SUBJECT: FINANCIAL & COST ACCOUNTING
Q1) ABC Ltd. Produces room coolers. The company is considering
whether it should continue to manufacture air circulating fans itself or
purchase them from outside. Its annual requirement is 25000 units. An outsider
vendor is prepared to supply fans for Rs 285 each. In addition, ABC Ltd will
have to incur costs of Rs 1.50 per unit for freight and Rs 10,000 per year for
quality inspection, storing etc of the product.
In the most recent year ABC Ltd. Produced 25000 fans at the
following total cost :
|
Material
|
Rs.
|
50,00,000
|
|
Labour
|
Rs.
|
20,00,000
|
|
Supervision & other indirect labour
|
Rs.
|
2,00,000
|
|
Power and Light
|
Rs.
|
50,000
|
|
Depreciation
|
Rs.
|
20,000
|
|
Factory Rent
|
Rs.
|
5,000
|
|
Supplies
|
Rs.
|
75,000
|
Power and light includes Rs 20,000 for general heating and
lighting, which is an allocation based on the light points. Indirect labour is
attributed mainly to the manufacturing of fans. About 75% of it can be
dispensed with along with direct labour if manufacturing is discontinued.
However, the supervisor who receives annual salary of Rs 75,000 will have to be
retained. The machines used for manufacturing fans which have a book value of
Rs 3,00,000 can be sold for Rs 1,25,000 and the amount realized can be invested
at 15% return. Factory rent is allocated on the basis of area, and the company
is not able to see an alternative use for the space which would be released.
Should ABC Ltd. Manufacture the fans or buy them?
Usha Company : Sales and Cost Data
|
Description
|
|
Product
|
|
Total
|
|
|
P
|
Q
|
R
|
|
|
Material
Cost per unit
|
|
|
|
|
|
Quantity
(Kg)
|
1.0
|
1.2
|
1.4
|
|
|
Rate
per Kg (Rs)
|
50
|
50
|
50
|
|
|
Cost
per unit (Rs)
|
50
|
60
|
70
|
|
|
Labour
Cost per unit
|
30
|
90
|
90
|
|
|
Variable
Overheads per unit
|
15
|
10
|
25
|
|
|
Fixed
Overheads (Rs .000)
|
|
|
|
9,175
|
|
Current
Sales (Units ,000)
|
100
|
50
|
60
|
210
|
|
Projected
Sales (Units ,000)
|
109
|
55
|
125
|
289
|
|
Selling
Price per unit (Rs)
|
150
|
200
|
270
|
|
Raw material used by the firm is in short supply and the firm can
expect a maximum supply of 350 lakh kg for next year. Is the company’s
projected sales mix most profitable or can it be changed for the better?
Q3) DSQ Company Ltd a diversified company has three divisions
cement fertilizers and textiles. The summary of the company’s profit is given
below :
(Rs/Crore)
|
|
Cement
|
Fertilizer
|
Textiles
|
Total
|
|
Sales
|
20.0
|
12.0
|
18.0
|
50.0
|
|
Less :
Variable Cost
|
8.0
|
9.6
|
5.4
|
23.0
|
|
Contribution
|
12.0
|
2.4
|
12.6
|
27.0
|
|
Less :
Fixed Cost (allocated to
|
8.0
|
4.8
|
7.2
|
20.0
|
|
divisions in
proportion to
|
|
|
|
|
|
volumes of Sales)
|
|
|
|
|
|
Profit
(Loss)
|
4.0
|
(2.4)
|
5.4
|
7.0
|
After allocating the
company’s fixed overheads to products the Fertilizers, division incurs a loss
of Rs 2.4 crore. Should the company drop this division?
SUB : FINANCIAL & COST
ACCOUNTING
1. Differentiate between idle cost and standard cost?
2. What is a trial balance? Explain its objective.
3. Distinguish between Accrual basis of accounting and cash basis of
accounting.
4. Standard costing is a valuable aid to
management discuss. State in brief limitation of standard costing?
5. Define Budgetary Control and explain the
pre-requisites for its successful introduction and implementation?
6. How the total cost variable cost and marginal cost differ from each
other?
7. What are the advantages of cost audit?
8. Which are the different ways by which the cost can be analyzed?
SUB :
FINACIAL & COST ACCOUNTING
9.
What are the objectives of cost accounting and what is
the relation with Management accounting department?
10.
Define costing. Discuss briefly the objectives and advantages of
costing.
11.
Differentiate between idle cost and standard cost?
12. Explain the significance of
cost accounting in a manufacturing company.
13.
Which ratios will help in determining the long term
solvency of a business and how?
14. Differentiate between
Management Accounting and Financial Accounting.
15.
Discuss the limitations of financial accounting and
explain the importance of cost accounting.
16.
How cost accounting is superior over financial
accounting? Explain the techniques of costing and their application and
suitability.
SUB : FINANCIAL ACCOUNTANCY
Total Marks: 80
Note :
All Questions are Compulsory
Each Question Carries Equal Marks (10 Marks)
17.
What are
the foreign currency transaction and translation exposures ? Describe the
accounting treatment for these exposures.
18.
How is MODVAT credit availed shown in financial
statements ?
