Corporate Finance

Ans wer: 1
Calculation of sales to profit {Earnings Before Tax (EBT)} for the ABC Company Ltd.
computing from the given data:

Sl. No. Particulars Amount (Rs.)

1 Output 10,000
2 Selling price per unit 10
3 Variable cost per unit 6
4 Contribution per unit 4
5 Total contribution (10000*4) 40,000
6 Less: Fixed cost –20,000
7 EBIT 20,000
8 Less: Interest –10,000
9 EBT 10,000

 Degree of Operating Leverage (DOL):

 Degree of Financial Leverage (DFL):

 Degree of Combined Leverage (DCL):

or

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Return on Equity:

Net income = EBIT – Tax

Net income = 6,00,000 – 30% * 6,00,000
Net income = 6,00,000 – 1,80,000
Net income = 4,20,000

Capital Structure to include 40% debt on Shareholder Equity = 100% - 40% = 60%
Equity Shareholders Fund = 25,00,000 * 60%
Equity Shareholders Fund = 15,00,000
Debt = 25,00,000 – 15,00,000
Debt = 10,00,000

 ROE if interest on Debt is 10%:

Interest on Debt = 10,00,000 * 10%
Inte rest on Debt = 1,00,000
Calculation of Ne w income for Return on Equity (ROE) if interest on debt is 10%:

Particulars Amount (Rs.)

EBIT 6,00,000
Less: Interest –1,00,000
EBT 5,00,000
Less: Tax@30% –1,50,000
EAT 3,50,000
Return on Proprietors Equity if interest on the debt is 10%:

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 ROE if interest on Debt is 20%:

Interest on Debt = 10,00,000 * 20%
Inte rest on Debt = 2,00,000
Calculation of Ne w income for Return on Equity if interest on debt is 20%:
Particulars Amount (Rs.)
EBIT 6,00,000
Less: Interest –2,00,000
EBT 4,00,000
Less: Tax@30% –1,20,000
EAT 2,80,000
Return on Proprietors Equity if interest on the debt is 20%:

Conclusion:
This ratio establishes the relationship between the net profits available to equity shareholders
and the amount of capital invested by them. Net profit for the purpose of this ratio is taken
after dividend payable to preference shareholders if any. Equity shareholders funds include
equity capital, reserves and other undistributed profits .
Inte rpretation of Return on Equity:
This ratio is one of the most important ratios used for measuring the overall efficiency of a
firm. Higher the ratio, better are the results. The return on equity capital investment should be
compared with the return of other similar firms in the same industry. This ratio shows the
profit percentage for equity shareholders. A high rate of return on equity shareholders funds is
favoured by investors and a higher market valuation is placed on such shares.

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Ans wer: 2
Weighted Average Cost of Capital (WACC): The Weighted average cost of capital
(WACC) is the average after-tax cost of a company’s various capital sources, including
common inventory, preferred inventory, bonds and any other long-term debt. By taking the
weighted average, the WACC shows how much interest the company pays for every money it
finances.
Calculation of Weighted Average Cost of Capital (WACC):

Fund Source Amount Ratio (R) Cost (C) Weighted Cost (R*C)
Debt 5,00,00 0.5 0.08 0.5*0.08 = 0.04
Equity 5,00,00 0.5 0.14 0.5*0.14 = 0.07
Total 10,00,00 0.11
Comparison of Weighted Average Cost of Capital (WACC) and Inte rnal Rate of Return
(IRR):
Project WACC IRR of project IRR-WACC
Project A 11% 12.00% 1.00%
Project B 11% 11.50% 0.50%
Project C 11% 11.00% 0.00%
Project D 11% 10.50% -0.50%
Project E 11% 10.00% -1.00%
The primary difference between WACC and IRR is that where WACC is the expected
average future costs of funds (from both debt and equity sources), IRR is an investment
analysis ability used by companies to decide if a project should be undertaken. A close
relationship exists between WACC and IRR, however, because together these concepts help
to make the decision for IRR calculations.
As a whole, the IRR method indicates that a project whose IRR is greater than or equal to the
firm's cost of capital should be accepted, and a project whose IRR is less than the firm's cost
of capital should be rejected.
In the above comparison table between WACC and IRR, the IRR is higher in case of project
A and project B. so the company should invest in these projects. The total amount of
investment of both project A and project B will be Rs. 2,20,000 (1,00,000 + 1,20,000)
respectively.
Taking into account its target capital structure, the equity portion the company should
invest in these projects is as follows:
Project Total Investment Investment in Equity
Project A 1,00,000 50,000
Project B 1,20,000 60,000
Total 1,10,000

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Modigliani – Miller’s valuation model is based on the assumption of same discount rate
or rate of return applicable to all the stocks. The irrelevance approach can be
represented mathe matically as follows below:

Where,
P0 = Market price of the share at the beginning of a period.
P1 =Market price of the share at the end of a period.
Ke = Cost of Capital.
D 1 = Dividends received at the end of a period.

Important Note: Market price (P0 ) of the share at the beginning of a period and Market price
(P1 ) of the share at the end of a period is not given in the question. Therefore, the dividend
payout ratio cannot be calculated from the given data for the Kuber Company. In this
scenario, the company cannot follow Irrelevance Approach (Modigliani and Miller) or
residual dividend policy.

