Chapter4:FinancialStatements

Konkantextiles,isintheprocessofputtingupasecondunitandhaveapproachedtheirbankfor
afreshtermloanofRs.60lakhforpurchaseofplantandmachinerycostingRs.80lakh.Atthe
inception of the unit, a couple of years back, they had availed of a term loan of Rs.48 lakh
carryinganinterestrateof12percent,repayableinsixequalannualinstalmentsandthesame
is regular. The new loan is sought at the same interest rate, repayable in five years. The
constructionofthefactorybuildingforthesecondunithasbeencompletedamonthbackand
their plan is to avail of the fresh term loan in the beginning of June this year and start
production there within the current year itself. On 30th April 2015, Konkan Textiles have
submittedtheirbalancesheet,ason31stMarch2015,andtheirMDhascalledthebankbranch
manager,inordertoknowthebanksresponsetotheirrequestbeforeplacingtheorderforthe
newmachinery.BeforeameetingwiththebankmanagerintheafternoonIthasbeendecided
tomakeanownquickanalysisofthebalancesheets(shownbelow)togetaclearviewonthe
following:

a)

Aretheirpresentsolvencyandliquiditypositionssatisfactory?

b) Konkantextilesclaimthatalltheirexpenditureonfixedassetsduringthepreviousyearhad
been on construction of the new factory building and that the same had been financed
entirelybytheirownfunds,Dothebalancesheetssupportthatclaim?
c)

Assumingthattheoperationsofthefirmduring thecurrentyearwouldbeatalevelnot
less than the previous year, would they be in a position to meet all their financial
commitmentstothebankincludingputtingup25percentofthecostofthenewplantand
machineryupfrontandpayingoffanyoutsideborrowingsthatmighthavebeenresortedto
inthepreviousyear?Couldheevenaskfortherepaymentofthenewloantocommence
bytheendofthecurrentyearitself?

Makearecordofyouranalysisandobservationsforthebanksfiles.

BalanceSheets
EQUITYANDLIABILITIES

3132015

ShareholdersFunds
Sharecapital(ParvalueRs.10)
Reservesandsurplus
NoncurrentLiabilities
Longtermborrowings

216
50
166
81
32

(Rs.inmillion)
3132014
150
50
100
80
40

Deferredtaxliabilities(net)
Longtermprovisions
CurrentLiabilities
Shorttermborrowings
Tradepayables
Othercurrentliabilities
Shorttermprovisions
ASSETS
NoncurrentAssets
Fixedassets
Noncurrentinvestments
Longtermloansandadvances
CurrentAssets
Currentinvestments
Inventories
Tradereceivables
Cashandcashequivalents
Shorttermloansandadvances

25
24
101
30
56
10
5
398

20
20
74
12
46
12
4
304

248
230
8
10
150
2
70
64
10
4
398

204
160
18
26
160
10
64
54
20
12
364

StatementofProfitandLossforYearEndingMarch31,2015
(Rs.inmillion)
600
RevenuesfromOperations
OtherIncome
15
615
TotalRevenues
Expenses
Materialexpenses
280
160
Employeebenefitexpenses
Financecosts
15
Depreciationandamortisationexpenses
25
55
Otherexpenses
TotalExpenses
535
ProfitbeforeExceptionalandExtraordinary
ItemsandTax
80
ExceptionalItems
ProfitbeforeExtraordinaryItemsandTax
80
ExtraordinaryItems
ProfitBeforeTax
80
11
TaxExpense

Profit(Loss)fortheperiod

69

Solution:
a)Currentratio=150/101=1.49
Acidtestratio=(15070)/101=0.79
Debtequityratio=(81+101)/216=0.84
Timesinterestearnedratio=(80+15)/15=6.3
Boththesolvencyandliquiditypositionsaresatisfactory.
b)

CashFlowStatementforthePeriod1.4.2014to31.3.2015
(Rs.inmillion)
A.CashFlowfromOperatingActivities
ProfitBeforeTax
Adjustmentsfor:
Depreciationandamortisationexpenses
Financecosts
Interestincome*
OperatingProfitBeforeWorkingCapitalChanges
Adjustmentsforchangesinworkingcapital:
Tradereceivablesandshorttermloanand
advances
Inventories
Tradepayables,shorttermprovisions,andother
currentliabilities
CashGeneratedfromOperations
Directtaxespaid
NetCashFromOperatingActivities
B.CashFlowFromInvestingActivities
Purchaseoffixedassets
Increaseofnoncurrentinvestments
Reductioninlongtermloansandadvances
Interestincome
NetCashUsedinInvestingActivities