19.
Distinguish between funds flow and cash flow
statement.
20.
Study
journalisation process of a manufacturing company. Show the process with the
help of a flow diagram.
21.
Discuss
the salient features of Accounting Standard 6 (AS-6) on Depreciation
Accounting.
22.
Collect
financial statements of ten companies in a fast moving consumer goods industry
and critically analyse their depreciation policy.
23.
What is deferred tax liability ? How is it
different from current tax liability ?
24.
Discuss
the accounting treatment of government grants relating to depreciation fixed
assets.
SUB : FINANCIAL Management
MARKS :
80
N.B.: 1) Attempt any Four Questions
25.
All questions carries equal marks.
NO. 1
ZIP ZAP ZOOM CAR COMPANY
Zip Zap Zoom Company Ltd is into manufacturing cars in the small
car (800 cc) segment. It was set up 15 years back and since its establishment
it has seen a phenomenal growth in both its market and profitability. Its
financial statements are shown in Exhibits 1 and 2 respectively.
The company enjoys the confidence of its
shareholders who have been rewarded with growing dividends year after year.
Last year, the company had announced 20 per cent dividend, which was the
highest in the automobile sector. The company has never defaulted on its loan
payments and enjoys a favourable face with its lenders, which include financial
institutions, commercial banks and debenture holders.
The competition in the car industry has increased in the past few
years and the company foresees further intensification of competition with the
entry of several foreign car manufactures many of them being market leaders in
their respective countries. The small car segment especially, will witness
entry of foreign majors in the near future, with latest technology being
offered to the Indian customer. The Zip Zap Zoom’s senior management realizes
the need for large scale investment in up gradation of technology and
improvement of manufacturing facilities to pre-empt competition.
Whereas on the one hand, the competition in the
car industry has been intensifying, on the other hand, there has been a
slowdown in the Indian economy, which has not only reduced the demand for cars,
but has also led to adoption of price cutting strategies by various car
manufactures. The industry indicators predict that the economy is gradually
slipping into recession.
(Amount in Rs. Crore)
|
Source of Funds
|
|
|
|
|
|
Share capital
|
350
|
|
|
|
|
Reserves
and surplus
|
250
|
600
|
||
|
Loans :
|
|
|
|
|
|
Debentures
(@ 14%)
|
50
|
|
|
|
|
Institutional borrowing (@ 10%)
|
100
|
|
|
|
|
Commercial
loans (@ 12%)
|
250
|
|
|
|
|
Total debt
|
|
400
|
||
|
Current
liabilities
|
|
200
|
||
|
|
|
1,200
|
||
|
Application of Funds
|
|
|
|
|
|
Fixed
Assets
|
|
|
|
|
|
Gross block
|
|
1,000
|
|
|
|
Less :
Depreciation
|
|
250
|
|
|
|
Net
block
|
|
750
|
|
|
|
Capital
WIP
|
|
190
|
|
|
|
Total
Fixed Assets
|
|
|
940
|
|
|
Current
assets :
|
|
|
|
|
|
Inventory
|
|
200
|
|
|
|
Sundry
debtors
|
|
40
|
||
|
Cash and bank balance
|
|
10
|
||
|
Other
current assets
|
10
|
|
|
|
|
Total current assets
|
|
260
|
||
|
|
|
-1200
|
||
Exhibit 2 Profit and Loss
Account for the year ended March 31, 200x
(Amount in Rs. Crore)
|
Sales revenue (80,000 units x Rs. 2,50,000)
|
|
|
2,000.0
|
||
|
Operating expenditure :
|
|
|
|
|
|
|
Variable
cost :
|
|
|
|
|
|
|
Raw material and
manufacturing expenses
|
1,300.0
|
|
|
|
|
|
Variable
overheads
|
|
|
100.0
|
|
|
|
Total
|
|
|
|
1,400.0
|
|
|
Fixed
cost :
|
|
|
|
|
|
|
R & D
|
|
|
20.0
|
|
|
|
Marketing
and advertising
|
|
|
25.0
|
|
|
|
Depreciation
|
|
|
250.0
|
|
|
|
Personnel
|
|
|
70.0
|
|
|
|
Total
|
|
|
|
|
365.0
|
|
Total
operating expenditure
|
|
|
1,765.0
|
||
|
Operating
profits (EBIT)
|
|
|
235.0
|
||
|
Financial expense :
|
|
|
|
|
|
|
Interest on debentures
|
7.7
|
|
|
|
|
|
Interest
on institutional borrowings
|
11.0
|
|
|
|
|
|
Interest on commercial loan
|
33.0
|
|
51.7
|
|
|
|
Earnings before tax (EBT)
|
|
|
183.3
|
||
|
Tax (@ 35%)
|
|
|
64.2
|
||
|
119.1
|
|
|
Dividends
|
70.0
|
|
Debt
redemption (sinking fund obligation)**
|
40.0
|
|
Contribution to reserves and surplus
|
9.1
|
|
|
|
*
Includes the cost of inventory and work in process (W.P) which is
dependent on demand (sales).
**
The loans have to be retired in the next ten years and the firm
redeems Rs. 40 crore every year.
