, the company pays dividend of 15% on its equity capital of Rs.2,00,000 and

during June, deferred payment installment (quarterly) of Rs.50,000 will fall due.5. It is expected that at the end of March 2003, there will be cash balance of Rs.28,000.

Q.4 SolutionCash budget for Alpha Co. Ltd. for 3 months ending 30 June, 2010

Particulars April May JuneOpening Balance b/fAdd:- Cash Receipts• Cash Sales• Collection from debtors.

A)…. (-) Cash Payment• Payment to creditors• Payment of Wages (W.N.3)• Payment of other expenditure• Payment equity dividend• Payment of installment

B)….

28000

4000080000

2000

56000128000

(29000)

64000160000

148000 186000 195000

760004000030000

-

95000500004000030000

-

1330005500040000

50000

146000 215000 2780002000 (29000) (83000)

Note:- It is assumed that company has sufficient overdraft facility.W.N.1) Collection from debtors

Feb March AprilSales 100000 160000 200000(-) Cash Sales 20000 32000 40000Credit Sales 80000 128000 160000

(2 M)

April May JuneW.N.2) Payment to supplier

March April May80000 100000 140000

5% discount 4000 5000 700076000 95000 133000

1 month:. April May JuneW.N.3) Wages

April May June½ Current month 25000 25000 30000

Cash at bank on 1st July, 2010 25,000Salaries and wages estimated monthly 10,000Interest payable: August 2010 5,000

½ Previous month 15000 25000 2500040000 50000 55000

Q.5 Prepare a cash budget for the months ended 30th September, 2010 based on the following information:

Estimated June Rs. July Rs. August Rs. September Rs.Cash sales -- 1,40,000 1,52,000 1,21,000Credit sales 1,00,000 80,000 1,40,000 1,20,000Purchases 1,60,000 1,70,000 2,40,000 1,80,000Other expenses -- 20,000 22,000 21,000

Credit Sales are collected 50% in the month sales are made and 50% in the month following.Collection from credit sales are subject to 5% discount, if payment is received during the month of purchase and 2 ½%, if payment is received in the following month. Creditors are paid either on a‘prompt’ or 30 days basis. It is estimated that 10% of the creditors are in the ‘prompt’ category.

(M.Com, May 1988 & Oct 1986)

Q.5) Solution

Particulars July Aug SeptOpening Balance b/fAdd:- Cash Receipt• Cash Sales• Collection from debtors.

i)……ii) Cash Payment• Salaries & wages• Interest payable• Cash - Purchases (10%)• Payment to suppliers• Other expenses ii)

……Closing balance (i-ii)

25000

14000086750

60750

152000105500

104250

121000125250

251750 318250 350500

10000-

1700014400020000

100005000

2400015300022000

10000-

1800021600021000

191000 214000 26500060750 104250 85500

W. N 1) Collection from debtorsJune Ju l y Aug Sept

Credit Sales 100000 80000 140000 1,20,000 Ju l y Aug Sept

50% in same month 38000 66500 5700050% in 1 month 48750 39000 68250

86750 105500 125250

EXTRA PRACTISE PROBLEM

(Q.6) LTC Brothers have requested to prepare their cash budget for the period January 20X1 throughJune 20X1. The following information is available.

a. The estimated sales for the period of January 20X1 through June 20X1 are as the follow:1,50,000 per month from January through March and 2,00,000 per month from April through to June.

b. The sales for the month of November & December of 20X0 have been 1,20,000 each.c. The division of Sales between cash & credit Sales is as follows: 30% cash & 70% credit.d. Credit collection pattern is : 40 & 60% after 1 and 2 month respectively.e. Bad debt losses are nil.f. Other anticipated receipt are (i) 70,000 from the sale of machine in April. (ii) 3,000

interest on securities on June.g. The estimated purchase of material are 60,000 per month from January to March &

80,000 per month from April to June.h. The payment for purchase are approximately a month after the purchase.i. The purchase for the month of December, 20X0 have been 60,000 for which payment

will be made in January 20X1.j. Miscellaneous cash purchase of 3,000 per month are planned, January through June.k. Wage payments are expected to be 25,000 per month, January through June.l. Manufacturing expenses are expected to be 32,000 per month, January through June.m. General Administrative and selling expenses are expected to be 15,000 per month.n. Dividend payment of 30,000 & Tax payment of 35,000 are scheduled in June 20X1.o. A machine worth 80,000 is planned to purchase on Cash in March 20X1.

Cash Balance as on 1st January 20X1 is 28,000.


Q.1) Concept Testing.(a) Cash budget(b) Motives for holding cash(c) Marketable securities

Q.2) Explain Strategies of Cash Management.

Q.3) Explain methods / tools / techniques / processes of cash management.

Q.4) What is optimal cash balance? State options for investing surplus cash.




CHAPTER: 5– COST OF CAPITAL

SECTION I – TYPES OF CAPITAL

Types of Capital, can be mainly classified as (a) owners capital & (b) Borrowed capital i.e. Debt

(a) Owner’s Capital can be further classified as(i) Equity Share Capital(ii) Preference Share Capital(iii)Retained Earnings / Internal funds / R & S.

(b) Borrowed Capital / Borrowed funds / Debts, includes Debentures, Bank Loan, Public deposits and other long term loan.

The above types of capital are explained in detail in chapter sources of finance.

SECTION II – COST OF CAPITAL

Risk – Return relationships of various securities Risk

Since the firm sells various securities to investors to raise capital for financing investment projects, it is therefore necessary that investment projects to be undertaken by the firm should generate atleast sufficient net cash flow to pay investors – shareholders and debt holders – their required rates of return. In fact, investment projects should yield more cash flows than to just satisfy the investors’ expectations in order to make net contribution to the wealth of ordinary shareholders. Viewed from all investors’ point of view, the firm’s cost of capital is the rate of return required by them for supplying capital for financing the firm’s investment projects by purchasing various securities. It may be emphasized that the rate of return required by all investors will be an overall rate. Thus, the

firm’s cost of capital is the ‘average’ of the opportunity costs (or required rates of return) of various securities which have claims on the firm’s assets.

• Cost of Equity Share Capital

Cost of Equity→ Cannot be estimated accurately, as there is no legal obligation to pay equity shareholders.→ Based on ‘expectations’ of shareholders.→ Only Net Income (N1) Approach believes in such estimation.

Commonly used three modelsModel 1: Total Yield Model Model 2: Dividend growth Model Model 3: FPS

ModelKe = D 1 + ( P 1 – P o ) x 100

Po

Ke = ( D 1 x 100) + GPo

EPS1 = PAT - Pref. Div No. of eq. sh.

& Ke = EP S 1 x 100Po

Good ApproximationKe = 1

P/E Ratio

Model 1 is suitable for listed & frequently traded (Liquid Shares) Model 2 is Suitable for any security, listed or unlisted. Model 3 is based on fundamental analysis, useful for portfolio management.

Cost of equity ( K e ) Notations: Po = Stock (share) price today

P1 = Stock after 1 year (expected)D1 = Dividend (expected) after 1 yearG = Growth in dividend % p.a. (expected)

EPS1 = Earnings per share after 1 year (expected)

Capital Asset Pricing Model (CAPM)Ke = Rf + β (Rm – Rf)Where: Rf is Risk free rate of return. Rm is market return (Eq. Nifty)β is Beta of a security.Ke = α + βRm [security Market Line (SML)]α is unsystematic diversifiable risk factor.β is Systematic non-diversifiable risk factor.

Equity is free source of capital. Do you agree?Ans: Equity is perceived as free source of capital because

a) There is no legal obligation to pay dividend (or any other from of return) to equity shareholders.

b) Equity shareholders are entitled to any benefit only if there is profit or accumulated profit(Lenders get interest even in case of loss)

c) Equity shareholders have only residual charge on assets in case of liquidation, after paying lenders & pref. shareholder.

Equity is however not a free source of capital because-

+ G

a) Though there is no legal obligation there is managerial obligation to give expected return to the shareholders, they are de-facto owners of the firm.

b) If Equity is really treated as ‘free source’ it will not take care of shareholders interests. This will conflict with ‘going concern’ concept of accounting, as shareholders will not continue their investment.

Hence, Equity is the costliest source because of,(i) High risk (ii) Residual Benefits only. (iii) Expectations matching with high risk-high return. These factors make it costliest source of capital.

• Cost of preference Share Capital

The cost of preference capital is a function of the dividend expected by investors.The cost of preference share is not adjusted for taxes because preference dividend is paid after the corporate taxes have been paid. Preference dividends do not save any taxes. Thus the cost of preference shares is automatically computed on an after tax basis. Since interest is tax deductible and preference is not, the after tax cost of preference shares is substantially higher than the after tax cost of debt.

Generally, in absence of information Kp = Proposed Preference dividend For e.g. 15% preference share capital:. Kp = 15%

Irredeemable preference shares

Kp = Prefer e nce dividend x 100Net proceeds

Not e :- Net proceeds = Face value + premium – discount – flotation cost.

Redeemable Preference Shares

Kp = Pref. divd + FV – NP N x 100

FV + NP2

Not e :- N = Number of Years

• Cost of Retained EarningsThe opportunity cost of the retained earnings (Internal funds) is the rate of return on dividendsforegone by equity shareholders.

There is however a difference between retained earnings and issue of equity shares from the firm’s point of view. The firm may have to issue new shares at a price lower than the current market price. Also, it may have to incur flotation costs. Thus external equity will cost more to the firm than the internal equity / Retained earnings.

ke = D 1 x 100 + G P0

+ G

The cost of retained earnings determined by dividend – valuation model implies that if the firm would have distributed earnings to shareholders, they could have invested it in the shares of other firms of similar risk at market price (Po) to earn a rate of return equal to Ke. Thus the firm should earn a return on retained funds equal to Ke to ensure growth of dividends and share price. If a return less than Ke is earned on retained earnings, the marker price of the firm’s share will fall.

Exampl e :- Current market price of XYZ Ltd. is Rs.90 and expected dividend per share next year is Rs.4.50. Dividends are expected to grow at a constant rate of 8 percent. Calculate cost of retained earning.

Solution

ke = D 1 x 100 + G P0= 4.5 x 100 + 8

90= 5% + 8%= 13%

If the company intends to retain earnings, it should at least earn a return of 13% on retained earnings to keep the current market price unchanged.

• Cost of Debt

Cost of Debt Capital : (post – tax)Owned Funds and Owed Funds are important sources of corporate capital. Owed Funds are nothing but Borrowed Funds. A company may borrowed from different sources like FIs, CBs, other companies and through Public Deposits which are repayable after 36 months.The most important source of BF is by issue of debentures. A debenture is a part of the total amount borrowed by issue of debentures.Debentures may or may not be secured. Generally they are secured. They may be secured against specific asset or may create a general charge on all assets.In India, debentures are of face value of Rs.100.Debentures may be redeemable or irredeemable. In the case of redeemable debentures the company makes a commitment of redeeming the debentures after a specific period of time say, 5 years or 10 years after the date of issue. Debentures may be redeemed at par, at discount or at premium. Similarly, debentures may be issued at par, or at discount or at premium. The discount offered is an expense or loss. Further, there may be other issue expenses like cost of advertising, brokerage, etc.

1) Cost of debt if irredeemable can be calculated as follows:Kd = I (1 – t)

NPWhere,Kd = Cost of debtI = Interest on debt calculated on Face Value t = tax rateNP = Net proceeds. i.e. the net amount collected at issue

NP = FV + Premium on issue – discount on issue – expense on issue

2) Cost of redeemable debt : (post – tax)

Kd = I + FV – NP N

FV + NP2

x ( 1 – t )

Where,Kd = Cost of debtI = Interest on debt calculated on Face ValueFV = Face ValueNP = Net proceedsN = No. of years after which the debt is redeemable t = tax rate

Note : If the problem says ignore tax or ask to calculate pre–tax cost of debt, ignore (1 - t).

Cost of debt is always less than Cost of Equity. Discuss.

Ans: It is borrowed capital with specified rate of interest. It is generally a secured debt. Features:

• On borrowed funds interest is paid.• Secured i.e. first charge on assets.• Interest is paid irrespective of profit or loss.• Borrower saves tax as interest is allowable deduction.• Cost of debt can be accurately estimated because of interest rate. (Which is fixed i.e.

independent of sales)

Equity: It is owners capital. It does not get any guaranteed returns. Features:

• Owners Capital, get voting rights.• Equity to any external person, dilutes control.• Low financial risk from issuer’s perspective.• High risk from investors point of view. (There is no guaranteed return)• Payment of equity dividend is not post-tax.• It does not save tax of the issuers.• Dividend is not taxable in the hands of receiver.• Cost of equity cannot be accurately estimated.• It is based on ‘expectations of shareholders’.

Thus equity is costlier than debt because-

i. Tax: Interest on debt is pretax & dividend on equity is post tax. Debt (interest) saves tax.ii. Estimation of cost: cost of debt is based on interest & tax cost of equity is based on expectations

of shareholder (Non-accurate). Expectations are based on risk-profile.iii. Risk Return matching: Debt is secured, low-risk investment. Low risk→Low return. Equity is

unsecured, high risk investment. High risk→High return.

SECTION III – WEIGHTED AVERAGE COST OF CAPITAL

Once the component costs have been calculated, they are multiplied by weights of the various sources of capital to obtain WACC.The following steps are to be used in computation of the WACC.

i. Calculate the cost of each specific source of fund.ii. Assign weight of specific costs based on its proportion in the capital structure.

iii. Multiply cost of each source by its proportion in the capital structure.iv. Add the weighted component cost to get the firms WACC.

Cost of Debt (Kd) is lower than Cost of Equity (Ke). As the proportion of Debt increases in capital structure Kd increases and also Ke increases as risk increases for equity shareholders.

The firm has to select such a capital structure where the WACC is minimum. WACC is an important tool in determining an optimum capital structure.

ko = ωeke + ωdωd

Where Ko = WACC ExampleCapital Component K W WK

→ Equity Share Capital 11% 10 1.10%→ Retained Earning 10% 25 2.50%→ Preference Shares 9% 15 1.35%→ Debt 6% 50 3.00%

WACC – 7.95%

Trading on EquityIt refers to use of borrowed funds so as to increase the return on equity (ROE). Use of borrowedfunds is also financial leverage. Features of Trading on Equit y .

High Debt – Equity Ratio [High Debt Proportion]. Low WACC. High Degree of Financial leverage (DFC). High ROE.Demerits High Financial Break Even point (BEP). High Financial risk. Low incremental borrowing power.

Points to Re m ember 1) Unless specified otherwise, we assume only two sources of capital: Debt and Equity.

Hence, if debt proportion is x% then equity has to be (100-x)% For e.g:- Debt proportion 25%:. Equity proportion will be 75%

2) Issue of bonus shares does not have any impact on WACC.[If reserves & surplus is not given separately with different cost]



SECTION : VI - COST OF CAPITAL :- PROBLEMS + SOLUTION

(Q.1) Cost of equity 30% Cost of debt 9%Equity is 1/3rd of capital and debt is 2/3rd

Calculate weighted average cost of capitalQ.1 Solution:-

W.A.C.C = 1 x 30% + 2 x 9%3 3

= 10% + 6%= 16%

(Q.2) Cost of equity 40% Cost of debt 16%Equity is 1/4th of capital and debt is 3/4th

Calculate weighted average cost of capitalQ.2 Solution:-

W.A.C.C = 1 x 40% + 3 x 16%4 4

= 10% + 12%= 22%

(Q.3) Cost of equity 36% Cost of debt 18%Equity is 40% of capital and debt is 60% Calculate weighted average cost of capital Q.3 Solution:-

W.A.C.C = (40% x 36%) + (60 x 18%)= 14.4% + 10.8%= 25.2%

(Q.4) Cost of equity 40% Cost of debt 12%Calculate weighted average cost of capital if Debt proportion is (1) 25%, (2) 50%, (3) 75%

Q.4 Solution:- ko = ωeke + ωdkd

= (75% x 40%) + (25% x 12%)= 30% + 3%= 33%

ko = ωeke + ωdkd

= (50% x 40%) + (50% x 12%)= 20% + 6%= 26%

ko = ωeke + ωdkd

= (25% x 40%) + (75% x 12%)= 10% + 9%

= 19%(Q.5) Cost of equity 30%Cost of debt 15% (If debt proportion is less than 60%)Calculate weighted average cost of capital if debt proportion is 20%, 50%, 80% Cost of debt 20% (If debt proportion is more than 60%)

Q.5 Solution:-Ko = WeKe + WdKd

Ωe Ke ωeke ωd kd ωdkd Ko

1.2.3.

80%50%20%

30%30%30%

24%15%6%

20%50%80%

15%15%20%

3%7.5%16%

27%22.5%22%

Q.6 In considering the most desirable capital structure for a company, the following estimates of the cost of debt and equity capital (both after tax) have been made at various levels of financial leverage:

Debt as a percentage oftotal capital employed

Cost of Debt Cost ofequity

0102030405060

5%5%5%

5.5%6%

6.5%7%

12%12%

12.50%13%14%16%20%

Advise the company of the optimal Debt Equity Mix on the basis of the Composite cost of capital. (MU, BMS, May 2006 & C.A. Final May 1978)

Q.6 Solution:-Ko = WeKe + WdKd

Option Ωe Ke Ωeke Ωd kd ωdkd Ko

1.2.3.4.5.6.7.

