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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 firms 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 policy:- It generally involves decision relating to period of credit, discount (if any) and other special items. Period of credit:- 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 firms credit terms are net 50, it is expected that customer will repay credit obligations not later than 50 days. Discount policy:- 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.

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Financial Management 2

(ii) Credit appraisal / analysis:- 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 CREDI T

GRAN T CREDI T

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 References:- 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 references:- 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 Reports:- 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 Experience:- In case of existing customers, the past experience of his account would be valuable sources of essential data for security and interpretation. Published Financial Statements:- 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 receivables: Another aspect of management of debtors is control of receivables. Merely setting of standards through 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.

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 companys 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.1200000 Selling Price per unit Rs.10 Variable Cost Price per unit Rs.7 Total Cost per unit Rs.9 Credit 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 by 25%. You are required to advise the firm regarding adopting the new credit policy, presuming that the firms required return on investment is 25%. Q.1 Solution Evaluation of Credit Proposal Particular Credit Period No of Units Sales @ 10 (-) Variable cost @ 7 Present Policy 1month 120000 1200000 840000 Proposed Policy 2 months 150000 1500000 1050000

Contribution (-) Fixed Cost (9-7) = 2x120000 Profit (a). . . . Receivables VC + FC x DCP 12 Cost of AR Capital cost (Receivables x ROI) (b). . . . Net Profit (a-b) . . . . Incremental NP

360000 240000 120000 840000 + 240000 12 x1 = 90000 = 90000 x 25% = 22500 97500 -

450000 240000 210000 1050000 + 240000 12 x2 = 215000 = 215000 x 25% = 53750 156250 58750

Recommendation: The company is advised to adopt 2 months credit period since it result into incremental net profit of Rs. 58750. Problem 2 Arvind Mills Ltd. manufactures readymade garments and sells them on credit basis through a network 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: Proposed Average Collection Period Expected annual Sales (Rs. Credit Policy (Days) Lakhs) I 30 65 II 40 70 III 50 74 IV 60 75 Which credit policy should the company adopt? (Assume 360 days in a year) Q.2 Solution
Evaluation of credit proposal

Particulars DCP (days) Sales (-) Variable cost (70%) Contribution (-) Fixed cost Profit (a) Receivables VC + FC x DCP 360 Cost of AR Capital cost (Reci x ROI) (b) Net profit (a b) Incremental NP

Present Policy 20 60 42 18 8 10 42 + 8 x 20 360 = 2.78 2.78 x 25% = 0.70 9.30 -

I 30 65 45.5 19.5 8 11.5 = 4.46 4.46 x 25% = 1.12 10.38 1.08

Proposed Policy II III 40 50 70 74 49 51.8 21 22.2 8 8 13 14.2 = 6.33 = 1.58 11.42 2.12 = 8.31 = 2.08 12.12 2.82

IV 60 75 52.5 22.5 8 14.5 = 10.08 = 2.52 11.98 2.68

Recommendation: Select proposed policy III since it result into highest incremental net profit. i.e. 2.82 lakhs. Problem 3 Ponds Ltd. has present sales level of 10,000 units at Rs. 300 per unit. Variable cost is Rs.200 per unit and 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 Increase In Sales % Of Bad Debts Existing 1 month 1% Proposed 2 months 3 months 15% 30% 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 DCP No of Units Sales @ (300 p.u.) (-) Variable cost @ 200 p.u. Contribution (-) Fixed Cost Profit (a). . . . Receivables VC + FC x DCP 12 Cost of AR Capital cost (Receivables x ROI) Defaulting cost (1% of sales) (b) . . . . . Net Profit (a-b) . . . . . . Incremental NP Present Policy 1month 10000 3000000 2000000 1000000 300000 700000 = 191667 Proposed Policy I II 2 months 3 months 11500 13000 3450000 3900000 2300000 2600000 1150000 1300000 300000 350000 850000 950000 = 433333 =737500

38333 30000 68333 63166.7 -

86667 103500 190167 659833 28166

147500 195000 342500 607500 (24167)

Recommendation: i.e. 2 months Select 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: Quantity lifted (No of TV sets) A B C 0 1000 1000 30 1000 1500 60 1000 2000 1000 90 1000 2500 1500 The selling price per TV set is Rs.9000. The expected contribution is 20% of the selling price. The cost 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 A Select Credit period 0 days since Quantity remains same inspite of increase in Credit period. Evaluation of credit proposal for B. Particulars DCP No. of units Sales @ 9000 p.u (-) Variable cost (80%) Contribution (20%) (a) Receivables Sales x DCP 360 Cost of AR Capital cost (Recv x ROI) (b) Net profit (a b) 1 0 1000 9000000 7200000 1800000 1800000 Proposed Policy 2 3 4 30 60 90 1500 2000 2500 13500000 18000000 22500000 10800000 14400000 18000000 2700000 3600000 4500000 1125000 225000 225000 2475000 3000000 600000 600000 3000000 5625000 1125000 1125000 3375000 Credit period (days)

Recommendation: 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. Proposed Policy 3 4 DCP 60 90 No. of units 1000 1500 Sales @ 9000 p.u 9000000 13500000 (-) Variable cost (80%) 7200000 10800000 Contribution (20%) (a) 1800000 2700000 Particulars

Receivables Sales x DCP 1500000 360 Cost of AR Capital cost (Recv x ROI) 300000 (b) 300000 Net profit (a b) 1500000

3375000 675000 675000 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 5 X & Co. whose current sales are Rs.600000 per annum and an average collection period of 30days wants to pursue a more liberal policy to improve sales. Increase In Collection Increase In Sales % Default Period (Days) Rs. Anticipated 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.2 Current 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 Solution
Evaluation of credit proposal

Credit Policy

Particulars DCP (days) No. of units Sales @3 p.u. (-) Variable cost @ 2 p.u. Contribution (-) Fixed cost (2.25 2) x 200000 Profit (a) Receivables VC + FC x DCP 360

Present Policy 30 200000 600000 400000 200000 50000 150000 37500

A 40 210000 630000 420000 210000 50000 160000 52222

Proposed Policy B C 50 60 216000 225000 648000 675000 432000 450000 216000 225000 50000 50000 166000 175000 66944 83333

D 75 230000 690000 460000 230000 50000 180000 106250

Cost of AR Capital cost (Recv x ROI) Defaulting cost (b) Net profit (a b) Incremental NP

7500 6000 13500 136500 -

10444 9450 19894 140106 3606

13389 12960 26349 139651 3151

16667 20250 36917 138083 1583

21250 27600 48850 131150 (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)
Extra Practise Problem Problem 7 Many times Customers play a very smart game. They pay the bills before time in initial period and once they get used to Companys 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 8 System Failure in USA, Economic Slowdown in Europe and Stock Market Meltdown in Asia have their 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 9 As a Marketing Executive, before extending credit facilities to the customers introduced by your Salesman, what precaution would you take to protect the interest of the Company. Problem 10 Construct of a Credit Rating Index (based on a 5-point rating scale) Factor Past Payment Net profit Margin Current ratio Debt-equity ratio Return on equity Factor Weight 0.25 0.25 0.15 0.15 0.20 Rating 5 3 4 2 3

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

Age Group ( in days ) A Ltd. B Ltd. 0 30 60 25 31 60 30 15 61 90 10 35 > 90 0 25 Comment on above ageing schedule of A Ltd. & B Ltd. Problem 12 Kalpataru Ltd. Collection Matrix
Percentage of receivables collected during the Month of Sales First following month Second following month Third following month Fourth following month January Sales 15 20 35 15 15 February Sales 17 22 37 17 7

Percent of Receivables (Standard) 45 35 15 5

March Sales 18 23 38 18 3

April Sales 19 24 39 18 0

May Sales 21 26 41 12 0

June Sales 25 28 43 4 0

Comment on collection matrix.

REVIEW QUESTIONS:Q.1 Concept Testing (a) Concept of Receivable Management. (b) Various costs associated with Accounts Receivable. (c) 5 cs 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.

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)

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 coordaining the financial side of a business. Cash budget serves the following purposes: a. To ensure that sufficient cash is available whenever required b. 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 budget is usually prepared for short periods ranging up to one year. Objective is to ensure short term liquidity an avoid default in timely discharge of current liabilities. Thrust is on current assets and liabilities and maintaining cash cushion for safety. Usually prepared by junior management team for perusal of senior managers. It is working capital management activity. Cash Forecast Cash forecast is for longer terms exceeding one year such as 3 years, 5 years, etc. Objective is to study sources of funds for various future requirements. Capital receipts and capital expenditure investment dominate this number game. Usually prepared by senior management for perusal of directors owners. It is more of investment planning activity.

Distinguish between Cash Flow Statement and Cash Budget: Cash Flow Statement Cash flow statement is prepared based on past data of income statement and balance sheet. Is historical in nature. Analytical tool. Is based on real data. Cash Budget Cash budget is prepared based on estimates of collection and outgo of cash. Is futuristic in nature. Planning tool. Is based on estimates.

SECTION II :- MOTIVES FOR HOLDING CASH There are 3 important motives for holding cash: Transaction Motives Business organization needs cash for conducting business transactions. The collection of cash is not perfectly matched with payment of cash. Hence, some cash balance is required to be maintained.

