Academiclub

Zip Zap Zoom Company Ltd is into manufacturing cars in the small car (800 cc) segment. It was set up 15 years back and since its establishment it has seen a phenomenal growth in both its market and profitability. Its financial statements are shown in Exhibits 1 and 2 respectively.

The company enjoys the confidence of its shareholders who have been rewarded with growing dividends year after year. Last year, the company had announced 20 per cent dividend, which was the highest in the automobile sector. The company has never defaulted on its loan payments and enjoys a favourable face with its lenders, which include financial institutions, commercial banks and debenture holders.

The competition in the car industry has increased in the past few years and the company foresees further intensification of competition with the entry of several foreign car manufactures many of them being market leaders in their respective countries. The small car segment especially, will witness entry of foreign majors in the near future, with latest technology being offered to the Indian customer. The Zip Zap Zoom's senior management realizes the need for large scale investment in up gradation of technology and improvement of manufacturing facilities to pre-empt competition.

Whereas on the one hand, the competition in the car industry has been intensifying, on the other hand, there has been a slowdown in the Indian economy, which has not only reduced the demand for cars, but has also led to adoption of price cutting strategies by various car manufactures. The industry indicators predict that the economy is gradually slipping into recession.

Reserves and surplus 250 600

Loans:

Debentures (@ 14%) 50

Institutional borrowing (@ 10%) 100

Commercial loans (@ 12%) 250

Total debt 400

Current liabilities 200

1.200

Application of Funds

Fixed Assets

Gross block 1,000

Less : Depreciation 250

Net block 750

Capital WIP 190

Total Fixed Assets 940

Current assets :

Inventory 200

Sundry debtors 40

Cash and bank balance 10

Other current assets 10

Total current assets 260

-1200

Exhibit 2 Profit and Loss Account for the year ended March 31, 200x

(Amount in Rs. Crore)

Sales revenue (80,000 units x Rs. 2,50,000) 2,000.0

Operating expenditure :

Variable cost:

Raw material and manufacturing expenses 1,300.0

Variable overheads		100.0
Total		1,400.0
Fixed cost:
R&D		20.0
Marketing and advertising		25.0
Depreciation		250.0
Personnel		70.0
Total		365.0
Total operating expenditure		1.765.0
Operating profits (EBIT)		235.0
Financial expense :
Interest on debentures		7.7
Interest on institutional borrowings	11.0
Interest on commercial loan	33.0	51.7
Earnings before tax (EBT)		183.3
Tax (@ 35%)		64.2
Earnings after tax (EAT)		119.1
Dividends		70.0
Debt redemption (sinking fund obligation)**		40.0
Contribution to reserves and surplus		9.1

** The loans have to be retired in the next ten years and the firm redeems Rs. 40 crore every year.

The company is faced with the problem of deciding how much to invest in up gradation of its plans and technology. Capital investment up to a maximum of Rs. 100 crore is required. The problem areas are three-fold.

• The company cannot forgo the capital investment as that could lead to reduction in its market share as technological competence in this industry is a must and customers would shift to manufactures providing latest in car technology.

• The company does not want to issue new equity shares and its retained earning are not enough for such a large investment. Thus, the only option is raising debt.

• The company wants to limit its additional debt to a level that it can service without taking undue risks. With the looming recession and uncertain market conditions, the company perceives that additional fixed obligations could become a cause of financial distress, and thus, wants to determine its additional debt capacity to meet the investment requirements.

Mr. Shortsighted, the company's Finance Manager, is given the task of determining the additional debt that the firm can raise. He thinks that the firm can raise Rs. 100 crore worth debt and service it even in years of recession. The company can raise debt at 15 per cent from a financial institution. While working out the debt capacity. Mr. Shortsighted takes the following assumptions for the recession years.

a) A maximum of 10 percent reduction in sales volume will take place.

b) A maximum of 6 percent reduction in sales price of cars will take place.

