MB0045 SET 2

Q1. The following data is available in respect of a company : Equity Rs.10lakhs,cost of capital 18% Debt Rs.5lakhs,cost of debt 13% Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40% SolutionStep I is to determine the cost of each component.Ke = ( D1/P0) + g= (2/32) + 0.1= 0.1625 or 16.25%Kp = [D + {(F P)/n}] / {F+P)/2} = [14 + (105 84)/8] / (105+84)/2 =16.625/94.5= 0.1759 or 17.59%Kr = Ke which is 16.25%Kd = [I(1 T) + {(F P)/n}] / {F+P)/2} = [12(1 0.4) + (105

90)/7] / (105+90)/2= [7.2 + 2.14] / 97.5= 0.096 or 9.6% Kt = I(1 T)= 0.11(1 0.4)= 0.066 or 6.6% Step II is to calculate the weights of each source. We = 200/750 = 0.267Wp = 100/750 = 0.133Wr = 100/750 = 0.133Wd = 300/750 = 0.4Wt = 50/750 = 0.06 Step III Multiply the costs of various sources of finance with corresponding weightsand WACC is calculated by adding all these components

WACC = We Ke + Wp Kp +Wr Kr + Wd Kd + Wt Kt = (0.267*0.1625) + (0.133*0.1759) + (0.133*0.1625) + (0.4*0.092) + (0.06*0.066)= 0.043 + 0.023 + 0.022 + 0.0384 + 0.004= 0.1457 or 14.57% The value of WACC is 14.57%

Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.

20,000 units Fixed costs Variable cost Interest on borrowed funds Selling price per unit Rs.3,500 Rs.0.05 per unit Nil 0.20

Solution EBIT 200000 Less interest on borrowed funds - NIL EBT 150000 DFL= EBIT {EBITI{Dp/(1-T)}} 200000/(20000050000{25000/(10.50)} DFL=2.0 The degree of financial leverage of ABC ltd is found to be 2.0. Q3. Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach? Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke

Solution: S= 1000,000/.22 =4545454.5 B=25,00,000

=K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 0.0496+.142 =.1915 or 19.15%

V = 5000000/0.1915 = 26,109,660.57

Q4. Examine the importance of capital budgeting.

Answer: Capital budgeting decisions are the most important decisions in corporate financial management. These decisions make or mar a business organisation. These decisions commit a firm to invest its current funds in the operating assets (i.e. long-term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. These decisions could be grouped into:

Decision to replace the equipments for maintenance of current level of business or decisions aiming at cost reductions, known as replacement decisions Decisions on expenditure for increasing the present operating level or expansion through improved network of distribution Decisions for production of new goods or rendering of new services Decisions on penetrating into new geographical area Decisions to comply with the regulatory structure affecting the operations of the company, like investments in assets to comply with the conditions imposed by Environmental Protection Act Decisions on investment to build township for providing residential accommodation to employees working in a manufacturing plant The reasons that make the capital budgeting decisions most crucial for finance managers are: These decisions involve large outlay of funds in anticipation of cash flows in future For example, investment in plant and machinery. The economic life of such assets has long periods. The projections of cash flows anticipated involve forecasts of many financial variables. The most crucial variable is the sales forecast. For example, Metal Box spent large sums of money on expansion of its production facilities based on its own sales forecast. During this period, huge investments in R & D in packaging

industry brought about new packaging medium totally replacing metal as an important component of packing boxes. At the end of the expansion Metal Box Ltd found itself that the market for its metal boxes has declined drastically. The end result is that metal box became a sick company from the position it enjoyed earlier prior to the execution of expansion as a blue chip. Employees lost their jobs. It affected the standard of living and cash flow position of its employees. This highlights the element of risk involved in these type of decisions. Equally we have empirical evidence of companies which took decisions on expansion through the addition of new products and adoption of the latest technology, creating wealth for shareholders. The best example is the Reliance Group. Any serious error in forecasting sales, the amount of capital expenditure can significantly affect the firm. An upward bias might lead to a situation of the firm creating idle capacity, laying the path for the cancer of sickness. Any downward bias in forecasting might lead the firm to a situation of losing its market to its competitors. Long time investments of the funds sometimes may change the risk profile of the firm. Most of the capital budgeting decisions involve huge outlay. The funds required during the phase of execution must be synchronised with the flow of funds. Failure to achieve the required coordination between the inflow and outflow may cause time over run and cost over-run. These two problems of time over run and cost overrun have to be prevented from occurring in the beginning of execution of the project. Quite a lot of empirical examples are there in public sector in India in support of this argument that cost overrun and time over run can make a companys operation unproductive. Capital budgeting decisions involve assessment of market for companys product and services, deciding on the scale of operations, selection of relevant technology and finally procurement of costly equipment. If a firm were to realise after committing itself to considerable sums of money in the process of implementing the capital budgeting decisions taken that the decision to diversify or expand would become a wealth destroyer to the company, then the firm would have experienced a situation of inability to sell the equipments bought. Loss incurred by the firm on account of this would be heavy if the firm were to scrap the equipments bought specifically for implementing the decision taken. Sometimes these equipments will be specialised costly equipments.