The company is faced with the problem of deciding how much to
invest in up
gradation of its plans and technology. Capital
investment up to a maximum of Rs. 100
crore is required. The problem areas are
three-fold.
The company cannot forgo the capital investment as that could lead
to reduction in its market share as technological competence in this industry
is a must and customers would shift to manufactures providing latest in car
technology.
The company does not want to issue new equity shares and its
retained earning are not enough for such a large investment. Thus, the only option
is raising debt.
The company wants to limit its additional debt to a level that it
can service without taking undue risks. With the looming recession and
uncertain market conditions, the company
perceives that additional fixed obligations
could become a cause of financial distress, and thus, wants to determine its
additional debt capacity to meet the investment requirements.
Mr. Shortsighted, the company’s Finance Manager, is given the task
of determining the additional debt that the firm can raise. He thinks that the
firm can raise Rs. 100 crore worth debt and service it even in years of
recession. The company can raise debt at 15 per cent from a financial
institution. While working out the debt capacity. Mr. Shortsighted takes the
following assumptions for the recession years.
a)
A
maximum of 10 percent reduction in sales volume will take place.
b)
A
maximum of 6 percent reduction in sales price of cars will take place.
Mr. Shorsighted prepares a projected income statement which is
representative of the recession years. While doing so, he determines what he
thinks are the “irreducible minimum” expenditures under recessionary
conditions. For him, risk of insolvency is the main concern while designing the
capital structure. To support his view, he presents the income statement as
shown in Exhibit 3.
Exhibit 3 projected Profit and Loss account
|
|
|
(Amount in Rs. Crore)
|
|
|
|
|
|
|
|
Sales
revenue (72,000 units x Rs. 2,35,000)
|
1,692.0
|
|
|
|
Operating
expenditure
|
|
|
|
|
|
Variable cost :
|
|
|
|
|
Raw
material and manufacturing expenses
|
1,170.0
|
|
|
90.0
|
|
|
|
||||
|
Total
|
|
|
|
|
1,260.0
|
||
|
Fixed cost :
|
|
|
|
|
|
|
|
|
R & D
|
---
|
|
|
|
|
|
|
|
Marketing
and advertising
|
15.0
|
|
|
|
|||
|
Depreciation
|
187.5
|
|
|
|
|||
|
Personnel
|
70.0
|
|
|
|
|||
|
Total
|
|
|
|
|
|
272.5
|
|
|
Total operating expenditure
|
1,532.5
|
|
|||||
|
EBIT
|
|
|
|
|
159.5
|
||
|
Financial expenses :
|
|
|
|
|
|
|
|
|
Interest on existing Debentures
|
7.0
|
|
|
|
|
|
|
|
Interest
on existing institutional borrowings
|
10.0
|
|
|
|
|
|
|
|
Interest on commercial loan
|
30.0
|
|
|
|
|
|
|
|
Interest
on additional debt
|
15.0
|
|
|
62.0
|
|||
|
EBT
|
|
|
|
|
97.5
|
||
|
Tax (@ 35%)
|
|
|
|
|
34.1
|
||
|
EAT
|
|
|
|
|
63.4
|
||
|
Dividends
|
|
|
|
|
--
|
||
|
Debt redemption (sinking fund obligation)
|
|
|
|
|
50.0*
|
|
|
|
Contribution to reserves and surplus
|
|
|
|
|
13.4
|
|
|
|
|
|
|
|
|
|
|
|
* Rs. 40 crore (existing debt) + Rs. 10 crore
(additional debt)
Assumptions of Mr. Shorsighted
R & D expenditure can be done away with till the economy picks
up. Marketing and advertising expenditure can be reduced by 40 per cent.
Keeping in mind the investor confidence that the company enjoys, he
feels that the company
can forgo paying dividends in the recession
period.
He goes with his worked out statement to the
Director Finance, Mr. Arthashatra, and advocates raising Rs. 100 crore of debt
to finance the intended capital investment. Mr. Arthashatra does not feel
comfortable with the statements and calls for the company’s financial analyst,
Mr. Longsighted.
Mr. Longsighted carefully analyses Mr.
Shortsighted’s assumptions and points out that insolvency should not be the
sole criterion while determining the debt capacity of the firm. He points out
the following :
Apart
from debt servicing, there are certain expenditures like those on R & D and
marketing that need to be continued to ensure the long-term health of the firm.
Certain
management policies like those relating to dividend payout, send out important
signals to the investors. The Zip Zap Zoom’s management has been paying regular
dividends and discontinuing this practice (even though just for the recession
phase) could raise serious doubts in the investor’s mind about the health of the
firm. The firm should pay at least 10 per cent dividend in the recession years.
Net Cash inflows are determined by an interplay of many variables
and such a simplistic view should not be taken while determining the cash flows
in recession. It is not possible to accurately predict the fall in any of the
factors such as sales volume, sales price, marketing expenditure and so on.
Probability distribution of variation of each of the factors that affect net
cash inflow should be analyzed. From this analysis, the probability
distribution of variation in net cash inflow should be analysed (the net cash
inflows follow a normal probability distribution). This will give a true
picture of how the company’s cash flows will behave in recession conditions.
