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MFRP – CA. SONALI JAGATH PRASAD Example 1 One way of determining the right mix of capital is to measure the impacts of different financing plans on Earnings Per Share (EPS). Solved Examples Based On Ebit-Eps Analysis – Part 1 Example Suppose a firm has a capital structure exclusively comprising of ordinary shares amounting to $ 10,00,000. The firm now wishes to raise additional $ 10,00,000 for expansion. The firm has four alternative financial plans: (A) It can raise the entire amount in the form of equity capital. (B) It can raise 50 per cent as equity capital and 50 per cent as 5% debentures. (C) It can raise the entire amount as 6% debentures. (D) It can raise 50 per cent as equity capital and 50 per cent as 5% preference capital. Further assume that the existing EBIT are $ 1,20,000, the tax rate is 35 per cent, outstanding ordinary shares 10,000 and the market price per share is $ 100 under all the four alternatives. Which financing plan or capital structure should the firm select? Solution TABLE 10.7 EPS under Various Financial Plans Financing plans A EBIT $ Less interest B C D 1,20,000 $ 1,20,000 $ 1,20,000 — 25,000 Earnings before taxes 1,20,000 Taxes Earning after taxes 42,000 78,000 Less preference dividend $ 1,20,000 60,000 95,000 60,000 33,250 21,000 61,750 __ 42,000 39,000 __ 1,20,000 78,000 __ 25,000 Earnings available to 78,000 61,750 ordinaryshareholders Number of shares 20,000 39,000 53,000 15,000 10,000 Earnings per share 3.9 4.1 3.9 3.5 15,000 Example 2 Company λ has a 1 million shares of common stock currently trading at $30 per share. Cost of equity is 8%. It also has 50,000 bonds with of $1,000 par paying 10% coupon annually maturing in 20 years currently trading at $950. The company's tax rate is 35%. Calculate the weighted average cost of capital. Answer First we need to calculate the weights of debt and equity. Market Value of Equity = 1,000,000 × $30 = $30,000,000 Market Value of Debt = 50,000 × $950 = $47,500,000 Total Market Value of Debt and Equity = $77,500,000 Weight of Equity = $30,000,000 / $77,500,000 = 38.71% Weight of Debt = $47,500,000 / $77,500,000 = 61.29% Weight of Debt can be calculated as 100% minus cost of equity = 100% − 38.71% = 61.29% WACC = 38.71% * 8% + 61.29% * 10% Example 3: During the year Shiner Corporation paid dividends of $18,000. Shiner also issued $150,000 in bonds and purchased land, a building, and some equipment for cash. Comparative Balance Sheet Shiner Corporation Assets Dec 31, 1996 Dec 31, 1995 Cash $37,000 $49,000 Accounts Receivable $26,000 $36,000 Prepaid Expenses $6,000 $0 Land $70,000 $0 Building $200,000 $0 Accumulated $11,000 $189,000 $0 Depreciation Equipment $68,000 $0 Accumulated $10,000 $58,000 $0 Depreciation Total Assets $386,000 $85,000 Liabilities and Stockholder Equity Accounts Payable Bonds Payable Common Stock Retained Earnings Total Liabilities and Stockholder Equity $40,000 $150,000 $60,000 $136,000 $386,000 $5,000 $0 $0 $20,000 $85,000 Income Statement Shiner Corporation Revenue Operating $269,000 Expenses Depreciation $21,000 Income before Income Taxes Income Tax Expense Net Income $492,000 $290,000 $202,000 $68,000 $134,000 ANSWER Statement of Cash Flows Cash Flow from Operating Activities Net Income $134,000 Adjustments to reconcile net income to net cash Accts Receivable decrease $10,000 Prepaid Expense increase ($6,000) Accts Payable Increase $35,000 Depreciation $21,000 $60,000 Net cash provided from Operating Activities $194,000 Investing Activities Land Purchase ($70,000) Building Purchase ($200,000) Equipment Purchase ($68,000) ($338,000) Financing Activities Dividend payment to shareholders ($18,000) Issuance of Bonds Payable $150,000 $132,000 Net Decrease in Cash ($12,000) Cash Jan 1, 1996 $49,000 Cash Dec 31, 1996 $37,000 Example 4: Capital budgeting problems are provided in separate sheet. http://www.scribd.com/doc/88868074/Capital-Budgeting-Solved-Problems Example 5: A company has three products: Product