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Saturday, 19 November 2016

IPU BBA - Semester 5 - Financial Management (Problems and Solutions)

Financial Management
Problems and Solutions
IPU BBA - Semester 5 - Financial Management (Problems and Solutions)

Question 1 : XY Ltd. wants to replace Its existing plant. It has received three mutually exclusive proposals I,II and III. The plants under the three proposals are expected to cost: Rs.2.50,000 each and have an estimated life of 5 years, 4 years and 3 years respectively. The company's required rate of return is 10%, The anticipated net cash inflows after taxes for the three plants are as follows:


Years Plant I Rs Plant II Rs Plant III Rs
1 80000 110000 130000
2 60000 90000 110000
3 60000 85000 20000
4 60000 35000 -
5 180000 - -

Which of the above proposals would you recommend to the management for acceptance using NPV technique for evaluation

Year PVP (10%)
1 0.909
2 0.826
3 0.751
4 0.683
5 0.621


Answer:
    Cost of plant = Rs.2.50,000
    Required rate of return = 10%

                           Calcuation of NPV of Plant I


Year CFAT PVF Total PV
1 50,000 0.909 72,720
2 60,000 0.826 49,560
3 60,000 0.751 45,060
4 60,000 0.683 40,980
5 1,80,000 0.621 1,11,780


Total present value of cash inflows
(-) Less PV of cash outflows
sp;             Net Present Value
3,20,100
   2,50,000
      70,100


                           Calculation of NPV of Plant II


Year CFAT PVF Total PV
1 1,10,000 0.909 99,990
2 90,000 0.826 74,340
3 85,000 0.751 63,835
4 35,000 0.683 23,905


Total present value of cash inflows
   (-) Less PV of cash outflows
           Net Present Value
2,62,070
2,50,000
   12,070

                      Calculation OF NPV of Plant III


Year CFAT PVF Total PV
1 1,30,000 0.909 1,18,170
2 1,10,000 0.826 90,860
3     20,000 0.751   15,020


Total present value of cash inflows
  (-) Less PV of cash outflows
        Net Present Value
  2,24,050
2,50,000
-25,950

The net present value of plant I is highest so the company should to invest in Plant I



Question 2: Pay off Ltd. producing articles mostly by manual labour and is considering to replace it by a new machine. Their are two alternative models M and N of the new machine. Prepare a statement of profitability showing the pay-back period from the following information.


           Estimated life of machine                      Machine M                           Machine N

                        4 years
                          (Rs.)
                            5 years
                              (Rs.)
Cost of machine                          9,000                             18,000
Estimated saving in scrap                             500                                   800
Estimated savings in direct wages                           6,000                                8,000
Additional cost of maintenance                              800                                1,000
Additional cost of supervision                           1200                                 1,800
Ignore taxation.




Answer:

Statement of Profitability is

              Estivated savings                                    M                               N
                   Direct wages                            6,000                           8,000
                   Scrap                               500                              800
              Total savings (A)                            6,500                            8,800
           (-) Additional cost

             Maintenance                               800                            1,000
             Supervision                            1,200                            1,800
             Total cost (B)                            2,000                            2,800
     Cash flows (A-B)                            4,500                            60,000
    Payback period                             9,000
                            4,500 
                          2 years
                          1,80,000
                            6,000
                           30 years



Question 3: A company has scales of Rs. 1 lakh. The variable costs are 40^ of the sales while the fixed operating costs amount to Rs.30000/-. The amount of interest or long term debt is Rs. 10000/-.Calculate the Composite leverage and also illustrate its impact if sales Increase by 556.


Answer:                                                   Sales = 1,00,000  
                                                                   Vc = 40%
                                                        Fixed cost= 30,000
                                               Interest on debt = Rs. 10,000
                                           Operating leverage = Sales-VC/EBIT
                                                                        = 1,00,000-40,000
                                                                                      30,000
                                                                        = 2
                                                               EBIT = Sales-VC-FC
                                                                        = 1,00,000-40,000-30,000
                                                                        = 30,000
                                             Financial leverage =EBIT/EBIT-interest
                                                                        = 
30,000/30,000-10,000
                                                                        = 1.5
                                            Composite leverage= Operating leverage Financial leverage
                                                                        = 2 ✕ 1.5
                                                                        = 3


Question 4: The following financial data have been furnished by A Ltd. and B Ltd. for the year ended 32.03.2012:


                      A Ltd.                     B Ltd.
    Operating Leverage                        3:1                      4:1
    Financial Leverage                        2:1                      3:1
     Interest charges P.A.            Rs. 12 Lacs               Rs. 10 Lacs
     Corporate tax rate                    40%                      40%
      Variable cost as% of Sales                     80%                      50%

Prepare income statement of the two companies. Also comment on the financial position and structure of the two companies.


