Case Studies

Case Study
Commercial Profitability and Financial Viability of Project*
1.1 INTRODUCTION
Commercial profitability and financial viability are vital facets of the project
to be assessed. The present case first enumerates the assumptions regarding the cost
related to virtually all the major inputs (raw materials, labour and overheads)
required to make particle board as well as of various relevant factors affecting their
sales revenue such as, capacity utilization, product/sales mix and selling price. It is
followed by a detailed and an in-depth examination of commercial profitability and
financial viability parameters of the proposed project. The study makes use of
theoretically sound techniques based for such an analysis.
1.2. ASSUMPTIONS
The assumptions, forming the basis of assessment of commercial profitability and

financial viability, are listed below. These assumptions are by and large
conservative in nature.
1.2.1 Sales Revenue Estimates
i. Plant will operate for 3 shifts (having average 22 hours effective working time)
for 300 annual effective production days.
ii. Plant in the first year of its commercial production on account of trial run, has
been assumed to run at 60%, at 70% in the second year, and at 90% level for
the remaining years (3rd to 10th).
iii. Financial analysis has been carried out for 10 years only as this period
conforms to the loan period of lending institution.
iv. The base prices of year 1 of various major particle board products, namely,
plain (interior and exterior) and veneered (one side and both sides), have been
assumed equivalent to those prevailing in Feb.1995. In the initial 2 years (2
and 3) these prices have been assumed to increase by 5% compared to their
immediate preceding year’s price levels for all products, across the board; the
subsequent years, 4 - 10, have been assumed to have price-escalation of 10%.
*
The case study is based on real life situation (prevailing in mid-nineties); the name of
organization is not mentioned for confidential reasons.
This material is being used for academic purposes only and is intended only for MBA students registered in
IIT Delhi in Semester II - 2020-21 and is not intended for wider circulation.
This 10% price increase is based on the suppliers’ quotations of average
increase in selling prices of particle board products during 1990-95.
v. The plant will be utilized to produce only 4 types of particle board, mentioned
in iv, in equal proportions.
1.2.2 Cost estimates
i. The price of major raw material, cotton stalk, has been assumed to be constant
@ Rs 450 per ton for first 6 years. The longer period of constant prices has
been taken, keeping in view (a) cotton stalk is currently virtually thrown as
waste material by farmers at a cost, and (b) cotton stalk price is still higher than
the comparable substitute like bagasse used in producing particle board; the
current cost of bagasse is Rs 250 per ton. In order to sustain and motivate the
farmers to ensure regular raw material supplies, its prices have been assumed
to increase to Rs 500 per ton in 7th year (to remain valid till 10th year).
ii. Chemical prices (mostly imported) have been assumed to increase @ 5% per
year. The assumption gains strength from relatively stable prices of chemicals
prevailed during last 3 years (1992-94) on the one hand and stability of foreign
exchange rate of Indian rupee in recent years owing to comfortable foreign
exchange position, on the other. Moreover, it is expected that custom duties
may slash further due to economic liberalization.
iii. Step-wise increase in veneering treatment expenditure has been assumed; it

has been kept constant for the first 3 years; this has been increased by 10% for
4-6 years and further by another 10% for 7-10 years.
iv. It is important to bring to the fore that power requirements are not influenced
in any significant way by volume of activity. However, power rates have been
kept constant for the first 3 years, increased by 5% during 4-6 years and further
by 10% during next 7-10 years.
v. On account of recycling of fine dust generated in the plant, fuel consumption

will virtually be not required except for initial start-up; there is built-in
mechanism for generating fuel in the plant itself. For these reasons, a very
nominal cost of fuel is assumed in our cost exercise.
vi. As per the discussion with the representative of the German Supplier of the
plant, maintenance costs are not likely to exceed 1% of plant and machinery
cost; spares will be provided for first 2 years along with plant. To this are added
the cost of lubricant and oil.
vii. Salaries and wages are as per the man-power planning of the plant. Their
emoluments are assumed to increase @ 10% per year for all the years under
reference.
viii. For the purpose of determining depreciation, straight line method of

depreciation is used on the one hand and different fixed assets have been
assumed to have varied life periods on the other. For instances, plant and
machinery is expected to have 15 years economic useful life with 20% as its
salvage value and building 10 years with 20% as its salvage value.
ix. Administrative overheads are substantially fixed in nature; only its small
segment has been taken as varying with production/sales. They are assumed to
increase @ of 10% approximately during the period under reference.
x. Selling overheads primarily consist of dealers’ commission of 10%, and other

selling expenses of 2%. This apart, to launch the new product, a provision of
Rs 50 lakh expenditure on advertisement is created in the initial 2 years.
xi. Interest on term loan as well as on working capital is based on the actual
interest expenses to be paid (between 17-18%) to the lending institution and
commercial banks/financial institutions lending for working capital purposes.
xii. Preliminary expenses, consisting substantially of interest cost during

construction period, have been proposed to have been amortized during 10
years.
xiii. Since the cotton stalk based plants are by and large to be located in backward
regions, they will be subject to initial 5 years tax holiday. In subsequent years,
it is assumed that cooperative’s income will be subject to 35% tax rate.
xiv. All figures have been expressed in integer values, for convenience purposes.
The approximation error component is likely to be too small to vitiate our
conclusions in any significant way. While reading data contained in Tables,
this point should be borne in mind.
xv. Above all, commercial profitability and financial profitability analysis to

