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SECTION B : FINANCIAL MANAGEMENT QUESTIONS 1. 2. Differentiate between the profit maximization and the wealth maximization objectives of financial management. ABC Limited has a present annual Sales turnover of Rs. 40,00,000. The unit sale price is Rs. 20. The variable cost are Rs.12 per unit and fixed costs amount to Rs.5,00,000 per annum. The present credit period of one month is proposed to be extended to either 2 or 3 months whichever will be more profitable. The following additional information is available – On the basis of Credit Period of 1 month Increase in sales by % of Bad debts to sales − 1 2 months 10% 2 3 months 30% 5
Fixed cost will increase by Rs. 75,000 when sales will increase by 30%. The company requires a pre-tax return on investment at 20%. Evaluate the profitability of the proposals and recommended best credit period for the company. 3. XYZ is interested in assessing the cash flows associated with the replacement of an old machine by a new machine. The old machine bought a few years ago has a book value of Rs. 90,000 and it can be sold for Rs. 90,000. It has a remaining life of five years after which its salvage value is expected to be nil. It is being depreciated annually at the rate of 20 per cent (written down value method.) The new machine costs Rs. 4,00,000. It is expected to fetch Rs. 2,50,000 after five years when it will no longer be required. It will be depreciated annually at the rate of 33 1/3 per cent (written down value method.) The new machine is expected to bring a saving of Rs. 1,00,000 per annum in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable to the firm is 50 per cent. Find out the relevant cash flow for this replacement decision. (Tax on capital gain/loss to be ignored) 4. Explain the Modigliani –Miller theory on the effect of gearing on the cost of capital to, and value of, the firm, in the absence of taxation. Explain how the theory is adjusted to take into account the effects of taxation. What are the principal weaknesses of this theory? Companies U and L are identical in every respect except that the former does not use debt in its capital structure, while the latter employs Rs. 6 lakh of 15 per cent debt. Assuming that, (a) all the M.M. assumptions are met , (b) the corporate tax rate is 35 per cent, (c) the EBIT is Rs. 2,00,000 and (d) the equity capitalization of the unlevered company is 20 per cent. What will be the value of the firms. U and L? Also, determine the weighted average cost of capital for both the firms. Three companies A, B and C are in the same type of business and hence have similar operating risks. However, the capital structure of each of them is different and the following are the details: A Equity Share Capital [Face value Rs. 10 per share] Market value per share Dividend per share Debentures 15 2.70 − 20 4 1,00,000 12 2.88 2,50,000 Rs. 4,00,000 B Rs. 2,50,000 C Rs. 5,00,000
000 1.) PE ratio (Market Price/EPS) 3. Profit Less: Interest on Debentures @ 12% Income-tax @ 50% Number of Equity Shares (Rs. AB limited provides you with following figures: Rs.000. 6. Its investment costs and annual profits are projected as follows: Year Investment Profits 0 1 2 3 4 5 Rs (2.00.20.000 and depreciation of the original investment is on straight line basis. 7. (a) ABC Limited is considering a new five – year project. Using average profits and average capital employed calculate the ARR for the project and the pay back period.000 2.000 1.S. The company needs Rs. and If the amount is raised by issuing equity shares. (b) Write short notes on: (i) Accounting rate of return . If the additional funds are raised as debt.40.00.000 60. You are Debt informed that a Debt Equity Ratio higher than 35% will push the P/E ratio Debt + Equity down to 8 and raise the interest rate on additional amount borrowed to 14%.000 10.P.000 10.000) 40. You are required to compute the weighted average cost of capital of each company. You are required to ascertain the probable price of the share: (i) (ii) 8.000 30.000 20.000 40.20. 2. This amount will earn at the same rate as funds already employed. (Earning per share) (Rs. 10 each) E.00.000 for expansion.) Ruling price in market (Rs.000 The residual value at the end of the project is expected to be Rs 40.22 [Face value per debenture Rs.50. 100] Market value per debenture Interest Rate − − 125 10% 80 8% Assume that the current levels of dividends are generally expected to continue indefinitely and the income-tax rate at 50%.000 3 30 10 The company has undistributed reserves of Rs.
