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P. V. Ratnam

SACHIN Ltd is commencing a new project for manufacture of a plastic component. The cost information shown in Table 1 has been ascertained for annual production of 12,000 units which is the full capacity.

The selling price per unit is expected to be Rs 96 and the selling expenses would be Rs 5 per unit. Eighty per cent of the selling expenses are variable.

In the first two years of operations, production and sales are expected to be as shown in Table 2. To assess the working capital requirements, the following additional information is available:

Stock of materials — 2.25 months' average consumption; work-in-process — nil; debtors, one month's average sales;

cash balance — Rs 10,000; creditors for supply of materials — one month's average purchase during the year; creditors for expenses — one month's average of all expenses during the year.

Prepare for the two years: a) the projected statement of profit/loss (ignoring taxation); and the projected statement of working capital requirements.

The projected profit and loss (P&L) statement and the projected statement of working capital requirement are presented in Tables 1 and 2.

Investment decision

INDO Plastics Ltd is a manufacturer of high-quality plastic products. Rasik, President, is considering computerising the company's ordering, inventory and billing procedures. He estimates that the annual savings from computerisation include a reduction of four clerical employees with annual salaries of Rs 50,000 each, Rs 30,000 from reduced production delays caused by raw materials inventory problems, Rs 25,000 from lost sales due to inventory stock-outs and Rs 18,000 associated with timely billing procedures.

The purchase price of the system is Rs 2,50,000 and installation costs are Rs 50,000. These outlays will be capitalised (depreciated) on a straight-line basis to a zero book salvage value which is also its market value at the end of five years. Operation of the new system requires two computer specialists with annual salaries of Rs 80,000 per person. Also, the annual maintenance and operating (cash) expenses of Rs 22,000 are estimated to be required. The company's tax rate is 40 per cent and its required rate of return (cost of capital) for this project is 12 per cent.

Required: Evaluate the project using the NPV method; evaluate the project using PI method; and calculate the project's payback period.

Note: a) the present value (PV) of annuity of Re1 at 12 per cent rate of discount for five years is 3,605; and b) the PV of Re 1 at 12 per cent rate of discount, received at the end of five years is 0.567.

i) The statement of NPV is shown in Table 5.

ii) PI method: Profitability index = PV of cash inflow / investment

283353 / 300000 = 0.94

iii) The payback period = Investment / annual cash inflow

300000 / 78600 = 3.82 years

Advice: The life is five years. It will result into negative NPV. Hence, it is not advisable to install this computer system.

Financing decision

GOVINDA Entertainers Ltd has 10,00,000 shares of Rs10 each with a market price of Rs 50 per share. It has also issued bonds for Rs 4 crore @ 12 per cent per annum. It is considering an expansion plan and needs to mobilise Rs 5 crore.

The alternatives being considered are: a) issue equity at Rs 40 per share; b) issue straight bonds at 10 per cent per annum; c) issue preference shares at 12 per cent per annum; d) finance 50 per cent with equity at Rs 40 per share and 50 per cent with bonds at 10 per cent per annum.

The company is in the 35 per cent tax bracket. If the company is hopeful of generating an EBIT of Rs 2.50 crore after expansion, which method of financing is the best from shareholders' viewpoint? What more information is required if the market price of equity shares is the criterion for decision-making?

The comparative statement of EPS (in rupees lakh) is shown in Table 6

Financing the expansion plan fully through bonds for Rs 5 crore is the best from the shareholders' point of view.

If the market price of equity shares is the criterion for decision-making, the information regarding PE ratio is required.

Formula: PE ratio = market price / EPS

Bond conversion

BETA Company is contemplating conversion of 500, 14 per cent convertible bonds of 1,000 each. The market price of the bond is Rs1,080. Bond indenture provides that one bond will be exchanged for 10 shares. The PE ratio before redemption is 20:1 and the anticipated PE ratio after redemption is 25:1. The number of shares outstanding prior to redemption is10,000. The EBIT amounts to Rs 2,00,000, The company is in the 35 per cent tax bracket. Should the company convert bonds into shares? Give reasons.

The comparative statement of EPS and the market price per share (500 bonds converted into 5000 shares) are presented in Table 7. The company should convert its debentures into shares. Market price of the debenture is Rs 1,080 each. One debenture is converted into 10 shares. After conversion, the market price of 10 shares would be Rs 2,166.70 (216.67 x 10). Hence, the conversion is beneficial to debenture-holders too.

(To be concluded)

(Suggested answers to the December 2002 CS (Final) paper on financial management.)

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