80

25
15
15
105

10
6
10
99
11
88

95
10
16
15
54

C.CashFlowfromFinancingActivities
Increaseinlongtermborrowings
Increaseinshorttermborrowings
Increaseindeferredtaxliabilities
Increaseinlongtermprovisions
Dividendpaid
Financecosts
NetCashFromFinancingActivities
NetCashGenerated(A+B+C)
CashAndCashEquivalentsAtBeginningOfPeriod
CashAndCashEquivalentsAtTheEndOfPeriod

(b)

8
18
5
4
3
15
1
35
20
10

Netcashgeneratedfromoperations=Rs.88lakh.Asthepurchaseoffixedassetsisseentobe
for Rs. 95 lakh, it is clear that the firm has resorted to some outside borrowing, viz., by way of
shorttermloanstocompletetheirnewbuilding.
(c)

Financialcommitmentsforthecurrentyear:

Interestontheexistingtermloan

=32x0.12

Interestontheproposedtermloan

=60x0.12x(10/12)=6

Instalmentsoftheexistingandnewtermloans=8+12

Marginmoneyat25%oftheplantcost=80x0.25

=20

Repaymentoftheoutsideshorttermloansraisedduringthepreviousyear=18

=3.84

=20

Total =Rs.67.84lakh

WithacashgeneratingcapacityofnotlessthanRs.88lakh,thefirmshouldbeableto
meet all the needed financial commitments within the current year, including payment of the
firstinstalmentoftheproposedtermloanifaskedforbythebank.

Chapter11:TechniquesofCapitalBudgeting

Suresh,arecentlyretiredteacher,hasrequestedyoutohelphimselectonefrom the
followingtwoproposalsbeforehim:
ProposalA:Toestablishandrunaprimaryschool
Fromthecomingmonth,hecouldstartaLKGclassfromasmallvacantbuildingowned
byoneofhisrelatives,bymodifyingthesameatacostofRs.5lakh.Thereafteratthe
end of each year, beginning from the first year, a fresh room would be added to the
existingbuildingtohousethestudentsofKG,firststandard,secondstandard,,tillthe
fifthstandard.TheestimatedexpensesforthesamewouldbeRs.4lakhattheendof
thefirstyearwhichwouldberisingperyearbyRs.1lakh.Foralltheyears,theaverage
netincomeperstudentwouldbeRs.10,000perannumasreckonedattheendofthe
yearandtheirstrengthperclasswouldbe20.Sureshisassuredofgettingabankloan
for all his project expenses at an interest rate of 12 percent. Once the fifth standard
completes its first year, Suresh could sell the school to his relative and get cash
compensationattwicethenetannualschoolincomeatthattime.

ProposalB:Investmentincommercialspace
Hitesh Builders, owned by one of his exstudents, are planning to start a commercial
buildingprojectandhavemadeaspecialprelaunchofferof650sqft.toSureshonthe
following terms: He needs to invest Rs.10 lakh at the end of each year with the first
payment due at the end of the same month. The building would be ready for the
businessinjustoneyearandhecouldexpectanannualrentofRs.3.6lakhbylettingout
his space there. Moreover, from the beginning of the second year he would be
appointed as the building supervisor at an annual remuneration of Rs.120, 000. An
annualincreaseof10percentcouldbeexpectedinboththerentandthesalary.Atthe
end of the seventh year the commercial space could be sold back to the builders at
Rs.120lakh.Entirefinancingwouldbearrangedbythebuilderthroughtheirbankatan
interestrateof13percent.
Whichoftheaboveproposals,accordingtoyou,isfinanciallymoreattractivetoSuresh
andwhy?

Solution:(AllamountsinRs.Lakh)

ProposalA:
Yearending

0 1 2

3 4 5
5

Investment
5 4 5 6 7 8 9

Cashinflow
2 4 6 8 10 12 42
Netcashflow 5 2 1 0 1 2 3 42

Costofcapital=12percent
PVofcosts=5+2/1.12+1/(1.12)2=7.58
Terminalvalueofcashinflows=1x(1.12)3+2x(1.12)2+3x1.12+42=49.27
ModifiedInternalRateofReturn(MIRR)istherinthefollowingequation:
7.58(1+r)7=49.27
r=(49.27/7.58)1/71=30.66percent.

