Financial Management - 11 Solution - Ss

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Financial Management
FINANCIAL MANAGEMENT -- 2011 UNIVERSITY PAPER SOLUTION

Section 1
Q1. (a) Concepts i. What do you understand by financial break even point? (A) It is the minimum level of EBIT needed to satisfy all fixed financial charges i.e. interest and preference dividends. It is the level of EBIT for which the firms EPS just equals zero. If EBIT is less than financial break even point, EPS will be negative. If EBIT is more than financial break even point, EPS would be positive. ii. What is meant by De - Merger in business restructuring? (A) De merger is a process of break up of the merged entity. De merger takes place mainly due to failure of the merger process. In case of de-merger a single entity is split up into two or more than two separate entities. iii. What is meant by Ploughing back the profits? (A) An internal fund is also known as Ploughing Back of Profits or Self Financing or accumulation of earnings over a period of time or Internal financing. Instead of distributing the entire profits to shareholders in the form of dividend, the company retains a part of its earnings for the purpose of; accumulation of earnings, investing in fixed assets and to meet working capital needs, if the need so arise. iv. What is Capital Rationing? (A) Under the capital rationing the objective is to select the combination of investment proposals that provide the highest net present values, subject to the budget constraint for the period. Capital rationing refers to a situation where a firm is constrained, for self-imposed or external reasons, to obtain necessary funds to invest in all profitable investment projects. In capital rationing the projects will be ranked, using the PI (Profitability Index) method in descending order of profitability. Thereafter the projects will be selected in descending order of profitability until the entire funds are exhausted. The selection of the projects might result in part of the budgeted fund being unused. Selections of projects on this basis will maximise the value of the firm under the conditions of capital rationing. v. What do you mean by Operating Cycle? (A) The operating cycle is the length of time between the company's cash outlay on raw materials, wages and other expenditures and the inflow of cash from the sale of goods. The operating cycle consists of the following events which continue throughout the life of business: - Conversion of cash into raw materials - Conversion of raw materials into work in progress - Conversion of work in progress into finished stock - Conversion of finished stock into accounts receivables through sales and - Conversion of accounts receivables into cash.
QUEST TUTORIALS: A -202, A wing, 2nd floor, Rajdarshan Society, Behind ICICI ATM, Near Platform No.1, Thane (W). Contact: 67120221 / 25394777 Website: www.questclasses.com Classes at Thane, Dadar & Kalyan
The duration of working capital can be calculated by the following equation: Operating Cycle (period) = Raw materials storage period (Add) Processing Period (Add) Finished Goods Storage period (Add) Debtors collection period (Less) Creditors payment period Operating cycle concept is important for management of cash and management of working capital because the longer the operating cycle the more financial resources the company needs. (b) (i) Total Average Profit after tax = 90,000 (addition of all 5 years profit) 5 = 18,000 Accounting Rate of Return (ARR) On the basis of original investment. ARR = Average Net Profit After Tax/ original investment x 100 = 18,000 x 100 60,000 = 30% On the basis of average investment. Average Investment = Original Investment Scrap Value + working capital + scrap value 2 = 60,000 3,000 + nil + 3000 2 = 31,500 ARR = Average Net Profit After tax/ average investment x 100 = 18,000 x 100 31,500 = 57.14% (ii) Given: Earnings per share (EPS) = ` 7 per share Market Price = ` 55.54 Flotation cost = 10% of price New price = 55.54 (10% of 55.54) = 55.54 5.545 = 49.905
Cost of Equity (Ke) = EPS x 100 NP = 7 / 49.905 x 100 = 14.03 % (iii) Working note: Particulars Materials Labour Variable Expenses Fixed Cash Expenses Selling price Per unit 16 24 40 8 80 Jan (900 units) 14,400 21,600 7,200 30,000 72,000 Feb (1200 units) 19,200 28,800 9,600 30,000 96,000
Cash budget for February Particulars Amount (`) (A) Receipts Sales Cash (1/3) 32,000 Credit (2/3) (1 month) 48,000 Total Receipts (A) 80,000 (B) Payment Purchases (material) (1 month) Labour Variable Expenses Fixed Cash Expenses Total Payments (B) Closing Balance (A B) Q.2 a. Projects initial net cash outlay = 2,00,000 + 50,000 = 2,50,000 Depreciation = Original Investment Scrap Value No of years = 2, 50,000 5 = 50,000 per year. b. Calculation of Cash Inflows for 5 years Particulars (A) Savings Reduction in 10 employees @15,000 each (10x15,000) Reduction in production delays Lost sales due to inventory stock out Timely billing procedures Total Savings (A)
14,400 28,800 9,600 30,000 82,800 (2,800)
Amount 1,50,000 8,000 12,000 3,000 1,73,000
