Case Study Analysis

CASE 1
SUMMARY

MINI CASE OF COST OF CAPITAL

Suman Joshi, Managing director of omega textile, was reviewing two very different investment proposals. The first one is for expanding the capacity of the current project and the second is for diversifying into a new line of business. We need to find WACC (weighed average cost of capital) with the help of following data.

Liabilities Equity capital Preference capital

Amount 350 100

Assets Fixed assets Investment Current loans Assets, and

Amount 700 100

Reserve and surplus Debentures Current provision liabilities &

200 450

advances

400

100 1200 1200

Omegas target capital structure has 50 percent equity, 10 percent preference, and 40 percent debt

Omega has Rs.100 par, 10 percent coupon, annual payment, noncallable debenture with 8 year to maturity. These debentures are currently selling at RS.112.

Omega has Rs.100 par, 9 percent, annual dividend, preference share with residual maturity of 5 years. The market price of these preference shares is Rs.106.

Omegas equity share is currently selling at Rs.80 per share. Its last dividend was Rs.2.80 and the dividend per share is expected to grow at a rate of 10 percent in future.

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Omegas equity beta is 1.1, the risk free rate is 7 percent, and the market risk premium is estimated to be 7 percent. Omegas tax rate is 30 percent.

The new business that Omega is considering has different financial characteristics than Omegas existing business. Firm engaged purely in such business have, on an average, the following characteristics: (1) Their capital structure has debt and equity in equal proportion. (2) Their cost of debt is 11 percent. (3) Their equity beta is 1.5. Questions: 1. What sources of capital would you consider relevant for calculating the WACC? 2. What is Omegas post-tax cost of debt? 3. What is Omegas cost of preference? 4. What is Omegas estimated cost of equity using dividend discount model? 5. What is Omegas estimated cost of equity using the capital asset pricing model? 6. What is Omegas WACC using CAPM for the cost of equity? 7. What would be your estimate cost of capital for the new business? 8. What is the difference between company cost of capital and project cost of capital?

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SOLUTION: 1. What sources of capital would you consider relevant for calculating the WACC? All sources other than non-interest bearing liabilities like equity, preference share, debenture and serves & surplus. Non-interest bearing liability which is given over here is current liability and provision.

2. What is Omegas post-tax cost of debt? Denotations: r 10% Bv -100 Bo -112 N 8 yrs

Formula for finding Kd Current value of debenture = interest (PVIFA Kd, n) +maturity value (PVIF Kd, n) At 7% 112 = 10(PVIFA 7%, 8) + 100(PVIF 7%, 8) = 10(5.971) + 100(0.582) =59.71+58.2 =117.91 At 8% 112 = 10(PVIFA 8%, 8) + 100(PVIF 8%, 8) = 10(5.747) + 100(0.540) = 57.47 + 54.0 = 111.47

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Interpolation:

Actual 112 at 7% at 8% 117.91

Difference 5.91 6.44

111.47

= 0.07 + (0.08-0.07)5.91/6.44 =7.92 %

Post tax cost of debt = 7.92(1-0.30) = 5.54 %

3. What is Omegas cost of preference? Denotations: r 9% Bv -100 Bo -106 N 5 yrs Formula for finding Kp Current value of share = interest (PVIFA Kp, n) +maturity value (PVIF Kp, n) At 7% 106 = 9(PVIFA 7%, 5) + 100(PVIF 7%, 5) = 9(4.100) + 100(0.713) =36.9 + 71.3 =108.2

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At 8% 106 = 9(PVIFA 8%, 5) + 100(PVIF 8%, 5) = 9(3.993) + 100(0.681) = 35.937 + 68.1 = 104.03 Interpolation: Actual at 7% at 8% 106 Difference 2.2 108.2 4.17 104.03

= 0.07 + (0.08-0.07)2.2/4.17 =7.53

4. What is Omegas estimated cost of equity using dividend discount model? Div0 = 2.80 P0 =80 G =10%

Ke = Div1 / P0 + g =2.80(1.10)/80+ 0.10 = 0.385 + 0.1080= 0.1385 = 13.85%

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5. What is Omegas estimated cost of equity using the capital asset pricing model? Denotations: Rm- 7 (Rm-Rf)-7 - 1.1

Ke= Rf+ (Rm-RF) = 7 + 1.1(7) = 14.70%

6. What is Omegas WACC using CAPM for the cost of equity? sources of fund proportion Equity 0.5 Preference 0.1 Debenture 0.4

Cost 14.7 7.53 5.54

WACC 7.35 0.753 2.216 10.319

7. What would be your estimate cost of capital for the new business? Sources of fund Proportion Equity 0.5 Debenture 0.5

Cost 17.5 7.7

WACC 8.75 3.85 12.6

Ke = Rf + (Rm-Rf) = 7 + (7) 1.5 = 17.5%

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8. What is the difference between company cost of capital and project cost of capital? Companys cost of capital is 10.32 and projects cost of capital is 12.6. Thus, Companys cost of capital is less than projects cost of capital so Suman Joshi, Managing director of omega textile shall continue with its current business.

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Case Study Analysis

CASE- 2 WORKING CAPITAL FINANCING

SUMMARY: This case represents a dilemma of a management graduate who has been placed in one of the leading banks of India. Suresh Pai faced one client who is in requirement of working capital finance. Suresh was the only one who could deal with this problem as other executives were of different departments. The demand of customer was of incremental working capital finance of Rs 60 lakh (From Rs 140 lakh and Rs 200 lakh). He was approaching predecessor of Suresh since many days but did not have any kind of feedback. He asked Suresh to do his best and provided him with various data of previous two years and also the projected data for next year. Suresh has a challenging task of computing all the details and compute the data and provide the result to the head of that bank. But he finds that lending can only be done by following second method of Tondon committee. For this approval he has to get an approval from head office as lending amount exceeds 1 crore. Important concepts related to case: Tondon committee: In 1974, a study group under the chairmanship of Mr. P. L. Tondon was constituted for framing guidelines for commercial banks for follow-up & supervision of bank credit for ensuring proper end-use of funds. The group submitted its report in August 1975, which came to be popularly known as Tondon Committees Report. Its main recommendations related to norms for inventory and receivables, the approach to lending, style of credit, follow ups & information system. It was a landmark in the history of bank lending in India. With acceptance of major recommendations by Reserve Bank of India, a new era of lending began in India.