Precautionary Motive There maybe uncertainties regarding receipt of cash and payment of cash. In order to protect against such uncertainties, it is necessary to maintain some cash balance. Speculative Motive Business organization would like to tap business opportunities arising from fluctuations in commodity 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 firms 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 firms 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 Payable One basic strategy of efficient cash management is to stretch the accounts payable. In other words, a firm 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 Management Another 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 Receivable Yet another strategy for efficient cash management is to collect accounts receivable as quickly as possible 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 Strategies We have shown the effect of individual strategies on the efficiency of cash management. Each one of 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 forecasting: 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. Reports: Most firms used there management information system (MIS) to prepare regular and sometimes even daily treasury reports to report the cash position. 4. Prompt billing: Invoices should be promptly sent to customers to minimize billing float.

5. Obtaining favorable credit terms of purchase: This depends on the companys bargaining power with the suppliers. 6. Concentration banking: 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 System:- 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 float:- 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.

(FOR MORE DETAILS (THEORY) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
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 January (actual) Sales Rs. 80,000 Purchase Rs. 45,000 Wages Rs. 20,000 Expenses Rs. 5,000

February (actual) 80,000 40,000 18,000 6,000 March (actual) 75,000 42,000 22,000 6,000 April (budgeted) 90,000 50,000 24,000 7,000 May (budgeted) 85,000 45,000 20,000 6,000 June (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 Solution th Cash budget for 3 months ending 30 June 2010. Particulars Opening Balance b/f Add:- Cash Receipts Cash Sales Collection from debtors. i) ii) Cash Payment Cash purchase Payment to suppliers Wages Rent Other expenses ii) (iii) Less:- Fixed deposits * Closing balance c/f W.N.1) Collection from debtors. Feb Total Sales 80000 (-) Cash Sales 20% 16000 Credit Sales 64000 2m Due & received April W N 2) Payment to Suppliers. Mar Total Purchase 42000 (-) Cash Purchase 10% 4200 Credit Purchase 37800 1m Due & Paid April May June May April 50000 5000 45000 June May 45000 4500 40500 Mar 75000 15000 60000

April 15000 18000 64000 97000 5000 37800 23000 500 6500 72800 24200 9200 15000

May 15000 17000 60000 92000 4500 45000 22000 500 5500 77500 14500 14500

June 14500 16000 72000 102500 3500 40500 19000 500 4500 68000 34500 19500 15000

April 90000 18000 72000

W N 3) Wages April of Previous month 11000 of Current month 12000 23000 + May 12000 10000 22000 + June 10000 9000 19000
st

Q.2 From the following information prepare a monthly cash budget for the three months ending 31 December, 2009: Sales Materials Wages Production Admin. And Months 2009 Rs. Rs. Rs. Rs. Selling Rs. June 3,000 1,800 650 225 160 July 3,250 2,000 750 225 160 August 3,500 2,400 750 250 175 September 3,750 2,250 750 300 175 October 4,000 2,300 800 300 200 November 4,250 2,500 900 350 200 December 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: month Overheads: month st Cash and bank balance: On 1 October it is expected to be Rs. 15,000 Other Information is: Plant and machinery to be installed in august at a cost of Rs.24,000. It will be paid for by st monthly of Rs.500 each from 1 October. st Preference share dividend @ 5% on Rs.50,000 is to be paid 1 December. st Calls on 250 equity shares @ Rs.2 per share expected on 1 October. st Dividends from investments amounting to Rs.250 are expected to 31 December. Income tax (advance) to be paid in December Rs.1500 Q.2 Solution st Cash budget for 3 months ending of 31 December, 09
Particulars Opening Balance b/f Add:- Cash receipts Cash sales Collection from debtors. Dividend from Investment. Call on shares (250 x 2) i) ii) Cash Payment Payment to suppliers Wages OHs Plant & Machinery Preference dividend (5% x 50000) Income tax advance ii) Closing balance (i-ii) Oct 15000 400 1350 500 17250 2400 78750 48750 500 4175 13075 Nov 13075 425 2812.5 16312.5 2250 875 525 500 4150 12162.5 Dec 12162.5 450 3037.5 250 15900 2300 975 562.5 500 2500 1500 8337.5 7562.5

W N 1) Wages ( month) of Previous month of Current month Oct 187.50 600 787.50 + Nov 200 675 875 + Dec 225 750 975

W N 2) Overheads (Production + A + S) of Previous month of Current month Oct 237.5 250 487.50 + Nov 250 275 525 July 3250 325 2950 + Dec 275 287.50 562.50 August 3500 350 3150

W N 3) Collection from debtors June Total Sales 3000 (-) Cash Sales (10%) 300 Credit Sales 2700 (4 M) Due 50% in due month 50% next month Oct 1350 -_ 1350 +

Nov 1462.5 1350 2812.5

Dec 1575 1462.5 3037.5

Q.3 Prepare cash budget for the three months ending 30 June 2010 from the following information: Month Sales Rs. Material Wages Rs. Overheads Purchase Rs. Rs. 9,600 3,000 1,700 9,000 3,000 1,900 9,200 3,200 2,000 10,000 3,600 2,200 10,400 4,000 2,300 the remaining sales, 50% are collected in the next month and

th

February 14,000 March 15,000 April 16,000 May 17,000 June 18,000 Sales: 10% sales are on cash. Of remaining balance in next month. Creditors: materials-2 months. Wages-1/4 month. Overheads- month. st Cash and bank balance on the 1 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. st Dividend at 5% on preference share capital of Rs.2,00,000/- is to be paid on 1 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 30 June 2010 Particulars Opening Balance b/f Add:- 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) W N 1) Collection from debtors Feb Total Sales 14000 (-) Cash Sales 1400 Credit Sales 12600 50% of credit sale 2m 50% of credit sales 1m W N 2) Overheads of Previous month of Current month W N 3) Wages (1/4 month) of Previous month of Current month April 750 2400 3150 + May 2800 2700 3500 +
th

th

April 6000 1600 13050 20650 9600 3150 1950 2000 16700 3950

May 3950 1700 13950 19600 9000 3500 2100 2000 16600 3000

June 3000 1800 1000 14850 9000 29650 9200 3900 2250 2000 10000 2000 29350 300

March 15000 1500 13500 May 6750 7200 13950 + May 1000 1100 2100 +

April 16000 1600 14400 June 7200 7650 14850 June 1100 1150 2250

May 17000 1700 15300

April 6300 6750 13050 April 950 1000 1950

June 900 3000 3900

Q.4 Prepare cash budget on Alpha Co. Ltd. for three months ended 30 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

th

February 1,00,000 40,000 30,000 20,000 March 1,60,000 80,000 30,000 30,000 April 2,00,000 1.00,000 50,000 40,000 May 2,80,000 1,40,000 50,000 40,000 June 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 month and other expenditure on the months 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 Solution Cash budget for Alpha Co. Ltd. for 3 months ending 30 June, 2010 Particulars April Opening Balance b/f 28000 Add:- Cash Receipts 40000 Cash Sales 80000 Collection from debtors. 148000 A). (-) Cash Payment 76000 Payment to creditors 40000 Payment of Wages (W.N.3) 30000 Payment of other expenditure Payment equity dividend Payment of installment 146000 B). 2000 Note:- It is assumed that company has sufficient overdraft facility. W.N.1) Collection from debtors Feb March April Sales 100000 160000 200000 (-) Cash Sales 20000 32000 40000 Credit Sales 80000 128000 160000 (2 M) April May W.N.2) Payment to supplier March April 80000 100000 5% discount 4000 5000 76000 95000 1 month:. April W.N.3) Wages Current month April 25000 May May 25000 June May 140000 7000 133000 June June 30000

May June 2000 (29000) 56000 128000 186000 64000 160000 195000

95000 133000 50000 55000 40000 40000 30000 50000 215000 278000 (29000) (83000)

 Previous month

15000 40000

25000 50000

25000 55000
th

Q.5 Prepare a cash budget for the months ended 30 September, 2010 based on the following information: st Cash at bank on 1 July, 2010 25,000 Salaries and wages estimated monthly 10,000 Interest payable: August 2010 5,000 Estimated June Rs. July Rs. August Rs. September Rs. Cash sales -- 1,40,000 1,52,000 1,21,000 Credit sales 1,00,000 80,000 1,40,000 1,20,000 Purchases 1,60,000 1,70,000 2,40,000 1,80,000 Other 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 %, 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 Opening Balance b/f Add:- 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) W. N 1) Collection from debtors June Credit Sales 100000 July 50% in same month 38000 50% in 1 month 48750 86750 July 25000 140000 86750 251750 10000 17000 144000 20000 191000 60750 Aug Sept 60750 104250 152000 121000 105500 125250 318250 350500 10000 10000 5000 24000 18000 153000 216000 22000 21000 214000 265000 104250 85500

July 80000 Aug 66500 39000 105500

Aug 140000 Sept 57000 68250 125250

Sept 1,20,000

EXTRA PRACTISE PROBLEM (Q.6) LTC Brothers have requested to prepare their cash budget for the period January 20X1 through June 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 1 January 20X1 is 28,000.
st

REVIEW QUESTIONS: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.