000. 80.800 after 3 years. financial and combined leverages. What is the company's rate of return on this contract. The firm's alternative is to invest in a new grinding machine costing Rs. 1.60. An immediate cash outlay of Rs. You are provided with the following figures of two companies from which you are required to calculate the operating . For the next four years.23 (ii) Indifference point 9. should the system be initiated? 11. 30. .000 300 700 400 300 100 200 12. 9.000 per year until the machine reaches zero book value. 5. 35.000. the revenues generated will be Rs. 10. (a) Write short notes on: (i) Marginal cost of capital (ii) Profitability Index (iii) Working capital cycle (b) A company is offered a contract which has the following terms. assuming a 5 % return on short-term investments. (i) determine the reduction in cash balances that can be achieved through the use of a lock box system.20. The new machine would generate a revenue of Rs. 4. The machine could be sold today for net cash of Rs.000 net cash.80. it must take depreciation of Rs. Further the process time 2 would be reduced by another 1 day. 80. it takes another 1 1 days for 2 processing these payments. This is not good since if the machine were held for 4 years it could probably be sold for Rs. not counting the Rs. 3. (ii) determine the opportunity cost of the present system.000 .000 followed by a cash inflow of Rs. 80.000. 80. since each lock box bank would collect mailed deposits twice daily. You are required to. In addition. only after which deposits are made. The company plans to initiate a lock box system in which customers mailed payments would reach the receipt location 2 1 days earlier.000 needed to transport and install it.000 annually but the annual cost expenses will be Rs. . ABC Limited currently has a centralised billing system. (iii) If the annual cost of the lock box system is Rs 80. Subsequently.20. ABC Ltd Sales Variable costs Contribution Fixed costs EBIT Interest Profit before tax 500 200 300 150 150 50 100 XYZLtd 1.00.00. ABC company is having difficulties with an automated grinding machine which has 4 years of service life and its operating costs are fairly sizable compared to its revenues.000.000 which is less than its current book value of Rs.000 with cash expense of Rs. ABC Limited has a daily average collection of Rs 5. It takes around 4 days for customers mailed payments to reach the central billing location.
000 10.000 6.000 76.000 units. The company issued debentures on 01. The company is considering a plan to grant more liberal terms by extending the duration of credit from 1 month to 2 months and expects the sales to the customer group to go up by 25 per cent.00.000 76.000 1.000 30. At present HPCL Ltd. 2.000 .000 2.100 each. will this relaxation in credit standard justify itself? 14. In the background of a normal expectation of a 20 per cent return on investment. The new machine would require tying up an additional Rs.000 60. 13.000 3.000 2.00.000 2000 (Rs.42. the product has a total cost of Rs.000 2. Depreciation would be by the straight line method.90 per unit and a variable cost of Rs. 1. The purchase prices have remained stable during the concerned period.000 50.000 BALANCE SHEET 1999 (Rs.000 2.000 14.80 per unit.) 82.40.000 19.36.000 of inventory and receivables over the 4 year period.000 3.000 59.000 76.000 50.000 2000 (Rs. and has an annual sales volume of 60.000 3.000 at which time it could be sold for Rs.80.000 19.000 22.214.171.124. ABC Ltd is now extending 1 month's credit to its selected customers. At current level of production.60.000 net cash. which matches with sales. What is the differential after tax cash flow stream for this proposal? Assume tax rate of 50% on Income and Capital gain.000 40.98. sells all finished goods from its own warehouse.000 14.000 7. It sells its products at Rs. the Directors of M/s HPCL Ltd.000 15. have taken a decision to diversify.000 11. Following information is provided to you: INCOME STATEMENTS 1999 (Rs.000 49.000 1.000.24 5.01.000 10.2000 and purchased Fixed Assets on the same day. It would be depreciated over a 4 year period to a book value of Rs. In a meeting held at Solan towards the end of 1999.) Fixed Assets (Net Block) Debtors Cash at Bank Stock Total Current Assets (CA) Creditors Total Current Liabilities (CL) 50.) Cash Sales Credit Sales Less: Cost of goods sold Gross profit Less: Expenses Warehousing Transport Administrative Selling Interest on Debenture Net Profit 13.000 94.70.000 17. 1.) 32.000 64.
