CASE STUDY – FINANCIAL MANAGEMENT

RISK AND RETURN

1. Mr. Alok Dixit is interested in investing in equity shares of Wipro and Dabur. Being
conservative in nature, he wants to determine the risk associated with investments. In specific
terms, he wants to seek data related to both levered and unlevered beta of these companies.
He approaches Ankit Shah, a financial consultant to do the needful. Ankit has collected the
relevant information detailed below.

i. Monthly returns on equity shares of Wipro and Dabur for a period of 2 years (w.e.f.
October 2009 to September 2011) along with portfolio of S&P CNX NIFTY.

Number WIPRO DABUR S&P CNX NIFTY

(MONTHS)
1 0.1455 0.0432 0.0654
2 0.1291 0.3070 0.1536
3 - 0.1036 - 0.0498 - 0.0749
4 - 0.0643 - 0.0369 0.0473
5 - 0.0673 - 0.0272 - 0.0178
6 0.1361 0.0286 - 0.0291
7 - 0.0111 - 0.1088 - 0.1465
8 0.0452 - 0.1338 0.0194
9 0.0277 0.0913 0.0663
10 0.0581 0.0110 - 0.0022
11 0.0313 0.0581 0.0854
12 0.1021 0.1043 0.0127
13 0.1652 0.0876 0.0914
14 - 0.0237 0.0617 0.0604
15 - 0.0581 0.0877 - 0.0099
16 - 0.0077 0.1400 0.0119
17 - 0.0401 - 0.0369 - 0.0080
18 - 0.0589 0.0473 - 0.0605
19 0.1335 0.1054 0.0746
20 0.0693 0.0249 0.0596
21 - 0.0391 0.1082 0.0480
22 - 0.0086 0.0480 0.0378
23 0.0196 0.0680 0.0813

ii. Return on 364 – day’s treasury bills issued by Government of India for the period
2010 – 11 is 5.15 percent per annum and 0.419 per month. This rate is to be used as a
proxy for risk-free rate of return.
iii. Debt-equity ratio (based on the average 2007 to 2011) is 1.6 percent for Wipro and
31.4 percent for Dabur.
 iv. Corporate tax is 35 percent.

Required: Compute the beta and interpret it for Alok.

CASH FLOW STATEMENT

LINK LEVER LTD.

2. Link Lever Ltd. is a medium sized enterprise, specializing in manufacturing of industrial

locks, fasteners, fixers and holdfasts. The company began its journey from Gorakhpur in
Eastern UP in 2009. It was co-founded by two friends – Arunashu Pal and Tamal Bose. They
started making small locks for residential purposes which were sold in the local markets of
Eastern UP. The locks were fairly successful as they were priced competitively and soon
became popular amongst the people.

Buoyed up by their success, the owners decided to expand operations. From 5 – worker
organization, working in a garage, they went on to become a 50-member strong company
working out of a small unit in Kanpur and catering to the markets of UP within a year of
operation. For financing their expansion, the owners took a loan from the State bank of India
and got their company registered as Pal and Bose Ltd.

By 2011-end, the Pal and Bose (PB) Ltd. had become brand name in UP and was
manufacturing fasteners, fixers and holdfasts apart from locks, which also were available for
various purposes from residential needs to industrial requirements.

Arunashu Pal, CEO of PB Ltd. had seen huge market potential for PB Ltd. and was already
planning ahead. He planned for opening up of a modern manufacturing plant outside UP, say,
in Jharkhand or Madhya Pradesh, so that he could expand business and create a brand name
which would be recognizable throughout India. Tamal Bose, the Joint CEO, was also
enthusiastic about the growth of PB Ltd. and wished to diversify into more areas like
automobile locks, electronically operated locking mechanism and surveillance security
systems.

To meet the additional fund requirements to (i) open up the proposed new plant outside UP,
(ii) buy modern machinery, (iii) train employees, (iv) advertise to create brand awareness and
(v) license advanced technology from foreign collaborators, the management of PB Ltd.
decided to take additional loan from the State Bank of India, having already paid the past
loan.

The manager of the State Bank of India, Kanpur Green Park Branch, Mr. Kuber Chand,
visited the premises of PB Ltd. and undertook a detailed appraisal to ascertain its credit
worthiness. After his satisfaction with the processes of the plant, he asked for the balance
sheet, income statement and the cash flow statement as per AS – 3. He assured the two
promoters that once the bank received all these documents in proper form, they would
process the loan application quickly.