(B) Expenses Two computer specialist @ 40,000 each (40,000 x 2) Annual Maintenance and operation cash expenses Total Expenses (B) Profit before depreciation & tax (PBDT) (A - B) (-) Depreciation Profit before Tax (PBT) (-) Tax @ 30% Profit after Tax (PAT) (+) Depreciation Cash Inflow c. Calculation of NPV Particulars PV of cash Inflow (71,700 x 3.605) (-) PV of cash outflow Net Present Value d. Profitability Index method = PVCI PVCO = 2,58,478.5 2,50,000 = 1.034 e. Simple Payback Period = Original Investment Annual Cash Inflow = 2,50,000 71,700 = 3.49 years Q3. (i) Net Assets Value Particulars (A) Assets Fixed Assets Current Assets Total Assets (A) (B) External liabilities Debentures Total External liabilities (B) Net Asset Value (A B) Per share value = NAV No. of shares Amount 2,58,478.5 2,50,000 8,478.5
80,000 12,000 92,000 81,000 50,000 31,000 9,300 21,700 50,000 71,700
Company X 1,22,000 51,000 1,73,000
Company Y 35,000 26,000 61,000
15,000 15,000 1,58,000
5,000 5,000 56,000
1,58,000 56,000 10,000 10,000 = ` 15.8 per share = ` 5.6 per share
Exchange Ratio according to Net Asset Value Company Y: Company X = 5.6: 15.8 = 0.35: 1 (For every share of company Y, company X will offer 0.35 share) (ii) Earnings per share (EPS) = Amount Available to Equity shareholder No. of Equity shares Company X = 24,000 10,000 = ` 2.4 per share Company Y = 15,000 5,000 = ` 3 per share
Exchange Ratio according to EPS Company Y: Company X = 3: 2.4 = 1.25: 1 (For every share of company Y, company X will offer 1.25 shares) (iii) Market price per share (MPS) Company X ` 24 per share
Company Y ` 27 per share
Exchange Ratio according to MPS Company Y: Company X = 27: 24 = 1.125: 1 (For every share of company Y, company X will offer 1.125 shares) Recommendation: Company X should go with Net Asset Value method since it has lesser exchange ratio. Q4. Particulars Sales (-) Variable Cost (70%) Contribution (-) Fixed Cost Profit (A) Total Cost (FC + VC) Average investment in receivables (debtors on cost) (B) Cost of Extending Credit 25% Opportunity cost Present Policy (20days) 60,00,000 42,00,000 18,00,000 8,00,000 10,00,000 50,00,000 20 x 50,00,000 360 = 2,77,777.78 Evaluation of credit plans Option 1 Option 2 (30days) (40days) 65,00,000 70,00,000 45,50,000 49,00,000 19,50,000 8,00,000 11,50,000 53,50,000 30 x 53,50,000 360 = 4,45,833.33 21,00,000 8,00,000 13,00,000 57,00,000 40 x 57,00,000 360 = 6,33,333.33 Option 3 (50days) 74,00,000 51,80,000 22,20,000 8,00,000 14,20,000 59,80,000 50 x 59,80,000 360 = 8,30,555.56 Option 4 (60days) 75,00,000 52,50,000 22,50,000 8,00,000 14,50,000 60,50,000 60 x 60,50,000 360 =10,08,333.33
69,444.45
1,11,458.33
1,58,333.33
2,07,638.89
2,52,083.33
6
1,58,333.33
Total Cost of Extending Credit (B) Net Benefits (A B) Incremental Benefits
69,444.45
1,11,458.33
2,07,638.89
2,52,083.33
9,30,555.55 ----
10,38,541.67 1,07,986.11
11,41,666.67 2,11,111.12
12,12,361.11 2,81,805.56
11,97,916.67 2,67,361.11
Recommendation: The company should adopt option 3 i.e. 50 days as credit policy since it has highest net margin of ` 12,12,361.11 and incremental benefits of ` 2,81,805.56 Q5. Earnings per Share = NPAT Preference shares No. of equity shares For A Ltd: 1.30 = NPAT 1, 00,000 NPAT = 1, 00,000 X 1.30 = 1, 30,000 For B Ltd: 0.65 = NPAT 1, 00,000 NPAT = 1, 00,000 X 0.65 = 65,000 Cost Sheet of A Ltd & B Ltd PARTICULARS Sales Less: Variable Cost Contribution Less: Fixed Cost EBIT Less: Interest EBT (100%) Less: Tax @35% EAT (NPAT) (65%) Combined Leverage = Contribution / EBT For A Ltd: 6 = Contribution / 2,00,000 Contribution = 2,00,000 X 6 = 12,00,000 For B Ltd: 15 = Contribution / 1,00,000 Contribution = 1,00,000 X 15 = 15,00,000 PLAN A (Rs.) PLAN B (Rs.) (100%) 20,00,000 (100%) 30,00,000 (40%) 8,00,000 (50%) 15,00,000 (60%) 12,00,000 (50%) 15,00,000 8,00,000 12,00,000 4,00,000 3,00,000 2,00,000 2,00,000 2,00,000 1,00,000 70,000 35,000 1,30,000 65,000
Operating Leverage = Contribution / EBIT For A Ltd: 3 = Contribution / EBIT EBIT = 12,00,000 / 3 = 4,00,000 For A Ltd: 5 = Contribution / EBIT EBIT = 15,00,000 / 5 = 3,00,000 (Note: Same sum in FM notes of QUEST TUTORIALS) Q6. Write short notes? a. Significance of capital Budgeting (A) The key function of the financial management is the selection of tie most profitable assortment of capital investment and it is the most important area of decision-making of the financial manager because any action taken by the manager in this area affects the working and the profitability of the firm for many years to come. The need of capital budgeting can be emphasised taking into consideration the very nature of the capital expenditure such as heavy investment in capital projects, long-term implications for the firm, irreversible decisions complications of the decision making. Significance and Importance of Capital budgeting: (1) Indirect Forecast of Sales: The investment in fixed assets is related to future sales of the firm during the life time of the assets purchased. It shows the possibility of expanding the production facilities to cover additional sales shown in the sales budget. Any failure to make the sales forecast accurately would result in investment or under investment in fixed assets and any erroneous forecast of asset needs may lead the firm to serious economic results. (2) Comparative Study of Alternative Projects: Capital budgeting makes a comparative study of the alternative projects for the replacement of assets which are wearing