Masters of Business Administration Semester 2 MB0045 Financial Management

Assignment Set- 2

Q1. Given the following information, prepare a cash budget: Month Sales Purchases Wages Production overheads Jan 100000 40000 10000 6000 Feb 120000 45000 15000 6500 March 150000 35000 18000 7000 April 160000 30000 20000 7700 May 175000 25000 22000 8000 June 200000 20000 24000 8500

Selling overheads 6000 6500 6600 6800 6200 6300

The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000. The company has a opening balance of cash of Rs. 40,000 on 1st Jan 2010. Prepare a cash budget for Jan to June.
Particulars Opening cash balance Cash receipts: Cash sales Credit sales Total cash available Cash payments Materials Wages Production overheads Jan 40000 50000 90000 Feb 90000 60000 25000 175000 40000 10000 6000 March 113000 75000 55000 243000 45000 15000 6500 April 170000 80000 67500 317500 35000 18000 7000 May 225900 87500 77500 390900 30000 20000 7700 June 326400 100000 83750 510150 25000 22000 8000

Selling overheads Purchase of asset Total cash payments Closing cash balances

6000 0 90000 62000 113000

6500 73000 170000

6600 25000 91600 225900

6800 64500 326400

6200 61200 448950

Working Notes: Credit Sales Calculation

Month Monthly Sales Cash Sales Credit Sales Receipts

Jan 100000 50000

Feb 120000 60000 25000 - Jan

Mar 150000 75000 25000 - Jan 30000 - Feb

Apr 160000 80000 30000 - Feb 37500 - Mar 147500

May 175000 87500 37500 - Mar 40000 April 165000

Jun 200000 100000 40000 April 43750 May 183750

50000

85000

130000

Q2. Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement. Raw material Direct labour Overheads Total cost Profit Selling price 60 22 44 126 18 140

The following additional information is available: Average raw material in stock one month Average materials in process 15 days Credit allowed by suppliers one month Credit allowed to debtors two months Time lag in payment of wages 15 days Time lag in payment of overheads one month Sales on cash basis 20% Cash balance to be maintained 80,000 You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.

As the annual level of acitivity is given at 1,00,000 units, it means that the monthly turnover

would be 1 , 0 0 ,000/12=8,333 units. The working capital requirement for this monthly turnover can now be estimated as follows : Estimation of Working Capital Requirements 1 Current Assets : Amount (Rs.) Amount (Rs.) Minimum Cash Balance 80,000 Inventories : 5,00,000 Raw Materials (8,333Rs. 6 0) Work-in-progress : 2,50,000 Materials (8,333Rs. 6 0)/2 Wages 50% of (8,333Rs. 22)/2 45,833 Overheads 50% of (8,333Rs. 44)/2 91,667 Finished Goods (8,333Rs. 126) 10,50,000 Debtors (8,333Rs. 12680%) 8,40,000 28,57,500 Gross Working Capital 28,57,500 II Current Liabilities : 5,00,000 Creditors for Materials (8,333Rs. 6 0) Creditors for Wages (8,333Rs. 22)/3 61,111 Creditors for Overheads (8,333Rs. 44) 3,66,667 9,27,778 9,27,778 Total Current Liabilities 19,29,722 Net Working Capital Working Notes : For Calculations Monthly Turnover is taken as 8,333.33 In the valuation of work-in-progress, the raw materials have been taken at full requirements for 15 days; but the wages and overheads have been taken only at 50% on the assumption that on an average all units in work-in-progress are 50% complete. 3 . Since, the wages are paid with a time lag of 10 days, the working capital provided by wages has been taken by dividing the monthly wages by 3 (assuming a month to consist of 30 days). 1. 2. Q3. Given the following information, calculate the weighted average cost of capital. Capital structure in millions Equity capital ( Rs.10 par value) 2 14% preference share capital Rs.100 each 1.5 Retained earnings 2 12% Debentures Rs.100 each 4 8% term loan 0.5 Total 10 The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital. Kre/ke=rf + b(er(m) rf

