Financial Management

Financial Management Level of knowledge Aim

: Basic :To assess whether students have acquired basic knowledge about what is financial management, what are the various tools of financial management and methods of financial management f

Detailed contents : 1. Meaning, Importance and objectives of financial management and functions of Finance Manager 2. Finance planning and forecasting cash budgets 3. Operating and financial leverage, cost volume profit analysis 4. Management of working capital - cash management, receivables management, Inventory management and financing of working capital 5. Sources of long term and short term finance – Term borrowings, commercial papers, Equity Shares, Preference shares, debentures etc. 6. Cost of Capital and capital structure theories – cost of different sources of finance 7. Dividend policies 8. Capital budgeting – Basics of capital budgeting and various techniques of capital budgeting

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Index Chapter 1 : Financial Management – an overview 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8

Topic Introduction Meaning of Financial Management Importance of Financial Management Objectives of Financial Management Functions of finance manager Financial management and organisational structure Financial management in India Self examination questions

Page no. 5 5 7 8 9 11 12 14

Chapter 2 : Finance planning and forecasting

2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8

Topic Introduction What is financial planning Need and Importance of Financial planning Factors to be considered in a financial plans Essential characteristics of financial plan Budgets Solved problems Self examination questions

Page no. 16 16 17 17 19 20 20 29

Chapter 3 : Operating and financial leverage, cost volume profit analysis 3.1 3.2 3.3 3.4 3.5 3.6

Topic Introduction Types of leverages Solved problems on leverages Cost volume profit analysis Solved problems on break-even point Self examination questions

Page no. 33 33 36 41 43 45

Chapter 4 : Management of working capital 4.1 4.2 4.3 4.4 4.5 4.6

Topic Introduction Meaning of the term working capital Importance of adequate working capital How to determine optimum working capital Working capital cycle Solved problems on working capital cycle 2

Page no. 47 47 48 49 49 52

4.7 4.8 4.9 4.10 4.11 4.12 4.13 4.14 4.15

Estimation of working capital requirements Solved problems on working capital estimation Factors affecting the working capital requirements Management of Working capital Cash Management Debtors management Inventories management Working capital financing in India Self examination questions

55 58 66 67 67 71 73 75 75

Chapter 5 : Sources of long term and short term finances 5.1 5.2 5.3 5.4 5.5 5.6 5.7

Topic Introduction Types of Requirement of funds Various sources of finance Long term sources of finance Short term sources of finance Modes of charges against a loan Self examination questions

Page no. 84 84 85 86 91 93 95

Chapter 6 : Cost of capital and capital structure theories 6.1 6.2 6.3 6.4 6.5 6.6

Topic Introduction Considerations in Capital structure planning Determination of cost of various sources of capital Weighted average cost of capital Theories of cost of capital Self examination questions

Page no. 97 97 99 106 108 111

Chapter 7 : Dividend policies

7.1 7.2 7.3 7.4 7.5

Topic Introduction Walter model Gordon model Irrelevance approach Self examination questions

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Page no. 115 116 118 120 124

Chapter 8 : Capital Budgeting

8.1 8.2 8.3 8.4 8.5

Topic Introduction What is capital budgeting ? Methods and techniques of capital budgeting Solved problems Self examination questions

Chapter 9 : assorted questions

Page no. 127 127 128 147 175 182

Students should note that this module is not meant to be an exclusive study material and students are required to refer to other recommended books. Questions in examination may not be necessarily from this material. Though every effort has been made to avoid errors or omissions in this module, there may be errors. Any mistake, error or discrepancy noticed noted may be brought to our notice which shall be taken care of in the next edition .It is notified that the author is not responsible for damage or loss to any one, of any kind, in any manner, therefrom. No part of this study material may be reproduced or copied in any form or by any means (including photocopying), without the written permission of the author.

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1 Financial Management – an overview 1.1 Introduction Management of funds is one of the most important functions of any organisation, be it a profit oriented organisation or social organisation like CRY. In this Chapter, we shall try to understand the basic concepts of financial management i.e. management of money matters. In our day-to-day life also we face many finance related problems which we try to solve on our own judgement or with the help of friends and relatives examples of such problems can be – 1. Mr A is willing to buy a car but is not sure from which bank he shall take loan. 2. Ms X is having Rs 5 lakhs that she is willing to invest profitably and without much risk. If we analyse carefully we can elaborate the problems as follows – 1. Which bank offers the cheapest interest rates? What will be the repayment period ? What will be the instalment per month? How much instalment Mr A can afford, considering his all other expenses? and so on 2. Whether to invest in government securities, Provident fund, Mutual funds, Debentures, Shares, gold or real estate ? To put it simply we can say that Mr A is facing a problem about procurement of funds whereas Ms X is facing problem as to investment of funds. Financial Management provides guidelines , tools and methods of solving the problems of procurement of funds and problems of investment of funds and is helpful for every organisation as well as individual. 1.2 Meaning of Financial management Various authors have defined the term financial management differently. The most acceptable definition of financial management deals with procurement of funds and their effective utilisation. There are, thus, two basic aspects of financial management – procurement of funds and their effective utilisation. 1.2.1 Procurement of funds – Procurement of funds or raising the funds is complex problem as funds can be obtained from indefinite sources, each having different characteristic in terms of risk, cost and control. E.g - let us evaluate some sources of funds (For detailed discussion of sources of funds refer following topics - cost of capital and sources of funds)

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R I S K

Risk High Cost Low (Bank loan) Cost High Risk Low (Equity shares)

COST Again Control risk is least for bank loan where as it is highest for Equity shares. One more constraint for procurement of funds is availability of funds e.g for a small business house only availability may be bank loan and the business may not be able to raise funds from public by way of equity shares. Procurement of funds inter alia includes – • Identification of sources of finance • Determination of finance mix from such sources • Raising of funds • Allocation of profits between dividends and retention of profits i.e internal fund generation In the current global scenario it is not enough to scout for available ways of raising finance but resource mobilisation has to be undertaken through innovative financial products which understand the business as well as investors needs an example can be convertible debentures which gets converted from debentures to equity shares after a predefined date. 1.2.2 Utilisation of Funds - A finance manager is also responsible for effective utilisation of funds. He is responsible to ensure that the funds are not kept idle and are invested properly. Utilisation of funds can be directly linked with the procurement of funds, if the funds are not utilised to generate income higher than the cost of procuring it then there is no point in running the business, say, for example if a bank is offering 5% interest on deposits then the banker must ensure that the amount of deposit is utilised to generate an income which is higher than 5%. The funds have to be so invested that the company can optimise its profitability without harming its solvency and liquidity. The finance manager has to invest in fixed assets and current assets in a right proportion so as to reap maximum yield. Utilisation of funds inter alia includes – • Identification of area of investments • Determination of finance mix for the utilisation • Assessing the risk level of the investment • Maximising the return on such investment 6

In present day scenario utilisation of funds can be done in indefinite ways making the job of finance manager more complicated and demanding. Following chart indicates the decision-making options available to a finance manager for utilisation of its funds.

R I S K

Risk High Returns high (Equity market) Risk Low Return Low (Government Security) RETURN

1.3 Importance of Financial Management The importance of finance manager cannot be over-emphasised. There is an ordinary belief that a finance manager is needed only in private organisations. However, sound finance manager is essential in all organisations – whether profit or non profit where funds are involved. Financial management is so essential as he plays a crucial role in making best use of resources. Commercial history is full of examples where firms have been liquidated not because their technology was obsolete or it lacked demand for its products but because of financial mismanagement, a recent example of ENRON INC can be very elaborative about this point. Financial management essentially optimises the output from the given input of funds. It attempts to use the funds in most productive manner. In underdeveloped countries like India where resources are scare and demands on funds are many, the need for finance manager is enormous. Finance management can be very effective in case of non-profit making organisations as which hardly pay proper attention to financial management. Very frequently we read about such organisations closing down because of lack of finance, in fact, many times, it is not lack of finance but it is lack of proper financial management. Many times these organisations keep their funds idle which has cost. Though motive of such organisations is not to make profits but it can certainly cut down its costs in order to have sound financial position. An example - Following extract is taken from board report of a company emphasising the turnaround in company’s financial position achieved due to sound financial management – “Better cash management and control over capital employed and working capital has helped the company in reducing its loans from Rs 580 crores to Rs 200 crores resulting into interest saving of approx Rs 30 crores, this has improved profit position of the

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company substantially. We hope to continue with similar performance in current year by undertaking further cost cutting and strict control over cash flows.” 1.4 Objectives of Financial Management – A basic understanding of objectives of financial management would help us in appreciating how a finance manager makes his decisions. Decisions can be made only when objectives are clear. Following are the fundamental objectives of finance manger – 1.4.1 Profit Maximisation – It cannot, however, be the sole objective of the company, but it is certainly one of the most important objectives. If a company is run with sole object of profit making then it can create certain problems like – i. Profit maximisation has to be attempted with a realisation of risks involved. Risk and profit is directly relates and motive of profit maximisation may lead to risk maximisation also. A finance manager with sole objective of profit maximisation may end up taking excessive risk, which may lead to failure of organisation. In practice, risk is given almost equal importance as that of profit and profit is maximised only till it reaches the acceptable risk level. ii. Profit maximisation may or may not take into account the time pattern of return i.e even if Project A is having more profit than Project B, project A may start giving return at the end of year 5 and Project B at the end of year 1. In such scenario finance manager has to consider both the things time and profit and not only profit. iii. Profit maximisation is a very narrow object and does not take into consideration social aspects, which can be very harmful to the society. 1.4.2 Wealth Maximisation –The policy of profit maximisation is considered as shortterm policy as it may give exorbitant benefits in short term but may end up affecting growth and survival of the company in the long run. Thus a company may start buying inferior raw materials in order to maximise profit, which it may actually get for some period, but will end up losing its goodwill and may have to close down. Hence, it is commonly agreed that the objective of a firm is to maximise its value or wealth. According to Van Horne – “Value is represented by the market price of the company’s common stock ………… The market price of a firm’s stock represents the focal judgement of all market participants as to what the market value of the particular firm is. It takes into consideration present and expected future earnings per share, the timing and the risk associated to the earning, company’s dividend policy etc.. The market price serves as performance indicator of the firm; it indicates how well management is doing on behalf of the stockholders.” Though market value of the firm depends upon various factors, it normally depends upon two Factors – a. The likely rate of earnings per share of the company (EPS) b. The Capitalisation rate

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Let us see one example. If for a company A ltd the market expectation of returns is 25% and it’s Earnings per share is Rs 5 (EPS = Earnings available to equity share holders/ no of equity shares outstanding) then the market price per share will be – 5/25*100 = Rs 20 per share. If we calculate in reverse way we can see that the return on every Rs 20 invested the shareholder will be getting Rs 5 i.e 25% which is as per his expectations. The expected return varies form company to company and industry to industry (which is 25% for A ltd), the logic for expected returns is simple - more the risk more will be the expected returns. The finance manager has to ensure that his decisions are such that the market value of the shares of the company is maximum in the long run. It is, therefore, duty of the finance manager to optimise the earning of the company so that its value is maximum. Wealth maximisation can thus be considered a better objective as it considers both risk and return of the company. It must be clearly understood that financial decision-making is related to the objective of business and objective of business over shadows the objective of wealth maximisation. To support the statement the following example can be taken – suppose a Public sector under taking, which is in business of steel pipes, is planning to undertake a research and development programme on fertility of baron lands for public welfare, then the finance manager cannot deny funds stating that this is wastage of funds and it wouldn’t maximise the company’s wealth. 1.5 Functions of Finance Manager The main function of finance manager revolves around procurement of funds and its effective utilisation. Thus all the decisions concerning management of funds are subject matter of finance function. This function involves a number of important decisions; some of these have been listed below – 1.5.1 Estimating the requirements of funds - In any business requirement of funds have to be carefully estimated. Certain funds are required for long term purposes i.e investment in fixed assets etc. Not only a careful estimation of such funds is required but also estimation of timing of its requirement is essential. Finance Manager also has to estimate the requirement of the working capital and how much funding will be required for funding its current assets. Forecasting these requirements require budgetary controls and techniques. To forecast the funds requirement all the physical activities of the organisation has to be forecasted like sales, requirement of fixaed assets, debtors etc. 1.5.2 Decision regarding the capital structure – After estimating the quantum of funds required the finance manager has to plan for the sources from where the funds should and can be raised. An optimum mix of the various sources has to be worked out for this purpose. As discussed earlier each source of finance has different cost, risk and

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control risk, a finance manager has to take into consideration all these factors and find out an optimum capital structure which will be best for the organisation. Finance manager has to maintain a proper proportion of outside borrowings and own funds. Again as every other decision this decision should also aim at wealth maximisation, which can be achieved by keeping the cost of capital (borrowed from outside as well as own funds) minimum. This is a golden rule of capital structure theories that lesser the cost of capital higher will be the market value of the business. 1.5.3 Investment decision – Funds procured should be invested in various kinds of assets. Long term loans / funds should be invested in Fixed assets and short term funds should be invested in current assets. The investment in any asset should be made after through examination of all the options, the technique for examining various capital projects is termed as capital budgeting. One thing a finance manager should always keep in mind is that money should never be kept idle as idle money always has a cost. 1.5.4 Dividend decision – The finance manager is concerned with the decision to the decision to declare and pay the dividends periodically, so that the equity investors get return on their investments. He has to help the top management in identifying how much amount can be distributed as dividends, keeping in mind organisations cash needs, expansion plans etc.. There are many other factors on which this decision depends like trend of earnings, the trend of market price of the shares, the tax implications etc. 1.5.5 Supply of funds to all departments and cash management – Though not a primary function, cash management and funds allocation is an important function of a finance manager. It is more than likely in any organisation that one branch or department is having excess cash and other may be having a shortage, this may hamper company’s day to day functioning as adequate funds is a necessity for smooth running of any business. Finance manager should ensure that cash is not kept idle as it may cost the organisation heavily. 1.5.6 Evaluating financial performances – Finance manager is always required to do the job of performance evaluator of the company. He has to supply top management information with financial analysis. Analysis of financial performance helps the management in seeing how the funds have been utilised in various divisions and what can be done to improve it. 1.5.7 Financial negotiations – A major responsibility of finance manager is to negotiate with bankers, financial institutions providing loans, debenture investors etc. Negotiation for finance is considered as a specialised job and involves lots of expertise. 1.5.8 Maintaining the share price of the company – stability in market price of the shares is extremely essential for every organisation as it maintains the company’s goodwill amongst the investors. It is responsibility of Finance manager to see that the prices of shares do not fluctuate extremely.

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1.6 Financial management and organisational structure – The chief financial executive (his designation may vary from company to company) works directly under the president or Managing director of the company. Besides routine work, he keeps the Board of directors informed about all the phases of business activity, including economic, social and political developments affecting the business behaviour. He also furnishes information about the financial status of the company by analysing it from time to time. The chief financial executive may have many officers under him to carry out his functions. Broadly, his functions are divided into two channels – A. Treasury functions B. Control functions The above statement is elaborated in the following chart Board of directors Managing director / President

VP (Marketing) (Prodn.)

V.P. (Finance)

V.P

Treasurer

Credit Management Cash Management Banking

Portfolio management

Controller

Financial Accounting MIS & Cost accounting

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Taxes

Internal audit

Budgeting

1.6.1 Relationship of finance manager with other managers Finance function can never be an independent function and is closely related with other management functions like production, marketing, personnel etc. we’ll take a close look at how these functions are co related, in order to understand position of finance manger in the organisation. Finance is blood of an organisation. It is the common thread which binds all the organisational functions as each function when carried out creates financial implications. The interface between finance and other functions can be described as follows –  Production – Finance – Production Function necessitates a large investment.

Productive uses of resources ensure a cost advantage for the firm. Optimum investment in inventories improves profit margins. Many parameters of the production function having effect on production cost or possible to be controlled through internal management, thus improving profits. One of the important decisions taken by Finance – Production departments together is the make or buy decision. In current scenario this decision has lead to heavy outsourcing to low cost countries.  Marketing – Finance – Many aspects of marketing management have direct

financial impact. How much inventory shall be hold so that prompt delivery can be guaranteed to the customer, has a direct impact on inventory holding cost of the company. Similarly credit period granted to customers by the marketing department directly affects the liquidity position of the company. Marketing campaigns and advertisements have huge cost and should always co-related with the revenue which it generates.  Personnel – Finance – In the globalised competitive scenario business firms are

moving to leaner and flat organisations. Investments in human resource development are also bound to increase. Restructuring of remuneration structure, Voluntary retirement schemes, stock options etc. have become major financial decisions in the areas of human resources management. 1.7 Changing face of financial management in India India has witnessed tremendous change in the concept of financial management ever since a the last decade. Ever since the Indian market opened up, Indian corporate sector has access to global financial markets. Currently there are unlimited opportunities available to the corporate sector in India to invest as well as borrow from foreign markets and to maximise the benefit by considering these increased options. Financial products like options, swaps, American depositary receipts (ADRs), Global depositary receipts (GDRs) etc. were totally unheard a few years ago. Some of the key indicators of changing era and reasons for this changing era are a. Rupee has become fully convertible on current account b. Industrial licensing has been abolished

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c. Allowing foreign institutional investors (FII) to invest in Indian market d. Allowing Foreign direct investment (FDI), though upto certain extent e. Allowing abroad listing of Indian companies e.g ICICI is listed in New york stock exchange. f. Share prices of new share issue are no longer regulated by the government g. ECB- External commercial borrowing is allowed. h. NRIs and OCBs are allowed to invest in unlisted companies. Though the changing financial market is outcome of several factors, the above mentioned factors are landmarks.

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1.8 Self-examination questions Write notes on – 1. The objectives of financial management 2. Distinguish between “Profit maximisation” and “Wealth maximisation” 3. Draw and explain organisational chart of a finance manager and his relationship with other departments 4. Discuss Functions of a Finance manager 5. Discuss how financial management is changing in Indian scenario 6. What are the important aspects of procurement of funds and its utilisation Select the correct options – 1. Which of the following are the functions of a Finance Manager a. b. c. d. e.

Negotiating loans with bankers Internal audit Deciding the advertiser Deciding company’s recruitment policies Cash management

2. The primary objective of a finance manager is a. b. c. d.

Wealth maximisation Profit maximisation Both of the above None of the above

3. Financial management is essential for – a. b. c. d. e.

Private sector enterprises Public sector enterprises Social organisations All of them None of them

4. The value of a company is reflected by – a. b. c. d.

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Profit of the company Number of employees Total assets of the company Market value of the shares of the company

5. What are the key aspects a finance manager must think before procuring the funds a. b. c. d. e.

Risk Cost of the funds Control risk All of the above None

6. To maximise the value of the company; cost of capital should be – a. minimum b. maximum c. company value doesn’t depend upon cost of capital 7. The cost of capital for a high risk project will be – a. b. c. d.

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high low zero cannot say

2 Financial planning and forecasting 2.1 Introduction Estimation of requirement of finance is essential before deciding the amount of funds that needs to be raised. Financial management provides various tools for this estimation commonly known as ‘Budgeting’. A finance manager has to prepare budgets periodically and accurately as inaccurate budgets may lead to either under financing or excess financing, both of which are detrimental to the interests of the organisation. The term accurate does not imply accuracy to last rupee but indicates a fairly accurate estimate. Timely preparation of budgets is necessary as with the help of budgets funds can be raised timely and smooth flow of operations can be ensured. 2.2 What is financial planning and nature of financial planning J.H.Bonnerville defined financial planning as “ the financial planning of a corporation has a two fold aspects, it refers not only to the capital structure of corporation but also to the financial policies which the corporation has adopted or intends to adopt.” According to Solomon and Pringle “narrowly conceived, financial planning may refer to the process of determining the financial requirements and financial structure necessary to support a given set of plans in the other areas” Above two definitions highlight following aspects of Financial management – 1. 2. 3. 4.

It determines the requirement of finance Financial planning is a process and not just a one time activity It invariably includes plans of other areas like production, marketing etc. It covers both capital structure and financial policies

Financial planning should always be bifurcated between long term planning and short term planning. Long term financial planning includes designing of the capital structure of the company, estimating requirements for long term funds, planning amount of investment in long term assets etc. Short term planning mainly includes planning and estimating working capital requirements and cash budgeting. Long term planning may be for up-to 5 to 20 years, whereas generally short term plans are for 1 to 2 years. The budgeting process covers estimates of almost all departments like Marketing, Production, Human resources, administration etc. The starting point of all the budgets is always the sales figure. Almost all the figures can be derived based on estimated sales. It should be noted that the sales figure and most of the other incomes and expenses are not only estimated in terms of money but also in terms of quantity for budgeting purposes.

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Estimation of requirement of investment for expansion of production capacities from sales figure can be determined as follows – Sales (Rs.) Sales (Units) Estimated production required for estimated sales Currently available production capacity Estimated Production capacity required to cover the shortfall Estimated expenditure involved to set-up such production facility* *- Please note that it is not necessary that the organisation will go for expansion based on the estimated requirement. Before expansion it will have to consider various factors and take various decisions like whether the increased demand is seasonal or permanent, whether to make or buy the product, whether demand is sufficiently high to cover the additional expenditure. It is imperative to note that planning is not only useful for predicting the requirement of funds but also it is an important control device for the management. Every department is answerable for spending more than the budgeted figures and earning lesser than the budgets. 2.3 Need and importance of financial planning The need and importance of financial management can never be over emphasised. Following points briefly highlight the need and importance of financial management – a. Ensuring enough liquidity i.e sufficient availability of cash balance b. Determining the timing and extent of borrowings c. To anticipate requirements of funds d. To minimise the cost of funds by looking for opportunities to invest idle funds e. To maintain company’s solvency 2.4 Factors to be considered in a financial plan Following factors needs to be considered before making a financial plan –

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Nature and seasonality of business – Nature of business plays a decisive role in financial planning. The requirement of funds, its timing and type wholly depends upon the business in which the organisation operates. Capital intensive industry requires heavy investment in long term finance like cement industry, aviation industry steel industry etc. whereas labour intensive organisations require comparatively higher funds for short term funding like Information technology. Financial plan must consider these requirements of the industry before forecasting the results. Again seasonality of business is certainly a dominating factor. For example If the finance manager is making finance plan for a air conditioner manufacturing company based the estimates that sales for the year will be Rs 360 lacs and so per month will be Rs 30 lacs and hence the working capital requirement will be Rs xxxxxx . Here it is more than likely that his estimation is wrong as ACs are sold more in summers i.e from March to May and is sold lesser in winters, so the basic estimate of sales per month itself is wrong as failed to appreciate seasonality of his business. This will obviously lead to over financing in winters and under financing in summers. It may be noted here that almost all the businesses have some sort of seasonality that the finance manager should be aware of before preparing the finance plans. Contingencies - A Finance manager should always make room for contingencies while making a finance plan. He should make some provisions for unforeseen risks otherwise he may fail to give a good finance plan. Management perceptions - Before deciding the sources of funds in a finance plan a finance manager must take into consideration management perceptions about risk, cost and control risk involved in raising finance. For example if management is not interested in diluting the control of existing shareholders then it may reject any proposal of raising funds through equity shares. If management is not prone to taking risks then perhaps large bank loans may never be raised by the organisation. Analysis of all the available alternatives – A finance manager must consider all the available alternatives, analyse its advantages and disadvantages, before deciding upon the mix that will be best for the interest of the organisation. Government policies – In preparing a financial plan, finance manager has to invariably take into account various government policies and controls. He must take full advantage of the government subsidies and other benefits made available by the government. Expansion plans – Expansion plans must be considered before deciding upon any finance plan as generally expansion plans require huge investments and may affect significantly all the other estimates. Inflation - A finance plan made by individuals also take into account inflation, so it is almost unnecessary to mention inflation as a major consideration for a fiancé plan. It is not necessary that inflation will only inflate the projected expense figures and will reduce

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the estimated profit figures, on the contrary inflation may increase the sales figures more than the expenses and may result into more profit (estimated). Uniqueness of the organisation – All the companies cannot have a similar finance plan as each unit is unique in itself and will require different finance mix to suit its needs. Again its not possible that all the units have access to all kinds of finances and then the finance plan should only consider whatever options are available to the particular units. 2.5 Essential characteristics of financial plan Though finance plan of every organisation is unique it invariably should have following characteristics in common – 2.5.1 Simplicity – Simplicity is a requirement for every plan let alone financial plan. All the financial plans should be simple and self content , so that it is more understandable even to non finance members of the management. 2.5.2 Flexibility – Rigid financial plans can never be successful all financial plans needs some sort of flexibility. It can be noted that what we have discussed till now about financial plan is that it is an estimation, and its nearly impossible to estimate with 100% accuracy. To cope up with this drawback in the estimates financial plans should be kept open for any unseen material changes that may occur in future. 2.5.3 Completeness – Completeness implies that whether all the estimates are considered in the financial plan or not. It should never happen that some department or some major expenses are completely missed out from the financial plans. Ensuring completeness is perhaps one of the most difficult task which a finance manager faces. 2.5.4 Vision – Vision and foresight is an absolute essential characteristic of any financial plan. Financial plan is not merely mathematical job but it involves thinking and foresight 2.5.5Control - Financial plans or budgets should be able to serve as a control tool by the management. The budgeted figures should be compared with the actual performance so that inefficiencies in the organisation can be controlled.

2.6 Budgeting Budgeting is a process comprising of designing, preparation, implementing and operating financial plans. Budget is an estimation as well as target. One of the most significant aspect of budgeting is that it helps in establishing responsibilities at various

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levels, as budgets are prepared department / branch / cost centre wise and each department head is responsible for following that budget. The ultimate budget encompassing most of the operations of the firm is known as ‘Master Budget’ and may comprise of the following – 1. Capital budgeting 2. Financial budgets – Cash budgets and projected financial statements (profit and balance sheet budgets) 3. Operating budgets – sales budget, production budget purchae budget etc. 2.6.1 Cash Budgets- Cash budgets are prepared periodically to identify cash inflows and outflows, as cash flows determine the requirement of funds and helps identifying investible funds. Cash budgets are nothing but cash flow statements. One must note that cash flow is different from profit or loss, to identify cash flow one must adjust all non cash items to the profit / loss. Other popular way for preparing cash budgets is to prepare estimated receipts and payments account. 2.6.2 Projected financial statements - The projected financial statement means projected Balance sheet and Profit and loss account. The requirement for preparing this budgets is financial statements of earlier periods and operating budgets. 2.7 Solved problems on Budgeting Problem 2.7.1 From the following information prepare balance sheet of A ltd. for the year ending on 31.3.2005 1. Financial position as on 1.4.2004 a. b. c. d. e.

Share capital Reserves Debentures Bank Loan Current liabilities

Rs. 000’s 7,50 10,00 50 2,00 2,00

Total Liabilities

22,00

a. b. c. d. e.

5,00 3,00 11,00 1,00 2,00

Debtors Inventories Fixed assets (net) Cash Investments

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Total Assets

22,00

2. Estimates for 2004-05 a. b. c. d.

Sales (Credit) Cost of production Depreciation Selling and distribution costs

Rs. 000’s 20,00 17,00 1,00 2,00

e. f. g. h. i.

Collection from debtors Increase in current liabilities Closing stock Debentures refunded Dividend paid

22,00 50 6,00 50 1,00

Solution – Projected Balance Sheet as at 31/3/2005 Liabilities Share Capital Reserves Bank Loan Current Liabilities Total

Amount 7,50 12,00 2,00 2,50

Assets Fixed Assets (net) Investments Debtors Inventories Cash Balance

24,00 Total

Rs. 000’s Amount 10,00 2,00 3,00 6,00 3,00 24,00

Working Notes – 1. Debtors = Opening Debtors + Credit sales – Collections = 5,00,000 + 20,00,000 22,00,000 2. Projected Income statement Projected Profit & Loss Account for the year ended 31/3/2005 Rs. 000’s Opening stocks Cost of Production Depreciation

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3,00 Sales 17,00 Closing stock 1,00

Rs. 000’s 20,00 6,00

Selling and distribution costs Net profit

2,00 3,00

Total

26,00

26,00

3. Profit transferred to reserves Net profit for the year ended 31/3/2005 (-) Dividend declared and paid

Rs.3,00,000 1,00,000

Transfer to reserves

2,00,000

4. Fixed assets = Opening balance – Depreciation = 11,00,000 – 1,00,000 = 10,00,000 5. Projected cash balance a. Opening Cash balance b. Collection from debtors c. Increase in current liabilities 50,000

1,00,000 22,00,000

Total receipts 23,50,000 Less : a. Cost of production b. Variable cost

17,00,000 2,00,000

c. Debentures repaid d. Payment of dividend 100,000

50,000

Total Payments

20,50,000

Net Cash balance

3,00,000

Problem 2.7.2 Following is the summerised Balance sheet of the Progressive Corporation Ltd. as on 31st December, 1998 Liabilities Share Capital Reserves Bank overdraft 22

Rs. 8,00,000 11,84,000 5,76,000

Assets Fixed assets Stocks Debtors

Rs. 4,48,000 11,52,000 16,00,000

Creditors

6,40,000 32,00,000

32,00,000

Other Information 1. Trade creditors are equal to last months purchases and debtors are equal to last two months sales (for both the years) 2. For the half year ended on 31.12.1998 sales amounted to Rs 50,42,000 and gross profit earned at an uniform rate was Rs 10,08,000 3. With effect from 1.1.1999 goods purchased will cost 25% higher and sales price will be increased by 20% 4. Sales and purchases are spread evenly throughout the year 5. Value of closing stock on 30.6.1999 is expected to be 10% higher than on 31.12.1998 6. Expenses other than purchases amounts to Rs 64,000 per month 7. No fixed assets are proposed to be sold or acquired during the period You are required to prepare Projected Balance sheet and Profit & loss account for half year ending 30.6.1999. (CS Final Dec) Solution Projected Balance sheet as at June 30, 1999 Liabilities Share capital Reserves (including profit for the year) Trade creditors

Rs Assets 8,00,000 Fixed assets 21,65,000 Stocks 8,00,000 Debtors Cash 37,65,600

Rs 4,48,000 12,67,200 20,16,800 33,600 37,65,600

Working notes – 1. Debtors = 2 months sales = (50,42,000*120%) / 6*2 = 60,50,400/3 =20,16,800 2. Creditors = 125% (last years creditors) = 125% * 640,000 = 8,00,000 3. Cash figure is balancing figure 4. Creditors have been increased by same percentage as that of purchases.