ProposalB:

Yearending
0 1 2
3
4
5
6
7

Investment
10 10 10
10
Cashinflow

4.8 5.28 5.81 6.39 7.03 127.73

Netcashflow 10 10 5.2 4.72 5.81 6.39 7.03 127.73
Costofcapital=13percent
PVofcosts=10+10/1.13+5.2/(1.13)2+4.72/(1.13)3=26.19

Terminalvalueofcashinflows=5.81x(1.13)3+6.39x(1.13)2+7.03
x1.13+127.73=152.22
MIRRistherinthefollowingequation:
26.19(1+i)7=152.22
r=(152.22/26.19)1/71=28.59percent.

Conclusion:RunningtheschoolisthebetteroptionasitsMIRRishigher.

Chapter12:EstimationofProjectCashFlows

ArushisallsettotakeoverthemanagementofthetwoyearoldAyurvedicdivisionof
theirfamilyfirmShaktiPharmafromRajeev,whohastoleavethejobinahurrytogo
abroad. Currently, this division has only one product, named Sanjeevani, which has a
remainingeconomic life of five years after which it would be withdrawn. Immediately
on taking over, Arush plans to sell the existing main machinery, originally bought at
Rs.40 lakh, and install a new one costing Rs.70 lakh whose better efficiency would
ensure a 5 percent increase in the annual sales of Sanjeevani over the present
projections.Whilethetotalannualmanufacturingcosts(otherthandepreciation)would
remain unchanged throughout because of cost efficiencies, it would be necessary to
makeafreshonetimeinvestmentofRs.8lakhtopurchaseacostliervarietyofherbal
raw material stock. For financing, he plans to raise a term loan of Rs.50 lakh and
additionalworkingcapitalloanofRs.5lakhfromtheirbank.Thetermloanwouldbeat
aninterestrateof12percentcompoundedquarterlyandrepayablein5equalannual
instalmentswithoutanyholidayperiod.Toensuresafetyofthecostlyrawmaterials,he
planstoutilisefreeofcost,asolidroominthebackyardofthefactory,whichisaboutto
be leased out by another division to a neighboring unit at a rental of Rs. 1 lakh per
annum.
The current annual sale of Sanjeevani is at Rs.300 lakh and as per the present
projectionstheannualsaleswouldincreaseby20%inthenexttwoyearsanddeclineby
10 % thereafter. While Rajeevs current annual remuneration is Rs.4.8 lakh, Arushs
wouldbeRs.6lakhandhisannualincrement25percentasagainstthe5percentofthe
outgoingofficer.

Toensurethatthechangestobeeffectedbyhimareworthwhile,Arushseeks
yourhelpincalculatingtheincrementalinternalrateofreturnoftheAyurvedicdivision
under his management. At your request he also furnishes the following additional
relatedinformation:Attheendofanyyearthenetsalvagevaluesofboththeexisting
andthenewmachinerywouldbeequaltotheirrespectivebookvaluesatthattimeand
theworkingcapitalcouldberecoveredatpar.DepreciationiscalculatedunderWritten
DownValue(WDV)methodonboththeexistingandproposednewmachineryat25%.
Incometaxrateforthefirmis30%.Pleaseshowyourdetailedcalculations.
Solution
(Rs.inthousands)
Year
0
1
2
3
4
5
InvestmentOutlay

Costofthenewmachinerytobe
purchased
Salvagevalueoftheexisting
machinerytobesold
Increaseinnetworkingcapital
Totalnetinvestment
Revenuesbeforetheproposed
changes
Revenuesaftertheproposed
changes
Increaseinrevenues
Depreciationonthenew
machinerytobepurchased
Depreciationontheexisting
machinerytobesold
IncrementalDepreciation
Rajeevsalary
Arushsalary
Additionalsalarycost
Opportunitycostofextrastorage
space
Increaseinnetoperatingprofit
Posttaxincreaseinnetoperating
profit
Increaseinoperatingcashflow
Terminalcashflow
Netterminalvalueofnew
machinerytobepurchased
Netterminalvalueoftheexisting
machinerytobesold
Recoveryofincrementalworking
capital
Totalterminalcashflow
(a)Netincreaseincashflow
IRRofthenetincreaseincash
flow
Depreciationrate