000 75.5. When Profit Maximization becomes a long-term objective the concern of the financial manager is to manage finances in such a way so as to maximize the EPS of the company.1.000 now and is expected to generate net cash receipts of Rs.00.000 30.000.000 per annum indefinitely.20.00. Ignoring tax consideration: (i) Calculate the value of equity shares and the gain made by the shareholders if the cost of equity rises to 21.00. 6.000 You are required to calculate the following ratios for the years 1999 and 2000.40.000 25.000 debentures at the market interest rate of 18%. SUGGESTED ANSWERS/HINTS 1.00.1. 15. Stock Turnover Ratio Net Profit to Net Worth Ratio. This level of dividend is expected to be paid indefinitely. The project would be financed by issuing Rs.00. The objective could be short term or long term. Give the reasons for change in the ratios for 2 years.000 1.000 75.000 1.000 has just been paid.000 1. i) ii) iii) iv) v) vi) Gross Profit Ratio Operating Expenses to Sales Ratio. The current market value is Rs. Objective of profit maximization: Under this objective the financial manager’s sole objective is to maximize profits. ZED Limited is presently financed entirely by equity shares. Profit maximization Value maximization. (ii) Prove that the weighted average cost of capital is not affected by gearing.000 42.05.25 Working Capital (CA . Ignore Taxation.000 1. The company is thinking of investing in a new project involving an outlay of Rs. Under the short-term objective the manager would intend to show profitability in a short run say one year. 2. and vii) Debtors Collection Period Ratio relating to capital employed should be based on the capital at the end of the year. The two most important objectives of financial management are as follows’ 1. Operating Profit Ratio Capital Turnover Ratio. A dividend of Rs.000 for the year 1999.6%.47. .000 − 1. 5. Assume opening stock of Rs.07.47.CL) Total Assets Represented by: Share Capital Reserve and Surplus Debentures 70. Objective of value maximization: Under this objective the financial manager strives to manage finances in such a way so as to continuously increase the market price of the companies shares.
hence one cannot be sure whether an investment fetching a Rs 10 Lac return after a period of five years is more or less valuable than an investment fetching a return of Rs 1. It takes into account present as well as futuristic earnings per share.000 88.417 48.81. will put downward pressure on the market price per share and hence reduce the company’s value. Hence it is commonly thought that maximizing profits in the long run is a better objective.60. and other factors that bear upon the market price of the share.41. This shall increase the Earning Per Share on a consistent basis.23.00.31. Shareholders who are not satisfied may sell their shares and invest in some other company.000 9.82.000 5.00. It does not consider the risk factor of projects to be undertaken.000 5. However even this objective has its own shortcomings. an objective of maximizing profits may not be the same as maximizing the market price of Share and hence the firms value.40.75. 44.95.36.000 31.000 43.000 5.26 Under the short term profit maximization objective a manager could continue to show profit increases by merely issuing stock and using the proceeds to invest in risk free or near to risk free securities.40.000 3.750 6. This objective does not allow the effect of dividend policy on the market price per share. in order to maximize the earning per share the companies may not pay any dividend. in many cases a highly levered firm may have the same earning per share as a firm having a lesser percentage of debt in the capital structure. In spite of the EPS being the same the market price per share of the two companies shall be different.00.000 36.333 2. This shall result in a consistent decrease in the share holders profit – that is earning per share shall fall.00. This action.417 9.000 2.40.00.333 2.Bad debt to sales Net sales Net Incremental Sales (A) Cost of sales Variable cost @ Rs.000 9.583 ♦ ♦ .667 − − − − Two months Rs.60.000 40.95.333 55. The market price serves as a barometer of the company’s performance. 2.000 31. In such cases the earning per share shall certainly increase.083 1.52. it indicates how well management is doing on behalf of its shareholders.000 39. duration and risk of these earnings.000 7. 40.20.000 29. however the market price per share could as well go down. 52.000 5.40. 12 Fixed cost Cost of sales Net Incremental Cost (B) Average Debtors at cost Increase in Average Debtors Cost of Incremental Debtors @ 20% (C) Total Incremental Cost (B+C) Net increase in Profit [A– (B+C)] One month Rs.667 Three months Rs.96. The market price of a firm’s share represents the focal judgement of all market participants as to the value of the particular firm.80. He may also opt for increasing profits through other non-operational activities like disposal of fixed assets etc. the timing. ♦ It does not specify the timing or duration of expected returns.000 49.5 Lac per year for the next five years. For the reasons just given.00.000 − 24.667 56. the dividend policy of the firm.12.000 26.000 2. Evaluation of Profitability under different credit periods Sales . if taken. which are as follows.23.000 − 2.00. Management is under continuous watch.