100%90%80%70%60%50%40%

12%12%12.50%13%14%16%20%

12%10.8%10%9.1%8.4%8%8%

0%10%20%30%40%50%60%

5%5%5%5.5%6%6.5%7%

0%0.5%1%1.65%2.4%3.25%4.2%

12%11.3%11%10.75%10.8%11.25%12.2%

Advise select option 4 since it results into lowest composite cost of capital (Ko)

Q.7 Weighted average cost of capital = 20% Cost of Debt = 12%Equity proportion = 25% Debt proportion = 75% Calculate cost of equity

Q.7 Solution:-ko = ωeke + ωdkd

20% = (25% x ke) + (75% x 12%)20% = 25% x ke + 9%11% = 25% x ke

:. ke = 44%Alternative Formula

ke = k0 + (k0-kd) x debtEquity

Q.8Weighted average cost of capital = 30%Cost of Debt = Rs.20% Debt = Rs.500Equity = Rs.250Calculate ke (1) in current situation

(2) If cost of debt is reduced by 5% (3) If debt : Equity ratio is 3

Q.8 Solution:-ke = k0 + (k0-kd) x debt

Equity= 30% + (30% - 20%) x 500

250= 30% + 10% x 2= 30% + 20%= 50%


= 30% + (30% - 15%) x 500250

= 30% + (15% x 2)= 60%


= 30% + (30% - 20%) x 3= 30% + 10% x 3= 60%

Q.9 M / s. Monica Enterprises believes in Net Operating Income Approach. Its Capital Structure has following parameters:Overall cost of capital 16% Cost of debt 14%Market value of debts Rs. 300 lacs Value of equity Rs. 260 lacs Calculate:a) Cost of equity at current level.b) If cost of debt is reduced by 2% what will be cost of equity, if the overall cost remains

unchanged.c) If bonus shares are issued in the ratio of 1:1 and overall cost gets reduced to 15%d) If debt-equity ratio is adjusted to 1.8 in current situation, then what will be cost of equity?

(MU, BMS, May 2005)

Q.9 Solution:- WACC = 16% Kd = 14%Debt = 300 lacsEquity = 260 lacs(1) :. ke = k0 + (k0-kd) x debt

Equity= 16% + (16% - 14%) x 300

260= 16% + 2% x 1.15

= 16% + 2.3%= 18.3%

(2) kd = 12%ke = k0 + (k0-kd) x debt

Equity= 16% + (16% - 12%) x 1.15= 16% + (14% x 1.15)= 16% + 4.6%= 20.6%

(3) ko = 15%ke = k0 + (k0-kd) x debt

Equity= 15% + (15% - 14%) x 1.15= 15% + (2% x 1.15)= 15% + 2.3%= 17.3%

(4) Debt – Equity Ratio = 1.8 ke = k0 + (k0-kd) x debt

Equity= 16% + (16% - 14%) x 1.8= 16% + (2% x 1.8)= 16% + 3.6%= 19.6%

Q.10Cost of EquityCost of DebtDebtEquity

= 30%= 10%= 300= 100

Calculate Weighted average cost of capital

Q.10 Solution:-ke = k0 + (k0-kd) x debt

Equity30% = k0 + (k0 - 10%) x 330% = 4 k0 - 30%

:. 60% = 4k0

:. k0 = 15% Alternative Way

Rs. ω k ωkEquity 100 25% 30% 7.5%Debt 300 75% 10% 7.5%

400 100% 15%

Q.11 Equity = Rs.440Preference shares = Rs.165Debt = Rs.275Cost of equity = 30%

Pref. = 20% Debt = 10%

Calculate WACC

Q.11 Solution:-Rs. ω k ωk

Equity 440 50% 30% 15%Preference 165 18.75% 20% 3.75%Debt 275 31.25% 10% 3.13%

880 100% 21.88%

:. WACC = 21.88%

Q.12Cost of Equity = 40%Cost of Preference = 20% Cost of Debt = 15% Equity = Rs.525Pref. = 168Debt = 782Calculate WACC


Equity 525 35.59% 40% 14.24% Preference 168 11.39% 20% 2.28% Debt 782 53.02% 15% 7.95%

1475 100% 24.47%

:. WACC = 24.47%

Q.13Equity = 50012% of Preference = 10015% Debt = 900Tax @ 40%, Cost of equity 30%. Calculate WACC.


Equity 500 33.33% 30% 10Preference 100 6.67% 12% 0.80Debt 900 60% 9% 5.4

1500 100% 16.20%

:. WACC = 16.20%

Cost of debtkd = I x (1 – Tax rate %)

= 15% x (1 – 40%)= 15% x (1 – 0.40)= 15% x 0.6= 9%

Cost of Preferencekd = Proposed dividend kp = 15%




EXTRA PRACTISE PROBLEMS

(Q.14)For varying levels of debt-equity mix, the estimates of the cost of debt and equity capital (after tax)are given below:

Debt as % of Total capitalemployed

Cost of debt Cost of equity

0 7.0 15.010 7.0 15.020 7.0 16.030 8.0 17.040 9.0 18.050 10.0 21.060 11.0 24.0

You are required to decide on the optimal debt-equity mix for the company by calculating the composite cost of capital.

ADDITIONAL IMPORTANT NOTES:-

CHAPTER: 6 – CAPITAL STRUCTURE

SOURCES OF FUNDS

CAPITAL STUCTURE (The means of capital by which a firm is financed)Capital Structure is a part of Financial Structure and is the mix of the various types of long term sources of funds i.e. debt / equity. Ex:→ Common Stock i.e. Equity Share Capital→ Preferred Stock i.e. Preference Share Capital→ Retained Earnings – (profit the company makes, but does not give to the shareholders in the form

of dividends)→ Bonds (debt)

The Target Capital StructureCapital Structur e : The combination of debt and equity used to finance a firmTarget Capital Structur e : The ideal mix of debt, preferred stock, and common equity with which the firm plans to finance its investments.

SECTION I → THEORY OF CAPITAL STRUCTURE

1. Net Income (N) Approach 2. Net operating Income (NOI)As per NI Approach we calculate WACC & use it as a benchmark to compare with ROI of Proposed investment. If ROI>WACC, we accept, the proposal.

As per NOI Approach, we estimate ROI of proposed investment. We deduct the cost of Debt (and cost of pref. if any) from ROI to get Ke (ROE). If Ke [ROE]> Expectation of shareholders, we accept, the proposal.

Ke

Cost%KO

Kd

KeCost%

Ko

→ Debt Proportion % Kd

→ Debt Proportion %Equation: ko = weke + wdwd Ke = Ko + (Ko – Kd) x Debt / EquityAssumption s : Cost of debt can be calculated &is constant.→ Cost of Equity (Net income to equity shareholders) is estimable and is calculated.→ Overall cost (WACC) is weighted avg. ofKe & Kd.→ Ke & Kd are independent variables & ko isdependent.

→ Cost of Debt can be calculated & is constant.→ Overall Return (ROI) i.e. PBIT or NetOperating income) is estimable & is constant.→ Ke is residual value after deducting kd fromWACC→ Ko & Kd are independent variables & ke isdependent.

3. Traditional Approach: According to the traditional financial structure theory the cost of capital is not independent of the capital structure of the firm and that there is an optimal capital structure. There are two types of risks:(a) Business risk: Business risks includes factors such as market fluctuations, availability of

material, etc and it will always be there more or less in the same measure.(b) Financial risk: Financial risks keeps on increasing after a certain stage as more and more

debt capital commitments are under taken.

Debt – Equity Ratio

Fig. 6.1 Traditional Approach indicating inter-relationship between Cost of Capital and Capital Structure

This theory states that there exists a correlation between the weighted average Cost of Capital and the Debt – Equity Ratio. The relation between the two when presented graphically takes the form of an U – shaped curve. Cost of Capital will be very high if the Debt – Equity ratio is zero. When debt is injected into the capital structure step – by – step the weighted average cost of capital will progressively come down only upto the lowest (optimum) point and then the cost of capital will go up with the further introduction of debt; since the debenture holders have to be offered a higher rate of interest, to compensate higher risk.

4. Modigliani – Miller Approach: The franco Modigliani and Merton H. Miller (M.M.) Approach on cost of capital states that there is no correlation between cost of capital and debt – equity ratio. This approach states that the average cost of capital of any firm is independent of its capital structure and equal to the capitalisation rate of pure equity stream of its class. The value of the firm and cost of capital is the same for all the firms irrespective of the proportion of debt included in a firms capital structure.

•

Ko

Fig. 6.2 – Modigliani – Miller Approach to Cost of Capital and Capital Structure

Assumptions:-i. Perfect Capital Market.ii. Rational Investors. & Managersiii. Homogeneous Expectations.iv. Equivalent Risk Classes.v. Absence of Taxes.“The value of a firm is equal to its expected operating income divided by the discount rate appropriate to its risk class. It is independent of its capital structure.”In symbols

V = D + E = O/rWhere V is the market value of the firm, D is the market value of debt, E is the market value ofequity, O is the expected operating income, and r is the discount rate applicable to the risk class which the firm belongs. Hence the value of the firm will be Independent of its Capital Structure, as per MM theory.



SECTION II :- PROBLEMS + SOLUTION

Q.1 Your friend approaches you with a proposal to setup a manufacturing unit having gestation period of 50 to 55 months and fund requirement of around Rs.15 crores. Explain to him the various sources to raise the fund for the project.

Q.1 Solution: Observations:a) Individual Promoter.b) Manufacturing unit, good asset base.c) Funds requirement Rs.150 million (Rs. 15 Crores)d) Gestation period 50-55 months (4-5yrs) Possible Sources of Capital - Equity, Debt.

→ Equity: It is owners capital with claim on profits after paying external liabilities.

Merits (to issuing firm)-• No legal obligation to pay dividend.• No charge on assets.• Improves borrowing capacity.• Improves Debt:- Equity ratio (Comfortable to lenders)

Demerits-• Voting Rights.• Dilution of control• Tax not saved on dividend paid.

Ways to Raise Equity.a) Promoters: Promoters should invest to the extent possible, as it does not dilute control. Limited

fund availability with the promoters, however, should not hamper growth.b) Private Placements: Equity can be placed with business associates, friends & other such

network. Advantage is control is diluted, but to known people. Also they not bring only money, but also bring business contacts / community. This improves business. Disadvantage is they really use voting rights & dilution of control is real. Nominee on board is common.

c) Public Issue: IPO offer can fetch virtually unlimited money. Advantage is that, public is not interested in control. They do not vote. Practically no dilution of control. Disadvantage is people are passive, they bring only funds & no other value addition. Also public issue is time consuming& costly.

d) Venture Capital: It is a risk capital invested at very early stage of business. It is suitable for technology / new upcoming areas of ventures.

e) Retained Earnings: Re-investment of profits is always good. It is low cost & less time consuming. It does not dilute control of the existing shareholders / Promoters.

→ Debt: It is borrowed capital.

Merits- → Fixed Interest.→ Saves Tax.→ Offers Leverage Benefits.→ No Loss of controlling stake / voting power.

Demerits- → Charge on assets.→ Interest to be paid irrespective of profits / loss.

Ways to raise Debt:i. Term Loan : From Banks (negotiated.)

ii. Debentures : By public issue.

Factors Determining Capital Structure in given Case:

a) Business Track Record: Appears to be a new business, so external funds will have limitation.b) Nature of Business: Manufacturing Unit- doesn’t seem to be a high technology unit. Not

Suitable for venture capital. Offers good asset – backup & good for borrowing.

c) Quantum of Investment: Rs. 15 Crore - Small size. Not suitable for public issue.

Suggested Capital Structure.Manufacturing Unit.

Rs.15 Crore

Equity (7.5 Crore) Debt (7.5 Crore)

••

Promoters (To extent possible)

Private Placements (Balance, friends & relatives)

. Term Loan from bank with factory assets as security

Q.2 X Ltd. a widely held company is considering a major expansion of its production facilities and the following alternatives are available: (Rs. in crores)

AlternativeParticulars A B CShare capitals (Rs.10) 50 20 1014% debentures - 20 15Loan from financial institution@ 18 p.a. Rate of Interest

- 10 25

Expected rate of return before tax is 25%. The company at present has low debt. Corporate taxation50%.

Which of alternatives you would choose?

Q.2 Solution

Evaluation of financing Alternative

Particulars A B CEBIT(-) Interest(20 x 14%) + (10 x 18) = 4.6 (15 x 14%) + (25 x 18) = 6.6EBT(-) Tax @ 50% EAT(-) Preference dividend

12.5-

12.54.6

12.56.6

12.56.25

7.93.95

5.92.95

6.25-

3.95-

2.95-

Earnings for ESH (a)No of Equity Shares (b)

6.255

3.952

2.951

:. EPS (a ÷ b) (Rs.) 1.25 1.98 2.95

Recommendation:- On the basis of EPS it is advised to select Alternative C.

Q.3 One-up Ltd. has equity share capital of Rs. 500000 divided into shares of Rs. 100 each. It wishes to raise further Rs. 300000 for expansion-cum-modernization scheme. The company plans the following financing alternatives:

→ By issuing equity shares only.→ Rs.100000 by issuing equity shares and Rs. 200000 through debentures or term loan @ 10% per

annum.→ By raising term loan only at 10%per annum.→ Rs.100000 by issuing equity shares and Rs. 200000 by issuing 8% preference shares.→ You are required to suggest the best alternative giving your comment assuming that the

estimated earning before interest and taxes (EBIT) after expansion is Rs.150000 and corporate of tax is 35%.

Q.3) Solution

Evaluation of Financing Alternatives.

ParticularsAlternatives

1 2 3 4EBIT(-) Interest

EBT / PBT(-) Tax @ 35%EAT / PAT / NPAT(-) Preference dividendEarnings for ESH a). . .

No of equity shares → Existing→ New b). . . .

EPS (a/b)

150000-

15000020000

(10% x 2L)

15000030000

(10% x 3L)

150000-

15000052500

13000045500

12000042000

15000052500

97500-

84500-

78000-

9750016000

97500 84500 78000 81500

50003000

50001000

5000-

50001000

8000 6000 5000 6000Rs.12.19 Rs.14.08 Rs.15.60 Rs.13.58

Recommendation:-The company is advised to select alternative 3 i.e. 10% term loan since it results into highest EPS i.e.Rs.15.60

Q.4 The existing capital structure of ABC Ltd. is as follows:

Rs.Equity shares of Rs.100 each 4000000Retained Earnings 10000009% Preference shares 25000007% Debentures 2500000

Company earns a return of 12% and the tax on income is 50%.

Company wants to raise Rs. 2500000 for its expansion project for which it is considering following alternatives:→ Issue of 20000 Equity shares at a premium of Rs. 25 per share.→ Issue of 10% Preference shares.→ Issue of 9% Debentures.→ Projected that the Price Earning ratios in the case of Equity, Preference and Debentures financing

Rs. 20, 17 and 16 respectively.Which alternative would you consider to be the best? Give reason for your choice.

(MU, BMS, May 2008)

Q.4) SolutionEvaluation of Financing Alternatives.

ParticularsAlternatives

1 2 3EBIT(-) Interest - Existing

- NewEBT / PBT(-) Tax @ 50%EAT / PAT / NPAT(-) Preference dividend → Existing

→ New Equity Earnings a). . . . No of equity shares Existing New

b). . . . EPS (a/b)MPS = PE x EPS

1500000(175000)

-

1500000(175000)

-

1500000(175000) (225000)

1325000662500

1325000662500

1100000550000

662500(225000)

-

662500(225000) (250000)

550000(225000)

-437500 187500 3250004000020000

40000-

40000-

60000 40000 400007.29 4.69 8.13

Rs.145.8(29 x 7.29)

Rs.79.73(17 x 4.69)

Rs.130.08(16 x 8.13)

ROI = PBIT x 100Capital employed

:. PBIT = Cap. Emp. x ROI100

= 12500000 x 12 100

= Rs.1500000

Recommendation: - Select Alternative 1 i.e. Issue of 20000 Equity shares, sinceIt results into highest MPS.




PRACTISE PROBLEMS

Q.8 The following financial information pertains to VX Ltd. as at 31st March, 2010.Balance Sheet (Rs. In lacs)

Fixed Assets (at cost less depreciation)Net Current AssetsTotal AssetsLess: Long term debtNet Assets Represented by: Equity capital Retained earnings

2006026021545

40545

Profit and Loss Account (Rs. In lacs)Net Profit before interest and taxInterest paidTax paidDividends declared

52201218

The company has identified a profitable investment opportunity and requires funds to the tune ofRs.20 lacs for fixed assets purchase and Rs.5 lacs for working capital.