Answer:
                                                                    
                                        Income statement of companies

             Particulars                   A (in lakhs)                   B (in lakhs)
              Sales                      180                        120
              Less: Variable cost                      108                          60
              contribution                        72                           So
              Less: fixed cost                        48                            45
              EBIT                         24                            15
           Less Interest                         12                                  10
           EBT                         12                              5
           Less: Tax @ 40%                         4.8                              2
           Earning after Tax                          7.2                              3
 
Comment:
Financial position of Company  A is better than B because it has less financial risk due to minimum degree of financial leverage when compared to Company B.

       However, it is true that there will be a more magnified impact an EPS of Company. B that A. It is  due to change in EBIT but its EBIT level due to low sales is very low suggesting that such an advantage is not substantial.

Working Notes:


Company A.                                              Financial Leverage = EBIT/EBT=2/1
          OR                                                                  EBIT      =   2  ✕ EBT
          Again,                                                      EBIT- Interest = EBT
         
OR                                                                  EBIT-12 = EBT
          Taking (1) and (2) we get                                2EBT-12 = EBT
          OR                                                                        EBT = 12
          OR                                                                        EBT = 12 lakh
          Hence,                                                                   EBIT=2✕12=   Rs. 24 lakh
                                                     Operating leverage given as = Contribution/EBT=3/1
                                                                                       EBIT =   Rs. 24 lakh.
          Hence,                                                      contribution   = 3 ✕ 24 = 72 lakh.
          Now,                                                   Variable cost     = 60% an sale.
                                                                         Contribution   = 100 - 60% i.e., 40% on sales
                                                                                 Sales      = 72/40 ✕ 100
                                                                                  Sales     = 180 lakh
Sales, EBT,EBIT and Contribution of Co. B can be computed on same pattern.
                           
                                    Financial Leverage  = EBIT/EBT=3/1
                                                                                    EBIT = 3✕ EBT
          Again                                                   EBIT-Interest = EBT
       Taking (1) and (2) we get                            3EBT - 10 = EBT
       OR                                                                   2EBT   = 10.
       OR                                                                     EBT   = 5 lakh.
       Hence,                                                                EBIT  =  3 EBT= 3✕15= 15 lakh.
                                                              Operating Leverage = Contribution / EBIT= 4/1
                                                                                    EBIT = 15 lakh
       Hence,                                                        Contribution = 4 ✕ 15 = 60 lakh.
       Now,                                                                        VC = 50% on sales
                                                                            Contribution = 100% - 50%= 50% on sales
                                                                                        Sales = 60/50✕100=120 lakh.


Question 5: Companies X and Y are identical in all respects except for debt eqyuit ratio. X having issued 10% debentures of Rs.18 Lacs and while Y has issued only equity. Both companies earn 20% before intt and tax on heir total assets of Rs. 30 Lacs.
       Assuming a tax rate of 40% capitalization rate of 15% for an all equity company computer valueof companies X and Y using
          (a) Net income approach
          (b) Net operating income approach

Answer:  

Valuation of companies under NI Approach

Particulars                               X                                Y
EBIT ( @ 20% on ✕ 30,00,000)                       6,00,000                        6,00,000
Less: Interest                       1,80,000
Earning before Tax                       4,20,000                         6,00,000
Less: Tax @ 40%                        1,68,000                         2,40,000
Earning available to equity shareholders.                        2,52,000                          3,60,000
Value of Equity(capitalises @15%)                      16,80,000                         24,00,000
    X=(2,52,000✕100/15)
    Y= (3,60,000✕100/15)