8 52. When taxation is introduced into the model.000 + Rs.2 Yr. the amount of increase being the present value of the tax shield on the interest payments.9 59. the firm may change its credit policy from the present credit period of one month to two months.4 Terminal cash flow: There will be a cash inflow of Rs. ’000) Yr.09.Depreciation on old machine Therefore.8 12.55.9 81.50. The MM theory of capital structure differs from the traditional view in its assumptions about shareholders behaviour.6 40.00. 3. 3. 5 100 26. 3 100 59.7 74.8 34. The MM theory negates the view that there can be an optimum level of gearing which can reduce the cost of capital and maximize the value of the firm. The market value of the firm. Simultaneously they will adjust their level of personal borrowing through the market in order to maintain their overall level of business risk at the same level.5 9. the total market value of the firm is not independent of its capital structure.Salvage value of old machine Amt.1 47. 1 Savings in Costs (A) Depreciation on new machine .583. Modiliani and Miller proved that the value of the firm is dependent upon the income generated from the business activities of a firm and not the way in which this income is allocated between the providers of capital.3 65.4 18.400).e.7 115. in the last year the total cash inflow will be Rs.. the interest on which is treated as a charge in the financial statements. (Rs. 2.400 (i.50.7 34.9 30.1 26. 2 100 88. 4 100 39.48. in such a situation increases with gearing.9 Yr.3 − 7. 2.667 which is more than Rs.4 74.3 107. Rs.9 14.5 47.3 −15. .8 73. This process. which is known as arbitrage will result in the firms having the same equilibrium total value. If the shares of two firms with different level of gearing but the same level of business risk are traded at different prices .3 18.3 11.0 115..6 Yr.5 12.5 18.2 30.27 The change of credit period from one month to two months is expected to increase the profit by Rs.5 25. So.5 87.10. This is because of the tax shield provided by loans.000 at the end of 5th year when the new machine will be scrapped away. incremental depreciation (B) Net incremental saving (A – B) Less: Incremental Tax @ 50% Incremental profit Depreciation (added back) Net cash flow 100 133. 59. So.3 69.2 26.2 Yr.1 40. This also implies that the WACC declines as gearing increases.000 3.000 90.000 Subsequent annual cash flows: (Amount Rs.) 4..3 7. then shareholders will switch their investment from the overvalued to the undervalued firm. Initial cash flow: Cost of new machine . 4.6 −7.
000 90. 2.000 2. 6.000 − 0.000 6.1511 6.80 0.8.5) = 5% − 0.00.000 0.75 (2.275 0.00.88/12) = 24% Cost of capital of Debenture at Market Value A B C − 1. In defining the arbitrage process it is assumed that personal borrowing is a perfect substitute of for corporate borrowing.60.0975(Rs.000 1.25 − (10/125) (1 − 0. Value of unlevered firm.8% C 18% +1.000 Weights After Cost Tax Weighted Cost 18% 16% 18% Cost of Capital of Shares at Market Value 1.60.60.000 2.20 (Ke = K0) K0 of levered firm EBIT Less interest Net income after interest Less taxes Nl for equity holders Total market value (V) Market value of debt (B) Market value of equity (V−B) = S Ke = (Nl ÷ S) = Rs.275(Rs. It is assumed that all earnings are paid out as dividends.35)] = Rs.00.000 5.500/Rs.000 K0 = K/(B/V) + Ke((B/V)=0.2.60.35)/0.6.20 0.8% = 16.000 K0 of unlevered firm = 0.80% 126.96.36.1990 8.000 Value of levered firm.000/Rs.000/Rs.00. It is difficult to identify firms with the same business risk.2.00.00. It is difficult to identify two firms with the same operating profile.25% = 19.6.60.000)+0.000 38.00 0. 6.25% .10. 71. This is unlikely to be true in actual practice.28 The main weaknesses of the theory are as follows: • • • • 5. Calculation of WACC Amount (Rs.60.00.20 = Rs.500 71.) i) A B C ii) 6.00. Vu = EBIT (1 − t)/Ke = Rs 2.000 Rs.8.000 (0.5) = 4% (8/80) (1 − 0.25.50. Vl = Vu + Bt = Rs.25% Weighted average cost of capital A 18% + 00% = 18% B 16% +0.00.000 (1-0.000 +[Rs.000 6. 8.70/15) = 18% (4/20) = 20% (2.