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Tondon committees recommendations: Breaking away from traditional methods of security oriented lending; the committee enjoyed upon the banks to move towards need based lending. The committee pointed out that the best security of bank loan is a well functioning business enterprise, not the collateral.

Major recommendations of the committee were as follows: 1. Assessment of need based credit of the borrower on a rational basis on the basis of their business plans. 2. Bank credit would only be supplementary to the borrowers resources and not replace them, i.e. banks would not finance one hundred percent of borrowers working capital requirement. 3. Bank should ensure proper end use of bank credit by keeping a closer watch on the borrowers business, and impose financial discipline on them. 4. Working capital finance would be available to the borrowers on the basis of industry wise norms (prescribe first by the Tondon Committee and then by Reserve Bank of India) for holding different current assets, viz. Raw materials including stores and others items used in manufacturing process. Stock in Process. Finished goods. Accounts receivables. 5. Credit would be made available to the borrowers in different components like cash credit; bills purchased and discounted working capital, term loan, etc., depending upon nature of holding of various current assets. 6. In order to facilitate a close watch under operation of borrowers, bank would require them to submit at regular intervals, data regarding their business and financial operations, for both the past and the future periods
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Methods of lending: There are 3 methods of lending money to the borrowers. The below mentioned is the 2 nd method of lending money. In order to ensure that the borrowers do enhance their contributions to working capital and to improve their current ratio, it is necessary to place them under the second method of lending recommended by the Tondon committee which would give a minimum current ratio of 1.33:1. The borrower will have to provide a minimum of 25% of total current assets from long-term funds. However, total liabilities inclusive of bank finance would never exceed 75% of gross current assets. As many of the borrowers may not be immediately in a position to work under the second method of lending, the excess borrowing should be segregated and treated as a working capital term loan which should be made repayable in installments. To induce the borrowers to repay this loan, it should be charged a higher rate of interest. For the present, the group recommends that the additional interest may be fixed at 2% per annum over the rate applicable on the relative cash credit limits. This procedure should be made compulsory for all borrowers (except sick units) having aggregate working capital limits of rs.10 lacs and over. Back to case: From borrowers file we find that the limits sanctioned to him are subject to the following norms: In assessing the working capital advance the bank will follow the average holding levels prevalent in their industry, which as updated on 01-04-2011 are as follows: Maximum holding level for raw material and stores: 3 months of consumption. Work in process: 0.5 months of cost of production Finished goods: 2 months of cost of sales Receivables: 3 months of net sales Trade credit: 2 months purchase or the actual credit period enjoyed whichever is higher The level of CA may be set at 3 percent of the rest of the CA.
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Q:1 The holding levels for raw materials, work in process, finished goods, debtors and creditors as seen from borrowers own projections. Q: 2 MPBF under the second method of lending as per the norms set by the bank Q: 3 whether to recommend any increase in the present working capital limit of Rs. 140 lacs or not and if the latter, how to explain the reasons to the client and the course of action desired by the bank. Solution: Answer 1: Computation of Holding level of Raw material =Raw Material Inventory/Raw Material Consumption =60/180*12 =4 Month Computation of Holding level of Work in progress = Work in Progress Inventory/ Cost of Production =20/380*12 =0.6315 Month Computation of Holding level of Finish good consumption period = Finish Good/ COGS =50/380*12 =1.57 Month Debtors conversion period = Debtors / Credit Sales =240 / 700 * 12 = 4.11 Months
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Creditors Deferral Period = Creditors / Credit Purchase =130 / 190 * 12 =8.21 Months Answer: 2 MPBF Criteria by Tondon committee As per the Tondon committee MPBF (Maximum Possible Bank Finance) the value of the current assets must be 25% of the total current assets. So this criteria is satisfied by the available data for projected year. Second Method of Lending Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. Here current liability inclusive of bank borrowings is not exceeding 75 % of current assets. As both the conditions are satisfied by the clients data Bank can provide extra working capital of 60 lacs. Answer: 3 Here, we have two option through which we can increase in working capital or not. As per the Companys Standard. We can not increase in working capital. Because we can not satisfy the criteria of companys standard. As per companys standard holding level for raw material is 3 months of consumption But as per projection it is 4 months. So it is not good for firm. Working process is 0.5 months of cost of production but as per projection it is 0.6 month Which is not good for company, finished goods is 2 months of cost of sales and as per projection it is 1.57.
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Here company can get benefit in Creditors Deferral Period. Because as per companys standard credit period is 2 months of purchase but as per projection it is 8.21 Months. So company can enjoy credit of 8 months. Which is beneficial for the company? As per second method of Tondon committee, We can accept the increment. Under this method, it was thought that the borrower should provide for a minimum of 25% of total current assets out of long-term funds i.e., owned funds plus term borrowings. A certain level of credit for purchases and other current liabilities will be available to fund the build up of current assets and the bank will provide the balance Maximum permissible banking finance (MPBF). Consequently, total current liabilities inclusive of bank borrowings could not exceed 75% of current assets. Here, company can fulfill all the criteria of tendon Committee and through which company can increase in working capital.

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