follow, is not ‘project specific’. It is based on a ‘typical’ particle board plant
using cotton stalk as a basic raw material and following German technology.
We believe that there is not likely to be much difference in labour costs around
the country and so of chemical prices. In sum, the difference in costs in various
parts of the country are not likely to be significant to vitiate the conclusions
regarding profitability and viability of the plant.
1.3 COMMERCIAL PROFITABILITY
Commercial profitability analysis has been carried out in terms of preparation of the
projected income statement to know the quantum of profit, projected balance sheet
to have insight regarding financial health particularly rates of return determining
various important profitability ratios and break-even points.
1.3.1 Projected Income Statement
Viewed from the perspective of commercial profitability, the project holds good
promise. This is apparent from expected positive operating profits (EBIT) from the
very first year of its commencement of production and sales and positive net profits
after taxes (EAT) from the second year (Table 1). Both sets of profits are steadily
rising through out the projected 10 year period under reference. For instance,
operating profits of 298 lakhs in year 1 have steadily risen to more than 4 times (Rs
1250 lakh) by year 5 and further, more than doubled to Rs 2643 lakh by year 10.
The rise is more pronounced in the case of net profits, the figures being Rs.36 lakh,
Rs 899 lakh and Rs 1646 lakh in years 2, 5 and 10 respectively.
Table 1: Projected Income Statement (Years 1-10)
Capacity (in percentage): (Amount in Rs lakh)
Particulars 60% 70% 80% 90% 90% 90% 90% 90% 90% 90%
Year 1 2 3 4 5 6 7 8 9 10
A Sales 1,730 2,120 2,862 3,148 3,463 3,809 4,190 4,609 5.070 5,577
B Cost of goods sold
Raw material consumption 47 55 71 71 71 71 79 79 79 79
Chemical consumption 584 714 918 964 1,012 1,062 1,116 1,171 1,230 1,291
Veneering treatment exp 100 117 150 165 165 165 182 182 182 182
Power consumption 124 124 124 130 130 130 143 143 143 143
Fuel consumption 1 1 1 1 1 1 2 2 2 2
Repairs, maintenance, lubricant and 21 25 30 32 33 35 37 39 41 43
oil
Salaries & wages – factory 55 61 67 73 81 89 98 107 118 130
Depreciation 154 154 154 154 154 154 154 154 154 154
Production cost 1,086 1,251 1,515 1,590 1,647 1,707 1,811 1,877 1,949 2,024
Gross profit (A-B) 644 869 1,347 1,558 1,816 2,102 2,379 2,732 3,121 3,553
C Administrative and selling overheads
Administrative 70 80 95 104 114 126 139 152 168 184
Selling 275 325 372 409 450 495 545 599 659 725
345 405 467 513 565 621 684 751 827 909
Operating profit/EBIT 299 464 880 1,045 1,252 1,481 1,695 1,981 2,294 2,644
D Financial charges
Interest on term loan 358 342 323 300 274 244 209 168 120 65
Interest on working capital 53 50 48 44 41 36 31 25 18 10
Profit after interest/PAT (112) 72 509 701 937 1,201 1,455 1,788 2,156 2,569
E Preliminary expenses written off 36 36 36 36 36 36 36 36 36 36
H Income tax provision Nil Nil Nil Nil Nil 408 497 613 742 887
Profit after tax (148) 36 473 665 901 757 922 1,139 1,378 1,646
This material is being used for academic purposes only and is intended only for MBA students registered in IIT Delhi in Semester II - 2020-21 and is not intended for wider
circulation.
As a result, its operating profit ratio has shown a sizeable increase from 17.22% in
year1 to an impressive 47.38% by year 10, the corresponding figures of gross profit
ratio being 37.15% and 63.59%. The net profit ratio has registered the most notable
increase of nearly 17 times, the respective figures being 1.71% and 29.52% in years
2 and 10. (Table 2).
The impressive profitability ratios are plausible owing to low and modest values of
major expenses ratios, such as cost of goods sold ratio, administrative expenses ratio
and selling expenses ratio. The major factors attributing to such low expense ratios
are availability of cheap raw material within very close proximity of factory site
(thus saving transportation costs), cheap labour, steady prices of chemicals, and so
on.
As per the trend, all the expenses ratios contained in Table 2 have shown decline
over the years. Marked decline has been noted in the case of cost of goods sold ratio;
it has decreased from 62.85% in year 1 to 36.31% by year 10. Administrative
expenses ratio varied in a small range of 3.3% to 4.0% and so the selling expenses
ratio, the range figures being 13% -15.9%.
Good operating performance, coupled with 5 years tax holiday, predict spectacular
and impressive rates of return on its total assets (ROTA) and on its shareholders
funds. For instance, ROTA has shown a consistent and steady increase from 7% in
year 1 to more than 7 times (49.1%) by year 5 and to an incredible figure of 105.69%
by year 10. Likewise, rate of return on shareholders funds has shown 10 times
increase (from 2.71% to 31.07%) during the period under reference (Table 2).
Apart from profitability, it was considered prudent to determine break-even point

(BEP) and margin of safety (MS). It is gratifying to note from Table 3 that the plant
reaches the BEP very early (year 2). Its cash break-even point reaches in year 1
(Table 4).
Table 2: Financial analysis in terms of major financial ratios pertaining to commercial profitability,
and rate of return on investment
Ref Name of the ratio Years

1 2 3 4 5 6 7 8 9 10
I(i) Profitability ratios:
(a) Gross profit ratio 37.15% 40.99% 47.03% 49.45% 52.39% 55.13% 56.79% 59.25% 61.55% 63.69%
(b) Operating profit ratio 17.22% 21.88% 30.72% 33.14% 36.09% 38.83% 40.49% 42.95% 45.24% 47.38%
(c) Net profit ratio 8.57% 1.71% 16.55% 21.06% 25.96% 19.84% 22.04% 24.69% 27.18% 29.52%
I(ii) Expenses ratio:

(a) Cost of goods sold ratio 62.85% 59.01% 52.97% 50.55% 47.61% 44.87% 43.21% 40.75% 38.45% 36.31%
(b) Administrative expenses ratio 4.04% 3.76% 3.31% 3.31% 3.31% 3.31% 3.31% 3.31% 3.31% 3.31%
(c) Selling expenses ratio 15.89% 15.36% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00% 13.00%
(d) Operating ratio 82.78% 78.12% 69.28% 66.86% 63.91% 61.17% 59.51% 57.05% 54.76% 52.62%
II Rate of return:
(a) Rate of return on total assets (ROTA) 6.98% 13.25% 29.50% 37.87% 49.10% 44.73% 54.41% 67.77% 84.50% 105.69%
(EAT + Interest) / Total assets * 100
(b) Rate of return on total shareholders’ (11.42%) 2.71% 31.04% 40.85% 45.95% 31.11% 30.08% 28.99% 27.45% 31.07%
funds (EAT/Shareholders funds)* 100
This material is being used for academic purposes only and is intended only for MBA students registered in IIT Delhi in Semester II - 2020-21 and is not intended for wider
circulation.
Table 3: Determination of BEP
(Amount in lakh of rupees)
Ref Particulars 1 2 3 4 5 6 7 8 9 10
A Sales 1,730 2,120 2,862 3,148 3,463 3,809 4,190 4,609 5,070 5,577
B Less variable costs
Veneering treatment exp. 100 117 150 165 165 165 182 182 182 182
Lubricant & oil 21 25 30 32 33 35 37 39 41 43
Administrative overheads 14 16 19 21 21 21 23 23 23 23
Selling overheads 247 293 335 368 368 368 405 405 405 405
Total variable cost 1,138 1,345 1,648 1,752 1,801 1,853 1,987 2,044 2,105 2,168
C Total contribution (A – B) 592 775 1,214 1,396 1,662 1,956 2,203 2,565 2,965 3,409
Contribution to volume ratio 34.22% 36.56% 42.41% 44.35% 47.99% 51.35% 52.58% 55.64% 58.48% 61.13%
Fixed costs
Salaries & wages (factory) 55 61 67 73 81 89 98 107 118 130
Depreciation 154 154 154 154 154 154 154 154 154 154
Preliminary expenses written off 36 36 36 36 36 36 36 36 36 36
Financial overheads 411 392 370 345 315 281 240 193 138 75
Total fixed costs 739 740 740 732 710 684 665 627 583 532
D Break even sales revenue in lakh 2,160 2,024 1,745 1,651 1,480 1,332 1,264 1,127 997 869
of rupees
E Margin of safety (430) 96 1,117 1,497 1,983 2,477 2,926 3,482 4,073 4,708
F Margin of safety ratio - 4.52% 39.03% 47.55% 57.26% 65.03% 69.83% 75.54% 80.33% 84.42%
This material is being used for academic purposes only and is intended only for MBA students registered in IIT Delhi in Semester II - 2020-21 and is not intended
for wider circulation.
Table 4: Determination of Cash Break Even Point (CBEP)
(Amount in lakh of rupees)
Ref Particulars 1 2 3 4 5 6 7 8 9 10
A Sales 1,730 2,120 2,862 3,148 3,463 3,809 4,190 4,609 5,070 5,577
B Less variable costs
Veneering treatment exp. 100 117 150 165 165 165 182 182 182 182
Lubricant & oil 21 25 30 32 33 35 37 39 41 43
Total variable cost 1,138 1,345 1,648 1,752 1,801 1,853 1,987 2,044 2,105 2,168
C Total contribution (A – B) 592 775 1,214 1,396 1,662 1,956 2,203 2,565 2,965 3,409
Contribution to volume ratio 34.22% 36.56% 42.41% 44.35% 47.99% 51.35% 52.58% 55.64% 58.48% 61.13%
C Cash fixed costs:
Salaries & wages (factory) 55 61 67 73 81 89 98 107 118 130
Financial overheads 411 392 370 345 315 281 240 193 138 75
Total cash fixed costs 549 540 550 542 520 494 475 437 393 342
G Cash break even point:
Total cash fixed costs 549 540 550 542 520 494 475 437 393 342
Cash break even sales revenue 1,604 1,477 1,297 1,222 1,084 962 903 786 672 559
Cash margin of safety 126 643 1,565 1,926 2,379 2,847 3,288 3,823 4,398 5,018
Cash margin of safety ratio 7.05% 30.33% 54.68% 61.18% 68.70% 74.74% 78.45% 82.95% 86.74% 89.98%
Owing to increase in sales revenue in sales revenue in greater proportion (primarily
due to higher level of capacity utilization from year 3 onwards) than increase in
variable costs, the BEP considerably decreased over the years. From Rs 1745 lakhs
in year 3, it has reduced to less than half (Rs 869) by year 10. As a result, margin of
safety, ratio has touched as high a figure as of 80% and more in years 9 and 10. In
terms of cash margin of safety the figures are still more impressive in that they fall
in the range of 75% - 90% during last 5 years (6-10 years) of our projections. These
figures are indicative of substantial cash generating capacity of the project.
From the above, it is very apparent that commercial profitability of cotton stalk
based particle board projects is sound.
4. FINANCIAL VIABILITY
Financial viability of the project is to be assessed, primarily in terms of discounted

cash flow techniques (net present value and internal rate of return), pay back period,
debt service coverage ratio and sensitivity analysis.
4.1 Discounted Cash Flow (DCF) Methods
The DCF method requires estimation of cash outflows required To implement the
project, cost of capital and cash inflows after taxes (CFAT), it is likely to yield
during its economic useful life (10 years in the present context) are to be estimated.
Cash outflows in terms of various capital cost (land & building, plant and
machinery, net working capital etc.) have been estimated at Rs 3917 lakhs (Table
5).
Working capital requirements during the project life (1-10 years) have been shown
in Table 6. Debtors component of working capital has been estimated at cost price
(excluding depreciation) as investment in debtors from the perspective of working
capital will be at cost price and not at selling price.
Table 5: Cost of the Project
(Amount in lacs of rupees)

Sr. No Item of cost Amount Rs.
A Land & land development 30
B Building 180
C Plant and machinery 1,920
D Supply-Indigenous 770
G Preliminary Pre-operative expenses 356
H Working capital 401
I Provision for contingency 260
Total 3,917
Cost of capital, based on the weighted average cost of equity capital (10% share),
redeemable preference share capital (30%) and loan (60%), entailing specific cost
of 20%, 18% and 17.5% respectively, is estimated to be 18%.
The existing proportions of various sources of finance is in conformity with lender’s