A, Product B and Product C. Income statements of the three product lines for the latest month are given below: Product Line Sales Variable Costs Contribution Margin Direct Fixed Costs Allocated Fixed Costs Net Income A $467,000 241,000 $226,000 91,000 93,000 $42,000 B $314,000 169,000 $145,000 86,000 62,000 − $3,000 C $598,000 321,000 $277,000 112,000 120,000 $45,000 Use the incremental approach to determine if Product B should be dropped. Solution By dropping Product B, the company will loose the sale revenue from the product line. The company will also obtain gains in the form of avoided costs. But it can avoid only the variable costs and direct fixed costs of product B and not the allocated fixed costs. Hence: If Product B is Dropped Gains: Variable Costs Avoided Direct Fixed Costs Avoided Less: Sales Revenue Lost Decrease in Net Income of the Company $169,000 $86,000 $255,000 $314,000 $59,000 Marginal Costing – Make or Buy Decisions Example 6 Dimpy Co. A radio manufacturing company finds that the existing cost of a component, Z 200, is Rs. 6.25. The same component is available in the market at Rs. 5.75 each, with an assurance of continued supply. The breakup of the existing cost of the component is: Rs. Materials 2.75 each Labour 1.75 each Other Variables 0.50 each Depreciation and other Fixed Cost 1.25 each 6.25 each (a) Should the company make or buy? Present the case, when the firm cannot utilize the capacity elsewhere, profitably, and when the capacity can be utilized, profitably. (b) What woul be your decision, if the supplier has offered the component at Rs. 4.50 each? Solution: (a) The decision to make or buy will be influenced by the fact whether the capacity to be released, by not manufacture of the component, can be utilized profitably, elsewhere, or not. If the capacity would be idle: Fixed costs are sunk costs. These fixed costs cannot be saved, as the capacity cannot be utilized in an alternative way, profitably. Even if the product is purchased, still the firm has to incur fixedcosts. Variable costs per unit, ignoring fixed costs are: Rs. Materials 2.75 Labour 1.75 Other variables 0.50 Total 5.00 By incurring Rs. 5, component, Z 200 can be manufactured by the firm, while it is available in the market at Rs. 5.75 each. So, it is desirable for the firm to make. If the capacity would not be idle: Capacity that is released would be utilized elsewhere, profitably. So, the costs that can be avoidedby buying are both variable costs as well as fixed costs. So, the total costs assume the character of variable costs. Costs that can be saved are Rs. Materials 2.75 each Labour 1.75 each Other Variables 0.50 each Depreciation and other Fixed Cost 1.25 each Total 6.25 Accounting for Managers The same product is available at Rs. 5.75. So, by buying, instead of making, there is a saving of Rs.0.50 per unit. So, if the capacity would not be idle, it is better to buy rather than making. (b) The marginal cost of the product (only variable expenses) is Rs. 5. If the price offered is Rs. 4.50 per unit, then the offer can be accepted as there will be saving of 50 paise per unit, even if the capacity released cannot be, profitably, employed. This is so because the price offered is less than the marginal cost of the product. Example 7 PV Co is evaluating an investment proposal to manufacture Product W33, which has performed well in test marketing trials conducted recently by the company’s research and development division. The following information relating to this investment proposal has now been prepared. Initial investment $2 million Selling price (current price terms) $20 per unit Expected selling price inflation 3% per year Variable operating costs (current price terms) $8 per unit Fixed operating costs (current price terms) $170,000 per year Expected operating cost inflation 4% per year The research and development division has prepared the following demand forecast as a result of its test marketing trials. The forecast reflects expected technological