However, as things were looking bright and rosy for PB Ltd. and it was at the threshold of a
massive expansion, a mishap took place. A fire broke out at PB Ltd’s manufacturing unit at
Kanpur. Some important documents were lost as the fire engulfed the administrative block.
The debtor’s ledger and the store ledger were completely destroyed in the fire.

On instructions from the CEO of PB Ltd., Alok Mehta, the CFO, prepared from the available
records an incomplete balance sheet as shown in Exhibit 1 and additional information
(Exhibit 2).

EXHIBIT I Incomplete Balance Sheet (Rs ‘000)

Particulars Year 2 Year 1

Long-term Assets:
Plant and Machinery (net of depreciation) 8,211 2,260
Land and buildings 1,950 2,000
Long term investments 720 720
Current Assets:
Marketable Securities 4,550 230
Sundry debtors * *
Inventories * *
Prepaid expenses 100 50
Interest receivable 150 100
Cash in hand 1,620 730
Cash at bank 971 600
Total Assets * *
Long – term Liabilities:
Share Capital 3,580 2,750
Preference share capital 1,000 1,200
Reserve and surplus 7,951 2,210
18% Convertible debentures 1,905 2,230
Current Liabilities:
Sundry creditors 680 890
Wages outstanding 85 55
Income tax payable 600 680
Total Liabilities 15,801 10,015

Exhibit 2 Additional Information

 1. Debenture holders holding 25 percent of the debentures outstanding as on 31 st March,
Year 1 exercised the option for conversion into equity shares during the financial year
and the same was put through.
2. Only one plant was sold during the year for Rs 1,00,000. The original cost of the machine
was Rs 6,00,000.
3. During Year 2, interim dividend of Rs 2,00,000 was paid, final dividend paid being Rs
3,00,000.
4. Preference share redemption was carried out at a premium of 8 percent.
5. Accumulated depreciation on plant and machinery at the end of Year 2 was Rs 10,20,000
and at the end of Year 2 was Rs 11,90,000.
6. The current ratio at the end of Year 1 and Year 2 was 3.098462 and 3.604396.
7. The quick ratio at the end of Year 1 and Year 2 was 3.015 and 3.443.

Required: From the above information, prepare (a) income statement for Year 2, (b)
reconstructed balance sheet for Years 1 – 2 and (c) AS – 3 based cash flow statement. Show the
detailed computations in working notes.

FINANCIAL STATEMENT ANALYSIS

INDIAN PAINTS LTD.

3. The financial statistics pertaining to profitability of Indian Paints Limited for the period
2006-2011 are tabulated below:
(Amount is in Rs crore)

Particulars Year, March 31

2006 2007 2008 2009 2010 2011
EBIT 107.06 120.77 125.82 163.47 177.20 194.99
Interest 21.68 19.58 22.33 20.29 22.12 14.59
EBT 85.38 100.19 103.49 143.18 155.08 180.40
Tax provisions 30.00 33.00 24.00 45.75 49.50 66.09
EAT 55.38 67.19 79.49 97.43 105.58 114.31
Sales 938.11 1,046.80 1,158.38 1,383.55 1,526.0 1,659.72
1
Total Assets 534.49 647.66 685.84 771.09 882.20 893.52
Average Total Assets - 591.07 666.75 728.46 826.64 887.86
Equity funds 226.41 260.50 304.51 357.41 411.20 410.56
Average equity funds - 243.45 282.50 330.96 384.30 410.88
Net fixed assets 194.28 256.68 306.87 333.29 382.95 375.76
Inventory (Finished 72.66 81.60 86.58 106.50 114.50 88.26
Goods)
Sundry debtors 66.92 80.74 79.95 86.67 121.65 118.96
Average fixed assets - 225.48 281.77 320.08 358.12 379.35
Average inventory - 77.13 84.09 96.54 110.50 101.38
 Average debtors - 73.83 80.34 83.31 104.16 120.30

From the above financial information, you are required to prepare a disaggregative analysis
related to ROA and ROE (both on pre-tax and post-tax basis) and interpret the results.

RELIANCE INDIA LTD.