= 15% Kp = d/np=1.4/115=1.215% Kd= i(1-t)+((rv-np)/n)/(rv+np)/2 =35(1-0.3)+((100-110)/5)/(100+110)/2 =21.42% Kd term loan=i(1-t)/np=(8(1-0.3)/110 =5.09% The Weighted Average Cost of Capital (WACC) is 5.09%

Q4. Calculate the present value of the following options: a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years (a) Present value for receiving Rs.10000 after 5 years at the prevailing interest rate of 10%

The present Value PV =FV{1/(1+i)^n} Where FV =Rs.10000 i = 10% n=5 PV = 10000{1/(1+0.10)^5)} =10000{1/1.61051)} =Rs.6209.21 (b) Present value for receiving Rs.10000 after 5 years at the prevailing interest rate of 10% payable semiannually. The present Value PV = FV{1/(1+i/m)n*m} Where FV = Rs.10000 i = 10% n=5 m=2 PV = 10000{1/(1+0.10/2)^5*2} = 10000{1/(1.62889)} =Rs. 6139.13 (c) The present value to receive to receive Rs. 5000., Every year for 5 years at the prevailing rate of 10% PA is PV = 5000* PVIFA (10%, 5Y) PV = 5000*{1 (1+i)^-5}/i

= 5000*{1 (1+0.1)^-5}/0.1 = 5000*(1 0.629092) =Rs.18953.00 (d) (1) Present Value for Rs. 5000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present value PV = FV / (1+ i)^n Where FV = Future value = 5000 i n = 10% =5 = 5000/1.61051 = Rs.3105.00 (2) Present Value for Rs. 10000 to be received after 5 years if the prevailing rate of interest is 10%pa. Present value PV = FV / (1+ i)^n Where FV = Future value = 10000 i n = 10% = 10 = 10000/2.59374 = Rs.3855.00 Q5. Explain each of the following: a) Operating cycle b) Shareholders wealth maximisation c) Capital rationing d) Economic order quantity a) Operating cycle: It is the time period involved in the conversion of raw material/resources into finished goods or services including the credit period involved for selling products/services. In simple language. let me give you an extreme example Suppose a business buy raw material on 1st jan and it takes one month to convert this raw material into finished goods. On 1st feb good are ready for sale i.e. stocked at warehouse on 1st march goods are sold and on 1st april payment is received. Now this revenue will be used to buy fresh raw material. The average time it takes for a retailer's or manufacturer's inventory to turn to cash. If a manufacturer turns its inventory six times per year (every two months) and allows customers to pay in 30 days, its operating cycle is approximately three months. Expressed as an indicator (days) of management performance efficiency, the operating cycle is a "twin" of the cash conversion cycle. While the parts are the same - receivables, inventory and payables - in the operating cycle, they are analyzed from the perspective of how well the company is managing these critical operational capital assets, as opposed to their impact on cash.

PV = 5000/(1+0.1)^5

PV = 10000/(1+0.1)^10

Formula:

b) Shareholders wealth maximization: Industrial organization affects the relative effectiveness of the shareholder wealth maximization norm in maximizing total social wealth. In nations where product markets are not strongly competitive, a strong shareholder primacy norm fits less comfortably with national wealth maximization than elsewhere because, where competition is weak, shareholder primacy induces managers to cut production and raise price more than they otherwise would. Where competition is fierce, managers do not have that option. There is a rough congruence between this inequality of fit and the varying strengths of shareholder primacy norms around the world. In continental Europe, for example, shareholder primacy norms have been weaker than in the United States. Because Europe's fragmented national product markets were historically less competitive than those in the United States, their greater skepticism of the norm's value came closer to fitting the structure of their product markets than did any similar skepticism here. As Europe's markets integrate, making its product markets more competitive, pressure has arisen to strengthen shareholder norms and institutions. c) Capital rationing: Capital rationing is a business decision to limit the amount available to spend on new investments or projects. The practice describes restricting channels of outflow of funds by placing a cap on the number of new projects. Capital rationing may be employed by different kinds of companies to achieve desired financial targets. The theory behind capital rationing practices is that, when fewer new projects are undertaken, the company is better able to manage them through more time and resources dedicated to existing projects and each new project. The placement of restrictions on the quantity of new investments or projects that a company will undertake. Capital rationing is executed through the imposition of a higher cost of capital for investment or the establishment of a ceiling on specific sections of the budget. This decision implies that the costs of raising new capital are prohibitively high with respect to expected returns, creating a situation where capital investment opportunities must compete for funds. Capital rationing may be prompted by past investments that yielded lower returns than expected. This may happen, for example, if a company is involved in too many projects at once leaving most of them too incomplete to yield a substantial profit. In such a case capital rationing may facilitate the maximization of existing projects. d) Economic order quantity: Economic order quantity is the level of inventory that minimizes the total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his early in-depth analysis of it. EOQ only applies where the demand for a product is constant over the year and that each new order is delivered in full when the inventory reaches zero. There is a fixed cost charged for each order placed, regardless of the number of units ordered. There is also a holding or storage cost for each unit held in storage (sometimes expressed as a percentage of the purchase cost of the item). We want to determine the optimal number of units of the product to order so that we minimize the total cost associated with the purchase, delivery and storage of the product. The required parameters to the solution are the total demand for the year, the purchase cost for each item, the fixed cost to place the order and the storage cost for each item per year. Note that the number of times an order is placed will also affect the total cost, however, this number can be determined from the other parameters

Q6. a) Discuss the advantages of ordering Economic order quantity of inventory. Economic order quantity is the level of inventory that minimizes the total inventory holding costs and ordering costs. It is one of the oldest classical production scheduling models. The framework used to determine this order quantity is also known as Wilson EOQ Model or Wilson Formula. The model was developed by F. W. Harris in 1913, but R. H. Wilson, a consultant who applied it extensively, is given credit for his early in-depth analysis of it. The Economic Order Quantity (EOQ) is the number of units that a company should add to inventory with each order to minimize the total costs of inventorysuch as holding costs, order costs, and shortage costs. The EOQ is used as part of a continuous review inventory system, in which the level of inventory is monitored at all times, and a fixed quantity is ordered each time the inventory level reaches a specific reorder point. The EOQ provides a model for calculating the appropriate reorder point and the optimal reorder quantity to ensure the instantaneous replenishment of inventory with no shortages. It can be a valuable tool for small business owners who need to make decisions about how much inventory to keep on hand, how many items to order each time, and how often to reorder to incur the lowest possible costs. The EOQ model assumes that demand is constant, and that inventory is depleted at a fixed rate until it reaches zero. At that point, a specific number of items arrive to return the inventory to its beginning level. Since the model assumes instantaneous replenishment, there are no inventory shortages or associated costs. Therefore, the cost of inventory under the EOQ model involves a tradeoff between inventory holding costs (the cost of storage, as well as the cost of tying up capital in inventory rather than investing it or using it for other purposes) and order costs (any fees associated with placing orders, such as delivery charges). Ordering a large amount at one time will increase a small business's holding costs, while making more frequent orders of fewer items will reduce holding costs but increase order costs. The EOQ model finds the quantity that minimizes the sum of these costs. The basic EOQ formula is as follows: TC = PD + HQ/2 + SD/Q where TC is the total inventory cost per year, PD is the inventory purchase cost per year (price P multiplied by demand D in units per year), H is the holding cost, Q is the order quantity, and S is the order cost (in dollars per order). Breaking down the elements of the formula further, the yearly holding cost of inventory is H multiplied by the average number of units in inventory. Since the model assumes that inventory is depleted at a constant rate, the average number of units is equal to Q/2. The total order cost per year is S multiplied by the number of orders per year, which is equal to the annual demand divided by the number of orders, or D/Q. Finally, PD is constant, regardless of the order quantity. Taking these factors into consideration, solving for the optimal order quantity gives a formula of: HQ/2 = SD/Q, or Q = the square root of 2DS/H. The latter formula can be used to find the EOQ. For example, say that a painter uses 10 gallons of paint per day at $5 per gallon, and works 350 days per year. Under this scenario, the painter's annual paint consumption (or demand) is 3,500 gallons. Also assume that the painter incurs holding costs of $3 per gallon per year, and order costs of $15 per order. In this case, the painter's optimal order