change and its effect on the anticipated life-cycle of Product W33. Year 1 2 3 4 Demand (units) 60,000 70,000 120,000 45,000 It is expected that all units of Product W33 produced will be sold, in line with the company’s policy of keeping no inventory of finished goods. No terminal value or machinery scrap value is expected at the end of four years, when production of Product W33 is planned to end. For investment appraisal purposes, PV Co uses a nominal (money) discount rate of 10% per year and a target return on capital employed of 30% per year. Ignore taxation. Required: (a) Identify and explain the key stages in the capital investment decision-making process, and the role of investment appraisal in this process. (b) Calculate the following values for the investment proposal: (i) net present value; (ii) internal rate of return; (iii) return on capital employed (accounting rate of return) based on average investment; and (iv) Payback period. © Discuss your findings on the above calcualtions. The key stages in the capital investment decision-making process are identifying investment opportunities, screening investment proposals, analysing and evaluating investment proposals, approving investment proposals, and implementing, monitoring and reviewing investments. Identifying investment opportunities Investment opportunities or proposals could arise from analysis of strategic choices, analysis of the business environment, research and development, or legal requirements. The key requirement is that investment proposals should support the achievement of organisational objectives. Screening investment proposals In the real world, capital markets are imperfect, so it is usual for companies to be restricted in the amount of finance available for capital investment. Companies therefore need to choose between competing investment proposals and select those with the best strategic fit and the most appropriate use of economic resources. Analysing and evaluating investment proposals Candidate investment proposals need to be analysed in depth and evaluated to determine which offer the most attractive opportunities to achieve organisational objectives, for example to increase shareholder wealth. This is the stage where investment appraisal plays a key role, indicating for example which investment proposals have the highest net present value. Approving investment proposals The most suitable investment proposals are passed to the relevant level of authority for consideration and approval. Very large proposals may require approval by the board of directors, while smaller proposals may be approved at divisional level, and so on. Once approval has been given, implementation can begin. Implementing, monitoring and reviewing investments The time required to implement the investment proposal or project will depend on its size and complexity, and is likely to be several months. Following implementation, the investment project must be monitored to ensure that the expected results are being achieved and the performance is as expected. The whole of the investment decision-making process should also be reviewed in order to facilitate organisational learning and to improve future investment decisions. (b) (i) Calculation of NPV Year 1 2 3 4 Income 1,236,000 1,485,400 2,622,000 1,012,950 Operating costs 676,000 789,372 1,271,227 620,076 Investment 0 (2,000,000) –––––––––– –––––––––– –––––––––– –––––––––– –––––––––– Net cash flow (2,000,000) Discount at 10% 1·000 560,000 696,028 1,350,773 392,874 0·909 0·826 0·751 0·683 –––––––––– –––––––––– –––––––––– –––––––––– –––––––––– Present values (2,000,000) 509,040 574,919 1,014,430 –––––––––– –––––––––– –––––––––– –––––––––– –––––––––– Net present value $366,722 Workings Calculation of income Year 1 2 3 4 Inflated selling price ($/unit) 20·60 21·22 21·85 22·51 Demand (units/year) 60,000 70,000 120,000 45,000 Income ($/year) 1,236,000 1,485,400 2,622,000 1,012,950 1213 Calculation of operating costs Year 1 2 3 4 Inflated variable cost ($/unit) 