Mr. Shorsighted prepares a projected income statement which is representative of the recession years. While doing so, he determines what he thinks are the "irreducible minimum" expenditures under recessionary conditions. For him, risk of insolvency is the main concern while designing the capital structure. To support his view, he presents the income statement as shown in Exhibit 3.

Exhibit 3 projected Profit and Loss account

(Amount in Rs. Crore)

Sales revenue (72,000 units x Rs. 2,35,000) 1,692.0

Operating expenditure

Variable cost:

Raw material and manufacturing expenses 1,170.0

Variable overheads 90.0

Total 1,260.0

Fixed cost:

R&D

Marketing and advertising 15.0

Depreciation 187.5

Personnel 70.0

Total 272.5

Total operating expenditure 1.532.5

159.5

EBIT

Financial expenses :

Interest on existing Debentures 7.0

Interest on existing institutional borrowings 10.0

Interest on commercial loan 30.0

62.0

	97.5
	34.1
	63.4
50.0*
13.4

Interest on additional debt 15.0

EBT

Tax (@ 35%) EAT

Dividends

Debt redemption (sinking fund obligation) Contribution to reserves and surplus

* Rs. 40 crore (existing debt) + Rs. 10 crore (additional debt) Assumptions of Mr. Shorsighted

• R&D expenditure can be done away with till the economy picks up.

• Marketing and advertising expenditure can be reduced by 40 per cent.

• Keeping in mind the investor confidence that the company enjoys, he feels that the company can forgo paying dividends in the recession period.

He goes with his worked out statement to the Director Finance, Mr. Arthashatra, and advocates raising Rs. 100 crore of debt to finance the intended capital investment. Mr. Arthashatra does not feel comfortable with the statements and calls for the company's financial analyst, Mr. Longsighted.

Mr. Longsighted carefully analyses Mr. Shortsighted's assumptions and points out that insolvency should not be the sole criterion while determining the debt capacity of the firm. He points out the following

• Apart from debt servicing, there are certain expenditures like those on R & D and marketing that need to be continued to ensure the long-term health of the firm.

• Certain management policies like those relating to dividend payout, send out important signals to the investors. The Zip Zap Zoom's management has been paying regular dividends and discontinuing this practice (even though just for the recession phase) could raise serious doubts in the investor's mind about the health of the firm. The firm should pay at least 10 per cent dividend in the recession years.

• Mr. Shortsighted has used the accounting profits to determine the amount available each year for servicing the debt obligations. This does not give the true picture. Net cash inflows should be used to determine the amount available for servicing the debt.

• Net Cash inflows are determined by an interplay of many variables and such a simplistic view should not be taken while determining the cash flows in recession. It is not possible to accurately predict the fall in any of the factors such as sales volume, sales price, marketing expenditure and so on. Probability distribution of variation of each of the factors that affect net cash inflow should be analyzed. From this analysis, the probability distribution of variation in net cash inflow should be analysed (the net cash inflows follow a normal probability distribution). This will give a true picture of how the company's cash flows will behave in recession conditions.

The management recognizes that the alternative suggested by Mr. Longsighted rests on data, which are complex and require expenditure of time and effort to obtain and interpret. Considering the importance of capital structure design, the Finance Director asks Mr. Longsighted to carry out his analysis. Information on the behaviour of cash flows during the recession periods is taken into account. The methodology undertaken is as follows :

(a) Important factors that affect cash flows (especially contraction of cash flows), like sales volume, sales price, raw materials expenditure, and so on, are identified and the analysis is carried out in terms of cash receipts and cash expenditures.

(b) Each factor's behaviour (variation behaviour) in adverse conditions in the past is studied and future expectations are combined with past data, to describe limits (maximum favourable), most probable and maximum adverse) for all the factors.

