Corporate Finance Tentative Soln by VIJAY

Que 1 Sanjana decides to invest in a Recurring Deposit at the rate of Rs. 2,000 per year
for 5 years and at Rs. 3000 per year for next 10 years. What shall be the value of her
investment at the end of 15 years, if the rate of interest is 10%?

If she wants to receive a lumpsum payment of Rs. 1,00,000 at the end of 15 years,
what should be the sum invested each year for 15 years at the same interest rate?

Solution

To solve the problem, we need to calculate the future value of Sanjana's Recurring Deposit
(RD) investments. Then, we'll determine the yearly investment required to receive a
lumpsum payment of Rs. 1,00,000 at the end of 15 years at the same interest rate.

Part 1: Future Value of Sanjana's Investment

Sanjana invests Rs. 2,000 per year for the first 5 years and Rs. 3,000 per year for the next
10 years. The interest rate is 10% per annum.

For the first 5 years:

Each Rs. 2,000 invested at the end of each year will grow with compound interest till the
end of the 15th year. We can use the future value of annuity formula to calculate the value
at the end of 15 years.

The future value of an annuity formula is:

Here, ( P = 2000 ) (annual investment), ( r = 10% = 0.10 ), and the number of periods
( n ) will vary because each annual investment has different number of years to
compound.

- The investment at the end of the 1st year will compound for 14 years.

- The investment at the end of the 2nd year will compound for 13 years.

- And so on, until the investment at the end of the 5th year will compound for 10

years. Calculating each:

[ FV_1 = 2000 (1 + 0.10)^{14} ]

[ FV_2 = 2000 (1 + 0.10)^{13} ]

[ FV_3 = 2000 (1 + 0.10)^{12} ]

[ FV_4 = 2000 (1 + 0.10)^{11} ]

[ FV_5 = 2000 (1 + 0.10)^{10} ]

Summing these values gives the total future value of the first 5 years of investment.

For the next 10 years:

Each Rs. 3,000 invested annually will compound similarly:

- The investment at the end of the 6th year will compound for 9 years. - The
investment at the end of the 7th year will compound for 8 years. - And so on,
until the investment at the end of the 15th year will compound for 0 years.

Calculating each:

[ FV_6 = 3000 (1 + 0.10)^9 ]

[ FV_7 = 3000 (1 + 0.10)^8 ]

[ FV_8 = 3000 (1 + 0.10)^7 ]

[ FV_9 = 3000 (1 + 0.10)^6 ]

[ FV_{10} = 3000 (1 + 0.10)^5 ]

[ FV_{11} = 3000 (1 + 0.10)^4 ]

[ FV_{12} = 3000 (1 + 0.10)^3 ]

[ FV_{13} = 3000 (1 + 0.10)^2 ]

[ FV_{14} = 3000 (1 + 0.10)^1 ]

[ FV_{15} = 3000 (1 + 0.10)^0 ]

Summing these values gives the total future value of the next 10 years of

investment. Total Future Value:

The total future value at the end of 15 years is the sum of the future values from the first 5
years and the next 10 years.

Part 2: Yearly Investment for a Lumpsum Payment of Rs. 1,00,000

To receive a lumpsum payment of Rs. 1,00,000 at the end of 15 years, with an annual
interest rate of 10%, we use the future value of annuity formula again:
P=3147
So, Sanjana should invest approximately Rs. 3,147.50 per year to receive a lumpsum
payment of Rs. 1,00,000 at the end of 15 years at an interest rate of 10%.

Question 2

Atharva Textiles is suffering from declining profits, one of the key reasons for which has
been pointed out as Inventory Management. The following details are collated by the
Finance Manager: Purchase price per unit is Rs. 1000. Cost incurred at the time of each
order is Rs. 600. The no. of orders placed in a year are 30. The firm incurs a cost of 5% to
carry Inventory cost. Average inventory held 2,500 units. Determine the current Total
Inventory Cost. Also advise what should be the Optimum Order quantity to minimize the
cost, if the annual demand for the enterprise is 1,65,000 units. What shall be the Total
Inventory Cost at that level

Solution

To determine the current Total Inventory Cost and the Optimum Order Quantity for Atharva
Textiles, we need to calculate the following components:
1. Current Total Inventory Cost:

- Ordering Cost

- Carrying Cost

2. Optimum Order Quantity using the Economic Order Quantity (EOQ)

model: - Ordering Cost at EOQ

- Carrying Cost at EOQ

Current Total Inventory Cost

Summary

- Current Total Inventory Cost: Rs. 1,43,000

- Optimum Order Quantity (EOQ): 1,990 units

- Total Inventory Cost at EOQ: Rs. 99,550

 By using the EOQ model, Atharva Textiles can reduce its total inventory cost from Rs.
1,43,000 to Rs. 99,550.

Question 3a

Priya Industries sells their products at Rs. 80 per unit. They incur a Variable cost of Rs. 45 to
make the product. Annual credit sales of Priya Limited is 50,000 units. They give a month’s
credit and have a closing debtor balance of Rs. 3,00,000. The Finance manager decides to
increase the credit period from existing 30 days to 45 days. They have an increase in sales
quantity by 10% with the closing debtors balance going up to Rs. 4,24,000. Cost of funds for
the firm is 20%. Calculate the investment in additional receivables. What should be the
considerations to assess the effectiveness of the additional credit period? Should Priya
Industries continue with the relaxed credit or reinstate it to 30 days?