23

Projected Profit & loss Account To opening stock To Purchases To gross profit

Rs 11,52,000 By sales 48,00,000 By Closing stock 13,65,600

Rs 60,50,400 12,67,200

To other expenses

73,17,600 3,84,000 By Gross profit

73,17,600 3,65,600

To net profit

9,81,600 37,65,600

37,65,600

Working notes – 1. Purchases = 6 months creditors (as creditors are one months purchases) = 6 * 8,00,000 = 48,00,000 2. Sales = 120% (last years sales) = 120% (50,42,000) = 60,50,400 3. Other expenses = 64,000 * 6 = 3,84,000 Problem 2.7.3 You are required to make a projected income statement and projected balance sheet for the year 1995-96 on the basis of following information available for 1994-95 Sales Expected growth rate Net profit margin Dividend paid (as % of net profit) Tax rate

Rs 10 Crores 40% 20% 40% 50%

Balance sheet as on 31.3.95 Liabilities Share capital Retained earnings Current liabilities

Rs. lakhs

Assets 175 Fixed assets 150 Current assets 545 870

24

Rs lakhs 400 470 870

You may make necessary assumptions (CWA final Dec 95) Solution : Projected Income statement for 1995-96 Rs. Lakhs 1400 560 280 280 112 168

Sales (40% increase) Profit before tax Less : Tax @ 50% Profit after tax (20% of sales) Less : Dividend (@ 40 % of above) Retained earnings Working notes

1. Sales are 40 % above previous years sales of Rs 1000 lakhs = 140% (Rs. 1000 lakhs) = Rs 14 crores 2. Net profit margin is stated to be 20% of the sales i.e Profit after tax = 20% (Rs1400 lakhs) = Rs 280 lakhs 3. As Net profit is after deducting tax of 50%, profit before tax is double of profit after tax i.e Profit before tax = Rs 280 lakhs * 2 = Rs 560 lakhs 4. It is assumed that the 40% increase in sales is also reflacted in increse in current assets and liabilities Projected Balance sheet as on 31.3.96 Liabilities Share capital Retained earnings Current liabilities Proposed dividend

Rs. Lakhs 175 318 763 112 1368

25

Assets Fixed assets Current assets Cash

Rs lakhs 400 658 310 1368

Working notes 1. Current liabilities and current assets is taken as 40% above previous years figures i.e Current liabilities = 545 * 140% =Rs 763 lakhs, Current assets = 470 * 140% = Rs. 658 lakhs 2. Cash is balancing figure 3. It is assumed that there is no increase in share capital and Fixed assets. Problem 2.7.4 (Cash budgeting) R ltd. has decided to raise Rs 80 lakhs for a proposed new project. The management has decided to raise half of the required funds through equity shares and half through bank loan. The estimated cash flows are as follows – Initial outlay (In April 2004) Land Machinery Stocks Other assets

Rs 30,00,000 Rs 20,00,000 Rs 10,00,000 Rs 6,00,000

Estimated sales and purchases for the period April to September 2004 is as follows April – Sales (S) = Rs 14 lakhs, Purchases (P)= Rs 10.40 lakhs May – S = Rs 15 lakhs, P = Rs 11.20 lakhs June– S = Rs 18.5 lakhs, P = Rs 14 lakhs July – S = Rs 25 lakhs, P = Rs 19.05 lakhs August – S = Rs 26.5 lakhs, P= Rs 20.25 lakhs September – S = Rs 28 lakhs, P = Rs 21.45 lakhs Other information – 1. Debtors are given 2 months credit period and creditors give 1 months credit period. 2. Preliminary expenses Rs 50,000 payable in May 3. General expense paid in each month Rs 50,000 4. Monthly salaries payable next month – Rs 80,000 for three months and Rs 95,000 there after Prepare a cash budget for the six months and calculate estimated cash balance as at each month end

26

Solution : April

Rs lakhs May June July August September 13.50 1.30 2.80 2.50 0.50

Opening cash balance Receipts: Issue of shares Issue of debentures Collection from Debtors

40.00 40.00 -

-

14.00

15.00

-18.50

-25.00

Total receipts (i)

80.00

13.50

15.30

17.80

21.00

25.50

Payments : Purchase of land Purchase of Machinery Purchase of other assets Preliminary expenses Paid to creditors Salaries General expenses

30.00 20.00 6.00 10.00 0.50

0.50 10.40 0.80 0.50

11.20 0.80 0.50

14.00 0.80 0.50

19.05 0.95 0.50

20.25 0.95 0.50

Total payments (ii)

66.50

12.20

12.50

15.30

20.50

21.70

Net cash balance (i-ii)

13.50

1.30

2.80

2.50

0.50

3.80

Problem 2.7.5 B Ltd. has following balance sheet for the year ended on 30th June 2000 Liabilities Share capital Profit & loss Trade creditors Other creditors

Rs. 1,00,000 44,600 25,000 9,000

Assets Fixed assets Stocks Bank Debtors

Rs. 1,26,000 25,000 3,000 24,600

1,78,600 1,78,600 The budget committee has given following forecast for the six months ended 31st December 2000: Month

Sales in units

May June July August Septembe 27

4000 4200 4500 4600 4800

Purchases 12,000 13,000 14,000 18,000 16,000

Salaries 8,000 8,000 8,000 10,000 10,000

Overhead s 7,000 7,000 7,000 7,000 7,000

Purchase of Fixed assets

Issue of shares

20,000

r October November December

5000 3800 3000

14,000 12,000 12,000

10,000 12,000 12,000

8,000 8,000 8,000

30,000

You are given the following information 1. The selling price in May 2000 was Rs. 6 per unit and this is to be increased to Rs 8 per unit in October 50% of sales are for cash and 50% on credit to be paid 2 months later 2. Purchases are to be paid 2 months after purchases 3. Wages are to be paid 75% in the month incurred and 25% in the following month 4. Overheads are to be paid for in the month after they are incurred 5. Fixed assets are to be paid in three equal monthly instalments starting from the month of purchase 6. Other income received in the month of August Rs 2,600 and December Rs 2,500 Prepare a cash budget from the following information Solution: Monthly Cash budget for the period ended Dec. 31,2000 July Opening Balance Receipts: Cash sales Collection from debtors Issue of capital Other income

August

Septembe October November December r 1,000 17,900 16,700 10,800

3,000

1500

13,500 12,000

13,800 12,600

14,400 13,500

20,000 13,800

15,200 14,400

12,000 20,000

-

2,600

20,000 -

-

-

2,500

28,500

30,500

48,900

51,700

46,300

45,300

Creditors Salaries – Current month - Previous month Overheads Fixed assets

12,000

13,000

14,000

18,000

16,000

14,000

6,000 2,000 7,000 -

7,500 2,000 7,000 -

7,500 2,500 7,000 -

7,500 2,500 7,000 -

9,000 2,500 8,000 -

9,000 3,000 8,000 10,000

Total

27,000

29,500

31,000

35,000

35,500

44,000

1,500

1,000

17,900

16,700

10,800

1,300

Total Payments :

Closing balance

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2.8 Self examination Questions 1. What do you understand by financial planning ? explain the characteristics of a sound financial plan ? 2. You are requested to do financial planning for a newly manufacturing company to be set up. What important considerations you take into account in doing so? 3. What is budgeting ? discuss various types of budgeting and its importance ? 4. MA Limited is commencing a new project for manufacture of a plastic component The following cost information has been ascertained for annual production of 12,000 units which is full capacity. Cost Per unit (Rs.) Materials 40 Direct labour and variable expenses 20 Fixed manufacturing expenses 6 Depreciation 10 Admin expenses (fixed) 4 Total 80 The selling price per unit is expected to be Rs 96 and selling expenses Rs 5 per unit 80% of which is variable In first two years production and sales are expected to be – Year 1 – sales = 5000 units, Production = 6000 units Year 2 – Sales = 8500 units, Production = 9000 units You are required to prepare projected profit & loss account for both the years 5. X ltd. has decided to raise Rs 160 lakhs for a proposed new project. The management has decided to raise 2/3rd of the required funds through equity shares and remaining through Debentures. The estimated cash flows are as follows – Initial outlay (In April 2004) Building Machinery Stocks Cars

Rs 60,00,000 Rs 40,00,000 Rs 20,00,000 Rs 12,00,000

Estimated sales and purchases for the period April to September 2004 is as follows

29

April – Sales (S) = Rs 42 lakhs, Purchases (P)= Rs 32 lakhs May – S = Rs 45 lakhs, P = Rs 36 lakhs June– S = Rs 50 lakhs, P = Rs 42lakhs July – S = Rs 52 lakhs, P = Rs 45 lakhs August – S = Rs 52 lakhs, P= Rs 47 lakhs September – S = Rs 54 lakhs, P = Rs 47 lakhs Other information – 1. 50% sales are on credit and Debtors are given 2 months credit period and creditors give 1 months credit period. 2. Preliminary expenses Rs 150,000 payable in May 5. General expense paid in each month Rs 85,000 6. Monthly wages payable next month – Rs 1,80,000 for three months and Rs 125,000 there after Prepare a cash budget for the six months and calculate estimated cash balance as at each month end 6. D Ltd. has following balance sheet for the year ended on 30th June 2000 Liabilities Share capital Profit & loss Trade creditors Other creditors

Rs. 1,20,000 24,600 5,000 29,000

Assets Fixed assets Stocks Bank Debtors

Rs. 26,000 1,25,000 13,000 14,600

1,78,600

1,78,600

The budget committee has given following forecast for the six months ended 31st December 2000: Month

Sales in units

May June July August Septembe r October November December 30

Purchases

Salaries

Overhead s

14,000 14,200 14,500 14,600 14,800

82,000 83,000 84,000 88,000 86,000

18,000 18,000 18,000 20,000 20,000

7,000 7,000 7,000 7,000 7,000

15,000 13,800 13,000

84,000 82,000 82,000

20,000 22,000 22,000

8,000 8,000 8,000

Purchase of Fixed assets

Issue of shares

30,000 58,000

You are given the following information 7. The selling price in May 2000 was Rs. 16 per unit and this is to be increased to Rs 18 per unit in October 50% of sales are for cash and 50% on credit to be paid 2 months later 8. Purchases are to be paid 2 months after purchases 9. Wages are to be paid 75% in the month incurred and 25% in the following month 10. Overheads are to be paid for in the month after they are incurred 11. Fixed assets are to be paid in three equal monthly instalments starting from the month of purchase 12. Other income received in the month of August Rs 2,600 and December Rs 2,500 Prepare a cash budget from the following information 2.8.1 Objective questions 1. -------------------- involves planning for cash inflows and out flows 2. The most important function of financial planning is anticipating ----------------. 3. Financial plan should have following characteristics a. b. c. d. e.

Simplicity Flexibility Foresight Completeness All of the above

4. Choose the considerations which a Finance manager has to follow while making a financial plan a. b. c. d. e. f.

Nature of business Inflation Seasonality of business Attitude of management All of the above None of the above

5. The uses of preparing a budget are – a. b. c. d. e.

31

Estimating the requirements of funds Control Deciding capital structure Preparation of Balance sheets Ascertaining the true profits of the enterprise

f. All of the above g. Options a, b and c h. Options b,c,d and e 6. Do you agree with the following statements – a. b. c. d.

32

It determines the requirement of finance Financial planning is a process and not just a one time activity It invariably includes plans of other areas like production, marketing etc. It covers both capital structure and financial policies

3 Operating and financial leverage, cost volume profit analysis 3.1 Introduction After ascertaining the financial requirements through a financial plan a manager has to ascertain the source of finance from where he should raise the funds. This decision depends upon how each type of funds affects the risk and returns of shareholders. Leverage analysis is one of the technique used to ascertain and quantify the firms risk return relationship of different alternative capital structures. 3.2 Types of leverages Leverage represents the ratio of one financial variable to some other related financial variable. In short it quantifies the expected change in one financial variable with respect to other related financial variable. There are three common types of leverages used in financial management – 1. Operating leverage 2. Financial leverage 3. Combined leverage Operating leverage [OL] – This ratio quantify the change in Earnings before interest and tax (EBIT) on account of change in contribution. All the costs can be bifurcated between two parts i. Variable costs ii. Fixed costs Variable costs is the cost which varies with the production whereas fixed cost remains constant. An example can be taken to elaborate this statement – consumption of raw materials varies with the production i.e if a component x requires y units of raw material then for production 2x quantity required will be 2y. Whereas some expenses like rent remains the same even if there is no production or production is 100%. It can be appreciated here that as the production goes up variable cost will also go up, but fixed cost is bound to remain same, increasing the profits of the company. Illustration – Company A manufactures plastic components, its cost structure is a s follows – Selling price per unit Rs 5, Cost of materials per unit Rs 3, Rent paid by the company Rs 1000 p.m

33

Company A sold 1000 units in month of march and 2000 units in month of April calculate its contribution and EBIT for both the months Solution – Sales (No of units * selling price) Less : Variable costs – Materials Contribution Less : Fixed costs – rent EBIT

March 5,000

Rs. April 10,000

3,000 2,000

6,000 4,000

1,000 1,000

1,000 3,000

It is clearly evident from above solution that though contribution as percentage of sales remains same i.e. 40%, EBIT as percentage of sales has gone up from 20% to 30%. This is because what we can call spreading of fixed expenses over a lager amount of sales. Operating leverage =

contribution EBIT

=

% Change in EBIT % Change in sales

In current problem = 100% / 200% i.e. 2 So we can state from this that for every 1% change in contribution there will be 2% change in EBIT. Extending this statement, as sales and contribution varies proportionately. We can say that for every 1% increase / decrease in sales there will be 2% increase / decrease in EBIT. It is important to note here that it is risky to have a high operating leverage since a slight fall in sales will result in a disproportionately higher fall in profit. 3.2.2 Financial Leverage [FL] – Capital structure of a company plays a vital role in determining the return to the equity shareholders. Financial leverage is an indicator of impact of capital structure on the returns to the shareholders. Kohler defines financial Leverage as “the tendency of residual net income to vary disproportionately with net income”. The concept of financial leverage is very similar to that of Operating leverage in respect to fixed charge. In operating leverage we saw that fixed expenses result in disproportionate rise or fall in EBIT as compared to sales, in FL the same criterion applies about fixed interest which results into disproportionate rise or fall in Earnings Before Tax (EBT). Illustration –

34

Continuing with the illustration given above (Company A ltd ) let us assume that the company pays fixed interest of Rs 500 p.m, then the profit will be as follows

Sales (No of units * selling price) Less : Variable costs – Materials Contribution Less : Fixed costs – rent EBIT Less : Interest Earnings before tax; after interest

Rs. March April 5,000 10,000 3,000 2,000

6,000 4,000

1,000 1,000

1,000 3,000

600 400

600 2,400

It is clearly evident from above solution that EBIT as percentage sales has gone up from 20% to 30%, whereas EBT as percentage of sales has gone up from 8% to 24%. Operating leverage =

EBIT EBT

=

% Change in EBT % Change in EBIT

In current problem = % change in EBT is 500% (I.e Rs 400 to Rs 2400 ) and % change in EBT is 200% (i.e Rs 1000 to Rs 3000) = 500% / 200% = 2.5 Excessive financial leverage is always considered as very risky for any company. As when company is in profits it gives very good results but in case of losses it can be hazardous and may put company’s existence at stake. 3.2.3 Combined Leverage [CL] – As the name suggests combined leverage is simply combined effect of both operating leverage and financial leverage. It can simply be calculated as Combined leverage = Operating leverage * financial leverage = contribution EBT The ratio of contribution to earnings before tax shows the combined effect of financial and operating leverage. A high operating and high financial leverage is considered to be very risky. If these leverages are very high then at a high level of production and selling company will earn high profits but a slight fall in sales will result in tremendous losses. A company must therefore maintain a proper balance

35

between these two leverages. Let us consider various leverage situations and its implications –

Operating Financial Implications leverage Leverag e Low Low It indicates that management is too conservative and is not willing to take risk. Though the company is in a low risk situation, it is losing on opportunities to earn higher income. High

Low

It can be considered as an ideal mix. Management is willing to take some risk on operations to earn higher profits, but is not taking undue risk on financial leverage.

Low

High

This situation can be more profitable than the above situation. As operating leverage is low, the company reaches its breakeven earlier

High

High

It is very risky situation and though it will give exceptional returns when company is in profits, in case falling sales losses will be tremendous.

3.3 Solved problems Problem 3.3.1

Sales Less : Variable costs Contribution Less : Fixed costs EBIT Less : Interest Profit before tax (PBT)

36

A Ltd. 500

B Ltd. 1,000

200 300

300 700

150 150

400 300

50 100

100 200

Please Calculate Operating, Financial and combined leverages and comment on the same Solution – Operating leverage (OL) = Financial Leverage (FL) =

Contribution / EBIT For A Ltd = Rs 300 lakhs / Rs 150 lakhs = 2 For B Ltd = Rs 700 lakhs / Rs 300 lakhs = 2.33 EBIT / PBT For A Ltd. = Rs 150 lakhs / Rs 100 lakhs = 1.5 For B Ltd. = Rs 300 lakhs / Rs 200 lakhs = 1.5

Combined Leverage (CL) = Contribution / PBT = OL * FL For A Ltd. = Rs 300 lakhs / Rs 100 lakhs = 3 For B Ltd. = Rs 700 lakhs / Rs 200 lakhs = 3.5 Comments – e. Operating leverage – it is higher for B ltd. than for A ltd. That means management B ltd is taking more business risk. ii. Financial leverage – Financial leverage for both the companies have the same degree of financial risk. It means that both the managements have similar perceptions about financial risks iii. Combined leverage – B ltd has combined leverage more than A ltd. i.e B ltd is riskier but profitable than A ltd. Problem 3.3.2 Calculate degree of operating, Financial and combined leverage for the following firms – Output (Units) Fixed costs (Rs) Variable cost per unit (Rs) Interest on borrowed funds (Rs) Selling price per unit (Rs)

Firm A Firm B 6,000 1,500 700 1,400 0.20 1.50 400 800 0.60 5.00

Solution – Sales (units * selling price) 37

Firm A Firm B 3,600 7,500

Less : Variable costs Contribution Less: Fixed costs EBIT Less : Interest Profit before tax

1,200 2,400

2,250 5,250

700 1,700

1,400 3,850

400 1,300

800 3,050

Operating leverage = Contribution / EBIT

1.41

1.36

Financial leverage = EBIT / PBT

1.31

1.26

Combined leverage = Contribution / PBT

1.85

1.72

Problem 3.3.2 A simplified income statement of Zenith Ltd. is given below. Calculate and interpret its degree of operating leverage, Financial leverage and combined leverage. Income statement for the year ending 31st March 1998 Rs Sales 10,50,000 Variable costs 7,67,000 Fixed costs

75,000

EBIT Interest Taxes Net income (CWA final, June 1998)

2,08,000 1,10,000 29,400 68,600

Solution – i. Contribution = Sales – Variable cost = Rs. 10,50,000 – 7,67,000 = Rs. 2,83,000 ii. Earnings before interest and taxes (EBIT) = contribution – fixed costs = 2,83,000 – 75,000 = Rs.2,08,000 iii. Earnings before tax (EBT) = EBIT – Interest = Rs 2,08,000 – 1,10,000 = Rs 98,000

38

iv. Operating leverage = Contribution / EBIT = 2,83,000 / 2,08,000 = 1.36 The above ratio indicates that for every 1% change in sales it is expected that EBIT will change by 1.36% V. Financial leverage = EBIT / EBT = 2,08,000 / 98,000 = 2.12 The above ratio indicates that for every 1% change in EBIT it is expected that EBT will change by 2.12% vi. Combined leverage = Operating leverage * financial leverage = 1.36 * 2.12 = 2.88 The above ratio indicates that for every 1% change in sales it is expected that EBT will change by 2.88% Problem 3.3.3 A firm has sales of Rs 2,00,000, variable cost of Rs 1,40,000, fixed cost of Rs 30,000 and interest of Rs 10,000. Calculate the leverages and ascertain the amount of sales required to double its Earnings before interest tax (EBIT). Solution – Sales Less : Variable cost Contribution Less : Fixed costs EBIT Less: Interest Profit before tax

Rs. 2,00,000 1,40,000 60,000 30,000 30,000 10,000 20,000

Operating Leverage = Contribution / EBIT = 6,00,000 / 3,00,000 = 2 Financial leverage = EBIT / EBT = 3,00,000 / 2,00,000 = 1.5 Combined leverage = Operating leverage * Financial leverage = 2 * 1.5 = 3 Operating leverage indicates that for every 1% change in sales there will be 2% change in EBIT.

39

Hence, for EBIT to get doubled i.e increase of 100%, sales should increase by (100/2)% = 50% . This can be elaborated as follows – Rs. 3,00,000

Sales (increased by 50%) Less : Variable cost Contribution Less : Fixed costs EBIT 3.3.4 Problem

2,10,000 90,000 30,000 60,000

From the following prepare income statement of A,B and C

Financial Leverage Interest Operating leverage Variable cost as a % sales Income tax

Firm A 3 Rs 200 4 66.67% 45%

Firm B 4 300 5 75% 45%

Firm C 2 1,000 3 50% 45%

(CA final, Nov 97) Solution – Firm A Financial leverage = EBIT / EBT = 3 i.e EBIT = 3 EBT Again EBIT – interest = EBT Therefore 3 EBT – Interest = EBT Considering both the equations 3EBT – 200 = EBT ; 2EBT = 200 i.e. EBT = 100 and EBIT = 3*100 = 300 Now operating leverage = 4 = Contribution / EBIT = contribution / 300 Therefore Contribution = 4*300 = 1,200 As variable cost is 66.67% of sales that means contribution is 33.33% of sales or sales is 3 times the contribution i.e. sales = 3*1200 = 3,600 Firm B Financial leverage = EBIT / EBT = 3 i.e EBIT = 3 EBT 40

Again EBIT – interest = EBT Therefore 4 EBT – Interest = EBT Considering both the equations 4EBT – 300 = EBT ; 3EBT = 300 i.e. EBT = 100 and EBIT = 4*100 = 400 Now operating leverage = 5 = Contribution / EBIT = contribution / 400 Therefore Contribution = 5*400 = 2,000 As variable cost is 75% of sales that means contribution is 25% of sales or sales is 4 times the contribution i.e. sales = 4*2,000 = 8,000 Firm C Financial leverage = EBIT / EBT = 2 i.e EBIT = 2 EBT Again EBIT – interest = EBT Therefore 2 EBT – Interest = EBT Considering both the equations 2EBT – 1,000 = EBT ; EBT = 1,000 i.e. EBT = 1,000 and EBIT = 2*1,000 = 2,000 Now operating leverage = 3 = Contribution / EBIT = contribution / 2,000 Therefore Contribution = 3*2,000 = 6,000 As variable cost is 50% of sales that means contribution is 50% of sales or sales is 2 times the contribution i.e. sales = 2*6,000 = 12,000 Income statement of Firms A,B and C can be drawn as follows – Firm A 3,600 2,400 1,200

Firm B 8,000 6,000 2,000

Firm C 12,000 6,000 6,000

Less : Fixed cost

900

1,600

4,000

EBIT

300

400

2,000

Less : interest EBT

200 100

300 100

1,000 1,000

45

45

450

Sales Less : Variable cost Contribution

Less : Taxes @ 45% 41

Profit after tax

55

55

550

3.4 Cost - Volume - profit analysis The analytical tools and techniques available to finance managers for studying the behaviour of profit in relation to changes in volume, cost and prices is known as the “Cost-Volume-Profit (CVP) analysis”. It is a tool used to determine the minimum quantity of sales for avoiding the losses and the quantity of sales at which the desired profit can be achieved. CVP analysis can be used to predict and evaluate the implications of its short run decisions about fixed costs, variable costs, sales volume and selling price for its profit plans on a continuous basis. Thus CVP technique seeks to establish – a. b. c. d. e.

The minimum amount of sales to avoid losses The level of sales to earn the targeted profit The effect of change in prices, costs and volumes on profits The effect on profits of various sales mix. The breakeven in terms of value and units under different conditions

3.4.1 Break-even point – The technique of calculation of breakeven point is used to calculate the quantity or amount of sales required to at least recover all the costs i.e a no profit no loss situation. Each unit sold covers up the whole variable cost and a part of fixed cost. The amount left over above the variable cost is termed as contribution per unit. Break-even point is the quantity of sales where the total contribution equals the total fixed cost. Break-even point (in units) = Total fixed cost / contribution per unit Contribution per unit = Sales price per unit – variable cost per unit Illustration 1 – Company x manufactures watches and has a capacity of 1,000 watches per year. Selling price per watch is Rs 2,500 and its variable cost per watch is Rs 1,500. The company has fixed costs to the extent of Rs 2,00,000. Calculate the company’s break-even point Solution – Selling price per unit Less : Variable cost

Rs. 2,500 1,500

Contribution per unit

1,000

Total fixed cost

2,00,000

42

Break even point = fixed cost / contribution per unit = 2,00,000 / 1,000 = 200 watches Thus the company must sell at least 200 watches per year to avoid losses. These can be elaborated as follows – Sales (200 watches sold) Rs 5,00,000 Variable cost 3,00,000 Contribution Fixed cost

2,00,000 2,00,000

Net profit / loss Nil Illustration 2 – Consider the above problem and calculate the quantity of watches company x must sell to achieve desired profitability of Rs 4,00,000 Solution – Quantity to be sold

= (Fixed costs + desired profit) / contribution per unit = (2,00,000 + 4,00,000) / 1,000 = 600 units

Thus the company must sell at least 600 watches per year to earn desired profits. These can be elaborated as follows – Sales (600 watches sold) Variable cost

Rs 15,00,000 9,00,000

Contribution Fixed cost

6,00,000 2,00,000

Net profit

4,00,000

3.4.2 Limitations of break-even analysis – Though a very effective pricing and control tool break-even analysis has its own limitations. The basic assumption about the selling price and cost is practically difficult to achieve. It is highly impossible that contribution varies with the sales price, as with increased volumes sales price generally goes down, which may or may not result into proportionate decrease in costs. Cost is influenced by several factors including the production process, plant and machinery needed, raw material used, wages paid etc. which are sure to vary with higher scale of production and may lead to wrong break-even analysis. 3.5 Solved problems

43

Problem Company A ltd manufactures cars and has a capacity of 5,000 cars per year. Selling price per car is Rs 2,00,000 and its variable cost per car is Rs 150,000. The company has fixed costs to the extent of Rs 500,00,000. Calculate the company’s break-even point and also calculate the quantity of cars that must be sold to achieve profitability of Rs 14,00,00,000

Solution Selling price per unit Less : Variable cost

Rs. 2,00,000 1,50,000

Contribution per car

50,000

Total fixed cost

500,00,000

Break even point = fixed cost / contribution per car = 5,00,00,000 / 50,000 = 1,000 cars Thus the company must sell at least 1000 cars per year to avoid losses. These can be elaborated as follows – Sales (1,000 cars sold) Variable cost Contribution Fixed cost

Rs 20,00,00,000 15,00,00,000 5,00,00,000 5,00,00,000

Net profit / loss

Nil

To earn a profit of Rs 14,00,00,000 Quantity to be sold = (Fixed costs + desired profit) / contribution per unit = (5,00,00,000 + 14,00,00,000) / 50,000 = 3,800 cars Thus the company must sell at least 3,800 cars per year to earn desired profits. These can be elaborated as follows – Sales (3,800 cars sold)

44

Rs 76,00,00,000

Variable cost

57,00,00,000

Contribution Fixed cost

19,00,00,000 5,00,00,000

Net profit

14,00,00,000

3.6 Self examination questions 1. Define the concept leverages, explain types of leverages and how to measure it 2. Explain the term break even point with examples 3. What are the limitations of break-even analysis 4. From the following prepare income statement of A,B and C

Financial Leverage Interest Operating leverage Contribution as a % sales Income tax

Firm A 2 Rs 2,50,000 2.2 25% 50%

Firm B 4 36,500 1.5 35% 50%

Firm C 3 1,20,000 3 22.5% 50%

5. Calculate the operating leverage from the following data Sales – Rs 50,000 Variable cost per unit = Rs 5 Fixed cost = Rs 2,000 Number of units sold = 5,000 6. Company B ltd manufactures steel and has a capacity of 25,000 tonnes per year. Selling price per ton is Rs 14,000 and its Cost of iron and labour (variable) is Rs 8,000. The company has fixed costs to the extent of Rs 8,00,00,000. Calculate the company’s break-even point and also calculate the quantity of cars that must be sold to achieve profitability of Rs 5,00,00,000 7. Operating leverage = a.

EBT / Profit after tax 45

b. c. d.

EBIT / EBT Contribution / EBIT None of the above 8. Financial Leverage = a. b. c. d.

EBT / Profit after tax EBIT / EBT Contribution / EBIT None of the above

9. If operating leverage of a firm is 6, then a. b. c. d.

With every 1% increase in sales its contribution will increase by 1% With every 6% increase in sales its contribution will increase by 1% With every 1% increase in sales its contribution will increase by 6% With every 6% increase in sales its contribution will increase by 16%

10. If combined leverage of a firm is 6, then e. f. g. h.

46

With every 1% increase in sales its EBT will increase by 1% With every 6% increase in sales its EBT will increase by 1% With every 1% increase in sales its contribution will increase by 6% With every 1% increase in sales its EBT will increase by 6%

4 Management of Working Capital 4.1 Introduction One of the most important day to day function of finance manager is to manage the working capital. In first chapter we studied that there are two major functions of a finance manager, one of them being procurement of funds. The function of procurement of funds can be bifurcated between – Procurement of long term funds to purchase fixed assets etc. and procurement of funds for short term purposes like funding for working capital. In this chapter we are going to study the methods of estimating, raising and controlling the working capital. 4.2 Meaning of the term working capital Working capital refers to the funds that are invested in current assets net of current liabilities. Current assets include Cash, inventory (stock), debtors, advances and other current assets. Current assets are required to use fixed assets profitably, for example If company is not maintaining stock of raw materials, which is a current asset, then there can be breakdown in production and result into losses. Similarly granting credit period to customers (resulting into debtors) is absolutely essential to generate higher sales. It is obvious that certain amount of funds will always be invested in the debtors, raw materials, work in progress, finished goods and day to day cash requirements. On the other hand the business will also receive some credit period from its suppliers resulting into reduction in the funds requirement. However, generally the requirement of funds in current assets is more than availability of funds from current liabilities. The term working capital is defined in two different ways – a. Gross working capital – The gross working capital refers to investment in all

current assets taken together b. Net Working capital – The term net working capital refers to excess of current assets over current liabilities. From the view point of time working capital can be defined as –

47

a. Permanent working capital – It also refers to hard core working capital. It is the

minimum level of investment in working capital required at all times by the business to carry out minimum level of activities. b.