out or are in danger of becoming obsolete so as to make the best possible investment in replacement of assets. For this purpose, the profitability of project is estimated. (3) Timing of Assets-Acquisition: Proper capital budgeting leads proper timing of assetsacquisition and improvement in qualitys assets purchased. It is due to the nature of demand and supply capital goods. The demand of capital goods does not arise sales impose on productive capacity and such situation occurs intermittently; On the other hand, supply of capital goods with availability is one of the functions of capital budgeting. (4) Cash Forecast: Capital investment requires substantial funds which can only be arranged by making determined efforts to ensure availability at the right time. Thus it facilitates cash forecast. (5) Worth-Maximization of Shareholders: The impact of long term capital investment decisions is far reaching. It protects the in of the shareholders and of the enterprise because
it avoids over- investment and under-investment in fixed assets. By selecting the most profitable projects, the management facilitates the wealth maximization of equity shareholders. (6) Irreversibility: Long term asset investment decision are not easily reversible and that too, at so much financial loss to the firm; due to difficulties in finding out market for such capital items once they have been used. Hence firm will incur more losses in that type of capital asset. (7) Huge Investment: Long term asset involves more initial cash outflow which makes it imperative for the firm to plan its investment programmes very carefully and make an advance arrangement of funds either from internal or external source of or both the source. (8) More Risky: Investment in long term asset increase average profit but it may lead to fluctuation in its earning, and then firm will become more risky. Hence investment decision decides the future of the business concern. (9) Difficult Decision: Capital budgeting decision is very difficult because it involves decision of future years cash flow, uncertainty of future and more risk. b. Letter of credit as a source of finance. (A) Business enterprises need funds to meet their different types of requirements. All the financial needs of a business may be grouped into the following three categories: 1. Long term financing need: The long-term decisions of a firm involve setting of the firm, expansion, diversification, modernization and other similar capital expenditure decisions. All these decisions involve huge investment, the benefits of which will be seen only in the longterm and these decisions are also irreversible in nature. By the nature of these projects, long-term sources of funds become the best-suited means of financing. Funds required to finance permanent or hard core working capital should also be procured from long term sources. 2. Medium term financing needs: Such requirements refer to those funds which are required for a period exceeding one year but not exceeding 5 years. For example, if a company resorts to extensive publicity and advertisement campaign then such type of expenses may be written off over a period of 3 to 5 years. These are called deferred revenue expenses and funds required for them are classified in the category of medium term financial needs. Sometimes long term requirements, for which long term funds cannot be arranged immediately, may be met from medium term sources and thus the demand of medium term financial needs are generated. As and when the desired long term funds are made available, medium term loans taken earlier may be paid off. 3. Short term financial needs: Such type of financial needs arise to finance in current assets such as stock, debtors, cash etc. Investment in these assets is known as meeting of working capital requirements of the concern. The requirement of working capital depends upon a number of factors which may differ from industry to industry and from company to company
in the same industry. The main characteristic of short term financial needs is that they arise for a short period of time not exceeding the accounting period i.e., one year. Letter of Credit is a short term source of finance. Suppliers, particularly the foreign supplier insists that the buyer should ensure that his bank would make the payment if he fails to honour its obligation. This is ensured through letter of credit (LC) arrangement. A bank opens a LC in favour of a customer to facilitate his purchase of goods. If the customer doesnt pay to the supplier within the credit period, the bank makes the payment under the LC arrangements. This arrangement passes the risk of supplier to the bank. Bank charges the amount for opening LC. It will extend such facilities to the financially sound customers. c. Functions of Finance Manger (A) Financial Management means planning, organizing, directing and controlling the financial activities such as procurement and utilization of funds of the enterprise. It means applying general management principles to financial resources of the enterprise. Following are the functions of finance manager Functions of Financial Manager The three main functions of a finance manager are investment decision, financing decision and dividend decision. a. Investment