Cost Academy

MAY, 1996 Gr.-I PAPER 2: MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS

Ques !"# 1 (a) Explain briefly the two basic principles of effective portfolio management. (b) As an investment manager you are given the following information :
.

Investment in e#uity shares of A. %ement &td. +teel &td. &i#uor &td. ".

Initial price $s. '( ,( /(

Dividends $s. ' ' ' 0/)

ar!et price at the end of the year $s. () -) 0,( 02))(

"eta ris! factor

).* ).. ).( ).33

1overnment of India "onds 02))) $is! free return may be ta!en at 0/4

5ou are re#uired to calculate : (i) Expected rate of returns of portfolio in each using %apital Assets 6ricing (ii) Average return of portfolio.

odel (%A6 )

A#s$er %&' 6ortfolio management refers to the selection of securities and their continuous shifting in the portfolio to optimise returns to suit the ob7ectives of the investor. T(e )&s!* Pr!#*!+,es "- P"r -",!" .&#&/e.e# : 8he two basic principles for effective portfolio management are : (i) Effective investment planning for the investment in securities by considering the following factors : (a) 9iscal2 financial and monetary policies of the 1overnment of India and the $eserve "an! of India. (b) Industrial and economic environment and its impact on industry prospects in terms of prospective technological changes2 competition in the mar!et2 capacity utilisation with industry and demand prospects etc. (ii) %onstant review of investment : 6ortfolio managers are re#uired to review their investment in securities on a continuous basis to identify more profitable avenues for selling and purchasing their investment. 9or this purpose they will have to carry the following analysis: (a) Assessment of #uality of management of the companies in which investment has already been made or is proposed to be made. (b) 9inancial and trend analysis of companies: balance sheets;profit and loss accounts to identify sound companies with optimum capital structure and better performance and to disinvest the holding of those companies whose performance is found to be slac!ening. (c) 8he analysis of securities mar!et and its trend is to be done on a continuous basis.

Cost Academy

8he above2 analysis will help the portfolio management to arrive at a conclusion as to whether the securities already in possession should be disinvested and new securities be purchased. 8his analysis will also reveal the timing for investment or disinvestments. %0' %!' &et us first calculate the Expected return on ar!et portfolio which is not given in the #uestion paper. 8otal Investment Dividends %apital gains $s. $s. $s. A. %ement &td. '( ' '( +teel &td. ,( ' '( &i#uor &td. /( ' 3) ". 1ovt. of India bonds 02))) 0/) ( <<<<<< <<<<< <<<<< 8otal 020)( 0/0/( 0/- = 0/( Expected return on mar!et portfolio > $s. ?????????????????????????? > $s. '-.,,4 00)( %apital Asset pricing odel : E($p) > $f = "p @E($ ) A $fB Chere2 E($p) > Expected return of the portfolio $f > $is! free rate of return "p > 6ortfolio beta i.e. mar!et sensivity index. E($ ) > Expected return on mar!et portfolio. @E($ ) A $fB > ar!et ris! premium. "y substituting the figures in the above e#uation we can calculate expected rate of returns of portfolio in each using %apital Assets 6ricing odel (%A6 ) as under : %ement &td. +teel &td. &i#uor &td. 1ovt. of India bonds %!!' > > > > 0/ = ).* ('-.,, A 0/) 0/ = ).. ('-.,, A 0/) 0/ = ).( ('-.,, A 0/) 0/ = ).33 ('-.,, A 0/) > > > > ',.*-4 ''.-,4 ').0.4 '-.'04

Average return of the portfolio ',.*- = ''.-, = ').0. = '-.'0 D / > ',.''4 E$ Average of "etas > ().* = ).. = ).( = ).33);/ average return > 0/ = )../.( ('-.,, A 0/) 1111111111111

> >

)../.(4 ',.''4

Ques !"# 2. Celsh &td. is faced with a decision to purchase or ac#uire on lease a mini car. 8he cost of the mini car is $s.02'-23-(. It has a life of ( years. 8he mini car can be obtained on lease by paying e#ual lease rentals annually. 8he leasing company desires a return of 0)4 on the gross value of the assets. Celsh &td. can also obtain 0))4 finance from its regular ban!ing channel. 8he rate of interest will be 0(4 p.a. and the loan will be paid in five annual e#uity installments2 inclusive of interest. 8he effective tax of the company is /)4. 9or the purpose of taxation it is to be assumed that the assets will be written off over a period of ( years on a straight line basis. (a) (b) Advise Celsh &td. about the method of ac#uiring the car . Chat should be the annual lease rental to be charged by the leasing company to match the loan option F 9or your exercise use the following discount factors : .

Cost Academy

Discount $ate 0)4 0(4 34 .

0 ).30 ).*. ).3'

' ).*, )..).*/

5ears , )..( ).-)...

/ ).-* ).(. )..0

( ).-' )./3 ).-(

A#s$er %&' 2e,s( L 3. %omputation of annual loan repayment installment. &oan amount 02'-23-( > ????????????????????????????? > $s.??????????????? > $s. ,'2*3' Annuity factor of 0(4 ,.*N" e : Annuity factor is based on the assumption that loan installment is repaid at the beginning of the year to be at part with rentals. +uch annuity factor at 0(4 wor!s out to be ,.*-. C".+u & !"# "- !# eres !# 3e0 +&4.e# s 5ear Epening "alance Ef principal Interest G 0(4 8otal $epayment of Installment %losing balance ) 02'-23-( Hil <<<<<<< 02'-23-( ,'2*3' <<<<<<< 3/2)., 0 3/2)., 0/2000 <<<<<<< 0.)*20*/ ,'2*3' <<<<<<< .(2'3' ' .(2'3' 002'3/ <<<<<<<< *-2(*,'2*3' <<<<<<<< (,2-3/ , (,2-3/ *2)(/ <<<<<<< -02./* ,'2*3' <<<<<<< '*2*(/ '*2*(/2),-I <<<<<< ,'2*3' ,'2*3' <<<<<<< Hil

I Difference between the installment amount and opening balance of /th year. S*(e3u,e "- C&s( Ou -,"$s !# 3e0 -!#&#*!#/ End of 5ear Annual loan re ? 6ayment Installment (0) ) 0 ' , / ( ,'2*3' ,'2*3' ,'2*3' ,'2*3' ,'2*3' ?? Interest G 0(4 Depreciation 8ax shield Het cash 6J out flows factor at 34 (() (0) A (/) ,'2*3' 0.2)3) 0.)) ).3' ).*/ )... .).0 ).-( present value of cash flows at 34 (-) ,'2*3' 0(2.', 0(2,)' 0(.)'( 0/233( (-2-)') <<<<<<<<< $s. *.2,,(

(') ?? 0/2000 00'3/ *2)(/ /2),?? 8otal

(,) ?? '(2,3, '(2,3, '(2,3, '(2,3, '(2,3,

(/) @(') =(,) x tB ?? 0(2*)'

0/2-.( 0*2'0. 0,2,.3 032(0, 002..' '020') 0)20(. (0)20(.)

Cost Academy

%omputation of Annual lease rentals : %ost of assets 02'-23-( > ???????????????????????????????? > $s. ?????????????????????? > $s. ,)2//. Annuity factors of 0)4 /.0. S*(e3u,e "- C&s( "u -,"$s 5 Le&s!#/ &, er#& !6e ($s) End of 8he year &ease payment 8ax shield ?? 0'20.3 0'20.3 *02.03 After tax cash out flows ,)2//. 0*2'-* (0'20.3) 6J factor at 34 0.)) ,.'/ ).-( 6resent value of cash outflows at 34 ,)2//. (320** (.230-)

) ,)2//. 0A/ ,)2//. ( ?? 8otal present value >

7e*!s!"# : 8he present value of cash outflows under lease financing is $s. *02.03 while that of debt financing (i.e. owning the asset) is $s. *.2,,(. 8hus leasing has an advantage over ownership in this case. %0' &et the annual lease rentals be K. 8herefore the after tax cost of lease rentals will be ).-) K 6resent value will be ).-) K x /.0. > '.)()' K E#uating '.()' K > $s. *.2,((L the value of K is obtained at $s. ,/23)-. 8herefore the lease rental should be $s. ,/23)- to match the loan option. 111111111111 Ques !"# 8 ar!s &td. is launching a new pro7ect for the manufacture of a uni#ue component. At full capacity of '/2))) units2 the cost will be as follows : . %ost per unit $s. aterial &abour and Jariable Expenses 9ixed anufacturing and Administrative Expenses Depreciation *) /) ') 0) 0()

8he selling price per unit is expected at rs.')) and the selling expenses per unit will be $s.0) *)4 of which is variable. In the first two years productions and sales are expected to be as follows : . 5ear 6roduction +ales 0 ' 0(2))) units ')2))) units 0/2))) units 0*2))) units

8o assets wor!ing capital re#uirement2 the following additional information is given : (a) (b) (c) (d) (e) +toc! of raw material A , months: average consumption Cor!?in?progress A Hil Debtors A 0 month average sales %reditors for supply of materials A ' months average purchases of the year %reditors for expenses A 0 month average of all expenses during the year

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(f) %ash balance A $s.')2))) +toc! of finished goods is ta!en at average cost. 5ou are re#uired to prepare for the two years : (0) A pro7ected statement of wor!ing capital re#uirements. (') A pro7ect statement of wor!ing capital re#uirements. A#s$er (0) M&r9s L 3. 6ro7ected statement of 6rofit;&oss 6roduction in units +ales in units +ales $evenue G $s. ')) per unit (A) %ost of 6roduction : aterial G $s. *) per unit Direct labour M variable expenses G $s. /) per unit 9ixed manufacturing M Administrative expenses G $s. ') on '/2))) units Depreciation at $s. 0) for '/2))) units 8otal %ost of 6roduction Add: Epening stoc! of finished goods at average cost I '(2')2))) x 0))) 0(2))) %ost of goods available &ess : %losing stoc! of finished goods at Average cost G ,'2**2))) x ,))) '02))) %ost of goods sold Add: +elling expenses (variable at $s. *) +elling expenses fixed at $s. ' %ost of sales (") 6rofit A A " 2"r9!#/ N" es %&' %reditors for supply of material aterials consumed Add : %losing stoc! of Average consumption (, months) &ess : Epening stoc! 6urchases Average purchases per month (%reditors) 5ear I $s. 0(2))) 0/2))) '*2))2))) 0'2))2))) -2))2))) /2*)2))) '2/)2))) <<<<<<<< '(2')2))) ??? 5ear II $s. ')2))) 0*2))) ,-2))2))) 0-2))2))) *2))2))) /2*)2))) '2/)2))) <<<<<<<< ,02')2))) 02-*2)))I

'(2')2))) 02-*2))) <<<<<<< ',2('2))) 020'2))) /*2))) '(20'2))) '2**2))) 5ear I $s. 0'2))2))) ,2))2))) 0(2))2))) ??? <<<<<< 0(2))2))) 02'(2)))

,'2**2))) /2-32.0/G <<<<<<<< '*20*2'*02//2))) /*2))) ,)20)2'*(2*32.0/ 5ear II $s. 0-2))2))) /2))2))) ')2))2))) ,2))2))) <<<<<<< 0.2))2))) 02/02--.

Cost Academy

%0'

%reditors (' months for goods) %reditors for expenses 8otal of current &iabilities (") I &abour2 anufacturing expenses M selling expenses

'2()2))) 02),2,,/I ,2(,2,,/ -2))2))) /2*)2))) 020'2))) /*2))) <<<<<<< 0'2/)2)))

'2*,2,,/ 02''2--.I /2)-2))0 *2))2))) /2*)2))) 02//2))) /*2))) <<<<<<< 0/2.'2)))

%2'

6ro7ected statement of wor!ing capital re#uirements %urrent Assets : 0. +toc! of aterials (, month average consumption) '. 9inished 1oods ,. Debtors (one moth) /. %ash 8otal %urrent Assets (A) %urrent &iabilities : %reditors for supply of materials %reditors for expenses (+ee C.H. (b) above) Estimated wor!ing capital (") $e#uirement Estimated Cor!ing %apital 5ear I $s. ,2))2))) 02-*2))) '2,,2,,/ ')2))) <<<<<<< .2'02,,/ '2()2))) 02),2,,/ <<<<<<<< ,2(,2,,/ <<<<<<<< ,2-*2))) 5ear II $s. /2))2))) /2-32.0/ ,2))2))) ')2))) <<<<<<<< 002*32.0/ '2*,2,,/ 02''2--. <<<<<<< /2)-2))0 <<<<<<<< .2*,2.0,

E! (er Ques !"# :. (a) ention briefly the symptoms of incipient industrial sic!ness. (b) %alculate the operating leverage2 financial leverage and combined leverage from the following data under +ituation I and II and 9inancial 6lan A and " : Installed %apacity Actual 6roduction and +ales +elling 6rice Jariable %ost 9ixed %ost : Nnder +ituation I Nnder +ituation II %apital structure : 9inancial 6lan A $s. E#uity Debt ($ate of Interest at ')4) 0)2))) 0)2))) ')2))) " $s. 0(2))) (2))) ')2))) /2))) units .(4 of the %apital $s.,) 6er Nnit $s.0( 6er Nnit $s.0(2))) $s.')2)))

Cost Academy

A#s$er %&' Industrial sic!ness is a gradual process and is not the result of overnight operations. If the sic!ness continues for a long period2 if may become chronic. In case2 care is not ta!en at the initial stage itself2 it may go beyond control and ultimately results in the death of the unit. Incipient sic!ness : If the downfall in the smooth functioning various operational areas of the unit continues unabated2 the actual process of sic!ness then starts. +uch a stage is considered to be incipient sic!ness and is identified by reference to the following symptoms : (0) 8here are continuous cash losses from year to year and the trend is expected to continue in future. (') Deterioration is expected in the current ratio in the current financial year2 even though the same may have been more than one in the previous financial year. (,) 8here is gradual erosion in the net worth during the previous and current financial years and is expected to continue in future also. (/) Deterioration continuous in the debt A e#uity position in the current financial year and subse#uently also. In a nutshell2 it may be seen that incipient industrial sic!ness is that stage where the unit incurs cash lossesL however2 the position of financial structure may not be very much alarming. 8his is the time to ta!e certain corrective measures to prevent the unit from turning into sic!ness. 8his will2 however2 re#uire proper identification2 care and follow A up programme. %0' (i) Eperating &everages : +ales (s) ,2))) units G $s. ,);? per unit &ess: Jariable %ost (J%) G $s. 0(;? per unit %ontribution (%) &ess : 9ixed %ost (9%) Eperating 6rofit (E6) (E"I8) Eperating &everage % E6 > > (ii) 9inancial &everages : A ($s) +ituation I Eperating 6rofit (E"I8) &ess : Interest on debt 6"8 ,)2))) '2))) <<<<<<< '*2))) +ituation I $s. 3)2))) /(2))) /(2))) 0(2))) <<<<<< ,)2))) +ituation II $s. 3)2))) /(2))) /(2))) ')2))) <<<<<< '(2)))

$s. /(2))) ,)2))) 0.(

$s. /(2))) '(2))) 0.* 9inancial 6lan " ($s) ,)2))) 02))) <<<<<<< '32)))

E6 '(2))) '(2))) 9inancial &everage > ????? > $s. ?????????????? > 0.)3 $s. ???????????? > 0.)/ 6"8 ',2))) '/2)))

Cost Academy

(iii) %ombined &everages : 9inancial 6lan (a) +ituation I A $s. 0.( x 0.). > 0." $s. 0.( x 0.)/ > 0.(-

OR O &td. has a present annual sales level of 0)2))) units at $s.,)) per unit. 8he variable cost is $s.')) per unit and the fixed costs amount to $s.,2))2))) p.a. 8he present credit period allowed by the company is 0 month. 8he company is considering a proposal to increase the credit period to ' months and , months and has made the following estimates : . Existing 6roposed %redit 6olicy 0 onth ' onths , onths Increase in +ales ?? 0(4 ,)4 4 of "ad Debts 04 ,4 (4 8here will be increase in fixed cost by $s.()2))) on amount of increase of sales beyond '(4 of present level. 8he company plans on a pre?tax return of ')4 on investment in receivables. 5ou are re#uired to calculate the most paying credit policy for the company. A#s$er ; L 3. E6&,u& !"# "- Cre3! P",!*4 6resent 6olicy 0 month ' months 0)2))) 002()) ,)2))2))) ')2))2))) <<<<<<<< 0)2))2))) ,2))2))) .2))2))) 02302--,*2,,, ,)2))) -2,02--. ,/2()2))) ',2))2))) <<<<<<<< 002()2))) ,2))2))) *2()2))) /2,,2,,, *-2--02),2()) -2(32*,/ '*20-.

A. +ales (Nnits) ". +ales income Jariable cost at %ontribution 9ixed %ost %. Het argin D. Investments in receivables (+ee wor!ing notes) E. Expected $eturn En receivables at ')4 9. "ad debts 1. Het 6rofit (% A E A 9) O. Increase in 6rofits

6roposed 6olicy , months 0,2))) ,32))2))) '-2))2))) <<<<<<<< 0,2))2))) ,2()2))) 32()2))) .2,.2()) 02/.2()) 023(2))) -2).2()) (?) ('2,,/

As ' months credit policy yield higher return2 it should be adopted. 2"r9!#/ N" e : %alculation showing investments in receivables : Jariable cost = 9ixed cost 9ormula > ?????????????????????????????????????? x Ho. of months credit 0' 0 month

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Investment

',2))2))) ???????????????????? x 0 0' ' months

> 02302---

'-2))2))) ?????????????????????? x ' > /2,,2,,, 0' , months '32()2))) ????????????????????? x , > .2,.2()) 0' 11111111111111111 Ques !"# <. Crite short notes on any four of the following : (a) 1lobal depository receipts or Euro %onvertible "onds. (b) argin oney. (c) Internal $ate of $eturn. (d) Pero "ase "udgeting (e) Impact of Inflation on Cor!ing %apital. A#s$er %&' G,"0&, 7e+"s! "r4 Re*e!+ s %G7Rs' : It is a negotiable certified denominated in N+ dollars which represents a Hon A N+ company:s publicly traded local currency e#uity shares. 1D$s are created when the local currency shares of an Indian company are delivered to Depository:s local custodian "an! against which the Depository ban! issues depository receipts in N+ dollars. 8he 1D$s may be traded freely in the overseas mar!et li!e any other dollar A expressed security either on a foreign stoc! exchange or in the over A the Acounter mar!et or among #ualified institutional buyers. "y issue of 1D$s Indian companies are able to tap global e#uity mar!et to raise foreign currency funds by way of e#uity. It has distinct advantage over debt as there is no repayment of the principal and service costs are lower. (+tudents may refer to 9+6 (H) A9A A 0) study paper for detailed discussion). (Er) Eur" C"#6er !0,e )"#3s : 8hey are bonds issued by Indian companies in foreign mar!et with the option to convert them into pre A determined number of e#uity shares of the company. usually price of e#uity shares at the time of conversion will fetch premium. 8he "onds carry fixed rate of interest. T(e Issue "- 0"#3s .&4 *&rr4 $" "+ !"#s : %all Eption : Nnder this the issuer can call the bonds for redemption before the date of maturity. Chere the issuer:s share price has appreciated substantially2 i.e.2 far in excess of the redemption value of bonds2 the issuer company can exercise the option. 8his call option forces the investments to convert the bonds into e#uity. Nsually2 such a case arises when the share prices reach a stage near 0,)4 to 0()4 of the conversion price.

Cost Academy

10

6ut option enables the buyer of the bond a right to sell his bonds to the issuer company at a pre A determined price and date. 8he payment of interest and the redemption of the bonds will be made by the issuer A company in N+ dollars. %0' M&r/!# M"#e4 : "an!ers !eep a cushion to safe guard against changes in value of securities while extending loans against which loans are given to customer. 8his cushion represents the margin oney. 8he #uantum of argin money depends upon the credit worthiness of the borrower and the nature of security. In pro7ect cost financing2 argin oney has to come from 6romoters: contribution.

In the case of borrowing for wor!ing capital argin oney has to be provided as per norms that are prescribed from time to time by $"I. In the case of new pro7ects argin oney re#uired for wor!ing capital is included in the 6ro7ect %ost. %*' I# er#&, R& e "- Re ur# : it is that rate at which discounted cash inflows are e#ual to the discounted cash outflows. In other words2 it is the rate which discounts the cash flows to Qero. It can be stated in the form of a ratio as follows :? %ash inflows D %ash outflows > 0 8his rate is to be found by trail and error method. 8his rate is used in the evaluation of investment proposals. In this method2 the discount rate is not !nown but the cash outflows and cash inflows are !nown. In evaluating investment proposals2 internal rate of return is compared with a re#uired rate of return2 !nown as cut A off rate. If it is more than cut A off rate2 the pro7ect is treated as acceptableL otherwise pro7ect is re7ected. %3' =er" )&se )u3/e !#/ : Pero "ased budget start from a concept of Hil budget. All items are treated as new and each function2 process2 pro7ect or activity is critically evaluated and 7ustified through cost A benefit analysis. 8he expenses are ta!en in the budget only thereafter. 8his approach differs from conventional budgeting as figures for the current year in a conventional budget are based on the figures for previous years and the trend disclosed. 8o prepare Pero "ased "udget it is necessary to (0) define ob7ectivesL (') ignore existing budgetL (,) prepare fresh budget bit by bit from the scratchL (/) do critical appraisal of each action;expenditureL and (() match the most effective "udget with the ob7ectives. %*' I.+&* "- !#-,& !"# "# $"r9!#/ *&+! &, : 8he impact of inflation on wor!ing capital is direct. 9or the same #uantity of sales2 the value of sundry debtors2 closing stoc! etc. increase as a result of inflation. 8he valuation of closing stoc! progressively on higher amounts would result in the company not being able to maintain its operating capability unless it finds extra funds as it triggers profit related cash outflows in respect of income tax2 dividends are bonus. Nnless proper planning is done2 the business is li!ely to fact a condition !nown as Rtechnically insolvencyS

Cost Academy

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MAY, 199> Gr.-I PAPER - 2: MANAGEMENT ACCOUNTING AN7 FINANCIAL ANALYSIS

Ques !"# 1 Excel &td. manufactures a special for sale at $s.,) per !g. 8he variable cost of manufacture is $s.0( per !g. 9ixed cost excluding depreciation is $s.'2()2))). Excel &td. is currently operating at ()4 capacity. It can produce a maximum of 02))2))) !gs. at full capacity. 8he 6roduction anager suggests that if the existing machines are fully replaced the company can achieve maximum capacity in the next five years gradually increasing the production by 0)4 per year. 8he 9inance manager estimates that for each 0)4 increase in capacity2 the additional increase in fixed cost will be $s.()2))). 8he existing machines with a current boo! value of $s.0)2)))2))) can be disposed of for $s.(2))2))). 8he Jice?6resident (finance) is willing to replace the existing machines provided the H6J on replacement is about $s./2(,2))) at 0(4 cost of capital after tax. (i) 5ou are re#uired the total value of machines necessary for replacement .
9or your exercise you may assume the following :

(a)

8he company follows the bloc! assets concept and all the assets are in the same bloc!. Depreciation will be on straight?line basis and the same basis is allowed for tax purposes. 8here will be no salvage value for the machines newly purchased. 8he entire cost of the assets will be depreciated over five year period. 8ax rate is at /)4 %ash inflows will arise at the end of the year $eplacement outflow will be at the beginning of the year (year )) 5ear Discount 9actor at 0(4 ) 0 0 ).*. ' ).., ).-/ ).(. ( )./3

(b) (c) (d) (e) (f) (ii)

En the basis of data given above2 the managing director feels that the replacement2 if carried out2 would at least yield post tax return of 0(4 in the three years provided the capacity build up is -)42 *)4 and 0))4 respectively. Do you agree F

Cost Academy

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A#s$er %!' %omputation of the total replacement value of machine. (Assuming that existing machines also have valid life for ( years) S e+ 1: I#*re.e# &, C&s( I#-,"$s 5ear Incremental %apacity Incremental production M sales (Tgs) $s. Incremental contribution Incremental 9ixed cost Incremental 6"8D 8ax G /)4 Incremental 6A8 "D Discount factors
8otal for ( years.

0 0)4 0)2)))

' ')4 ')2))) $s. ,2))2))) 02))2))) '2))2))) *)2))) 1,2?,??? )..302'))

, ,)4 ,)2))) $s. /2()2))) 02()2))) ,2))2))) 02')2))) 1,@?,??? ).-020*2*))

/ /)4 /)2))) $s. -2))2))) '2))2))) /2))2))) 02-)2))) 2,:?,??? ).(. 02,-2*))

( ()4 ()2))) $s. .2()2))) '2()2))) (2))2))) '2))2))) 8,??,??? )./3 02/.2)))

02()2))) ()2))) 02))2))) /)2))) 6?,??? ).*.

(2/-2)))

Discounted value of 6A8"D ('2'))

S e+ 2 : I#*re.e# &, *&s( "u -,"$ &et the total cost of replacement Disposal value of existing machines Incremental %ash outflow S e+ 8 : T&A s&6!#/s "# 3e+re*!& !"# (Incremental bloc!;() x 8ax rate x (Annuity factor of 0(4 for ( years) @(K A (2))2))));(B x /)4 x ,.,( > ).'-* K A 02,/2))) S e+ :: T" &, 7!s*"u# e3 C&s( !#-,"$s 8otal Incremental Discounted cash inflows (2/-2))) = ).'-* K A 02,/2))) > /20'2))) = ).'-* K K (2))2))) (K A (2))2))))

S e+ <: EBu& !"# H6J > +um of discounted cash inflows A +um of the discounted cash outflows /2(,2))) > (/20'2))) = ).'-* K) A (K A (2))2)))) /2(,2))) > /20'2))) = ).'-* K A K = (2))2))) /2(,2))) A /20'2))) A (2))2))) > ).'-* K A K ? /2(32))) > ? )..,' K Er2 )..,' K > /2(32))) Er2 K > /2(32)));)..,' > $s. -2'.2)/3

Cost Academy

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%!!'

Evaluation whether replacement would yield post tax return of 0(4 in , years. 0 ' Incremental capacity 0)4 ,)4 Incremental 6"8D Depreciation (-2'.2)/3 A (2))2))));( Incremental 6"8 8ax G /)4 Incremental 6A8 6A8 = Depreciation Discount 9actors Discounted cash inflows 8otal discounted cash inflow Discounted incremental cash outflow 02))2))) '(2/0) ./2(3) '32*,//2.(/ .)20-/ ).*. -02)/, /20)2'.02'.2)/3 ,2))2))) '(2/0) '2./2(3) 02)32*,02-/2.(/ 023)20-/ )..02//2('(

, ()4 (2))2))) '(2/0) /2./2(3) 02*32*,'2*/2.(/ ,20)20-/ ).-'2)/2.)*

NPC 2,@8,2>> C"#*,us!"# : As (e #e +rese# 6&,ue !s +"s! !6e (e 6!e$ "- (e M&#&/!#/ 7!re* "r !s *"rre* . A, er#& !6e S",u !"# %!' C&s( I#-,"$s : %apacity +ales &ess : variable cost %ontribution (A) -)4 0*.)) 3.)) 3.)) .)4 '0.)) 0).() 0).() ,.() ..)) )..(.,' *)4 '/.)) 0'.)) 0'.)) /.)) *.)) ).-(.'* (9igures in la!hs of $upees) 3)4 0))4 '..)) 0,.() 0,.() /.() 3.)) ).(. (.0, ,).)) 0(.)) 0(.)) (.)) 0).)) )./3 /.3)

&ess : 9ixed cost (") ,.)) 6rofit before (%) -.)) Depreciation M 8ax Discount factors (D) ).*. 6resent values 6A8"D (% x D) (E) (.''

+um 8otal of 6resent values In E (9) $s. '(.*( After 8ax present Jalues (1) > (0 A 8)9 > $s. '(.*( x ).- > $s. 0(.(0 T&A s&6!#/s "# 3e+re*!& !"# &et UK: be the cost of machines purchased. 8he salvage value of old machine is $s. ( la!hs. Het outflow of new machines would be (K A () la!hs.

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K?( Depreciation on straight line basis on this would be ?????????????????? la!hs ( Chich will be the same for ( years. K?( 8he present value of such recurring depreciation in e#ual sum would be ?????????????? x ,.,( ( N" e : ,.,( is the sum total of present values for ( years of uniform flow. K?( 8ax saving on such depreciation is ?????????????? x ,.,( x )./ > $s. ).'-* K A $s. 0.,/ ( EBu& !"# : Het 6resent value of replacement > in flows in H years A out flow in the year ). According to the Jice A 6resident (9inance) H6J should be e#ual to $s. /.(, la!hs. Oence the e#uation ).'-* K A 0.,/ = 0(.(0 A (K A () > /.(, > ).'-* K = 0/.0. A K = ( > /.(, la!hs or2 )..,' K > 0/.-/ la!hs 0/.-/ K > ??????????? > $s. ').)) la!hs )..,' 8he cost of new machines is $s. ') la!hs. %!!' %apacity 6rofit before Depreciation M 8axes &ess : Depreciation 6rofit after Depreciation (A A ") &ess: 8ax G /)4 6rofit after 8ax 6rofit after 8ax but Depreciation added bac! i.e. inflow (" = E) Discount factor 6resent Jalues of 9 Het 6resent Jalue I 8otal of O A Initial outflow > $s. 0(.,' A 0(.)) > $s. ).,' la!hs As the Het 6resent Jalue is positive (though in a small sum) the view of the correct. 111111111 anaging Director is A " -)4 -.)) (.)) 0.)) D E )./) ).-) *)4 *.)) (.)) ,.)) 0.') 0.*) ($upees in la!hs) 0))4 0).)) (.)) (.)) '.)) ,.))

9 1 O

(.-) ).*. /.*.'

-.*) )..(.0-*

*.)) ).-(.'*

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Ques !"# 2. (a) (b)

(i) (ii)

Chat are the causes of industrial sic!ness F ention a few symptoms which might indicate that industrial sic!ness lies ahead.

A firm has sales of $s..(2))2))) variable cost of $s./'2))2))) and fixed cost of $s.-2))2))). It has a debt of $s./(2))2))) at 34 and e#uity of $s.((2))2))) (i) (ii) (iii) (iv) (v) (vi) Chat is firm:s $EI F Does it have favourable financial leverage F If the firm belongs to an industry whose asset turnover is ,2 does it have a high or low asset leverage F Chat are the operating2 financial and combined leverages of the firm F If the sales drop to $s.()2))2)))2 what will be the new E"I8 F At what level the E"8 of the firm will be e#ual to Qero F

A#s$er %&' %!' C&uses "- I#3us r!&, s!*9#ess : 8he 8iwari %ommittee appointed by the 1overnment of India to loo! into industrial sic!ness has identified various causes of industrial sic!ness in India. 8he %ommittee has broadly classified such causes into internal and external causes. Among the internal causes inade#uate technical !now how2 location disadvantage2 outdated production process2 high cost of inputs2 brea! A even point too high2 economic siQe of pro7ect2 under A estimation of financial re#uirements and unduly large investments in fixed assets are some of the causes which may be mentioned in this respect. "eside this the dependence on a single customer and the limited number of products2 poor sales realisation2 defective pricing policy2 boo!ing of large orders at fixed prices under inflationary conditions2 lac! of !nowledge of mar!eting techni#ues2 etc.2 are leading to the industrial sic!ness in India. 8he poor resources management and faulty financial management policies li!e wrong dividend policy and faulty costing etc. are also contributing to Industrial sic!ness. Among the external causes identified by the committee are2 government price control2 fiscal duties2 fre#uent changes in government policies2 procedural delays on the part of financial;licensing;other controlling or regulating authorities ("an!2 $"I2 9inancial Institutions2 1overnment Departments2 $86 authorities etc.). besides this natural calamities2 political situation (domestic as well as international)2 stri!es and multiplicity of labour unions are also responsible for industrial sic!ness in India.
%!!'

+tudents may refer to 9+6(H) A9A? ' and 9+6 (H) advanced Accounts A / wherein it has been discussed how the ratios can be used for predicting corporate insolvency and corporate ban!ruptcy. As far as the case of industrial sic!ness in India is concerned2 the 8iwari %ommittee had identified certain symptoms which would be #uite helpful in the detection of sic!ness at the incipient stage. +uch symptoms of sic!ness are continuous irregularity in cash credit accounts2 low capacity utilisation2 profit fluctuations2 downward trend in sales and stagnation or fall in profits followed by contraction in the share of the mar!et2 high rate of re7ection of goods manufactured2 reduction in credit summations2 failure to pay statutory liabilities2 large and longer outstanding in the bill accounts2 longer period of credit allowed on sale documents negotiated through the ban! and fre#uent returns by customers of the same2 constant utilisation of cash credit facilities to the maximum and failure to pay timely installment of principal and interest on term loans and installment credits2 nonAsubmission of periodical financial data;stoc! statements2 etc. in time2 financing capital expenditure out of funds provided for wor!ing capital purpose2 rapid turnover of !ey personnel2 existence of a large number of law suits against the company2 rapid expansion and too much diversification within a short time2 sudden;fre#uent changes in management A whether professional or otherwise and;or dominated by one man;few individuals2 diversion of funds for purposes other than running the unit2 any ma7or change in the shareholdings. 2"r9!#/ :

%0'

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+ales &ess : Jariable cost %ontribution &ess : 9ixed %osts E"I8 &ess : 34 interest on $s. /(2))2))) E"I8

$s. .(2))2))) /'2))2))) ,,2))2))) -2))2))) '.2))2))) /2)(2))) ''23(2)))

(i) (ii)

E"I8 E"I8 '.2))2))) $EI > ????????????????? > ????????????????????? > $s. ??????????????????????? > '.4 Investment Debt = E#uity 02))2))2))) +ince the return on investment ('.4) is higher than the interest payable on debt at 342 the firm has a favourable financial leverage. Het +ales Asset 8urnover > ?????????????????????????????????????????????? 8otal assets > 8otal Investment

(iii)

.(2))2))) 9irm:s Asset 8urnover is > ???????????????????? > )..( 02))2))2))) 8he industry average is ,. hence the firm has low asset leverage. %ontribution ,,2))2))) (iv) Eperating leverage > ??????????????????? > ????????????????? > 0.'''' E"I8 '.2))2))) E"I8 '.2))2))) 9inancial leverage > ????????????? > ?????????????????????????? > 0.0.-/ E"8 ''23(2))) %ontribution ,,2))2))) %ombined leverage > ????????????????????? > ?????????????????????? > 0./,* E"8 ''23(2))) Er %ombined leverage > Eperating leverage x 9inancial leverage > 0.'''' x 0.0.-/ > 0./,* (v) If the sales drop to $s. ()2))2))) from $s. .(2))2)))2 the fall is by ,,.,,4 Oence E"I8 will drop by /)..,4. (4 9all in sales x operating leverage) Oence the new E"I8 will be $s. '.2))2))) x (0 A /)..,4) > $s. 0-2))2'3) or rounded upto $s. 0-2))2))). (vi) E"8 to become Qero means 0))4 reduction in E"8. +ince the combined leverage is 0./,*2 sales have to drop by 0));0./,* i.e. -3.(/4. hence the new sales will be $s. .(2))2))) x (0 A -3.(/4) > $s. ''2*/2()) (approx.)

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Ques !"# 8. (a) 8he "alance +heet of +mart &td. as on &iabilities +hare %apital $eserves &ong 8erm &oan +hort term &oans 6ayables 6rovisions

arch ,02 033. is as follows : (9igures in la!hs of rupees) Assets ')) 0/) ,-) ')) 0') *) 00)) 9ixed Assets Inventories $eceivables %ash and "an! ()) ,)) '/) -) . . 00))

+ales for the year were -)) la!hs. 9or the year endings on arch ,02 033* sales are expected to increase by ')4. 8he profit margin and dividend pay out ratio are expected to be /4 and ()4 respectively. 5ou are re#uired to : (i) Vuantify the amount of external funds re#uired. (ii) Determine the mode of raising the funds given the following parameters : (a) %urrent ratio should at least be 0.,,. (b) $atio of fixed assets to long term loans should be 0.(. (c) &ong term debt to e#uity ratio should not exceed 0.)(. 8he funds are to be raised in the order of short term ban! borrowings2 long term loans and e#uities.

(iii) (b)

8he turnover of $ &td. is $s.-) la!hs of which *)4 is on credit. Debtors are allowed one month to clear off the dues. A factor is willing to advance 3)4 of the bills raised on credit for a fee of '4 a month plus a commission of /4 on the total amount of debts. $ &td. as a result of this arrangement is li!ely to save $s.'02-)) annually in management costs and avoid bad debts at 04 on the credit sales.

A#s$er

%&' (i)

External funds re#uirement (E9$) is given by the following formula. A & E9$ > ??? ? ??? W+ A ms0 (0 A d) + + Chere E9$ external funds re#uirement A + & > > > > +0 D W+ > > > 8otal assets 6revious sales 6ayables and 6rovisions 6rofit argin

6ro7ected sales for the next year Dividend payout ratio Expected increase in sales.

"y substituting the figures2 we get following :

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020)) ')) E9$ > ???????? ? ???????? 0') A @).)/ x .') x ).(B -)) -)) > 0.( x 0') A 0/./ > $s. 0*) A 0/./ > $s. 0-(.- la!hs (ii) (a) ode of raising the funds : +hort term borrowings %urrent ratio should be 0.,, -)) x 0.' 0.,, > ?????????????????????????????????????????????????????????????????????????????????????????? ')) x 0.' = +8"" @Chere +8"" is short term ban! borrowingsBsB 0.,, D0 >.')D'/) = +8"" ("y substituting and solving the e#uation) +8"" will be Existing loans Additional borrowings (b) &ong term debt : $atio of fixed assets to long term loans > 0.( ()) x 0.'D &8 > 0.( 0.( &8 &8 &oans already existing Additional (c) E#uity : External funds &ess : Additional ban! borrowings Additional long term loans "alance additional e#uity Pr""- : Debt e#uity ratio should not exceed 0.)( /))D ''/.'( = 0-* > 0.)' Oence the condition is satisfied2 Hote : (i) &ong term debt > ,-) = /) > /)) (ii) E#uity share capital > ')) = '/.'( > ''/.'( (iii) $eserve will also increase by ')4 > 0/) x 0.' > 0-* 0)0.,( /).)) 0/0.,( '/.'( 0-(.-) > $s. -)) $s. /)) ,-) <<<<<< /) ,)0.,( ')).)) 0)0.,(

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(iii)

8he funds are to be raised in the order of +8"" &ong term loans E#uity 8otal 0)0.(, /).)) '/.'( 0-(.-)

%0'

F&* "r4 &rr&#/e.e# Assuming the turnover given in the problem is annual turnover2 the calculations are as follows :
%ost of factoring : $s.

9ee of '4 on 3)4 of $s. /2))2))) (*)4 of -) la!hs > /* la!hs;0' > / la!hs is the monthly credit sales) commission at /4 on $s. /2))2))) &ess : +avings in cost +avings in annual management cost is $s. '02-)) Oence for the month : ?????????????? 0' > $s. 02*))

>

..')) 0-2))) ??????????????? ',2'))

>

04 saving of "ad debts on $s. /2))2)))> $s. /2))) Het cost in factoring C"s "- )&#9 A36&#*e : Interest at 0*4 p.a for one month on 3)4 of $s. /2))2))) (2/)) 6rocessing fee at '4 on $s. /2))2))) *2))) Add : "ad debts loss that cannot be avoided /2))) (2*)) 0.2/))

<<<<<<< 0.2/))

+ince costs of both alternatives are e#ual2 it is immaterial whether $ &td. goes in for factoring or ban! loan. 1111111 Ques !"# : EI8OE$ (a) (b) Explain briefly2 odigliani and iller approach on cost of capital.

8he "eta %oefficient of 8arget &td. is 0./. 8he company has been maintaining *4 rate of growth in dividends and earnings. 8he last dividend paid was $s./ per share. $eturn on 1ovt. securities is 0)4. $eturn on mar!et portfolio is 0(4. 8he current mar!et price of one share of 8arget &td. is $s.,-. (i) (ii) Chat will be the e#uilibrium price per share of 8arget &td F Could you advise purchasing the share F

E$ (i) R6romoters: contribution is one of the principal means of financing the pro7ectS A Discuss.

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(ii)

P &td. is foreseeing a growth rate of 0'4 p.a. in the next ' years. 8he growth rate is li!ely to fall to 0)4 for the third year and fourth year. After that the growth rate is expected to stabilise at *4 p.a. If the last dividend paid was $s.0.() per share and the investors: re#uired rate of return is 0-42 find out the intrinsic value per share of P &td. as of date. 5ou may use the following table : 5ears ) 0 0 ).*' )../ , ).-/ / ).(( ( )./*

. Discounting 9actor at 0-4

A#s$er

%F!rs A, er#& !6e' %&' M"3!/,!&#! &#3 M!,,er &++r"&*( " *"s "- *&+! &, : odigliani and iller:s argue that the total cost of capital of a particular corporation is independent of its methods and level of financing. According to them a change in the debt A e#uity ratio does not affect the cost of capital. 8his is because a change in the debt A e#uity ratio changes the ris! element of the company which in turn changes the expectations of the shareholders from the particular shares of the company. hence they contend the leverages has little effect on the over A all cost of capital or on the mar!et price. odigliani and Assu.+ !"#s : 0. %apital mar!et are perfect. Information is costless and readily available to all investorsL there are no transaction costsL and all securities are infinitely divisible. Investors are assumed to be rational2 and to behave accordingly. 8he average expected future operating earnings of a firm are represented by a sub7ective random variable. It is assumed that the expected values of the probability distributions of all investors are the same. Implied in the illustration is that the expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings. 9irms can be categoriQed into Re#uivalent returnS classes. All firms within a class have the same degree of business ris!. 8he absence of corporate income taxes is assumed iller made the following assumptions and the derivations there from.

'.

,. /.

T(e!r (ree 0&s!* +r"+"s! !"#s &re : 0. 8he total mar!et value of the firm and its cost of capital are independent of its capital structure. 8he total mar!et value of a firm is given by capitaliQing the expected stream of operating earnings at a discount rate appropriate for its ris! class. 8he expected yield of a share of stoc!2 Te2 is e#ual to the capitaliQation rate of a pure e#uity stream2 plus a premium for financial ris! e#ual to the difference between the pure e#uity A capitaliQation rate and T7 times the ratio ";+. in other words2 Te increases in a manner to exactly offset the use of cheaper debt funds. 8he cutoff rate for investment purposes is completely independent of the way in which an investment in financed. 8his proposition along with the first implies a complete separation of the investment and financing decisions of the firm.

'.

,.

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C"#*,us!"# : 8he theory propounded by them is based on the prevalence of perfect mar!et conditions which are rare to find. %orporate taxes and personal taxes are a reality and they exert appreciable influence over decision ma!ing whether to have debt or e#uity. %0' %!' %A6 formula > E($s) > $f = b @E ($m) A $fB

Chere : E ($s) > Expected rate of return of the security (E$) the cost of e#uity $f > ris! free returns E($m) > mar!et rate or return " > "etta coefficient given 0./ +ubstituting the values E ($s) > 0) = 0./ (0(4 ? 0)4) E ($s) > 0.4 Dividend 1rowth D0 odel > ?????? = g2 where D02 is dividend per share in year 02 6) ar!et price;share in year )

1 is growth rate of dividends2 6) >

E ($s) being ).0.2 we can ma!e the e#uation as / (0.)*) ).0. > ????????????????? = ).)* 6) / (0.)*) ).)3 > ????????????????? 6) / (0.)*) 6) > ?????????????? ).)3 > $s. /* %!!' 8he share of 8arget &td. is under valued. ($s. ,- current mar!et price as against $s. /* e#uilibrium price). Oence it can be purchased. %Se*"#3 A, er#& !6e' %!' 8he promoter is re#uired to provide funds irrespective of whether the pro7ect is an existing one or new venture. 6romoters: contribution consists of : (a) +hare capital to be subscribed by the promoters in the form of e#uity share capital and ; or preference share capital. (b) (c) (d) (e) E#uity shares issued as rights shares to the existing shareholders. %onvertible debentures issued as RrightsS to existing shareholders. Nnsecured loans. +eed capital assistance.

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(f) Jenture capital. (g) Internal cash accruals. In the case of pro7ects established in 7oint or assisted sector2 the contribution of state industrial investment corporation towards share capital is also considered as part of promoters: total contribution. 8he 1overnment of India has classified the locations into three categories A A2 " and % such as : %ategory A %ategory " %ategory % as no industrial district. as districts where industrial activity has started as districts where industrial activity has gained sufficient ground.

1enerally promoters are expected to contribute minimum ')4 of cost of the pro7ect in the case of listed and unlisted companies uniformly. Oowever2 concessional norms for contributions have been prescribed by All India 9inancial Institutions depending upon whether the pro7ect is located in notified (bac!ward) area in category AL " or % districts. 6romoters: contribution indicates the extent of their involvement in a pro7ect in terms of their own financial sta!e. In case the promoters are unable to raise funds to meet the norms of financial institutions2 they can avail the benefit of seed capital assistance under any of the schemes of $D% or ID"I or $%8% etc. the investments made by recognised mutual funds are also considered as promoter:s contribution provided the investment is covered by non A disposal underta!ing or buy A bac! clause. Among different means of finance such as capital incentives2 deferred payment guarantees2 lease finance;hire purchasing2 term loans from financial institutions in the form of rupee loans and foreign currency loans etc.2 promoters contribution is one of the most important sources of finance. %!!' 6resent value of dividend stream for first ' years. $s. 0.() (0.0') x ).*- = 0.() (0.0')' x )../ $s. 0.-* x ).*- = 0.** x )../ $s. 0./( = 0.,3 > '.*/ 6resent value of dividend stream for next ' years $s. 0.** (0.0) x ).-/ = 0.** (0.0)' x ).(( $s. '.). x ).-/ = '.'* x ).(( $s. 0.,, = 0.'( > '.(* (") (A)

ar!et value of e#uity share at the end of / th year computed by using the constant dividend growth model2 would be : D( 6/ > ?????????????? Ts ? 1n Chere D( is dividend in the fifth year2 1n is the growth rate and Ts is re#uired rate of return. How D( > D/ (0 = 1n)

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D( > $s. '.'* (0 = ).)*) > $s. './ 6/ $s. './> ??????????????????? ).0- A ).)* > $s. ,)..( 6resent mar!et value of 6/ > ,)..( x ).(( > $s. 0-.30 Oence the intrinsic value per share of P &td. would be A = " = % i.e.2 '.*/ = '.(* = 0-.30 > $s. ''.,, 11111111111111 Ques !"# <. Crite short notes on : (a) %ross %urrency $oll Ever. (b) 9inancial +waps. (c) 9ixed Jersus 9lexible "udget (d) 8ools of 9inancial 9orecasting A#s$er %&' Cr"ss Curre#*4 R",, O6er : %ross currency $oll Ever contacts are contracts to cover overseas leg of long Aterm foreign exchange liabilities or assets. 8he cover is initially obtained for six months and later extended for further period of six months and so on. $oll over charge or benefit depends on forward premium or discount2 which in turn2 is a function of interest rate differentials between N+ dollar and the other currency. 8here is no ris! of currency appreciation or depreciation in the overseas leg : $oll over for a maturity period exceeding six months is not possible because in the inter A ban! mar!et2 #uotations beyond six months are not available. Nnder the $oll Ever %ontract the basic rate of exchange is fixed but loss or gain arise at the time of each $oll over depending upon the mar!et conditions. %0' F!#&#*!&, s$&+s : 9inancial swaps are a funding techni#ue which permit a borrower to access one mar!et and then exchange the liability for another type of liability. Investors can exchange one type of asset for another with a preferred income stream. +waps by themselves are not a funding instrument2 they are a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. All swaps involve exchange of a series of periodic payments between two parties2 usually through an intermediary which is a large international financial institution. 8he two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant primary financial mar!ets. 8he two ma7or types of financial swaps are interest rate swaps and currency swaps. 8he two are combined to give a cross A currency interest rate swap. A number of variations are possible within each ma7or type. In the following papa the concept of interest rate and currency swaps has been described. (c)

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I# eres r& e s$&+s : Cith an interest rate swap2 interest A payment obligations are exchanged between two parties2 but they are denominated in the same currency. 8he swap can be longer term in nature than either the forward or the future contracts. 8erms extend out to 0( years or more2 whereas the range for forward or futures contracts is upward to five year. 8he mar!et for swaps is unregulated and began in the early 03*)s:. the most common interest rate swap is the floating Afixed rate exchange. 9or example2 a corporate that has borrowed on a fixed rate2 term basis may swap with a counter party to ma!e floating rate interest payment:s. Curre#*4 s$&+s : 5et another device for shifting ris! is the currency swap. In a currency swap2 two parties exchange debt obligations denominated in different currencies. Each party agrees to pay the other:s interest obligation. At maturity2 principal amounts are exchanged2 usually at a rate of exchange agreed upon advance. 8he currency swap mar!et traces its roots to the 03-):s2 when parallel loans were arranged between two borrowers of different nationalities. In currency swaps both the principal and interest in one currency are swapped for principal and interest in another currency. En maturity the principal amounts are swapped bac!. Nsually in practice swap is intermediated by a ban! which ta!es away a part of the savings2 leaving the balance to be shared by the parties. +wap gains or losses arises because of spread compression which varies in different financial mar!ets. %*' F!Ae3 6ersus F,eA!0,e )u3/e : 8he idea of introducing budgets in a business organisation is to exercise control over day A to A day operations of the business. %ontrol2 in order to be effective2 re#uires a standard or a target with which actual performance can be compared for the purpose of measurement of the results for timely action2 if necessary. +uch standard should ta!e into consideration the characteristics and behaviour of cost. %ost is composed of different elementsL behaviour of each element of cost has to be given due recognition in setting standards of fixing budget estimates. Insofar as direct materials and direct labour are concerned2 standards can be set at so much per unit of output because these vary in direct proportion to output. Everheads however pose a big problem because of two special characteristics : (a) certain items of overhead costs are common costs with regard to individual lots or units of product and2 (b) certain other items of overhead costs include fixed elements that do not vary in strict proportion to changes in production volume. 8he presence of common costs necessitates the selection of apportionment ratio based on the standards derived from departmental figures rather than the standard of output. +imilarly2 fixed expenses will remain the same between two levels of output. In view of these two reasons2 an average standard overhead cost per unit of output will not provide the manager an ade#uate basis for control comparisons. 8his had led to the development of flexible budgets. F!Ae3 )u3/e : A budget prepared on the basis of a standard or a fixed level of activity is called a fixed budget. It does not change with the change in the level of activity. In reality2 it is2 however2 ineffective and meaningless primarily because the actual capacity utilisation varies from time to time. It is a self contained and self identified single budget. Nnli!e the flexible budget2 it dose not show changes in costs according to the level of activity. Expenses2 therefore2 are not classified into fixed2 semi A variable and variable and as such2 there is hardly any need for the detailed analysis of each expense item. A specific level of activity or standard is determined and expenses are estimated at that level. Oowever2 in estimating the expenses at specific level of activity operational plans and analysis of historical costs is done. 8he level of activity at which the expenses are estimated in fixed budgets is determined by the production budget. F,eA!0,e )u3/e : RInstitute of %ost and anagement AccountantS (I% A) &ondon terminology defines a flexible budget as a budget which2 by recogniQing the difference between fixed2 semi A

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variable and variable costs is designed to change in relation to the level of activity attained. A fixed budget2 on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. A fixed budget2 on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. In a fixed budgetary control2 budgets are prepared for one level of activity2 where in a flexible budgetary control system2 a series of budgets are prepared one for each of a number of alternative production levels or volumes. 9lexible budgets represent the amount of expenses that is reasonably necessary to achieve each level of output specified. In other words2 the allowances given under flexible budgetary control system serve as standard of what costs should be at each level of output. Nee3 : 8he need for preparation of flexible budgets arises in the following circumstances : (i) (ii) (iii) (iv) (v) %3' seasonal fluctuations in sales an;or production A for example2 in soft drin!s industryL a company which !eeps on introducing new products or ma!e changes in the design of its products fre#uentlyL industries engaged in ma!e A to Aorder business li!e ship buildingL an industry which is influenced by changes in fashionL and general changes in sales.

T"",s "- F!#&#*!&, F"re*&s !#/ : (0) Day:s sales method is a traditional method under which an attempt is made to calculate the number of days sales and tie it up with the balance sheet items. As different components of the balance sheet are forecasted in terms of day:s sale2 this method measures the resources that are to be financed. 6ercentage of sales method is another tool of financial forecasting in which the balance sheet items are expressed as percentages of sales. 8his will clearly (to some extent) show the financial needs caused by increase in sales.

(')

S!.+,e re/ress!"# .e ("3 : En the basis of past relationship between sales and different items2 a line of the best fit is drawn. 8his method re#uires lin!ing sales with one item at a time. 8hus data about different items can be pro7ected with changes in sales level of study and evaluation. Mu, !+,e re/ress!"# .e ("3 : in the case of simple regression method sales are considered as a function of one variable. ultiple regression line is drawn considering the sales as a function of several variables. A financial analyst may adopt any of the above techni#ues depending upon the availability of data and purpose of forecasting.

Cost Academy

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F!#&, %Ne$' EA&.!#& !"# N"6., 199>, Gr.-I

P&+er 2: M&#&/e.e# A**"u# !#/ & F!#&#*!&, &#&,4s!s
Ques !"# 1. 8+& &td. a highly profitable and paying company is planning to expand its present capacity by 0))4. 8he estimated cost of the pro7ect is $s.02))) la!hs out of which $s.()) la!hs is to be met out of loan funds. 8he company has received two offers from their ban!ers : Jalue of loan Interest 6eriod $epayment Ether expenses (to be treated as revenue expenditure) 9uture exchange rate Eption 0 Eption ' $s.()) la!hs N+ X 0/ la!hs e#ual to $s.()) la!hs 0(4 payable yearly -4 payable (fixed) yearly in N+ X ( years ( years (In ( installments. 9irst installment is payable 0 year after draw down) 04 of the value of 04 at N+ X > $s.,the loan Average) ?? End of 0 year IN+ X > $s.,* thereafter to increase by $s.' p.a.

8he company is liable to pay Income?tax at ,(4 and eligible for '(4 depreciation on C.D. value. 5ou may assume that at the end of (th year the company will be able to claim balance in CDJ for tax purposes. 8he company follows Accounting +tandard A+?II for accounting charges in 9oreign Exchange rate. (0) (') (,) (/) %ompare the total outflow of cash under the above options. Nsing discounted cash flow techni#ues2 evaluate the above offers. Is there any ris!2 which the company should ta!e care of F In case 8+& has large volume of exports would your advise be different.

8he following discounting table may be adopted : 5ears : ) Discounting 9actor : 0 0 ).3'0 ' ).*/* , )..*0 / )..') ( ).--,

A#s$er 1. O+ !"# I 5ear $epayment Ef principal ?? 0)) 0)) 0)) 0)) 0)) ()) Interest at 0(4 ?? .( -) /( ,) 0( = ''( Ether expenses (.)) ?? ?? ?? ?? <<<< = (.)) 8ax saving 0..( '-.'( '0.)) 0(..( 0).() (.'( *).() ($s. in la!hs) Het outflow ,.'( 0/*..( 0,3.)) 0'3.'( 003.() 0)3..( -/3.()

) 0 ' , / ( 8otal outflows

>

Cost Academy

27

O+ !"# II Exch? year repay? inter? other total Ange ment of est at charges amt $ate principal <<<<<<<<<<<<<<<<<<<<<<< N+X ,,* /) /' // /) 0 ' , / ( ?? '.* '.* '.* '.* ?? ).*/) ).-.' ).()/ ).,,).0/) ).0/) repay? balance inter? other total tax net ment of being est charges payment savings out? principal premium <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< $s. in &a!hs ?? ?? ?? (.)/ (.)/ 0..-/ ,.'.-

?? ,.-/) 0)).)) ?? ,./.' 0)).)) ?? ,.,)/ 0)).)) ?? ,.0,- 0)).))

-./ ,0.3') 0'.)) '-.**) 0..-) '0.0-* ',.' 0/..*/

0,*.,' 00..,'0'-.(** 0,*.** 0).*.*0'*.))' 0,*..-* 0).)/*0'*..') 0,..3*/ 3.0*/0'*.*))

'.* ).0-* ?? '.3-* 0)).)) '*.* ...'* 0,-.('* '/.*0/000..0/ <<<<<<<<<<<<<<<<<<<<Y<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 0/.) '.(') ).0/)0-.--)()).)) **.)) 0)'./* (.)/-3(.(') -*./')-'..0)) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<

As per A+ A 002 the premium paid on exchange rate difference2 on loans ac#uired for the purpose of capital expenditure2 should be capitalised. 8he same is applicable under the Indian income Atax Act for tax calculations also. 5ear opening Jalue premium total depreciation on premium At '(4 0.-) /.') ..(( 00./-,.03 tax saving at ,(4 ).(0./. '.-/ /.)0 ''.00 closing CDJ

0 ' , / (

??? /.*) 0'.-) ''.-( ,/.,3

-./) 0'.)) 0..-) ',.') '*.*)

-.) 0-.*) ,).') /(.*( -,.03I

/.*) 0'.-) ''.-( ,/.,3 Hil

I Assumed that full benefit will be claimed for tax purposes. 8ax savings on interest other charges and premium. 5ear Amount Ef interest M other charges (.)/) ,0.3') '-.**) '0.0-* 0/..*/ ...'* 8ax savings 8ax savings on premium 8otal 8ax savings

) 0 ' , / (

0..-/ 00.0.' 3./)* ../)* (.0./ '..)/

??? ).(-) 0./.) '.-/) /.)0) ''.00)

0..-/ 00..,' 0).*.* 0).)/* 3.0*/ '/.*0/

Cost Academy

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(') Discounted cash flow : Eption I 5ear ) 0 ' , / ( Het out flow ),.'() 0/*..() 0,3.)) 0'3.'() 003.()) 0)3..() Discounting factor 0.))) ).3'0 ).*/* )..*0 )..') ).--, Discounted value ,.'( 0,-.33 00..*. 0)).3/ *-.)/ .'..<<<<<< (0..*(

Discounted cash flow : option II

5ear

1ross Eutflow (.)/) 0,*.,') 0,*.**) 0,*..-* 0,..3*/ 0,-.('*

8otal tax saving 0..-/ 00..,' 0).*.* 0).)/* 3.0*/ '/.*0/

Het out flow ,.'.0'-.(** 0'*.))' 0'*..') 0'*.*)) 000..0/

discounting factor ??? ).3'0 ).*/* )..*0 )..') ).--,

Discounted value ,.'.00-.(*. 0)*.(/( 0)).(,) 3'..,./.)-/3(../)

0 0 ' , / (

%8'

8he absolute and discounted value of option II seems to be better than option I. Oowever the company has to be careful about future exchange rate. 8he rate indicated is more by rule of thumb than based on any scientific approach. 8he company should cover the foreign exchange rate and then wor! out the value. In case the company has good volume of exports2 then it may help the company to hedge the future payments with outflow. In that case the company may ta!e a lenient view of the possible exchange ris!. 1111111 (a) 8he following details are available in respect of a firm : (i) (ii) (iii) (iv) Annual re#uirement of inventory /)2))) units %ost per unit (other than carrying and ordering cost)$s.0%arrying cost are li!ely to be 0(4 per year %ost of placing order $s./*) per order

%:'

2.

Determine the economic ordering #uantity. (b) 8he experience of the firm being out of stoc! is summarised below : (0) +toc! out (Ho. of units) Ho. of times

Cost Academy ()) 0 (0)

29

/)) '() 0))

()

' , /
0)

(') (,) (/)

(0))

) *) (*)) 9igures in brac!ets indicate percentage of time the firm has been out of stoc!. (') (,) +toc! out costs are $s./) per unit %arrying cost of inventory per unit is $s.') Determine the optimal level of stoc! out inventory. (c) .
. I e. N". A6/. N". "- u#! s !#6e# "r4 A6/. C"s +er u#!

A firm has ( different levels in its inventory. 8he relevant details re given. +uggest a brea!down of the items into A2" and % classifications :

0 ' , / (
Answer

')2))) 0)2))) ,'2))) '*2))) -)2)))

$s.-) $s.0)) $s.00 $s.0) $s.,./)

%&'

%arrying cost per unit per annum > %ost per unit x %arrying cost 4 p.a. > $s. 0- x ).0( > $s. './) How from the formula for Economic Erder Vuantity (EEV) ' x 8otal consumption p.a. x ordering cost per order > ????????????????????????????????????????????????????????????????????????????????????? carrying cost per unit ' x /)2))) x /*) > ??????????????????????????????????????? > /2))) units './) A, er#& !6e $"r9!#/ : Erdering siQe (units) 02))) Ho. of orders re#uired /) Average inventory (units) ()) 8otal carrying cost of Average inventory in $s.02')) 8otal ordering cost > Ho of orders x cost of 6lacing each order 032')) 32-)) .2-*) /2*)) ,2*/) '2/)) 023')

'2))) ') 02))) '2/))

'2()) 002'() ,2)))

/2))) 0) '2))) /2*))

(2))) * '2()) -2)))

*2))) ( /2))) 32-))

0)2))) / (2))) 0'2)))

Cost Academy

30

8otal cost in $s.

')2/))

0'2)))

0)2-*)

32-))

32*/)

0'2)))

0,23')

Oence lease cost of $s. 32-)) is at the ordering siQe of /2))) units. %0' safety stoc! level (units) ()) /)) '() stoc! out (units) ) 0)) '() 0() 0)) /)) ,)) 0() /() ,() ')) () ()) /)) '() 0)) () stoc! out cost G $s. /) per unit $s. ) /2))) 0)2))) -2))) 0-2))) 0'2))) -2))) 0*2))) 0/2))) *2))) '2))) ')2))) 0-2))) 0)2))) /2))) '2))) expected stoc! out costs $s. '2*)) 02-') */) '-) /) ) probability of stoc! out ) ).)0 ).)0 ).)' ).)0 ).)' ).), ).)0 ).)' ).), ).)/ ).)0 ).)' ).), ).)/ ).0) expected stoc! out at this level $s. ) /) 0)) 0') 0-) '/) 0*) 0*) '*) '/) *) ')) ,') ,)) 0-) ')) carrying cost at $s. ') per unit $s. ) 02))) '2))) (2))) *2))) 0)2))) 8otal expected stoc! out cost $s. ) /) '-)

*/)

()

02-')

'2*)) 8otal safety stoc! cost $s. '2*)) '2-') '2*/) (2'-) *2)/) 0)2)))

+afety stoc! &evel (units) ) () 0)) '() /)) ())

Eptimum safety stoc! where the total cost is the least is at () units level. %*' Item Ho. 0 ' , / ( Nnits ')2))) 0)2))) ,'2))) '*2))) -)2))) 02()2))) 4 of total Nnits 0,., -.. '0., 0*.. /).)) 0)).) Nnit cost $s. -).)) 0)).)) 00.)) 0).)) ,./) 8otal cost $s. 0'2))2))) 0)2))2))) ,2('2))) '2*)2))) '2)/))) ,)2,-2))) 4 of total cost ,3.(B A ,'.3B 00.-B" 3.'B -.*) 0)).))

Items Hos. I and II being very valuable are to be controlled first though in #uantity are hardly ')4 of the total2 hence can be classified as A. Hext priority is for Items , and / though #uantity wise /)4 to be classified as " and last priority item ( though in #uantity bul! but value is less hence to be classified as %.

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8.%&'

8he fixed assets and e#uities of Eastern anufacturing %o. &td. are supplied to you both at the beginning and at the end of the year 033-?3. : 6lant &ess depreciation Investment in +hares of +outhern anufacturing %ompany "onds 6ayable %apital +toc! $etained earnings 0;/;3- ($s.) -,2()) 02,'2))) '2()2))) /2))2))) '2,*2))) ,0;,;3. ($s.) 02/'2()) '23)2))) .)2))) /20)2))) /20)2())

5ou are not in a position to have complete "alance +heet data or an income statement for the year in spite of the fact that you have obtained the following information. (a) (b) Dividend of $s.,.2()) were paid. 8he net income included $s.0,2))) as profit on sale of e#uipment. 8here has been an increase of $s.3,2))) in the value of gross plant assets even through e#uipments worth $s.'32))) with a net boo! value of $s.032))) was disposed of.

9rom the particulars given above2 prepare a statement of sources and uses of net wor!ing capital. (b) 8he management off N6 and Down &td. are worried about their increasing labour turnover in the factory and before analysing the causes and ta!ing remedial steps2 they want to have an idea of the profit foregone as a result of labour turnover in the last year.

&ast year sales amounted to $s.*,2),2,)) and the 6;J ratio was ')4. 8he total number of actual hours wor!ed by the direct labour force was /./( la!hs. As a result of the delay by the personnel department in filling vacancies due to labour turnover2 02))2))) potentially productive hours were lost. 8he actual direct labour hours included ,)2))) hours attributable to training new recruits2 out of which half of the hours were unproductive. An analysis of costs incurred conse#uent on labour turnover revealed the following : $s. +ettlement %ost due to &eaving $ecruitment %osts +election %ost 8raining %osts ,)2/3) Assuming that the potential lost as a conse#uence of labour turnover could have been sold at prevailing prices2 find out the profit forgone last year on account of labour turnover. A#s$er %&' Cor!ing Hotes : (i) 6urchase of plant Het increase in 1ross value Add : 1ross value of plant sold (ii) Depreciation on plant and machinery P,&# &#3 .&*(!#er4 &**"u# $s. -,2()) "5 +ale of plant M /,2*') '-2./) 0'2.()

$s. 3,2))) '32))) 02''2)))

8o "alance b;d

achinery A;c

$s. 032)))

Cost Academy

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8o 6urchases

02''2))) <<<<<<<< 02*(2())

"y Depreciation (balancing figure) '/2))) "y "alance c;d 02/'2()) 02*(2())
$s.

(iii) 9unds from operations

Increase in retained earnings @/20)2()) A '2,*2)))B Add : Dividend paid Add : Depreciation on plant &ess : 1ain on sale of e#uipment

02.'2()) ,.2()) '/2))) '2,/2))) 0,2))) '2'02)))

S & e.e# "- s"ur*es &#3 uses "- -u#3

+ources $s. Nses $s.

9unds from operation +ale of e#uipment

'2'02))) ,'2)))

Decrease in net wor!ing capital '2//2()) ("alancing figure) <<<<<<<<< /23.2()) %0' 2"r9!#/ N" es :

6urchase of plant 6urchase of investments ('23)2))) A 02,'2)))) 6ayment of "onds dividends

02''2))) 02,*2))) 02*)2))) ,.2()) <<<<<<<< /23.2())

$s.

(0) Actual hours wor!ed &ess : Nnproductive training hours Actual productive hours (') +ales

/2/(2))) 0(2))) /2,)2)))

$s. *,2),2,)) *,2),2,)) +ales per productive hours ???????????????????? > 03.,0 /2,)2)))

(,) 6otential productive hours lost > 02))2))) +ales foregone > 02))2))) hours x 03.,0 > $s. 032,02))) (/) %ontribution foregone > +ales foregone x p;v ratio > $s. 032,02))) x ')4 > $s. ,2*-2')) S & e.e# "- Pr"-! -"re/"#e ,&s 4e&r "# &**"u# O- ,&0"ur ur#"6er "- U+ &#3 3"$# L 3.
$s.

%ontribution foregone (notes 0 to /) +ettlement cost due to leaving $ecruitment costs +election costs 8raining costs

,2*-2))) /,2*') '-2./) 0'2.() ,)2/3) (2))2)))

Cost Academy

33

Ques !"# :.%&' 9rom the following prepare Income +tatement of %ompany A2" and %. "riefly comment on each company:s performance : %ompany 9inancial &everage Invest Epening &everage Jariable %ost as a percentage to +ales Income?tax $ate %0' A ,:0 $s.')) /:0 -- ';,4 /(4 " /:0 $s.,)) (:0 .(4 /(4 % ':0 $s.02))) ,:0 ()4 /(4

K &td.2 a widely held company is considering a ma7or expansion facilities and the following alternatives are available : A +hare %apital 0/4 Debentures &oan from a 9inancial Institution G 0*4 p.a. $ate of Interest. () ?? ?? Alternatives ($s. In la!hs) " % ') ') 0) 0) 0( '(

Expected rate of return before tax is '(4. 8he rate of dividend of the company is not less than ')4. 8he company at present at present has low debt. %orporate taxation ()4. OR %&' 8he following information is available in respect of A"% &td. : (0) (') (,) (/) . onth Zanuary 9ebruary arch April ay Zune Zuly August (() (-) ,/2))) aterials received $s. ')2))) ''2))) '/2))) '-2))) '*2))) ,)2))) ,'2))) (02))) +ales $s. ,)2))) ,,2))) ,-2))) ,32))) /'2))) /(2))) /*2))) 0,2))) Cages and Expenses $s. 32()) 0)2))) 0)2()) 002))) 002()) 0'2))) 0'2()) aterials are purchased and received one month before being used and payment is made to suppliers two months after receipt of materials. %ash is received from customers three months after finished goods are sold delivery to them.B Ho time lag applies to payments of wages and expenses. 8he following figures apply to recent and future months :

%ash balance at the beginning of April is $s.0)2))). All products are sold immediately they have been made and that materials used and sums spent on wages and expenses during any particular month relate strictly to the sales made during that month.

Cost Academy

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6repare cash flow month by month from April to Zuly2 profit and loss forecast for four months (April?Zuly) and a movement of funds statement for the four months period (April? Zuly). %0' Chat are the matters to be considered in the context of wor!ing capital management in public sector underta!ing F A#s$er %&' F!rs A, er#& !6e 2"r9!#/ #" es : C".+&#4 A E"I8 , 9inancial leverage > ????????????? > ???? or E"I8 > , x E"8 [[[[..(0) E"8 0 Again E"I8 A Interest > E"8 Er E"I8 A ')) > E"8 [[[[[[[[[[[[[[[[[(') 8a!ing (0) M (') we get ,E"8 A ')) > E"8 Er2 'E"8 > ')) or E"8 > $s. 0)) Oence E"I8 > ,E"8 > $s. ,)) %ontribution / Again we have operating leverage > ????????????????? > ??????? E"I8 0 E"I8 > $s. ,))2 hence we get %ontribution > / x E"I8 > $s. 02')) ' How variable cost > -- ??? 4 on sales , ' %ontribution > 0)) A -- ??? i.e. ,,???4 on sales , 02')) Oence sales > ???????????? > $s. ,2-)) ,,0;, 4 +ame way E"I82 E"82 contribution and sales for %ompany ) and C can be wor!ed out. C".+&#4 ) E"I8 / 9inancial leverage > ??????????? > ?????? or E"I8 > / E"8 [[[[..(,) E"8 0 Again E"I8 A interest > E"8 or E"I8 A ,)) > E"8 [[[[[[..(/) 8a!ing (,) M (/) we get2 /E"8 A ,)) > E"8 Er2 ,E"8 > ,)) or E"8 > 0)) Oence E"I8 > / x E"8 > /)) %ontribution ( Again we have operating leverage > ???????????????????? > ????? E"I8 0 E"I8 > /)) Oence we get contribution > ( x E"I8 > '2))) How variable cost > .(4 on sales %ontribution > 0)) A .(4 i.e. '(4 on sales '2))) Oence sales > ?????????? > $s. *2))) '(4 C".+&#4 C E"I8 ' 9inancial leverage > ?????????? > ???? or E"I8 > ' E"8 [[[[[ (() E"8 0

Cost Academy

35

Again E"I8 A Interest > E"8 or E"I8 A 02))) > E"8 [[[[[.(-) 8a!ing (() and (-) we get2 'E"8 A 02))) > E"8 or E"8 > 02))) Oence E"I8 > ' x E"8 > ' x 02))) > '2))) %ontribution , Again we have operating leverage > ???????????????????? > ???? E"I8 0 E"I8 > '2)))2 Oence we get contribution > , x E"I8 > -2))) How variable cost > ()4 on sales. %ontribution > 0)) A () > ()4 on sales -2))) Oence sales > ???????????? > $s. 0'2))) ()4 I#*".e S & e.e# : A " $s. $s. ,2-)) *2))) '2/)) -2))) 02')) '2))) 3)) ,)) ')) 0)) /( (( 02-)) /)) ,)) 0)) /( (( % $s. 0'2))) -2))) -2))) /2))) '2))) 02))) 02))) /() (()

+ales &ess : Jariable cost %ontribution &ess : 9ixed cost E"I8 &ess : Interest E"8 &ess : 8ax /(4 EA8

C"..e# s "# *".+&#4Ds +er-"r.&#*e : 8he financial position of company % can be regarded better than that of other companies A M " because of the following reasons : (i) 9inancial leverage is the measure of financial ris!. %ompany % has the least financial ris! as it has minimum degree of financial leverage. Ho doubt it is true that there will be a more magnified impact on earnings per share on A M " companies than that of % due to change in E"I8 but their E"I8 level due to low sales in very low suggesting that such an advantage is not great. (ii) Degree of combined leverage is maximum in company " A ')2 for %ompany A A 0' and for %ompany % A -2 clearly2 the total ris! (business and financial) complexion of company % is the lowest2 while that of other firms are very high. 8he ability of company % to meet interest liability is better than that of companies A M ".