52.30 per share.17.000 Therefore.000 Earnings before tax (EBT) Income-tax @ 50% Profit after tax Total number of shares Earnings per share (EPS) P/E ratio Market price per share 60.00. However.000 × 100 = 41.000 1.000 is borrowed = Rs.000 100 12 5. Earnings before interest and tax (EBIT): 20% on Rs. P/E ratio in such a case would be Rs.26.000= Rs 1.15.000 1. the issue price will be substantially lower than Rs.000 (ii) If Rs.00. 3. Debentures Rs.000 is raised by issue of equity shares Rs.50.000 (iii) Debt/Equity ratio if Rs.667 shares @ Rs.26.000 × 100 = 20% Rs. Probable price of shares of AB Limited: (i) If Rs.188.8.131.52.40.000 + Rs 40.000 40.5.00.000 is borrowed Rs.00.7.000 2. 17.00.3.20 60.000 46. in practice.80.2.000 4.000 3.000 [Refer to working note(i)] Less: Debenture interest: Old 12% on Rs.2% Rs.000 − Rs 40.000/5 years = Rs 22.40.000 2 .60.000 Average investment = Rs2. (a) Accounting rate of return: Average profits = Rs 1.00.2.00.000 New 14% on Rs.667 3 10 30 3.2.29 7.000 × Share capital Reserves Total (ii) Rate of return at present: Rs.00.000 1.00.000 It has been assumed that the additional amount will be raised by issuing 6.000 15.00.2.00. Working notes: (i) Capital employed at present: Rs.00.45.00.000 28.000 6.000 1.15 8 25.00.000 − 2. 8. 8.
000 − Rs40. for example a company is considering two projects viz.000 * =payback year= 3 years 8 months.000 62. The component costs may remain constant upto a certain level and then start increasing. One of the methods of comparing/ranking such proposals is to work out what is known as profitability index (PI).000 = Rs 42. The weights represent the proportion of funds the firm intends to employ.50.000) 1.50.68.000 72.000 5 10.000 52.45.000 (18. 9.. (a) (i) Marginal cost of capital: It is the cost of raising an additional rupee of capital.30 ARR = Rs 22. It may be calculated as follows: PI = Present value of net cash inflows Initial cash outlay Suppose. Such a level / point is known as the indifference point. The marginal cost of capital is calculated with the intended financing proportion as weights. (ii) Profitability Index: In capital budgeting.000 34.While deciding about the type and mix of a capital structure .000 42.000 per annum 5years 0 1 40. Mathematically.000 52.000 96.000 Payback Annual depreciation to be added back Rs2.000) 82. Profits Rs (1) Depreciation Rs (2) 42. ARR = Average annual profit after tax × 100 Average investment in the project (ii) The indifference point of EBIT refers to that level of EBIT at which the EPS remains the same irrespective of the debt – equity mix .000 2 30. there will be no difference between average cost of capital and marginal cost of capital.000 4 10. When the funds are raised in the same proportion and if the component costs remain unchanged. the firm may have two or more financial plans which result in the same EPS for a given level / point of EBIT.000 42. (b) (i) Accounting rate of return is the annualized net income earned on the average funds invested in the project. In that case both the average cost and marginal cost will increase but the marginal cost of capital will rise at a faster rate. A and B.000 Cash flow Rs (1)+(2)=(3) (2. a firm may evaluate the effect of different financial plans on the level of EPS .000 42. Out of the several permutations available .50.000 42. there are cases when we have to compare or rank a number of proposals each involving different amount of cash flows.000 = 15. It is also called benefit-cost ratio. The present value of net cash flows and initial outlay are as follows: .000)* Note: Residual value of the investment has been added to the investment before the average investment is obtained.000 3 20.000 Cumulative Rs (4) (2. It is derived when the average cost of capital is computed with marginal weights. This has the effect of lowering the ARR where a residual value exists.2% Rs1.