You are required to state the sources of funds that are available to company and also discuss the problem to choose debt to fund the new project.

ADDITIONAL IMPORTANT NOTES:-

CHAPTER: 7 – LEVERAGE

LEVERAG E :-Leverage refers to amplified benefit on comparatively lower level of investment or lower sales. Suchenhancement of profit is usually seen because of fixed costs. These could be operating fixed cost or financial fixed cost. As sales volume increases fixed cost do not increase. Hence, it results in higher level of profit.Fixed cost however also leads to higher level of break even-point. Higher break-even point is a risk. Thus highly leveraged firms feature high risk and high return. Leverages are also refered in the context of optimal utilization such as asset leverage and working capital leverage.

SECTION I → TYPES OF LEVERAGE

1. Operating Leverage:-Operating leverage refers to enhancement of profits because of fixed operating expenses. As salesincrease fixed cost do not increase which results in proportionately higher profits. Degree of operating leverage calculated as

DOL = Contribution = % change in PBITPBIT % change in Sales

Higher fixed expenses indicate higher operating break-even point and hence higher business risk.Fixed operating expenses are determined by nature of business and industry. For instance, heavy engineering units would have higher level of fixed overheads whereas service industry would have lower overheads. Thus DOL is dictated by these factors and managers have little liberty to adjust it at their will.

2. Financial Leverage:-Financial leverage refers to higher level of profit because of higher fixed financial expenses. Theseinclude interest on loan & debentures as well as preference dividend. Degree of financial leverage is calculated as:-PBIT = % Change in PBT PBT = % Change in PBITHigher financial leverage indicates higher financial break-even point & higher financial risk. Capital structure to some extent is determined by nature of business and industry. However, finance managers have greater flexibility in choice of capital structure. They can decide quantum of borrowed capital and preference shares. Aggressive policies will lead to higher borrowings, higher DFL, which will result in high risk & high return profile.Conservative policies would lead to lower level of borrowings, and therefore low risk low return profile.It may be argued that capital intensive units are more likely to have higher debt to equity proportion and hence higher financial leverage. (e.g. Power Sector Units).

3. Combined Leverage.Combined leverage refers to higher profits because of fixed costs. These include fixed operatingexpenses as well as fixed financial expenses. Degree of combined leverage is calculated as:

DCL = Contribution = % change in PBIT PBIT % change in Sales

Alternate FormulaDCL = DOL x DFL.

DCL is a complete indicator of leverage benefits & leverage risks. DCL also indicates overall break- even point. While operating fixed costs are determined by nature of business & industry. Financial fixed costs can be adjusted by appropriate choice of capital structure. Aggressive firms choose higher level of DCL whereas conservative go for lower level of DCL.

→ Distinguish between Operating Leverage and Financial Leverage

The differences between the two leverages are as follows:

Operating Leverage Financial Leverage1. Objective The objective is to magnify the

effect of changes in sales on operating profit.

The objective is to magnifythe effect of changes in operating profits on earning per share.

2. Relationship It establishes relationshipbetween operating profit and sales.

It establishes relationshipbetween operating profit and return on equity

3. Measurement It measures a firm ability to usefixed cost assets to magnify the operating profits.

It measures a firm ability touse fixed cost funds to magnify the return to equity shareholders.

4. Relationship It relates to the assets side ofthe Balance sheet.

It relates to the liability sideof the Balance sheet.

5. Effect on income It affects the profit beforeinterest and tax

It affects the profit afterinterest and tax

6. Risk It involves operating risk ofbeing unable to cover fixed operating cost.

It involves financial risk ofbeing unable to cover fixed financial cost.

7. Decision It is concerned with investmentdecision

It is concern with financialdecision

8. Stage It is described as first stageleverage.

It is described as second stageleverage.

9. Formula DOL = ContributionPBIT

DFL = PBITPBIT



SECTION II:- LEVERAGE:- PROBLEMS + SOLUTI O N Problem: 1Jigna Ltd. sells 1,00,000 units of product. Selling price is Rs.10 per unit and variable cost is Rs. 3, ifthe fixed cost for the year amounts to Rs. 4,00,000, find out the effect on profit, if the company sells1,10,000 units and 80,000 units.

Q.1 SolutionParticulars Amt (Rs.) Amt (Rs.) Amt (Rs.)

Units 100000 110000 80000Sales(-) Variable costContribution(-) Fixed cost

1000000300000

1100000330000

800000240000

700000400000

770000400000

560000400000

Profit 300000 370000 160000Comment :-The companies profit when the sales is 110000 units is Rs. 370000 and when the sales are 80000 units, the profit is Rs.160000 i.e. 10% Increase in sales Increase profit by 23.33% and 20% decrease in sales, reduces profit by 46.67%

Problem: 2Ambika Ltd. sells 2,000 units per annum. The selling price per unit is Rs. 300 and the variable costper unit is Rs. 70. The fixed operating cost is Rs. 60,000.

Calculate operating leverage.

Q.2 SolutionParticulars Amt (Rs.)

Sales (2000 x 300)(-) Variable cost (70 x 2000) Contribution(-) Fixed CostPBIT

60000014000046000060000

400000

Operating Leverage = ContributionPBIT

= 460000400000

= 1.15

Problem: 3Y Ltd. sells its product at Rs. 20 per unit. Variable cost per unit is Rs. 15. Find out the degree of operating leverage for sale of 3,000 units, and 3,500 units. What do you understand from the degreeof operating leverage of these sales volumes? Fixed cost is Rs. 10,000.Q.3 Solution

Particulars Amt (Rs.) Amt (Rs.)Units 3000 3500Sales(-) Variable costContribution(-) Fixed cost

6000045000

7000052500

1500010000

1750010000

PBIT 5000 7500Operating Leverage = Contribution(3000 units) PBIT

= 150005000

= 3

Operating Leverage = Contribution(3500 units) PBIT

= 175007500

= 2.3

Higher units / sales, results into lower operating / business risk and vice versa.Problem: 4Compute financial leverage from the following information:

Rs.Interest 10,000Sales (1,000 units) 1,00,000Variable Cost 50,000Fixed Cost 30,000

Q.4 SolutionParticulars Amt (Rs.)

Sales(-) Variable costContribution(-) Fixed costPBIT(-) Interest

1000005000050000300002000010000

PBIT 10000

Financial Leverage = PBIT PBT

= 2000010000

= 2

Problem: 5

Shruti Ltd. has the following structure:

Rs.Equity share capital 5,00,00010% preference share capital 5,00,0008% debentures 5,50,000

The present EBIT is Rs. 2,50,000, tax rate is 50%. Calculate financial leverage.

Q.5 SolutionRs.

EBIT (Earning Before Interest Tax) 250000- Interest (550000 x 8%) 44000PBT 206000 (-) Tax @ 50% 103000PAT 103000

Financial Leverage = PBIT PBT

= 250000206000

= 1.21

Problem: 6Y Ltd. has sales of Rs. 2,00,000. Variable cost is 50% of sales while the fixed operating costamounts to Rs. 60,000. Interest on long-term loan amounted to Rs. 20,000.You are requested to calculate the composite leverage and analyze the impact if sales increase by10%.

Q.6 Solution

Particulars Rs. Sales ↑ 10%Sales(-) Variable cost

200000100000

220000110000

Contribution(-) Fixed cost

10000060000

11000060000

PBIT(-) Interest

4000020000

5000020000

PBT 20000 30000

Composite Leverage = Contribution(at present) PBT

= 10000020000

= 5Composite Leverage = Contribution(at 10% ↑) PBT

= 11000030000

= 3.67Analysis

Increase in Sales reduces the combined risk and vice versa.

Problem: 7The following information is available in respect of two firms, P Ltd. and Q Ltd.

P Ltd. Rs. Q Ltd. Rs.Sales 500 1,000-variable cost 200 300Contribution 300 700-Fixed cost 150 400EBIT 150 300-Interest 50 100Profit before tax 100 200

You are required to calculate different leverages for both the firms and also comment on their relative risk position.

Q.7 Solution

Particulars P Ltd. Q Ltd.1) Operating Leverage ratio

= ContributionPBIT

300150

= 2

700300

= 2.32) Financial Leverage ratio

= PBIT PBT

150100

= 1.5

300200

= 1.53) Combined Leverage ratio

= Operating Leverage ratio x FinancialLeverage ratio

2 x 1.5= 3

2.3 x 1.5= 3.45

Comment:-1) Operating leverage :- Q Ltd. has comparatively higher operating risk.2) Financial Leverage :- The financial risk of both companies is same.3) Combined Leverage :- The combine risk is higher for Q Ltd.

Problem: 8A simplified Income Statement of Zenith Ltd. is given below. Calculate its degree of operatingleverage, degree of financial leverage and degree of combined leverage.

Sales ?Variable cost 2,00,000Fixed cost 75,000EBIT 2,08,000Interest 1,10,000Taxes (30%) 29,400Net Income 68,600

Q.8 SolutionRevenue statement for year-----

Particulars Rs.Sales *(-) Variable cost

483000200000

Contribution(-) Fixed cost

28300075000

PBIT(-) Interest

208000110000

PBT(-) Tax (30%)

9800029400

PAT 68600

Operating Leverage Ratio = ContributionPBIT

= 283000208000

= 1.36Financial Leverage Ratio = PBIT

PBT= 208000

98000= 2.12

Combined Leverage Ratio = ContributionPBT

= 28300098000

= 2.9




PRACTISE PROBLEMS

Q.9 Case Study: Observe the following dataIncome Statement

Sales 50 L 50 LPBIT 5 L 5 L- Interest 0.4 L 1.6 LPBT 4.6 L 3.4 L- Tax 2.3 L 1.7 LPAT 2.3 L 1.7 L

Sources of FundsEquity 16 L 4 LDebt 4 L 16 L

Company A has more profit than company B. So, Company A is better. Do you agree? Discuss

Q.18 Interest Rs.1200/- DFL 3, DOL 2, PV Ratio 1/3, Interest Rate @ 10%, Debt: Equity is 2 : 1 Tax @ 50%(A) Prepare Income Statement(B) Calculate RoI(C) Is financial leverage favorable? (D) Calculate Asset Leverage(E) If Industry Asset leverage is 1.1, is this firm efficient?

CHAPTER: 8 – CAPITAL BUDGETING

SECTION I:- INTRODUCTION TO CAPITAL BUDGETING

Capital budgeting is the process of generating, evaluating, selecting, implementing and following- up on capital expenditure projects. The term Capital budgeting is used interchangeably with capital expenditure decision, capital expenditure management & long-term investment decision.The methods employed to evaluate the worth of capital expenditure proposals are known as capital budgeting techniques. The popular methods are:-1. Average rate of return2. Pay back period3. Net present value4. Internal rate of return5. Profitability index

The following are the basic features of capital budgeting:-• Potentially large anticipated benefits• A relatively high degree of risk• A relatively long time period between the initial outlay & the anticipated return

Discuss the phases of Capital BudgetingCapital budgeting is a complex process which may be dividend into following phases:1. Identification of potential investment opportunities2. Assembling of proposed investments3. Decision making4. Preparation of capital budgeting and appropriations5. Implementation6. Performance review

1. Identification of potential investment opportunitiesThe capital budgeting process begins with the identification of potential investment opportunities.Typically the planning body develops the estimates of future sales, which serves as the basis for setting production target. This information in turn is helpful in identifying required investments in plant and equipment etc.

For imaginative identification of investment ideas it is helpful toi) Monitor external environment regularly to scout investment opportunities,ii) Formulate a well defined corporate strategy based on a through analysis of strengths,

weaknesses, opportunities and threats,iii) Share corporate strategy and perspective with person who are involved in the process of capital

budgeting and,iv) Motivate employees to make suggestions.

e.g. Ratan Tata → Nano, Bill gates → Computer Software, Warren Buffet → Insurance etc.

2. Assembling of investment proposals

Investment proposal identified by the production department and other department is usually submitted in a standardized capital investment proposal firm. Generally, most of the proposals before they reach the capital budgeting committee are routed through several persons. The objective of routing a proposal through several persons is primarily to ensure that the proposal is viewed from different angles. It also helps in creating a climate for bringing about co-ordination of interrelated activities.

Investment proposals are usually classified into various categories for a facilitating decision –making, budgeting and control.

3. Decision – makingThe management does Project appraisal and arrives at a decision regarding selection of project.Project appraisal is done regarding financial feasibility, technical feasibility, economic feasibility, managerial competence and market appraisal. Capital budgeting techniques are used while undertaking financial viability study of the project.

4. Preparation of capital budget and appropriationProject involving smaller outlays and which executives at lower levels can decide are often coveredby a blanket appropriation for expeditious action. Project involving larger outlays are included in capital budget after necessary approvals. Before undertaking such project appropriation order is usually required. The purpose of this check is mainly to ensure that the funds position of the firm is satisfactory at the time of implementation. Further it provides an opportunity to review the project at the time of implementation. In this step project cost is decided, funds are raised and financial closure of the project is achieved.

5. ImplementationTranslating an investment proposal into a concrete project is a complex, time consuming and risk –fraught task. Delays in implementation, which are common, can lead to substantial cost – overruns. For expeditious implementation at reasonable cost, the following are helpful.

• Adequate formulation of project: The major reason for delay is inadequate formulation of projects. Put differently, necessary homework in terms of preliminary studies and comprehensive and detail formulation of the projects is not done. Many surprises and shocks are likely to spring on the way. Hence the need for adequate formulation of the project cannot be overemphasized.

E.g. Posco Ltd. and Arcelor Mittal Ltd. projects in India is facing implementation problem due to above reasons.

• Use of the principle of responsibilities accountin g : Assigning specific responsibility to project managers for a completing a project within a definite time frame and cost limit is helpful for expeditious execution and cost control.

• Use of network technique s : For project planning and control several network techniques like PERT (Program Evaluation Review Technique) and CPM (Critical Path Method) are available. With the help of these techniques monitoring becomes easier.

E.g. Dhirubhai Ambani (RIL) was known for faster implementation of project. Also Tata Motors‘Nano Plant’ at Sanand started in record time of 1 year on 2nd June ’10.

6. Performance Review

Performance review, post completion audit, is a feedback device. It is a measure for comparing actual performance with project performance. It may be conducted, most appropriately, when the operations of the project have established. It is useful in several ways:

a) It throws the light on how realistic were the assumptions underlying the project.b) It provides a documented log of experience that is highly valuable for decision making;c) It helps in uncovering judgmental biases;d) It includes a desired caution among project sponsors. (Reward for appropriate

implementation to project manager and vice versa)

Rationale of Capital Expenditure decision s :

The rationale underlying the capital budgeting decision is efficiency. Thus, the firm must replace worn and obsolete plants and machinery, acquire fixed asset for current and new products and make strategic investment decisions. This will enable the firm to achieve its objective of maximizing profits either by way of increased revenues or by cost reductions. The quality of these decisions is improved by capital budgeting. Capital budgeting decisions can be of two types: (i) those which expand revenue (ii) those which reduce costs.(i) Investment Decisions Affecting Revenue:

Such investment decisions are expected to bring in additional revenue, thereby raising the size ofthe firm’s total revenue. They can be the result of either expansion of present operations or the development of a new product line. Both types of investment decisions involve acquisition of new fixed assets. Both types of investment decisions are income expansionary in nature.(e.g. Tata steel acquisition of Corus, RIL setting Oil and Gas exploration in K.G. basin etc.)

(ii) Investment Decisions Reducing Costs:Such decisions by reducing costs, add to the total earnings of the firm. The classic example of suchinvestment decisions is the replacement proposals. When an asset wears out or becomes outdated, the firm must decide whether to continue with the existing asset or replace it. The firm evaluates the benefit from the new machine in term of lower operating cost and the outlay that would be needed to replace the machine. An expenditure on a new machine may be quite justifiable in the light of the total cost savings that result.

Kinds of Capital Budgeting Decision s :

Capital budgeting refers to the total process of generating, evaluating, selecting, implementing and following up on capital expenditure alternatives. The firm allocates or budgets financial resources to new investment proposals. Basically the firm may be confronted with three types of capital decisions: (i) the accept – reject decision; (ii) the capital rationing decision; and (iii)the mutually exclusive project accepted.(i) The Accept-Reject Decision

This is a fundamental decision in capital budgeting. If the project is accepted, the firm invests in it;if the proposal is rejected, the firm does not invest in it. In general, all those proposals, which yield a rate of return greater than a certain required rate of return or cost of capital is accepted and the rest, are rejected. Under the accept-reject decision, all the independent projects that satisfy the minimum investment criterion should be implemented.

(ii) Capital Rationing Decision:In a situation where the firm has unlimited funds, capital budgeting becomes a very simple processin that all independent investment proposals yielding return greater than some predetermined level are accepted. However, this is not the situation prevailing in most of the business firms in the real world. They have a fix capital budget or limitation of availability of funds at a given point of time.