   Value of debt                      18,00,000
   Total value of company                       34,80,000                          24,00,000


(b) Net operating income approach
     
Valuation of companies under NOI Approach
      
Particulars                               X                           Y
Capitalisation of earnings at 15%                    24,00,000                   24,00,000
      [6,00,000(1-0.4)/0.15

Less: value of debt [18,00,000(1-0.4)]                    10,80,000
Value of equity                    13,20,000                   24,00,000
Add: Value of Debt                     18,00,000
Total value of company                      31,20,000                    24,00,000



Question 6:
      (a) Explain commercial paper and certificate, of deposits.
      (b) ABC Ltd. has the following capital structure:

Particulars Book value (Rs.) Market value (Rs.)
Equity capital (25000 shares of Rs.10 each)          25000           450000
13% preference capital (5000 shares of Rs.10 each)          50000              45000
Reserve and surplus         150000      ........
14% Debentures (15000 debentures of Rs.10 each)          150000                  145000
Total           600000          640000

Dividend per share is? 2.40 and it is expected to grow at a rate of 15% forever. Preference shares and debentures are redeemable at per after 5 years and 6 years respectively. Tax rate is -30%. Compute the weighted average cost of capital taking market value as weights.


Answer: 
Commercial Paper (CP) is an unsecured money market instrument issued in the form of a promissory note.

A corporate would be eligible to issue CP provided-
a. the tangible net worth of the company, as per the latest audited balance sheet, is not less than Rs. 4 crore
b. company has been sanctioned working capital limit by bank(s) or all-India financial institution(s); and
c. the borrowed account of the company is classified as a Standard Asset by the financing bank(s) / institution(s).

b.
 
Source (A) Amount (MV) (B) Proportion After Tax Cost Product (A✕B)
Equity 4,50,000 0.70 0.18 0.126
Preference     45,000 0.07 0.16 0.011
Debentures 1,45,000 0.23 1.18 0.271

6,40,000      1
Total=0.408
                                   
OR
Weighted avg. cost of capital = 40.8%
Calculation:
1. K(e) = D(1)P(0) + g
    K(e) = 2.40/70 + 0.15 = 0.18
    K(e) = 0.18
2. K(p) = Pref.Dividend + (RV-NS)/N/ (RV+NS)/2
    K(p) = 1.30 + (10-9)/5/(10+9)/2
    K(p) = 1.30 + 0.20/19/2   = 1.5/9.5
    K(p) = 0.16
    K(d) = Interest (I-tax) + (RV-NS)/N/ (RV + NS)/2
    K(d) = 14(1-0.30)+ (10-9.7)/6/(10+9.7)/2
    K(d) = 9.8+1.8/19.7/2=11.6/9.85
    K(d) = 1.18

                                                                        
Question 7: A company is considering one of the two mutually exclusive projects it should undertake. The company anticipates a cost of capital of 12% and the net after tax cash flows of the projects are given below:

    Year   Project A (Rs.)   Project B (Rs.)
0
1
2
3
4
5
5500000
  380000
1800000
1900000
1100000
7500000
5800000
4090000
3300000
4400000
5000000
   100000



Compute the NPV of each project and state which project would you recommend and why?

Answer:

Calculate of NPV of Project A


Year Cash in flow P.V. Factor@12% Value
1
2
3
4
5
38,00,000
1,80,000
1,90,000
1,10000
7,50,000
0.893
0.797
0.712
0.636
0.567
3,39,340
1,43,460
1,35,280
    69960
4,25,250



11,13,290

P.V. of total cash inflow=11,13,290
       Less: cash outflow = 5,50,000
       Net present value = 5,63,290
NPV= Total P.V. of cash inflow-cash outflow




Calculation of NPV of Project B


Year Cash in flow P.V. Factor Value
1
2
3
4
5
4,00,000
3,30,000
4,40,000
5,00,000
1,00,000
0.893
0.797
0.712
0.636
0.567
3,57,200
2,63,010
3,13,280
3,18,000
    56,700





13,08,190

Total P.V. of cash inflows=13,08,190
Less: Cash outflow = 5,80,000
Net present value = 7,28,190


Based on NPV Project B should be recommended as its NPV is more than project A and it is more profitable.





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