7000.00

2250.00
800.00
5550.00

34992.00

31492.80

36741.60
1749.60

33067.44
1574.64

30000.00 36000.00 43200.00 38880.00

37800.00 45360.00 40824.00

1800.00 2160.00 1944.00

1750.00

1312.50

984.38

738.28

553.71

562.50
1187.50
480.00
600.00
120.00

421.88
890.63
504.00
750.00
246.00

316.41
667.97
529.20
937.50
408.30

237.30
500.98
555.66
1171.88
616.22

177.98
375.73
583.44
1464.84
881.40

100.00
392.50

100.00
923.38

100.00
767.73

100.00
532.41

100.00
217.51

274.75
1462.25

646.36
1536.99

537.41
1205.38

372.69
873.66

152.25
527.99

1661.00

534.00

5550.00

1462.25

1536.99

1205.38

873.66

800.00
1927.00
2454.99

0.11
25%

Taxrate
30%
*TheincrementalIRRoftheAyurvedicdivisionwouldbe11percent.

Chapter14:TheCostofCapital

The Managing Director of Kuber and company has called you, his special assistant, to
discussanexpansionprojectthatisunderhisactiveconsideration.Theprojectwithan
initial investment of Rs.800 million is expected to bring incremental net cash flow of
Rs.300 million per annum from the end of the first year itself for the next six years.
Theirbankershavealreadyassuredhimoftheirwillingnesstopartfinancetheproject
withafreshtermloanofRs.100millionatareducedinterestrateof11percent.Asthe
share market is extremely buoyant,he is fully confident of raising the entire balance
needed funds through a rights issue of equity at the prevailing market price itself. He
hasmadeavailabletoyouthefollowingfinancialinformationonthecompanyandthe
market and asked you to work out the net benefit cost ratio of the project to satisfy
himself of its financial viability before asking for a detailed appraisal. He is very
particularthatthepresentdebtequityratioofthecompany(atmarketvalues)should
becontinuedtobemaintainedinthefuturealso.
_____________________________________________________________________

No.ofoutstandingequitysharesoffacevalueRs.10andmarketvalueRs.160each=10million.
Betaofthecompanysequityshares=1.25
No.of8year12%nonconvertibleRs.100pardebenturesofcurrentmarketpriceofRs.110eachissued5
yearsback=2million
Outstandingintheexistingtermloanfrombankavailedofthreeyearsbackcarryinganinterestrateof
12percentperannum
=Rs.100million
AnnualisedreturnonNiftyatpresent=18%
Presentandexpectedincometaxrate=30%
Equitydividendpaymentdetailsforthepast10years:
Year
T9 T8 T7 T6 T5 T4 T3 T2 T1 Yearjustended(T)
Dividendpershare(Rs.) 2
3
1
4
NIL NIL 2
NIL 2
NIL
Prevailingyieldon10yeartreasurybonds=8.5%
PrepareabriefandsuccinctreporttoyourMDshowingallyourcalculations.


Solution:
Marketvalueofequity=10x160=Rs.1600million
Marketvalueofdebentures=2x110=Rs.220million
Marketvalueofloan=Rs.100
Presentdebtequityratio=320/1200=0.2
Costofequity=8.5+1.25(188.5)=20.38%
Costofdebenture=(12+(100110)/3)/(0.4x100+0.6x110)=8.18%
Costofbankloan=11%
Averagecostofdebt=(220/320)x8.18+(100/320)x11=9.06
Posttaxaveragecostofdebt=9.06x0.70=6.34%
Costofcapital=0.2x6.34+20.38=21.65%
Presentvalueofbenefits=300(1/1.2165+1/1.21652+1/1.21653+1/1.21654+1/1.21655+1/1.21656)