A large number of investment proposals compete for these limited funds. The firm must, therefore, ration them. The firm allocates funds to projects in a manner that it maximizes long-run returns. Thus, capital rationing refers to the situation in which the firm has more acceptable investments, requiring a greater amount of finance than is available with the firm. Ranking of the investment projects is employed in capital rationing. Projects can be ranked on the basis of some predetermined criterion such as the rate of return. The project with the highest return is ranked first and the project with the lowest acceptable return last. The projects are ranked in the descending order of the rate of return. It may be noted that only acceptable projects should be ranked and higher Ranked projects till funds are available should be selected for implementation.

(iii)Mutually Excusive Project DecisionsMutually exclusive projects are projects, which compete with other projects in such a way that theacceptance of one will exclude the acceptance of the other projects. The alternatives are mutually exclusive and only one may be chosen. Suppose a company is intending to buy a new folding machine. There are three competing brands, each with different initial investment and operating cost. The three machines represent mutually exclusive alternatives, as only one of the three machines can be selected. Mutually excusive investment decisions acquire significance when more than one proposal is acceptable. Then some techniques have to be used to determine the “best” one. The acceptance of this “best” alternative automatically eliminates the other alternatives.



SECTION II - PROBLEMS + SOLUTIONS

Q.1 A machine is available for purchase at a cost of Rs. 80000. It is expected to have a life of 5 yrs& scrap value of Rs. 10000 at the end of 5yr period. It is estimated to generate a profit in its life as follows:

Year Amount1 200002 400003 300004 150005 25000

These estimates are of profits before the calculation of straight line depreciation. Ignore tax. Provide for depreciation and calculate Accounting Rate of Return.

Q.1 Solution -Depreciation = Cost – Scrap

Life= 80,000 – 10,000

5= Rs.70,000

5= Rs.14,000

Year PBDT (-) De p n =1. 20,000 14,0002. 40,000 14,0003. 30,000 14,0004. 15,000 14,0005. 25,000 14,000

PBT/PAT6,00026,00016,0001,00011,000

TOTAL NPAT 60,000Avg. NPAT = 60,000

5= Rs.12,000

ARR based on O.Inv = Avg. NPAT x 100O.Inv

= 12,000 x 10080,000

= 15%ARR based on ‘Avg. Invst.’ = Avg. NPAT x 100

Avg. Invst.= 12,000 x 100

45,000= 26.67%

Avg. Invst = O.C – Scrap + Scrap + Net W.Cap2

= 80,000 – 10,000 + 10,000 + 02

= 35,000 + 10,000 + 0= Rs.45,000

Q.2 The CFO of Infotech India Ltd. is considering the purchase of a new machine to replace an old machine which has been in operation for the last 5 years. The details relating to available alternative machines are as follows:

Old Machine (Rs.) New Machine (Rs.)Purchase Price 200000 300000Power per year 10000 22500Consumable Stores Per Year 30000 37500Other Changes Per Year 40000 45000Wages Per Running Hour 15 26.25Selling Price Per Unit 6.25 6.25Material Cost Per Unit 2.50 2.50Estimated Life of Machine 10 yrs. 10 yrs.Machine Running Hrs. Per Year 2000 hrs. 2000 hrs.Units Of Output Per Hour 24 units 36 unitsTax at 40% of Net Profit

Assuming that the above sales and cost of sales hold good for the entire economic life of the machines, suggest which of the two alternatives should be preferred; using ARR. Depreciation has to be charged according to Straight Line Method.

Q.2 SolutionInfotech India Ltd.

Evaluation of AlternativesParticulars Old Machine New MachineNo. of Units 48000

(2000 x 24)72000(2000 x 36)

:. Sales @ 6.25 (a)… 300000 450000(-) Variable CostPower Consumable Other Charges Wages

Material @ 2.50

10000300004000030000(2000 x 15)120000

22500375004500052500(2000 x 26.25)180000

(b)… 230000 337500NPBDT (a – b)…(-) Depreciation

7000020000(200000 ÷ 10)

11250030000(300000 ÷ 10)

NPBT(-) Tax @ 40%

5000020000

8250033000

NPAT= Avg. NPAT

30000 49500

:. ARR based on O.Inv.= Avg. NPAT x 100

O. Inv.

ARR based on Avg. Inv= Avg. NPAT x 100

Avg. Inv.

= 30000 x 100200000

= 15%

= 30000 x 100100000

= 30%

= 49500 x 100300000

= 16.5%

= 49500 x 100150000

= 33%RecommendationBased on ARR, the company should prefer new machine since it results into higher ARR.

Q.3 Calculate the average rate of return with the following data:

Year0

Rs.1

Rs.2

Rs.3

Rs.Investment 90000 - - -Sales Revenue - 120000 100000 80000Operating Cost - 60000 50000 40000

Q.3 Solution 1 2 3

Sales 1,20,000 1,00,000 80,000(-) Oper. Cost 60,000 50,000 40,000PBT = NPAT 60,000 50,000 40,000

:. Avg. NPAT = 1,50,000 = Rs.50,0003

ARR based on O.Inv = Avg. NPAT x 100O.Inv.

= 50,000 x 100

= 2,00,000 – 5000 + 5000 + 0

==

97,500 + 5,0001,02,500

Avg. NPAT = 13,000(+) Depn = 19,500

90,000= 55.56%

ARR based on ‘Avg. Invst.’ = Avg. NPAT x 100Avg. Invst.

= 50,000 x 10045,000

= 111.11%Avg. Invst = O.C – Scrap + Scrap + Net W.Cap

2= 90,000 – 0 + 0 + 0

2= Rs.45,000

Q.4 Sengupta Company Ltd. wishes to buy a machine costing Rs. 2,00,000. The life of this machine is 10 years and its scrap value would be Rs. 5000.The following details are provided:

Average Annual NPBT Rs.20,000Tax Rate 35% Depreciation (already charged) SLM basis

1.Payback period2.Payback profitability3.ARR (Accounting Rate of Return Method)

Q.4 SolutionDepn = Cost – Scrap

Life= 2,00,000 – 5,000

10= Rs.19,500

Avg. PBT 20,000 (-) Tax @ 35% 7,000:. Avg. NPAT 13,0003) ARR based on O.Inv = Avg. NPAT x 100

O.Inv= 13,000 x 100

2,00,000= 6.5%

ARR based on ‘Avg. Invst.’ = Avg. NPAT x 100Avg. Invst.

= 13,000 x 1001,02,500

= 12.68%Avg. Invst = O.C – Scrap + Scrap + Net W.Cap

2

2

Annual CIF = 32,500

1) Payback Period = Initial OutlayAnnual CIF

= 2,00,000= 32,500= 6.15 Years.

2) Payback profitability = Annual CIF x (Life – PBP)= 32,500 x (10 – 6.15…)= Rs.1,25,000

Annual CIF x Life= 32,500 x 10 = 3,25,000 (-) Cash outflow = 2,00,000PB Profitability = 1,25,000

For cross check

Note: Scrap is ignored in calculation of PB profitability.

Q.5 Beta Gama Ltd. is producing articles mostly on hand labor and is considering replacing it by a new machine. There are two alternative models P and Q of the new machine. Prepare a statement of profitability showing the pay-back period from the following information:

Machine P Machine QEstimated life of machine 4 years 5 years

Rs. Rs.Cost of machine 9000 18000Estimated savings in scrap 500 800Estimated savings in direct wages 6000 8000Additional cost of Maintenance 800 1000Additional cost of Supervision 1200 1800

Q.5 Solution

Particulars Machine P Machine QEst. Savings in ScrapEst. Savings in direct wages

(A) - Addn cost of maintenance Addn cost of Supervision

(B) - NSBDT = CIF

5006000

8008000

6500 8800800

120010001800

2000 28004500 6000

Payback Period = Initial Outlay Annual Cash inflow

Machine P = 9000 = 2 years4500

Machine Q = 18000 = 3 years6000

Q.6 Shantanu Company Ltd. is proposing to expand its production. It can go in for an automatic machine costing Rs.50,000 or an ordinary machine costing Rs.50,000(Model 1) . The life of both these machines is 5 years. The annual sales and costs are as below:

AutomaticRs.

Ordinary(Model 1) Rs.

Sales 50000 50000Materials 15000 15000Labor 7000 6000Variable Overheads 7000 6000

Calculate payback period and payback profitability (MU, BMS, Oct. 1996)

Q.6 SolutionAutomatic Ordinary

Sales 50,000 50,000 (-) V.C 29,000 27,000Contribution 21,000 23,000 (-) F.C - - PAT 21,000 23,000

Payback PeriodInitial Outlay = 50,000 = 50,000Annual CIF 21,000 23,000

= 2.38yrs = 2.17yrs

Payback profitability = Annual CIF x (Life – PBP) Automatic = 50,000 x (5 – 2.38)

= Rs.55,000Ordinary = 50,000 x (5 – 2.17)

= Rs.65,000

Q.7 From the following details of Brebone Ltd. Calculate payback period and payback profitability.Rs.

Sales 8000Variable Cost 3000Fixed Cost 2000 (excluding depreciation) Investment 10000Life 10 years. Tax @ 50%

Q.7 SolutionRs.

Sales 8,000 (-) V.C 3,000Contribution 5,000 (-) F.C 2,000PBDT 3000 (-) depr 1000PBT 2000 (-) Tax @ 50% 1000PAT 1000 (+) depr 1000Annual CIF 2000Depn = O.C – Scrap

Life

= 10,000 – 010

= Rs.1,000

Payback Period = Initial OutlayAnnual CIF

= 10,0002,000

= 5 Yrs

Payback Profitability= Annual CIF x (Life – PBP)= 2,000 x (10 – 5)= 2,000 x 5= Rs.10,000

Q.8 M & M Ltd. is considering the purchase of a new machine for the immediate expansion program. There are 3 types of machines in the market for this purpose as follows:

ParticularsMachine A

Rs.Machine B

Rs.Machine C

Rs.Cost of machine 17500 12500 9000Estimate savings in scrap per year 400 750 250Estimate savings in direct wages per year 2750 6000 2250Additional Cost of Indirect Materials per year - 400 -Expected savings in Indirect Materials per annum 100 - 250Additional cost of maintenance per year 750 550 500Additional cost of supervision - 800 -Estimated Life of machine (Yrs) 10 6 5Taxation at 40% profit

You are required to advise the management which type of machine should be purchase on the basis of Payback Period.

Q.8 SolutionParticulars Machine A Machine B Machine C

Est. savings in scrapEst. savings in direct wagesEst. savings in indirect material

4002,750

100

7506000

-

2502250250

(A) Addn cost of indirect material Addn cost of maintenance Addn cost of supervision

3250 6750 2750-

750-

400550800

-500

-

(B)NSBDT (A – B) (-) Depn

PBT(-) TaxPAT(+) DepnAnnual Cash inflow

750 1750 50025001750

50002083

22501800

750300

29171167

450180

4501750

17502083

2701800

2200 3833 2070Payback Period = Initial Outlay

Annual cash inflowMachine A = 17,500 = 7.95 Years

2200

Machine B = 12500 = 3.26 Years3833

Machine C = 9000 = 4.35 Years2070

Recommendatio n :-On the basis of the payback period it is advisable to select machine – B as it has the lowest payback period.

Q.9 Calculate Payback period from the following information of Rama Newsprint Ltd. Investment Rs. 1 lakhEstimated life 10 yearsTax Rate 50%

YearProfit BeforeDepreciation

Rs.

DepreciationRs.

Profit AfterDepreciation

Rs.Tax @ 50%

1 40000 10000 30000 150002 60000 10000 50000 250003 50000 10000 40000 200004 50000 10000 40000 20000

Q.9 SolutionYear PAT + Depn = CIF CCIF

1 15,000 10,000 25,000 25,0002 25,000 10,000 35,000 60,0003 20,000 10,000 30,000 90,0004 20,000 10,000 30,000 1,20,000

Payback Period = 3yrs + 10,000 x 1230,000

= 3yrs 4 MonthsQ.10 Your Company is considering the question of investment in a project for which the following data are available:

Capital Outlay Rs. 2,20,000Depreciation Charges 20% p.a. (Straight Line Method)

Forecast of annual income before charging depreciation, but after all other charges:

YearProfit Before

Depreciation Rs.1 1000002 1000003 800004 800005 40000

From the above data, the management want you to calculate the following:a) Pay Back Periodb) Rate of Return On Original Investmentc) Rate of Return On Average Investment

Ignore Taxation

Q.10 SolutionDepn = 2,20,000 x 20% = Rs.44,000Year PBDT = CIF - De p n = PAT CCIF

1 1,00,000 44,000 56,000 1,00,000

2 1,00,000 44,000 56,000 2,00,0003 80,000 44,000 36,000 2,80,0004 80,000 44,000 36,000 3,60,0005 40,000 44,000 (4000) 4,00,000

4,00,000 NPAT 1,80,000a) Payback Period = 2 Yrs + 20,000 x 12

80,000= 2 Yrs 3 months

:. Avg. NPAT = 36,000b) ARR based on O.Inv. = Avg. NPAT x 100

O.Inv.= 36,000 x 100

2,20,000= 16.36%

c) ARR based on ‘Avg. Invst.’ = Avg. NPAT x 100Avg. Invst.

= 36,000 x 1001,10,000

= 32.73% Avg. Invst = O.C – Scrap + Scrap + Net W.Cap

2= 2,20,000 – 0 + 0 + 0

2= Rs.1,10,000

Q.11 The existing manufacturing units have yearly fixed overheads of Rs.1,00,000. It wishes to expand the production by purchasing one of the two types of machinery Model A and Model B each costing Rs.5,00,000 and having an estimated life of 5 years. The estimated annual sales and costs under both of these models are given as under:

Model ARs.

Model BRs.

Sales 2000000 2450000Materials 920000 1112200Labour 412450 567800Variable Overheads 380900 495670

Compute the comparative profitability of each model of machinery under the payback period and also calculate Payback profitability. Ignore Depreciation and taxation. (MU, BMS, April 2004)

Q.11 SolutionModel (A) Model (B)

Sales 20,00,000 24,50,000 (-) V.C 17,13,350 21,75,670Contn. 2,86,650 2,74,330 (-) F.C - - PBDT = CIF 2,86,650 2,74,330

Payback period= Initial Outlay = 5,00,000 = 5,00,000

Annual CIF 2,86,650 2,74,330= 1.74yrs = 1.82 yrs

Payback profitability = Annual CIF X (LIFE – PBP) A = 2,86,650 X (5 – 1.74)

= 9,33,250B = 2,74,330 x (5 – 1.82)

= 8,71,650

Q.12 A company can make either of two investments at period to assuming a required rate of return of 10%, determine for each project:

1.The Payback period2.The discounted payback period3.The profitability index

You may assume straight line depreciation.

P QCost of investment (Rs.) 200000 280000Expected life (no salvage) 5 years 5 yearsProjected net income(after depreciation, interest and taxes)Year12345

Rs.1000010000200002000020000

Rs.2400024000240002400024000.

(Q.12) SolutionProject P Cash outflow = Rs.200000Yr. PAT De p n CIF CCIF PV@10% PVCIF CPVCIF1 10,000 40,000 50,000 50,000 0.909 45,000 454502 10,000 40,000 50,000 1,00,000 0.826 41,300 867503 20,000 40,000 60,000 1,60,000 0.751 45,060 1318104 20,000 40,000 60,000 2,20,000 0.683 40,980 1727905 20,000 40,000 60,000 2,80,000 0.621 37,260 210050

2,10,050Depn = Cost – Scrap value

Life= 2,00,000 – 0

5= Rs.40,000

1) Payback period = 3yrs + 40,000 x 1260,000

= 3yrs and 8 months2) Discounted PB period = 4 yrs + 27210 x 12

37260= 4yrs and 8.76 months

3) Profitability Index = PVCIF PVCOF

mailto:PV@10%25

= 210050200000

= 1.05Project Q Cash outflow = Rs.280000Yr. PAT + De p n = CIF PV@10% PVCIF CCIF 1 24,000 56,000 80,000 0.900 72,720 72,7202 24,000 56,000 80,000 0.826 66,080 1,38,8003 24,000 56,000 80,000 0.751 60,080 1,98,8804 24,000 56,000 80,000 0.683 54,640 2,53,5205 24,000 56,000 80,000 0.621 49,680 3,03,200

3,03,2001) Payback period = Initial Outlay

Annual CIF= 2,80,000 = 3.5yrs (3yrs 6months)

80,0002) Discounted payback period (P)

= 4yrs + 26,480 x 1249,680

= 4yrs 6.40 months3) Profitability Index = PVCIF

PVCOF= 303200

280000= 1.08

Q.13 A company whose cost of capital is 12% is considering 2 projects A and B. The following data is available:

Project ARs.

Project BRs.

