Corporate Finance

June 2024 Examination

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?

Calculate showing formula and detailed working. Amounts may be rounded off to nearest
rupee. (10 marks)

Ans 1. Introduction

A Recurring Deposit (RD) is a type of term deposit offered by banks and financial institutions. It
allows individuals to deposit a fixed amount of money at regular intervals, typically monthly, for a
predetermined period of time. The deposited amount earns a fixed rate of interest, similar to a
Fixed Deposit (FD), but instead of depositing a lump sum amount at once, you contribute smaller
amounts periodically.

Concept & Application

To calculate the value of Sanjana's investment at the end of 15 years, we can use the formula for the future
value of an ordinary annuity:

Value of Investment at the End of 15 Years

We have two annuities:
1. An annuity of Rs. 2,000 per year for 5 years
2. An annuity of Rs. 3,000 per year for the next 10 years
Using the formula for the future value of an ordinary annuity:
FV = P1 * ((1 + r)^n1 - 1) / r * (1 + r)
+ P2 * ((1 + r)^n2 - 1) / r * (1 + r)
Where:
 FV = Future Value
 P1, P2 = Annual payments
 r = Interest rate per period
 n1, n2 = Number of periods

Plugging in the values:

FV = 2000 * ((1 + 0.10)^5 - 1) / 0.10 * (1 + 0.10)
+ 3000 * ((1 + 0.10)^10 - 1) / 0.10 * (1 + 0.10)
Calculating this will give us the value of her investment at the end of 15 years.

Lumpsum Payment of Rs. 1,00,000 at the End of 15 Years

To find the sum Sanjana needs to invest each year for 15 years to receive a lump sum of Rs. 1,00,000 at the
end of 15 years, we can use the formula for the present value of an ordinary annuity:
PV = PMT * ((1 - (1 + r)^-n) / r)
Where:
 PV = Present Value
 PMT = Annual payment
 r = Interest rate per period
 n = Number of periods

Plugging in the values:

100000 = PMT * ((1 - (1 + 0.10)^-15) / 0.10)
Solving for PMT will give us the annual payment Sanjana needs to make for 15 years to receive Rs. 1,00,000
at the end of 15 years.
Here's an interpretation of how a Recurring Deposit works:
1. Regular Deposits: You commit to depositing a fixed amount of money into the RD account at regular
intervals, usually monthly. This can be as low as a few hundred rupees to a higher amount, depending on the
bank's policies and your financial capability.
2. Fixed Tenure: When you open an RD account, you agree upon a specific tenure for which you will
continue making these deposits. Typically, RDs have a tenure ranging from 6 months to 10 years, but this
can vary among different banks.
3. Interest Rate: The interest rate offered on an RD is predetermined by the bank and remains fixed for the
entire tenure. Generally, the interest rates for RDs are lower than those for Fixed Deposits because the bank
gets to hold the money for a longer duration.
4. Interest Calculation: Interest on RDs is typically compounded quarterly. The interest earned is added to
the principal amount, and subsequent interest calculations are based on this increased amount.
5. Maturity Amount: At the end of the RD tenure, you receive the total amount deposited along with the
accumulated interest. This maturity amount is paid out either as a lump sum or can be reinvested into another
RD or any other investment option of your choice.
6. Penalties for Default: If you miss depositing the monthly installment, banks may levy penalties, and the
interest earned may also be lower for that specific period.
7. Tax Implications: Interest earned on RDs is taxable as per your income tax slab. However, banks
deduct TDS (Tax Deducted at Source) if the interest earned exceeds a certain threshold.
8. Flexible Withdrawals: Unlike Fixed Deposits where premature withdrawals might incur penalties, RDs
offer more flexibility. You can withdraw the amount anytime during the tenure, but this may affect the
interest earned and could also lead to penalties.

Conclusion

Overall, RDs are suitable for individuals looking for a disciplined approach to saving and earning
a steady return on their investment over a fixed period. It's a low-risk investment option,
particularly for those who can commit to regular deposits and don't require immediate access to
their funds.

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? (10 marks)

Ans 2. Introduction

Atharva Textiles is navigating through turbulent waters marked by declining profits, primarily
attributed to inefficiencies in inventory management. Inventory management, a critical aspect of
operations for manufacturing and retail businesses, involves a careful balance between order
quantities, holding costs, and order costs to ensure the availability of products while minimizing
expenses.
Concept & Application

Inventory management plays a crucial role in the profitability of any business, including
Atharva Textiles. Here's how poor inventory management could contribute to declining
profits and some strategies to address this issue:

1. Overstocking: Holding excess inventory ties up capital and incurs storage costs. If Atharva
Textiles has been overstocking raw materials, work-in-progress, or finished goods, it can lead to
increased carrying costs, obsolescence, and the risk of products becoming outdated. This ties up
capital that could be used more effectively elsewhere in the business.

Solution: Implement inventory forecasting techniques to better predict demand and adjust
procurement accordingly. Utilize inventory management software to track inventory levels in real-
time and automate reordering processes.