20 whereas Project B's ratio is 1. profitability index may also be calculated as under: PI = Sum of discounted cash inflows Sum of discounted cash outflows (iii) Working capital cycle: This refers to the length of time between the firm's paying cash for materials. overheads and raw materials. work-in-progress (WIP) is generated.000 = 1.. gets converted into sundry debtors.34. This cycle is also known as "Operating Cycle" and can be depicted as follows: WORKING CAPITAL CYCLE CASH DEBTORS RAW MATERIALS (Creditors) LABOUR AND OVERHEADS FINISHED STOCK WORK-IN-PROGRESS (WIP) . Short-term funds are required to meet the requirement of money during this period.000 29. (creditors) (entering into the production process/stock). In the production cycle. This cash is then again used to pay for raw materials. and the inflow of cash from debtors (sales). The time period is dependent upon the length of time within which the original cash gets converted into cash again. The debtors are realised after the credit period.000 It may be noted that as long as the profitability index is equal to or greater than 1.17 calculated as under: A= B= Rs.29.000 In the case of the above example. etc. Project A has profitability index of 1. WIP is converted into finished goods.000 Rs. Alternatively. the project is acceptable.20 Rs.31 Project A Rs.000 30. Present value of net cash inflows Initial cash outlay 36.17 Rs.30.000 Project B Rs 34.36. The finished goods when sold on credit.000 = 1.00. Thus there is a complete cycle from cash to cash. When costs are incurred on labour.
10.60.50.000 5.000 (Refer to working note 1) 2. 30.000 300 700 400 300 100 200 2.800 = PV (1 +r)n =Rs. 10.193 = (1+r)3 In the compound value table.000 1. 35.800/ Rs.30.5 3 Existing Machine (c) 0 1.000 (Refer to working note 2) 2.000 Cash Flow XYZLtd 1.10.000 Cash outflow may be treated as a principal which the company deposit into an account that pays an unknown rate of interest but returns a compound amount of Rs. 30.193 in the 3 years is 6% interest rate.000 (Refer to working note 3) 500 200 300 150 150 50 100 2 1.00.40.000 1.60.500) exceeds the cost of the lock box system (Rs 80.000 1.33 1. 35. financial and combined leverages(Rupees in lakhs) ABCLtd Sales Less Variable costs Contribution Fixed costs EBIT Less interest EBT DOL(contribution/EBIT) DFL(EBIT/EBT) DCL(DOL × DFL) 12. the actual rate of interest on the contract is slightly greater than 6%.00.5 Differential (d) = (b) – (c) -5.000 2 (ii) 5% × Rs 17. Year (a) 0 1 2 3 4 New Machine (b) -5. . Thus.000 4.10.800 after 3 years.000 = Rs 17.000 70.50.000 2.50. Determination of operating.60. FV Or Rs. value closest to the value of 1.000) .000 1. Now. the system should be initiated.00.5 3.500 (iii) Since the opportunity cost of the present system (Rs 87. 35.10.000 (1+r)3 Or Rs.000 Statement showing differential after tax cash flow stream for the proposal.10.000 = (1+r)3 Or 1.10.000 = Rs 87. (i) Total time saving = 3 1 days 2 Time savings × Daily average collection = Reduction in cash balances achieved 3 1 × Rs 5. 11.32 (b) The amount of Rs.000 1.
Calculation of Initial Cash Flow Rs. Annual revenues Less : Cash expenses Less : Depreciation (Refer to working note 3) Income before tax Less : Taxes (50%) Net income after tax Add : Depreciation Cash flow after tax 3.000 ------------1.000 2.000 3. Annual Cash Flows after tax: New Machine Rs.000 ------------80.1.00.60.10.000 80. 4.00.000 ------------(20.000 2.80.10.000 (40.000 ------------Existing Machine 80.000 80. 5.000 --------------80.000 ------------1.000) 10.40.000 80.000 ------------2.80.000 184.108.40.206.000 ------------1.000 80.000 1.60.60.000 ------------40.000 1.000 ------------2. 4.000) 80.000 ------------1.000 −80.000 ------------- -------------- .00.000 ------------9.10.30.000 ------------70.80.000 ------------1.20. Cash Flow in the Last Year: New Machine Book value of machine Less :Cash Proceeds of machine Gain / (Loss) Tax Savings /(Additional Tax) Add : Cash received Net Cash received Add : Return of working capital Add : Annual cash inflow Final year cash flow 220.127.116.11.000 70.000 ------------60.000 ------------70.10.000 ------------Existing Machine Year 1-2 Rs.60.20.000 1.000 80.33 Working Notes 1.80.000) Net Initial outlay 2.000 --------------6.000 ------------30.000 2.000 ------------Years 3-4 Rs.000 Outflow: Cost of New Machine Add : Transportation and installation cost of machine Add : Increase in Inventory & receivables Total cash outflow Inflow: Salvage value (of old machine) Add : Tax saving on loss 50% (Rs.000 40. 5.000 Rs.000 5.000 1.40.000 3.000 --------------5.40.000 70.000 ------------5.