The management recognizes that the alternative
suggested by Mr. Longsighted rests on data, which are complex and require
expenditure of time and effort to obtain and interpret. Considering the
importance of capital structure design, the Finance Director asks Mr.
Longsighted to carry out his analysis. Information on the behaviour of cash
flows during the recession periods is taken into account.
The methodology undertaken is as follows :
(a)
Important factors that affect cash flows (especially contraction of
cash flows), like sales volume, sales price, raw materials expenditure, and so
on, are identified and the analysis is carried out in terms of cash receipts
and cash expenditures.
(b)
Each factor’s behaviour (variation behaviour) in adverse conditions
in the past is studied and future expectations are combined with past data, to
describe limits (maximum favourable), most probable and maximum adverse) for
all the factors.
(c)
Once this information is generated for all the factors affecting
the cash flows, Mr. Longsighted comes up with a range of estimates of the cash
flow in future recession periods based on all possible combinations of the
several factors. He also estimates the probability of
occurrence of each estimate of cash flow.
Assuming a normal distribution of the expected
behaviour, the mean expected
value of net cash inflow in adverse conditions came out to be Rs.
220.27 crore with standard deviation of Rs. 110 crore.
Keeping in mind the looming recession and the uncertainty of the
recession behaviour, Mr. Arthashastra feels that the firm should factor a risk
of cash inadequacy of around 5 per cent even in the most adverse industry
conditions. Thus, the firm should take up only that amount of additional debt
that it can service 95 per cent of the times, while maintaining cash adequacy.
NO. 2
COOKING LPG LTD
DETERMINATION OF WORKING CAPTIAL
Introduction
Cooking LPG Ltd Gurgaon is a private sector firm dealing in the
bottling and supply of domestic LPG for household consumption since 1995. The
firm has a network of distributors in the districts of Gurgaon and Faridabad.
The bottling plant of the firm is located on National Highway – 8 (New Delhi –
Jaipur), approx. 12 kms from Gurgaon. The firm has been consistently performing
we.” and plans to expand its market to include the whole National Capital
Region.
The production process of the plant consists of receipt of the bulk
LPG through tank trucks, storage in tanks, bottling operations and distribution
to dealers. During the bottling process, the cylinders are subjected to
pressurized filling of LPG followed by quality control and safety checks such
as weight, leakage and other defects. The cylinders passing through this
process are sealed and dispatched to dealers through trucks. The supply and
distribution section of the plant prepares the invoice which goes along with
the truck to the distributor.
Statement of the Problem :
Mr. I. M. Smart, DGM(Finance) of the company, was analyzing the
financial performance of the company during the current year. The various
profitability ratios and parameters of the company indicated a very
satisfactory performance. Still, Mr. Smart was not fully content-specially with
the management of the working capital by the company. He could recall that
during the past year, in spite of stable demand pattern, they had to, time and
again, resort to bank overdrafts due to non-availability of cash for making
various payments. He is aware that such aberrations in the finances have a cost
and adversely affects the performance of the company. However, he was unable to
pinpoint the cause of the problem.
He discussed the problem with Mr. U.R.
Keenkumar, the new manager (Finance). After critically examining the details,
Mr. Keenkumar realized that the working capital was hitherto estimated only as
approximation by some rule of thumb without any proper computation based on
sound financial policies and, therefore, suggested a reworking of the working
capital (WC) requirement. Mr. Smart assigned the task of determination of WC to
him.
Profile of Cooking LPG Ltd.
1)
Purchases
: The company purchases LPG in bulk from various importers ex-Mumbai and
Kandla, @ Rs. 11,000 per MT. This is transported to its Bottling Plant at
Gurgaon through 15 MT capacity tank trucks (called bullets), hired on annual
contract basis. The average transportation cost per bullet ex-either location
is Rs. 30,000. Normally, 2 bullets per day are received at the plant. The
company make payments for bulk supplies once in a month, resulting in average
time-lag of 15 days.
2)
Storage and Bottling : The bulk storage capacity at the plant is
150 MT (2 x 75 MT storage tanks) and the plant is capable of filling 30 MT LPG
in cylinders per day. The plant operates for 25 days per month on an average.
The desired level of inventory at various stages is as under.
LPG in
bulk (tanks and pipeline quantity in the plant) – three days average production
/ sales. Filled Cylinders – 2 days average sales.
Work-in Process inventory – zero.
3)
Marketing : The LPG is supplied by the company in 12 kg cylinders,
invoiced @ Rs. 250 per cylinder. The rate of applicable sales tax on the
invoice is 4 per cent. A commission of Rs. 15 per cylinder is paid to the
distributor on the invoice itself. The filled cylinders are delivered on
company’s expense at the distributor’s godown, in exchange of equal number of
empty cylinders. The deliveries are made in truck-loads only, the capacity of
each truck being 250 cylinders. The distributors are required to pay for deliveries
through bank draft. On receipt of the draft, the cylinders are normally
dispatched on the same day. However, for every truck purchased on pre-paid
basis, the company extends a credit of 7 days to the distributors on one
truck-load.
4)
Salaries
and Wages : The following payments are made :
Direct labour – Re. 0.75 per cylinder (Bottling expenses) – paid on
last day of the month. Security agency – Rs. 30,000 per month paid on 10th of subsequent month.