4. From the following selected financials of Reliance Industries Ltd. (RIL) for the period 2006
– 2011, appraise its financial health from the point of view of liquidity, solvency, and
profitability.
Selected financial data and ratios (Amount in Rs crore)

(I) Related to 2006 2007 2008 2009 2010 2011

Liquidity
Analysis
Current Assets: 9,844.48 13,025.31 17,925.2 23,245.88 28,988.62 24,591.03
5
Marketable Inv. 3,387.25 536.80 536.19 536.11 536.11 16.58
Inventory 2,299.85 4,976.07 7,510.14 7,231.22 7,412.88 10,119.82
Debtors 1,134.17 2,722.46 2,975.49 3,189.93 3,927.81 4,163.62
Advances 2,922.58 3,310.27 6,756.22 12,064.38 13,503.03 8,144.85
Cash and bank bal. 100.63 1,760.71 147.21 224.24 3,608.79 2,146.16
Current Liabilities:
Short-term bank 337.76 2,148.27 7,193.77 9,145.14 12,684.39 11,438.69
borrowings
Sundry creditors 3,754.50 5,847.20 8,288.10 366.78 366.95 310.42
Interest accrued 223.00 389.23 380.15 676.45 525.37 728.18
Creditors for capital 104.72 175.16 717.48 2,670.75 3,471.80 3,890.98
goods
Other current 892.08 1,270.24 1,580.89 4,107.03 4,885.94 2,073.61
liabilities & prov.
Other data and
ratios:
Net working capital 4,532.42 3,195.21 - 235.14 6,279.73 7,054.17 3,149.15
Credit sales 22,886.51 45,073.88 49,743.5 56,247.03 73,164.10 89,124.16
4
Cost of goods sold 21,290.91 45,957.85 54,642.6 41,657.92 53,345.03 65,535.84
0
Cost of raw material 18,155.98 41,023.35 50,378.6 34,721.39 45,931.87 58,342.31
used 5
Credit purchases 21,608.85 45,083.06 56,884.4 60,246.91 70,014.80 68,516.87
9
Average debtors 988.31 1,928.31 2,848.97 3,094.02 3,558.87 4,045.71
Average creditors 3,170.68 4,800.85 7,067.65 9,413.58 11,515.60 12,688.31
Current ratio 1.85 1.33 0.99 1.75 1.66 1.49
Acid test ratio 0.87 0.51 0.20 0.26 0.55 0.38
Debtors turnover 23 23 17 17.63 18.62 21.40
Creditors turnover 7 9 8 6.40 6.08 5.40
Debtors cycle (days) 16 16 21 21 20 17
Creditors cycle 54 39 45 57 60 67
(days)
(II) Related to
Solvency
Analysis
Free Reserves 9,307.89 21,834.29 23,656.3 33,056.50 39,010.23 48,411.09
1
Paid up Capital 1,053.49 1,395.85 1,395.92 1,395.95 1,393.09 1,393.17
Preference Capital 0.00 0.00 0.00 0.00 0.00 0.00
Bonus equity capital 481.77 481.77 481.77 481.77 481.77 481.77
Total equity 10,843.15 23,711.91 25,534.0 34,934.22 40,885.09 50,286.03
0
Long-term 9,798.03 16,780.21 12,564.5 11,149.38 6,172.98 8,185.60
borrowings 4
Current Liabilities 5,312.06 9,830.10 18,160.3 12,955.22 17,131.52 16,454.48
9
Total debt 15,110.09 26,610.31 30,724.9 24,104.60 23,304.50 24,640.08
3
EBIT 4,032.37 6,307.71 6,551.17 7,735.86 10,537.34 11,581.10
Interest 1,215.56 1,827.85 1,555.40 1,434.72 1,468.66 877.04
Total debt-equity 1.39 1.12 1.20 0.69 0.57 0.49
ratio
Long-term debt- 0.90 0.71 0.49 0.31 0.15 0.16
equity ratio
Interest coverage 3.32 3.45 4.21 5.39 7.17 13.20
ratio
(III) Related to
Profitability
Analysis
Sales 22,886.51 45,073.88 49,743.5 56,247.03 73,164.10 89,124.46
(manufacturing) 4
Cost of goods sold 21,290.91 45,957.85 54,642.6 41,657.92 53,345.03 65,535.84
0
EBDIT (including 5,597.48 9,123.85 9,388.26 10,982.88 14,260.84 14,982.01
other earnings)
EBIT 4,032.37 6,307.71 6,551.17 7,735.86 10,537.34 11,581.10
EBT 2,786.00 4,434.17 4,982.75 6,301.14 9,068.68 10,704.06
EAT 2,646.50 3,242.17 4,106.85 5,160.14 7,571.68 9,069.34
Interest 1,215.55 1,827.84 1,555.40 1,434.72 1,468.66 877.04
Average total capital 19,235.95 27,053.82 34,388.0 50,030.24 54,560.80 61,738.85
 employed 4
Average total assets 29,622.14 43,325.86 60,415.7 52,764.91 57,292.51 65,428.89
7
Average equity 10,715.17 17,277.53 24,622.9 1,396.38 1,394.94 1,393.51
funds 6
Gross Profit % 24.46 20.24 18.87 18.41 19.40 17.43
Operating profit 17.62 13.99 13.17 13.75 14.40 12.99
ratio %
Net profit ratio % 11.56 7.19 8.26 9.95 11.48 11.21
Cost of goods sold 93.03 101.96 109.85 80.34 80.92 81.03
ratio %
Rate of return on 20.07 18.74 16.47 13.18 16.56 16.11
capital employed
(ROCE) 1
ROR (Total assets) 2 13.03 11.70 9.37 12.40 15.77 15.20
ROR (Equity funds) 24.70 18.77 16.68 16.26 20.09 20.08
1. ROCE = (EAT + Interest)/Average Capital Employed
2. ROR (Total assets) = (EAT + Interest)/Average Assets

