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MB0045 : a) Discuss the advantages of ordering Economic order quantity of inventory.
b) Discuss the Dividend discount model of measuring cost of equity.

Answer :  Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.

Advantages of ordering Economic order quantity of inventory.

  • Constant or uniform demand: The demand or usage is even through-out the period
  • Known demand or usage: Demand or usage for a given period is known i.e. deterministic
  • Constant unit price: Per unit price of material does not change and is constant irrespective of the order size
  • Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory
  • Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

Dividend discount model of measuring cost of equity

The Dividend Discount Model is a way of valuing a company based on the theory that a stock is worth the discounted sum of all of its future dividend payments.In other words, it is used to evaluate stocks based on the net present value of the future dividends.

Dividend discount model is a tool that produces a number based on the data provided. The equation can be written as

whereP0 is the current stock price, D1 is the expected dividend, r is the required rate of return, and g is the expected growth rate in perpetuity.

This equation is also used to estimate cost of capital by solving for r

From the first equation, one might notice that in the long run, the growth rate cannot exceed the cost of equity; rg cannot be negative, i.e., r>g. In the short run if g>r, then usually a two stage DDM is used:

Therefore,

whereg denotes the short-run expected growth rate, denotes the long-run growth rate, and N is the period (number of years), over which the short-run growth rate is applied.

MB0045  : Explain each of the following:

a) Operating cycle

b) Shareholders wealth maximisation

c) Capital rationing

d) Economic order quantity

Answer : Operating Cycle

The time gap between acquisition of resources and collection of cash from customers is known as the operating cycle

Operating cycle of a firm involves the following elements.

  • Acquisition of resources from suppliers
  • Making payments to suppliers
  • Conversion of raw materials into finished products
  • Sale of finished products to customers
  • Collection of cash from customers for the goods sold

The five phases of the operating cycle occur on a continuous basis. There is no synchronisation between the activities in the operating cycle. Cash outflows occur before the occurrences of cash inflows in operating cycle.

Cash outflows are certain. However, cash inflows are uncertain because of uncertainties associated with effecting sales as per the sales forecast and ultimate timely collection of amount due from the customers to whom the firm has sold its goods.

Since cash inflows do not match with cash out flows, firm has to invest in various current assets to ensure smooth conduct of day to day business operations. Therefore, the firm has to assess the operating cycle time of its operation for providing adequately for its working capital requirements.

Shareholders wealth maximisation

Wealth maximisation means maximising the net wealth of a company’s shareholders. Wealth maximisation is possible only when the company pursues policies that would increase the market value of shares of the company. It has been accepted by the finance managers as it overcomes the limitations of profit maximisation.

The following arguments are in support of the superiority of wealth maximisation over profit maximisation

  • Wealth maximisation is based on the concept of cash flows. Cash flows are a reality and not based on any subjective interpretation. On the other hand, profit maximisation is based on accounting profit and it also contains many subjective elements.
  • Wealth maximisation considers time value of money. Time value of money translates cash flows occurring at different periods into a comparable value at zero period. In this process, the quality of cash flows is considered critically in all decisions as it incorporates the risk associated with the cash flow stream. It finally crystallises into the rate of return that will motivate investors to part with their hard earned savings. Maximising the wealth of the shareholders means positive net present value of the decisions implemented.

Capital Rationing

Firms may have to make a choice from among profitable investment opportunities, because of the limited financial resources. Capital rationing refers to a situation in which the firm is under a constraint of funds, limiting its capacity to take up and execute all the profitable projects. Such a situation may be due to external factors or due to the need to impose internal constraints, keeping in view of the need to exercise better financial control.

Capital rationing may be needed due to:

  • External factors
  • Internal constraints imposed by management

 

External capital rationing

External capital rationing is due to the imperfections of capital market. Imperfections are caused mainly due to:

  • Deficiencies in market information
  • Rigidities that hamper the force flow of capital between firms

When capital markets are not 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:-

  • The inability of the firm to procure required funds from capital market because the firm does not command the required investor’s confidence
  • National and international economic factors may make the market highly volatile and unstable
  • Inability of the firm to satisfy the regularity norms for issue of instruments for tapping the market for funds
  • High cost of issue of securities i.e. high floatation costs. Smaller firms may have to incur high costs of issue of securities. This discourages small firms from tapping the capital market 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.

Economic order quantity (EOQ)

Economic order quantity (EOQ) refers to the optimal order size that will result in the lowest ordering and carrying costs for an item of inventory based on its expected usage.