(FOR MORE DETAILS (P ROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)

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) Owners 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 firms cost of capital is the rate of return required by them for supplying capital for financing the firms 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

firms cost of capital is the average of the opportunity costs (or required rates of return) of various securities which have claims on the firms 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 models Model 1: Total Yield Model Model 2: Dividend growth Model Ke = D1 + (P1 Po) x 100 Po Ke = (D1 x 100) + G Po Model 3: FPS Model EPS1 = PAT-Pref. Div No. of eq. sh. & Ke = EPS1 x 100 Po Good Approximation Ke = 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 (Ke) Notations: Po = Stock (share) price today P1 = Stock after 1 year (expected) D1 = Dividend (expected) after 1 year G = Growth in dividend % p.a. (expected) EPS1 = Earnings per share after 1 year (expected)

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

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 = Preference dividend x 100 Net proceeds Note:- Net proceeds = Face value + premium discount flotation cost. Redeemable Preference Shares Kp = Pref. divd + FV NP N FV + NP 2 Note:- N = Number of Years Cost of Retained Earnings The opportunity cost of the retained earnings (Internal funds) is the rate of return on dividends foregone by equity shareholders. There is however a difference between retained earnings and issue of equity shares from the firms 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 = D1 x 100 + G + G P0

x 100

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 firms share will fall. Example:- 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 = D1 x 100 + G + 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) NP Where, Kd = Cost of debt I = Interest on debt calculated on Face Value t = tax rate NP = 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 + NP 2

x (1t)

Where, Kd = Cost of debt I = Interest on debt calculated on Face Value FV = Face Value NP = Net proceeds N = No. of years after which the debt is redeemable t = tax rate Note : If the problem says ignore tax or ask to calculate pretax 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 issuers 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 becausei. 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 riskLow return. Equity is unsecured, high risk investment. High riskHigh 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. Calculate the cost of each specific source of fund. Assign weight of specific costs based on its proportion in the capital structure. Multiply cost of each source by its proportion in the capital structure. 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 = eke + dd Where Ko = WACC Example Capital Component Equity Share Capital Retained Earning Preference Shares Debt

i. ii. iii. iv.

K 11% 10% 9% 6%

W 10 25 15 50

WK 1.10% 2.50% 1.35% 3.00% WACC 7.95%

Trading on Equity It refers to use of borrowed funds so as to increase the return on equity (ROE). Use of borrowed funds is also financial leverage. Features of Trading on Equity. 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 Remember 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]

(FOR MORE DETAILS (THEORY) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
SECTION : VI - COST OF CAPITAL :- PROBLEMS + SOLUTION (Q.1) Cost of equity 30% Cost of debt 9% rd rd Equity is 1/3 of capital and debt is 2/3 Calculate weighted average cost of capital Q.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% th th Equity is 1/4 of capital and debt is 3/4 Calculate weighted average cost of capital Q.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 = eke + dkd = (75% x 40%) + (25% x 12%) = 30% + 3% = 33% ko = eke + dkd = (50% x 40%) + (50% x 12%) = 20% + 6% = 26% ko = eke + dkd = (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
1. 2. 3. e 80% 50% 20% Ke 30% 30% 30% eke 24% 15% 6% d 20% 50% 80% kd 15% 15% 20% dkd 3% 7.5% 16% Ko 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 of Cost of Debt Cost of total capital employed equity 0 5% 12% 10 5% 12% 20 5% 12.50% 30 5.5% 13% 40 6% 14% 50 6.5% 16% 60 7% 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 1. 2. 3. 4. 5. 6. 7. e 100% 90% 80% 70% 60% 50% 40% Ke 12% 12% 12.50% 13% 14% 16% 20% eke 12% 10.8% 10% 9.1% 8.4% 8% 8% d 0% 10% 20% 30% 40% 50% 60% kd 5% 5% 5% 5.5% 6% 6.5% 7% dkd 0% 0.5% 1% 1.65% 2.4% 3.25% 4.2% Ko 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 = eke + dkd 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 debt Equity

Q.8 Weighted average cost of capital Cost of Debt Debt Equity Calculate ke Q.8 Solution:ke = k0 + (k0-kd) x debt
Equity = 30% + (30% - 20%) x 500 250 = 30% + 10% x 2 = 30% + 20% = 50%

= 30% = Rs.20% = Rs.500 = Rs.250 (1) in current situation (2) If cost of debt is reduced by 5% (3) If debt : Equity ratio is 3

ke = k0 + (k0-kd) x debt
Equity = 30% + (30% - 15%) x 500 250 = 30% + (15% x 2) = 60%

ke = k0 + (k0-kd) x debt
Equity = 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 lacs Equity = 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.10 Cost of Equity = 30% Cost of Debt = 10% Debt = 300 Equity = 100 Calculate Weighted average cost of capital Q.10 Solution:ke = k0 + (k0-kd) x debt
Equity

30% = k0 + (k0 - 10%) x 3 30% = 4 k0 - 30% :. 60% = 4k0 :. k0 = 15% Alternative Way Rs. Equity 100 Debt 300 400 Q.11 Equity = Rs.440 Preference shares = Rs.165 Debt = Rs.275 Cost of equity = 30% Pref. = 20% Debt = 10% Calculate WACC

25% 75% 100%

k 30% 10%

k
7.5% 7.5% 15%

Q.11 Solution:Rs. Equity 440 Preference 165 Debt 275 880 :. WACC = 21.88% Q.12 Cost of Equity = 40% Cost of Preference = 20% Cost of Debt = 15% Equity = Rs.525 Pref. = 168 Debt = 782 Calculate WACC Q.12 Solution:Rs. Equity 525 Preference 168 Debt 782 1475 :. WACC = 24.47%

50% 18.75% 31.25% 100%

k 30% 20% 10%

k
15% 3.75% 3.13% 21.88%

35.59% 11.39% 53.02% 100%

k 40% 20% 15%

k 14.24% 2.28% 7.95% 24.47%

Q.13 Equity = 500 12% of Preference = 100 15% Debt = 900 Tax @ 40%, Cost of equity 30%. Calculate WACC. Q.13 Solution:Equity Preference Debt Rs. 500 100 900 1500

33.33% 6.67% 60% 100%

k 30% 12% 9%

k
10 0.80 5.4 16.20%

:. WACC = 16.20% Cost of debt kd = I x (1 Tax rate %) = 15% x (1 40%) = 15% x (1 0.40) = 15% x 0.6 = 9% Cost of Preference kd = Proposed dividend kp = 15%

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
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 capital employed 0 10 20 30 40 50 60 Cost of debt 7.0 7.0 7.0 8.0 9.0 10.0 11.0 Cost of equity 15.0 15.0 16.0 17.0 18.0 21.0 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 Structure Capital Structure: The combination of debt and equity used to finance a firm Target Capital Structure: 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 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. Ke
Cost%

2. Net operating Income (NOI) 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.

KO

Cost%

Ke

Kd Debt Proportion % Equation: ko = weke + wdwd Assumptions: 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. of Ke & Kd. Ke & Kd are independent variables & ko is dependent.

Ko Kd
Debt Proportion % Ke = Ko + (Ko Kd) x Debt / Equity Cost of Debt can be calculated & is constant. Overall Return (ROI) i.e. PBIT or Net Operating income) is estimable & is constant. Ke is residual value after deducting kd from WACC Ko & Kd are independent variables & ke is dependent.

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 Approa indicating inter ch -relationship between Cost Capital and Capital Structure of 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. & Managers iii. 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/r Where V is the market value of the firm, D is the market value of debt, E is the market value of equity, 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.

(FOR MORE DETAILS (THEORY) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
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. Charge on assets. Interest to be paid irrespective of profits / loss. From Banks (negotiated.)

Demerits-

Ways to raise Debt: i. Term Loan :

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- doesnt 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)

Promoters (To extent possible) Private Placements (Balance, friends & relatives)

Debt (7.5 Crore)

. 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) Particulars Share capitals (Rs.10) 14% debentures Loan from financial institution @ 18 p.a. Rate of Interest Alternative A B C 50 20 10 20 15 10 25

Expected rate of return before tax is 25%. The company at present has low debt. Corporate taxation 50%. Which of alternatives you would choose? Q.2 Solution Evaluation of financing Alternative Particulars EBIT (-) Interest (20 x 14%) + (10 x 18) = 4.6 (15 x 14%) + (25 x 18) = 6.6 EBT (-) Tax @ 50% EAT (-) Preference dividend A 12.5 12.5 6.25 6.25 B 12.5 4.6 7.9 3.95 3.95 C 12.5 6.6 5.9 2.95 2.95 -

Earnings for ESH No of Equity Shares :. EPS (a b)

(a) (b) (Rs.)

6.25 5 1.25

3.95 2 1.98

2.95 1 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. Particulars EBIT (-) Interest EBT / PBT (-) Tax @ 35% EAT / PAT / NPAT (-) Preference dividend Earnings for ESH a). . . No of equity shares Existing New b). . . . EPS (a/b) 1 150000 150000 52500 97500 97500 5000 3000 8000 Rs.12.19 Alternatives 2 3 150000 150000 20000 30000 (10% x 2L) (10% x 3L) 130000 120000 45500 42000 84500 78000 84500 78000 5000 1000 6000 Rs.14.08 5000 5000 Rs.15.60 4 150000 150000 52500 97500 16000 81500 5000 1000 6000 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: Equity shares of Rs.100 each Retained Earnings 9% Preference shares 7% Debentures Rs. 4000000 1000000 2500000 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) Solution Evaluation of Financing Alternatives. Particulars EBIT (-) Interest - Existing - New EBT / 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 ROI = PBIT x 100 Capital employed 1 1500000 (175000) 1325000 662500 662500 (225000) 437500 40000 20000 60000 7.29 Rs.145.8 (29 x 7.29) Alternatives 2 1500000 (175000) 1325000 662500 662500 (225000) (250000) 187500 40000 40000 4.69 Rs.79.73 (17 x 4.69) 3 1500000 (175000) (225000) 1100000 550000 550000 (225000) 325000 40000 40000 8.13 Rs.130.08 (16 x 8.13)

:. PBIT = Cap. Emp. x ROI 100 = 12500000 x 12 100 = Rs.1500000 Recommendation: - Select Alternative 1 i.e. Issue of 20000 Equity shares, since It results into highest MPS.