Temporary working capital – It is the requirement of investment in working capital over and above permanent working capital. This investment varies from time to time and changes as per seasonal requirements. As the volume of temporary working capital varies from time to time it can funded by very short term sources of finance.

Permanent and temporary working capital can be elaborated with the help of diagrams as follows – A m o u n t of WC

Permanent

Time Or

A m o u n t of WC

Permanent

Time WC – working capital in Rs. 4.3 Importance of adequate working capital

48

Every Business need funds for its day to day operations. Adequacy of funds will ensure smooth running of such day to day operations. A Finance manager has to ensure the smooth running of such operations by arranging adequate funds to the business and simultaneously ensuring that the funds arranged are not excessive and is not resulting to excessive cost. A very big amount of working capital would mean that the company has idle funds. Since funds have a cost, the company has to pay large amount as interest on such funds. Having excess funds, known as over capitalisation, has been a big reason for sick companies in India

If the firm has inadequate working capital it is termed as under capitalised. Such firms always have risk of insolvency. This is because shortage of funds may lead to a situation where the firm may not be able to meet its liabilities. It is interesting to note that many firms which are otherwise prosperous may fail because of lack of liquidity. 4.4 How to determine optimum working capital Current ratio (with acid test ratio to support it) has traditionally been considered best indicator of the working capital situation; current ratio = Current assets / current liabilities. Academically it is believed that a current ratio of 2 for a manufacturing firm is ideal ratio i.e current assets = 2 * current liabilities (approx) is considered as ideal. Another indicator for ideal working capital mix is quick ratio = quick current assets / current liabilities. Academically it is believed that a quick ratio of 1 for a manufacturing firm is ideal ratio. The reason to mention it as academic is that practically ideal ratios vary from industry to industry and should be decided by finance manager for his own company considering the production process, normal credit terms, location of the company and customers etc.. An example can be taken of Hero Honda Motors Ltd, a two wheeler manufacturing company. The company has current ration less than 1 as company is already utilising its full capacities and due to excessive demand for its products does not offer any credit period, eliminating debtors and huge turnover of its products also result into very less finished goods inventory. Here it won’t be correct to say that company is not investing in current assets and hence is losing on profitability, as the company is able to sell to its full capacity without pilling up stocks and debtors so for Hero Honda current ratio less than 1 can be considered as ideal. On the other hand a company who deals in a high credit period industry may have a current ratio of above 3. Here also we can’t say that the company is over capitalised and is investing excessively in its current assets, as the company is just following trend of the industry in which it is operating. Hence ideal ratio should be determined on basis of facts of each company and should be compared with the average of the industry in which it operates. 4.5 Working capital cycle The working capital cycle refers to the length of time between the firms paying cash for materials, etc., entering into production process and inflow of cash from debtors.

49

For example – Company A buys material worth Rs 5,000 on 1 st January 2004, keeps it in stock upto 15th January 2004 and then start processing, the material is in process till 31st January 2004. After completing the production it takes one month to sell the product i.e Finished goods stock is maintained for 1 month and is sold on 2nd March 2004, it offers its customer 1 months credit and so recovers the cash only on 31st March 2004. Now it is clearly evident here that the investment of Rs 5,000 in materials gets recovered only after three months and in between it takes various forms of current assets viz. Cash, Raw materials, work in progress, finished goods, debtors and again cash. Important point here is that we have only considered material cost and ignored labour and overheads cost other wise the invested amount will go up. Now consider a situation where Company A is getting credit period of 1 month, it can be noticed that though material is purchased on 1st January 2004, amount of Rs 5,000 is invested only from 31st of January and now the period of investment is reduced to 2 months. The above example can be elaborated diagrammatically as – Cash

Debtors

Raw Materials, Labour & overheads

Work in progress

Finished goods The working capital cycle consists of the following events for a manufacturing company which keeps on repeating – a. b. c. d.

Conversion of cash into raw materials Conversion of Raw materials into work-in-progress Conversion of work in progress into finished goods Conversion of Finished goods into debtors

50

e. Conversion of debtors into cash again. Working capital is always measured in terms of days, as follows Working capital cycle / operating cycle [in number of days] = R + W + F + D – C R - Raw materials storage period in number of days W - Number of days of work in progress F - Number of days of finished goods in stock D – Debtors collection period C – Credit period availed In the current example – R = 15 days (1st January – 15th January) W = 15 days (16th January – 31st January) F = 30 days (1st February – 2nd March) D = 30 days (2nd March to 31st March) C = 30 days (1st January – 31st January) Working capital cycle or operating cycle (in days) = 15+15+30+30 –30 = 60 days The various components of operating cycle can be calculated as follows 1. Raw material storage period [R] =

Average stock of raw materials Average cost of consumption per day

2. Work in progress holding period [W]=

Average work-in-progress inventory Average cost of production per day

3. Finished goods storage period [F]=

Average Finished goods inventory Average cost of goods sold per day

4. Debtors collection period [D]

=

Average book debts Average credit sales per day

5. Credit period availed [C]

=

Average creditors Average credit purchases per day

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The above formulas are applied to forecast the working capital cycle and can be compared with other companies in the same industry. The deviation with industry average shows the efficiencies or inefficiencies of the organisation. For example let us assume that the average debtors collection period for competitors of company A is 15 days and company is offering a credit period of 30 days, then it can be said that the company A higher risk and is locking excessive funds in current assets. 4.6 Solved problems on calculation of working capital cycle Problem 4.6.1 From the following information calculate the period of operating cycle of A Ltd. : Rs. Raw material consumed during the year Average stock of raw materials

7,20,000 50,000

Cost of production Average work in progress inventory Cost of goods sold Average finished goods inventory

6,00,000 30,000 7,20,000 40,000

Average collection period from debtors Average credit period availed Assume 360 days in a year

35 days 25 days

Solution – 1. Raw material storage period [R] =

Average stock of raw materials Average cost of consumption per day

2. WIP holding period [W]

= = = =

50,000 / (7,20,000 / 360) 50000 / 2000 25 days. Average work-in-progress inventory Average cost of production per day

= = =

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30,000 / (6,00,000 / 360) 30,000 / 1667 18 days (approx)

3. Finished goods storage period [F]=

Average Finished goods inventory Average cost of goods sold per day

= = =

4. 5.

Debtors collection period [D] Credit period availed [C] Operating / working capital cycle

40,000 / (7,20,000/360) 40,000/2,000 20 days

= 35 days = 25 days = R + W +F+ D –C = 25 + 18 + 20 +35 –25 = 73 days

Number of operating cycles in a year = 360 / 73 = 4.93 Problem 4.6.2 A ltd. has obtained the following data concerning the average working capital cycle for other companies in the same industry: Raw material stock turnover Credit received Work in progress turnover Finished goods Debtor’s collection period

25 days -35 days 10 days 32 days 55 days 87 days

Using the following data, calculate the current working capital cycle for A ltd. and briefly comment on it. Sales Cost of production (also cost of goods sold) Average Raw material inventory Average work in progress Average finished goods stock Average debtors Other information 53

(Rs. In ‘000) 500 210 8 9 18 35

Out of cost of production Rs 60,000 is consumption of raw materials.60% of the sales is on credit, credit period availed is 55 days. Assume 360 days of a year. Solution – 1. R

=

8 / (60 /360)

=

Days (approx.) 48 days

2. W 3. F

= =

9 / (210 /360) 18 / (210 /360)

= =

15 days 31 days

4. D

=

35 / (300 /360)

=

43 days

5. C

=

55 days

Operating cycle = R + W + F + D – C Operating cycle = 48 + 15 + 31 + 43 – 55 =

82 days.

Comments –

R

Company Industry A average 48 25

W

15

10

F D

31 43

32 55

C

-55

-35

Problem 4.6.3

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Comments The raw material storage period is considerably higher than industry average, so the company must try and reduce its raw material stocks Higher number of days in work in progress indicates inefficiencies in production. Almost at par with the industry Debtors are offered lesser credit period than average, the company can perhaps increase the credit period in order to achieve higher sales Credit period availed is higher than average indicating availability of more funds. Though it may result in higher cost of raw materials or loss of goodwill amongst the creditors.

From the following data, compute the duration of the operating cycle for each of the two years – Stock : Raw Materials Work in progress Finished goods Purchases Cost of goods sold Sales Debtors Creditors

Year 1

Year 2

20,000 14,000 21,000 96,000 1,40,000 1,60,000 32,000 16,000

27,000 18,000 24,000 1,35,000 1,80,000 2,00,000 50,000 18,000

Year 1 Days

Year 2 Days

Assume 360 days per year for computation purpose Solution –

Raw material stock holding period [R]: Year 1 – 20,000 / (96,000 /360) Year 2 – 27,000 / (1,35,000 /360) Work in progress [W]: Year 1 – 14,000 / (1,40,000 /360) Year 2 – 18,000 / (1,80,000 /360) (As cost of production is not given calculation is done on the basis of cost of goods sold)

75 72 36 36

Finished goods [F]: Year 1 – 21,000 / (1,40,000 /360) Year 2 – 24,000 / (1,80,000 /360)

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Debtors [D]: Year 1 – 32,000 / (1,60,000 /360) Year 2 – 50,000 / (2,00,000 /360)

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Creditors [C]: Year 1 – 16,000 / (96,000 /360) Year 2 – 18,000 / (1,35,000 /360)

60

Operating cycle = R + W + F + D - C

55

48

90

48 177

198

4.7 Estimation of working capital requirements In practice working capital cycle is mainly used for comparison with previous periods and competitors, so that inefficiencies in operations can be pointed out and rectified. Hence the main purpose of working capital cycle is control. But more essential thing is perhaps funding for the working capital requirements, which can be done only when working capital requirements is estimated in terms of money and not days. Banks providing working capital and short term loans always demand such estimations and give loan on the basis of such estimations. Such estimations can be done on the basis of operating cycle. The formulas for estimation of current assets is given below Formulas for Estimation of various current assets i. Funds invested in Raw materials inventory can be calculated as follows – The funds invested in raw materials inventory can be estimated on the basis of production budget, cost per unit and the estimated holding period as follows – The following formula can be used for this purpose – Estimated production in units * estimated cost of raw material per unit * average raw materials holding period (in months / days) 12 months / 365 (or 360) days ii. Funds invested in work in progress can be calculated as follows The following formula can be used for this purpose – Estimated production in units * estimated cost of production per unit * average WIP holding period (in months / days) 12 months / 365 (or 360) days iii. Funds invested in finished goods inventory can be calculated as follows The following formula can be used for this purpose – Estimated production in units * estimated cost of goods sold per unit * average Finished goods holding period (in months / days) 12 months / 365 (or 360) days iv. Funds tied up in debtors can be calculated as follows 56

The following formula can be used for this purpose – Estimated credit sales in units * estimated cost of sales per unit (excluding depreciation) * average debtors collection period (in months / days) 12 months / 365 (or 360) days

Formulas for Estimation of various current liabilities i. Calculation of estimated amount of trade creditors: The following formula can be used for this purpose – Estimated yearly credit purchases in units * estimated cost of raw materials per unit * average credit period granted by creditors (in months / days) 12 months / 365 (or 360) days ii. Calculation of estimated amount of direct wages: The following formula can be used for this purpose – Estimated production in units * estimated direct labour cost per unit * average time lag in payment of wages (in months / days) 12 months / 365 (or 360) days iii. Calculation of estimated amount of overheads (other than depreciation and amortisation): The following formula can be used for this purpose – Estimated yearly production in units * estimated overheads cost per unit * average time lag in payment of overheads (in months / days) 12 months / 365 (or 360) days Note - The amount of overheads may be separately calculated for different types of overheads. In case of sales overheads, the relevant item would be sales volume instead of production volume. Some important points 57

i. Effect of shift working – A company may operate in more than 1 shift in that case the production is substantially higher. Let us say that for a 2 shift working production is approx double that of 1 shift working, in such case current assets like stocks should also get doubled, as daily requirement will be twice. But in reality it hardly happens and though the stock levels go up it, it is never in proportion with the production. Though in examination students should assume the stock levels going up in same proportion as that of production unless otherwise stated. ii. Measurement of working capital in terms of Cash outflows – Working capital requirement should be estimated as accurately as possible so that funds can be raised accordingly. Excess funds result into additional interest expenditure. Hence in practice amount of debtors and finished goods etc are adjusted for non-cash items, which are not required to be funded. Let us see one example – Company A has debtors worth Rs 25,000, but the total cost of the goods sold to these debtors is Rs 20,000 which includes Rs 5,000 depreciation. Now here we can see that actual cash out flow on the goods sold to these debtors is just Rs 15,000 (selling price – profit – depreciation), or it can be said that only Rs 15,000 is blocked with the debtors and this is the amount which needs to be funded. If the company A takes loan based on debtors amount of Rs 25,000 then the company is unnecessary taking excess loan to the extent of Rs 10,000 on which it will be bearing interest. To avoid this current asset figures are estimated excluding all the non cash items. iii. Work in progress – Work in progress is half completed production. product can be in any stage for estimating working capital WIP is assumed to be 50% complete. Important point here is WIP is assumed to be 100% material and 50% labour and overheads otherwise stated. 4.8 Solved problems Problem 4.8.1 The Cost sheet of A ltd. is as follows – Raw Materials Labour Overheads Depreciation Profit Selling price Average holding/realisation period is as follows –

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Cost per unit (Rs) 50 20 30 10 10 120

As the always always unless

Raw materials – 1 month, Finished goods – 1 month, creditors – 2 month, Debtors 2 months. Assume that there is no working capital. Other information – Expected output is 54,000 units per year.

Solution Rs. A Current assets 1. Raw materials = (Cost per unit * production * estimated period of stock in months) / 12 months = (50*54,000*1) / 12

2,25,000

2. Finished goods = (Cost of production per unit * production * estimated period of stock in months) / 12 months = (100 * 54000*1) / 12

4,50,000

3. Debtors = (sales in units * cost of sales per unit (excluding depreciation) * average debtors collection period (in months) / 12 months = (100* 54000 *2 ) / 12

9,00,000

Total current assets 4. Creditors = (purchases in units * purchase cost per unit * average credit period availed (in months) / 12 months = (50*54000 *2) / 12

15,75,000

4,50,000

Total current liabilities

4,50,000

Net working capital

11,25,000

Working notes – 1. Calculation of cost of production for the purpose of calculation of Finished goods stock

59

Rs. Raw Materials Labour Overheads Total

50 20 30 100

2. Debtors are also valued at same rate as selling expenses are not given. 3. Debtors and finished goods exclude depreciation and profit as they are noncash items 4. Work in progress is assumed to be nil Problem 4.8.2 The cost sheet of Hi-Tech Ltd. provides the following data: Raw Material Direct labour Overheads (including depreciation of Rs.10) Total Cost Profit Selling price 1) 2)

3) 4) 5) 6) 7) 8) 9)

Rs 30 20 20 -----70 10 -----80 ------

Average Raw material in stock is for 1 month Work-in-progress (assume 50 % completion stage for Raw materials, wages and overheads) will approximate to 1/2 month’s production Finished goods lie in the warehouse for 1 month Credit allowed to Debtors is 1 month. 25 % of Sales are on cash basis. Cash balance expected to be Rs.2,00,000.00 Credit allowed by suppliers is 1 month Average time lag in payment of wages is 2 months Average time lag in payment of overheads is 1 month Assume a 10 % margin You are required to prepare a statement of the working capital needed to finance a level of the activity of 60,000 units of output per year.

Solution: As the annual level of activity is given at 60,000 units, it means that the monthly turnover would be 60,000 / 12 = 5,000 units

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Estimation of Working Capital Requirement I Current Assets: Minimum Cash Balance Raw Material Stock (5000 x 30) Work-in-progress [(5000 x 60) / 2] x 50 % Finished Goods (5000 x 60) Debtors (5000 x 60 x 75%) Gross Working Capital II

Current Liabilities: Creditors for materials (5000 x 30) Creditors for Wages (5000 x 20 x 2) Creditors for Overheads (5000 x 10) Total Current Liabilities

Amount (Rs.) 2,00,000 1,50,000 75,000 3,00,000 2,25,000 9,50,000 ======= 1,50,000 2,00,000 50,000 ------------4,00,000 ========

Excess of Current Assets over Current Liabilities (I – II) 5,50,000 Add :- 10 % margin Net working capital requirement

55,000 6,05,000

Problem 4.8.3 The management of Royal Industries has called for a statement showing the working capital to finance a level of activity of 1,80,000 units of output for the year. The cost structure for the company’s product for the above mentioned activity level is detailed below – Raw Material Direct labour Overheads (including depreciation of Rs.5) Total Cost Profit Selling price Additional information – a. Minimum desired cash balance is Rs 20,000

61

Rs 20 5 15 -----40 10 -----50 ------

b. Raw materials are held in stock for average period of 2 months c. Work in progress (assume 50% completion stage for all labour, material and overheads) will approximate to half months production. d. Finished goods remain in warehouse, on an average for a month e. Supplier for materials extend 1 month’s credit and debtors are given 2 months credit period. Cash sales are 25% of total sales f. There is a time lag in payment of wages of a month and half a month in case of overheads g. You are required to prepare a statement showing working capital requirements. (CS final, Dec 90) Solution Statement of working capital requirements I Current Assets: Minimum Cash Balance

Amount (Rs.) 20,000

Raw Material Stock (15,000 x 20x2)

6,00,000

Work-in-progress [(15,000 x 35) / 2] x 50 %

1,31,250

Finished Goods (15,000 x 35)

5,25,000

Debtors (15,000 x 35 x 2 x 75%)

7,87,500

Gross Working Capital

20,63,750 =======

II

Current Liabilities: Creditors for materials (15,000 x 20) Creditors for Wages (15,000 x 5) Creditors for Overheads (15,000 x 10) / 2 Total Current Liabilities

Excess of Current Assets over Current Liabilities (I – II) Notes –

62

3,00,000 75,000 75,000 ------------4,50,000 ======== 16,12,750

1. Work in progress, finished goods and debtors exclude depreciation being non cash items. 2. production is assumed to be equal in all months i.e Production per month = 1,80,000 / 12 = 15,000 units Problem 4.8.4 H ltd plans to sell 30,000 units next year. The expected cost of goods sold is as follows – Rs. (per unit) Raw materials 100 Manufacturing expenses 30 Selling, administration and financial expenses 20 Selling price 200 The duration at various stages of operating cycle is expected to be as follows : Raw material stage Work in progress stage Finished goods Debtors

2 months 1 month ½ month 1 month

Assuming monthly sales level of 2,500 units, estimate the gross working capital requirement if desired cash balance is 5% of the gross working capital requirement, and work in progress is 25% complete with respect to manufacturing expenses. Solution: Statement of working capital requirements I Current Assets:

Amount (Rs.)

Raw Material Stock (2,500 x 100 x2) Work-in-progress : Raw materials in WIP ( 2500 x 100) Manufacturing expenses 25% (2,500x30)

Amount (Rs.) 5,00,000

2,50,000 18,750 2,68,750

Finished Goods : Raw materials in WIP ( 2500 x 100 x1/2) Manufacturing expenses (2,500x30x1/2)

2,50,000 37,500 1,62,500

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Debtors (2,500 x 150 x 1)

3,75,000 13,06,250

Cash balance (13,06,250 *5/95)

68,750

Working Capital requirement

13,75,000

========= Note – Selling and distribution expenses never for part of finished goods and WIP but is always included in Debtors Problem 4.8.4 Happy Family is a small trading company whose balance sheet as at 31 st March 1998 was as under : Liabilities Capital General reserve Bank loan Creditors Liability for income tax

Rs 50,500 7,000 40,000 11,300 9,700 1,18,500

Assets Building Furniture Cash Motor car Stock in trade Debtors

Rs 50,000 10,000 9,500 15,000 12,000 22,000 1,18,500

On the basis of following information pertaining to the year ended 31.3.1999, you are required to prepare a statement of changes in working capital: a. Sold motor car on 30.9.1998 for Rs 18,000 and on the same date purchased 100 equity shares of Rs 10 each in X ltd. b. Sales for the year were 20% higher than that in the last year. Purchase of materials increased by 10%. Customers were allowed 2 months credit and suppliers allowed 1 month credit. Debtors on 31st March 1998 represented sales of February and march ( to be evenly allocated) and creditors also represented purchases for March (monthly average) c. Business expenditure for the year amounted to Rs 1,800 per month (paid in each month). There were no other receipts and payments during the year. Gross profit rate was 30% on turnover. d. Provide for interest on bank loan at 6% p.a and for income tax liability Rs 5,000 ( ICWA final, June 1999)

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Solution – Statement showing changes in working capital – 31.3.98 Current Assets Stock Debtors Cash & Bank balance

12,000 22,000 9,500

31.3.99 50,280 26,400 1,170

Increase Decrease 38,280 4,400 42,680

Current liabilities Creditors Interest on bank loan Liability for taxes

11,300 9,700

12,430 2,400 5,000

Net Increase in Working capital

8,330 8,330 1,130 2,400

4,700 4,700 35,520

3,530

Working notes – 1. As sales are going up by 20%, debtors will also go up by 20%, as debtors are equal to last 2 months sales (which is going up by 20%). Debtors as on 31.3.1999 = 22,000 + 20%(22,000) = 26,400 2. As purchases are going up by 10%, creditors will go up by 10%. Creditors = 11,300 + 10%(11,300) = 12,430 3. Amount of sales for 1999 = Debtors / 2 *12 = 26,400/ 2 * 12 = 1,58,400 (As debtors = 2 months sales) 4. Amount of purchases for 1999 = creditors *12 = 12,430 *12 = 1,49,160 (As creditors = 1 months purchases) 5.

Stock in trade for 31.3.99 can be calculated as follows :

Trading Account for the year ended 31.3.1999 Rs To Opening stock 12,000 By sales To purchases 1,49,160 To gross profit (30% of sales)

47,520 By closing stock 2,08,680

6.

Calculation of Cash balance as on 31.3.99 Trading Account for the year ended 31.3.1999

65

Rs 1,58,400 50,280 2,08,680

To Opening balance To collection from debtors To Sale of motor car

Rs 9,500 By payment to creditors 1,54,000 By purchase of investment 18,000 By other expenses By income tax for last year By closing balance

Rs 1,48,030 1,000 21,600 9,700 1,170

1,81,500

1,81,500

7. Collection from debtors = opening balance + sales during the year – closing balance = 22,000 + 158,400 – 26,400 = 154,000 8. Payment to creditors = opening balance + purchases during the year – closing balance = 11,300 + 149,160 – 12,430 = 1,48,030 4.9 Factors affecting the working capital requirement i. Seasonality of business – Seasonality of industry would obviously affect the working capital requirements. Unlike we have seen in earlier problems, it is difficult to predict working capital on the basis of assumptions like sales accrue evenly throughout the period. Let us take an example of Air condition manufacturing company, if we assume that sales are even throughout the year then perhaps the company will be short of funds in summers when demand (and so the working capital) is higher and company may carry unnecessary funds in winter season. Thus a finance manager should estimate working capital according to seasonality of business. ii. Nature of business and production process – Service industry and trading activities require very less working capital whereas manufacturing concerns always have huge working capital requirement. Companies having shorter production process require lesser working capital as compared to companies having lengthy production process. iii. Credit policies of the company – The credit policies of the company plays a major role in determining the requirement of working capital. Company allowing liberal credit may end up having lesser finished goods stock but will have large investment in the debtors. A company having strict credit policies and efficient debt collection system will have lesser investment in debtors. Credit policy of the company also depends upon the company’s reputation and demand for its products in the market, a well established company may not offer any credit to its customers whereas a new company having same product may offer few months credit. iv. Inventory policy – The inventory policy of a company also has a impact on the working capital requirements since a large amount of funds is

66

normally locked up in the inventories. An efficient firm stock raw material for a smaller period and may require lesser amount of working capital v. Contingencies – Contingencies play an important role in working capital requirements, unpredicted shortage of raw materials, heavy rise in demand for products, strikes etc. may shatter the estimates. vi. Competition – Working capital requirements are affected by degree of competition. Large inventory is essential to assure timely delivery and credit period may be higher to cope up with high level of competition in buyers market vii. Dividend and taxation policies - Level of working capital requirements vary according to dividend and taxation policies. 4.10 Management of Working capital Estimation of working capital requirements is just par of the finance manager. An equally important job is management of working capital. We have already discussed that operating cycle and working capital estimation are control tools as well, i.e. it gives the management an idea whether the company is having an adequate level working capital or it is carrying excess / lower working capital. Excess working capital leads to increase in interest costs whereas lower working capital carries the risk of insolvency. It is acumen of the finance manager to strike a balance between the risk and profitability. In current Indian scenario especially after depression in industry since year 2000 the concept of working capital management has gained significant importance. It will not be wrong to say that many companies could recover from heavy losses and were able to turnaround to profits only because of excellent working capital management. In last few years companies have consistently taken efforts on reduction of unnecessary inventories by following Just in time purchase techniques, improving delivery systems, improving communications and co-ordination between marketing, production and purchase departments. The companies also have taken special efforts to reduce their debtors’ collection period and recovery of bad debts. Banking industry has paid a keen role in cash management of companies by providing facilities like collection centres etc. Though academically current ratio of 2 is considered to be ideal, currently most of the companies are eying for a substantially lesser ratio. We’ll now discuss various aspects of working capital management bifurcating between management of each aspect of current assets and current liabilities. 4.11 Management of cash - Management of cash has always been one of the important functions of a finance manager, though now a days it appears to be a bit simpler job as compared to earlier days thanks to technological advancement of banking industry. The term management of cash includes management of actual cash and cash equivalents like liquid bank balances and other liquid investments. A major problem in cash management has always been the geographical diversity of business.

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Let us see one example of a Pune based two-wheeler manufacturing company. The company has it’s dealers network spread all over India and abroad but has its production facilities and most of the suppliers in and around Pune. Now let us discuss a case where the company has a receivable of an amount from a dealer in Assam, say on 1.1.2004 of Rs 10,00,000 and on the same day (or in 2-3 days time) has a payment due to a Pune based supplier, Say Rs 5,00,000 then though company has a receivablefrom its dealer in Assam, cannot use the same amount to settle the dues of the Pune based supplier. Now the company has no option but to borrow from the banks till the time the cheque gets cleared in the company’s account (the payment may take a long time to reach the company and even longer time to clear cheque from remote place). A similar problem is faced when one department of the company has excess cash, whereas another is short of cash. To summarise the requirement of proper cash management can be highlighted as under – 1. An effective cash management ensures that there is no shortage of funds as well as there are no idle funds 2. Cash is required for meeting day to day expenses like – petty expense, payment to creditors, payment of wages, payment of various government dues etc. 3. Liquidity can always be used for taking profitable opportunities which requires liquidity. For example a sudden fall in share market may become right time for investment in share market and company having enough liquid cash / bank balance can only take shares and take the speculative advantages. 4. Cash balance is absolutely necessary to cope up with unforeseen contingencies. 4.11.1 Estimation of cash requirements – The first step of cash management is cash estimation. These estimations are done with the help of cash budgets. Cash budgets are prepared periodically to identify cash inflows and outflows, as cash flows determine the requirement of funds and helps identifying investible funds. Cash budgets are nothing but cash flow statements. One must note that cash flow is different from profit or loss, to identify cash flow one must adjust all non cash items to the profit / loss. Other popular way for preparing cash budgets is to prepare estimated receipts and payments account. The preparation of cash budgets offers following advantages – 1. It gives information about timing and quantum of liquid funds required to be raised 2. It shows the amount of internal accruals; management can assess how much is needed fro day to day operations and how much is available for purchase of long term assets.]

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3. It shows the need for additional amount of cash required so that loans can be raised accordingly. Format of cash budget – XYZ Ltd. Cash budget Period Month 1 Opening Balance Receipts: 1. Cash sales 2. Collection from debtors 3. Issue of capital 4.Other income (Scrap etc.) 5. Loans taken 6.Miscelleneous receipts (dividend, interest etc.) Total Payments : Creditors Salaries Wages Interest Overheads - Fixed overheads - Variable over heads - selling overheads Dividend Fixed assets Taxes Other items Total Closing balance Minimum desired balance Surplus / (shortfall) 69

Month 2

Month 3

Month 4

Month..

Month..