Administrative
staff and managers – Rs. 3.75 lakh per annum, paid on monthly basis on the last
working day.
5)
Overheads
:
Administrative (staff, car, communication etc) – Rs. 25,000 per
month – paid on the 10th of subsequent month.
Power (including on DG set) – Rs. 1,00,000 per month paid on the 7th Subsequent month.
Renewal
of various licenses (pollution, factory, labour CCE etc.) – Rs. 15,000 per
annum paid at the beginning of the year.
Insurance – Rs. 5,00,000 per annum to be paid at the beginning of
the year.
Housekeeping etc – Rs. 10,000 per month paid on the 10th of the subsequent month.
Regular maintenance of cylinders (statutory testing) – Rs. 5 lakh
per annum – paid on monthly basis on the 15th of the subsequent month.
All transportation charges as per contracts – paid on the 10th subsequent month. Sales tax
as per applicable rates is deposited on the 7th of the subsequent month.
6)
Sales : Average sales are 2,500 cylinders per day during the year.
However, during the winter months (December to February), there is an
incremental demand of 20 per cent.
7)
Average
Inventories : The average stocks maintained by the company as per its policy
guidelines
:
Consumables
(caps, ceiling material, valves etc) – Rs. 2 lakh. This amounts to 15 days
consumption.
Maintenance spares – Rs. 1 lakh Lubricants – Rs. 20,000
Diesel (for DG sets and fire engines) – Rs. 15,000 Other stores
(stationary, safety items) – Rs. 20,000
8)
Minimum
cash balance including bank balance required is Rs. 5 lakh.
9)
Additional
Information for Calculating Incremental Working Capital During Winter.
No
increase in any inventories take place except in the inventory of bulk LPG,
which increases in the same proportion as the increase of the demand. The
actual requirements of LPG for additional supplies are procured under the same
terms and conditions from the suppliers.
The labour cost for additional production is paid at double the
rate during wintes. No changes in other administrative overheads.
The
expenditure on power consumption during winter increased by 10 per cent.
However, during other months the power consumption remains the same as the
decrease owing to reduced production is offset by increased consumption on
account of compressors /Acs.
Additional amount of Rs. 3 lakh is kept as cash balance to meet
exigencies during winter. No change in time schedules for any payables / receivables.
The
storage of finished goods inventory is restricted to a maximum 5,000 cylinders
due to statutory requirements.
M/S HI-TECH ELECTRONICS
M/s. Hi
– tech Electronics a consumer electronics outlet was opened two years ago in
Dwarka, New Delhi. Hard work and personal attention shown by the proprietor,
Mr. Sony, has brought success. However, because of insufficient funds to
finance credit sales, the outlet accepted only cash and bank credit cards. Mr.
Sony is now considering a new policy of offering installment sales on terms of
25 per cent down payment and 25 per cent per month for three months as well as
continuing to accept cash and bank credit cards.
Mr. Sony feels this policy will boost sales by
50 percent. All the increases in sales will be credit sales. But to follow
through a new policy, he will need a bank loan at the rate of 12 percent. The
sales projections for this year without the new policy are given in Exhibit 1.
Exhibit 1 Sales Projections and Fixed costs
|
Month
|
Projected sales without instalment
|
Projected sales with instalment
|
|
|
option
|
option
|
|
|
|
|
|
January
|
Rs.
6,00,000
|
Rs. 9,00,000
|
|
February
|
4,00,000
|
6,00,000
|
|
March
|
3,00,000
|
4,50,000
|
|
April
|
2,00,000
|
3,00,000
|
|
May
|
2,00,000
|
3,00,000
|
|
June
|
1,50,000
|
2,25,000
|
|
July
|
1,50,000
|
2,25,000
|
|
August
|
2,00,000
|
3,00,000
|
|
September
|
3,00,000
|
4,50,000
|
|
October
|
5,00,000
|
7,50,000
|
|
November
|
5,00,000
|
15,00,000
|
|
December
|
8,00,000
|
12,00,000
|
|
Total
Sales
|
43,00,000
|
72,00,000
|
|
Fixed cost
|
2,40,000
|
2,40,000
|
He further expects 26.67 per cent of the sales to be cash, 40 per
cent bank credit card sales on which a 2 per cent fee is paid, and 33.33 per
cent on installment sales. Also, for short term seasonal requirements, the film
takes loan from chit fund to which Mr. Sony subscribes @ 1.8 per cent per
month.
Their success has been due to their policy of
selling at discount price. The purchase per unit is 90 per cent of selling
price. The fixed costs are Rs. 20,000 per month. The proprietor believes that
the new policy will increase miscellaneous cost by Rs. 25,000.
The business being cyclical in nature, the working capital finance
is done on trade – off basis. The proprietor feels that the new policy will
lead to bad debts of 1 per cent.
(a)
As a
financial consultant advise the proprietor whether he should go for the
extension of credit facilities.
(b)
Also prepare cash budget for one year of operation of the firm
ignoring interest. The minimum desired cash balance & Rs. 30,000, which is
also the amount the firm, has on January 1. Borrowings are possible which are
made at the beginning of a month and repaid at the end when cash is available.