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PRACTISE PROBLEMS Q.8 The following financial information pertains to VX Ltd. as at 31 March, 2010. Balance Sheet (Rs. In lacs) Fixed Assets (at cost less depreciation) 200 Net Current Assets 60 Total Assets 260 Less: Long term debt 215 Net Assets 45 Represented by: Equity capital 40 Retained earnings 5 45 Profit and Loss Account (Rs. In lacs) Net Profit before interest and tax 52 Interest paid 20 Tax paid 12 Dividends declared 18 The company has identified a profitable investment opportunity and requires funds to the tune of Rs.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:st

CHAPTER: 7 LEVERAGE
LEVERAGE:Leverage refers to amplified benefit on comparatively lower level of investment or lower sales. Such enhancement 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 sales increase fixed cost do not increase which results in proportionately higher profits. Degree of operating leverage calculated as DOL = Contribution = % change in PBIT PBIT % 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. These include interest on loan & debentures as well as preference dividend. Degree of financial leverage is calculated as:PBIT = % Change in PBT PBT = % Change in PBIT Higher 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 operating expenses as well as fixed financial expenses. Degree of combined leverage is calculated as: DCL = Contribution = % change in PBIT PBIT % change in Sales

Alternate Formula DCL = DOL x DFL. DCL is a complete indicator of leverage benefits & leverage risks. DCL also indicates overall breakeven 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: 1. Objective Operating Leverage Financial Leverage The objective is to magnify the The objective is to magnify effect of changes in sales on the effect of changes in operating profit. operating profits on earning per share. It establishes relationship It establishes relationship between operating profit and between operating profit and sales. return on equity It measures a firm ability to use It measures a firm ability to fixed cost assets to magnify the use fixed cost funds to operating profits. magnify the return to equity shareholders. It relates to the assets side of It relates to the liability side the Balance sheet. of the Balance sheet. It affects the profit before It affects the profit after interest and tax interest and tax It involves operating risk of It involves financial risk of being unable to cover fixed being unable to cover fixed operating cost. financial cost. It is concerned with investment It is concern with financial decision decision It is described as first stage It is described as second stage leverage. leverage. DOL = Contribution DFL = PBIT PBIT PBIT

2. Relationship 3. Measurement

4. Relationship 5. Effect on income 6. Risk 7. Decision 8. Stage 9. Formula

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

Q.1 Solution Particulars Units Sales (-) Variable cost Contribution (-) Fixed cost Profit Amt (Rs.) Amt (Rs.) Amt (Rs.) 100000 110000 80000 1000000 1100000 800000 300000 330000 240000 700000 770000 560000 400000 400000 400000 300000 370000 160000

Comment :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: 2 Ambika Ltd. sells 2,000 units per annum. The selling price per unit is Rs. 300 and the variable cost per unit is Rs. 70. The fixed operating cost is Rs. 60,000. Calculate operating leverage. Q.2 Solution Particulars Sales (2000 x 300) (-) Variable cost (70 x 2000) Contribution (-) Fixed Cost PBIT Operating Leverage = Contribution PBIT = 460000 400000 = 1.15 Problem: 3 Y 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 degree of operating leverage of these sales volumes? Fixed cost is Rs. 10,000. Q.3 Solution Particulars Amt (Rs.) Amt (Rs.) Units 3000 3500 Sales 60000 70000 (-) Variable cost 45000 52500 Contribution 15000 17500 (-) Fixed cost 10000 10000 PBIT 5000 7500 Operating Leverage = Contribution (3000 units) PBIT = 15000 5000 =3 Amt (Rs.) 600000 140000 460000 60000 400000

Operating Leverage = Contribution (3500 units) PBIT = 17500 7500 = 2.3 Higher units / sales, results into lower operating / business risk and vice versa. Problem: 4 Compute financial leverage from the following information: Interest Sales (1,000 units) Variable Cost Fixed Cost Q.4 Solution Particulars Sales (-) Variable cost Contribution (-) Fixed cost PBIT (-) Interest PBIT Financial Leverage = PBIT PBT = 20000 10000 =2 Problem: 5 Shruti Ltd. has the following structure: Equity share capital 10% preference share capital 8% debentures Rs. 5,00,000 5,00,000 5,50,000 Amt (Rs.) 100000 50000 50000 30000 20000 10000 10000 Rs. 10,000 1,00,000 50,000 30,000

The present EBIT is Rs. 2,50,000, tax rate is 50%. Calculate financial leverage. Q.5 Solution EBIT (Earning Before Interest Tax) - Interest (550000 x 8%) PBT (-) Tax @ 50% PAT Rs. 250000 44000 206000 103000 103000

Financial Leverage = PBIT PBT = 250000 206000 = 1.21 Problem: 6 Y Ltd. has sales of Rs. 2,00,000. Variable cost is 50% of sales while the fixed operating cost amounts 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 by 10%. Q.6 Solution Particulars Sales (-) Variable cost Contribution (-) Fixed cost PBIT (-) Interest PBT Composite Leverage = Contribution (at present) PBT = 100000 20000 =5 Composite Leverage = Contribution (at 10% ) PBT = 110000 30000 = 3.67 Analysis Increase in Sales reduces the combined risk and vice versa. Problem: 7 The following information is available in respect of two firms, P Ltd. and Q Ltd. Sales -variable cost Contribution -Fixed cost EBIT -Interest Profit before tax P Ltd. Rs. 500 200 300 150 150 50 100 Q Ltd. Rs. 1,000 300 700 400 300 100 200 Rs. Sales 10% 200000 220000 100000 110000 100000 110000 60000 60000 40000 50000 20000 20000 20000 30000

You are required to calculate different leverages for both the firms and also comment on their relative risk position. Q.7 Solution Particulars 1) Operating Leverage ratio = Contribution PBIT 2) Financial Leverage ratio = PBIT PBT 3) Combined Leverage ratio = Operating Leverage ratio x Financial Leverage ratio P Ltd. 300 150 =2 150 100 = 1.5 2 x 1.5 =3 Q Ltd. 700 300 = 2.3 300 200 = 1.5 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: 8 A simplified Income Statement of Zenith Ltd. is given below. Calculate its degree of operating leverage, degree of financial leverage and degree of combined leverage. Sales Variable cost Fixed cost EBIT Interest Taxes (30%) Net Income Q.8 Solution Revenue statement for year----Particulars Sales (-) Variable cost Contribution (-) Fixed cost PBIT (-) Interest PBT (-) Tax (30%) PAT * Rs. 483000 200000 283000 75000 208000 110000 98000 29400 68600 ? 2,00,000 75,000 2,08,000 1,10,000 29,400 68,600

Operating Leverage Ratio

Financial Leverage Ratio

Combined Leverage Ratio

= Contribution PBIT = 283000 208000 = 1.36 = PBIT PBT = 208000 98000 = 2.12 = Contribution PBT = 283000 98000 = 2.9

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PRACTISE PROBLEMS Q.9 Case Study: Observe the following data Income Statement Sales 50 L 50 L PBIT 5L 5L - Interest 0.4 L 1.6 L PBT 4.6 L 3.4 L - Tax 2.3 L 1.7 L PAT 2.3 L 1.7 L Sources of Funds Equity 16 L 4L Debt 4L 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 followingup 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 return 2. Pay back period 3. Net present value 4. Internal rate of return 5. 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 Budgeting Capital budgeting is a complex process which may be dividend into following phases: 1. Identification of potential investment opportunities 2. Assembling of proposed investments 3. Decision making 4. Preparation of capital budgeting and appropriations 5. Implementation 6. Performance review 1. Identification of potential investment opportunities The 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 to i) 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 making The 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 appropriation Project involving smaller outlays and which executives at lower levels can decide are often covered by 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. Implementation Translating 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 accounting: 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 techniques: 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 nd Nano Plant at Sanand started in record time of 1 year on 2 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 decisions: 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 of the firms 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 such investment 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 Decisions: 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 process in 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 Decisions Mutually exclusive projects are projects, which compete with other projects in such a way that the acceptance 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.

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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 Amount 1 20000 2 40000 3 30000 4 15000 5 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 1. 2. 3. 4. 5.

PBDT (-) 20,000 40,000 30,000 15,000 25,000

Dep = 14,000 14,000 14,000 14,000 14,000

TOTAL NPAT Avg. NPAT = 60,000 5 = Rs.12,000 ARR based on O.Inv = Avg. NPAT x 100 O.Inv = 12,000 x 100 80,000 = 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.Cap 2 = 80,000 10,000 + 10,000 + 0 2 = 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: Purchase Price Power per year Consumable Stores Per Year Other Changes Per Year Wages Per Running Hour Selling Price Per Unit Material Cost Per Unit Estimated Life of Machine Machine Running Hrs. Per Year Units Of Output Per Hour Tax at 40% of Net Profit Old Machine (Rs.) New Machine (Rs.) 200000 300000 10000 22500 30000 37500 40000 45000 15 26.25 6.25 6.25 2.50 2.50 10 yrs. 10 yrs. 2000 hrs. 2000 hrs. 24 units 36 units

PBT/PAT 6,000 26,000 16,000 1,000 11,000 60,000

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 Solution Infotech India Ltd.