=300x3.194=Rs.958.2
Netbenefitcostratiooftheexpansionproject=958.2/8001=0.2

10

Chapter19:CapitalStructureandFirmValue

The Managing Director (MD) of your company had received two important calls that
morning.Thefirstonewasfromthecompanysbankersagreeingtofinancetheentire
amount of Rs.100 million needed for the firms expansion project to be completed
within this year. They were offering a term loan at a lucrative 12 percent interest
repayable in 5 equated annual instalments. The second call from Mumbai was from a
wellknownmerchantbankwhichofferedtoarrangetheentireneededfundsthrough
anequityissueofRs.10parsharesatapriceofRs.20pershareandalsoofferedtosend
theirmantomakeapresentationbeforethedirectorsthenextdaymorning.TheMD
was well aware that you, the finance manager were very much in favour of accepting
thebankofferandthusrequestedyoutomakeuseoftheoccasionbymakingyourown
presentation on the merits of the bank offer. You decide to use the following data to
comeupwithsomesimplecalculationstocounterthelikelysuavetalkbythemerchant
banker.
Present capital of the firm is made up of an equity of Rs.300 million out of Rs.10 par
equitysharesandRs.100millionofdebenturescarryinganinterestrateof14percent.
For the next year, the companys fixed costs would amount to Rs.400 million and the
variable costs would be at 20 percent of the sales. Annual depreciation under WDV
methodwouldbeRs.80million;thenormaltaxrate30percentandMATwouldbeat
Rs. 1.91 million. As per the opinion obtained from an eminent industry and market
expert long associated with your company, the applicable P/E ratio for the company
wouldcontinuetobe8andthesalesscenariofornextyearwouldmostprobablybeas
follows:
Stateofthe
economy

Probability Sales(Rs.in
(p)
million)

SuperBoom
0.2
1000
Boom
0.3
800
Normal
0.3
650
Recession
0.2
520

Youdecidetoshowbyyourcalculationswhyforthecomingyear,fromapurely
earningspointofview:
(a)Thebankloanoptionwouldbebetterthantheequityoption.
11

(b)Thebusinessoperationswouldbeadequateingeneratingsufficientcashtoservice
theproposedloaninadditiontotheexistingannualinterestpaymenton
debentures,annualsinkingfundinvestmentofRs.20millionandmaintainingthe
existingdividendpayoutatRs.1pershare.
(c)Howtheloanoptionwouldaddmoretoshareholdervaluethantheequityoption?

Solution
(a)Currently,theno.ofequitysharesis30millionanddebentureinterestisRs.14
million.
EquatingtheformulaforEPSoftheequityoptionwiththatofthebankloantogetthe
PBITindifferencepoint:
[(PBIT14)x0.7]/35= [(PBIT26)x0.7]/30

30xPBIT14x30=35xPBIT35x26

PBIT=(35x2614x30)/5=Rs.98million
TheexpectedPBITfornextyearwouldbeasperthefollowingcalculations:
Stateof
Probability Sales
Variable
Fixed
PBIT
Probability
the
(p)
operating operating
xPBIT
economy
costs
costs
Super
0.2
1000
200
400
400
80
Boom
Boom
0.3
800
160
400
240
72
Normal
0.3
650
130
400
120
36
Recession 0.2
520
104
400
16
3.2

Expected Rs.191.2
PBIT
million

AstheexpectedPBITnextyearwouldbenearlytwiceasmuchasthePBITindifference
value, the bank loan would indeed be a better option than the equity one. This is
becauseforthesamePBIT,EPSundertheloanoptionwouldbehigherthanthatunder
theequityoption.

(b)

12

PBITin
Intereston Profit
recessionary debentures before
period
tax
16
14
2

MAT

1.91

Profit
after
tax
0.09

Depreciation Cashflow
from
operations
80
Rs.80.09
million

Equatedannualinstalmentsonthebankloan=100/PVIFA(12%,5yrs)=100/3.605
=Rs.27.74million
Sinkingfunddeposit

=20
DividendatRe.1on30millionshares
=30
Totalannualcashcommitment

=Rs.77.74million
Itisseenthateveninarecession,theoperationalcashflow(evenwithoutconsidering
tax shield on loan interest) alone would be sufficient to service thebank loan besides
dividendandsinkingfunddeposit.
(c)
Price
Expected

Interest PBT Tax

PAT
EPS P/E per
PBIT
share
Equity
191.2
14
177.2 53.16 124.04 3.54 8 Rs.28.35
option
Loanoption
191.2
26
165.2 49.56 115.64 3.85
8 Rs.30.84
Thehighersharepriceundertheloanoptionwouldincreaseshareholderswealth.