requirement of capital structure of cooperative form of business organization. Loan
from lending institution is to be at 17.5% as per its current rate of interest charged;
it makes available 30% finances to the concerned State Government which, in turn,
provides it to the project in form of redeemable preference share capital. Obviously,
the State Government will be expecting yield at least equal to the rate of interest
(17.5%) + service charge, say 0.5%. As a result, cost of preference share capital is
taken as 18%. In tune with sound tenets of finance theory, cost of equity (since it
entails risk) is to be higher than cost of preference shares and debt; in the present
context, it is assumed to be equal to 20%.
It may be noted that weighted average cost of capital is taken at 18% for all the years
for conservative and consistency reasons, notwithstanding the possibility of its
decrease in years 6-10 due to tax shield on interest payment.
Cash inflows (CFAT) have been derived by recasting projected income statement
(Table 1) which excludes, non-cash expenses (depreciation and amortization of
preliminary expenses) and financial expenses. In 10th year, adjustment has been
made for salvage value of plant and machinery and building, notional value of land,
and recovery of working capital. The values worked out on the basis of the above
criterion, (cash inflows) have been shown in Table 6 which contained NPV
calculations at l8% cost of capital/required rate of return.
The project is financially viable as it yields positive NPV of Rs 845 lakhs†. It
promises an impressive internal rate of return (IRR) of 22.1%; it is higher than cost
of capital (Table 7).
4.2 Debt Service Coverage Ratio (DSCR)
The particle board project holds potentials of generating adequate cash flows to
service its debt repayment schedule. Its debt service coverage ratio (shown in Table
9) is at a very satisfactory level of 2.67, taking into account the repayment period of
10 years (loan as well as long-term working capital loan from some other source).
In operational terms, it implies that in the event of actual cash inflows turning out
to be even less than 50% of the estimated cash inflows, still the firm engaged in the
particle board manufacturing is not likely to encounter any major problem in
repayment.
Table 6: Determination of net present value (NPV)

(Amount in lakhs of rupees )
Years Cash Present value Total present Cash Present value
@
inflows factor @18% value of cash outflows of cash
cost of capital inflows outflows@@
0 1.00 3,917 3,917
1 453 0.847 384 76 64
2 618 0.718 444 110 79
3 1,034 0.609 630 59 36
4 1,199 0.516 619 27 14
5 1,406 0.437 614 28 12
6 1,227 0.370 454 70 26
7 1,352 0.314 425 33 10
8 1,522 0.266 405 35 9
9 1,706 0.225 384 37 8
10 1,911 0.191 365 0
10(a) 590 0.191 113 0
(10b) 45 0.191 9 0
10(c) 874 0.191 167 0
(10d) 36 0.191 7 0
Total present value of cash inflows 5,020 4,175
Less cash outflows/cost of the project 4,175
Net present value 845
10(a) Salvage value of plant and machinery is taken at 20%

(10b) National value of land is taken at 1.5 times the initial cost
†
In operational terms, it implies that the project can absorb sizeable cost escalation of the project, say,
increase in the cost of plant and machinery.
10(c) Recovery of working capital in the 10th year
(10d) Salvage value of building is taken at 20%
@ = Profit after tax + Preliminary Exp. written off + Depreciation + Financial Charges
(Table 1)
@@ Includes outflows (years 1 – 9) for working capital requirement. For brevity,
details of working capital computation are not provided.
Table 7: Determination of internal rate of return (IRR)
(Amount in lakhs of rupees )

Years Cash inflows Present Present Present Present
value factor value of value factor value of
at 22% cash inflow at 23% cash inflow
1 453 0.820 371.46 0.813 368.29
2 618 0.672 415.30 0.661 408.50
3 1034 0.551 569.73 0.537 555.26
4 1199 0.451 540.75 0.437 523.96
5 1406 0.370 520.22 0.355 499.13
6 1227 0.303 371.78 0.289 354.60
7 1352 0.249 336.65 0.235 317.72
8 1522 0.204 310.28 0.191 290.70
9 1706 0.167 284.90 0.155 264.43
10 3456 0.137 473.47 0.126 435.46
4194.54 4018.05
Present value of cash outflow 4,175

IRR lies between 22% and 23%, i.e., 22.1% app.
Table 8: Determination of DSCR and DCSCR debt and capital (owners, government and lenders) service coverage ratio
(Amount in lakhs of rupees)
Particulars 1 2 3 4 5 6 7 8 9 10
(a) Total cash available to service 453 618 1,034 1,199 1,406 1,227 1,352 1,522 1,706 1,911
debt & capital (Table 6)
(b) Installment sum 523 523 523 523 523 523 523 523 523 523
(c) DSCR (a)/(b) 0.86 1.18 1.98 2.29 2.69 2.35 2.59 2.91 3.26 3.65
(d) Average DSCR (years 1 – 10) = 2.67
(e) Payment of dividend to 0 0 286 566 566 283 283 283 283 283
owners and Government of
Maharashtra
(f) Redemption of preference 0 0 0 0 0 0 0 0 0 1,085
shares
(g) Total sum payable (b+e+f) 523 523 809 1,089 1,089 806 806 806 806 1,891
(h) Debt and capital service 0.86 1.18 1.28 1.10 1.29 1.52 1.68 1.88 2.12 1.01
coverage ratio (a)/(g)
Average debt and capital service coverage ratio (DCSCR) (years 1 – 10) = 1.39
As far as servicing obligations of all the stakeholders (owners as well as lenders) are
concerned, the relevant financial statistics contained in Table 8 indicates that the
average DCSCR is 1.39 for the period under reference. The ratio is satisfactory.
Thus, the project, in spite of its having high debt-equity ratio, seems to be having
enough funds generated from the project not only to serve its lenders well but also its
owners/investors/cooperative members. Inasmuch it is likely to be left with some funds
after meeting all these claims to take care of contingencies and have some funds left to
finance expansion. In effect, both DSCR and DCSCR support that the project is
financially sound and viable (Table 8).
4.3 Sensitivity Analysis
The project enjoys good margin of safety is manifested in many ways. Low break-even
point, positive NPV, satisfactory debt service coverage ratio is only a selective list.
Sensitivity analysis carried out in this regard also prove the same. It is amply borne out
by the fact that the project continues to show positive NPV and IRR greater than cost
of capital even in situation when cash inflows are assumed to be lower by 15%, across
the board, for all years (Table 9).
5 CONCLUDING OBSERVATIONS
The cotton based particle board projects seem to satisfy the commercial profitability
and financial viability criteria reasonably well. The project generates more than
adequate cash f1ows to service not only the lenders well but also owners. Above all, it
is gratifying to note that the project is bestowed with satisfactory margins of safety on
many important financial Parameters. Sensitivity analysis is also a pointer towards the
same.
Table 9: Sensitivity Analysis
(Amount in lakhs of rupees)