NO.4
SMOOTHDRIVE TYRE LTD
Smoothdrive Tyre Ltd manufacturers tyres under the brand name
“Super Tread’ for the domestic car market. It is presently using 7 machines
acquired 3 years ago at a cost of Rs. 15 lakh each having a useful life of 7
years, with no salvage value.
After extensive research and development, Smoothdrive
Tyre Ltd has recently developed a new tyre, the ‘Hyper Tread’ and must decide
whether to make the investments necessary to produce and market the Hyper
Tread. The Hyper Tread would be ideal for drivers doing a large amount of wet
weather and off road driving in addition to normal highway usage. The research
and development costs so far total Rs. 1,00,00,000. The Hyper Tread would be
put on the market beginning this year and Smoothdrive Tyrs expects it to stay
on the market for a total of three years. Test marketing costing Rs. 50,00,000,
shows that there is significant market for a Hyper Tread type tyre.
As a financial analyst at Smoothdrive Tyre, Mr. Mani asked by the
Chief Financial Officer (CFO), Mr. Tyrewala to evaluate the Hyper-Tread project
and to provide a recommendation or whether or not to proceed with the
investment. He has been informed that all previous investments in the Hyper
Tread project are sunk costs are only future cash flows should be considered.
Except for the initial investments, which occur immediately, assume all cash
flows occur at the year-end.
Smoothedrive Tyre must initially invest Rs.
72,00,00,000 in production equipments to make the Hyper Tread. They would be
depreciated at a rate of 25 per cent as per the written down value (WDV) method
for tax purposes. The new production equipments will allow the company to
follow flexible manufacturing technique, that is both the brands of tyres can
be produced using the same equipments. The equipments is expected to have a 7-year
useful life and can be sold for Rs. 10,00,000 during the fourth year. The
company does not have any other machines in the block of 25 per cent
depreciation. The existing machines can be sold off at Rs. 8 lakh per machine
with an estimated removal cost of one machine for Rs. 50,000.
Operating Requirements
11.1 and 11.2 respectively.
Exhibit 11.1 Existing
Machines
Labour costs (expected to increase 10 per cent annually to account
for inflation) :
(a)
20
unskilled labour @ Rs. 4,000 per month
(b)
20
skilled personnel @ Rs. 6,000 per month.
(c)
2
supervising executives @ Rs. 7,000 per month.
(d)
2 maintenance personnel @ Rs. 5,000 per month. Maintenance cost :
Years 1-5 : Rs. 25 lakh
Years 6-7 : Rs. 65 lakh
Operating expenses : Rs. 50 lakh expected to increase at 5 per cent
annually. Insurance cost / premium :
Year 1 : 2 per cent of the original cost of
machine
After year 1 : Discounted by 10 per cent.
Exhibit
11.2 New production Equipment
Savings in cost of utilities : Rs. 2.5 lakh Maintenance costs :
Year 1 – 2 : Rs. 8 lakh
Year 3 – 4 : Rs. 30 lakh
Labour costs :
9 skilled personnel @ Rs. 7,000 per month
1 maintenance personnel @ Rs. 7,000 per month.
Cost of
retrenchment of 34 personnel : (20 unskilled, 11 skilled, 2 supervisors and 1
maintenance personnel) : Rs. 9,90,000, that is equivalent to six months salary.
Insurance premium
Year 1 : 2 per cent of the purchase cost of
machine
After year 1 : Discounted by 10 per cent.
The opening expenses do not
change to any considerable extent for the new equipment and the difference is
negligible compared to the scale of operations.
Smoothdrive Tyre intends to sell Hyper Tread of two distinct
markets :
1.
The
original equipment manufacturer (OEM) market : The OEM market consists
primarily of the large automobile companies who buy tyres for new cars. In the
OEM market, the Hyper Tread is expected to sell for Rs. 1,200 per tyre. The
variable cost to produce each Hyper Tread is Rs. 600.
2.
The replacement market : The replacement market consists of all
tyres purchased after the automobile has left the factory. This markets allows
higher margins and Smoothdrive Tyre expects to sell the Hyper Tread for Rs.
1.500 per tyre. The variable costs are the same as in
the OEM market.
Smoothdrive Tyre expects to raise prices by 1
percent above the inflation rate.
The variable costs will also increase by 1 per cent above the
inflation rate. In addition, the Hyper Tread project will incur Rs. 2,50,000 in
marketing and general administration cost in the first year which are expected
to increase at the inflation rate in subsequent years.
Smoothdrive Tyre’s corporate tax rate is 35 per cent. Annual
inflation is expected to remain constant at 3.25 per cent. Smoothdrive Tyre
uses a 15 per cent discount rate to evaluate new product decisions.
The Tyre Market
Automotive industry analysts expect automobile manufacturers to
have a production of 4,00,000 new cars this year and growth in production at
2.5 per year onwards. Each new car needs four new tyres (the spare tyres are
undersized and fall in a different category) Smoothdrive Tyre expects the Hyper
Tread to capture an 11 per cent share of the OEM market.
The industry analysts estimate that the replacement tyre market
size will be one crore this year and that it would grow at 2 per cent annually.