Chapter25:CreditManagement
13

YourfriendMs.Shraddhahadrecentlybeenappointedasthefirstfulltimemanagerat
The Auxiliary Store at Melville Park, which exclusively catered to the needs of the
residents of that condo. The owners of the store had been so impressed by her
intelligencethattheyhadgiventheyoungladyfulldiscretiontochangeanycreditnorm
asshedeemedfit.
ThefirstthingshedidwastoputaceilingofRs.10,000percustomerduringtheseven
days credit period allowed. As a result, the sales for the first month decreased from
Rs.25lakhtoRs.22lakhbutsoalsowerethebaddebtsfigureswhichhalvedtojust2
percent of the sales. On that month end, a Saturday, she got a surprise invite for a
meetingwiththemembersoftheexecutivecommitteeoftheresidentsassociationin
the morning of the next day. While happy to get an opportunity to know the people
who mattered most among her customers, she was also slightly apprehensive of the
sudden invitation. In the meeting the committee requested her to give a 10 per cent
discounttoallthecustomersonalltheirpurchases.Shethenimpromptusuggestedthat
itwouldhelpmattersiftheassociationcouldundertaketopromptlyrecoverandremit
tothemanyunpaidresidentsduesifthestoresnormaleffortsatrecoveryfail.When
they agreed to do so, as a quid pro quo, she agreed to a five percent discount on all
purchasesbytheresidentswithimmediateeffect,ifthepaymentsweremadewithin7
days of the purchase. Further down during the meeting when the committee exerted
sufficientpressure,shealsoagreedtoextendthetotalcreditperiodonpurchasesto10
daysafteronemonthfromthatday.
Before making the discount decision, she had made a rough estimate that half the
customerswouldavailthediscountandthesalesforthemonthwouldrisetoRs.30lakh
andthemonthendreceivablesfigurewhichhadcomedownfromRs.14lakhtoRs.11
lakhwouldincreasebyRs.1lakh.Alsoaccordingtoherestimatesifthecreditperiodwas
raisedto10daysafteramonth,themonthlysaleswouldincreasebyyetanotherRs.8
lakhandthemonthendreceivableswouldtouchRs.20lakh.Shealreadyknewthatthe
storestaxratewas30percent,thecontributionmarginwas20percentandthecostof
capitalwas12percentperannum.
Afterthemeetingshepromptlycallsyougivingalltheabovedetailsandletsyouknow
how eager she is to know how her snap decisions are going to affect the stores
profitability.Everreadytooblige,youdecidetoworkoutthelikelyresidualprofitsof
thestoreduringthefirstthreemonthsofhermanagement,basedontheinformation
received.Showyourdetailedcalculations.

14

Solution:

(Rs.inlakh)
Endofmonth0

3
Sales
25

22

30

38
Receivables 14

11

12

20
Baddebts
4%

2%
0

0
ACP
14x30/25 11x30/22 12x30/30 20x30/38

=16.8
=15
=12
=15.8
Firstmonth:
S=3lakh,V=80%,bn1=2%,t=30%,k=1%,ACP=15days
RI=[S(1V)Sbn](1t)k[S/30xACPxV]
=(3x0.20+3x0.02)x0.70.1x(3/30x15x0.80)
=0.258

i.e.adecreaseinresidualprofitsbyRs.25,800
Secondmonth:
S=8lakh,V=80%,bn2=0%,t=30%,k=1%,ACP=12days
RI=[S(1V)DIS](1t)+k[So/30(ACPoACPn)S/30xACPnxV]
=[8x0.200.5x30x0.05]x0.70+0.1[22/30x38/30x12x0.8]
=0.559

i.e.anincreaseinresidualprofitsbyRs.55,900overthefirstmonth.
Thirdmonth:
S=8lakh,V=80%,bn1=0%,t=30%,k=1%,ACP=15.8days
RI=[S(1V)Sbn](1t)k[So/30(ACPnACPo)+S/30xACPnxV]

=[8x0.28x0]x0.70.1[30/30(15.812)+8/30x15.8x0.8]

=0.403
i.e.anincreaseinresidualprofitsbyRs.40,300overthesecondmonth.

15

16