VARIED PRODUCTS LTD.

5. The following selected financial data have been taken from the annual reports of Varied
Products Ltd. You are required to appraise the company’s financial position from the point of
view of: (i) Corporate management, (ii) Lending institutions, and (iii) Investors.
a. Selected financial statistics (Rs in Lacs) (Index: Base Year 1 = 100)

Particulars Year 10 (Index Year 9 (Index) Year 8 (Index)

Total Income 10,615 (498) 9,093 (427) 8,280 (389)
Depreciation 225 (479) 126 (268) 101 (215)
Profit before tax 803 (453) 815 (46) 540 (305)
Taxation 405 (526) 474 (616) 315 (409)
Profit after tax 398 (398) 341 (341) 225 (225)
Dividend 91 (260) 91 (260) 70 (200)
Retained profit 307 (473) 250 (385) 155 (238)
Fixed assets 1,655 (338) 991 (202) 914 (187)
Investments 177 (385) 165 (358) 165 (358)
Indebtedness 1,097 (213) 885 (172) 760 (148)
Share capital 917 (321) 603 (211) 603 (211)
Reserves 806 (413) 795 (408) 615 (315)
Net worth 1,723 (358) 1,399 (291) 1,218 (253)

b. Significant ratios

Particulars Year 10 (Index) Year 9 (Index) Year 8 (Index)

1. Measurement of investment:
 Percentage return on investment 32.7 39.5 32.9
Percentage return on equity 29.9 25.9 19.7
Dividend cover ratio 4.67 3.99 3.48
2. Measurement of performance:
Percentage of profit before tax to 7.7 9.3 6.7
sales
Percentage of profit after tax to 3.8 3.9 2.8
sales
Assets turnover ratio 3.6 3.8 4.1
3. Measurement of financial
status:
Percentage of term loan to 41.1 14.2 19.4
tangible net worth
Current ratio 1.25 1.25 1.15
4. General:
Dividend per equity share (Rs) 1.60 1.60 1.20
Earnings per equity share (Rs) 7.48 6.39 4.17
* Excluding bonus shares issued on March 31, Year 10
c. Statement of changes in financial position

CAPITAL BUDGETING

HOTEL SEAWIND (NET PRESENT VALUE)

The Hotel Seawind is one of the premier four-star hotels in Goa. Since its inception in 2010, it
has been the favourite choice of the visitors to the city. It boasts of facilities such as swimming
pools, a gymnasium, boutiques, a discotheque, 24 x 7 coffee shop and multi-cuisine restaurant. It
has rooms which are classified into three types, as shown below:

Class Number of rooms Daily tariff (Rs)

Economy 200 2,500
Executive 100 4,000
Deluxe 25 6,000
The current financial details of Seawind are summarized below:
i. Staff Salaries

