Download During August 2012, company produced and sold 3000 boxes of

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.