Investment 140000 140000Cash Flows:

Year12345

200004000060000

100000110000

10000080000400002000020000

330000 260000

Select the most suitable project by using the following methods:a) Pay Back Period b) Net Present Value c) Profitability IndexThe present values of Rs.1 at 12% are:

Year 1 0.9Year 2 0.8Year 3 0.7Year 4 0.6Year 5 0.55

mailto:PV@10%25

Q.13) Solution:-COF Rs.140000 COF Rs.140000

Project A Project BYear PV @ 12% CIF CCIF PVCIF CIF CCIF PVCIF

12345

0.90.80.70.6

0.55

200004000060000

100000110000

2000060000

120000220000330000

1800032000420006000060500

10000080000400002000020000

100000180000220000240000260000

9000064000280001200011000

PVCIF 212500 205000a) Payback Period

Project A = 3 years + 20000 x 12100000

= 3 years 2.4 months.

Project B = 1 year + 40000 x 1280000

= 1 year 6 months. Recommendation : Select Project B since Lower PBP.

b) Net present value = PVCIF – PVCOF Project A = 212500 – 140000

= Rs.72500

Project B = 205000 – 140000= Rs.65000

Recommendation : Select Project A since Higher NPV

c) Profitability index = PVCIF PVCOF

Project A = 212500140000

= 1.52

Project B = 205000140000

= 1.46Recommendation : Select Project A since Higher PI

Conclusio n :- A conservative company should opt for project B [Lower Risk (PBP) and Lower Return] whereas an aggressive company should opt for project A [Higher Risk (PBP) and Higher Returns]

Q.14 Your Company can make either of the following two investments at the beginning of 2010. The particulars available in this respect are:

Project I Project IIEstimated cost (to be incurred initially) Rs.Estimated life in yearsScrap value at the end of estimated lifeEstimated Net Cash Flows (Rs) End of 2010

200004

Nil

5500

280005

Nil

5600

End of 2011 7000 9000End of 2012 8500 9000End of 2013 7500 9000End of 2014 - 9000

It estimated that each of the alternative projects will require an additional working capital of Rs.2000 which will be received back in full after the expiry of each project life. In estimating net cash flow, depreciation has been provided under SLM.

Cost of finance to your company may be taken at 10% p.a. The present value of Rs. 1 to be received at the end of each year, at 10% is given below:

Year 1 2 3 4 5P.V. 0.91 0.83 0.75 0.68 0.62

Evaluate the investment proposals using NPV and profitability Index methods.

(Q.14) Solution Project I :Yr. CIF PV@10% PVCIF1 5,500 0.91 50052 7,000 0.83 58103 8,500 0.75 63754 7,500 0.68 51005 2000 0.68 1360

23,650PVCOF (-) 22,000NPV 1,650

P.I = PVCIF PVCOF

= 23,650 = 1.07522,000

Project IIYr. CIF PV@10% PVCIF1 5,600 0.91 50962 9,000 0.83 74703 9,000 0.75 67504 9,000 0.68 61205 9,000 0.62 55806 2,000 0.62 1240

32256PVCOF (-) 30000

NPV 2256P.I = PVCIF = 32,256 = 1.0752

PVCOF 30,000

Evaluation: As per NPV select Project II since higher NPV As per PI select Project II since higher PI.

Selection:- Hence project II is recommended.

Q.15 A company has an investment opportunity costing Rs. 40,000 with the following expected net cash flow (i.e. after taxes and before depreciation)

Year Net Cash InflowsRs.

1 7000

mailto:PV@10%25

mailto:PV@10%25

2) Payback profitability = Cash inflow – C= 82,000 – 40,000= Rs.42,000

2 70003 70004 70005 70006 80007 100008 150009 1000010 4000

Using 10% as the cost of capital (rate of discount) determine the following:1.Payback period and payback profitability2.NPV at 10% discounting factor and 15% discounting factor3.Profitability index at 10% discounting factor and 15% discounting factor4.Internal rate of return with the help of 10% discounting factor and 15% discounting factor.

Q.15 SolutionYear Cash inflow CCIF PV @ 10% PVCIF1 7000 7000 0.909 63632 7000 14000 0.826 57823 7000 21000 0.751 52574 7000 28000 0.683 47815 7000 35000 0.621 43476 8000 43000 0.564 45127 10000 53000 0.513 51308 15000 68000 0.467 70059 10000 78000 0.424 4240

10 4000 82000 0.386 1544 PVCIF 48961

1) Payback Period = 5yrs + 5000 x 128000

= 5yrs and 7.5months

ash outflow

2) PV CIF = 48961- PV COF = (40,000)

NPV @ 10% 8961

Year Cash inflow PV@15% PVCIF1 7000 0.870 60902 7000 0.756 52923 7000 0.658 46064 7000 0.572 40045 7000 0.497 34796 8000 0.432 34567 10000 0.376 37608 15000 0.327 49059 10000 0.284 284010 4000 0.247 988

mailto:PV@15%25

Year Depreciation Profit before tax Profit after tax123

786454

104118260

8292186

2) PV CIF 39420(-) PV COF (40000)

NPV @ 15% - 580

3) Profitability index = PVCIF PVCOF

@ 10% → = 4896140000

= 1.22@ 15% → = 39420

40000= 0.99

4) IRR = D1 + PVCIF (H) – PVCOF x (D2 – D1) PVCIF (H) – PVCIF (L)

= 10% + 48,961 – 40,000 x (15% - 10%)48,961 – 39,420

= 10% + 8961 x 5%9541

= 10% + 4.69%= 14.69%

Q.16 Runwal group has short listed two projects Karma and Dharma for final consideration. It wants to take up only one project of the two and not both. The investment required for project Karma is Rs.190 lakhs while that for project Dharma is Rs. 400 lakhs. The other details related to project Karma and Dharma are given below:

Project KarmaYear Depreciation Profit before tax Profit after tax

123

242016

7882100

566074

Project Dharma

The cost of capital of company is 10% and the PV of Re. 1 at the end of 1st, 2nd and 3rd year @14% rate is 0.8772, 0.7695 and 0.6750 respectively using NPV method, which project would you recommend.What will be your answer under Payback period method?

(Q.16) SolutionProject KarmaYear PAT CIF CCIF PV@14% PVCIF1 56 80 80 0.8772 70.1762 60 80 160 0.7695 61.563 74 90 250 0.6750 60.75

192.486Payback period = 2yrs + 30 x 12

mailto:PV@14%25

mailto:@14%25

Project Dharma

90= 2yrs 4 months

Year PAT Depn CIF CCIF PV@14% PVCIF1 82 78 160 160 0.8772 140.3522 92 64 156 316 0.7695 120.0423 186 54 240 556 0.6750 162

422.394Payback Period = 2yrs + 84 x 12

240= 2yrs 4.2 months

Recommendatio n :On the basis of payback period, it is advisable to select karma as it has lower pay back period. (i.e.2yrs 4 months)

Project KarmaP.V CIF 192.486(-)P.V COF 190.000NPV 2.486

Project DharmaP.V CIF 422.394(-) P.V COF 400.000NPV 22.394

Recommendatio n :On the basis of NPV method it is advisable to select Dharma as it has higher NPV (i.e. 22.394)

Q.17 A product is currently being manufactured on a machine that has book value of Rs. 30000. The machine was originally purchased for Rs. 60000 ten years ago. The per unit costs of the product are: Direct Labor Rs.8; Direct Materials Rs.10; Variable OHS Rs.5; Fixed OHS Rs.5; and total is Rs.28. In the past year 6000 units were produced and sold for Rs. 50 per unit. It is expected that the old machine can be used indefinitely for the future.

An equipment manufacturer has offered to accept the old machine at Rs. 20000, a trade in for a new version. The purchase price of the new machine is Rs 100000. The projected per unit costs associated with the new machine are: Direct Labor Rs.4; Direct Materials Rs.7; Variable OHS Rs.4; Fixed OHS Rs.7; and total is Rs.22. The management expects that if the new machine is purchased, the new working capital requirement of the company would be less by Rs. 10000. The fixed OH costs are allocations from other departments plus depreciation of the equipment.

The new machine has an expected life of 10 years with no salvage value; straight line method of depreciation is employed by the company. It is also expected that the future demand of the product will remain at 6000 units per year. Should the new equipment be acquired?

Corporate tax is 40%. (PV of Annuity is Re.1 at 10% rate of discount for 9 years is 5.759. PV ofRe.1 at 10% rate of discount, received at end of tenth year is 0.386) (MU, BMS, Oct. 2002)

(Q.17) Solution.

mailto:PV@14%25

Evaluation of proposalOld MachineO.C 60,000Total depn *30,000B.V / WDV 30,000

Depn p.a. = 30,000 = 3,00010

New machineDepn = 1,00,000 = 10,000

10

Revenue statement for the yea r ………Particulars OldMac. New Mac. Sales (6,000 x 50) 3,00,000 3,00,000(-) Variable cost 1,38,000 90,000Contribution 1,62,000 2,10,000(-) F.C - - . PBDT 1,62,000 2,10,000(-) Depn 3,000 10,000PBT 1,59,000 2,00,000 (-) Tax @ 40% 63,600 80,000PAT 95,400 1,20,000 (+) Depn 3,000 10,000CIF 98,400 1,30,000

Not e :- Fixed OHs is ignored to the extent of allocation from other department.

:. Additional cash inflow = 1,30,000 – 98,400

Calculation of cash outflow

= Rs.31,600

Particular Rs.

Purchase priceLess: Exchange price

Release of working capitalSavings in tax on loss of sale of old machine (10000 x 40%)

COF

1,00,000 (20,000) (10,000) (4,000)66,000

Calculation of NPVYr. C.I.F PV@10% PVCIF1 – 10 31,600 6.145 1,94,182

(-) PVCOF 66,000 :. NPV 1,28,182

Recommendatio n :-The company is advised to purchase new machine since NPV is positive.

Q.18 Vijay Electronics wants to take up a new project for the manufacture of electronic device which has good market. Further details are given below:

i) Cost of the project as estimated:(Rs. In Lacs)

Land 2.00Buildings 3.00Machinery 10.00Working Capital Margin 5.00

ii) Project will go into production immediately and will be operational for 5 years. iii) The annual working results are estimated as follows:

(Rs. In Lacs) Sales 21.00(-) Variable Cost 8.00

mailto:PV@10%25

(Q.18) SolutionsParticularsSales 21(-) V.C 8 Contribution 13(-) F.C 4PBDT 9(-) Dep

n 2PBT 7(-) Tax 2.8PAT 4.2Dep

n 2Cash inflow 6.2

Fixed Cost (Excluding Depreciation) 4.00Depreciation of assets 2.00iv) At the end of Operational period, it is expected the fixed assets can be sold for Rs.5 lakhs

(without any profit).v) Cost of capital of the firm is 10%. Applicable tax rate is 40%.

Note: 1. The present value of an annuity of Re.1 at 10% rate of discount for 5 years is Rs.3.791.2. The present value of Re.1 at 10% rate of discount for year 1 is Re.0.909 and for year 5 is

Re.0.61.a) You are required to evaluate the proposal by working out the NPV and advice the firm

for taking investment decisionb) List down 5 factors that should be considered before taking the decision.

Yr. CIF PV@10% PVCIF1.5 6.2 3.791 23.50425 5 0.61 3.055 5 0.61 3.05

PVCIF 29.6042 (-)PVCOF 20.0000NPV → 9.6042

AdviceSince NPV is positive company is advised to take investment of the new projec t .

(b) Factors which should be considered before taking decisions. (1) Financial feasibility(2) Technical feasibility (3) Economic feasibility (4) Market appraisal(5) Management competence




PRACTISE PROBLEM S :-

(Q.19) One of three projects of a company is doing poorly and is being considered for replacement. The projects (A, B and C) are expected to require Rs 2,00,000 each, have an estimated life of 5 years, 4 years and 3 years respectively and have no salvage value. The required rate of return is 10 per cent. The anticipated cash flows after taxes (CFAT) for the three projects are as follows:

mailto:PV@10%25

CFATYEAR A B C

1 Rs 50,000 Rs 80,000 Rs 1,00,0002 Rs 50,000 Rs 80,000 Rs 1,00,0003 Rs 50,000 Rs 80,000 Rs 10,0004 Rs 50,000 Rs 30,000 ──5 Rs 90,000 ── ──

A) Rank each project applying the methods of pay back, average rate of return, net present value, internal rate of return and profitability index.

B) Explain why the five capital budgeting systems yield conflicting answers.C) What would be the profitability index if the internal rate of return equals the required return on

investment? What is the significance of a profitability index of less than one?D) Recommend the project to be adopted and give reasons.

(Q.20) Aman Limited is a leading manufacturer of automotive components. It supplies to the original equipment manufacturers as well as the replacement market. Its projects typically have a short life as it introduces new models periodically.

You have recently joined Aman Limited as a financial analyst reporting to Ravi Sharma, the CFO of the company. He has provided you the following information about three projects, A, B, and C, that are being considered by the Executive Committee of Sona Limited:• Project A is an extension of an existing line. Its cash flow will decrease over time.• Project B involves a new product. Building its market will take some time and hence its cash

flow will increase over time.• Project C is concerned with sponsoring a pavilion at a Trade Fair. It will entail a cost initially

which will be followed by a huge benefit for one year. However, in the year following that a substantial cost will be incurred to raze the pavilior.

The expected net cash flows of the three projects are as follows:

Year Project A Project B Project C0 (15,000) (15,000) (15,000)1 11,000 3,500 42,0002 7,000 8,000 (4,000)3 4,800 13,000 ──

Ravi Sharma believes that all three projects have risk characteristics similar to the average risk of the firm and hence the firm’s cost of capital, viz. 12 percent, will apply to them.

You are asked to evaluate the projects.(a) What is payback period and discounted payback period? Find the payback periods and the discounted payback periods of Projects A and B.(b) What is the net present value (NPV)? What are the properties of NPV? Calculate the NPVs of projects A, B and C.(c) What is internal rate of return (IR)? What are the problems with IRR? Calculate the IRRs of projects A, B and C.

Q.21 A choice is to be made between two competing projects which require an equal investment ofRs. 50,000 and are expected to generate net cash flows as under:

Project I Project IIEnd of year 1 Rs.25,000 Rs. 10,000

Calculate:Pay Back Period.Average Ratio of Return.

End of year 2End of year 3End of year 4End of year 5End of year 6Tax Rate

Rs. 15,000Rs. 10,000Rs. NIL Rs. 12,000Rs. 6,00050%

Rs. 12,000Rs. 18,000Rs. 25,000Rs. 8,000Rs.4,00040%

Pay Back Profitability. (MU, B.Com., April 2007)

CHAPTER: 9 – SOURCES OF SHORT TERM & LONG TERM FINANCE

Finance is the lifeblood of an organization can exist without it. Finance is required because receipts don’t match expenditure, inflows don’t match outflows. Sources of finance are categorized in 3 ways:1. According to the period i.e. short, medium and long term2. According to the ownership i.e. owners fund and borrowed funds3. According to the generation i.e. internal and external sources

SECTION : I - SHORT TERM SOURCES OF FINANC E :-

Short terms of finance are required primarily to meet working capital requirements. The focus is on maintaining liquidity at a reasonable cost. The various sources of short term finance are:1. Trade Credi t :- This is the credit extended by suppliers of material and other resources.

2. Cash Credits / Overdrafts :- Under this arrangement the borrower can borrow upto a fixed limit and repay it as and when he desires. Interest is charged only running balance and not on the sanctioned amount. A minimal charge is payable for availing this facility.

3. Loans repayable in one yea r :- They are either credited to the current of the borrower or given to him in cash. A fixed rate of interest is charged and the loan amount is repayable on demand or in periodical installments.

4. Purchase / Discount of Bill s :- A bill may be discounted with the bank and when it matures on a future date the bank collects the amount from the party who had excepted the bill. When a bank is short of funds it can sell or rediscount the bill on the other hand the bank with surplus funds would invest in bill. However, with discount rate at 10-11 percent for 90-day paper, bill discounting is an expensive sources of short-term funds.

5. Letter of Credi t :- A letter of credit is an instrument issued by a bank on behalf of an importer, whereby the bank agrees to honour the draft drawn on the importer provided certain conditions are satisfied. Through the letter of credit arrangement, the credit of the importer is substituted by the credit of the bank. Hence, it virtually eliminates the risk of the exporter when he sells to an unknown importer in a foreign country. When an L/C is opened by the bank in favour of the customer it takes the responsibility of honoring the obligation in case the customer fails to do so. In this case even though the customer provides the credit the risk is born by the bank.

6. Inter-Corporate Deposits :- A deposit made by one company with another, normally for a period of up to 6 months is referred to as an inter-corporate deposit. Such deposit are usually of 3 types:

a) Call Deposits:- In theory, a call deposit is withdrawable by the lender on giving a days notice.In practice however the lender has to wait for at least three days.

b) Three Month Deposit s :- More popular in practice, these deposits are taken by borrowers to tide over a short term cash inadequacy that may be caused due to one or more of the following factors: disruption in production, excessive imports of raw material, tax payment delay in collection, dividend payment, and unplanned capital expenditure.

c) Six Month Deposits :- Normally, lending companies do not extend deposits beyond this time frame. Such deposits are usually made with first-class borrowers.

As inter-corporate deposits represent unsecured borrowing, the lending company must satisfy itself about the credit worthiness of the borrowing firm.