Particulars No. of Units :. Sales @ 6.25 (-) Variable Cost Power Consumable Other Charges Wages Material @ 2.50 NPBDT (-) Depreciation NPBT (-) Tax @ 40%

Evaluation of Alternatives Old Machine 48000 (2000 x 24) (a) 300000 10000 30000 40000 30000 (2000 x 15) 120000 230000 70000 20000 (200000 10) 50000 20000 30000 = 30000 x 100 200000 = 15% = 30000 x 100 100000 = 30%

New Machine 72000 (2000 x 36) 450000 22500 37500 45000 52500 (2000 x 26.25) 180000 337500 112500 30000 (300000 10) 82500 33000 49500 = 49500 x 100 300000 = 16.5% = 49500 x 100 150000 = 33%

(b) (a b)

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

Recommendation Based 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: Year Investment Sales Revenue Operating Cost Q.3 Solution Sales (-) Oper. Cost PBT = NPAT :. Avg. NPAT = 1 1,20,000 60,000 60,000 2 1,00,000 50,000 50,000 3 80,000 40,000 40,000 0 Rs. 90000 1 Rs. 120000 60000 2 Rs. 100000 50000 3 Rs. 80000 40000

1,50,000 = Rs.50,000 3 ARR based on O.Inv = Avg. NPAT x 100 O.Inv. = 50,000 x 100

90,000 = 55.56% ARR based on Avg. Invst. = Avg. NPAT x 100 Avg. Invst. = 50,000 x 100 45,000 = 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.20,000 Tax Rate 35% Depreciation (already charged) SLM basis 1.Payback period 2.Payback profitability 3.ARR (Accounting Rate of Return Method) Q.4 Solution n Dep = Cost Scrap Life = 2,00,000 5,000 10 = Rs.19,500 Avg. PBT 20,000 (-) Tax @ 35% 7,000 :. Avg. NPAT 13,000 3) 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 100 Avg. Invst. = 13,000 x 100 1,02,500 = 12.68% Avg. Invst = O.C Scrap + Scrap + Net W.Cap 2 = 2,00,000 5000 + 5000 + 0 = = Avg. NPAT (+) Depn = = 2 97,500 + 5,000 1,02,500 13,000 19,500

Annual CIF

32,500 = = = = = = = Initial Outlay Annual CIF 2,00,000 32,500 6.15 Years. Annual CIF x (Life PBP) 32,500 x (10 6.15) Rs.1,25,000

1) Payback Period

2) Payback profitability

Annual CIF x Life = 32,500 x 10 = 3,25,000 For cross check (-) Cash outflow = 2,00,000 PB Profitability = 1,25,000 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 Q Estimated life of machine 4 years 5 years Rs. Rs. Cost of machine 9000 18000 Estimated savings in scrap 500 800 Estimated savings in direct wages 6000 8000 Additional cost of Maintenance 800 1000 Additional cost of Supervision 1200 1800 Q.5 Solution Particulars Est. Savings in Scrap Est. Savings in direct wages (A) n Add cost of maintenance n Add cost of Supervision (B) NSBDT = CIF Payback Period Machine P Machine Q = = = Initial Outlay Annual Cash inflow 9000 = 2 years 4500 18000 = 3 years 6000 Machine P Machine Q 500 800 6000 8000 6500 8800 800 1000 1200 1800 2000 2800 4500 6000

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:

Sales Materials Labor Variable Overheads Calculate payback period and payback profitability Q.6 Solution Sales (-) V.C Contribution (-) F.C PAT Payback Period Initial Outlay Annual CIF = = Payback profitability = Automatic = = Ordinary = = Automatic 50,000 29,000 21,000 21,000 50,000 21,000 2.38yrs Ordinary 50,000 27,000 23,000 23,000 = 50,000 23,000 = 2.17yrs

Automatic Rs. 50000 15000 7000 7000

Ordinary (Model 1) Rs. 50000 15000 6000 6000 (MU, BMS, Oct. 1996)

Annual CIF x (Life PBP) 50,000 x (5 2.38) Rs.55,000 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 8000 Variable Cost 3000 Fixed Cost 2000 (excluding depreciation) Investment 10000 Life 10 years. Tax @ 50% Q.7 Solution Rs. Sales 8,000 (-) V.C 3,000 Contribution 5,000 (-) F.C 2,000 PBDT 3000 (-) depr 1000 PBT 2000 (-) Tax @ 50% 1000 PAT 1000 (+) depr 1000 Annual CIF 2000 n Dep = O.C Scrap Life

= =

10,000 0 10 Rs.1,000 = = = Initial Outlay Annual CIF 10,000 2,000 5 Yrs Payback Profitability = Annual CIF x (Life PBP) = 2,000 x (10 5) = 2,000 x 5 = Rs.10,000

Payback Period

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

You are required to advise the management which type of machine should be purchase on the basis of Payback Period. Q.8 Solution Particulars Est. savings in scrap Est. savings in direct wages Est. savings in indirect material (A) n Add cost of indirect material n Add cost of maintenance n Add cost of supervision (B) NSBDT (A B) n (-) Dep PBT (-) Tax PAT (+) Depn Annual Cash inflow Payback Period = Initial Outlay Annual cash inflow Machine A = 17,500 = 7.95 Years 2200 Machine A Machine B Machine C 400 750 250 2,750 6000 2250 100 250 3250 6750 2750 400 750 550 500 800 750 1750 500 2500 5000 2250 1750 2083 1800 750 2917 450 300 1167 180 450 1750 270 1750 2083 1800 2200 3833 2070

Machine B

= 12500 = 3.26 Years 3833 Machine C = 9000 = 4.35 Years 2070 Recommendation: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 lakh Estimated life 10 years Tax Rate 50% Profit Before Profit After Depreciation Year Depreciation Depreciation Tax @ 50% Rs. Rs. Rs. 1 40000 10000 30000 15000 2 60000 10000 50000 25000 3 50000 10000 40000 20000 4 50000 10000 40000 20000 Q.9 Solution Year PAT + Depn = CIF CCIF 1 15,000 10,000 25,000 25,000 2 25,000 10,000 35,000 60,000 3 20,000 10,000 30,000 90,000 4 20,000 10,000 30,000 1,20,000 Payback Period = 3yrs + 10,000 x 12 30,000 = 3yrs 4 Months Q.10 Your Company is considering the question of investment in a project for which the following data are available: Capital Outlay Rs. 2,20,000 Depreciation Charges 20% p.a. (Straight Line Method) Forecast of annual income before charging depreciation, but after all other charges: Profit Before Year Depreciation Rs. 1 100000 2 100000 3 80000 4 80000 5 40000 From the above data, the management want you to calculate the following: a) Pay Back Period b) Rate of Return On Original Investment c) Rate of Return On Average Investment Ignore Taxation Q.10 Solution n Dep = 2,20,000 x 20% n Year PBDT = CIF - Dep 1 1,00,000 44,000 = Rs.44,000 = PAT 56,000

CCIF 1,00,000

1,00,000 44,000 80,000 44,000 80,000 44,000 40,000 44,000 4,00,000 NPAT a) Payback Period = 2 Yrs + 20,000 x 12 80,000 = 2 Yrs 3 months :. Avg. NPAT = 36,000 b) ARR based on O.Inv. =

2 3 4 5

56,000 36,000 36,000 (4000) 1,80,000

2,00,000 2,80,000 3,60,000 4,00,000

Avg. NPAT x 100 O.Inv. = 36,000 x 100 2,20,000 = 16.36% c) ARR based on Avg. Invst. = Avg. NPAT x 100 Avg. Invst. = 36,000 x 100 1,10,000 = 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 A Model B Rs. Rs. Sales 2000000 2450000 Materials 920000 1112200 Labour 412450 567800 Variable 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 Solution Sales (-) V.C n Cont . (-) F.C PBDT = CIF Payback period = Initial Outlay Annual CIF Model (A) 20,00,000 17,13,350 2,86,650 2,86,650 = 5,00,000 2,86,650 = 1.74yrs Model (B) 24,50,000 21,75,670 2,74,330 2,74,330 = 5,00,000 2,74,330 = 1.82 yrs

Payback profitability = Annual CIF X (LIFE PBP) A = 2,86,650 X (5 1.74) = 9,33,250 B = 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 period 2.The discounted payback period 3.The profitability index You may assume straight line depreciation. P Cost of investment (Rs.) 200000 Expected life (no salvage) 5 years Projected net income (after depreciation, interest and taxes) Year Rs. 1 10000 2 10000 3 20000 4 20000 5 20000 Q 280000 5 years Rs. 24000 24000 24000 24000 24000.

(Q.12) Solution Project P Cash outflow n Yr. PAT Dep 1 10,000 40,000 2 10,000 40,000 3 20,000 40,000 4 20,000 40,000 5 20,000 40,000

= Rs.200000 CIF CCIF 50,000 50,000 50,000 1,00,000 60,000 1,60,000 60,000 2,20,000 60,000 2,80,000

PV@10% 0.909 0.826 0.751 0.683 0.621

PVCIF 45,000 41,300 45,060 40,980 37,260 2,10,050

CPVCIF 45450 86750 131810 172790 210050

Depn = Cost Scrap value Life = 2,00,000 0 5 = Rs.40,000 1) Payback period = 3yrs + 40,000 x 12 60,000 = 3yrs and 8 months 2) Discounted PB period = 4 yrs + 27210 x 12 37260 = 4yrs and 8.76 months 3) Profitability Index = PVCIF PVCOF

= 210050 200000 = 1.05 Project Q Cash outflow = Rs.280000 n Yr. PAT + Dep = CIF 1 24,000 56,000 80,000 2 24,000 56,000 80,000 3 24,000 56,000 80,000 4 24,000 56,000 80,000 5 24,000 56,000 80,000 1) Payback period = Initial Outlay Annual CIF = 2,80,000 = 3.5yrs (3yrs 6months) 80,000 2) Discounted payback period (P) = 4yrs + 26,480 x 12 49,680 = 4yrs 6.40 months 3) Profitability Index = PVCIF PVCOF = 303200 280000 = 1.08

