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Suman Joshi, Managing director of omega textile, was reviewing two very
different investment proposals. The first one is for expanding the capacity
of the current project and the second is for diversifying into a new line of
business.
We need to find WACC (weighed average cost of capital) with the help of
following data.
Amou
Liabilities Amount Assets nt
Debentures 450
Current liabilities &
provision 100
1200 1200
Page 1
Case Study Analysis
Omegas equity share is currently selling at Rs.80 per share. Its last
dividend was Rs.2.80 and the dividend per share is expected to
grow at a rate of 10 percent in future.
Omegas equity beta is 1.1, the risk free rate is 7 percent, and the
market risk premium is estimated to be 7 percent.
Omegas tax rate is 30 percent.
Questions:
Page 2
Case Study Analysis
SOLUTION:
(PVIF Kd, n)
At 7%
112 = 10(PVIFA 7%, 8) + 100(PVIF )
7%, 8
= 10(5.971) + 100(0.582)
=59.71+58.2
=117.91
At 8%
112 = 10(PVIFA 8%, 8) + 100(PVIF )
8%, 8
= 10(5.747) + 100(0.540)
= 57.47 + 54.0
= 111.47
Interpolation:
Actu Differen
al 112 ce
Page 3
Case Study Analysis
5.91
at 117.9
7% 1
6.44
at 111.4
8% 7
= 0.07 + (0.08-0.07)5.91/6.44
=7.92 %
)
Kp, n
At 7%
= 9(4.100) + 100(0.713)
=36.9 + 71.3
=108.2
At 8%
= 9(3.993) + 100(0.681)
Page 4
Case Study Analysis
= 35.937 + 68.1
= 104.03
Interpolation:
Actu Differenc
al 106 e
2.2
at
7% 108.2
4.17
at 104.0
8% 3
= 0.07 + (0.08-0.07)2.2/4.17
=7.53
Ke = Div1 / P0 + g
=2.80(1.10)/80+ 0.10
= 13.85%
Page 5
Case Study Analysis
= 7 + 1.1(7)
= 14.70%
7. What would be your estimate cost of capital for the new business?
Source
s of Proport WAC
fund ion Cost C
Equity 0.5 17.5 8.75
Debentu
re 0.5 7.7 3.85
12.6
Ke = Rf + (Rm-Rf)
= 7 + (7) 1.5
= 17.5%
Page 6
Case Study Analysis
Page 7
Case Study Analysis
the data and provide the result to the head of that bank. But he finds that
lending can only be done by following second method of Tondon
committee. For this approval he has to get an approval from head office as
lending amount exceeds 1 crore.
Tondon committee:
Page 8
Case Study Analysis
3. Bank should ensure proper end use of bank credit by keeping a closer
watch on the borrowers business, and impose financial discipline on
them.
Stock in Process.
Finished goods.
Accounts receivables.
Methods of lending:
Page 9
Case Study Analysis
Back to case:
From borrowers file we find that the limits sanctioned to him are subject to
the following norms:
In assessing the working capital advance the bank will follow the average
holding levels prevalent in their industry, which as updated on 01-04-2011
are as follows:
Q:1 The holding levels for raw materials, work in process, finished goods,
debtors and creditors as seen from borrowers own projections.
Page 10
Case Study Analysis
Q: 2 MPBF under the second method of lending as per the norms set by
the bank
Solution:
Answer 1:-
=60/180*12
=4 Month
=20/380*12
=0.6315 Month
=50/380*12
=1.57 Month
=240 / 700 * 12
= 4.11 Months
=130 / 190 * 12
Page 11
Case Study Analysis
=8.21 Months
Answer: 2
As per the Tondon committee MPBF (Maximum Possible Bank Finance) the
value of the current assets must be 25% of the total current assets. So
this criteria is satisfied by the available data for projected year.
Under this method, it was thought that the borrower should provide for a
minimum of 25% of total current assets out of long-term funds i.e., owned
funds plus term borrowings. A certain level of credit for purchases and
other current liabilities will be available to fund the build up of current
assets and the bank will provide the balance (MPBF). Consequently, total
current liabilities inclusive of bank borrowings could not exceed 75% of
current assets.
As both the conditions are satisfied by the clients data Bank can provide
extra working capital of 60 lacs.
Answer: 3
Here, we have two option through which we can increase in working capital or not.
Because we can not satisfy the criteria of companys standard. As per companys standard
holding level for raw material is 3 months of consumption But as per projection it is 4
months. So it is not good for firm. Working process is 0.5 months of cost of production but as
per projection it is 0.6 month Which is not good for company, finished goods is 2 months of
cost of sales and as per projection it is 1.57.
Page 12
Case Study Analysis
Here company can get benefit in Creditors Deferral Period. Because as per companys
standard credit period is 2 months of purchase but as per projection it is 8.21 Months. So
company can enjoy credit of 8 months. Which is beneficial for the company?
Under this method, it was thought that the borrower should provide for a minimum of
25% of total current assets out of long-term funds i.e., owned funds plus term borrowings.
A certain level of credit for purchases and other current liabilities will be available to fund
the build up of current assets and the bank will provide the balance Maximum permissible
banking finance (MPBF). Consequently, total current liabilities inclusive of bank
borrowings could not exceed 75% of current assets.
Here, company can fulfill all the criteria of tendon Committee and through which company
can increase in working capital.
Page 13