(iii)

E)ITE I# eres r& !" -"r (ree C".+&#!es : % > ?'2)))D 02))) > ' " > /))D,)) > 0.,, A > ,))D')) > 0.( %0' $eturn on $s. () la!hs G '(4 &ess : Interest on Debenture Interest on loan 8axable profit A 0'.() ??? ??? <<<<< 0'.() " 0'.() '.*) 0.*) <<<<< ..3) % 0'.() '.0) /.() <<<<< (.3)

Cost Academy

36

Income tax ()4 6rofit after tax available 8o share holders $ate of return on +hare capital

-.'( -.'( 0'.(4

,.3( ,.3( 03..(4

'.3( '.3( '3.(4

9rom shareholders point of view alternative % (highest) is to be chosen. Se*"#3 A, er#& !6e %&' C&s( -"re*&s -r". A+r!, " Fu,4 April 0)2))) ,)2))) /)2))) 002))) ''2))) ,,2))) .2))) ay .2))) ,,2))) /)2))) 002()) '/2))) ,(2()) /2()) Zune /2()) ,-2))) /)2()) 0'2))) '-2))) ,*2))) '2()) Amount In $s. Zuly '2()) ,32))) /02()) 0'2()) '*2))) /)2()) 02)))

Epening balance %ollections from debtors 6ayments : Cages M expenses 6ayment to suppliers %losing balance

Pr"-! & L"ss -"re*&s -"r : ."# (s A+r!, 5 Fu,4 +ales (April to Zuly) %losing stoc! (Zuly purchase) &ess : Epening stoc! A ( arch purchase) 6urchase (April to Zuly) Cages M expenses (April to Zuly 6rofit for the / month period M"6e.e# "- Fu#3s S & e.e# +toc! (Epening) April $eceivables (Epening) April arch purchase %redit allowed , month Zanuary sales 9ebruary sales arch sales %redit received ' months 9ebruary purchases arch purchase '/2))) 020-2))) /.2))) 02*.2))) 032))) '/2))) ,)2))) ,,2))) ,-2))) 332))) %reditors (Epening) April ''2))) '/2))) /-2))) ,'2))) 02,(2))) -'2))) $s. 032))) 0-2))) ,(2))) $s. 02./2))) ,'2))) '2)-2)))

%losing stoc! (end of Zuly)2 Zuly purchase $eceivable (end of Zuly)2 ay to Zuly sales %reditors (end of Zuly)2 Zune and Zuly purchase How movement of funds statement can be wor!ed out S"ur*es : 6rofit earned during / months Add : Increase in creditors (-'2))) A /-2)))) A++,!*& !"# :

Cost Academy

37

&ess : Increase in receivables (02,(2))) A 332)))) &ess : Increase in stoc! (,'2))) A '/2)))) Epening cash balance Oence closing cash balance %0' In the context of wor!ing capital be considered : (0)

,-2))) *2))) //2))) (?) 32))) 0)2))) 02))) anagement in public sector underta!ings the following should

6ublic sector underta!ings are often blamed for over inventory resulting in bloc!ing of capital and space or less often for under inventory upsetting production schedule. "oth are signs of inefficient inventory management. 8here is generally no provision for wor!ing capital margin at the time of estimating cost of pro7ect. %onse#uently there is no provision of long A term funds for wor!ing capital and the enterprise has to obtain financing from short A term sources. ost of the public sector units are capital intensive hence ratio of current assets to fixed assets is generally low. ost of the public sector underta!ings lac!s application of wor!ing capital management techni#ues specially relating to receivables li!e discount rate2 credit period and credit standards. 8he reason being that they sell bul! of their output to 1overnment departments. 11111111111

(')

(,) (/)

Ques !"# <

Crite short notes on : (a) "ridge 9inance. (b) %all and put option with reference to debentures. (c) %apital Asset 6ricing odel (%A6 ). (d) 9orward as hedge instrument.

A#s$er %&' )r!3/e F!#&#*e : "ridge 9inance refers2 normally2 to loans ta!en by a business2 usually from commercial ban!s for a short period2 pending disbursement of term loans by financial institutions2 normally it ta!es time for the financial institution to finalised procedures of creation of security2 tie A up participation with other institution etc. even though a positive appraisal of the pro7ect has been made. Oowever2 once the loans are approved in principle2 firms2 in order not to lose further time in starting their pro7ects arrange for bridge finance. +uch temporary loan is normally repaid out of the proceeds of the principal term loans. It is secured by hypothecation of moveable assets2 personal guarantees and demand promissory notes. 1enerally rate of interest on bridge finance is higher as compared with that on term loans. %0' C&,, &#3 +u "+ !"# $! ( re-ere#*e " 3e0e# ures : (0) A debenture is an instrument for a fixed period of time mostly at fixed rate of interest. (') How a days the rate of interest varies significantly. (,) Cith inflow of enormous foreign funds this has assumed greater significance. (/) A call option gives a liberty to the issuer of the debenture to pay bac! the amount earlier to the redemption date at a pre A determined price (stri!e price) within the specified period. In case the option is not exercised the debenture continues. (() En the other hand2 a put option means2 a right to investors to demand bac! the money earlier to the redemption data at a pre A determined price (stri!e price ) within the specified period. (-) 8he debenture holder can get bac! the money and invest it elsewhere.

Cost Academy

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(.) 8hese !inds of options are necessary to ma!e the instrument investor friendly and to ensure li#uidity in debentures mar!et. %*' C&+! &, Asse Pr!*!#/ M"3e, %CAPM' : %A6 provides a conceptual frame wor! for evaluating any investment decision where capital is committed with a goal of producing future returns. Important assumptions in %A6 are : (i) 8here is an efficient mar!et meaning existence of competitive mar!et where financial securities and capital assets are bought and sold with full information of ris! and return available to all participants.

(ii) 8here exists rational investment goals. (iii) All assets are divisible and li#uid assets. (iv) Investors are free to borrow at ris! less rate of interest. (v) +ecurities can be exchanged without payment of bro!erage2 commission or taxes and without any transaction costs. (vi) +ecurities or capital assets face no ban!ruptcy or insolvency. %A6 can be used to estimate the expected return of any portfolio with the following formula. > > > > > > $f = "p @E ($m) A $fB Expected return of the portfolio. $is! free rate of return. 6ortfolio "eta i.e.2 mar!et sensivity index. Expected return on mar!et portfolio. ar!et ris! premium.

E($6) E($p) $f "p $ ($m) E ($m) A $f %3'

F"r$&r3 &s (e3/e !#s ru.e# : International transactions both trade and financial give rise to currency exposures. A currency exposure if left unmanaged leaves a corporate open to profits or losses arising on account of fluctuations in currency ratio. Ene way in which corporate can protect itself from effects of fluctuations in currency rates in through buying or selling in forward mar!ets. A forward transaction is a transaction re#uiring delivery at a future date of a specified amount of one currency for a specific amount of another currency. 8he exchange rate is determined at the time of entering into the contract but the payment and delivery ta!es place on maturity. %orporate use forwards to hedge themselves against fluctuations in currency price that would have a significant impact on their financial position. "an!s use forward to offset the forward contracts entered into with non A ban! customers.

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MAY, 199@ Gr. 5 I PAPER 2: MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS

Ques !"# 1. + Engineering %ompany is considering to replace or repair a particular machine2 which has 7ust bro!en down. &ast year this machine cost $s.')2))) to run and maintain. 8hese costs have been increasing in real terms in recent years with the age of the machine. A further useful life of ( years is expected2 if immediate repairs of $s.032))) are carried out. If the machine is not repaired it can be sold immediately to realise about $s.(2))) (Ignore loss;gain on such disposal). Alternatively2 the company can buy a new machine for $s./32))) with an expected life of 0) years with no salvage value after providing depreciation on straight line basis. In this case2 running and maintenance costs will reduce to $s.0/2))) each year and are not expected to increase much in real terms for a few years at least. + Engineering %ompany regard a normal return of 0)4 p.a. after tax as a minimum re#uirement on any new investment. %onsidering capital budgeting techni#ues2 which alternative will you choose F 8a!e corporate tax rate of ()4 and assume that depreciation on straight line basis will be accepted for tax purposes also. 1iven cumulative present value of $e.0 p.a. at 0)4 for ( years $s.,..302 0) years $s.-.0/(. A#s$er E6&,u& !"# "- +r"+"s&, " re+&!r eA!s !#/ .&*(!#e "r 0u4 & #e$ .&*(!#e -"r MEs S. E#/!#eer!#/ C".+&#4 %!' T" re+&!r eA!s !#/ .&*(!#e : $s. Present value of after tax outflows %ost of repairs immediately net of tax $s. 32()) (()4 of $s. 032)))) E#uivalent annual cost for ( year $s. 32())D,2.30 $unning and maintenance cost per annum net of tax (()4 of $s. ')2)))) %!!' T" 0u4 & #e$ .&*(!#e : $s. Present value of after tax cash outflows 6urchase cost of new machine &ess : +ale proceeds of old machine E#uivalent annual cost for 0) years $s. //2)))D -.0/( 8ax saving of depreciation ($s. /32)));0)) x ()4 $unning and maintenance cost p.a. net of tax (()4 of $s. 0/2)))) 8otal net e#uivalent cash outflows p.a. /32))) <(2))) //2))) .20-) ('2/()) <.2))) 002.0) '2()0)2))) 0'2()-

+ince2 net e#uivalent cash outflows p.a. for buying a new machine $s. 002.0) is less than net e#uivalent cash outflows of $s. 0'2()- for repairing of an existing machine. 8herefore2 it is advisable that the company should go for buying a new machine. %Se*"#3 S",u !"#' %!' T" re+&!r &# eA!s !#/ .&*(!#e. $s. 32()) ,.230) /.2/0)

Prese# 6&,ue "- &- er &A *&s( "u -,"$s

%ost of repair immediately net of tax ($s. 032))) x ()4) $unning M maintenance cost for( years ($s. ')2))) x ()4 x ,..30) 8otal net present value of after tax cash outflows for ( years Oence2 net e#uivalent cash outflows p.a. $s. /.2/0)D ,2.30

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%!!' T" 0u4 #e$ .&*(!#e

$s.

Prese# 6&,ue "- &- er &A *&s( "u -,"$s

6urchase cost of new machine &ess : +ale proceeds of old machine 8ax benefit on depreciation p.a. ($s. /32)));0)) x ()4 $unning and maintence cost p.a. (()4 of $s. 0/2)))) /32))) (2))) ('2/()) .2))) /2(() '.23-) .023-) 002.0) //2)))

Het cash outflows for 0) years ($s. /2(() x -.0/() 8otal net 6resent value of after tax cash outflows for 0) years Oence2 net e#uivalent cash outflow p.a. $s. .023-)D -.0/(

+ince2 net e#uivalent cash outflows p.a. for buying a new machine $s. 002.0) is less than net e#uivalent outflows of $s. 0'2()- for repairing of an existing machine. 8herefore2 it is advisable that the company should go for buying a new machine. 11111111111111 2.%&' A limited company operates a lodging house with a restaurant2 shops and recreational facilities attached. Its manager has entrusted you with the planning of the coming year:s operations2 more particularly on the level of profits the company was li!ely to earn. 8he lodging house has 0)) double?bed rooms2 which are li!ely to be rented at $s.0() per day. 8he manager expects an occupancy ratio of .(4 for a period of '() days during the tourist season. It is also anticipated that both the beds in a room will be occupied during the period. Each person staying in the lodging house is expected to spend2 on the basis of past statistics2 $s.,) per day in the shops attached to the lodge and $s.-) per day in the restaurant. 8he recreational facilities are not charged to the customer. +ome other relevant data available to you is as under : (i) Jariable cost to volume ratio : %ost of goods sold +upplies Ethers (ii) (iii) +hops /)4 (4 (4 $estaurant ,)4 0(4 0)4

9or the lodging house2 the variable costs are $s.'( per day per occupied room for cleaning2 laundry etc. Annual fixed costs for the entire complex are $s.032()2))).

9rom the above2 you are re#uired to prepare : (a) (b) (b) an income statement for the coming yearL and an analysis to indicate whether the manager:s suggestion of reducing the room rent to $s.0'( per day to enhance the occupancy ratio to 3)4 should be accepted. An investor is see!ing the price to pay for a security2 whose standard deviation is ,.)) per cent. 8he correlation coefficient for the security with the mar!et is ).* and the mar!et standard deviation is '.' per cent. 8he return from government securities is (.' per cent and from the mar!et portfolio is 3.* per cent. 8he investor !nows that2 by calculating the re#uired return2 he can then determine the price to pay for the security. Chat is the re#uired return on the security F

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A#s$er %&' EA+e* e3 I#*".e S & e.e# "- A L 3. C".+&#4 (A) $evenue : Ootel $oom receipts (0)) rooms x '() days x $s. 0() x .(4) +hops (0)) rooms x ' persons x '() days x $s. ,) x .(4) $estaurant (0)) rooms x ' persons x '() days x $s. -) x .(4) (") Jariable costs : Ootel $ooms (0)) rooms x '() days x $s. '( x .(4) +hops ($s. 002'(2))) x ()4) $estaurant ($s. ''2()2))) x ((4) (%) %ontribution (A A ") &ess : 9ixed costs Expected profits %0' $s. /2-*2.() (2-'2()) 0'2,.2()) $s. '*20'2()) 002'(2))) ''2()2))) -02*.2()) $s. ''2-*2.() ,320*2.() 032()2))) 032-*2.() $s. '*20'2()) 0,2()2))) '.2))2))) -*2-'2())

I#*".e S & e.e# 0&se3 "# M&#&/erDs su//es !"#s. (A) $evenue : Ootel $oom receipts (0)) rooms x '() days x $s. 0'( x 3)4) +hops (0)) rooms x ' persons x '() days x $s. ,) x 3)4) $estaurant (0)) rooms x ' persons x $s. -) x 3)4) (") Jariable costs

$s. $s. Ootel $oom (0)) rooms x '() days x $s. '( x 3)4) (2-'2()) +hops ($s. 0,2()2))) x ()4) -2.(2))) $estaurant ($s. '.2))2))) x ((4) 0/2*(2))) '.2''2()) (%) %ontribution (A A ") /02/)2))) &ess : 9ixed costs 032()2))) 6rofit '023)2))) 8he profit based on manager:s suggestion $s. '023)2))) is higher than the expected profit $s. 032-*2.()2 therefore it is advisable that the manager:s suggestion of reducing the room rent to $s. 0'( per day to enhance the occupancy ratio to 3)4 should be accepted. %0' %orrelation coefficient between the security and the mar!et x +td. Deviation of the security return. "eta coefficient > ????????????????????????????????????????????????????????????????????????????????????????????????????????? +td. Deviation of the mar!et return. > ().*) x ().,)D().'') > 0.)30 How2 re#uired return on the security : $ate of return on ris! free security = beta coefficient (regd. $eturn on mar!et portfolio A rate of return on ris! free security) > (.' = 0.)30 (3.* A (.') > (.' = (.)' > 0).''4 111111111111

Ques !"#
8.%&' 8he present credit terms of 6 %ompany are 0;0) net ,). Its annual sales are $s.*) la!hs2 its average collection period is ') days. Its variable costs and average total costs to sales are ).*( and ).3( respectively and its cost of capital is 0) per cent. 8he proportion of sales on which customers currently ta!e discount is ).( 6 %ompany is considering relaxing its discount terms to ';0) net ,). +uch relaxation is expected to increase sales by $s.( la!hs2 reduce the average collection period to 0/ days and increase the proportion of discount sales to ).*. Chat will be the effect of relaxing the discount policy on company:s profit F 8a!e year as ,-) days.

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(b)

A company operating in a country having the dollar as its unit of currency has today invoiced sales to an Indian company2 the payment being due three months from the date of invoice. 8he invoice amount is X 0,2.() and at today:s spot rate of X ).)'.( per $e.02 is e#uivalent to $s.(2))2))). It is anticipated that the exchange rate will decline by (4 over the three month period and in order to protect the dollar proceeds2 the importer proposes to ta!e appropriate action through foreign exchange mar!et. 8he three forward rate is #uoted as X ).)'., per $e.0 5ou are re#uired to calculate the expected loss and to show2 how it can be hedged by forward contract.

(c)

K %o. &td. issued commercial paper as per following detail : Date of issue 0.th Zanuary2 033* Date of maturity 0.th April2 033* Ho. of days 3) Interest rate 00.'(4 p.a. Chat was the net amount received by the company on issue of commercial paper F

A#s$er %&' E6&,u& !"# "- e--e* "- re,&A!#/ (e 3!s*"u# +",!*4 "# *".+&#4Ds +r"-!
$s.

A. Incremental $evenue Increase in contribution ($s. (2))2))) x 0(4) $eduction in investment in receivable x cost of capital 6resent : $s. *) la!hs x ).3( x ') daysD ,-)days > $s. /2''2'''

.(2)))

6roposed > ($s. *) la!hs x ).3( = $s. ( la!hs x ).*() x 0/ days D,-) days > $s. ,20'2)*, $eduction in investment in receivable $s. 020)20,3 ($s. /2''2''' A $s. ,20'2)*,) %ost of savings on investment in receivable ($s. 020)20,3 x 0)4) 002)0/ *-2)0/ ". Incremental %ost Increase in discount 6resent : ($s. *) la!hs x 04 x ).() > $s. /)2))) 6roposed : ($s. *( la!hs x '4 x ).*) > $s. 02,-2))) Het increase in discount > $s. 3-2))) %. Het effect on 6rofits (A A ") > $s. *-2)0/ A $s. 3-2))) > (?) $s. 323*-

+ince2 the proposed discount policy will reduce the profits of the company to the extent of $s. 323*-. therefore2 it is not advisable for the company to relax the present discount policy. %0' C&,*u,& !"# "- (e eA+e* e3 ,"ss 3ue " -"re!/# eA*(&#/e r& e -,u* u& !"# Present cost X0,2.() Gtoday spot rate of X ).)'.( per $e. 0 Cost after 3 months X0,2.() G expected spot rate of X).)'-0'( per $e. 0 ($efer to wor!ing note) Expected loss 9orward cover is available today at 0 $e. > X).)'., for , months > $s. (2))2))) > $s. (2'-2,0<<<<<<<<<<< $s. '-2,0-

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If we ta!e forward cover now for payment after months net amount to be paid is (X0,2.() ; X).)'.,) > '2).2--, Oence2 by forward contract the company can cover $s. ''2-(, ($s. '-2,0- A $s. ,2--,) i.e. about *-4 of the expected loss. 2"r9!#/ N" e : Expected spot rate after 3 months. It is anticipated by the company that the exchange rate will decline by (4 over the three months period. 8he expected rate will be 6resent rate A (4 of the present rate > X).)'.( A (4 of X).)'.( > X).)'-0'( Alternatively2 the expected rate may also be calculated as follows : X).)'.( x 3(4 > X).)'-0'( Se*"#3 A, er#& !6e S",u !"# C&,*u,& !"# "- eA+e* e3 ,"ss 3ue " -"re!/# eA*(&#/e r& e -,u* u& !"#s Present cost X0,2.() G $s. ,-.,($efer to wor!ing note) Cost after 3 months X0,2.() G expected spot rate of $s. ,*.0* ($efer to wor!ing note ') Expected loss $s. /23323().)) $s. (2'/23.(.)) <<<<<<<<<<<<< $s. '(2)'(.))

9orward cover is available today at $s. ,-.-, for 0 N+ X ($efer to wor!ing note ,) If we ta!e forward cover now for payment after , months net amount to be paid is $s. (2),2--, (X0,2.() G $s. ,-.-, per X). Oence2 by forward contract the company can cover $s. '02,-' ($s. '(2)'( A $s. ,2--,) i.e. about *(.,4 of the expected loss. 2"r9!#/ #" es : 0. 8oday spot rate X ).)'.( per $e. 0

or2 0 X > 0D).)'.( or $s. ,-.,-

'. Expected spot rate after 3 months It is anticipated by the company that the exchange rate will decline by (4 over the three months period. 8he expected rate will be 6resent rate = (4 of $s. ,-.,- > $s. ,*.0* ,. Today forward rate X ).)'., per $e. 0 or 0X > 0D ).)'., > $s. ,-.-, %*' N" e : It has been assumed that the amount of commercial paper issued is $s. ( crores. Oence2 the net amount received by the company on issue of commercial paper is an follows : Interest: 00.'(4 p.a. > 00.'( x 3)D ,-( > '.../4 for 3) days Oence2 interest will be > '.../D (0))='.../)\ $s. ( crores > $s. 0,2/32(-, Het amount received at the time of issue > $s. ( crores A $s. 0,2/32(-, > $s. /2*-2()2/,. EIT;ER

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Ques !"# :. (a) (b)

Chat is 9inancial 9orecasting F Describe in brief2 its utility and how it is effected 8he following figures are made available to you :

$s. Het profits for the year 0*2))2))) &ess : Interest on secured debentures at 0(4 p.a. (debentures were issued , months after the commencement of the year) 020'2()) 0-2*.2()) &ess : Income?tax at ,(4 and dividend distribution tax *2/,2.() 6rofit after tax *2/,2.() Humber of e#uity shares ($s.0) each) 02))2))) ar!et #uotation of e#uity share $s.0)3..) 8he company has accumulated revenue reserves of $s.0' la!hs. 8he company is examining a pro7ect calling for an investment obligation of $s.0) la!hs: this investment is expected to earn the same rate of return as funds already employed. 5ou are informed that a debt e#uity ratio (Debt divided by debt plus e#uity) higher than -)4 will cause the price earning ratio to come down by '(4 and the interest rate on additional borrowals will cost company ,)) basis points more than on their current borrowal on secured debentures. 5ou are re#uired to advise the company on the probable price of the e#uity share if (a) the additional investment were to be raised by way of loansL or (b) the additional investment were to be raised by way of e#uity. OR A newly established company manufacturing two products furnishes the %ost +heets as under : 6roducts $s.;unit & " Direct aterials Direct labour Jariable Everheads +elling 6rice /) ,) 0/ 0)) ') 0( . ()

9ixed overheads excluding ban! interest amount to $s.-2))2))) p.a. spread out evenly throughout the year. +ales forecast is as under : 6roduct Zuly August +ept. Ect. Hov.:3* & (units) /2')) /2-)) ,2-)) /2))) /2()) " (units) '20)) '2,)) 0.*)) '2))) 023)) 6roduction : .(4 of each month:s sales will be produced in the month of sale and '(4 in the previous month. +ales 6attern : &: ??Ene?third of sales will be on cash basis on which a cash discount of '4 is allowed. ??Ene?third will be on documents against payment basis. 8he documents will be discounted by the ban! in the month of sales itself. ??"alance of one?third will be on documents against acceptance basis. 8he payment under this scheme will be received in the third month. 9or e.g. for sales made in +eptember2 payment will be received in Hovember.

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":

*)4 of the sales will be against cash to be received in the month of sales and the balance ')4 will be received next following month.

Direct aterials : ()4 of the direct materials re#uired for each month:s production will be purchased in the previous month and the balance in the month of production itself. 8he payment will be made in the month next following the purchase. Direct Cages : *)4 of the direct wages will be paid in the month of use of direct labour for production and the balance in the next following month. Jariable Everheads : ()4 to be paid in the month of incurrence and the balance in the next following month. 9ixed Everheads : /)4 will be paid in the month of incurrence and the other /)4 in the next following month. 8he balance of ')4 represents depreciation. 8he bill discounting charges payable to the "an! in the month in which the bills are discounted amount to () paise per rs.0)) of bills discounted. A cash balance of $s.02))2))) will be maintained on 0st Zuly2 033*. 6repare a cash budget month wise for Zuly2 August and +eptember2 033*. A#s$er %F!rs A, er#& !6e' %&' 9orecasting is the first stage in the financial planning process. 8his refers to the formal process of predicting future events which will effect significantly the functioning of an enterprise. 9inancial forecasting2 therefore2 implies the techni#ue of determining in advance the re#uirements and utilisation of funds for a future period. It is a techni#ue of systematic presentations of data in the form of financial statements2 ratios etc. Chile forecasting refers to finding the most profitable course of events or at best a range of probabilities2 planning is deciding what one will do about it. 6lanning deals with the futurity of present decisions in terms of (a) setting goals and developing strategies to achieve them and (b) translating strategies into detailed operational programmes and assuring that plans are carried out. 8he former one can be called as strategic planning2 the other is termed as programming. 9inancial forecasting aims at pre A determining the demand for funds and the avenues wherein the funds are to be utilised. 8hus2 a systematic pro7ection of financial data is made in the form of pro7ected financial statements with the help of fund flow statements2 ratio analysis etc. 8hese pro7ections are based on past record of the organisation with a view to predict the future financial performance. 9orecasting generates information which is utilised by the management of an enterprise2 for ma!ing proper decisions and for 7udging the financial efficiency of the funds and pro7ecting a scale of standards to be followed in the future course. Another ob7ective of financial forecasting is to use it as control device. +tandards of financial performance of an enterprise could be laid down through financial forecasting for evaluating the results and assuring its growth. Eptimum utilisation of funds can be achieved through forecasting. A pre A testing of financial feasibility of implementation of production prospects or programmes can also be made by rupees forecasting. 8hrough use of computers2 financial forecasting has scaled new heights. 9inancial forecasting has utility for a business organisation because (i) (ii) (iii) It generates useful information for decision ma!ing. It provides significant information for successful financial planning. It facilitates the organisation to plan its growth and its financial needs.

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(iv)

It functions as a control device by providing a standard of financial performance for the future. (v) It enables the organisation to ma!e optimum utilisation of available funds; resources. (vi) It ma!es the organisation to adopt appropriate financial policies. (vii) It updates the financial plans periodically and ma!e them relevant according to changing circumstances. 9inancial forecasting uses the followings tools: (a) Day:s sales method (b) 6ercentage of sales method (c) +imple regression method (d) ultiple regression method. 9inancial forecasting helps an organisation in the preparation of statements li!e proforma income statement2 proforma balance sheet2 fund flows statement2 cash budget etc. as tools for long and medium term financial planning. %0' 2"r9!#/ N" e: Present earnings/ share : 6rofit before taxes &ess : 8axes at ,(4 6rofit after tax Ho. of e#uity shares E.6.+. > $s. 0)23-2*.( D02))2))) E.6.+. > $s. 0).3. ar!et price $s. 0)3..) Oence2 6;E > $s. 0)3..)D$s. 0).3. > 0) %&' Pr"0&0,e +r!*eE s(&re, !- (e &33! !"#&, !#6es .e# $ere " 0e r&!se3 04 $&4 "- ,"&#s 6resent capital employed :
$s.

$s. 0-2*.2()) (23)2-'( 0)23-2*.( 02))2)))

E#uity Debenture (&ong term) $evenue reserves

0)2))2))) 0)2))2))) 0'2))2)))

$s. ,'2))2)))

6re A Interest and pre A tax profits given $s. 0* la!hs $ate of return E"I8 > $s. 0* la!hs x 0)) D$s. ,' la!hs > (-.'(4 Debt e#uity ratio2 if $s. 0) la!hs (additional investment) were to be borrowed (Debt $s. ') la!hs and e#uity $s. '' la!hs)2 will be $s. ') la!hs x 0))D $s. /' la!hs > /..-) +ince2 the debt e#uity ratio will not exceed -)4 6;E will remain same. If $s. 0) la!hs is to be borrowed2 the earning will be as under : $s. $eturn of (-.'(4 on $s. /' la!hs &ess : Interest at 0(4 on existing $s. 0) la!hs debenture 02()2))) Interest on fresh borrowed amount of $s. 0) la!hs at 0*402*)2))) 6rofit after interest before tax &ess : 8ax at ,(4 6rofit after tax $s. ',2-'2()) ,2,)2))) ')2,'2()) .2002,.( 0,2'020'(

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Ho. of e#uity shares E.6.+. > $s. 0,2'020'(D02))2))) > $s. 0,.'0 6robable price of e#uity share > $s. 0,.'0 x 0) > $s. 0,'.0) ($efer to wor!ing note) %0'

02))2)))

Pr"0&0,e +r!*eE s(&re, !- &33! !"#&, !#6es .e# $ere " 0e r&!se3 04 $&4 "- eBu! 4. If $s. 0) la!hs were to be raised by way of e#uity shares to be raised at mar!et rates. 8he existing mar!et price of $s. 0)3..) may come down a little and may possible settle at $s. 0)). hence2 new e#uity shares to be raised will be $s. 0)2))2))); $s. 0)) > 0)2))) shares If $s. 0) la!hs is to be raised by way of e#uity shares2 the earning will be as under :? 6rofit before interest and tax &ess : Interest on debentures 6rofit after interest before tax &ess : 8ax G ,(4 6rofit after tax Ho. of e#uity shares E.6.+. > $s. 0/2,*20'( D020)2)))> $s. 0,.). 6robable price of e#uity share > $s. 0,.). x 0) > $s. 0,)..) ($efer to wor!ing note) $s. ',2-'2()) 02()2))) ''20'2()) .2./2,.( 0/2,*20'( 020)2)))

8he suggested solution will be to issue fresh debentures to finance expansion. A#s$er %Se*"#3 A, er#& !6e' C&s( )u3/e -"r Fu,4, Au/us &#3 Se+ e.0er, 199@ 6articulars (A) Re*e!+ s +ales
($efer to wor!ing note 0)

Zuly:3* $s. ,2-02'))

Aug. :3* $s. /20-2-))

+ept.:3* $s. /2.'2-))

(")

P&4.e# s Direct aterials ($efer to wor!ing note ') Direct Cages ($efer to wor!ing note ,) Jariable overheads ($efer to wor!ing note /) 9ixed overheads ($efer to wor!ing note () "ill Discounting charges ($efer to wor!ing note -)

02,,2.() 02,-2*.( /-2*0, /)2))) .)) <<<<<<< ,2(*20,*

'20-2'() 02-'2.() .(2-** /)2))) .-. <<<<<<< /23(2/((

'2)02'() 02/,2-'( .)2/,* /)2))) -)) <<<<<<<< /2((230,

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(%) (D) (E)

Sur+,usE 7e-!*! "- C&s( %A 5 )' Add : Epening "alance %losing "alance (% = D)

,2)-' 02))2))) 02),2)-'

(.*2*(() 02),2)-' '/2').

0-2-*. '/2'). /)2*3/

2"r9!#/ N" es : 6articulars

0. +ales :

Zune:3* ??? ???

Zuly:3* /2')2))) 02)(2))) <<<<<<<< (2'(2)))

Aug.2:3* /2-)2))) 020(2))) <<<<<<<< (2.(2)))

+ept.:3* ,2-)2))) 3)2))) <<<<<<<< /2()2)))

Ect.:3* ??? ???

& "

%ash inflow from sales : & 0;, cash less discount ??? 02,.2')) 02()2'-. 020.2-)) (0;, of $s. (0;, of $s. (0;, of $s. /2')2))) x 3*4)/2-)2))) x 3*4),2-)2))) x 3*4) 02/)2))) (0;, of $s. /2')2)))) ??? */2))) (*)4 of $s. 02)(2)))) ??? <<<<<<<< ,2-02')) ??? ,20() (.(4 of /2')) units) 02(,2,,, (0;, of $s. /2-)2)))) ??? 3'2))) (*)4 of $s. 020(2)))) '02))) (')4 of 02)(2)))) <<<<<<<< /20-2-)) ,2/() (.(4 of /2-)) units) 3)) ('(4 of ,2-)) units) <<<<<<<< /2,() 02.'( (.(4 of '2,)) units) /() ('(4 of 02*)) units) <<<<<<< '20.( 02')2))) (0;, of $s. ,2-)2)))) 02/)2))) .'2))) (*)4 of $s. 3)2)))) ',2))) (')4 of 020(2)))) <<<<<<<< /2.'2-)) '2.)) (.(4 of ,2-)) units) 02))) ('(4 of /2))) units) <<<<<<<< ,2.)) 02,() (.(4 of 02*)) units) ()) ('(4 of '2))) units) <<<<<<< 02*() ???

0;, D;6 discounts

???

???

0;, DA collection " *)4 %ash

??? ???

??? ???

')4 collection

???

???

8otal '. 6roduction (Vty) & .(4

,2))) (.(4 of /2))) units) 020'( ('(4 of /2()) units) <<<<<< /20'( 02()) (.(4 of '2))) units) /.( ('(4 of 023)) units) <<<<<<< 023.(

'(4

02)() 020() ('(4 of ('(4 of /2')) units) /2-)) units) <<<<<<<< <<<<<<< 02)() /2,)) ??? 02(.( (.(4 of '20)) units)

"

.(4

'(4

('( (.( ('(4 of ('(4 of '20)) units) '2,)) units) <<<<<< <<<<< ('( '20()

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Direct material re#uirements: ($s.) & /'2))) 02.'2))) (02)() units (/2,)) units x $s. /)) x $s. /)) 0)2()) (('( units x $s. ')) <<<<<<<< ('2()) /,2))) ('20() units x $s. ')) <<<<<<<< '20(2))) 02./2))) (/2,() units x $s. /)) /,2()) ('20.( units x $s. ')) <<<<<<<<< '20.2()) 02/*2))) (,2.)) units x $s. /)) ,.2))) (02*() units x $s. ')) <<<<<<<<< 02*(2))) 3'2()) (()4 of $s. 02*(2)))) 02)'2'() (()4 of $s. '2)/2())) <<<<<<<<<< 023/2.() '2)02'() 02-(2))) (/20'( units x $s. /)) ,32()) (023.( units x $s. ')) <<<<<<<< '2)/2()) ???

"

6urchases : ($s.) '-2'() 02).2()) 02)*2.() (()4 of (()4 of (()4 of $s. ('2())) $s. '20(2))) $s. '20.2())) 02).2()) 02)*2.() 3'2()) (()4 of (()4 of (()4 of $s. '20(2))))$s. '20.2()))($s. 02*(2)))) <<<<<<<< <<<<<<<<< <<<<<<<<< 02,,2.() '20-2'() '2)02'() ???<<<<<< 02,,2.() '20-2'()

???

6ayment ($s) ,. Direct wages & "

,02()) 02'32))) 02,)2()) 02002))) (02)() x $s. ,))(/2,)) x $s. ,))(/2,() x $s. ,))(,2.)) x $s.,)) .2*.( ,'2'() ,'2-'( '.2.() (('( x $s.0()('20() x $s.0()('20.( x $s.0()(02*() x $s0() <<<<<<<< <<<<<<<< <<<<<<<< <<<<<<<<< ,32,.( 02-02'() 02-,20'( 02,*2.() ??? .2*.( ,'2'() (')4 of (')4 of $s. ,32,.() $s. 02-02'()) 02'32))) 02,)2()) (*)4 of (*)4 of $s. 02-02'()) $s. 02-,20'() <<<<<<<< <<<<<<<< 02,-2*.( 02-'2.() ,'2-'( (')4 of $s. 02-,20'() 02002))) (*)4 of $s. 02,*2.()) <<<<<<<<< 02/,2-'(

??? ???

6ayment ')4 &

???

*)4 "

<<<

???

/.

Jariable overheads & 0/2.)) -)2')) -)23)) (02*)) (02)() x $s.0/)(/2,)) x $s.0/)(/2,() x$s.0/)(,2.)) x $s0/) " ,2-.( 0(2)() 0(2''( (('( x $s..)('20() x $s..)('20.( x $s..) <<<<<<<<< <<<<<<<<< <<<<<<<<< 0*2,.( .(2'() .-20'( 0'23() (02*() x $s..) <<<<<<<<<< -/2.()

??? ???

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Jariable overheads payment ($s.) ()4 ????

,.2-'( (()4 of $s. .(2'()) 320** (()4 of $s. 0*2,.() <<<<<<<< /-2*0, /)2)))

,*2)-, (()4 of $s. .-20'() ,.2-'( (()4 of $s. .(2'()) <<<<<<<<<< .(2-** /)2)))

,'2,.( (()4 of $s.-/2.()) ,*2)-, (()4 of $s. .-20'() <<<<<< .)2/,* /)2)))

???

()4

????

???

(. -.

9ixed overheads payment "ill discounting charges

???

"ill discounted ???? 02/)2))) ($efer to wor!ing note 0 above) %harges G () paise per $s. 0)) .))

02(,2,,, .-.

02')2))) -))

??? ????

Ques !"# <. Crite short notes on any four of the following : (a) Calter:s approach to Dividend 6olicy. (b) Different !inds of float with reference to management of %ash. (c) Appraisal of pro7ects under inflationary conditions. (d) Euro convertible bonds. (e) 9unctions of 9inance manager. A#s$er %&' 2&, erDs &++r"&*( " 7!6!3e#3 P",!*4 : Calter:s approach to Dividend policy supports the doctrine that the investment policy of a firm cannot be separated from its dividend policy and both are according to him interlin!ed. Oe argues that in the long run2 share prices reflect only the present value of expected dividends. $etention influence stoc! prices only through their effect on future dividends. 8he relationship between dividend and share price on the basis of Calter:s formula is shown below : (E A D) D = $a ?????????????? Jc > <<<<<<<<<<$c<<<< $c Chere2 Jc $a $c E > > > > ar!et value of ordinary shares of the company. $eturn on internal retention2 i.e.2 the rate company earns on retained profits. %apitalisation rate2 i.e.2 the rate expected by investors by was of return from particular category of shares. Earning per share.

D > Dividend per share. 6rof. Calter:s formula is based on the relationship between the firm:s (i) return on investment or internal rate of return ($a) and (ii) cost of %apital or re#uired rate of return (i.e.2 $c).

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8he optimum dividend policy of a firm is determined by the relationship of $a and $c. If $ a]$c i.e.2 the firm can earn higher return than what the shareholders can earn on their investments2 the firm should retain the earning. +uch firms are termed as growth firms2 and in their case the optimum dividend policy would be to plough bac! the earnings. If $a^$c i.e. the firm does not have profitable investment opportunities2 the optimum dividend policy would be to distributed the entire earnings as dividend. In case of firms2 where $a > $c2 it does not matter whether the firm retains or distribute its earning. ssumptions : Calter:s dividend policy is based on the following assumptions : (i) 8he firm does the entire financing through retained earnings. sources of funds such as debt or new e#uity capital. It does not use external

(ii) 8he firm $c and $a remain constant with additional investment. (iii) 8here is no change in the !ey variables2 namely2 beginning E2 D. (iv) 8he firm as a very long life. %0' 7!--ere# 9!#3s "- -,"& $! ( re-ere#*e " M&#&/e.e# "- C&s( : 8he term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process. 9our !inds of float can be identified : (i) !ill "lat : An invoice is the formal document that a seller prepares and sends to the purchaser as the payment re#uest for goods sold or services provided. 8he time between the sale and the mailing of the invoice is the billing float.

(ii) #ail "loat : 8his is the time when a che#ue is being processed by post office2 messenger service or other means of delivery. (iii) Che$ue processing float : 8his is the time re#uired for the seller to sort2 record and deposit the che#ue after it has been received by the company. (iv) !an% Processing flat : 8his is the time from the deposit of the che#ue to the crediting of funds in the seller account. %*' &++r&!s&, "- +r"Ge* s u#3er !#-,& !"#&r4 *"#3! !"#s : 8he timing of pro7ect appraisal is significant from the point of view of appraisers. A pro7ect under normal conditions is viewed from different angles2 viQ2 technical feasibility2 commercial and financial viability and economic and social considerations and managerial aspects. Oowever2 normal conditions seldom exist and a pro7ect is sub7ected to inflationary pressures from time to time because the pro7ect has to be implemented over a long time frame. During such a period2 it will be difficult to predict when the trade cycle sets in and the up A turn the economy is generated. "esides this2 the siQe and magnitude of the pro7ect also varies from organisation to organisation. In such a situation2 inflation is bound to affect the pro7ect appraisal and implementation process. In a developing country li!e ours2 inflation has become a part of life and has been steadily increasing over a period of years. 8herefore2 it is always prudent to ma!e ade#uate provision for a probable escalation in the pro7ect costs as a cushion to inflationary 7er!s. It is well !nown that during a period of inflation2 the pro7ect cost is bound to escalate on all heads viQ. &abours2 raw materials2 cost of fixed assets2 building materials2 remunerations of technician and managerial personnel etc. "esides2 such conditions erode the purchasing power of the consumers and are li!ely to affect the pattern of demand. 8hus2 not only the costs of production

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but also the pro7ected statements of profitability2 cash flows etc.2 will get seriously affected. 9inancial institutions may revise their lending rates of interest during such inflationary times. In these circumstances2 pro7ect appraisal has to be done generally !eeping in view the following guidelines which are adopted normally by governmental agencies2 ban!s and financial institutions. (a) (b) It is always advisable to ma!e provisions for cost escalation for all heads !eeping in mind the rate of inflation2 li!ely delay in completion of pro7ect etc. 8he various sources of finance should be scrutinised carefully with response to possible revision in the rates of interest by lenders which will affect the cost of borrowing2 the collateral securities offered2 margins re#uired etc. Ad7ustments are to be made in the profitability and cash flow pro7ections to ta!e care of the inflationary pressure affecting future pro7ections. It is also advisable to critically examine the financial viability of the pro7ect at the revised rates and reasons the economic 7ustification of the pro7ect. 8he appropriate measure for this is the economic rate of return for the pro7ect which will e#uate the present cost of capital expenditure to net cash flows over the pro7ect life. 8he rate of return should be acceptable which also accommodates the rate of inflation. In an inflationary situation2 pro7ects having early pay bac! periods should be preferred because pro7ects with a longer pay bac! periods may tend to be ris!y.

(c) (d)

(e)

"ecause inflation can have ma7or effect on business. It is critically important and must be recognised. R8he most effective way to deal with inflation is to build into each cash flow element2 using the best available information about how each element will be affected. +ince one cannot estimate future rates of inflation2 errors are bound to be made. 8herefore2 inflation adds to uncertainty2 ris! ness and complexity to capital budgeting fortunately2 computers and spread sheet models are available to help inflation analysis. 8hus2 in practice2 the mechanics of inflation ad7ustments are not difficult. %3' Eur" C"#6er !0,e 0"#3 : Euro %onvertible bonds are #uasi A debt securities (unsecured) which can be converted into depository receipts or local shares. E%"s offer the investor an option to convert the bond into e#uity at a fixed price after the minimum loc! in period. 8he price of e#uity shares at the time of conversion will have a premium element. 8he bonds carry a fixed rate of interest. 8hese are bearer securities and generally the issue of such bonds may carry two options viQ.2 call option and put option. A call option allows the company to force conversion if the mar!et price of the shares exceed a particular percentage of the conversion price. A put option allow the investors to get his money bac! before maturity. In the case of E%"s2 the payment of interest and the redemption of the bonds will be made by the issuer company in N+ dollars. E%"s issues are listed at &ondon or &uxemburg stoc! exchanges. Indian companies which have opted E%"s issue are Zindal +trips2 $eliance2 Essar 1u7arat2 +terlite etc. Indian companies are increasingly loo!ing at Euro A %onvertible bond in place of 1lobal Depository $eceipts because 1D$s are falling into dis ? favour among international fund managers. An issuing company desirous of raising the E%"s is re#uired to obtain prior permission of the Department of Economic Affairs2 inistry of 9inance2 1overnment of India2 %ompanies having , years of good trac! record will only be permitted to raise funds. 8his condition is not applicable in the case of pro7ects in infrastructure sector. 8he proceeds of E%"s would be permitted only for following purposes : (i) Import of capital goods. (ii) $etiring foreign currency debts. (iii) %apitalising Indian 7oint venture abroad.

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(iv) '(4 of total proceedings can be used for wor!ing capital and general corporate restructuring. 8he impact of such issues has been to procure for the issuing companies finances at very competitive rates of interest. 9or the country a higher debt means a forex outgo in terms of interest. %e' Fu#* !"#s "- F!#&#*e M&#&/er : 8he 9inance manager:s main ob7ective to manage funds in such a way so as to ensure their optimum utilisation and their procurement in a manner that the ris!2 cost and control considerations are properly balanced in a given situation. 8o achieve these ob7ectives the finance anager perform the following functions : (0) Estimating the re$uirement of "unds : "oth for long A term purposes i.e. investment in fixed assets and for short term i.e. for wor!ing capital. 9orecasting the re#uirements of funds involves the use of techni#ues of budgetary control and long A range planning. &ecision regarding Capital 'tructure : Ence the re#uirement of funds has been estimated2 a decision regarding various sources from which these funds would be raised has to be ta!en. A proper balance has to be made between the loan funds and own funds. Oe has to ensure that he raises sufficient long term funds to finance fixed assets and other long term investments and to provide for the needs of wor!ing capital. (nvestment &ecision : 8he investment of funds2 in a pro7ect has to be made after careful assessment of the various pro7ects through capital budgeting. Assets management policies are to be laid down regarding various items of current assets. 9or e.g. receivable in coordination with sales manager2 inventory in coordination with production manager. &ividend &ecision : 8he finance manager is concerned with the decision as to how much to retain and what portion to pay as dividend depending on the company:s policy. 8rend of earnings2 trend of share mar!et prices2 re#uirement of funds for future growth2 cash flow situation etc.2 are also to be considered. Evaluating financial performance : A finance manager has to constantly review the financial performance of the various units of organisation generally in terms of $.E.I. +uch a review helps the management in seeing how the funds have been utilised in various divisions and what can be done to improve it. "inancial negotiation : 8he finance manager plays a very important role in carrying out negotiations with the financial institutions2 ban!s and public depositors for raising of funds on favourable terms. Cash #anagement : 8he finance manager lays down the cash management and cash disbursement policies with a view to supply ade#uate funds to all units of organisation and to ensure that there is no excessive cash. )eeping touch with stoc% exchange :9inance manager is re#uired to analyse ma7or trends in stoc! mar!et and their impact on the price of the company share.

(')

(,)

(/)

(()

(-)

(.)

(*)

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F!#&, eA&.!#& !"# N"6e.0er, 199@ Gr.-I

P&+er 2 : M&#&/e.e# A**"u# !#/ & F!#&#*!&, A#&,4s!s Ques !"# 1. (a) . 9ollowing are the data on a capital pro7ect being evaluated by the management of K &td. 6ro7ect $s./)2))) / years 0(4 0.)-/ F F F F )

Annual cost saving Nseful life I.$.$. 6rofitability Index (6I) H6J %ost of capital %ost of pro7ect 6aybac! +alvage value

9ind the missing values considering the following table of discount factor only : . Discount factor 0(4 0/4 0,4 0'4 0 year ' years , years / years (b) . 6ro7ect 0 ' , / ( Amount $s. ,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2))) 6rofitability Index 0.'' ).3( 0.') 0.0* 0.') 0.)( ).*-3 )..().-(* ).(.' '.*(( ).*.. )..-3 ).-.( ).(3' '.30, ).**( )..*, ).-3, ).-0, '.3./ ).*3, )..3. )..0' ).-,,.),* 8he following

+ &td. has $s.0)2))2))) allocated for capital budgeting purposes. proposals and associated profitability indexes have been determined :

Chich of the above investments should be underta!en F Assume that pro7ects are indivisible and there is no alternative use of the money allocated for capital budgeting. A#s$er %&' C"s "- Pr"Ge* M At 0(4 I.$.$.2 the sum total of cash inflows > cost of the pro7ect i.e. Initial cash outlay 1iven : Annual cost saving Nseful life I.$.$. $s. /)2))) / years 0(4

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How2 considering the discount factor table G 0(4 cumulative present value of cash inflows for / years is '.*((. 8herefore2 8otal of cash inflows for / years for 6ro7ect Oence2 cost of the pro7ect is P&40&*9 +er!"3 "- (e +r"Ge* M 6aybac! period > %ost of the pro7ectD Annual cost saving > $s. 020/2'))D /)2))) > '.*(( or ' years 00 months approximately C"s "- *&+! &, If the profitability index (6I) is 02 cash inflows and outflows would be e#ual. In this case2 (6I) is 0.)-/. 8herefore2 cash inflows would be more by ).-/ than outflow. Discounted cash inflows 6rofitability Index (6I) > ??????????????????????????????????????????? %ost of the pro7ect Er2 0.)-/ Discounted cash inflows > ??????????????????????????????????? $s. 020/2')) is ($s. /)2))) x '.*(() > $s. 020/2')) > $s. 020/2'))

Er2 0.)-/ x $s. 020/2')) > $s. 02'02()3 Oence2 Discounted cash inflows > $s. 02'02()3 +ince2 Annual cost saving is $s. /)2))). hence2 cumulative discount factor for / years 02'02()3 > $s.????????????????? /)2))) > ,.),..'( or ,.),* %onsidering the discount factor table at discount rate of 0'42 the cumulative discount factor for / years is ,.),*. Oence2 the cost of capital is 0'4 Ne +rese# 6&,ue "- (e +r"Ge* . H.6.J. > > %0' 6ro7ect 0 ' , / ( 8otal present values of cash inflows A %ost of the pro7ect $s. 02'02()3 A $s. 020/2')) > $s. .2,)3

S & e.e# s("$!#/ r&#9!#/ "- +r"Ge* s "# (e 0&s!s "- Pr"-! &0!,! 4 I#3eA Amount $s. ,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2))) 6.I. 0.'' ).3( 0.') 0.0* 0.') 0.)( $an! 0 ( ' , ' /

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Assuming that pro7ects are indivisible and there is no alternative use of the money allocation for capital budgeting on the basis of 6.I.2 the + &td. is advised to underta!e investment in pro7ects 02 , M (. Oowever2 among the alternative pro7ects the allocation should be made to the pro7ects which adds the most to the shareholders wealth. 8he H6J method2 by its definition2 will always select such pro7ects. S & e.e# s("$!#/ NPC "- (e +r"Ge* s 6ro7ect (i) 0 ' , / ( Amount ($s) (ii) ,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2))) 6.I. (iii) 0.'' ).3( 0.') 0.0* 0.') 0.)( %ash inflows of 6ro7ect ($s) (iv) > @(ii)x(iii)B ,2--2))) 02/'2()) /2')2))) (2,02))) '2/)2))) /2')2))) H.6.J. of pro7ect ($s) (v) > @(iv) A (ii)B --2))) (?) .2()) .)2))) *02))) /)2))) ')2)))

8he allocation of funds to the pro7ects 02 , and ( (as selected above on the basis of 6.I) will give H.6J. Ef $s. 02.-2))) and $s. 02()2))) will remain unspent. Oowever2 the H.6.J. of the pro7ects ,2 / and ( is $s. 02302))) which is more than the H.6.J. of pro7ects 02 , and (. further2 by underta!ing pro7ects ,2 / and ( no money will remain unspent. 8herefore2 +. &td. is advised to underta!e investments in pro7ects ,2 / and (. 1111111111111 Ques !"# 2 (a) K &td. an Indian company has an export exposure of 0) million (0)) lacs) yen2 value +eptember end. 5en is not direct #uoted against $upee. 8he current spot rates are N+D;IH$ > /0..3 and N+DFZ65 > 0'3..( It is estimated that 5en will depreciate to 0// level and $upee to depreciate against dollar to /,. 9orward rate for +eptember2 033* N+D;5en > 0,..,( and N+D;IH$ > /'.*3 5ou are re#uired : (i) to calculate the expected loss if hedging is not done. Oow the position will change with company ta!ing forward cover F (ii) (b) if the spot rate on ,)th +eptember 033* was eventually N+D;5en > 0,..*( and N+D;IH$ > /'..*2 is the decision to ta!e forward cover 7ustified F 6 %o. has to ma!e payment of $s.' million ($s.') lacs) on 0- th April2 033*. It has a surplus money today i.e. 0(th Zanuary2 033* and the company has decided to invest in %ertificate of Deposit (%D:s) of a leading nationalised ban! at *.))4 p.a. Chat money is re#uired to be invested now F 8a!e year as ,-( days.

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(c)

Describe the interface of 9inancial 6olicy with %orporate +trategic

anagement.

Answer %&' %!' C&,*u,& !"# "- (e eA+e* e3 ,"ss !- (e3/!#/ !s #" 3"#e. Exposure of (0)) la!hs) yen at current spot rate of $s. ,'.'0 per 0)) yen ($efer to Cor!ing note 0) Exposure of (0)) la!hs) yen at estimated rate of $s. '3.*- per yen ($efer to wor!ing note ') Expected loss without forward cover C&,*u,& !"# "- eA+"sure !- (e C".+&#4 &9es -"r$&r3 *"6er Exposure of (0)) la!hs) yen at forward rate of $s. ,0.', per 0)) year ($efer to wor!ing note ,) If the company ta!es forwards cover the company loss is ($s. ,02',2))) A $s. ,'2'02)))) %!!' C&,*u,& !"# "- eA+"sure & (e s+" r& e "- 8? ( Se+ e.0er, 199@ Exposure of (0)) la!hs) yen at the spot rate of $s. ,0.), per 0)) yen ($efer to wor!ing note /) ,02),2))) $s. ,'2'02))) '32*-2))) <<<<<<<<< '2,(2))) ,02',2))) 3*2)))

Oence without forward cover the loss was $s. 020*2))) ($s. ,02),2))) A $s. ,'2'02)))). Oence2 decision of the company to ta!e forward cover is 7ustified. 2"r9!#/ N" es : 0. +pot (current) N+D; IH$ > /0..3 and N+D; Z65 > 0'3..( 8herefore2 spot (current) Z65; IH$ > /0..3; 0'3..( > $s. ).,''0 per yen or2 $s. ,'.'0 per 0)) yen '. Expected N+D; IH$ > /, and N+D; Z65 > 0// 8herefore2 Expected Z56; IH$ > /,;0// > $s. ).,0', or2 $s. ,0.), per 0)) yen. %0' oney re#uired to be invested today i.e. 0( th Zanuary2 033* to ma!e payment of $s. ' million ($s. ') la!hs) on 0-th April2 033*. 9or ma!ing payment of $s. ' million ($s. ') la!hs) on 0- th April2 033* the surplus money to be invested today i.e. 0(th Zanuary2 033* in %ertificate of Deposits (%Ds) for 30 days G *4 p.a. is ')2))2))) $s. ?????????????????? ($efer to wor!ing note) 02)0233/(' > $s. 032-)2**3.-or2 $s. 032-)2*3) (rounded off)

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2"r9!#/ N" e : Interest on $e. 0 at *4 p.a. on %ertificate of Deposit (%D:s) of A leading nationalised ban! 30 Interest on $e. 0 for 30 days $s. ).)* x ?????? ,-( 8he amount to be received for $s. 0 invested now after 30 days %C'

$s. ).)* $s. ).)033/(' $s. 0.)033/('

8he two important functions of the finance manager are : (i) allocation of funds (viQ. investment decision) and (ii) generation of funds (viQ. financing decision). 8he theory of finance ma!es two crucial assumptions to provide guidance to the finance manager in ma!ing these decisions. 8hese are : 0. '. 8he ob7ective of the firm is to maximise the wealth of shareholders 8he capital mar!ets are efficient.

8he corporate finance theory implies that : 0. '. ,. /. Ewners have the primary interest in the firm 8he current value of share is the measure of shareholders: wealth. 8he firm should accept only those investments with generate positive net face values. 8he firm capital structure and dividend decisions are irrelevant as they are solely guider by efficient capital mar!ets and management has no control over them.

Oowever2 the theory of finance has undergone fundamental changes over the past. It is felt that finance theory is not complete and meaningful without its lin!age with the strategic management. +trategic management establishes an efficient and effective match between the firm:s competence and opportunities with the ris! created by the environment changes. I# er-&*e "- F!#&#*!&, P",!*4 &#3 S r& e/!* M&#&/e.e# : (0) 9inancial policy re#uire the resource deployments such as materials2 labour etc. +trategic management considers all mar!ets such as material2 labour and capital as imperfect and changing. +trategies are developed to manage the business firm in uncertain and imperfect mar!et conditions and environment. 9or forecasting2 planning and formulation of financial policies2 for generation and allocation of resources the finance manager is re#uired to analyse changing mar!et conditions and environment. (') 8he strategy focuses as to how to compete in a particular product A mar!et segment or industry. 9or framing strategy it is considered that the shareholders are not the only interested group in the firm. 8here are many other influential constituent such as lenders2 employees2 customers2 suppliers etc. the success of a company depends on its ability to service in the product A mar!et environment which is possible only when the company consider to maintain and improve its product A mar!et positions. +uch consideration have important implications for framing corporate finance policies. (,) 8he strategic management is multi A dimensional. It focuses on growth2 profitability and flow of funds rather than only on the maximisation of mar!et value of shares. 8his focus helps the management to create enough corporate wealth for achieving mar!et dominance and the ultimate successful survival of the company. it re#uires to frame financial policy !eeping in view the interest of other parties such as government2 employees2 society etc. and not only of shareholders.

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Oence2 the financial policy of a company is closely lin!ed with its corporate strategy. 8he company strategy establishes an efficient and effective match between its competences and opportunities and environmental ris!s. 9inancial policies of a company should be developed in the context of its corporate strategy2 within the overall framewor! of the firm:s strategy2 there should be consistency between financial policies A investment2 debt and dividend. 9or example2 a company can sustain a high growth strategy only when investment pro7ects generate high profits and it follows a policy of low payout and high debt. Ques !"# 8 8he following is the "alance sheet as at ,0st +hare %apital : 0)2))) e#uity shares of $s.0)) each fully paid up '(2))) 004 cum preference shares of $s.0) each fully paid up $eserves and surplus +ecured loans Nnsecured loans 8rade creditors Eutstanding expenses $epresented by 9ixed assets %urrent assets Advances and deposits

arch 033* of + %o. &td. $s. 0)2))2))) '2()2))) $s. 0'2()2))) '(2))2))) ')2))2))) 0'2))2))) 0*2))2))) .2()2))) 3(2))2)))

((2))2))) ,.2))2))) ,2))2)))

3(2))2)))

8he company plans to manufacture a new product in line with its current production2 the capital cost of which is estimated to be $s.'( la!hs. 8he company desires to finance the new pro7ect to the extent of rs.0- la!hs by issue of e#uity shares at a premium of $s.0)) per share and the balance to be raised from internal sources. Additional information made available to you are : (a) $ate of dividends declared in the five years i.e. year ended ,0 st arch2 033*2 ,0st arch 033.2 ,0st arch 033-2 ,0st arch 033( and ,0st arch 033/ were '/42 '/42 ')42 ')4 and 0*4 respectively. Hormal earning capacity (net of tax) of the business is 0)4. 8urnover in the last three years was $s.*) la!hs (,0;,;3*)2 $s.-) la!hs (,0;,;3.) and $s.() la!hs (,0;,;3-). Anticipated additional sales from the new pro7ect $s.,) la!hs annually. Het profit before tax from the existing business which was 0)4 in the last three years is expected to increase to 0'4 on account of new product sales. Income?tax rate is ,(4 8he trend of mar!et price of the e#uity share of the company2 #uoted on the +toc! Exchange was : 5ear 033.?3* 033-?3. 033(?3Oigh $s. ,)) '() '/) &ow $s. 03) 0*) 0*)

(b) (c) (d) (e) (f) (g) .

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5ou are re#uired to examine whether the company:s proposal is 7ustified. Do you have any suggestions to offer in this regard F All wor!ings must form part of your answer. A#s$er (a) Earning per share for the year ended ,0st 8urnover Het 6rofit (0)4 of $s. *)2))2)))) &ess : Income tax G ,(4 6rofit after tax &ess : 6reference dividend (004 of $s. '2()2)))) 6rofit available for e#uity shareholders : (A) Humber of e#uity shares : (") Earning per share : (A); (") (b) Expected earning per share after the manufacture of new product (Hew pro7ect financed to the extent of $s. 0- la!hs by issue of e#uity shares) Anticipated turnover ($efer to wor!ing note 0) Het 6rofit (0'4 of $s. 020)2))2)))) &ess : Income tax G ,(4 6rofit after tax &ess : 6reference dividend (004 of $s. '2()2)))) 6rofit available for e#uity shareholders : (A) Humber of e#uity shares : (") ($efer to wor!ing note ') (Expected earning per share : (A); (") (c) 6rice earning ratio for the year ended as on ,0st Average price per share (,)) = 03)); ' : (A) Earning per share : (") ($efer to (a) above) 6rice earning ratio : (A); (") arch2 033* of + %o. &td. $s. '/( $s. /3.'( /.3./ or ( times (rounded off) Zustification : En the basis of (a)2 (b) and (c) above. 0. 8here will be decline in mar!et value of share after the new pro7ect financed by issue of e#uity shares and internal sources become operational. Expected mar!et value of share will be E.6.+ x 6;E ratio i.e.2 $s. /-.0/ x ( > $s. ',)..) $s. 020)2))2))) 0,2')2))) /2-'2))) <<<<<<<< *2(*2))) '.2()) <<<<<<< *2,)2()) 0*2))) $s. /-.0/ arch2 033* of + co. &td. Rs. *)2))2))) *2))2))) '2*)2))) <<<<<<<<< (2')2))) '.2()) <<<<<<<< /23'2()) 0)2))) $s. /3.'(

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'. 8he stoc! exchange #uotation reveal that the company share has been #uoted at below boo! value of $s. ,() per share ($efer to wor!ing note ,). 8he proposed financing pattern is not going to increase E.6.+. It will on the other hand decline marginally. 8hus2 the existing e#uity shareholders will not be benefited much from the new issue. Oowever2 in case shares are offered to the outsiders2 they will gain since a share with intrinsic (boo!) value of $s. ,() is being offered at a price of $s. ')). 8hus2 the company:s proposal to finance the new pro7ect to the extent of $s. 0- la!hs by issue of e#uity shares at a premium of $s. 0)) per share and balance from internal sources is not 7ustified and the company should2 therefore2 reconsider the scheme of financing the pro7ect by a new e#uity issue. 8he + co. &td. present debt e#uity ratio is ).(, ($efer to wor!ing note (). As per the prudential norm2 the debt e#uity ratio shall not exceed ' :0. According2 the company seems to possess debt capacity; leverage. It can raise the re#uired funds say2 by issue of debenture G 0'4 to 0,4 interest. Expected earnings per share after the manufacture of new product (Hew pro7ect financed to the extent of 0- la!hs by issue of debenture G 0'4) Anticipated turnover ($efer to wor!ing note 0) Expected profit on turnover &ess : Interest on debenture (0'4 on $s. 0- la!hs) Het profit before tax &ess : Income tax G,(4 Het profit after tax &ess : 6reference dividends 6rofit available for e#uity shareholders Ho. of e#uity shares Earning per share Zustification : 0. 8here will be increase in the mar!et value of share after the new pro7ect financed by issue of debentures and internal accruals become operational. Expected mar!et value of share will be E.6.+ x 6;t ratio i.e. $s. .).(. x ( times > $s. ,('.*( '. 8he E.6.+. will increase to $s. .).(. ,. 8he debt e#uity ratio of the + co. &td. will be ).3- ($efer to wor!ing note -) after the new pro7ect is financed by issue of debentures. 8he ratio ).3- is within the prudential norm of ' : 0. +uggestion : En the basis of the above wor!ings2 it is suggested that it will be better if the company raise the funds2 re#uired for financing the new pro7ect2 by issuing debentures instead of e#uity shares. 8his is because the mar!et price per share and earning per share is higher in case of debenture financing without undue ris!. Cor!ing Hotes : $s. 0. nticipated turnover 6resent turnover Add : Anticipated additional sales of new product *)2))2))) ,)2))2))) $s. 020)2))2))) 0,2')2))) 023'2))) <<<<<<<< 002'*2))) ,23/2*)) <<<<<<<<< .2,,2')) '.2()) <<<<<<<<< .2)(2.)) 0)2))) $s. .).(.

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020)2))2))) '. *um+er of new e$uity shares to +e issued 9unds re#uired by issue of e#uity shares : (A) 9unds raised by issue of 0 new e#uity share : (") Ho. of new e#uity share to be issued : (A); (") ,. !oo% value of one e$uity share 0)2))) e#uity shares of $s. 0)) each fully paid up Add : $eserves and surplus Ho. of e#uity shares "oo! value of one e#uity share lternatively 9ixed assets %urrent Assets Advance M deposits &ess : 6reference share capital +ecured loans Nnsecured loans 8rade creditors Eutstanding expenses Ho. of e#uity shares "oo! value of one share /. Present de+t e$uity ratio +ecured loans > ?????????????????????????????????????????????????? +hared capital = $eserve and surplus $s. ') la!hs > ???????????????????????????????? $s. ,..() la!hs > ).(, (. Expected de+t e$uity ratio +ecured loans = proposed debentures > ?????????????????????????????????????????????????????? +hare capital = $eserve and surplus $s. ') la!hs = $s. 0- la!hs > ????????????????????????????????????????????? $s. ,..() la!hs > ).3$s. ((2))2))) ,.2))2))) ,2))2))) '2()2))) ')2))2))) 0'2))2))) 0*2))2))) .2()2))) $s. 0-2))2))) $s. ')) *2))) $s. 0)2))2))) '(2))2))) ,(2))2))) 0)2))) ,()

3(2))2)))

-)2))2))) ,(2))2))) 0)2))) ,()

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Ques !"# : A company is engaged in the manufacture of specialised sub?assemblies re#uired for certain electronic e#uipments. 8he company envisages that in the forthcoming month. December 033*2 the sales will ta!e a pattern in the ratio of , : / : ' respectively of sub?assemblies A%"2 %" and D6. 8he following is the schedule of components re#uired for manufacture : +ub?assembly A%" %" D6 6urchase price +elling price (') ()) ,() %omponent re#uirements "ase board I%)* I%0' 0 0 0 $s.-) * ' ' ') / 0) / 0' I%'' * *

8he direct labour time and variable overheads re#uired for each of the sub?assemblies are : 1rade A A%" %" D6 Direct wage rate per hour * / $s.( &abour hours per sub?assembly 1rade " Jariable overheads .per sub?assembly $s. 0,0' '/ * '/ / ??

8he &abours wor! * hours a day for '( days a month. 8he opening stoc!s of sub?assemblies and components for December 033* are as under : +ub?assemblies A%" %" D6 *)) 02')) '2*)) "ase "oard I%)* I%0' I%'%omponents 02-)) 02')) -2))) /2)))

9ixed overheads amount to $s..2(.2')) for the month and a monthly profit target of $s.0' lacs has been set. 8he company is poised for a reduction of closing inventories for December2 033* of sub? assemblies and components by 0)4 in #uantity as compared to the opening stoc!. 6repare the following budgets for December 033* : +ales budget in #uantity and value. 6roduction budget in #uantity %omponent usage budget in #uantity %omponent purchase budget in #uantity and value anpower budget showing the number of wor!ers and the amount of wages payable.

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OR
A new formed company has applied to the commercial ban! for the first time for financing its wor!ing capital re#uirements. 8he following information is available about the pro7ections for the current year : Estimated level of activity : 02)/2))) completed units of production plus /2))) units of wor!?in? progress. "ased on the above activity2 estimated cost per unit is : $aw material Direct wages Everheads (exclusive of depreciation) 8otal cost +elling price $s. *) per unit $s. ,) per unit $s. -) per unit $s.0.) per unit $s.')) per unit.

$aw materials in stoc! : average / wee!s consumption2 wor!?in?progress (assume ()4 completion stage of conversion cost) (materials issued at the start of the processing). 9inished goods in stoc! %redit allowed by suppliers %redit allowed to debtors;receivables &ag in payment of wages %ash at ban! (for smooth operation) is expected to be *2))) units Average / wee!s Average * wee!s Average 0 _ wee!s $s.'(2)))

Assume that production is carried on evenly throughout the year ((' wee!s) and wages and overheads accrue similarly. All sales are on credit basis only. 9ind out : (i) the net wor!ing capital re#uiredL (ii) the maximum permissible ban! finance under first and second methods of financing as per 8andon %ommittee Horms.

F!rs A, er#& !6e

A#s$er 2"r9!#/ N" e : 0. +tatement showing contribution +ub assemblies +elling price per unit (p.u) : (A) M&r/!#&, C"s +.u. Components "ase "oard I%)* I%0' I%',a+our 1rade A 1rade " -aria+le production overhead 8otal arginal cost p.u. : (") %ontribution p.u. : ` > (A) A (") +ales ratio : (D) %ontribution x sales ratio :@(E) > (%) x (D)B A%" $s. (') %" $s. ()) D6 $s. ,() 8otal $s

-) 0-) /* 0/) -/ ,<<<< /'/ 3, '**

-) /) 0') /* ,) /* '/ <<<< ,.) 0,) / (')

-) /) /* -/ ') ,' '/ <<<< '** -' ' 0'/

3,'

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.. &esired contri+ution for the forthcoming month &ecem+er/ 0112 $s. 9ixed overheads Desired profit Desired contribution

.2(.2')) 0'2))2))) <<<<<<<< 032(.2'))

,. 'ales mix re$uired i.e. num+er of +atches for the forthcoming month &ecem+er/ 0112 +ales mix re#uired > Desired contribution; contribution x sales ratio > $s. 032(.2')); 3,' ($efer to wor!ing notes 0 M ') > '20))

)u3/e e3 -"r 7e*e.0er, 199@ S&,es 0u3/e !# Bu&# ! 4 &#3 6&,ue

+ub ? assemblies +ales (#uantity) ('20)) x , : / : ') ($efer to wor!ing note ,) +elling prices p.u. ($s) +ales value ($s) A%" -2,)) (') ,'2.-2))) %" *2/)) ()) /'2))2))) D6 /2')) ,() 0/2.)2))) *32/-2))) 8otal

Pr"3u* !"# 0u3/e !# Bu&# ! 4 +ub ? assemblies +ales Add: %losing stoc! (Epening stoc! less 0)4) 8otal #uantity re#uired &ess : Epening stoc! 6roduction A%" -2,)) .') <<<<< .2)') *)) <<<<<< -2'') %" *2/)) 02)*) <<<<< 32/*) 02')) <<<<<< *2'*) D6 /2')) '2(') <<<<< -2.') '2*)) <<<<<< ,23')

C".+"#e# us&/e 0u3/e !# Bu&# ! 4 +ub A assemblies 6roduction "ase broad (0 each) %omponent I%)* (*:':') %omponent I%0' (/:0):/) %omponent I%'- (':-:*) A%" -2'') -2'') /32.-) (-2'') x *) '/2**) (-2'') x /) 0'2//) (-2'') x ') %" *2'*) *2'*) 0-2(-) (*2'*) x ') *'2*)) (*2'*) x 0)) /32-*) (*2'*) x -) D6 ,23') ,23') .2*/) (,23') x ') 0(2-*) (,23') x /) ,02,-) (,23') x *) 8otal ??? 0*2/') ./20-) 02',2,-) 3,2/*)

C".+"#e# Pur*(&se 0u3/e !# Bu&# ! 4 &#3 6&,ue +ub A assemblies "ase board I%)* I%0' I%'8otal

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Nsage in production Add : closing stoc! (Epening stoc! less 0)4) &ess : Epening stoc! 6urchase (#uantity) 6urchase price ($s.) 6urchase value ($s)

0*2/') ./20-) 02//) 02)*) <<<<<< <<<<<<< 032*-) .(2'/) 02-)) 02')) <<<<<<< <<<<<<<< 0*2'-) ./2)/) -) ')

02',2,-) (2/)) <<<<<<<< 02'*2.-) -2))) <<<<<<<< 02''2.-) 0' 0/2.,20')

3,2/*) ,2-)) <<<<<< 3.2)*) /2))) <<<<<<< 3,2)*) * .2//2-/) /.23/20-)

0)23(2-)) 0/2*)2*))

anpower budget showing the number of wor!ers and the amount of wages payable <<<<<<<<Direct &abour<<<<<<<<<<<<< <<<<<1rade A<<<<<< <<<<<<<<1rade "<<<<< Oours per 8otal Oours per 8otal Nnit Oours units hours * / /32.-) /32-*) 0(2-*) <<<<<<< 020(20') ')) (.02))) (2.-2))) 00' *

8otal

+ub ? Assemblies A%" %" D6

"udgeted 6roduction -2'') *2'*) ,23')

(A) 8otal hours (") Oours per man per month (%) Humber of Cor!ers per month (A; ") (D) Cage rate per month ($s.) (E) Cage payable ($s) : (% x D)

332(') 332,-) ,02,-) <<<<<<< '2,)2'/) ')) 020(' *)) 32'02-)) 0/23.2-))

Se*"#3 A, er#& !6e A#s$er (i) Es !.& e "- (e reBu!re.e# "- $"r9!#/ *&+! &, $s. A. %urrent Assets : $aw material stoc! ($efer to wor!ing note ,) Cor! in progress stoc! ($efer to wor!ing note ') 9inished goods stoc! ($efer to wor!ing note /) Debtors ($efer to wor!ing note () %ash and ban! balance ". %urrent &iabilities : %reditors for raw materials ($efer to wor!ing note -) %reditors for wages ($efer to wor!ing note .) Het Cor!ing capital (A A ") -2-/2-0( (2))2))) 0,2-)2))) ',2(,2*/<<'(2))) .20(2./) 302.,0 *2).2/.0 <<<<<<<< /-23(233) ((2),2/-0 $s.