Grade Number Amount per annum Total (Rs)

per person (Rs)
(1) (2) (3) (4)
A 1 20,00,000 20,00,000
B 25 8,00,000 2,00,00,000
C 70 3,00,000 2,10,00,000
D 200 1,50,000 3,00,00,000
Total 7,30,00,000
ii. Profit from restaurant: Rs 1,00,00,000
 iii. Profits from the coffee shop: Rs 30,00,000
iv. Profit from the boutique and discotheque: Rs 25,00,000
v. Room tariffs:
 Economy class: 200 X Rs 2,500 x 350 days x 0.40 (occupancy) Rs 7,00,00,000
 Executive class: 100 x Rs 4,000 x 350 x 0.40 5,60,00,000
 Deluxe class: 25 x Rs 6,000 x 350 x 0.40 2,10,00,000
-------------------
14,70,00,000
===========
vi. Annual maintenance cost (electricity charges, land tax, water tax, office stationery
and other miscellaneous expenses): Rs 5,00,00,000
vii. Profits before tax (PAT/EBT): Total revenues – Total cost

Total Revenues:
 Room tariffs Rs 14,70,00,000
 Profit from restaurant 1,00,00,000
 Profit from coffee shop 30,00,000
 Profit from boutique/discotheque 25,00,000
-----------------------
16,25,00,000
Total Costs:
 Salary 7,30,00,000
 Maintenance cost 5,00,00,000
-----------------------
12,30,00,000
--------------------
3,95,00,000
viii. Profit after tax (PAT)
 Tax 1,38,25,000
--------------------
2,56,75,000
===========
In the past few years, the occupancy in Seawind has declined from 55 percent to 40 percent
which has denied its profits attributed to (i) stiff competition from new four-star hotels that have
come up recently and (ii) its inability to offer value-added services to its customers.

In order to check the decline in profits and to plan out the future strategy to maximize its
revenues, Rahul Singh, the CEO of Seawind, has hired the Trump Consultants.
The Trump Consultants have suggested two proposals for the consideration of the CEO of Hotel
Seawind as detailed below:

Proposal I: The first proposal is to increase its rating from four-star to five-star. Due to this, the
occupancy rate of new rooms would be 50%; however, the occupancy rate of existing rooms
would remain unchanged. The upgradation would involve the following:
 Increase in the number of rooms: economy class – 100; executive class – 80; deluxe class –
25.
 Build a casino and a ball room.
 Increase in staff: B grade – 40; C grade – 100 and D grade – 300

The upgradation plan would require additional expenses detailed below:

i. Cost of building of casino and ball room: Rs 4,00,00,000.

ii. Cost of building extra rooms in the hotel:
 Economy class – Rs 8,00,000 per room
 Executive class – Rs 12,00,000 per room
 Deluxe class – Rs 20,00,000 per room

The additional maintenance cost would amount to Rs 1,40,00,000.

As a result, incremental profit from casino would be Rs 50 lakh and coffee shop would be Rs 24
lakh.

Proposal II: The details of the second proposal of the consultants are given below:

i. Creation of casino and entertainment centre at a cost of Rs 4,00,00,000.

ii. Creation of an ayurveda spa at a cost of Rs 50,00,000
iii. Creation of a helipad at a cost of Rs 20,00,000
iv. Increase in staff: B grade – 2; C grade – 10; D grade – 30

The incremental profit generated from the proposal would be as shown below:

 From casino, spa helipad and the entertainment centre, Rs 2,50,00,000

 From restaurant, coffee shop and discotheque, Rs 50,00,000
 Increase in occupancy rate to 45 percent

The additional maintenance cost would be Rs 1,00,00,000.

Required: Which proposal of Trump Consultant should Rahul Singh accept? Why? Ignore
depreciation for tax purposes. Assume cost of capital as 13%. Assume both proposals would
provide incremental profits/room tariffs for next 4 years only. Assume national sale value of
capital assets built in proposal I as Rs 15 crore at year end 4?
TEL SAMRAT (HIRING Vs BUYING)

7. Tel Samrat is a large Indian Conglomerate with interest in petroleum, petroleum products,
textiles, telecom and life sciences. It has a refinery in Ankleshwar in Gujrat. The refinery has
a peak capacity for producing 27 lakh tons of finished petroleum products. Ankleshwar is a
major oil terminal with sophisticated state of art facility for docking of very large crude
carrier (VLCC) and ultra large crude carrier (ULCC). Tel Samrat imports crude oil from the
Middle East for its refinery operations and has its own fleet of oil tankers for this purpose.

Tel Samrat has been availing of the services of rented oil barges from the British Company,
MAR-OIL for loading fuel oil for running its tankers in Ankleshwar; MAR-OIL has an
Indian subsidy – MAR OIL INDIA (MOI) which provides the barge services in India. Tel
Samrat pays MOI for its services at the rate of Rs 40,000 per hour to cover running and
maintenance costs. On an average, Tel Samrat has been hiring barges for 90 hours per month
for its fleet of 15 tankers. However, the contract with MOI stipulates payment for atleast 100
hours.