PV@10% 0.900 0.826 0.751 0.683 0.621

PVCIF 72,720 66,080 60,080 54,640 49,680 3,03,200

CCIF 72,720 1,38,800 1,98,880 2,53,520 3,03,200

Q.13 A company whose cost of capital is 12% is considering 2 projects A and B. The following data is available: Project A Project B Rs. Rs. Investment 140000 140000 Cash Flows: Year 1 20000 100000 2 40000 80000 3 60000 40000 4 100000 20000 5 110000 20000 330000 260000 Select the most suitable project by using the following methods: a) Pay Back Period b) Net Present Value c) Profitability Index The present values of Rs.1 at 12% are: Year 1 0.9 Year 2 0.8 Year 3 0.7 Year 4 0.6 Year 5 0.55

Q.13) Solution:COF Rs.140000 Year 1 2 3 4 5 PV @ 12% 0.9 0.8 0.7 0.6 0.55 = = Project B = CIF 20000 40000 60000 100000 110000 PVCIF Project A CCIF 20000 60000 120000 220000 330000

COF Rs.140000 PVCIF 18000 32000 42000 60000 60500 212500 CIF 100000 80000 40000 20000 20000 Project B CCIF 100000 180000 220000 240000 260000 PVCIF 90000 64000 28000 12000 11000 205000

a) Payback Period Project A

20000 x 12 100000 3 years 2.4 months. 1 year +

3 years +

40000 x 12 80000 = 1 year 6 months. Recommendation : Select Project B since Lower PBP. b) Net present value = Project A = = Project B PVCIF PVCOF 212500 140000 Rs.72500

= 205000 140000 = Rs.65000 Recommendation : Select Project A since Higher NPV c) Profitability index = Project A = = Project B = PVCIF PVCOF 212500 140000 1.52

205000 140000 = 1.46 Recommendation : Select Project A since Higher PI Conclusion:- 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 II Estimated cost (to be incurred initially) Rs. 20000 28000 Estimated life in years 4 5 Scrap value at the end of estimated life Nil Nil Estimated Net Cash Flows (Rs) End of 2010 5500 5600

End of 2011 7000 9000 End of 2012 8500 9000 End of 2013 7500 9000 End 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 5 P.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% 1 5,500 0.91 2 7,000 0.83 3 8,500 0.75 4 7,500 0.68 5 2000 0.68 PVCOF (-) NPV P.I = PVCIF PVCOF = 23,650 = 1.075 22,000 Project II Yr. CIF PV@10% 1 5,600 0.91 2 9,000 0.83 3 9,000 0.75 4 9,000 0.68 5 9,000 0.62 6 2,000 0.62 PVCIF 5005 5810 6375 5100 1360 23,650 22,000 1,650

PVCIF 5096 7470 6750 6120 5580 1240 32256 PVCOF (-) 30000 NPV 2256 P.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 Inflows Rs. 1 7000

2 7000 3 7000 4 7000 5 7000 6 8000 7 10000 8 15000 9 10000 10 4000 Using 10% as the cost of capital (rate of discount) determine the following: 1.Payback period and payback profitability 2.NPV at 10% discounting factor and 15% discounting factor 3.Profitability index at 10% discounting factor and 15% discounting factor 4.Internal rate of return with the help of 10% discounting factor and 15% discounting factor. Q.15 Solution Year Cash inflow 1 7000 2 7000 3 7000 4 7000 5 7000 6 8000 7 10000 8 15000 9 10000 10 4000 1) Payback Period = = 2) Payback profitability = = = 2) PV CIF - PV COF NPV @ 10% Year 1 2 3 4 5 6 7 8 9 10 Cash inflow 7000 7000 7000 7000 7000 8000 10000 15000 10000 4000 = = CCIF 7000 14000 21000 28000 35000 43000 53000 68000 78000 82000 PV @ 10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386 PVCIF 5yrs + 5000 x 12 8000 5yrs and 7.5months Cash inflow Cash outflow 82,000 40,000 Rs.42,000 48961 (40,000) 8961 PVCIF 6090 5292 4606 4004 3479 3456 3760 4905 2840 988 PVCIF 6363 5782 5257 4781 4347 4512 5130 7005 4240 1544 48961

PV@15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247

2) (-) 3) Profitability index @ 10% @ 15%

PV CIF PV COF NPV @ 15% = = = = = PVCIF PVCOF 48961 40000 1.22 39420 40000 0.99

39420 (40000) - 580

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 Karma Profit before tax Profit after tax 78 56 82 60 100 74 Project Dharma Year Depreciation Profit before tax Profit after tax 1 78 104 82 2 64 118 92 3 54 260 186 st nd rd The cost of capital of company is 10% and the PV of Re. 1 at the end of 1 , 2 and 3 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? Year 1 2 3 Depreciation 24 20 16 (Q.16) Solution Project Karma Year PAT CIF 1 56 80 2 60 80 3 74 90 Payback period

CCIF 80 160 250 =

PV@14% 0.8772 0.7695 0.6750

PVCIF 70.176 61.56 60.75 192.486 2yrs + 30 x 12

= Project Dharma n Year PAT Dep 1 82 78 2 92 64 3 186 54 Payback Period CIF 160 156 240 = =

90 2yrs 4 months CCIF 160 316 556 PV@14% 0.8772 0.7695 0.6750 PVCIF 140.352 120.042 162 422.394

2yrs + 84 x 12 240 2yrs 4.2 months

Recommendation: 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 Karma P.V CIF 192.486 (-)P.V COF 190.000 NPV 2.486 Project Dharma P.V CIF 422.394 (-) P.V COF 400.000 NPV 22.394 Recommendation: 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 of Re.1 at 10% rate of discount, received at end of tenth year is 0.386) (MU, BMS, Oct. 2002)

(Q.17) Solution.

Evaluation of proposal Old Machine O.C 60,000 Total depn *30,000 B.V / WDV 30,000 Dep p.a. = 30,000 = 3,000 10 New machine n Dep = 1,00,000 = 10,000 10
n

Revenue statement for the year Particulars OldMac. Sales (6,000 x 50) 3,00,000 (-) Variable cost 1,38,000 Contribution 1,62,000 (-) F.C PBDT 1,62,000 n (-) Dep 3,000 PBT 1,59,000 (-) Tax @ 40% 63,600 PAT 95,400 (+) Depn 3,000 CIF 98,400

New Mac. 3,00,000 90,000 2,10,000 . 2,10,000 10,000 2,00,000 80,000 1,20,000 10,000 1,30,000

Note:- Fixed OHs is ignored to the extent of allocation from other department. :. Additional cash inflow Calculation of cash outflow Particular Purchase price Less: Exchange price Release of working capital Savings in tax on loss of sale of old machine (10000 x 40%) COF Calculation of NPV Yr. C.I.F PV@10% PVCIF 1 10 31,600 6.145 1,94,182 (-) PVCOF 66,000 :. NPV 1,28,182 Recommendation:The company is advised to purchase new machine since NPV is positive. Rs. 1,00,000 (20,000) (10,000) (4,000) 66,000 = = 1,30,000 98,400 Rs.31,600

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 2.00 Buildings 3.00 Machinery 10.00 Working 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

Fixed Cost (Excluding Depreciation) 4.00 Depreciation of assets 2.00 iv) 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 decision b) List down 5 factors that should be considered before taking the decision. (Q.18) Solutions Particulars Sales (-) V.C Contribution (-) F.C PBDT n (-) Dep PBT (-) Tax PAT n Dep Cash inflow

21 8 13 4 9 2 7 2.8 4.2 2 6.2

Yr. 1.5 5 5

CIF 6.2 5 5

PV@10% 3.791 0.61 0.61 PVCIF (-)PVCOF NPV

PVCIF 23.5042 3.05 3.05 29.6042 20.0000 9.6042

Advice Since NPV is positive company is advised to take investment of the new project. (b) Factors which should be considered before taking decisions. (1) Financial feasibility (2) Technical feasibility (3) Economic feasibility (4) Market appraisal (5) Management competence

(F OR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
PRACTISE PROBLEMS:(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:

CFAT
YEAR 1 2 3 4 5 A Rs 50,000 Rs 50,000 Rs 50,000 Rs 50,000 Rs 90,000 B Rs 80,000 Rs 80,000 Rs 80,000 Rs 30,000 C Rs 1,00,000 Rs 1,00,000 Rs 10,000

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 0 1 2 3 Project A (15,000) 11,000 7,000 4,800 Project B (15,000) 3,500 8,000 13,000 Project C (15,000) 42,000 (4,000)

Ravi Sharma believes that all three projects have risk characteristics similar to the average risk of the firm and hence the firms 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 of Rs. 50,000 and are expected to generate net cash flows as under: Project I Project II End of year 1 Rs.25,000 Rs. 10,000

End of year 2 End of year 3 End of year 4 End of year 5 End of year 6 Tax Rate Calculate: Pay Back Period. Average Ratio of Return. Pay Back Profitability.

Rs. 15,000 Rs. 10,000 Rs. NIL Rs. 12,000 Rs. 6,000 50%

Rs. 12,000 Rs. 18,000 Rs. 25,000 Rs. 8,000 Rs.4,000 40%

(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 dont match expenditure, inflows dont match outflows. Sources of finance are categorized in 3 ways: 1. According to the period i.e. short, medium and long term 2. According to the ownership i.e. owners fund and borrowed funds 3. According to the generation i.e. internal and external sources SECTION : I - SHORT TERM SOURCES OF FINANCE: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 Credit:- 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 year:- 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 Bills:- 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 Credit:- 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 Deposits:- 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 Regulation:- The lack of legal hassles and bureaucratic red tape makes an intercorporate deposit transaction very convenient. b) Secrecy:- Brokers are discreet about their lists of borrowers and lenders. c) Importance of Personal Contacts:- 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 Paper:- 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 CP? Highly rated listed companies, primary dealers and All-India financial institutions have been permitted to raise short-term resources. Eligibility of Issuing CP Minimum 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) and The 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 CP The 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 CP The minimum amount required to be invested by a single investor is atleast Rs.5 lakhs. It is issued in denominations of Rs.5 lakh or multiples thereof.