2. Underutilized Inventory: Unused or slow-moving inventory can also contribute to declining

profits. If certain fabrics, materials, or finished products are not selling as expected, they can tie
up valuable warehouse space and capital.

Solution: Conduct regular inventory audits to identify slow-moving items and take proactive
measures to clear them out. Consider offering discounts, bundling products, or repurposing
materials to reduce excess inventory levels.

3. Stockouts: Conversely, inadequate inventory levels can result in stockouts, leading to lost
sales and dissatisfied customers. If Atharva Textiles frequently runs out of popular products or
materials, it can impact revenue and customer loyalty.

Solution: Optimize inventory replenishment processes to ensure adequate stock levels while
minimizing excess inventory. Set up automated reorder points based on historical sales data and
lead times to prevent stockouts.
4. Inefficient Production Planning: Inefficient production planning and scheduling can lead to
bottlenecks, delays, and excess work-in-progress inventory. If production processes are not
streamlined, it can result in increased lead times and production costs.

Solution: Implement lean manufacturing principles to optimize production workflows and reduce
lead times. Utilize production scheduling software to balance workloads, prioritize orders, and
improve resource utilization.

5. Inaccurate Demand Forecasting: Poor demand forecasting can result in inaccurate

inventory projections, leading to either overstocking or stockouts. If Atharva Textiles fails to
anticipate changes in customer preferences or market demand, it can impact inventory
management.

Solution: Invest in data analytics and market research to better understand customer behavior and
forecast demand more accurately. Collaborate with sales and marketing teams to gather insights
and adjust inventory plans accordingly.

To determine the current Total Inventory Cost and find the Optimum Order Quantity (EOQ),
we can use the Economic Order Quantity formula and the Total Inventory Cost formula.

1. Current Total Inventory Cost: Total Inventory Cost = (Purchase price per unit * Average
inventory held) + (Cost incurred per order * Number of orders) + (Carrying cost per unit * Average
inventory held)

Given:

• Purchase price per unit = Rs. 1000

• Cost incurred per order = Rs. 600

• Number of orders = 30
• Carrying cost = 5% of purchase price per unit

• Average inventory held = 2500 units

Substituting the values: Carrying cost per unit = 5% of Rs. 1000 = Rs. 50 Total Inventory Cost =
(1000 * 2500) + (600 * 30) + (50 * 2500)

Total Inventory Cost = 25,00,000 + 18,000 + 1,25,000 = Rs.

26,43,000
Therefore, the current Total Inventory Cost is Rs. 26,43,000.

2. Optimum Order Quantity (EOQ): EOQ = √[(2 * Demand * Cost per order) / Carrying cost
per unit]

Given:

• Annual demand = 1,65,000 units

• Cost per order = Rs. 600

• Carrying cost per unit = Rs. 50

Substituting the values: EOQ = √[(2 * 165000 * 600) / 50]

EOQ = √(19,80,00,000 / 50) = √3,96,000 = 630 units

(approximately)
Therefore, the Optimum Order Quantity to minimize the cost is
approximately 630 units.
3. Total Inventory Cost at EOQ: Total Inventory Cost = (Purchase price per unit * EOQ / 2) +
(Cost incurred per order * Annual demand / EOQ) + (Carrying cost per unit * EOQ / 2)

Now, let's calculate:

1. Current Total Inventory Cost: Total Inventory Cost = (1000 * 2500) + (600 * 30) + (50 *
2500)

2. Optimum Order Quantity (EOQ): EOQ = √[(2 * 165000 * 600) / 50]

3. Total Inventory Cost at EOQ: Total Inventory Cost = (1000 * EOQ / 2) + (600 * 165000 /
EOQ) + (50 * EOQ / 2)

Total Inventory Cost (at EOQ) = 6,30,000 + 9,95,238 + 31,500 = Rs.

16,56,738 (approximately)
Therefore, the Total Inventory Cost at EOQ is approximately Rs.
16,56,738.

Conclusion

Once we calculate these values, we can determine the current Total Inventory Cost and the Total
Inventory Cost at the Optimum Order Quantity level.

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? (5 marks)

Ans 3a.

Introduction:

In an ever-evolving business landscape, managing credit terms is critical for financial stability and
growth. Priya Industries, operating in a competitive market, faces the decision of extending its
credit period to enhance sales. This analysis delves into the implications of such a move,
considering factors like increased sales, investment in receivables, cost of funds, and customer
satisfaction.

Concept & Application

To calculate the investment in additional receivables due to the increased credit period, we need to
compare the difference in closing debtor balances before and after the extension. Then, we can
determine the increase in investment in receivables.

1. Initial Investment in Receivables: Initial closing debtor balance = Rs. 3,00,000

2. New Investment in Receivables: New closing debtor balance = Rs. 4,24,000

3. Increase in Investment in Receivables: Increase in investment = New closing debtor balance -

Initial closing debtor balance

Now, let's calculate:

Increase in investment = Rs. 4,24,000 - Rs. 3,00,000

To assess the effectiveness of the additional credit period and decide whether Priya Industries
should continue with the relaxed credit or reinstate it to 30 days, several considerations should be
taken into account:

1. Impact on Sales: Evaluate whether the increase in sales justifies the extension of the credit
period. Analyze if the 10% increase in sales volume compensates for the potential increase in bad
debts and financing costs associated with the extended credit period.