An alternative to hiring the barges from MOI is to acquire oil barges. A Japanese firm
Ichikawa Harima Heavy Industries (IHI) is offering two oil barges for 40 million Yen with a
service life of 10 years. The barges would have a salvage value of 4 million Yens. [Exchange
rate: Current Rs 2.5/Yen; After 10 Years, Rs 5/yen).

The insurance cost for the barges would be 1 percent per year for 1-5 years and 2 percent for
years 6-10 as per the Loyd Registrar of Shipping (LRS) regulations. The running and
maintenance costs for the two barges would be Rs 20,00,000 per year for the first 5 years and
Rs 40,00,000 annually for the next 5 years.

The yearly employee/staff/crew cost for the first 5 years would be given below:

Rank Number Monthly Salary (Rs)

Captain 1 80,000
Chief Engineer 1 80,000
Chief Officer 1 60,000
Duty Engineer 1 60,000
Oil man 1 15,000
Seaman 1 15,000
Shore staff 2 14,000
3,24,000
After 5 years, the salary of employees/crew/staff would increase by 10 percent.

Required: Should Tel Smart acquire the two barges from IHI? Or should it continue availing
of the services of MOI? Assume 12 percent required rate of return.

CHOOLAH CHIMNEY LTD. (NET PRESENT VALUE)

8. Choolah Chimney Ltd. (CCL) is a leading manufacturer of items used in kitchens such as gas
stoves, electric chimneys, ovens and so on. it has grown significantly under the CEO Vivek
Razdan’s dynamic leadership. In line with his belief to enhance competitiveness by using
research and development for launching innovative products in the market, the CCL has
recently developed zero maintenance Electric Chimney (known as Zimney) which is ideally
suited for Indian cooking. The research and development cost of Zimney amounts to Rs
20,00,000.

To gauge the market prospects for Zimney, a market survey was conducted by Bazar Gyani,
the V.P., Marketing, at an estimated cost of Rs 5,00,000. The results of the survey were very
positive showing a significant demand for Zimney. The survey report also indicated that
Zimney could capture 8 percent of the current market size of 1,00,000 units of gas electric
chimney. Considering the growth of satellite towns/cities and residential colonies, the market
is expected to grow at 2 percent annually. The VP, Marketing suggested to the CEO that a
market penetration pricing strategy would be most suitable and Zimney should be priced at
Rs 5,000 per unit in the initial year of the launch. The price could be raised in subsequent
years by 5 percent annually. The marketing and administrative costs are expected to be Rs
4,00,000 per year.

The CCL is presently using 6 machines 3 years ago at a cost of Rs 10,00,000 each, having a
useful life of 7 years, with no salvage value. These machines are currently being used for
manufacturing other types of chimneys. They could be sold for Rs 2,00,000 per machine with
a removal cost of Rs 30,000 for each.

The machine to manufacture Zimney is available in that market for Rs 1,00,00,000 with a
useful life of 4 years and salvage value of Rs 10,00,000. It can produce other types of
chimneys also.

The new machine, being state of the art technology would improve the productivity of the
workers as will reduce the unit variable cost of manufacture to Rs 600, which would increase
by 5 percent annually.

Exhibit I summarizes the labour cost with the existing machine and the new equipment.

Category Existing New Machine/Equipment

Number Monthly salary (Rs) Number Monthly salary (Rs)
Skilled labour 20 4,000 15 4,000
Maintenance men 2 6,000 1 6,000
Floor managers 3 8,000 2 8,000
 The maintenance costs currently amount to Rs 1,00,000 per year (existing machine). They
would total Rs 70,000 with the new equipment. The net working capital required to start
production of Zimney would be Rs 60,00,000.

The policy of CCL is to pay five months salary as compensation in case of lay-off of
employees.

Required: Should the CCL launch the Zimney? Assume the following: (i) Tax, 35 percent,
(ii) Required rate of return, 14 percent and (iii) Straight line depreciation for the tax
purposes.

REMOTE ADDICTION LTD.

9. Remote Addiction Ltd. makes 53 cm colour TV sets. They currently sell 40,000 units per
year which corresponds to 100 percent of their manufacturing capacity. The marketing team,
based on the market information from their dealers, feels that Remote Addiction Ltd. could
sell 50,000 units per year at the existing selling price, level of advertising, and existing dealer
commissions. However, the plant is not geared up to producer at these levels. The bottleneck
is the speed of the assembly line which will support only 40,000 units per year even when
operating in round the clock shifts. The only way to increase manufacturing capacity would
be to replace the current assembly line with a new higher speed assembly line.

