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 |
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.