Therefore, capital budgeting decisions are irreversible. All capital budgeting decisions involves three elements. These three elements are: cost quality timing

Decisions must be taken at the right time which would enable the firm to procure the assets at the least cost for producing products of required quality for the customer. Any lapse on the part of the firm in understanding the effect of these elements on implementation of capital expenditure decision taken, will strategically affect the firms profitability. Liberalisation and globalisation gave birth to economic institutions like world trade organisations. General Electrical can expand its market into India snatching the share already enjoyed by firms like Bajaj Electricals or Kirloskar Electric company. Ability of GE to sell its products in India at a rate less than the rate at which Indian companies sell cannot be ignored. Therefore, the growth and survival of any firm in todays business environment demands a firm to be pro-active. Pro-active firms cannot avoid the risk of taking challenging capital budgeting decisions for growth. The social, political, economic and technological forces generate high level of uncertainty in future cash flow streams associated with capital budgeting decisions. These factors make these decisions highly complex. Capital budgeting decisions are very expensive. To implement these decisions, firms will have to tap the capital market for funds. The composition of debt and equity must be optimal keeping in view the expectations of investors and risk profile of the selected project. Therefore capital budgeting decisions for growth have become an essential characteristic of successful firms today.

Q5. Explain briefly Capital Rationing.

(a) Capital Rationing: When there is a scarcity of funds, capital rationing is resorted to.Capital rationing means the utilization of existing funds in most profitable manner by selectingthe acceptable projects in the descending order or ranking with limited available funds.

The firmmust be able to maximize the profits by combining the most profitable proposals. Capitalrationing may arise due to (i) external factors such as high borrowing rate or non -availability of loan funds due to constraints of Debt-Equity Ratio; and (ii) Internal Constraints Imposed bymanagement. Project should be accepted as a whole or rejected. It cannot be accepted andexecuted in piecemeal.IRR or NPV are the best basis of evaluation even under Capital Rationing situations. Theobjective is to select those projects which have maximum and positive NPV. Preferenceshould be given to interdependent projects. Projects are to be ranked in the order of NPV.Where there is multi-period Capital Rationing, Linear Programming Technique should be usedto maximize NPV. In times of Capital Rationing, the investment policy of the company maynot be the optimal one.In nutshell Capital Rationing leads to:(i) Allocation of limited resources among ranked acceptable investments.(ii) This function enables management to select the most profitable investment first.(iii) It helps a company use limited resources to the best advantage by investing only in theprojects that offer the highest return.(iv) Either the internal rate of return method or the net preset value method may be used inranking investments.

Ways of Resorting Capital Rationing : There are various ways of resorting to capital rationing,some of which are : (i) By Way of Retained Earnings : A firm may put up a ceiling when it has been financinginvestment proposals only by way of retained earnings (ploughing back of profits). Since theamount of capital expenditure in that situation cannot exceed the amount of retained earnings,it is said to be an example of capital rationing. (ii) By Way of Responsibility Accounting : Capital Rationing may also be introduced by following the concept of responsibility accounting , whereby management may introduce capitalrationing by authorising a particular department to make investment only upto a specified limit,beyond which the investment decisions are to be taken by higher-ups.(iii) By Making Full Utilization of Budget as Primary Consideration : In Capital Rationing it may alsobe more desirable to accept several small investment proposals than a few large investmentproposals so that there may be full utilisation of budgeted amount. This may result inaccepting relatively less profitable investment proposals if full

utilisation of budget is aprimary consideration. Thus Capital Rationing does not always lead to optimum results.

Q6.Explain the concepts of working capital

Money required by the company to meet out day today expenses to finance production and stocks to pay wages and other production etc. is called the working capital of the company. Working capital is used in operating the business. It is mostly dept is circulation by releasing it back after selling the products and reinvesting it in further production. It is because of this regular cycle that the working capital requirements are usually for short periods. Though, both fixed and working capitals shall be recovered from the business, the differences lies in the rate of their recovery. Working capital shall be recovered much more quickly as compared to fixed capitals which would last for several years. As the process of production become more round about and complicated the production to fixed working capital increase correspondingly.

Therefore, working capital management refers to the management of current assets and current liabilities. Working capital, however, represents investment in current assets, such as cash, marketable securities, inventories and bills receivables. Current liabilities mainly include bills payable, notes payable and miscellaneous accruals. Net working capital is the excess of current assets over current liabilities here. Current assets are those assets which are normally converted into cash within an accounting year; and current liabilities are usually paid within an accounting year.

What for is working capital required by firm very much depends on the nature of the business which the firm is conducting. If the firm has business which deals with public utility services, obviously the requirement will be low. It is primarily because the amount becomes available as soon as services are sold and also the services arranged by the firm and immediately sold, without much difficulty and complication. On the other hand trading concerns need heavy amounts because these require funds for carrying goods traded. Similarly many industrial units will also need heavy amounts for carrying on their business. Many manufacturing concerns will also need sufficiently heavy amounts, that of course depends on the nature of commodities which are being manufactured.