4.11.2 System of Cash Management – The next step of cash management is proper allocation of funds amongst various departments / locations and maintaining appropriate balance / liquidity at each place. The collection mechanism can be made efficient by – a. Speeding up the mailing time of payments from the customers b. Reducing the time lag between collection of cheques and its deposition with the banks. Two important methods to speed up collection process are – 1. concentration banking and 2. lock box system 1. Concentration banking – In concentration banking the company establishes number of collection centres according to locations of its customers. Instead of mailing the payments the customers deposits the money in the collection centres, which it deposits immediately in the local branch of the main bank, and the collection centres transfer the funds to the Head office of the company. The importance of this can be elaborated as follows – Continuing with the example of the two-wheeler company discussed above, let us see how concentration banking will help the company – a. The collection process (mailing time of the dealer + clearing time for the cheque) will be very high as the place is quite far and mailing will take time, again outstation cheques take long time to get cleared, where as under concentration banking the time of mailing is completely avoided as the dealer will deposit the cheque in the collection centre near to his dealership place and clearing will also take lesser time as the dealer will obviously give cheque drawn on a local bank. b. let us assume that total such collections in a year are Rs 3,65,00,000 in a year (365 days) and the collection process is expected to be reduced by 5 days by using the concentration banking, also the rate of interest on working capital loan is 10% p.a. Now we can see that the total interest saving will be 5 days collection * 10% = (3,65,00,000 / 365 * 5 * 10%) = Rs 5,00,000 p.a. . Even if the company incurs Rs 1,00,000 as charges for availing collection bank facility, it will stand to gain Rs 4,00,000. An extension of concentration banking has been introduced by the bankers, where they allow same day clearing i.e. when the dealer deposits the cheque, bank gives immediate credit in the company’s account, saving the days of clearing also, of course the cheque is reversed if the dealer’s bank does not honour the cheque. 2. Lock box facility – The purpose of lock box system is to eliminate the time between the receipt of remittance by the company and depositing it in the bank. Under this system the company rents local post office boxes and authorise banks at each location to collect the remittances in the box. After

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collecting the remittances the bank deposits it in the company’s account. This also relieves the company from handling of the cheques. 3. Reducing the floats – Float here means the time periods that affect the cash movements in various stages of collection process. Floats can be bifurcated as follows – a. 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 invoice is the billing float b. Mail float – This is the time when a cheque is being processed by post office or currior c. Cheque processing float – This is the time required for the seller to sort, record and deposit the cheque after it has been received by the company d. Bank processing float – This is the time from the deposit of the cheque to the crediting of funds in the sellers account Lesser the float faster will be the collection process. To achieve this aim finance manager must ensure that some basic procedures are followed, like – cheques are deposited on time, timely delivery of invoices, regular analysis of uncleared cheques etc. 4.12 System of debtors Management – The basic difference between cash management and management of other current assets is that the system of cash management can be solely designed by finance manager and he need not take consent of other departments and that makes the task bit easier. Whereas in case of debtors and inventory management a finance manager has to take into consideration decisions of other departments like Marketing department and production department. Say for example – if a finance manager, considering the serious position of working capital, decides to grant no credit to debtors then the marketing department will certainly object this decision as it won’t be able to achieve the sales targets without appropriate credit period and perhaps in a competitive market will substantially lose it’s market share. Similarly if a finance manager decided to keep Raw material inventory to the extent of 30 days consumption, which is equal to the industry average, Production manager may argue against it as reduction in raw material stock may hamper the production. Selling goods on credit has a cost, the cost includes – a. Interest on the amount of loans raised to fund the investment in debtors b. Administrative cost like cost of maintaining records c. Collection cost d. Bad debts – debts which cannot be recovered

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Some of the important determinants of the investment in working capital are – a. Credit policy of the company b. Discount policy of the company c. Collection policy d. Credit analysis 1. Credit policy – Credit policy determines the period of credit to be granted to debtors, decides as to which types of debtors should be given credit period and how much. Granting credit is absolutely essential as – a. It helps in increasing sales and market share b. Credit sales generally has higher margins, thus it adds to profitability of the company c. In case of intense competition it is absolutely essential to grant credit period Credit policy plays a very important role in debtors management and hence it should be decided carefully after considering various marketing and financial aspects. It is necessary to keep on revising the credit policies with changing market situations. 2. Discount policy – Practically every business offers cash discount for speedy collection of debts. It helps the seller to improve his liquidity. Cash discount is generally granted in slabs like say discount of 2% for payment in 0-15 days from sales, 1% for payment in 16-30 days and so on. Let us take an example to elaborate the importance of the cash discount – Trader A has an annual sale of Rs 600 lakhs and has average credit period of 3 months. Trader A has decided to offer 2% discount on cash sales, now suppose 50% of the customers avail this discount, reducing the debtors from Rs 150 lakhs (3/12 *600) to Rs 75 lakhs. Now suppose Trader A pays interest @ 18% p.a on working capital loans, then he is saving Rs 75 lakhs * 18% p.a = Rs 13.5 lakhs against the cost of discount = Rs 300 lakhs * 2% = Rs 6 lakhs. 3. Collection policy – Efficient and timely collection of debtors is absolutely essential for avoiding bad debts and reducing the unnecessary investment in the debtors. Delay in collection period unnecessary adds up to investment in the debtors, i.e. if credit period of 60 days is necessary to make a good sale then investment in debtors for these 60 days is only essential, additional recovery period (say of 10 days) adds only to the investment without adding anything to the sales. It is important that clear-cut procedures regarding credit collection are set up. The procedures shall include guidelines regarding the time period of dues after which the collection procedures should be initiated, what should be the format of initial letters and legal letters, which cases of defaulters should be taken to courts (this basically involves assessment of cost of legal action and actual dues) etc. One important analytical tool used by the collection department is aging analysis. Ageing analysis bifurcates the dues between various periods throwing out dues that are outstanding beyond the credit period. It also highlights

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dues outstanding for abnormally long period, which is generally provided for in the accounts. 4. Credit analysis - Having determined the credit terms, the firm has to evaluate credit worthiness of individual customers. It is an absolute essential procedure as it helps the company in substantially reducing its bad debts. This procedure includes credit rating, in which each and every customer (except for cash customers) are rated according to their creditworthiness and their credit period etc are determined according to their ratings. The credit rating depends upon analysis of various factors like – a. Past experience of the company with the customer b. Latest financial performance of the customer like Balance sheet c. Trade references etc.

4.12.1 Factoring Factoring is the debt collection service provided by the bankers. Bankers provide like buying the debtors of a company and extending credit upto 70-80% of the invoice value. It is nothing but financing the sundry debtors and is a type of working capital finance. Operation of factoring is very simple, clients enter into an agreement with the ‘factor’ working out an factoring agreement according to his requirements. The Factor then takes the responsibility of monitoring, follow up, collection and risk taking and provision of advance. The factors generally fixes up a limit customer wise for the seller. Some of the benefits and limitations of factoring are – a. The company can convert directly its debtors into cash ( after deducting the factoring commission) b. Factoring ensures a definite pattern of cash inflows c. Factoring eliminates the need of a credit and collection department in the company saving on administration and staff costs. This is particularly very useful for seasonal businesses where firms can’t afford to maintain such department for whole year, as work for such department is only for a season. d. Collection and recovery has been considered as a big problem by almost all businesses and factoring reduces or nullifies this problem. The limitations of factoring are – a. It is costlier source of finance as the cost includes both factoring fees and interest on the advance till the amount is recovered from the debtors b. Bad debts can still be the responsibility of the company and not the factor. If factor agrees to take the risk as to the bad debts then the factoring fees are even higher

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Thus before availing the services of a Factor the finance manager must consider the costs and benefits associated with factoring and should appraise its utility to his company. Some other popular ways of management of debtors are Debt securitisation, Invoice discounting etc. Debt securitisation is used by financial concerns like banks NBFCs etc. A detailed study of these tools will be done in next semester. 4.13 System of Inventory Management In case of any manufacturing industry inventories is perhaps the biggest element of working capital and hence maximum funds are blocked in the inventories (stocks). Keeping inventories at its optimum level is always a tough task as excess or shortage of inventories may create tremendous problems, like – 1. Shortage of raw materials may lead to interruptions in production schedule resulting in under utilisation of capacity. Interruption in production increases the cost of production as wages and overheads are incurred even when production is halted. 2. Reduction in Finished goods may lead to excessive delay in deliveries to customers, resulting into reduction in sales 3.

Excessive stock blocks up funds which has a cost

4.

Inventories are non liquid assets and can’t be converted in cash easily.

Therefore inventory control should be done carefully. There are various techniques developed for inventory control which are discussed in brief – 1. Minimum and Maximum levels – This is perhaps the simplest form of inventory management, under his method management simply decides what should be the minimum and maximum level of various items in inventory. These levels are decided after considering the availability and importance of various items. It also takes into consideration cost of purchases and lead time (time period between ordering of material and actual receiving the material). Cost of procurement is an important point especially for imported items as carriage costs are heavy for imports and the cost can be spread over only bulk quantity. 2. Re order quantity – The re-ordering quantity is the level of stock where new procurement orders are required to be placed without delay. 3. Economic order quantity [E.O.Q.] – It is an important concept in the purchase of raw materials and in the storage of finished goods and in-transit

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inventories. EOQ techniques gives a formula to determine the optimum quantity to be ordered. EOQ = 2AO/ C A = Total usage in units for a period O = ordering cost per order C = Carrying cost per unit 4. Just in time purchase – This is a relatively new concept and is far easier to implement if stock records are maintained on computers. Under this method high value inventories are procured only when it is required in production, suppliers are specially developed so that they can arrange these items very promptly This was just a brief introduction to the tools of inventories, as a detailed study is part of subject of costing and not financial management.

4.14 Working capital financing in India Indian banks have been traditionally been extending credit to industry and trade solely on the basis of securities like hypothecation of stocks etc. The organisation’s ability to repay these loans and actual usage of these loans were never checked. This resulted into heavy losses to bankers and defalcation of funds by the promoters. To cure this problem Reserve Bank of India has set up various committees to study the matter and provide appropriate guidelines, analysis some of the committees are discussed below – 1. The Dahejia committee report – In 1969 Dahejia committee pointed out that there was no relationship between optimum requirements for production and the bank loans. It was general tendency of the businessmen to take short term loans and use it for other than production purposes. It was also pointed out that there are multiple hypothecations on the same stocks. The Dahejia committee suggested that the bank should make appraisal of credit applications with reference to the total financial situation of the client. It also suggested that all the Cash credit bank accounts should be bifurcated between the hard core which would cover the permanent working capital and a strictly short term component which should be fluctuating part of the account. 2. The Tandon committee report – The Tandon committee was set up by the RBI in 1974. Along with the suggestions regarding to whom working capital loans should be granted, how much loan should be granted, the committee gave three different methods for calculation of working capital. Though earlier these methods were mandatory for the bankers now it is only recommendatory in nature. The three methods are as follows –

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Method I – Bank finance to be granted = 75% (Current Assets – Current liabilities [excluding bank borrowings]) Method II – Bank finance to be granted = 75% (Current Assets) – Current liabilities [excluding bank borrowings] Method III – Bank finance to be granted = 75% (Current Assets – Core current assets) – Current liabilities [excluding bank borrowings] 3. Chore committee – In 1979 chore committee was formed by RBI to analyse funding of working capital the committee gave certain major suggestions regarding enhancement of borrower’s contribution in the working capital, compulsory periodic review of cash credit accounts by bankers etc.

4.15 Self examination questions 4.15.1 Problems 1. M/s A ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep some margins as under (i.e agreed to finance excluding the margins) – Raw materials Work in progress Finished goods Debtors

20% 40% 15% 30%

Following are the estimates for the year 2002-03 Annual Sales Cost of Production Raw Materials purchased Opening stock of Raw materials Opening stock of Raw materials

Rs. 000’s 14,40 12,00 7,05 1,40 1,25

Other information – Raw material is in stock for 2 months, WIP 15 days and FG 1 month. Debtors get 1 months credit and creditors give 15 days credit. Company has received an advance of Rs. 15,000 1. Estimate the amount of working capital requirement 2. Estimate the amount of loan likely to be approved by the bankers.

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Note - Margin is the amount which is not funded by the bankers e.g. if bankers decide to fund debtors excluding 30% margin that means if company estimates debtors to be Rs 100 then bank will fund only Rs 70

2. M/s B ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep some margins as under (i.e agreed to finance excluding the margins) – Raw materials Work in progress Finished goods Debtors Cash

30% 35% 12.5% 42% 0%

Estimated annual production is 60,000 units and break-up of selling price is as under – Raw Materials Direct wages Overheads (includes depreciation 10%) Profit Selling price

60% 10% 20% 10% 100%

Other information – Raw material is in stock for 2 months, work in progress (WIP) 1 month and FG 3 month. Debtors get 3 months credit and creditors give 2 months credit, wages are paid after one month. Calculate WIP considering 100% RM + 50% wages and overheads. Selling price is estimated @ 5 Rs per unit. Cash requirement is Rs 20,000 1. Estimate the amount of working capital requirement 2. Estimate the amount of loan likely to be approved by the bankers. 3. M/s C ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep 30% margins on all current assets excluding Cash balance (i.e agreed to finance excluding the margins) other information is as follows Raw Materials Labour Overheads (Depreciation included in overheads Rs 20)

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Cost per unit 40 10 60

Selling price

120

Average holding/realisation period is as follows – Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%) – 1½ month, Debtors – 2 month, Creditors – 1 month, wages – 1/2 month, overheads – 30 days, Finished goods – 2 month. 80 % of sales is on credit, Expected cash balance is 75,000 1. Estimate the amount of working capital requirement 2. Estimate the amount of loan likely to be approved by the bankers.

4. Explain in details what is working capital, with its definitions 5. Write short notes on 1. 2. 3. 4.

Reducing the floats in collection system Factoring Working capital cycle Concentration banking

6. Discuss various formulas given by Tandon committee 7. How each item of current assets can be managed 8. Consider the following financial facts of Company A ltd. – Current assets a. Inventory b. Debtors c. Other current assets Current liabilities a. Creditors b. Other liabilities

Rs. 140 lacs Rs. 200 lacs Rs. 20 lacs Rs. 100 lacs Rs. 20 lacs

Calculate the permissible bank finance according to methods given by Tandon committee 9. The Cost sheet of A ltd. is as follows – Raw Materials Labour

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Cost per unit 50 18

Overheads (Depreciation included in overheads Rs 10) Selling price

35 125

Average holding/realisation period is as follows – Raw materials – 11/2 month, WIP (Completion - Material 50%, labour & overheads 50%) – 1 month, Debtors – 2 month, Creditors – 1 month, wages – 1/2 month, overheads – 1/3rd month, Finished goods – 1 month. Other information – 1. 75 % of sales is on credit 2. Expected cash balance is 55,000 Expected output is 60,000 units per annum. Calculate the amount of working capital required. 1. T ltd is a trading company whose balance sheet as at 31st March 2004 was as under : Liabilities Capital General reserve Bank loan Creditors Liability for income tax

Rs 1,50,500 17,000 34,000 17,300 19,700 2,38,500

Assets Building Furniture Cash Motor car Stock in trade Debtors

Rs 1,10,000 70,000 19,500 12,000 15,000 12,000 2,38,500

On the basis of following information pertaining to the year ended 31.3.2005, you are required to prepare a statement of changes in working capital: a. Furniture on 30.6.2004 for Rs 18,000 and on the same date purchased 100 units of UTI at Rs 100 each. b. Sales for the year were 30% higher than that in the last year. Purchase of materials increased by 15%. Customers were allowed 1.5 months credit and suppliers allowed 1 month credit (Policy was same for 2004) c. Overheads for the year amounted to Rs 3,500 per month (paid in next month). There were no other receipts and payments during the year. Gross profit rate was 40% on turnover. d. Provide for interest on bank loan at 9% p.a and for income tax liability Rs 7,500

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10. Compute the amount of working capital from the following balance sheet Balance sheet as at 31.3.2004 Liabilities

Rs

Capital Long term loans Expenses payable Creditors Liability for income tax Bills payable Proposed dividend

50,000 40,000 12,000 10,000 10,000 5,000 8,000 1,35,000

Assets

Rs

Building Furniture Cash Motor car Stock in trade Debtors

40,000 20,000 15,000 10,000 30,000 20,000 135,000

11.You are given below the Profit & loss account for two years for a company – Year 1

Profit & loss Account Year 2

Opening stock Raw materials Stores Other expense Depreciation

80,000 3,00,000 1,00,000 2,00,000 1,00,000

1,00,000 Sales 4,00,000 Closing stock 1,20,000 Misc. income 2,60,000 1,00,000

Net profit

1,30,000

1,80,000

9,10,000

11,60,000

Year 1

Year 2

8,00,000 10,00,000 1,00,000 1,50,000 10,000 10,000

9,10,000 11,60,000

Sales are expected to be Rs 12,00,000 in year 3. As a result, other expenses will increase by Rs 50,000 besides other charges. Only raw materials are in stock. Assume sales and purchases are in cash terms and closing stock is expected to go up by the same amount as between year 1 and year 2. You may assume that no dividend is being paid. Estimate the cash generated from operations in year 3. 12. Prepare a working capital forecast from the following information :

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Production during the previous year was 10,00,000 units. The same level of activity is intended to be maintained during the current year. The expected ratios of cost to selling are : Raw materials Direct wages Overheads

40% 20% 20%

The raw materials ordinarily remain in stores for 3 months, WIP for 2 months and finished goods for 3 months. Credit period given by creditors is 4 months and given to debtors is 2 months. Wages and overheads are overdue for ½ months and minimum cash balance should be Rs 2,00,000. selling price is 8 per unit you are required to make a 10% provision for contingencies ( except cash). 4.15.2 Objective questions / problems 1. state whether following statements are true or false, giving reasons e. A company should have large balances of cash in hand so that it can meet all contingencies f. A finance manager must aim at reducing inventories without considering production requirements g. A company should never sale on credit to avoid investment in debtors. h. Working capital cycle is useful for analyzing efficiency of the organization i. Higher the credit period, the greater are the chances of recovery of a debt j. Factoring is not recommended for companies having lesser collection periods 2.Company D ltd. – Current assets a. Inventory b. Debtors c. Other current assets Current liabilities a. Creditors b. Other liabilities

Rs. 330 lacs Rs. 150 lacs Rs. 20 lacs Rs. 120 lacs Rs. 30 lacs

Core current assets are Rs. 200 lacs

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Q1. The maximum permissible bank finance as per Tandon committee recommendations is – a.Rs. 180 lacs b.Rs. 262.5 lacs c. Rs. 250.75 lacs d.Rs. 120 lacs Q2.The minimum permissible bank finance as per Tandon committee recommendations is – k. Rs. 180 lacs l. Rs. 20 lacs m. Rs. 75 lacs n. Rs. 175 lacs Q 3. Calculate the maximum permissible bank finance as per Tandon committee recommendations if Core current assets are Rs. 170 lacs – a. Rs. 180 lacs b. Rs. 20 lacs c. Rs. 15 lacs d. Rs. 262.5 lacs 3. The Cost sheet of A ltd. is as follows – Raw Materials Labour Overheads Depreciation Selling price

Cost per unit 500 200 300 100 1100

Average holding/realisation period is as follows – Raw materials – 1 month, Finished goods – 1 month, creditors – 1 month Other information – Expected output is 4500 units per month. O 1. The estimated figure of raw materials for calculation of working capital is – a. 33,75,000 b. 22,50,000 c. 12,50,000 d. none of the above. Q 2. The estimated figure of Finished goods is –

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a. b. c. d.

22,50,000 58,00,000 43,55,000 45,00,000

Q3. Which other figure is same as the estimated figure of raw materials – a. Creditors for materials b. Creditors for overheads c. Work in progress d. None of the above

4. state whether following statements are true or false, giving reasons 1.

Increasing the sales should be the only criterion before giving credit to the customers

2.

Credit rating refers to ranking the various debtors who seek credit.

3.

Inventories constitute very small portion of working capital

4.

Collection floats can never be reduced

5. ----------------- is the method of granting loans against collection debtors 6. The cash investment in working capital is lower because ----------------- and ---------------- includes non cash items

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5. Sources of Long term and short term finances 5.1 Introduction One of the most important function of a finance manager is procurement of funds. Number of such sources are available to a finance manager and he has to make a decision as to which will suit him the best. The procurement of funds is not a easy task considering the fact that it is governed by various factors which we will be seeing ahead. Funds are required by an enterprise for various purposes like for implementing a new project, undertaking an expansion, diversification, modernisation, day to day working, retiring old dues etc. Estimation of cost of the new project and exact requirement of funds is a critical step for raising the funds. The aggregate cost indicates the quantum of funds needed for bringing the project into existence. Therefore great care should be taken while estimating such costs. The cost of project usually comprises of the following items – a. b. c. d. e. f. g. h.

Purchase of land and land development charges Construction or purchase of building Plant and machinery especially for manufacturing concerns. Other fixed assets Technical know how and royalty charges Preliminary expense Interest during construction period Other expenses

After estimation of cost of the project the issue to be decided is from which source finance should be raised and how much from each source. A detailed study of capital

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mix is done in topic on capital structure theories, here we will be analysing pros and cons of various available resource. 5.2Types of requirement of funds Any enterprise has requirement of funds having varied repayment schedules. Financial needs can be classified under three groups according to time of repayment as follows – 1. Long term Finance – Funds required for acquiring long term assets, starting of new project etc. are classified under long term loans. Such funds are generally raised for a period ranging from 5-20 years. Funds required to finance permanent working capital also raised form long term sources of finance 2. Medium term finance – Loans which are raised for a period of 1-5 years are termed as medium term finance. These kind of funds are raised for the purpose company’s medium term requirements like small projects or projects where long term finance can’t be raised etc. It may be noted that this term is mainly a theoretical term and practically finances are bifurcated between only two categories – long term and short term. 3. Short term financial needs – These funds are raised for a short period of time; up-to maybe 1 year. Short terms loans are used for financing company’s current assets, These funds are of utmost importance as investment in working capital is essential to use fixed assets profitabaly. 5.3 Various sources of finance I. Long term sources – Some example of long term sources of finance are as follows 1. 2. 3. 4. 5. 6. 7. 8.

Equity and preference shares Retained earnings – reserves like Profit & loss account, general reserves etc. Debentures long term loans from banks Loans from financial institutions Leases and hire purchases Government subsidies International instruments like American depositary receipts, Global depositary receipts, euro issue et.

II. Medium term sources – Some example of medium term sources of finance are as follows 1. 2. 3. 4.

Public deposits Loans from banks Medium term leases and hire purchase agreements Medium term venture funds

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III. Short term sources - Some example of Short term sources of finance are as follows 1. 2. 3. 4. 5. 6.

Working capital loans from banks Commercial papers Certificate of deposits Advances from customers Inter corporate deposits Trade creditors

There are other ways of classification of business – 1.

According to ownership – a. Owned share capital b. Retained earnings

2. According to source of generation – a. Internal sources e.g retained earnings b. External sources e.g debentures, loans 5.4 Long term sources of finance Ordinary or equity shares – A public limited company may raise funds from promoters or from the investing public by way of ordinary shares. Ordinary shareholders are owners of the company and share risks of the business. Equity shares can only be paid back on liquidation (except for buy back of shares) and hence there is no risk as to repayment. Being the owners they elect directors of the company to run the company. The concept of equity shares is applicable only for companies and not for small businesses. The remuneration for equity shareholders is called dividend. As dividends can be declared only when company is in profits (except for exceptional cases) the risk is minimum, in case of loans interest has to be paid even when the company is in huge losses. Cost of equity shares is maximum as the risk borne by the shareholders is also maximum. The advantages and drawbacks of raising equity are as follows – Advantages – a. It is a permanent source of finance i.e not repayable. b. Dividends is not a mandatory payment. c. Company can raise further capital from shareholders, if required, by way of right shares. Disadvantages – a. it is the costliest source of finance

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b. It may dilute the control. As equity shareholders are owners of the company new shares issued to other investors dilutes the ownership of existing shareholders c. Dividend is not tax deductible. Preference share capital – These are special kind of shares in which the shareholder enjoys priority over equity shareholders in case of repayment of capital on winding up of the company, Preference shareholders also enjoy priority in respect of payment of dividend. Preference shares are a mixture of both equity shares and debt. There are various types of preference shares – 1. Redeemable preference shares – In India only redeemable preference shares are allowed to be issued. This preference shares are redeemable on a predefined date. 2. Cumulative preference shares – These type of preference shares stipulate mandatory payment of dividend, if in an year of loss dividend is not paid then the same gets accumulated till the time the accumulated amount is paid. 3. Convertible preference shares – On a predefined date investors are given an option to convert their preference shares into equity shares 4. Cumulative convertible preference shares – it’s a hybrid type having features of shares mentioned in point no 3 & 4 above. 5. Partly convertible preference shares - On a predefined date investors are given an option to convert a part of their preference shares into equity shares, remaining part (or unconverted part) is redeemed on that date. The advantages and disadvantages of preference shares are as follows – Advantages – a. As dividend on preference share is affixed charge it has a leverage advantage b. It does not dilute the shareholders control, There is no risk of takeover. c. Preference shares can be redeemed after certain period Disadvantages – a. b. c. d.

It is very high cost source of finance It is repayable Dividend is not tax deductible. If dividend is not paid on cumulative preference shares for three consecutive years then they get rights of equity shareholders

Debentures or bonds – Debentures or bonds are the instruments used for raising funds from public. It is basically a loan instrument and does not carry any ownership

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rights. Debentures have varying face values generally varying from Rs 100 to Rs 1,000 and carry different rates of interest. Debentures are generally floated on the basis of debenture trust deed. Debentures are secured against the property of the company. It is a safer option for prospective investors than that of equity shares. Debenture holders are paid fixed or floating interest every year, immaterial of whether the company is in profits or losses. In last one or two decades variants of debentures are gaining increasing popularity. The more popular variants are – 1. Partly convertible debentures – Investors are given an option to convert a part of their debentures, on an predefined date, into equity shares and remaining amount is repaid 2. Fully convertible debentures - Investors are given an option to convert their debentures, on an predefined date, fully into equity shares and remaining amount is repaid There are certain advanced versions like bonds with coupons, debentures or bonds with floating rate notes etc. a detailed study of these advanced instruments will be done in the next term. Advantages of issuing debentures – 1. The cost of debentures is substantially lower than that of cost of equity and preference shares, as, not being the owners of the company, debenture holders carry lesser risk 2. Debenture financing does not result in dilution of control 3. It has a leverage advantage as interest on debentures is a fixed charge. 4. The cost of raising funds by debentures is cheaper also because of tax deductibility of debenture interest Disadvantages – 1. Debenture interest and capital repayment are obligatory repayments and in a situation of cash losses the company may suffer more because of this burden 2. Debenture issue increases the financial risk associated with the firm as it has a leveraging effect 3. Issue of debenture to public requires to berated by CRISIL or other recognised credit rating institutes, this makes debenture issue difficult for small companies. Loans From Financial Institution – In India certain specialised institutes provide long term loans to industry. This institutions are called financial institutes, examples of which are – Industrial finance corporation of India (IFCI), The life insurance corporation of India ( LIC), Industrial credit and investment corporation of India (ICICI) [ ICICI is merged with ICICI bank in year 2002 and hence it is no more a financial institution], The state financial corporation (SFC) etc. Financial institutions are specialised in giving long-

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term loans and huge loans. The company asking loan has to convince the institution about Economical, technical, managerial, financial and commercial ability of the project for which the loan is required. The institutions grant long term loans with interest varying for each company. These loans are generally repayable over a period of 6 – 10 years in annual, semi-annual or quarterly instalments. Advantages of raising funds from financial institutions (FIs)– 1. FIs can provide huge loans, required especially for infrastructure projects. It is difficult to raise such huge loans from any other source 2. Interest being tax deductible cost of such funds is comparatively lower. 3. Repayment period is quite high and it is ideal for projects having big gestation period. 4. FIs generally appoint nominee directors on the boards of the companies financed by them, these directors are experts in their field and provides useful guidance to the company. Disadvantages of raising funds from financial institutions – 1. It is impossible for small organisations to get funds from FIs 2. The procedure for raising funds from FIs is very complicated and it takes very long time. Term lending by Banks – The primary role of the commercial banks is to cater the borrowing requirements of industry. Banks in India are specialised in short term lending and avoid giving large and very long term finances to industry. Banks are specialised in giving short term finances ( or what we can call medium term finances ) for buying fixed assets and working capital loans. The discussion on bank loans exclude retail loans as the primary motive of this subject is not personal financing. Though it is said that working capital loans are short term, they are actually more permanent than a term loan. This is because term loans are always repayable on a fixed date and the account gets settled on that date. Whereas working capital loans are only reviewed periodically but never repaid, though it is repayable on demand. Let us take an example of Cash credit account, in this account a borrower is allowed to overdraw upto a certain sanctioned limit say Rs 50,000, then throughout the life time of that loan the borrower ensure that the overdrawn balance is nearer to Rs 50,000 and bank does not get its funds back. Bankers always provide loans on the basis some security like fixed assets or current assets. Advantages of term lending from banks –

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1. The procedure of raising funds from banks is perhaps the simplest 2. Bank offers lot of flexibility in providing loans and offer variety of lending instruments to suit every business necessity 3. Interest on loan being a tax deductible item, cost of bank borrowings is lesser. 4. Bank borrowing does not dilute the control of the management Disadvantages of term lending from banks – 1. Bank borrowings increases risk associated with the organisation. 2. Bank borrowing requires hypothecation of firm’s assets. Retained earnings – Long term funds may also be provided by accumulating the profits of the company by ploughing them back into the business. Such funds belong to the ordinary shareholders and increases the net worth of the company. It is mandatory for a public limited company to set aside certain amount as reserves. Companies keep aside certain funds over and above the legal requirements for its own expansion plans. Dividends are always declared after considering such plans and cash flow position of the company. Venture capital financing – The venture capital financing refers to financing of new high risk ventures promoted by qualified entrepreneurs who lack experience and funds to give shape to their ideas. The concept of venture capital is investment in high risk proposals where chances of success can also be high and profits can be huge e.g an email portal or a website. Some common methods of venture capital financing are – a. Equity financing – The venture capital undertaking usually requires funds for a longer period but may not be able to give returns in initial stages. In such cases the venture capitalists provide funds by way of investment in equity shares. The venture capital can earn his profits by selling the equity shares once the market value of the company is up. b. Conditional loan – a conditional loan is repayable in the form of a royalty after the venture is able to generate sales. No interest is paid on such loans. c. Participating debentures – Such security carries charges in three phases in very initial stage no interest is charged, after some period (predefined) low interest is charged and in the last stage heavy interest is levied.

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d. Income note – Under this method of financing the undertaking has to pay the venture capitalist both interest and royalty on sales. This gives the venture capital investor a fixed as well as a variable income.