(c) Once this information is generated for all the factors affecting the cash flows, Mr. Longsighted comes up with a range of estimates of the cash flow in future recession periods based on all possible combinations of the several factors. He also estimates the probability of occurrence of each estimate of cash flow.

Assuming a normal distribution of the expected behaviour, the mean expected value of net cash inflow in adverse conditions came out to be Rs. 220.27 crore with standard deviation of Rs. 110 crore. Keeping in mind the looming recession and the uncertainty of the recession behaviour, Mr. Arthashastra feels that the firm should factor a risk of cash inadequacy of around 5 per cent even in the most adverse industry conditions. Thus, the firm should take up only that amount of additional debt that it can service 95 per cent of the times, while maintaining cash adequacy.

To maintain an annual dividend of 10 per cent, an additional Rs. 35 crore has to be kept aside. Hence, the expected available net cash inflow is Rs. 185.27 crore (i.e. Rs. 220.27 - Rs. 35 crore) Analyse the debt capacity of the company.

NO. 2

COOKING LPG LTD DETERMINATION OF WORKING CAPTIAL

Introduction

Cooking LPG Ltd, Gurgaon, is a private sector firm dealing in the bottling and supply of domestic LPG for household consumption since 1995. The firm has a network of distributors in the districts of Gurgaon and Faridabad. The bottling plant of the firm is located on National Highway - 8 (New Delhi - Jaipur), approx. 12 kms from Gurgaon. The firm has been consistently performing we." and plans to expand its market to include the whole National Capital Region.

The production process of the plant consists of receipt of the bulk LPG through tank trucks, storage in tanks, bottling operations and distribution to dealers. During the bottling process, the cylinders are subjected to pressurized filling of LPG followed by quality control and safety checks such as weight, leakage and other defects. The cylinders passing through this process are sealed and dispatched to dealers through trucks. The supply and distribution section of the plant prepares the invoice which goes along with the truck to the distributor. Statement of the Problem :

Mr. I. M. Smart, DGM(Finance) of the company, was analyzing the financial performance of the company during the current year. The various profitability ratios and parameters of the company indicated a very satisfactory performance. Still, Mr. Smart was not fully content-specially with the management of the working capital by the company. He could recall that during the past year, in spite of stable demand pattern, they had to, time and again, resort to bank overdrafts due to non-availability of cash for making various payments. He is aware that such aberrations in the finances have a cost and adversely affects the performance of the company. However, he was unable to pinpoint the cause of the problem.

He discussed the problem with Mr. U.R. Keenkumar, the new manager (Finance). After critically examining the details, Mr. Keenkumar realized that the working capital was hitherto estimated only as approximation by some rule of thumb without any proper computation based on sound financial policies and, therefore, suggested a reworking of the working capital (WC) requirement. Mr. Smart assigned the task of determination of WC to him. Profile of Cooking LPG Ltd.

1) Purchases : The company purchases LPG in bulk from various importers ex-Mumbai and Kandla, @ Rs. 11,000 per MT. This is transported to its Bottling Plant at Gurgaon through 15 MT capacity tank trucks (called bullets), hired on annual contract basis. The average transportation cost per bullet ex-either location is Rs. 30,000. Normally, 2 bullets per day are received at the plant. The company make payments for bulk supplies once in a month, resulting in average time-lag of 15 days.

2) Storage and Bottling : The bulk storage capacity at the plant is 150 MT (2 x 75 MT storage tanks)
and the plant is capable of filling 30 MT LPG in cylinders per day. The plant operates for 25 days
per month on an average. The desired level of inventory at various stages is as under.

• LPG in bulk (tanks and pipeline quantity in the plant) - three days average production / sales.

• Filled Cylinders - 2 days average sales.

• Work-in Process inventory - zero.