Years Cash Present value Total present Present value of Present value
inflows factor @18% value of cash cash inflows of cash
cost of capital inflows decreased by inflows
10% decreased by
15%
1 453 0.847 384 345 326
2 618 0.718 444 399 377
3 1,034 0.609 630 567 535
4 1,199 0.516 619 557 526
5 1,406 0.437 614 553 522
6 1,227 0.370 454 409 386
7 1,352 0.314 425 382 361
8 1,522 0.266 405 364 344
This material is being used for academic purposes only and is intended only for MBA students registered in IIT
Delhi in Semester II - 2020-21 and is not intended for wider circulation.
9 1,706 0.225 384 345 326
10 1,911 0.191 365 329 310
10(a) 590 0.191 113 113 113
(10b) 45 0.191 9 9 9
10(c) 874 0.191 167 167 167
(10d) 36 0.191 7 7 7
Total present value of cash inflows 5,020 4,546 4,309
Less cash outflows/cost of the project 4,175 4,175 4,175
Net present value 845 371 134
10(a) Salvage value of plant and machinery is taken at 20%

(10b) National value of land is taken at 1.5 times the initial cost
10(c) Recovery of working capital in the 10th year
(10d) Salvage value of building is taken at 20%
Zip Zap Zoom Car Company: (A Case on Corporate Debt Capacity)
Zip Zap Zoom Company is into manufacturing cars in the small car (800 cc) segment.
It was setup 15 years back and since its establishment it has seen a phenomenal growth
in both its market share and profitability. The financial statements (P&L A/C and
Balance Sheet) are shown in Exhibits 1 and 2 respectively.
The company enjoys the confidence of its shareholders who have been rewarded with
growing dividends year after year. Last year too, the company had announced 20%
dividend, which was the highest in the automobile sector. The company has never
defaulted on its loan payments and enjoys a favorable face with its lenders, which
include financial institutions, commercial banks and other private debenture holders.
The competition in the car industry has increased in the past few years and the company
foresees further intensification of competition with the entry of several foreign car
manufacturers; many of who are market leaders in their respective countries. The small
car segment especially, will witness entry of foreign majors in the near future, with
latest technology being offered to the Indian customer. Zip Zap Zoom company’s senior
management realizes the need for large scale investment in upgradation of technology
and improvement of manufacturing facilities to preempt competition.
Whereas on one hand, the competition in the car industry has been intensifying, on the
other hand, there has been a slowdown in the Indian economy, which has not only
reduced the demand for cars, but also led to adoption of price cutting strategies by
various car manufacturers. Industry indicators predict that the economy is gradually
slipping into recession.
Prepared by Ms Pearl Uppal and Shiv Chandra (MBA Full-Time students)

Exhibit 1: Balance sheet as at March 31 current year (Amount in Rs Crore)
Sources of funds
Share capital Rs 350
Reserves and surplus 250 Rs 600
Loans
Debentures (@14%) 50
Institutional borrowing (@10%) 100
Commercial loans (@12%) 250
Total debt 400
Current liabilities 200
Total 1200
Application of funds
Fixed assets:
Gross block Rs 1000
Less: Depreciation (250)
Net block 750
Capital WIP 190
Total fixed assets Rs 940
Current assets:
Inventory 200
Sundry debtors 40
Cash & bank balance 10
Other current assets 10
Total current assets 260
Total 1200
Exhibit 2: Statement of Profit and Loss for the year ended March 31, current year
(Amount in Rs crore)
Sales volume 80,000
(×) Selling price Rs 250,000
Sales revenue Rs 2,000.0

Operating expenditure:
Variable cost
Raw material and manufacturing expenses2 Rs 1,300.0
Variable overheads 100.0
Total variable cost 1,400.0
Fixed cost:
R&D Rs 20.0
Marketing and advertising 25.0
Depreciation 250
Personnel 70.0
Total fixed cost 365.0
Total operating expenditure 1,765.0
EBIT 235.0
Financial expense:
Interest on debentures Rs 7.7
Interest on instl. Borrowings 11.0
Interest on comml. Loan 33.0
Total interest 51.7
EBT 183.3
Taxes (@ 35%) 64.2
EAT 119.1
Dividends 70.0
Debt redemption (Sinking fund obligation)3 40.0
Contribution to reserves and surplus 9.1
2. Includes the cost of inventory and WIP which is dependent on demand (sales).
3. The loans have to be retired in the next ten years and the firm redeems Rs 40 Cr. every year.
The company is faced with the problem of deciding how much to invest in upgradation
of its plants and technology. Capital investment up to a maximum of Rs 100 crore is
required. The problem has three aspects:
• The company cannot forgo the capital investment as that could lead to reduction
in its market share (Technological competence in this industry is a must.
Customers would shift to manufacturers providing latest in car technology)
• The company does not want o issue new equity and its retained earnings are not
enough for such a large investment. Thus the only option is raising debt.
• The company wants to limit its additional debt to a figure that it can service without
taking undue risks. With the looming recession and uncertain market conditions,
the company perceives that additional fixed obligations could become a cause of
financial distress, and thus wants to determine its additional debt capacity to meet
the Investment requirements.
Mr. Shortsighted, the company’s Finance Manager is given the task of determining the
additional debt that the firm can raise. He thinks that the firm can raise Rs 100 crore
worth debt and service it even in years of recession. The company can raise debt at 15%
from a financial institution. While working out the debt capacity, Mr. Shortsighted takes
the following assumptions for the recession years:
a) A maximum of 10% reduction in sales volume will take place.
b) A maximum of 6% reduction in sales price of cars will take place.
Mr. Shortsighted prepares the following income statement which is representative of

the recession years. While doing so, he determines what he thinks are the “irreducible
minimum” expenditures under recessionary conditions. For him risk of insolvency is
the main concern while designing capital structure. To support his view he presents the
income statement shown in Exhibit 3. He works on the assumptions (given after the
Exhibit 3).
Exhibit 3: Statement of Projected profit and loss

