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

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

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.

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.

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

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.

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?

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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1 comment:

1. Thanks for sharing informative article. Organizations dealing with finance management looking for qualified debt collectors to stabilize cash flow in their organization.

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