Smoothdrive Tyre expects the Hyper Tread to capture an 8 per cent market share.
You also decide to consider net working capital (NWC) requirements
in this scenario. The net working capital requirement will be 15 per cent of
sales. Assume that the level of working capital is adjusted at the beginning of
the year in relation to the expected sales for the year. The working capital is
to be liquidated at par, barring an estimated loss of Rs. 1.5 crore on account
of bad debt. The bad debt will be a tax-deductible expenses.
As a finance analyst, prepare a report for
submission to the CFO and the Board of Directors, explaining to them the
feasibility of the new investment.
COMPUTATION OF COST OF CAPITAL OF PALCO LTD
In October 2003 Neha Kapoor a recent MBA graduate and newly
appointed assistant to the Financial Controller of Palco Ltd, was given a list
of six new investment projects proposed for the following year. It was her job
to analyse these projects and to present her findings before the Board of
Directors at its annual meeting to be held in 10 days. The new project would
require an investment of Rs. 2.4 crore.
Palco Ltd was founded in 1965 by Late Shri A. V. Sinha. It gained
recognition as a leading producer of high quality aluminum, with the majority
of its sales being made to Japan. During the rapid economic expansion of Japan
in the 1970s, demand for aluminum boomed, and palco’s sales grew rapidly. As a
result of this rapid growth and recognition of new opportunities in the energy
market, Palco began to diversify its products line. While retaining its
emphasis on aluminum production, it expanded operations to include uranium
mining and the production of electric generators, and finally, it went into all
phases of energy production. By 2003, Palco’s sales had reached Rs. 14 crore
level, with net profit after taxes attaining a record of Rs. 67 lakh.
As Palco expanded its products line in the
early 1990s, it also formalized its caital budgeting procedure. Until 1992,
capital investment projects were selected primarily on the basis of the average
return on investment calculations, with individual departments submitting these
calculations for projects falling within their division. In 1996, this
procedure was replaced by one using present value as the decision making
criterion. This change was made to incorporate cash flows rather than
accounting profits into the decision making analysis, in addition to adjusting
these flows for the time value of money. At the time, the cost of capital for
Palco was determined to be 12 per cent, which has been used as the discount
rate for the past 5 years. This rate was determined by taking a weighted
average cost Palco had incurred in raising funds from the capital market over
the previous 10 years.
It had originally been Neha’s assignment to update this rate over
the most recent 10-year period and determine the net present value of all the
proposed investment opportunities using this newly calculated figure. However,
she objected to this procedure, stating that while this calculation gave a good
estimate of “the past cost” of capital, changing interest rates and stock
prices made this calculation of little value in the present. Neha suggested
that current cost of raising funds in the capital market be weighted by their
percentage mark-up of the capital structure. This proposal was received
enthusiastically by the Financial Controller of the Palco, and Neha was given
the assignment of recalculating Palco’s cost of capital and providing a written
report for the Board of Directors explaining and justifying this calculation.
To determine a weighted average cost of capital for Palco, it was
necessary for Neha to examine the cost associated with each source of funding
used. In the past, the largest sources of
Exhibit 1 Palco Ltd Balance Sheet for Year
Ending March 31, 2003
|
|
Assets
|
|
|
|
Liabilities
and Equity
|
|||
|
Cash
|
|
Rs.
|
90,00,000
|
Accounts
payable
|
Rs.
|
8,50,000
|
||
|
Accounts receivable
|
|
3,10,00,000
|
Short-term debt
|
|
1,00,000
|
|||
|
Inventories
|
|
|
1,20,00,000
|
Accrued
taxes
|
|
11,50,000
|
||
|
Total current assets
|
|
|
5,20,00,000
|
Total current liabilities
|
|
1,20,00,000
|
||
|
Net
fixed assets
|
|
|
19,30,00,000
|
|
Long-term
debt
|
|
7,20,00,000
|
|
|
Goodwill
|
|
|
|
70,00,000
|
|
Preference
shares
|
|
4,80,00,000
|
|
Total
assets
|
|
|
25,20,00,000
|
|
Retained
earnings
|
|
1,00,00,000
|
|
|
|
|
|
|
|
|
Equity shares
|
|
11,00,000
|
|
|
|
|
|
|
|
Total
liabilities and
|
|
|
|
|
|
|
|
|
|
equity shareholders
|
|
25,20,00,000
|
|
|
|
|
|
|
|
fund
|
|
|
|
|
|
|
|
|
|
|
|
|
She further determined that the strong growth patterns that Palco
had exhibited over the last ten years were expected to continue indefinitely
because of the dwindling supply of US and Japanese domestic oil and the growing
importance of other alternative energy resources. Through further
investigations, Neha learnt that Palco could issue additional equity share,
which had a par value of Rs. 25 pre share and were selling at a current market
price of Rs. 45. The expected dividend for the next period would be Rs. 4.4 per
share, with expected growth at a rate of 8 percent per year for the foreseeable
future. The flotation cost is expected to be on an average Rs. 2 per share.
Preference shares at 11 per cent with 10 years maturity could also
be issued with the help of an investment banker with an investment banker with
a per value of Rs. 100 per share to be redeemed at par. This issue would
involve flotation cost of 5 per cent.