Characteristics of the Inter-Corporate Deposit Market:a) Lack of Regulatio n :- The lack of legal hassles and bureaucratic red tape makes an inter-

corporate deposit transaction very convenient.b) Secrec y :- Brokers are discreet about their lists of borrowers and lenders.c) Importance of Personal Contact s :- Lending decisions in the inter-corporate deposit markets

are based on personal contacts and market information which may sometime lack reliability.

7. Short-Term Loan From Financial Institution :- The Life Insurance Corporation of India, The General Insurance Corporation of India. and The Unit Trust of India provide short-term loans to manufacturing companies with an excellent track record

. Features:a. They are totally unsecured.b. The loan is given for the period of 1 year and can be renewed for 2 consecutive years,

provided the original eligibility criteria are satisfied.c. After a loan is repaid, the company has to wait for at least 6 months before availing of a

fresh loan.d. The loans carry a higher interest rate. However, there is a rebate of 1 % for prompt

payment.

8. Commercial Pape r :- Large firms who are financially strong issue commercial paper. It represents a short-term unsecured promissory note issued by firms of high credit rating.Its important features include:1. Maturity ranges from 90-180 days.2. It is sold at a discount from its face value and redeemed at its face value. Thus the implicit

interest rate is a function of size of the discount and the period of maturity.3. CP are either directly placed with investors or sold though dealers / merchant bankers.

Usually bought by investors who keep it till the maturity and hence there is no well developed secondary market.

Who can issue C P ?Highly rated listed companies, primary dealers and All-India financial institutions have beenpermitted to raise short-term resources.

Eligibility of Issuing CPMinimum tangible net worth as per latest audited balance sheet is Rs.5 crore.Company has been sanctioned working capital limit by bank(s) or All-India financial institution(s) andThe company is classified as a Standard Asset by the financing bank(s) institution(s)

Minimum Credit Rating required from recognised credit rating agencies

Maturity period of CPThe CP can be issued for maturities between 15 days to 1 year from the date of its issue.

Minimum amount of investment and denomination of CPThe minimum amount required to be invested by a single investor is atleast Rs.5 lakhs. It isissued in denominations of Rs.5 lakh or multiples thereof.

9. Factorin g :- Factoring is a financial transaction whereby a business sells its accounts receivables at discount to a factor. The three parties directly are: the seller, debtor, and the factor. The seller is owed money (usually for worked performed or goods sold) by the second party, the debtor. The seller than sells the debtor’s accounts at a discount to the third party, the factor. The debtor than directly pays the factor the full value of invoice.

Factoring differs from a bank loan in three main ways. First, the emphasis is on the value of the receivables, not the firm’s credit worthiness. Secondly, factoring is not a loan- it is the purchased of an asset (the receivable). Finally, a bank loan involves two parties whereas factoring involves three.

Features of Factoring Arrangemen t :a) The factor selects the account of the client that would be bought by it.b) The factor assumes responsibility for collecting the debt of accounts handled by it.c) The factor advance money to the client against not-yet-collected and not-yet-due debts. Typically

the amount advanced is 70-80% of the face value of the debt and carries and interest rate, which may be equal to or marginally higher than the lending rate of commercial banks.

d) Factoring may be on a recourse basis or non-recourse basis (full credit risk). (Presently, in India it is done only on a recourse basis)

Forfaiting is similar to factoring. It is the purchasing of an exporter’s receivables (the amount importers owe the exporter) at a discount by paying cash. The forfaiter, the purchaser of the receivables), becomes the entity to whom the importer is obliged to pay its debt. By purchasing these receivables- which are usually guaranteed by the importer’s bank- the forfaiter frees the exporter from credit and from the risk of not receiving payment from the importer who purchased the goods on credit.

SECTION : II - SOURCES OF LONG-TERM FINANCE

9.1 IntroductionAs you are aware finance is the life blood of business. It is of vital significance for modern businesswhich requires huge capital. Funds required for a business may be classified as long term and short term. You have learnt about short term finance in the previous Part Finance is required for a long period also. It is required for purchasing fixed assets like land and building, machinery etc. Even a portion of working capital, which is required to meet day to day expenses, is of a permanent nature. To finance it we require long term capital. The amount of long term capital depends upon the scale of business and nature of business. In this lesson, you will learn about various sources of long term finance and the advantages and disadvantages of each source.

9.2 Long Term Finance – Its meaning and purposeA business requires funds to purchase fixed assets like land and building, plant and machinery,furniture etc. These assets may be regarded as the foundation of a business. The capital required for these assets is called fixed capital. A part of the working capital is also of a permanent nature. Funds required for this part of the working capital and for fixed capital is called long term finance.

Purpose of long term finance:Long term finance is required for the following purposes:

1. To Finance fixed assets:Business requires fixed assets like machines, Building, furniture etc. Finance required to buy theseassets is for a long period, because such assets can be used for a long period and are not for resale.

2. To finance the permanent part of working capital:Business is a continuing activity. It must have a certain amount of working capital which would beneeded again and again. This part of working capital is of a fixed or permanent nature. This requirement is also met from long term funds.

3. To finance growth and expansion of business:Expansion of business requires investment of a huge amount of capital permanently or for a longperiod.

FACTORS DETERMINING LONG – TERM FINANCIAL REQUIREMENTS:The amount required to meet the long term capital needs of a company depend upon many factors.These are:(a) Nature of Business:The nature and character of a business determines the amount of fixed capital. A manufacturingcompany requires land, building, machines etc. So it has to invest a large amount of capital for a long period. But a trading concern dealing in, say, washing machines will require a smaller amount of long term fund because it does not have to buy building or machines.(b) Nature of goods produced:If a business is engaged in manufacturing small and simple articles it will require a smaller amountof fixed capital as compared to one manufacturing heavy machines or heavy consumer items like cars, refrigerators etc. which will require more fixed capital.(c) Technology used:In heavy industries like steel / cement the fixed capital investment is larger than in the case of abusiness producing plastic jars using simple technology or producing goods using labour intensive technique or service sector companies.

Lease Financin g :1) Lease: A contract of lease may be defined as “A contract whereby the owner of an asset (lessor)grants to the another party (lessee) the exclusive right to use the asset usually for an agreed period of time in return for the payment of rent.”

Important features here are:a) Owner and User are different

b) Depreciation claim is not with the user (lessee) as he is not the owner. Lessor (owner) claim the depreciation.

c) Lease (rent) payment is a tax-deductible expense.d) In most transactions, asset is delivered directly to the lessee by the manufacturer / supplier.

Lessor makes payment to the supplier and receives rent from lessee in future periods.e) Lease funded assets do not alter Debt Equity ratio.

2) Types of Leases:

Distinction between: Operating Lease and Finance Lease:1. Operating Lease 2. Finance Lease1) In an operating lease all the risks andrewards incidental to ownership are not transferred by the lessee to the lessor.

1) In a finance lease the lessor transfers to allthe risks and rewards incidental to the ownership of the asset to the lessee.

2) Operating lease is cancelable by either partyduring the lease period.

2) Finance lease is non- cancellable and itinvolves payment of lease rentals over an obligatory non-cancellable lease period.

3) In an operating lease the lessor does notrelay on only a single lessee for recovery of his investment since the lease period are shorter such as even an hour, a day, a week, or a month and so on. The lessor is ultimately interested in the residual value of the asset.

3) In a finance lease the lessor is only a financer and usually not interested in the asset.

4) An operating lease is termed as a ‘ServiceLease’

4) Finance lease is also termed as ‘full-payoutleases.’

5) In an operating lease the cost of asset is notfully amortised during the primary lease (non- cancellable) period.

5) The finance lease enable the lessor torecover his investment in the asset lease plus to derive a profit.

6) Operating lease being shorter than theexpected economic life of the asset no such option of purchase of the asset by the lesseeexists there.

6) In a finance lease the lessee has the option topurchase the asset at a price on a date the option becomes exercisable or at the end of thelease agreement period.

7) An operating lease is generally for a periodshorter than the economic life of the leased asset.

7) In a finance lease the lease term is for themajor part of the economic life of the asset.

8) In an operating lease the lessor other thanfinancing the cost of leased asset, also provides such as repairs, maintenance and technical advice.

8) In a finance lease the lessee is responsiblefor the repairs and maintenance, insurance and risk of obsolescence of the asset leased.

9) In an operating lease the lessor bears the riskof obsolescence of the asset leased.

9) In a finance lease the lessee has to bear therisk of obsolescence of the asset leased.

10) Examples: Aircrafts, Buildings, Heavymachinery, railway, Buses etc.

10) Examples: Hiring a cap, chartering of Aircrafts, Hiring of cranes etc.

3) Leveraged Leas e :- Under leveraged leses there are three parties. The lessor, the lessee and the financial institution / Bank who lends a major cost of the asset leased. The lessor contributes 20% to 50% of the cost and the lender contributes 50% to 80% of the cost of the asset. The periodic lease rental is being appropriately divided between the lender and the lessor.

4) Sale and Lease Bac k :- In case of sale and lease back as the name suggest, the firm sells an asset that it already owns to another firm / party and (hires) gets it on lease back from the buyer which is usually a financial institution or a leasing company.

5) Direct Leas e :- In case of direct lease the lessee acquires the equipment directly from the manufacturer or arrange the desired equipment to be purchased by the leasing company.

6) Cross Border Lease / International Lease :- A cross border lease is also known as an international lease or a trans-national lease. In this case lessee and the lessor are domiciled in different countries. It is an agreement between the nationals of two countries.

7) Triple Net Leas e :- In case of triple net lease is obligated to pay the following typical executory costs in addition to and separate from the basic lease rental payments. Such additional executory costs are:-(i) Sales Tax(ii) Property Tax(iii) Repairs(iv) Parts and Accessories(v) Insurance(vi) Maintenance and Servicing

8) Master Leas e :- Master leases are structure for lessees who either will be leasing several pieces of equipment to be received over a period of time or leasing equipment that will require frequent substitution.

10) Hire Purchas e :- In case of hire purchase transaction, the goods are delivered by the owner to another person on the agreement that such person pays the agreed amount in the periodical installment.

Important features here are:(a) Ownership of the asset is transferred to the buyer only on payment of last installment.(b) Buyer claims depreciation on the asset.

Lease Hire Purchase• Lessor claims depreciation • Buyer claim depreciation• On completion of contract residual

(salvage) value goes to Lessor.• On completion of contract residual

(salvage) value goes to Buyer.• In absence of specific agreement

otherwise, asset is to be returned to the lessor after the lease period.

• Asset is conclusively purchased by the buyer at the end of the agreement period.

• Lease payment is fully deductible for tax.

• Only interest portion of EMI/ Hire value is tax deductible.

11. Venture CapitalVenture capital is money provided by professionals who invest alongside management in young,rapidly growing companies that have a potential to develop into significant economic contributors. Venture capital is an important sources of equity for start-up companies.

Venture capitalists generally:• Finance new and rapidly growing companies.• Purchase equity securities• Assist in the development of new product or services• Add value to the company through active participation• Take higher risk with the expectation of higher rewards• Have a long term orientation

When considering an investment, venture capitalists carefully screen the technical and business merits of the proposed company. Venture capitalists only invest in a small percentage of the businesses they review and have a long-term perspective. They also actively work with the company’s management, especially with contact and strategy formulation. Companies such as Digital Equipment Corporation, Apple, Federal Express, Compaq, Sun Microsystems, Intel, Microsoft and Genentech are famous examples of companies that received venture capital early in their development period.

In India, these funds are governed by the Securities and Exchanged Board of India (SEBI) guidelines. According to this, venture capital fund means a fund established in the form of the company or trust, which raises monies through loans, donations, and issue of securities or units as the case may be, and makes or proposes to make investments in accordance with these regulations.

The basic principal underlying venture capital-invest in high –risk projects with the anticipation of high returns. These funds are then invested in several fledging enterprises, which require funding, but unable to access it through the conventional sources such as bank and financial institutions. Typically first generation entrepreneurs start such enterprises. Such enterprises generally do not have any major collateral to offer as security, hence banks and financial institution are averse to funding them. Venture capital funding may be by way of investment in the equity of the new enterprises or a combination of debt and equity, though equity is the most preferred route.

Since most of the venture finance is through this route are in new areas (worldwide venture capital follows “hot industries” like infotech, electronic and biotechnology), the probability of success in very low. All project financed have a potentially high return. Some projects fail and some give moderate returns. The investment, however, is a long- term risk capital as such projects normally take 3 to 7 years to generate substantial returns. Venture capitalists give “more than money” to the venture and seek to add value to the investee unit by active participation in its management. They monitor and evaluate project on a continuous basis.

To conclude, a venture financier is one who funds a start up company, in most cases promoted by a first generation technocrat promoter with equity. A venture capitalist is not a lender, but an equity partner. He is driven by maximization: wealth maximization. Venture capitalists are sources of expertise for the companies they finance. Exit is preferably through listing on stock exchanges. This method has been extremely successful in USA, and venture funds have been credited with the success of technology companies in Silicon valley.




Q.1) Concept Testing.(a) Any 3 Short Term Source of Finance.(b) Any 3 Long Term Source of Finance.(c) Any 2 modern Long Term Source of Finance. (d) Inter corporate deposit.(e) Merits and Demerits of Equity Share Capital. (f) Types of Debentures.(g) ADR.(h) Venture Capital.

Q.2) Differentiate Equity Shares and Preference Share Capital.

Q.3) What is Securitisation? Explain motives / Advantages of Securitisation.




CHAPTER: 10 – BUSINESS RESTRUCTURING

SECTION I :- IMPORTANCE

Business restructuring refers to a broad array of activities that expand or contract a firm’s operations or substantially modify its financial structure or bring about a significant change in its organizational structure and internal functioning. Inter alia, it includes activities such as mergers, purchases of business units, takeovers, slump sales, demergers, leveraged buyouts, and organizational restructuring. We will refer to these activities collectively as mergers, acquisitions, and restructuring (a widely used, though not a very accurate term) or just business restructuring. Sacrificing some rigour, these activities may be classified as shown in Exhibit

On the Indian scene, too, corporates are seriously looking at mergers, acquisitions, and restructuring which have indeed become the orders of the day. Most of the business groups and their companies seem to be engaged in some kind of business restructuring or the other. From the house of Tata’s to the house of AV Birla, from an engineering giant like Larsen & Toubro to a banking behemoth like State Bank of India, everyone seems to be singing the anthem of business restructuring. The pace and intensity of business restructuring has increased since the beginning of the liberalization era, thanks to greater competitive pressures and a more permissive environment.

SECTION II :- BUSINESS RESTRUCTURING Business restructuring occurs in myriad ways. Sacrificing some rigour, important restructuringtransactions may be classified as shown in Exhibit. They are described below.

Types of Business Restructuring ActivitiesCorporate restricting occurs in myriad ways. Sacrificing some rigour, important restrictingtransactions may be classified as shown in Exhibit. They are described below:

Exhibit 10.1 Types of Business Restructuring Activities

Acquisitions: Acquisition, a broad term, inter alia, subsumes the following transaction:Merge r : A merger refers to a combination of two or more companies into one company. It may involve absorption or consolidation. In an absorption, one company acquires another company. For

example, Hindustan Lever Limited absorbed Tata Oil Mills Company, ICICI bank absorbed Bank of Rajasthan, Hindustan Computers Limited, Hindustan Instruments Limited, Indian software company Limited, and Indian Reprographics Limited combined to form HCL Limited. In India, mergers are called amalgamations in the legal parlance (hereafter we shall use the terms and mergers and amalgamations interchangeably) are usually of the absorption variety. The acquiring company (also reffered to as the amalgamated company or the merged company) acquires and takes over the assets and liabilities of the acquired company (also referred to as the amalgamating company or the merging company or the target company)

Typically, the shareholders of the amalgamating company receive shares of the amalgamated in exchange for their share in the amalgamating company. E.g. Shareholders of Centurion Bank of Punjab (amalgamating co.) received shares of HDFC Bank (amalgamated co.)

Purchase of Division or Plan t : A company may acquire a division or plant of another company. For example, SRF India bought the nylon cord division of CEAT Limited. E.g. Abott bought the healthcare division from Piramal Ltd.

Takeove r : A takeover generally involves the acquisition of a certain stake in equity capital of a company which enables the acquirer to exercise control over the affairs of the company. E.g Mahindra Telecom takeover of Satyam, United Breweries Ltd. acquired majority stake in Deccan Aviation Ltd. (Now Kingfisher Airlines), Daichi takeover of Ranbaxy Ltd. etc.

Divestitures: While acquisitions lead to expansion of assets or increase of control, divestitures result in contraction of assets or relinquishment of control. The common forms of divestitures are briefly described below:Partial selloff – A partial selloff involves the sale of a business division or plant of one company to another. It is the mirror image of a purchase of a business division.Demerger – A demerger involves the transfer by a company of one or more of its business divisions to another company which is newly set up. For example, the Great Eastern Shipping Company transferred its offshore division to a new company called The Great Eastern Shipping Company. The company whose business division is transferred is called the demerged company and the company to which the business division is transferred is called the resultant company.