8·32 Demand (units/year) Variable costs ($/year) Inflated fixed costs ($/year) 8·65 9·00 9·36 60,000 70,000 120,000 45,000 499,200 605,500 1,080,000 421,200 176,800 183,872 191,227 198,876 268,333 –––––––––– –––––––––– –––––––––– –––––––––– Operating costs ($/year) 676,000 789,372 1,271,227 620,076 –––––––––– –––––––––– –––––––––– –––––––––– Alternative calculation of operating costs Year 1 2 3 4 Variable cost ($/unit) 8 8 8 8 Demand (units/year) 60,000 70,000 120,000 45,000 Variable costs ($/year) Fixed costs ($/year) 480,000 560,000 960,000 360,000 170,000 170,000 170,000 170,000 –––––––––– –––––––––– –––––––––– –––––––––– Operating costs ($/year) 650,000 730,000 1,130,000 530,000 Inflated costs ($/year) 676,000 789,568 1,271,096 620,025 (ii) Calculation of internal rate of return Year 0 1 2 3 4 $ $$$ $ Net cash flow (2,000,000) 560,000 696,028 1,350,773 392,874 Discount at 20% 1·000) 0·833 0·694 0·579 0·482 –––––––––– –––––––––– –––––––––– –––––––––– –––––––––– Present values (2,000,000) 466,480 483,043 782,098 189,365 –––––––––– –––––––––– –––––––––– –––––––––– –––––––––– Net present value ($79,014) Internal rate of return = 10 + ((20 – 10) x 366,722)/(366,722 + 79,014) = 10 + 8·2 = 18·2% (iii) Calculation of return on capital employed Total cash inflow = 560,000 + 696,028 + 1,350,773 + 392,874 = $2,999,675 Total depreciation and initial investment are same, as there is no scrap value Total accounting profit = 2,999,675 – 2,000,000 = $999,675 Average annual accounting profit = 999,675/4 = $249,919 Average investment = 2,000,000/2 = $1,000,000 Return on capital employed = 100 x 249,919/1,000,000 = 25% (iv) Calculation of discounted payback Year 0 1 2 3 4 574,919) 1,014,430 268,333 $ $$$ $ PV of cash flows Cumulative PV (2,000,000) 509,040) (2,000,000) (1,490,960) (916,041) 98,389 366,722 Discounted payback period = 2 + (916,041/1,014,430) = 2 + 0·9 = 2·9 years (c) Discuss your findings in each section of (b) above and advise whether the investment proposal is financially acceptable. The investment proposal has a positive net present value (NPV) of $366,722 and is therefore financially acceptable. The results of the other investment appraisal methods do not alter this financial acceptability, as the NPV decision rule will always offer the correct investment advice. The internal rate of return (IRR) method also recommends accepting the investment proposal, since the IRR of 18·2% is greater than the 10% return required by PV Co. If the advice offered by the IRR method differed from that offered by the NPV method, the advice offered by the NPV method would be preferred. The calculated return on capital employed of 25% is less than the target return of 30%, but as indicated earlier, the investment proposal is financially acceptable as it has a positive NPV. The reason why PV Co has a target return on capital employed of 30% should be investigated. This may be an out-of-date hurdle rate that has not been updated for changed economic circumstances. The discounted payback period of 2·9 years is a significant proportion of the forecast life of the investment proposal of four years, a time period which the information provided suggests is limited by technological change. The sensitivity of the investment proposal to changes in demand and life-cycle period should be analysed, since an earlier onset of technological obsolescence may have a significant impact on its financial acceptability. Example 8 Break Even Analysis. Whittier Company sells mulching mowers at $400 each. Variable cost per unit is $325, and total fixed costs are $45,000. Required: 1. Calculate the contribution margin ratio. 2. Calculate the sales that Whittier Company must make to earn an operating income of $37,500. 