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(ii) T(e .&A!.u. +er.!ss!0,e 0&#9 -!#&#*e &s +er T&#3"# C"..! ee N"r.s "irst #ethod : .(4 of the net wor!ing capital financed by ban! i.e. .(4 of $s. /-23(233) ($efer to (i) above) > $s. ,(2'0233, 'econd #ethod : (.(4 of current assets) A %urrent liabilities (i.e. .(4 of $s. ((2),2/-0) A $s. *2).2/.0 ($efer to (i) above) > $s. /02'.2(3- A $s. *2).2/.0 > $s. ,,2')20'( 2"r9!#/ N" es : 0. nnual cost of production $s2 *,2')2))) ,02')2))) -'2/)2))) 02.-2*)2))) $s. ,2')2))) -)2))) 02')2))) (2))2)))

$aw material re#uirements (02)/2))) x Nnits x $s. *)) Direct wages (02)/2))) units x $s. ,)) Everheads (exclusive of depreciation) (02)/2))) x $s. -)) '. 3or% in progress stoc% $aw material re#uirements (/2))) units x $s. *)) Direct wages (()4 x /2))) units x $s. ,)) Everheads (()4 x /2))) units x $s. -)) ,. 4aw material stoc%

It is given that raw material in stoc! is average / wee!s consumption. +ince2 the company is newly formed2 the raw material re#uirement for production and wor! in progress will be issued and consumed during the year. Oence2 the raw material consumption for the year (() wee!s) is as follows : 9or finished goods 9or wor! in progress $s. *,2')2))) <,2')2))) *-2/)2))) $s. *-2/)2))) ?????????????????????? x / wee!s (' wee!s i.e.2 $s. -2-/2-0( /. "inished goods stoc% *2))) units G $s. 0.) per unit > $s. 0,2-)2))) (. &e+tors for sale %redit allowed to debtors %redit sales for year ((' wee!s) i.e. (02)/2))) units A *2))) units) +elling price per unit

$aw material stoc!

Average * wee!s 3-2))) units $s. '))

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%redit sales for the year (3-2))) units x $s. '))) Debtors

$s. 023'2))2))) $s. 023'2))2))) ???????????????????? x * wee!s (' wee!s i.e.2 $s. '32(,2*/-

-. Creditors for raw material : %redit allowed by suppliers 6urchases during the year ((' wee!s) i.e. ($s. *,2')2))) = $s. ,2')2))) = $s. -2-/2-0() ($efer to wor!ing notes 02 ' and , above) %reditors Average / wee!s $s. 3,2)/2-0( $s. 3,2)/2-0( ????????????????????? x / wee!s (' wee!s i.e.2 $s. .20(2./) .. Creditors for wages &ag in payment of wages Direct wages for the year ((' wee!s) i.e. ($s. ,02')2))) = $s. -)2)))) ($efer to wor!ing notes 0 and ' above) %reditors Average 00;' wee!s $s. ,02*)2))) $s. ,02*)2))) ????????????????????????? x 00;' wee!s (' wee!s i.e.2 $s. 302.,0 Ques !"# <. Crite short notes on any four of the following : (a) (b) (c) (d) (e) ultiple discriminate analysis 6ac!ing credit 9actoring Inflation and financial management Eb7ectives of portfolio management.

A#s$er %&' Mu, !+,e 3!s*r!.!#& e &#&,4s!s : 8he traditional study of performance of a firm through financial ratios provide for wor!ing out a number of separate clues A such as ratios to sic!ness or failure. It would be more useful to combine the different ratios into a single measure of the probability of sic!ness2 failure or insolvency. 8he techni#ue of multiple discriminent analysis ( DA) help to do so. Edward I. Altman developed an empirical model to predict corporate ban!ruptcy using ultiple Discriminant Analysis ( DA). Altman stated that univariate ratio analysis is susceptible to faulty interpretation and is potentially confusing because the order importance of financial ratios was not clear. Ebviously2 an independent assessment of some ratios does not lead to any conclusive opinion without analysis the behaviour of other relevant ratios. Altman derived the final discriminant function as follows : P > 0.' K0 = 0./ K' = ,., K, = ).-)K/ = ).333K(

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Chere2 K0 K' K, K/ K( P P %0' > Cor!ing capital; 8otal Assets > $etained Earnings; 8otal Assets > E"I8; 8otal Assets > ar!et value of E#uity; "oo! value of 8otal Debt

> +ales; 8otal Assets > Everall index2 P] '.-.( is non A ban!rupt region2 ^ '.-.( is the ban!ruptcy region and 0.*0 ^ P ^ '.33 is the Qone of ignorance.

P&*9!#/ *re3! : 6ac!ing credit is an advance made available by ban!s to an exporter. Any exporter2 having at hand a firm export order placed with him by his foreign buyer or an irrevocable letter of credit opened in his favour2 can approach a ban! for availing of pac!ing credit. An advance so ta!en by an exporter is re#uired to be li#uidated within 0*) days from the date of its commencement by negotiation of export bills or receipts of export proceeds an approved manner. 8hus pac!ing credit is essentially a short ? term advance. Hormally2 ban!s insist upon their customers to lodge the irrevocable letters of credit opened in favour of the customer by the overseas buyers. 8he letter of credit and firms: sale contracts not only serve as evidence of a definite arrangement for realisation of the export proceeds but also indicate the amount of finance re#uired by the exporter. 6ac!ing %redit2 in the case of customers of long standing may also be granted against firm contracts entered into by them with overseas buyers. 6ac!ing credit may be of the following types : (a) Clean pac%ing credit : 8his is an advance made available to an exporter only on production of a firm export order or a letter of credit without exercising any charge or control over raw material or finished goods. It is clean type of export advance. Each proposal is weighed according to particular re#uirements of the trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also2 Export %redit guarantee %orporation (E%1%) cover should be obtained by the ban!. Pac%ing credit against hypothecation of goods : Export finance is made available on certain terms and conditions where the exporter has pledge able interest and the goods are hypothecated to the ban! as security with stipulated margin. At the time of utilising the advance2 the exporter is re#uired to submit2 along with the firm export order or letter or credit2 relative stoc! statements and thereafter continue submitting them every fortnight and whenever there is any movement in stoc!. Pac%ing credit against pledge of goods : Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the ban!s with approved clearing agents who will ship the same from time to time as re#uired by the exporter. 8he possession of the goods so pledged lies with the ban! and are !ept under its loc! and !ey.

(b)

(c)

%*'

F&* "r!#/ : 9actoring is a new financial service that is presently being developed in India. 9actoring involves provision of specialised services relating to credit investigation2 sales ledger management2 purchase and collection of debts2 credit protection as well as provision of finance against receivables and ris! bearing. In factoring2 accounts receivables are generally sold to a financial Institution (a subsidiary of commercial ban! A called R9actorS)2 who charges commission and bears the credit ris!s associated with the accounts receivables purchased by it.

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Its operation is very simple. %lients enter into an agreement with the RfactorS wor!ing out a factoring arrangement according to his re#uirements. 8he factor then ta!es the responsibility of monitoring2 follow up2 collection and ris! ta!ing and provision of advance. 8he factor generally fixes up a limit customer A wise for the client (seller). 9actoring offers the following advantages which ma!es it #uite attractive to many firms : (0) 8he firm can convert accounts receivables into cash without bothering about repayment. (') 9actoring ensures a definite pattern of cash in flows. (,) %ontinuous factoring virtually eliminates the need for the credit department. 8hat is why receivables financing through factoring is gaining popularity as useful source of financing short term funds re#uirements of business enterprises because of inherent advantage of flexibility it affords to the borrowing firm. 8he seller firm may continue to finance its receivables on a more or less automatic basis. It sales expand or contract2 it can vary the financing proportionately. Oowever2 factoring as a means of financing is comparatively costly source of financing since its cost of financing is higher than the normal lending rates. %3' I#-,& !"# &#3 -!#&#*!&, .&#&/e.e# : 9inancial management is basically concerned with the proper management of finance which is regarded as the life blood of business enterprise. 8he direct conse#uence of inflation has been to distort the significance of operating results and utility of financial statements (based on historical cost) for various managerial accounting and decision ma!ing purposes. Even though it is beyond the scope of finance manager to control inflation. Oe2 however2 tries to measure the impact of inflation on his business so as to re A orient various financial management policies according to the fast changing circumstances. +ome of the prominent areas which are affected by inflation and are re#uired to be re A oriented are as follows : 0. "inancing decisions : 8his involves identifying the sources from which the finance manager should raise the #uantum of funds re#uired by a company. the debenture holder and preference shareholders are interested in fixed income while e#uity shareholders are interested in higher profits to earn high dividend. 8he finance manager is re#uired to estimate the amount of profits he is going to earn in future. Chile estimating the revenue and costs.2 he must ta!e into consideration the inflation factor. (nvestment decisions : 8he capital budgeting decisions will be biased if the impact of inflation is not correctly factored in the analysis. 8his is because the cash flows of an investment pro7ect occur over a long period of time. 8herefore2 the finance manager should be concerned about the impact of inflation on the pro7ect:s profitability. 3or%ing capital decisions : 8he finance manager is re#uired to consider the impact of inflation while estimating the re#uirements of wor!ing capital. 8his is because of the increasing input prices and manufacturing costs2 more funds may have to be tied up in inventories and receivables. &ividend payout policy : 8his involves the determination of the percentage of profits earned by the enterprise which is to be paid to be paid to the shareholders. Chile ta!ing this decision2 the finance manager has to !eep in mind the inflation factor. 8herefore2 while ma!ing this decision he has to see that the capital of the company remain intact even after the payment of dividend. 8his is because in a inflationary situation the depreciation provided on the basis of historical costs of assets would not provide ade#uate funds for replacement of fixed assets at the expiry of their useful lives.

'.

,.

/.

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%e'

O0Ge* !6es "- +"r -",!" .&#&/e.e# : 6ortfolio management refers to the selection of securities and their continuous shifting in the portfolio for optimiQing the return for investor. 8he following are the ob7ectives of portfolio management. (i) (ii) (iii) (iv) (v) (vi) 'ecurity/ safety of principal : +ecurity not only involves !eeping the principal sum intact but also !eeping intact its purchasing power. 'ta+ility of income : +o as to facilitate planning more accurately and systematically the reinvestment or consumption of incomeL Capital growth : Chich can be attained by reinvesting in growth securities or through purchase of growth securities. #ar%eta+ility :8he case with which security can be bought or sold. 8his is essential to provide flexibility to investment portfolio. ,i$uidity : It is desirable for an investor to ta!e advantage of attractive opportunities in the mar!et. &iversification : 8he basic ob7ective of building a portfolio is to reduce the ris! of loss of capital; income by investing in various types of securities and over a wide range of industries.

(vii) "avoura+le tax status : 8he effective yield an investor gets from his investment depends on tax to which it is sub7ected. "y minimising tax burden2 yield can be improved effectively.

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F!#&, eA&.!#& !"# M&4, 1999 Gr.-I P&+er 2 : M&#&/e.e# A**"u# !#/ & F!#&#*!&, A#&,4s!s
Ques !"# 1. (a) A company is considering two mutually exclusive pro7ects K and 5. 6ro7ect K costs $s.,)2))) and 6ro7ect 5 $s.,-2))). 5ou have been given below the net present value2 probability distribution for each pro7ect. 6ro7ect K H6J Estimate 6robability $s. ,2))) ).0 -2))) )./ 0'2))) )./ 0(2))) ).0
(i)

H6J Estimate $s. ,2))) -2))) 0'2))) 0(2)))

6ro7ect 5 6robability ).' )., )., ).'

(ii) (iii) (iv) (b)

%ompute the expected net present value of 6ro7ects K and 5. %ompute the ris! attached to each pro7ect i.e.2 +tandard Deviation of each probability distribution. Chich pro7ect do you consider more ris! and whyF %ompute the profitability index of each pro7ect. Determine the ris! ad7usted net present value of the following pro7ects: A 02))2))) ( years ,)2))) )./ " 02')2))) ( years /'2))) ).* % '20)2))) ( years .)2))) 0.'

Het cash outlays ($s.) 6ro7ect life Annual cash inflow ($s.) %oefficient of variation

8he company selects the ris!?ad7usted rate of discount on the basis of the coefficient of variation: . %oefficient of variation $is! ad7usted rate of discount 6resent value factor 0 to ( years at ris! ad7usted rate of discount ,..30 ,.-)( ,./,, ,.'./ ,.0'. '.*-/ '.-*3

ore than A#s$er %&' H6J Estimate <<$s. ,2))) -2)))

).) )./ ).* 0.' 0.'.) '.)

0)4 0'4 0/4 0-4 0*4 ''4 '(4

Pr"Ge* H 6robability H6J estimate x probability $s. ,)) '2/)) Deviation from expected H6J i.e. $s. 32))) -2))) ,2))) +#uare of +#uare of the the deviation deviation x probability $s. $s. ,2-)2))2))) ,-2))2))) 3)2))2))) ,-2))2)))

).0 )./

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0'2))) 0(2))) Expected H6J Pr"Ge* Y H6J Estimate $s. ,2))) -2))) 0'2))) 0(2))) Expected H6J
(i)

)./ ).0

/2*)) 02()) <<<<< 32)))

? ,2))) ? -2)))

3)2))2))) ,2-)2))2)))

,-2))2))) ,-2))2))) <<<<<<<<< 02//2))2)))

6robability

H6J estimate x probability $s. -)) 02*)) ,2-)) ,2))) <<<<< 32)))

Deviation from expected H6J i.e. $s. 32))) -2))) ,2))) ? ,2))) ? -2)))

).' )., )., ).'

+#uare of +#uare of the the deviation deviation x probability $s. $s. ,2-)2))2))) .'2))2))) 3)2))2))) 3)2))2))) ,2-)2))2))) '.2))2))) '.2))2))) .'2))2))) <<<<<<<< 023*2))2)))

8he expected net present value of pro7ects K and 5 is $s. 32))) each.

(ii) +tandard Deviation > s#uare of the deviation x probability In case of pro7ect K : +tandard Deviation > $s. 02//2))2))) > $s. ,2.3( In case of 6ro7ect 5 : +tandard Deviation > $s. 023*2))2))) > $s. /2/() +tandard deviation (iii) Coefficient of variation > ??????????????????????????????????????? Expected net present value ,2.3( In case of 6ro7ect K : %oefficient of variation > ?????????? > )./' 32))) /2/() In case of 6ro7ect 5 : %oefficient of variation > ???????????? > )./3 or ).() 32))) 6ro7ect 5 is ris!ier since it has a higher coefficient of variation. Discounted cash inflow (iv) 6rofitability Index > ?????????????????????????????????? Discounted cash outflow 32))) = ,)2))) In case of 6ro7ect K : 6rofitability Index > ???????????????????????????? > 0.,) ,)2))) 32))) = ,-2))) /(2))) In case of 6ro7ect 5 : 6rofitability Index > ??????????????????????????????????? > ????????????? > 0.'( ,-2))) ,-2)))

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%0'

S & e.e# s("$!#/ (e 3e er.!#& !"# "- (e r!s9 &3Gus e3 #e +rese# 6&,ue Het %oefficient %ash of Eutlays variation $s. (ii) 02))2))) 02')2))) '20)2))) $is! ad7usted discount $ate (iv) 0'4 0/4 0-4 Annual cash inflow $s. (v) ,)2))) /'2))) .)2))) 6J factor Discounted 0 A ( years cash inflow at ris! ad7usted rate Ef discount $s. $s. (vi) (vii) > (v)x(vi) ,.-)( ,./,, ,.'./ 02)*20() 02//20*'2'320*) Het 6resent value

6ro7ects

(i) (ii) A " %

(iii) )./ ).* 0.')

$s. (viii)>(vii) A *20() '/20*0320*)

Ques !"# 2. (a)

K %o. &td. an Indian %ompany has to ma!e payment of , million (,) la!hs) N+ Dollars after - months against import of plant and machinery. Chat are the different alternatives to hedge against this foreign currency exposure. 1ive explanations. Describe different !inds of float with reference to management of cash.

(b)

(c) % developed original specification of a product and founded % anufacturing &td. In 033. the firm manufactured 3*) Hos. at an average price of $s.3)) each. In 033* due to continuous price rise of the inputs2 he raised his prices at an average of 0'42 since he !new he could sell his plant:s full capacity of 3*) Hos. per year. In spite of price rise for the product2 which sold for over $s.02))) for the first time2 % was surprised to learn in late 033* (as may be seen from the financial statements) that % anufacturing &td. show a decline in earnings and still worse2 decline in cash flow. Ois accountant has brought the following : (i) (ii) (iii) (iv) Ce are following 9I9E system for the purpose of issues. %osts are going up faster than 0'4 and they will go up further in 0333. Ce are not setting aside enough to replace the machineryL we need to set aside $s.02-(2)))2 not $s.02()2))) so as to be able to buy new machinery. It is still not late to switch to &I9E for 033*. 8his will reduce closing inventory to $s.,2,)2))) and raise cost of goods sold. % +ales %ost of goods sold Epening inventory $aw material &abour Depreciation End inventory 1ross margin Administration expenses E"I8 Interest Income?tax anufacturing &td. Income +tatement ($s. )))) 033* 033. 02))* 3)) '() /)) 0./ 0() (?) ,') .*) ''* 0)) 0'* () .* ,3 -(/ '/3' 0(/ () 0)/ ('

,') ()) ')) 0() (?) ,3)

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6rofit after tax Add : non?cash expenses Inventory change %ash flow $e#uired : (0) (')

,3 0() (?) .) 003

(' 0() (?) .) 0,'

Chat is the weighted average inflation factor for the firm using &I9E F If the firm desire a 0(4 profit margin on sales2 how much should the firm charge for the product per unit F

A#s$er %&' K co. &td.2 an Indian %ompany which has to ma!e payment of , million (,) la!hs) N+ Dollar after - months against import of plant and machinery has the following alternatives to hedge against this foreign currency exposure :? (i) "orward cover : K co. &td. can ta!e a full forward cover against its foreign exchange exposure and entirely hedge its ris!. It can contract with a ban! to buy N+X forward at an agreed exchange rate. +uppose the - months forward rate is $s. /'./); N+X 0. 8his means that K %o. &td. has definite cost of $s. /'./) x , million rupees i.e.2 $s. 02'.' la!hs2 irrespective of the actual exchange rate at the end of six months. "oreign currency option : 8he foreign currency option is the right (not an obligation) to buy or sell a currency at an agreed exchange rate (exercise 6rice) on or before an agreed maturity period. 8he right to buy is called a call option and right to sell in put option. A foreign currency option holder will exercise his right only if it is advantageous to do so. K co. &td. can buy a - months put option in rupees at $s./'./) (say) plus (4 (say) premium for purchasing the option i.e. maximum final (cost) $s. /'./) x ,) la!hs x 0.)( i.e. $s. 0,,(.- la!hs (including the cost of the premium $s. -,.- la!hs). +uppose at the end of - months2 the exchange rate becomes $s. //2 the company should exercise its put option since it will sell (pay) IH$ /'./) (the exercise price) to obtain one N+X. In the open mar!et it will be re#uired to pay IH$ //. En the other hand2 if the rupees appreciates and the exchange rate at the end of six months is IH$ /'; N+ X2 the %o. will not exercise its option. In the open mar!et2 it need to pay only IH$ /' (instead of IH$ /'./) exercise price) to buy one N+ X. Oowever2 it has already paid the option premium. If it does not exercise the option2 its total cost will be $s. ,) la!hs x $s. /' = $s. -,.- > $s. 0,',.- la!hs. Except for the cost of option premium2 the foreign currency option provides a uni#ue hedging alternative2 one can avoid the loss by exercising appropriate option and gain from the favourable change in the exchange rate by not exercising the option. #oney mar%et operations : Another hedging techni#ue is the money mar!et operations. K co. can borrow , million N+ X. How convert into rupees at the current exchange rate and invest in the money mar!et in India for - months. If interest rate parity holds2 the difference in the forward rate and the spot rate is the reflection of the differences in the interest rates in two countries. 8hus2 K co. will be able to hedge against the change in the exchange rate. 8he problem with the money mar!et alternative is that all mar!ets are not open all currencies are not fully convertible. 8he Indian rupee is not fully convertible and there are restrictions on the free flow of funds outside the country.

(ii)

(iii)

%0'

7!--ere# 9!#3s "- -,"& $! ( re-ere#*e " .&#&/e.e# "- C&s( : 8he term float is used to refer to the periods that affect cash as it ma!es through the different stages of the collection process. 9our types of float can be identified as : (i) !illing float : An invoice is the formal document that a seller prepares and sends to the purchaser as the payment re#uest for the goods sold or services provided. 8he time between the sale and mailing of the invoice is the billing float .

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(ii) (iii) (iv) %*' %!'

#ail float : 8his is the time when a che#ue is being processed by post office2 messenger service or other means of delivery. Che$ue processing float : 8his is the time re#uired for the seller to sort2 record and deposit the che#ue after it has been received by the company. !an% processing float : 8his is the time from the deposit of the che#ue to the crediting of funds in the seller account. 033* Expenses ($s. )))) 033. Expenses '() /)) -() /3) ')) 0-(I *(( 0)) 3(( ,') ,,) 0./ 0() -(/ <3' ./-

$aw material Epening inventory Add : 6urchases &ess : %losing inventory "ased on &I9EI &abour Depreciation %ost of goods sold Add : Administration expenses

,') ()) *') ,,)

I %onsideration on replacement cost basis 3(( Oence2 weighted average inflation factor for the firm in 033* > ??????? ./> 0.'* i.e. '*4 over 033. (') If the firm desires a 0( per cent profit margin on sales the price which the firm should charge for the product per unit can be identified in two ways :? (i) In 033.2 E"I8 as a percentage of sales was 0..04 Oence2 if we ta!e the weighted average inflation in 033* over 033. and increase prices to that extent the charge per product in 033* will be. 32))2))) $s.??????????????????? x 0.'* > 020.(.() 3*) Er in other words Average price in 033. x (0 = inflation4) > $s. 30*.,- x 0.'* > $s. 020.(.() per product I.e. 8otal sales will be ($s. 020.(.() x 3*) Hos.) > $s. 002('2))) approximately lternatively/ (ii) 8otal cost in 033*2 for 3*) Hos. is $s. 32((2))) Oence2 for each no. > $s. 3./.() In order to earn 0(4 profit margin on sales (E"I8 level)2 the sales price product will be 3./.() $s. ??????????? > $s. 00/-.() ).*( 8otal sales will be ($s. 020/-.() x 3*) Hos.) > $s. 002',2(.) N" e : 9igures have been rounded off.

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Ques !"# 8.%&' V &td. sells goods at a uniform rate of gross profit of ')4 on sales including depreciation as part of cost of production. Its annual figures are as under : +ales (At ' months: credit) aterials consumed (+uppliers credit ' months) Cages paid ( onthly at the beginning of the subse#uent month) anufacturing expenses (%ash expenses are paid?one month in arrear) Administration expenses (%ash expenses are paid?one month in arrear) +ales promotion expenses (6aid #uarterly in advance) $s. '/2))2))) -2))2))) /2*)2))) -2))2))) 02()2))) .(2)))

8he company !eeps one month stoc! each of raw materials and finished goods. A minimum cash balance of $s.*)2))) is always !ept. 8he company wants to adopt a 0)4 safety margin in the maintenance of wor!ing capital. 8he company has no wor! in progress. 9ind out the re#uirements of wor!ing capital on cash cost basis. (b) "riefly indicate the causes of industrial sic!ness in India. (0' = * > ') mar!s)

A#s$er %&' 2"r9!#/ N" es : 1. anufacturing expenses +ales &ess : 1ross profit margin at ')4 8otal manufacturing cost &ess : aterials consumed -2))2))) Cages /2*)2))) anufacturing expenses &ess : %ash manufacturing expenses (()2))) x 0') Depreciation 2.

$s. '/2))2))) /2*)2))) 032')2))) 0)2*)2))) *2/)2))) -2))2))) '2/)2)))

8otal cash costs $s. anufacturing costs 032')2))) &ess : Depreciation '2/)2))) %ash anufacturing costs 0-2*)2))) Add : Administrative expenses 02()2))) Add : sales promotion expenses <.(2))) 8otal cash costs 032)(2))) S & e.e# s("$!#/ (e reBu!re.e# s "- $"r9!#/ *&+! &, "- (e *".+&#4. $s. Current ssets : Debtors 0;-th of total cash costs (0;- x $s. 032)(2)))) ,.0.2()) ($efer to wor!ing note ') sales promotion expenses (prepaid) 0*2.() +toc! of raw materials (0 month) ()2))) 9inished goods (0;0' of cash manufacturing costs) ($s. 0-2*)2))) x 0;0') ($efer to wor!ing note ') %ash in hand &ess : %urrent liabilities %reditors for goods (' months) Cages (0 month) 02))2))) /)2))) 02/)2))) <*)2))) -2)-2'()

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anufacturing expenses (0 months) Administrative expenses (0 months) Het wor!ing capital Add : safety margin 0)4 Cor!ing capital re#uired %0' C&uses "- I#3us r!&, s!*9#ess :

()2))) 0'2())

'2)'2()) /2),2.() </)2,.( /2//20'(

8he causes of industrial sic!ness in India may be broadly classified as follows : A. I# er#&, *&uses : Nnder this category2 the following causes are generally responsible fro the industrial sic!ness in India. %1' P,&##!#/ (a)Technical feasi+ility : JiQ. Inade#uate technical !now A how2 locational disadvantages2 outdated production process. (b)Economic via+ility : Oigh cost of inputs2 brea! A even point too high2 uneconomic siQe of pro7ect2 under A estimation of demand2 poor labour relations2 lac! of trained; s!illed labour or technically competent personnel. (c) #ar%eting management : Dependence on a single customer or a limited number of customers; single or a limited number of products2 poor sales realisation2 defective pricing policy2 boo!ing of large orders at fixed prices in an inflationary mar!et2 wea! mar!et feedbac! and mar!et research. &ac! of !nowledge of mar!eting techni#ues2 unscrupulous sales; purchase practices. (d)"inancial #anagement : 6oor resources management and financial planning2 faulty costing2 liberal dividend policy2 general financial indiscipline and application of funds for unauthoriQed purposes2 deficiency of funds2 over A trading2 unfavorable gearing or !eeping adverse debt A e#uity ratio2 inade#uate wor!ing capital2 absence of cost consciousness2 lac! of effective collection machinery. (e) dministrative management : Ever %entralisation2 lac! of professionalism2 lac! of feed A bac! to management. (') I.+,e.e# & !"# : %ost over A runs resulting from delays in getting licence; sanctions2 etc. inade#uate mobiliQation of finance. (,) Fu#* !"#&, M&#&/e.e# : (a)Production management : Inappropriate product A mix2 poor #uality control2 high cost of production2 poor inventory management2 inade#uate maintenance and replacement2 lac! of timely and ade#uate modernisation2 etc.2 high wastage2 poor capacity utilisation. (b),a+our management relations : Excessively high wage structure2 inefficient handling of labour problems2 excessive manpower2 poor labour productivity2 lac! of proper management information system and controls2 lac! of timely diversification2 excessive expenditure on $esearch M Development2 dividend loyalties (Chere the same management has interest in more than one unit2 cases are !nown where promoters of limited companies who also have their own private interest first tend to loo! after the interest of the latter2 often at the cost of the former)2 dissension within the management2 incompetent and dishonest management. ). EA er#&, *&uses &#3 " (er -&* "rs : 8he following factors may be mentioned in this respect.

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(a) 5overnment controls and policies/ etc.: 1overnment price controls2 fiscal duties2 abrupt changes in 1overnment polices affecting costs; prices; imports; exports; licensing. (b) 6rocedural delays on the part of financial; licensing;other controlling or regulating authorities li!e "an!s2 $"I2 9inancial Institutions2 1overnment departments2 &icensing Authorities2 $86 authorities2 etc. (c) #ar%et Constraints : ar!et saturation $evolutionary technological advances rendering the products obsolete2 and $ecession A fall in domestic; export demand. (d) Extraneous factors : Hatural calamities2 political situation (domestic as well as international)2 and stri!es and multiplicity of labour unions2 et. Ques !"# :. 1 &td. will commence operations as the beginning of the year and the budgets for activity and costs for the first three #uarters of operation are shown below : "udgets A Vuarters I2 II and III 6eriod covered A months Activity : +ales (units) 6roduction (units) %osts : ($s. ))))
Direct aterials :

I 0?, 32))) 0)2)))

II /?0.2))) ')2)))

III .?3 0(2))) 0(2)))

A () " /) 6roduction labour 0*) 9actory overheads (excluding depreciation) *) Depreciation of production machinery 0/ Administration expenses ,) +elling M distribution expenses '3 8otal %osts /',

0)) *) '*( 00) 0/ ,) ,. -(-

.( -) ',) 3( 0/ ,) ,( (,3

Hote : Jariable labour costs become ()4 higher for activity in excess of 032))) units per #uarter due to the necessity of overtime wor!ing. In #uarter IJ2 the sales volume could range from an extreme low of 0(2))) units to an extreme of '02)))) units2 but most li!ely of 0*2))) units. In month 32 it will be possible to accurately estimate sales for Vuarter IJ and the production level for that #uarter will be set e#ual to the sales volume. Activity for each #uarter is spread evenly throughout that #uarter. %ost structures will remain same in Vuarters I to III2 but are expected to differ in Vuarter IJ only in the following aspects : (i) (ii) (iii) (iv) aterial A will rise in price by ')4. All production labour wage rate will increase by 0' _4. Jariable labour input per unit of output will decrease (due to learning curve effect) to *)4 8he threshold of overtime wor!ing remains at 032))) units. 9ixed factory overheads and the fixed element of selling and distribution costs will each rise by ')4.

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8he effect of these change is considered too small to re#uire a change in the standard cost per unit of $s.,) which is used for stoc! valuation. $e#uired : (a) 6roduce a statement which analyses under each cost classification given in the budgets2 the variable cost per unit and the fixed costs which will be effective in Vuarter IJ. (b) 6repare a flexible budget of estimated costs for Vuarter IJ with step points which will facilitate simple interpretation of costs for the most li!ely levels.

64
A large profit ma!ing 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 mar!etable product. At present2 the waste is removed by a contractor for disposal on payment by the company of $s.() la!hs p.a. for the next four years. 8he contract can be terminated upon installation of the aforesaid machine on payment of a compensation of $s.,) lacs before the processing operation starts. 8his compensation is not allowed as deduction for tax purposes. 8he machine re#uired for carrying out the processing will cost $s.')) lacs to be financed by a loan repayable in / e#ual installments commencing from the end of year 0. 8he interest rate is 0-4 p.a. At the end of the /th year2 the machine can be sold for $s.') lacs and the cost of dismantling and removal will be $s.0( lacs. +ales and direct costs of the product emerging from waste processing for / years are estimated as under : 5ear +ales aterial consumption Cages Ether expenses 9actory Everheads Depreciation (as per income?tax rules) 0 ,'' ,) .( /) (( () ' ,'' /) .( /( -) ,* , /0* *( *( (/ 00) '* $s. (lacs) / /0* *( 0)) .) 0/( '0

I#! !&, s "*9 "- .& er!&,s reBu!re3 0e-"re *"..e#*e.e# "- (e +r"*ess!#/ "+er& !"#s !s Rs.2? ,&9(s & (e s &r "- 4e&r 1. T(e s "*9 ,e6e,s "- .& er!&,s " 0e .&!# &!#e3 & (e e#3 "- 4e&r 1, 2 &#3 8 $!,, 0e Rs.<< ,&9(s &#3 (e s "*9s & (e e#3 "- 4e&r : $!,, 0e #!,. T(e s "r&/e "- .& er!&,s $!,, u !,!se s+&*e $(!*( $"u,3 " (er$!se (&6e 0ee# re# e3 "u -"r Rs.1? ,&9(s +.&. L&0"ur *"s !#*,u3e $&/es "- :? $"r9ers, $("se r&#s-er " (!s +r"*ess $!,, re3u*e !3,e !.e +&4.e# s "Rs.1< ,& (s !# 4e&r 1 &#3 Rs.1? ,& (s !# 4e&r 2. F&* "r4 "6er(e&3s !#*,u3e &++"r !"#.e# "/e#er&, -&* "r4 "6er(e&3s eA*e+ " (e eA e# "- !#sur&#*e *(&r/es "- Rs.8? ,&9(s +.&. +&4&0,e "# (!s 6e# ure. T(e *".+&#4Ds &A r& e !s <?I.

6resent value factors for four years are as under : 5ear 0 ' 6resent value factors ).*.) )..(-

, ).-(*

/ ).(.'

Advise the management on the desirability of installing the machine for processing the waste. All calculations should form part of the answer. (') mar!s) A#s$er F!rs A, er#& !6e 2"r9!#/ N" e 0. Direct material cost for manufacturing for per unit of production :

Cost Academy $s. ()2))) A :?????????????????????????? > $s. (

81

0)2))) $s. /)2)) " : ?????????????????????????? > $s. / 0)2))) Direct material cost (variable cost) for materials A and " for all #uarters on commutation comes to $s. ( and $s. / for materials A and " respectively. In Vuarter IJ price of material A rise by ')4 i.e. $s. - ($s. ( x 0.')) '. "ixed and varia+le cost of production la+our : Vuarter I 6roduction (Nnits) 0)2))) 6roduction labour ($s.) 02*)2))) %hange in production labour cost Jariable cost (per unit) > ?????????????????????????????????????????????? %hange in production units $s. ()2))) > ???????????????????? > $s. 0) (2))) units 9ixed cost > $s. 02*)2))) A $s. 02))2))) (0)2))) units x $s. 0)) > $s. *)2)))
9or Vuarter II (')2))) units) $s.

Vuarter II 0(2))) '2,)2)))

%hange (2))) ()2)))

Jariable cost of ')2))) units G $s. 0) p.u. 9ixed cost Evertime premium on 02))) units G $s. ( p.u. 9or Vuarter IJ (0*2))) units) Jariable cost of 0*2))) units G $s. 3 p.u. ($s. 0) x 0.0'( x ).*)) 9ixed cost ($s. *)2))) x 0.0'() 8otal production labour cost ,. "ixed and varia+le cost component of factory overheads Vuarter I 6roduction (units) 0)2))) 9actory overheads ($s.) *)2))) (excluding depreciation) Vuarter II ')2))) 020)2)))

'2))2))) *)2))) <<(2))) '2*(2))) $s. 02-'2))) <<3)2))) '2('2))) %hange 0)2))) ,)2)))

Jariable cost component of factory overheads %hange in factory overhead cost > ??????????????????????????????????????????????? %hange in production units $s. ,)2))) > ???????????????????? > $s. , p.u. 0)2))) Oence2 fixed cost component of factory overheads > $s. 020)2))) A $s. -)2))) (')2))) units x $s. ,) > $s. ()2))) 9or Vuarter IJ 9ixed cost (component) $s. ()2)))

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Add : ')4 increase of $s. ()2))) 8otal fixed cost /. "ixed and varia+le cost component of selling and distri+ution expenses Vuarter I Vuarter II +ales (units) 32))) 0.2))) +elling M distribution expenses ($s.) '32))) ,.2))) Jariable cost component of selling M distribution expenses %hange in selling M distribution expenses > ???????????????????????????????????????????????????????????? %hange in sales units $s. *2))) > ??????????????????????????? > $e 0 per unit *2))) Oence2 fixed cost component of selling M distribution expenses > $s. ,.2))) A $s. 0.2))) (0.2))) units x $e.0) > $s. ')2))) 9or Vuarter IJ. 9ixed %ost (component) Add: ')4 increase of $s. ')2))) 8otal fixed cost. (a)

0)2))) -)2))) %hange *2))) *2)))

S & e.e# "- 6&r!&0,e *"s +er u#! &#3 -!Ae3 *"s s u#3er /!6e# *"s *,&ss!-!*& !"# e--e* !6e !# Bu&r er IC 6articulars Jariable %ost p.u. $s. <<<<<<Vuarter IJ 8otal fixed cost $s

Ques !"# <. Crite short notes on : (a) (b) (c) (d) ethods of Jenture %apital 9inancing. +ystematic and Nnsystematic $is! in connection with 6ortfolio Investment. 9actors influencing the dividend policy of the firm. +pecial features of 9inancial anagement in a public sector underta!ing.

A#s$er %&' Me ("3s "- Ce# ure C&+! &, F!#&#*!#/ : 8he venture capital financing refers to financing and funding of the small scale enterprises2 high technology and ris!y ventures. +ome common methods of venture capital financing are as follows: (i) E$uity financing : 8he venture capital underta!ings generally re#uires funds for a longer period but may not be able to provide returns to the investors during the initial stages. 8herefore2 the venture capital finance is generally provided by way of e#uity share capital. 8he e#uity contribution of venture capital firm does not exceed /34 of the total e#uity capital of venture capital underta!ings so that the effective control and ownership remains with the entrepreneur. (ii) Conditional ,oan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. Ho interest is paid on such loans. In India Jenture %apital financers

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charge royalty ranging between ' to 0( per centL actual rate depends on other factors of the venture such as gestation period2 cash flow patterns2 ris!ness and other factors of the enterprise. +ome Jenture %apital 9inancers give a choice to the enterprise of paying a high rate of interest (which could be well above ') per sent) instead of royalty on sales once it becomes commercially sound. (iii) (ncome *ote : It is a hybrid security which combines the features of both conventional loan and conditional loan. 8he entrepreneur has to pay both interest and royalty on sales but at substantially low rates. ID"I:s Jenture %apital 9und provides funding e#ual to *) *..(4 of the pro7ects cost for commercial application of indigenous technology or adopting imported technology to domestic applications. Participating &e+enture : +uch security carries in three phases A in the start up phase2 no interest is charged2 next stage a low rate of interest is charged upto a particular level of operations2 after that2 a high rate of interest is re#uired to be paid. %0' S4s e.& !* &#3 u#s4s e.& !* R!s9 !# *"##e* !"# $! ( P"r -",!" I#6es .e# : S4s e.& !* r!s9 : It is the ris! which cannot be eliminated by diversification. 8his part of ris! Arises because every security has a built in tendency to move in with the fluctuations in the mar!et. 8he investors are exposed to mar!et ris! even when they hold well diversified portfolio of securities. It is because all individual securities move together in the same manner and therefore no investors can avoid or eliminate this ris!2 what so over precautions or diversification may be resorted to. 8he examples of systematic ris! are: 8he government changes the interest rate policyL the corporate tax rate is increasedL the government resort to massive deficit financingL the inflation rate increases etc. U#s4s e.& !* r!s9: It is the ris! which can be eliminated by diversification. 8his ris! represents the fluctuations in return of a security due to factors specific to particular firm only and not to the mar!et as a whole. 8he investors can totally reduce this ris! through diversification. It is because when a large number of securities enter a portfolio2 many random fluctuations in returns from these securities will automatically set off each other. 8he examples of unsystematic ris!s are: Cor!ers declared stri!e in a companyL the $esearch and Development expert of the company leavesL a formidable competitor enters the mar!etL the company loses a big contract in a bid etc. %*' (i) F&* "rs !#-,ue#*!#/ (e 3!6!3e#3 +",!*4 "- (e -!r. : 8he following are the important factors which generally determine the dividend policy of a firm. &ividend payout ratio : A ma7or aspect of the dividend policy of a firm is its dividend payout (D;6) ratio2 i.e.2 the percentage share of the net earnings distributed to shareholders as dividends. +ince dividend policy of the firm affects both the shareholders: wealth and the long term growth of the firm2 an optimum dividend policy should stri!e out a balance between current dividends and future growth which maximises the price of the firm:s shares. 8he D;6 ratio of a firm should be determined with reference to two basic ob7ectives maximising the wealth of the firm:s owners and providing sufficient funds to finance growth; expansion plans. 'ta+ility of dividends : +tability of dividends is another ma7or aspect of dividend policy. 8he term dividend stability refers to the consistency or lac! of variability in the stream of future dividends. 6recisely2 it means that at certain minimum amount of dividend is paid regularly. ,egal/ contractual and internal constraints and restrictions : 8he firms: dividend decision is also affected by certain legal2 contractual and internal re#uirements and commitments. &egal factors stem from certain statutory re#uirements2 contractual restrictions arise from certain statutory re#uirements2 contractual restrictions arise from certain loan convents and internal constraints are the result of the firm:s li#uidity position. 8hough legal rules do not re#uire a dividend

(ii) (iii)

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declaration2 they specify the conditions under which dividends can be declared. +uch conditions pertain to (a) capital impairment2 (b) net profits2 (c) insolvency2 (d) illegal accumulation of excess profit and2 (e) payment of statutory dues before declaration of dividends. (iv) Tax consideration : 8he firm:s dividend policy is directed by the provisions of income A tax law. If a firm has a large number of owners2 in high tax brac!et2 its dividend policy may be to have higher retention. As against this if the ma7ority of shareholders are in lower tax brac!et re#uiring regular income the firm may resort to higher dividend payout2 because they need current income and the greater certainty associated with receiving the dividend now2 instead of the less certain prospect of capital gains later. Capital mar%et consideration : If the firm has an access to capital mar!et for fund raising2 it may follow a policy of declaring liberal dividend. Oowever2 if the firm has only limited access to capital mar!ets2 it is may li!ely to adopt low dividend payout ratio. +uch firms are li!ely to rely more heavily on retained earnings. (nflation : &astly2 inflation is also one of the factors to be rec!oned with at the time of formulating the dividend policy. Cith raising prices2 accumulated depreciation may be inade#uate to replace obsolete e#uipments. 8hese firms have to rely upon retained earnings as a source of funds to ma!e up the deficiency. 8his consideration becomes all the more important if the assets are to be replaced in the near future. %onse#uently2 their dividend payout ratio tends to be low during periods of inflation. S+e*!&, -e& ures "- F!#&#*!&, M&#&/e.e# !# & +u0,!* se* "r u#3er &9!#/ %PSUs' : 0. 4ole of financial advisor : 8he financial advisor occupies an important position in public sector underta!ings. Ois concurrence is re#uired on all proposals which have financial implications. '. Capital !udgeting decisions : 8he power upto certain limits2 in respect of individual capital expenditure items has been delegated to the board of public sector underta!ings. 9or ma!ing investments beyond the limit the proposal goes to public Investment "oard which appraises and recommends pro7ects to the central 1overnment. ,. Capital structure decisions : +uch decisions involves the identification of different sources of finance. Hormally 6+Ns are financed on the basis of half their capital being in the shape of loans. 8he funds are also provided to 6+Ns directly by the government. 8he following factors are ta!en into consideration at the time of designing capital structure (i) gestation period2 (ii) level of business ris! (iii) capital intensity of pro7ect and (iv) freedom pricing. /. 3or!ing capital management : 8he inventory constitutes a ma7or portion of the wor!ing capital of public sector underta!ings and hence proper inventory management should be given top priority by public sector underta!ings. (. udit : 6ublic sector under ta!ings in addition to regular audit conducted by professional accounts2 are sub7ect to efficiency A cum A propriety audit by the comptroller and Audit 1eneral of India whose reports are presented to parliament every year. nnual report :8he annual reports of public sector units though similar to those of private sector units2 tend to provide more information.

(v)

(vi)

%3'

-.

.. Pricing policy : 8he bureau of public sector underta!ing has laid down certain guidelines for pricing by 6+Ns with the ob7ective to serve the overall interest of the community at large. *. 'tatus of pu+lic sector underta%ing : 6+Ns are organised mainly as departmental enterprise or statutory corporation or companies.

FINAL EHAMINATION NOCEM)ER 5 1999 Gr. I

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MANAGEMENT ACCOUNTING AN7 FINANCIAL ANALYSIS

Ques !"# 1. (a) A"% %ompany &td. has been producing a chemical product by using machine P for the last two years. How the management of the company is thin!ing to replace this machine either by K or by 5 machine. 8he following details are furnished to you : P K 5

"oo! value ($s.) 02))2))) $esale value now ($s.) 020)2))) 6urchase price ($s.) 02*)2))) '2))2))) Annual fixed cost (including depreciation) ($s.) 3'2))) 02)*2))) 02,'2))) Jariable running costs (including labour) per unit ($s.) , 0.() '.() 6roduction per hour (unit) * * 0' 5ou are also provided with the following details : +elling price per unit ($s.) ') %ost of materials per unit ($s.) 0) Annual operating hours '2))) Cor!ing life of each of the three machines (as from now) ( years. +alvage value of machines P $s.0)2)))2 K $s.0(2)))2 5 $s.0*2))). 8he company charges depreciation using straight line method. It is anticipated that an additional cost of $s.*2))) p.a. would be incurred on special advertising to sell the extra output of machine 5. Assume tax rate of ()4 and cost of capital 0)4. 8he present value of $e.0 to be received at the end of the year at 0)4 is as under : 5ear 6resent value 0 .3)3 ' .*', ..(0 / .-*, ( .-'0

$e#uired : Nsing H6J method2 you are re#uired to analyse the feasibility of the proposal and ma!e recommendations. (b) 8he 1lobe anufacturing %ompany &td. is considering an investment in one of the two mutually exclusive proposals A6ro7ects K and 52 which re#uire cash outlays of $s.,2/)2))) and $s.,2,)2))) respectively. 8he certainty A e#uivalent (%.E.) approach is used in incorporating ris! in capital budgeting decisions. 8he current yield on government bond is *4 and this be used as the ris!less rate. 8he expected net cash flows and their certainty A e#uivalents are as follows : <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 6ro7ect K 6ro7ect 5<<<<<< 5ear?end %ash flow %.E. %ash flow %.E. $s. $s. <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 0 02*)2))) ).* 02*)2))) ).3 ' '2))2))) ).. 02*)2))) ).* , '2))2))) ).( '2))2))) ).. 6resent value factors of $e.0 discounted at *4 at the end of year 02 ' and , are .3'-2 .*(. and . .3/ respectively. $e#uired : (i) Chich pro7ect should be accepted F (ii) If ris! ad7usted discount rate method is used2 which pro7ect would be analysed with a higher rate F A#s$er %&'

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A)C C".+&#4 L 3. C".+u & !"# "- 4e&r,4 *&s( !#-,"$ achine +ales (units) +elling price per unit ($s) +ales: (A) &ess: %osts Jariable running costs /*2))) aterial cost 02-)2))) Annual fixed cost 3'2))) Additional cost (special adv.) 8otal costs: (") 6rofit before tax: (A) A (") &ess: 8ax G ()4 6rofit after tax Add: Depreciation %ash inflow P 0-2))) ') ,2')2))) '/2))) 02-)2))) 02)*2))) K 0-2))) ') ,2')2))) 5 '/2))) ') /2*)2)))

,2))2))) ???? <<<<<<<< ,2))2))) ')2))) 0)2))) 0)2))) ')2))) ,)2)))

-)2))) '2/)2))) '23'2))) 02,'2))) /2,'2))) ????? *2))) <<<<<<< <<<<<<< '23'2))) /2/)2))) '*2))) /)2))) 0/2))) ')2))) 0/2))) ')2))) ,,2))) ,-2/)) /.2))) (-2/))

C".+u & !"# "- *&s( !#-,"$ !# < ( Ye&r achinery %ash inflow Add: salvage value of machines %ash inflow P ,)2))) 0)2))) /)2))) C".+u & !"# "- Ne Prese# C&,ue 5ear < 0 ' , / ( achine Discounting 9actor ).3)3 ).*')..(0 ).-*, ).-'0 %ash inflow $s. ,)2))) ,)2))) ,)2))) ,)2))) /)2))) P 6.J. of cash inflow $s. '.2'.) '/2.*) ''2(,) ')2/3) '/2*/) 0203230) 020)2))) 3230) K %ash inflow $s. /.2))) /.2))) /.2))) /.2))) -'2))) 6.J. of %ash inflow $s. /'2.', ,*2*'' ,(2'3. ,'20)0 ,*2()' 02*.2//( 02*)2))) .2//( %ash inflow $s. (-2/)) (-2/)) (-2/)) (-2/)) ./2/)) 5<<< 6.J. of cash inflow $s. (02'-..-) /-2(*-./) /'2,(-./) ,*2('0.') /-2')'./) '2'/23,/.)) '2))2))).)) '/23,/.)) K /.2))) 0(2))) -'2))) 5<< (-2/)) 0*2))) ./2/))

&ess: 6urchase price Het present value

Re*"..e#3& !"#s: 8he Het 6resent Jalue is higher in the case of achine 5. 8herefore2 it is advisable that the company should replace machine P with machine 5. Oowever2 as the cost of investment is not the same for all machines2 it would be better to base the decision on profitability index which is as under: 6.J. of cash inflow 6.I. > ?????????????????????????????? 6.J. of cash outflow

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0203230) achine P > ?????????????????? > 0.)3 020)2))) 02*.2//( achine K > ??????????????????? > 0.)/0 02*)2))) '2'/23,/ achine 5 > ???????????????????? > 0.0' '2))2))) +ince the profitability index of machine 5 is the highest therefore machine P should be replaced by machine 5. %0' %!' 5ear end S & e.e# s("$!#/ Ne Prese# C&,ue "- Pr"Ge* H %ash flow $s. %.E. (b) ).* ).. ).( Ad7usted cash flow (c) > (a) x (b) 02//2))) 02/)2))) 02))2))) 6resent value factor at *4 (d) ).3').*(. )..3/ 8otal present value $s. (e) > (c) x (d) 02,,2,// 020323*) .32/)) ,2,'2.'/ ,2/)2))) (.2'.-)

(a) 0 02*)2))) ' '2))2))) , '2))2))) &ess: Initial Investment Het present value

S & e.e# s("$!#/ Ne Prese# C&,ue "- Pr"Ge* Y 5ear end $s.<<<< 0 ' , (a) 02*)2))) 02*)2))) '2))2))) (b) ).3 ).* ).. (c) > (a) x (b) (d) 02-'2))) ).3'02//2))) ).*(. 02/)2))) )..3/ (e) > (c) x (d) 02()2)0' 02',2/)* 020020-)<<<<< ,2*/2(*) ,2,)2)))<<<<< (/2(*) %ash flow 9low $s. %.E. Ad7usted cash flow $s. 6resent value factor at *4 8otal 6resent value

&ess: Initial investment Het 6resent Jalue

7e*!s!"#: +ince the net present value of pro7ect 5 is positive2 the pro7ect 5 should be accepted. (ii) +ince the certainty A e#uivalent (%.E) coefficient of pro7ect K is lower than pro7ect2 52 the pro7ect x is ris!ier than pro7ect 5. therefore2 if ris! ad7usted discount rate method is used the pro7ect K would be analysed with a higher rate. 111111111111111111

Ques !"# 2. %&'%!' If fixed costs out : (0) (') (,) (/)

are $s./2)))2 variable costs $s.,'2))) and brea!?even point $s.')2)))2 find 6rofit?volume ratio +ales Het profit argin of safety

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(ii)

If fixed costs are $s.'/2)))2 margin of safety $s./)2))) and brea!?even *)2))). 9ind out (0) (') (,) (/) +ales 6rofit?volume ratio. Het profit Jariable costs

%0'

8he odern %hemicals &td. re#uires $s.'(2))2))) for a new plant. 8his plant is expected to yield earning before interest and taxes of $s.(2))2))). Chile deciding about the financial plan2 the company considers the ob7ective of maximising earnings per share. It has three alternatives to finance the pro7ect A by raising debt of $s.'2()2))) or $s.0)2))2))) or $s.0(2))2))) and the balance2 in each case2 by issuing e#uity shares. 8he company:s share is currently selling at $s.0()2 but is expected to decline to $s.0'( in case the funds are borrowed in excess of $s.0)2))2))). 8he funds can be borrowed at the rate of 0)4 upto $s.'2()2)))2 at 0(4 over $s.'2()2))) and upto$s.0)2))2))) and at ')4 over $s.0)2))2))). 8he tax rate applicable to the company is ()4. Chich form of financing should the company choose F Explain a to how the wealth maximisation ob7ective is superior to the profit maximisation ob7ective.

%*'

A#s$er %&' %!' %1' Pr"-! 5 6",u.e r& !" 9ixed cost +ince2 "rea! A even 6oint > ????????????????? 6; v ratio 9ixed cost 8herefore2 6; v ratio > ??????????????????????????? x 0)) "ea! A even point $s. /2))) > ?????????????????????? x 0)) $s. ')2))) %2' S&,es If 6; v ratio is ')42 the variable cost to sales would be *)4. Jariable cost x 0)) 8herefore2 sales > ?????????????????????????????? *) $s. ,'2))) x 0)) > ???????????????????????????????? *) > $s. /)2))) %8' Ne Pr"-! Het 6rofit: +ales A Jariable costs A 9ixed costs > $s. /)2))) A $s. ,'2))) A $s. /2))) > $s. /2))) %:' M&r/!# "- s&-e 4 argin of safety : +ales A "rea! Aeven sales > $s. /)2))) A $s. ')2))) > $s. ')2)))

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%!!' %1' S&,es +ales: "rea! A even sales > > $s. *)2))) = $s. /)2))) > $s. 02')2))) %2' Pr"-! 5 6",u.e r& !" 9ixed costs 6;v $atio > ?????????????????????????????? x 0)) "rea! A even sales $s. '/2))) > ????????????????????????? x 0)) $s. *)2))) > ,)4 %8' Ne Pr"-! Het profit : %ontribution A 9ixed costs > ($s. 02')2))) x ,)4) A $s. '/2))) > $s. 0'2))) %:' C&r!&0,e C"s s Jariable costs > +ales A %ontribution > $s. 02')2))) A $s. ,-2))) > $s. */2))) %0' C&,*u,& !"# "- E&r#!#/ +er s(&re -"r (ree &, er#& !6es " -!#&#*e (e +r"Ge* Alternatives I II III 6articulars to raise debt to raise debt to raise debt Ef $s. '2()2))) of $s. 0)2))2))) of $s. 0(2))2))) And e#uity of and e#uity of and e#uity of $s. ''2()2))) $s. 0(2))2))) $s. 0)2))2))) $s. $s. $s. Earnings before interest and tax (2))2))) (2))2))) (2))2))) &ess: Interest on debt '(2))) 02,.2()) '2,.2()) At the rate of (0)4 on $s. '2()2)))) (0)4 on $s. '2()2)))) (0)4 on $s. '2()2)))) (0(4 on $s. .2()2))))(0(4 on $s. .2()2)))) <<<< <<<< (')4 on $s. (2))2)))) Earnings before tax '2-'2()) &ess : 8ax G ()4 02,02'() Earnings after tax : (A) 02,02'() Y Humber of shares : (") ($efer to wor!ing note) Earning per share: (A); (") /2.(2))) '2,.2()) '2,.2()) 0(2))) 0(2*,, ,2-'2()) 02*02'() 02*02'() 0)2))) 0*.0'( *2))) 0-./)argin of safety

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7e*!s!"#: 8he earning per share is higher in alternative II i.e.2 if the company finance the pro7ect by raising debt of $s. 0)2))2))) and issue e#uity shares of $s. 0(2))2))). therefore2 the company should choose this alternative the pro7ect. 2"r9!#/ #" e: Alternatives I E#uity financing: (A) $s. ''2()2))) ar!eting price per share: (") $s. 0() Humber of e#uity share: (A); (") 0(2))) %*' II $s. 0(2))2)) $s. 0() 0)2))) III $s. 0)2))2))) $s. 0'( *2)))

It is commonly believed that maximisation of profit is the basic ob7ective of a business enterprise. In other wor!s2 a finance manager while considering all financing2 investment and other relevant decisions2 should examine each alternative with reference to whether or not it would maximise profit. "ut in a study of business finance2 it is agreed that profit maximisation is too narrow as an ob7ective2 since it does not ta!e into account the extent of ris!2 the timing of returns and certain other important factors such as obligation to wor!ers2 consumers2 society etc. Cealth maximisation ob7ective appears to be superior to the profit maximisation. 8he term wealth maximisation means maximising shareholders wealth in terms of its economic value as represented by the present value of all the future cash flows in the form of dividend or other benefits expected from the firm. 8he mar!et price of the share reflects this present value. According to Jan Oorne Rthe mar!et price of a firm:s stoc! represents the final Zudgment of al mar!et participants as to what the value of the particular firm is. it ta!es into account present and prospective future earnings per share2 the timing and ris! of these earnings2 the dividend policy of the firm and many other factors that bear upon the mar!et price of the stoc!. 8he mar!et price serves as a performance index or report card of a firm:s progress. 8herefore2 wealth maximisation is superior to profit maximisation ob7ective which can be considered as a part of wealth maximisation strategy. <<<<<<<<<<<<

Ques !"# 8. %&' $adiance 1arments &td. manufactures readymade garments and sells them on credit basis through a networ! of dealers. Its present sale is $s.-) la!h p.a. with ') days credit period. 8he company is contemplating an increase in the credit period with a view to increasing sales. 6resent variable costs are .)4 of sales and the total fixed costs $s.* la!h p.a. 8he company expects pre?tax return on investment G '(4. +ome other details are given as under : 6roposed %redit 6olicy I II III IJ Average %ollection 6eriod (days) ,) /) () -) Expected Annual +ales ($s. la!hs) -( .) ./ .(

$e#uired : Chich credit policy should the company adopt F 6resent your answer in a tabular form. Assume ,-) ? days a year. %alculations should be made upto two digits after decimal. %0' 8he following is the capital structure of +imons %ompany &td. as on ,0;0';033* : E#uity shares :0)2))) shares (of $s.0)) each) 0)4 6reference shares (of $s.0)) each) 0'4 Debentures $s. 0)2))2))) /2))2))) -2))2))) ')2))2)))

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8he mar!et price of the company:s share is $s.00) and it is expected that a dividend of $s.0) per share would be declared for the year 033*. 8he dividend growth rate is -4. (i) If the company is in the ()4 tax brac!ets2 compute the weighted average cost of capital. (ii) Assuming that in order to finance an expansion plan2 the company intends to borrow a fund of $s.0) la!h bearing 0/4 rate of interest2 what will be the company:s revised weighted average cost of capital F 8his financing decision is expected to increase dividend from $s.0) to $s.0' per share. Oowever2 the mar!et price of e#uity share is expected to decline from $s.00) to $s.0)( per share.

A#s$er
%&' S & e.e# s("$!#/ e6&,u& !"# "- (e +r"+"se3 *re3! +",!*!es (Amt. In $s. la!hs) %redit 6olicies 6resent Average collection (') days) 6eriod (days) +ales (Annual) -).)) &ess: Jariable cost /'.)) %ontribution 0*.)) &ess: 9ixed costs *.)) 6rofit 0).)) Increase in profit com? 6ared to present profit: (A) ? ?? Investments in debtors ().)) (variable cost = 9ixed cost) Debtors turnover 0* (,-) days; average collection period) Average investment In Debtors '..* (investment in debtors; Debtors turnover) Additional investment in debtors %ompared to present &evel ?? $e#uired return on Additional in investment ('(4): (") ?? Incremental profit (A) A (") ?? I (,) days) -(.)) /(.() 03.() *.)) 00.() 0.() (,.() 0' II (/) days) .).)) /3.)) '0.)) *.)) 0,.)) ,.)) (..)) 3 6roposed III (() days) ./.)) (0.*) ''.') *.)) 0/.') /.') (3.*) ..') IJ (-) days) .(.)) ('.() ''.() *.)) 0/.() /.() -).() -

/./-

-.,,

*.,

0).)*

0.-* )./' 0.)*

,.(( ).*3 '.00

(.(' 0.,* '.*'

..,) 0.*, '.-.

7e*!s!"#: 8he company should adopt the credit policy III (with collection period of () days) as it yields a maximum profit to the company. %0' %!' +ource of 9inance (a) C".+u & !"# "- (e $e!/( e3 &6er&/e *"s "- *&+! &, 6roportion (b) After tax cost (4) (0 A tax rate i.e.2 ()4) (c) Ceighted average cost of capital (4) (d) > (b) x (c)

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E#uity share 0)4 6reference share 0'4 Debentures Ceighted average cost of %apital %!!' +ource of 9inance (a) E#uity shares

).(

0(.)3 ($efer to wor!ing note 0) ).' 0).)) ).,-.))

..(/ '.)) 0.*) 00.,/

C".+u & !"# "- Re6!se3 $e!/( e3 &6er&/e *"s "- *&+! &, 6roportion After tax cost (4) (0 A tax rate i.e. ()4) (b) ).,,, Ceighted average cost of capital (4) (d) > (b) x (c) (.*) 0.,, 0.') '.,, 0).--

(c) 0../' ($efer to wor!ing note ') 0)4 preference shares ).0,, 0).)) 0'4 Debentures ).')) -.)) 0/4 &oan ).,,, ..)) $evised weighted average cost of capital 2"r9!#/ #" es: (0) %ost of e#uity shares (Te) Dividend per share Te > ????????????????????????????????? = 1rowth rate ar!et price per share 0) > ??????????? = ).)00) > ).0()3 or 0(.)34 (') $evised cost of e#uity shares (Te) 0' $evised Te > ?????? = ).)0)( > ).0./' or 0../'4 111111111

Ques !"# :. (a) r. +atya 6rasad2 the 6resident of the %ompany was very happy with 033* results sinse they exceeded the profit budget. All the same he wanted to !now the relative contributions of manufacture and mar!eting departments to the overall company result. 8he company products can be grouped unto two main lines of business : Electric eters (E ) and Electronic Instruments (EI). "oth E and EI are industrial measuring instruments and perform similar functions. Oowever2 these products differ in their manufacturing technology (E is based on mechanical and electrical technology2 whereas EI is based on microchip technology) and their use characteristics. E and EI are substitute products in the same sense that a mechanical watch and digital watch are substitutes. $e#uired :

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(i) (ii)

6repare a statement that you would li!e to present to r. +atya 6rased. Oow would you ma!e a case for a share in the company:s bonus pool in respect of the following managers :

1eneral anager (E )2 ar!eting anager (E )2 anufacturing anager (E )2 1eneral anager (EI)2 ar!eting anager (EI) and anufacturing anager (EI) Income statement for the year 033* ($s. :)))) "udget +ales %ost of goods sold 1ross margin &ess : Ether operating expenses : ar!eting 02*($MD 02/*) Administration 02,/) 0-2*.' 32--* .2')/ 02//) 3,' 02-./ Actual 0.2)-0 32*-( .203-

/2-.'2('*

/2)/,20() EI $s.0*) $s.')$s.() $s.(/ --2))) -'20.' $s..-) la!hs $s.,') la!hs 0(4 34 Actual ,2(,) 02//) 02-./ 3,'

Additional Information E +elling price per unit Average selling price planned 033* Actual Jariable 6roduct %ost per unit Average standard manufacturing cost planned 033* Actual Jolume Information Nnits produced and sold?planned 033* Actual 8otal Industry sales 033* Actual 8otal Industry variable product costs 033* Actual %ompany:s share of the mar!et per cent of 6hysical units : 6lanned Actual 9irm wide fixed expenses ($s. U)))) anufacturing ar!eting Administrative $ M D (Exclusively for Electronic Instruments) (b) E$ (a) A firm an investment proposal2 re#uiring an outlay of $s./)2))). 8he investment proposal is expected to have ' years economic life with no salvage value. In year I2 there is a )./ probability that cash inflow after tax will be $s.'(2))) and ).- probability that cash inflow after tax will be $s.,)2))). 8he probabilities assigned to cash inflows after tax for the year II are as follows : $s./) $s.,) $s.') $s.'0 02'/2*)) 02/02..) $s.//) la!hs $s.0-) la!hs 0)4 0-4 6lanned ,2*.' 02*(02,/) 02/*)

Chat is performance budgeting and what are its re#uisites F

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8he %ash inflow year : 8he %ash inflow year II

$s.'(2))) $s.0'2))) $s.0-2))) $s.''2))) 6robability ).' )., ).(

$s.,)2))) $s.')2))) $s.'(2))) $s.,)2))) 6robability )./ ).( ).0

8he firm uses a 0)4 discount rate for this type of investment. $e#uired : (a) %onstruct a decision tree for the proposed investment pro7ect. (b) Chat net present value will the pro7ect yield if worst outcome is realised F Chat is the probability of occurrence of this H6J F (c) Chat will be the best and the probability of that occurrence F (d) Cill the pro7ect be accepted F (0)4 Discount factor 0 year ' year (b) ).3)3 ).*'-)

Do the profitability index and the H6J criterion of evaluating investment proposals lead to the same acceptance A re7ection and ran!ing decisions F In what situations will they give conflicting results F

A#s$er %&' %!'

Electric "udget (a) 02'/2*))

A s & e.e# " 0e +rese# e3 " Mr. S& 4& Pr&s&3 I#*".e S & e.e# -"r (e 4e&r, 199@
eters (E ) Electric instruments (EI) Actual (b) 02/02..) /'2(,20)) '32..20.) Jariance (a) A (b) 0-23.) (9av) .2,*23)) (Adv) /2*020.) (Adv.) 0'2')2). ) "udget (a) --2))) 020*2*)2))) ,,2))2))) Actual (b) -'20.' 02'*2).2/,' ,,2(.2'** Jariance (a) A (b) ,2*'* (Adv.) 32'.2/,' (9av) (.2'** (Adv.) *2.)20// (9av) "udget (a) Actual (b) 8otal

6roduct

6articulars

Jarianc (a) A (b)

Vuantity

+ales Jalue &ess: variable manufactu ring cost %ontributi on &ess: 9ixed manufactu ring cost 1ross margin &ess other operating expenses ar!eting $MD

/323'2))) '/23-2)))

02-*2.'2))) (.23-2)))

02.)2-)2(, ' -,2,/2/(*

02**2(,'

(2,*2/(* (Adv)

'/23-2)))

0'2.(23,)

*(2*)2)))

3/2()20//

020)2.-2))) ,*2.'2)))

02).2'-2). / ,(2,)2)))

,2/323'-

,2/'2))) (9av)

.'2)/2))) 0*2(-2)))

.023-2)./ 0/2/)2)))

.23'(Adv) /20-2))) (9av)

0/2*)2))) 0,2/)2))) '(2'*2)))

32,'2))) 0-2./2))) ,02()2)./

Administra tion 6rofit before tax

(2/*2))) (9av.) ,2,/2))) (Adv) -2''2)./

N" e : F&6. > 9avourableL Adv. > Adverse

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%!!'

8he 1eneral anager (E ) and 1eneral anager (EI) made an adverse contribution of $s. 0'2')2).) and a favourable contribution of $s. *2.)20// respectively in the company:s bonus pool ($efer to (i) above). 9urther2 the actual fixed manufacturing and fixed mar!eting costs are less than the budgeted fixed manufacturing and fixed mar!eting costs i.e.2 there are favourable variances2 the benefit of this is to be dividend among the two products on some basis. 9or the share of manufacturing wor!ing given below: 6roduct anufacturing cost variance ($efer to (i) above) anager (E ) and (EI) to the company:s bonus pool refer to Electric eters /2*020.) (Adv) <<<<<< Electric Instruments<<< (.2'** (Adv.)

8he manufacturing cost variance arise due to price variance and #uantity variance as computed below: 6roducts anufacturing price variance: Actual #ty. (+td. 6rice A Actual 6rice) anufacturing #uantity variance: +td. 6rice (+td. Vty ? -'20.') Actual #ty.) Electric eters Electric Instrument > -'20.' ($s.()A$s. (/) > $s. '2'/2-** (Adv) > $s.()(--2)))A

> 0/02..) ($s. ') A $s. '0) > $s. 02/02..) (Adv) > $s. ') (02'/2*)) A 02/02..)) > $s. ,2,32/)) (Adv.)

> $s. 02302/)) (9av.)

+ince the manufacturing cost variance is adverse the manufacturing manager (E ) and (EI) reduces the profit of the company. further2 the budgeted; actual manufacturing cost is more than the industry average cost as shown below: "udget Actual Actual Industry Average 6lanned Actual Actual Average (/ /-.,' $s.,') -'0.' Industry

$s.per unit

')

'0

0*.)( () $s.0-) la!hs 02/02..)B ).0-

la!hs ).)3

9or the share of given below: 6roducts +ales Jariance ($efer to (i) above)

ar!eting manager (E ) and (EI) in the company bonus pool refer to wor!ing Electric eters $s. .2,*23)) (Adv) Electric Instruments<<<< $s2 32'.2/,' (9av)

8he total sales variances arise to sale due to sales price variance and sale #uantity variance which are computed below: <<<<<<<<< 6roducts Electric eters Electric Instruments +ales price variance: Actual #ty. (+td. 6rice ? > $s. 02/02..) ($s. /) A $s. ,)) > -'20.'($s.0*) A $s. ')-)

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Actual 6rice) +ales #uantity variance: +td. 6rice (+td. Vty ? Actual #ty)

> $s. 0/20.2.)) (Adv.) > $s. /) (02'/2*)) A 02/02..)) > $s. -2.*2*)) (9av.)