Solution

To determine whether Priya Industries should continue with the extended credit period, we
need to calculate the investment in additional receivables and evaluate the impact of this
change on the company's profitability. Here are the steps:

1. Calculate the investment in additional receivables

First, we need to determine the change in the receivables balance due to the extended credit period.

Original Scenario (30 days credit)

- Annual credit sales: 50,000 units

- Selling price per unit: Rs. 80

- Monthly sales (in units): (frac{50,000}{12} approx 4,167) units

[ {Closing Debtor Balance at 30 days} = Rs. 3,00,000 ]

New Scenario (45 days credit)

- Sales increase by 10%, so new annual sales: (50,000 times 1.10 =

55,000) units - Monthly sales (in units): (frac{55,000}{12} approx 4,583)
units

[ {Closing Debtor Balance at 45 days} = Rs. 4,24,000 ]

Investment in Additional Receivables

[ {Investment in Additional Receivables} = {New Debtor Balance} - {Old Debtor

Balance} ] [ {Investment in Additional Receivables} = 4,24,000 - 3,00,000 = Rs.

1,24,000 ] 2. Assess the Effectiveness of the Additional Credit Period

To assess whether the additional credit period is beneficial, we need to consider the
additional profit generated from the increased sales and the cost of the additional investment
in receivables.

Additional Sales and Contribution Margin

- Additional sales due to the extended credit period: (55,000 - 50,000 =

5,000) units - Contribution margin per unit: ( {Selling price per unit} -
{Variable cost per unit} )

[ {Contribution Margin per Unit} = 80 - 45 = Rs. 35 ]

- Additional contribution margin from increased sales:

[ {Additional Contribution} = 5,000 times 35 = Rs. 1,75,000 ]

Cost of Additional Investment in Receivables

- Cost of funds for the firm: 20%

- Cost of additional investment in receivables:

[ {Cost of Additional Receivables} = 1,24,000 times 0.20 = Rs. 24,800 ]

Net Benefit/Loss

[ {Net Benefit} = {Additional Contribution} - {Cost of Additional

Receivables} ] [ {Net Benefit} = 1,75,000 - 24,800 = Rs. 1,50,200 ]

Considerations for Effectiveness

1. Net Benefit: The net benefit of Rs. 1,50,200 indicates that the increase in sales and the
resulting contribution margin outweigh the cost of the additional investment in receivables.

2. Cash Flow Impact: Assess whether the company can comfortably manage the
increased level of receivables without facing liquidity issues.

3. Credit Risk: Evaluate if the longer credit period might increase the risk of defaults or
delayed payments from customers.

4. Competitive Advantage: Consider if the extended credit period provides a competitive

advantage that could lead to longer-term benefits in market share or customer loyalty.

5. Operational Capacity: Ensure that the company has the operational capacity to
handle the increased sales volume effectively without compromising on quality or
delivery times.

Conclusion

Given the calculated net benefit of Rs. 1,50,200, Priya Industries should continue with the
extended credit period of 45 days as it leads to a substantial increase in profitability.
However, they should
also monitor the factors mentioned above to ensure that this policy remains beneficial in
the long term.

3b

A firm sells 2000 baskets at Rs. 100 each. The Basket has a making charge of Rs. 50 each
and a fixed operating cost of manufacture of Rs. 50,000/year. Calculate the Contribution
and DOL. Also show the impact if SP increases by 50% on the contribution and DOL.
What does the change in DOL signify?

Soln

To calculate the Contribution and Degree of Operating Leverage (DOL) for the firm, and to
analyze the impact of a 50% increase in the selling price, we'll follow these steps:

1. Calculate Contribution

Contribution per unit is calculated as:

[ {Contribution per Unit} = {Selling Price per Unit} - {Variable Cost per Unit} ]

Given:

- Selling price (SP) per unit = Rs. 100

- Making charge (variable cost) per unit = Rs. 50

[ {Contribution per Unit} = 100 - 50 = Rs. 50 ]

Total Contribution is:

[ {Total Contribution} = {Contribution per Unit} times {Quantity Sold} ]

[ {Total Contribution} = 50 times 2000 = Rs. 1,00,000 ]

Significance of Change in DOL

The Degree of Operating Leverage (DOL) measures the sensitivity of operating income to
changes in sales volume. A higher DOL indicates that a small change in sales volume will
result in a larger change in operating income. Conversely, a lower DOL indicates less
sensitivity.
Interpretation:

- Original Scenario: With a DOL of 2, a 1% increase in sales would result in a 2% increase in

operating income.

- New Scenario (after SP increase): With a DOL of 1.33, a 1% increase in sales would result
in a 1.33% increase in operating income.

The reduction in DOL from 2 to 1.33 signifies that the firm's operating income has become
less sensitive to changes in sales volume after the price increase. This is because the
higher selling price increases the contribution margin, thereby reducing the proportion of
fixed costs relative to the total contribution. As a result, the firm benefits from increased
stability in operating income, even though the percentage impact of changes in sales
volume on operating income is reduced.