5.5 Short term sources of finance There are various sources of short term finances available some of them are discussed below – 5.5.1 Bank advances – Bankers are more interested in more liquid advance ai.e the advances which can be called back easily. Banks provide numerous types of short term finances to meet almost every business demand. Some important types are discussed below – 1. Bank overdraft – Under this facility customers are allowed to withdraw in excess of credit balance standing in their current deposit account. A fixed limit is granted to the borrower within which the borrower is to overdraw his account. Borrower has to formally open an current account with the bank. The customer can borrow at any time within his limits. Interest is charged on daily balances. Bankers take security for overdrafts like LIC receipts, FD receipts, shares etc. Bankers revive the limits granted every year according to the performance of the borrower. 2. Clean overdrafts – Request for clean advances are entertained only from parties which are financially sound and reputed. The bank provides this facility only on the basis of goodwill and past experience of the borrower. The term clean overdraft means overdraft which is not backed by any security. A clean advance is granted only for a short period. 3. Cash credit – Cash credit is an arrangement under which a customer is allowed an advance upto certain limit. The bank lends (approves) a certain amount to a borrower, who as per his need can borrow the amount at any time and to any extent subject to maximum limit sanctioned by the banks. The remaining amount remains in his account. Interest is charged only on the amount actually borrowed by him. Though these accounts are repayable on demand, banks generally do not recall such advances and keep on reviving the maximum limit periodically. Cash credit limit is generally sanctioned against hypothecation of stocks etc. 4. Bill discounting – These advances are against security of bills. The mechanism works as follows –

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Mr A sells goods to Mr B on 6 months credit and is in need of cash urgently. Then Mr A draws a bill of exchange (also called hundi) on Mr B and Mr B, undertakes to pay the amount mentioned in that bill ( equal to the sales amount) 6 months further. Now Mr A discounts / endorses the bill with the bank and bank pays him the amount mentioned in the bill less interest for 6 months. At the end of 6 months bankers present the bill to Mr B which he honours. It is very good source of short term finance. It’s a very effective alternative for overdraft or Cash credit. In recent times many big companies have started this scheme for their suppliers, as rates of bill discounting are lesser than normal bank loans. Of course the rates are lesser for bigger companies, ordinarily bill discounting charges are higher than normal loans. 5. Packing credit - Packing credit is an advance extended by bank to an exporter for the purpose of buying, manufacturing, processing, packing and shipping goods to overseas buyers. The exporter must have a firm export order in order to avail this facility. The packing credit has to be repaid within 180 days from the date of its commencement, by negotiating the export bill or from the receipt of export proceeds. There are various sub types of packing credit like clean packing credit, packing credit against hypothecation of goods etc. 5.5.2 Commercial paper - The commercial paper is nothing but a “Promissory note” issued by a company, approved by RBI, negotiable by endorsement and delivery. The commercial paper is issued at face value less discount and is honoured at the face value. E.g Company ABC ltd may issue a 6 months commercial paper carrying face value of Rs 1,00,00,000 at Rs 96,00,000. At the end of 6 months it has to honour the commercial paper by paying the whole amount of Rs 1,00,00,000. Being a negotiable instrument Commercial paper can change hands till the time of maturity. There are certain restrictions of commercial paper as it does not carry any security. These eligibility norms are as follows – a. The issuing company must have a tangible net worth of Rs 4 crores are more as per latest balance sheet b. crores

The company must have a working capital limit not less than Rs 4

c. balance sheet

The current ratio should be minimum 1.33 : 1 as per latest

d. like CRISIL etc

The company must have some specified ratings from institutions

e. The borrowal account of the company should be classified as standard asset by the company’s bankers

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f. No commercial paper should be issued for a period less than 15 days and a period more 1 year. g. As per guidelines issued by RBI, a company has to issue commercial paper only through the same bank from where it has taken any loan. 5.5.3 Trade creditor - Creditor is a source of short term finance as creditors supply goods on credit which is required to be paid only after certain period of time. Credit periods offered in India generally do not extend beyond 6 months. This finance is without ant explicit cost, except may be the amount of cash discount forgone. It generates automatically in the course and is common to all businesses. 5.5.4 Advances from customers – Most of the Manufacturers or constructors of big projects prefer taking periodically advances from customers. Example of this can be bridge contractors who take advances from government at regular intervals. This is a useful source of finance and is cost free. 5.5.5 Certificate of deposit – The certificate of deposit is similar to that of a fixed deposit except for the fact that it is liquidated not on demand but only on maturity. The holder can liquidate it at any time by just selling it in secondary market. 5.5.5 Inter-corporate deposit – The companies use this option to borrow from another company when it is in urgent need of funds and does not have time to go through bank formalities. The rate of Inter-corporate deposits is usually higher than bank borrowings and varies with the company’s reputation, amount and time involved. It is good source of investment for companies wishing to park their idle money for a short period of time. 5.5.6 Lease and hire purchase agreements – Under a lease contract the lessor purchases an asset and then gives it on rent to the lessee. In most of the cases the lessee uses the asset throughout its life. Lease is a very good source of finance as it is easy to get an asset on lease and it’s a smart alternative to term loans against assets. It is not correct to say that lease is a short term loan, it can be best classified as a medium term loan. Some leases, like in case of land, are for a very long period, say 99 years. Hire purchase is a simple agreement between two parties where one party purchases the asset and transfers it to another party, the buyer party pays the dues in instalments over a period of time. There are many other sources of specialised finance like seed financing, bridge loans, debt securatisation etc.. 5.6 Modes of charges against a loan As we have seen in most of the cases any loan, be it debentures or bank loan, requires certain charges against assets of the company. These charges work as security for the lenders / investors. The term charge basically means that the assets under charge cannot be sold / disposed off without the permission of person holding that charge and

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the sale proceeds are first adjusted against the dues of charge holder. The various types of charges are as follows – 1. Pledge – a charge against goods (stocks) and movable assets 2. Hypothecation – a charge against goods (stocks) and movable assets 3. Mortgage – a charge against immovable properties like building, land etc. 4. Negotiation – A charge against negotiable instruments 5. Assignment – a charge against Life Insurance policy, NSC certificates etc. Different types of securities are given in the following paragraphs – 1. Personal and tangible security – The bank can always take action against the borrower, though prefers to take some kind of promissory note or a bond from the borrower. Many times bankers demand guarantee from a third party. This kind of security is termed as personal security. Under tangible security bankers prefer to take security of tangible assets which can be sold or transferred in case of default by the buyer. A good tangible security should be readily marketable. The most liquid form of such security is Fixed deposit with the bankers. 2. Primary and collateral security – Primary security is the principal security and is furnished to secure the repayment of advance. It is deposited by the borrower himself. The term collateral security is applied when a supporting security is given along with the primary security. Example – A gives his stock as primary security and his friend Y deposits his shares as collateral security for the loan taken by A. 3. Margin – A bank keeps certain margin on any security hypothecated or mortgaged to it. The difference between value of security and the amount upto, which the borrower can withdraw, is known as margin. The margin is necessary since in case of default by the borrower the bank may not be able to realise the full value of such security. The percentage of margin depends on the creditworthiness of the borrower and of the security i.e the margin may be higher in case of hypothecation of shares than that of gold.

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5.7 Self examination questions objective type ( a question can have more than one option as correct answer) 1. Which of the following conditions should be satisfied for issuing Commercial paper – a. The issuing company must have a tangible net worth of Rs 4 crores are more as per latest balance sheet b. The company should be having profit above Rs 10 crores in last financial year c. The company must have a working capital limit not less than Rs 4 crores d. The current ratio should be minimum 1.33 : 1 as per latest balance sheet e. The company must have some specified ratings from institutions like CRISIL etc f. The borrowal account of the company should be classified as standard asset by the company’s bankers g. Company must not have any debentures outstanding. 2. What are the advantages of raising funds through equity shares – a. b. c. d. e. f.

It is a very low cost option of raising funds Issue of equity shares carry lesser risk as they are not repayable There is no security required for raising equity capital Dividend is allowed as a deduction for taxation purposes All of the above None of the above

3. A company wishes to raise a short term loan without undertaking heavy documentation, which source it shall prefer – a. Commercial paper or inter-corporate deposit

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b. c. d. e.

Cash credit Overdraft Public deposit Debentures

4. A supplier of goods wants to encash his outstanding bills to fund his expenses, he should use – a. b. c. d.

Bill discounting Bank overdraft Cash credit None of the above

5. Venture capital funding is more recommended to – a. b. c. d.

Inexperienced and highly qualified entrepreneurs Unskilled businessmen Government Corporate sector

Detail questions 1. Write a detailed note on various factors a finance manger need to consider before raising funds from any source 2. What are the various modes of raising short term funding from banks 3. Distinguish between equity funding and debenture funding, specifically stating its advantages and disadvantages 4. Write a note on commercial paper 5. Explain various types of charges against the assets

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6 Cost of capital and capital structure theories 6.1 Introductions As we have already discussed in the first chapter; the basic function of a finance manager is procurement of funds. We have also seen the basic problems faced in procurement of funds is availability of funds, cost of procurement, risk involved, management perceptions etc. It is a big task for a finance manager to optimise the mix of procurement of funds (i.e. deciding a right capital structure), which will take care of all the factors mentioned above. Though theoretically calculation of capital structure depends solely upon one factor that is wealth maximisation. For achieving this goal the finance manager has to ensure that the cost of capital is minimum, as lower the cost of capital higher will be the firms wealth at any given level of profitability. In this chapter we’ll be seeing the methods of calculating cost of each source of capital and overall cost of capital. 6.2 Considerations in Capital structure planning The term capital structure simply means the mix of sources from which an organisation raises it’s long term funds. To take an example – A ltd. wants to start a new business and the estimated requirement of funds is Rs 10,00,000. The company has options of contributing the money from it’s reserves, issue fresh equity, raise bank loan or issue preference shares. Now the finance manager of A ltd faces 2 questions – 1. Which sources to be used; and 2. How much to borrow from each source. Answers to this 2 questions is nothing but planning the capital structure of the company 97

In planning the capital structure one must consider following points – 1. There is no definite model of capital structure i.e. it is not fix that a capital structure having ……% of equity and ……% debt is ideal. Each and every organisation has to decide on it’s own mix of capital structure considering it’s preferences and objectives. It is therefore important to note that different types of capital structure will be required for different types of undertakings 2. Government policy – It is a major factor in planning capital structure. Example can be taken of bank loans and public deposits, The interest rates and other requirements of these two sources are continuously monitored by Reserve bank of India and one major change in it may affect the organisation heavily. 3. Taxation laws – Taxation laws always play a decisive role in determination of capital structure. Example –Preference dividend is not tax deductible and therefore it is costlier source of finance. If in future it is made tax deductible, then it will be a much more attractive source of finance. 4. Cost of funds – as discussed earlier the ideal capital structure must have minimum cost, so that the wealth can be maximum 5. Flexibility – The company should be able to raise further funds quickly, also company should be able to repay some of the capital 6. Solvency – The capital structure should not have high risk of insolvency. This can be achieved by raising certain amount by way of non refundable funds. 7. Lesser Risk – Though loan funds are cheaper the company should not take 100% funds as loan, as the risk factor associated with the company increases substantially 8. Control – An ideal capital structure always ensure minimum loss of control over the company. 9. Earnings per share – Capital structure affects the earnings per share of a company and thus the returns to the shareholders. The finance manager must take this into consideration before deciding the capital structure. 10. Legal requirements – Legal requirements must be taken into consideration while deciding upon the capital structure, like, in India, Public deposits can be raised only by limited companies and not by private companies 11. Availability of funds – It is not possible that all the organisations can raise finance from all the sources of funds and therefore a finance manager has to consider the availability of sources of funds for his organisation before deciding

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the capital structure. In India only companies are allowed to raise debentures or raise equity capital carrying limited liability. 12. Purpose of finance - The purpose of raising the finance is essential for determining the capital structure of the company. Finance manager should not raise long term funds when the company requires short term financing, say for funding its working capital requirements. 13. Period of finance – This is again an important constraint, a company requiring funds only for 5-6 years may not go for a fresh equity issue but may prefer going for bank loans or debentures. 14. Investors perceptions – The finance manager has to consider the requirements of proposed investors before raising the funds 6.3 Determination of cost of various sources of finance We have already seen that cost of capital is a significant factor in determining the capital mix. The basic aim of running an undertaking is to earn a return at least equal to it’s cost of capital. The first step, after estimation of financial requirements, in determining capital structure is perhaps determination of cost of various sources of capital available to the company. The various sources of finance, methods of determination cost those sources of capital can be determined as follows – a. Cost of debt - Determination of cost of debt is a very easy task as compared to determination of cost of equity. Ideally cost of debt should be simply the rate of interest agreed, but in practice this is hardly the case. There are two major factors which determines the cost of debt – 1. Taxation 2. Actual inflow of funds Let us take one example to clarify further – Company A issues 15% debentures having face value of Rs 100 each (students should note that interest / dividend is always payable on face value) if the company issues the debentures @ Rs 100 and if there is no taxation then the cost of debt is 15%. But now let us assume that the company issues this debentures @ Rs 120 each (this is a regular practice to issue debentures at a premium or discount) and the company pays it’s taxes @ 40%. Now the cost to company is per debenture issued = Interest – tax saved on interest / amount received = 15-(15*40%) / 120 = 15-6 / 120 = 7.5% Now it can be clearly seen that though apparently the cost of raising funds is 15%, due to taxation and premium it is coming top half i.e. 7.5%. To put it as a formula –

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Kd = I * (1-T) / P Where, Kd = Cost of debt I = Interest T = Taxes P = Net proceeds to the company

Illustration 6.3.1 company issues Rs 10,00,000 12% debentures of face value Rs 100 each. The company pays income tax @ 40%. Calculate the cost of capital of the company considering that the issue is @ 10 % premium, 10% discount. Also consider a case where the company pays a brokerage for issue of debentures 2% and issues it at par. Solution 1. Cost of debentures, when company issues debentures @ 10% premium, can be calculated as follows Kd

= I (1 – T) / P = 1,20,000 (1 - 0.4) / 11,00,000 = 72,000 / 11,00,000 = 6.54%

2. Cost of debentures, when company issues debentures @ 10% discount , can be calculated as follows Kd

= I (1 – T) / P = 1,20,000 (1 - 0.4) / 9,00,000 = 72,000 / 9,00,000 = 8%

3. Cost of debentures, when company issues debentures par and pays the brokerage, can be calculated as follows Kd

100

= I (1 – T) / P = 1,20,000 (1 - 0.4) / 10,00,000 –2%(10,00,000) = 72,000 / 9,80,000 = 7.35%

b. Cost of preference shares – In the case of preference shares, the dividend cannot be taken as cost; the reasons are same as that of debt fund. The proceeds from issue of preference shares vary because of issue price and other charges, similarly taxes may be payable on preference dividend which increases its cost. Let us see one example Illustration 6.3.2 Suppose a company issues 1000 12% preference shares of face value Rs 100 at Rs 105 each. The company pays Rs 5,000 as underwriting commission. The company is required to pay a dividend tax of 10% on the dividend paid by the company. Calculate the cost of preference share capital to the company. Solution – cost of preference shares

= (Dividend + tax on dividend) / net proceeds = 12,000 + 10%(12,000) / (1,05,000 – 5,000) = (12,000 + 1,200) / 1,00,000 = 13,200 / 1,00,000 = 13.20 %

Here, we can note that the cost has gone up because of the dividend tax, which the company is required to bear. Illustration 6.3.3 A company issues Rs 10,00,000 12% preference shares of face value Rs 100 each. The company pays dividend tax @ 10%. Calculate the cost of capital of the company considering that the issue is @ 10 % premium, 10% discount. Also consider a case where the company pays a brokerage for issue of debentures 2% and issues it at par. Solution 1. Cost of Preference shares, when company issues @ 10% premium, can be calculated as follows Kp

= 1,20,000 + (1,20,000 * 10%) / 11,00,000 = 1,32,000 / 11,00,000 = 12 %

2. Cost of Preference shares, when company issues @ 10% discount , can be calculated as follows Kp

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= 1,20,000 (1,20,000 * 10%) / 9,00,000 = 1,32,000 / 9,00,000 = 14.67%

3. Cost of Preference shares, when company issues par and pays the brokerage, can be calculated as follows Kp

= 1,20,000 (1,20,000 * 10%) / 10,00,000 –2%(10,00,000) = 1,32,000 / 9,80,000 = 13.47 %

It can also be noticed that the cost of 12% debentures is substantially cheaper than the cost of preference shares. This is because Dividend do not have any tax benefit, in fact it adds to the cost to company. c. Cost of equity shares – Calculation of the cost of ordinary shares is a complex procedure, as the dividend rate is not fixed as in the case of preference shares. Thus the calculation of cost of equity shares is not just mathematics but it requires analysis of investors’ perceptions and price movement of shares. There are four main approaches for determining the cost of equity shares, those are – 1. 2. 3. 4.

Dividend price approach (D/P) Price earning approach (E/P) Dividend and growth approach (D/P + growth) Realised yield approach

The above mentioned approaches are discussed below : 1. Dividend price approach – According to this approach the amount of dividend is what is expected by the equity shareholder and hence the dividend is the cost of equity shares. The cost of equity shares can be determined with the help of the dividend amount and the market price of the shares. Let us assume that Mr A wants to invest in company B on the expectation that the company will pay @20% dividend on face value of Rs 100, now let us suppose that the company declares dividend of Rs 10 per share (10%), now as Mr A wants 20% returns on his investment he will be ready to invest Rs 50 (10 /20%) so that he’ll get 20% return on his investment. Hence the market price varies according to the dividend as the cost of capital (dividend rate expected) remains the same. Let us take one more example – Illustration 6.3.4 Market price of equity shares of A ltd (face value Rs 10) is Rs 15. If the company is paying dividends to its shareholders consistently @20% and is expected to maintain it’s rate of dividend, calculate the cost of equity shares of the company. Also calculate the market price of the company, if, due to some reasons the investors start expecting 12% returns from the company. Solution –

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Cost of equity shares = Dividend / Price *100 = 2/15 *100 = 13.33% It can be said that to maintain the current market price (i.e. Rs. 15) the company should declare dividend @ 20% every year. Now if the investors start expecting 12% returns from the company then the market price of the company will be – Dividend / price = cost of capital 2/ price = 12% Price = 2/12% = Rs. 16.67 The approach is very simple to apply but is based on an unpractical assumption that investors only look forward to dividend as the source of return. Though dividend plays a key role in determining the market price, and thus the cost of equity capital, it is not the sole determinant of the market price. This approach fails to take into account other factors, the most important being the capital appreciation in the value of shares. Now consider a practical case of Infosys technologies Ltd. – The market price of the shares of the company is say Rs 4000 ( face value Rs 5 per share), the company is consistently declaring dividend @ 200%, now let us calculate the cost of capital of the company ( which is nothing but the investors expected returns from the company) as per the D/P approach – Cost of equity share capital

= Dividend / Price *100 = (5*200%) /4000 *100 = 10 /4000 * 100 = 0.25%

Now as per D/P approach the cost of capital of the company is 0.25% per annum, which is highly impossible as the investor can simply invest in Fixed Deposit of a nationalised bank @ 6% without any risk. The term risk is important as if the investor invests Rs 4000 in shares the share value may come down drastically in even one day, whereas the amount of fixed deposit remains the same. Thus day by day this approach is losing significance (especially for listed companies), as today’s investors are more keen on capital appreciation of the share price rather than the amount of dividend. 2. Price Earning approach – According to this approach the market price of shares of a company depends upon the earnings of accompany and not dividend. To simplify it can be said that the cost of equity shares is based on the expected rate of earnings of a company. The argument is that each investor expects a certain amount of earnings, whether distributed or not, from the company in whose shares he invests. Illustration 6.3.5

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An investor expects a return in terms of earnings @ 20% from a company and face value of the company is Rs 100. Calculate the market value of the shares of the company if the company is earning @ 50% ( i.e. earnings per share = Rs 50) Solution – Cost of equity capital 20% Price

= Earnings / Price = 50 / Price = 50 /20% = Rs 250 per share

This approach seems to nullify the effect of dividend on the share price. Though practically it is more acceptable, this approach also does not seem to solve the problem of calculation of cost of equity capital. 3. Dividend and growth approach (D/P + growth) – This approach advocates that investors expect not only dividend but also growth in the earnings expected from the retained reserves. This growth rate in dividend (g) is taken to be equal to the compound growth rate in the earnings per share. Illustration 6.3.6 Calculate the cost of capital of company A if expected dividend from company A is Rs 5 and the market price of the company is Rs 50, the growth expected in the dividends and earnings is 5% per annum. Solution – Ke

= D / P*100 + G = 5 / 50 * 100 + 5% = 15%

Where, Ke = Cost of equity capital D = Expected dividend P = Current market price G = expected growth in the earnings and dividend Though this approach is a more realistic approach, it does not answer how to quantify the expected dividend and the growth rate. 4. Realised yield approach – This approach advocates that the past experience about the yield is the best estimate of the cost of capital as the same trend can be expected to continue. The formula used is just the same as that of dividend + growth approach, the only difference is instead of expected dividend and growth, past dividend and growth is considered. This approach is quite useful for stagnant companies or companies having a moderate estimable growth rate.

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New age companies growing at unexpected rate can not use this model to determine their cost of capital. It can be seen that all the four approaches are based on different factors and may give totally different answers. Which approach should be used by a particular company remains a question. A finance manager has to consider circumstances peculiar to his company before using a particular approach. For example companies following steady dividend policy may use dividend price approach. d. Cost of reserves – It is commonly believed that the reserves do not have cost, which is not correct. Reserves are part of earnings which belongs to shareholders and should be rightfully distributed to the shareholders. It is like reinvestment by shareholders of their funds. Thus the cost of reserves can be said to be the cost of ordinary equity shares. Illustration 6.3.7 A company’s share is quoted in market at Rs 60 (face value Rs 10). The company pays Rs 3 as dividend and expected growth rate by the investor is 12%. Please compute a. The company’s cost of equity capital using all possible methods. b. If expected growth rate is 13% per annum calculate the market price per share under dividend growth approach. c. If the company’s cost of capital is 16% and anticipated growth rate is 11% per annum Solution – The relationship among cost of capital, dividend, price and expected growth rate is given by formula: I Dividend price model Cost of equity capital

= Dividend / Price * 100 = 3 / 60 *100 = 5%

I Dividend and growth model a. Cost of equity capital

= Dividend / Price * 100 + growth = 3/60*100% + 10% = 5% + 10% = 15%

b. Market price

= Dividend / (cost of equity capital – growth rate)

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= Rs 3 / (15% -13%) = 3 / 2% = Rs 150 c. Market price

= Dividend / (cost of equity capital – growth rate) = 3 / (16% - 11%) = 3 / 5% = Rs 60.

6.4 Weighted average cost of capital The overall or composite cost of all the sources put together is called weighted average cost of capital. While making important financial decisions weighted average cost of capital is used. Each investment is financed from a pool of funds which represents various sources from which the funds have been raised. Any decision of investment therefore has to be made with reference to the overall cost of capital and not with reference to a specific source of fund. The weighted average cost of capital can be calculated as follows – Ko = K1*W1+K2*W2……….+ Kn + Wn Where, K0 = Weighted average cost of capital K1,2………n = cost of sources 1,2….n W1,2,……..n = Weight of sources 1,2…….n Illustration 6.4.1 Consider the following capital structure of A ltd.: Rs. Equity capital 4,00,000 Reserves 1,00,000 Preference shares 1,00,000 Long term loans 2,00,000 Total 8,00,000 The cost of various sources are – Equity capital = 20%, Preference shares = 12%, Loans = 10% Calculate the weighted average cost of capital and make suitable assumptions. Solution – Assumptions –

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a. Cost of retained earnings is taken to be same as cost of equity b. There are no taxes, as taxes will reduce cost of loan. Computation of weighted average cost of capital (WACC) Source Proportion a Equity capital Reserves Preference shares Loan Overall cost of capital Illustration 6.4.2

Cost B

0.50 0.125 0.125 0.25 1.00

20% 20% 12% 10%

Weighted cost a*b 10% 2.50% 1.50% 2.50% 16.5%

Consider the following capital structure of A ltd.: Rs. Equity capital 5,00,000 Reserves 1,00,000 Preference shares 2,00,000 Long term loans 7,00,000 Total 15,00,000 The cost of various sources are – Equity capital = 20%, Preference shares (before taxes) = 12%, Loans (before taxes) = 15%. Tax rate on income is 40%, company is required to pay 10% tax on preference dividend. Calculate the weighted average cost of capital and make suitable assumptions. Solution – Assumptions – a. b.

Cost of retained earnings is taken to be same as cost of equity The cost of equity shares is calculated after considering taxation.

Cost of capital after taxes are – 1. Preference shares = Dividend rate + tax on dividend = 12% + 1.2% = 13.2% 2. Loan = Interest – tax on interest = 15% - 40%(15) = 9% Computation of weighted average cost of capital (WACC) Source Proportion A

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Cost B

Weighted cost a*b

Equity capital Reserves Preference shares Loan Overall cost of capital

0.33 0.07 0.13 0.47 1.00

20% 20% 13.2% 9%

6.67% 1.40% 1.72% 4.23% 14.02%

6.5 Theories of cost of capital Though there are many methods suggested and books written on this subject, there are two popular approaches followed for determination of cost of capital viz. the traditional approach and Modigliani and Miller approach. 6.5.1 Traditional approach – The traditional theorists argue that a firms overall cost of capital changes with the change in mix of its of debt and equity i.e. by increasing the amount of loan content in the total capital or by decreasing the same. Loans are cheaper than equity, because interest rates of loans are lesser than rates of equity and interest is tax deductible. Traditional approach says that as the proportion of debt increases in the company the weighted average cost of capital goes down and vice versa. Increase in debt increases the risk associated with the firm and high proportion of debt again increases the cost of capital. This phenomenon can be illustrated with the following diagram –

W A C C DEBT WACC – Weighted average cost of capital Thus, a company should strive to reach the optimal capital structure and increase the debt mix only till the WACC is reducing. Reaching this optimal level, practically, is a difficult task but a finance manager should starve for this level.

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Illustration 6.5.1 (self examination question) Company A wants to raise Rs 1,00,000 from debt and equity source. The cost of equity capital is expected to be 20% and that of debt is 10% (net of tax). The company expects the cost of equity to go up by 1% with every 10% (10% of total Rs 1,00,000) increase in debt mix (i.e. if debt goes above Rs 10,000 then the cost will go up to 21%) similarly the debt cost is also likely to go up by 1.5% with every 10% increase in the debt share of total amount. You are required to calculate the optimal level of debt and equity mix of the company where the WACC will be minimum. 6.5.2 Modigliani and Miller approach [MM] – The other approach is that of Modigliani and Miller. They argue that the total cost of capital any given organisation is independent of its method and level of financing. In other words they advocated that the change in debt equity mix does not affect the cost of capital at all and the total cost of capital of an enterprise remains the same. They make the following proposition – 1. The total market value of a firm and its cost of capital are independent of its capital structure. The total market value of the firm is given by capitalising the expected stream of operating earnings at a discounted rate considered appropriate for its risk class 2. The cut off rate for investment purposes is completely independent of the way in which the investment is financed Modigliani and Miller takes an example of arbitrage to prove the hypothesis. Some of the assumptions made by Modigliani and Miller like no taxes, existence of capital market are totally impracticable. In current scenario their statement that the debt mix does not affect the cost of capital seems to be not applicable, as debt mix is taken into consideration by the investors before investing in a company. The following formula elaborates the theory of Modigliani and Miller – Ke = Ko + (Ko – Kd) * Debt / equity Where, Ke Ko Kd

= Cost of equity = Overall cost of capital = Cost of debt

Illustration 6.5.2 Company A has a capital of Rs 2,50,000 and has earnings before interest and taxes of Rs 50,000. The finance manager wants to take a decision regarding how its capital structure should be based on the following information –

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Amount of debt Rs. 0 50,000 1,00,000 1,50,000 2,00,000

Interest rate (%) (after tax) 0 8 8 9 9.5

Equity capitalisation rate (cost of equity) % 10 10.5 11.0 11.5 12.3

You are required to determine the WACC and the optimum capital structure by traditional approach. Also determine the equity capitalisation rate (cost of equity) by MM approach Solution – 1. Calculation of optimum capital mix as per the traditional approach – The optimum capital mix is the stage at which the WACC is minimum Cost of equity (Ke) 0.10 0.105 0.110 0.115 0.123

Weight of equity (We) 2,50,000 2,00,000 1,50,000 1,00,000 50,000

Cost of debt (Kd) 0 0.08 0.08 0.09 0.095

Weight of debt (Wd) 0 50,000 1,00,000 1,50,000 2,00,000

Ke * We

Kd*Wd

Ko

25,000 21,000 16,500 11,500 6,150

0 4,000 8,000 13,500 19,000

25,000 25,000 24,500 25,000 25,150

The optimum capital mix is debt of Rs 1,00,000 and equity of Rs 1,50,000 as the WACC is minimum at this level ( Rs 24,500) 2. According to MM approach the overall cost of capital remains unchanged and the cost equity rises linearly with cost of debt. The cost equilibrium of of capital is equal to equity capitalisation rate which is 10% in present problem. The equity capitalisation rate can be capitalised as follows – Ke = Ko + (Ko – Kd) * Debt / equity Where, Ke Ko Kd

= Cost of equity = Overall cost of capital = Cost of debt

Debt (Rs.)

Kd (%)

Ko (%)

Ko+(Ko-Kd)

0 50,000

0 8

10 10

10+(10-0) 10+(10-8)

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Debt / equity 0 1/4

Ke (%) 10 10.5

1,00,000 1,50,00 2,00,000

8 9 9.5

10 10 10

10+(10-8) 10+(10-9) 10+(10-9.5)

2/3 3/2 4

11.3 11.5 12

6.6 Self examination questions 6.6.1 Objective questions 1. State whether following statements are true or false, giving reasons a.

Increase in debt funds increases the risk associated with the company -

b. MM argues that the cost of capital of a firm remains unchanged though the debt equity mix in the capital structure is changed c.

Excessive debt may affect the solvency position of a company

d.

Taxation policies do not have any effect on the cost of capital

e.

Preference shares is the cheapest source of finance

f. A company should never opt for debt option as it increases the risk of insolvency g.

Reserves do not have any cost

h.

Equity share issue has a risk of losing control.

i. A finance manager has to consider various government policies before deciding the capital structure of the company 2. A finance manager has to consider risk, ……… and ……….. before deciding the capital structure of the company. 3. Cost of debt is ………………. Than cost of share capital 4. The cost of reserves can be taken to be same as ……………. 5. …………… Source of finance is cheapest because of it’s tax advantage

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6. Dividend tax increase cost of both ……………. and ………… 7. ………….., ………….., …………, ……………. are the four approaches followed for valuation of cost of equity shares. 8. quantification of cost of equity shares is a difficult task because it does not carry ………..