3) Marketing : The LPG is supplied by the company in 12 kg cylinders, invoiced @ Rs. 250 per cylinder. The rate of applicable sales tax on the invoice is 4 per cent. A commission of Rs. 15 per cylinder is paid to the distributor on the invoice itself. The filled cylinders are delivered on company's expense at the distributor's godown, in exchange of equal number of empty cylinders. The deliveries are made in truck-loads only, the capacity of each truck being 250 cylinders. The distributors are required to pay for deliveries through bank draft. On receipt of the draft, the cylinders are normally dispatched on the same day. However, for every truck purchased on pre-paid basis, the company extends a credit of 7 days to the distributors on one truck-load.

4) Salaries and Wages : The following payments are made :

• Direct labour - Re. 0.75 per cylinder (Bottling expenses) - paid on last day of the month.

• Security agency - Rs. 30,000 per month paid on 10^th of subsequent month.

• Administrative staff and managers - Rs. 3.75 lakh per annum, paid on monthly basis on the last working day.

5) Overheads:

• Administrative (staff, car, communication etc) - Rs. 25,000 per month - paid on the 10^th of subsequent month.

• Power (including on DG set) - Rs. 1,00,000 per month paid on the 7^th Subsequent month.

• Renewal of various licenses (pollution, factory, labour CCE etc.) - Rs. 15,000 per annum paid at the beginning of the year.

• Insurance - Rs. 5,00,000 per annum to be paid at the beginning of the year.

• Housekeeping etc - Rs. 10,000 per month paid on the 10^th of the subsequent month.

• Regular maintenance of plant - Rs. 50,000 per month paid on the 10^th of every month to the vendors. This includes expenditure on account of lubricants, spares and other stores.

• Regular maintenance of cylinders (statutory testing) - Rs. 5 lakh per annum - paid on monthly basis on the 15^th of the subsequent month.

• All transportation charges as per contracts - paid on the 10^th subsequent month.

• Sales tax as per applicable rates is deposited on the 7^th of the subsequent month.

6) Sales : Average sales are 2,500 cylinders per day during the year. However, during the winter months
(December to February), there is an incremental demand of 20 per cent.

7) Average Inventories : The average stocks maintained by the company as per its policy guidelines :

• Consumables (caps, ceiling material, valves etc) - Rs. 2 lakh. This amounts to 15 days consumption.

9) Additional Information for Calculating Incremental Working Capital During Winter.

• No increase in any inventories take place except in the inventory of bulk LPG, which increases in the same proportion as the increase of the demand. The actual requirements of LPG for additional supplies are procured under the same terms and conditions from the suppliers.

• The labour cost for additional production is paid at double the rate during wintes.

• The expenditure on power consumption during winter increased by 10 per cent. However, during other months the power consumption remains the same as the decrease owing to reduced production is offset by increased consumption on account of compressors /Acs.

• Additional amount of Rs. 3 lakh is kept as cash balance to meet exigencies during winter.

• The storage of finished goods inventory is restricted to a maximum 5,000 cylinders due to statutory requirements.

M/s. Hi - tech Electronics, a consumer electronics outlet, was opened two years ago in Dwarka, New Delhi. Hard work and personal attention shown by the proprietor, Mr. Sony, has brought success. However, because of insufficient funds to finance credit sales, the outlet accepted only cash and bank credit cards. Mr. Sony is now considering a new policy of offering installment sales on terms of 25 per cent down payment and 25 per cent per month for three months as well as continuing to accept cash and bank credit cards.

Mr. Sony feels this policy will boost sales by 50 percent. All the increases in sales will be credit sales. But to follow through a new policy, he will need a bank loan at the rate of 12 percent. The sales projections for this year without the new policy are given in Exhibit 1. Exhibit 1 Sales Projections and Fixed costs.

He further expects 26.67 per cent of the sales to be cash, 40 per cent bank credit card sales on which a 2 per cent fee is paid, and 33.33 per cent on instalment sales. Also, for short term seasonal requirements, the film takes loan from chit fund to which Mr. Sony subscribes @ 1.8 per cent per month.