Equity Carveout : In an equity carveout, a parent company sells a portion of its equity in a wholly owned subsidiary. The sale may be to the general investing public or a strategic investor.

Other forms of Business restructuringGoing Privat e : Going private means converting a company whose stock is publicly held into aprivate company. (e.g. Coal India Ltd., BSNL Ltd. proposed issued).

Leveraged Buyou t : A leveraged buyout involves transfer of ownership, effected substantially with the help of debt finance. (e.g. Zain buyout by Bharati Airtel Ltd).

Privatisatio n : Privatisation involves transfer of ownership (represented by equity shares), partial or total, of public enterprises from the government to individuals and non – government institutions.

Organisational Restructuring : Organisational restructuring is done through initiatives like regrouping of businesses, decentralization, and downsizing to enhance performance.

TakeoversA takeover generally involves the acquisition of a certain block of equity capital of a company whichenables the acquirer to exercise control over the affairs of the company. In theory, the acquirer must buy more than 50 percent of the paid-up of the acquired company to enjoy complete control. In practice, however, effective control can be exercised with a smaller holding, usually between 20 and40 percent, because the remaining shareholders, scattered and ill-organised, are not likely to challenge the control of the acquirer. A takeover is friendly if the incumbent management supports it and is hostile if it opposes it.

Takeovers have become commonplace in the Indian corporate world. Some of the prominent transactions of recent years are the takeover of Indal by Hindalco. IPCL by Reliance Industries, VSNL by Tatas, BALCO by sterlite Industries, and Raasi Cements by India Cements.

A takeover may be done through the following ways:

Open market purchase – The acquirer buys the shares of the listed company in the stock market. Generally, hostile takeovers are initiated in this manner.

Negotiated acquisition – The acquirer buys shares of the target company from one or more existing shareholders in a negotiated transaction.[e.g. Daichi Sankyo Ltd. acquired promoter’s stake in Ranbaxy Ltd.]

Preferential allotment – The acquirer buys shares of the target company through a preferential allotment of equity shares. Obviously such an acquisition is a friendly acquisition meant to give the acquirer a strategic stake in the company and also infuse funds into the company.

Common Forms of Business AlliancesBusiness alliances come in a variety of forms. The more commonly used forms are: joint ventures,strategic alliances, equity partnerships, licensing, franchising alliances, and network alliances.

Joint Ventures – A joint ventures (JV) is set up as an independent legal entity in which two or more separate organisations participate. The JV agreement spells out how ownership, operational responsibilities, and financial risks and rewards will be shared by the cooperating members. Needless to add, each member preserves its own corporate identity and autonomy.

Strategic Alliances – A strategic alliance is a cooperative relationship like the JV. However, it does not, unlike a JV result in the creation of a separate legal entity. A strategic alliance may involve an agreement to transfer technology, provide R&D service, or grant marketing rights. A strategic alliance may be a precursor to a JV or even an acquisition.

Equity Partnership – Beside having the characteristics of a strategic alliance, an equity partnership also involves one party taking a minority equity stake in the other party.

Licensing – There are two popular types of licensing. The first type involves licensing a specific technology, product, or process; the second type involves licensing a trademark, copyright.

Franchising Alliance – A firm may grant rights to sell goods and services to multiple licensees operating in different geographical locations.[e.g. Macdonald’s Ltd., Titan Industries Ltd., Eurokids Pvt. Ltd. etc.]

Network Alliances – A network alliance is a web of inter-connecting alliances among companies that often transcend national and industrial boundaries. Under such arrangements two companies

may collaborate in one market but complete in another. Such alliances are common in multimedia, computer, airline, and telecommunication industries.

Rationale for Business AlliancesBusiness alliances are motivated by a desire to share risk and again access to new markets, reducecosts, receive favourable regulatory treatment, or acquire (or exit) a business.

Sharing Risks and Resources – Developing new technologies can be a very risky and expensive proposition. Further, such endeavours require pooling technical capabilities of different organisations. Hence, firms in high technology industries form business alliances so that diverse know-how can be pooled, adequate funding can be arranged, acceptable risk sharing mechanisms can be worked out.

Access to New Markets – The cost of accessing a new market may be prohibitive because huge outlays are required on advertising, promotion, warehousing and distribution. To solve this problem, a company may enter into an alliance to market its products or services through the sales force, distribution outlays, or Internet site of another firm.

Cost Reduction – Business alliances can help in reducing costs through sharing or combining of facilities in joint manufacturing operations, mutually beneficial purchaser supplier relationships.

Favourable Regulatory Treatment – Regulatory authorities like the Department of justice in theUS generally look upon JVs more favourable than mergers or acquisitions.

Prelude to Acquisition or Exit – A JV or strategic alliance may be a prelude to acquire another company. Alternatively, it may be used as a means for exiting a business.

What Makes a Business Alliances SucceedThe following factors are critical to the success of a business alliance: The partners have complementary strengths. The cost of developing a new product is exorbitant for a single firm. The partners have the ability to cooperate with one another. There is clarity of purpose, roles, and responsibilities. The apportionment of risks and rewards are perceived as equitable by all parties. The partners have similar time horizons and financial expectations.In AGM of RIL, on 22 June ’10 Chairman Mukesh Ambani articulated Asset light ↔ Partnership heavy approach for diversification in telecom sector.

SECTION III :- REASONS FOR BUSINESS RESTRUCTURING

Mergers may be classified into several types: horizontal, vertical, conglomerate, and co-generic. A horizontal merger represents a merger of firms engaged in the same line of business. A vertical merger represents a merger of firms engaged at different stages of production in an industry. A conglomerate merger represents a merger of firms engaged in unrelated lines of business. A cogeneric merger represents a merger of firms engaged in related lines of business.

The principal economic rationale of a merger is that the value of the combined entity is expected to be greater than the sum of the independent values of the merging entities. If firms A and B merge, the value of the combined entity, V (AB), is expected to be greater than (VA + VB), the sum of the independent values of A and B.

A variety of reasons like growth, diversification, economies of scale, managerial effectiveness, utilization of tax shields, lower financing costs, strategic benefit, and so on are cited in support of

merger proposals. Some of them appear to be plausible in the sense that they create value; others seem to be dubious as they do not create value.

Plausible Reasons / Advantages

• Strategic Benefit – If a firm has decided to enter or expand in a particular industry, acquisition of a firm engaged in that industry, rather than dependence on internal expansion, may offer several strategic advantages: (i) As a pre-emptive move it can prevent a competitor from establishing a similar position in that industry. (ii) It offers a special ‘timing’ advantage because the merger alternative enables a firm to ‘leap frog’ several stages in the process of expansion. (iii) It may entail less risk and even less cost. (iv) In a ‘saturated’ market, simultaneous expansion and replacement (through a merger) makes more sense than creation of additional capacity through internal expansion.

• Economies of Scale – When two are more firms combine, certain economies are realised due to the larger volume of operations of the combined entity. These economies arises because of more intensive utilization of production capacities, distribution networks, engineering services, research and development facilities, data processing systems, so on and so forth. Economies of scale are most prominent in the case of horizontal mergers where the scope for more intensive utilization of resources is greater. In vertical mergers the principal sources of benefits are improved coordination of activities, lower inventory levels, and higher market power of the combined entity. Finally, even in conglomerate mergers there is scope for reduction or elimination of certain overhead expenses.

Can there be diseconomies of scale? Yes, if the scale of operations and the size of organization become too large and unwieldy. Economists talk of the optimal scale of operation at which the unit cost is minimal. Beyond this optimal point the unit cost tends to increase.

• Economies of Scope – A company may use a specific set of skills or assets that it possesses to widen the scope of its activities. For example, Hindustan Unilever Ltd. can enjoy economies of scope if it acquires a consumer product company that benefits from its highly regarded consumer marketing skills.

• Economies of Vertical Integration – When companies engaged at different stages of production or value chain merge, economies of vertical integration may be realised. For example, the merger of a company engaged in oil exploration and production (like ONGC) with a company engaged in refining and marketing (like HPCL) may improve coordination and control.

Vertical integration, however, is not always a good idea. If a company does everything in-house, it may not get the benefit of outsourcing from independent suppliers who may be more efficient in their segments of the value chain.

• Complementary Resources – If two firms have complementary resources, it may make sense for them to merge. For example, a small firm with an innovative product may need the engineering capability and marketing reach of a big firm. With the merger of the two firms it may be possible to successfully manufacturer and market the innovative product. Thus, the two firms, thanks to their complementary resources, are worth more together than they are separately.

• Tax Shields – When a firm with accumulated losses and/or unabsorbed depreciation merges with a profit-making firm, tax shields are utilised better. The firm with accumulated losses and/or unabsorbed depreciation may not be able to derive tax advantages for a long time. However, when it merges with a profit-making firm, its accumulated losses and/or unabsorbed depreciation can be set off against the profits of the profit-making form and tax benefits can be quickly realised.

• Utilisation of Surplus Funds – A firm in a mature industry may generate a lot of cash but may not have opportunities for profitable investment. Such a firm ought to distribute generous dividends and even buy back its shares, if the same is possible. However, most managements have a tendency to make further investments, even though they may not be very profitable. In such a situation, a merger with another firm involving cash compensation often represents a more efficient utilization of surplus funds. (e.g. Generous dividend → Infosys Ltd., Buyback of Shares – HUL Ltd, Cash compensation → Mittal Steels)

• Managerial Effectiveness – One of the potential gains of merger is an increase in managerial effectiveness. This may occur if the existing management team, which is performing poorly, is replaced by a more effective management team. Often a firm, plagued with managerial inadequacies, can gain immensely from the superior management that is likely to emerge as a sequel to the merger. Another allied benefit of a merger may be in the form of greater congruence between the interests of the managers and the shareholders.(e.g. Merger of Bank of Rajasthan with ICICI Ltd)

Dubious Reasons for Mergers / Business Restructuring Often mergers are motivated by a desire to diversify, lower financing costs, and achieve a higher rateof earnings growth. Prima facie, these objectives look worthwhile, but they are not likely to enhance value.

• Diversification – A commonly stated motive for mergers is to achieve risk reduction through diversification. The extent to which risk is reduced, of course, depends on the correlation between the earnings of the merging entities. While negative correlation brings greater reduction in risk, positive correlation brings lesser reduction in risk.

Corporate diversification, however, may offer value at least in two special cases: (i) if a company is plagued with problems which can jeopardize its existence and its merger with another company can save it from potential bankruptcy. (ii) If investors do not have the opportunity of ‘home-made’ diversification because one of the companies is not traded in the marketplace, corporate diversification may be the only feasible route to risk reduction.

• Lower Financing Costs – The consequence of larger size and greater earnings stability, many argue, is to reduce the cost of borrowing for the merged firm. The reason for this is that the creditors of the merged firm enjoy better protection than the creditors of the merging firms independently. If two firms, A and B, merge, the creditors of the merged firm (call it firm AB) are protected by the equity of both the firms. While this additional protection reduces the cost of debt, it imposes an extra burden on the shareholders; shareholders of firm A must support the debt of firm B, and vice versa. In an efficiently operating market, the benefit to shareholders from lower cost of debt would be offset by the additional burden borne by them – as a result there would be no net gain.

• Earnings Growth – A merger may create the appearance of growth in earnings. This may stimulate a price increase if the investors are fooled. An example may be given to illustrate this phenomenon.

Financial Positions of Ace Limited and Aim LimitedParticulars Ace Ltd. before Aim Ltd. before

merger mergerAce Ltd. after merger

The market The marketIs ‘smart’ is ‘foolish’

(1) (2) (3) (4)Earnings per share Rs.2 Rs.2 Rs.2.67 Rs.2.67Price per share Rs.40 Rs.20 Rs.40 Rs.53.4

Price-earning ratio 20 10 15 20Number of shares 10 million 10 million 15 million 15 millionTotal earnings Rs.20 million Rs.20 million Rs.40 million Rs.40 millionTotal value Rs.400 million Rs.200 million Rs.600 million Rs.800 million

Value of Control and Value of Synergy

Value of Control – Acquiring firms often are willing to pay a price that is higher than the status quo value for the right to control the management of target firms.The value of control stems from the changes that can be made to improve performance Investments can be made for debottlenecking capacity, redundant assets can be liquidated, operations can be streamlined, financing structure can be changed, managerial system and processes can be strengthened, more competent people can be brought in, so on and so forth. The value of control can be defined as follows:Value of control = Value of the firm, if it is – value of firm with current

Optimally managed managementClearly, the value of control is substantial if the firm is currently being run very inefficiency and the scope for improvements is considerable. On the other hand, the value of control is negligible if the firm is being managed efficiently.(e.g. Tata Motors acquisition of Jaguar Land Rover)

Value of Synergy – In most acquisitions, there is a potential for synergy which may come in one or more of the following ways: Lower operating costs due to economic of scale. Savings in outlays on R & D, advertising, marketing, and various shared services Higher growth rate because of greater market power of the combined entity. Longer growth period from enhanced competitive advantages. Lower cost of capital due to higher debt capacity. Better utilisation of tax shelters

Valuing synergy may not be easy because synergy is easy to imagine but difficult to realise. (e.g. Vodafone acquisition of Essar stake in Hutch)

SECTION IV :- LEGAL PROCEDURE OF BUSINE S S RESTRUCTURING

Sections 391 to 394 of the Companies Act, 1956 contain the provisions for amalgamations. The procedure for amalgamation normally involves the following steps:

1. Examination of Object Clauses – The memorandum of association of both the companies should be examined to check if the power to amalgamate is available. Further, the object clause of the amalgamated company (transferee company) should permit it to carry on the business of the amalgamating company (transferor company). If such clauses do not exists, necessary approvals of the shareholders, boards of directors, and Company Law Board are required.

2. Intimation to Stock Exchanges – The stock exchanges where the amalgamated and amalgamating companies are listed should be informed about the amalgamation proposal. From time to time, copies of all notices, resolutions, and orders should be mailed to the concerned stock exchanges.

3. Approval of the Draft Amalgamation Proposal by the Respective Boards – The draft

amalgamation proposal should be approved by the respective boards of directors. The board of

each company should pass a resolution authorizing its directors/executives to pursue the matter further.

4. Application to the High Court/s – Once the draft of amalgamation proposal is approved by the respective boards, each company should make an application to the High Court of the state where its registered office is situated so that it can convene the meetings of shareholders and creditors for passing the amalgamation proposal.

5. Dispatch of Notice to Shareholders and Creditors – In order to convene the meetings of shareholders and creditors, a notice and an explanatory statement of the meeting, as approved by the High Court, should be dispatched by each company to its shareholders and creditors so that they get 21 days advance intimation. The notice of the meetings should also be published in two newspapers (one English and one vernacular). An affidavit confirming that the notice has been dispatched to the shareholders/creditors and that the same has been published in newspapers should be field in the court.

6. Holding of Meetings of Shareholders and Creditors – A meeting of shareholders should be held by each company for passing the scheme of amalgamation. At least 75 percent (in value) of shareholders, in each class, who vote either in person or by proxy, must approve the scheme of amalgamation. Likewise, in a separate meeting, the creditors of the company must approve of the amalgamation scheme. Here, too, at least 75 percent (in value) of the creditors who vote, either in person or by proxy, must approve of the amalgamation scheme.

7. Petition to the High Court for Confirmation and Passing of High Court Orders – Once the amalgamation scheme is passed by the shareholders and creditors, the companies involved in the amalgamation should present a petition to the High Court for confirming the scheme of amalgamation. The High Court will fix a date of hearing. A notice about the same has to be published in two newspapers. After hearing the parties concerned and ascertaining that the amalgamation scheme is fair and reasonable, the High Court will pass an order sanctioning the same. However, the High Court is empowered to modify the scheme and pass orders accordingly.

8. Filing the Order with the Registrar – Certified true copies of the High Court order must be filed with the Registrar of Companies within the time limit specified by the Court.

9. Transfer of Assets And Liabilities - After the final orders have been passed by both the High Courts, all the assets and liabilities of the amalgamating company will, with effect from the appointed date, have to be transferred to the amalgamated company.

10. Issue of Shares and Debentures – The amalgamated company, after fulfilling the provisions of the law, should issue shares and debentures of the amalgamated company. (Cash payment may have to be arranged in some cases.) The new shares and debentures so issued will then be listed on the stock exchange



SECTION – PROBLEMS AN D SOLUTIONS

(Q.1) The Balance Sheet of X Co. Ltd. on 31st March, 2010 are as follows :Balance Sheet of X Co. Ltd.