> $s. 0-20-2/.' (9av.) >$s. 0*) (--2))) ? -'20.') > $s. -2*32)/) (Adv)

8he mar!eting manager (E ) reduces the company bonus pool by $s. .2,*23)) and mar!eting manger (EI) increases the company bonus pool by $s. 32'.2/,'. further2 the 4 of mar!et share and average price realisation of the company as compared to Industry is given below: 4 ar!et share 6roducts 6hysical #ty. Jalue Electric 6lanned 0)4 eters Actual 0-4 3..4 ($s. /'.(, la!hs; $s. //) la!hs) Electric Instruments 6lanned Actual<<<< 0(4 34 0-.*4 ($s.0'*.)* la!hs; $s..-) la!hs)

Average price realisation Electric eters 6lanned Actual $s. per unit /) ,)

Electric Instrument Actual 6lanned Actual Industry Average /3.-( 0*) ')($s. //) la!hs 02/02..); ).0-)

Actual Industry Average 00).)' ($s. .-) la!hs (-'20.' ).)3)

9rom above it is clear that mar!eting manager (E ) follows the strategy of lower price of product for increasing mar!et share and mar!eting manager (EI) follows the strategy of higher price which reduces mar!et share. %0' 6erformance budgeting may be described as a budgeting system where the input costs are related to the performance i.e. the end results. 6erformance budgeting is therefore2 loo!ed upon as a budget based on functions2 activities and pro7ects and is lin!ed to the budgetary system on the basis of ob7ectives2 classification of expenditure etc. the performance budgeting techni#ue is the process of analysing2 identifying2 simplifying and crystalliQing specific performance ob7ectives of a 7ob to be achieved over a period in the framewor! of the organisational ob7ectives2 the purpose and ob7ectives of the 7ob. ReBu!s! es: 0. Establishment of a well defined responsibility centres action points where operations are performed and financial transaction in terms of money ta!e place. '. Establishment for each responsibility centre a programmes of expected performances in physical units of that centre. 9or example2 the performance budget for a sales department may be units of goods sold during a budget period. ,. 9orecasting the cost of activities re#uired for achieving the expected performance. /. Evaluation of actual performance as compared with standard performance by a system of performance reporting.

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P& ( N". F"!# +r"0&0!,! 4 A, er#& e A#s$er: %&' '(2))) ).' 0'2))) )., 0-2))) 0 ' , )./ / ( ,)2))) ).( '(2))) ).)0.)) ).)* ).0' ).') ).'/ ).,)

).(
Cash outlay 40,000

''2)))

')2)))

).0 ,)2)))

8he decision tree above shows that there are six possible outcomes each represented by a path. 8he net present value of each path at 0)4 discount rate is given below: 6ath (cash inflow year 0 x (cash inflow year ' x 8otal cash Discount factor year 0) discount factor year ') inflow (a) 0 '. ,. /. (. -. ($s. '(2))) x ).3)3) > ''2.'( ($s. '(2))) x ).3)3) > ''2.'( ($s. '(2))) x ).3)3 > ''2.'( ($s. ,)2))) x ).3)3) > '.2'.) ($s. ,)2))) x ).3)3) > '.2'.) ($s. ,)2))) x ).3)3) > '.2'.) (b) ($s. 0'2))) x ).*'-) > 3230' ($s. 0-2))) x ).*'-) > 0,2'0($s. ''2))) x ).*'-) > 0*20.' ($s. ')2))) x ).*'-) > 0-2'() ($s. '(2))) x ).*'-) > ')2-() ($s. ,)2))) x ).*'-) > '/2.*) (c) > (a) > (b) $s. ,'2-,. ,(23/0 /)2*3. /,2.3) /.23') ('2)() %ash outflow (d) $s. /)2))) /)2))) /)2))) /)2))) /)2))) /)2))) Het 6resent value <<<<<< (e) > (c) A (d) $s. ? .2,-, ? /2)(3 *3. ,2.3) .23') 0'2)()

S & e.e# s("$!#/ (e eA+e* e3 #e +rese# 6&,ue 6ath Het present Zoint Expected

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Jalue G 0)4 ($efer above) 0 ' , / ( (a) ? .2,-, ? /2)(3 *3. ,2.3) .23') 0'2)()

probability ($efer above) (b) ).)* ).0' ).') ).'/ ).,) ).)-

net present (a) x (b) ? (*3.)/ ? /*..)* 0.3./) 3)3.-) '2,.-.)) .',.)) <<<<<<< ,2000.**

(b) (c) (d) %0'

If the worst outcome is realised the Het 6resent value which the pro7ect will yield is $s. .2,-, (negative). 8he probability of occurrence of this Het 6resent value is *4. 8he best outcome will be path - when Het 6resent value is higher i.e.2 $s. 0'2)() (positive). 8he probability of occurrence of this Het 6resent value is -4. 5es2 the pro7ect will be accepted since the Expected Het 6resent value x probability sum total is positive.

In most of the situations the Het present value method (H6J) and profitability Index (6I) yield same accept or re7ect decision. In general terms2 under 6I method a pro7ect is acceptable if probability index value is greater than I and re7ected if it is less than I. Nnder H6J method a pro7ect is acceptable if Het 6resent value of a pro7ect is positive and re7ected if it is negative. %learly a pro7ect offering a profitability index greater than I must also offer a net present value which is positive. "ut a conflict may arise between two methods if a choice between mutual exclusive pro7ects has to be made %onsider the following example: 6J of cash inflows Initial cash outflows Het 6resent value 6.I. 6ro7ect A '2))2))) 02))2))) 02))2))) '2))2))) ???????????? > ' 02))2))) 6ro7ect " 02))2))) </)2))) -)2))) 02))2))) ??????????? > '.( /)2)))

According to H6J method2 pro7ect A would be preferred2 whereas according to profitability index method pro7ect " would be preferred. 8his is because Het 6resent value gives ran!ing on the basis of absolute value of $upees. Chereas profitability index gives ran!ing on the basis of ratio. Although 6I method is based on H6J2 it is better evaluation techni#ue than H6J in a situation of capital rationing. Ques !"# <. Crite short notes on the following : (a) Inter?relationship between investment2 financing and dividend decisions. (b) 9inancial forecasting techni#ues. (c) %urrent cost accounting method ad7usting financial statements. (d) "asic principles of portfolio management. (/ x ( > ') mar!s) A#s$er %&' Inter A relationship between investment2 financing and dividend decisions 8he finance functions are dividend into three ma7or decisions2 viQ.2 investment2 financing and dividend decisions. It is correct to say that these decisions are inter A related because the

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underlying ob7ective of these three decisions is the same2 i.e.2 maximisation of shareholders: wealth. +ince investment2 financing and dividend decisions are all interrelated2 one has to consider the 7oint impact of these decisions on the mar!et price of the company:s shares and these decisions should also be solved 7ointly. 8he decision to invest in a new pro7ect needs the finance for the investment. 8he financing decision2 in turn2 is influenced by and influences dividend decision because retained earnings used in internal financing deprive shareholders of their dividends. An efficient financial management can ensure optimal 7oint decisions. 8his is possible by evaluating each decisions in relation to its effect on the shareholders: wealth. 8he above three decisions are briefly examined below in the light of their inter A relationship and to see how they can help in maximising the shareholders: wealth i.e.2 mar!et price of the company:s shares: (nvestment decision: 8he investment of long term funds is made after a careful assessment of the various pro7ects through capital budgeting and uncertainty analysis. Oowever2 only that investment proposal is to be accepted which is expected to yield at least so much return as is ade#uate to meet its cost of financing. 8his have an influence on the profitability of the company and ultimately on its wealth. "inancing decision: 9unds can be raised from various sources. Each source of funds involves different issues. 8he finance manager has to maintain a proper balance between long A term and short A term funds. Cithin the total volume of long Aterm funds2 he has to ensure a proper mix of loan funds and owners: funds. 8he optimum financing mix will increase return to e#uity shareholders and thus maximise their wealth. &ividend decision: 8he finance manager is also concerned with the decision to pay or declare dividend. Oe assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of dividends and what portion should be retained in the business. An optimal dividend pay A out ratio maximises shareholders: wealth. 8he above discussion ma!es it clear that investment2 financing and dividend decisions are interrelated and are to be ta!en 7ointly !eeping in view their 7oint effect on the shareholders: wealth. %0' F!#&#*!#/ F"re*&s !#/ Te*(#!Bue 9inancial forecasting is the starting point in the planning process. It facilitates pre A testing of the financial feasibility of various programmes2 acts2 as a control device2 helps in raising funds2 and improves utilisation of surplus cash. A few forecasting techni#ues are briefly discuss as under : (i) Percentage of 'ales #ethod It is the simplest approach to forecasting financial re#uirements of a firm. 8his method expresses the firm:s financial needs in terms of the percentage of annual sales invested in each individual item of "alance sheet. Nnder this method2 the forecaster computer past relationship between assets and liabilities on one hand and sales on the other on the assumption that the same relationship will continue2 he applies new sales forecast figure to get an estimate of the financial re#uirements. 8his method is more suitable for short A term forecasting. (ii) 'imple 4egression #ethod An alternative method used to forecast financial re#uirements is the simple regression or scatter diagram method. Cith the sales forecast as the starting point and based on the past relationship between sales and "alance sheet items2 it is possible to construct a line A of best fit or the regression line. It is possible to lin! sales with one item of asset at the time. 8his method is more suitable for long A term forecasting.

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(iii)

#ultiple 4egression #ethod A more sophisticated approach to financial forecasting calls for the use of multiple regression analysis. Nnli!e simple regression method2 here sales are assumed to be a function several variables. It is2 therefore2 a superior method. Curre# C"s A**"u# !#/ Me ("3 &3Gus !#/ -!#&#*!&, s & e.e# s It is a well A !nown method of ad7usting financial statements according to changing price level i.e.2 inflation. 1enerally2 two main accounting problems are encountered when there is several inflation in the economy. 8hese are : (a) Oow to ad7ust profit; loss shown by conventional profit and loss statement so that it shows a realistic operating resultL and (b) Oow to reflect the shareholders: investment (or the net assets) more truly. Nnder the inflationary condition2 if financial statement are prepared under conventional accounting system2 profit figure is overstated and financial position understated. In order to remove these limitations2 items of the financial statements are brought to their current values using specific price index. It thus re#uires the following ad7ustments: (i) Depreciation ad7ustment (ii) %ost of sales ad7ustment (iii) onetary wor!ing capital ad7ustment (iv) 1earing ad7ustment. As a result of these ad7ustments2 fixed assets are shown in the "alance sheet at their current value and not at their depreciated original cost value. +imilarly2 stoc!s are shown at their value to the business and not at the lower of cost or mar!et value. It thus enables a realistic assessment of performance (accounting and economic profit will not differ) and helps in ma!ing a better comparison of two companies set A up at different points of time2 ma!es the rate of return more meaningful2 provides a more meaningful information for investment and credit decisions2 and prevents distortion in share prices. )&s!* Pr!#*!+,es "- P"r -",!" M&#&/e.e# 8here are two basic principles of 6ortfolio management2 viQ. (i) Effective investment planning : for the investment in securities by considering the following factors: (a) 9iscal2 financing and monetary policies of the government and the $eserve "an! of India. (b) Industrial and economic environment and its impact on industry prospect in terms of prospective technological changes2 competition in the mar!et2 capacity utilisation by the industry and demand prospect etc. (ii) Constant review of investment : 6ortfolio managers are re#uired to review their investment in securities and continue selling and purchasing their investments in a more profitable avenues. 9or this purpose2 the following analysis is re#uired: (a) Assessment of #uality of management of the company. (b) 9inancial and trend analysis of "alance +heet and 6rofit and &oss Account items in order to direct the flow of investment to profitable avenues. (c) Analysis of securities mar!et. security carries charges in three phases A in the start up phase2 no interest is charged2 next stage a low rate of interest is charged upto a particular

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FINAL %NE2' EHAMINATION NOCEM)ER, 1996 Gr.-I PAPER 2 : MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS
A#s$er %&' Hine 1ems &td. has 7ust installed achine??$ at a cost of $s.'2))2))). 8he machine has a five year life with no residual value. 8he annual value of production is estimated at 02()2))) units2 which can be sold at $s.- per unit. Annual operating costs are estimated at $s2'2))2))) (excluding depreciation) at this output level. 9ixed costs are estimated at $s., per unit for the same level of production. Hine 1ems &td. has 7ust come across another model called achinea+ capable of giving the same output at an annual operating cost of $s.02*)2))) (exclusive of depreciation). 8here will be no change in fixed costs. %apital cost of this machine is $s.'2()2))) and the estimated life is for five years with nil residual value. 8he company has an offer for sale of achinea$ at $s.02))2))). "ut the cost of dismantling and removal will amount to $s.,)2))). As the company has not yet commenced operations2 it wants to sell achinea$ and purchase achinea+. Hine 1ems &td. will be a Pero?tax company for seven years in view of several incentives and allowances available. 8he cost of capital may be assumed at 0/4. 6.J. factors for five years are as follows : 5ear 6.J. 9actors 0 ).*.. ' )..-3 , ).-.( / ).(3' ( ).(03 (i) (ii) Advise whether the company should opt for the replacement. Cill there be any change in your view2 if achinea$ has not been installed but the company is in the process of selecting one or the other machine F

+upport your view with necessary wor!ings (b) Discuss briefly the impact of taxation on %orporate 9inancing. A#s$er %&' %!' Re+,&*e.e# "- M&*(!#e 5 R : I#*re.e# &, *&s( "u -,"$ (i) %ash outflow on achine A + &ess : +ale value of achine A $ &ess : cost of dismantling and removal ($s. 02))2))) A $s. ,)2)))) Het Eutflow Incremental cash flow from achine A + Annual %ash flow from achine A + Annual %ash flow from achine A $ $s. '2()2))) $s. .)2))) $s. 02*)2))) $s. '2.)2))) $s. '2()2)))

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Het incremental cash inflow

<<<<<<<<<< $s. ')2)))

6resent value of incremental cash in flows > $s. ')2))) x ().*.. = )..-3 = ).-.( = ).(3' = ).(03) > ')2))) x ,./,' > $s. -*2-/) H6J of achine A + > $s. -*2-/) A $s. 02*)2))) > (?) $s. 02002,-). $s. '2))2))) spent on replacement. achine A $ is a sun! cost and hence it is not relevant for deciding the achine A + is in the negative2 replacement is not

7e*!s!"# : +ince Het present value of advised.

If the company is in the process of selecting one of the two machines2 the decision is to be made on the basis of independent evaluation of two machines by comparing their Het 6resent values. %!!' I#3e+e#3e# e6&,u& !"# "- M&*(!#e 5 R &#3 M&*(!#e 5 S : achine A $ achine A + Nnits produced 02()2))) 02()2))) +elling price per unit ($s.) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<< +ale value 32))2))) 32))2))) &ess : Eperating %ost (exclusive of depreciation) '2))2))) 02*)2))) <<<<<<<<<<<<<<<<<<<<<<<<<<<<< %ontribution .2))2))) .2')2))) &ess : 9ixed cost /2()2))) /2()2))) <<<<<<<<<<<<<<<<<<<<<<<<<<<<< Annual %ash flow '2()2))) '2.)2))) 6resent value of cash flows 9or ( years %ash outflow Het 6resent value As the H6J of %ash in flow of fall on machine A +. *2(*2))) 32'-2-/) '2))2))) '2()2))) -2(*2))) -2.-2-/) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< achine A + is higher than that of achine A $2 the choice should

N" e : As the company is a Qero tax company for seven years ( achine life in both cases is only for five years)2 depreciation and the tax effect on the same are not relevant for consideration. %0' I.+&* "- T&A& !"# "# C"r+"r& e F!#&#*!#/ : 8ax is levied on the profits of the company. 8ax is also levied on the dividends received by the shareholders in their hands though such dividends are declared out of after tax profits. 8hus the corporate entity and the owners suffer tax twice in a sense. 8his pushes the cost of e#uity capital. En the other hand interest paid on the debt capital is a deductible expenditure and hence company does not pay tax on interest on debt capital. 8his reduces the cost of debts. Debt is a less costly source of funds and if the finance manager prudently mixes debt and e#uity2 the weighted average cost of capital will get greatly reduced. Depreciation is not an outgo in cash but it is deductible in computing the income sub7ect to tax. 8here will be saving in tax on depreciation and such savings could be profitably employed. 8hus both... interest and depreciation provide tax shield and have a tendency to increase E6+. 9urther the unabsorbed depreciation can be carried forward indefinitely and this will be helpful for loss ma!ing concerns which start earning profits in future. 8he depreciation loss of one company

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can be carried forward for set off in another company:s profits in the case of amalgamations in specified circumstances and such a provision will help growth of companies and rehabilitation of sic! units. 8he finance manager of amalgamating company will bear this benefit for the tax shield it carries in planning the activities. 8hus the impact of tax will be felt in cost of capital2 earnings per share and the cash in flows which are relevant for capital budgeting and in planning the capital structure. 8ax considerations are important as they affect the li#uidity of the concerns. 8hey are relevant in deciding the leasing of the assets2 transactions of sale and lease bac!2 and also in floating 7oint venture in foreign countries where tax rates and concessions may be advantageous. 8ax implications will be felt in choosing the siQe and nature of industry and in its location as the tax laws give fillip to small units producing certain products and incentives are given for bac!wards areas. 8ax considerations in these matters are relevant for purpose of preserving M protecting internal funds. 1111111111111 Ques !"# 2 (a) Eutline the methods and tools of financial management. (b) 8he annual cash re#uirement of A &td. is $s.0) la!hs. 8he company has mar!etable securities in lot siQes of $s.()2)))2 $s.02))2)))2 $s.'2))2)))2 $s.'2()2))) and $s.(2))2))). %ost of conversion of mar!etable securities per lot is $s.02))). 8he company can earn (4annual yield on its securities. 5ou are re#uired to prepare a table indicating which lot siQe will have to be sold by the company. Also show that the economic lot siQe can be obtained by the "aumob odel.

A#s$er %&' 9inance anager has to decide optimum capital structure to maximise the wealth of the shareholders. 9or this 7udicious use of financial leverage or trading on e#uity is important to increase the return to shareholders. In planning the capital structure2 the aim is to have proper mix of debt2 e#uity and retained earnings. E6+ Analysis2 6E $atios and mathematical models are used to determine the proper debt A e#uity mix to derive advantage to the owners and enterprise. In the area of wor!ing capital management2 certain techni#ues are adopted such as A"% Analysis2 Economic order #uantities2 cash management models2 etc.2 to improve li#uidity and to maintain ade#uate circulating capital. 9or evaluation of firm:s performance2 $atio Analysis is pressed into service A with the help of rations an investor can decide whether to invest in a firm or not. 9unds flow statement2 providing funds in right #uantities and at right time. %0' T&0,e !#3!*& !#/ ," s!Je "- se*ur! !es 8otal annual cash re#uirements > 8 > $s. 0)2))2))) &ot siQe ($s) > % Humber of &ots > (8;%) ()2))) ') 02))2))) 0) 0)2))) '2))2))) ( (2))) '2()2))) / /2))) (2))2))) ' '2)))

%onversion cost ($s) > (8;%)b')2)))

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Chere b > cost of conversion per lot. Interest charges 8otal %ost $s. > (c;')I $s. 02'() '02'() '2()) 0'2()) (2))) 0)2))) -2'() 0)2'() 0'2()) 0/2())

Economic &ot siQe is

$s. '2))2))) at which total costs are minimum.

2!,,!&. F. )&u.", M"3e, : %ash management model of Cilliam Z. "aumol assumes that the concerned company !eeps all its cash on interest yielding deposits from which it with draws as and when re#uired . it also assumes that cash usage is linear over time. 8he amount of money is with drawn from deposits in such a way that the cost of withdrawal are optimally balanced with those of interest foregone by holding cash. 8he model is almost same as economic stoc! order #uantity model. (EEV) A +tudents may refer to 9+6 (H) A9A A , study paper. ' x 8b 9ormula Economic lot siQe > ?????????????? I Chere 8 > 6ro7ected cash re#uirement > $s. 0)2))2))) b > %onversion cost per lot > $s. 02))) I > Interest earned on mar!etable securities per annum > (4 "y substituting the figures in the formula. ' x 0)2))2))) x 02))) Economic lot siQe > ???????????????????????????????? ).)( > $s. '2))2))) Ques !"# 8 (i) (ii) (iii)

Explain the term R9oreign Exchange $ate $is!S. ention any four of the tools available to cover Exchange $ate $is!. Alert &td. is planning to import a multi?purpose machine from Zapan at a cost of ,2/)) la!hs yen. 8he company can avail loans at 0*4 interest p.a. with #uarterly rests with which it can import the machine. Oowever there is an offer from 8o!yo branch of an India based ban! extending credit of 0*) days at ')4 p.a. against opening of an irrevocable letter of credit.

Ether Information : 6resent exchange rate $s.0)) > ,/) yen. 0*) days forward rate $s.0)) > ,/( yen. %ommission charges for letter of credit at '4 per 0' months. Advise whether the offer from the foreign should be accepted F A#s$er %!' F"re!/# EA*(&#/e R& e R!s9 : 8his ris! relates to the uncertainty attached to the exchange rates between two currencies. 9or example2 the amount borrowed in foreign currency is to be repaid in the same currency or in some other acceptable currency.

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8hus if the foreign currency becomes stronger than (say) Indian rupees2 the Indian borrower has to repay the loan in terms of more rupees than the rupees be obtained by way of loan. 8he extra rupees he pays is not due to an increase in interest rate but because of unfavorable exchange rate. %onversely he will gain if the rupee is stronger. 8he fluctuation in the exchange rate causes uncertainty and this uncertainty gives rise to exchange rate ris!. %!!' 8he following tools are available to cover exchange rate ris! : (a) (b) (c) (d) (e) (f) (g) (h) (i) %!!!' +pot contracts. $upee forward contract. $upee role over contract. %ross currency forward contract. %ross currency role over contract. %ross currency options. %urrency futures. %urrency and interest rate swaps. Arbitrage.

O+ !"# I %T" -!#&#*e (e +ur*(&se 04 &6&!,!#/ ,"&# & 1@I +er &##u.': Cost of machine ,2/)) la!h yen as $s. 0)) > ,/) yen Add : Interest at /.(4 I Vuarter Add : Interest at /.(4 II Vuarter (on $s. 0)/( la!hs) 8otal outflow in rupees > > > > 4s. in la%hs 02))).)) /(.)) /..), 02)3'.),

Alternatively2 interest may also be calculated on compounded basis2 i.e. $s. 02))) x @0.)/(B' > $s. 02)3'.), O+ !"# II %T" &**e+ (e "--er -r". -"re!/# 0r&#*(' : Cost of letter of credit At 04 on ,2/)) la!hs yen as $s. 0)) > ,/) yen > Add : Interest I Vuarter > Interest II Vuarter > (A) P&4.e# & (e e#3 "- 1@? 3&4s : %ost Interest at '4 p.a. @,2/)) x ';0)) x 0*);,-(B ,2/)).)) la!hs yen ,,.(, la!hs yen <<<<<<<<<<<<<< ,/,,.(, la!hs yen > 4s. in la%hs 0).)) )./( )./. <<<<<< 0).3'

%onversion at $s. 0)) > ,/( yen @ ,/,,.(,;,/( x 0))B (") > $s. 33(.', 8otal %ost : A = " > 0))-.0( la!hs A36!*e : Eption Ho. ' is cheaper. Oence the offer can be accepted. 11111111

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Ques !"# :. (a) ROigher the return2 higher will be the ris!S. In this context discuss the various ris!s associated with portfolio planning. (b) 9ollowing is the data regarding six securities : . $eturn (4) $is! (4) . (+tandard Deviation) (i) (ii) A * / " * ( % 0' 0' D / / E 3 ( 9 * -

Chich of the securities will be selected F Assuming perfect correlation2 analyse whether it is preferable to invest .(4 in security A and '(4 in security %.

E$ 9oods &td. is presently operating at -)4 level producing ,-2))) pac!ets of snac! foods and proposed to increase capacity utilisation in the coming year ,, 0;,4 over the existing level of production. T(e -",,"$!#/ 3& & (&s 0ee# su++,!e3 : (i) Nnit cost structure of the product at current level : $aw aterial Cages (Jariable) Everheads (Jariable) 9ixed Everhead 6rofit +elling 6rice %!!' $s. / ' ' 0 , . 0' .

R&$ .& er!&,s $!,, re.&!# !# s "res -"r 1 ."# ( 0e-"re 0e!#/ !ssue3 -"r +r"3u* !"#. M& er!&, $!,, re.&!# !# +r"*ess -"r -ur (er 1 ."# (. Su++,!ers /r&# 8 ."# (s *re3! " (e *".+&#4. 9inished goods remain in 1odown for 0 month. Debtors are allowed credit for ' months. &ag in wages and overhead payments is 0 month and these expenses accrue evenly throughout the production cycle. Ho increase either in cost of inputs or selling price is envisaged. 6repare a pro7ected profitability statement and the wor!ing capital re#uirement at the new level2 assuming that a minimum cash balance of rs.032()) has to be maintained. E! (er

(iii) (iv) (v) (vi)

A#s$er %&' 8here are four different types of ris!s in portfolio planning. 0. (nterest rate ris% : it is due to changes in interest rates from time to time. 6rice of the securities move invertly with change in the rate of interest. '. Purchasing power ris% : As inflation affects purchasing power adversely. Inflation rates vary over time and the investors are caught unaware when the rate of inflation changes abruptly.

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,. !usiness ris% : It arises from sale and purchase of securities affected by business cycles and technological changes. /. "inancial ris% :8his arises due to changes in the capital structure of the company. it is expressed in terms of debt A e#uity ratio. Although a leveraged company:s earnings are more2 too much dependence on debt financing may endanger solvency and to some extent the li#uidity. %0' (i) +ecurity A has a return of *4 for a ris! of /42 whereas securities " and 9 have a higher ris! for the same rate of return. Oence security a dominates securities " and 9. for the same degree of ris! of /4 security D has only a return of /4. Oence this security is also dominated by A. securities % and E have a higher return as well as a higher degree of ris!. Oence the securities which will be selected are A2 % and E. (ii) Chen perfect positive correlation exist between securities2 their ris! and return can be averaged with the proportion. Oence the average value of A and % together for a proportion of , : 0 for ris! and return will be as follows : $is! (, x / = 0 x0') ; / > -4 $eturn (, x * = 0 x 0') ; / > 34 %omparing the above average ris! and return with security E2 it is better to invest in E as it has lesser ris! ((4) for the same return of 34. %"r' FOO7S LIMITE7 Pr"Ge* e3 Pr"-! &0!,! 4 s & e.e# & @?I *&+&*! 4 U#! s " 0e +r"3u*e3 %86,???E6? A @?' K :@,??? +&*9e s. A. %ost of +ales : $aw material $s. / x /*2))) > Cages $s. ' x /*2))) > Everheads (Jariable) $s. ' x /*2))) > Everheads 9ixed $s. 0 x ,-2))) > ". 6rofit %. +ale value $s. ,.'( x /*2))) $s. 0' x /*2))) > >

$s. 023'2))) 3-2))) 3-2))) ,-2))) /2')2))) 02(-2))) (2.-2)))

A, er#& !6e,4 : If we assumes the movement in stoc! levels2 because of increase in capacity2 i.e. from -)4 to *)42 the profitability statement will be as follows. Nnits to be produced A cost of goods sold : $aw aterial Cages Everheads (variable) Everheads (9ixed) (,-2)));-) x *)) /*2))) pac!ets $s. (/ x /*2)))) (' x /*2)))) (' x /*2)))) ,-2))) /2')2))) &ess : Increase in stoc! of aterials = CI6 = 9inished goods ($efer wor!ing note) 0*2))) 023'2))) 3-2))) 3-2))) (0x ,-2))))

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Ad7usted cost of sales ". 6rofit %. sales

(0' x /.2))))I

/2)'2))) 02-'2))) (2-/2)))

IEpening stoc! = production A closing stoc! > ,2))) = /*2))) A /2))) > /.2))) 2"r9!#/ N" es : %apacity Humber of units of production $aw material stoc! (0 month) CI6 stoc! : aterial (0 month) Cages (0;' month) Jariable overheads (0;' month) 9ixed overheads (0;' month) 9inished goods (0 month) Increase in stoc! 2"r9!#/ N" es : C"s "- s&,es 5 &6er&/e +er ."# ( $aw material Cages Everheads (variable) Everheads (fixed) 6rofit +ales value 6er annum 023'2))) 3-2))) 3-2))) ,-2))) <<<<<<<< /2')2))) 02(-2))) <<<<<<<< (2.-2))) 6er month 0-2))) *2))) *2))) ,2))) <<<<<<<< ,(2))) 0,2))) <<<<<<< /*2))) %ost;Nnit / / ' ' 0 3 -)4 ,-2))) $s. 0'2))) 0'2))) ,2))) ,2))) 02()) ()..() '.2))) (*..() (*2()) *)4 /*2))) $s. 0-2))) 0-2))) /2))) /2))) 02()) ,(2))) .-2()) 0*2)))

Pr"Ge* e3 S & e.e# "- 2"r9!#/ *&+! &, & @?I *&+&*! 4 %urrent Assets : $aw material (/*2))) ;0' x /) 0-2))) Cor! in 6rocess '(2()) aterials (/*2))) x / x 0;0') 0-2))) Cages (/*2))) x ' x 0;'/) /2))) Jariable overheads (/*2))) x ' x 0;'/) /2))) 9ixed overheads (/*2))) x )..( x 0;'/) 02()) 9inished goods (/*2))) x *..( x 0;0') ,(2))) .-2()) +undry debtors 3-2))) 02.'2()) %ash balance 032()) (A) 023'2))) &ess : %urrent &iabilities : %reditors for goods (/*2))) x / x , ;0') %reditors for expenses (/*2))) x /..( x 0;0') Het wor!ing capital (A) A (") /*2))) 032)))

(") -.2))) 02'(2)))

N" e : (i) +ince wages and overheads payments accrue evenly2 it is assumed that they will be in process for half a month in average. (ii) 9ixed overheads per unit > $s. ,-2)));/*2))) > $s. )..(

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Ques !"# <. Crite short notes on the following : (a) American Depository $eceipts (AD$+) (b) 9inancial 9orecasting 8echni#ues. (c) 9lexible "udget. (d) $andom Cal! 8heory. %&' A#s$ers A.er!*&# 7e+"s! "r4 Re*e!+ s %A7RS' : 8hese are depository receipts issued by a company in N+A and are governed by the provisions of securities and Exchange %ommission of N+A. As the regulations are severe2 Indian companies tap the American mar!et through private debt placement of 1D$+ listed in &ondon and &uxemburg stoc! exchanges. Apart from legal impediments2 AD$+ are costlier than 1lobal Depository $eceipts (1D$+). &egal fees are considerably high for N+ listing. $egistration fee in N+A is also substantial. Oence AD$+ are less popular than 1D$+. %0' F!#&#*!&, -"re*&s !#/ e*(#!Bues : 8hese are employed in forecasting the financial re#uirements. +ome of the techni#ues are described below : (a) Percent of 'ales method : In this the financial needs are estimated on the basis of a sales forecast. A change in sales is li!ely to have an impact on many items of assets and liabilities and hence these items are expressed for changes in levels of activity. A sound !nowledge of the relation between Lsales and assets is necessary to use this method. 8his is very useful for short A term forecasting. 'imple 4egression method : Cith sales forecast as starting point and based on past relationship between sales and assets items2 it is possible to construct a line of best fit or the regression line for them. 8his method is useful for long A term forecasting. #ultiple 4egression method : In this it is assumed that sales are a function of several variables2 while in simple regression method only one variable is considered. Oence this is superior.

(b)

(c)

8he use of a particular method will depend upon circumstances of each case and availability of data. %*' F,eA!0,e )u3/e : 8his budget is designed to change with changes in levels of activities attained. 8he budget shows how costs vary with changes in activity levels. 8he segregations of costs into fixed2 variable and semi A variable is necessary to construct the flexible budget. It is assumed that fixed costs will remain fixed only upto a certain level of activity and after a certain level they may tend to vary2 though not li!e variable costs. 8he formation of flexible budgets will enable the enterprise to !now its different levels of activity. 9lexible budgets are desirable in the following cases : (0) Chere sales are unpredictable e.g. luxury and semi A luxury trades. (') Chere in the case of new venture2 it is not possible to foresee precisely public demand e.g. 9ashions and novelty trade. (,) Chere the business is seasonal A e.g. soft drin!s. (/) Chere progress depends on ade#uate supply of labour but labour is the !ey factor in that area.

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%3'

R&#3". 2&,9 T(e"r4 : It is generally believed that stoc! mar!et prices can never be predicted because they are not a result of any underlying factors but are mere statistical ups and downs. 8his hypothesis is !nown as $andom Cal! Oypothesis. According to this theory there is no relationship between present prices of shares and their future prices. It is argued that stoc! mar!et prices are independent. .1. Tendall found that changes in security prices behave nearly as if they are generated by a suitably designed roulette wheel for each outcome is statistically independent of past history. +uccessive pea!s and troughs in prices are unconnected. In layman:s language it may be said that prices on the stoc! exchange behave exactly the way a drun! would behave while going in a blind lane A up and down with an unsteady gait going in any direction he li!es2 bending bac!ward and forward2 going on sides now and then.

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MAY, 1996 Gr.-I PAPER 2: MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS

Ques !"# 1. (c) Explain briefly the two basic principles of effective portfolio management. (d) As an investment manager you are given the following information :
.

Investment in e#uity shares of A. %ement &td. +teel &td. &i#uor &td.

Initial price $s. '( ,( /(

Dividends $s. ' ' ' 0/)

ar!et price at the end of the year $s. () -) 0,( 02))(

"eta ris! factor

).* ).. ).( ).33

%. 1overnment of India "onds 02))) $is! free return may be ta!en at 0/4

5ou are re#uired to calculate : (i) Expected rate of returns of portfolio in each using %apital Assets 6ricing (iii) Average return of portfolio.

odel (%A6 )

A#s$er %&' 6ortfolio management refers to the selection of securities and their continuous shifting in the portfolio to optimise returns to suit the ob7ectives of the investor. T(e )&s!* Pr!#*!+,es "- P"r -",!" .&#&/e.e# : 8he two basic principles for effective portfolio management are : (i) Effective investment planning for the investment in securities by considering the following factors : (a) 9iscal2 financial and monetary policies of the 1overnment of India and the $eserve "an! of India. (b) Industrial and economic environment and its impact on industry prospects in terms of prospective technological changes2 competition in the mar!et2 capacity utilisation with industry and demand prospects etc. (ii) %onstant review of investment : 6ortfolio managers are re#uired to review their investment in securities on a continuous basis to identify more profitable avenues for selling and purchasing their investment. 9or this purpose they will have to carry the following analysis: (a) Assessment of #uality of management of the companies in which investment has already been made or is proposed to be made. (b) 9inancial and trend analysis of companies: balance sheets;profit and loss accounts to identify sound companies with optimum capital structure and better performance and to disinvest the holding of those companies whose performance is found to be slac!ening.

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(c) 8he analysis of securities mar!et and its trend is to be done on a continuous basis. 8he above2 analysis will help the portfolio management to arrive at a conclusion as to whether the securities already in possession should be disinvested and new securities be purchased. 8his analysis will also reveal the timing for investment or disinvestments. %0' %!' &et us first calculate the Expected return on paper. ar!et portfolio which is not given in the #uestion Dividends $s. ' ' ' 0/) <<<<< 0/%apital gains $s. '( '( 3) ( <<<<< 0/(

A. %ement &td. +teel &td. &i#uor &td. ". 1ovt. of India bonds 8otal

8otal Investment $s. '( ,( /( 02))) <<<<<< 020)(

0/- = 0/( Expected return on mar!et portfolio > $s. ?????????????????????????? > $s. '-.,,4 00)( %apital Asset pricing odel :

E($p) > $f = "p @E($ ) A $fB Chere2 E($p) $f "p E($ ) @E($ ) A $fB > > > > > Expected return of the portfolio $is! free rate of return 6ortfolio beta i.e. mar!et sensivity index. Expected return on mar!et portfolio. ar!et ris! premium.

"y substituting the figures in the above e#uation we can calculate expected rate of returns of portfolio in each using %apital Assets 6ricing odel (%A6 ) as under : %ement &td. +teel &td. &i#uor &td. > 0/ = ).* ('-.,, A 0/) > 0/ = ).. ('-.,, A 0/) > 0/ = ).( ('-.,, A 0/) > > > > ',.*-4 ''.-,4 ').0.4 '-.'04

1ovt. of India bonds > 0/ = ).33 ('-.,, A 0/) %!!' Average return of the portfolio ',.*- = ''.-, = ').0. = '-.'0 > ????????????????????????????????????????????? > ',.''4 / E$ Average of "etas > ().* = ).. = ).( = ).33);/ average return > 0/ = )../.( ('-.,, A 0/)

> >

)../.(4 ',.''4

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Ques !"# 2. Celsh &td. is faced with a decision to purchase or ac#uire on lease a mini car. 8he cost of the mini car is $s.02'-23-(. It has a life of ( years. 8he mini car can be obtained on lease by paying e#ual lease rentals annually. 8he leasing company desires a return of 0)4 on the gross value of the assets. Celsh &td. can also obtain 0))4 finance from its regular ban!ing channel. 8he rate of interest will be 0(4 p.a. and the loan will be paid in five annual e#uity installments2 inclusive of interest. 8he effective tax of the company is /)4. 9or the purpose of taxation it is to be assumed that the assets will be written off over a period of ( years on a straight line basis. (c) (d) Advise Celsh &td. about the method of ac#uiring the car . Chat should be the annual lease rental to be charged by the leasing company to match the loan option F 9or your exercise use the following discount factors : . Discount $ate 0)4 0(4 34 . A#s$er %&' 2e,s( L 3. %omputation of annual loan repayment installment. &oan amount 02'-23-( > ????????????????????????????? > $s.??????????????? > $s. ,'2*3' Annuity factor of 0(4 ,.*N" e : Annuity factor is based on the assumption that loan installment is repaid at the beginning of the year to be at part with rentals. +uch annuity factor at 0(4 wor!s out to be ,.*-. C".+u & !"# "- !# eres !# 3e0 +&4.e# s 5ear Epening "alance Ef principal Interest G 0(4 8otal $epayment of Installment %losing balance ) 02'-23-( Hil <<<<<<< 02'-23-( ,'2*3' <<<<<<< 3/2)., 0 3/2)., 0/2000 <<<<<<< 0.)*20*/ ,'2*3' <<<<<<< .(2'3' ' .(2'3' 002'3/ <<<<<<<< *-2(*,'2*3' <<<<<<<< (,2-3/ , (,2-3/ *2)(/ <<<<<<< -02./* ,'2*3' <<<<<<< '*2*(/ '*2*(/2),-I <<<<<< ,'2*3' ,'2*3' <<<<<<< Hil 0 ).30 ).*. ).3' ' ).*, )..).*/ 5ears , )..( ).-)... / ).-* ).(. )..0 ( ).-' )./3 ).-(

I Difference between the installment amount and opening balance of /th year. S*(e3u,e "- C&s( Ou -,"$s !# 3e0 -!#&#*!#/ End of 5ear Annual loan re ? 6ayment Installment Interest G 0(4 Depreciation 8ax shield Het cash 6J out flows factor at 34 present value of cash flows at

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34 (0) ) 0 ' , / ( ,'2*3' ,'2*3' ,'2*3' ,'2*3' ,'2*3' ?? (') ?? 0/2000 00'3/ *2)(/ /2),?? 8otal %omputation of Annual lease rentals : %ost of assets 02'-23-( > ???????????????????????????????? > $s. ?????????????????????? > $s. ,)2//. Annuity factors of 0)4 /.0. S*(e3u,e "- C&s( "u -,"$s 5 Le&s!#/ &, er#& !6e ($s) End of 8he year ) 0A/ ( 8otal present value &ease payment ,)2//. ,)2//. ?? > 8ax shield ?? 0'20.3 0'20.3 *02.03 After tax cash out flows ,)2//. 0*2'-* (0'20.3) 6J factor at 34 0.)) ,.'/ ).-( 6resent value of cash outflows at 34 ,)2//. (320** (.230-) (,) ?? '(2,3, '(2,3, '(2,3, '(2,3, '(2,3, (/) @(') =(,) x tB ?? 0(2*)' 0/2-.( 0,2,.3 002..' (() (0) A (/) ,'2*3' 0.2)3) 0*2'0. 032(0, '020') 0.)) ).3' ).*/ )... .).0 ).-( (-) ,'2*3' 0(2.', 0(2,)' 0(.)'( 0/233( (-2-)') <<<<<<<<< $s. *.2,,(

0)20(. (0)20(.)

7e*!s!"# : 8he present value of cash outflows under lease financing is $s. *02.03 while that of debt financing (i.e. owning the asset) is $s. *.2,,(. 8hus leasing has an advantage over ownership in this case. %0' &et the annual lease rentals be K. 8herefore the after tax cost of lease rentals will be ).-) K 6resent value will be ).-) K x /.0. > '.)()' K E#uating '.()' K > $s. *.2,((L the value of K is obtained at $s. ,/23)-. 8herefore the lease rental should be $s. ,/23)- to match the loan option. 111111111111

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Ques !"# 8. ar!s &td. is launching a new pro7ect for the manufacture of a uni#ue component. At full capacity of '/2))) units2 the cost will be as follows : . %ost per unit $s. aterial &abour and Jariable Expenses 9ixed anufacturing and Administrative Expenses Depreciation *) /) ') 0) 0()

8he selling price per unit is expected at rs.')) and the selling expenses per unit will be $s.0) *)4 of which is variable. In the first two years productions and sales are expected to be as follows : . 5ear 0 ' 6roduction 0(2))) units ')2))) units +ales 0/2))) units 0*2))) units

8o assets wor!ing capital re#uirement2 the following additional information is given : (g) (h) (i) (7) (!) (l) +toc! of raw material A , months: average consumption Cor!?in?progress A Hil Debtors A 0 month average sales %reditors for supply of materials A ' months average purchases of the year %reditors for expenses A 0 month average of all expenses during the year %ash balance A $s.')2)))

+toc! of finished goods is ta!en at average cost. 5ou are re#uired to prepare for the two years : (,) (/) A#s$er M&r9s L 3. (0) 6ro7ected statement of 6rofit;&oss 5ear I $s. 0(2))) 0/2))) '*2))2))) 5ear II $s. ')2))) 0*2))) ,-2))2))) A pro7ected statement of wor!ing capital re#uirements. A pro7ect statement of wor!ing capital re#uirements.

6roduction in units +ales in units +ales $evenue G $s. ')) per unit (A) %ost of 6roduction : aterial G $s. *) per unit Direct labour M variable expenses G $s. /) per unit

0'2))2))) -2))2)))

0-2))2))) *2))2)))

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9ixed manufacturing M Administrative expenses G $s. ') on '/2))) units Depreciation at $s. 0) for '/2))) units 8otal %ost of 6roduction Add: Epening stoc! of finished goods at average cost I '(2')2))) x 0))) 0(2))) %ost of goods available &ess : %losing stoc! of finished goods at Average cost G ,'2**2))) x ,))) '02))) %ost of goods sold Add: +elling expenses (variable at $s. *) +elling expenses fixed at $s. ' %ost of sales (") 6rofit A A " 2"r9!#/ N" es %&' %reditors for supply of material aterials consumed Add : %losing stoc! of Average consumption (, months) &ess : Epening stoc! 6urchases Average purchases per month (%reditors) %reditors (' months for goods) %0' %reditors for expenses 8otal of current &iabilities (") I &abour2 anufacturing expenses M selling expenses

/2*)2))) '2/)2))) <<<<<<<< '(2')2))) ???

/2*)2))) '2/)2))) <<<<<<<< ,02')2))) 02-*2)))I

'(2')2))) 02-*2))) <<<<<<< ',2('2))) 020'2))) /*2))) '(20'2))) '2**2))) 5ear I $s. 0'2))2))) ,2))2))) 0(2))2))) ??? <<<<<< 0(2))2))) 02'(2))) '2()2))) 02),2,,/I ,2(,2,,/ -2))2))) /2*)2))) 020'2))) /*2))) <<<<<<< 0'2/)2)))

,'2**2))) /2-32.0/G <<<<<<<< '*20*2'*02//2))) /*2))) ,)20)2'*(2*32.0/ 5ear II $s. 0-2))2))) /2))2))) ')2))2))) ,2))2))) <<<<<<< 0.2))2))) 02/02--. '2*,2,,/ 02''2--.I /2)-2))0 *2))2))) /2*)2))) 02//2))) /*2))) <<<<<<< 0/2.'2)))

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%2'

6ro7ected statement of wor!ing capital re#uirements %urrent Assets : 0. +toc! of aterials (, month average consumption) '. 9inished 1oods ,. Debtors (one moth) /. %ash 8otal %urrent Assets (A) 5ear I $s. ,2))2))) 02-*2))) '2,,2,,/ ')2))) <<<<<<< .2'02,,/ '2()2))) 02),2,,/ <<<<<<<< ,2(,2,,/ <<<<<<<< ,2-*2))) E! (er 11111111111111 5ear II $s. /2))2))) /2-32.0/ ,2))2))) ')2))) <<<<<<<< 002*32.0/ '2*,2,,/ 02''2--. <<<<<<< /2)-2))0 <<<<<<<< .2*,2.0,

%urrent &iabilities : %reditors for supply of materials %reditors for expenses (+ee C.H. (b) above) Estimated wor!ing capital (") $e#uirement Estimated Cor!ing %apital

Ques !"# :. (c) ention briefly the symptoms of incipient industrial sic!ness. (d) %alculate the operating leverage2 financial leverage and combined leverage from the following data under +ituation I and II and 9inancial 6lan A and " : Installed %apacity Actual 6roduction and +ales +elling 6rice Jariable %ost 9ixed %ost : Nnder +ituation I Nnder +ituation II %apital structure : 9inancial 6lan A $s. E#uity Debt ($ate of Interest at ')4) 0)2))) 0)2))) ')2))) " $s. 0(2))) (2))) ')2))) /2))) units .(4 of the %apital $s.,) 6er Nnit $s.0( 6er Nnit $s.0(2))) $s.')2)))

A#s$er %&' Industrial sic!ness is a gradual process and is not the result of overnight operations. If the sic!ness continues for a long period2 if may become chronic. In case2 care is not ta!en at the initial stage itself2 it may go beyond control and ultimately results in the death of the unit. Incipient sic!ness : If the downfall in the smooth functioning various operational areas of the unit continues unabated2 the actual process of sic!ness then starts. +uch a stage is considered to be incipient sic!ness and is identified by reference to the following symptoms :

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(0) 8here are continuous cash losses from year to year and the trend is expected to continue in future. (') Deterioration is expected in the current ratio in the current financial year2 even though the same may have been more than one in the previous financial year. (,) 8here is gradual erosion in the net worth during the previous and current financial years and is expected to continue in future also. (/) Deterioration continuous in the debt A e#uity position in the current financial year and subse#uently also. In a nutshell2 it may be seen that incipient industrial sic!ness is that stage where the unit incurs cash lossesL however2 the position of financial structure may not be very much alarming. 8his is the time to ta!e certain corrective measures to prevent the unit from turning into sic!ness. 8his will2 however2 re#uire proper identification2 care and follow A up programme. %0' (i) Eperating &everages : +ales (s) ,2))) units G $s. ,);? per unit &ess: Jariable %ost (J%) G $s. 0(;? per unit %ontribution (%) &ess : 9ixed %ost (9%) Eperating 6rofit (E6) (E"I8) Eperating &everage % E6 > > (ii) 9inancial &everages : A ($s) +ituation I Eperating 6rofit (E"I8) &ess : Interest on debt 6"8 ,)2))) '2))) <<<<<<< '*2))) +ituation I $s. 3)2))) /(2))) /(2))) 0(2))) <<<<<< ,)2))) +ituation II $s. 3)2))) /(2))) /(2))) ')2))) <<<<<< '(2)))

$s. /(2))) ,)2))) 0.(

$s. /(2))) '(2))) 0.* 9inancial 6lan " ($s) ,)2))) 02))) <<<<<<< '32)))

E6 '(2))) '(2))) 9inancial &everage > ????? > $s. ?????????????? > 0.)3 $s. ???????????? > 0.)/ 6"8 ',2))) '/2))) (iii) %ombined &everages : 9inancial 6lan (a) +ituation I A $s. 0.( x 0.). > 0." $s. 0.( x 0.)/ > 0.(-

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OR O &td. has a present annual sales level of 0)2))) units at $s.,)) per unit. 8he variable cost is $s.')) per unit and the fixed costs amount to $s.,2))2))) p.a. 8he present credit period allowed by the company is 0 month. 8he company is considering a proposal to increase the credit period to ' months and , months and has made the following estimates : . Existing 6roposed %redit 6olicy 0 onth ' onths , onths Increase in +ales ?? 0(4 ,)4 4 of "ad Debts 04 ,4 (4 8here will be increase in fixed cost by $s.()2))) on amount of increase of sales beyond '(4 of present level. 8he company plans on a pre?tax return of ')4 on investment in receivables. 5ou are re#uired to calculate the most paying credit policy for the company. A#s$er ; L 3. E6&,u& !"# "- Cre3! P",!*4 6resent 6olicy 0 month ' months 0)2))) 002()) ,)2))2))) ')2))2))) <<<<<<<< 0)2))2))) ,2))2))) .2))2))) 02302--,/2()2))) ',2))2))) <<<<<<<< 002()2))) ,2))2))) *2()2))) /2,,2,,,

A. +ales (Nnits) ". +ales income Jariable cost at %ontribution 9ixed %ost %. Het argin D. Investments in receivables (+ee wor!ing notes)

6roposed 6olicy , months 0,2))) ,32))2))) '-2))2))) <<<<<<<< 0,2))2))) ,2()2))) 32()2))) .2,.2()) 02/.2()) 023(2))) -2).2()) (?) ('2,,/

E. Expected $eturn ,*2,,, *-2--En receivables at ')4 9. "ad debts ,)2))) 02),2()) 1. Het 6rofit -2,02--. -2(32*,/ (% A E A 9) O. Increase in 6rofits '*20-. As ' months credit policy yield higher return2 it should be adopted. 2"r9!#/ N" e : %alculation showing investments in receivables : Jariable cost = 9ixed cost 9ormula > ?????????????????????????????????????? x Ho. of months credit 0'

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0 month Investment ',2))2))) ???????????????????? x 0 0' ' months '-2))2))) ?????????????????????? x ' > /2,,2,,, 0' , months '32()2))) ????????????????????? x , > .2,.2()) 0' 11111111111111111 > 02302---

Ques !"# <. Crite short notes on any four of the following : (f) 1lobal depository receipts or Euro %onvertible "onds. (g) argin oney. (h) Internal $ate of $eturn. (i) Pero "ase "udgeting (7) Impact of Inflation on Cor!ing %apital. A#s$er %&' G,"0&, 7e+"s! "r4 Re*e!+ s %G7Rs' : It is a negotiable certified denominated in N+ dollars which represents a Hon A N+ company:s publicly traded local currency e#uity shares. 1D$s are created when the local currency shares of an Indian company are delivered to Depository:s local custodian "an! against which the Depository ban! issues depository receipts in N+ dollars. 8he 1D$s may be traded freely in the overseas mar!et li!e any other dollar A expressed security either on a foreign stoc! exchange or in the over A the Acounter mar!et or among #ualified institutional buyers. "y issue of 1D$s Indian companies are able to tap global e#uity mar!et to raise foreign currency funds by way of e#uity. It has distinct advantage over debt as there is no repayment of the principal and service costs are lower. (+tudents may refer to 9+6 (H) A9A A 0) study paper for detailed discussion). (Er) Eur" C"#6er !0,e )"#3s : 8hey are bonds issued by Indian companies in foreign mar!et with the option to convert them into pre A determined number of e#uity shares of the company. usually price of e#uity shares at the time of conversion will fetch premium. 8he "onds carry fixed rate of interest. T(e Issue "- 0"#3s .&4 *&rr4 $" "+ !"#s : %all Eption : Nnder this the issuer can call the bonds for redemption before the date of maturity. Chere the issuer:s share price has appreciated substantially2 i.e.2 far in excess of the redemption value of bonds2 the issuer company can exercise the option. 8his call option forces the investments to convert the bonds into e#uity. Nsually2 such a case arises when the share prices reach a stage near 0,)4 to 0()4 of the conversion price.

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6ut option enables the buyer of the bond a right to sell his bonds to the issuer company at a pre A determined price and date. 8he payment of interest and the redemption of the bonds will be made by the issuer A company in N+ dollars. %0' M&r/!# M"#e4 : "an!ers !eep a cushion to safe guard against changes in value of securities while extending loans against which loans are given to customer. 8his cushion represents the margin oney. 8he #uantum of argin money depends upon the credit worthiness of the borrower and the nature of security. In pro7ect cost financing2 argin oney has to come from 6romoters: contribution.

In the case of borrowing for wor!ing capital argin oney has to be provided as per norms that are prescribed from time to time by $"I. In the case of new pro7ects argin oney re#uired for wor!ing capital is included in the 6ro7ect %ost. %*' I# er#&, R& e "- Re ur# : it is that rate at which discounted cash inflows are e#ual to the discounted cash outflows. In other words2 it is the rate which discounts the cash flows to Qero. It can be stated in the form of a ratio as follows :? %ash inflows ??????????????????????????? > 0 %ash outflows 8his rate is to be found by trail and error method. 8his rate is used in the evaluation of investment proposals. In this method2 the discount rate is not !nown but the cash outflows and cash inflows are !nown. In evaluating investment proposals2 internal rate of return is compared with a re#uired rate of return2 !nown as cut A off rate. If it is more than cut A off rate2 the pro7ect is treated as acceptableL otherwise pro7ect is re7ected. %3' =er" )&se )u3/e !#/ : Pero "ased budget start from a concept of Hil budget. All items are treated as new and each function2 process2 pro7ect or activity is critically evaluated and 7ustified through cost A benefit analysis. 8he expenses are ta!en in the budget only thereafter. 8his approach differs from conventional budgeting as figures for the current year in a conventional budget are based on the figures for previous years and the trend disclosed. 8o prepare Pero "ased "udget it is necessary to (0) define ob7ectivesL (') ignore existing budgetL (,) prepare fresh budget bit by bit from the scratchL (/) do critical appraisal of each action;expenditureL and (() match the most effective "udget with the ob7ectives. %*' I.+&* "- !#-,& !"# "# $"r9!#/ *&+! &, : 8he impact of inflation on wor!ing capital is direct. 9or the same #uantity of sales2 the value of sundry debtors2 closing stoc! etc. increase as a result of inflation. 8he valuation of closing stoc! progressively on higher amounts would result in the company not being able to maintain its operating capability unless it finds extra funds as it triggers profit related cash outflows in respect of income tax2 dividends are bonus. Nnless proper planning is done2 the business is li!ely to fact a condition !nown as Rtechnically insolvencyS

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MAY, 199> Gr.-I PAPER - 2: MANAGEMENT ACCOUNTING AN7 FINANCIAL ANALYSIS

Ques !"# 1 Excel &td. manufactures a special for sale at $s.,) per !g. 8he variable cost of manufacture is $s.0( per !g. 9ixed cost excluding depreciation is $s.'2()2))). Excel &td. is currently operating at ()4 capacity. It can produce a maximum of 02))2))) !gs. at full capacity. 8he 6roduction anager suggests that if the existing machines are fully replaced the company can achieve maximum capacity in the next five years gradually increasing the production by 0)4 per year. 8he 9inance manager estimates that for each 0)4 increase in capacity2 the additional increase in fixed cost will be $s.()2))). 8he existing machines with a current boo! value of $s.0)2)))2))) can be disposed of for $s.(2))2))). 8he Jice?6resident (finance) is willing to replace the existing machines provided the H6J on replacement is about $s./2(,2))) at 0(4 cost of capital after tax. (i) 5ou are re#uired the total value of machines necessary for replacement . 9or your exercise you may assume the following : (g) 8he company follows the bloc! assets concept and all the assets are in the same bloc!. Depreciation will be on straight?line basis and the same basis is allowed for tax purposes. 8here will be no salvage value for the machines newly purchased. 8he entire cost of the assets will be depreciated over five year period. 8ax rate is at /)4 %ash inflows will arise at the end of the year $eplacement outflow will be at the beginning of the year (year )) 5ear Discount 9actor at 0(4 ) 0 0 ).*. ' ).., ).-/ ).(. ( )./3

(h) (i) (7) (!) (l) (iii)

En the basis of data given above2 the managing director feels that the replacement2 if carried out2 would at least yield post tax return of 0(4 in the three years provided the capacity build up is -)42 *)4 and 0))4 respectively. Do you agree F

A#s$er %!' %omputation of the total replacement value of machine. (Assuming that existing machines also have valid life for ( years) S e+ 1: I#*re.e# &, C&s( I#-,"$s 5ear Incremental %apacity Incremental production M sales (Tgs) 0 0)4 0)2))) ' ')4 ')2))) , ,)4 ,)2))) / /)4 /)2))) ( ()4 ()2)))

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Incremental contribution Incremental 9ixed cost Incremental 6"8D 8ax G /)4 Incremental 6A8 "D

$s. 02()2))) ()2))) 02))2))) /)2))) 6?,???

$s. ,2))2))) 02))2))) '2))2))) *)2))) 1,2?,??? )..302'))

$s. /2()2))) 02()2))) ,2))2))) 02')2))) 1,@?,??? ).-020*2*))

$s. -2))2))) '2))2))) /2))2))) 02-)2))) 2,:?,??? ).(. 02,-2*))

$s. .2()2))) '2()2))) (2))2))) '2))2))) 8,??,??? )./3 02/.2)))

Discount factors ).*. Discounted value of 6A8"D ('2')) 8otal for ( years. (2/-2))) S e+ 2 : I#*re.e# &, *&s( "u -,"$ &et the total cost of replacement Disposal value of existing machines Incremental %ash outflow

K (2))2))) (K A (2))2))))

S e+ 8 : T&A s&6!#/s "# 3e+re*!& !"# (Incremental bloc!;() x 8ax rate x (Annuity factor of 0(4 for ( years) @(K A (2))2))));(B x /)4 x ,.,( > ).'-* K A 02,/2))) S e+ :: T" &, 7!s*"u# e3 C&s( !#-,"$s 8otal Incremental Discounted cash inflows

(2/-2))) = ).'-* K A 02,/2))) > /20'2))) = ).'-* K

S e+ <: EBu& !"# H6J > +um of discounted cash inflows A +um of the discounted cash outflows /2(,2))) > (/20'2))) = ).'-* K) A (K A (2))2)))) /2(,2))) > /20'2))) = ).'-* K A K = (2))2))) /2(,2))) A /20'2))) A (2))2))) > ).'-* K A K ? /2(32))) > ? )..,' K Er2 )..,' K > /2(32))) Er2 K > /2(32)));)..,' > $s. -2'.2)/3 %!!' Evaluation whether replacement would yield post tax return of 0(4 in , years. Incremental capacity Incremental 6"8D Depreciation (-2'.2)/3 A (2))2))));( Incremental 6"8 8ax G /)4 Incremental 6A8 6A8 = Depreciation Discount 9actors Discounted cash inflows 8otal discounted cash inflow Discounted incremental cash outflow NPC 0 0)4 02))2))) '(2/0) ./2(3) '32*,//2.(/ .)20-/ ).*. -02)/, /20)2'.02'.2)/3 2,@8,2>> ' ,)4 ,2))2))) '(2/0) '2./2(3) 02)32*,02-/2.(/ 023)20-/ )..02//2('( , ()4 (2))2))) '(2/0) /2./2(3) 02*32*,'2*/2.(/ ,20)20-/ ).-'2)/2.)*

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C"#*,us!"# : As (e #e +rese# 6&,ue !s +"s! !6e (e 6!e$ "- (e M&#&/!#/ 7!re* "r !s *"rre* . A, er#& !6e S",u !"# %!' C&s( I#-,"$s : %apacity +ales &ess : variable cost %ontribution (A) -)4 0*.)) 3.)) 3.)) .)4 '0.)) 0).() 0).() ,.() ..)) )..(.,' *)4 '/.)) 0'.)) 0'.)) /.)) *.)) ).-(.'* (9igures in la!hs of $upees) 3)4 0))4 '..)) ,).)) 0,.() 0,.() /.() 3.)) ).(. (.0, 0(.)) 0(.)) (.)) 0).)) )./3 /.3)

&ess : 9ixed cost (") ,.)) 6rofit before (%) -.)) Depreciation M 8ax Discount factors (D) ).*. 6resent values 6A8"D (% x D) (E) (.''

+um 8otal of 6resent values In E (9) $s. '(.*( After 8ax present Jalues (1) > (0 A 8)9 > $s. '(.*( x ).- > $s. 0(.(0 T&A s&6!#/s "# 3e+re*!& !"# &et UK: be the cost of machines purchased. 8he salvage value of old machine is $s. ( la!hs. Het outflow of new machines would be (K A () la!hs. K?( Depreciation on straight line basis on this would be ?????????????????? la!hs ( Chich will be the same for ( years. K?( 8he present value of such recurring depreciation in e#ual sum would be ?????????????? x ,.,( ( N" e : ,.,( is the sum total of present values for ( years of uniform flow. K?( 8ax saving on such depreciation is ?????????????? x ,.,( x )./ > $s. ).'-* K A $s. 0.,/ ( EBu& !"# : Het 6resent value of replacement > in flows in H years A out flow in the year ). According to the Jice A 6resident (9inance) H6J should be e#ual to $s. /.(, la!hs. Oence the e#uation ).'-* K A 0.,/ = 0(.(0 A (K A () > /.(, > ).'-* K = 0/.0. A K = ( > /.(, la!hs

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or2 )..,' K > 0/.-/ la!hs 0/.-/ K > ??????????? > $s. ').)) la!hs )..,' 8he cost of new machines is $s. ') la!hs. %!!' %apacity 6rofit before Depreciation M 8axes &ess : Depreciation 6rofit after Depreciation (A A ") &ess: 8ax G /)4 6rofit after 8ax 6rofit after 8ax but Depreciation added bac! i.e. inflow (" = E) Discount factor 6resent Jalues of 9 Het 6resent Jalue I 8otal of O A Initial outflow > $s. 0(.,' A 0(.)) > $s. ).,' la!hs As the Het 6resent Jalue is positive (though in a small sum) the view of the correct. 111111111
Ques !"# 2. (a) (b)

-)4 A " -.)) (.)) 0.)) D E )./) ).-)

*)4 *.)) (.)) ,.)) 0.') 0.*)

($upees in la!hs) 0))4 0).)) (.)) (.)) '.)) ,.))

9 1 O

(.-) ).*. /.*.'

-.*) )..(.0-*

*.)) ).-(.'*

anaging Director is

(i) (iii)

Chat are the causes of industrial sic!ness F ention a few symptoms which might indicate that industrial sic!ness lies ahead.

A firm has sales of $s..(2))2))) variable cost of $s./'2))2))) and fixed cost of $s.-2))2))). It has a debt of $s./(2))2))) at 34 and e#uity of $s.((2))2))) (i) (vii) (viii) (ix) (x) (xi) Chat is firm:s $EI F Does it have favourable financial leverage F If the firm belongs to an industry whose asset turnover is ,2 does it have a high or low asset leverage F Chat are the operating2 financial and combined leverages of the firm F If the sales drop to $s.()2))2)))2 what will be the new E"I8 F At what level the E"8 of the firm will be e#ual to Qero F

A#s$er %&' %!' C&uses "- I#3us r!&, s!*9#ess : 8he 8iwari %ommittee appointed by the 1overnment of India to loo! into industrial sic!ness has identified various causes of industrial sic!ness in India.

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8he %ommittee has broadly classified such causes into internal and external causes. Among the internal causes inade#uate technical !now how2 location disadvantage2 outdated production process2 high cost of inputs2 brea! A even point too high2 economic siQe of pro7ect2 under A estimation of financial re#uirements and unduly large investments in fixed assets are some of the causes which may be mentioned in this respect. "eside this the dependence on a single customer and the limited number of products2 poor sales realisation2 defective pricing policy2 boo!ing of large orders at fixed prices under inflationary conditions2 lac! of !nowledge of mar!eting techni#ues2 etc.2 are leading to the industrial sic!ness in India. 8he poor resources management and faulty financial management policies li!e wrong dividend policy and faulty costing etc. are also contributing to Industrial sic!ness. Among the external causes identified by the committee are2 government price control2 fiscal duties2 fre#uent changes in government policies2 procedural delays on the part of financial;licensing;other controlling or regulating authorities ("an!2 $"I2 9inancial Institutions2 1overnment Departments2 $86 authorities etc.). besides this natural calamities2 political situation (domestic as well as international)2 stri!es and multiplicity of labour unions are also responsible for industrial sic!ness in India. %!!' +tudents may refer to 9+6(H) A9A? ' and 9+6 (H) advanced Accounts A / wherein it has been discussed how the ratios can be used for predicting corporate insolvency and corporate ban!ruptcy. As far as the case of industrial sic!ness in India is concerned2 the 8iwari %ommittee had identified certain symptoms which would be #uite helpful in the detection of sic!ness at the incipient stage. +uch symptoms of sic!ness are continuous irregularity in cash credit accounts2 low capacity utilisation2 profit fluctuations2 downward trend in sales and stagnation or fall in profits followed by contraction in the share of the mar!et2 high rate of re7ection of goods manufactured2 reduction in credit summations2 failure to pay statutory liabilities2 large and longer outstanding in the bill accounts2 longer period of credit allowed on sale documents negotiated through the ban! and fre#uent returns by customers of the same2 constant utilisation of cash credit facilities to the maximum and failure to pay timely installment of principal and interest on term loans and installment credits2 non A submission of periodical financial data;stoc! statements2 etc. in time2 financing capital expenditure out of funds provided for wor!ing capital purpose2 rapid turnover of !ey personnel2 existence of a large number of law suits against the company2 rapid expansion and too much diversification within a short time2 sudden;fre#uent changes in management A whether professional or otherwise and;or dominated by one man;few individuals2 diversion of funds for purposes other than running the unit2 any ma7or change in the shareholdings. 2"r9!#/ : +ales &ess : Jariable cost %ontribution &ess : 9ixed %osts E"I8 &ess : 34 interest on $s. /(2))2))) E"I8 $s. .(2))2))) /'2))2))) ,,2))2))) -2))2))) '.2))2))) /2)(2))) ''23(2)))

%0'

(ii) (ii)

E"I8 E"I8 '.2))2))) $EI > ????????????????? > ????????????????????? > $s. ??????????????????????? > '.4 Investment Debt = E#uity 02))2))2))) +ince the return on investment ('.4) is higher than the interest payable on debt at 342 the firm has a favourable financial leverage. Het +ales Asset 8urnover > ?????????????????????????????????????????????? 8otal assets > 8otal Investment .(2))2))) 9irm:s Asset 8urnover is > ???????????????????? > )..(

(iii)

02))2))2))) 8he industry average is ,. hence the firm has low asset leverage.

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(iv)

%ontribution ,,2))2))) Eperating leverage > ??????????????????? > ????????????????? > 0.'''' E"I8 '.2))2))) E"I8 '.2))2))) 9inancial leverage > ????????????? > ?????????????????????????? > 0.0.-/ E"8 ''23(2))) %ontribution ,,2))2))) %ombined leverage > ????????????????????? > ?????????????????????? > 0./,* E"8 ''23(2))) Er %ombined leverage > Eperating leverage x 9inancial leverage > 0.'''' x 0.0.-/ > 0./,*

(vi)

If the sales drop to $s. ()2))2))) from $s. .(2))2)))2 the fall is by ,,.,,4 Oence E"I8 will drop by /)..,4. (4 9all in sales x operating leverage) Oence the new E"I8 will be $s. '.2))2))) x (0 A /)..,4) > $s. 0-2))2'3) or rounded upto $s. 0-2))2))).

(vi)

E"8 to become Qero means 0))4 reduction in E"8. +ince the combined leverage is 0./,*2 sales have to drop by 0));0./,* i.e. -3.(/4. hence the new sales will be $s. .(2))2))) x (0 A -3.(/4) > $s. ''2*/2()) (approx.) <<<<<<<<<<<<<

Ques !"# 8. (a) 8he "alance +heet of +mart &td. as on &iabilities +hare %apital $eserves &ong 8erm &oan +hort term &oans 6ayables 6rovisions

arch ,02 033. is as follows : (9igures in la!hs of rupees) Assets ')) 0/) ,-) ')) 0') *) 00)) 9ixed Assets Inventories $eceivables %ash and "an! ()) ,)) '/) -) . . 00))

+ales for the year were -)) la!hs. 9or the year endings on arch ,02 033* sales are expected to increase by ')4. 8he profit margin and dividend pay out ratio are expected to be /4 and ()4 respectively. 5ou are re#uired to : (i) (iv) Vuantify the amount of external funds re#uired. Determine the mode of raising the funds given the following parameters : (d) %urrent ratio should at least be 0.,,. (e) $atio of fixed assets to long term loans should be 0.(.

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(f) (v) (b)

&ong term debt to e#uity ratio should not exceed 0.)(.

8he funds are to be raised in the order of short term ban! borrowings2 long term loans and e#uities. 8he turnover of $ &td. is $s.-) la!hs of which *)4 is on credit. Debtors are allowed one month to clear off the dues. A factor is willing to advance 3)4 of the bills raised on credit for a fee of '4 a month plus a commission of /4 on the total amount of debts. $ &td. as a result of this arrangement is li!ely to save $s.'02-)) annually in management costs and avoid bad debts at 04 on the credit sales.

A#s$er

%&' (i)

External funds re#uirement (E9$) is given by the following formula. A & E9$ > ??? ? ??? W+ A ms0 (0 A d) + + Chere E9$ external funds re#uirement A + & +0 D W+ > > > > > > > 8otal assets 6revious sales 6ayables and 6rovisions 6rofit argin 6ro7ected sales for the next year Dividend payout ratio Expected increase in sales.

"y substituting the figures2 we get following :

020)) ')) E9$ > ???????? ? ???????? 0') A @).)/ x .') x ).(B -)) -)) > 0.( x 0') A 0/./ > $s. 0*) A 0/./ > $s. 0-(.- la!hs (ii) (a) ode of raising the funds : +hort term borrowings %urrent ratio should be 0.,, -)) x 0.' 0.,, > ?????????????????????????????????????????????????????????????????????????????????????????? ')) x 0.' = +8"" @Chere +8"" is short term ban! borrowingsBsB .') 0.,, > ??????????????????? 0 '/) = +8"" ("y substituting and solving the e#uation) +8"" will be Existing loans Additional borrowings ,)0.,( ')).)) 0)0.,(

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(b)

&ong term debt : $atio of fixed assets to long term loans > 0.( ()) x 0.' ??????????????????? > 0.( &8 0.( &8 &8 &oans already existing Additional > $s. -)) $s. /)) ,-) <<<<<< /)

(c)

E#uity : External funds &ess : Additional ban! borrowings Additional long term loans "alance additional e#uity Pr""- : Debt e#uity ratio should not exceed 0.)( /)) ??????????????????? > 0.)' ''/.'( = 0-* Oence the condition is satisfied2 Hote : (iv) &ong term debt > ,-) = /) > /)) (v) E#uity share capital > ')) = '/.'( > ''/.'( (vi) $eserve will also increase by ')4 > 0/) x 0.' > 0-* 0)0.,( /).)) 0/0.,( '/.'( 0-(.-)

(iii)

8he funds are to be raised in the order of +8"" &ong term loans E#uity 8otal 0)0.(, /).)) '/.'( <<<<<< 0-(.-)

%0'

F&* "r4 &rr&#/e.e# Assuming the turnover given in the problem is annual turnover2 the calculations are as follows :
%ost of factoring : $s.

9ee of '4 on 3)4 of $s. /2))2))) (*)4 of -) la!hs > /* la!hs;0' > / la!hs is the monthly credit sales) commission at /4 on $s. /2))2))) &ess : +avings in cost

>

..')) 0-2))) ??????????????? ',2'))

>

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+avings in annual management cost is $s. '02-)) Oence for the month : ?????????????? 0' > $s. 02*))

04 saving of "ad debts on $s. /2))2)))> $s. /2))) Het cost in factoring C"s "- )&#9 A36&#*e : Interest at 0*4 p.a for one month on 3)4 of $s. /2))2))) (2/)) 6rocessing fee at '4 on $s. /2))2))) *2))) Add : "ad debts loss that cannot be avoided /2))) (2*)) 0.2/))

<<<<<<< 0.2/))

+ince costs of both alternatives are e#ual2 it is immaterial whether $ &td. goes in for factoring or ban! loan. 1111111 Ques !"# : EI8OE$ (a) (b) Explain briefly2 odigliani and iller approach on cost of capital.