The marketing manager, Mr. Becho Kumar, strongly feels that it is extremely important for
the Remote Addiction Ltd. to grab the additional market share that it is available to them for
the asking. He is, therefore, keen to install a high speed assembly line install to boost the
manufacturing capacity so as to meet the anticipated level of 50,000 units per year. He
approached the managing director, Mr. Dhanda Singh, to explore the possibility of replacing
the existing assembly line with a higher speed assembly line.

Mr. Dhanda Singh called the finance manager, Mr. Rupaya Gupta, and asked him to make a
recommendation regarding the replacement of the existing assembly line with a higher speed
assembly line. He clearly stated that the recommendation should be based on a required rate
of return of 15 percent. Mr. Rupaya Gupta sought some time to collect information and
perform a financial analysis in order to make his recommendation. Mr. Dhanda Singh asked
him to go ahead with the necessary financial analysis.

Mr. Gupta made inquiries regarding a higher speed assembly line and decided that the next
higher speed compared to what they currently had would support a manufacturing capacity of
80,000 units per year. This could be purchased for Rs 1,00,00,000 and would have a useful
economic life of 5 years with no salvage value at the end of 5 years. The current book value
of the existing assembly line is Rs 16,00,000 with a market value of Rs 12,00,000. The tax
laws as a special case allow straight line depreciation for TV manufacturing assembly lines.
Mr. Gupta then collected all other relevant financial information corresponding to the
existing assembly line operating at a manufacturing level of 40,000 units per year as well as
the proposed new assembly line operating at a manufacturing level of 50,000 units per year.
This information is summarized in Exhibit 1.

EXHIBIT 1

Particulars Existing assembly line New assembly line

(40,000 units per year) (50,000 units per year)
Selling price (Rs per unit) 19,900 19,990
Material cost (Rs per unit) 7,500 7,500
Labour cost (Rs per unit) 1,600 2,700
Manufacturing Overheads (Rs per 1,800 2,350
unit)
Dealer commissions (Rs per unit) 800 800
Advertising cost (Rs per year) 2,00,00,000 2,00,00,000
Depreciation (Rs per year) 3,20,000 3,20,000
Working Capital requirement (Rs) 41,00,000 48,00,000
Income tax rate (per cent) 35 35

Find out the financial analysis of Mr. Rupaya Gupta, should the existing assembly line
replaced by the new higher speed assembly line?

If Mr. Rupaya Gupta comes up with the advice that Remote Addiction Ltd. should not
replace the existing assembly line with a new higher speed assembly line. Mr. Becho Kumar
was very disappointed to hear this and met Mr. Rupaya Gupta to understand what should be
done so that the proposal for a new higher speed assembly line could be accepted. Mr. Gupta
explained that even though the projected sales of 50,000 units per year were significantly
higher than the existing sales of 40,000 per units per year, it was still not high enough. Mr.
Becho Kumar needed to figure out a way to increase the sales further. He hired the market
research firm of Bazaar Pulse Pvt. Ltd. to determine ways to increase sales beyond 50,000
units per year. They came up with the following three mutually exclusive options.

i. Increase sales through trade push. This involves increasing dealer commission from
Rs 800 per unit to Rs 1,100 per unit to attain a sales level of 53,000 units per year.
ii. Increase sales through customer push. This involves increasing the advertising
expenditure from Rs 2,00,00,000 per year to Rs 4,00,00,000 per year to attain a sales
level of 55,000 units per year.
iii. Increase sales by exploiting the price elasticity of demand. This involves reducing the
selling price of the TV sets from Rs 19,900 per unit to Rs 18,900 per unit to attain a
sales level of 59,000 units per year.
 Mr. Becho Kumar approaches Mr. Rupaya Gupta with the three options and requested him to
perform a financial analysis to determine if purchasing the new higher speed assembly line
could now be justified. Before starting the detailed financial analysis, Mr. Rupaya Gupta first
assessed whether any of the previous data he had collected and estimated would change for
the above three options over and above the specific changes that are mentioned in the
options. He concluded that the only additional data that would change would be the working
capital requirement at the different sales levels. He estimated these working capital
requirements as follows:

Sales level (units per year) Working capital requirement (Rs)

53,000 50,00,000
55,000 51,00,000
59,000 53,00,000

With Mr. Dhanda Singh’s approval, Mr. Rupaya Gupta then proceeded with a financial
analysis for all three options. What is Mr. Rupaya Gupta’s final recommendation to Mr.
Dhanda Singh?