9. As per MM approach the cost of capital …………………. Even if the debt equity mix is altered. 6.6.2 subjective questions 1. Explain the major considerations of capital structure planning 2. What is weighted average cost of capital ? and how it is calculated ? 3. Explain the risk, cost and control risk associated with each source of finance. 4. Explain the traditional approach of cost of capital with the help of suitable graph. 5. What is Modigliani and Miller approach of cost of capital Problems 6. A company issues Rs 5,00,00,000 14.5% debentures of face value Rs 100 each. The company pays income tax @ 32.5 %. Calculate the cost of capital of the company considering that the issue is @ 12 % premium, 12% discount. Also consider a case where the company pays a brokerage for issue of debentures 2.25% and issues it at par. 7. Company A has a capital of Rs 3,85,000 and has earnings before interest and taxes of Rs 78,000. The finance manager wants to take a decision regarding how its capital structure should be based on the following information – Amount of debt Rs. 0 35,000 1,00,000 1,50,000 2,00,000 3,00,000

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Interest rate (%) (after tax) 0 8.5 8.75 9.25 10 10.75

Equity capitalisation rate (cost of equity) % 11 11.25 11.50 12.50 12.75 12.75

You are required to determine – 1. The WACC and the optimum capital structure by traditional approach. 2. Also determine the equity capitalisation rate (cost of equity) by MM approach 8. Consider the following capital structure of A ltd.: Equity capital Reserves Preference shares Long term loans Total

Rs. 15,00,000 12,00,000 12,00,000 27,00,000 66,00,000

The cost of various sources are – Equity capital = 22.5%, Preference shares (before taxes) = 13%, Loans (before taxes) = 16%. Tax rate on income is 40%, company is required to pay 10% tax on preference dividend. Calculate the weighted average cost of capital and make suitable assumptions. 9. A company’s share is quoted in market at Rs 160 (face value Rs 10). The company pays Rs 8 as dividend and its earnings per share is Rs 12. The expected growth rate by the investor is 15%. Please compute a. The company’s cost of equity capital using all possible methods. b. If expected growth rate is 17% per annum calculate the market price per share under dividend growth approach. c. If the company’s cost of capital is 17% and anticipated growth rate is 12% per annum 10 Suppose a company issues 5000 13% preference shares of face value Rs 100 at Rs 90 each. The company pays Rs 3,000 as underwriting commission. The company is required to pay a dividend tax of 12.5% on the dividend paid by the company. Calculate the cost of preference share capital to the company. 11. Calculate cost of each source of capital and the WACC Equity capital Reserves Preference shares (15%) 18% debentures Total

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Rs. 22,00,000 8,00,000 15,50,000 14,28,000 59,78,000

Additional information – 1. Cost of Equity capital is 28% 2. Preference shares are issued at Rs 110 per share (face value Rs 100) 3. Debentures are issued at Rs 105 per debenture (face value Rs 100). 4. Tax rate on income is 33.5%, company is required to pay 12% tax on preference dividend. 11 An investor expects a return in terms of earnings @ 25% from a company and face value of the company is Rs 100. Calculate the market value of the shares of the company if the company is earning @ 60% ( i.e. earnings per share = Rs 50)

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7. Dividend policies 7.1 Introduction Dividend is amount paid to shareholders / owners for their investment in the company. Dividend is distribution of profits and the amount of profits left out after paying dividend is known as reserves. Dividend is of utmost importance in case unlisted companies at it is the only source of revenue available to shareholders for getting returns on their investment. In case of listed (listed on stock exchanges) companies also dividend is important, but the shareholders can get their returns also from appreciation in the share value. Deciding the dividend policy is an important function of the finance manager and is decided based on the primary aim of maximisation of shareholders wealth. Various approaches are followed for determining what should be ideal dividend policy; some of them are reproduced in this chapter. The factors, which affect the dividend policy of a company, can be discussed as below – a. Cash flows - Dividend payment automatically results in a cash outflow. The finance manager has to consider the cash flow position of the company before deciding the dividend policy of the company. Though a company may borrow funds to pay the dividend, it is not a prudent policy. b. Company’s expansion plans – As mentioned in the irrelevance approach below in this chapter, dividend decision can be dependant on the capital budgeting of the company. To make it simple it can be said that the dividend decisions depend heavily on the companies plans to invest in expansion etc. Companies having heavy growth may decide to keep dividends on hold, or declare lesser dividends even in year of huge profits to fund its expansion plans. Whereas stagnant companies may declare huge dividends as they may not have any expansion plans. c. Legal aspects - In many countries dividend cannot be declared without transferring a certain amount to reserves. Also dividend cannot be declared without providing for depreciation in the accounts of the company. Hence a finance manager has to take into account all the legal restrictions before declaring dividend. 115

d. Effect on market price of the company – This is one of the most important factor that determines the company’s dividend policy. Undoubtedly dividend declaration affects the market price of the company. The effect of dividend mainly depends upon the perceptions of the investors, their preference to liquidity and the reason for investment. e. Tax considerations – Dividend policy depends a lot on tax considerations. It is because the taxability affects both the company as well as the shareholders. The amount of dividend is decided after taking into consideration the structure of individual taxation and the dividend taxes. f. Level of inflation – The dividend decision is also linked up with the level of inflation in the economy. Increasing inflation inflates the net profit figures, whereas the value in real terms may remain constant. The prices of assets go up and the firm may require resources in excess of depreciation fund to replace its existing assets. This may result in lesser funds available for paying the dividends. Similarly the investors requirements also goes up with the increasing inflation and they may expect higher dividends, so that its value remains the same in real terms. g. Other factors – There are several other factors which affects the dividend policy of the company like Management perceptions, rate of inflation in the economy, industry practices, special occasions etc. 7.2 Walter approach Prof. James Walter argues that in the long run, share price reflect only the present value of expected dividends. Retentions influence stock prices only through their effect on further dividends. It can be used to calculate different possible market prices and considers the increase in dividend on account of internal returns on retained earnings. The formula is simple to understand and easy to compute. Walter gives the following formula – P

=

D + Ra (E-D) Ke Ke

Where, P Ra E D Ke

= Market value of equity shares of the company = Return on retained earnings ( return on reserves) = Earnings per share = Dividend per share = cost of equity i.e. equity capitalisation rate.

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Though this formula takes into consideration the internal rate of returns and cost of equity, the formula has certain shortcomings – h. The formula does not take into account taxation i. It ignores management policies and shareholders attitude towards the dividend j. It ignores legal restrictions on declaration of dividends. One important point in the Walter model is that it says – 1. if internal rate of return is more than the capitalisation rate then the company must retain as much as possible to maximise the share price i.e. 0% dividend and 100% retention will maximise the shareholders wealth. 2. If internal rate of return is lesser than the capitalisation rate then the company must declare maximum dividend to maximise the share price i.e. 100% dividend and 0% retention will maximise the shareholders wealth The above statements can be elaborated with the help of following illustration – Illustration 7.2.1 Consider the following data related to three companies A ltd., B ltd. and C Ltd

Internal rate of return (Ra) Cost of equity capital (Ke) Earnings per share (E)

A Ltd. (%)

B Ltd. (%)

C Ltd. (%)

15 10 Rs 8

20 15 Rs 10

10 15 Rs 8

Calculate the value of an equity share for each of these companies applying Walter’s formula, when Dividend payment ratio (i.e % dividend paid out of the earnings) is 50%, 25% and 90%. Also calculate the % of dividend at which the share price of each company will be maximum. Solution – 1. P

=

D + Ra (E-D) Ke Ke

When D/P ratio is 50%

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A Ltd. B Ltd. C Ltd. = (4 + 15% * ( 8- = (5 + 20% (10- = (4 + 10%(8-

When D/P ratio is 25%

When D/P ratio is 90%

4) / 10%) / 10%

5)/ 15%)/ 15%

4)/15%) /15%

= Rs 100

= Rs 77.78

= Rs 44.44

=(2 + 15% (8-2) / =(2.5 + 20%(10- = (2+10%(810%) / 10% 2.5)/15%) / 15% 2)/15%)/ 15% = Rs 110

= Rs 83.33

= Rs 40

=(7.2+15%(87.2)/10%)/10%

=(9-20%(109)/15%)/15%

=(7.2+10%(87.2)/15%)/15%

= Rs 84

= Rs 68.89

= Rs 51.52

2. As it can be seen in case of company A and company B the returns on retained earnings (Ra) is more than Cost of equity capital (Ke) when Ra > Ke, 0% dividend and 100% retention will maximise the share price Share price of Company A at 0% dividend payout ratio – Ra = 15 Ke = 10 P

= (0+15%(8-0)/10%)/10% = Rs 90

Share price of Company B at 0% dividend payout ratio – Ra = 20 Ke = 15 P

= (0+20%(10-0) / 15%) / 15% = Rs 88.89

3. As it can be seen in case of company C the returns on retained earnings (Ra) is lesser than Cost of equity capital (Ke) when Ra < Ke, 100% dividend and 0% retention will maximise the share price Share price of Company C at 100% dividend payout ratio – Ra = 10 Ke = 15 P

= (8+10%(8-8)/15%)/15% = Rs 54

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Hence it can be concluded that when Ra > Ke, Share price is maximum at 0% dividend and when Ra < Ke, share price is maximum when dividend is 100%. 7.3 Gordon approach Prof. Gordon asserts that investor prefers current dividend to the future capital gains, as future capital gain is uncertain. The dividend policy affects the market value of the shares. Under Gordon model the market price can be determined as follows – P=

E(1-Rr) Ke – (Rr*Ra)

Where, E Rr Ke Ra

= Earnings per share (EPS) = Retention ratio (E – D) = Cost of equity = Internal rate of returns

Thus the Gordon formula suggests that the market price of shares depend upon the dividend paid by the company and the expected growth rate. Illustration 7.3.1 Consider the following information of A ltd EPS Rate of return Equity capitalisation rate (Ke)

Rs 10 20% 17%

Find out the market price of share under Gordon model if the dividend payout is 50%, 25% , 75% Solution – P=

E(1-Rr) Ke – (Rr*Ra)

1. At 50% dividend payout – E = Rs 10 Rr = 50% (or 0.50) 119

Ra = 20%(or 0.20) Ke = 17% P

= 10(1-0.5) /0.17-(0.50*0.20) = 5 / 0.07 = Rs 71.43

2. At 25% dividend payout – E = Rs 10 Rr = 75% (or 0.75) Ra = 20%(or 0.20) Ke = 17% P

= 10(1-0.75) /0.17-(0.75*0.20) = 2.5 / 0.02 = Rs 500

3. At 75% dividend payout – E = Rs 10 Rr = 25% (or 0.25) Ra = 20%(or 0.20) Ke = 17% P

= 10(1-0.25) /0.17-(0.25*0.20) = 7.5 / 0.12 = Rs 62.5

7.4 Irrelevance approach The irrelevance approach suggests that dividend policy has no effect on the market price of the company. In short the market price is immaterial of that of dividend. According to this school of thought the value of firm depends upon the earning and not dividends. There are two models which advocates this approach, they are as follows – Residuals theory – As the name indicates this theory believes that the dividend is residual part of the earnings; the first decision taken is how much shall be reinvested. This theory is based on an assumption that investment proposals are financed by retained earnings. Thus dividends can not be maintained at a particular level year after year as it depends upon the company’s investment decision. Modigliani – Miller approach - The MM approach also is based on the concept that the market price depends upon the earnings and not the dividend. MM used the

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concept of arbitrage to elaborate this approach. The formuls given by MM is as follows – Po =

(Di + Pi) (1+Ke)

Where, Po = Current market price Di = Expected dividend at the end of period Pi = Expected market price at the end of period Ke = Cost of equity capital Similar to the MM approach on cost of capital, this approach also is more or less a theoretical approach as the assumptions are quite impracticable e.g. Assumptions like no corporate tax, existence of perfect capital market hardly stands correct in practice. To sum up though some approaches believe that dividend is irrelevant, in practice dividend is certainly a relevant factor for determining the market price, especially in Indian scenario it is a very important factor as Indians usually prefer liquidity. Illustration 7.4.1 Diamond engineering company has 10,00,000 equity shares outstanding at the start of the accounting year 1997. The ruling market price per share is Rs 150. The board of Directors of the company contemplates declaring Rs 8 per share as dividend at the end of the current year. The rate of capitalisation appropriate to risk class to which company belongs is 12% (Ke) a. Based on MM approach, calculate the market price per share of the company when the contemplated dividend is i. Declared and ii. Not declared b. How many new shares are to be issued by the company at the end of the accounting year on the assumption that the Net income for the year is Rs 2 crores? Investment budget is Rs 4 crores and i. The above dividends are distributed and ii. They are not distributed. c. Show that the total market value of the shares at the end of the accounting year will remain the same whether dividends are either distributed or not distributed. Also find out the current market value of the firm under both situations.

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(ICWA, Final, Dec 97) Solution – a. The formula given by MM is as follows – Po =

(Di + Pi)

1 + Ke Where, Po = Rs 150 Ke = 12% Di = 8 i. If dividend is declared 150 = (8 + Pi) / (1+0.12) Pi = (150 * 1.12) –8 Pi = Rs 160 ii. If dividend is not declared 150 = (0 + Pi) / (1+0.12) Pi = (150 * 1.12) –0 Pi = Rs 168 b. Calculation of number of shares to be issued

Net income Total dividend (10,00,000 * 8 ) Retained earnings

200 80 120

Rs lakhs Dividends not distributed 200 200

Investment budget

400

400

Amount to be raised by new issues (a)

280

200

160 1,75,000

168 1,19,050

Dividends distributed

Relevant market price (Rs per share) (b) No of new shares issued (a) / (b) c. Total number of shares at the end of the year

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Dividends distributed

Dividends not distributed

Existing shares New issue

10,00,000 1,75,000

10,00,000 1,19,048

Total no of shares (a)

11,75,000

11,19,048

160

168

18,80,00,000

18,80,00,064

Market price per share (b) Market value of shares (a) * (b)

To conclude total value of shares remains almost unaltered whether dividends are distributed or not.

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7.5 Self examination questions 7.5.1 Detailed questions – 1. Consider the following data related to three companies Z ltd., X ltd. and Y Ltd

Internal rate of return (Ra) Cost of equity capital (Ke) Earnings per share (E)

Z Ltd. (%)

X Ltd. (%)

Y Ltd. (%)

12 18 Rs 10.5

21 13 Rs 15

19 14 Rs 12

Calculate the value of an equity share for each of these companies applying Walter’s formula, when Dividend payment ratio (i.e % dividend paid out of the earnings) is 25%, 50% and 100%. Also calculate the % of dividend at which the share price of each company will be maximum. 2. Consider the following information of A ltd EPS Rate of return Equity capitalisation rate (Ke)

Rs 15 25% 15%

Find out the market price of share under Gordon model if the dividend payout is 50%, 25%, 75% 3. Company A has 55,000 equity shares outstanding at the start of the accounting year. The ruling market price per share is Rs 125. The board of Directors of the company contemplates declaring Rs 5 per share as dividend at the end of the current year. The rate of capitalisation appropriate to risk class to which company belongs is 15% (Ke) d. Based on MM approach, calculate the market price per share of the company when the contemplated dividend is i. Declared and ii. Not declared

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e. How many new shares are to be issued by the company at the end of the accounting year on the assumption that the Net income for the year is Rs 25,00,000? Investment budget is Rs 35,00,000 and i. The above dividends are distributed and ii. They are not distributed. f. Show that the total market value of the shares at the end of the accounting year will remain the same whether dividends are either distributed or not distributed. Also find out the current market value of the firm under both situations. 4. Write pros and cons of Walter model of dividend policy 5.Explain in details what are the factors a finance manager should consider before deciding the dividend policy of the company 7.5.2 objective questions – 1. Some of the key assumptions of Modigliani and Miller approach are – a. b. c. d.

No corporate taxes Existence of perfect capital market No transaction costs No government control

2. Gordon’s model asserts that – a. b. c. d.

Dividend policy is irrelevant for market price Investors prefer dividend rather than future appreciation in price Both None

3. Walter model argues that – a. Share price reflect only the present value of expected dividends b. Dividend policy is a residual decision and is a by-product of capital budgeting decision c. Investor only considers present dividend d. None of the above 4. Which one of the following is not a factor determining the dividend policy of the company – a. Taxation b. Legal requirements c. Company’s labour policies

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d. e. f. g. h.

Market expectations Cash flows Policy followed by the competitors Company’s expected returns on it’s investment Level of inflation in the economy

5. Which of the following is not a part of Walters formula – a. P b. Ra c. E d. Pi e. D

= Market value of equity shares of the company = Return on retained earnings (return on reserves) = Earnings per share = Expected market price at the end of period = Dividend per share

6. According to Modigliani and Miller – a. b. c. d.

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Dividend affects the market price Share price depends upon the earnings and not the dividend Inflation affects the dividend Bonus shares affect the market price

8. Capital budgeting 8.1 Introduction After studying sources of finance, estimation of financial requirements and cost analysis, we will now discuss the application of the finances raised. This investment of funds is also termed as capital budgeting. Capital budgeting decisions are necessary to decide where to invest, how much should be invested and which investment will be most beneficial to the company. 8.2 What is capital budgeting? The term capital budgeting indicates budgeting for capital assets. The capital budgeting mainly involves decisions as to setting up of new plant, expansion of existing facilities, make or buy decisions etc. It includes a financial analysis of various proposals regarding capital expenditure, mainly analysing the benefits arising from the project and choosing the best alternative. The capital budgeting decisions involve extensive use of various capital budgeting techniques. 8.2.1 Factors affecting the capital budgeting decisions - The reasons why these decisions are of utmost importance, and why it needs to be taken carefully can be summerised as follows – a. Generally capital budgeting decisions involve huge investment and loss of such investment may lead to bankruptcy of the company b. The decisions like purchase of land, plant, building, patents etc. cannot be reversed easily and it becomes a sunk cost. c. Capital budgeting decisions involve long term and permanent commitments and has an effect over the company’s future earnings.

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d. Capital budgeting decisions are necessarily backed by huge funding decisions and failure in the implementation of the project may lead to problem of excess funding. e. Capital budgeting decisions are tough to take as it is difficult to forecast he future cash inflows from the assets with accuracy. A businessman always has a number of opportunities to invest his money. A company manufacturing two wheelers may have numerous options of either buying a spare part say a spark plug or manufacture it by itself. Such kind of decisions involves various aspects like analysis of cost and benefit, opportunity costs, gestation period etc. Though our study of all these factors and techniques will be aiming to maximise the monetary profits, in real life there may be other factors that may affect the capital budgeting decisions. Some of the examples of such factors can be – Social aspects – a company may decide to undertake a social project even though it may not be economically viable Business aspect – A company maybe able to buy a product cheaper than manufacture it but still it may manufacture it for utilising its labour effectively, or to maintain the secrecy of the ingredients of the company’s products. Legal and political aspect – A project may be started at a particular location due to some legal or political aspects, even though the same project can be operated cheaper from some other location. Risk involved – A business man prefer investing in a low return low risk project, even though he may have an option to invest in some high risk and high return project. 8.3 Methods and techniques of capital budgeting The capital budgeting techniques are bifurcated between 2 broad approaches – a. Traditional techniques– 1. Payback period method 2. Accounting rate of returns method b. Discounted cash flow techniques – 1. Profitability index 2. Net present value method 3. Terminal value method; and 4. Internal rate of return (IRR) method Following are the traditional techniques of capital budgeting 8.3.1 Pay back period – This method is used to simply calculate the period within which the cost of the project will be completely recovered. The calculation is done on the basis of cash flows. The period of payback is the period within which the total cost of

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the project is recovered. Cash inflow is nothing but profit after tax but before depreciation Merits of the payback period method 1. The method is very simple to understand and apply. It clearly states the period till which no profit can be expected from the project. Knowing the payback period is essential for every investment as most of the businessman are interested in knowing when are they going to get their money back. 2. The method aims at selecting projects generating liquidity in earlier years, this is important for decision making when cash availability is a constraint and / or cost of capital is very high. 3. The payback period method is also used to analyse the risk associated with the project, lesser the payback period lesser the risk and vice versa. Demerits of the payback period method 1. The payback period method totally ignores profitability aspect and talks only about the capital recovery. Suppose A ltd wants to invest in a project having a payback period of 3 years and expects a return of 15% on its investment. If the payback period of project Z is 2.5 years and the return is 10% on the investment then A ltd will choose the project if the payback period method is followed, and end up getting lesser returns than what is expected. 2. It is not necessary that every businessman is interested in choosing a project with lesser payback period and he may be interested in choosing a project with higher profitability. 3. The method doers not take into consideration the time value of money and tha opportunity cost, which is considered under the net present value method. Illustration 8.3.1 Company A wishes to invest Rs 10,00,000 in a project. The estimated profit before depreciation and taxes is Rs 6,00,000 per year. The depreciation is to be provided @ 20% straight line on the project cost. The tax rate is @ 50%, calculate the payback period for the project. Solution – The cash flow from the project can be estimated as follows (i.e. Profit after tax + depreciation) –

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Profit before depreciation and tax Less : depreciation @20% on 10,00,000

Rs. 6,00,000 2,00,000

Profit before tax Less : Tax @ 50%

4,00,000 2,00,000

Profit after tax Add : depreciation

2,00,000 2,00,000

Net cash flow

4,00,000

* Students are requested to note that the cash flow should be calculated in this way only and do not reduce taxes directly from profit before depreciation and tax. Depreciation has been added back as it is non-cash expenditure The payback period

=

Rs

10,00,000 4,00,000

=

2.5 years or 2 years and 6 months.

If the finance manager is required to choose amongst two or more projects he will obviously choose the project having lesser payback period. Again before appraising a project the finance manager should also decide the maximum payback period which his company is willing to accept, so if he is appraising three projects having 5,6 and 7 years payback period Illustration 8.3.2 Company A is willing to invest in a project costing Rs 50,000. The company provides depreciation @ 20% on the project cost ( SLM method). The estimated profit after tax for 5 years is as follows – Year 1 2 3 4 5

Amount Rs. 0 550 1,700 3,250 6,750

Compute the payback period of the project Solution – 130

As the payback period can be calculated only on the basis of cash inflows, first step will be to identify the cash inflows – Year

Profit after tax

1 2 3 4 5

0 550 1,700 3,250 6,750

+

depreciation

=

10,000 10,000 10,000 10,000 10,000

Cash flow 10,000 10,550 11,700 13,250 16,750

As the cash flows are uneven we cannot simply divide the total cash out flow. Instead a total of cash flow after each year should be taken – Year

Cash flow

Cumulative Cash flow

1 2 3 4 5

10,000 10,550 11,700 13,250 16,750

10,000 20,550 32,250 45,500 62,250

It can be clearly seen that the payback period lies somewhere between year 4 and 5 It can be calculated as follows – Last years revenue = 16,750 Assuming that the revenue accrues evenly throughout the year, revenue per month = 16,750 / 12 = 1396. Now up-to year 4 we have recovered 45,500 that means Rs 4,500 remains to be recovered in year 5. Thus the no of months of year 5 required = 4500 / 1396 = 3.22 = nearly 4 months Hence the payback period = 4 years and 4 months. 8.3.2 Accounting rate of return method (ARR) – Accounting or average rate of return means the average annual yield on the project. The average rate of return is Profit after tax as a percentage of the total amount invested. It is simple mathematics like if A is getting Rs 12 on Investment of Rs 120 means he is getting 10% return on his investment (12/120). It is important to note here that this method does not take into consideration cash flows but considers profits Merits of the accounting rate of return method – 1. This method is easy to understand and apply

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2. It covers the major aspect of profitability and helps the investor in knowing his rate of return. Demerits of the accounting rate of return method – 1. It ignores the time value of money 2. It does not take into consideration the uneven flow of cash and does not calculate the returns on year to year basis 3. It is not a good comparing technique i.e. project chosen by using this method can be less profitable than the project rejected by using this technique. Illustration 8.3.3 A ltd is wishing to start a new project requiring a capital investment of Rs 15,00,000 and expected profit after tax as follows – Year

Profit after tax Rs. 75,000 1,00,000

1 2 3 4 5

1,87,500 1,95,000 1,20,000 6,77,500

Assuming that the project has only 5 years life and there will be no salvage value at the end of the 5th year calculate the ARR of the project. Solution – The ARR can be calculated with the help of following formula – ARR (in%)

=

Total profits * 100 Net investment in the project * no of years of profit

In current problem – Total profit Total investment Number of years

132

= Rs 6,77,500 = Rs 15,00,000 =5

ARR =

6,77,500*100 15,00,000 * 5

=

9.03%

Now consider the company has an option to invest the same amount @ 12% pa. Then it is quite clear that the company will not go for the project but will select to invest in the fixed deposit. Illustration 8.3.4 Let us consider that the same company does not have an option to invest in fixed deposit but has an option to choose one out of two projects having Profit after tax as follows (investment amount is same ) – Year 1 2 3 4 5

Project A 75,000 1,00,000 1,87,500 1,95,000 1,20,000

Project B 0 0 0 3,00,000 3,77,500

6,77,500

6,77,500

Assuming that the projects have only 5 years life and there will be no salvage value at the end of the 5th year calculate the ARR of both the projects. Solution – ARR of project A is already calculated in illustration 8.3.3, which is 9.03% ARR of project B =

Total profits * 100 Net investment in the project * no of years of profit

In current problem – Total profit Total investment Number of years ARR =

= Rs 6,77,500 = Rs 15,00,000 =5

6,77,500*100 15,00,000 * 5

133

=

9.03%

It can be clearly inferred from the ARR technique that both the projects are equal, though there is no revenue for three years in case of project B. This problem highlights the main limitation of this method. It can be clearly seen that choosing project A is better as the revenue starts in earlier years, though the ARR method is unable to pick project A as a better project

Following are the discounted cash flow techniques of capital budgeting 8.3.4 Net present value technique (NPV) or discounted cash flow technique – This is the most popular method for evaluation of a capital project. This method is designed to take into account the time value of money. Net present value of a project is nothing but the present value of all the cash flows spread over a period of time. Net Present Value (NPV) = CF0 + (1+K)^0

CF1 +…………………….+ (1+K) ^1

CFn (1+K)^n

Where, CF 0 to n = Cash flow at the end of year 0 to n. It includes both a cash inflow and a cash outflow. n K

= Life of the project = Cost of capital used as discounting rate.

This method of capital budgeting is based on determination of amount and timing of the cash flows. The cash flows include both cash inflows and cash outflows. The cash inflows can be calculated by simply adding depreciation and non-cash items to profit after tax. Merits of the Net present value method – 1. NPV method takes into account the time value of money 2. NPV is nothing but the value of money as on today, when it is received at a later date. This eliminates the drawbacks of ARR method as it considers timing of cash flow as well as uneven cash flows. 3. The whole stream of cash flows is considered

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4. It is the best way to analyse a project when the company has multiple choices as it is a very effective comparative analysis 5. It gives due weight-age to timing of cash flow, due to discounting the cash flows at a later date gets reduced more than the cash flows at earlier dates. It is obvious that the following 2 projects are not same even though their total cash flow is same Year Project A Project B 1 5,00,000 3,00,000 2 4,00,000 4,00,000 3 3,00,000 5,00,000 Assuming that the cash outflow of both the projects is same, Project A is better than projects B even though both projects have same total cash inflow. Calculation of net present value – Illustration 8.3.5 Let us assume that the initial cash out flow of project A is Rs 5,00,000.The project is expected to generate a cash inflow as follows – Year

Cash inflow Rs. 1 2 3 4 5

Total

1,15,000 1,14,000 1,34,000 1,40,000 2,50,000

7,53,000

Now assume that the discounting rate or the expected rate of return from project A is 10%. Calculate the net present value of project A and write your conclusions. Solution – 1. The concept of NPV requires calculating what Rs 1,15,000 is worth today when it is going to be received at the end of the year. To put it simply if a person can invest Rs 1,00,000 @ 10% for a year then he’ll receive Rs 1,10,000 at the end of the year or if he is receiving Rs 1,10,000 then it is worth Rs 1,00,000 today. This what is net present value. Now let us calculate the Present Value for Rs 1,15,000 @ 10% If a person invests Rs 100 today gets Rs 110 after 1 year, if he is getting Rs 1,15,000 after 1 year how much he is investing – 135

1,15,000 / 110 *100 = Rs 1,04,545 We can counter check it by – 1,04,545 + 104,545 * 10% = 1,15,000 2. In other word the multiplying factor @ 10% discounting rate for year 1 is 100/110 = 0.909 (which is present value of Re 1 received after 1 year). Similarly for year 2 it will be – 100 / 121 = 0.826. 121 is calculated as follows – 100*10%+100 = 110 + 110*10% = 121 (discounting rate is always calculated considering compounding interest)

3. The table of discounting @10% for 6 years is – Year Discount factor @ 10% 1 0.909 2 0.826 3 0.751 4 0.683 5 0.621 6 0.564 4. Calculation of NPV for the given project – Year

Cash inflows / (outflow)

0 1 2 3 4 5

(5,00,000) 1,15,000 1,14,000 1,34,000 1,40,000 2,50,000 NPV

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621

Present value Rs. (5,00,000) 1,04,545 94,164 1,00,634 95,620 1,55,250 50,231

5. To conclude we can say that @ 10%, effectively the company is getting Rs 5,50,231 as on today against the investment of Rs 5,00,000 and hence company is having a positive net present value of Rs 50,231. 6. A proposal can be acceptable (from financial viewpoint) only when its’ net present value = or > 0. 8.3.4.1 Discounting table at various discounting percentages (upto 10 years)

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Year 1 2 3 4 5 6 7 8 9 10

5% 0.952 0.907 0.863 0.822 0.783 0.746 0.710 0.676 0.644 0.614

8% 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463

10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322

Year 1 2 3 4 5 6 7 8 9 10

20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162

22% 0.820 0.672 0.551 0.451 0.370 0.303 0.249 0.204 0.167 0.137

25% 0.800 0.640 0.512 0.410 0.328 0.262 0.210 0.168 0.134 0.107

30% 0.769 0.592 0.455 0.350 0.269 0.207 0.159 0.123 0.094 0.073

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

16% 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227

Students should note that this table is not exclusive and in examination some other factor may also be asked (say 7% or 26%), students should master the art of calculation of these factors. Illustration 8.3.6 Company A is willing to invest in a project costing Rs 50,000. The estimated Cash flows for 5 years is as follows – Year

Amount Rs.