5% 1.000 Proposed plan : [(60.7 50.000 × 100 =15% 1.000 × 100 3.000 × 100 3.000 units × Rs. Profit on additional sales Selling price per unit Less variable cost per unit Marginal contribution/unit Number of additional units to be sold (ii) Cost of additional investment in receivables (a) Average investments in receivables: Present plan = (60.70. 100 80 20 × 15.08% 3.000 21.30.000 57.00.000 (b) (c) Additional investments in receivables = Rs.17. 4.6 days 17.000 × 100 =14.50.000 16. Operating profit ratio Operating profit / Total sales 4.98.000 15.3 49.000 936.99 87.000 Cost of additional investments in receivables = 0. 3.000 × 100 3.00. Capital turnover ratio Sales / capital employed 5. Operating expense to sales ratio Operating exp / Total sales 3.00. 80)]/6 (12÷1) = Rs.00. Stock turnover ratio COGS / Average stock 6.00. 11.000 2.20 × Rs. Debtors collection period Average debtors / Average daily sales (Refer to working note) . 4.73 67.3% 15. 14.000 × 100 3.36.00.000 − Rs.000 Rs. 6.000 2. 11. Rs.000 3.00.000 units × Rs.000 Rs.5 days 7.000 (iii) Summary Profits on additional sales Less increased cost of investments Net increase in profits Thus. 6.2% 19.00. Net Profit to Networth Net profit / Networth 15.000 = Rs.000.000 2.000 × 100 76.50.000 739. 3. Gross profit ratio Gross profit/sales Computation of Ratios 1999 2000 64.54 1. 1.74.47.000 units × Rs.3% 20.000 5% 3.000 × 100 3.000 = 2.30. 1.000 =3.50.000 =3 1.000 82.74.000 1.34 13.000 =4.00.90)/Debtors turnover.50.9 77.000 5.000 50.00. the relaxation of credit standards is justified.000 1.74.90) + (15.74. 12(12÷1) = Rs.000 = Rs.
70.00. The increase in the Average collection period indicates that the company has become liberal in extending credit on sales.000 debenture at the rate of 18%.000 0.000 5.000 Hence. 1.25. An indepth analysis reveals that the decline in the warehousing and the administrative expenses has been partly set off by an increase in the transport and the selling expenses. 5. a decline in this ratio cannot be necessarily be interpreted as an increase in operational efficiency.00.00.20. 15. However.00. The decline in the stock turnover ratio implies that the company has increased its investment in stock. .35.000 1.000 15.000] Surplus available for dividends Original Dividend Increased Dividend Value of Equity (Dividend ÷C/C) Rs.73 3.05.000 365 Rs.35 Working note: Average daily sales = Credit sales / 365 2.25. Article WACC 12% 8% 20% Existing WACC: As there is no debt capital at present.000 1.) 6.000 365 Rs.5 times.739.20. This is indicated by a decline in the Capital turnover from 3 to 2. (i) Project Cash inflows Less: Debenture Interest [18% ×5. Therefore.216 = 6.936.00.000 25.000 90. II.000 and Rs 3. The operating profit ratio has remained the same in spite of a decline in the Gross profit margin ratio . In case the capital turnover would have remained at 3 the company would have increased sales and profits by Rs 67. there is no effect on WACC if the firm raises Rs.350 respectively. It appears as if the decision to expand the business has not shown the desired results.000 = × 100 = 20% Market Value of Equity 6.0% Article I.6% 18. Return on Networth has declined indicating that the additional capital employed has failed to increase the volume of sales proportionately.000 6.42. the cost of capital of equity will be its WACC also. In fact the company has not benefited at all in terms of operational performance because of the increased sales. Similarly there is a decline in the ratio of Operating expenses to sales.000 Proportion 5/9 4/9 Cost 21.000 Original value Gains to shareholders (ii) Calculation of New WACC Shares Debentures MV (Rs.99 Reasons : The decline in the Gross profit ratio could be either due to a reduction in the selling price or increase in the direct expenses (since the purchase price has remained the same). The company has not been able to deploy its capital efficiently. ke is Dividends 1.35.000 1. there is a corresponding increase in the current assets due to such a policy. However since Operating expenses have little bearing with sales .
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