3. Check your answer by preparing a contribution margin income statement based on the sales dollars calculated. Calculation: 1. Contribution margin ratio ($400$325) / $400 = 0.1875 2. Sales dollars = (Target income + Total fixed expense) / Contribution margin ratio = ($45,000 + $37,500) / 0.1875 = $440,000 3. Contribution margin income statement based on sales revenue of $440,000: Sales Total variable expense (0.8125 3 $440,000) Total contribution margin Total fixed expense Operating income $440,000 357,500 $ 82,500 45,000 $ 37,500 Indeed, sales revenue of $440,000 does yield operating income of $37,500 Margin of Safety The margin of safety is the units sold or the revenue earned above the break-even volume Example 9 P&G company produces many products for household use. Company sells products to storekeepers as well as to customers. Detergent-DX is one of the products of P&G. It is a cleaning product that is produced, packed in large boxes and then sold to customers and storekeepers. P&G uses a traditional standard costing system to control costs and has established the following materials, labor and overhead standards to produce one box of Detergent-DX: Direct materials: 1.5 pounds @ $12 per pound Direct labor: 0.6 hours $24 per hour Variable manufacturing overhead: 0.6 hours @ $5.00 $18.00 $14.40 $3.00 ——- $35.40 ——During August 2012, company produced and sold 3,000 boxes of Detergent-DX. 8,000 pounds of direct materials were purchased @ $11.50 per pound. Out of these 8,000 pounds, 6,000 pounds were used during August. There was no inventory at the beginning of August. 1600 direct labor hours were recorded during the month at a cost of $40,000. The variable manufacturing overhead costs during August totaled $7,200. Required: Compute materials price variance and materials quantity variance. (Assume that the materials price variance is computed at the time of purchase.) Compute direct labor rate variance and direct labor efficiency variance. Compute variable overhead spending variance and variable overhead efficiency variance. Solution: (1) Materials variances: = (8,000 pounds × $11.50) – (8,000 pounds × $12) = $92,000 – $96,000 = $4,000 Favorable = (6,000 pounds × $12) – (4,500 pounds × $12) = $72,000 – $54,000 = $18,000 Unfavorable (2) Labor variances: = $40,000 – (1,600 hours × $24) = $40,000 – $38,400 = $1,600 Unfavorable = (1,600 hours × $24) – (1,800 hours × $24) = $38,400 – $43,200 =$4,800 Favorable (3) Variable overhead variances: = (1,600 hours × $4.5) – (1,600 hours × $5) = $7,200 – $8,000 = $800 Favorable = (1,600 hours × $5) – (1,800 hours × $5) = $1,000 Favorable Example 10 –Analysis of Performance Given below are the Income Statement and Balance Sheet of Xanadu Manufacturing Company for the years 2012 and 2011. Equity & Liabilities 2011 2012 Assets 2011 2012 Equity 110 120 Non-Current Assets 115 120 - Share Capital 50 50 - Net Fixed Assets 95 100 - Retained Earnings 60 70 - Intangible Assets 10 10 Non Current Liabilities 50 60 - Long Term Investments 10 10 - Long Term Loans 41 50 Current Assets 115 140 - Employee Benefits 9 10 - Cash 15 20 Current Liabilities 70 80 - Marketable Securities 10 10 - Bank Borrowings 45 50 - Inventories 40 50 - Payables 25 30 - Receivables 50 60 230 260 230 260 Total Equities & Liabilities Total Assets Income Statement 2011 (US $ million) 2012 80 100 (45) (60) Gross Profit 35 40 Less : Selling & Distribution Expenses (6) (8) Less : General & Administration Expenses (5) (6) Particulars Sales Less : Cost of Goods Sold Operating Profit 24 26 Less : Interest (4) (6) Add : Other Income - 4 Profit Before Tax 20 24 Tax 6 8 Profit After Tax 14 16 The equity capital of US$ 50 million comprises of 50 million shares of a par value of US $1 per share. During the years 2001 and 2012, the company declared and paid out dividends of US$ 4 million and US$ 6 million respectively. Calculate the following ratios for both the years. As an approximation, You may use end of the year numbers instead of average, wherever required 1. 2. 3. 4. 5. 6. Current ratio Accounts Receivable Ratio Times Interest Earned Ratio Return on Equity Earnings Per Share Dividend Pay-out Ratio Comment on the trends of the ratios in the two years and give at least one reason why the ratio could have changed from year 2011 to 2012.