SMU MB0045 SET 2 SOLUTION


Q1.The following data is available in respect of a company :
      Equity Rs.10lakhs,cost of capital 18%
      Debt Rs.5lakhs,cost of debt 13%
      Calculate the weighted average cost of funds taking market values as weights assuming tax rate as 40%
        Hint: Use the equation
        WACC = We Ke + WpKp +Wr Kr + WdKd + WtKt
A.1 COMING SOON

Q2. ABC Ltd. provides the information as shown in table 6.21 regarding the cost, sales, interests and selling prices. Calculate the DFL.

A. 2 EBIT = output*(selling price – variable cost) – fixed cost 
EBIT = 20000*(0.20-0.05) – 3500 = -500 
Dp/(1-T) = 0 as we don’t have any dividend preferred and no tax rate 
In our case interest(I) is 0 
There for : 
DFL = -500/(-500-0-0) = -500/-500 = 1 
DLF for the problem with provided data will be 1 

Q3.Two companies are identical in all respects except in the debt equity profile. Company X has 14% debentures worth Rs. 25,00,000 whereas company Y does not have any debt. Both companies earn 20% before interest and taxes on their total assets of Rs. 50,00,000. Assuming a tax rate of 40%, and cost of equity capital to be 22%, find out the value of the companies X and Y using NOI approach?
Hint: use the formula K0 = [B/(B+S)]Kd + [S/(B+S)]Ke
A.3 Solution: 
S= 1000,000/.22 =4545454.5 
B=25,00,000 
=K0=[25,00,000/[2500000+4545454.5)].14+[4545454.5/2500000+4545454.5)].22 
0.0496+.142 =.1915 or 19.15% 
V = 5000000/0.1915 = 26,109,660.57 

Q4. Examine the importance of capital budgeting.
A4. Capital budgeting decisions are the most important decisions in Corporate financial management. These decisions make or mar a business organization.  These decisions commit a firm to invest its current funds in the operating assets (i,elong­term assets) with the hope of employing them most efficiently to generate a series of cash flows in future. 
These decisions could be grouped into
1.  Replacement  decisions:  These  decisions may be decision  to replace  the  equipments for maintenance of current level of business or decisions aiming at cost reductions. 
2.  Decisions on  expenditure  for increasing  the  present operating level or expansion through improved network of distribution. 
3.  Decisions for products of new goods or rendering of new services. 
4.  Decisions on penetrating  into new geographical area. 
5.  Decisions to comply with  the  regulatory structure affecting  the  operations of the  company. Investments in assets to comply with the conditions imposed by Environmental Protection Act come under this category. 
6.  Decisions on investment to  build township  for  providing residential accommodation  to 
employees working in a manufacturing plant. 


Q5. Briefly explain the process of capital rationing.
A5. Capital Rationing may be due to 
a.  External factors b.  Internal constraints imposed by management

External  Capital  Rationing:  External Capital Rationing is due to  the  imperfections of capitalmarkets Imperfection may be caused by:­
a.  Deficiencies in market information 
b.  Rigidities that hamper the force flow of Capital between firms. 
Whencapital marketsarenot favourable to the company the firm cannot tap the capital market for executing new projects even though the projects have positive net present values.  The following reasons attribute to the external capital rationing:­
1.  Inability of the firm to procure required funds from Capital market because the firm does not command the required investor’s confidence. 
2.  National and international economic factors may make the market highly volatile and instable. 
3.  Inability of the firm  to  satisfy the  regularity norms for issue of instruments  for  tapping the market for funds. 
4.  High Cost of issue of Securities I,e High floatation cost. Smaller firms smaller firms may have to incur high costs of issue of securities.  This discourages small firms from tapping the capital markets for funds.
Internal Capital Rationing: Impositions of restrictions by a firm on the funds allocated for fresh investment is called internal capital rationing.  This decision may be the result of a conservative policy pursued by a firm.  Restriction may be imposed on divisional heads on the total amount that they can commit on  new projects. 
Another internal restriction for Capital budgeting decision may be imposed by a firm based on the 
need to generate a  minimum  rate  of return.  Under this criterion  only projects capable  of
generating the management’s expectation on the rate of return will be cleared.  Generally internal
capital rationing is used by a firm as a means of financial control.

 Q6. Explain the concepts of working capital .
A6 . There are two important concepts of Working Capital – gross and net

Gross Working  Capital:  Gross Working Capital refers to  the  amounts invested  in  the  various components of current assets.  This concept has the following practical relevance. 
a.  Management of current assets is the crucial aspect of Working Capital Management. 
b.  It is an important component of operating capital.  Therefore, for improving the profitability on  its investment a finance manager of a company must give top priority to efficient management of current assets. 
c.  The need to plan  and  monitor  the  utilization  of  funds of a firm  demands working  capital management as applied to current assets. 
d.  It helps in the fixation of various areas of financial responsibility.

Net Working Capital
Net Working Capital is the excess of current assets over current liabilities and provisions. Net Working  Capital is positive.  when  current assets exceed  current  liabilities and negative when current liabilitiesexceed current assets.  This concept has the
following practical relevance. 
1.  It indicates the ability of the firm to effectively use the spontaneous finance in managing the firm’s Working Capital requirements. 
2.  A firm’s short  term  solvency is measured  through the  net  Working Capital position  it 
commands.
Permanent Working Capital
Permanent Working Capital is the minimum amount of investment required to be made in current assets at all times to carry on the day to day operation of firm’s business. This minimum level of current asset has been given the name of core current assets by the Tandon Committee. It is also known as fixed Working Capital.

Temporary Working Capital
It is also known  as Variable Working  Capital or fluctuating Working  Capital. The firm’s working  capital requirements vary depending upon the seasonal and cyclical changes in demands for a firm’s products.  The extra Working Capital required as per the changing production and sales levels of a firm is known as Temporary Working Capital.

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