1 2 3 4 5

10,000 10,550 11,700 13,250 16,750

Calculate the NPV of the project @ 10% and 5% and comment on its viability Solution –

137

Calculation of the Net present value @ 10% discounting factor Year

Cash inflows / (outflow)

0 1 2 3 4 5

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621

Present value Rs. (50,000) 9,090 8,714 8,787 9,050 10,402 (3957)

Discounting factor @ 5% 1 0.952 0.907 0.863 0.822 0.783

Present value Rs. (50,000) 9,520 9,569 10,097 10,892 13115 3193

(50,000) 10,000 10,550 11,700 13,250 16,750 NPV Calculation of the Net present value @ 5% discounting factor Year

Cash inflows / (outflow)

0 1 2 3 4 5

(50,000) 10,000 10,550 11,700 13,250 16,750 NPV

Comment – The proposal is unacceptable at 10% discounting factor as the NPV is negative, whereas the same proposal is acceptable at 5% discounting rate as the NPV is positive. Note - a positive NPV means a more than expected returns, if a company is considering two projects and wishing to continue only with the one which is more profitable then the projects are compared at the same discounting rate and the project with higher net present value is selected even if NPVs of both the project are positive. Illustration 8.3.7 Please evaluate the following two projects with Net present value technique – Year 0 1 2 3 4 5

Cost

Project X (80,000) 20,000 10,000 35,000 40,000 50,000

Project Y (80,000) 50,000 40,000 20,000 15,000 15,000

Consider the project at 15% discounting rate and chose the better alternative. 138

Solution – Evaluation of project X @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(80,000) 20,000 10,000 35,000 40,000 50,000 NPV

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497

Present value Rs. (80,000) 17,400 7,560 23,030 22,880 24,850 15,720

Evaluation of project y @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(80,000) 50,000 40,000 20,000 15,000 15,000 NPV

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497

Present value Rs. (80,000) 43,500 30,240 13,160 8,580 7,455 23,235

Comments – As NPV of project Y is higher than that of project X it is better to accept project Y. It can be also noticed that the total cash inflow of project X is Rs 1,55,000 whereas total cash inflow of project Y is Rs 1,40,000 and still project Y is showing more returns under the NPV technique. This because of the time value of money, it highlights the point that the question when? is equally important as that of How much? Illustration 8.3.8 Company A ltd. is considering 2 projects – Project A costs Rs 95,000 and project B costs Rs 1,10,000, the cash outflow is split in 2 parts for project B half amount has to be paid immediately and half to be paid at the end of year 2. The expected cash inflows are as follows – Year 1 2 3 4 5 139

Project A 20,000 50,000 35,000 20,000 25,000

Project B 75,000 60,000 50,000 -

Evaluate the two projects with the NPV technique at 8% discounting rate. Solution – Evaluation of project A @ 8% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(95,000) 20,000 50,000 35,000 20,000 25,000 NPV

Discounting factor @ 8% 1 0.926 0.857 0.794 0.735 0.681

Present value Rs. (95,000) 18,520 42,850 27,790 14,700 17,025 25,885

Evaluation of project B @ 8% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(55,000) 20,000* 60,000 50,000 NPV

Discounting factor @ 8% 1 0.926 0.857 0.794 0.735 0.681

Present value Rs. (55,000) 17,140 47,640 36,750 46,530

* - Inflow – outflow = 75,000-55,000 = 20,000 Comments – Project B is better than project A as the NPV of project B is much more than project A. Illustration 8.3.9 Company A is considering a project with expected life of 5 years. The initial cash outflow is expected to be as follows – Machinery purchased Working Capital

Rs 2,72,000 Rs. 60,000 Rs. 3,32,000

140

The working capital will be fully realised at the end of the 5th year. The estimated scrap value of the plant is Rs 10,000 The expected cash flow is as follows Year Rs. 1 70,000 2 1,00,000 3 1,30,000 4 90,000 5 5,000 You are required to evaluate the project considering the rate of discounting to be 11% and 15% Solution – Evaluation of the project @ 12% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 5 5

(3,32,000) 70,000 100,000 130,000 90,000 5,000 60,000 10,000 NPV

Discounting factor @ 12% 1 0.893 0.797 0.712 0.636 0.567 0.567 0.567

Present value Rs. (3,32,000) 62,510 79,700 92,560 57,240 2,835 34,020 5,670 2,535

In the year 5 the realised current assets and scrap are taken as cash inflows. At 12% present value the project is acceptable as the NPV is positive. Evaluation of the project @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 5 5

(3,32,000) 70,000 100,000 130,000 90,000 5,000 60,000 10,000 NPV

141

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497 0.497 0.497

Present value Rs. (3,32,000) 60,900 75,600 85,540 51,480 2,485 29,820 4,970 -21,205

Comment – Though the project is acceptable at 12% discounting factor, it is not acceptable at 15% discounting factor as the NPV is negative 8.3.5 Profitability index method (PI) – This is a part of discounted cash flow technique and it explains the cost benefit relations between the inflows and the outflows of a proposal. The PI shows that how much inflows are expected for every one rupee of outflows. PI can be calculated as PI =

Present value of inflows Present value of inflows

Illustration 8.3.10 Please evaluate the following two projects with Net present value technique – Year 0 1 2 3 4 5

Project X (70,000) 30,000 20,000 35,000 40,000 50,000

Cost

Project Y (75,000) 50,000 40,000 20,000 25,000 5,000

Consider the project at 8% discounting rate and calculate the Profitability index of both the projects. Solution Calculation of PI of project x @ 8% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(70,000) 30,000 20,000 35,000 40,000 50,000 Total cash outflows Total cash inflows

142

Discounting factor @ 8% 1 0.926 0.857 0.794 0.735 0.681

Present value Rs. (70,000) 27,780 17,140 27,790 29,400 34,050 (70,000) 1,36,160

PI

=

Present value of inflows Present value of inflows

=

1,36,160 70,000

=

1.95

Calculation of PI of project Y @ 8% discounting rate

PI

Year

Cash inflows / (outflow)

0 1 2 3 4 5

(75,000) 50,000 40,000 20,000 25,000 5,000 Total cash outflows Total cash inflows

=

Discounting factor @ 8% 1 0.926 0.857 0.794 0.735 0.681

Present value Rs. (75,000) 46,300 34,280 15,880 18,375 3,405 (75,000) 118,240

Present value of inflows Present value of inflows

=

1,18,240 75,000

=

1.58

8.3.6 Internal rate of return (IRR) – Internal rate of return is the rate at which the discounted cash inflows are equal to discounted cash outflows. The internal rate of return of a project is the discount rate at which the net present value of a project is nil. The IRR is compared with the minimum rate of return expected by the firm for its investment. The merits of IRR method can be summarised as follows – 1. Its takes into account the time value of money

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2. It gives the exact amount of returns which the project is offering, unlike NPV method where positive NPV only denotes that the returns are more than the minimum desired returns and it never outlines the exact amount of returns 3. This method is independent of that of NPV method and may give different results from the NPV method. Demerits of the IRR method – 1. The calculation process is difficult and tedious 2. As it may give different results from that of NPV method, it is difficult to form a decision just on the basis of IRR method. Illustration 8.3.11 An investment of Rs 1,36,000 yields the following cash inflows – Year 1 2 3 4 5

Rs. 30,000 40,000 60,000 30,000 20,000 1,80,000

Calculate the internal rate of return of the above proposal Solution – Calculation of present value of project @ 8% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,36,000) 30,000 40,000 60,000 30,000 20,000 NPV

Discounting factor @ 8% 1 0.926 0.857 0.794 0.735 0.681

Present value Rs. (1,36,000) 27,780 34,280 47,640 22,050 13,620 9,370

Calculation of present value of project @ 10% discounting rate Year 144

Cash inflows / (outflow)

Discounting factor

Present value

0 1 2 3 4 5

(1,36,000) 30,000 40,000 60,000 30,000 20,000

@ 10% 1 0.909 0.826 0.751 0.683 0.621

Rs. (1,36,000) 27,270 33,040 45,060 20,490 12,420 2,280

Note – It can be noted that the NPV declines with the increase in the discounting rate as we are required to reach 0 we have to further increase the rate. Let us assume it to be 10.7% Calculation of present value of project @ 10.7% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,36,000) 30,000 40,000 60,000 30,000 20,000

Discounting factor @ 10.7% 1 0.903 0.816 0.737 0.665 0.602

Present value Rs. (1,36,000) 27,090 32,640 44,220 19,950 12,040 -60

The NPV @ 10.7% is –60 or almost nil. Many times it is impracticable to calculate the exact IRR and therefore the IRR at which the net present value closes to zero can also be taken as IRR. Note – though the IRR can be calculated by interpolation method, students can calculate by trial and error. The golden rule for trial and error method is – if IRR is negative at any given discounting rate use a lesser rate and if IRR is positive use higher rate.

Illustration 8.3.12 Please evaluate the following two projects by IRR technique – Year 0 1 2 3 4 145

Cost

Project X (1,01,600) 30,000 10,000 35,000 40,000

Project Y (85,000) 55,000 35,000 20,000 25,000

5

50,000

15,000

Solution 1. Calculation of present value of project X @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,01,600) 30,000 10,000 35,000 40,000 50,000 NPV

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497

Present value Rs. (1,01,600) 26,100 7,560 23,030 22,880 24,850 2,820

As NPV is positive NPV should be calculated at a higher rate – say 20% Calculation of present value of project X @ 20% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,01,600) 30,000 10,000 35,000 40,000 50,000 NPV

Discounting factor @ 20% 1 0.833 0.694 0.579 0.482 0.402

Present value Rs. (1,01,600) 24,990 6,940 20,265 19,280 20,100 -10,025

As NPV is negative NPV should be calculated at a lesser rate – say 16% (16% as NPV is closer to zero for 15%) Calculation of present value of project X @ 16% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,01,600) 30,000 10,000 35,000 40,000 50,000 NPV

146

Discounting factor @ 16% 1 0.862 0.743 0.641 0.552 0.476

Present value Rs. (1,01,600) 25,860 7,430 22,435 22,080 23,800 5

As NPV is 5 i.e almost zero, it can be said that the IRR of project X is 16% 2. Calculation of present value of project Y @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(85,000) 55,000 35,000 20,000 25,000 15,000 NPV

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497

Present value Rs. (85,000) 47,850 26,460 13,160 14,300 7,455 24,225

As NPV is positive, NPV should be calculated at a higher rate – say 30% Calculation of present value of project Y @ 30% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(85,000) 55,000 35,000 20,000 25,000 15,000 NPV

Discounting factor @ 30% 1 0.769 0.592 0.455 0.350 0.269

Present value Rs. (85,000) 42,295 20,720 9,100 8,750 4,035 -100

As NPV is –100, IRR is slightly lesser than 30% say 29.95%. In such case IRR can be taken as 30%. 8.4 Solved problems Problem 8.4.1 A ltd is evaluating a project having an initial investment of Rs 40,000 and the following cash inflows – Year 1 2 3 4 5 147

Rs. 5,000 7,000 7,000 6,000 12,000

6 7

15,000 10,000

The company’s opportunity cost is 12% and the company is wishing to evaluate the project on the basis of NPV method and profitability index (PI) method. Solution – Calculation of present value of the project @ 12% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 6 7

(40,000) 5,000 7,000 7,000 6,000 12,000 15,000 10,000 NPV

Discounting factor @ 12% 1 0.893 0.797 0.712 0.636 0.567 0.507 0.452

Present value Rs. (40,000) 4,465 5,579 4,984 3,816 6,804 7,605 4,520 -2,227

As NPV @12% discounting rate is negative the proposal should be rejected. Profitability Index

=

Present value of cash inflows Present value of cash outflows

PI

= 37773 / 40000 = 0.94

Problem 8.4.2 A company proposes to undertake two mutually exclusive projects AXE and BXE : Initial capital outlay Economic life (years) After tax annual cash inflows Year 1 2 3 4 5

148

AXE Rs 22,50,000 4 6,00,000 12,50,000 10,00,000 7,50,000 -

BXE Rs. 30,00,000 7 5,00,000 7,50,000 7,50,000 12,00,000 12,50,000

6 7

-

10,00,000 8,00,000

The company’s cost of capital is 16%. Please calculate the net present value and IRR for both the projects Solution 1. Calculation of NPV of both the projects Calculation of present value of the project AXE @ 16% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4

(22,50,000) 6,00,000 12,50,000 10,00,000 7,50,000 NPV

Discounting factor @ 16% 1 0.862 0.743 0.641 0.552

Present value Rs. (22,50,000) 5,17,200 9,28,750 6,41,000 4,14,000 2,50,950

Calculation of present value of the project BXE @ 16% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 6 7

(30,00,000) 5,00,000 7,50,000 7,50,000 12,00,000 12,50,000 10,00,000 8,00,000 NPV

Discounting factor @ 16% 1 0.862 0.743 0.641 0.552 0.476 0.410 0.354

Present value Rs. (30,00,000) 4,31,000 5,57,250 4,80,750 6,90,000 5,93,750 4,10,000 2,83,200 4,46,350

As NPV of project BXE is substantially higher than project AXE project BXE is more profitable. 2. Calculation of IRR of both the projects Calculation of present value of the project AXE @ 20% discounting rate Year

149

Cash inflows / (outflow)

Discounting factor @ 20%

Present value Rs.

0 1 2 3 4

(22,50,000) 6,00,000 12,50,000 10,00,000 7,50,000 NPV

1 0.833 0.694 0.579 0.482

(22,50,000) 4,99,800 8,67,500 5,79,000 3,61,500 57,800

Calculation of present value of the project AXE @ 21% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4

(22,50,000) 6,00,000 12,50,000 10,00,000 7,50,000 NPV

Discounting factor @ 21% 1 0.826 0.683 0.564 0.467

Present value Rs. (22,50,000) 4,95,600 8,53,650 5,64,000 3,50,250 13,500

The IRR of AXE appears to be slightly higher than 21% Calculation of present value of the project BXE @ 20% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 6 7

(30,00,000) 5,00,000 7,50,000 7,50,000 12,00,000 12,50,000 10,00,000 8,00,000 NPV

Discounting factor @ 20% 1 0.833 0.694 0.579 0.482 0.402 0.335 0.279

Present value Rs. (30,00,000) 4,16,500 5,20,500 4,34,250 5,78,400 5,02,500 3,35,000 2,23,200 10,350

Calculation of present value of the project BXE @ 21% discounting rate Year

Cash inflows / (outflow)

0 1

(30,00,000) 5,00,000

150

Discounting factor @ 21% 1 0.826

Present value Rs. (30,00,000) 4,13,000

2 3 4 5 6 7

7,50,000 7,50,000 12,00,000 12,50,000 10,00,000 8,00,000 NPV

0.683 0.564 0.467 0.386 0.319 0.263

5,12,250 4,23,000 5,60,400 4,82,500 3,19,000 2,10,400 -79,450

IRR of project AXE is slightly higher than 21% and in case of BXE it is slightly higher than 20%. Problem 8.4.3 Precision instruments is considering two mutually exclusive projects X and Y. Following details are made available to you : Rs. In lacs Project X Project Y Project cost Cash inflows Year 1 2 3 4 5

700

700

100 200 300 450 600

500 400 200 100 100

Assume no residual value at the end of fifth year. The firms cost of capital is 10%. Required, in respect of each of the two projects : i. NPV using 10% discounting rate ii. IRR and iii. Profitability index (ICWA inter, June 1995) Solution 1. Calculation of Net present value Calculation of present value of the project X @ 10% discounting rate Year

Cash inflows / (outflow)

0 1 2

(700) 100 200

151

Discounting factor @ 10% 1 0.909 0.826

Rs lakhs Present value Rs. (700) 90.90 165.20

3 4 5

300 450 600 Present value of inflows NPV

0.751 0.683 0.621

225.30 307.35 372.60 1,161.35 461.35

Calculation of present value of the project Y @ 10% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(700) 500 400 200 100 100 Present value of inflows NPV

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621

Present value Rs. (700) 454.50 330.40 150.20 68.30 62.10 1,065.50 365.50

2. Profitability index PI =

Total present value of all cash inflows Total present value of cash outflows

PI of project X

= =

PI of project Y

= =

1,161.35 700 1.659 1,065.50 700 1.522

3. Internal rate of return (IRR) Calculation of present value of the project X @ 27% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(700) 100 200 300 450 600 NPV

152

Discounting factor @ 27% 1 0.787 0.620 0.488 0.384 0.303

Rs lakhs Present value Rs. (700) 78.70 124 146.40 172.80 181.80 3.70

Calculation of present value of the project X @ 28% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(700) 100 200 300 450 600 NPV

By interpolation formula IRR = 27 +

Discounting factor @ 28% 1 0.781 0.610 0.477 0.373 0.291

Rs lakhs Present value Rs. (700) 78.10 122.00 143.10 167.65 174.60 -14.35

3.70 *1 3.70+14.35

= 27.21% IRRR of project X = 27.21% Calculation of present value of the project Y @ 37% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(700) 500 400 200 100 100 NPV

Discounting factor @ 37% 1 0.73 0.533 0.389 0.284 0.207

Rs lakhs Present value Rs. (700) 365 213.20 77.80 28.40 20.70 5.10

Calculation of present value of the project Y @ 38% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5

(700) 500 400 200 100 100 NPV

By interpolation formula IRR = 37 + = 37.63%

153

Discounting factor @ 38% 1 0.725 0.525 0.381 0.276 0.200

5.10 5.10+3

*1

Rs lakhs Present value Rs. (700) 362.50 210 76.20 27.60 20.70 -3.00

IRR of project Y = 37.63% Summary of both the projects Profitability index Net present value Internal rate of return

Project X 1.659 461.35 27.21%

Project y 1.522 365.50 37.63%

Problem 8.4.4 National electronics ltd., an electric goods manufacturing company, is producing a large range of electronic goods. It has under consideration 2 projects “X” and “Y”, each costing Rs 120 lacs. The projects are mutually exclusive and the company is considering the question of selecting one of the two. Cash flows have been worked out for both the projects and the details are given below. “X” has a life of 8 years and “Y” has a life of 6 years. Both will have zero salvage value at the end of their operational lives. The company is already making profits and its tax rate is 50%. The cost of capital of the company is 15%. The profit before depreciation and taxes are as follows Rs lakhs Year Project “X” Project “Y” 1 25 40 2 35 60 3 45 80 4 65 50 5 65 30 6 55 20 7 35 8 15 1. The company follows straight line method of depreciation. Find out NPV of both project [ICWA Inter, June 1996] 2. Also calculate Profitability index of both the projects Solution Calculation of cash flows of project X

154

Year

Profit

Depreciation

PBT

Tax

PAT

1 2 3 4 5 6 7 8

25 35 45 65 65 55 35 15

15 15 15 15 15 15 15 15

10 20 30 50 50 40 20 0

5 10 15 25 25 20 10 0

5 10 15 25 25 20 10 0

Cash flow (PAT + depreciation) 20 25 30 40 40 35 25 15

Calculation of present value of the project X @ 15% discounting rate Year

Cash inflows / (outflow)

0 1 2 3 4 5 6 7 8

(120) 20 25 30 40 40 35 25 15 NPV

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327

Rs lakhs Present value Rs. (120) 17.40 18.90 19.74 22.88 19.88 15.12 9.40 4.91 8.23

Calculation of cash flows of project Y Year

Profit

Depreciation

PBT

Tax

PAT

1 2 3 4 5 6

40 60 80 50 30 20

20 20 20 20 20 20

20 40 60 30 10 0

10 20 30 15 5 0

10 20 30 15 5 0

Cash flow (PAT + depreciation) 30 40 50 35 25 20

Calculation of present value of the project Y @ 15% discounting rate Year

155

Cash inflows / (outflow)

Discounting factor @ 15%

Rs lakhs Present value Rs.

0 1 2 3 4 5 6 7 8

(120) 30 40 50 35 25 20 NPV

1 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327

(120) 26.10 30.24 32.90 20.02 12.43 8.64 10.33

Comment – based on NPV technique project Y is better than project x . PI

=

PI of X = = PI of Y = =

Present value of all cash inflows Present value of cash outflows 128.23 120.00 1.07 130.33 120.00 1.09

Summary of both the projects Profitability index Net present value Lakhs)

(Rs.

Project X 1.07 8.23

Project y 1.09 10.33

Problem 8.4.5 AP Udyog is considering a new automatic blender. The new blender would last for 10 years and would be depreciated to zero over the 10 year period. The old blender will also last for 10 more years and would be depreciated to zero over the same 10 year period. The old blender has a book value of Rs 20,000 but could be sold for Rs 30,000 (The original cost was Rs 40,000). The new blender would cost Rs 1,00,000. It would reduce labour expenses by Rs 12,000 a year. The company is subject to a 50% tax rate on regular income as well as capital gains. Their cost of capital is 8%. There is no investment tax credit in effect. You are required to – a. Identify all the relevant cash flows this replacement decision. b. Compute the present value, net present value and profitability index 156

c. Find out whether this is an attractive project. (CS final June 97) Solution – i. Calculation on the sale of the old machine

Rs.

Sale price

30,000

Book value Profit on sale Tax on sale @ 50%

20,000 10,000 5,000

After-tax cash receipts from sale of old machine (30,000 – 5,000)

25,000

ii. Cash outflow to replace old machine with new : Cost of new machine Cash flow from sale of old machine

1,00,000 25,000

Net cash flow

75,000

iii. Depreciation on new machine = 1,00,000 / 10 = Rs 10,000 Depreciation on old machine = 20,000 / 10 = Rs 2,000 iv. Total increase in cash inflows (annual) Cash flow 12,000 8,000 4,000

Annual labour savings Less: depreciation (incremental) Increased profit before tax Tax on increased profits @50% Profit after tax

2,000 2,000

Add: Depreciation (non cash item) Increased cash inflow

8,000 10,000

v. Calculation of net present value of the incremental cash inflows and cash out flows @ 8% Year

157

Cash inflows / (outflow)

Discounting factor @ 8%

Present value Rs.

0 1 2 3 4 5 6 7 8 9 10

(75,000) 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 10,000 NPV

1 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463

(75,000) 9,260 8,570 7,940 7,350 6,810 6,300 5,830 5,400 5,000 4,630 -7,900

Note – Students may note here that when cash flows are same for a particular period, as we can see in the current example, the calculation can also be done as follows – 10,000 x (Total of pv factors from year 1 to 10 i.e 6.710) = 67,100 Students should note that this method can be followed only when cash flow is same every year. vi. Profitability index = =

67,100 75,000 0.895

Comments – As the net present value of the project is negative and PI is < 1, the project is not financially viable at the given cost of capital of the company (8 %) Problem 8.4.6 Swastik Ltd. manufacturers of special purpose machine tools, have two divisions which are periodically assisted by visiting teams of consultants. The management is worried about the steady increase of expense in this regard over the years. An analysis of last years expenses reveals the following – Rs. Consultants remuneration 2,50,000 Travel and conveyance 1,50,000 Accommodation expenses 6,00,000 Boarding charges 2,00,000 Special allowance 50,000 12,50,000

158

The management estimates accommodation expenses to increase by Rs 2,00,000 annually. As part of the cost reduction drive, Swastik Ltd. are proposing to construct centre to take care of the accommodation requirements of the consultants. This centre will additionally save the company Rs 50,000 in boarding charges and Rs 2,00,000 in the cost of executive training programmes hitherto conducted outside the company premises every year. The following details are available regarding the construction and maintenance of the new centre: a. b. c. d.

Land: at a cost of Rs 8,00,000 already owned by the company, will be used. Construction cost: Rs 15,00,000 including special furnishings Cost of annual maintenance : Rs 1,50,000 Construction cost will be written off over 5 years being the useful life.

Assuming that the write off of construction cost as aforesaid will be available for tax purposes, the rate of tax will be 50% and that the desired rate of return is 15%. You are required to analyse the feasibility of proposal and make recommendations. [CA Nov 94] Solution – 1. Calculation of net cash flow if the company decides to construct new centre : Year 1

Year 2

Year 3

Year 4

Rs. lakhs Year 5

a. Saving in cost i. Accommodation ii. Boarding iii. Training Total savings

8.00 0.50 2.00 10.50

10.00 0.50 2.00 12.50

12.00 0.50 2.00 14.50

14.00 0.50 2.00 16.50

16.00 0.50 2.00 18.50

b. Incremental costs i. Maintenance cost ii. Depreciation Total cost

1.50 3.00 4.50

1.50 3.00 4.50

1.50 3.00 4.50

1.50 3.00 4.50

1.50 3.00 4.50

Net savings

6.00

8.00

10.00

12.00

14.00

Less : tax @ 50%

3.00

4.00

5.00

6.00

7.00

Net savings after tax

3.00

4.00

5.00

6.00

7.00

Add : depreciation

3.00

3.00

3.00

3.00

3.00

159

Net cash flow

6.00

7.00

8.00

9.00

10.00

2. Calculation of NPV @ 15% Year

Cash inflows / (outflow)

0 1 2 3 4 5

(15) 6.00 7.00 8.00 9.00 10.00

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572 0.497

NPV

Rs lakhs Present value Rs. (15) 5.22 5.29 5.26 5.15 4.97 10.89

As the NPV is positive Rs 10.89 lakhs , the proposal of building a new guest house should be accepted. Notes – 1. The cost of land is a sunk cost and hence is not considered for calculation purposes. 2. All expenses other than accommodation and boarding of consultants remains even if guest house is built. Problem 8.4.7 Jolly company has an investment opportunity costing Rs 40,000 with the following expected cash inflow: Year 1 2 3 4 5 6 7 8 9 10

Inflows 7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000

Using 10% as the cost of capital (rate of discounting) determine the i. Net present value and ii. Profitability index (CS final June 92)

160

Solution – Calculation of the net present value of the investment opportunity @ 10% Year

Cash inflows / (outflow)

0 1 2 3 4 5 6 7 8 9 10

(40,000) 7,000 7,000 7,000 7,000 7,000 8,000 10,000 15,000 10,000 4,000 NPV

Profitability Index

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621 0.564 0.513 0.467 0.424 0.386

=

PV of cash inflows PV of cash outflows

=

48,611 40,000 1.215

=

Present value Rs. (40,000) 6,363 5,782 5,117 4,571 4,347 4,512 5,130 7,005 4,240 1,544 8,611

Problem 8.4.8 A ltd. installed a machine with an estimated life of 5 years and used it for 3 years. The initial cost including installation charges amounted to Rs 80 lakhs. According to current assessment, the machine can be used for another 4 years. The company has just received an offer of Rs 50 lakhs for the machine. It is unlikely that a similar offer will be received in near future. The machine is used for manufacturing of a product which has a falling demand. Losses are anticipated over the next 2 years. Details of profitability projections for the next four years are as follows – Rs lakhs Year 1 Year 2 Year 3 Year 4 Sales 50.00 45.00 40.00 35.00 Less : variable cost 27.00 24.50 23.00 18.00 Fixed cost allocated 8.00 7.50 6.50 6.00 Depreciation 16.00 16.00 Net profit / (loss) -1.00 -3.00 10.50 11.00

161

As the estimated working results are not very good and as the company has got a very good offer for the machinery, MD feels that the machine should be sold immediately. What is your advice to the MD ? Cost of capital of the company is 15%, ignore taxation. (ICWA Inter Dec 1998) Solution 1. Calculation of cash flows for 4 years – Net Profit / (loss) Add : Depreciation Add : Fixed cost

Year 1 -1.00 16.00 8.00

Year 2 -3.00 16.00 7.50

Year 3 10.50 6.50

Rs lakhs Year 4 11.00 6.00

Total cash inflow

23.00

20.50

17.00

17.00

It is assumed that the fixed cost will remain fixed even if the machine is sold and hence it is not considered as an outflow when production is continued. 2. Net present value of the project @ 15% discounting rate Year

Cash inflows / (outflow)

1 2 3 4

23.00 20.50 17.00 17.00 PV

Discounting factor @ 15% 0.870 0.756 0.658 0.572

Rs lakhs Present value Rs. 20.01 15.498 11.186 9.724 56.418

Comments – It can be observed that @ 15% discounting rate the present value of cash inflows by continuing the production is 56.41 lakhs as against the realisable sale price of Rs 50 lakhs. Thus it is advisable to continue with the production rather than selling the machinery. Problem 8.4.9 Satya corporation is toying with the idea of replacing its existing machine. The following are the relevant data – 1. Existing Machine Purchased 2 years ago Remaining life – 6 years Salvage value – Rs 500 162

Current book value – Rs 2,600 and its realisable market value – Rs 3,000 Annual depreciation – Rs 350 2. New machine Capital cost of Rs 8,000 Estimated useful life – 6 years Estimated salvage value – Rs 800 The replaced machine would permit an output expansion. As a result, sales is expected to rise by Rs 1,000 per year, operating expenses would decline by Rs 1,500 per year. It would require an additional inventory of Rs 2,000 and would cause an increase in accounts payable by Rs 500. Assuming corporate tax rate of 40% and cost of capital of 15%, advice the company [ ICWA Dec 1998] Solution – 1. Calculation of incremental cash flows from purchase of new machinery – Rs. 1. Incremental cash outflow (Year 1) Cost of new machinery Add : Addition to working capital a. Inventory b. Increase in account payable Total Less : Net sale price (3,000 – tax on profit @ 40% of Rs 400) Net cash outflow of year 1

8,000 2,000 (500) 9,500 2,840 6,660

2. Subsequent cash inflows Increase in sales Add : savings in cost Less : increase in depreciation (Rs 1,200 – 350)

1,000 1,500 850

Increase in profit before tax

1,650

Less : tax @ 40% Net profit

660 990

Add : depreciation Net cash flow

850 1840

2. Calculation of net present value @ 15% discounting factor. Year

163

Cash inflows / (outflow)

Discounting factor @ 15%

Present value Rs.