8he "eta %oefficient of 8arget &td. is 0./. 8he company has been maintaining *4 rate of growth in dividends and earnings. 8he last dividend paid was $s./ per share. $eturn on 1ovt. securities is 0)4. $eturn on mar!et portfolio is 0(4. 8he current mar!et price of one share of 8arget &td. is $s.,-. (i) (iii) Chat will be the e#uilibrium price per share of 8arget &td F Could you advise purchasing the share F

(i) (iii)

E$ R6romoters: contribution is one of the principal means of financing the pro7ectS A Discuss. P &td. is foreseeing a growth rate of 0'4 p.a. in the next ' years. 8he growth rate is li!ely to fall to 0)4 for the third year and fourth year. After that the growth rate is expected to stabilise at *4 p.a. If the last dividend paid was $s.0.() per share and the investors: re#uired rate of return is 0-42 find out the intrinsic value per share of P &td. as of date. 5ou may use the following table : 5ears ) 0 ).*0 )../ ' ).-/ , ).(( / )./* (

. Discounting 9actor at 0-4

Answer (9irst Alternative)

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%&'

M"3!/,!&#! &#3 M!,,er &++r"&*( " *"s "- *&+! &, : odigliani and iller:s argue that the total cost of capital of a particular corporation is independent of its methods and level of financing. According to them a change in the debt A e#uity ratio does not affect the cost of capital. 8his is because a change in the debt A e#uity ratio changes the ris! element of the company which in turn changes the expectations of the shareholders from the particular shares of the company. hence they contend the leverages has little effect on the over A all cost of capital or on the mar!et price. odigliani and Assu.+ !"#s : 0. %apital mar!et are perfect. Information is costless and readily available to all investorsL there are no transaction costsL and all securities are infinitely divisible. Investors are assumed to be rational2 and to behave accordingly. 8he average expected future operating earnings of a firm are represented by a sub7ective random variable. It is assumed that the expected values of the probability distributions of all investors are the same. Implied in the illustration is that the expected values of the probability distributions of expected operating earnings for all future periods are the same as present operating earnings. 9irms can be categoriQed into Re#uivalent returnS classes. All firms within a class have the same degree of business ris!. 8he absence of corporate income taxes is assumed iller made the following assumptions and the derivations there from.

'.

,. /.

T(e!r (ree 0&s!* +r"+"s! !"#s &re : 0. 8he total mar!et value of the firm and its cost of capital are independent of its capital structure. 8he total mar!et value of a firm is given by capitaliQing the expected stream of operating earnings at a discount rate appropriate for its ris! class. 8he expected yield of a share of stoc!2 Te2 is e#ual to the capitaliQation rate of a pure e#uity stream2 plus a premium for financial ris! e#ual to the difference between the pure e#uity A capitaliQation rate and T7 times the ratio ";+. in other words2 Te increases in a manner to exactly offset the use of cheaper debt funds. 8he cutoff rate for investment purposes is completely independent of the way in which an investment in financed. 8his proposition along with the first implies a complete separation of the investment and financing decisions of the firm.

'.

,.

C"#*,us!"# : 8he theory propounded by them is based on the prevalence of perfect mar!et conditions which are rare to find. %orporate taxes and personal taxes are a reality and they exert appreciable influence over decision ma!ing whether to have debt or e#uity. %0' %!' %A6 formula > E($s) > $f = b @E ($m) A $fB

Chere : E ($s) > Expected rate of return of the security (E$) the cost of e#uity $f > ris! free returns E($m) > mar!et rate or return " > "etta coefficient given 0./ +ubstituting the values E ($s) > 0) = 0./ (0(4 ? 0)4) E ($s) > 0.4

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Dividend 1rowth

D0 odel > ?????? = g2 where D02 is dividend per share in year 02 6) ar!et price;share in year )

1 is growth rate of dividends2 6) >

E ($s) being ).0.2 we can ma!e the e#uation as / (0.)*) ).0. > ????????????????? = ).)* 6) / (0.)*) ).)3 > ????????????????? 6) / (0.)*) 6) > ?????????????? ).)3 > $s. /* %!!' 8he share of 8arget &td. is under valued. ($s. ,- current mar!et price as against $s. /* e#uilibrium price). Oence it can be purchased. %Se*"#3 A, er#& !6e' %!' 8he promoter is re#uired to provide funds irrespective of whether the pro7ect is an existing one or new venture. 6romoters: contribution consists of : (a) +hare capital to be subscribed by the promoters in the form of e#uity share capital and ; or preference share capital. (b) E#uity shares issued as rights shares to the existing shareholders. (c) (d) (e) (f) (g) %onvertible debentures issued as RrightsS to existing shareholders. Nnsecured loans. +eed capital assistance. Jenture capital. Internal cash accruals.

In the case of pro7ects established in 7oint or assisted sector2 the contribution of state industrial investment corporation towards share capital is also considered as part of promoters: total contribution. 8he 1overnment of India has classified the locations into three categories A A2 " and % such as : %ategory A %ategory " %ategory % as no industrial district. as districts where industrial activity has started as districts where industrial activity has gained sufficient ground.

1enerally promoters are expected to contribute minimum ')4 of cost of the pro7ect in the case of listed and unlisted companies uniformly. Oowever2 concessional norms for contributions have been prescribed by All India 9inancial Institutions depending upon whether the pro7ect is located in notified (bac!ward) area in category AL " or % districts.

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6romoters: contribution indicates the extent of their involvement in a pro7ect in terms of their own financial sta!e. In case the promoters are unable to raise funds to meet the norms of financial institutions2 they can avail the benefit of seed capital assistance under any of the schemes of $D% or ID"I or $%8% etc. the investments made by recognised mutual funds are also considered as promoter:s contribution provided the investment is covered by non A disposal underta!ing or buy A bac! clause. Among different means of finance such as capital incentives2 deferred payment guarantees2 lease finance;hire purchasing2 term loans from financial institutions in the form of rupee loans and foreign currency loans etc.2 promoters contribution is one of the most important sources of finance. %!!' 6resent value of dividend stream for first ' years. $s. 0.() (0.0') x ).*- = 0.() (0.0')' x )../ $s. 0.-* x ).*- = 0.** x )../ $s. 0./( = 0.,3 > '.*/ 6resent value of dividend stream for next ' years $s. 0.** (0.0) x ).-/ = 0.** (0.0)' x ).(( $s. '.). x ).-/ = '.'* x ).(( $s. 0.,, = 0.'( > '.(*

(A)

(")

ar!et value of e#uity share at the end of / th year computed by using the constant dividend growth model2 would be : D( 6/ > ?????????????? Ts ? 1n Chere D( is dividend in the fifth year2 1n is the growth rate and Ts is re#uired rate of return. How D( > D/ (0 = 1n)

D( > $s. '.'* (0 = ).)*) > $s. './ 6/ $s. './> ??????????????????? ).0- A ).)* > $s. ,)..( 6resent mar!et value of 6/ > ,)..( x ).(( > $s. 0-.30 Oence the intrinsic value per share of P &td. would be A = " = % i.e.2 '.*/ = '.(* = 0-.30 > $s. ''.,, 11111111111111 Ques !"# <. Crite short notes on : (e) %ross %urrency $oll Ever. (f) 9inancial +waps. (g) 9ixed Jersus 9lexible "udget (h) 8ools of 9inancial 9orecasting (c)

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A#s$er %&' Cr"ss Curre#*4 R",, O6er : %ross currency $oll Ever contacts are contracts to cover overseas leg of long Aterm foreign exchange liabilities or assets. 8he cover is initially obtained for six months and later extended for further period of six months and so on. $oll over charge or benefit depends on forward premium or discount2 which in turn2 is a function of interest rate differentials between N+ dollar and the other currency. 8here is no ris! of currency appreciation or depreciation in the overseas leg : $oll over for a maturity period exceeding six months is not possible because in the inter A ban! mar!et2 #uotations beyond six months are not available. Nnder the $oll Ever %ontract the basic rate of exchange is fixed but loss or gain arise at the time of each $oll over depending upon the mar!et conditions. %0' F!#&#*!&, s$&+s : 9inancial swaps are a funding techni#ue which permit a borrower to access one mar!et and then exchange the liability for another type of liability. Investors can exchange one type of asset for another with a preferred income stream. +waps by themselves are not a funding instrument2 they are a device to obtain the desired form of financing indirectly which otherwise might be inaccessible or too expensive. All swaps involve exchange of a series of periodic payments between two parties2 usually through an intermediary which is a large international financial institution. 8he two payment streams are estimated to have identical present values at the outset when discounted at the respective cost of funds in the relevant primary financial mar!ets. 8he two ma7or types of financial swaps are interest rate swaps and currency swaps. 8he two are combined to give a cross A currency interest rate swap. A number of variations are possible within each ma7or type. In the following papa the concept of interest rate and currency swaps has been described. I# eres r& e s$&+s : Cith an interest rate swap2 interest A payment obligations are exchanged between two parties2 but they are denominated in the same currency. 8he swap can be longer term in nature than either the forward or the future contracts. 8erms extend out to 0( years or more2 whereas the range for forward or futures contracts is upward to five year. 8he mar!et for swaps is unregulated and began in the early 03*)s:. the most common interest rate swap is the floating Afixed rate exchange. 9or example2 a corporate that has borrowed on a fixed rate2 term basis may swap with a counter party to ma!e floating rate interest payment:s. Curre#*4 s$&+s : 5et another device for shifting ris! is the currency swap. In a currency swap2 two parties exchange debt obligations denominated in different currencies. Each party agrees to pay the other:s interest obligation. At maturity2 principal amounts are exchanged2 usually at a rate of exchange agreed upon advance. 8he currency swap mar!et traces its roots to the 03-):s2 when parallel loans were arranged between two borrowers of different nationalities. In currency swaps both the principal and interest in one currency are swapped for principal and interest in another currency. En maturity the principal amounts are swapped bac!. Nsually in practice swap is intermediated by a ban! which ta!es away a part of the savings2 leaving the balance to be shared by the parties. +wap gains or losses arises because of spread compression which varies in different financial mar!ets. %*' F!Ae3 6ersus F,eA!0,e )u3/e : 8he idea of introducing budgets in a business organisation is to exercise control over day A to A day operations of the business. %ontrol2 in order to be effective2 re#uires a standard or a target with which actual performance can be compared for the purpose of measurement of the results for timely action2 if necessary. +uch standard should ta!e into consideration the characteristics and behaviour of cost. %ost is composed of different elementsL

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behaviour of each element of cost has to be given due recognition in setting standards of fixing budget estimates. Insofar as direct materials and direct labour are concerned2 standards can be set at so much per unit of output because these vary in direct proportion to output. Everheads however pose a big problem because of two special characteristics : (a) certain items of overhead costs are common costs with regard to individual lots or units of product and2 (b) certain other items of overhead costs include fixed elements that do not vary in strict proportion to changes in production volume. 8he presence of common costs necessitates the selection of apportionment ratio based on the standards derived from departmental figures rather than the standard of output. +imilarly2 fixed expenses will remain the same between two levels of output. In view of these two reasons2 an average standard overhead cost per unit of output will not provide the manager an ade#uate basis for control comparisons. 8his had led to the development of flexible budgets. F!Ae3 )u3/e : A budget prepared on the basis of a standard or a fixed level of activity is called a fixed budget. It does not change with the change in the level of activity. In reality2 it is2 however2 ineffective and meaningless primarily because the actual capacity utilisation varies from time to time. It is a self contained and self identified single budget. Nnli!e the flexible budget2 it dose not show changes in costs according to the level of activity. Expenses2 therefore2 are not classified into fixed2 semi A variable and variable and as such2 there is hardly any need for the detailed analysis of each expense item. A specific level of activity or standard is determined and expenses are estimated at that level. Oowever2 in estimating the expenses at specific level of activity operational plans and analysis of historical costs is done. 8he level of activity at which the expenses are estimated in fixed budgets is determined by the production budget. F,eA!0,e )u3/e : RInstitute of %ost and anagement AccountantS (I% A) &ondon terminology defines a flexible budget as a budget which2 by recogniQing the difference between fixed2 semi A variable and variable costs is designed to change in relation to the level of activity attained. A fixed budget2 on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. A fixed budget2 on the other hand is a budget which is designed to remain unchanged irrespective of the level of activity actually attained. In a fixed budgetary control2 budgets are prepared for one level of activity2 where in a flexible budgetary control system2 a series of budgets are prepared one for each of a number of alternative production levels or volumes. 9lexible budgets represent the amount of expenses that is reasonably necessary to achieve each level of output specified. In other words2 the allowances given under flexible budgetary control system serve as standard of what costs should be at each level of output. Nee3 : 8he need for preparation of flexible budgets arises in the following circumstances : (vi) seasonal fluctuations in sales an;or production A for example2 in soft drin!s industryL (vii) a company which !eeps on introducing new products or ma!e changes in the design of its products fre#uentlyL (viii) industries engaged in ma!e A to Aorder business li!e ship buildingL (ix) an industry which is influenced by changes in fashionL and (x) general changes in sales. %3' T"",s "- F!#&#*!&, F"re*&s !#/ :

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(0)

Day:s sales method is a traditional method under which an attempt is made to calculate the number of days sales and tie it up with the balance sheet items. As different components of the balance sheet are forecasted in terms of day:s sale2 this method measures the resources that are to be financed. 6ercentage of sales method is another tool of financial forecasting in which the balance sheet items are expressed as percentages of sales. 8his will clearly (to some extent) show the financial needs caused by increase in sales.

(')

S!.+,e re/ress!"# .e ("3 : En the basis of past relationship between sales and different items2 a line of the best fit is drawn. 8his method re#uires lin!ing sales with one item at a time. 8hus data about different items can be pro7ected with changes in sales level of study and evaluation. Mu, !+,e re/ress!"# .e ("3 : in the case of simple regression method sales are considered as a function of one variable. ultiple regression line is drawn considering the sales as a function of several variables. A financial analyst may adopt any of the above techni#ues depending upon the availability of data and purpose of forecasting.

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F!#&, %Ne$' EA&.!#& !"# N"6., 199>, Gr.-I

P&+er 2 : M&#&/e.e# A**"u# !#/ & F!#&#*!&, &#&,4s!s Ques !"# 1. 8+& &td. a highly profitable and paying company is planning to expand its present capacity by 0))4. 8he estimated cost of the pro7ect is $s.02))) la!hs out of which $s.()) la!hs is to be met out of loan funds. 8he company has received two offers from their ban!ers : Jalue of loan Interest 6eriod $epayment Ether expenses (to be treated as revenue expenditure) 9uture exchange rate Eption 0 Eption ' $s.()) la!hs N+ X 0/ la!hs e#ual to $s.()) la!hs 0(4 payable yearly -4 payable (fixed) yearly in N+ X ( years ( years (In ( installments. 9irst installment is payable 0 year after draw down) 04 of the value of 04 at N+ X > $s.,the loan Average) ?? End of 0 year IN+ X > $s.,* thereafter to increase by $s.' p.a.

8he company is liable to pay Income?tax at ,(4 and eligible for '(4 depreciation on C.D. value. 5ou may assume that at the end of (th year the company will be able to claim balance in CDJ for tax purposes. 8he company follows Accounting +tandard A+?II for accounting charges in 9oreign Exchange rate. (() (-) (.) (*) %ompare the total outflow of cash under the above options. Nsing discounted cash flow techni#ues2 evaluate the above offers. Is there any ris!2 which the company should ta!e care of F In case 8+& has large volume of exports would your advise be different.

8he following discounting table may be adopted : 5ears : ) Discounting 9actor : 0 0 ).3'0 ' ).*/* , )..*0 / )..') ( ).--,

A#s$er
1. O+ !"# I 5ear ) 0 ' , / ( 8otal outflows $epayment Ef principal ?? 0)) 0)) 0)) 0)) 0)) ()) Interest at 0(4 ?? .( -) /( ,) 0( = ''( Ether expenses (.)) ?? ?? ?? ?? <<<< = (.)) 8ax saving 0..( '-.'( '0.)) 0(..( 0).() (.'( *).() ($s. in la!hs) Het outflow ,.'( 0/*..( 0,3.)) 0'3.'( 003.() 0)3..( -/3.()

>

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O+ !"# II Exch? year repay? inter? other total Ange ment of est at charges amt $ate principal <<<<<<<<<<<<<<<<<<<<<<< N+X ,,* /) /' // /) 0 ' , / ( ?? '.* '.* '.* '.* ?? ).*/) ).-.' ).()/ ).,,).0/) ).0/) repay? balance inter? other total tax net ment of being est charges payment savings out? principal premium <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< $s. in &a!hs ?? ?? ?? (.)/ (.)/ 0..-/ ,.'.-

?? ,.-/) 0)).)) ?? ,./.' 0)).)) ?? ,.,)/ 0)).)) ?? ,.0,- 0)).))

-./ ,0.3') 0'.)) '-.**) 0..-) '0.0-* ',.' 0/..*/

0,*.,' 00..,'0'-.(** 0,*.** 0).*.*0'*.))' 0,*..-* 0).)/*0'*..') 0,..3*/ 3.0*/0'*.*))

'.* ).0-* ?? '.3-* 0)).)) '*.* ...'* 0,-.('* '/.*0/000..0/ <<<<<<<<<<<<<<<<<<<<Y<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 0/.) '.(') ).0/)0-.--)()).)) **.)) 0)'./* (.)/-3(.(') -*./')-'..0)) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<

As per A+ A 002 the premium paid on exchange rate difference2 on loans ac#uired for the purpose of capital expenditure2 should be capitalised. 8he same is applicable under the Indian income Atax Act for tax calculations also. 5ear opening Jalue ??? /.*) 0'.-) ''.-( ,/.,3 premium total depreciation on premium At '(4 0.-) /.') ..(( 00./-,.03 tax saving at ,(4 ).(0./. '.-/ /.)0 ''.00 closing CDJ

0 ' , / (

-./) 0'.)) 0..-) ',.') '*.*)

-.) 0-.*) ,).') /(.*( -,.03I

/.*) 0'.-) ''.-( ,/.,3 Hil

I Assumed that full benefit will be claimed for tax purposes. 8ax savings on interest other charges and premium. 5ear Amount Ef interest M other charges (.)/) ,0.3') '-.**) '0.0-* 0/..*/ ...'* 8ax savings 8ax savings on premium 8otal 8ax savings

) 0 ' , / (

0..-/ 00.0.' 3./)* ../)* (.0./ '..)/

??? ).(-) 0./.) '.-/) /.)0) ''.00)

0..-/ 00..,' 0).*.* 0).)/* 3.0*/ '/.*0/

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(') Discounted cash flow : Eption I

5ear ) 0 ' , / (

Het out flow ),.'() 0/*..() 0,3.)) 0'3.'() 003.()) 0)3..()

Discounting factor 0.))) ).3'0 ).*/* )..*0 )..') ).--,

Discounted value ,.'( 0,-.33 00..*. 0)).3/ *-.)/ .'..<<<<<< (0..*(

Discounted cash flow : option II

5ear

1ross Eutflow (.)/) 0,*.,') 0,*.**) 0,*..-* 0,..3*/ 0,-.('*

8otal tax saving 0..-/ 00..,' 0).*.* 0).)/* 3.0*/ '/.*0/

Het out flow ,.'.0'-.(** 0'*.))' 0'*..') 0'*.*)) 000..0/

discounting factor ??? ).3'0 ).*/* )..*0 )..') ).--,

Discounted value ,.'.00-.(*. 0)*.(/( 0)).(,) 3'..,./.)-/3(../)

0 0 ' , / (

%8'

8he absolute and discounted value of option II seems to be better than option I. Oowever the company has to be careful about future exchange rate. 8he rate indicated is more by rule of thumb than based on any scientific approach. 8he company should cover the foreign exchange rate and then wor! out the value. In case the company has good volume of exports2 then it may help the company to hedge the future payments with outflow. In that case the company may ta!e a lenient view of the possible exchange ris!. 1111111 (a) 8he following details are available in respect of a firm : (i) (ii) (iii) (iv) Annual re#uirement of inventory /)2))) units %ost per unit (other than carrying and ordering cost)$s.0%arrying cost are li!ely to be 0(4 per year %ost of placing order $s./*) per order

%:'

2.

Determine the economic ordering #uantity. (b) 8he experience of the firm being out of stoc! is summarised below : (0) +toc! out (Ho. of units)
()) 0

Ho. of times
(0)

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/)) '() 0))

()

' , /
0)

(') (,) (/)

(0))

) *) (*)) 9igures in brac!ets indicate percentage of time the firm has been out of stoc!. (/) (() +toc! out costs are $s./) per unit %arrying cost of inventory per unit is $s.') Determine the optimal level of stoc! out inventory. (c) A firm has ( different levels in its inventory. 8he relevant details re given. +uggest a brea!down of the items into A2" and % classifications : .
. I e. N". A6/. N". "- u#! s !#6e# "r4 A6/. C"s +er u#!

0 ' , / (
Answer

')2))) 0)2))) ,'2))) '*2))) -)2)))

$s.-) $s.0)) $s.00 $s.0) $s.,./)

%&'

%arrying cost per unit per annum > %ost per unit x %arrying cost 4 p.a. > $s. 0- x ).0( > $s. './) How from the formula for Economic Erder Vuantity (EEV) ' x 8otal consumption p.a. x ordering cost per order > ????????????????????????????????????????????????????????????????????????????????????? carrying cost per unit ' x /)2))) x /*) > ??????????????????????????????????????? > /2))) units './) A, er#& !6e $"r9!#/ : Erdering siQe (units) 02))) '2))) ') 02))) '2/)) '2()) 002'() ,2))) /2))) 0) '2))) /2*)) (2))) * '2()) -2))) *2))) ( /2))) 32-)) 0)2))) / (2))) 0'2)))

Ho. of orders re#uired /) Average inventory (units) ()) 8otal carrying cost of Average inventory in $s.02')) 8otal ordering cost > Ho of orders x cost of 6lacing each order 032')) 8otal cost in $s. ')2/))

32-)) 0'2)))

.2-*) 0)2-*)

/2*)) 32-))

,2*/) 32*/)

'2/)) 0'2)))

023') 0,23')

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Oence lease cost of $s. 32-)) is at the ordering siQe of /2))) units. %0' safety stoc! level (units) ()) /)) '() 0)) stoc! out (units) ) 0)) '() 0() /)) ,)) 0() /() ,() ')) () ()) /)) '() 0)) () stoc! out cost G $s. /) per unit $s. ) /2))) 0)2))) -2))) 0-2))) 0'2))) -2))) 0*2))) 0/2))) *2))) '2))) ')2))) 0-2))) 0)2))) /2))) '2))) expected stoc! out costs $s. '2*)) 02-') */) '-) /) ) probability of stoc! out ) ).)0 ).)0 ).)' ).)0 ).)' ).), ).)0 ).)' ).), ).)/ ).)0 ).)' ).), ).)/ ).0) expected stoc! out at this level $s. ) /) 0)) 0') 0-) '/) 0*) 0*) '*) '/) *) ')) ,') ,)) 0-) ')) carrying cost at $s. ') per unit $s. ) 02))) '2))) (2))) *2))) 0)2))) 8otal expected stoc! out cost $s. ) /) '-)

*/)

()

02-')

'2*)) 8otal safety stoc! cost $s. '2*)) '2-') '2*/) (2'-) *2)/) 0)2)))

+afety stoc! &evel (units) ) () 0)) '() /)) ())

Eptimum safety stoc! where the total cost is the least is at () units level. %*' Item Ho. 0 ' , / ( Nnits ')2))) 0)2))) ,'2))) '*2))) -)2))) 02()2))) 4 of total Nnits 0,., -.. '0., 0*.. /).)) 0)).) Nnit cost $s. -).)) 0)).)) 00.)) 0).)) ,./) 8otal cost $s. 0'2))2))) 0)2))2))) ,2('2))) '2*)2))) '2)/))) ,)2,-2))) 4 of total cost ,3.(B A ,'.3B 00.-B" 3.'B -.*) 0)).))

Items Hos. I and II being very valuable are to be controlled first though in #uantity are hardly ')4 of the total2 hence can be classified as A. Hext priority is for Items , and / though #uantity wise /)4 to be classified as " and last priority item ( though in #uantity bul! but value is less hence to be classified as %.

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Ques !"# 8.%&' 8he fixed assets and e#uities of Eastern anufacturing %o. &td. are supplied to you both at the beginning and at the end of the year 033-?3. : 6lant &ess depreciation Investment in +hares of +outhern anufacturing %ompany "onds 6ayable %apital +toc! $etained earnings 0;/;3- ($s.) -,2()) 02,'2))) '2()2))) /2))2))) '2,*2))) ,0;,;3. ($s.) 02/'2()) '23)2))) .)2))) /20)2))) /20)2())

5ou are not in a position to have complete "alance +heet data or an income statement for the year in spite of the fact that you have obtained the following information. (c) (d) Dividend of $s.,.2()) were paid. 8he net income included $s.0,2))) as profit on sale of e#uipment. 8here has been an increase of $s.3,2))) in the value of gross plant assets even through e#uipments worth $s.'32))) with a net boo! value of $s.032))) was disposed of.

9rom the particulars given above2 prepare a statement of sources and uses of net wor!ing capital. (b) 8he management off N6 and Down &td. are worried about their increasing labour turnover in the factory and before analysing the causes and ta!ing remedial steps2 they want to have an idea of the profit foregone as a result of labour turnover in the last year. &ast year sales amounted to $s.*,2),2,)) and the 6;J ratio was ')4. 8he total number of actual hours wor!ed by the direct labour force was /./( la!hs. As a result of the delay by the personnel department in filling vacancies due to labour turnover2 02))2))) potentially productive hours were lost. 8he actual direct labour hours included ,)2))) hours attributable to training new recruits2 out of which half of the hours were unproductive. An analysis of costs incurred conse#uent on labour turnover revealed the following : $s. +ettlement %ost due to &eaving /,2*') $ecruitment %osts '-2./) +election %ost 0'2.() 8raining %osts ,)2/3) Assuming that the potential lost as a conse#uence of labour turnover could have been sold at prevailing prices2 find out the profit forgone last year on account of labour turnover. A#s$er %&' Cor!ing Hotes : (i) 6urchase of plant Het increase in 1ross value Add : 1ross value of plant sold (ii) Depreciation on plant and machinery P,&# &#3 .&*(!#er4 &**"u# 8o "alance b;d 8o 6urchases $s. -,2()) 02''2))) <<<<<<<< 02*(2()) $s. "5 +ale of plant M achinery A;c 032))) "y Depreciation (balancing figure) '/2))) "y "alance c;d 02/'2()) 02*(2())

$s. 3,2))) '32))) 02''2)))

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(iii) 9unds from operations Increase in retained earnings @/20)2()) A '2,*2)))B Add : Dividend paid Add : Depreciation on plant &ess : 1ain on sale of e#uipment

02.'2()) ,.2()) '/2))) <<<<<<<< '2,/2))) 0,2))) <<<<<<<< '2'02)))

+ources 9unds from operation +ale of e#uipment

S & e.e# "- s"ur*es &#3 uses "- -u#3 $s. Nses '2'02))) ,'2))) 6urchase of plant 6urchase of investments ('23)2))) A 02,'2)))) 6ayment of "onds dividends

$s. 02''2))) 02,*2))) 02*)2))) ,.2()) <<<<<<<< /23.2())

Decrease in net wor!ing capital '2//2()) ("alancing figure) <<<<<<<<< /23.2()) %0' 2"r9!#/ N" es :

$s.

(0) Actual hours wor!ed &ess : Nnproductive training hours Actual productive hours (') +ales

/2/(2))) 0(2))) <<<<<<< /2,)2)))

$s. *,2),2,)) *,2),2,)) +ales per productive hours ???????????????????? > 03.,0 /2,)2))) > 02))2)))

(,) 6otential productive hours lost

+ales foregone > 02))2))) hours x 03.,0 > $s. 032,02))) (/) %ontribution foregone > +ales foregone x p;v ratio > $s. 032,02))) x ')4 > $s. ,2*-2')) S & e.e# "- Pr"-! -"re/"#e ,&s 4e&r "# &**"u# O- ,&0"ur ur#"6er "- U+ &#3 3"$# L 3. $s. %ontribution foregone (notes 0 to /) +ettlement cost due to leaving $ecruitment costs +election costs 8raining costs ,2*-2))) /,2*') '-2./) 0'2.() ,)2/3) (2))2)))

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Ques !"# :.%&' 9rom the following prepare Income +tatement of %ompany A2" and %. "riefly comment on each company:s performance : %ompany 9inancial &everage Invest Epening &everage Jariable %ost as a percentage to +ales Income?tax $ate %0' A ,:0 $s.')) /:0 -- ';,4 /(4 " /:0 $s.,)) (:0 .(4 /(4 % ':0 $s.02))) ,:0 ()4 /(4

K &td.2 a widely held company is considering a ma7or expansion facilities and the following alternatives are available : A () ?? ?? Alternatives ($s. In la!hs) " % ') 0) ') 0( 0) '(

+hare %apital 0/4 Debentures &oan from a 9inancial Institution G 0*4 p.a. $ate of Interest.

Expected rate of return before tax is '(4. 8he rate of dividend of the company is not less than ')4. 8he company at present at present has low debt. %orporate taxation ()4. OR %&' 8he following information is available in respect of A"% &td. : (.) (*) (3) (0)) . onth Zanuary 9ebruary arch April ay Zune Zuly August (00) (0') aterials received $s. ')2))) ''2))) '/2))) '-2))) '*2))) ,)2))) ,'2))) ,/2))) +ales $s. ,)2))) ,,2))) ,-2))) ,32))) /'2))) /(2))) /*2))) (02))) Cages and Expenses $s. 32()) 0)2))) 0)2()) 002))) 002()) 0'2))) 0'2()) 0,2))) aterials are purchased and received one month before being used and payment is made to suppliers two months after receipt of materials. %ash is received from customers three months after finished goods are sold delivery to them.B Ho time lag applies to payments of wages and expenses. 8he following figures apply to recent and future months :

%ash balance at the beginning of April is $s.0)2))). All products are sold immediately they have been made and that materials used and sums spent on wages and expenses during any particular month relate strictly to the sales made during that month. 6repare cash flow month by month from April to Zuly2 profit and loss forecast for four months (April?Zuly) and a movement of funds statement for the four months period (April? Zuly).

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%0'

Chat are the matters to be considered in the context of wor!ing capital management in public sector underta!ing F

A#s$er %&' F!rs A, er#& !6e 2"r9!#/ #" es : C".+&#4 A E"I8 , 9inancial leverage > ????????????? > ???? or E"I8 > , x E"8 [[[[..(0) E"8 0 Again E"I8 A Interest > E"8 Er E"I8 A ')) > E"8 [[[[[[[[[[[[[[[[[(')

8a!ing (0) M (') we get ,E"8 A ')) > E"8 Er2 'E"8 > ')) or E"8 > $s. 0)) Oence E"I8 > ,E"8 > $s. ,)) %ontribution / Again we have operating leverage > ????????????????? > ??????? E"I8 0 E"I8 > $s. ,))2 hence we get %ontribution > / x E"I8 > $s. 02')) ' How variable cost > -- ??? 4 on sales , ' %ontribution > 0)) A -- ??? i.e. ,,???4 on sales , 02')) Oence sales > ???????????? > $s. ,2-)) ,,0;, 4 +ame way E"I82 E"82 contribution and sales for %ompany ) and C can be wor!ed out. C".+&#4 ) E"I8 / 9inancial leverage > ??????????? > ?????? or E"I8 > / E"8 [[[[..(,) E"8 0 Again E"I8 A interest > E"8 or E"I8 A ,)) > E"8 [[[[[[..(/) 8a!ing (,) M (/) we get2 /E"8 A ,)) > E"8 Er2 ,E"8 > ,)) or E"8 > 0)) Oence E"I8 > / x E"8 > /)) %ontribution ( Again we have operating leverage > ???????????????????? > ????? E"I8 0 E"I8 > /)) Oence we get contribution > ( x E"I8 > '2))) How variable cost > .(4 on sales %ontribution > 0)) A .(4 i.e. '(4 on sales

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'2))) Oence sales > ?????????? > $s. *2))) '(4 C".+&#4 C E"I8 ' 9inancial leverage > ?????????? > ???? or E"I8 > ' E"8 [[[[[ (() E"8 0 Again E"I8 A Interest > E"8 or E"I8 A 02))) > E"8 [[[[[.(-) 8a!ing (() and (-) we get2 'E"8 A 02))) > E"8 or E"8 > 02))) Oence E"I8 > ' x E"8 > ' x 02))) > '2))) %ontribution , Again we have operating leverage > ???????????????????? > ???? E"I8 0 E"I8 > '2)))2 Oence we get contribution > , x E"I8 > -2))) How variable cost > ()4 on sales. %ontribution > 0)) A () > ()4 on sales -2))) Oence sales > ???????????? > $s. 0'2))) ()4 I#*".e S & e.e# : A " $s. $s. ,2-)) *2))) '2/)) -2))) 02')) '2))) 3)) ,)) ')) 0)) /( (( 02-)) /)) ,)) 0)) /( (( % $s. 0'2))) -2))) -2))) /2))) '2))) 02))) 02))) /() (()

+ales &ess : Jariable cost %ontribution &ess : 9ixed cost E"I8 &ess : Interest E"8 &ess : 8ax /(4 EA8

C"..e# s "# *".+&#4Ds +er-"r.&#*e : 8he financial position of company % can be regarded better than that of other companies A M " because of the following reasons : (i) 9inancial leverage is the measure of financial ris!. %ompany % has the least financial ris! as it has minimum degree of financial leverage. Ho doubt it is true that there will be a more magnified impact on earnings per share on A M " companies than that of % due to change in E"I8 but their E"I8 level due to low sales in very low suggesting that such an advantage is not great. Degree of combined leverage is maximum in company " A ')2 for %ompany A A 0' and for %ompany % A -2 clearly2 the total ris! (business and financial) complexion of company % is the lowest2 while that of other firms are very high.

(ii)

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(iii)

8he ability of company % to meet interest liability is better than that of companies A M ".

E)ITE I# eres r& !" -"r (ree C".+&#!es : % '2))) > ????????????????????? > ' 02))) /)) > ????????????????????? > 0.,, ,)) ,)) > ????????????????????? > 0.( ')) A $eturn on $s. () la!hs G '(4 &ess : Interest on Debenture Interest on loan 8axable profit Income tax ()4 6rofit after tax available 8o share holders $ate of return on +hare capital 0'.() ??? ??? <<<<< 0'.() -.'( -.'( 0'.(4 " 0'.() '.*) 0.*) <<<<< ..3) ,.3( ,.3( 03..(4 % 0'.() '.0) /.() <<<<< (.3) '.3( '.3( '3.(4

"

%0'

9rom shareholders point of view alternative % (highest) is to be chosen. Se*"#3 A, er#& !6e %&' C&s( -"re*&s -r". A+r!, " Fu,4 April 0)2))) ,)2))) /)2))) 002))) ''2))) ,,2))) .2))) ay .2))) ,,2))) /)2))) 002()) '/2))) ,(2()) /2()) Zune /2()) ,-2))) /)2()) 0'2))) '-2))) ,*2))) '2()) Amount In $s. Zuly '2()) ,32))) /02()) 0'2()) '*2))) /)2()) 02)))

Epening balance %ollections from debtors 6ayments : Cages M expenses 6ayment to suppliers %losing balance

Pr"-! & L"ss -"re*&s -"r : ."# (s A+r!, 5 Fu,4 +ales (April to Zuly) %losing stoc! (Zuly purchase) $s. 02./2))) ,'2)))

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<<<<<<<< '2)-2))) &ess : Epening stoc! A ( arch purchase) 6urchase (April to Zuly) Cages M expenses (April to Zuly 6rofit for the / month period M"6e.e# "- Fu#3s S & e.e# April arch purchase April %redit allowed , month Zanuary sales 9ebruary sales arch sales April %redit received ' months 9ebruary purchases arch purchase '/2))) 020-2))) /.2))) 02*.2))) 032)))

+toc! (Epening) $eceivables (Epening)

'/2))) ,)2))) ,,2))) ,-2))) 332)))

%reditors (Epening)

''2))) '/2))) /-2))) ,'2))) 02,(2))) -'2))) $s. 032))) 0-2))) ,(2))) ,-2))) *2))) //2))) (?) 32))) 0)2))) 02)))

%losing stoc! (end of Zuly)2 Zuly purchase $eceivable (end of Zuly)2 ay to Zuly sales %reditors (end of Zuly)2 Zune and Zuly purchase How movement of funds statement can be wor!ed out S"ur*es : 6rofit earned during / months Add : Increase in creditors (-'2))) A /-2)))) A++,!*& !"# : &ess : Increase in receivables (02,(2))) A 332)))) &ess : Increase in stoc! (,'2))) A '/2)))) Epening cash balance Oence closing cash balance %0' In the context of wor!ing capital be considered : (0)

anagement in public sector underta!ings the following should

6ublic sector underta!ings are often blamed for over inventory resulting in bloc!ing of capital and space or less often for under inventory upsetting production schedule. "oth are signs of inefficient inventory management. 8here is generally no provision for wor!ing capital margin at the time of estimating cost of pro7ect. %onse#uently there is no provision of long A term funds for wor!ing capital and the enterprise has to obtain financing from short A term sources. ost of the public sector units are capital intensive hence ratio of current assets to fixed assets is generally low. ost of the public sector underta!ings lac!s application of wor!ing capital management techni#ues specially relating to receivables li!e discount rate2 credit period and credit standards. 8he reason being that they sell bul! of their output to 1overnment departments.

(')

(,) (/)

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Ques !"# <

Crite short notes on : (e) (f) (g) (h) "ridge 9inance. %all and put option with reference to debentures. %apital Asset 6ricing odel (%A6 ). 9orward as hedge instrument.

A#s$er %&' )r!3/e F!#&#*e : "ridge 9inance refers2 normally2 to loans ta!en by a business2 usually from commercial ban!s for a short period2 pending disbursement of term loans by financial institutions2 normally it ta!es time for the financial institution to finalised procedures of creation of security2 tie A up participation with other institution etc. even though a positive appraisal of the pro7ect has been made. Oowever2 once the loans are approved in principle2 firms2 in order not to lose further time in starting their pro7ects arrange for bridge finance. +uch temporary loan is normally repaid out of the proceeds of the principal term loans. It is secured by hypothecation of moveable assets2 personal guarantees and demand promissory notes. 1enerally rate of interest on bridge finance is higher as compared with that on term loans. C&,, &#3 +u "+ !"# $! ( re-ere#*e " 3e0e# ures : (0) A debenture is an instrument for a fixed period of time mostly at fixed rate of interest. (') How a days the rate of interest varies significantly. (,) Cith inflow of enormous foreign funds this has assumed greater significance. (/) A call option gives a liberty to the issuer of the debenture to pay bac! the amount earlier to the redemption date at a pre A determined price (stri!e price) within the specified period. In case the option is not exercised the debenture continues. (() En the other hand2 a put option means2 a right to investors to demand bac! the money earlier to the redemption data at a pre A determined price (stri!e price ) within the specified period. (-) 8he debenture holder can get bac! the money and invest it elsewhere. (.) 8hese !inds of options are necessary to ma!e the instrument investor friendly and to ensure li#uidity in debentures mar!et. %*' C&+! &, Asse Pr!*!#/ M"3e, %CAPM' : %A6 provides a conceptual frame wor! for evaluating any investment decision where capital is committed with a goal of producing future returns. Important assumptions in %A6 are : (i) 8here is an efficient mar!et meaning existence of competitive mar!et where financial securities and capital assets are bought and sold with full information of ris! and return available to all participants.

%0'

(ii) 8here exists rational investment goals. (iii) All assets are divisible and li#uid assets. (iv) Investors are free to borrow at ris! less rate of interest. (v) +ecurities can be exchanged without payment of bro!erage2 commission or taxes and without any transaction costs.

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(vi) +ecurities or capital assets face no ban!ruptcy or insolvency. %A6 E($6) E($p) $f "p $ ($m) E ($m) A $f %3' can be used to estimate the expected return of any portfolio with the following formula. > $f = "p @E ($m) A $fB > > > > > Expected return of the portfolio. $is! free rate of return. 6ortfolio "eta i.e.2 mar!et sensivity index. Expected return on mar!et portfolio. ar!et ris! premium.

F"r$&r3 &s (e3/e !#s ru.e# : International transactions both trade and financial give rise to currency exposures. A currency exposure if left unmanaged leaves a corporate open to profits or losses arising on account of fluctuations in currency ratio. Ene way in which corporate can protect itself from effects of fluctuations in currency rates in through buying or selling in forward mar!ets. A forward transaction is a transaction re#uiring delivery at a future date of a specified amount of one currency for a specific amount of another currency. 8he exchange rate is determined at the time of entering into the contract but the payment and delivery ta!es place on maturity. %orporate use forwards to hedge themselves against fluctuations in currency price that would have a significant impact on their financial position. "an!s use forward to offset the forward contracts entered into with non A ban! customers. 111111111

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FINAL EHAMINATION MAY, 199@ Gr. 5 I PAPER 2: MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS
Ques !"# 1. + Engineering %ompany is considering to replace or repair a particular machine2 which has 7ust bro!en down. &ast year this machine cost $s.')2))) to run and maintain. 8hese costs have been increasing in real terms in recent years with the age of the machine. A further useful life of ( years is expected2 if immediate repairs of $s.032))) are carried out. If the machine is not repaired it can be sold immediately to realise about $s.(2))) (Ignore loss;gain on such disposal). Alternatively2 the company can buy a new machine for $s./32))) with an expected life of 0) years with no salvage value after providing depreciation on straight line basis. In this case2 running and maintenance costs will reduce to $s.0/2))) each year and are not expected to increase much in real terms for a few years at least. + Engineering %ompany regard a normal return of 0)4 p.a. after tax as a minimum re#uirement on any new investment. %onsidering capital budgeting techni#ues2 which alternative will you choose F 8a!e corporate tax rate of ()4 and assume that depreciation on straight line basis will be accepted for tax purposes also. 1iven cumulative present value of $e.0 p.a. at 0)4 for ( years $s.,..302 0) years $s.-.0/(. A#s$er
E6&,u& !"# "- +r"+"s&, " re+&!r eA!s !#/ .&*(!#e "r 0u4 & #e$ .&*(!#e

-"r MEs S. E#/!#eer!#/ C".+&#4 %!' T" re+&!r eA!s !#/ .&*(!#e : $s. Present value of after tax outflows %ost of repairs immediately net of tax $s. 32()) (()4 of $s. 032)))) $s. 32()) E#uivalent annual cost for ( year ??????????????? ,2.30 $unning and maintenance cost per annum net of tax (()4 of $s. ')2)))) %!!' T" 0u4 & #e$ .&*(!#e : $s. Present value of after tax cash outflows 6urchase cost of new machine &ess : +ale proceeds of old machine /32))) <(2))) //2))) '2()0)2))) 0'2()-

$s. //2))) E#uivalent annual cost for 0) years ????????????????? -.0/( 8ax saving of depreciation ($s. /32)));0)) x ()4 $unning and maintenance cost p.a. net of tax (()4 of $s. 0/2)))) 8otal net e#uivalent cash outflows p.a.

.20-) ('2/()) <.2))) 002.0)

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+ince2 net e#uivalent cash outflows p.a. for buying a new machine $s. 002.0) is less than net e#uivalent cash outflows of $s. 0'2()- for repairing of an existing machine. 8herefore2 it is advisable that the company should go for buying a new machine. %Se*"#3 S",u !"#' %!' T" re+&!r &# eA!s !#/ .&*(!#e. $s. Prese# 6&,ue "- &- er &A *&s( "u -,"$s %ost of repair immediately net of tax ($s. 032))) x ()4) $unning M maintenance cost for( years ($s. ')2))) x ()4 x ,..30) 8otal net present value of after tax cash outflows for ( years /.2/0) Oence2 net e#uivalent cash outflows p.a. $s. ????????????? ,2.30 %!!' T" 0u4 #e$ .&*(!#e $s. Prese# 6&,ue "- &- er &A *&s( "u -,"$s 6urchase cost of new machine &ess : +ale proceeds of old machine 8ax benefit on depreciation p.a. ($s. /32)));0)) x ()4 $unning and maintence cost p.a. (()4 of $s. 0/2))))

32()) ,.230) <<<<<< /.2/0)

/32))) (2))) ('2/()) .2))) /2(()

//2)))

Het cash outflows for 0) years ($s. /2(() x -.0/() 8otal net 6resent value of after tax cash outflows for 0) years .023-) Oence2 net e#uivalent cash outflow p.a. $s. ????????????????? -.0/(

'.23-) .023-) 002.0)

+ince2 net e#uivalent cash outflows p.a. for buying a new machine $s. 002.0) is less than net e#uivalent outflows of $s. 0'2()- for repairing of an existing machine. 8herefore2 it is advisable that the company should go for buying a new machine. 11111111111111

Ques !"# 2.%&' A limited company operates a lodging house with a restaurant2 shops and recreational facilities attached. Its manager has entrusted you with the planning of the coming year:s operations2 more particularly on the level of profits the company was li!ely to earn. 8he lodging house has 0)) double?bed rooms2 which are li!ely to be rented at $s.0() per day. 8he manager expects an occupancy ratio of .(4 for a period of '() days during the tourist season . It is also anticipated that both the beds in a room will be occupied during the period. Each person staying in the lodging house is expected to spend2 on the basis of past statistics2 $s.,) per day in the shops attached to the lodge and $s.-) per day in the restaurant. 8he recreational facilities are not charged to the customer. +ome other relevant data available to you is as under :

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(i)

Jariable cost to volume ratio : %ost of goods sold +upplies Ethers +hops /)4 (4 (4 $estaurant ,)4 0(4 0)4

(iv) (v)

9or the lodging house2 the variable costs are $s.'( per day per occupied room for cleaning2 laundry etc. Annual fixed costs for the entire complex are $s.032()2))).

9rom the above2 you are re#uired to prepare : (c) (d) (b) an income statement for the coming yearL and an analysis to indicate whether the manager:s suggestion of reducing the room rent to $s.0'( per day to enhance the occupancy ratio to 3)4 should be accepted. An investor is see!ing the price to pay for a security2 whose standard deviation is ,.)) per cent. 8he correlation coefficient for the security with the mar!et is ).* and the mar!et standard deviation is '.' per cent. 8he return from government securities is (.' per cent and from the mar!et portfolio is 3.* per cent. 8he investor !nows that2 by calculating the re#uired return2 he can then determine the price to pay for the security. Chat is the re#uired return on the security F

A#s$er %&' EA+e* e3 I#*".e S & e.e# "- A L 3. C".+&#4 (") $evenue : Ootel $oom receipts (0)) rooms x '() days x $s. 0() x .(4) +hops (0)) rooms x ' persons x '() days x $s. ,) x .(4) $estaurant (0)) rooms x ' persons x '() days x $s. -) x .(4) (") Jariable costs : Ootel $ooms (0)) rooms x '() days x $s. '( x .(4) +hops ($s. 002'(2))) x ()4) $estaurant ($s. ''2()2))) x ((4) (%) %ontribution (A A ") &ess : 9ixed costs Expected profits %0' I#*".e S & e.e# 0&se3 "# M&#&/erDs su//es !"#s. (A) $evenue : Ootel $oom receipts (0)) rooms x '() days x $s. 0'( x 3)4) +hops (0)) rooms x ' persons x '() days x $s. ,) x 3)4) $estaurant (0)) rooms x ' persons x $s. -) x 3)4) (") Jariable costs Ootel $oom (0)) rooms x '() days x $s. '( x 3)4) $s. (2-'2()) $s. $s. '*20'2()) 0,2()2))) '.2))2))) -*2-'2()) $s. /2-*2.() (2-'2()) 0'2,.2()) ''2-*2.() ,320*2.() 032()2))) 032-*2.() $s. '*20'2()) 002'(2))) ''2()2))) -02*.2()) $s.

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+hops ($s. 0,2()2))) x ()4) $estaurant ($s. '.2))2))) x ((4) (%) %ontribution (A A ") &ess : 9ixed costs 6rofit

-2.(2))) 0/2*(2)))

'.2''2()) /02/)2))) 032()2))) '023)2)))

8he profit based on manager:s suggestion $s. '023)2))) is higher than the expected profit $s. 032-*2.()2 therefore it is advisable that the manager:s suggestion of reducing the room rent to $s. 0'( per day to enhance the occupancy ratio to 3)4 should be accepted. %0' %orrelation coefficient between the security and the mar!et x +td. Deviation of the security return. "eta coefficient > ????????????????????????????????????????????????????????????????????????????????????????????????????????? +td. Deviation of the mar!et return. ().*) x ().,) > ???????????????????? > 0.)30 ().'') How2 re#uired return on the security : $ate of return on ris! free security = beta coefficient (regd. $eturn on mar!et portfolio A rate of return on ris! free security) > (.' = 0.)30 (3.* A (.') > (.' = (.)' > 0).''4

Ques !"# 8.%&' 8he present credit terms of 6 %ompany are 0;0) net ,). Its annual sales are $s.*) la!hs2 its average collection period is ') days. Its variable costs and average total costs to sales are ).*( and ).3( respectively and its cost of capital is 0) per cent. 8he proportion of sales on which customers currently ta!e discount is ).( 6 %ompany is considering relaxing its discount terms to ';0) net ,). +uch relaxation is expected to increase sales by $s.( la!hs2 reduce the average collection period to 0/ days and increase the proportion of discount sales to ).*. Chat will be the effect of relaxing the discount policy on company:s profit F 8a!e year as ,-) days. (b) A company operating in a country having the dollar as its unit of currency has today invoiced sales to an Indian company2 the payment being due three months from the date of invoice. 8he invoice amount is X 0,2.() and at today:s spot rate of X ).)'.( per $e.02 is e#uivalent to $s.(2))2))). It is anticipated that the exchange rate will decline by (4 over the three month period and in order to protect the dollar proceeds2 the importer proposes to ta!e appropriate action through foreign exchange mar!et. 8he three forward rate is #uoted as X ).)'., per $e.0 5ou are re#uired to calculate the expected loss and to show2 how it can be hedged by forward contract. (c) K %o. &td. issued commercial paper as per following detail : Date of issue 0.th Zanuary2 033* Date of maturity 0.th April2 033* Ho. of days 3) Interest rate 00.'(4 p.a. Chat was the net amount received by the company on issue of commercial paper F

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A#s$er %&' E6&,u& !"# "- e--e* "- re,&A!#/ (e 3!s*"u# +",!*4 "# *".+&#4Ds +r"-! $s. A. Incremental $evenue Increase in contribution ($s. (2))2))) x 0(4) $eduction in investment in receivable x cost of capital $s. *) la!hs x ).3( x ') days 6resent : ??????????????????????????????????????????? > $s. /2''2''' ,-) days ($s. *) la!hs x ).3( = $s. ( la!hs x ).*() x 0/ days 6roposed : ???????????????????????????????????????????????????????????????????????? > $s. ,20'2)*, ,-) days $eduction in investment in receivable $s. 020)20,3 ($s. /2''2''' A $s. ,20'2)*,) %ost of savings on investment in receivable ($s. 020)20,3 x 0)4) 002)0/ *-2)0/ ". Incremental %ost Increase in discount 6resent : ($s. *) la!hs x 04 x ).() 6roposed : ($s. *( la!hs x '4 x ).*) Het increase in discount %. Het effect on 6rofits (A A ") .(2)))

> $s. /)2))) > $s. 02,-2))) > $s. 3-2))) > $s. *-2)0/ A $s. 3-2))) > (?) $s. 323*-

+ince2 the proposed discount policy will reduce the profits of the company to the extent of $s. 323*-. therefore2 it is not advisable for the company to relax the present discount policy. %0' C&,*u,& !"# "- (e eA+e* e3 ,"ss 3ue " -"re!/# eA*(&#/e r& e -,u* u& !"# Present cost X0,2.() Gtoday spot rate of X ).)'.( per $e. 0 Cost after 3 months X0,2.() G expected spot rate of X).)'-0'( per $e. 0 ($efer to wor!ing note) Expected loss 9orward cover is available today at 0 $e. > X).)'., for , months If we ta!e forward cover now for payment after months net amount to be paid is (X0,2.() ; X).)'.,) > '2).2--, Oence2 by forward contract the company can cover $s. ''2-(, ($s. '-2,0- A $s. ,2--,) i.e. about *-4 of the expected loss. 2"r9!#/ N" e : Expected spot rate after 3 months. It is anticipated by the company that the exchange rate will decline by (4 over the three months period. 8he expected rate will be > $s. (2))2))) > $s. (2'-2,0<<<<<<<<<<< $s. '-2,0-

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6resent rate A (4 of the present rate > X).)'.( A (4 of X).)'.( > X).)'-0'( Alternatively2 the expected rate may also be calculated as follows : 3( X).)'.( x ????? > X).)'-0'( 0)) Se*"#3 A, er#& !6e S",u !"# C&,*u,& !"# "- eA+e* e3 ,"ss 3ue " -"re!/# eA*(&#/e r& e -,u* u& !"#s Present cost X0,2.() G $s. ,-.,($efer to wor!ing note) Cost after 3 months X0,2.() G expected spot rate of $s. ,*.0* ($efer to wor!ing note ') Expected loss $s. /23323().)) $s. (2'/23.(.)) <<<<<<<<<<<<< $s. '(2)'(.))

9orward cover is available today at $s. ,-.-, for 0 N+ X ($efer to wor!ing note ,) If we ta!e forward cover now for payment after , months net amount to be paid is $s. (2),2--, (X0,2.() G $s. ,-.-, per X). Oence2 by forward contract the company can cover $s. '02,-' ($s. '(2)'( A $s. ,2--,) i.e. about *(.,4 of the expected loss. 2"r9!#/ #" es : 0. 8oday spot rate X ).)'.( per $e. 0 0 or2 0 X > ?????????????? or $s. ,-.,).)'.( '. Expected spot rate after 3 months It is anticipated by the company that the exchange rate will decline by (4 over the three months period. 8he expected rate will be 6resent rate = (4 of $s. ,-.,- > $s. ,*.0* ,. Today forward rate 0 X ).)'., per $e. 0 or 0X > ?????????????? > $s. ,-.-, ).)'., %*' N" e : It has been assumed that the amount of commercial paper issued is $s. ( crores. Oence2 the net amount received by the company on issue of commercial paper is an follows : 00.'( x 3) Interest :00.'(4 p.a. > ????????????????? ,-(

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> '.../4 for 3) days Oence2 interest will be '.../ > ???????????????????? x $s. ( crores 0)) = '.../ > $s. 0,2/32(-, Het amount received at the time of issue > $s. ( crores A $s. 0,2/32(-, > $s. /2*-2()2/,. EIT;ER Ques !"# :. (a) (b) Chat is 9inancial 9orecasting F Describe in brief2 its utility and how it is effected 8he following figures are made available to you :

$s. Het profits for the year 0*2))2))) &ess : Interest on secured debentures at 0(4 p.a. (debentures were issued , months after the commencement of the year) 020'2()) 0-2*.2()) &ess : Income?tax at ,(4 and dividend distribution tax *2/,2.() 6rofit after tax *2/,2.() Humber of e#uity shares ($s.0) each) 02))2))) ar!et #uotation of e#uity share $s.0)3..) 8he company has accumulated revenue reserves of $s.0' la!hs. 8he company is examining a pro7ect calling for an investment obligation of $s.0) la!hs: this investment is expected to earn the same rate of return as funds already employed. 5ou are informed that a debt e#uity ratio (Debt divided by debt plus e#uity) higher than -)4 will cause the price earning ratio to come down by '(4 and the interest rate on additional borrowals will cost company ,)) basis points more than on their current borrowal on secured debentures. 5ou are re#uired to advise the company on the probable price of the e#uity share if (c) (d) the additional investment were to be raised by way of loansL or the additional investment were to be raised by way of e#uity.

OR A newly established company manufacturing two products furnishes the %ost +heets as under : 6roducts $s.;unit & " Direct aterials /)
,)

')
0(

Direct labour

Jariable Everheads +elling 6rice

0/ 0))

. ()

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9ixed overheads excluding ban! interest amount to $s.-2))2))) p.a. spread out evenly throughout the year. +ales forecast is as under : 6roduct & (units) " (units) Zuly /2')) '20)) /2-)) '2,)) August ,2-)) 0.*)) +ept. /2))) '2))) Ect. Hov.:3* /2()) 023))

6roduction : .(4 of each month:s sales will be produced in the month of sale and '(4 in the previous month. +ales 6attern : &: ??Ene?third of sales will be on cash basis on which a cash discount of '4 is allowed.
??Ene?third will be on documents against payment basis.

8he documents will be discounted by the ban! in the month of sales itself. ??"alance of one?third will be on documents against acceptance basis. 8he payment under this scheme will be received in the third month. 9or e.g. for sales made in +eptember2 payment will be received in Hovember. ": *)4 of the sales will be against cash to be received in the month of sales and the balance ')4 will be received next following month.

Direct aterials : ()4 of the direct materials re#uired for each month:s production will be purchased in the previous month and the balance in the month of production itself. 8he payment will be made in the month next following the purchase. Direct Cages : *)4 of the direct wages will be paid in the month of use of direct labour for production and the balance in the next following month. Jariable Everheads : ()4 to be paid in the month of incurrence and the balance in the next following month. 9ixed Everheads : /)4 will be paid in the month of incurrence and the other /)4 in the next following month. 8he balance of ')4 represents depreciation. 8he bill discounting charges payable to the "an! in the month in which the bills are discounted amount to () paise per rs.0)) of bills discounted. A cash balance of $s.02))2))) will be maintained on 0st Zuly2 033*.
6repare a cash budget month wise for Zuly2 August and +eptember2 033*.

A#s$er %F!rs A, er#& !6e' %&' 9orecasting is the first stage in the financial planning process. 8his refers to the formal process of predicting future events which will effect significantly the functioning of an enterprise. 9inancial forecasting2 therefore2 implies the techni#ue of determining in advance the re#uirements and utilisation of funds for a future period. It is a techni#ue of systematic presentations of data in the form of financial statements2 ratios etc. Chile forecasting refers to finding the most profitable course of events or at best a range of probabilities2 planning is deciding what one will do about it. 6lanning deals with the futurity of present decisions in terms of (a) setting goals and developing strategies to achieve them and (b) translating strategies into detailed operational programmes and assuring that plans are carried out. 8he former one can be called as strategic planning2 the other is termed as programming.

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9inancial forecasting aims at pre A determining the demand for funds and the avenues wherein the funds are to be utilised. 8hus2 a systematic pro7ection of financial data is made in the form of pro7ected financial statements with the help of fund flow statements2 ratio analysis etc. 8hese pro7ections are based on past record of the organisation with a view to predict the future financial performance. 9orecasting generates information which is utilised by the management of an enterprise2 for ma!ing proper decisions and for 7udging the financial efficiency of the funds and pro7ecting a scale of standards to be followed in the future course. Another ob7ective of financial forecasting is to use it as control device. +tandards of financial performance of an enterprise could be laid down through financial forecasting for evaluating the results and assuring its growth. Eptimum utilisation of funds can be achieved through forecasting. A pre A testing of financial feasibility of implementation of production prospects or programmes can also be made by rupees forecasting. 8hrough use of computers2 financial forecasting has scaled new heights. 9inancial forecasting has utility for a business organisation because (viii) It generates useful information for decision ma!ing. (ix) (x) (xi) It provides significant information for successful financial planning. It facilitates the organisation to plan its growth and its financial needs. It functions as a control device by providing a standard of financial performance for the future.

(xii) It enables the organisation to ma!e optimum utilisation of available funds; resources. (xiii) It ma!es the organisation to adopt appropriate financial policies. (xiv) It updates the financial plans periodically and ma!e them relevant according to changing circumstances. 9inancial forecasting uses the followings tools : (a) Day:s sales method (b) 6ercentage of sales method (c) +imple regression method (d) ultiple regression method. 9inancial forecasting helps an organisation in the preparation of statements li!e proforma income statement2 proforma balance sheet2 fund flows statement2 cash budget etc. as tools for long and medium term financial planning. %0' 2"r9!#/ N" e : Present earnings/ share : 6rofit before taxes &ess : 8axes at ,(4 6rofit after tax Ho. of e#uity shares $s. 0)23-2*.( E.6.+. > ????????????????????? 02))2))) E.6.+. > $s. 0).3. ar!et price $s. 0)3..) $s. 0)3..) Oence2 6;E > ??????????????????? > 0) $s. 0).3. $s. 0-2*.2()) (23)2-'( 0)23-2*.( 02))2)))

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%&'

Pr"0&0,e +r!*eE s(&re, !- (e &33! !"#&, !#6es .e# $ere " 0e r&!se3 04 $&4 "- ,"&#s 6resent capital employed :
$s.

E#uity Debenture (&ong term) $evenue reserves 6re A Interest and pre A tax profits given $s. 0* la!hs $s. 0* la!hs x 0)) $ate of return E"I8 > ?????????????????????????????? > (-.'(4 $s. ,' la!hs

0)2))2))) 0)2))2))) 0'2))2)))

$s. ,'2))2)))

Debt e#uity ratio2 if $s. 0) la!hs (additional investment) were to be borrowed (Debt $s. ') la!hs and e#uity $s. '' la!hs)2 will be $s. ') la!hs x 0)) ?????????????????????????? > /..-)4 $s. /' la!hs +ince2 the debt e#uity ratio will not exceed -)4 6;E will remain same. If $s. 0) la!hs is to be borrowed2 the earning will be as under : $s. $eturn of (-.'(4 on $s. /' la!hs &ess : Interest at 0(4 on existing $s. 0) la!hs debenture 02()2))) Interest on fresh borrowed amount of $s. 0) la!hs at 0*402*)2))) 6rofit after interest before tax &ess : 8ax at ,(4 6rofit after tax Ho. of e#uity shares $s. 0,2'020'( E.6.+. > ????????????????????????? > $s. 0,.'0 02))2))) 6robable price of e#uity share > $s. 0,.'0 x 0) ($efer to wor!ing note) > $s. 0,'.0) %0' Pr"0&0,e +r!*eE s(&re, !- &33! !"#&, !#6es .e# $ere " 0e r&!se3 04 $&4 "- eBu! 4. If $s. 0) la!hs were to be raised by way of e#uity shares to be raised at mar!et rates. 8he existing mar!et price of $s. 0)3..) may come down a little and may possible settle at $s. 0)). hence2 new e#uity shares to be raised will be $s. 0)2))2))); $s. 0)) > 0)2))) shares If $s. 0) la!hs is to be raised by way of e#uity shares2 the earning will be as under :? 6rofit before interest and tax $s. ',2-'2()) $s. ',2-'2()) ,2,)2))) ')2,'2()) .2002,.( 0,2'020'( 02))2)))

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&ess : Interest on debentures 6rofit after interest before tax &ess : 8ax G ,(4 6rofit after tax Ho. of e#uity shares $s. 0/2,*20'( E.6.+. > ???????????????????????? > $s. 0,.). 020)2))) 6robable price of e#uity share > $s. 0,.). x 0) ($efer to wor!ing note) > $s. 0,)..)

02()2))) ''20'2()) .2./2,.( 0/2,*20'( 020)2)))

8he suggested solution will be to issue fresh debentures to finance expansion. A#s$er %Se*"#3 A, er#& !6e' C&s( )u3/e -"r Fu,4, Au/us &#3 Se+ e.0er, 199@ 6articulars (") Re*e!+ s +ales
($efer to wor!ing note 0)

Zuly:3* $s. ,2-02'))

Aug. :3* $s. /20-2-))

+ept.:3* $s. /2.'2-))

(")

P&4.e# s Direct aterials ($efer to wor!ing note ') Direct Cages ($efer to wor!ing note ,) Jariable overheads ($efer to wor!ing note /) 9ixed overheads ($efer to wor!ing note () "ill Discounting charges ($efer to wor!ing note -)

02,,2.() 02,-2*.( /-2*0, /)2))) .)) <<<<<<< ,2(*20,* ,2)-' 02))2))) 02),2)-'

'20-2'() 02-'2.() .(2-** /)2))) .-. <<<<<<< /23(2/(( (.*2*(() 02),2)-' '/2').

'2)02'() 02/,2-'( .)2/,* /)2))) -)) <<<<<<<< /2((230, 0-2-*. '/2'). /)2*3/

(%) (D) (E)

Sur+,usE 7e-!*! "- C&s( %A 5 )' Add : Epening "alance %losing "alance (% = D)

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2"r9!#/ N" es : 6articulars

'. +ales :

Zune:3* ??? ???

Zuly:3* /2')2))) 02)(2))) <<<<<<<< (2'(2)))

Aug.2:3* /2-)2))) 020(2))) <<<<<<<< (2.(2)))

+ept.:3* ,2-)2))) 3)2))) <<<<<<<< /2()2)))

Ect.:3* ??? ???

& "

%ash inflow from sales : & 0;, cash less discount ??? 02,.2')) 02()2'-. 020.2-)) (0;, of $s. (0;, of $s. (0;, of $s. /2')2))) x 3*4)/2-)2))) x 3*4),2-)2))) x 3*4) 02/)2))) (0;, of $s. /2')2)))) ??? */2))) (*)4 of $s. 02)(2)))) ??? <<<<<<<< ,2-02')) 02(,2,,, (0;, of $s. /2-)2)))) ??? 3'2))) (*)4 of $s. 020(2)))) '02))) (')4 of 02)(2)))) <<<<<<<< /20-2-)) 02')2))) (0;, of $s. ,2-)2)))) 02/)2))) .'2))) (*)4 of $s. 3)2)))) ',2))) (')4 of 020(2)))) <<<<<<<< /2.'2-)) ???

0;, D;6 discounts

???

???

0;, DA collection " *)4 %ash

??? ???

??? ???

')4 collection

???

???

8otal '. 6roduction (Vty) & .(4 ???

,20() (.(4 of /2')) units)

,2/() (.(4 of /2-)) units) 3)) ('(4 of ,2-)) units) <<<<<<<< /2,() 02.'( (.(4 of '2,)) units) /() ('(4 of 02*)) units) <<<<<<< '20.(

'2.)) (.(4 of ,2-)) units) 02))) ('(4 of /2))) units) <<<<<<<< ,2.)) 02,() (.(4 of 02*)) units) ()) ('(4 of '2))) units) <<<<<<< 02*()

,2))) (.(4 of /2))) units) 020'( ('(4 of /2()) units) <<<<<< /20'( 02()) (.(4 of '2))) units) /.( ('(4 of 023)) units) <<<<<<< 023.(

'(4

02)() 020() ('(4 of ('(4 of /2')) units) /2-)) units) <<<<<<<< <<<<<<< 02)() /2,)) ??? 02(.( (.(4 of '20)) units)

"

.(4

'(4

('( (.( ('(4 of ('(4 of '20)) units) '2,)) units) <<<<<< <<<<< ('( '20()

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Direct material re#uirements : ($s.) & /'2))) 02.'2))) (02)() units (/2,)) units x $s. /)) x $s. /)) 0)2()) (('( units x $s. ')) <<<<<<<< ('2()) /,2))) ('20() units x $s. ')) <<<<<<<< '20(2))) 02./2))) (/2,() units x $s. /)) /,2()) ('20.( units x $s. ')) <<<<<<<<< '20.2()) 02/*2))) (,2.)) units x $s. /)) ,.2))) (02*() units x $s. ')) <<<<<<<<< 02*(2))) 3'2()) (()4 of $s. 02*(2)))) 02)'2'() (()4 of $s. '2)/2())) <<<<<<<<<< 023/2.() '2)02'() 02-(2))) (/20'( units x $s. /)) ,32()) (023.( units x $s. ')) <<<<<<<< '2)/2()) ???

"

6urchases : ($s.) '-2'() 02).2()) 02)*2.() (()4 of (()4 of (()4 of $s. ('2())) $s. '20(2))) $s. '20.2())) 02).2()) 02)*2.() 3'2()) (()4 of (()4 of (()4 of $s. '20(2))))$s. '20.2()))($s. 02*(2)))) <<<<<<<< <<<<<<<<< <<<<<<<<< 02,,2.() '20-2'() '2)02'() ???<<<<<< 02,,2.() '20-2'()

???

6ayment ($s) ,. Direct wages & "

,02()) 02'32))) 02,)2()) 02002))) (02)() x $s. ,))(/2,)) x $s. ,))(/2,() x $s. ,))(,2.)) x $s.,)) .2*.( ,'2'() ,'2-'( '.2.() (('( x $s.0()('20() x $s.0()('20.( x $s.0()(02*() x $s0() <<<<<<<< <<<<<<<< <<<<<<<< <<<<<<<<< ,32,.( 02-02'() 02-,20'( 02,*2.() ??? .2*.( ,'2'() (')4 of (')4 of $s. ,32,.() $s. 02-02'()) 02'32))) 02,)2()) (*)4 of (*)4 of $s. 02-02'()) $s. 02-,20'() <<<<<<<< <<<<<<<< 02,-2*.( 02-'2.() ,'2-'( (')4 of $s. 02-,20'() 02002))) (*)4 of $s. 02,*2.()) <<<<<<<<< 02/,2-'(

??? ???

6ayment ')4 &

???

*)4 "

<<<

???

/.

Jariable overheads & 0/2.)) -)2')) -)23)) (02*)) (02)() x $s.0/)(/2,)) x $s.0/)(/2,() x$s.0/)(,2.)) x $s0/) " ,2-.( 0(2)() 0(2''( (('( x $s..)('20() x $s..)('20.( x $s..) <<<<<<<<< <<<<<<<<< <<<<<<<<< 0*2,.( .(2'() .-20'( 0'23() (02*() x $s..) <<<<<<<<<< -/2.()

??? ???

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Jariable overheads payment ($s.) ()4 ????

,.2-'( (()4 of $s. .(2'()) 320** (()4 of $s. 0*2,.() <<<<<<<< /-2*0, /)2)))

,*2)-, (()4 of $s. .-20'() ,.2-'( (()4 of $s. .(2'()) <<<<<<<<<< .(2-** /)2)))

,'2,.( (()4 of $s.-/2.()) ,*2)-, (()4 of $s. .-20'() <<<<<< .)2/,* /)2)))

???

()4

????

???

(. -.

9ixed overheads payment "ill discounting charges

???

"ill discounted ???? 02/)2))) ($efer to wor!ing note 0 above) %harges G () paise per $s. 0)) .))

02(,2,,, .-.

02')2))) -))

??? ????

Ques !"# <. Crite short notes on any four of the following : (f) (g) (h) (i) (7) Calter:s approach to Dividend 6olicy. Different !inds of float with reference to management of %ash. Appraisal of pro7ects under inflationary conditions. Euro convertible bonds. 9unctions of 9inance manager.

Answer
%&' 2&, erDs &++r"&*( " 7!6!3e#3 P",!*4 : Calter:s approach to Dividend policy supports the doctrine that the investment policy of a firm cannot be separated from its dividend policy and both are according to him interlin!ed. Oe argues that in the long run2 share prices reflect only the present value of expected dividends. $etention influence stoc! prices only through their effect on future dividends. 8he relationship between dividend and share price on the basis of Calter:s formula is shown below : (E A D) D = $a ?????????????? Jc > <<<<<<<<<<$c<<<< $c Chere2 Jc $a $c > > > ar!et value of ordinary shares of the company. $eturn on internal retention2 i.e.2 the rate company earns on retained profits.

%apitalisation rate2 i.e.2 the rate expected by investors by was of return from particular category of shares. E > Earning per share. D > Dividend per share. 6rof. Calter:s formula is based on the relationship between the firm:s (i) return on investment or internal rate of return ($a) and (ii) cost of %apital or re#uired rate of return (i.e.2 $c).