(Amount in Rs crore)
Sales volume 72,000
() Selling price () 235,000
Sales revenue 1,692.0
Operating expenditure
Variable cost:
Raw material and manufacturing expenses Rs 1,170.0
Variable overheads 90.0
Total variable cost 1,260.0
Fixed cost:
R&D -
Marketing and advertising 15.0
Depreciation 187.5
Personnel 70.0
Total fixed cost 272.5
Total operating expenditure 1,532.5
EBIT 159.5
Financial expenses:
Interest on existing debentures Rs 7.0
Interest on existing instl. Borrowings 10.0
Interest on existing comml. Loan 30.0
Interest on additional debt 15.0
Total interest 62.0
EBT 97.5
Taxes (@ 35%) 34.1
EAT 63.4
Dividends -
Debt redemption (Sinking fund obligation)* 50.0
Contribution to reserves and surplus 13.4
*(Rs 40 Cr (existing debt) + Rs 10 Cr (Additional debt)
Assumptions of Mr. Shortsighted
• R&D expenditure can be done away with till the economy picks up.
• Marketing and advertising expenditure can be reduced by 40%.
• Keeping in mind that the investor confidence that the company enjoys, he feels
that the company can forgo paying dividends in the recession period.
He goes with his worked out statement to the Director Finance Mr. Arthashatra and
advocates raising Rs 100 crore worth of debt to finance the intended capital investments.
Mr. Arthashatra does not feel comfortable with the statements and calls for the
company’s financial analyst Mr. Longsighted.
Mr. Longsighted carefully analyses Mr. Shortsighted’s assumptions and points out
insolvency should not be the sole criterion while determining the debt capacity of the
firm. He points out the following:
• “Apart from debt servicing, there are certain expenditures like that on R&D and
marketing that need to be continued to ensure the long term health of the firm”.
• “Certain management policies like those relating to dividend payout, send out
important signals to the investors. Zip Zap Zoom’s management has been paying
regular dividends and discontinuing this practice (even though just for the
recession Phase) could raise serious doubts in the investor’s mind about the health
of the firm. The firm should pay atleast 10% dividend in the recession years”.
• “Mr. Shortsighted has used the accounting profits to determine the amount
available each year for servicing the debt obligations. This does not give the true
picture. Net cash inflows should he used to determine the amount available for
servicing the debt”.
• “Net Cash Inflows are determined by an interplay of many variables and such a
simplistic view should not be taken while determining the cash flows in recession.
It is not possible to accurately predict the fall in any of the factors such as sales
volume, sales price, marketing expenditure etc.
Probability distribution of variation of each of the factors that affect net cash
inflow should he analyzed. From this analysis, the probability distribution of
variation of net cash inflow should be analyzed (the net cash inflows follow a
normal probability distribution). This will give a true picture of how the
company’s cash flows will behave in recession conditions.”
The management recognizes that the alternative suggested by Mr. Longsighted rests on
data, which are complex and require expenditure of time and effort to obtain and
interpret. Considering the importance of capital structure design, The Director Finance
asks Mr. Longsighted to carry out his analysis. Information on the behavior of cash
flows during the recession periods is taken into account.
The methodology undertaken is as follows:

a) Important factors that effect cash flows (especially contraction of cash flows), like
sales volume, sales price, raw materials expenditure, etc., are identified and the
analysis is carried out in terms of cash receipts and cash expenditures.
b) Each factor’s behavior (variation behavior) in adverse conditions in the past is

studied and future expectations are combined with past data, to describe limits
(maximum favorable, most probable and maximum adverse) for all the factors.
c) Once this information is generated for all factors affecting cash flow, Mr.
Longsighted comes up with a range of estimates of the cash flow in future
recession periods based on all possible combinations of the several factors. He also
estimates the probability of occurrence of each estimate of cash flow.
Assuming a normal distribution of the expected behavior, the mean expected value of
net cash inflow in adverse conditions came out be Rs 220.27 crore with standard
deviation of Rs 110 crore.
Keeping in mind the looming recession and the uncertainty of the recession behavior,
Mr. Arthashastra feels that the firm should cater to a risk of cash inadequacy of around
5% even in the most adverse industry conditions. Thus the firm should take up only that
amount of additional debt that it can service 95% of the times, while maintaining cash
adequacy.
To maintain an annual dividend of 10%, an additional Rs 35 crore has to he kept aside.

Hence the expected available net cash inflow is Rs 185.27 crore (subtracting Rs 35 crore
from Rs 220.27 crore).
Exhibit 4: Determination of Cash Flows (Amount in Rs crore)
Cash Available for Dividends = EAT + Depreciation - Debtors - SF Obligation

= Rs 259.15
Cash Available at 15% contraction = 220.27
Cash Required for Dividends = 35.00
Average Cash flow available for Additional Debt obligations
= 185.27
Determination of Debt Capacity

Tolerance Limit = 5%
Standard Deviation = 120
Cash Flow Under most adverse conditions* 4.45
Existing Cash Reserve 10.00
Cash Available 14.45
Debt Obligation per Rs. Cr. of Additional Debt
Interest (15 % less Tax Shield) 0.0975
Sinking Fund Obligation 0.1000
Total 0.1975
Debt Capacity 73.15
* Calculation of Cash Flow under most adverse conditions is based on the normal distribution
(Z distribution):
Z value = Cash Inflow - Mean value of Cash Inflow (1)

Std. Deviation
The Z value corresponding to tolerance limit is -1.64
Replacing the values in equation (1)

We get the value cash inflow is Rs. 4.45 Cr.
The following formula is used to calculate the additional cash available in recession conditions
to service debt (catering for 5% risk tolerance):
X -  = 1.64

Here:
X is the additional cash available each year for servicing fixed obligations
 = 185.27
 = 110 crore
-1 .64 is that value of Z which gives caters to 95% of the area of the standard normal curve.
Taking all the above into account, Mr. Longsighted works out the additional debt
capacity as shown in Exhibit 4. The additional debt capacity as calculated by him is
73.1 5 crore.
Mr. Arthashastra too is convinced that there is no need to take up debt which can lead
to a risk of cash inadequate, especially in the present economic scenario. Mr.
Shortsighted too, realizes the importance of maintaining cash adequacy even in the most
unfavorable conditions Thus, it is decided that the firm will raise an additional debt of
only 73.15 crore at present and not take any undue risk. Further investments can he
undertaken when the industry conditions revive.
Royal Hotels Ltd. : (A case on capital structure decisions)*
Royal Hotels Ltd. is a luxury hotel with following financials:
Income Statement of Royal Hotels Ltd for the year ending on March 31, 2014
(Amount in `crore)
Particulars
Sales revenue 650
Operating costs 450
Operating profit 200
Financing costs 10
Earnings before tax 190
Taxes @30% + 3% EC 58.71
Earnings after tax 131.29
Preference dividend 6.50
Preference dividend tax @16.995% 1.10
Earnings available to equity shareholders 123.68
*Prepared by Ms.MV Shivaani (Research Scholar, Department of Management Studies)
Balance Sheet of Royal Hotels Ltd as at March 31, 2014
(Amount (in ` crore)
Particulars
Shareholders’ funds:
Share capital:
Equity `250
13% Preference shares 50 ` 300
Reserves and surplus:
General reserve 90
Long term assets replacement reserve 10 `100
Non current liabilities:
Secured loans: 10% debentures `100
Current liabilities ` 100