COST OF CAPITAL

COMPUTATION OF COST OF CAPITAL OF PALCO LTD.

In October 2011, 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 analyze 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 1969 by Late Shri A.V. Sinha. It gained recognition as a leading
producer of high quality aluminium, with the majority of its sales being made to Japan. During
the rapid economic expansion of Japan in the 1970s, demand for aluminium 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
aluminium production, it expanded operations t include uranium mining and the production of
electric generators, and, finally, it went into all phases of energy production. By 2007, 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 product line in the early 1990s, it also formalized its capital budgeting
procedure. Until 1996, capital investment projects were selected primarily on the basis of the
average return on investment calculations, with individual departments submitting these
calculations for projects failing within their division. In 2000, 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 percent, 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 funding
had been the issuance of new equity shares and internally generated funds. Through
conversations with Financial Controller and other members of the Board of Directors, Neha
learnt that the firm, in fact, wished to maintain its current financial structure as shown in Exhibit
1.

Exhibit I Palco Ltd. Balance Sheet for Year ending March 31, 2011

Liabilities and equity Rs Assets Rs

Accounts payable 8,50,000 Cash 90,00,000
Short-term debt 1,00,000 Accounts receivable 3,10,00,000
Accrued taxes 11,50,000 Inventories 1,20,00,000
Total current liabilities 1,20,00,000 Total current assets 5,20,00,000
Long-term debt 7,20,00,000 Net fixed assets 19,30,00,000
Preference shares 4,80,00,000 Goodwill 70,00,000
Retained earnings 1,00,00,000
Equity shares 11,00,000
Total liabilities and equity 25,20,00,000 Total assets 25,20,00,000
shareholders’ 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 shares, which had a par value
of Rs 25 per share and were selling at a current market price of Rs 45. The expected dividend for
the next period would be Rs 4.40 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 percent with 10 years maturity could also be issued with the help of an
investment banker with a par value of Rs 100 per share to be redeemed at par. This issue would
involve flotation cost of 5 percent.

Finally, Neha learnt that it would be possible for Palco to raise an additional Rs 20 lakh through
a 7-year loan from PNB at 12 percent. Any amount raised over Rs 20 lakh would cost 14 percent.
Short-term debt has always been used 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 percent, while any additional funds
raised via long-term debt would necessarily have a 10-year maturity with a 14 percent coupon
yield. The flotation cost of issue is expected to be 5 percent. The issue price of bond would be Rs
100 to be redeemed at par.

In the past, Palco had calculated a weighted average of these sources of funds to determine its
cost of capital. In discussion with the current Financial Controller, the point was raised that while
this served as an appropriate calculation for external funds, it did not take into account the cost of
internally generated funds. The financial Controller agreed that there should be some cost
associated with retained earnings and need to be incorporated in the calculations but didn’t have
any clue as to what should be the cost.

Palco Ltd. is subjected to the corporate tax rate of 40 percent.

From the facts outlined above, what report would Neha submit to the Board of Directors of Palco
Ltd.?

WORKING CAPITAL MANGEMENT

COOKING LPG LTD. (DETERMINATION OF WORKING CAPITAL)

Introduction

Cooking LPG Ltd., Gurgaon, is a private sector firm dealing in the bottling and supply of
domestic LPG for household consumption since 2005. 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 well and plans to expand its market to include the whole national Capital
Region.
 The production process of the plat 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.

i. 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 makes payments for bulk supplies once in a month,
resulting in average time-lag of 15 days.
ii. 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.
iii. 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 percent. 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 distributors’ 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.
iv. 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.
v. 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 7 th of subsequent
month.
 Renewal of various licences (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 plant – Rs 50,000 per month paid on the 10th of every month
to the vendors. This includes expenditure on account of lubricants, spares and other
stores.
 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 of subsequent month.
 Sales tax as per applicable rates is deposited on the 7th of the subsequent month.
vi. 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 percent.
vii. 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
viii. Minimum cash balance including bank balance required is Rs 5 lakh.
ix. Additional Information for Calculating Incremental Working Capital During Winter
 No increase in any inventories takes 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 winters.
 No changes in other administrative overheads.
 The expenditure on power consumption during winter increases by 10 percent.
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.