Their success has been due to their policy of selling at discount price. The purchase per unit is 90 per cent of selling price. The fixed costs are Rs. 20,000 per month. The proprietor believes that the new policy will increase miscellaneous cost by Rs. 25,000.

The business being cyclical in nature, the working capital finance is done on trade - off basis. The proprietor feels that the new policy will lead to bad debts of 1 per cent.

(a) As a financial consultant, advise the proprietor whether he should go for the extension of credit facilities.

(b) Also prepare cash budget for one year of operation of the firm, ignoring interest. The minimum desired cash balance & Rs. 30,000, which is also the amount the firm, has on January 1. Borrowings are possible which are made at the beginning of a month and repaid at the end when cash is available.

Smoothdrive Tyre Ltd manufacturers tyres under the brand name "Super Tread' for the domestic car market. It is presently using 7 machines acquired 3 years ago at a cost of Rs. 15 lakh each having a useful life of 7 years, with no salvage value.

After extensive research and development, Smoothdrive Tyre Ltd has recently developed a new tyre, the 'Hyper Tread' and must decide whether to make the investments necessary to produce and market the Hyper Tread. The Hyper Tread would be ideal for drivers doing a large amount of wet weather and off road driving in addition to normal highway usage. The research and development costs so far total Rs. 1,00,00,000. The Hyper Tread would be put on the market beginning this year and Smoothdrive Tyrs expects it to stay on the market for a total of three years. Test marketing costing Rs. 50,00,000, shows that there is significant market for a Hyper Tread type tyre. As a financial analyst at Smoothdrive Tyre, Mr. Mani asked by the Chief Financial Officer (CFO), Mr. Tyrewala to evaluate the Hyper-Tread project and to provide a recommendation or whether or not to proceed with the investment. He has been informed that all previous investments in the Hyper Tread project are sunk costs are only future cash flows should be considered. Except for the initial investments, which occur immediately, assume all cash flows occur at the year-end.

Smoothedrive Tyre must initially invest Rs. 72,00,00,000 in production equipments to make the Hyper Tread. They would be depreciated at a rate of 25 per cent as per the written down value (WDV) method for tax purposes. The new production equipments will allow the company to follow flexible manufacturing technique, that is both the brands of tyres can be produced using the same equipments. The equipments is expected to have a 7-year useful life and can be sold for Rs. 10,00,000 during the fourth year. The company does not have any other machines in the block of 25 per cent depreciation. The existing machines can be sold off at Rs. 8 lakh per machine with an estimated removal cost of one machine for Rs. 50,000.

The operating requirements of the existing machines and the new equipment are detailed in Exhibits 11.1 and 11.2 respectively.

Labo. costs (e_Xpec_ted,o₁„c_reaSe₁0p_ace„,_a„„ua_lly,o account for inflation) :

• Operating expenses : Rs. 50 lakh expected to increase at 5 per cent annually.
Insurance cost / premium :

Cost of retrenchment of 34 personnel : (20 unskilled, 11 skilled, 2 supervisors and 1 rjiaintenance

The opening expenses do not change to any considerable extent for the new equipment and the difference is negligible compared to the scale of operations. Smoothdrive Tyre intends to sell Hyper Tread of two distinct markets :

1. The original equipment manufacturer (OEM) market : The OEM market consists primarily of the large automobile companies who buy tyres for new cars. In the OEM market, the Hyper Tread is expected to sell for Rs. 1,200 per tyre. The variable cost to produce each Hyper Tread is Rs. 600.

2. The replacement market : The replacement market consists of all tyres purchased after the automobile has left the factory. This markets allows higher margins and Smoothdrive Tyre expects to sell the Hyper Tread for Rs. 1.500 per tyre. The variable costs are the same as in the OEM market.

Smoothdrive Tyre expects to raise prices by 1 percent above the inflation rate. The variable costs will also increase by 1 per cent above the inflation rate. In addition, the Hyper Tread project will incur Rs. 2,50,000 in marketing and general administration cost in the first year which are expected to increase at the inflation rate in subsequent years.