600
Application of funds:
Long term assets:
Land and buildings (net) `200

Furniture and fittings `200
Current assets `200
`600
Due to growing concept of 3Ps (Planet, People and Profit) the Board of Directors of Royal
Hotels, in order to emerge as socially responsible organization, comes up with the novel idea
of “Green Hotel”. A green hotel is environmental friendly (in terms of reduced CFC
emissions, reduced power usage) and economically sustainable. Building on this concept,
various studies conducted concluded that the project is likely to be technically feasible,
economically viable, commercially profitable and financially sound. BOD also proposes to
rename the hotel as Royal Greens Ltd.
Projected Income statement of Royal Greens is as follows:
(Amount in ` crore)
Particulars
Total revenue 850
Operating costs 550
EBIT 300
Now, the management is faced with the daunting task of raising the required finances of ` 100
crore.
CEO uses this opportunity to evaluate two Finance managers, Mr. Rohan and Mr. Sohan, due
for promotion. He asks each of them to suggest the soundest way of financing this expansion
project.
Proposal of Mr. Rohan:
He recommends raising ` 100 crore through 2 crore equity shares of Face value of Rs 10
each, issued at a premium of ` 40 each: Reasons for this proposal are:
1)Equity doesn’t involve any fixed commitments, its cost is zero. 2) Payment of interest on
debt and eventual redemption of debt will reduce available cash. 3) The benefit from
increased revenues should go to equity holders only. 4) Raising debt will increase financial
risk of the firm. 5) Firm will be able to have a favorable debt equity ratio. 6) This favorable
debt equity ratio and no risk of default of non- payment to financiers may increase the firm’s
overall rating.
Proposal of Mr. Sohan:
He recommends raising ` 100 crore through issue of 11% redeemable debentures as:
1. (X-I1) (1-t) - PD (1+PDT) = (X-I2) (1-t) - PD (1+PDT)
N1 N2
(X-`10crore) (1-.309) - `6.5crore(1.16995) = (X-`21crore) (1-.309) ` 6.5crore(1.16995)
27crore 25crore
X (EBIT) = `169 crore
2. Since expected EBIT `300 crore is more than required EBIT `169 crore, the firm can raise
money through issue of debt (based on EBIT-EPS Analysis).
3. Interest on debt is tax deductible; it leads to cash inflow to the extent of tax saving on
interest.
4.Equity is a costlier source of funds as equity shareholders are exposed to more risk.
5. As per Signaling Theory, issue of debt is a good signal, and leads to increase in market
price of shares.
6. Even on raising debt, firm will still have better debt equity ratio than industry average
(as suggested by ratio analysis).
7. Favorable debt equity ratio lends flexibility to firm in terms of raising funds in future.
8. Above all equity- holders are in pensive mood because of unstable stock market,
raising funds through equity may be difficult proposition.
Perplexed by the contradicting recommendations of his two prodigy, the CEO refers this
complex task to consultant Ms. Shivaani who is considered to be a financial wizard. She
states that equity capital carries a higher cost due to of higher risk compared to debt and
leveraging up to a point reduces overall cost of capital (as enunciated in Traditional
approach of capital structure) and equity- shareholders are benefitted by a higher EPS. Thus,
an optimum mix of debt and equity is a prerequisite of sound capital structure. She submits
the following report to CEO of Royal Greens.
Evaluation of proposed financing mix on the basis of desirable attributes of sound financing
mix:
S. Refer
Debt Equity Debt+Equity
No. Attributes Note
1 EBIT-EPS analysis ✓  ✓ 1
2 Compliance of covenants  ✓ ✓ 2
3 Wealth maximization ✓  ✓ 1,4
4 Avoidance of bankruptcy costs  ✓  3
5 Flexibility   ✓ 3
6 Capital structure ratios  ✓ ✓ 5,6,
7 Tolerable financial leverage ✓ ✓ ✓ 7
8 Signaling Theory ✓  ✓ 8
9 Tax saving on interest ✓  ✓ 9
10 Absence of agency cost  ✓ ✓ 10
11 Security rating ✓ ✓ ✓ 11
12 Timing ✓ ✓ ✓ 12
From, the contents of the table it seems reasonable to advice a mix of debt and equity to raise
required funds of ` 100 crore. Due to a covenant in working capital loan agreement it is
advised to raise debt and equity in ratio of 50:50 (refer Note 2) i.e. `50 crore through issue
of 50, 00,000 11% debentures of face value ` 100 and balance ` 50 crore through 1 crore
equity shares of FV ` 10, issued at a premium of ` 40 per share.
Notes:
1. The basic objective of financial management is maximization of shareholders wealth,