quantity can be found as follows: EOQ the square root of (2 3,500 15) /3 187 gallons. The number of orders is equal to D/Q, or 3,500 / 187. Thus the painter should order 187 gallons about 19 times per year, or every three weeks or so, in order to minimize his inventory costs. The EOQ will sometimes change as a result of quantity discounts, which are provided by some suppliers as an incentive for customers to place larger orders. For example, a certain supplier may charge $20 per unit on orders of less than 100 units and only $18 per unit on orders over 100 units. To determine whether it makes sense to take advantage of a quantity discount when reordering inventory, a small business owner must compute the EOQ using the formula (Q the square root of 2DS/H), compute the total cost of inventory for the EOQ and for all price break points above it, and then select the order quantity that provides the minimum total cost. For example, say that the painter can order 200 gallons or more for $4.75 per gallon, with all other factors in the computation remaining the same. He must compare the total costs of taking this approach to the total costs under the EOQ. Using the total cost formula outlined above, the painter would find TC PD HQ/2 SD/Q (5 3,500) (3 187)/2 + (15 3,500)/187 $18,062 for the EOQ. Ordering the higher quantity and receiving the price discount would yield a total cost of (4.75 3,500) (3 200)/2 (15 3,500)/200 $17,187. In other words, the painter can save $875 per year by taking advantage of the price break and making 17.5 orders per year of 200 units each. b) Discuss the Dividend discount model of measuring cost of equity. The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments. In other words, it is used to evaluate stocks based on the net present value of the future dividends. Dividend discount model is a tool that produces a number based on the data provided. Dividend discount model is a widely accepted financial tool used to evaluate stocks based on the net present value of the future dividends. It works by analyzing and making assumptions related to growth in dividends and interest rates. Its a tool that is heavily based on speculation but what sets it apart from other financial tools is its ability to compare specific numbers based on the given data with accuracy. Dividend discount model can only be applied to stocks that pay dividends. Dividends are portion of earnings that a company decides to give out as cash or stock to its shareholders. Companies that offer dividends, like Microsoft, are usually very stable and secure and have financial strength to continue paying dividends. Dividend discount model can also help investors decide if the future growth in dividends is worth the investment today. The concept of time value of money is crucial in calculations related to dividend discount model. Future growth in dividend payments is discounted to present value of the stock to see if the stock is undervalued or overvalued. Basic dividend discount model formula states that:

There are no two stocks alike so dividend discount model is available both for companies where growth is imminent and companies with no growth. No growth dividend discount model assumes that a company will pay the same amount of dividend until infinity. Constant growth dividend discount model assumes that the company will grow and so the dividends will also grow. No growth dividend discount model dictates the formula:

Where P is the current price, Div is the dividend the company currently pays and r is the discount rate. Formula for constant growth dividend discount model is:

g is the growth rate which is assumed in most cases. Lets say that a company is paying $.60 in dividends and the required rate of return in other securities is equal to 6%. Looking at other growth stocks, assume 2% growth rate.

Using dividend discount model, we just figured out the current price of the stock which is $15. Now lets say that the stock is currently selling for $12, which makes the stock undervalued. If the stock were to be $18, we can assume that it is overvalued. Its a good idea to buy a stock that is undervalued because the amount of future cash flows it is able to generate. Using dividend discount model, it is very easy to identify growth or income stocks that can prove to be profitable if the investment is made in the present. On the other hand, one has to keep in mind that dividend discount model is highly speculative and is based on variety of assumptions. In theory it is one of the best financial tools available to investors but in the real world it is better to use wide range of tools to evaluate stocks.