2. Profitability: Assess the impact of the extended credit period on profitability. Consider the
additional variable costs incurred due to the increase in sales volume, as well as the cost of funds
associated with financing the additional receivables.

3. Cash Flow: Examine the effect of the extended credit period on cash flow. Determine if the
delay in receiving payments from customers adversely affects the company's liquidity and ability
to meet its financial obligations.

4. Risk of Bad Debts: Evaluate the risk of bad debts associated with the extended credit period.
Consider the creditworthiness of customers and the likelihood of payment default, especially with
the longer credit term.

5. Opportunity Cost: Consider the opportunity cost of tying up funds in receivables for a longer
period. Assess whether the benefits of increased sales outweigh the cost of financing the additional
investment in receivables.

6. Competitive Position: Analyze the impact of the extended credit period on Priya Industries'
competitive position. Determine if the longer credit term provides a competitive advantage
compared to competitors or if it erodes profitability.

Conclusion
Based on these considerations, Priya Industries should weigh the benefits and drawbacks of the
extended credit period and make an informed decision on whether to continue with the relaxed
credit or revert to the original credit term of 30 days. They should strive to strike a balance
between increasing sales and profitability while maintaining healthy cash flow and managing the
risk of bad debts. Additionally, they should monitor the impact of the extended credit period
closely and be prepared to adjust their credit policies accordingly to optimize business
performance.

b) 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? (5marks)

Ans 3b.

Introduction

The Degree of Operating Leverage (DOL) is a financial metric that helps determine a company’s
earning potential and its sensitivity to changes in sales volume, reflecting on the company’s fixed
and variable costs.

Concept & Application

To calculate the Contribution Margin and Degree of Operating Leverage (DOL) for the given
scenario, let's break down the information provided:

1. Selling price per basket (SP) = Rs. 100

2. Number of baskets sold (Q) = 2000

3. Variable cost per basket (VC) = Making charge per basket = Rs. 50
4. Fixed operating cost (F) = Rs. 50,000

Using this information, we can calculate the Contribution Margin (CM) and Degree of Operating
Leverage (DOL) using the following formulas:

Contribution Margin (CM) = SP - VC Degree of Operating Leverage (DOL) = Contribution Margin

/ Profit Before Interest and Taxes (PBIT)

First, let's calculate the initial Contribution Margin (CM) and Degree of Operating Leverage
(DOL):

1. Contribution Margin (CM): CM = SP - VC = Rs. 100 - Rs. 50 = Rs. 50

2. Total Revenue (TR) = SP * Q = Rs. 100 * 2000 = Rs. 2,00,000

Total Variable Cost (TVC) = VC * Q = Rs. 50 * 2000 = Rs. 1,00,000

Total Contribution Margin (TCM) = TR - TVC = Rs. 2,00,000 - Rs. 1,00,000 = Rs. 1,00,000

3. Profit Before Interest and Taxes (PBIT) = TCM - F = Rs. 1,00,000 - Rs. 50,000 = Rs. 50,000

4. Degree of Operating Leverage (DOL): DOL = CM / PBIT = Rs. 50,000 / Rs. 50,000 = 1

Now, let's calculate the impact of a 50% increase in Selling Price (SP) on the Contribution Margin
(CM) and Degree of Operating Leverage (DOL):

1. New Selling Price (SP_new) = Rs. 100 + 50% of Rs. 100 = Rs. 150

2. New Contribution Margin (CM_new) = SP_new - VC = Rs. 150 - Rs. 50 = Rs. 100

3. Total Revenue (TR_new) = SP_new * Q = Rs. 150 * 2000 = Rs. 3,00,000

4. Total Variable Cost (TVC_new) = VC * Q = Rs. 50 * 2000 = Rs. 1,00,000

5. Total Contribution Margin (TCM_new) = TR_new - TVC_new = Rs. 3,00,000 - Rs. 1,00,000
= Rs. 2,00,000

6. Profit Before Interest and Taxes (PBIT_new) = TCM_new - F = Rs. 2,00,000 - Rs. 50,000 =
Rs. 1,50,000

7. Degree of Operating Leverage (DOL_new) = CM_new / PBIT_new = Rs. 100 / Rs. 1,50,000 ≈
0.67

The change in Degree of Operating Leverage (DOL) signifies the sensitivity of the company's
profits to changes in sales volume. A higher DOL indicates that a small change in sales volume
will lead to a proportionately larger change in profits, assuming all other factors remain constant.
Conversely, a lower DOL implies that changes in sales volume will have a smaller impact on
profits.

Conclusion

In this case, the decrease in DOL from 1 to approximately 0.67 indicates that the firm's profit is
less sensitive to changes in sales volume after the increase in Selling Price (SP) by 50%. This
suggests that the firm's operating leverage has decreased, possibly due to a smaller proportion of
fixed costs relative to total costs.