for which MPS can be taken as a proxy, therefore, real indifference point (instead of
indifference point based on EPS) will be rational guide in determining the source of
finance.
P/E1X[(X-I1) (1-t) - PD (1+PDT)] = P/E2X[(X-I2) (1-t) - PD (1+PDT)]
N1 N2
10[(X-`10 crore) (1-.309) - `6.5 crore (1.16995) ] = 9.75[(X-`21crore) (1-.309) -` 6.5crore(1.16995)]
27 crore 25 crore
X= `239.5 crore
Since the projected EBIT at `300 crore is more than `239.5 crore, firm can finance
through debt.
2. In WC loan agreement, a restrictive covenant has been found stating that, the Long
Term Debt/ Equity ratio cannot be more than 40% at any given point of time.
So, Maximum debt that can be raised = (100+x) = .4[400+ (100-x)]
This implies firm can raise only `71.4 crore through debt.
3. Since raising debt can lead to bankruptcy costs, a schedule of bankruptcy cost at
varying levels of debt is presented below.
Level of debt `100 crore 110 120 130 140 150 160 170
Bankruptcy costs Zero ` 50 lakh 1 crore 2 4 7 11 16
In case the maximum possible debt i.e. ` 70 crore is raised then ,the total debt ,would amount
to `170 crore and accordingly, bankruptcy costs are likely to be ` 16 crore. Also, exhausting
the complete debt source right away may reduce the flexibility to raise funds in future. Keep
this in mind; raising ` 50 crore through debt and the balance ` 50 crore through equity seems
reasonable. This way total debt would amount to `150 crore, thereby leading to a saving of `9
crore towards bankruptcy costs. Therefore, a 50:50 debt-equity mix is proposed.
4. Statement showing determination of market price per share under various financing
plans:
Figures in ` ( crore)
Proposed Only
Exisiting Only debt
Particulars mix equity
Sales revenue 650 850 850 850
Operating costs 450 550 550 550
EBIT 200 300 300 300
Interest 10 15.50 21 10
EBT 190 284.50 279 290
Taxes @30.9% 58.71 87.91 86.21 89.61
EAT 131.29 196.58 192.78 200.39
Preference dividend 7.60 7.60 7.60 7.60
Earnings available to equity-
holders 123.68 188.98 185.18 192.78
No. of equity shares 25 26 25 27
EPS (Rs.) 4.95 7.26 7.40 7.14
Expected P/E multiple 9.95 9.5 10
MPS (Rs.) 72.32 70.37 71.40

*It has been assumed that because of high profitability and lower fixed obligations , there is
no significant difference in P/E ratio under debt and equity alternative. Also due to factors
like signaling theory and less financial risk and favorable ratios, P/E ratio of proposed mix is
likely to be 9.95.
5. If the funds are raised in proposed ratio :

Long term debt/ Equity ratio is likely to be
`150 crore/ `.450 crore = 3 times or debt is 33.3% of equity, hence the covenant can be
said to be complied with.
6. To ensure firm does not default on interest payment interest coverage ratio has been
calculated as follows:
EBIT, `300 crore/ Interest ` 15.5.crore = 19.35 times
It means that even if EBIT falls by whopping 90%, firm will be still able to meet its
interest obligations.
7. To further assure that the proposed mix does not increase financial risk of the firm,
degree of financial leverage is calculated as follows:
EBIT
EBT- Preference dividend (1+ dividend payment tax)
(1-Tax rate)
`300 crore = 1.0968
`284.5 core -`6.5 crore(1.16995)
(1-.309)
It represents almost negligible chance of default in meeting commitments towards fixed
charge securities.
8. Signaling theory states that investors see issue of debt as a signal of growth.
9. Since interest on debentures is allowed to be deducted while calculating taxable

income, interest X tax rate is a tax saving and notional inflow.
10. Usually issue of debt leads to emergence of agency costs, in the present context, debt
is just 1/3 of equity, so, it is believed agency costs are not likely to arise.
11. Given, sound capital structure ratios, firm’s security rating is not expected to
deteriorate (subsequent to raising of debt).
12. Given, firm’s credentials and market conditions, issuance of either or both of debt and
equity are likely to succeed.

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Case Study

Commercial Profitability and Financial Viability of Project*

The assumptions, forming the basis of assessment of commercial profitability and

1.2.1 Sales Revenue Estimates

1.2.2 Cost estimates

iii. Step-wise increase in veneering treatment expenditure has been assumed; it

v. On account of recycling of fine dust generated in the plant, fuel consumption

viii. For the purpose of determining depreciation, straight line method of

x. Selling overheads primarily consist of dealers’ commission of 10%, and other

xii. Preliminary expenses, consisting substantially of interest cost during

xv. Above all, commercial profitability and financial profitability analysis to

1.3.1 Projected Income Statement

Apart from profitability, it was considered prudent to determine break-even point

Ref Name of the ratio Years

I(ii) Expenses ratio:

Financial viability of the project is to be assessed, primarily in terms of discounted

4.1 Discounted Cash Flow (DCF) Methods

(Amount in lacs of rupees)

The existing proportions of various sources of finance is in conformity with lender’s

4.2 Debt Service Coverage Ratio (DSCR)

Table 6: Determination of net present value (NPV)

10(a) Salvage value of plant and machinery is taken at 20%

Table 7: Determination of internal rate of return (IRR)

(Amount in lakhs of rupees )

Present value of cash outflow 4,175

(Amount in lakhs of rupees)

4.3 Sensitivity Analysis

Table 9: Sensitivity Analysis

(Amount in lakhs of rupees)

10(a) Salvage value of plant and machinery is taken at 20%

Prepared by Ms Pearl Uppal and Shiv Chandra (MBA Full-Time students)

Current liabilities 200

Sales revenue Rs 2,000.0

Mr. Shortsighted prepares the following income statement which is representative of

Exhibit 3: Statement of Projected profit and loss

*(Rs 40 Cr (existing debt) + Rs 10 Cr (Additional debt)

Assumptions of Mr. Shortsighted

The methodology undertaken is as follows:

b) Each factor’s behavior (variation behavior) in adverse conditions in the past is

To maintain an annual dividend of 10%, an additional Rs 35 crore has to he kept aside.

Cash Available for Dividends = EAT + Depreciation - Debtors - SF Obligation

Determination of Debt Capacity

Z value = Cash Inflow - Mean value of Cash Inflow (1)

Replacing the values in equation (1)

Sales revenue 650

Operating costs 450

Operating profit 200

Earnings before tax 190

Taxes @30% + 3% EC 58.71

Earnings after tax 131.29

Preference dividend 6.50

Preference dividend tax @16.995% 1.10

Earnings available to equity shareholders 123.68

*Prepared by Ms.MV Shivaani (Research Scholar, Department of Management Studies)

(Amount (in ` crore)

13% Preference shares 50 ` 300

Reserves and surplus:

Long term assets replacement reserve 10 `100

Non current liabilities:

Secured loans: 10% debentures `100

Current liabilities ` 100

Long term assets:

Land and buildings (net) `200