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8he optimum dividend policy of a firm is determined by the relationship of $a and $c. If $ a]$c i.e.2 the firm can earn higher return than what the shareholders can earn on their investments2 the firm should retain the earning. +uch firms are termed as growth firms2 and in their case the optimum dividend policy would be to plough bac! the earnings. If $a^$c i.e. the firm does not have profitable investment opportunities2 the optimum dividend policy would be to distributed the entire earnings as dividend. In case of firms2 where $a > $c2 it does not matter whether the firm retains or distribute its earning. ssumptions : Calter:s dividend policy is based on the following assumptions : (i) 8he firm does the entire financing through retained earnings. sources of funds such as debt or new e#uity capital. It does not use external

(v) 8he firm $c and $a remain constant with additional investment. (vi) 8here is no change in the !ey variables2 namely2 beginning E2 D. (vii) 8he firm as a very long life. %0' 7!--ere# 9!#3s "- -,"& $! ( re-ere#*e " M&#&/e.e# "- C&s( : 8he term float is used to refer to the periods that affect cash as it moves through the different stages of the collection process. 9our !inds of float can be identified : (i) !ill "lat : An invoice is the formal document that a seller prepares and sends to the purchaser as the payment re#uest for goods sold or services provided. 8he time between the sale and the mailing of the invoice is the billing float.

(ii) #ail "loat : 8his is the time when a che#ue is being processed by post office2 messenger service or other means of delivery. (iii) Che$ue processing float : 8his is the time re#uired for the seller to sort2 record and deposit the che#ue after it has been received by the company. (iv) !an% Processing flat : 8his is the time from the deposit of the che#ue to the crediting of funds in the seller account. %*' &++r&!s&, "- +r"Ge* s u#3er !#-,& !"#&r4 *"#3! !"#s : 8he timing of pro7ect appraisal is significant from the point of view of appraisers. A pro7ect under normal conditions is viewed from different angles2 viQ2 technical feasibility2 commercial and financial viability and economic and social considerations and managerial aspects. Oowever2 normal conditions seldom exist and a pro7ect is sub7ected to inflationary pressures from time to time because the pro7ect has to be implemented over a long time frame. During such a period2 it will be difficult to predict when the trade cycle sets in and the up A turn the economy is generated. "esides this2 the siQe and magnitude of the pro7ect also varies from organisation to organisation. In such a situation2 inflation is bound to affect the pro7ect appraisal and implementation process. In a developing country li!e ours2 inflation has become a part of life and has been steadily increasing over a period of years. 8herefore2 it is always prudent to ma!e ade#uate provision for a probable escalation in the pro7ect costs as a cushion to inflationary 7er!s. It is well !nown that during a period of inflation2 the pro7ect cost is bound to escalate on all heads viQ. &abours2 raw materials2 cost of fixed assets2 building materials2 remunerations of technician and managerial personnel etc. "esides2 such conditions erode the purchasing power of the

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consumers and are li!ely to affect the pattern of demand. 8hus2 not only the costs of production but also the pro7ected statements of profitability2 cash flows etc.2 will get seriously affected. 9inancial institutions may revise their lending rates of interest during such inflationary times. In these circumstances2 pro7ect appraisal has to be done generally !eeping in view the following guidelines which are adopted normally by governmental agencies2 ban!s and financial institutions. (a) (b) It is always advisable to ma!e provisions for cost escalation for all heads !eeping in mind the rate of inflation2 li!ely delay in completion of pro7ect etc. 8he various sources of finance should be scrutinised carefully with response to possible revision in the rates of interest by lenders which will affect the cost of borrowing2 the collateral securities offered2 margins re#uired etc. Ad7ustments are to be made in the profitability and cash flow pro7ections to ta!e care of the inflationary pressure affecting future pro7ections. It is also advisable to critically examine the financial viability of the pro7ect at the revised rates and reasons the economic 7ustification of the pro7ect. 8he appropriate measure for this is the economic rate of return for the pro7ect which will e#uate the present cost of capital expenditure to net cash flows over the pro7ect life. 8he rate of return should be acceptable which also accommodates the rate of inflation. In an inflationary situation2 pro7ects having early pay bac! periods should be preferred because pro7ects with a longer pay bac! periods may tend to be ris!y.

(c) (d)

(e)

"ecause inflation can have ma7or effect on business. It is critically important and must be recognised. R8he most effective way to deal with inflation is to build into each cash flow element2 using the best available information about how each element will be affected. +ince one cannot estimate future rates of inflation2 errors are bound to be made. 8herefore2 inflation adds to uncertainty2 ris! ness and complexity to capital budgeting fortunately2 computers and spread sheet models are available to help inflation analysis. 8hus2 in practice2 the mechanics of inflation ad7ustments are not difficult. %3' Eur" C"#6er !0,e 0"#3 : Euro %onvertible bonds are #uasi A debt securities (unsecured) which can be converted into depository receipts or local shares. E%"s offer the investor an option to convert the bond into e#uity at a fixed price after the minimum loc! in period. 8he price of e#uity shares at the time of conversion will have a premium element. 8he bonds carry a fixed rate of interest. 8hese are bearer securities and generally the issue of such bonds may carry two options viQ.2 call option and put option. A call option allows the company to force conversion if the mar!et price of the shares exceed a particular percentage of the conversion price. A put option allow the investors to get his money bac! before maturity. In the case of E%"s2 the payment of interest and the redemption of the bonds will be made by the issuer company in N+ dollars. E%"s issues are listed at &ondon or &uxemburg stoc! exchanges. Indian companies which have opted E%"s issue are Zindal +trips2 $eliance2 Essar 1u7arat2 +terlite etc. Indian companies are increasingly loo!ing at Euro A %onvertible bond in place of 1lobal Depository $eceipts because 1D$s are falling into dis ? favour among international fund managers. An issuing company desirous of raising the E%"s is re#uired to obtain prior permission of the Department of Economic Affairs2 inistry of 9inance2 1overnment of India2 %ompanies having , years of good trac! record will only be permitted to raise funds. 8his condition is not applicable in the case of pro7ects in infrastructure sector. 8he proceeds of E%"s would be permitted only for following purposes : (v) Import of capital goods. (vi) $etiring foreign currency debts.

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(vii) %apitalising Indian 7oint venture abroad. (viii) '(4 of total proceedings can be used for wor!ing capital and general corporate restructuring. 8he impact of such issues has been to procure for the issuing companies finances at very competitive rates of interest. 9or the country a higher debt means a forex outgo in terms of interest. %e' Fu#* !"#s "- F!#&#*e M&#&/er : 8he 9inance manager:s main ob7ective to manage funds in such a way so as to ensure their optimum utilisation and their procurement in a manner that the ris!2 cost and control considerations are properly balanced in a given situation. 8o achieve these ob7ectives the finance anager perform the following functions : (0) Estimating the re$uirement of "unds : "oth for long A term purposes i.e. investment in fixed assets and for short term i.e. for wor!ing capital. 9orecasting the re#uirements of funds involves the use of techni#ues of budgetary control and long A range planning. &ecision regarding Capital 'tructure : Ence the re#uirement of funds has been estimated2 a decision regarding various sources from which these funds would be raised has to be ta!en. A proper balance has to be made between the loan funds and own funds. Oe has to ensure that he raises sufficient long term funds to finance fixed assets and other long term investments and to provide for the needs of wor!ing capital. (nvestment &ecision : 8he investment of funds2 in a pro7ect has to be made after careful assessment of the various pro7ects through capital budgeting. Assets management policies are to be laid down regarding various items of current assets. 9or e.g. receivable in coordination with sales manager2 inventory in coordination with production manager. &ividend &ecision : 8he finance manager is concerned with the decision as to how much to retain and what portion to pay as dividend depending on the company:s policy. 8rend of earnings2 trend of share mar!et prices2 re#uirement of funds for future growth2 cash flow situation etc.2 are also to be considered. Evaluating financial performance : A finance manager has to constantly review the financial performance of the various units of organisation generally in terms of $.E.I. +uch a review helps the management in seeing how the funds have been utilised in various divisions and what can be done to improve it. "inancial negotiation : 8he finance manager plays a very important role in carrying out negotiations with the financial institutions2 ban!s and public depositors for raising of funds on favourable terms. Cash #anagement : 8he finance manager lays down the cash management and cash disbursement policies with a view to supply ade#uate funds to all units of organisation and to ensure that there is no excessive cash. )eeping touch with stoc% exchange :9inance manager is re#uired to analyse ma7or trends in stoc! mar!et and their impact on the price of the company share.

(')

(,)

(/)

(()

(-)

(.)

(*)

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F!#&, eA&.!#& !"# N"6e.0er, 199@ Gr.-I

P&+er 2 : M&#&/e.e# A**"u# !#/ & F!#&#*!&, A#&,4s!s Ques !"# 1. (a) . Annual cost saving Nseful life I.$.$. 6rofitability Index (6I) H6J %ost of capital %ost of pro7ect 6aybac! +alvage value 6ro7ect $s./)2))) / years 0(4 0.)-/ F F F F ) 9ollowing are the data on a capital pro7ect being evaluated by the management of K &td.

9ind the missing values considering the following table of discount factor only : . Discount factor 0 year ' years , years / years (b) . 6ro7ect 0 ' , / ( Amount $s. ,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2))) 6rofitability Index 0.'' ).3( 0.') 0.0* 0.') 0.)( 0(4 ).*-3 )..().-(* ).(.' '.*(( 0/4 ).*.. )..-3 ).-.( ).(3' '.30, 0,4 ).**( )..*, ).-3, ).-0, '.3./ 0'4 ).*3, )..3. )..0' ).-,,.),* 8he following

+ &td. has $s.0)2))2))) allocated for capital budgeting purposes. proposals and associated profitability indexes have been determined :

Chich of the above investments should be underta!en F Assume that pro7ects are indivisible and there is no alternative use of the money allocated for capital budgeting. A#s$er %&' C"s "- Pr"Ge* M At 0(4 I.$.$.2 the sum total of cash inflows > cost of the pro7ect i.e. Initial cash outlay 1iven : Annual cost saving $s. /)2))) Nseful life / years I.$.$. 0(4

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How2 considering the discount factor table G 0(4 cumulative present value of cash inflows for / years is '.*((. 8herefore2 8otal of cash inflows for / years for 6ro7ect Oence2 cost of the pro7ect is P&40&*9 +er!"3 "- (e +r"Ge* M %ost of the pro7ect 6aybac! period > ?????????????????????????????? Annual cost saving $s. 020/2')) > ???????????????????????????? /)2))) > '.*(( or ' years 00 months approximately C"s "- *&+! &, If the profitability index (6I) is 02 cash inflows and outflows would be e#ual. In this case2 (6I) is 0.)-/. 8herefore2 cash inflows would be more by ).-/ than outflow. Discounted cash inflows 6rofitability Index (6I) > ??????????????????????????????????????????? %ost of the pro7ect Er2 0.)-/ Discounted cash inflows > ??????????????????????????????????? $s. 020/2')) is ($s. /)2))) x '.*(() > $s. 020/2')) > $s. 020/2'))

Er2 0.)-/ x $s. 020/2')) > $s. 02'02()3 Oence2 Discounted cash inflows > $s. 02'02()3 +ince2 Annual cost saving is $s. /)2))). hence2 cumulative discount factor for / years 02'02()3 > $s.????????????????? /)2))) > ,.),..'( or ,.),* %onsidering the discount factor table at discount rate of 0'42 the cumulative discount factor for / years is ,.),*. Oence2 the cost of capital is 0'4 Ne +rese# 6&,ue "- (e +r"Ge* . H.6.J. > > %0' 6ro7ect 8otal present values of cash inflows A %ost of the pro7ect $s. 02'02()3 A $s. 020/2')) > $s. .2,)3

S & e.e# s("$!#/ r&#9!#/ "- +r"Ge* s "# (e 0&s!s "- Pr"-! &0!,! 4 I#3eA Amount $s. 6.I. $an!

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0 ' , / ( -

,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2)))

0.'' ).3( 0.') 0.0* 0.') 0.)(

0 ( ' , ' /

Assuming that pro7ects are indivisible and there is no alternative use of the money allocation for capital budgeting on the basis of 6.I.2 the + &td. is advised to underta!e investment in pro7ects 02 , M (. Oowever2 among the alternative pro7ects the allocation should be made to the pro7ects which adds the most to the shareholders wealth. 8he H6J method2 by its definition2 will always select such pro7ects. S & e.e# s("$!#/ NPC "- (e +r"Ge* s 6ro7ect (i) 0 ' , / ( Amount ($s) (ii) ,2))2))) 02()2))) ,2()2))) /2()2))) '2))2))) /2))2))) 6.I. (iii) 0.'' ).3( 0.') 0.0* 0.') 0.)( %ash inflows of 6ro7ect ($s) (iv) > @(ii)x(iii)B ,2--2))) 02/'2()) /2')2))) (2,02))) '2/)2))) /2')2))) H.6.J. of pro7ect ($s) (v) > @(iv) A (ii)B --2))) (?) .2()) .)2))) *02))) /)2))) ')2)))

8he allocation of funds to the pro7ects 02 , and ( (as selected above on the basis of 6.I) will give H.6J. Ef $s. 02.-2))) and $s. 02()2))) will remain unspent. Oowever2 the H.6.J. of the pro7ects ,2 / and ( is $s. 02302))) which is more than the H.6.J. of pro7ects 02 , and (. further2 by underta!ing pro7ects ,2 / and ( no money will remain unspent. 8herefore2 +. &td. is advised to underta!e investments in pro7ects ,2 / and (. 1111111111111

Ques !"# 2. (a)

K &td. an Indian company has an export exposure of 0) million (0)) lacs) yen2 value +eptember end. 5en is not direct #uoted against $upee. 8he current spot rates are N+D;IH$ > /0..3 and N+DFZ65 > 0'3..(

It is estimated that 5en will depreciate to 0// level and $upee to depreciate against dollar to /,. 9orward rate for +eptember2 033* N+D;5en > 0,..,( and N+D;IH$ > /'.*3

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5ou are re#uired : (i) to calculate the expected loss if hedging is not done. Oow the position will change with company ta!ing forward cover F (iii) (b) if the spot rate on ,)th +eptember 033* was eventually N+D;5en > 0,..*( and N+D;IH$ > /'..*2 is the decision to ta!e forward cover 7ustified F 6 %o. has to ma!e payment of $s.' million ($s.') lacs) on 0- th April2 033*. It has a surplus money today i.e. 0(th Zanuary2 033* and the company has decided to invest in %ertificate of Deposit (%D:s) of a leading nationalised ban! at *.))4 p.a. Chat money is re#uired to be invested now F 8a!e year as ,-( days. Describe the interface of 9inancial 6olicy with %orporate +trategic anagement.

(c)

Answer %&' %!' C&,*u,& !"# "- (e eA+e* e3 ,"ss !- (e3/!#/ !s #" 3"#e. Exposure of (0)) la!hs) yen at current spot rate of $s. ,'.'0 per 0)) yen ($efer to Cor!ing note 0) Exposure of (0)) la!hs) yen at estimated rate of $s. '3.*- per yen ($efer to wor!ing note ') Expected loss without forward cover C&,*u,& !"# "- eA+"sure !- (e C".+&#4 &9es -"r$&r3 *"6er Exposure of (0)) la!hs) yen at forward rate of $s. ,0.', per 0)) year ($efer to wor!ing note ,) If the company ta!es forwards cover the company loss is ($s. ,02',2))) A $s. ,'2'02)))) ,02',2))) 3*2))) $s. ,'2'02))) '32*-2))) <<<<<<<<< '2,(2)))

%!!'

C&,*u,& !"# "- eA+"sure & (e s+" r& e "- 8? ( Se+ e.0er, 199@ Exposure of (0)) la!hs) yen at the spot rate of $s. ,0.), per 0)) yen ($efer to wor!ing note /) ,02),2)))

Oence without forward cover the loss was $s. 020*2))) ($s. ,02),2))) A $s. ,'2'02)))). Oence2 decision of the company to ta!e forward cover is 7ustified. 2"r9!#/ N" es : ,. +pot (current) N+D; IH$ > /0..3 and N+D; Z65 > 0'3..( 8herefore2 spot (current) Z65; IH$ > /0..3; 0'3..( > $s. ).,''0 per yen or2 $s. ,'.'0 per 0)) yen /. Expected N+D; IH$ > /, and N+D; Z65 > 0// 8herefore2 Expected Z56; IH$ > /,;0//

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> $s. ).,0', or2 $s. ,0.), per 0)) yen. %0' oney re#uired to be invested today i.e. 0( th Zanuary2 033* to ma!e payment of $s. ' million ($s. ') la!hs) on 0-th April2 033*. 9or ma!ing payment of $s. ' million ($s. ') la!hs) on 0- th April2 033* the surplus money to be invested today i.e. 0(th Zanuary2 033* in %ertificate of Deposits (%Ds) for 30 days G *4 p.a. is ')2))2))) $s. ?????????????????? ($efer to wor!ing note) 02)0233/(' > $s. 032-)2**3.-or2 $s. 032-)2*3) (rounded off) 2"r9!#/ N" e : Interest on $e. 0 at *4 p.a. on %ertificate of Deposit (%D:s) of A leading nationalised ban! 30 Interest on $e. 0 for 30 days $s. ).)* x ?????? ,-( 8he amount to be received for $s. 0 invested now after 30 days %C' $s. ).)* $s. ).)033/(' $s. 0.)033/('

8he two important functions of the finance manager are : (i) allocation of funds (viQ. investment decision) and (ii) generation of funds (viQ. financing decision). 8he theory of finance ma!es two crucial assumptions to provide guidance to the finance manager in ma!ing these decisions. 8hese are : ,. /. 8he ob7ective of the firm is to maximise the wealth of shareholders 8he capital mar!ets are efficient.

8he corporate finance theory implies that : (. -. .. *. Ewners have the primary interest in the firm 8he current value of share is the measure of shareholders: wealth. 8he firm should accept only those investments with generate positive net face values. 8he firm capital structure and dividend decisions are irrelevant as they are solely guider by efficient capital mar!ets and management has no control over them.

Oowever2 the theory of finance has undergone fundamental changes over the past. It is felt that finance theory is not complete and meaningful without its lin!age with the strategic management. +trategic management establishes an efficient and effective match between the firm:s competence and opportunities with the ris! created by the environment changes. I# er-&*e "- F!#&#*!&, P",!*4 &#3 S r& e/!* M&#&/e.e# : (0) 9inancial policy re#uire the resource deployments such as materials2 labour etc. +trategic management considers all mar!ets such as material2 labour and capital as imperfect and changing. +trategies are developed to manage the business firm in uncertain and imperfect mar!et conditions and environment. 9or forecasting2 planning and formulation of financial

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policies2 for generation and allocation of resources the finance manager is re#uired to analyse changing mar!et conditions and environment. (') 8he strategy focuses as to how to compete in a particular product A mar!et segment or industry. 9or framing strategy it is considered that the shareholders are not the only interested group in the firm. 8here are many other influential constituent such as lenders2 employees2 customers2 suppliers etc. the success of a company depends on its ability to service in the product A mar!et environment which is possible only when the company consider to maintain and improve its product A mar!et positions. +uch consideration have important implications for framing corporate finance policies. (,) 8he strategic management is multi A dimensional. It focuses on growth2 profitability and flow of funds rather than only on the maximisation of mar!et value of shares. 8his focus helps the management to create enough corporate wealth for achieving mar!et dominance and the ultimate successful survival of the company. it re#uires to frame financial policy !eeping in view the interest of other parties such as government2 employees2 society etc. and not only of shareholders. Oence2 the financial policy of a company is closely lin!ed with its corporate strategy. 8he company strategy establishes an efficient and effective match between its competences and opportunities and environmental ris!s. 9inancial policies of a company should be developed in the context of its corporate strategy2 within the overall framewor! of the firm:s strategy2 there should be consistency between financial policies A investment2 debt and dividend. 9or example2 a company can sustain a high growth strategy only when investment pro7ects generate high profits and it follows a policy of low payout and high debt. Ques !"# 8. 8he following is the "alance sheet as at ,0st +hare %apital : 0)2))) e#uity shares of $s.0)) each fully paid up '(2))) 004 cum preference shares of $s.0) each fully paid up $eserves and surplus +ecured loans Nnsecured loans 8rade creditors Eutstanding expenses $epresented by 9ixed assets %urrent assets Advances and deposits arch 033* of + %o. &td. $s. 0)2))2))) '2()2))) $s. 0'2()2))) '(2))2))) ')2))2))) 0'2))2))) 0*2))2))) .2()2))) 3(2))2)))

((2))2))) ,.2))2))) ,2))2)))

3(2))2)))

8he company plans to manufacture a new product in line with its current production2 the capital cost of which is estimated to be $s.'( la!hs. 8he company desires to finance the new pro7ect to the extent of rs.0- la!hs by issue of e#uity shares at a premium of $s.0)) per share and the balance to be raised from internal sources. Additional information made available to you are : (h) $ate of dividends declared in the five years i.e. year ended ,0 st arch2 033*2 ,0st arch 033.2 ,0st arch 033-2 ,0st arch 033( and ,0st arch 033/ were '/42 '/42 ')42 ')4 and 0*4 respectively.

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(i) (7) (!) (l) (m) (n) .

Hormal earning capacity (net of tax) of the business is 0)4. 8urnover in the last three years was $s.*) la!hs (,0;,;3*)2 $s.-) la!hs (,0;,;3.) and $s.() la!hs (,0;,;3-). Anticipated additional sales from the new pro7ect $s.,) la!hs annually. Het profit before tax from the existing business which was 0)4 in the last three years is expected to increase to 0'4 on account of new product sales. Income?tax rate is ,(4 8he trend of mar!et price of the e#uity share of the company2 #uoted on the +toc! Exchange was : 5ear 033.?3* 033-?3. 033(?3Oigh $s. ,)) '() '/) &ow $s. 03) 0*) 0*)

5ou are re#uired to examine whether the company:s proposal is 7ustified. Do you have any suggestions to offer in this regard F All wor!ings must form part of your answer. Answer (a) Earning per share for the year ended ,0st 8urnover Het 6rofit (0)4 of $s. *)2))2)))) &ess : Income tax G ,(4 6rofit after tax &ess : 6reference dividend (004 of $s. '2()2)))) 6rofit available for e#uity shareholders : (A) Humber of e#uity shares : (") Earning per share : (A); (") (b) Expected earning per share after the manufacture of new product (Hew pro7ect financed to the extent of $s. 0- la!hs by issue of e#uity shares) Anticipated turnover ($efer to wor!ing note 0) Het 6rofit (0'4 of $s. 020)2))2)))) &ess : Income tax G ,(4 6rofit after tax &ess : 6reference dividend (004 of $s. '2()2)))) 6rofit available for e#uity shareholders : (A) Humber of e#uity shares : (") $s. 020)2))2))) 0,2')2))) /2-'2))) <<<<<<<< *2(*2))) '.2()) <<<<<<< *2,)2()) 0*2))) arch2 033* of + co. &td. $s. *)2))2))) *2))2))) '2*)2))) <<<<<<<<< (2')2))) '.2()) <<<<<<<< /23'2()) 0)2))) $s. /3.'(

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($efer to wor!ing note ') (Expected earning per share : (A); (") (c) 6rice earning ratio for the year ended as on ,0st Average price per share (,)) = 03)); ' : (A) Earning per share : (") ($efer to (a) above) 6rice earning ratio : (A); (") arch2 033* of + %o. &td. $s. '/( $s. /3.'( /.3./ or ( times (rounded off) Zustification : En the basis of (a)2 (b) and (c) above. ,. 8here will be decline in mar!et value of share after the new pro7ect financed by issue of e#uity shares and internal sources become operational. Expected mar!et value of share will be E.6.+ x 6;E ratio i.e.2 $s. /-.0/ x ( > $s. ',)..) /. 8he stoc! exchange #uotation reveal that the company share has been #uoted at below boo! value of $s. ,() per share ($efer to wor!ing note ,). 8he proposed financing pattern is not going to increase E.6.+. It will on the other hand decline marginally. 8hus2 the existing e#uity shareholders will not be benefited much from the new issue. Oowever2 in case shares are offered to the outsiders2 they will gain since a share with intrinsic (boo!) value of $s. ,() is being offered at a price of $s. ')). 8hus2 the company:s proposal to finance the new pro7ect to the extent of $s. 0- la!hs by issue of e#uity shares at a premium of $s. 0)) per share and balance from internal sources is not 7ustified and the company should2 therefore2 reconsider the scheme of financing the pro7ect by a new e#uity issue. 8he + co. &td. present debt e#uity ratio is ).(, ($efer to wor!ing note (). As per the prudential norm2 the debt e#uity ratio shall not exceed ' :0. According2 the company seems to possess debt capacity; leverage. It can raise the re#uired funds say2 by issue of debenture G 0'4 to 0,4 interest. Expected earnings per share after the manufacture of new product (Hew pro7ect financed to the extent of 0- la!hs by issue of debenture G 0'4) Anticipated turnover ($efer to wor!ing note 0) Expected profit on turnover &ess : Interest on debenture (0'4 on $s. 0- la!hs) Het profit before tax &ess : Income tax G,(4 Het profit after tax &ess : 6reference dividends 6rofit available for e#uity shareholders Ho. of e#uity shares Earning per share Zustification : $s. 020)2))2))) 0,2')2))) 023'2))) <<<<<<<< 002'*2))) ,23/2*)) <<<<<<<<< .2,,2')) '.2()) <<<<<<<<< .2)(2.)) 0)2))) $s. .).(. $s. /-.0/

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/. 8here will be increase in the mar!et value of share after the new pro7ect financed by issue of debentures and internal accruals become operational. Expected mar!et value of share will be E.6.+ x 6;t ratio i.e. $s. .).(. x ( times > $s. ,('.*( (. 8he E.6.+. will increase to $s. .).(. -. 8he debt e#uity ratio of the + co. &td. will be ).3- ($efer to wor!ing note -) after the new pro7ect is financed by issue of debentures. 8he ratio ).3- is within the prudential norm of ' : 0. +uggestion : En the basis of the above wor!ings2 it is suggested that it will be better if the company raise the funds2 re#uired for financing the new pro7ect2 by issuing debentures instead of e#uity shares. 8his is because the mar!et price per share and earning per share is higher in case of debenture financing without undue ris!. Cor!ing Hotes : $s. 0. nticipated turnover 6resent turnover Add : Anticipated additional sales of new product *)2))2))) ,)2))2))) 020)2))2))) $s. 0-2))2))) $s. ')) *2))) $s. 0)2))2))) '(2))2))) ,(2))2))) 0)2))) ,() $s. ((2))2))) ,.2))2))) ,2))2))) '2()2))) ')2))2))) 0'2))2))) 0*2))2))) .2()2)))

'. *um+er of new e$uity shares to +e issued 9unds re#uired by issue of e#uity shares : (A) 9unds raised by issue of 0 new e#uity share : (") Ho. of new e#uity share to be issued : (A); (") ,. !oo% value of one e$uity share 0)2))) e#uity shares of $s. 0)) each fully paid up Add : $eserves and surplus Ho. of e#uity shares "oo! value of one e#uity share lternatively 9ixed assets %urrent Assets Advance M deposits &ess : 6reference share capital +ecured loans Nnsecured loans 8rade creditors Eutstanding expenses Ho. of e#uity shares "oo! value of one share /. Present de+t e$uity ratio +ecured loans > ?????????????????????????????????????????????????? +hared capital = $eserve and surplus $s. ') la!hs > ???????????????????????????????? $s. ,..() la!hs

3(2))2)))

-)2))2))) ,(2))2))) 0)2))) ,()

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> ).(, (. Expected de+t e$uity ratio +ecured loans = proposed debentures > ?????????????????????????????????????????????????????? +hare capital = $eserve and surplus $s. ') la!hs = $s. 0- la!hs > ????????????????????????????????????????????? $s. ,..() la!hs > ).3Ques !"# :. A company is engaged in the manufacture of specialised sub?assemblies re#uired for certain electronic e#uipments. 8he company envisages that in the forthcoming month. December 033*2 the sales will ta!e a pattern in the ratio of , : / : ' respectively of sub?assemblies A%"2 %" and D6. 8he following is the schedule of components re#uired for manufacture : +ub?assembly A%" %" D6 6urchase price +elling price (') ()) ,() %omponent re#uirements "ase board I%)* I%0' 0 0 0 $s.-) * ' ' ') / 0) / 0' I%'' * *

8he direct labour time and variable overheads re#uired for each of the sub?assemblies are : 1rade A A%" %" D6 Direct wage rate per hour * / $s.( &abour hours per sub?assembly 1rade " Jariable overheads .per sub?assembly $s. 0,0' '/ * '/ / ??

8he &abours wor! * hours a day for '( days a month. 8he opening stoc!s of sub?assemblies and components for December 033* are as under : +ub?assemblies A%" %" D6 %omponents *)) 02')) '2*)) "ase "oard I%)* I%0' I%'02-)) 02')) -2))) /2)))

9ixed overheads amount to $s..2(.2')) for the month and a monthly profit target of $s.0' lacs has been set.

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8he company is poised for a reduction of closing inventories for December2 033* of sub? assemblies and components by 0)4 in #uantity as compared to the opening stoc!. 6repare the following budgets for December 033* : +ales budget in #uantity and value. 6roduction budget in #uantity %omponent usage budget in #uantity %omponent purchase budget in #uantity and value anpower budget showing the number of wor!ers and the amount of wages payable.

OR
A new formed company has applied to the commercial ban! for the first time for financing its wor!ing capital re#uirements. 8he following information is available about the pro7ections for the current year : Estimated level of activity : 02)/2))) completed units of production plus /2))) units of wor!?in? progress. "ased on the above activity2 estimated cost per unit is : $aw material Direct wages Everheads (exclusive of depreciation) 8otal cost +elling price $s. *) per unit $s. ,) per unit $s. -) per unit $s.0.) per unit $s.')) per unit.

$aw materials in stoc! : average / wee!s consumption2 wor!?in?progress (assume ()4 completion stage of conversion cost) (materials issued at the start of the processing). 9inished goods in stoc! %redit allowed by suppliers %redit allowed to debtors;receivables &ag in payment of wages %ash at ban! (for smooth operation) is expected to be *2))) units Average / wee!s Average * wee!s Average 0 _ wee!s $s.'(2)))

Assume that production is carried on evenly throughout the year ((' wee!s) and wages and overheads accrue similarly. All sales are on credit basis only. 9ind out : (i) the net wor!ing capital re#uiredL (iii) the maximum permissible ban! finance under first and second methods of financing as per 8andon %ommittee Horms.

F!rs A, er#& !6e

A#s$er 2"r9!#/ N" e : 0. +tatement showing contribution +ub assemblies +elling price per unit (p.u) : (A) A%" $s. (') %" $s. ()) D6 $s. ,() 8otal $s

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M&r/!#&, C"s +.u. Components "ase "oard I%)* I%0' I%',a+our 1rade A 1rade " -aria+le production overhead 8otal arginal cost p.u. : (") %ontribution p.u. : ` > (A) A (") +ales ratio : (D) %ontribution x sales ratio :@(E) > (%) x (D)B -) 0-) /* 0/) -/ ,<<<< /'/ 3, '** -) /) 0') /* ,) /* '/ <<<< ,.) 0,) / (') -) /) /* -/ ') ,' '/ <<<< '** -' ' 0'/

3,'

.. &esired contri+ution for the forthcoming month &ecem+er/ 0112 $s. 9ixed overheads Desired profit Desired contribution

.2(.2')) 0'2))2))) <<<<<<<< 032(.2'))

,. 'ales mix re$uired i.e. num+er of +atches for the forthcoming month &ecem+er/ 0112 +ales mix re#uired > Desired contribution; contribution x sales ratio > $s. 032(.2')); 3,' ($efer to wor!ing notes 0 M ') > '20))

)u3/e e3 -"r 7e*e.0er, 199@

S&,es 0u3/e !# Bu&# ! 4 &#3 6&,ue +ub ? assemblies +ales (#uantity) ('20)) x , : / : ') ($efer to wor!ing note ,) +elling prices p.u. ($s) +ales value ($s) A%" -2,)) (') ,'2.-2))) %" *2/)) ()) /'2))2))) D6 /2')) ,() 0/2.)2))) *32/-2))) 8otal

Pr"3u* !"# 0u3/e !# Bu&# ! 4 +ub ? assemblies +ales Add: %losing stoc! (Epening stoc! less 0)4) 8otal #uantity re#uired &ess : Epening stoc! 6roduction A%" -2,)) .') <<<<< .2)') *)) <<<<<< -2'') %" *2/)) 02)*) <<<<< 32/*) 02')) <<<<<< *2'*) D6 /2')) '2(') <<<<< -2.') '2*)) <<<<<< ,23')

C".+"#e# us&/e 0u3/e !# Bu&# ! 4

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+ub A assemblies 6roduction "ase broad (0 each) %omponent I%)* (*:':') %omponent I%0' (/:0):/) %omponent I%'- (':-:*)

A%" -2'') -2'') /32.-) (-2'') x *) '/2**) (-2'') x /) 0'2//) (-2'') x ')

%" *2'*) *2'*) 0-2(-) (*2'*) x ') *'2*)) (*2'*) x 0)) /32-*) (*2'*) x -)

D6 ,23') ,23') .2*/) (,23') x ') 0(2-*) (,23') x /) ,02,-) (,23') x *)

8otal ??? 0*2/') ./20-) 02',2,-) 3,2/*)

C".+"#e# Pur*(&se 0u3/e !# Bu&# ! 4 &#3 6&,ue +ub A assemblies Nsage in production Add : closing stoc! (Epening stoc! less 0)4) &ess : Epening stoc! 6urchase (#uantity) 6urchase price ($s.) 6urchase value ($s) "ase board I%)* I%0' 02',2,-) (2/)) <<<<<<<< 02'*2.-) -2))) <<<<<<<< 02''2.-) 0' 0/2.,20') I%'3,2/*) ,2-)) <<<<<< 3.2)*) /2))) <<<<<<< 3,2)*) * .2//2-/) /.23/20-) 8otal

0*2/') ./20-) 02//) 02)*) <<<<<< <<<<<<< 032*-) .(2'/) 02-)) 02')) <<<<<<< <<<<<<<< 0*2'-) ./2)/) -) ')

0)23(2-)) 0/2*)2*))

anpower budget showing the number of wor!ers and the amount of wages payable <<<<<<<<Direct &abour<<<<<<<<<<<<< <<<<<1rade A<<<<<< <<<<<<<<1rade "<<<<< Oours per 8otal Oours per 8otal Nnit Oours units hours * / /32.-) /32-*) 0(2-*) <<<<<<< 020(20') ')) (.02))) (2.-2))) 00' *

8otal

+ub ? Assemblies A%" %" D6

"udgeted 6roduction -2'') *2'*) ,23')

(A) 8otal hours (") Oours per man per month (%) Humber of Cor!ers per month (A; ") (D) Cage rate per month ($s.) (E) Cage payable ($s) : (% x D)

332(') 332,-) ,02,-) <<<<<<< '2,)2'/) ')) 020(' *)) 32'02-)) 0/23.2-))

Se*"#3 A, er#& !6e A#s$er (i) Es !.& e "- (e reBu!re.e# "- $"r9!#/ *&+! &, $s. $s.

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A. %urrent Assets : $aw material stoc! ($efer to wor!ing note ,) Cor! in progress stoc! ($efer to wor!ing note ') 9inished goods stoc! ($efer to wor!ing note /) Debtors ($efer to wor!ing note () %ash and ban! balance ". %urrent &iabilities : %reditors for raw materials ($efer to wor!ing note -) %reditors for wages ($efer to wor!ing note .) Het Cor!ing capital (A A ") .20(2./) 302.,0 *2).2/.0 <<<<<<<< /-23(233) -2-/2-0( (2))2))) 0,2-)2))) ',2(,2*/<<'(2))) ((2),2/-0

(ii) T(e .&A!.u. +er.!ss!0,e 0&#9 -!#&#*e &s +er T&#3"# C"..! ee N"r.s "irst #ethod : .(4 of the net wor!ing capital financed by ban! i.e. .(4 of $s. /-23(233) ($efer to (i) above) > $s. ,(2'0233, 'econd #ethod : (.(4 of current assets) A %urrent liabilities (i.e. .(4 of $s. ((2),2/-0) A $s. *2).2/.0 ($efer to (i) above) > $s. /02'.2(3- A $s. *2).2/.0 > $s. ,,2')20'( 2"r9!#/ N" es : 0. nnual cost of production $s2 *,2')2))) ,02')2))) -'2/)2))) 02.-2*)2))) $s. ,2')2))) -)2))) 02')2))) (2))2)))

$aw material re#uirements (02)/2))) x Nnits x $s. *)) Direct wages (02)/2))) units x $s. ,)) Everheads (exclusive of depreciation) (02)/2))) x $s. -)) '. 3or% in progress stoc% $aw material re#uirements (/2))) units x $s. *)) Direct wages (()4 x /2))) units x $s. ,)) Everheads (()4 x /2))) units x $s. -))

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,. 4aw material stoc% It is given that raw material in stoc! is average / wee!s consumption. +ince2 the company is newly formed2 the raw material re#uirement for production and wor! in progress will be issued and consumed during the year. Oence2 the raw material consumption for the year (() wee!s) is as follows : 9or finished goods 9or wor! in progress $s. *,2')2))) <,2')2))) *-2/)2))) $s. *-2/)2))) ?????????????????????? x / wee!s (' wee!s i.e.2 $s. -2-/2-0( /. "inished goods stoc% *2))) units G $s. 0.) per unit > $s. 0,2-)2))) (. &e+tors for sale %redit allowed to debtors %redit sales for year ((' wee!s) i.e. (02)/2))) units A *2))) units) +elling price per unit %redit sales for the year (3-2))) units x $s. '))) Debtors Average * wee!s 3-2))) units $s. ')) $s. 023'2))2))) $s. 023'2))2))) ???????????????????? x * wee!s (' wee!s i.e.2 $s. '32(,2*/-. Creditors for raw material : %redit allowed by suppliers 6urchases during the year ((' wee!s) i.e. ($s. *,2')2))) = $s. ,2')2))) = $s. -2-/2-0() ($efer to wor!ing notes 02 ' and , above) %reditors Average / wee!s $s. 3,2)/2-0( $s. 3,2)/2-0( ????????????????????? x / wee!s (' wee!s i.e.2 $s. .20(2./) .. Creditors for wages &ag in payment of wages Direct wages for the year ((' wee!s) i.e. ($s. ,02')2))) = $s. -)2)))) ($efer to wor!ing notes 0 and ' above) Average 00;' wee!s $s. ,02*)2))) $s. ,02*)2)))

$aw material stoc!

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%reditors

????????????????????????? x 00;' wee!s (' wee!s i.e.2 $s. 302.,0

Ques !"# <. Crite short notes on any four of the following : (f) ultiple discriminate analysis (g) 6ac!ing credit (h) 9actoring (i) Inflation and financial management (7) Eb7ectives of portfolio management. A#s$er %&' Mu, !+,e 3!s*r!.!#& e &#&,4s!s : 8he traditional study of performance of a firm through financial ratios provide for wor!ing out a number of separate clues A such as ratios to sic!ness or failure. It would be more useful to combine the different ratios into a single measure of the probability of sic!ness2 failure or insolvency. 8he techni#ue of multiple discriminent analysis ( DA) help to do so. Edward I. Altman developed an empirical model to predict corporate ban!ruptcy using ultiple Discriminant Analysis ( DA). Altman stated that univariate ratio analysis is susceptible to faulty interpretation and is potentially confusing because the order importance of financial ratios was not clear. Ebviously2 an independent assessment of some ratios does not lead to any conclusive opinion without analysis the behaviour of other relevant ratios. Altman derived the final discriminant function as follows : P > 0.' K0 = 0./ K' = ,., K, = ).-)K/ = ).333K( Chere2 K0 K' K, K/ K( P P %0' > Cor!ing capital; 8otal Assets > $etained Earnings; 8otal Assets > E"I8; 8otal Assets > ar!et value of E#uity; "oo! value of 8otal Debt > +ales; 8otal Assets > Everall index2 P] '.-.( is non A ban!rupt region2 ^ '.-.( is the ban!ruptcy region and 0.*0 ^ P ^ '.33 is the Qone of ignorance.

P&*9!#/ *re3! : 6ac!ing credit is an advance made available by ban!s to an exporter. Any exporter2 having at hand a firm export order placed with him by his foreign buyer or an irrevocable letter of credit opened in his favour2 can approach a ban! for availing of pac!ing credit. An advance so ta!en by an exporter is re#uired to be li#uidated within 0*) days from the date of its commencement by negotiation of export bills or receipts of export proceeds an approved manner. 8hus pac!ing credit is essentially a short ? term advance. Hormally2 ban!s insist upon their customers to lodge the irrevocable letters of credit opened in favour of the customer by the overseas buyers. 8he letter of credit and firms: sale contracts not only serve as evidence of a definite arrangement for realisation of the export proceeds but also indicate the amount of finance re#uired by the exporter. 6ac!ing %redit2 in the case of customers of long standing may also be granted against firm contracts entered into by them with overseas buyers. 6ac!ing credit may be of the following types : (a) Clean pac%ing credit : 8his is an advance made available to an exporter only on production of a firm export order or a letter of credit without exercising any charge or

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control over raw material or finished goods. It is clean type of export advance. Each proposal is weighed according to particular re#uirements of the trade and credit worthiness of the exporter. A suitable margin has to be maintained. Also2 Export %redit guarantee %orporation (E%1%) cover should be obtained by the ban!. (b) Pac%ing credit against hypothecation of goods : Export finance is made available on certain terms and conditions where the exporter has pledge able interest and the goods are hypothecated to the ban! as security with stipulated margin. At the time of utilising the advance2 the exporter is re#uired to submit2 along with the firm export order or letter or credit2 relative stoc! statements and thereafter continue submitting them every fortnight and whenever there is any movement in stoc!. Pac%ing credit against pledge of goods : Export finance is made available on certain terms and conditions where the exportable finished goods are pledged to the ban!s with approved clearing agents who will ship the same from time to time as re#uired by the exporter. 8he possession of the goods so pledged lies with the ban! and are !ept under its loc! and !ey.

(c)

%*'

F&* "r!#/ : 9actoring is a new financial service that is presently being developed in India. 9actoring involves provision of specialised services relating to credit investigation2 sales ledger management2 purchase and collection of debts2 credit protection as well as provision of finance against receivables and ris! bearing. In factoring2 accounts receivables are generally sold to a financial Institution (a subsidiary of commercial ban! A called R9actorS)2 who charges commission and bears the credit ris!s associated with the accounts receivables purchased by it. Its operation is very simple. %lients enter into an agreement with the RfactorS wor!ing out a factoring arrangement according to his re#uirements. 8he factor then ta!es the responsibility of monitoring2 follow up2 collection and ris! ta!ing and provision of advance. 8he factor generally fixes up a limit customer A wise for the client (seller). 9actoring offers the following advantages which ma!es it #uite attractive to many firms : (0) 8he firm can convert accounts receivables into cash without bothering about repayment. (') 9actoring ensures a definite pattern of cash in flows. (,) %ontinuous factoring virtually eliminates the need for the credit department. 8hat is why receivables financing through factoring is gaining popularity as useful source of financing short term funds re#uirements of business enterprises because of inherent advantage of flexibility it affords to the borrowing firm. 8he seller firm may continue to finance its receivables on a more or less automatic basis. It sales expand or contract2 it can vary the financing proportionately. Oowever2 factoring as a means of financing is comparatively costly source of financing since its cost of financing is higher than the normal lending rates.

%3'

I#-,& !"# &#3 -!#&#*!&, .&#&/e.e# : 9inancial management is basically concerned with the proper management of finance which is regarded as the life blood of business enterprise. 8he direct conse#uence of inflation has been to distort the significance of operating results and utility of financial statements (based on historical cost) for various managerial accounting and decision ma!ing purposes. Even though it is beyond the scope of finance manager to control inflation. Oe2 however2 tries to measure the impact of inflation on his business so as to re A orient various financial management policies according to the fast changing circumstances. +ome of the prominent areas which are affected by inflation and are re#uired to be re A oriented are as follows : 0. "inancing decisions : 8his involves identifying the sources from which the finance manager should raise the #uantum of funds re#uired by a company. the debenture holder and

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preference shareholders are interested in fixed income while e#uity shareholders are interested in higher profits to earn high dividend. 8he finance manager is re#uired to estimate the amount of profits he is going to earn in future. Chile estimating the revenue and costs.2 he must ta!e into consideration the inflation factor. '. (nvestment decisions : 8he capital budgeting decisions will be biased if the impact of inflation is not correctly factored in the analysis. 8his is because the cash flows of an investment pro7ect occur over a long period of time. 8herefore2 the finance manager should be concerned about the impact of inflation on the pro7ect:s profitability. 3or%ing capital decisions : 8he finance manager is re#uired to consider the impact of inflation while estimating the re#uirements of wor!ing capital. 8his is because of the increasing input prices and manufacturing costs2 more funds may have to be tied up in inventories and receivables. &ividend payout policy : 8his involves the determination of the percentage of profits earned by the enterprise which is to be paid to be paid to the shareholders. Chile ta!ing this decision2 the finance manager has to !eep in mind the inflation factor. 8herefore2 while ma!ing this decision he has to see that the capital of the company remain intact even after the payment of dividend. 8his is because in a inflationary situation the depreciation provided on the basis of historical costs of assets would not provide ade#uate funds for replacement of fixed assets at the expiry of their useful lives.

,.

/.

%e'

O0Ge* !6es "- +"r -",!" .&#&/e.e# : 6ortfolio management refers to the selection of securities and their continuous shifting in the portfolio for optimiQing the return for investor. 8he following are the ob7ectives of portfolio management. (i) (ii) (iii) (iv) (v) (vi) 'ecurity/ safety of principal : +ecurity not only involves !eeping the principal sum intact but also !eeping intact its purchasing power. 'ta+ility of income : +o as to facilitate planning more accurately and systematically the reinvestment or consumption of incomeL Capital growth : Chich can be attained by reinvesting in growth securities or through purchase of growth securities. #ar%eta+ility :8he case with which security can be bought or sold. 8his is essential to provide flexibility to investment portfolio. ,i$uidity : It is desirable for an investor to ta!e advantage of attractive opportunities in the mar!et. &iversification : 8he basic ob7ective of building a portfolio is to reduce the ris! of loss of capital; income by investing in various types of securities and over a wide range of industries.

(vii) "avoura+le tax status : 8he effective yield an investor gets from his investment depends on tax to which it is sub7ected. "y minimising tax burden2 yield can be improved effectively.

F!#&, eA&.!#& !"#

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M&4, 1999 Gr.-I P&+er 2 : M&#&/e.e# A**"u# !#/ & F!#&#*!&, A#&,4s!s
Ques !"# 1. (a) A company is considering two mutually exclusive pro7ects K and 5. 6ro7ect K costs $s.,)2))) and 6ro7ect 5 $s.,-2))). 5ou have been given below the net present value2 probability distribution for each pro7ect. 6ro7ect K H6J Estimate 6robability $s. ,2))) ).0 -2))) )./ 0'2))) )./ 0(2))) ).0
(i)

H6J Estimate $s. ,2))) -2))) 0'2))) 0(2)))

6ro7ect 5 6robability ).' )., )., ).'

%ompute the expected net present value of 6ro7ects K and 5.

(v) (vi) (vii) (b)

%ompute the ris! attached to each pro7ect i.e.2 +tandard Deviation of each probability distribution. Chich pro7ect do you consider more ris! and whyF %ompute the profitability index of each pro7ect. Determine the ris! ad7usted net present value of the following pro7ects: A 02))2))) ( years ,)2))) )./ " 02')2))) ( years /'2))) ).* % '20)2))) ( years .)2))) 0.'

Het cash outlays ($s.) 6ro7ect life Annual cash inflow ($s.) %oefficient of variation

8he company selects the ris!?ad7usted rate of discount on the basis of the coefficient of variation: . %oefficient of variation $is! ad7usted rate of discount . ).) )./ ).* 0.' 0.'.) ore than '.) A#s$er %&' H6J Estimate <<$s. ,2))) -2))) 6robability 0)4 0'4 0/4 0-4 0*4 ''4 '(4 6resent value factor 0 to ( years at ris! ad7usted rate of discount ,..30 ,.-)( ,./,, ,.'./ ,.0'. '.*-/ '.-*3

Pr"Ge* H H6J estimate x probability $s. ,)) '2/)) Deviation from expected H6J i.e. $s. 32))) -2))) ,2))) +#uare of +#uare of the the deviation deviation x probability $s. $s. ,2-)2))2))) ,-2))2))) 3)2))2))) ,-2))2)))

).0 )./

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0'2))) 0(2))) Expected H6J

)./ ).0

/2*)) 02()) <<<<< 32))) Project Y

? ,2))) ? -2)))

3)2))2))) ,2-)2))2)))

,-2))2))) ,-2))2))) <<<<<<<<< 02//2))2)))

H6J Estimate $s. ,2))) -2))) 0'2))) 0(2)))

6robability

H6J estimate x probability $s. -)) 02*)) ,2-)) ,2))) <<<<< 32)))

Deviation from expected H6J i.e. $s. 32))) -2))) ,2))) ? ,2))) ? -2)))

).' )., )., ).'

+#uare of +#uare of the the deviation deviation x probability $s. $s. ,2-)2))2))) .'2))2))) 3)2))2))) 3)2))2))) ,2-)2))2))) '.2))2))) '.2))2))) .'2))2))) <<<<<<<< 023*2))2)))

Expected H6J
(i)

8he expected net present value of pro7ects K and 5 is $s. 32))) each.

(ii) +tandard Deviation > s#uare of the deviation x probability In case of pro7ect K : +tandard Deviation > $s. 02//2))2))) > $s. ,2.3( In case of 6ro7ect 5 : +tandard Deviation > $s. 023*2))2))) > $s. /2/() +tandard deviation (iii) Coefficient of variation > ??????????????????????????????????????? Expected net present value ,2.3( In case of 6ro7ect K : %oefficient of variation > ?????????? > )./' 32))) /2/() In case of 6ro7ect 5 : %oefficient of variation > ???????????? > )./3 or ).() 32))) 6ro7ect 5 is ris!ier since it has a higher coefficient of variation. Discounted cash inflow (iv) 6rofitability Index > ?????????????????????????????????? Discounted cash outflow 32))) = ,)2))) In case of 6ro7ect K : 6rofitability Index > ???????????????????????????? > 0.,) ,)2))) 32))) = ,-2))) /(2))) In case of 6ro7ect 5 : 6rofitability Index > ??????????????????????????????????? > ????????????? > 0.'( ,-2))) ,-2)))

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%0'

S & e.e# s("$!#/ (e 3e er.!#& !"# "- (e r!s9 &3Gus e3 #e +rese# 6&,ue Het %oefficient %ash of Eutlays variation $s. (ii) 02))2))) 02')2))) '20)2))) $is! ad7usted discount $ate (iv) 0'4 0/4 0-4 Annual cash inflow $s. (v) ,)2))) /'2))) .)2))) 6J factor Discounted 0 A ( years cash inflow at ris! ad7usted rate Ef discount $s. $s. (vi) (vii) > (v)x(vi) ,.-)( ,./,, ,.'./ 02)*20() 02//20*'2'320*) Het 6resent value

6ro7ects

(i) (ii) A " %

(iii) )./ ).* 0.')

$s. (viii)>(vii) A *20() '/20*0320*)

Ques !"# 2. (a)

K %o. &td. an Indian %ompany has to ma!e payment of , million (,) la!hs) N+ Dollars after - months against import of plant and machinery. Chat are the different alternatives to hedge against this foreign currency exposure. 1ive explanations. Describe different !inds of float with reference to management of cash.

(b)

(c) % developed original specification of a product and founded % anufacturing &td. In 033. the firm manufactured 3*) Hos. at an average price of $s.3)) each. In 033* due to continuous price rise of the inputs2 he raised his prices at an average of 0'42 since he !new he could sell his plant:s full capacity of 3*) Hos. per year. In spite of price rise for the product2 which sold for over $s.02))) for the first time2 % was surprised to learn in late 033* (as may be seen from the financial statements) that % anufacturing &td. show a decline in earnings and still worse2 decline in cash flow. Ois accountant has brought the following : (i) (v) (vi) (vii) Ce are following 9I9E system for the purpose of issues. %osts are going up faster than 0'4 and they will go up further in 0333. Ce are not setting aside enough to replace the machineryL we need to set aside $s.02-(2)))2 not $s.02()2))) so as to be able to buy new machinery. It is still not late to switch to &I9E for 033*. 8his will reduce closing inventory to $s.,2,)2))) and raise cost of goods sold. % +ales %ost of goods sold Epening inventory $aw material &abour Depreciation End inventory 1ross margin Administration expenses E"I8 Interest Income?tax 6rofit after tax anufacturing &td. Income +tatement ($s. )))) 033* 033. 02))* 3)) '() /)) 0./ 0() (?) ,') .*) ''* 0)) 0'* () .* ,3 ,3 -(/ '/3' 0(/ () 0)/ (' ('

,') ()) ')) 0() (?) ,3)

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Add : non?cash expenses Inventory change %ash flow $e#uired : (,) (/)

0() (?) .) 003

0() (?) .) 0,'

Chat is the weighted average inflation factor for the firm using &I9E F If the firm desire a 0(4 profit margin on sales2 how much should the firm charge for the product per unit F

A#s$er %&' K co. &td.2 an Indian %ompany which has to ma!e payment of , million (,) la!hs) N+ Dollar after - months against import of plant and machinery has the following alternatives to hedge against this foreign currency exposure :? (i) "orward cover : K co. &td. can ta!e a full forward cover against its foreign exchange exposure and entirely hedge its ris!. It can contract with a ban! to buy N+X forward at an agreed exchange rate. +uppose the - months forward rate is $s. /'./); N+X 0. 8his means that K %o. &td. has definite cost of $s. /'./) x , million rupees i.e.2 $s. 02'.' la!hs2 irrespective of the actual exchange rate at the end of six months. "oreign currency option : 8he foreign currency option is the right (not an obligation) to buy or sell a currency at an agreed exchange rate (exercise 6rice) on or before an agreed maturity period. 8he right to buy is called a call option and right to sell in put option. A foreign currency option holder will exercise his right only if it is advantageous to do so. K co. &td. can buy a - months put option in rupees at $s./'./) (say) plus (4 (say) premium for purchasing the option i.e. maximum final (cost) $s. /'./) x ,) la!hs x 0.)( i.e. $s. 0,,(.- la!hs (including the cost of the premium $s. -,.- la!hs). +uppose at the end of - months2 the exchange rate becomes $s. //2 the company should exercise its put option since it will sell (pay) IH$ /'./) (the exercise price) to obtain one N+X. In the open mar!et it will be re#uired to pay IH$ //. En the other hand2 if the rupees appreciates and the exchange rate at the end of six months is IH$ /'; N+ X2 the %o. will not exercise its option. In the open mar!et2 it need to pay only IH$ /' (instead of IH$ /'./) exercise price) to buy one N+ X. Oowever2 it has already paid the option premium. If it does not exercise the option2 its total cost will be $s. ,) la!hs x $s. /' = $s. -,.- > $s. 0,',.- la!hs. Except for the cost of option premium2 the foreign currency option provides a uni#ue hedging alternative2 one can avoid the loss by exercising appropriate option and gain from the favourable change in the exchange rate by not exercising the option. #oney mar%et operations : Another hedging techni#ue is the money mar!et operations. K co. can borrow , million N+ X. How convert into rupees at the current exchange rate and invest in the money mar!et in India for - months. If interest rate parity holds2 the difference in the forward rate and the spot rate is the reflection of the differences in the interest rates in two countries. 8hus2 K co. will be able to hedge against the change in the exchange rate. 8he problem with the money mar!et alternative is that all mar!ets are not open all currencies are not fully convertible. 8he Indian rupee is not fully convertible and there are restrictions on the free flow of funds outside the country.

(ii)

(iii)

%0'

7!--ere# 9!#3s "- -,"& $! ( re-ere#*e " .&#&/e.e# "- C&s( : 8he term float is used to refer to the periods that affect cash as it ma!es through the different stages of the collection process. 9our types of float can be identified as : (v) !illing float : An invoice is the formal document that a seller prepares and sends to the purchaser as the payment re#uest for the goods sold or services provided. 8he time between the sale and mailing of the invoice is the billing float .

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(vi) (vii) (viii) %*' %!'

#ail float : 8his is the time when a che#ue is being processed by post office2 messenger service or other means of delivery. Che$ue processing float : 8his is the time re#uired for the seller to sort2 record and deposit the che#ue after it has been received by the company. !an% processing float : 8his is the time from the deposit of the che#ue to the crediting of funds in the seller account. 033* Expenses ($s. )))) 033. Expenses '() /)) -() /3) ')) 0-(I *(( 0)) 3(( ,') ,,) 0./ 0() -(/ <3' ./-

$aw material Epening inventory Add : 6urchases &ess : %losing inventory "ased on &I9EI &abour Depreciation %ost of goods sold Add : Administration expenses

,') ()) *'0 ,,)

I %onsideration on replacement cost basis 3(( Oence2 weighted average inflation factor for the firm in 033* > ??????? ./> 0.'* i.e. '*4 over 033. (') If the firm desires a 0( per cent profit margin on sales the price which the firm should charge for the product per unit can be identified in two ways :? (i) In 033.2 E"I8 as a percentage of sales was 0..04 Oence2 if we ta!e the weighted average inflation in 033* over 033. and increase prices to that extent the charge per product in 033* will be. 32))2))) $s.??????????????????? x 0.'* > 020.(.() 3*) Er in other words Average price in 033. x (0 = inflation4) > $s. 30*.,- x 0.'* > $s. 020.(.() per product I.e. 8otal sales will be ($s. 020.(.() x 3*) Hos.) > $s. 002('2))) approximately lternatively/ (ii) 8otal cost in 033*2 for 3*) Hos. is $s. 32((2))) Oence2 for each no. > $s. 3./.() In order to earn 0(4 profit margin on sales (E"I8 level)2 the sales price product will be 3./.() $s. ??????????? > $s. 00/-.() ).*( 8otal sales will be ($s. 020/-.() x 3*) Hos.) > $s. 002',2(.) N" e : 9igures have been rounded off.

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Ques !"# 8.%&' V &td. sells goods at a uniform rate of gross profit of ')4 on sales including depreciation as part of cost of production. Its annual figures are as under : +ales (At ' months: credit) aterials consumed (+uppliers credit ' months) Cages paid ( onthly at the beginning of the subse#uent month) anufacturing expenses (%ash expenses are paid?one month in arrear) Administration expenses (%ash expenses are paid?one month in arrear) +ales promotion expenses (6aid #uarterly in advance) $s. '/2))2))) -2))2))) /2*)2))) -2))2))) 02()2))) .(2)))

8he company !eeps one month stoc! each of raw materials and finished goods. A minimum cash balance of $s.*)2))) is always !ept. 8he company wants to adopt a 0)4 safety margin in the maintenance of wor!ing capital. 8he company has no wor! in progress. 9ind out the re#uirements of wor!ing capital on cash cost basis. (b) "riefly indicate the causes of industrial sic!ness in India. (0' = * > ') mar!s)

A#s$er %&' 2"r9!#/ N" es : 1. anufacturing expenses +ales &ess : 1ross profit margin at ')4 8otal manufacturing cost &ess : aterials consumed -2))2))) Cages /2*)2))) anufacturing expenses &ess : %ash manufacturing expenses (()2))) x 0') Depreciation 2.

$s. '/2))2))) /2*)2))) 032')2))) 0)2*)2))) *2/)2))) -2))2))) '2/)2)))

8otal cash costs $s. anufacturing costs 032')2))) &ess : Depreciation '2/)2))) %ash anufacturing costs 0-2*)2))) Add : Administrative expenses 02()2))) Add : sales promotion expenses <.(2))) 8otal cash costs 032)(2))) S & e.e# s("$!#/ (e reBu!re.e# s "- $"r9!#/ *&+! &, "- (e *".+&#4. $s. Current ssets : Debtors 0;-th of total cash costs (0;- x $s. 032)(2)))) ,.0.2()) ($efer to wor!ing note ') sales promotion expenses (prepaid) 0*2.() +toc! of raw materials (0 month) ()2))) 9inished goods (0;0' of cash manufacturing costs) ($s. 0-2*)2))) x 0;0') ($efer to wor!ing note ') %ash in hand &ess : %urrent liabilities %reditors for goods (' months) Cages (0 month) 02))2))) /)2))) 02/)2))) <*)2))) -2)-2'()

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anufacturing expenses (0 months) Administrative expenses (0 months) Het wor!ing capital Add : safety margin 0)4 Cor!ing capital re#uired %0' C&uses "- I#3us r!&, s!*9#ess :

()2))) 0'2())

'2)'2()) /2),2.() </)2,.( /2//20'(

8he causes of industrial sic!ness in India may be broadly classified as follows : A. I# er#&, *&uses : Nnder this category2 the following causes are generally responsible fro the industrial sic!ness in India. %1' P,&##!#/ (a)Technical feasi+ility : JiQ. Inade#uate technical !now A how2 locational disadvantages2 outdated production process. (b)Economic via+ility : Oigh cost of inputs2 brea! A even point too high2 uneconomic siQe of pro7ect2 under A estimation of demand2 poor labour relations2 lac! of trained; s!illed labour or technically competent personnel. (c) #ar%eting management : Dependence on a single customer or a limited number of customers; single or a limited number of products2 poor sales realisation2 defective pricing policy2 boo!ing of large orders at fixed prices in an inflationary mar!et2 wea! mar!et feedbac! and mar!et research. &ac! of !nowledge of mar!eting techni#ues2 unscrupulous sales; purchase practices. (e)"inancial #anagement : 6oor resources management and financial planning2 faulty costing2 liberal dividend policy2 general financial indiscipline and application of funds for unauthoriQed purposes2 deficiency of funds2 over A trading2 unfavorable gearing or !eeping adverse debt A e#uity ratio2 inade#uate wor!ing capital2 absence of cost consciousness2 lac! of effective collection machinery. (e) dministrative management : Ever %entralisation2 lac! of professionalism2 lac! of feed A bac! to management. (') I.+,e.e# & !"# : %ost over A runs resulting from delays in getting licence; sanctions2 etc. inade#uate mobiliQation of finance. (,) Fu#* !"#&, M&#&/e.e# : (a)Production management : Inappropriate product A mix2 poor #uality control2 high cost of production2 poor inventory management2 inade#uate maintenance and replacement2 lac! of timely and ade#uate modernisation2 etc.2 high wastage2 poor capacity utilisation. (b),a+our management relations : Excessively high wage structure2 inefficient handling of labour problems2 excessive manpower2 poor labour productivity2 lac! of proper management information system and controls2 lac! of timely diversification2 excessive expenditure on $esearch M Development2 dividend loyalties (Chere the same management has interest in more than one unit2 cases are !nown where promoters of limited companies who also have their own private interest first tend to loo! after the interest of the latter2 often at the cost of the former)2 dissension within the management2 incompetent and dishonest management. ). EA er#&, *&uses &#3 " (er -&* "rs : 8he following factors may be mentioned in this respect.

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(e) 5overnment controls and policies/ etc.: 1overnment price controls2 fiscal duties2 abrupt changes in 1overnment polices affecting costs; prices; imports; exports; licensing. (f) 6rocedural delays on the part of financial; licensing;other controlling or regulating authorities li!e "an!s2 $"I2 9inancial Institutions2 1overnment departments2 &icensing Authorities2 $86 authorities2 etc. (g) #ar%et Constraints : ar!et saturation $evolutionary technological advances rendering the products obsolete2 and $ecession A fall in domestic; export demand. (h) Extraneous factors : Hatural calamities2 political situation (domestic as well as international)2 and stri!es and multiplicity of labour unions2 et.

Ques !"#

E! (er

:.

1 &td. will commence operations as the beginning of the year and the budgets for activity and costs for the first three #uarters of operation are shown below : "udgets A Vuarters I2 II and III 6eriod covered A months Activity : +ales (units) 6roduction (units) %osts : ($s. ))))
Direct aterials :

I 0?, 32))) 0)2)))

II /?0.2))) ')2)))

III .?3 0(2))) 0(2)))

A () " /) 6roduction labour 0*) 9actory overheads (excluding depreciation) *) Depreciation of production machinery 0/ Administration expenses ,) +elling M distribution expenses '3 8otal %osts /',

0)) *) '*( 00) 0/ ,) ,. -(-

.( -) ',) 3( 0/ ,) ,( (,3

Hote : Jariable labour costs become ()4 higher for activity in excess of 032))) units per #uarter due to the necessity of overtime wor!ing. In #uarter IJ2 the sales volume could range from an extreme low of 0(2))) units to an extreme of '02)))) units2 but most li!ely of 0*2))) units. In month 32 it will be possible to accurately estimate sales for Vuarter IJ and the production level for that #uarter will be set e#ual to the sales volume. Activity for each #uarter is spread evenly throughout that #uarter. %ost structures will remain same in Vuarters I to III2 but are expected to differ in Vuarter IJ only in the following aspects : (i) (v) (vi) aterial A will rise in price by ')4. All production labour wage rate will increase by 0' _4. Jariable labour input per unit of output will decrease (due to learning curve effect) to *)4 8he threshold of overtime wor!ing remains at 032))) units.

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(vii)

9ixed factory overheads and the fixed element of selling and distribution costs will each rise by ')4.

8he effect of these change is considered too small to re#uire a change in the standard cost per unit of $s.,) which is used for stoc! valuation. $e#uired : (c) 6roduce a statement which analyses under each cost classification given in the budgets2 the variable cost per unit and the fixed costs which will be effective in Vuarter IJ. (d) 6repare a flexible budget of estimated costs for Vuarter IJ with step points which will facilitate simple interpretation of costs for the most li!ely levels.

64
A large profit ma!ing 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 mar!etable product. At present2 the waste is removed by a contractor for disposal on payment by the company of $s.() la!hs p.a. for the next four years. 8he contract can be terminated upon installation of the aforesaid machine on payment of a compensation of $s.,) lacs before the processing operation starts. 8his compensation is not allowed as deduction for tax purposes. 8he machine re#uired for carrying out the processing will cost $s.')) lacs to be financed by a loan repayable in / e#ual installments commencing from the end of year 0. 8he interest rate is 0-4 p.a. At the end of the /th year2 the machine can be sold for $s.') lacs and the cost of dismantling and removal will be $s.0( lacs. +ales and direct costs of the product emerging from waste processing for / years are estimated as under : 5ear +ales aterial consumption Cages Ether expenses 9actory Everheads Depreciation (as per income?tax rules) 0 ,'' ,) .( /) (( () ' ,'' /) .( /( -) ,* , /0* *( *( (/ 00) '* $s. (lacs) / /0* *( 0)) .) 0/( '0

Initial stoc! of materials re#uired before commencement of the processing operations is $s.') la!hs at the start of year 0. 8he stoc! levels of materials to be maintained at the end of year 02 ' and , will be $s.(( la!hs and the stoc!s at the end of year / will be nil. 8he storage of materials will utilise space which would otherwise have been rented out for $s.0) la!hs p.a. &abour cost include wages of /) wor!ers2 whose transfer to this process will reduce idle time payments of $s.0( laths in year 0 and $s.0) laths in year '. 9actory overheads include apportionment of general factory overheads except to the extent of insurance charges of $s.,) la!hs p.a. payable on this venture. 8he company:s tax rate is ()4. 6resent value factors for four years are as under : 5ear 0 ' 6resent value factors ).*.) )..(, ).-(* / ).(.'

Advise the management on the desirability of installing the machine for processing the waste. All calculations should form part of the answer. (') mar!s) A#s$er F!rs A, er#& !6e

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2"r9!#/ N" e 0. Direct material cost for manufacturing for per unit of production : $s. ()2))) A :?????????????????????????? > $s. ( 0)2))) $s. /)2)) " : ?????????????????????????? > $s. / 0)2))) Direct material cost (variable cost) for materials A and " for all #uarters on commutation comes to $s. ( and $s. / for materials A and " respectively. In Vuarter IJ price of material A rise by ')4 i.e. $s. - ($s. ( x 0.')) '. "ixed and varia+le cost of production la+our : Vuarter I 6roduction (Nnits) 0)2))) 6roduction labour ($s.) 02*)2))) %hange in production labour cost Jariable cost (per unit) > ?????????????????????????????????????????????? %hange in production units $s. ()2))) > ???????????????????? > $s. 0) (2))) units 9ixed cost > $s. 02*)2))) A $s. 02))2))) (0)2))) units x $s. 0)) > $s. *)2)))
9or Vuarter II (')2))) units) $s.

Vuarter II 0(2))) '2,)2)))

%hange (2))) ()2)))

Jariable cost of ')2))) units G $s. 0) p.u. 9ixed cost Evertime premium on 02))) units G $s. ( p.u.

'2))2))) *)2))) <<(2))) '2*(2))) $s. 02-'2))) <<3)2))) '2('2))) Vuarter II ')2))) 020)2))) %hange 0)2))) ,)2)))

9or Vuarter IJ (0*2))) units) Jariable cost of 0*2))) units G $s. 3 p.u. ($s. 0) x 0.0'( x ).*)) 9ixed cost ($s. *)2))) x 0.0'() 8otal production labour cost ,. "ixed and varia+le cost component of factory overheads Vuarter I 6roduction (units) 0)2))) 9actory overheads ($s.) *)2))) (excluding depreciation) Jariable cost component of factory overheads %hange in factory overhead cost > ??????????????????????????????????????????????? %hange in production units $s. ,)2))) > ???????????????????? > $s. , p.u. 0)2)))

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Oence2 fixed cost component of factory overheads > $s. 020)2))) A $s. -)2))) (')2))) units x $s. ,) > $s. ()2))) 9or Vuarter IJ 9ixed cost (component) Add : ')4 increase of $s. ()2))) 8otal fixed cost /. "ixed and varia+le cost component of selling and distri+ution expenses Vuarter I Vuarter II +ales (units) 32))) 0.2))) +elling M distribution expenses ($s.) '32))) ,.2))) Jariable cost component of selling M distribution expenses %hange in selling M distribution expenses > ???????????????????????????????????????????????????????????? %hange in sales units $s. *2))) > ??????????????????????????? > $e 0 per unit *2))) Oence2 fixed cost component of selling M distribution expenses > $s. ,.2))) A $s. 0.2))) (0.2))) units x $e.0) > $s. ')2))) 9or Vuarter IJ 9ixed %ost (component) Add: ')4 increase of $s. ')2))) 8otal fixed cost. (a) S & e.e# "- 6&r!&0,e *"s +er u#! &#3 -!Ae3 *"s s u#3er /!6e# *"s *,&ss!-!*& !"# e--e* !6e !# Bu&r er IC 6articulars Jariable %ost p.u. $s. <<<<<<Vuarter IJ 8otal fixed cost $s $s. ()2))) 0)2))) -)2))) %hange *2))) *2)))

Ques !"# <. Crite short notes on : (e) (f) (g) (h) ethods of Jenture %apital 9inancing. +ystematic and Nnsystematic $is! in connection with 6ortfolio Investment. 9actors influencing the dividend policy of the firm. +pecial features of 9inancial anagement in a public sector underta!ing.