Liabilities Rs. Assets Rs.Share Capital :Authorised Capital of 10000 shares of Rs. 100 eachIssued Capital :10000 shares of Rs. 100 each fully paidReserves & SurplusCapital Reserve 200000General Reserve 70000 Unsecured LoansCurrent Liabilities & ProvisionsSundry Creditors

1000000

Fixed Assets :Goodwill 80000Others 800000Current Assets, Loans and Advances

880000

9000001000000

270000200000

310000

Total 1780000 Total 1780000

Balance Sheet of Y Co. Ltd.Liabilities Rs. Assets Rs.Share Capital :Authorised Capital 200000 shares ofRs. 10 eachIssued Capital :80000 shares of Rs. 10 each fully paidReserves & Surplus : General Reserve Secured LoansCurrent Liabilities & ProvisionsSundry Creditors

2000000

Fixed Assets :Current Assets,Loans and Advances: Bank 200000Others 660000

1600000

860000800000

800000500000

360000Total 2460000 Total 2460000

It was proposed that X Co. Ltd. should be taken over by Y Co. Ltd. The following arrangements were accepted by both the companies.

(a) Goodwill of X Co. Ltd. is considered valueless(b) Arrears of depreciation in X Co. Ltd. amounted to Rs.40,000 (c) The holder of every 2 shares in X Co. Ltd. was to receive.

(i) as fully paid 10 shares in Y Co. Ltd. and(ii) so much cash as is necessary to adjust the right of shareholders of both the companies in

accordance with the intrinsic value of the shares as per their Balance Sheets subject to necessary adjustment with regard to goodwill and depreciation in X Co. Ltd.’s Balance Sheet.

You are required to:1. Determine the composition of purchase consideration.2. Show the Balance Sheet after absorption.

Q.1) Solution:-Computation of Intrinsic Value per Share

Particulars X Co. Ltd.Rs.

Y Co. Ltd.Rs.

Share CapitalCapital Reserve General Reserve TotalLess : Goodwill being valueless 80000

Arrears of Depreciationto be provided for 40000

Tangible Net Worth = Value of Net AssetsNumber of Shares

(Paid up Capital ÷ Rs. 100 Rs.10 respectively) Intrinsic Value per Share

100000020000070000

800000

8000001270000 1600000

(120000) Nil1150000 1600000

10000Rs.115

80000Rs.20

Scheme of AmalgamationBasis of Exchange : 10 shares in Y Co. Ltd.

+ Cash for every two shares in X Co. Ltd.Rs.

Intrinsic Value of Two Shares in X Co. Ltd. = Rs. 115 x 2Less : Intrinsic Value of Ten Shares in Y Co. Ltd. = Rs. 20 x 2Balance cash to paid in respect of every 2 shares in X Co. Ltd.Purchase Consideration will be as underEquity Shares in Y Co. Ltd.

= (10000 ÷ 2) x 10 shares x Rs.20 (Issue Price) Cash paid to adjust the rights = (10000 ÷ 2) x Rs.30Total Purchase Consideration

230.00200.0030.00

1000000150000

1150000

Balance Sheet of Y CO. Ltd. (after absorption) as on…….Liabilities Rs. Assets Rs.Share Capital :Authorised : 2,00,000 shares of Rs.10 eachIssued & Subscribed :1,30,000 shares of Rs. 10 each fullypaid (of which 50,000 shares issued for consideration other than cash) Reserves and Surplus :Securities PremiumGeneral Reserve (given) Secured Loans Unsecured LoansCurrent Liabilities & Provisions :Sundry Creditors

(3,10,000 + 3,60,000)

20,00,000

Fixed Assets :Cost 16,00,000Add : Addition on

Acquisition 8,00,000Less : Arrears of

Depreciation (40,000)Current Assets,

Loans & Advances :Current Assets

(9,00,000 + 6,60,000) Cash at Bank

(2,00,000 + 1,50,000)

23,60,000

15,60,000

50,000

13,00,000

5,00,0008,00,0005,00,0002,00,000

6,70,00039,70,000 39,70,000

(Q.2) On September 30, 2009 the Balance Sheet of Dull Past Ltd. was as follows :

Liabilities Rs. Assets Rs.Authorised :10000 Ordinary shares of Rs. 10 each1000 6% Cumulative Preference Shares of Rs. 100 each

Issued :6000 Ordinary Shares of Rs. 10 each, fully paid600, 10% Cumulative PreferenceShares of Rs. 100 each, fully paid15% DebenturesCurrent Liabilities :Trade Creditors 130000Bank Overdraft (Secured by acharge on the freehold property) 61000

100000

100000

Freehold Land & Building at costPlant & Machinery 80000Less : Depreciation writtenoff to date 30000Tools and PatentsCurrent Assets :Stock in trade 70000Trade Debtors 30000Cash in hand 1000Profit and Loss A/c.

100000

5000010000

10100080000

200000

60000

6000030000

191000341000 341000

It was decided to reconstruct the company and for this purpose. Bright future Ltd. was registered with a capital of Rs. 200000 divided into 8000 ordinary shares of Rs.10 each and 1200; 11.5% preference shares of Rs. 100 each to take over the assets and liabilities of the old company.The debenture holders of Dull Past Ltd. agreed to accept 11.5% preference share in the new company in exchange of their debentures.The preference shareholders were to receive one preference share in Bright Future Ltd. for every three shares held by them in the old company and the ordinary share holders were to be allotted one ordinary share of Rs. 8 paid in the new company for every four shares held by them in the old company.Bright Future Ltd. issued 3500 ordinary shares of Rs. 10 each at par and called up the Balance of Rs.2 on the shares issued to the old shareholders in Dull Past Ltd.The preliminary expenses of Bright Future Ltd. which have been paid were Rs. 240.

You are required to :(1) Give the journal entries to record the above transactions in the books of the old company.(2) Show the Balance Sheet of Bright Future Ltd. under purchase method in vertical form.

Q.2) Solution

Calculation of Purchase Consideration :Rs.

1. Preference Shareholders 1 x 600 x Rs.100 20,000 11.5% Preference Shares3

2. For Equity Shareholders 12,000 Equity Shares1,500 Equity Shares of Rs.10 each at Rs. 8 each --- Total Purchase Consideration : 32,000

Journal of Dull Past Ltd.Dr.Rs.

Cr.Rs.

Realisation A/c Dr.To Freehold Land & Building A/cTo Plant & Machinery A/c To Tools & Patterns A/c To Stock-in Trade A/cTo Trade Debtors A/cTo Cash in hand A/c

(Being various assets transferred to Realisation A/c)

2,91,0001,00,000

80,00010,00070,00030,0001,000

Depreciation on Plant & Machinery A/c Dr.Trade Creditors A/c Dr. Bank Overdraft A/c Dr.15% Debentures A/c Dr.

To Realisation A/c(Being liabilities taken over by Bright Future Ltd. & accumulated depreciation on Plant & Machinery transferred to Realisation Account)

30,0001,30,000

61,00030,000

2,51,000

Equity Share Capital A/c Dr.To Equity Shareholders A/c

(Being equity share capital transferred to shareholders A/c)

60,00060,000

Equity Shareholders A/c Dr.To Profit & Loss A/c

(Being accumulated loss transferred to Shareholders Account)

80,00080,000

10% Preference Share Capital A/c Dr.To Preference Shareholders A/cTo Realisation A/c

(Being the amount payable to preference shareholders transfer to their account and profit to Realisation Account)

60,00020,00040,000

Bright Future Ltd. A/c Dr.To Realisation A/c

(Being purchase consideration receivable from Bright FutureLtd.)

32,00032,000

11.5% Preference Shares in Bright Future Ltd. A/c Dr.Equity Shares In Bright Future Ltd. A/c Dr.

To Bright Future Ltd. A/c(Being preference & equity shares received against purchase consideration)

20,00012,000

32,000

Preference Shareholders A/c Dr.To 11.5% Preference Shares in Bright Future Ltd. A/c

(Being settled claim of preference shareholders by the issue of11.5% preference shares)

20,00020,000

Realisation A/c Dr.To Equity Shareholders A/c

(Being profit on realisation transferred to shareholders A/c)

32,00032,000

Equity Shareholders A/c Dr.To Equity Shares in Bright Future Ltd. A/c

(Being equity shares in Bright Future Ltd. issued to equity shareholders)

12,00012,000

Bright Future Ltd.Balance Sheet as at 30th September, 2009

ScheduleNo.

Rs. Rs.

I. Sources of Funds1. Shareholders Funds :

a) Capitalb) Reserves and Surplus

2. Loan Funds :a) Secured Loansb) Unsecured Loans

Total

II. Application of Funds1. Fixed Assets :

a) Gross Blockb) Less : Depreciation c) Net Blockd) Capital Work-in-Progress

2. Investments3. Current Assets, Loans & Advances

a) Inventoriesb) Sundry Debtorsc) Cash and Bank Balances d) Other Current Assetse) Loans and Advances

Less : Current Liabilities & Provisions a) Liabilitiesb) Provisions

Net Current Assets4. a) Miscellaneous Expenditure to the

extent not written off or adjustedb) Profit & Loss Account

Total

12

3

4----

-----

--

--

1,00,0008,000 1,08,000

61,00061,000

Nil

-----

70,00030,00038,76010,000

Nil

1,69,000

1,60,000NilNil

-----

18,760

Nil240

1,48,760

1,30,000Nil

1,30,000

--

1,69,000

Schedule forming part of Balance Sheet :

Schedule 1 Share Capital

Authorised :8,000 Equity Shares of Rs.10 each1,200 7% Preference Shares of Rs. 100 each

Issued and Subscribed :5,000 Equity Shares of Rs. 10 each500 11.5% Preference Shares of Rs. 100 each(of these, 1,500 equity shares and all the preference shares have been issued for consideration other than cash)

Rs.

80,0001,20,0002,00,000

50,00050,000

-

1,00,000Schedule 2 Reserve and Surplus

Capital ReserveRs.

8,0008,000

Schedule 3 Secured Loans

Bank Overdraft (Secured by a charge on Freehold Property)Rs.

61,00061,000

Schedule 4 Fixed Asset

Freehold BuildingsPlant & Machinery

Rs.1,00,000

50,0001,50,000

Schedule 5 Current Liabilities

Trade CreditorsRs.

1,30,0001,30,000

W.N.1Capital Reserve :Assets taken over :

Freehold Land & Building Rs. 1,00,000Plant and Machinery Rs. 50,000Tools and Patterns Rs. 10,000Current Assets Rs. 1,01,000

Rs. 2,61,000Less : Liabilities taken over :

Current Liabilities Rs. 1,91,00015% Debentures Rs. 30,000 Rs. 2,21,000 Net Assets taken over Rs. 40,000Purchase consideration Rs. 32,000 Capital Reserve Rs. 8,000

W.N.2Cash / Bank Balance :

Cash Balance Rs. 1,000Add : Issue of Shares (3,500 x 10) Rs. 35,000Add : Calls of Shares (1,500 x 2) Rs. 3,000

Rs. 39,000

Less : Preliminary Expenses Rs. 240 Balance Rs. 38,760

(Q.3) A Ltd. and B Ltd. were amalgamated on and from 1st April, 2010. A new company AB Ltd. was formed to take over the business of existing companies. The balance sheets of A Ltd. and B Ltd. as on 31st March, 2010 are given below:

(figures in thousands)

Share Capital :Equity share of Rs.10 each12% Preference shares ofRs.100 eachReserves and Surplus Capital Reserve General Reserve Profit and Loss A/c Secured LoansTrade CreditorsTax Provisions

A Ltd. B. LtdFixed AssetsLess: Depreciation

Investments Current Assets: StockDebtorsCash & Bank Balance

A Ltd. B. Ltd

2,400

1,200

8001,200

4001,6001,200

800

1,600

800

600600200800400200

4,800800

4,0001,600

1,2001,6001,200

3,200600

2,600600

600800600

9600 5200 9,600 5,200Other Informations:(i) Preference shareholders of the two companies are issued equivalent number of 15% preference

shares of AB Ltd. at an issue price of Rs.125 per share.(ii) AB Ltd. will issue one equity share of Rs.10 each for every share of A Ltd. and B Ltd. The

shares are issued at a premium of Rs.5 per share.Prepare the balance sheet of AB Ltd. on the assumption that the amalgamation is in the nature of merger.

Q.3 Solution

Particulars A Ltd. B Ltd.1) 15% Preference Share for Preference Shareholders

A Ltd. (12000 shares @ 125) B Ltd. (8000 shares @ 125)

2) ES for Equity ShareholdersA Ltd. (240000 shares @ 15) B Ltd. (160000 shares @ 15)

1500000-

3600000-

-1000000

-2400000

PC 5100000 3400000

Particular l/f Rs. Rs.Business Purchase A/c . . .

To Liquidators of A Ltd. A/c. To Liquidators of B Ltd. A/c.

Liquidators of A Ltd. A/c Dr. Liquidators of B Ltd. A/c Dr.

To 15% Preference Shares (20000 x 100) To Equity Share Capital (400000 x 10)To Securities Premium

Fixed Assets A/c . Dr. Investment A/c. . . Dr. Stock A/c . . . Dr. Debtors A/c . . . Dr. Cash & Bank balance A/c Dr. Profit & Loss A/c Dr.

8500000

51000003400000

660000022000001800000240000018000002500000

51000003400000

200000040000002500000

To CR A/c.To General Reserve A/cTo P & L A/c. . .To Secured Loans A/c . . . To Trade CreditorsTo Tax provisions A/cTo Business Purchase A/c

14000001800000600000

2400000160000010000008500000

In balance sheet Net debit balance is P&L A/c Rs.100000 will appear on asset side.

Balance Sheet as on 1st April 2010Liabilities Rs. Assets Rs.Share CapitalAuthorised capitalCalled up / Issued11% Preference SharesEquity Share capital

Reserves & Surplus Capital Reserve Securities Premium

Secured LoansSecured Loans

Unsecured Loans

Current Liabilities Tax provisions Trade Creditors

?

20000004000000

14000002500000

2400000

Nil

10000001600000

Fixed Assets

Investment

Current Assets Loans & Advances StockDebtorsCash & Bank balance

Miscellaneous expenditureP & L A/c

6600000

2200000

180000024000001800000

100000

14900000 14900000

Q.4) XYZ Ltd. is considering merger with PQR Ltd. XYZ Ltd’s. shares are currently traded atRs.25. It has 200000 shares outstanding and its EAT amount to Rs.400000. PQR Ltd. has100000 shares outstanding; its current MPS is Rs.12.50 and its EAT are Rs.100000. The merger will be effected by means of a Stock Swap (exchange). PQR Ltd. has agreed to a plan under which XYZ Ltd. will offer the current Market Value of PQR Ltd’s Shares:

(i) What is the pre-merger EPS and P/E ratios of both the companies?(ii) If PQR Ltd’s P/E Ratio is 8, What is its current MPS? What is the exchange ratio?

What will XYZ Ltd’s post-merger EPS be?(iii) What must be the exchange ratio for XYZ Ltd’s so that the pre and post-merger

EPS to be the same? (CS (Final), June 2001)Q.4) Solution :Given Data:

Particulars XYZ Ltd. PQR Ltd.MPS (Rs.)No. of Equity SharesEarnings after Tax (Rs.)

25200000400000

12.50100000100000

(i) a) Earnings after Tax Pre-Merger EPS =No. of Equity Shares

XYZ Ltd. PQR Ltd.= 400000

200000= Rs.2

= 100000100000

= Re.1

b)P/E = MPS

EPSXYZ Ltd. PQR Ltd.

= 252

= 12.50 Times

= 12.501

= 12.50 Times

(ii) If PQR Ltd’s P/E = 8 (a) Current MPS:

P/E =

8 =

MPS EPS MPS

1

(b) Exchange Ratio:XYZ PQR25 8

= 25 = 3.1258

Exchange Ratio = XYZ : PQRMPS = Rs.8 = 3.125 : 1

(c) Post-Merger EPS of XYZ Ltd.XYZ EAT + PQR EAT = Total EAT4 lakhs + 1 lakh = 5 lakhs

XYZ PQR25 8

100000 ?100000 x 8 = 32000 Shares

25XYZ Ltd.:Old Shares200000

++

New Shares32000

==

Total Shares232000 Shares

New EPS = Total Earnings after Tax Total No. of Equity Shares

= 500000232000

= Rs.2.15

(iii) Desired exchange ratio for XYZ Ltd. so that Pre-Merger and Post-Merger EPS is the same.Total No. of Shares in = Post-Merger Earnings Post-Merger Company Pre-Merger EPS of XYZ Ltd.

= 5000002

= 250000 Shares

Total No. of Shares in No of Shares in No of New SharesPost-Merger Company – - Pre-Merger XYZ Ltd. = required to be issued2,50,000 - 200000 = 50000 Shares

Exchange Ratio:XYZ PQR100000 50000

1 ?

= 50000 x 1 = 0.50100000

Exchange Ratio = 0.5 : 1




REVIEW QUESTIONS:-

Q.1) Concept Testing.(a) Business Restructuring.(b) Exchange Ratio in a merger.

Q.2) Explain Reasons for Business Restructuring?

Q.3) Explain legal procedure of Business Restructuring?

Note:- Complete solution of all practise problems of all chapters will be uploaded on website www.SCOrEBMS.com on 2nd Oct. ‘10

S COrE The be st in Exams

http://www.SCOrEBMS.com/

42737918 fm management notes

Documents