9. Factoring:- 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 debtors 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 firms 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 Arrangement: 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 exporters 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 importers 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 Introduction As you are aware finance is the life blood of business. It is of vital significance for modern business which 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 purpose A 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 these assets 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 be needed 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 long period. 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 manufacturing company 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 amount of 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 a business producing plastic jars using simple technology or producing goods using labour intensive technique or service sector companies. Lease Financing: 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 1) In an operating lease all the risks and rewards incidental to ownership are not transferred by the lessee to the lessor. 2) Operating lease is cancelable by either party during the lease period. 2. Finance Lease 1) In a finance lease the lessor transfers to all the risks and rewards incidental to the ownership of the asset to the lessee. 2) Finance lease is non- cancellable and it involves payment of lease rentals over an obligatory non-cancellable lease period.

3) In an operating lease the lessor does not relay 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. 4) An operating lease is termed as a Service Lease 5) In an operating lease the cost of asset is not fully amortised during the primary lease (noncancellable) period. 6) Operating lease being shorter than the expected economic life of the asset no such option of purchase of the asset by the lessee exists there. 7) An operating lease is generally for a period shorter than the economic life of the leased asset. 8) In an operating lease the lessor other than financing the cost of leased asset, also provides such as repairs, maintenance and technical advice. 9) In an operating lease the lessor bears the risk of obsolescence of the asset leased. 10) Examples: Aircrafts, Buildings, Heavy machinery, railway, Buses etc.

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

4) Finance lease is also termed as full-payout leases. 5) The finance lease enable the lessor to recover his investment in the asset lease plus to derive a profit. 6) In a finance lease the lessee has the option to purchase the asset at a price on a date the option becomes exercisable or at the end of the lease agreement period. 7) In a finance lease the lease term is for the major part of the economic life of the asset. 8) In a finance lease the lessee is responsible for the repairs and maintenance, insurance and risk of obsolescence of the asset leased. 9) In a finance lease the lessee has to bear the risk of obsolescence of the asset leased. 10) Examples: Hiring a cap, chartering of Air crafts, Hiring of cranes etc.

3) Leveraged Lease:- 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 Back:- 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 Lease:- 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 Lease:- 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 Lease:- 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 Purchase:- 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 Lessor claims depreciation On completion of contract residual (salvage) value goes to Lessor. In absence of specific agreement otherwise, asset is to be returned to the lessor after the lease period. Lease payment is fully deductible for tax. Hire Purchase Buyer claim depreciation On completion of contract residual (salvage) value goes to Buyer. Asset is conclusively purchased by the buyer at the end of the agreement period. Only interest portion of EMI/ Hire value is tax deductible.

11. Venture Capital Venture 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 companys 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.

(FOR MORE DETAILS (THEORY) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
REVIEW QUESTIONS: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.

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)

CHAPTER: 10 BUSINESS RESTRUCTURING

SECTION I :- IMPORTANCE Business restructuring refers to a broad array of activities that expand or contract a firms 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 Tatas 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 restructuring transactions may be classified as shown in Exhibit. They are described below. Types of Business Restructuring Activities Corporate restricting occurs in myriad ways. Sacrificing some rigour, important restricting transactions 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: Merger: 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 Plant: 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. Takeover: 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 restructuring Going Private: Going private means converting a company whose stock is publicly held into a private company. (e.g. Coal India Ltd., BSNL Ltd. proposed issued). Leveraged Buyout: A leveraged buyout involves transfer of ownership, effected substantially with the help of debt finance. (e.g. Zain buyout by Bharati Airtel Ltd). Privatisation: 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.

Takeovers A takeover generally involves the acquisition of a certain block of equity capital of a company which enables 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 and 40 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 promoters 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 Alliances Business 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. Macdonalds 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 Alliances Business alliances are motivated by a desire to share risk and again access to new markets, reduce costs, 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 the US 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 Succeed The 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 rate of 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 Limited Particulars Ace Ltd. before Aim Ltd. before Ace Ltd. after merger merger merger The market The market Is smart is foolish (1) (2) (3) (4) Earnings per share Rs.2 Rs.2 Rs.2.67 Rs.2.67 Price per share Rs.40 Rs.20 Rs.40 Rs.53.4

Price-earning ratio Number of shares Total earnings Total value

20 10 million Rs.20 million Rs.400 million

10 10 million Rs.20 million Rs.200 million

15 15 million Rs.40 million Rs.600 million

20 15 million Rs.40 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 management Clearly, 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 BUSINESS 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

(FOR MORE DETAILS (THEORY) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)

SECTION PROBLEMS AN D SOLUTIONS

(Q.1) The Balance Sheet of X Co. Ltd. on 31 March, 2010 are as follows : Balance Sheet of X Co. Ltd. Liabilities Rs. Assets Share Capital : Fixed Assets : Authorised Capital of 10000 Goodwill 80000 shares of Rs. 100 each 1000000 Others 800000 Issued Capital : Current Assets, 10000 shares of Rs. 100 each Loans and Advances fully paid 1000000 Reserves & Surplus Capital Reserve 200000 General Reserve 70000 270000 Unsecured Loans 200000 Current Liabilities & Provisions Sundry Creditors 310000 Total 1780000 Total Balance Sheet of Y Co. Ltd. Liabilities Rs. Assets Share Capital : Fixed Assets : Authorised Capital 200000 shares of Current Assets, Rs. 10 each 2000000 Loans and Advances: Issued Capital : Bank 200000 80000 shares of Rs. 10 each fully paid 660000 800000 Others Reserves & Surplus : General Reserve 800000 Secured Loans 500000 Current Liabilities & Provisions Sundry Creditors 360000 Total 2460000 Total
st

Rs. 880000 900000

1780000 Rs. 1600000

860000

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 Share Capital Capital Reserve General Reserve Total Less : Goodwill being valueless 80000 Arrears of Depreciation to be provided for 40000 Tangible Net Worth = Value of Net Assets Number of Shares (Paid up Capital Rs. 100 Rs.10 respectively) Intrinsic Value per Share X Co. Ltd. Rs. 1000000 200000 70000 1270000 (120000) 1150000 10000 Rs.115 Y Co. Ltd. Rs. 800000 800000 1600000 Nil 1600000 80000 Rs.20

Scheme of Amalgamation Basis 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 2 230.00 Less : Intrinsic Value of Ten Shares in Y Co. Ltd. = Rs. 20 x 2 200.00 Balance cash to paid in respect of every 2 shares in X Co. Ltd. 30.00 Purchase Consideration will be as under Equity Shares in Y Co. Ltd. = (10000 2) x 10 shares x Rs.20 (Issue 1000000 Price) Cash paid to adjust the rights = (10000 2) x Rs.30 150000 Total Purchase Consideration 1150000 Balance Sheet of Y CO. Ltd. (after absorption) as on. Liabilities Rs. Assets Share Capital : Fixed Assets : Authorised : 2,00,000 shares of Rs. Cost 16,00,000 10 each 20,00,000 Add : Addition on Acquisition 8,00,000 Issued & Subscribed : 1,30,000 shares of Rs. 10 each fully Less : Arrears of paid (of which 50,000 shares issued Depreciation (40,000) 13,00,000 for consideration other than cash) Current Assets, Reserves and Surplus : Loans & Advances : Securities Premium 5,00,000 Current Assets General Reserve (given) (9,00,000 + 6,60,000) 8,00,000 Secured Loans 5,00,000 Cash at Bank Unsecured Loans (2,00,000 + 1,50,000) 2,00,000 Current Liabilities & Provisions : Sundry Creditors (3,10,000 + 3,60,000) 6,70,000 39,70,000 Rs.