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A#s$er %&' Me ("3s "- Ce# ure C&+! &, F!#&#*!#/ : 8he venture capital financing refers to financing and funding of the small scale enterprises2 high technology and ris!y ventures. +ome common methods of venture capital financing are as follows: (i) E$uity financing : 8he venture capital underta!ings generally re#uires funds for a longer period but may not be able to provide returns to the investors during the initial stages. 8herefore2 the venture capital finance is generally provided by way of e#uity share capital. 8he e#uity contribution of venture capital firm does not exceed /34 of the total e#uity capital of venture capital underta!ings so that the effective control and ownership remains with the entrepreneur. (ii) Conditional ,oan: A conditional loan is repayable in the form of a royalty after the venture is able to generate sales. Ho interest is paid on such loans. In India Jenture %apital financers charge royalty ranging between ' to 0( per centL actual rate depends on other factors of the venture such as gestation period2 cash flow patterns2 ris!ness and other factors of the enterprise. +ome Jenture %apital 9inancers give a choice to the enterprise of paying a high rate of interest (which could be well above ') per sent) instead of royalty on sales once it becomes commercially sound. (iii) (ncome *ote : It is a hybrid security which combines the features of both conventional loan and conditional loan. 8he entrepreneur has to pay both interest and royalty on sales but at substantially low rates. ID"I:s Jenture %apital 9und provides funding e#ual to *) *..(4 of the pro7ects cost for commercial application of indigenous technology or adopting imported technology to domestic applications. Participating &e+enture : +uch security carries in three phases A in the start up phase2 no interest is charged2 next stage a low rate of interest is charged upto a particular level of operations2 after that2 a high rate of interest is re#uired to be paid. %0' S4s e.& !* &#3 u#s4s e.& !* R!s9 !# *"##e* !"# $! ( P"r -",!" I#6es .e# : S4s e.& !* r!s9 : It is the ris! which cannot be eliminated by diversification. 8his part of ris! Arises because every security has a built in tendency to move in with the fluctuations in the mar!et. 8he investors are exposed to mar!et ris! even when they hold well diversified portfolio of securities. It is because all individual securities move together in the same manner and therefore no investors can avoid or eliminate this ris!2 what so over precautions or diversification may be resorted to. 8he examples of systematic ris! are: 8he government changes the interest rate policyL the corporate tax rate is increasedL the government resort to massive deficit financingL the inflation rate increases etc. U#s4s e.& !* r!s9: It is the ris! which can be eliminated by diversification. 8his ris! represents the fluctuations in return of a security due to factors specific to particular firm only and not to the mar!et as a whole. 8he investors can totally reduce this ris! through diversification. It is because when a large number of securities enter a portfolio2 many random fluctuations in returns from these securities will automatically set off each other. 8he examples of unsystematic ris!s are: Cor!ers declared stri!e in a companyL the $esearch and Development expert of the company leavesL a formidable competitor enters the mar!etL the company loses a big contract in a bid etc. %*' F&* "rs !#-,ue#*!#/ (e 3!6!3e#3 +",!*4 "- (e -!r. : 8he following are the important factors which generally determine the dividend policy of a firm.

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(i)

&ividend payout ratio : A ma7or aspect of the dividend policy of a firm is its dividend payout (D;6) ratio2 i.e.2 the percentage share of the net earnings distributed to shareholders as dividends. +ince dividend policy of the firm affects both the shareholders: wealth and the long term growth of the firm2 an optimum dividend policy should stri!e out a balance between current dividends and future growth which maximises the price of the firm:s shares. 8he D;6 ratio of a firm should be determined with reference to two basic ob7ectives maximising the wealth of the firm:s owners and providing sufficient funds to finance growth; expansion plans. 'ta+ility of dividends : +tability of dividends is another ma7or aspect of dividend policy. 8he term dividend stability refers to the consistency or lac! of variability in the stream of future dividends. 6recisely2 it means that at certain minimum amount of dividend is paid regularly. ,egal/ contractual and internal constraints and restrictions : 8he firms: dividend decision is also affected by certain legal2 contractual and internal re#uirements and commitments. &egal factors stem from certain statutory re#uirements2 contractual restrictions arise from certain statutory re#uirements2 contractual restrictions arise from certain loan convents and internal constraints are the result of the firm:s li#uidity position. 8hough legal rules do not re#uire a dividend declaration2 they specify the conditions under which dividends can be declared. +uch conditions pertain to (a) capital impairment2 (b) net profits2 (c) insolvency2 (d) illegal accumulation of excess profit and2 (e) payment of statutory dues before declaration of dividends. Tax consideration : 8he firm:s dividend policy is directed by the provisions of income A tax law. If a firm has a large number of owners2 in high tax brac!et2 its dividend policy may be to have higher retention. As against this if the ma7ority of shareholders are in lower tax brac!et re#uiring regular income the firm may resort to higher dividend payout2 because they need current income and the greater certainty associated with receiving the dividend now2 instead of the less certain prospect of capital gains later. Capital mar%et consideration : If the firm has an access to capital mar!et for fund raising2 it may follow a policy of declaring liberal dividend. Oowever2 if the firm has only limited access to capital mar!ets2 it is may li!ely to adopt low dividend payout ratio. +uch firms are li!ely to rely more heavily on retained earnings. (nflation : &astly2 inflation is also one of the factors to be rec!oned with at the time of formulating the dividend policy. Cith raising prices2 accumulated depreciation may be inade#uate to replace obsolete e#uipments. 8hese firms have to rely upon retained earnings as a source of funds to ma!e up the deficiency. 8his consideration becomes all the more important if the assets are to be replaced in the near future. %onse#uently2 their dividend payout ratio tends to be low during periods of inflation. S+e*!&, -e& ures "- F!#&#*!&, M&#&/e.e# !# & +u0,!* se* "r u#3er &9!#/ %PSUs' : 3. 4ole of financial advisor : 8he financial advisor occupies an important position in public sector underta!ings. Ois concurrence is re#uired on all proposals which have financial implications. 0). Capital !udgeting decisions : 8he power upto certain limits2 in respect of individual capital expenditure items has been delegated to the board of public sector underta!ings. 9or ma!ing investments beyond the limit the proposal goes to public Investment "oard which appraises and recommends pro7ects to the central 1overnment. 00. Capital structure decisions : +uch decisions involves the identification of different sources of finance. Hormally 6+Ns are financed on the basis of half their capital being in the shape of loans. 8he funds are also provided to 6+Ns directly by the government. 8he following factors are ta!en into consideration at the time of designing capital structure (i) gestation period2 (ii) level of business ris! (iii) capital intensity of pro7ect and (iv) freedom pricing.

(ii)

(iii)

(iv)

(v)

(vi)

%3'

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0'. 3or!ing capital management : 8he inventory constitutes a ma7or portion of the wor!ing capital of public sector underta!ings and hence proper inventory management should be given top priority by public sector underta!ings. 0,. udit : 6ublic sector under ta!ings in addition to regular audit conducted by professional accounts2 are sub7ect to efficiency A cum A propriety audit by the comptroller and Audit 1eneral of India whose reports are presented to parliament every year. nnual report :8he annual reports of public sector units though similar to those of private sector units2 tend to provide more information.

0/.

0(. Pricing policy : 8he bureau of public sector underta!ing has laid down certain guidelines for pricing by 6+Ns with the ob7ective to serve the overall interest of the community at large. 0-. 'tatus of pu+lic sector underta%ing : 6+Ns are organised mainly as departmental enterprise or statutory corporation or companies.

1111111111111111

FINAL EHAMINATION NOCEM)ER 5 1999 Gr. I MANAGEMENT ACCOUNTING AN7 FINANCIAL ANALYSIS

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Ques !"# 1. (c) A"% %ompany &td. has been producing a chemical product by using machine P for the last two years. How the management of the company is thin!ing to replace this machine either by K or by 5 machine. 8he following details are furnished to you : P K 5

"oo! value ($s.) 02))2))) $esale value now ($s.) 020)2))) 6urchase price ($s.) 02*)2))) '2))2))) Annual fixed cost (including depreciation) ($s.) 3'2))) 02)*2))) 02,'2))) Jariable running costs (including labour) per unit ($s.) , 0.() '.() 6roduction per hour (unit) * * 0' 5ou are also provided with the following details : +elling price per unit ($s.) ') %ost of materials per unit ($s.) 0) Annual operating hours '2))) Cor!ing life of each of the three machines (as from now) ( years. +alvage value of machines P $s.0)2)))2 K $s.0(2)))2 5 $s.0*2))). 8he company charges depreciation using straight line method. It is anticipated that an additional cost of $s.*2))) p.a. would be incurred on special advertising to sell the extra output of machine 5. Assume tax rate of ()4 and cost of capital 0)4. 8he present value of $e.0 to be received at the end of the year at 0)4 is as under : 5ear 6resent value 0 .3)3 ' .*', ..(0 / .-*, ( .-'0

$e#uired : Nsing H6J method2 you are re#uired to analyse the feasibility of the proposal and ma!e recommendations. (d) 8he 1lobe anufacturing %ompany &td. is considering an investment in one of the two mutually exclusive proposals A6ro7ects K and 52 which re#uire cash outlays of $s.,2/)2))) and $s.,2,)2))) respectively. 8he certainty A e#uivalent (%.E.) approach is used in incorporating ris! in capital budgeting decisions. 8he current yield on government bond is *4 and this be used as the ris!less rate. 8he expected net cash flows and their certainty A e#uivalents are as follows : <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 6ro7ect K 6ro7ect 5<<<<<< 5ear?end %ash flow %.E. %ash flow %.E. $s. $s. <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< 0 02*)2))) ).* 02*)2))) ).3 ' '2))2))) ).. 02*)2))) ).* , '2))2))) ).( '2))2))) ).. 6resent value factors of $e.0 discounted at *4 at the end of year 02 ' and , are .3'-2 .*(. and . .3/ respectively. $e#uired : (i) Chich pro7ect should be accepted F

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(iii) A#s$er %&'

If ris! ad7usted discount rate method is used2 which pro7ect would be analysed with a higher rate F

A)C C".+&#4 L 3. C".+u & !"# "- 4e&r,4 *&s( !#-,"$ achine +ales (units) +elling price per unit ($s) +ales: (A) &ess: %osts Jariable running costs /*2))) aterial cost 02-)2))) Annual fixed cost 3'2))) Additional cost (special adv.) 8otal costs: (") 6rofit before tax: (A) A (") &ess: 8ax G ()4 6rofit after tax Add: Depreciation %ash inflow P 0-2))) ') ,2')2))) '/2))) 02-)2))) 02)*2))) K 0-2))) ') ,2')2))) 5 '/2))) ') /2*)2)))

,2))2))) ???? <<<<<<<< ,2))2))) ')2))) 0)2))) 0)2))) ')2))) ,)2)))

-)2))) '2/)2))) '23'2))) 02,'2))) /2,'2))) ????? *2))) <<<<<<< <<<<<<< '23'2))) /2/)2))) '*2))) /)2))) 0/2))) ')2))) 0/2))) ')2))) ,,2))) ,-2/)) /.2))) (-2/))

C".+u & !"# "- *&s( !#-,"$ !# < ( Ye&r achinery %ash inflow Add: salvage value of machines %ash inflow P ,)2))) 0)2))) /)2))) K /.2))) 0(2))) -'2))) 5<< (-2/)) 0*2))) ./2/))

C".+u & !"# "- Ne Prese# C&,ue 5ear < 0 ' , / ( achine Discounting 9actor ).3)3 ).*')..(0 ).-*, ).-'0 %ash inflow $s. ,)2))) ,)2))) ,)2))) ,)2))) /)2))) P 6.J. of cash inflow $s. '.2'.) '/2.*) ''2(,) ')2/3) '/2*/) 0203230) 020)2))) 3230) K %ash inflow $s. /.2))) /.2))) /.2))) /.2))) -'2))) 6.J. of %ash inflow $s. /'2.', ,*2*'' ,(2'3. ,'20)0 ,*2()' 02*.2//( 02*)2))) .2//( %ash inflow $s. (-2/)) (-2/)) (-2/)) (-2/)) ./2/)) 5<<< 6.J. of cash inflow $s. (02'-..-) /-2(*-./) /'2,(-./) ,*2('0.') /-2')'./) '2'/23,/.)) '2))2))).)) '/23,/.))

&ess: 6urchase price Het present value

Re*"..e#3& !"#s: 8he Het 6resent Jalue is higher in the case of achine 5. 8herefore2 it is advisable that the company should replace machine P with machine 5.

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Oowever2 as the cost of investment is not the same for all machines2 it would be better to base the decision on profitability index which is as under: 6.J. of cash inflow 6.I. > ?????????????????????????????? 6.J. of cash outflow 0203230) achine P > ?????????????????? > 0.)3 020)2))) 02*.2//( achine K > ??????????????????? > 0.)/0 02*)2))) '2'/23,/ achine 5 > ???????????????????? > 0.0' '2))2))) +ince the profitability index of machine 5 is the highest therefore machine P should be replaced by machine 5. %0' %!' 5ear end S & e.e# s("$!#/ Ne Prese# C&,ue "- Pr"Ge* H %ash flow $s. %.E. (b) ).* ).. ).( Ad7usted cash flow (c) > (a) x (b) 02//2))) 02/)2))) 02))2))) 6resent value factor at *4 (d) ).3').*(. )..3/ 8otal present value $s. (e) > (c) x (d) 02,,2,// 020323*) .32/)) ,2,'2.'/ ,2/)2))) (.2'.-)

(a) 0 02*)2))) ' '2))2))) , '2))2))) &ess: Initial Investment Het present value

S & e.e# s("$!#/ Ne Prese# C&,ue "- Pr"Ge* Y 5ear end $s.<<<< 0 ' , (a) 02*)2))) 02*)2))) '2))2))) (b) ).3 ).* ).. (c) > (a) x (b) (d) 02-'2))) ).3'02//2))) ).*(. 02/)2))) )..3/ (e) > (c) x (d) 02()2)0' 02',2/)* 020020-)<<<<< ,2*/2(*) ,2,)2)))<<<<< (/2(*) %ash flow 9low $s. %.E. Ad7usted cash flow $s. 6resent value factor at *4 8otal 6resent value

&ess: Initial investment Het 6resent Jalue

7e*!s!"#: +ince the net present value of pro7ect 5 is positive2 the pro7ect 5 should be accepted. (iii) +ince the certainty A e#uivalent (%.E) coefficient of pro7ect K is lower than pro7ect2 52 the pro7ect x is ris!ier than pro7ect 5. therefore2 if ris! ad7usted discount rate method is used the pro7ect K would be analysed with a higher rate.

Ques !"# 2. %&'%!' If fixed costs are $s./2)))2 variable costs $s.,'2))) and brea!?even point $s.')2)))2 find out : (() 6rofit?volume ratio

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(-) (.) (*) (iii)

+ales Het profit argin of safety

If fixed costs are $s.'/2)))2 margin of safety $s./)2))) and brea!?even *)2))). 9ind out (() (-) (.) (*) +ales 6rofit?volume ratio. Het profit Jariable costs

%0'

8he odern %hemicals &td. re#uires $s.'(2))2))) for a new plant. 8his plant is expected to yield earning before interest and taxes of $s.(2))2))). Chile deciding about the financial plan2 the company considers the ob7ective of maximising earnings per share. It has three alternatives to finance the pro7ect A by raising debt of $s.'2()2))) or $s.0)2))2))) or $s.0(2))2))) and the balance2 in each case2 by issuing e#uity shares. 8he company:s share is currently selling at $s.0()2 but is expected to decline to $s.0'( in case the funds are borrowed in excess of $s.0)2))2))). 8he funds can be borrowed at the rate of 0)4 upto $s.'2()2)))2 at 0(4 over $s.'2()2))) and upto$s.0)2))2))) and at ')4 over $s.0)2))2))). 8he tax rate applicable to the company is ()4. Chich form of financing should the company choose F Explain a to how the wealth maximisation ob7ective is superior to the profit maximisation ob7ective.

%*'

A#s$er %&' %!' %1' Pr"-! 5 6",u.e r& !" 9ixed cost +ince2 "rea! A even 6oint > ????????????????? 6; v ratio 9ixed cost 8herefore2 6; v ratio > ??????????????????????????? x 0)) "ea! A even point $s. /2))) > ?????????????????????? x 0)) $s. ')2))) %2' S&,es If 6; v ratio is ')42 the variable cost to sales would be *)4. Jariable cost x 0)) 8herefore2 sales > ?????????????????????????????? *) $s. ,'2))) x 0)) > ???????????????????????????????? *) > $s. /)2))) %8' Ne Pr"-! Het 6rofit: +ales A Jariable costs A 9ixed costs > $s. /)2))) A $s. ,'2))) A $s. /2))) > $s. /2)))

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%:' M&r/!# "- s&-e 4 argin of safety : +ales A "rea! Aeven sales > $s. /)2))) A $s. ')2))) > $s. ')2))) %!!' %1' S&,es +ales: "rea! A even sales > > $s. *)2))) = $s. /)2))) > $s. 02')2))) %2' Pr"-! 5 6",u.e r& !" 9ixed costs 6;v $atio > ?????????????????????????????? x 0)) "rea! A even sales $s. '/2))) > ????????????????????????? x 0)) $s. *)2))) > ,)4 %8' Ne Pr"-! Het profit : %ontribution A 9ixed costs > ($s. 02')2))) x ,)4) A $s. '/2))) > $s. 0'2))) %:' C&r!&0,e C"s s Jariable costs > +ales A %ontribution > $s. 02')2))) A $s. ,-2))) > $s. */2))) %0' C&,*u,& !"# "- E&r#!#/ +er s(&re -"r (ree &, er#& !6es " -!#&#*e (e +r"Ge* Alternatives I II III 6articulars to raise debt to raise debt to raise debt Ef $s. '2()2))) of $s. 0)2))2))) of $s. 0(2))2))) And e#uity of and e#uity of and e#uity of $s. ''2()2))) $s. 0(2))2))) $s. 0)2))2))) $s. $s. $s. Earnings before interest and tax (2))2))) (2))2))) (2))2))) &ess: Interest on debt '(2))) 02,.2()) '2,.2()) At the rate of (0)4 on $s. '2()2)))) (0)4 on $s. '2()2)))) (0)4 on $s. '2()2)))) (0(4 on $s. .2()2))))(0(4 on $s. .2()2)))) <<<< <<<< (')4 on $s. (2))2)))) Earnings before tax '2-'2()) &ess : 8ax G ()4 02,02'() /2.(2))) '2,.2()) ,2-'2()) 02*02'() argin of safety

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Earnings after tax : (A) 02,02'() Y Humber of shares : (") ($efer to wor!ing note) Earning per share: (A); (")

'2,.2()) 0(2))) 0(2*,,

02*02'() 0)2))) 0*.0'( *2))) 0-./)-

7e*!s!"#: 8he earning per share is higher in alternative II i.e.2 if the company finance the pro7ect by raising debt of $s. 0)2))2))) and issue e#uity shares of $s. 0(2))2))). therefore2 the company should choose this alternative the pro7ect. 2"r9!#/ #" e: Alternatives I E#uity financing: (A) $s. ''2()2))) ar!eting price per share: (") $s. 0() Humber of e#uity share: (A); (") 0(2))) %*' II $s. 0(2))2)) $s. 0() 0)2))) III $s. 0)2))2))) $s. 0'( *2)))

It is commonly believed that maximisation of profit is the basic ob7ective of a business enterprise. In other wor!s2 a finance manager while considering all financing2 investment and other relevant decisions2 should examine each alternative with reference to whether or not it would maximise profit. "ut in a study of business finance2 it is agreed that profit maximisation is too narrow as an ob7ective2 since it does not ta!e into account the extent of ris!2 the timing of returns and certain other important factors such as obligation to wor!ers2 consumers2 society etc. Cealth maximisation ob7ective appears to be superior to the profit maximisation. 8he term wealth maximisation means maximising shareholders wealth in terms of its economic value as represented by the present value of all the future cash flows in the form of dividend or other benefits expected from the firm. 8he mar!et price of the share reflects this present value. According to Jan Oorne Rthe mar!et price of a firm:s stoc! represents the final Zudgment of al mar!et participants as to what the value of the particular firm is. it ta!es into account present and prospective future earnings per share2 the timing and ris! of these earnings2 the dividend policy of the firm and many other factors that bear upon the mar!et price of the stoc!. 8he mar!et price serves as a performance index or report card of a firm:s progress. 8herefore2 wealth maximisation is superior to profit maximisation ob7ective which can be considered as a part of wealth maximisation strategy. <<<<<<<<<<<<

Ques !"# 8. %&' $adiance 1arments &td. manufactures readymade garments and sells them on credit basis through a networ! of dealers. Its present sale is $s.-) la!h p.a. with ') days credit period. 8he company is contemplating an increase in the credit period with a view to increasing sales. 6resent variable costs are .)4 of sales and the total fixed costs $s.* la!h p.a. 8he company expects pre?tax return on investment G '(4. +ome other details are given as under : 6roposed %redit 6olicy I II III IJ Average %ollection 6eriod (days) ,) /) () -) Expected Annual +ales ($s. la!hs) -( .) ./ .(

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$e#uired : Chich credit policy should the company adopt F 6resent your answer in a tabular form. Assume ,-) ? days a year. %alculations should be made upto two digits after decimal. %0' 8he following is the capital structure of +imons %ompany &td. as on ,0;0';033* : E#uity shares :0)2))) shares (of $s.0)) each) 0)4 6reference shares (of $s.0)) each) 0'4 Debentures $s. 0)2))2))) /2))2))) -2))2))) ')2))2)))

8he mar!et price of the company:s share is $s.00) and it is expected that a dividend of $s.0) per share would be declared for the year 033*. 8he dividend growth rate is -4. (i) If the company is in the ()4 tax brac!ets2 compute the weighted average cost of capital. (iii) Assuming that in order to finance an expansion plan2 the company intends to borrow a fund of $s.0) la!h bearing 0/4 rate of interest2 what will be the company:s revised weighted average cost of capital F 8his financing decision is expected to increase dividend from $s.0) to $s.0' per share. Oowever2 the mar!et price of e#uity share is expected to decline from $s.00) to $s.0)( per share.

A#s$er
%&' S & e.e# s("$!#/ e6&,u& !"# "- (e +r"+"se3 *re3! +",!*!es (Amt. In $s. la!hs) %redit 6olicies 6resent Average collection (') days) 6eriod (days) +ales (Annual) -).)) &ess: Jariable cost /'.)) %ontribution 0*.)) &ess: 9ixed costs *.)) 6rofit 0).)) Increase in profit com? 6ared to present profit: (A) ? ?? Investments in debtors ().)) (variable cost = 9ixed cost) Debtors turnover 0* (,-) days; average collection period) Average investment In Debtors '..* (investment in debtors; Debtors turnover) Additional investment in debtors %ompared to present &evel ?? $e#uired return on Additional in investment ('(4): (") ?? Incremental profit (A) A (") ?? I (,) days) -(.)) /(.() 03.() *.)) 00.() 0.() (,.() 0' II (/) days) .).)) /3.)) '0.)) *.)) 0,.)) ,.)) (..)) 3 6roposed III (() days) ./.)) (0.*) ''.') *.)) 0/.') /.') (3.*) ..') IJ (-) days) .(.)) ('.() ''.() *.)) 0/.() /.() -).() -

/./-

-.,,

*.,

0).)*

0.-* )./' 0.)*

,.(( ).*3 '.00

(.(' 0.,* '.*'

..,) 0.*, '.-.

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7e*!s!"#: 8he company should adopt the credit policy III (with collection period of () days) as it yields a maximum profit to the company. %0' %!' +ource of 9inance (a) E#uity share 0)4 6reference share 0'4 Debentures Ceighted average cost of %apital C".+u & !"# "- (e $e!/( e3 &6er&/e *"s "- *&+! &, 6roportion (b) ).( After tax cost (4) (0 A tax rate i.e.2 ()4) (c) Ceighted average cost of capital (4) (d) > (b) x (c) ..(/ '.)) 0.*) 00.,/

0(.)3 ($efer to wor!ing note 0) ).' 0).)) ).,-.))

%!!' +ource of 9inance (a) E#uity shares

C".+u & !"# "- Re6!se3 $e!/( e3 &6er&/e *"s "- *&+! &, 6roportion After tax cost (4) (0 A tax rate i.e. ()4) (b) ).,,, Ceighted average cost of capital (4) (d) > (b) x (c) (.*) 0.,, 0.') '.,, 0).--

(c) 0../' ($efer to wor!ing note ') 0)4 preference shares ).0,, 0).)) 0'4 Debentures ).')) -.)) 0/4 &oan ).,,, ..)) $evised weighted average cost of capital 2"r9!#/ #" es: (') %ost of e#uity shares (Te) Dividend per share Te > ????????????????????????????????? = 1rowth rate ar!et price per share 0) > ??????????? = ).)00) > ).0()3 or 0(.)34 (') $evised cost of e#uity shares (Te) 0' $evised Te > ?????? = ).)0)( > ).0./' or 0../'4

Ques !"# :. (c) r. +atya 6rasad2 the 6resident of the %ompany was very happy with 033* results sinse they exceeded the profit budget. All the same he wanted to !now the relative contributions of manufacture and mar!eting departments to the overall company result.

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8he company products can be grouped unto two main lines of business : Electric eters (E ) and Electronic Instruments (EI). "oth E and EI are industrial measuring instruments and perform similar functions. Oowever2 these products differ in their manufacturing technology (E is based on mechanical and electrical technology2 whereas EI is based on microchip technology) and their use characteristics. E and EI are substitute products in the same sense that a mechanical watch and digital watch are substitutes. $e#uired : (i) (iii) 6repare a statement that you would li!e to present to r. +atya 6rased. Oow would you ma!e a case for a share in the company:s bonus pool in respect of the following managers :

1eneral anager (E )2 ar!eting anager (E )2 anufacturing anager (E )2 1eneral anager (EI)2 ar!eting anager (EI) and anufacturing anager (EI) Income statement for the year 033* ($s. :)))) "udget +ales %ost of goods sold 1ross margin &ess : Ether operating expenses : ar!eting 02*($MD 02/*) Administration 02,/) 0-2*.' 32--* .2')/ 02//) 3,' 02-./ Actual 0.2)-0 32*-( .203-

/2-.'2('*

/2)/,20() EI $s.0*) $s.')$s.() $s.(/ --2))) -'20.' $s..-) la!hs $s.,') la!hs 0(4 34 Actual ,2(,) 02//) 02-./ 3,'

Additional Information E +elling price per unit Average selling price planned 033* Actual Jariable 6roduct %ost per unit Average standard manufacturing cost planned 033* Actual Jolume Information Nnits produced and sold?planned 033* Actual 8otal Industry sales 033* Actual 8otal Industry variable product costs 033* Actual %ompany:s share of the mar!et per cent of 6hysical units : 6lanned Actual 9irm wide fixed expenses ($s. U)))) anufacturing ar!eting Administrative $ M D (Exclusively for Electronic Instruments) (d) $s./) $s.,) $s.') $s.'0 02'/2*)) 02/02..) $s.//) la!hs $s.0-) la!hs 0)4 0-4 6lanned ,2*.' 02*(02,/) 02/*)

Chat is performance budgeting and what are its re#uisites F E$

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(c)

A firm an investment proposal2 re#uiring an outlay of $s./)2))). 8he investment proposal is expected to have ' years economic life with no salvage value. In year I2 there is a )./ probability that cash inflow after tax will be $s.'(2))) and ).- probability that cash inflow after tax will be $s.,)2))). 8he probabilities assigned to cash inflows after tax for the year II are as follows :

8he %ash inflow year : 8he %ash inflow year II

$s.'(2))) $s.0'2))) $s.0-2))) $s.''2))) 6robability ).' )., ).(

$s.,)2))) $s.')2))) $s.'(2))) $s.,)2))) 6robability )./ ).( ).0

8he firm uses a 0)4 discount rate for this type of investment. $e#uired : (e) (f) (g) (h) %onstruct a decision tree for the proposed investment pro7ect. Chat net present value will the pro7ect yield if worst outcome is realised F Chat is the probability of occurrence of this H6J F Chat will be the best and the probability of that occurrence F Cill the pro7ect be accepted F (0)4 Discount factor 0 year ' year (d) ).3)3 ).*'-)

Do the profitability index and the H6J criterion of evaluating investment proposals lead to the same acceptance A re7ection and ran!ing decisions F In what situations will they give conflicting results F

A#s$er %&' %!'

Electric "udget (a) 02'/2*))

A s & e.e# " 0e +rese# e3 " Mr. S& 4& Pr&s&3 I#*".e S & e.e# -"r (e 4e&r, 199@
eters (E ) Electric instruments (EI) Actual (b) 02/02..) /'2(,20)) '32..20.) Jariance (a) A (b) 0-23.) (9av) .2,*23)) (Adv) /2*020.) (Adv.) 0'2')2).) "udget (a) --2))) 020*2*)2))) ,,2))2))) Actual (b) -'20.' 02'*2).2/,' ,,2(.2'** Jariance (a) A (b) ,2*'* (Adv.) 32'.2/,' (9av) (.2'** (Adv.) *2.)20// (9av) "udget (a) Actual (b) 8otal

6roduct

6articulars

Jarianc (a) A (b)

Vuantity

+ales Jalue &ess: variable manufactu ring cost %ontributi on &ess: 9ixed manufactu ring cost 1ross

/323'2))) '/23-2)))

02-*2.'2))) (.23-2)))

02.)2-)2(, ' -,2,/2/(*

02**2(,'

(2,*2/(* (Adv)

'/23-2)))

0'2.(23,)

*(2*)2)))

3/2()20//

020)2.-2))) ,*2.'2)))

02).2'-2). / ,(2,)2)))

,2/323'-

,2/'2))) (9av) .23'-

.'2)/2)))

.023-2)./

Cost Academy 0*2(-2)))

210 0/2/)2)))

margin &ess other operating expenses ar!eting $MD

(Adv) /20-2))) (9av)

0/2*)2))) 0,2/)2))) '(2'*2)))

32,'2))) 0-2./2))) ,02()2)./

Administra tion 6rofit before tax

(2/*2))) (9av.) ,2,/2))) (Adv) -2''2)./

N" e : F&6. > 9avourableL Adv. > Adverse %!!' 8he 1eneral anager (E ) and 1eneral anager (EI) made an adverse contribution of $s. 0'2')2).) and a favourable contribution of $s. *2.)20// respectively in the company:s bonus pool ($efer to (i) above). 9urther2 the actual fixed manufacturing and fixed mar!eting costs are less than the budgeted fixed manufacturing and fixed mar!eting costs i.e.2 there are favourable variances2 the benefit of this is to be dividend among the two products on some basis. 9or the share of manufacturing wor!ing given below: 6roduct anufacturing cost variance ($efer to (i) above) anager (E ) and (EI) to the company:s bonus pool refer to Electric eters /2*020.) (Adv) <<<<<< Electric Instruments<<< (.2'** (Adv.)

8he manufacturing cost variance arise due to price variance and #uantity variance as computed below: 6roducts anufacturing price variance: Actual #ty. (+td. 6rice A Actual 6rice) anufacturing #uantity variance: +td. 6rice (+td. Vty ? -'20.') Actual #ty.) Electric eters Electric Instrument > -'20.' ($s.()A$s. (/) > $s. '2'/2-** (Adv) > $s.()(--2)))A

> 0/02..) ($s. ') A $s. '0) > $s. 02/02..) (Adv) > $s. ') (02'/2*)) A 02/02..)) > $s. ,2,32/)) (Adv.)

> $s. 02302/)) (9av.)

+ince the manufacturing cost variance is adverse the manufacturing manager (E ) and (EI) reduces the profit of the company. further2 the budgeted; actual manufacturing cost is more than the industry average cost as shown below: "udget Actual Actual Industry Average 6lanned Actual Actual Average (/ /-.,' $s.,') -'0.' Industry

$s.per unit

')

'0

0*.)( () $s.0-) la!hs 02/02..)B ).0-

la!hs ).)3

9or the share of given below:

ar!eting manager (E ) and (EI) in the company bonus pool refer to wor!ing

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6roducts +ales Jariance ($efer to (i) above)

Electric eters $s. .2,*23)) (Adv)

Electric Instruments<<<< $s2 32'.2/,' (9av)

8he total sales variances arise to sale due to sales price variance and sale #uantity variance which are computed below: <<<<<<<<< 6roducts Electric eters Electric Instruments +ales price variance: Actual #ty. (+td. 6rice ? > $s. 02/02..) ($s. /) A $s. ,)) > -'20.'($s.0*) A $s. ')-) Actual 6rice) > $s. 0/20.2.)) (Adv.) > $s. 0-20-2/.' (9av.) +ales #uantity variance: +td. 6rice (+td. Vty ? Actual #ty) > $s. /) (02'/2*)) A 02/02..)) > $s. -2.*2*)) (9av.) >$s. 0*) (--2))) ? -'20.') > $s. -2*32)/) (Adv)

8he mar!eting manager (E ) reduces the company bonus pool by $s. .2,*23)) and mar!eting manger (EI) increases the company bonus pool by $s. 32'.2/,'. further2 the 4 of mar!et share and average price realisation of the company as compared to Industry is given below: 4 ar!et share 6roducts 6hysical #ty. Jalue Electric 6lanned 0)4 eters Actual 0-4 3..4 ($s. /'.(, la!hs; $s. //) la!hs) Electric Instruments 6lanned Actual<<<< 0(4 34 0-.*4 ($s.0'*.)* la!hs; $s..-) la!hs)

Average price realisation Electric eters 6lanned Actual $s. per unit /) ,)

Electric Instrument Actual 6lanned Actual Industry Average /3.-( 0*) ')($s. //) la!hs 02/02..); ).0-)

Actual Industry Average 00).)' ($s. .-) la!hs (-'20.' ).)3)

9rom above it is clear that mar!eting manager (E ) follows the strategy of lower price of product for increasing mar!et share and mar!eting manager (EI) follows the strategy of higher price which reduces mar!et share. %0' 6erformance budgeting may be described as a budgeting system where the input costs are related to the performance i.e. the end results. 6erformance budgeting is therefore2 loo!ed upon as a budget based on functions2 activities and pro7ects and is lin!ed to the budgetary system on the basis of ob7ectives2 classification of expenditure etc. the performance budgeting techni#ue is the process of analysing2 identifying2 simplifying and crystalliQing specific performance ob7ectives of a 7ob to be achieved over a period in the framewor! of the organisational ob7ectives2 the purpose and ob7ectives of the 7ob. ReBu!s! es:

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(. Establishment of a well defined responsibility centres action points where operations are performed and financial transaction in terms of money ta!e place. -. Establishment for each responsibility centre a programmes of expected performances in physical units of that centre. 9or example2 the performance budget for a sales department may be units of goods sold during a budget period. .. 9orecasting the cost of activities re#uired for achieving the expected performance. *. Evaluation of actual performance as compared with standard performance by a system of performance reporting. P& ( N". F"!# +r"0&0!,! 4 A, er#& e A#s$er: %&' '(2))) ).' 0'2))) )., 0-2))) 0 ' , )./ / ( ,)2))) ).( '(2))) ).)0.)) ).)* ).0' ).') ).'/ ).,)

).(
Cash outlay 40,000

''2)))

')2)))

).0 ,)2)))

8he decision tree above shows that there are six possible outcomes each represented by a path. 8he net present value of each path at 0)4 discount rate is given below: 6ath (cash inflow year 0 x (cash inflow year ' x 8otal cash Discount factor year 0) discount factor year ') inflow (a) 0 '. ,. /. (. ($s. '(2))) x ).3)3) > ''2.'( ($s. '(2))) x ).3)3) > ''2.'( ($s. '(2))) x ).3)3 > ''2.'( ($s. ,)2))) x ).3)3) > '.2'.) ($s. ,)2))) x ).3)3) > '.2'.) (b) ($s. 0'2))) x ).*'-) > 3230' ($s. 0-2))) x ).*'-) > 0,2'0($s. ''2))) x ).*'-) > 0*20.' ($s. ')2))) x ).*'-) > 0-2'() ($s. '(2))) x ).*'-) > ')2-() (c) > (a) > (b) $s. ,'2-,. ,(23/0 /)2*3. /,2.3) /.23') %ash outflow (d) $s. /)2))) /)2))) /)2))) /)2))) /)2))) Het 6resent value <<<<<< (e) > (c) A (d) $s. ? .2,-, ? /2)(3 *3. ,2.3) .23')

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-.

($s. ,)2))) x ).3)3) > '.2'.)

($s. ,)2))) x ).*'-) > '/2.*)

('2)()

/)2)))

0'2)()

S & e.e# s("$!#/ (e eA+e* e3 #e +rese# 6&,ue 6ath Het present Jalue G 0)4 ($efer above) (a) 0 ' , / ( ? .2,-, ? /2)(3 *3. ,2.3) .23') 0'2)() Zoint probability ($efer above) (b) ).)* ).0' ).') ).'/ ).,) ).)Expected net present (a) x (b) ? (*3.)/ ? /*..)* 0.3./) 3)3.-) '2,.-.)) .',.)) <<<<<<< ,2000.**

(b) (c) (d) %0'

If the worst outcome is realised the Het 6resent value which the pro7ect will yield is $s. .2,-, (negative). 8he probability of occurrence of this Het 6resent value is *4. 8he best outcome will be path - when Het 6resent value is higher i.e.2 $s. 0'2)() (positive). 8he probability of occurrence of this Het 6resent value is -4. 5es2 the pro7ect will be accepted since the Expected Het 6resent value x probability sum total is positive.

In most of the situations the Het present value method (H6J) and profitability Index (6I) yield same accept or re7ect decision. In general terms2 under 6I method a pro7ect is acceptable if probability index value is greater than I and re7ected if it is less than I. Nnder H6J method a pro7ect is acceptable if Het 6resent value of a pro7ect is positive and re7ected if it is negative. %learly a pro7ect offering a profitability index greater than I must also offer a net present value which is positive. "ut a conflict may arise between two methods if a choice between mutual exclusive pro7ects has to be made %onsider the following example: 6J of cash inflows Initial cash outflows Het 6resent value 6.I. 6ro7ect A '2))2))) 02))2))) 02))2))) '2))2))) ???????????? > ' 02))2))) 6ro7ect " 02))2))) </)2))) -)2))) 02))2))) ??????????? > '.( /)2)))

According to H6J method2 pro7ect A would be preferred2 whereas according to profitability index method pro7ect " would be preferred.

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8his is because Het 6resent value gives ran!ing on the basis of absolute value of $upees. Chereas profitability index gives ran!ing on the basis of ratio. Although 6I method is based on H6J2 it is better evaluation techni#ue than H6J in a situation of capital rationing. Ques !"# <. Crite short notes on the following : (e) (f) (g) (h) Inter?relationship between investment2 financing and dividend decisions. 9inancial forecasting techni#ues. %urrent cost accounting method ad7usting financial statements. "asic principles of portfolio management. (/ x ( > ') mar!s)

A#s$er
%&' I# er 5 re,& !"#s(!+ 0e $ee# !#6es .e# , -!#&#*!#/ &#3 3!6!3e#3 3e*!s!"#s 8he finance functions are dividend into three ma7or decisions2 viQ.2 investment2 financing and dividend decisions. It is correct to say that these decisions are inter A related because the underlying ob7ective of these three decisions is the same2 i.e.2 maximisation of shareholders: wealth. +ince investment2 financing and dividend decisions are all interrelated2 one has to consider the 7oint impact of these decisions on the mar!et price of the company:s shares and these decisions should also be solved 7ointly. 8he decision to invest in a new pro7ect needs the finance for the investment. 8he financing decision2 in turn2 is influenced by and influences dividend decision because retained earnings used in internal financing deprive shareholders of their dividends. An efficient financial management can ensure optimal 7oint decisions. 8his is possible by evaluating each decisions in relation to its effect on the shareholders: wealth. 8he above three decisions are briefly examined below in the light of their inter A relationship and to see how they can help in maximising the shareholders: wealth i.e.2 mar!et price of the company:s shares: (nvestment decision: 8he investment of long term funds is made after a careful assessment of the various pro7ects through capital budgeting and uncertainty analysis. Oowever2 only that investment proposal is to be accepted which is expected to yield at least so much return as is ade#uate to meet its cost of financing. 8his have an influence on the profitability of the company and ultimately on its wealth. "inancing decision: 9unds can be raised from various sources. Each source of funds involves different issues. 8he finance manager has to maintain a proper balance between long A term and short A term funds. Cithin the total volume of long Aterm funds2 he has to ensure a proper mix of loan funds and owners: funds. 8he optimum financing mix will increase return to e#uity shareholders and thus maximise their wealth. &ividend decision: 8he finance manager is also concerned with the decision to pay or declare dividend. Oe assists the top management in deciding as to what portion of the profit should be paid to the shareholders by way of dividends and what portion should be retained in the business. An optimal dividend pay A out ratio maximises shareholders: wealth. 8he above discussion ma!es it clear that investment2 financing and dividend decisions are interrelated and are to be ta!en 7ointly !eeping in view their 7oint effect on the shareholders: wealth. %0' F!#&#*!#/ F"re*&s !#/ Te*(#!Bue

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9inancial forecasting is the starting point in the planning process. It facilitates pre A testing of the financial feasibility of various programmes2 acts2 as a control device2 helps in raising funds2 and improves utilisation of surplus cash. A few forecasting techni#ues are briefly discuss as under : (i) Percentage of 'ales #ethod It is the simplest approach to forecasting financial re#uirements of a firm. 8his method expresses the firm:s financial needs in terms of the percentage of annual sales invested in each individual item of "alance sheet. Nnder this method2 the forecaster computer past relationship between assets and liabilities on one hand and sales on the other on the assumption that the same relationship will continue2 he applies new sales forecast figure to get an estimate of the financial re#uirements. 8his method is more suitable for short A term forecasting. (ii) 'imple 4egression #ethod An alternative method used to forecast financial re#uirements is the simple regression or scatter diagram method. Cith the sales forecast as the starting point and based on the past relationship between sales and "alance sheet items2 it is possible to construct a line A of best fit or the regression line. It is possible to lin! sales with one item of asset at the time. 8his method is more suitable for long A term forecasting. (iii) #ultiple 4egression #ethod A more sophisticated approach to financial forecasting calls for the use of multiple regression analysis. Nnli!e simple regression method2 here sales are assumed to be a function several variables. It is2 therefore2 a superior method. Curre# C"s A**"u# !#/ Me ("3 &3Gus !#/ -!#&#*!&, s & e.e# s It is a well A !nown method of ad7usting financial statements according to changing price level i.e.2 inflation. 1enerally2 two main accounting problems are encountered when there is several inflation in the economy. 8hese are : (a) Oow to ad7ust profit; loss shown by conventional profit and loss statement so that it shows a realistic operating resultL and (b) Oow to reflect the shareholders: investment (or the net assets) more truly. Nnder the inflationary condition2 if financial statement are prepared under conventional accounting system2 profit figure is overstated and financial position understated. In order to remove these limitations2 items of the financial statements are brought to their current values using specific price index. It thus re#uires the following ad7ustments: (v) (vi) (vii) Depreciation ad7ustment %ost of sales ad7ustment onetary wor!ing capital ad7ustment

(viii) 1earing ad7ustment. As a result of these ad7ustments2 fixed assets are shown in the "alance sheet at their current value and not at their depreciated original cost value. +imilarly2 stoc!s are shown at their value to the business and not at the lower of cost or mar!et value.

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It thus enables a realistic assessment of performance (accounting and economic profit will not differ) and helps in ma!ing a better comparison of two companies set A up at different points of time2 ma!es the rate of return more meaningful2 provides a more meaningful information for investment and credit decisions2 and prevents distortion in share prices. )&s!* Pr!#*!+,es "- P"r -",!" M&#&/e.e# 8here are two basic principles of 6ortfolio management2 viQ. (i) Effective investment planning : for the investment in securities by considering the following factors: (a) 9iscal2 financing and monetary policies of the government and the $eserve "an! of India. (b) Industrial and economic environment and its impact on industry prospect in terms of prospective technological changes2 competition in the mar!et2 capacity utilisation by the industry and demand prospect etc. (ii) Constant review of investment : 6ortfolio managers are re#uired to review their investment in securities and continue selling and purchasing their investments in a more profitable avenues. 9or this purpose2 the following analysis is re#uired: (d) (e) (f) (g) Assessment of #uality of management of the company. 9inancial and trend analysis of "alance +heet and 6rofit and &oss Account items in order to direct the flow of investment to profitable avenues. Analysis of securities mar!et. Participating &e+enture : +uch security carries charges in three phases A in the start up phase2 no interest is charged2 next stage a low rate of interest is charged upto a particular

FINAL %NE2' EHAMINATION

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NOCEM)ER, 1996 Gr.-I PAPER 2 : MANAGEMENT ACCOUNTING & FINANCIAL ANALYSIS

A#s$er %&' Hine 1ems &td. has 7ust installed achine??$ at a cost of $s.'2))2))). 8he machine has a five year life with no residual value. 8he annual value of production is estimated at 02()2))) units2 which can be sold at $s.- per unit. Annual operating costs are estimated at $s2'2))2))) (excluding depreciation) at this output level. 9ixed costs are estimated at $s., per unit for the same level of production. Hine 1ems &td. has 7ust come across another model called achinea+ capable of giving the same output at an annual operating cost of $s.02*)2))) (exclusive of depreciation). 8here will be no change in fixed costs. %apital cost of this machine is $s.'2()2))) and the estimated life is for five years with nil residual value. 8he company has an offer for sale of achinea$ at $s.02))2))). "ut the cost of dismantling and removal will amount to $s.,)2))). As the company has not yet commenced operations2 it wants to sell achinea$ and purchase achinea+. Hine 1ems &td. will be a Pero?tax company for seven years in view of several incentives and allowances available. 8he cost of capital may be assumed at 0/4. 6.J. factors for five years are as follows : 5ear 6.J. 9actors ).*.. . )..-3 * ).-.( 3 ).(3' 0) ).(03 (i) (iii) Advise whether the company should opt for the replacement. Cill there be any change in your view2 if achinea$ has not been installed but the company is in the process of selecting one or the other machine F

+upport your view with necessary wor!ings (b) Discuss briefly the impact of taxation on %orporate 9inancing.

A#s$er %&' %!' Re+,&*e.e# "- M&*(!#e 5 R : I#*re.e# &, *&s( "u -,"$ (i) %ash outflow on achine A + &ess : +ale value of achine A $ &ess : cost of dismantling and removal ($s. 02))2))) A $s. ,)2)))) Het Eutflow Incremental cash flow from achine A + $s. '2()2))) $s. .)2))) $s. 02*)2)))

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Annual %ash flow from Annual %ash flow from

achine A + achine A $

Het incremental cash inflow

$s. '2.)2))) $s. '2()2))) <<<<<<<<<< $s. ')2)))

6resent value of incremental cash in flows > $s. ')2))) x ().*.. = )..-3 = ).-.( = ).(3' = ).(03) > ')2))) x ,./,' > $s. -*2-/) H6J of achine A + > $s. -*2-/) A $s. 02*)2))) > (?) $s. 02002,-). $s. '2))2))) spent on replacement. achine A $ is a sun! cost and hence it is not relevant for deciding the achine A + is in the negative2 replacement is not

7e*!s!"# : +ince Het present value of advised.

If the company is in the process of selecting one of the two machines2 the decision is to be made on the basis of independent evaluation of two machines by comparing their Het 6resent values. %!!' I#3e+e#3e# e6&,u& !"# "- M&*(!#e 5 R &#3 M&*(!#e 5 S : achine A $ achine A + Nnits produced 02()2))) 02()2))) +elling price per unit ($s.) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<< +ale value 32))2))) 32))2))) &ess : Eperating %ost (exclusive of depreciation) %ontribution &ess : 9ixed cost Annual %ash flow 6resent value of cash flows 9or ( years %ash outflow Het 6resent value As the H6J of %ash in flow of fall on machine A +. '2))2))) 02*)2))) <<<<<<<<<<<<<<<<<<<<<<<<<<<<< .2))2))) .2')2))) /2()2))) /2()2))) <<<<<<<<<<<<<<<<<<<<<<<<<<<<< '2()2))) '2.)2))) *2(*2))) '2))2))) 32'-2-/) '2()2)))

-2(*2))) -2.-2-/) <<<<<<<<<<<<<<<<<<<<<<<<<<<<<<< achine A + is higher than that of achine A $2 the choice should

N" e : As the company is a Qero tax company for seven years ( achine life in both cases is only for five years)2 depreciation and the tax effect on the same are not relevant for consideration. %0' I.+&* "- T&A& !"# "# C"r+"r& e F!#&#*!#/ : 8ax is levied on the profits of the company. 8ax is also levied on the dividends received by the shareholders in their hands though such dividends are declared out of after tax profits. 8hus the corporate entity and the owners suffer tax twice in a sense. 8his pushes the cost of e#uity capital. En the other hand interest paid on the debt capital is a deductible expenditure and hence company does not pay tax on interest on

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debt capital. 8his reduces the cost of debts. Debt is a less costly source of funds and if the finance manager prudently mixes debt and e#uity2 the weighted average cost of capital will get greatly reduced. Depreciation is not an outgo in cash but it is deductible in computing the income sub7ect to tax. 8here will be saving in tax on depreciation and such savings could be profitably employed. 8hus both... interest and depreciation provide tax shield and have a tendency to increase E6+. 9urther the unabsorbed depreciation can be carried forward indefinitely and this will be helpful for loss ma!ing concerns which start earning profits in future. 8he depreciation loss of one company can be carried forward for set off in another company:s profits in the case of amalgamations in specified circumstances and such a provision will help growth of companies and rehabilitation of sic! units. 8he finance manager of amalgamating company will bear this benefit for the tax shield it carries in planning the activities. 8hus the impact of tax will be felt in cost of capital2 earnings per share and the cash in flows which are relevant for capital budgeting and in planning the capital structure. 8ax considerations are important as they affect the li#uidity of the concerns. 8hey are relevant in deciding the leasing of the assets2 transactions of sale and lease bac!2 and also in floating 7oint venture in foreign countries where tax rates and concessions may be advantageous. 8ax implications will be felt in choosing the siQe and nature of industry and in its location as the tax laws give fillip to small units producing certain products and incentives are given for bac!wards areas. 8ax considerations in these matters are relevant for purpose of preserving M protecting internal funds. 1111111111111 Ques !"# 2 (a) Eutline the methods and tools of financial management. (b) 8he annual cash re#uirement of A &td. is $s.0) la!hs. 8he company has mar!etable securities in lot siQes of $s.()2)))2 $s.02))2)))2 $s.'2))2)))2 $s.'2()2))) and $s.(2))2))). %ost of conversion of mar!etable securities per lot is $s.02))). 8he company can earn (4annual yield on its securities. 5ou are re#uired to prepare a table indicating which lot siQe will have to be sold by the company. Also show that the economic lot siQe can be obtained by the "aumob odel.

A#s$er %&' 9inance anager has to decide optimum capital structure to maximise the wealth of the shareholders. 9or this 7udicious use of financial leverage or trading on e#uity is important to increase the return to shareholders. In planning the capital structure2 the aim is to have proper mix of debt2 e#uity and retained earnings. E6+ Analysis2 6E $atios and mathematical models are used to determine the proper debt A e#uity mix to derive advantage to the owners and enterprise. In the area of wor!ing capital management2 certain techni#ues are adopted such as A"% Analysis2 Economic order #uantities2 cash management models2 etc.2 to improve li#uidity and to maintain ade#uate circulating capital. 9or evaluation of firm:s performance2 $atio Analysis is pressed into service A with the help of rations an investor can decide whether to invest in a firm or not. 9unds flow statement2 providing funds in right #uantities and at right time.

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%0'

T&0,e !#3!*& !#/ ," s!Je "- se*ur! !es 8otal annual cash re#uirements > 8 > $s. 0)2))2))) &ot siQe ($s) > % Humber of &ots > (8;%) ()2))) ') 02))2))) 0) 0)2))) '2))2))) ( (2))) '2()2))) / /2))) (2))2))) ' '2)))

%onversion cost ($s) > (8;%)b')2))) Chere b > cost of conversion per lot. Interest charges 8otal %ost $s. > (c;')I $s. 02'() '02'()

'2()) 0'2())

(2))) 0)2)))

-2'() 0)2'()

0'2()) 0/2())

Economic &ot siQe is

$s. '2))2))) at which total costs are minimum.

2!,,!&. F. )&u.", M"3e, : %ash management model of Cilliam Z. "aumol assumes that the concerned company !eeps all its cash on interest yielding deposits from which it with draws as and when re#uired . it also assumes that cash usage is linear over time. 8he amount of money is with drawn from deposits in such a way that the cost of withdrawal are optimally balanced with those of interest foregone by holding cash. 8he model is almost same as economic stoc! order #uantity model. (EEV) A +tudents may refer to 9+6 (H) A9A A , study paper. ' x 8b 9ormula Economic lot siQe > ?????????????? I Chere 8 > 6ro7ected cash re#uirement > $s. 0)2))2))) b > %onversion cost per lot > $s. 02))) I > Interest earned on mar!etable securities per annum > (4 "y substituting the figures in the formula. ' x 0)2))2))) x 02))) Economic lot siQe > ???????????????????????????????? ).)( > $s. '2))2))) Ques !"# 8 (i)
(ii)

Explain the term R9oreign Exchange $ate $is!S.

ention any four of the tools available to cover Exchange $ate $is!.

(iii)

Alert &td. is planning to import a multi?purpose machine from Zapan at a cost of ,2/)) la!hs yen. 8he company can avail loans at 0*4 interest p.a. with #uarterly rests with which it can import the machine. Oowever there is an offer from 8o!yo branch of an India based ban! extending credit of 0*) days at ')4 p.a. against opening of an irrevocable letter of credit.

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Ether Information : 6resent exchange rate $s.0)) > ,/) yen. 0*) days forward rate $s.0)) > ,/( yen. %ommission charges for letter of credit at '4 per 0' months.
Advise whether the offer from the foreign should be accepted F

A#s$er %!' F"re!/# EA*(&#/e R& e R!s9 : 8his ris! relates to the uncertainty attached to the exchange rates between two currencies. 9or example2 the amount borrowed in foreign currency is to be repaid in the same currency or in some other acceptable currency. 8hus if the foreign currency becomes stronger than (say) Indian rupees2 the Indian borrower has to repay the loan in terms of more rupees than the rupees be obtained by way of loan. 8he extra rupees he pays is not due to an increase in interest rate but because of unfavorable exchange rate. %onversely he will gain if the rupee is stronger. 8he fluctuation in the exchange rate causes uncertainty and this uncertainty gives rise to exchange rate ris!. %!!' 8he following tools are available to cover exchange rate ris! : (a) (b) (c) (d) (7) (!) (l) +pot contracts. $upee forward contract. $upee role over contract. %ross currency forward contract. %ross currency role over contract. %ross currency options. %urrency futures.

(m) %urrency and interest rate swaps. (n) Arbitrage.

%!!!'

O+ !"# I %T" -!#&#*e (e +ur*(&se 04 &6&!,!#/ ,"&# & 1@I +er &##u.': Cost of machine ,2/)) la!h yen as $s. 0)) > ,/) yen Add : Interest at /.(4 I Vuarter Add : Interest at /.(4 II Vuarter (on $s. 0)/( la!hs) > > > 4s. in la%hs 02))).)) /(.)) /..),

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8otal outflow in rupees

>

02)3'.),

Alternatively2 interest may also be calculated on compounded basis2 i.e. $s. 02))) x @0.)/(B' > $s. 02)3'.), O+ !"# II %T" &**e+ (e "--er -r". -"re!/# 0r&#*(' : Cost of letter of credit At 04 on ,2/)) la!hs yen as $s. 0)) > ,/) yen > Add : Interest I Vuarter > Interest II Vuarter (A) P&4.e# & (e e#3 "- 1@? 3&4s : %ost Interest at '4 p.a. @,2/)) x ';0)) x 0*);,-(B ,2/)).)) la!hs yen ,,.(, la!hs yen <<<<<<<<<<<<<< ,/,,.(, la!hs yen > > 4s. in la%hs 0).)) )./( )./. <<<<<< 0).3'

%onversion at $s. 0)) > ,/( yen @ ,/,,.(,;,/( x 0))B (") > $s. 33(.', 8otal %ost : A = " > 0))-.0( la!hs A36!*e : Eption Ho. ' is cheaper. Oence the offer can be accepted. 11111111

Ques !"# :. (a) ROigher the return2 higher will be the ris!S. In this context discuss the various ris!s associated with portfolio planning. (b) 9ollowing is the data regarding six securities : . $eturn (4) $is! (4) . (+tandard Deviation) (i) (iii) A * / " * ( % 0' 0' D / / E 3 ( 9 * -

Chich of the securities will be selected F Assuming perfect correlation2 analyse whether it is preferable to invest .(4 in security A and '(4 in security %.

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OR
9oods &td. is presently operating at -)4 level producing ,-2))) pac!ets of snac! foods and proposed to increase capacity utilisation in the coming year ,, 0;,4 over the existing level of production.
T(e -",,"$!#/ 3& & (&s 0ee# su++,!e3 :

(i)

Nnit cost structure of the product at current level : $aw aterial Cages (Jariable) Everheads (Jariable) 9ixed Everhead 6rofit +elling 6rice $s. / ' ' 0 , . 0' .

%6!!'

R&$ .& er!&,s $!,, re.&!# !# s "res -"r 1 ."# ( 0e-"re 0e!#/ !ssue3 -"r +r"3u* !"#. M& er!&, $!,, re.&!# !# +r"*ess -"r -ur (er 1 ."# (. Su++,!ers /r&# 8 ."# (s *re3! " (e *".+&#4.

(viii) (ix) (x) (xi)

9inished goods remain in 1odown for 0 month. Debtors are allowed credit for ' months. &ag in wages and overhead payments is 0 month and these expenses accrue evenly throughout the production cycle. Ho increase either in cost of inputs or selling price is envisaged. 6repare a pro7ected profitability statement and the wor!ing capital re#uirement at the new level2 assuming that a minimum cash balance of rs.032()) has to be maintained. E! (er

A#s$er %&' 8here are four different types of ris!s in portfolio planning. (. (nterest rate ris% : it is due to changes in interest rates from time to time. 6rice of the securities move invertly with change in the rate of interest. -. Purchasing power ris% : As inflation affects purchasing power adversely. Inflation rates vary over time and the investors are caught unaware when the rate of inflation changes abruptly. .. !usiness ris% : It arises from sale and purchase of securities affected by business cycles and technological changes. *. "inancial ris% :8his arises due to changes in the capital structure of the company. it is expressed in terms of debt A e#uity ratio. Although a leveraged company:s earnings are more2 too much dependence on debt financing may endanger solvency and to some extent the li#uidity. %0' (i) +ecurity A has a return of *4 for a ris! of /42 whereas securities " and 9 have a higher ris! for the same rate of return. Oence security a dominates securities " and 9. for the same degree of ris! of /4 security D has only a return of /4. Oence this security is also dominated by A. securities % and E have a higher return as well as a higher degree of ris!.

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Oence the securities which will be selected are A2 % and E. (ii) Chen perfect positive correlation exist between securities2 their ris! and return can be averaged with the proportion. Oence the average value of A and % together for a proportion of , : 0 for ris! and return will be as follows : $is! (, x / = 0 x0') ; / > -4 $eturn (, x * = 0 x 0') ; / > 34 %omparing the above average ris! and return with security E2 it is better to invest in E as it has lesser ris! ((4) for the same return of 34. %"r' FOO7S LIMITE7 Pr"Ge* e3 Pr"-! &0!,! 4 s & e.e# & @?I *&+&*! 4 U#! s " 0e +r"3u*e3 %86,???E6? A @?' K :@,??? +&*9e s. A. %ost of +ales : $aw material Cages Everheads (Jariable) Everheads 9ixed ". 6rofit %. +ale value A, er#& !6e,4 : If we assumes the movement in stoc! levels2 because of increase in capacity2 i.e. from -)4 to *)42 the profitability statement will be as follows. Nnits to be produced A cost of goods sold : $aw aterial Cages Everheads (variable) Everheads (9ixed) &ess : Increase in stoc! of aterials = CI6 = 9inished goods ($efer wor!ing note) Ad7usted cost of sales ". 6rofit %. sales (,-2)));-) x *)) /*2))) pac!ets $s. (/ x /*2)))) (' x /*2)))) (' x /*2)))) (0 x ,-2)))) /2')2))) 0*2))) /2)'2))) 02-'2))) (2-/2))) 023'2))) 3-2))) 3-2))) ,-2))) $s. / x /*2))) $s. ' x /*2))) $s. ' x /*2))) $s. 0 x ,-2))) $s. ,.'( x /*2))) $s. 0' x /*2))) > > > > > > $s. 023'2))) 3-2))) 3-2))) ,-2))) /2')2))) 02(-2))) (2.-2)))

(0' x /.2))))I

IEpening stoc! = production A closing stoc! > ,2))) = /*2))) A /2))) > /.2))) 2"r9!#/ N" es : %apacity Humber of units of production $aw material stoc! (0 month) %ost;Nnit / -)4 ,-2))) $s. 0'2))) *)4 /*2))) $s. 0-2)))

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CI6 stoc! : aterial (0 month) Cages (0;' month) Jariable overheads (0;' month) 9ixed overheads (0;' month) 9inished goods (0 month) Increase in stoc! 2"r9!#/ N" es :

/ ' ' 0 3 (*2())

0'2))) ,2))) ,2))) 02()) ()..() '.2))) (*..() .-2())

0-2))) /2))) /2))) 02()) ,(2))) 0*2)))

C"s "- s&,es 5 &6er&/e +er ."# ( $aw material Cages Everheads (variable) Everheads (fixed) 6rofit +ales value 6er annum 023'2))) 3-2))) 3-2))) ,-2))) <<<<<<<< /2')2))) 02(-2))) <<<<<<<< (2.-2))) 6er month 0-2))) *2))) *2))) ,2))) <<<<<<<< ,(2))) 0,2))) <<<<<<< /*2)))

Pr"Ge* e3 S & e.e# "- 2"r9!#/ *&+! &, & @?I *&+&*! 4 %urrent Assets : $aw material (/*2))) ;0' x /) Cor! in 6rocess aterials (/*2))) x / x 0;0') Cages (/*2))) x ' x 0;'/) Jariable overheads (/*2))) x ' x 0;'/) 9ixed overheads (/*2))) x )..( x 0;'/) 9inished goods (/*2))) x *..( x 0;0') +undry debtors %ash balance &ess : %urrent &iabilities : %reditors for goods (/*2))) x / x , ;0') %reditors for expenses (/*2))) x /..( x 0;0') Het wor!ing capital (A) A (") /*2))) 032))) (") -.2))) 02'(2))) 0-2))) '(2()) 0-2))) /2))) /2))) 02()) ,(2))) .-2()) 3-2))) 02.'2()) 032()) (A) 023'2)))

N" e : (i) +ince wages and overheads payments accrue evenly2 it is assumed that they will be in process for half a month in average. (iii) 9ixed overheads per unit > $s. ,-2)));/*2))) > $s. )..( Ques !"# <.

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Crite short notes on the following : (e) American Depository $eceipts (AD$+) (f) 9inancial 9orecasting 8echni#ues. (g) 9lexible "udget. (h) $andom Cal! 8heory.
A#s$ers

%&'

A.er!*&# 7e+"s! "r4 Re*e!+ s %A7RS' : 8hese are depository receipts issued by a company in N+A and are governed by the provisions of securities and Exchange %ommission of N+A. As the regulations are severe2 Indian companies tap the American mar!et through private debt placement of 1D$+ listed in &ondon and &uxemburg stoc! exchanges. Apart from legal impediments2 AD$+ are costlier than 1lobal Depository $eceipts (1D$+). &egal fees are considerably high for N+ listing. $egistration fee in N+A is also substantial. Oence AD$+ are less popular than 1D$+.

%0'

F!#&#*!&, -"re*&s !#/ e*(#!Bues : 8hese are employed in forecasting the financial re#uirements. +ome of the techni#ues are described below : (a) Percent of 'ales method : In this the financial needs are estimated on the basis of a sales forecast. A change in sales is li!ely to have an impact on many items of assets and liabilities and hence these items are expressed for changes in levels of activity. A sound !nowledge of the relation between Lsales and assets is necessary to use this method. 8his is very useful for short A term forecasting. 'imple 4egression method : Cith sales forecast as starting point and based on past relationship between sales and assets items2 it is possible to construct a line of best fit or the regression line for them. 8his method is useful for long A term forecasting. #ultiple 4egression method : In this it is assumed that sales are a function of several variables2 while in simple regression method only one variable is considered. Oence this is superior.

(b)

(c)

8he use of a particular method will depend upon circumstances of each case and availability of data. %*' F,eA!0,e )u3/e : 8his budget is designed to change with changes in levels of activities attained. 8he budget shows how costs vary with changes in activity levels. 8he segregations of costs into fixed2 variable and semi A variable is necessary to construct the flexible budget. It is assumed that fixed costs will remain fixed only upto a certain level of activity and after a certain level they may tend to vary2 though not li!e variable costs. 8he formation of flexible budgets will enable the enterprise to !now its different levels of activity. 9lexible budgets are desirable in the following cases : (() Chere sales are unpredictable e.g. luxury and semi A luxury trades. (-) Chere in the case of new venture2 it is not possible to foresee precisely public demand e.g. 9ashions and novelty trade. (.) Chere the business is seasonal A e.g. soft drin!s. (*) Chere progress depends on ade#uate supply of labour but labour is the !ey factor in that area.

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%3'

R&#3". 2&,9 T(e"r4 : It is generally believed that stoc! mar!et prices can never be predicted because they are not a result of any underlying factors but are mere statistical ups and downs. 8his hypothesis is !nown as $andom Cal! Oypothesis. According to this theory there is no relationship between present prices of shares and their future prices. It is argued that stoc! mar!et prices are independent. .1. Tendall found that changes in security prices behave nearly as if they are generated by a suitably designed roulette wheel for each outcome is statistically independent of past history. +uccessive pea!s and troughs in prices are unconnected. In layman:s language it may be said that prices on the stoc! exchange behave exactly the way a drun! would behave while going in a blind lane A up and down with an unsteady gait going in any direction he li!es2 bending bac!ward and forward2 going on sides now and then.

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FINAL EHAMINATION NOCEM)ER 5 2???, Gr. 5 I PAPER 2: MANAGEMENT & FINANCIAL ANALSIS
Ques !"# 1. (a) Chat are the issues that need to be considered by an Indian Investor and incorporated within the Het 6resent Jalue (H6J) model for the evaluation of foreign investment proposalsF (b) K5P &td.2 has the following boo! value capital structure: E#uity %apital (in shares of $s. 0) each2 fully paid up A at par) 004 preference %apital (in shares of $s. 0)) each2 fully paid up A at par) $etained Earnings 0,.(4 Debentures (of $s. 0)) each) 0(4 8eam &oans $s. 0( crores $s. 0 crore $s. ') crores $s. 0) crores $s. 0'.( crores

8he next expected dividend on e#uity shares per share is $s. ,.-)L the dividend per share is expected to grow at the rate of .4. 8he mar!et price per share is $s. /). 6reference stoc!2 redeemable after ten years2 is currently selling at $s. .( per share. Debentures2 redeemable after six years2 are selling at $s. *) per debenture. 8he Income A tax rate for the company is /)4 (i) $e#uired:

%alculate the weighted average cost of capital using: (a) (b) (ii) boo! value proportionsL and mar!et value proportions. Define the weighted marginal cost of capital schedule for the company2 if it raises $s. 0) crores next year2 given the following information: (a) (b) (c) (d) the amount will be raised by e#uity and debt in e#ual proportionsL the company expects to retain $s. 0.() crores earnings next yearL the additional issue of e#uity shares will result in the next price per share being fixed at $s. ,'L the debt capital raised by way of term loans will cost 0(4 for the first $s. '.() crores and 0-4 for the next $s. '.( crores. (*=0' > ') mar!s)

Answer
%&' 8he issues that need to be considered by an Indian investor and incorporated with the net 6resent value (H6J) model for the evaluation of foreign investment proposals are the following:

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(0)

Taxes on income associated with foreign pro7ects : 8he host country levies taxes (rates differ from country to country) on the income earned in that country by the ulti Hational %ompany ( H%). a7or variations that occur regarding taxation of H%:s are as follows: (i) (ii) (iii) any countries rely heavily on indirect taxes such as excise duty2 value added tax and turnover taxes etc. Definition of taxable income differs from country to country and also some allowances e.g. rates allowed for depreciation. +ome countries allow tax exemption or reduced taxation on income from certain RdesirableS investment pro7ects in the form of tax holidays2 exemption from import and export duties and extra depreciation on plant and machinery etc. 8ax treaties entered into with different countries e.g. double taxation avoidance agreements. Effer of tax havens in the form of low or Pero corporation tax rates.

(iv) (v) (')

Political ris%s : 8he extreme ris!s of doing business in overseas countries can be seiQure of property; nationaliQation of industry without paying full compensation. 8here are other ways of interferences in the operations of foreign subsidiary e.g. levy of additional taxes on profits or exchange control regulations may bloc! the flow of funds2 restrictions on employment of foreign managerial; technical personnel2 restrictions on imports of raw materials; supplies2 regulations re#uiring ma7ority ownership vesting within the host country. H6J model can be used to evaluate the ris! of expropriation by considering probabilities of the occurrence of various events and these estimates may be used to calculate expected cash flows. 8he resultant expected net present value may be sub7ected to extensive sensivity analysis.

(,)

Economic ris%s :8he two principle economic ris!s which influences the success of a pro7ect are exchange rate changes and inflation. 8he impact of exchange rate changes and inflation upon incremental revenue and upon each element of incremental cost need to be computed.

%0'%!'%&'

S & e.e# s("$!#/ *".+u & !"# "- $e!/( e3 &6er&/e *"s "- *&+! &, 04 us!#/ )""9 C&,ue +r"+"r !"#s Ceight %ost of ("oo! value capital proportions) (a) (b) ).'().0($efer to wor!ing note 0) ).)0. ).0(/, ($efer to wor!ing note ') ).,/' ).0($efer to wor!ing note 0) ).0.0 ).0'. ($efer to wor!ing note ,) ).'0/ ).)3 ($efer to wor!ing note /) <<<< 0.)) Ceighted cost of capital (c) > (a) x (b) ).)/)3).))'-' ).(/.' ).)'0.0 ).)03'<<<<<<< ).0,3'. or 0,.3,4

+ources of 9inance

Amount ("oo! value) ($s. in %rores) <<<<<<<<<<<<<<<<<<<<<< E#uity capital 0( 004 preference capital $etained earnings 0,.(4 Debentures 0(4 term loans 0 ') 0) 0'.( <<<<< <(*.(

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%0'

S & e.e# s("$!#/ *".+u & !"# "- $e!/( e3 &6er&/e *"s "- *&+! &, 04 us!#/ .&r9e 6&,ue +r"+"r !"#s +ource of 9inance Amount Ceight cost of Ceighted cost of ($s. in crores) ( ar!et value capital capital 6roportions (a) (b) (c) > (a) x (b) E#uity capital -).)) )..,3 ).0).00*'/ ($s. 0.( crores x $s. /))($efer to wor!ing note 0) 004 6reference capital )..( ).))3 ).0(/, ).))0,* ($s. 0 la!h x $s. .()($efer to wor!ing note ') 0,.(4 Debentures *.)) ).)3* ).0'. ).)0'/( ($s. 0) la!hs x $s. *))($efer to wor!ing note ,) 0(4 8erm loans 0'.() ).0(/ ).)3 ).)0,*($efer to wor!ing note /) <<<<< <<<<< *0.'( 0.)) <<<<<<< Ceighted average cost of capital ).0/(3, Er 0/.(34 N" e: +ince retained earnings are treated as e#uity capital for purposes of calculation of cost of specific of finance2 the mar!et value of the ordinary shares maybe ta!en to represent the combined mar!et value of e#uity shares and retained earnings. 8he separate mar!et values of retained earnings and ordinary shares may also be wor!ed out by allocating to each of these a percentage of total mar!et value e#ual to their percentage share of the based on boo! value. (ii) S & e.e# s("$!#/ $e!/( e3 .&r/!#&, *"s "- *&+! &, s*(e3u,e -"r (e *".+&#4, !- ! r&!ses Rs. 1? *r"res #eA 4e&r, /!6e# (e -",,"$!#/ !#-"r.& !"# : %hun! source of 9inance $etained earning Debt Ceighted average cost of capital '. E#uity +hares Debt Ceighted average cost of capital ,. E#uity shares Debt '.( '.( ).( ).0*'( ($efer to wor!ing note () ).( ).)3($efer to wor!ing note -) 0 0 ).( Amount Ceight ($s. in crores) 0.( 0.( (a) ).( ).( cost of capital Ceighted cost of %apital (b) (c) > (a) x (b) ).0).)* ($efer to wor!ing note 0) ).)3 ).)/( ($efer to wor!ing note -) <<<<<<< ).0'( Er 0'.(4 ).)30'( ).)/( <<<<<<< ).0,-'( Er 0,.-'(4 ).)30'( ).)/* <<<<<< ).0,3'( Er 0,.3'(4 2"r9!#/ N" es:

0.

