The Institute of Chartered Financial Analysts of India University 2010 C.A Chartered Accountant Professional Edution II (PE-II) Revision Test s- 4B- Financial Management - Question Paper

Rs. 2,75,000 Rs. 2,25,000 Rs. 5,00,000 Rs. 10,00,000

= 1% compound monthly.

Rs. 31,12,500

2

Rs.

19.000

_____ By Balance c/d

1,85,500

(iii) Funds from Operations

= 14% +1.01% = 15.01%

Advise: The IRR is 15%. The project should be rejected as the IRR is less than the minimum return required by the company.

Calculation of Operating, Financial and Combined Leverage

EBIT 9,00,000

Financial leverage =

EBT 6,00,000 Combined leverage = Operating leverage x Financial leverage = 1.67 x 1.50 = 2.505 = 2.51

Computation of Weighted Average Cost of Capital using Market Value Weights Cost of Equity (ke)

D1

= + g Po

Rs.2

_K _ I(1-T) + (RV-NP)/N ^d    (RV + NP)/2

_ 9(1 - 0.35) + (100 - 98) /10 (100 + 98)/2

_ ⁵⁸⁵ + ^{0 20} _ 6.11%

99

Cost of Preference Shares (kp)

_ PD + (RV - NP)/N

Kp

(RV + NP)/2

= 11 + (100 - 97)/10 = 11.30 = _{11 47}%

(100 + 97)/2 98.5 . %

Calculation of WACC using Market Value Weights

WACC using market value weights = 13.02%

9. (a) Traditional Phase and Modern Phase of Financial Management

During the Traditional Phase, financial management was considered necessary only during occasional events such as takeovers, mergers, expansion, liquidation, etc. Also, when taking financial decisions in the organisation, the needs of outsiders (investment bankers, people who lend money to the business and other such people) to the business was kept in mind.

Whereas, on the other hand, the Modern Phase is still going on. The scope of financial management has greatly increased now. It is important to carry out financial analysis for a company. This analysis helps in decision-making. During this phase, many theories have been developed regarding efficient markets, capital

budgeting, option pricing, valuation models and also in several other important fields in financial management.

(b)    Debt Financing and Equity Financing

Financing a business through borrowing is cheaper than using equity. This is because:

   Lenders require a lower rate of return than ordinary shareholders. Debt financial securities present a lower risk than shares for the finance providers because they have prior claims on annual income and liquidation.

   A profitable business effectively pays less for debt capital than equity for another reason: the debt interest can be offset against pre-tax profits before the calculation of the corporate tax, thus reducing the tax paid.

   Issuing and transaction costs associated with raising and servicing debt are generally less than for ordinary shares.

(c)    Investment Decisions and Dividend Decisions

Investment decisions are those decisions that determine how scarce resources in terms of funds available are committed to projects which can range from acquiring a piece of plant to the acquisition of another company. Funds procured from different sources have to be invested in various kinds of assets. Long-term funds are used in a project for various fixed assets and also for current assets. The investment of funds in a project has to be made after careful assessment of the various projects through capital budgeting. A part of long-term funds is also to be kept for financing the working capital requirements. Asset management policies are to be laid down regarding various items of current assets. The inventory policy would be determined by the production manager and the finance manager keeping in view the requirement of production and the future price estimates of raw materials and the availability of funds.

Whereas, on the other hand, Dividend decisions are those decisions that relate to the determination as to how much and how frequently cash can be paid out of the profits of an organisation as income for its owners/shareholders. The owner of any profit-making organization looks for reward for his investment in two ways, the growth of the capital invested and the cash paid out as income; for a sole trader this income would be termed as drawings and for a limited liability company the term is dividends.

The dividend decisions thus have two elements - the amount to be paid out and the amount to be retained to support the growth of the organisation, the latter being also a financing decision; the level and regular growth of dividends represent a significant factor in determining a profit-making company's market value, i.e. the value placed on its shares by the stock market.

(i)    Funds flow statement is based on the accrual accounting system. In case of preparation of cash flow statements all transactions effecting the cash or cash equivalents only is taken into consideration.

(ii)    Funds flow statement analyses the sources and application of funds of longterm nature and the net increase or decrease in long-term funds will be reflected on the working capital of the firm. The cash flow statement will only consider the increase or decrease in current assets and current liabilities in calculating the cash flow of funds from operations.

(iii)    Funds Flow analysis is more useful for long range financial planning. Cash flow analysis is more useful for identifying and correcting the current liquidity problems of the firm.

(iv)    Funds flow statement tallies the funds generated from various sources with various uses to which they are put. Cash flow statement starts with the opening balance of cash and reaches to the closing balance of cash by proceeding through sources and uses.

10. (a) Composition of ROE using DuPont

There are three components in the calculation of return on equity using the

traditional DuPont model- the net profit margin, asset turnover, and the equity

multiplier. By examining each input individually, the sources of a company's return

on equity can be discovered and compared to its competitors.