0 1 2 3 4 5 6 6 6

(6,600) 1,840 1,840 1,840 1,840 1,840 1,840 1,500 480 NPV

1 0.870 0.756 0.658 0.572 0.497 0.432 0.432 0.432

(6,600) 1,601 1,391 1,211 1,052 915 795 648 207 1,220

In year 6 additional cash inflows will be – Recovery of working capital Sale proceeds of machinery Less : tax on sale @40%

Rs 1,500 Rs 800 Rs 320 Rs 480

Since the NPV of the project is positive the company should go for replacement of old machinery. Problem 8.4.10 A large profit making company is considering the installation of a machine to process the waste produced by one of its existing manufacturing process to be converted into a marketable product. At present, the waste is removed by a contractor for disposal on payment by the company of Rs 50 lacs per annum for next 4 years. The contract can be terminated on installation of the aforesaid machine on payment of a compensation of Rs 30 lakhs before the processing operation starts. This compensation is not allowed as deduction for tax purposes. The machine required for carrying out the processing will cost Rs 200 lakhs to be financed by a loan repayable in 4 equal instalments commencing from the end of year 1. The interest rate is 16% p.a At the end of 4th year, the machine can be sold for Rs 20 lakhs and the cost for dismantling and removal will be Rs 15 lakhs. Sales and direct cost of the product emerging from waste processing for 4 years are estimated as under: Sales Material consumption Wages Other expenses Factory overheads Depreciation ( As per income tax) 164

1 322 30 75 40 55 50

2 322 40 75 45 60 38

3 418 85 85 54 110 28

4 418 85 100 70 145 21

Initial stock required before commencement of the processing operations is Rs 20 lacs at the start of year 1. The stock levels of materials to be maintained at the end of year 1,2 and 3 will be Rs 55 lacs and the stock at the end of year 4 will be nil. The storage of material will utilise the space which otherwise would have been rented out for Rs 10 lakhs per annum. Labour cost includes wages of 40 workers, whose transfer to this process will reduce idle time payments of Rs 15 lacs in year 1 and Rs 10 lacs in year 2. Factory overheads include apportionment of general factory overheads except to the extent of insurance charges of Rs 30 lakhs per annum attributable to this venture.The company’s tax rate is 50% for revenue incomes. Advice the management on the desirability of installing the machinery for processing the waste. All calculation should form part of the answer. Required rate of return is 15%. (CA final, May 1999) Solution 1. Statement of incremental cash flows from operations Sales

1 322

2 322

Rs lakhs 3 4 418 418

Less : Material consumption Wages Other expenses Factory overheads (Insurance) Loss of rent Interest Depreciation Total cost

30 60 40 30 10 32 50 252

40 65 45 30 10 24 38 252

85 85 54 30 10 16 28 308

85 100 70 30 10 8 21 324

Incremental profits before tax Less: Tax @ 50% Net profit

70 35 35

70 35 35

110 55 55

94 47 47

Add : depreciation Net cash flow

50 85

38 73

28 83

21 68

Overheads other than insurance is not considered as they remain unchanged even though the project is not executed 2. Statement of incremental cash flows (net) 1 165

2

3

Rs lakhs 4

Net cash flow from operations (Increase) / realisation of inventories Contract payment saved (Net of tax saving @ 50%) Loan repayment Profit on sale of machine Total incremental cash flows

85 (35)

73 -

83 -

68 55

25

25

25

25

(50) -

(50) -

(50) -

(50) 5

25

48

58

103

3. Net present value of all cash flows @ 15%Year

Cash inflows / (outflow)

0 1 2 3 4

(50) 25 48 58 103

Discounting factor @ 15% 1 0.870 0.756 0.658 0.572

NPV Cash outflow of year 1 is

Rs lakhs Present value Rs. (50) 21.75 36.29 38.16 58.92 105.12

– Compensation for contract + increase in inventory level - Rs 30 lakhs + Rs 20 lakhs = Rs 50 lakhs.

Comment - It is advisable to implement the proposal as the net present value is positive. Problem 8.4.11 A company is setting up a plant at a cost of Rs 300 lakhs of investment in fixed assets. It has to decide whether to locate the plant in a forward area (FA) or backward are (BA). Locating in backward area means a cash subsidy of Rs 15 lakhs from the central government. Besides the taxable profit to the extent of 20% is exempt for 10 years. The project envisages a borrowing of RS 200 lakhs in either case. The cost of borrowing will be 12% in forward area and 10% in backward area. However the revenue costs are bound to be higher in the BA. The borrowing principle has to be repaid in 4 equal annual instalments beginning from the end of year 4. With the help of following information and by using Discounted Cash Flow technique you are required to suggest proper location for the project. Assume straight-line depreciation with no residual value. Earning before interest and tax (Rs in lakhs) Year FA 1 -6 2 34 3 54 166

BA -50 -20 10

4 5 6 7 8 9 10

74 108 142 156 230 330 430

20 45 100 155 190 230 330

Assume – 1. Discounting rate to be 15% 2. Rate of Income tax to be 50% 3. Central subsidy is not to affect depreciation or tax. 4. No other relief and rebates will be available to the company other than those mentioned above. [CA final May 1991] Solution 1. Calculation of cash flows from the operation for Forward area Year

EBIT

Interest

1 2 3 4 5 6 7 8 9 10

-6 34 54 74 108 142 156 230 330 430

24 24 24 24 18 12 6 -

Depreciatio n 30 30 30 30 30 30 30 30 30 30

PBT

Tax

PAT

Inflow

-60 -20 20 60 100 120 200 300 400

50 60 100 150 200

-60 -20 20 60 50 60 100 150 200

-30 10 30 50 90 80 90 130 180 230

2. Calculation of cash flows from the operation for Backward area Year

EBIT

Interest

1 2 3 4 5 6 7 8 9

-50 -20 10 20 45 100 155 190 230

20 20 20 20 15 10 5 -

167

Depreciatio n 30 30 30 30 30 30 30 30 30

PBT

Tax

PAT

Inflow

-100 -70 -40 -30 60 120 160 200

40 80

-100 -70 -40 -30 60 120 120 120

-70 -40 -10 30 90 150 150 150

10

330

-

30

300

120

180

210

3. Calculation of net present value of project in forward area @ 15% discounting factor Rs lakhs Year Cash inflows / Cash Net cash Discounting Present (outflow) outflows flows factor value @ 15% Rs. 0 (100) (100) 1 (100) 1 -30 -30 0.870 (26.10) 2 10 10 0.756 7.56 3 30 30 0.658 19.74 4 50 50 0 0.572 0 5 90 50 40 0.497 19.88 6 80 50 30 0.432 12.96 7 90 50 40 0.376 15.04 8 130 0.327 42.51 9 180 0.284 51.12 10 230 0.247 56.81 NPV 99.52 Cash outflow of year 1 = Total cash outflow – loan amount = Rs 300 lakhs – Rs 200 lakhs = Rs 100 lakhs. 4. Calculation of net present value of project in backward area @ 15% discounting factor Rs lakhs Year Cash inflows / Cash Net cash Discounting Present (outflow) outflows flows factor value @ 15% Rs. 0 (85) (85) 1 (85) 1 -70 -70 0.870 -60.9 2 -40 -40 0.756 -30.24 3 -10 -10 0.658 -6.58 4 50 -50 0.572 -28.60 5 30 50 -20 0.497 -9.94 6 90 50 40 0.432 17.28 7 150 50 100 0.376 37.6 8 150 150 0.327 49.05 9 150 150 0.284 42.60 10 210 210 0.247 51.87 NPV 22.86 Cash outflow of year 1 = Total cash outflow – loan amount – subsidy = Rs 300 lakhs – Rs 200 lakhs – Rs 15 lakhs = Rs 85 lakhs.

168

Working notes – 1. Taxability of backward area starts only from year 8th as in year 6 and 7 the losses of year 1 to 5 are adjusted against the profits. 2. For year 8,9 and 10 tax is levied only on 80% of the profits as 20% profit is exempt. 3. Ideally the discounting factor shall be 12% and 10%, which is cost of capital at FA and BA respectively, in that case interest should be ignored. But as the problem states the cost of capital to be 15%, calculations done considering interest as cash out flow Comment – As NPV of FA is positive and NPV of BA is negative project should be located in FA.

Problem 8.4.12 X ltd. is considering two mutually exclusive projects X and Y. Following details are made available to you : Rs. In lacs Project X Project Y Project cost Cash inflows Year 1 2 3 4 5

1,000

1,000

200 150 320 450 500

200 600 250 100 150

Assume no residual value at the end of fifth year. The firms cost of capital is 10%. Required, in respect of each of the two projects: i. NPV using 10% discounting rate ii. IRR and iii. Profitability index iv. Payback period Solution – 1. Net present value of cash flows of project X @ 10%-

169

Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,000) 200 150 320 450 500

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621

NPV

Rs lakhs Present value Rs. (1,000) 181.80 123.90 240.32 307.35 310.5 163.87

2. Net present value of cash flows of project Y @ 10%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,000) 200 600 250 100 150

Discounting factor @ 10% 1 0.909 0.826 0.751 0.683 0.621

NPV 4. i. Profitability index of project X

ii. Profitability index of project Y

Rs lakhs Present value Rs. (1,000) 181.80 495.60 187.75 68.30 93.15 26.60

=

1163.8 1000

=

1.164

=

1026.60 1000

=

1.027

5. Calculation of internal rate of return for project X a. Net present value of cash flows of project X @ 15%Year

Cash inflows / (outflow)

0 1 2

(1,000) 200 150

170

Discounting factor @ 15% 1 0.870 0.756

Rs lakhs Present value Rs. (1,000) 174.00 113.40

3 4 5

320 450 500

0.658 0.572 0.497

NPV

210.56 257.40 248.5 3.86

AS net present value Rs 3.86 lacs (almost nil), it can be said that the IRR of the project is slightly higher than 15% b. Net present value of cash flows of project Y @ 12%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(1,000) 200 600 250 100 150 NPV

Discounting factor @ 12% 1 0.893 0.797 0.712 0.636 0.567

Rs lakhs Present value Rs. (1,000) 178.6 478.20 178.00 63.60 85.05 -16.55

As net present value Rs 16.55 lacs, it can be said that the IRR of the project is higher than 10% but lesser than 12%. The IRR can be calculated by interpolation method. IRR

= 10 + (26.60 / 16.55+26.60) *2 = 10+1.24 = 11.25 %

IRR of project Y is 11.25% 6. Calculation of Payback period a. Project X = cumulative cash flow up to year 4 = 200+150+320+450 =1,120 i.e the payback period is somewhere in between year 3 and year 4. Total cash flow till year 3 = 670, remaining cash flow = 1,000-670 = 330 Monthly returns in year 4 = 450/12 = 37.5 Number of months to recover Rs 330 = 330/37.5 = 8.8 or 9 months Payback period = 3 years and 9 months b. Project Y = cumulative cash flow for 3 years = 200+600+250 = 1050 i.e payback period is higher than 3 years the cash flow for year 4 is Rs 100 the amount remains to be recovered is Rs 50 (i.e half of Rs 100), hence payback period is 3 years and 6 months. Summary of both the projects – 171

Net present value IRR Profitability index Payback period

Project X 163.87 15% 1.164 3 years and 9 months

Project Y 26.60 11.25% 1.027 3 years and 6 months

In light of first three methods project X is better than project Y, while under payback period method project Y is better than project X Problem 8.4.13 A company is considering as to which of two mutually exclusive projects it should undertake. The finance directors thinks that the project with the higher NPV should be chosen whereas the managing director thinks that the one with higher IRR should be undertaken especially as both the projects have the same initial outlay and length of life. The company anticipates a cost of capital of 10% and the net after tax cash flows of the project are as follows – Year Project X Project Y 0 (200) (200) 1 35 218 2 80 10 3 90 10 4 75 4 5 20 3 Required – 1. Calculate the NPV and IRR of each project 2. state with reasons which project you would recommened The discounting factors are as follows – Year 1 2 3 4 5 [ CA final May 1995] Solution – 1. Analysis of project x

172

10% 0.91 0.83 0.75 0.68 0.62

20% 0.83 0.69 0.58 0.48 0.41

a. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(200) 35 80 90 75 20

Discounting factor @ 10% 1 0.91 0.83 0.75 0.68 0.62

Rs lakhs Present value Rs. (200) 31.85 66.40 67.50 51.00 12.40

NPV

29.15

b. Net present value of cash flows of project X @ 20%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(200) 35 80 90 75 20

Discounting factor @ 20% 1 0.83 0.69 0.58 0.48 0.41

Rs lakhs Present value Rs. (200) 29.05 55.20 52.20 36.00 8.20

NPV

-19.35

IRR for project X can be calculated by interpolation method as follows – IRR

= 10 + (29.15 / 29.15+19.35)*10 = 16%

a. Net present value of cash flows of project X @ 10%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(200) 35 80 90 75 20 NPV

173

Discounting factor @ 10% 1 0.91 0.83 0.75 0.68 0.62

Rs lakhs Present value Rs. (200) 31.85 66.40 67.50 51.00 12.40 29.15

2. Analysis of project Y a. Net present value of cash flows of project Y @ 10%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(200) 218 10 10 4 3

Discounting factor @ 10% 1 0.91 0.83 0.75 0.68 0.62

Rs lakhs Present value Rs. (200) 198.38 8.30 7.50 2.72 1.86

NPV

18.76

b. Net present value of cash flows of project Y @ 20%Year

Cash inflows / (outflow)

0 1 2 3 4 5

(200) 218 10 10 4 3

Discounting factor @ 10% 1 0.83 0.69 0.58 0.48 0.41

Rs lakhs Present value Rs. (200) 180.94 6.90 5.80 1.92 1.23

NPV IRR for project Y can be calculated by interpolation method as follows – IRR

= 10 + (18.76 / 18.76+3.21)*10 = 18.54%

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-3.21

8.5 Self examination questions Problems – Problem 8.5.1 Company Z wishes to invest Rs 150,000 in a project. The estimated profit before depreciation and taxes is Rs 55,000 per year. The depreciation is to be provided @ 15% WDV on the project cost. The tax rate is @ 35%, calculate the payback period for the project. Problem 8.5.2 Company C is willing to invest in a project costing Rs 2,50,000. The company provides depreciation @ 25% on the project cost ( SLM method). The estimated profit before tax (but after depreciation) for 7 years is as follows – Year 1 2 3 4 5 6 7

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Amount Rs. –10,000 55,000 72,000 97,000 67,500 25,000 95,000

Compute the payback period of the project, assuming tax rate of 40%. Problem 8.5.3 A ltd is wishing to start a new project with a capital investment of Rs 1,20,00,000 and expected profit before tax and depreciation as follows – Year 1 2

Profit before tax Rs. 7,25,000 12,00,000

3 4 5 6

37,87,500 19,95,000 41,20,000 17,50,000

Assuming that the project has only 6 years life and there will be no salvage value at the end of the 6th year calculate the ARR of the project. Assume tax to be 25% Problem 8.5.4 Choose the better project by using payback period method and ARR method – Assume investment in each project to be Rs 5,00,000 and profit after tax as follows Year 1 2 3 4 5

Project A 55,000 1,20,000 1,75,000 2,00,000 1,00,000

Project B 0 0 0 3,00,000 4,50,000

6,50,000

7,50,000

Assume straight-line method of depreciation Problem 8.5.5 Company A is considering a project with initial cash out flow of Rs 3,50,000.The project is expected to generate a cash inflow as follows – Year 1

176

Cash inflow Rs. 25,000

2 3 4 5 6 7

1,25,000 75,000 1,50,000 1,25,000 50,000 50,000 Total

6,00,000

Now assume that the discounting rate or the expected rate of return from the project is 10%, 15% and 25%. Calculate the net present value of project A and write your conclusions. The discounting table for 10%,15% and 25% is as follows Year 10% 25% 15% 1 0.909 0.800 0.870 2 0.826 0.640 0.756 3 0.751 0.512 0.658 4 0.683 0.410 0.572 5 0.621 0.328 0.497 6 0.564 0.262 0.432 Problem 8.5.6 Please evaluate the following two projects with Net present value technique – Year 0 1 2 3 4 5

Cost

Project X (120,000) 25,000 10,000 45,000 50,000 55,000

Project Y (120,000) 56,000 48,000 22,000 15,000 25,000

The amounts are after tax and depreciation. Consider the project at 10%, 15% and 20% discounting rate and chose the better alternative. Make suitable assumptions. The discounting table for 10%,15% and 20% is as follows Year 10% 15% 20% 1 0.909 0.870 0.833 2 0.826 0.756 0.694 3 0.751 0.658 0.579 4 0.683 0.572 0.482 5 0.621 0.497 0.402 Problem 8.5.7

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Company A is considering a project with expected life of 7 years. The initial cash outflow is expected to be as follows – Land purchased (not depreciable) Plant Working Capital

Rs 5,00,000 Rs 7,50,000 Rs. 60,000

The working capital will be fully realised at the end of the 5th year. The estimated scrap value of the plant is Rs 25,000. The company has received the land under special scheme and the same is not sellable. The expected Profit before tax is as follows Year 1 2 3 4 5 6 7

Rs. 1,50,000 1,20,000 1,00,000 2,90,000 55,000 1,50,000 1,15,000

Tax rate is 35% You are required to evaluate the project considering – 1. 2. 3. 4.

NPV technique using rate of discounting to be 12% and 15% . Payback period method Profitability index method and IRR method

The discounting table for 12% and 15% Year 1 2 3 4 5 6 7

Problem 8.5.8

178

12% 0.893 0.797 0.712 0.636 0.567 0.507 0.452

15% 0.870 0.756 0.658 0.572 0.497 0.432 0.376

AQ ltd is considering the installation of a machine to process a new produced by one of its existing manufacturing process, which is currently outsourced. At present, the product is manufactured by a contractor for on payment by the company of Rs 10 lakhs per quarter for next 3 years. The contract can be terminated on installation of the aforesaid machine on payment of a compensation of Rs 50 lakhs before the processing operation starts, same is deductible for tax purposes. The machine required for carrying out the processing will cost Rs 150 lakhs, the machine can be sold for Rs 10 lakhs at the end of its useful life. Sales and direct cost of the product emerging from the new product for 3 years are estimated as under: Rs lakhs 1 2 3 Sales 250 315 320 Total cost 150 190 195 Depreciation ( As per income tax) 50 50 50 Initial working capital required before commencement of the processing operations is Rs 15 lakhs at the start of year 1.The working capital will get realised to the extent of 95% at the end year 3.The amount of expenses include Rs 15 lakhs as fixed cost which is immaterial of the implementation of the project .The company’s tax rate is 50% for revenue incomes. Advice the management on the desirability of installing the machinery for processing the waste. All calculation should form part of the answer. Required rate of return is 12%. Discounting table @ 12% is as follows – Year 1 2 3

12% 0.893 0.797 0.712

Problem 8.5.8 A ltd is evaluating a project having an initial investment of Rs 1,25,000 and the following cash inflows – Year 1 15,000 2 9,000 3 9,000 4 22,000 5 33,000 6 45,000 7 35,000 179

Rs.

8 –3,000 9 15,000 10 –12,000 The company is estimating maintenance expenses at the end of year 3 and 5 of Rs 5,000 and 6,000 respectively payable in the same year. The company’s opportunity cost is 16% and the company is wishing to evaluate the project on the basis of NPV method and profitability index (PI) method and also calculate the IRR of the project. The discounting table @ 16% is as follows – Year 1 2 3 4 5 6 7 8 9 10

16% 0.862 0.743 0.641 0.572 0.476 0.410 0.354 0.305 0.263 0.227

Objective questions 1. Which of the following techniques use discounting methods – a. b. c. d. e.

Net present value method Accounting rate of return method Payback period method Profitability index method Internal rate of return

2. Internal rate of return is the rate at which – a. b. c. d. e.

The present value of all the cash inflows is nil Rate desired by the company Net present value of all cash inflows and outflows is nil. A proposal is acceptable. None of the above

3. The major disadvantage of payback period method is – a. It is simple b. It ignores rate of return c. It does not consider all the cash flows 180

d. All of the above e. None of the above 4. The discounting factor applied to cash flows of a particular project is not – a. b. c. d.

Rate of opportunity cost Cost of capital The desired rate of return Rate of interest on government securities

5. State whether the following statements are true or false – a. Generally capital budgeting decisions involve huge investment and loss of such investment may lead to bankruptcy of the company b. The decisions like purchase of land, plant, building, patents etc. cannot be reversed easily and it becomes a sunk cost. c. Capital budgeting decisions involve long term and permanent commitments and has an effect over the company’s future earnings. d. Capital budgeting decisions are necessarily backed by huge funding decisions and failure in the implementation of the project may lead to problem of excess funding. e. Capital budgeting decisions are tough to take as it is difficult to forecast he future cash inflows from the assets with accuracy. f. Payback period method is the best method of capital budgeting g. NPV method and IRR method always gives preference to same project

181

9 Some assorted questions Problem 9.1 Company – A Ltd. Sales (All credit) Cost of goods sold Other information Balances Inventory Debtors Creditors

Rs. Lacs. 1,000 90% As on 1-1-99 100 85 55

Rs. Lacs As on 31-12-99 105 90 65

Please answer the following questions assuming 360 days in a year. 1. The inventory cycle of A Ltd. is a. 41 b. 45 c. 102 d. Data insufficient 2. Debtors cycle of A ltd. , ignoring the profit portion, is a. 31.5 b. 35 c. 38 d. Can’t be calculated

182

3. Creditors cycle of A ltd. is (rounded off to nearest rupee) a. 24 b. 28 c. 32 d. 22 4.Calculate the figure of purchases, based on cost of sales – a. 900 b. 895 c. 1205 d. 905 5. Debtors cycle of A ltd. , including the profit portion, is a. 31.5 b. 35 c. 38 d. Can’t be calculated Problem 9.2 The Cost sheet of A ltd. is as follows – Raw Materials Labour Overheads Depreciation Selling price

Cost per unit 50 20 30 10 110

Average holding/realisation period is as follows – Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%) – ½ month, Debtors – 1 month, Creditors – 1 month, wages – 1/3 rd month, overheads – 30 days, Finished goods – 1 month. Other information – 1. 75 % of sales is on credit 2. Expected cash balance is 1,00,000 3. Expected output is 4500 units per month. Please answer the following questions – 1. The estimated figure of raw materials for calculation of working capital is – a. 3,37,500 b. 2,25,000 c. 1,25,000

183

d. none of the above. 2. The figure of estimated outstanding wages is – a. b. c. d.

30,000 45,000 33,500 25,000

3. The estimated figure of Finished goods is – a. b. c. d.

2,25,000 5,80,000 4,35,500 4,50,000

4. The estimated figures of debtors for calculation of working capital requirement and actual debtors respectively are – a. b. c. d.

3,37,500 and 4,38,750 2,55,000 and 5,00,000 3,37,500 and 5,00,000 none of the above

5. Which other figure is same as the estimated figure of raw materials a. b. c. d.

Creditors for materials Creditors for overheads Work in progress None of the above

Problem 9.3 The Net operating profit of Company A ltd. is 2,10,000 and the total market value of its 12 % debt is Rs. 3,00,000. The equity capitalisation rate of an unlevered firm of same risk class is 16%. use Modiglian Miller approach 1. The value of unlevered firm, when tax rate is 30% is – a. b. c. d.

10,00,000 9,18,750 5,35,000 7,00,000

184

2. The value of levered firm, when tax rate is 30%, is – a. b. c. d.

12,50,000 10,08,750 6,50,000 8,35,000

Problem 9.4 Company – A ltd. Earnings per share – Rs.10 Dividend pay out ratio – 50% Rate of return – 15% The capitalisation rate – 12.5% Use Walter model for dividend decision and answer the following queations 1. The market price (p) of A ltd shares at current dividend pay out ratio is – a. b. c. d.

80 78 88 95

2. What should be optimum pay out ratio of the firm A ltd, in order to maximise the share price – a. b. c. d.

100% 50% 55% 0%

3. What will be the share price at the pay out ration mentioned in Q.2 a. b. c. d.

96 100 125 Data insufficient

Problem 9.5 Company A ltd. – Current assets d. Inventory

185

Rs. 340 lacs

e. Other current assets Current liabilities c. Creditors d. Other liabilities e. Bank borrowings

Rs.

20 lacs

Rs. 100 lacs Rs. 20 lacs Rs. 180 lacs

Core current assets are Rs. 180 lacs 1. The maximum permissible bank finance as per Tandon committee recommendations is – a. Rs. 180 lacs b. Rs. 200 lacs c. Rs. 250 lacs d. Rs. 120 lacs 2. The minimum permissible bank finance as per Tandon committee recommendations is – a. Rs. 180 lacs b. Rs. 15 lacs c. Rs. 120 lacs d. Rs 20 lakhs 3.. Calculate the maximum permissible bank finance as per Tandon committee recommendations if Core current assets are Rs. 170 lacs – a. Rs. 180 lacs b. Rs. 20 lacs c. Rs. 15 lacs d. Rs. 120 lacs Problem 9.6 Please write the formulas of Value of the firm, Cost of equity under Modigiani and Miller approach of capital structure theories, without corporate taxes and with corporate taxes Problem 9.7 A Ltd. sells goods in the domestic market on a gross profit of 25%. Its annual figures are as follows : 1. Domestic sales on 1 month credit Rs. 12,00,000 2. Export at 3 months credit, selling price 10 % below domestic price Rs. 5,40,000 3. Material with two months credit Rs. 4,50,000 4. Wages paid ½ month in arrears Rs. 3,60,000

186

5. Manufacturing expense paid 1 month in arrears Rs. 5,40,000 6. Depreciation Rs. 60,000 7. Administration expense paid 1 month in arrears Rs. 1,20,000, not to be considered for Finished goods valuation 8. Sales expenses payable quarterly in advance Rs. 60,000 Stock of Raw materials and FG are kept for 1 month. Cash requirement Rs. 1,00,000. Please ascertain the working capital requirement for A Ltd. Problem 9.8 1. Write a detailed note on working capital cycle with all the formulas 2. Write in details at least 3 sources of long term capital 3. Commercial Paper 4 .Tandon Committee recommendations on Working Capital funding with formulas 5. Explain what is working capital cycle with all its formulas Problem 9.9 The Cost sheet of A ltd. is as follows – Raw Materials Labour Overheads (Depreciation included in overheads Rs 10) Selling price

Cost per unit 40 20 40 110

Average holding/realisation period is as follows – Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%) – ½ month, Debtors – 1 month, Creditors – 1 month, wages – 1/3rd month, overheads – 30 days, Finished goods – 1 month. Other information – 1. 80 % of sales is on credit 2. Expected cash balance is 75,000 Expected output is 5500 units per month. Calculate the amount of working capital required Problem 9.10

187

1. Which one of the following is not a factor determining the dividend policy of a Company a. b. c. d. 2.

Cash flow Tax on dividends for company Profit reinvestment opportunities Future viability of the companies major project

The Cost sheet of A ltd. is as follows – Cost per unit Raw Materials Labour Overheads Depreciation Selling price

50 20 30 10 110

Average holding/realisation period is as follows – Raw materials – 1 month, Finished goods – 1 month, creditors – 1 month Other information – Expected output is 4500 units per month. O 1. The estimated figure of raw materials for calculation of working capital is – a. 3,37,500 b. 2,25,000 c. 1,25,000 d. None of the above. Q 2. The estimated figure of Finished goods is – a. 2,25,000 b. 5,80,000 c. 4,35,500 d. 4,50,000 Q3. Which other figure is same as the estimated figure of raw materials – a. Creditors for materials b. Creditors for overheads c. Work in progress d. None of the above

188

3

Please consider the following cash flow from a project Year Cash Flow (Rs) (50,000) 1 10,000 2 10,450 3 11,800 4 12,250 5 16,750 Q1. The IRR ( Internal rate of return for the above project) is approx: a. 6.6% b. 13% c. 14.5% d. 10.7% Q2. The Profitability index of the project @ 10% discounting rate is : a. 0.850 b. 0.907 c. 1.000 d. Data insufficient Q3. The Net present value of the project @ 10% is approx – a. –4650 b. 2500 c. 2236 d. -8250 Q4. The payback period of the above project is – a. 4 years 4 months b. 5 years c. 2 years e. Data insufficient Q5. Company expects a minimum return of 13% on every project it undertakes. State whether the company will accept the above proposal or not – a. It will reject b. It will accept

4.

To maximize the Company’s value, cost of capital should be – a. Maximum b. Company value does not depend on Cost of Capital c. Minimum d. Can’t say

189

Problem 9.11 1. The cost sheet of Hi-Tech Ltd. provides the following data: Raw Material Direct labour Overheads (including depreciation of Rs.10) Total Cost Profit Selling price

Cost per unit (Rs.) 30 20 20 -----70 10 -----80 ------

10)Average Raw material in stock is for 1 month 11) Work-in-progress (assume 50 % completion stage for Raw materials, wages and overheads) will approximate to 1/2 month’s production 12)Finished goods lie in the warehouse for 1 month 13)Credit allowed to Debtors is 1 month. 25 % of Sales are on cash basis. 14)Cash balance expected to be Rs.2,00,000.00 15)Credit allowed by suppliers is 1 month 16)Average time lag in payment of wages is 2 months 17)Average time lag in payment of overheads is 1 month 18)Assume a 10 % margin You are required to prepare a statement of the working capital needed to finance a level of the activity of 60,000 units of output per year. 2. Write note on working capital cycle and explain how each component of working capital cycle is calculated. Problem 9.12 1. M/s A ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep some margins as under (i.e agreed to finance excluding the margins) – Raw materials Work in progress Finished goods Debtors

20% 40% 15% 30%

Following are the estimates for the year 2002-03

190

Annual Sales Cost of Production Raw Materials purchased Opening stock of Raw materials Opening stock of Raw materials

Rs. 000’s 14,40 12,00 7,05 1,40 1,25

Other information – Raw material is in stock for 2 months, WIP 15 days and FG 1 month. Debtors get 1 months credit and creditors give 15 days credit. Company has received an advance of Rs. 15,000 3. Estimate the amount of working capital requirement 4. Estimate the amount of loan likely to be approved by the bankers. 2. M/s B ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep some margins as under (i.e agreed to finance excluding the margins) – Raw materials 30% Work in progress 35% Finished goods 12.5% Debtors 42% Cash 0% Estimated annual production is 60,000 units and break-up of selling price is as under – Raw Materials 60% Direct wages 10% Overheads (includes depreciation 10%) 20% Profit 10% Selling price 100% Other information – Raw material is in stock for 2 months, work in progress (WIP) 1 month and FG 3 month. Debtors get 3 months credit and creditors give 2 months credit, wages are paid after one month. Calculate WIP considering 100% RM + 50% wages and overheads. Selling price is estimated @ 5 Rs per unit. Cash requirement is Rs 20,000 3. Estimate the amount of working capital requirement 4. Estimate the amount of loan likely to be approved by the bankers. 3 M/s C ltd. have approached bankers for their working capital requirements. The bankers agreed to finance but decided to keep 30% margins on all current assets excluding Cash balance (i.e agreed to finance excluding the margins) other information is as follows -

191

Raw Materials Labour Overheads (Depreciation included in overheads Rs 20) Selling price

Cost per unit 40 10 60 120

Average holding/realisation period is as follows – Raw materials – 1 month, WIP (Completion - Material 100%, labour & overheads 50%) – 1½ month, Debtors – 2 month, Creditors – 1 month, wages – 1/2 month, overheads – 30 days, Finished goods – 2 month. 80 % of sales is on credit, Expected cash balance is 75,000 3. Estimate the amount of working capital requirement 4. Estimate the amount of loan likely to be approved by the bankers.

192