Decision Investment decision relates to the selection of assets in which funds will be invested by a firm. The assets, which can be acquired, fall into two broad groups: Long term assets which yield a return over a period of time in future (Capital Budgeting) Short term or current assets, defined as those assets which in the normal course of business are convertible into cash without diminution in value, usually within a year (working capital management) Capital Budgeting The first and the most important decision that any firm has to make is to define the business that it wants to be in. This decision has a significant bearing on how capital is allocated in the firm. A plan has to be deployed to invest in buildings, machineries, equipment, research and development, brands and other long-lived assets. This is capital budgeting process. Considerable managerial time, attention, and energy are devoted to identify, evaluate and implement investment projects. From a financial point of view the magnitude, timing and the risk of cash flows associated with the project have to be studied. Capital budgeting decision involves evaluating each investment with respect to the related benefits and returns and also the risk and uncertainties associated with it. Working Capital Management This refers to investment in working capital (current assets less current liabilities). The finance manager has to properly manage current assets such as cash, inventory and account receivables. He has to ensure trade off between liquidity and profitability. Adequate level of current assets is necessary to maintain required level of liquidity of funds. On the other hand, if the funds are idle the profitability may be low. Current assets are to be fully and efficiently utilized to attain these twin objectives i.e. liquidity and profitability.
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b. Financing Decision The decision to finance the operations of the business enterprise, has to be made by the finance manager. This decision is referred to as financing-mix or capital structure or leverage. Capital structure refers to the proportion of debt (fixed interest sources of financing) and equity capital (variable dividend securities). The financing decision of a firm relates to the choice of proportion of these sources to finance the investment requirements. c. Dividend Policy Decision The third major decision of financial management is the decision relating to the dividend policy. Two alternatives are available in dealing with the profits of the firm they can be distributed to the shareholders in the form of dividends or they can be retained in the business itself. The decision as to which system should be followed forms the basis for dividend decision. Further the preference of the shareholders and the investment opportunities available to the firm influence the dividend policy of the firm. Apart from the above primary functions, a finance manager also undertakes the following subsidiary function: 1. Cash management: The finance manager has to ensure that all sections i.e. branches, factories, departments and units of the organization are supplied with adequate funds. Sections which have excess of funds have to contribute to the central pool for use in other sections which need funds. An adequate supply of cash at all points of time is absolutely essential for the smooth flow of business operations. 2. Evaluating financial performance: Management control systems are often based upon financial analysis. One prominent example is the ROI (return on investment) system of divisional control. A finance manager has to constantly review the financial performance of the various units of the organization. 3. Financial negotiations: A major portion of the time of the finance manager is utilized in carrying out negotiations with the financial institutions, banks and public depositors. He has to furnish a lot of information to these institutions and persons and has to ensure that raising of funds is within the statues like companies Act, etc. Negotiations for outside financing require specialized skills. 4. Keeping touch with stock exchange quotations and behaviour of share prices. This involves analyzing major trends in the stock market and judging their impact on the prices of the shares of the company.

Financial Management - 11 Solution - Ss

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Quest tutorials -Classes for BMS, BBI & BFM

FINANCIAL MANAGEMENT -- 2011 UNIVERSITY PAPER SOLUTION

Quest tutorials -Classes for BMS, BBI & BFM

Quest tutorials -Classes for BMS, BBI & BFM

14,400 28,800 9,600 30,000 82,800 (2,800)

Amount 1,50,000 8,000 12,000 3,000 1,73,000

Quest tutorials -Classes for BMS, BBI & BFM

Company X 1,22,000 51,000 1,73,000

Company Y 35,000 26,000 61,000

15,000 15,000 1,58,000

5,000 5,000 56,000

Quest tutorials -Classes for BMS, BBI & BFM

Company Y ` 27 per share

Quest tutorials -Classes for BMS, BBI & BFM

Total Cost of Extending Credit (B) Net Benefits (A B) Incremental Benefits

Quest tutorials -Classes for BMS, BBI & BFM

Quest tutorials -Classes for BMS, BBI & BFM

Quest tutorials -Classes for BMS, BBI & BFM

Quest tutorials -Classes for BMS, BBI & BFM

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