(i)    Net Profit Margin: The net profit margin is simply the after-tax profit a company generates for each rupee of revenue.

Net profit margin = Net Income + Revenue

Net profit margin is a safety cushion; the lower the margin, lesser the room for error.

(ii)    Asset Turnover: The asset turnover ratio is a measure of how effectively a company converts its assets into sales. It is calculated as follows:

Asset Turnover = Revenue + Assets

The asset turnover ratio tends to be inversely related to the net profit margin;

i.e., the higher the net profit margin, the lower the asset turnover.

(iii)    Equity Multiplier: It is possible for a company with bad sales and margins to take on excessive debt and artificially increase its return on equity. The equity multiplier, a measure of financial leverage, allows the investor to see what portion of the return on equity is the result of debt. The equity multiplier is

Calculation of Return on Equity

To calculate the return on equity using the DuPont model, simply multiply the three components (net profit margin, asset turnover, and equity multiplier.)

Return on Equity = Net profit marginx Asset turnover x Equity multiplier

(b)    Trading on Equity

The term trading on equity' is derived from the fact that debts are contracted and loans are raised mainly on the basis of equity capital. Those who provide debt have a limited share in the firm's earnings and hence want to be protected in terms of earnings and values represented by equity capital. Since fixed charges do not vary with the firm's earnings before interest and tax, a magnified effect is produced on earnings per share. Whether the leverage is favourable in the sense increase in earnings per share more proportionately to the increased earnings before interest and tax depends on the profitability of investment proposals. If the rate of return on investment exceeds their explicit cost financial leverage is said to be positive.

In other words, it can be stated that trading on equity means using borrowed funds to generate returns in anticipation that the return would be more than the interest paid on those funds. Therefore, trading on equity occurs when a company uses bonds, preference shares or any other type of debt to increase its earnings on equity shares. For example, a company may use long-term debt to purchase assets that are expected to generate earnings more than the interest on the debt. The earnings in excess of the interest on the debt will increase the earnings of the company's equity shareholders. This increase in earnings indicates that the company was successful in trading on equity.

(c)    Seed Capital Assistance

The Seed capital assistance scheme is designed by IDBI for professionally or technically qualified entrepreneurs and/or persons possessing relevant experience, skills and entrepreneurial traits. All the projects eligible for financial assistance from IDBI, directly or indirectly through refinance are eligible under the scheme. The project cost should not exceed Rs. 2 crores and the maximum assistance under the project will be restricted to 50% of the required promoter's contribution or Rs. 15 lacs whichever is lower.

The Seed Capital Assistance is interest-free but carries a service charge of one per cent per annum for the first five years and at increasing rate thereafter. However, IDBI will have the option to charge interest at such rate as may be determined by IDBI on the loan if the financial position and profitability of the company so permits

during the currency of the loan. The repayment schedule is fixed depending upon the repaying capacity of the unit with an initial moratorium upto five years.

For projects with a project cost exceeding Rs. 200 lacs, seed capital may be obtained from the Risk Capital and Technology Corporation Ltd. (RCTC). For small projects costing upto Rs. 5 lacs, assistance under the National Equity Fund of the SIDBI may be availed.

(d) Capital Budgeting Process

The extent to which the capital budgeting process needs to be formalised and systematic procedures established depends on the size of the organisation; number of projects to be considered; direct financial benefit of each project considered by itself; the composition of the firm's existing assets and management's desire to change that composition; timing of expenditures associated with the projects that are finally accepted.

(i)    Planning: The capital budgeting process begins with the identification of potential investment opportunities. The opportunity then enters the planning phase when the potential effect on the firm's fortunes is assessed and the ability of the management of the firm to exploit the opportunity is determined. Opportunities having little merit are rejected and promising opportunities are advanced in the form of a proposal to enter the evaluation phase.

(ii)    Evaluation: This phase involves the determination of proposal and its investments, inflows and outflows. Investment appraisal techniques, ranging from the simple payback method and accounting rate of return to the more sophisticated discounted cash flow techniques, are used to appraise the proposals. The technique selected should be the one that enables the manager to make the best decision in the light of prevailing circumstances.

(iii)    Selection: Considering the returns and risks associated with the individual projects as well as the cost of capital to the organisation, the organisation will choose among projects so as to maximise shareholders' wealth.

(iv)    Implementation: When the final selection has been made, the firm must acquire the necessary funds, purchase the assets, and begin the implementation of the project.

(v)    Control: The progress of the project is monitored with the aid of feedback reports. These reports will include capital expenditure progress reports, performance reports comparing actual performance against plans set and post completion audits.

(vi) Review: When a project terminates, or even before, the organisation should review the entire project to explain its success or failure. This phase may have implication for firms planning and evaluation procedures. Further, the review may produce ideas for new proposals to be undertaken in the future.

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