EOQ model answers the following key quantum of inventory management.

  • What should be the quantity ordered for each replenishment of stock?
  • How many orders are to be placed in a year to ensure effective inventory management?

EOQ is defined as the order quantity that minimises the total cost associated with inventory management.

EOQ is based on the following assumptions:

  • Constant or uniform demand: The demand or usage is even through-out the period
  • Known demand or usage: Demand or usage for a given period is known i.e. deterministic
  • Constant unit price: Per unit price of material does not change and is constant irrespective of the order size
  • Constant Carrying Costs: The cost of carrying is a fixed percentage of the average value of inventory
  • Constant ordering cost: Cost per order is constant whatever be the size of the order

Inventories can be replenished immediately as the stock level reaches exactly equal to zero. Constantly there is no shortage of inventory.

MB0045 : Calculate the present value of the following options:
a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa

b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually

c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa

d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years

Solution:

a) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa.

 

Present valve                                      =          10, 000*PVIF (10%, 5y)

                                                =          10,000*0.621

=          6210

 

The PV of Rs. 10,000 after 5years is Rs. 6210.

b) Rs. 10,000 to be received after 5 years if the prevailing rate of interest is 10%pa payable semi annually

 

Present valve                                      =          10, 000*PVIF (5%, 10y)

                                                =          10,000*0.614

=          6140

 

The PV of Rs. 10,000 after 5years is Rs. 6140.

c) Rs. 5000 to be received every year for 5 years if the prevailing interest rate is 10% pa

 

Present valve                                      =          5, 000*PVIF (10%, 5y)

                                                =          5,000*0.621

=          3105

 

The PV of Rs. 5,000 after 5years is Rs. 3105.

d) Rs. 5000 to be received after 5 years and Rs. 10,000 to be received after 10 years

 

Present valve of annuity                   =          5, 000*PVIF (10%, 5y)

                                                =          5,000*0.621

=          3105

 

Present valve of annuity                   =          10, 000*PVIF (10%, 10y)

                                                =          10,000*0.386

=          3860

The PV of Rs. 5,000 after 5years is Rs. 3105 and PV of Rs. 10,000 after 10years is Rs.3860.

MB0045 :  Given the following information, calculate the weighted average cost of capital.

Capital structure in millions

Equity capital ( Rs.10 par value)                             2

14% preference share capital Rs.100 each     1.5

Retained earnings                                          2

12% Debentures Rs.100 each                         4

8% term loan                                                  0.5

Total                                                               10

 

The market price per equity share is Rs. 45. The company is expected to declare a dividend per share of Rs.5 and dividends are expected to grow at 15% pa. The preference shares are redeemable at Rs. 115 after 5 years and are currently traded at Rs. 90 in the market. Debentures will be redeemed after 5 years at Rs.110. The corporate tax rate is 30%. Calculate the Weighted average cost of capital.

Solution:

Step I is to determine the cost of each component.

Ke        =          (D1/P0) + g

=          (5/45) + 0.15

=          0.2611 or 26.11%

Kp        =          [D + {(F-P/n}]  / [{F+P/2]

=          [14+ (215-90)/5]  /  (215-90)/2

=          14+25/62.5   =   0.624 or 62.4%

Kr        =          Ke which is 26.11%

Kd        =          [1(1-T) + (F-P) /n}] / {F+P)/2]

=          [12(1-0.3) + (210-90)/5] / (210-90)/2

=          8.4+24/60    = 0.54 or 54%

Kt        =          1(1-T)

=          0.8(1-0.3)   = 0.56 or 56%

Step II    is to calculate the weight of each source.

We       =          2/10     = 0.2

Wp       =          15/10   = 0.15

Wr        =          2/10     = 0.2

Wd       =          4/10     = 0.4

Wt        =          0.510   = 0.05

Step III

WACC            = Weke + Wpkp + Wrk r+ WdKd + WtKt

= (0.2*0.2611) + (0.15*0.624) + (0.2*0.2611) + (0.4*0.54) + (0.05*0.56)

= 0.052 + 0.0936 + 0.052 + 0.216 + 0.028

= 0.4416 or 44.16%

MB0045: Given the following information in terms of per unit costs, prepare a statement showing the working capital requirement.