Finally, Neha learnt that it would be possible
for Palco to raise an additional Rs. 20 lakh through a 7 – year loan from
Punjab National Bank at 12 per cent. Any amount raised over Rs. 20 lakh would
cost 14 per cent. Short-term debt has always been usesd by Palco to meet
working capital requirements and as Palco grows, it is expected to maintain its
proportion in the capital structure to support capital expansion. Also, Rs. 60
lakh could be raised through a bond issue with 10 years maturity with a 11
percent coupon at the face value. If it becomes necessary to raise more funds
via long-term debt, Rs. 30 lakh more could be accumulated through the issuance
of additional 10-year bonds sold at the face value, with the coupon rate raised
to 12 per cent, while any additional funds raised via long-term debt would
necessarily have a 10 – year maturity with a 14 per cent coupon yield. The
flotation cost of issue is expected to be 5 per cent. The issue price of bond
would be Rs. 100 to be redeemed at par.
Palco Ltd is subjected to the corporate tax
rate of 40 per cent.
From the facts outlined above, what report
would Neha submit to the Board of Directors of palco Ltd?
NO. 6
ARQ LTD
ARQ Ltd is an Indian company based in Greater Noida which
manufactures packaging materials for food items. The company maintains a
present fleet of five fiat cars and two Contessa Classic cars for its chairman,
general manager and five senior managers. The book value of the seven cars is
Rs. 20,00,000 and their market value is estimated at Rs. 15,00,000. All the
cars fall under the same block
of depreciation @ 25 per cent.
A German multinational company (MNC) BYR Ltd,
has acquired ARQ Ltd in all cash deal. The merged company called BYR India Ltd
is proposing to expand the manufacturing capacity by four folds and the
organization structure is reorganized from top to bottom. The German MNC has
the policy of providing transport facility to all senior executives (22) of the
company because the manufacturing plant at Greater Noida was more than 10 kms
outside Delhi where most of the
executives were staying.
Prices of the cars to be provided to the Executives have been as
follows :
|
Manager (10)
|
Santro King
|
Rs.
3,75,000
|
|
DGM and GM (5)
|
Honda
City
|
6,75,000
|
|
Director (5)
|
Toyota Corolla
|
9,25,000
|
|
Managing Director (1)
|
Sonata
Gold
|
13,50,000
|
|
Chairman (1)
|
Mercedes benz
|
23,50,000
|
The company is evaluating two options for providing these cars to
executives
Option 1 : The company will buy the cars and pay the executives
fuel expenses, maintenance expenses, driver allowance and insurance (at the
year – end). In such case, the ownership of the car will lie with the company.
The details of the proposed allowances and expenditures to be paid are as
follows :
|
Particulars
|
Fuel expenses
|
Maintenance allowance
|
|
Manager
|
Rs. 2,500
|
Rs. 1,000
|
|
DGM and GM
|
5,000
|
1,200
|
|
Director
|
7,500
|
1,800
|
|
Managing Director
|
12,000
|
3,000
|
|
Chairman
|
18,000
|
4,000
|
b)
Driver Allowance: Rs. 4,000 per month (Only Chairman, Managing
Director and Directors are eligible for driver allowance.)
c)
Insurance
cost: 1 per cent of the cost of the car.
The useful life for the cars is assumed to be
five years after which they can be sold at 20 per cent salvage value. All the
cars fall under the same block of depreciation @ 25 per cent using written down
method of depreciation. The company will have to borrow to finance the purchase
from a bank
with interest at 14 per cent
repayable in five annual equal instalments payable at the end of the year.
Option 2 : ORIX, The fleet management company has offered the 22 cars of the
same make at lease for the period of five years. The monthly lease rentals for
the cars are as follows (assuming that the total of monthly lease rentals for
the whole year are paid at the end of each year.
|
Santro Xing
|
Rs.
9,125
|
|
Honda City
|
16,325
|
|
Toyota Corolla
|
27,175
|
|
Sonata Gold
|
39,250
|
|
Mercedes Benz
|
61,250
|
Under this lease agreement the leasing company,
ORIX will pay for the fuel, maintenance and driver expenses for all the cars.
The lessor will claim the depreciation on the cars and the lessee will claim
the lease rentals against the taxable income. BYR India Ltd will have to hire
fulltime supervisor (at monthly salary of Rs. 15,000 per month) to manage the
fleet of cars hired on lease. The company will have to bear additional
miscellaneous expense of Rs. 5,000 per month for providing him the PC, mobioe
phone and so on.
The company’s effective tax
rate is 40 per cent and its cost of capital is 15 per cent. Analyse the
financial viability of the two options. Which option would you recommend? Why?
Financial
Management
Q1. What is meant by ‘Financial management’ Explain its
importance.. (10 marks)
Q2. Define current assets and Give four examples (10 marks)
Q3. What is capital structure of a company? (10 marks)
Q4. What is meant by Financial Planning? (10 marks)
Q5. State the decisions involved in Financial management. (10
marks)
Q6. Different types of investments time horizons. (10 marks)
Q7. What types of shares are available in the market? (10
marks)
Q8. Why we use WACC?
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