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Ans wer: 3
3a) The change in the net working capital between 2018 and 2017:
Introduction:
Working Capital: Working capital is the lifeblood and nerve centre of a business. Just as the
circulation of blood is essential in the human body for maintaining life, working capital is
very essential to maintain the smooth running of a business. No business can run successfully
without an adequate amount of working capital.
Working capital refers to that part of the firm’s capital which is required for financings short-
term or current assets such as cash, marketable securities, debtors, and inventories. In other
words, working capital is the number of funds necessary to cover the cost of operating the
enterprise.
Definition:
Working capital measures how much in liquid assets a company has available to build its
business or organisation. The number can be positive or negative, depending on how much
debt the company is carrying. In general, companies that have a lot of working capital will be
more successful since they can expand and improve their operations. Companies with
negative working capital may lack the funds necessary for growth. Working capital has
greater significance not only for small firms but also for large firms. The need for working
capital is directly related to sales growth.
The working capital tries to involve how much funds to be invested in each type of current
assets and what should be the proportion of long-term to short-term funds while financing
current. Working capital also gives investors an idea of the company's underlying operational
efficiency. Money that is tied up in inventory or money that customers still owe to the
company cannot be used to pay off any of the company's obligations. So, if a company is not
operating in the most efficient manner (slow collection), it will show up as an increase in the
working capital. This can be seen by comparing the working capital from one period to
another; slow collection may signal an underlying problem in the company's operations.
A measure of both a company's efficiency and its short-term financial health. The working
capital ratio is calculated as:

Positive working capital means that the company is able to pay o ff its short-term
liabilities. Negative working capital means that a company currently is unable to meet its
short-term liabilities with its current assets (cash, accounts receivable and inventory).
Working Capital is also known as "Net Working Capital", or the "Working Capital
Ratio".

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Calculation of Net working capital for the year between 2017 & 2018:
Particulars Year 2017 Year 2018
Curre nt Assets Amount (Rs. Lakhs) Amount (Rs. Lakhs)
Raw materials 20,00,000 30,00,000
Finished goods 15,00,000 15,00,000
Receivables 10,00,000 30,00,000
Other current assets 5,00,000 7,00,000
Total Current Assets (A) 50,00,000 82,00,000
Curre nt liabilities
Creditors 25,00,000 35,00,000
Other current liabilities 15,00,000 20,00,000
Total Current Liabilities (B) 40,00,000 55,00,000
Net Working Capital (A-B) 10,00,000 27,00,000

Inte rpretation and Analysis:

1. From the above table, net working capital is Rs. 10,00,000 and Rs. 27,00,000 for the years
2017 and 2018 respectively.
2. In the year 2018, there was an increase in the net working capital from the previous year.
3. From the above table or information, it can be seen that the net working capital is
increasing in the year 2018 with the increase in total current liabilities.

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3b) The change in MPBF limit assigned by the bank from the year 2017 to 2018:
Introduction:
MPBF stands for Maximum Permissible Banking Finance in Indian Banking Sector. As per
the recommendations of Tandon Committee, the organisations are discouraged from
accumulating of stocks of current assets and are considered to move towards very lean
inventories and receivable levels.
Depending on the size of the credit required, two methods are in practice to fund the working
capital needs of the corporate:
1. Method I
2. Method II
Explanation:
Method I: For organisations whose credit requirement is less than Rs.10,00,000/- banks can
find the working capital required. Working capital is calculated as the difference of total
current assets and current liabilities other than bank borrowings (called Maximum
Permissible Bank Finance or MPBF). Banks can finance a maximum of 75% of the
required amount and the rest of the 25% balance amount has to come out of long-term funds
of a working capital gap as margin.
Calculation of Net working capital for the year between 2017 & 2018:
Particulars Year 2017 Year 2018
Curre nt Assets Amount (Rs. Lakhs) Amount (Rs. Lakhs)
Raw materials 20,00,000 30,00,000
Finished goods 15,00,000 15,00,000
Receivables 10,00,000 30,00,000
Other current assets 5,00,000 7,00,000
Total Current Assets (A) 50,00,000 82,00,000
Curre nt liabilities
Creditors 25,00,000 35,00,000
Other current liabilities 15,00,000 20,00,000
Total Current Liabilities (B) 40,00,000 55,00,000

Method I = MPBF for the Year 2017:

Where,
TCA = Total Current Asset.
OCL = Other Current Liabilities.

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Method 1 = MPBF for the Year 2018:

Where,
TCA = Total Current Asset.
OCL = Other Current Liabilities.

Under MPBF approach method, the banks will fix the working capital finance limits of an
organisation at either 75% of the company’s current assets or the difference between 75% of
current assets and non-bank current liabilities. The essential concept of the approach is that
insufficient for credit and must be controlled or restricted.
Method II: For organisations with credit requirement of more than Rs.10,00,000/- this
method is used. In this method of approach, the borrower finances a minimum of 25% of its
total current assets out of long-term funds. The rest will be provided by the bank through
MPBF. Thus, total current liabilities inclusive of bank borrowings cannot exceed more than
75% of current assets.
Method II = MPBF for the Year 2017:

Where,
TCA = Total Current Asset.
OCL = Other Current Liabilities.

Method II = MPBF for the Year 2018:

Where,
TCA = Total Current Asset.
OCL = Other Current Liabilities.

Under this method, the minimum acceptable current ratio was identified, thus fixing the
minimum contribution of the corporate to funding working capital gap margin. At the same
time, the maximum current assets extents were prescribed through a series of inventories and
receivables standards.
Conclusion:
I have calculated above the MPBF by two methods for the year 2017 and 2018 respectively,
and there is lots of difference in the MPBF amount. MPBF amounts are less in both methods,
if we compare the two years i.e., 2017 and 2018, the working capital financing by the bank
will be decreased rapidly.

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