Raw material            60

Direct labour            22

Overheads                44

Total cost                 126

Profit                        18

Selling price             140

 

The following additional information is available:

Average raw material in stock              one month

Average materials in process                15 days

Credit allowed by suppliers                  one month

Credit allowed to debtors                     two months

Time lag in payment of wages             15 days

Time lag in payment of overheads       one month

Sales on cash basis                               20%

Cash balance to be maintained            80,000

 

You are required to prepare a statement showing the working capital required to finance a level of activity of 100,000 units of output. You may assume production is carried out evenly throughout the year and payments occur similarly. Assume 360 days in a year.


Solution:

Estimation of Working Capital

 a)      Investment in inventory

 1.      Raw material                        =          RMC x RMCP

 360

=          100,000 x 60 x 30

360

=          500,000

2.      Work in process inventory =          COP x WIPCP

 360

                                              

=          100,000 x 126 x 15

360

=          525,000

3.      Finished goods inventory     =          COS x FGCP

 360

                                               =          100000 x 126 x 60

360

=          2,100,000

b)     Investment in debtors                 =          Cost of credit sales x DCP

360

=          80,000 x 126 x 60

360

=          1,680,000

c)      Cash Balance                               =          80,000

d)     Total Current Asset (A+B+C)   =          4,885,000

e)      Current Liabilities

 1.      Creditors                                =          Purchase of raw materials x PDP

360

=          100,000 x 60 x 30 / 360 = 500,000

Wages                                     =          100,000 x 22 x 15 / 360 =91,667

3.      Overheads                              =          100000 x 44 x 30/360 = 366,667

f)       Total Current Liabilities             =          958334

                                    Net Working Capital (D – F)           =          3,926,666      

MB0045 : Given the following information, prepare a cash budget:
 

Month Sales Purchases Wages Production overheads Selling overheads
Jan 100000 40000 10000 6000 6000
Feb 120000 45000 15000 6500 6500
March 150000 35000 18000 7000 6600
April 160000 30000 20000 7700 6800
May 175000 25000 22000 8000 6200
June 200000 20000 24000 8500 6300

 

The company has a policy of selling its goods at 50% cash and the balance on credit. On credit sales, 50% is paid in the following month and balance 50% two months from the sale. Purchases are paid one month from the month of purchase. Wages are paid in the following month and overheads are also paid in the following month. The company plans a capital expenditure, in the month of April, for Rs. 25,000.

The company has a opening balance of cash of Rs. 40,000 on 1st Jan 2010. Prepare a cash budget for Jan to June.

Solution: 

Cash Budget

 

Jan

Feb

March

April

May

June

Opening Cash Balance

40000

90000

113000

170000

225900

326400

Cash Receipts:
Cash Sales

50000

60000

75000

80000

87500

100000

Credit Sales

25000

30000

37500

40000

43750

25000

30000

37500

40000

Total Cash available

90000

175000

243000

317500

390900

510150

Cash Payments:
Materials

40000

45000

35000

30000

25000

Wages

10000

15000

18000

20000

22000

Production overheads

6000

6500

7000

7700

8000

Selling overheads

6000

6500

6600

6800

6200

Capital Expenditure

25000

Total cash payments

0

62000

73000

91600

64500

61200

Closing cash balances

90000

113000

170000

225900

326400

448950

MB0045 : Explain the Net operating income approach to capital structure theories.

Answer : The net operating income approach assumes that creditors do not increase their required rate of return as a company takes on debt, but investors do. Further, the rate at which investors increase their required rate of return as the financing mix is shifted toward debt exactly offsets the weighting away from the more expensive equity and toward the cheaper debt. The result is that the cost of capital remains constant regardless of the financing mix. This approach concludes that there is no optimal financing mixany mix is as good as any other.

Net Operating Income Approach was also suggested by Durand. This approach is of the opposite view of Net Income approach. This approach suggests that the capital structure decision of a firm is irrelevant and that any change in the leverage or debt will not result in a change in the total value of the firm as well as the market price of its shares. This approach also says that the overall cost of capital is independent of the degree of leverage.

Features of NOI approach:

  • At all degrees of leverage (debt), the overall capitalization rate would remain constant. For a given level of Earnings before Interest and Taxes (EBIT), the value of a firm would be equal to EBIT/overall capitalization rate.
  • The value of equity of a firm can be determined by subtracting the value of debt from the total value of the firm. This can be denoted as follows:
    Value of Equity = Total value of the firm – Value of debt
  • Cost of equity increases with every increase in debt and the weighted average cost of capital (WACC) remains constant. When the debt content in the capital structure increases, it increases the risk of the firm as well as its shareholders. To compensate for the higher risk involved in investing in highly levered company, equity holders naturally expect higher returns which in turn increases the cost of equity capital.

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