Smoothdrive Tyre's corporate tax rate is 35 per cent. Annual inflation is expected to remain constant at 3.25 per cent. Smoothdrive Tyre uses a 15 per cent discount rate to evaluate new product decisions. The Tyre Market

Automotive industry analysts expect automobile manufacturers to have a production of 4,00,000 new cars this year and growth in production at 2.5 per year onwards. Each new car needs four new tyres (the spare tyres are undersized and fall in a different category) Smoothdrive Tyre expects the Hyper Tread to capture an 11 per cent share of the OEM market.

The industry analysts estimate that the replacement tyre market size will be one crore this year and that it would grow at 2 per cent annually. Smoothdrive Tyre expects the Hyper Tread to capture an 8 per cent market share.

You also decide to consider net working capital (NWC) requirements in this scenario. The net working capital requirement will be 15 per cent of sales. Assume that the level of working capital is adjusted at the beginning of the year in relation to the expected sales for the year. The working capital is to be liquidated at par, barring an estimated loss of Rs. 1.5 crore on account of bad debt. The bad debt will be a tax-deductible expenses.

As a finance analyst, prepare a report for submission to the CFO and the Board of Directors, explaining to them the feasibility of the new investment.

In October 2003, Neha Kapoor, a recent MBA graduate and newly appointed assistant to the Financial Controller of Palco Ltd, was given a list of six new investment projects proposed for the following year. It was her job to analyse these projects and to present her findings before the Board of Directors at its annual meeting to be held in 10 days. The new project would require an investment of Rs. 2.4 crore.

Palco Ltd was founded in 1965 by Late Shri A. V. Sinha. It gained recognition as a leading producer of high quality aluminum, with the majority of its sales being made to Japan. During the rapid economic expansion of Japan in the 1970s, demand for aluminum boomed, and palco's sales grew rapidly. As a result of this rapid growth and recognition of new opportunities in the energy market, Palco began to diversify its products line. While retaining its emphasis on aluminum production, it expanded operations to include uranium mining and the production of electric generators, and finally, it went into all phases of energy production. By 2003, Palco's sales had reached Rs. 14 crore level, with net profit after taxes attaining a record of Rs. 67 lakh.

As Palco expanded its products line in the early 1990s, it also formalized its caital budgeting procedure. Until 1992, capital investment projects were selected primarily on the basis of the average return on investment calculations, with individual departments submitting these calculations for projects falling within their division. In 1996, this procedure was replaced by one using present value as the decision making criterion. This change was made to incorporate cash flows rather than accounting profits into the decision making analysis, in addition to adjusting these flows for the time value of money. At the time, the cost of capital for Palco was determined to be 12 per cent, which has been used as the discount rate for the past 5 years. This rate was determined by taking a weighted average cost Palco had incurred in raising funds from the capital market over the previous 10 years.

It had originally been Neha's assignment to update this rate over the most recent 10-year period and determine the net present value of all the proposed investment opportunities using this newly calculated figure. However, she objected to this procedure, stating that while this calculation gave a good estimate of "the past cost" of capital, changing interest rates and stock prices made this calculation of little value in the present. Neha suggested that current cost of raising funds in the capital market be weighted by their percentage mark-up of the capital structure. This proposal was received enthusiastically by the Financial Controller of the Palco, and Neha was given the assignment of recalculating Palco's cost of capital and providing a written report for the Board of Directors explaining and justifying this calculation.

To determine a weighted average cost of capital for Palco, it was necessary for Neha to examine the cost associated with each source of funding used. In the past, the largest sources of funding had been the issuance of new equity shares and internally generated funds. Through conversations with Financial Controller and other members of the Board of Directors, Neha learnt that the firm, in fact, wished to maintain its current financial structure as shown in Exhibit 1.