).0*'( ($efer to wor!ing note () ).( ).)3 ($efer to wor!ing note -)

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0. %ost of e#uity capital and retained earnings (Te) D0 Te > ???? = g 6) Chere2 Te > %ost of e#uity capital D0 6) 1 > Expected dividend at the end of year 0 > %urrent mar!et price of e#uity share. > 1rowth rate of dividend

How it is given that D0 > $s. ,.-)2 p) > $s. /) and g > .4 $s. ,.-) 8herefore2 Te > ?????????? = ).). $s. /) Er2 '. Te > 0-4

%ost of preference capital (Tp) D=9A6 n Tp > ??????????????????? 9=6 ' Chere2 D > 6reference dividend 9 > 9ace value of preference shares 6 > %urrent mar!et price of preference shares H > $edemption period of preference shares How2 it is given that D > 0042 9 > $s. 0))2 6 > $s. .( and n > 0) years 00 = $s. 0)) A $s. .( 0) 8herefore Tp > ????????????????????????????????? x 0)) $s. 0)) = $s. .( ' > 0(./,4

,.

%ost of debentures (Td)

r(0 A t) 9 A 6 n Td > ????????????????????????????? 9=6 ' Chere2 r > Interest on debentures t > 8ax rate applicable to the company 9 > 9ace value of debentures

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6 > %urrent mar!et price of debentures n > $edemption period of debentures How2 it is given that r > 0,.(42 t > /)42 9 > $s. 0))2 6 > $s. *) and n > - years 0,.( (0 A )./)) = $s. 0)) A $s. *) 8herefore2 Td > ???????????????????????????????????????????? x 0)) $s. 0)) = $s. *) ' > 0'..)4 /. %ost of term loans (Tt) where2 r > $ate of interest on term loans t > 8ax rate applicable to the company. How2 r > 0(4 and t > /)4

8herefore2 Tt > 0(4 (0 A )./)) > 34 (. %ost of fresh e#uity share (Te) D0 Te > ???? = g 6 How2 D0 > $s. ,.-)2 6 > $s. ,' and g > ).). $s. ,.-) 8herefore2 Te > ??????????? = ).). $s. ,' > 0*.'(4 -. %ost of debt (Td) Td > r(0 A t) (9or first $s. '.( crores) r > 0(4 and t > /)4 8herefore2 Td > 0(4 (0 A /)4) > 34 (9or the next $s. '.( crores) r > 0-4 and t > /)4 8herefore2 Td > 0-4 (0 A /)4) > 3.-4 111111111111

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Ques !"#s 2 %&' 8he following table shows interest rates for the Nnited +tates dollar and 9rench francs. 8he spot exchange rate is ..)( francs per dollar. %omplete the missing entries : , months Dollar interest rate (annually compounded) 9ranc Interest rate (annually compounded) 9orward franc per dollar 9orward discount on franc 6er cent per year %0' 00 _4 03 _4 F F - months 0' c4 F F ? -.,4 0 year F ')4 ..(')) F

8he $ecovery 1eneral Oospital operates a separate department specifically for private health patients. In ')))2 the patients paid a fixed fee of $s. *() per day for the use of hospital facilities and this is expected to remain unchanged for the year '))0. in addition2 the patients pay an extra fee to the physicians for their services. 8his is a private arrangement between the patient and the physician2 and has no effect on the finances of the hospital. 9or the year ending ,0 st December2 '))) the department expected to receive revenue of $s. 02,32-02'() for private health care. Expenditure chargeable to the department for the year '))) will be as follows : "asis of Allocation 6atient Days "ad capacity ($s.) ($s.) ''2))2))) ???? ??? 0'2))2))) '-2))2))) ,2.)2))) ??? '2))2))) -(2.)2))) 02')2))) ??? ??? ??? ',2.)2))) <<<<<<<<??? '/23)2)))

eals 6orter:s +alaries &aundry &aboratory aintenance 1eneral Administrative +ervices Ether Expenses I All variable expenses

It is estimated that all costs will increase by 0)4 in the year '))0. in addition2 rent and rates of $s. /)2))2))) was charged directly to the department2 since it is the sole occupier of a separate building within the hospital grounds. 8his is expected to increase to $s. ()2))2))) for the year '))0. 8he salaries of the nursing staff are charged to the department at the end of the year according to the following schedule : Annual patient Days &ess than .2))) .2))) A 0)2))) 0)2))) A 0,2))) Ever A 0,2))) Hurses +upplied , / ( *

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8he average salary of the nursing staff for the year '))0 is estimated at $s. .)2))) per annum (actual for the year '))) was $s. -(2))) p.a.). 8he department has a maximum capacity of -) beds2 but in the year '))) a number of beds were unoccupied because of insufficient demand and there have been demand from a number of parties that the department is losing money and should be closed down. 5ou are re#uired to find out "rea! A even point to cover. (i) (ii) All fixed costs for next year 9ixed cost specific to private department.

5ou are also re#uired to find out the re#uisite fees per patient day to brea! A even in the year @Hote: 6lease adopt ,-( days to a calendar yearB A#s$er %&' C".+u & !"# "- .!ss!#/ e# r!es !# (e &0,e 9or computing the missing entries in the table we will use interest rates parity theorem (I$6). 8his theorem states that the exchange rate of two countries will be affected by their interest rate differential. In other words2 the currency of one country with a lower interest rate should be at a forward premium in terms of currency of country with higher interest rates and vice versa. 8his implies that the exchange rate (forward and spot) differential will be e#ual to the interest rate differential between the two countries. i.e2 Interest rate differential > Exchange rate differential (0 = rf) +f;d Er ????????????????? > ??????????? (0 = rd) 9f;d Chere rf is the rate of interest of country 9 (say the foreign country) rd is rate of interest of country D (say domestic country)2 sf;d is the rate between the two countries 9 and D and 9 f;d is the forward rate between the two countries 9 and D. ,. onths (* = 0' > ') mar!s)

Dollar interest rate > 00 _4 (annually compounded) 9rance interest rate > 03 _4 (annually compounded) How2 differential in interest rate > Differential between forward and spot rate i.e. 0 = .00( 0 = .03( > Differential between forward and spot rate

Er Differential between forward and spot rate > 3,4 8herefore2 9orward discount on franc percent per year > 9orward discount on franc percent for , months > > 0))4 ? 3,.,4 ? -..4 ? -..;/ or A0.-.(4

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9orward franc

> 8oday:s spot rate (difference between forward and +pot rate) > ).0/0*// dollar (0))4 ? 0.-.(4) 9orward franc > ).0,3/-*0 dollar 9orward 9ranc per dollar > 0;.0,3/-*0 > ..0. - months Dollar interest rate > 0' c4 (annually compounded) 9orward discount on franc 4 per year Oence - months 9orward rate > > 9orward franc per dollar > or 9orward franc per dollar > Again2 differential in interest rate between the two countries How2 Er Er Er Er Er Er 0 5ear 9rance interest rate > ')4 (annually compounded) 9orward franc per dollar > ..(')) 8oday:s spot rate is ..)( (given) francs per dollar i.e. 0 9ranc > ).0/0*// dollar 9orward francs is ..(' francs per dollar i.e. franc > ).0,'3.* dollar Difference ).))**-- dollar 9orward discount on francs per cent per year > Again2 Differential in interest rates "etween the two countries i.e. 0 = Dollar interest rate 0 = ).') > > ..)( ..(' > ).))**-- x 0)) ).0/0*// ? -.'(4 or A -.,4 (rounded off) Differential between forward rate and spot rate 0 = Dollar interest rate > 0 = .0'( 0 = 9ranc interest rate 0.0'( > 0 = 9ranc interest rate 0 = 9ranc interest rate 9ranc interest rate > > > > ? -.,4 or ? ,.0(4 for - months ).0/0*// dollar (+pot rate) (0))4 ? ,.0(4) ).0,.,. dollars 0;).0,.,. ..'* francs

> Differential between forward and spot rate Differential between forward and pot rate > (0))4 ? -.,4) 3,..4 > 0.0''( 3,..4 0.03.3. A 0 0.3.3. 03.*4

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Er Dollar interest rate

> > >

0.') x ).3,./ A 0 0.0'( A 0 ).0'( or 0'.(4

%0'

%!'

C".+u & !"# "- )re&9-e6e# +"!# " *"6er &,, -!Ae3 *"s s -"r #eA 4e&r 9ixed costs %ontribution per patient day $s. .32/32))) /0) > > $s..32/32))) $s./0) 032,*. patient days

"rea!?even point (".E.6) > How2 9ixed costs for next year ($efer to wor!ing note 0) %ontribution per patient day ($efer to wor!ing note ') ".E.6

+ince annual patient days are over 0,2))) days2 therefore nurses re#uired will be *. Accordingly2 $evised fixed cost> > $s..32/32))) = $s.,2()2))) (( nurses x $s..)2))) p.a.) $s.*'2332))) > $s.*'2332))) $s./0)

"rea!?even point to cover all fixed costs > day

')2'/0 patient days or ((./- average patients per

%!!' )re&9-e6e# +"!# " *"6er -!Ae3 *"s s s+e*!-!* " +r!6& e 3e+&r .e# 9ixed costs specific to private department > $s.()2))2)))

N" e : It is assumed that other fixed costs will continue to be incurred even if the departmental is closed down %ontribution per patient day ($efer to wor!ing note ') "rea!?even point > > > $s./0)

$s.()2))2))) $s./0) 0'203( patient days or ,,./0 average patients per day

C".+u & !"# "- reBu!s! e -ees +er +& !e# 3&4 " 0re&9-e6e# !# (e 4e&r 2??1 %Assu.!#/ 3e.&#3 s&.e &s !# (e 4e&r 2???' $e#uisite fees to brea!?even > %ontribution re#uired to recover fixed cost per 6atient day = Jariable cost per patient day $s.*'2332))) 0-2/'(

%ontribution re#uired to recover fixed cost per patient day > >

$s.()(.'-

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Jariable cost per patient day > $s.//) ($efer to wor!ing note ') 8herefore2 re#uisite fees to brea!?even > 2"r9!#/ N" es : 0. 9ixed costs for the next year 9ixed cost for previous year 6orter:s salaries Add : 1eneral Administrative services 9ixed cost for previous year Add : 0)4 increases in costs 9ixed cost for next year Add : 9ixed costs specific to the department Add : inimum salaries of nursing staff Add : inimum salaries of nursing staff (, Hurses x $s..)2)))) 8otal fixed cost for next year '. %ontribution per patient day for next year $evenue per patient day : (A) Jariable cost per patient day (for the yea ')))) : (") > Jariable cost per patient day (for year '))0) : (%) ($s./)) = 0)4 of $s./))) %ontribution per patient day : (A) A (%) $evenue for the year $evenue per patient day . > $s.2,32-02'() *() > > > > $s. *() > $s.-(2.)2))) 0-2/'( patient daysI $s./)) > $s.//) $s.*() A $s.//) $s./0) 0-2/'( patient days > '023)) days > $s.()(.'- = $s.//) $s.3/(.'Rs. 02')2))) ',2.)2))) '/23)2))) '2/32))) '.2,32))) ()2))2))) ..2,32))) '20)2))) '20)2))) .32/32)))

aximum patient days > ,-( days x -) ( aximum patients) ,. %alculation of profit for the year ')))

Rs. %ontribution 0-2/'( patient days x contribution per day ($s.*() A $s./))) &ess : 9ixed costs 6orter:s salary and general administrative services $ent and $ates $s./)2))2))) +alaries of nursing staff (* Hos. x $s.-(2)))) $s. (2')2))) (+ince annual patient days exceeds 0,2)))) .)20)2))) ,2*02'() Es !.& e3 +r"-! -"r 4e&r 2??1, %Assu.!#/ 3e.&#3 s&.e &s !# (e 4e&r 2???' .,2302'() $s.'/23)2)))

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Rs. %ontribution 0-2/'( patient days x %ontribution per day ($s.*() A //)) &ess : 9ixed cost eals and general administrative services ($s.'/23)2))) x 0.0)) '.2,32))) $ent and $ates ()2))2))) +alaries of nursing staff (* Hos. x $s..)2)))) (2-)2)))

Rs. -.2,/2'()

*'2332))) (0(2-/2.()) 11111111 Ques !"# 8. (a) A "an! is analysing the receivables of Zac!son %ompany in order to identify acceptable collateral for a short?term loan. 8he company:s credit policy is ';0) net ,). 8he ban! lends *) per cent on accounts where customers are not currently overdue and where the average payment period does not exceed 0) days past the net period. A schedule of Zac!son:s receivables has been prepared. Oow much will the ban! lend on a pledge of receivables. If the ban! uses a 0) per cent allowance for cash discount and returns F Account ./ 30 0). 0)* 00/ 000', Amount $s. '(2))) 32))) 002()) '2,)) 0*2))) '32))) 0/2))) 02)*2*)) Days Eutstanding in days 0( /( '' 3 () 0'. Average 6ayment 6eriod historically ') -) '/ 0) /( 0) /*

(b)

"ig Eil is wondering whether to drill for oil in Cestchester %ountries. 8he prospects are as follows : Depth of Cell 9eet '2))) /2))) -2))) 8otal %ost illions of Dollars / ( %umulative 6robability of 9inding Eil ).( ).).. 6J of Eil (If found) illions of Dollars 0) 3 *

Draw a decision tree showing the successive drilling decisions to be made by "ig Eil. Oow deep should it be prepared to drill F (c) R8he information age has given a fresh perspective on the role of finance management and finance managers. Cith the shift in paradign it is imperative that the role of %hief 9inancial Efficer (%9E) changes from a controller to a facilitator.S %an you describe the emergent role which is described by the spea!er;author F

A#s$er.

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(a)

Analysis of the receivables of Zac!son %ompany by the ban! in order to identify acceptable collateral for a short?term loan : (i) 8he Zac!son %ompany:s credit policy is ';0) net ,). 8he ban! lends *) per cent on accounts where customers are not currently overdue and where the average payment period does not exceed 0) days past the net period i.e. thirty days. 9rom the schedule of receivable of Zac!son %ompany Account Ho. 30 and Account Ho. 00/ are currently overdue and for Account Ho. 0', the average payment period exceed /) days. Oence Account Hos. 302 00/ and 0', are eliminated. 8herefore2 the selected Accounts are Account Hos. ./2 0).2 0)* and 00-. (ii) S & e.e# s("$!#/ (e *&,*u,& !"# "- (e &."u# $(!*( (e 0&#9 $!,, ,e#3 "# & +,e3/e "- re*e!6&0,es !- (e 0&#9 uses & 1? +er *e# &,,"$&#*e -"r *&s( 3!s*"u# &#3 re ur#s Account Ho. (a) ./ '(2))) 0). 002()) 0)* '2,)) 00- '32))) Amount ($s.) Amount ($s.) (b) > 3)4 of (a) ''2()) 0)2,() '2).) '-20)) 8otal loan amount 3) percent of (c) > *)4 of (b) 0*2))) *2'*) 02-(')2**) /*2*0*)4 of amount ($s.)

(b)

8he given data is easily represented by the following decision tree diagram

8here are three decision points in the tree indicated by D02 D' and D,. Nsing rolling bac! techni#ue2 we shall ta!e the decision at decision point D , first and then use it to arrive decision at a decisions point D' and then use it to arrive decision at a decision point D0.

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S & e.e# s("$!#/ (e e6&,u& !"# "- 3e*!s!"# & 7e*!s!"# +"!# 78 Decision Event 6robability 6.J. of Eil (if found) ( illions of dollars) =' ??/.)) '. Do not drill ?(.)) Expected 6.J. of Eil (if found) ( illions of dollars) ).() ?/.()

0. Drill upto 9inding Eil ).'( -2))) feet Dry )..( ($efer to wor!ing note)

+ince the Expected 6.J. of Eil (if found) on drilling upto -2))) feet A / millions of dollar is greater than the cost of not drilling A( millions of dollars. 8herefore2 "ig Eil should drill upto -2))) feet. S & e.e# s("$!#/ e6&,u& !"# "- 3e*!s!"# & 3e*!s!"# P"!# 72 Decision Event 6robability 6.J. of Eil (if found) ( illions of dollars) / ?/ ?'./ '. Do not drill ? / Expected 6.J. of Eil (if found) ( illions of dollars) ).?,.'

0. Drill upto 9inding Eil ).' /2))) feet Dry ).* ($efer to wor!ing note)

+ince the Expected 6.J. of Eil (if found) on drilling upto /2))) feet A './ millions of dollar is greater than the cost of not drilling A/ millions of dollars. 8herefore2 "ig Eil should drill upto /2))) feet. S & e.e# s("$!#/ e6&,u& !"# "- 3e*!s!"# & 3e*!s!"# P"!# 71 Decision Event 6robability 6.J. of Eil (if found) ( illions of dollars) ?'./ ?0.* '. Do not drill HI& Expected 6.J. of Eil (if found) ( illions of dollars) ,.) ?0.'

0. Drill upto 9inding Eil ).( '2))) feet Dry ).( ($efer to wor!ing note)

+ince the Expected 6.J. of Eil (if found) on drilling upto '2))) feet is 0.* million of dollars (positive)2 "ig Eil should drill upto '2))) feet. 2"r9!#/ N" es &et x be the event of not finding oil at '2))) feets and y be the event of not finding oil at /2))) feet and Q be the event of not finding oil at -2))) feets. Ce !now that2 6 (x y) > 6 (x) x 6 (y;x)

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Chere2 6 (K y) is the 7oint probability of not finding oil at '2))) feets and /2))) feets2 6(x) is the probability of not finding oil at '2))) feets and 6 (y;x) is the probability of not finding oil at /2))) feets2 if the event x has already occurred. 6 (x y) > 0 ? %umulative probability of finding oil at /2))) feet > 0 ? ).- > )./ 6(x) > 0 ? 6robability of finding oil at '2))) feets > 0 ? ).( > ).( Oence2 6 (y;x) > 6 (x y) > )./ > ).* 6(x) ).(

8herefore2 probability of finding oil between '2))) feets to /2)))) feets > 0 ? ).* > ).' we !now that2 6 (x y Q) > 6 (x) x 6 (y;x) x 6 (Q;x y) where2 6 (x y Q) is the 7oint probability of not finding oil at '2))) feets2 /2))) feets and -2))) feets2 6(x) and 6(y;x) are as explained earlier and 6(Q;x y) is the probability of not finding oil at -2))) feets if the event x and y has already occurred. 6(x y Q) > 6(Q;x y) > > 0 ? cumulative probability of finding oil at -2))) feets 0 ? ).. > )., 6(x y Q) 6(x) x 6(y;x) > )., . > )., > )..( ).( x ).* )./

8herefore2 probability of finding oil between /2))) feets to -2))) feets > 0 A )..( > ).'( (c) 8he information age has given a fresh perspective on the role of financial management and finance managers. Cith the shift in paradigm it is imperative that the role of %hief 9inance Efficer (%9E) changes from a controller to a facilitator. In the emergent role %hief 9inance Efficer act as a catalyst to facilitate changes in an environment where the organisation succeeds through self managed teams. 8he %hief 9inance Efficer must transform himself to a from end organiser and leader who spends more time in networ!ing2 analysing the external environment2 ma!ing strategic decisions2 managing and protecting cash flows. In due course2 the role of %hief 9inance Efficer will shift from an operational to a strategic level. Ef course on an operation level the %hief 9inance Efficer cannot be excused from his bac!end duties. 8he !nowledge re#uirements for the evolution of a %hief 9inance Efficer will extend from being aware about capital productivity and cost of capital to human resources initiatives and competitive environment analysis. Oe has to develop general managements s!ills for a wider focus encompassing all aspects of business that depend on or dictate finance. 111111111

EIT;ER Ques !"# :. A company is evaluating a new venture that will cost $s.0) crores. 8he venture will have a return on investment of ') percent and the firm forecasts a 0' percent growth in earnings from the pro7ect. 8he treasurer has identified the following sources for financing the pro7ect :

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(a) (b) (c)

E#uity shares to be sold at $s./)) per share. %onvertible debentures with a - percent coupon to net $s.3*) (face value $s.02))))2 and convertible at $s.()) per share after '))'. Debentures with warrants with a - percent coupon to net $s.3*) (face value rs.02)))) and2 with each bond having one warrant entitling the holder to buy one e#uity share at $s.()) after '))'. 8he financing decision is being made in the fourth #uarter of '))). Ever the past ten years2 A company has been growing at a 0) percent rate of sales and earnings. 8he treasurer expects the company to continues to grow at 0) percent even though the firm has traditionally paid /) percent of its earnings as dividends. 8he treasurer expects A:s e#uity shares to continue to rise in price. using the price trend over the past ( years2 he has pro7ected probable mar!et price ranges for the next three years. 8he historical data and the pro7ections of the treasurer are given below : 5ear $s. 033( 033033. 033* 0333 %urrent '') '() ,,) '.) ,*) /() '))0 '))' ')), Oistorical ar!et price 5ear 9orecasted 6robability ar!et 6rice $s. ')4 -)4 ')4 ')4 -)4 ')4 ')4 -)4 ')4 /() ()) -)) (() -') ()) -)) .))

8he proforma balance +heet and Income +tatement prepared by the treasurer for the year '))) is shown below : A %ompany &td. 6roforma "alance +heet (December ,02 '))))) '))) E#uity +hares ($s.0)) +hare premium $etained earnings "onds (.4) ortgage (-4) Accounts 6ayable Ether %urrent &iabilities 0333 6lant and E#uipment (&ess : Accumulated Depreciation Inventories $eceivables %ash and ban! "alance Ether %urrent Assets '))) '2('2))) (-'2)))) 023)2))) -/2))) //2))) ''2))) /2))) ,2'/2))) ($s. U)))) 0333 '2,02))) ((32)))) 02.'2))) -'2))) /(2))) 0*2))) ,2))) ,2))2)))

0)2))) 0)2))) /)2))) /)2))) 02,-2))) 02'.2))) 3)2))) ('2))) ,)2))) ((2))) .2))) -2))) 002))) 0)2))) ,2'/2))) ,2))2)))

6roforma Income +tatement ($s. U)))) +ales '))) 0333 /2')2))) ,2*)2))) E"I8 .02()) -(2))) InterestI *2))) .2))) E"8 -,2()) (*2))) HIA8 ,02.() '32))) E6+ ,0..( '3.))

I $ounded off.

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8he management of A &td. was initially impressed by the fact that the new venture will increase sales by $s.0' crores. anagement is also interested in the expected 0' percent growth rate of the venture. As per %ompany:s 9inancial policy2 the firm debt?asset ratio should not be above /) percent. Cith the above information and detailed analysis for next , years2 what will be the long?term sources of financing for the new proposal F a!e suitable assumptions in your answer2 wherever necessary figures could be rounded off. Income?tax rate applicable to the company is to be ta!en at ()4. (') mar!s) OR Dyer &td. manufactures a variety of products using a standardised process2 which ta!es one month to complete. Each production batch is started at the beginning of a month and is transferred to finished goods at the beginning of the next month. 8he cost structure2 based on current selling price is : (4) +ales price Jariable %osts $aw aterials Ether Jariable %osts 8otal Jariable %ost A used for +toc! Jaluation %ontribution (4) 0)) ,) /) .) ,)

Activities levels are constant throughout the year and annual sales2 all of which are made on credit are $s.'/2))2))). Dyer &td. is now planning to increase sales volume by ()4 and unit sales price by 0)4L such expansion would not alter the fixed costs of $s.()2))) per month2 which includes monthly depreciation of plant of rs.0)2))). +imilarly raw material and other variable costs per unit will not alter as a result of the price rise. In order to facilitate the envisaged increase several changes would be re#uired in the long run. 8he relevant changes are :a (i) 8he average credit period allowed to customers will increase to .) daysL

(ii) +uppliers will continue to be paid on strictly monthly termsL (iii) $aw material stoc!s held will continue to be sufficient for one month:s productionL (iv) +toc!s of finished goods held will increase to one month:s outputL (v) 8here will be no change in the production period and other variable costs will continue to be paid for in the month of productionL (vi) 8he current end?of?month wor!ing capital position is : ($s. U)))) $aw aterials CI6 9inished 1oods Debtors %reditors -) 0/) .) '.) ')) /.) -)

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Het Cor!ing %apital A Excluding %ash

/0)

%ompliance with the long?term changes re#uired by the expansion will be spread over several months. 8he relevant points concerning the transitional arrangements are : (i) 8he cash balance anticipated at the end of the ay is $s.*)2))).

(ii) Npto and including Zune all sales will be made on one month:s credit. from Zuly all sales will be on the transitional credit terms which will mean : -)4 of sales will ta!e ' months: credit /)4 of sales will ta!e , months: credit (iii) +ales price increase will occur with effect from sales in the month of August. (iv) 6roduction will increase by ()4 with effect from the month of Zuly. $aw material purchases made in Zune will reflect this. (v) +ales volume will increase by ()4 from sales made in Ectober. $e#uired : (a) +how the long?term increase in annual profit and long?term wor!ing capital re#uirements as a result of the plans for expansion and a price increase. (%osts of financing the extra wor!ing capital re#uirements may be ignored). (b) 6roduce a monthly cash forecast for the period from Zune to December2 the first seven months of the transitional period. 6repare also a wor!ing capital position at the end of December. (c) Nsing your findings for (a) and (b) above2 ma!e brief comments to the management of Dyer &td. on the ma7or factors concerning the financial aspects of the expansion which should be brought to their attention. Assume that there are ,-) days in a year and each month contains ,) days. (') mar!s) A#s$er. %F!rs A, er#& !6e' 8he various steps for detailed analysis of given information for next , years for determining the long term sources of financing for the new proposal costing $s.0) crores are as follows : S e+ 1 : 7e er.!#!#/ (e s!Je "- "--er!#/ -"r 6&r!"us s"ur*es "- -!#&#*!#/ (i) E#uity shares to be sold at rs./.)) per share %ost of new venture Ho. of e#uity shares to be offered > > > $s.0) crores $s.0) crores $s./)) '2()2))) shares

(ii) %onvertible debentures with a -4 coupon to net $s.3*) (face value $s.02))))2 and convertible at $s.()) per share after '))'.

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Ho. of debentures to be offered

>

$s.0) crores > 02)'2))) (rounded off) $s.3*)

(iii) Debentures with warrants with a - percent coupon to net $s.3*) (face value $s.02)))) and with each bond having one warrant entitling the holder to buy one e#uity share at $s.()) after '))'. Ho. of debentures to be offered > $s.0) crores > 02)'2))) (rounded off) $s.3*)

S e+ 2 : C".+u & !"# "- e&r#!#/s 0e-"re !# eres &#3 &A %E)IT' -"r #eA 4e&r E"I8 (without new venture) E"I8 (with new venture) > > > > > > > %urrent E"I8 x 1rowth factor $s...0( crores x 0.0) $s...*-( crores %urrent E"I8 x 1rowth factor = Investment in new venture x $.E.I of new venture $s...0( crores x 0.0) = $s.0) crores x ')4 $s...*-( crores = $s.' crores $s.3.*-( crores

S e+ 8 : C".+u & !"# "- e&r#!#/s 0e-"re !# eres &#3 &A %E)IT' &- er 8 4e&rs %& (e e#3 "+,&##!#/ ("r!J"#' E"I8 (without new venture) E"I8 (with new venture) > > > > > > > %urrent E"I8 x (1rowth factor), $s...0( crores x (0.0)), $s.3.(0. crores %urrent E"I8 x (1riwth factor), = Investment in new venture x ($.E.I of new venture)' $s...0( x (0.0)), = $s.0) crores x (')4) x (0.0')' $s.3.(0-- crores = $s.'.()** crores $s.0'.)'(/ crores

S e+ : : T" 3e er.!#e ,!9e,!(""3 "- !ssue "- eBu! 4 s(&res 04 *"#6ers!"# "- 3e0e# ure !# " eBu! 4 "r 04 eAer*!se "- $&rr&# s &- er 4e&r 2??2. Expected price of e#uity shares during , year planning period. 5ear $s. $s./() x ')4 > $s.()) x -)4 > $s.-)) x ')4 > Expected price 3) ,)) 0') (0) '))0 '))' $s. $s. $s./*) x ')4 > 3$s.(() x -)4 > ,,) $s.-') x ')4 > 0'/ (() ')), $s.()) x ')4 > 0)) $s.-)) x -)4 > ,-) $s..)) x ')4 >0/) -))

+ince the expected price of e#uity shares is more than the conversion and option price of $s.()) per share2 it is li!ely that some e#uity will be created by ')), as a result of conversion or exercise of warrants2 if one of these financing method is used. S e+ < : C&,*u,& !"# "- (e e--e* "# E)IT 3ue " eAer*!se "- $&rr&# s In forecasting future earnings per share2 the firm must consider a li!ely profit on the additional capital provided by the exercise of warrants. E"I8 (if warrants are exercised) > $s.0) crores x 0'.(/4

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> ).-,3(/ crores ($efer to wor!ing note 0 M ') S e+ 6 : S & e.e# s("$!#/ *&,*u,& !"# "- e&r#!#/ +er s(&re -"r #eA 4e&rsD -"r 6&r!"us &, er#& !6es ($s. in crores) Alternatives . Ho new E#uity %onvertible Carrant venture share debt debt Earning before interest and tax &ess : Interest Eld debt ($efer to wor!ing note ,) Hew debt ($efer to wor!ing note /) Earning before tax (E"8) *.//, &ess : 8ax G ()4 Earning after tax (EA8) Ho. of shares (la!hs) Earning per share ($s. ..*-( ).*0) 3.*-( ).*0) 3.*-( ).*0) ).-0' ..)(( ,.('.( ,.('.( 0) ,(.'. /.('.( /.('.( 0'.( ,-.'' 3.)(( /.''0( /.''0( 0) /'.'0( 3.*-( ).*0) ).-0' *.//, /.''0( /.''0( 0) /'.'0( (e e#3 "- +,&##!#/ ($s. in crores) . Carrant debt 0'.)'(/ ).-,3(/ ).*0) ).*0) ).*0) ).*0) ).-0' 00.'/'3 (.-'0/ (.-'0/ 00.'

S e+ > : S & e.e# s("$!#/ *".+u & !"# "- E&r#!#/s +er s(&re & ("r!J"# -"r 6&r!"us &, er#& !6es Alternatives E#uity share 0'.)'(/

Ho new venture Earning before interest and tax (E"I8) Add : Earnings before interest M tax by exercise of warrants ($efer to step () &ess : Interest Eld debt Hew debt Earnings before tax (E"8) &ess : 8ax G ()4 Earnings after tax (EA8) Ho. of shares (la!hs) Earning per share (E6+) ($s.) 3.(0-

%onvertible debt 0'.)'(/

*..)00.'0(/ 00.'0(/ /.,(, (.-).. (.-).. /.,(, (.-).. (.-).. 0) 0'.() 0'.)/ ($efer to wor!ing note 0) ($efer to wor!ing note ') /,.(, //.*/-.(. (0.))

S e+ @ : C".+u & !"# "- !#*re&se !# re &!#e3 e&r#!#/s -"r 6&r!"us &, er#& !6es *&# 0e 3e er.!#e3 &s -",,"$s : 0st year earnings after tax = , years Earnings after tax (0 A Dividend payout) Ho. of years ' Ho new venture > > $s.,.(' %rores = $s./.,(, crores x -)4 x , years ' $s...)* crores

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Issue of e#uity shares > > Issue of convertiable debentures > > Issued of warrant debt > >

$s./.('. crores = $s.(.-)* crores x -)4 x , years ' $s.3.0'0 crores $s./.''0( crores = $s.(.-)* crores x -)4 x , years ' $s.*/- crores $s./.''0( crores = $s.(.-'0 crores x -)4 x , years ' $s.*.(* crores

S e+ 9 : A#&,4s!s -"r .e&sur!#/ (e 3e/ree "- r!s9 !# *&+! &, s ru* ure ($s. in crores) Ho new Carrant Jenture Earning of the year '))) Eld debt Hew debt Eld e#uity Hew e#uity Debt asset ratio End of the year ')), Eld debt Hew debt Eld e#uity Hew e#uity Increase in retained earnings Debt asset ratio 2"r9!#/ N" es : 0. E#uity shares from conversion of debentures : share debt debt E#uity %onvertible

0'.) 0'.) . 0*.0*.,3.'4 0'.) 0'.) . 0*...)*-( '(.-*-( ,0.*4

0'.) 0'.) . 0*.'*.'32-4 0'.) 0'.) . 0*.0).) 3.0'0 ,...'0 '/.04

0'.) 0).' ''.' . 0*.0*.(/.(4 0'.) ''.' . 0*.0).' *.*/,..-/'/.04

0'.) 0).' ''.' . 0*.0*.(/.(4 0'.) 0).' ''.' . 0*.(.0) *.*(* ,'.((*4 /).(4

Debentures issued x +hares per debenture (on conversion) > 02)'2))) debentures x ' share per debenture > '2)/2))) shares E#uity shares from exercise of warrants "onds issued x +hares per bond (Exercise of warrants) > 02)'2))) bonds x 0 share per bond > 02)'2))) shares Jalue of shares > 02)'2))) shares x $s.()) (option price)

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> '.

$s.(.0) crores

$eturn on new e#uity shares 3on exercise of warrants) 8he return on additional %apital provided by the exercise of warrants to issue e#uity shares is the lower figure between average return for the firm and the return on the new proposal if adopted. A6er&/e re ur# "# .&r9e "- -!r. > Debt = > > E"I8 . ar!et value of e#uity shares

$s. ..0( crores . ($s.3 crores = $s., crores) = (0) la!hs shares x $s./()) $s...0( crores 0' crores = /( crores

> $s...0( crores (. crores > 0'.(/4 $.E.I from new proposal > ')4 +ince the average return on mar!et value of firm is lower than $.E.I. from new proposal (')4). Oence2 return on new e#uity shares on exercise of warrants is 0'.(/4. ,. Interest on old debt ($s. in crores) .4 "onds of $s.3 crores -4 ortgage of $s., crores /. Interest on new debt -4 debentures of $s.0).' crores > $s.).-0' crores C"#*,us!"#s : 0. '. Issue of e#uity shares for financing the pro7ect offers high earnings and is within the company:s 9inancial 6olicy. Issue of convertible debentures for financing the pro7ect offers high earnings but the firm:s debt asset ratio exceeds /)4 now and there is a possibility of it being within the company:s 9inancial 6olicy by year ')),. Issue of warrants for financing the pro7ect offers high earnings but is beyond the company 9inancial 6olicy (Debt asset ratio exceeds /)4) both now and in the year ')),. ).-,) ).0*) ).*0)

,.

In conclusion2 the firm should consider financing the pro7ect to gain the large rise in earnings. 8he e#uity shares only or a mixture of e#uity shares and debt financing2 represents the most attractive financing alternative. Cith mixed financing2 the firm can achieve a significant rise in earnings without increasing the ris! of exceeding the /) percent debt A asset guidelines. Assu.+ !"#s :

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0. It is assumed that the earnings from new pro7ect occurs at the end of the year. '. It is assumed that all the debentures will be converted into shares in the year ')),. ,. It is assumed that all the holders of the warrants will buy e#uity share in the year ')),. A#s$er. %Se*"#3 A, er#& !6e' %&' S & e.e# s("$!#/ (e ,"#/- er. !#*re&se !# &##u&, +r"-! &s & resu, "- (e +,&#s -"r eA+&#s!"# &#3 & +r!*e !#*re&se Existing +ales : (A) Jariable costs $aw materials Ether variable costs 9ixed costs 8otal costs : (") 6rofit : (A) A (") Increase in profit ($s. U)))) Expansion and 6rice increase ,23-) 02)*) 02//) ($s.3-) x 0.() -)) ,20') */) .')I

'2/)) ($s.'2/)) x 0.( x 0.0)) .') ($s..') x 0.() 3-) -)) '2'*) 0') a

I 8he increase in profit due to price increase is $s.,2-)2))) ($s.,32-)2))) A $s.,-2))2)))) and sue to volume increase is $s.,2-)2))) (()4 x $s.'/2))2))) x ,)4 (contribution) S & e.e# s("$!#/ !#*re&se !# ,"#/ er. $"r9!#/ *&+! &, reBu!re.e# &s & Resu, "- (e +,&#s -"r eA+&#s!"# &#3 & +r!*e !#*re&se ($s. U)))) $aw material (December purchase) ($s.-) x 0.() CI6 (December 6roduction) ($s.0/) x 0.() 9inished 1oods ($efer to wor!ing note 0) Debentures ($efer to wor!ing note ') &ess : %reditors ($s. -) x 0.() Het wor!ing capital re#uirement
Increase in wor!ing capital re#uirement is $s.*2)'2))) ($s.0'20'2))) A $s./20)2))))

3) '0) '0) (0) .3' 02,)' 3) 02'0'

%0'

M"# (,4 C&s( F"re*&s -"r (e +er!"3 Fu#e " 7e*e.0er ($s. U)))) onths Zune Zuly August +ept. Epening balance *) %ollection from debtors ')) ($efer to wor!ing note ,) 8otal cash available : (A) '*) 6ayment for purchases -) ($efer to wor!ing note /) 0)) ')) ,)) 3) () () 3) ?')) 0') ? *) 3)

Ect. ?,,) '0' ?00* 3)

Hov. ?,-* '') ?0/* 3)

Dec. ?,3* '*?00' 3)

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6ayment for variable costs *) 6ayment for fixed costs /) (excluding depreciation) 8otal payment L (") 0*) %losing balance : (A) A (")0)) %*'

0') /) '() ()

0') /) '() ?'))

0') /) '() ? ,,)

0') /) '() ? ,-*

0') /) '() ? ,3*

0') /) '() ? ,-'

C"..e# s " (e .&#&/e.e# "- 74er L 3. "# (e .&G"r -&* "rs *"#*er#!#/ (e -!#&#*!&, &s+e* s "- (e eA+&#s!"# (0) Increase of Cor!ing %apital re#uirement 8he wor!ing capital re#uirement has increased from existing of $s./20)2))) (net) to $s.0'20'2))) (net). 8his wor!ing capital re#uirement excludes increase in cash re#uirement. 8he wor!ing capital re#uirement has increased because of expansion and change in credit terms. (') Increase of cash re#uirement 9rom the monthly cash forecast in the statement (b) above it is apparent that due to expansion the cash is in deficit. 8he shortage of cash is $s.'2))2))) in the month of August. 8he shortage of cash is maximum of $s.,23*2))) in the month of Hovember. 8o meet out the cash re#uirement the company is re#uired to increase;obtain wor!ing facility from ban!s;financial institutions. 2"r9!#/ N" es : 0. 9inished goods : ($s. U)))) Epening stoc! 6roduction for the months ( ay and Zune) ($s.'))2))) x .)4 x ' months) 6roduction for the months (Zuly to Hovember) ($s.'2))2))) x 0.( times x .)4 x ( months) &ess : %ost of sales (issues) ay to August ($s.'2))2))) x .)4 x / months) +eptember to Hovember ($s.'2))2))) x 0.( times x .)4 x , months) '0) '. Debtors : Npto and including Zune all sales will be made on one month:s credit. 9rom Zuly credit policy will be. -)4 of sales on ' months: credit /)4 of sales on , months: credit Debtors for December will be as follows : /)4 of sales of Ectober > $s.02,'2))) (/)4 of $s.,2,)2)))) Add : +ales of Hov. and December > $s.-2-)2))) ($s.,2,)2))) x ' months) $s..23'2))) ,. %ollection from debtors Ene month:s credit is allowed for all sales made upto and including Zune. 9rom Zuly the credit policy will be

.) '*) 02)() 02/)) (-) -,)

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-)4 of sales on ' months: credit /)4 of sales on , months: credit ay +ales %ollection from debtors Zune ')) a ($s. U)))) Zuly August +ept. ')) ')) ')) ')) '') a Ect. '') 0') Hov. ,,) *) Dec. ,,) ** ,,) **

(-)4 of (/)4 of $s.'))) $s.'))) 0,' (-)4 of $s.'')) ')) ')) a 0')

(/)4 of (/)4 of $s.'')) $s.'')) 0,' 03*

(-)4 of (-)4 of $s.'')) $s.,,)) '0' '') '*-

/. 6ayment for purchases %reditors are paid on monthly terms i.e. $s.-)2))) for ay and $s.3)2))) ($s.'2))2))) x 0.( times x ,)4) for the months Zune to December.

11111111111

Ques !"# <. Crite short notes on any four of the following : (a) a7or elements of a completed financial plan. (b) (c) (d) (e) Hon?financial performance measures. Pero base review in the context of budgeting 6ec!ing order theory of capital structure. Effect of 1overnment imposed freeQe on dividends on stoc! prices and the volume of capital investment in the bac!ground of iller? odigliani ( ) theory on dividend policy

A#s$er. %&' M&G"r e,e.e# s "- & *".+,e e3 -!#&#*!&, +,&# : 8he financial plan of a large company is a substantial document whereas in a smaller organisation the plan would some elements but they are not very much is detail and hence re#uire less documentation. Ho business whether big or small can be successful without sound financial plans. 9inancial plans are needed both for short term as well as for long term. &ong term financial plans are the estimates for the long term capital needs2 designing the capital structure and financing the long term re#uirements of funds whereas the short term financial plans are related to the management of wor!ing capital2 including cash forecasting.

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In nutshell a complete financial plan of an organisation companies of the following elements. 0. 6roforma (that is forecasted) "alance sheet2 Income statement and +tatement describing sources and uses of funds. 8he proforma "alance sheet embody forecasts of all assets and liabilities. 8he proforma statement is a pro7ection of income over a period of time in the future. 8hese statements embody the firm:s financial goals2 policies and procedures. '. 9ollowing capital expenditures which is usually bro!en down by category into the following : (a) (b) (c) Investment for replacement. 9or expansion of new products. 9or mandated expenditure such as pollution control e#uipment.

8here may be narrative description 7ustifying why these amounts are needed for investment2 and the description of business strategies to be used to reach these financial goals. 8hese description might cover areas such as research and development efforts2 steps to improve productivity2 design and mar!eting of new products2 pricing strategy and so on. 8hese written descriptions record the end result of discussions and negotiations between operating managers2 corporate staff and top management. 8hey ensure that everyone involved in implementing plan understands what is to be done. %0' N"#--!#&#*!&, +er-"r.&#*e .e&sures : Accounting control and performance reporting systems should not focus entirely on cost control. 8he manager should see performance reports as a device to help them and not as a device for underta!ing biased post mortems. 8here is also a danger that if performance reports include only monetary items2 managers will ignore other important variables that cannot be #uantified. 8he performance report should thus be supplemented with data on non financial performance measures which include measures such as : (i) ar!et performance measures : 8hese include the following measures : (a) (b) (c) (d) ar!et share for each ma7or product. %ustomers visited;total customers. Humber of new customers. 8hird party #uality rating for all products in the industry.

(ii) Vuality measures : 8hese include the following : (a) (b) Incoming material #uality is measured by inspection reports which analyse percentage of defects by product and by supplier. %ustomer satisfaction is the ultimate measure of #uality.

(iii) Delivery measures : 8hese includes the measures such as :

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(a) (b)

%ycle time2 which can be measured in various ways such as the measure of length of time re#uired from the placing of an order by customer to delivery. +upplier delivery performance measures which usually consist of showing on an exception basis for each supplier the number of early and late deliveries.

(iv) 9lexibility innovation and inventory reduction measures : 9lexibility is measured by the total launch time for new product2 delivery times2 percentage of on time deliveries etc. Innovation relates to ability of company to bring new and better products to the mar!et #uic!ly. Inventory reduction include measures such as reduction of set up time2 reduction of supplier delivery time etc. (v) Individual activity level measures : 8hese include measures such as : (a) (b) 8ime ta!en to set up machinery for new production. Ho. of Accounts receivable processed per hour.

(vi) Inprocess #uality is ensured by establishing control points at various stages in the production process for ensuring variation of a process;production from specification. An effective operational control and performance measurement system should emphasiQe both financial and non?financial measures and specific strategies of an organisation. anagement Accounting systems have recently begum to place a greater emphasis on collecting and reporting non?financial #uantitative and #ualitative information on such variables that are necessary to compete successfully in today:s competitive environment. 8he non?financial performance measures2 thus focus on such factors as #uality2 reliability2 customers: satisfaction2 new product lead times2 customer response time and delivery and supplier performance. %*' =er" 0&se re6!e$ !# (e *"# eA "- 0u3/e !#/ : ost of services and support departments in a factory and most of mar!eting2 $esearch M Development and administrative departments are discretionary expenses centres and there is no way of !nowing what the optimum expense of a discretionary expense centre is. 8herefore2 in the programming process and also in the subse#uent budget preparation process2 the tendency is to ta!e the current level of expense in a discretionary expense centre as a starting point2 ad7usting it upward for inflation2 and ad7usting it further for anticipated changes in the wor!load. An alternative approach is to ma!e a through analysis of each discretionary expense centres on a schedules that will cover all of them over a period of ( years or so. 8he analysis provides a new base. +uch an analysis is called a RQero base reviewS. As a part of this approach2 following basic #uestions are raised : (i) +hould the function be performed at all F (ii) Chat should the #uality level be F Are we doing too much F (iii) +hould it be performed in this way F (iv) Oow much should it cost F A Qero?base review is time consuming2 and it is also li!ely to be a traumatic experience for the managers whose operations are being reviewed. 8his is one reason why such reviews are scheduled once in every / or ( years2 rather than annually.

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%3'

Pe*9!#/ "r3er (e"r4 "- *&+! &, s ru* ure : 8he pec!ing order theory was proposed by Donaldson in 03-0. 8he pec!ing order theory suggests that firm rely for finance2 as much as they can2 on internally generated funds. If internally generated funds are not enough then they will move to additional debt finance then e#uity. 8his is because the issue cost of internally generated funds have the lowest issue cost and cost of new e#uity is the highest. yers has suggested that the firm follows a U odified pec!ing order: in their approach to financing. yers has suggested asymmetric information as a reason for heavy reliance on internal generated funds. Oe demonstrate that with asymmetric information2 e#uity shares are interpreted by the mar!et as bad news since managers are only motivated to issue e#uity share when share mar!ets are undeveloped. 9urther2 the use of internal finance ensure that there is regular source of finance which might be in line with company:s expansion programme. If additional funds are re#uired over and above internally generated funds2 then borrowings will be next alternative in this theory. 8hus pec!ing order theory rests on : 0. +tic!ly dividend policy. '. A preference for internal funds. ,. An aversion to issue e#uity shares.

%e'

E--e* "- G"6er#.e# !.+"se3 -reeJe "# 3!6!3e#3s "# s "*9 +r!*es &#3 (e 6",u.e "*&+! &, !#6es .e# !# (e 0&*9/r"u#3 "- %M"3!/,!&#! &#3 M!,,erDs' %MM' (e"r4 "# 3!6!3e#3 +",!*4 : According to theory2 under a perfect mar!et situation2 the dividend of a firm is irrelevant as it does not affect the value of firm. 8hus under :s theory the government imposed freeQe on dividend should ma!e no difference on stoc! prices. 9irms if do not pay dividends will have higher retained earnings and will either reduce the volume of new stoc! issues2 repurchase more stoc! from mar!et or simply invest extra cash in mar!etable securities. In all the above cases2 the loss by investors of cash dividends will be made up in the form of capital gains. Chether the 1overnment imposed freeQe on dividends have effect on volume of capital investment in the bac!ground of theory on dividend policy have two argument. Ene argument is that if the firms !eeps their investment decision separate from their dividend and financing decision then the freeQe on dividend by the 1overnment will have no effect on volume of capital investment. If the freeQe restricts dividend the firm can repurchase shares or invest excess cash in mar!etable securities e.g. in shares of other companies. Ether argument is that the firms do not separate their investment decision from dividend and financing decisions. 8hey prefer to ma!e investment from internal funds. In this case2 the freeQe of dividend by government could lead to increased real investment. 111111111111

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Final examination May, 2001 Gr. I Pa er 2 ! Mana"ement Acco#ntin" $ Financial Analysis

Ques !"#s 1 Pe A 8e 9ashions is a high A fashion women:s garments manufacturer. It is planning to introduce a new fashion garment in the mar!et in the forthcoming Diwali season. 9our metres of cloth (material) are re#uired to layout the dress pattern. After cutting2 some material remains that can be sold as a cut A piece. 8he left A over material can also used to manufacture a machine cap M handbag. Pe A 8e exports to sell '2()) dresses2 if matching caps M handbags are not provided and ')4 more2 if matching caps and handbags are made available. 8he mar!et research indicates that the cap and; or handbag cannot be sold independently2 but only as accessories with the dress. 8he following combination of sales is expected: %omplete sets of dress2 cap and handbag Dress and cap only Dress and handbag only Dress only -*4 0'4 )34 <004 0))4

8he material used in the dress costs $s. -) per metre. 8he cost of cutting the dress2 if the cap and handbag are not manufactured2 is estimated at $s. ') a dress and the resulting remnants can be sold for $s. ( for each dress cut out. If the cap and handbag are to be manufactured2 it re#uires a more delicate and s!illful cutting and hence cutting cost will increase by $s. * per dress. 8he selling prices and the other costs to complete the three items2 once they are cut2 are as follows: +elling 6rice 6er Nnit Ether %osts per Nnit $s. $s. Dress /)).)) /*.)) %ap '3.)) -.() Oandbag 0*.)) ,.)) Ether costs per unit excludes the cost of material and cutting. (a) (b) 5ou are re#uired to prepare a statement showing: +hould the company go in for caps and handbags along with dressesF answer. +ubstantiate your

Chat are the non A #uantitative factors that could influence the company:s decision to manufacture caps and handbag that match the dressF (0-=/ > ') mar!s) A#s$er %&' S & e.e# s("$!#/ +r"-! &0!,! 4 "- =e 5 Te F&s(!"#s If matching caps and handbags Are not provided with dresses If matching caps and handbags are provided

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Cith dresses Expected sales; 9orecasted +ales (6ieces) +ales revenue: (A) %osts aterials (i) ($efer to wor!ing note ,) %utting (ii) Ethers (iii) Eperating profit: (A) A (") '2()) $s. 0)2))2))) ('2()) dresses x $s. /))) (2*.2()) ()2))) ('2()) dresses x $s. ')) 02')2))) ('2()) dresses x $s. /*) '2/'2()) ,2))) $s. 0,20020*) ($efer to wor!ing note ') .20*2,() *02,-) ($efer to wor!ing note /) 02--2(,) ($efer to wor!ing note () ,2//23/)

+ince2 the company can earn an additional profit of $s. 02)'2//) ($s. ,2//23/) A $s. '2/'2())) if matching caps and handbags are provided along with dresses. 8herefore2 the company should go for manufacturing matching caps and handbags and provide them along with dresses. 2"r9!#/ N" es: 0. Expected sales in forthcoming seasons2 if caps and handbags are provided with dresses. %omplete sets of dress2 cap and handbag Dress and cap only Dress and handbag only Dress only (-*4 of ,2)))) (0'4 of ,2)))) (34 of ,2)))) (004 of ,2)))) '2)/) dresses ,-) dresses '.) dresses ,,) dresses <<<<<<<<<<< ,2))) dresses

'. +ales revenue of expected sales2 if caps and handbags are provided with dresses. $s. %omplete set of dress2 cap and handbag ('2)/) dresses x $s. //.) 32002**) Dress and cap only (,-) dresses x $s. /'3) 02(/2//) Dress and handbag only ('.) dresses x $s. /0*) 020'2*-) Dress only (,,) dresses x $s /))) 02,'2))) <<<<<<<< 0,20020*) ,. aterials 9or '2()) dresses (/ metres x $s. -) per metre A $s. () 9or ,2))) dresses '2-.) dresses (/ metres x $s. -) per metre) = ,,) dresses (/ metres x $s. -) per metre A $s. () /. %utting costs for ,2))) dresses. ('2-.) dresses x $s. '*=,,) dresses x $s. ')) (. Ether costs for ,2))) dresses %omplete set of dress2 cap and handbag ('2)/) dresses x $s. (..()) Dress and cap only (,-) dresses x $s. (/.()) Dress and handbags only ('.) dresses x $s. (0) $s. (2*.2()) .20*2,() $s. *02,-) $s. 020.2,)) 03.-') 0,2..)

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Dress only (,,) dresses x $s. /*) %0'

<<0(2*/) 02--2(,)

Hon A #uantitative factors that could influence the company:s decision to manufacture caps and handbags that match the dress are: 0. $eliability of various estimates of costs2 sales and prices. '. 6roper consideration of #uality in terms of design2 color and durability. ,. 8iming of production and distribution of four combination i.e. complete set of dress2 dress and cap2 dress and handbags and dress only has been planned suitably in advance. /. Effect on the production2 sale of other product lines of Pe? 8e 9ashions has to be examined. 11111111

Ques !"#s 2 %&' any companies calculate the internal rate of return of the incremental after A tax cash A flows from financial leases. Chat problems do you thin! this may give rise toF 8o what rate should the internal rate of return be comparedF Discuss. %0' 8he O&& has $s. *.)) crore of 0)4 mortgage bonds outstanding under an open A end scheme. 8he scheme allows additional bonds to be issued as long as all of the following conditions are met: (0) 6re A tax interest coverage 1reater than /. (') Het depreciated value of mortgage assets remains twice the amount of the mortgage debt. Debt. (,) Debt A to A e#uity ratio remains below (. 8he O&& has net income after taxes of $s. ' crore and a /)4 tax A rate2 $s. /) crore in e#uity and $s. ,) crore in depreciated assets2 covered by the mortgage. (* 0' > ') mar!s) A#s$er %&' ain problems faced in using Internal $ate of $eturn can be enumerated as under: (0) 8he I$$ method cannot be used to choose between alternative lease bases with different lives or payment patterns. (') If the firms do not pay tax or pay at constant rate2 then I$$ should be calulataed from the lease cash A flows and compared to after A tax rate of interest. Oowever2 if the firm is in a temporary non A tax paying status2 its cost of capital changes over time2 and there is no simple standard of comparison. (,) Another problem is that ris! is not constant. 9or the lessee2 the payments are fairly ris! less and interest rate should reflect this. 8he salvage value for the asset2 however2 is probably much ris!ier. As such two discount rates are needed. I$$ gives only one rate2 and thus2 each cash A flow is not implicitly discounted to reflect its ris!. (/) ultiple roots rarely occur in capital budgeting since the expected cash A flow usually change signs once. Cith leasing2 this is not the case often. A lessee will have an immediate cash Income before = "ond Interest ????????????????????????????????????????????? remains "ond Interest

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inflow2 a series of outflows for a number of years2 and then an inflow during the terminal year. Cith two changes of sign2 there may be2 in practice fre#uently two solutions for the I$$. %0' &et x be the crores of $upees of new 0)4 debt which could be sold under each of the three given conditions. How2 the value of x under each of the three conditions is as follows: 0. Pre &A !# eres *"6er&/e Re.&!#s /re& er (&# : $s. ' crores; (0 A )./) = * crores x ).0 = x x ).0 (* crores x ).0) x (x x ).0) or $s. ,.,, crores = ).*) crores = ).0) x ().* crores = $s. ).0) x) or2 $s. /.0, crores = ).0) x<<< $s. ).*) crores = $s. ).0) x Er2 $s. /.0, crores = ).0) x > / ($s. ).*) crores = $s. ).0) x) Er2 $s. /.0, cores = ).0) x > $s. ,.' crores = $s. )./) x Er2 $s. ).,) K > ).3, Er2 x > $s. ).3,; ).,) Er2 x > $s. ,.0) crores Additional mortgage re#uired shall be a maximum of $s. ,.0) crores. '. Ne 3e+re*!& e3 6&,ue "- ."r /&/e &sse s re.&!#s $!*e (e &."u# "- ."r /&/e 3e0 (Assuming that ()4 of the proceeds of new issue would be added to the base of mortgaged assets) $s. ,) crores = ).( x i.e.2 ????????????????????????????? > ' $s. * crores = x Er2 $s. ,) crores = ).( x > '($s. * crores = x) Er2 $s. 0.( x > $s. 0/ crores $s. 0/ cores Er2 x > ???????????????????????? 0.( or2 x > 3.,, crores Additional mortgage re#uired to satisfy condition Ho. ' is $s. 3.,, crores ,. 7e0 " eBu! 4 r& !" re.&!#s 0e,"$ < $s. crores = x i.e. ????????????????????????? ^( $s. /) crores Income before = "ond Interest ???????????????????????????????????????? "ond Interest

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Er2 $s. * crores = x > $s. ')) crores Er2 K > $s. 03' crores +ince all the conditions are to be met2 the least i.e.2 $s. ,.0) crores (as per condition A 0) can be borrowed by issuing additional bonds. N" e: +ince in the #uestion2 it is given that debt to e#uity ratio remains below (2 the value of debt is computed by using this condition. Oowever2 the new additional debt (x) is exorbitant and is not computed with the value of new additional debt (x) computed under conditions 0 and '. 9or getting the comparable value of new additional debt x the debt to e#uity ratio should be read as ).(. Accordingly2 value of additional debt would be $s. 0' crores. 11111111 Ques !"# 8 %&' +hoe %ompany sells to a wholesaler in 1ermany. 8he purchases price of a shipment is ()2))) deutsche mar!s with term of 3) days. Npon payment2 shoe %ompany will convert the D to dollars. 8he present spot rate for D per dollars is 0..02 whereas the 3) A day forward rate is 0..). 5ou are re#uired to calculate and explain: (i) If shoe %ompany were to hedge its foreign A exchange ris!2 what would it doF necessary are necessaryF (ii) Is the deutsche mar! at a forward premium or at a forward discountF (iii) Chat is the implied differential in interest rates between the two countriesF (use interest A rate parity assumption) %0' Z6& has two dates when it receives its cash inflows i.e.2 9eb 0( and Aug. 0(. En each of these dates2 it expects to receive $s. 0( core. %ash expenditure are expected to be steady throughout the subse#uent - month period. 6resently2 the $EI in mar!etable securities is *4 per annum2 and the cost of transfer from securities to cash is $s. 0'( each time a transfer occurs. (i) Chat is the optimal transfer siQe using the EEV modelF Chat is the average cash balanceF (ii) Chat would be your answer to part (i)2 if the $EI were 0'4 per annum and the transfer costs were $s. .(F Chy do they differ from those in part (i)F (0)=0) > ') mar!s) A#s$er %&' (i) If +hoe %ompany were to hedge its foreign exchange ris!2 it would enter into forward contract of selling deutsche mar!s 3) days forward. It would sell ()2))) deutsche mar!s 3) days forward. Npon delivery of ()2))) D 3) days hence2 it would receive N+ X '32/0' i.e. ()2))) D ; 0..). if it were to receive N+ X payment today it would receive N+ X '32'/) i.e.2 ()2))) D ; 0..0. Oence2 +hoe %ompany will be better off by X 0.' if it hedges its foreign exchange ris!. (ii) 8he deutsche mar! is at a forward premium. 8his is because the 3) days forward rate of deutsche mar!s per dollar is less then the current spot rate of deutsche mar!s per dollar. 8his implies that deutsche mar! is expected to be strengthen i.e. 9ewer deutsche mar! will be re#uired to buy dollars. Chat

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(iii) 8he interest rate parity assumption is that high interest rates on a currency is offset by forward discount and low interest rate on a currency is offset by forward premiums. 9urther2 the spot and forward exchange rates moves in tandem2 with the lin! between them based on interest differential. 8he movement between two currencies to ta!e advantage of interest rate differential is a ma7or determinant of the spread between forward and spot rates. 8he forward discount or premium is approximately e#ual to interest differential between the currencies i.e. 9(D ;N+ X) A +(D ;N+ X) x ,-( > rD <<<<<<<<<<<<<<<<<<<<< <<<< +(D ; N+ X) 3) Er2 0..) A 0..0 x ,-( > rD 0..0 3) or2 ? ).)',. > rD A rN+ X A rN+ X A rN+ X

8herefore2 the differential interest rate is A '.,.42 which means if interst rate partiy holds2 interest rate in the N+ should be '.,.4 higher than in 1ermany. %0' %!' O+ !.&, r&#s-er s!Je 04 us!#/ ( EOQ ."3e, According to EEV model2 %> '98 ????????? r

Chere2 % > %ash re#uired each time to restore balance to minimum cash. 9 > 8otal cash re#uired during the year. 8 > %ost of each transaction between cash and securities. r > $ate of interest on securities. How2 9 > $s. ,)2))2))2)))2 8 > $s. 0'(2 r > *4 per annum. ' x $s. ,)2))2))) x $s. 0'( 8herefore2 % > ?????????????????????????????????????? ).)* > $s. 32-*2'/( $s. 32-*2'/( Average cash balance > %;' > ???????????????????????? $s. /2*/20', ' %!!' Eptimal transfer siQe using E.E.V model if r > ).0' and 8 > $s. .( is as follows ' x $s. ,)2))2))2))) x $s. .( % > ?????????????????????????????????????????? ).0'

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> $s. -20'2,.' . $s. -20'2,.' Average cash balance > ?????????????????????? > $s. ,2)-20*' 8he reasons for change in the figures are: (a) Oigher opportunity cost of holding tends to lower cash balance than before. (b) 8ransaction cost is lower and there is a clear cut incentive in fre#uent conversion of securities to cash. A, er#& !6e s",u !"#: +ince it is given in the #uestions that Z.6.& has two dates when it receives its cash inflow i.e.2 9ebruary 0( and August 0(. on each of these dates2 it expects to receive $s. 0( crores. According to EEV model % will be wor!ed out as follows: How2 9 > $s. 0(2))2))2))). 8 > $s. 0'( r > ).)/ i.e. ().)*;) ' x $s. 0(2))2))2))) x $s. 0'( (i) % > ???????????????????????????????????????????????? ).)/ > $s. 32-*2'/(

' x $s. 0(2))2))2))) x $s. .( (ii) % > ???????????????????????????????????? ).)> $s. -20'2,.' EIT;ER Ques !"# : %&' 6iyush &oon!er and Associates presently pay a dividend of $e. 0.)) per share and has a share price of $s. ').)).. (i) If this dividend were expected to grow at a rate of 0'4 per annum forever2 what is the firm:s expected or re#uired return on e#uity using a dividend A discount model approachF (ii) Instead of this situation in part (i)2 suppose that the dividends were expected to grow at a rate of ')4 per annum for ( years and 0)4 per year thereafter. How what is the firm:s expected2 or re#uired2 return on e#uityF %0' 8he credit manager of K5P &td. is reappraising the company:s credit policy. 8he company sells its products on terms of net ,). cost of goods sold is *(4 of sales and fixed costs are further (4 of sales. K5P classifies its %ustomers on a scale of 0 to /. during the post five years2 the experience was as under: %lassification Default as A percentage of sales ) ' Average collection period A in days for non? defaulting account /( /'

0 '

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, /

0) ')

/) *)

8he average rate of interest is 0(4. Chat conclusions do you draw about the company:s credit policyF Chat other factors should be ta!en into account before changing the present policyF Discuss. %*' %orporate financial plans are often used as a basis for 7udging the subse#uent performance. Chat do you thin! can be learned from such comparisonsF Chat problems are li!ely to arise and how would you cope with thoseF Discuss. (*=-=- > ') mar!s) OR Alcobex etal %ompany (A %) does business in three products 6 02 6' and 6,. product 6' are manufactured in the company2 while product 6 , is procured from outside and resold as a combination with either product 60 or 6'. the sales volume budgeted for the three products for the year '))) A '))0 (April A arch) are as under: 6roduct 60 6' 6, $s. in la!hs 02')) ()) /)) @Dec. 0333 to arch '))) $s. ').)) la!h 6. April '))) to Zuly '))) $s. '(.)) la!h 6. . Aug. '))) to Hov. '))) to $s. ,).)) la!h 6. . Dec '))) to arch '))0 $s. /(.)) la!h 6. B

"ased on the budgeted +ales value2 the cash flow forecast for the company is prepared based on the following assumptions: (0) +ales realisation is considered at: ()4 %urrent month '(4 +econd month '(4 8hird month (') (,) (/) (() (-) 6roduction programme for each month is based on the sales value of the next month. $aw material consumption of the company is !ept at (34 of the month:s production *04 of the raw materials consumed are components. $aw material and components to the extent2 at '(4 are procured through import. 8he 6urchases budget is as follows: (i) Indigenous raw materials are purchased two months before the actual consumption. (ii) %omponents are procured in the month of consumption (iii) Imported raw materials and components are bought three months prior to the month of consumption.

(.) 8he company avails of the following credit terms from suppliers: (i) $aw materials are paid for in the month of purchasesL (ii) %ompany gets one month:s credit for its components2 (iii) 9or imported raw material and components payments are made one month prior to the daters of purchases. (*) %urrently the company has a cash credit facility of $s. 0/).** la!hs.

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(3) Expenses are given below and are expected to be constant throughout the year: Cages and +alaries Administrative Expenses +elling and distribution Expenses $s. ,0' la!hs $s. ,'' la!hs $s. (, la!hs.

(0))Dividend of $s. (*.), la!hs is to be paid in Ectober (00) (0') (0,) 8ax of $s. ',.3' la!hs will be paid in e#ual installments in four A #uarters: i.e.2 Zanuary April2 Zuly and Ectober. 8he term A loan of $s. ',..,' la!hs is repayable in two e#ual installments half A yearly2 i.e.2 Zune; December. %apital expenditure of $s. '3'.// la!hs for the year is expected to be spread e#ually during the 0' month period.

5ou are re#uired to prepare a %ash flow statement (cash "udget) for the period for Zune A Hovember2 '))). (') mar!s) F!rs A, er#& !6e: A#s$er %&' %!'

F!r.Ds eA+e* e3 "r reBu!re3 re ur# "# eBu! 4 (Nsing a dividend discount model approach)

According to dividend discount model approach the firm:s expected or re#uired return on e#uity is computed as follows: D0 Te > ?????? = g 6) Chere2 Te > cost of e#uity share capital or (9irm:s expected or re#uired return on e#uity share capital) D0 > Expected dividend at the end of year 0 6) > %urrent mar!et price of the share. g > Expected growth rate of dividend. How2 D0 > D) (0 = g) or $s. 0 (0 = ).0') or $s. 0.0'2 6) > $s. ') and g > 0'4 per annum. $s. 0.0' 8herefore2 Te > ????????????????????? = 0'4 $s. ') Er2 Te > $s. 0..-4 (ii) F!r.Ds eA+e* e3 "r reBu!re3 re ur# "# eBu! 4

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(if dividends were expected to grow at a rate of ')4 per annum for ( years and 0)4 per year thereafter) +ince in this situation if dividends are expected to grow at a super normal growth rate g s2 for n years and thereafter2 at a normal2 perpetual growth rate of g n beginning in the year n = 02 then the cost of e#uity can be determined by using the following formula: Div) (0 = gs)t Divn = 0 0 6) > ????????????????????????? = ??????????????????????????x ??????????????? 8>0 (0 = Te)t Te A gn (0 = Te)n Chere2 gs > $ate of growth in earlier years. gn > $ate of %onstant growth in later years. 6) > Discounted value of dividend stream. Te > 9irm:s expected2 re#uired return on e#uity (cost of e#uity capital). How2 ( gs > ')4 for ( years2 gn > 0)4 n

D) (0 = ).'))t Div ( = 0 0 6) > ??????????????????? = ????????????????? x ?????????????? t > 0 (0 = Te)t Te A ).0) (0 = Te)t 0.') 0.// 0.., '.). './3 './3 (0 = ).0)) 6) > ???????????? = ????????????????? = ?????????????? = ?????????????????? =??????????????? = ???????????????????????? (0 = Te)0 (0 = Te)' (0 = Te), (0 = !e)/ (0 = Te)( Te A ).0) 0 x ??????????????? (0 = Te)( or2 6) > $s. 0.') (6J902 Te) = $s. 0.// (6J9'2 Te) = $s. 0.., (6J9,2 Te) = $s. '.). (6J9/2 Te) = $s. './3 (6J9(2 Te) = $s2 '../ (6J9(2 Te) Te A ).0) "y trial and error we are re#uired to find out Te How2 assume Te > 0*4 then we will have 6) > $s. 0.') ().*/.() = $s. 0.// ()..0*') = $s. 0.., ().-)*-) = $s. '.). ().(0(*3) = $s. './3 ()./,.0)) = $s. '../ ()./,.0) x 0 ?????????????????????? ).0* A ).0) > $s. 0).0. = $s. 0.),/ = $s. 0.)(' = $s. 0.)-. = $s. 0.)3 = $s. 0/.3. > $s. ').', +ince the present value of dividend stream is more than re#uired it indicates that T e is greater than 0*4. How2 assume Te > 034 we will have 6) > $s. 0.') ().*/),) = $s. 0.// ()..)-0) = $s. 0.., ().(3,/) = $s. '.). ()./3*-) = $s. './3 ()./03)) = $s. '../ ()./03)) x 0 ??????????????????? ).03 A ).0) > $s. 0.))* = $s. 0.)0- = $s. 0.)'- = $s. 0.),' = $s. 0.)/, = $s. 0'..- > $s. 0..*3

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+ince the mar!et price of share (expected value of dividend stream) is $s. '). therefore the discount rate is closer to 0*4 than it is to 0342 we can get the extent rate by interpolation by using the following formula: r A (6J+ A 6JD) Te > ????????????????????????????????? x r 6J Chere2 r > Either of two interest rates

6J+> 6resent value of share 6JD> 6resent value of dividend stream r > Difference in value of dividend stream 6J> Difference in calculated present value of dividend stream. 0*4 ? ($s. ') A $s. ').',) Te > ??????????????????????????????????????? x ).)0 $s. ').', A $s. 0..*3 0*4 ? (? $s. ).',) > ???????????????????????? x ).)0 $s. '.,/ > 0*4 = ).0)4 > 0*.0)4 8herefore2 the firm:s expected2 or re#uired2 return on e#uity is 0*.0)4. At this rate the present discounted value of dividend stream is e#ual to the mar!et price of the share. %0' +ince the amount of revenue generated from each category of customer is not given in the #uestions. &et us consider $s. 0)) as the amount of revenue generated from each type of customer. 8herefore2 $s. 0)) shall be ta!en as the basis for reappraisal of company:s credit policy. %lassifi ? %ation 1ross 6rofit G 0(4 ($s) (i) 0 ' , / 0( 0( 0( 0( "ad debts Interest cost 8otal %ost ($s) ($efer to Cor!ing ($s) note) ($s) (ii) Hil ' 0) ') (iii) 0.(. 0./. 0./) '.*) (iv) > (ii) = (iii) 0.(. ,./. 00./) ''.*) Het effect ($s) +trategy.

(v) > (i) A (iv) 0,./, 00.(, ,.-) (..*)) Accept Accept Accept $e7ect

I It is given that cost of goods sold is *(4. 8herefore 1ross 6rofit is 0(4 of sales. 8he reappraisal of the company:s credit policy indicates that the company either follows a lenient credit policy or it is inefficient in collection of debts. Even though the company sells its products on terms of net ,) days2 it allows average collection period for more than ,) to al categories of its customersL the net effect i.e. 1ross 6rofit less 8otal cost is favourable in respect of categories 02 ' and , therefore these customers shall be ta!en into fold. 9or the customers covered in

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category / the net effect is unfavorable i.e. total cost is more than the gross profit. 8he company should try to reduce bad debt 4 for this category of customers at least by ..*4 (i.e. at 0'.')4). If the company is able to do so2 the company can allow the credit period of *) days for at least increasing the mar!et share. 8he other factors to be ta!en into consideration before changing the present policy includes (i) past performance of the customers and (ii) their credit worthiness. 8he information so re#uired may be outsourced as well as in sourced. 2"r9!#/ N" es: Computation of (nterest cost: Average rate of interest x cost of goods sold x Average collection period in days for non A defaulting accounts. Interest cost > ????????????????????????????????????????????????????????????????????????????????????????????????????????????? ,-( days 0(4 x $s. *( x /( days 9or category 0 > ????????????????????????????????????? > $s. 0.(.

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