23,60,000

15,60,000 50,000

39,70,000

(Q.2) On September 30, 2009 the Balance Sheet of Dull Past Ltd. was as follows : Liabilities Authorised : 10000 Ordinary shares of Rs. 10 each 1000 6% Cumulative Preference Shares of Rs. 100 each Issued : 6000 Ordinary Shares of Rs. 10 each, fully paid 600, 10% Cumulative Preference Shares of Rs. 100 each, fully paid 15% Debentures Current Liabilities : Trade Creditors 130000 Bank Overdraft (Secured by a charge on the freehold property) 61000 Rs. Assets Freehold Land & Building at cost 100000 Plant & Machinery 80000 Less : Depreciation written 100000 off to date 30000 Tools and Patents 200000 Current Assets : Stock in trade 70000 30000 60000 Trade Debtors Cash in hand 1000 60000 Profit and Loss A/c. 30000 Rs. 100000 50000 10000

101000 80000

191000 341000

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 : 1. Preference Shareholders 1 x 600 x Rs.100 3 2. For Equity Shareholders 1,500 Equity Shares of Rs.10 each at Rs. 8 each Total Purchase Consideration : Rs. 20,000 11.5% Preference Shares 12,000 Equity Shares --32,000

Journal of Dull Past Ltd. Realisation A/c Dr. To Freehold Land & Building A/c To Plant & Machinery A/c To Tools & Patterns A/c To Stock-in Trade A/c To Trade Debtors A/c To Cash in hand A/c (Being various assets transferred to Realisation A/c) Depreciation on Plant & Machinery A/c Dr. 30,000 Trade Creditors A/c Dr. 1,30,000 Bank Overdraft A/c Dr. 61,000 15% Debentures A/c Dr. 30,000 To Realisation A/c (Being liabilities taken over by Bright Future Ltd. & accumulated depreciation on Plant & Machinery transferred to Realisation Account) Equity Share Capital A/c Dr. 60,000 To Equity Shareholders A/c (Being equity share capital transferred to shareholders A/c) Equity Shareholders A/c Dr. 80,000 To Profit & Loss A/c (Being accumulated loss transferred to Shareholders Account) 10% Preference Share Capital A/c Dr. 60,000 To Preference Shareholders A/c To Realisation A/c (Being the amount payable to preference shareholders transfer to their account and profit to Realisation Account) Bright Future Ltd. A/c Dr. 32,000 To Realisation A/c (Being purchase consideration receivable from Bright Future Ltd.) 11.5% Preference Shares in Bright Future Ltd. A/c Dr. 20,000 Equity Shares In Bright Future Ltd. A/c Dr. 12,000 To Bright Future Ltd. A/c (Being preference & equity shares received against purchase consideration) Preference Shareholders A/c Dr. 20,000 To 11.5% Preference Shares in Bright Future Ltd. A/c (Being settled claim of preference shareholders by the issue of 11.5% preference shares) Realisation A/c Dr. 32,000 To Equity Shareholders A/c (Being profit on realisation transferred to shareholders A/c) Equity Shareholders A/c Dr. 12,000 To Equity Shares in Bright Future Ltd. A/c (Being equity shares in Bright Future Ltd. issued to equity shareholders) Dr. Rs. 2,91,000 Cr. Rs. 1,00,000 80,000 10,000 70,000 30,000 1,000

2,51,000

60,000 80,000 20,000 40,000

32,000

32,000

20,000

32,000 12,000

I.

Bright Future Ltd. th Balance Sheet as at 30 September, 2009 Schedule Rs. No. Sources of Funds 1. Shareholders Funds : a) Capital 1 1,00,000 b) Reserves and Surplus 2 8,000 2. Loan Funds : a) Secured Loans 3 61,000 b) Unsecured Loans Nil Total Application of Funds 1. Fixed Assets : a) Gross Block b) Less : Depreciation c) Net Block d) Capital Work-in-Progress 2. Investments 3. Current Assets, Loans & Advances a) Inventories b) Sundry Debtors c) Cash and Bank Balances d) Other Current Assets e) Loans and Advances Less : Current Liabilities & Provisions a) Liabilities b) Provisions Net Current Assets 4. a) Miscellaneous Expenditure to the extent not written off or adjusted b) Profit & Loss Account Total

Rs.

1,08,000 61,000 1,69,000

II.

4 -

70,000 30,000 38,760 10,000 Nil 1,48,760 1,30,000 Nil 1,30,000

1,60,000 Nil Nil -

18,760 Nil 240 1,69,000

Schedule forming part of Balance Sheet : Schedule 1 Share Capital Rs. 80,000 1,20,000 2,00,000 50,000 50,000 -

Authorised : 8,000 Equity Shares of Rs.10 each 1,200 7% Preference Shares of Rs. 100 each Issued and Subscribed : 5,000 Equity Shares of Rs. 10 each 500 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)

1,00,000 Schedule 2 Capital Reserve Schedule 3 Secured Loans Rs. 61,000 61,000 Rs. 1,00,000 50,000 1,50,000 Current Liabilities Rs. 1,30,000 1,30,000 Reserve and Surplus Rs. 8,000 8,000

Bank Overdraft (Secured by a charge on Freehold Property) Schedule 4 Freehold Buildings Plant & Machinery Schedule 5 Trade Creditors Fixed Asset

W.N.1 Capital Reserve : Assets taken over : Freehold Land & Building Plant and Machinery Tools and Patterns Current Assets Less : Liabilities taken over : Current Liabilities 15% Debentures Net Assets taken over Purchase consideration Capital Reserve W.N.2 Cash / Bank Balance : Cash Balance Add : Issue of Shares Add : Calls of Shares Less : Preliminary Expenses Balance
st

Rs. Rs. Rs. Rs. Rs. Rs. Rs. 1,91,000 30,000 Rs. Rs. Rs. Rs.

1,00,000 50,000 10,000 1,01,000 2,61,000 2,21,000 40,000 32,000 8,000

(3,500 x 10) (1,500 x 2)

Rs. Rs. Rs. Rs. Rs. Rs.

1,000 35,000 3,000 39,000 240 38,760

(Q.3) A Ltd. and B Ltd. were amalgamated on and from 1 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. st as on 31 March, 2010 are given below: (figures in thousands)

A Ltd. Share Capital : Equity share of Rs.10 each 12% Preference shares of Rs.100 each Reserves and Surplus Capital Reserve General Reserve Profit and Loss A/c Secured Loans Trade Creditors Tax Provisions 2,400 1,200 800 1,200 400 1,600 1,200 800 9600

B. Ltd Fixed Assets 1,600 Less: Depreciation 800 Investments Current Assets: 600 Stock 600 Debtors 200 Cash & Bank Balance 800 400 200 5200

A Ltd. B. Ltd 4,800 3,200 800 600 4,000 2,600 1,600 600 1,200 1,600 1,200 600 800 600

9,600

5,200

Other 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 1) 15% Preference Share for Preference Shareholders A Ltd. (12000 shares @ 125) B Ltd. (8000 shares @ 125) 2) ES for Equity Shareholders A Ltd. (240000 shares @ 15) B Ltd. (160000 shares @ 15) A Ltd. 1500000 B Ltd. 1000000 2400000 3400000 Rs. 5100000 3400000 5100000 3400000 2000000 4000000 2500000 6600000 2200000 1800000 2400000 1800000 2500000

3600000 PC 5100000 l/f Rs. 8500000

Particular 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 . Investment A/c. . . Stock A/c . . . Debtors A/c . . . Cash & Bank balance A/c Profit & Loss A/c Dr. Dr. Dr. Dr. Dr. Dr.

To CR A/c. 1400000 To General Reserve A/c 1800000 To P & L A/c. . . 600000 To Secured Loans A/c . . . 2400000 To Trade Creditors 1600000 To Tax provisions A/c 1000000 To Business Purchase A/c 8500000 In balance sheet Net debit balance is P&L A/c Rs.100000 will appear on asset side. Liabilities Share Capital Authorised capital Called up / Issued 11% Preference Shares Equity Share capital Reserves & Surplus Capital Reserve Securities Premium Secured Loans Secured Loans Unsecured Loans Current Liabilities Tax provisions Trade Creditors Balance Sheet as on 1 April 2010 Rs. Assets Fixed Assets ? 2000000 Investment 4000000 Current Assets 1400000 Loans & Advances 2500000 Stock Debtors Cash & Bank balance 2400000 Miscellaneous expenditure P & L A/c Nil 1000000 1600000 14900000
st

Rs. 6600000 2200000

1800000 2400000 1800000 100000

14900000

Q.4) XYZ Ltd. is considering merger with PQR Ltd. XYZ Ltds. shares are currently traded at Rs.25. It has 200000 shares outstanding and its EAT amount to Rs.400000. PQR Ltd. has 100000 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 Ltds Shares: (i) What is the pre-merger EPS and P/E ratios of both the companies? (ii) If PQR Ltds P/E Ratio is 8, What is its current MPS? What is the exchange ratio? What will XYZ Ltds post-merger EPS be? (iii) What must be the exchange ratio for XYZ Ltds 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.) 25 12.50 No. of Equity Shares 200000 100000 Earnings after Tax (Rs.) 400000 100000 (i) a) Pre-Merger EPS = Earnings after Tax No. of Equity Shares

XYZ Ltd. = 400000 200000 = Rs.2 b) MPS

EPS

PQR Ltd. = 100000 100000 = Re.1

P/E =

XYZ Ltd. = 25 2 = 12.50 Times (ii) If PQR Ltds P/E = 8 (a) Current MPS: P/E = MPS EPS 8 = MPS 1 MPS = Rs.8

PQR Ltd. = 12.50 1 = 12.50 Times

(b) Exchange Ratio: XYZ PQR 25 8 = 25 = 3.125 8 Exchange Ratio = =

XYZ : 3.125 :

PQR 1

(c) Post-Merger EPS of XYZ Ltd. XYZ EAT + PQR EAT = Total EAT 4 lakhs + 1 lakh = 5 lakhs XYZ PQR 25 8 100000 ? 100000 x 8 = 32000 Shares 25 XYZ Ltd.: Old Shares + New Shares 200000 + 32000 New EPS = Total Earnings after Tax Total No. of Equity Shares = 500000 232000 = Rs.2.15

= =

Total Shares 232000 Shares

(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. = 500000 2 = 250000 Shares Total No. of Shares in Post-Merger Company 2,50,000 No of Shares in - Pre-Merger XYZ Ltd. - 200000 No of New Shares = required to be issued = 50000 Shares

Exchange Ratio: XYZ 100000 1 = 50000 x 1 100000 Exchange Ratio

PQR 50000 ? = = 0.50 0.5 : 1

(FOR MORE DETAILS (PROBLEMS AND SOLUTIONS) REFER HIMALAYA PUBLICATION FINANCIAL MANAGEMENT PROF. PAWAN JHABAK BOOK)
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 nd www.SCOrEBMS.com on 2 Oct. 10

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The be st in Exams